John Mauldin's Outside the Box : Geopolitics, Europe

Europe: The State of the Banking System

John Mauldin — Thu, 08 Jul 2010 13:55:00 GMT

We're bombarded with information from the minute we wake up until the second we fall asleep. I was watching a news network last night for 45 minutes and the exact stories started coming back around. Nothing new to report, but the same topics on repeat, with the rare nominal development.

When I need something different (and relevant to me), I go to STRATFOR.com. They provide deep insight and explanation of events the networks can't begin to tackle. Today I'm including an extensive article on the banking situation in Europe. Enjoy, and sign up for their free email list to receive weekly reports and special offers.

John Mauldin
Editor, Outside the Box

Europe: The State of the Banking System

July 1, 2010 | 1245 GMT

PATRIK STOLLARZ/AFP/Getty Images
The European Central Bank in Frankfurt, Germany

Summary

In the last six months, the eurozone has faced its biggest economic challenge to date — one sparked by the Greek debt crisis which has migrated to the rest of the monetary union. But well before the sovereign debt crisis, Europe was facing a full-blown banking crisis that did not seem any closer to being resolved than when it began in late 2008. With investors and markets focused on European governments' debt problems, the banking issues have largely been ignored. However, the sovereign debt crisis and banking crisis have become intertwined and could feed off each other in the near future.

Analysis

July 1 is a milestone for eurozone banks, with 442 billion euros ($541 billion) worth of European Central Bank (ECB) loans coming due. The loans were part of the ECB's one-year liquidity offering made in 2009, which was intended to help stabilize the banking system.

However, one year after the ECB provision was initially offered, the eurozone's banks are still struggling, and now Europe's banks must collectively come up with the cash roughly equivalent to Poland's gross domestic product (GDP).

Fears regarding the potentially adverse consequences of removing ECB liquidity are gripping many European banks and, by extension, investors who were already panicked by the sovereign debt crisis in the Club Med countries (Greece, Portugal, Spain and Italy). These concerns are as much a testament to the severity of the eurozone's ongoing banking crisis as to the lack of resolve that has characterized Europe's handling of the underlying problems.

Origins of Europe's Banking Problems

Europe's banking problems precede the eurozone's ongoing sovereign debt crisis and even exposure to the U.S. subprime mortgage imbroglio. The European banking crisis has its origins in two fundamental factors: euro adoption in 1999 and the general global credit expansion that began in the early 2000s. The combination of the two created an environment that inflated credit bubbles across the Continent, which were then grafted onto the European banking sector's structural problems.

In terms of specific pre-2008 problems we can point to five major factors. Not all the factors affected European economies uniformly, but all contributed to the overall weakness of the Continent's banking sector.

1. Euro Adoption and Europe's Local Subprime Bubble

The adoption of the euro — in fact, the very process of preparing to adopt the euro that began in the early 1990s with the signing of the Maastricht Treaty — effectively created a credit bubble in the eurozone. As the adjacent graph indicates, the cost of borrowing in peripheral European countries (Spain, Portugal, Italy and Greece in particular) was greatly reduced due, in part, to the implied guarantee that once they joined the eurozone their debt would be as solid as Germany's government debt.

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In essence, euro adoption allowed countries like Spain access to credit at lower rates than their economies could ever justify based on their own fundamentals. This eventually created a number of housing bubbles across Europe, but particularly in Spain and Ireland (the two eurozone economies currently boasting the relatively highest levels of private-sector indebtedness). As an example, in 2006 there were more than 700,000 new homes built in Spain — more than the total new homes built in Germany, France and the United Kingdom combined, even though the United Kingdom was experiencing a housing bubble of its own at the time.

It could be argued that the Spanish case was particularly egregious because Madrid attempted to use access to cheap housing as a way to integrate its large pool of first-generation Latin American migrant workers into Spanish society. However, the very fact that Spain felt confident enough to attempt such wide-scale social engineering indicates just how far peripheral European countries felt they could stretch their use of cheap euro loans. Spain is today feeling the pain of a collapsed construction sector, with unemployment approaching 20 percent and with the Spanish cajas (regional savings banks) reeling from their holdings of 58.9 percent of the country's mortgage market. The real estate and construction sectors' outstanding debt is equal to roughly 45 percent of the country's GDP.

2. Europe's 'Carry Trade'

"Carry trade" usually refers to the practice in which loans are taken in a low interest rate country with a stable currency and "carried" for investment in the government debt of a high interest rate economy. The European practice, which extended the concept to consumer and mortgage loans, was championed by the Austrian banks that had experience with the method due to their proximity to the traditionally low interest rate economy of Switzerland.

In the carry trade, the loans extended to consumers and businesses are linked to the currency of the country where the low interest loan originates. Because of this, Swiss francs and euros served as the basis for most of such lending across Europe. Loans in these currencies were then extended as low interest rate mortgages and other consumer and corporate loans in higher interest rate economies in Central and Eastern Europe. Since loans were denominated in foreign currency, when their local currency depreciated against the Swiss franc or euro, the real financial burden of the loan increased.

This created conditions for a potential economic maelstrom at the onset of the financial crisis in 2008 when consumers in Central and Eastern Europe saw their monthly mortgage payments grow as investors pulled out from emerging markets in order to "flee to safety," leading these countries' domestic currencies to fall. The problem was particularly dire for Central and Eastern European countries with a great amount of exposure to such foreign currency lending (see adjacent table).

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3. Crisis in Central/Eastern Europe

The carry trade led Europe's banks to be overexposed to Central and Eastern European economies. As the European Union enlarged into the former Communist sphere in Central Europe, and as security and political uncertainties in the Balkans subsided in the early 2000s, European banks sought new markets where they could make use of their expanded access to credit provided by euro adoption. Banking institutions in mid-level financial powers such as Sweden, Austria, Italy and even Greece sought to capitalize on the carry trade by going into markets that their larger French, German, British and Swiss rivals largely shunned.

This, however, created problems for the banking systems that became overexposed to Central and Eastern Europe. The International Monetary Fund and the European Union ended up having to bail out several countries in the region, including Romania, Hungary, Latvia and Serbia. And before the eurozone ever contemplated a Greek or eurozone bailout, it was discussing a potential 150 billion-euro rescue fund for Central and Eastern Europe at the urging of the Austrian and Italian governments.

4. Exposure to 'Toxic Assets'

The exposure to various credit bubbles ultimately left Europe vulnerable to the financial crisis, which peaked with the collapse of Lehman Brothers in September 2008. But the outright exposure to various financial derivatives, including the U.S. subprime market, was by itself considerable.

While the Swedish, Italian, Austrian and Greek banking systems expanded into the new markets in Central and Eastern Europe, the established financial centers of France, Germany, Switzerland, the Netherlands and the United Kingdom dabbled in various derivatives markets. This was particularly the case for the German banking system, where the Landesbanken — banks with strong ties to regional governments — faced chronically low profit margins caused by a fragmented banking system of more than 2,000 banks and a tepid domestic retail banking market. The Landesbanken on their own face between 350 billion and 500 billion euros worth of toxic assets — a considerable figure for the 2.5 trillion-euro German economy — and could be responsible for nearly half of all outstanding toxic assets in Europe.

5. Demographic Decline

Another problem for Europe is that its long-term outlook for consumption, particularly in the housing sector, is dampened by the underlying demographic factors. Europe's birth rate is at 1.53, well below the population "replacement rate" of 2.1. Exacerbating the demographic imbalance is the increasing life expectancy across the region, which results in an older population. The average European age is already 40.9, and is expected to hit 44.5 by 2030.

An older population does not purchase starter homes or appliances to outfit those homes. And if older citizens do make such purchases, they are less likely to depend as much on bank lending as first-time homebuyers. That means not just less demand, but that any demand will depend less upon banks, which means less profitability for financial institutions. Generally speaking, an older population will also increase the burden on taxpayers in Europe to support social welfare systems, dampening consumption further.

In this environment, housing prices will continue to decline (barring another credit bubble, which would of course exacerbate problems). This will further restrict lending activities because banks will be wary of granting loans for assets that they know will become less valuable over time. At the very least, banks will demand much higher interest rates for these loans, but that too will further dampen the demand.

The Geopolitics of Europe's Banking System

Given these challenges, the European banking system was less than rock-solid even before the onset of the global recession in 2008. However, Europe's response as a Continent to the crisis so far has been muted, with essentially every country looking to fend for itself. Therefore, at the heart of Europe's banking problems lie geopolitics and "capital nationalism."

Europe's geography encourages both political stratification and unity in trade and communications. The numerous peninsulas, mountain chains and large islands all allow political entities to persist against stronger rivals and continental unification efforts, giving Europe the highest global ratio of independent nations to area. Meanwhile, the navigable rivers, inland seas (Black, Mediterranean and Baltic), Atlantic Ocean and the North European Plain facilitate the exchange of ideas, trade and technologies among the disparate political actors.

This has, over time, incubated a continent full of sovereign nations that intimately interact with one another but are impossible to unite politically. Furthermore, in terms of capital flows, European geography has engendered a stratification of capital centers. Each capital center essentially dominates a particular river valley where it can use its access to a key transportation route to accumulate capital. These capital centers are then mobilized by the proximate political powers for the purposes of supporting national geopolitical imperatives, so Viennese bankers fund the Austro-Hungarian Empire, for example, while Rhineland bankers fund the German Empire. With no political unity, the stratification of capital centers becomes more solidified over time.

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The European Union's common market rules stipulate the free movement of capital across the borders of its 27 member states. Theoretically, with barriers to capital movement removed, the disparate nature of Europe's capital centers should wane; French banks should be active in Germany, and German banks should be active in Spain. However, control of financial institutions is one of the most jealously guarded privileges of national sovereignty in Europe.

One reason for this "capital nationalism" is that Europe's corporations and businesses are far less dependent on the stock and bond market for funding than their U.S. counterparts, relying primarily on banks. This comes from close links between Europe's state champions in industry and finance (for example, the close historical links between German industrial heavyweights and Deutsche Bank). Such links, largely frowned upon in the United States for most of its history, were seen as necessary by Europe's nation-states in the late 19th and early 20th centuries because of the need to compete with industries in neighboring states. European states in fact encouraged — in some ways even mandated — banks and corporations to work together for political and social purposes of competing with other European states and providing employment. This also goes for Europe's medium-sized businesses — Germany's mid-sized businesses are a prime example — which often rely on regional banks they have political and personal relationships with.

Regional banks are an issue unto themselves. Many European economies have a special banking sector dedicated to regional banks owned or backed by regional governments, such as the German Landesbanken or the Spanish cajas which in many ways are used as captive firms to serve the needs of both the local governments (at best) and local politicians (at worst). Many Landesbanken actually have regional politicians sitting on their boards while the Spanish cajas have a mandate to reinvest around half of their annual profits in local social projects, tempting local politicians to control how and when funds are used.

Europe's banking architecture was therefore wholly unprepared to deal with the severe financial crisis that hit in September 2008. With each banking system tightly integrated into the political economy of each EU member state, an EU-wide "solution" to Europe's banking problems — let alone the structural issues, of which the banking problems are merely symptomatic — has largely evaded the Continent. While the European Union has made progress in enhancing EU-wide regulatory mechanisms by drawing up legislation to set up micro- and macro-prudential institutions (with the latest proposal still in the implementation stages), the fact remains that outside of the ECB's response of providing unlimited liquidity to the eurozone system, there has been no meaningful attempt to deal with the underlying structural issues on the political level.

EU member states have, therefore, had to deal with banking problems largely on a case-by-case (and often ad hoc) basis, as each government has taken extra care to specifically tailor its financial assistance packages to support the most and upset the fewest constituents. In contrast, the United States — which took an immediate hit in late 2008 — bought up massive amounts of the toxic assets from the banks, swiftly transferring the burden onto the state.

ECB to the 'Rescue'

Europe's banking system obviously has problems, but exacerbating the problems is the fact that Europe's banks know that they and their peers are in trouble. This is causing the interbank market to seize up and thus forcing Europe's banks to rely on the ECB for funding.

The interbank market refers to the wholesale money market that only the largest financial institutions are able to participate in. In this market, the participating banks are able to borrow from one another for short periods of time to ensure that they have enough cash to maintain normal operations. Normally, the interbank market essentially regulates itself. Banks with surplus liquidity want to put their idle cash to work, and banks with a liquidity deficit need to borrow in order to meet the reserve requirements at the end of the day, for example. Without an interbank market there is no banking "system" because each individual bank would be required to supply all of its own capital all the time.

In the current environment in Europe, many banks are simply unwilling to lend money to each other, as they do not trust their peers' creditworthiness, even at very high interest rates. When this happened in the United States in 2008, the Federal Reserve and Federal Deposit Insurance Corporation stepped in and bolstered the interbank market directly and indirectly by both providing loans to interested banks and guaranteeing the safety of the loans banks were willing to grant each other. Within a few months, the U.S. crisis mitigation efforts allowed confidence to return and this liquidity support was able to be withdrawn.

The ECB originally did something similar, providing an unlimited volume of loans to any bank that could offer qualifying collateral, while national governments offered their own guarantees on newly issued debt. But unlike in the United States, confidence never fully returned to the banking sector due to the reasons listed above, and these provisions were never canceled. In fact, this program was expanded to serve a second purpose: stabilizing European governments.

With economic growth in 2009 weak, many EU governments found it difficult to maintain government spending programs in the face of dropping tax receipts. They resorted to deficit spending, and the ECB (indirectly) provided the means to fund that spending. Banks could purchase government bonds, deposit them with the ECB as collateral and walk away with a fresh liquidity loan (which they could use, if they so chose, to buy yet more government debt).

The ECB's liquidity provisions were ostensibly a temporary measure that would eventually be withdrawn as soon as it was no longer necessary. So on July 1, 2009, the ECB offered the first of what was intended to be its three "final" batches of 12-month loans as part of a return to a more normal policy. On that day 1,121 banks took out a record total of 442 billion euros in liquidity loans (followed by another 75 billion euros taken out in September and 96 billion euros in December). The 442 billion euro operation has come due July 1. The day before, banks tapped the ECB's shorter-term liquidity facilities to gain access to 294.8 billion euros to help them bridge the gap.

Europe now faces three problems. First, global growth has not picked up sufficiently in the last year, so European banks have not had a chance to grow out of their problems. This would have been difficult to accomplish on such a short timeframe. Second, the lack of a unified European banking regulator — although the European Union is trying to set one up — means that there has not yet been any pan-European effort to fix the banking problems. And even the regulation that is being discussed at the EU-level is more about being able to foresee a future crisis than resolving the current one. So banks still need the emergency liquidity provisions now as they did a year ago (to some degree the ECB saw this coming and has issued additional "final" batches of long-term liquidity loans). In fact, banks remain so unwilling to lend to one another that they have deposited nearly the equivalent amount of credit obtained from ECB's liquidity facilities back into its deposit facility instead of lending it out to consumers or other banks.

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Third, there is now a new crisis brewing that not only is likely to dwarf the banking crisis, but could make solving the banking crisis impossible. The ECB's decision to facilitate the purchase of state bonds has greatly delayed European governments' efforts to tame their budget deficits. There is now nearly 3 trillion euros of outstanding state debt just in the Club Med economies — vast portions of which are held by European banks — illustrating that the two issues have become as mammoth as they are inseparable.

There is no easy way out of this imbroglio. Reducing government debts and budget deficits means less government spending, which means less growth because public spending accounts for a relatively large portion of overall output in most European countries. Simply put, the belt-tightening that Germany and the markets are forcing upon European governments likely will lead to lower growth in the short term (although in the long term, if austerity measures prove credible, it should reassure investors of the credibility of the eurozone's economies). And economic growth — and the business it generates for banks — is one of the few proven methods of emerging from a banking crisis. One cannot solve one problem without first solving the other, and each problem prevents the other from being approached, much less solved.

There is, however, a silver lining. Investor uncertainty about the European Union's ability to solve its debt and banking problems is making the euro ever weaker, which ironically will support European exporters in the coming quarters. This not only helps maintain employment (and with it social stability), but it also boosts government tax receipts and banking activity — precisely the sort of activity necessary to begin addressing the banking and debt crises. But while this might allow Europe to avoid a return to economic recession in 2010, it alone will not resolve the European banking system's underlying problems.

For Europe's banks, this means that not only will they have to write down remaining toxic assets (the old problem), but they now also have to account for dampened growth prospects as a result of budget cuts and lower asset values on their balance sheets due to sovereign bonds losing value.

Ironically, with public consumption down as a result of budget cuts, the only way to boost growth would be for private consumption to increase, which is going to be difficult with banks wary of lending.

The Way Forward?

So long as the ECB continues to provide funding to the banks — and STRATFOR does not foresee any meaningful change in the ECB's posture in the near term or even long term — Europe's banks should be able to avoid a liquidity crisis. However, there is a difference between being well-capitalized but sitting on the cash due to uncertainty and being well-capitalized and willing to lend. Europe's banks are clearly in the former state, with lending to both consumers and corporations still tepid.

In light of Europe's ongoing sovereign debt crisis and the attempts to alleviate that crisis by cutting down deficits and debt levels, European countries are going to need growth, pure and simple, to get out of the crisis. Without meaningful economic growth, European governments will find it increasingly difficult — if not impossible — to service or reduce their ever-larger debt burdens. But for growth to be engendered, the Europeans are going to need their banks, currently spooked into sitting on liquidity, to perform the vital function that banks normally do: finance the wider economy.

As long as Europe faces both austerity measures and reticent banks, it will have little chance of producing the GDP growth needed to reduce its budget deficits. If its export-driven growth becomes threatened by decreasing demand in China or the United States, it could also face a very real possibility of another recession which, combined with austerity measures, could precipitate considerable political, social and economic fallout.

The Global Crisis of Legitimacy

John Mauldin — Thu, 06 May 2010 19:04:00 GMT

From my friend George Friedman, founder & CEO of STRATFOR, here's my newest favorite quote concerning economic recessions: "Like forest fires, they are painful when they occur, yet without them, the forest could not survive. They impose discipline, punishing the reckless, rewarding the cautious." The thin line of where risky becomes reckless is something I'd like to focus us on today. No matter the risk-level of your portfolio, if you are reading this you are probably smart enough to know that when you play with fire you may get burned. You have to know how to look for smoke, or signs of a potential catastrophe, so you know not to grab the doorknob with both hands.

I'm including George's discussion of the contributing facets of a recession, its inevitability and the idea of risk. As if the title won't intrigue you to begin with, take my advice and give "The Global Crisis of Legitimacy" a read. STRATFOR uses its signature analytic approach to decipher today's issues, applying historical context ranging from Adam Smith to the Lehman Brothers. Also, join their mailing list to receive two weekly intelligence pieces, and find that fire before your next investment opportunity comes along.

John Mauldin
Editor, Outside the Box

The Global Crisis of Legitimacy

May 4, 2010 | 0856 GMT

By George Friedman

Financial panics are an integral part of capitalism. So are economic recessions. The system generates them and it becomes stronger because of them. Like forest fires, they are painful when they occur, yet without them, the forest could not survive. They impose discipline, punishing the reckless, rewarding the cautious. They do so imperfectly, of course, as at times the reckless are rewarded and the cautious penalized. Political crises - as opposed to normal financial panics - emerge when the reckless appear to be the beneficiaries of the crisis they have caused, while the rest of society bears the burdens of their recklessness. At that point, the crisis ceases to be financial or economic. It becomes political.

The financial and economic systems are subsystems of the broader political system. More precisely, think of nations as consisting of three basic systems: political, economic and military. Each of these systems has elites that manage it. The three systems are constantly interacting - and in a healthy polity, balancing each other, compensating for failures in one as well as taking advantage of success. Every nation has a different configuration within and between these systems. The relative weight of each system differs, as does the importance of its elites. But each nation contains these systems, and no system exists without the other two.

Limited Liability Investing

Consider the capitalist economic system. The concept of the corporation provides its modern foundation. The corporation is built around the idea of limited liability for investors, the notion that if you buy part or all of a company, you yourself are not liable for its debts or the harm that it might do; your risk is limited to your investment. In other words, you may own all or part of a company, but you are not responsible for what it does beyond your investment. Whereas supply and demand exist in all times and places, the notion of limited liability investing is unique to modern capitalism and reshapes the dynamic of supply and demand.

It is also a political invention and not an economic one. The decision to create corporations that limit liability flows from political decisions implemented through the legal subsystem of politics. The corporation dominates even in China; though the rules of liability and the definition of control vary, the principle that the state and politics define the structure of corporate risk remains constant.

In a more natural organization of the marketplace, the owners are entirely responsible for the debts and liabilities of the entity they own. That, of course, would create excessive risk, suppressing economic activity. So the political system over time has reallocated risk away from the owners of companies to the companies' creditors and customers by allowing corporations to become bankrupt without pulling in the owners.

The precise distribution of risk within an economic system is a political matter expressed through the law; it differs from nation to nation and over time. But contrary to the idea that there is a tension between the political and economic systems, the modern economic system is unthinkable except for the eccentric but indispensible political-legal contrivance of the limited liability corporation. In the precise and complex allocation of risk and immunity, we find the origins of the modern market. Among other reasons, this is why classical economists never spoke of "economics" but always of "political economy."

The state both invents the principle of the corporation and defines the conditions in which the corporation is able to arise. The state defines the structure of risk and liabilities and assures that the laws are enforced. Emerging out of this complexity - and justifying it - is a moral regime. Protection from liability comes with a burden: Poor decisions will be penalized by losses, while wise decisions are rewarded by greater wealth. Because of this, society as a whole will benefit. The entire scheme is designed to increase, in Adam Smith's words, "The Wealth of Nations" by limiting liability, increasing the willingness to take risk and imposing penalties for poor judgment and rewards for wise judgment. But the measure of the system is not whether individuals benefit, but whether in benefiting they enhance the wealth of the nation.

The greatest systemic risk, therefore, is not an economic concept but a political one. Systemic risk emerges when it appears that the political and legal protections given to economic actors, and particularly to members of the economic elite, have been used to subvert the intent of the system. In other words, the crisis occurs when it appears that the economic elite used the law's allocation of risk to enrich themselves in ways that undermined the wealth of the nation. Put another way, the crisis occurs when it appears that the financial elite used the politico-legal structure to enrich themselves through systematically imprudent behavior while those engaged in prudent behavior were harmed, with the political elite apparently taking no action to protect the victims.

In the modern public corporation, shareholders - the corporation's owners - rarely control management. A board of directors technically oversees management on behalf of the shareholders. In the crisis of 2008, we saw behavior that devastated shareholder value while appearing to enrich the management - the corporation's employees. In this case, the protections given to shareholders of corporations were turned against them when they were forced to pay for the imprudence of their employees - the managers, whose interests did not align with those of the shareholders. The managers in many cases profited personally through their compensation system for actions inimical to shareholder interests. We now have a political, not an economic, crisis for two reasons. First, the crisis qualitatively has moved beyond the boundaries of a cyclical event. Second, the crisis is rooted in the political-legal definitions of the distribution of corporate risk and the legally defined relations between management and shareholder. In leaving the shareholder liable for actions by management, but without giving shareholders controls to limit managerial risk taking, the problem lies not with the market but with the political system that invented and presides over the limited liability corporation.

Financial panics that appear natural and harm the financial elite do not necessarily create political crises. Financial panics that appear to be the result of deliberate manipulation of the allocation of risk under the law, and from which the financial elite as a whole appears to have profited even while shareholders and the public were harmed, inevitably create political crises. In the case of 2008 and the events that followed, we have a paradox. The 2008 crisis was not unprecedented, nor was the federal bailout. We saw similar things in the municipal bond crisis of the 1970s, and the Third World Debt Crisis and Savings and Loan Crisis in the 1980s. Nor was the recession that followed anomalous. It came seven years after the previous one, and compared to the 1970s and early 1980s, when unemployment stood at more than 10 percent and inflation and mortgages were at more than 20 percent, the new one was painful but well within the bounds of expected behavior.

The crisis was rooted in the appearance that it was triggered by the behavior not of small town banks or third world countries, but of the global financial elite, who took advantage of the complexities of law to enrich themselves instead of the shareholders and clients to whom it was thought they had prior fiduciary responsibility.

This is a political crisis then, not an economic one. The political elite is responsible for the corporate elite in a unique fashion: The corporation was a political invention, so by definition, its behavior depends on the political system. But in a deeper sense, the crisis is one of both political and corporate elites, and the perception that by omission or commission they acted together - knowingly engineering the outcome. In a sense, it does not matter whether this is what happened. That it is widely believed that this is what happened alone is the origin of the crisis. This generates a political crisis that in turn is translated into an attack on the economic system.

The public, which is cynical about such things, expects elites to work to benefit themselves. But at the same time, there are limits to the behavior the public will tolerate. That limit might be defined, with Adam Smith in mind, as the point when the wealth of the nation itself is endangered, i.e., when the system is generating outcomes that harm the nation. In extreme form, these crises can delegitimize regimes. In the most extreme form - and we are nowhere near this point - the military elite typically steps in to take control of the system.

This is not something that is confined to the United States by any means, although part of this analysis is designed to explain why the Obama administration must go after Goldman Sachs, Lehman Brothers and others. The symbol of Goldman Sachs profiting from actions that devastate national wealth, or of the management of Lehman wiping out shareholder value while they themselves did well, creates a crisis of confidence in the political and financial systems. With the crisis of legitimacy still not settling down after nearly two years, the reaction of the political system is predictable. It will both anoint symbolic miscreants, and redefine the structure of risk and liability in financial corporations. The goal is not so much to achieve something as to create the impression that it is achieving something, in other words, to demonstrate that the political system is prepared to control the entities it created.

The Crisis in Europe

We see a similar crisis in Europe. The financial institutions in Europe were fully complicit in the global financial crisis. They bought and sold derivatives whose value they knew to be other than stated, the same as Americans. Though the European financial institutions have asserted they were the hapless victims of unscrupulous American firms, the Europeans were as sophisticated as their American counterparts. Their elites knew what they were doing.

Complicating the European position was the creation of the economic union and the euro by the economic and political elite. There has always been a great deal of ambiguity concerning the powers and authority of the European Union, but its intentions were always clear: to harmonize Europe and to create European-wide solutions to economic problems. This goal always created unease in Europe. There were those who were concerned that a united Europe would exist to benefit the elites, rather than the broader public. There were also those who believed it was designed to benefit the Franco-German core of Europe rather than Europe as a whole. Overall, this reflected minority sentiment, but it was a substantial minority.

The financial crisis came at Europe in three phases. The first was part of the American subprime crisis. The second wave was a uniquely European crisis. European banks had taken massive positions in the Eastern European banking systems. For example, the Czech system was almost entirely foreign (Austrian and Italian) owned. These banks began lending to Eastern European homebuyers, with mortgages denominated in euros, Swiss francs or yen rather than in the currencies of the countries involved (none yet included in the eurozone). Doing this allowed banks to reduce interest rates, as the risk of currency fluctuation was pushed over to the borrower. But when the zlotys and forints began to plunge, these monthly mortgage payments began to soar, as did defaults. The European core, led by Germany, refused a European bailout of the borrowers or lenders even though the lenders who created this crisis were based in eurozone countries. Instead, the International Monetary Fund (IMF) was called in to use funds that included American and Chinese, as well as European, money to solve the problem. This raised the political question in Eastern Europe as to what it meant to be part of the European Union.

The third wave is represented by crisis in sovereign debt in countries that are part of the eurozone but not in the core of Europe - Greece, of course, but also Portugal and possibly Spain. In the Greek case, the Germans in particular hesitated to intervene until it could draw the IMF - and non-European money and guarantees - into the mix. This obviously raised questions in the periphery about what membership in the eurozone meant, just as it created questions in Eastern Europe about what EU membership meant.

But a much deeper crisis of legitimacy arose. In Germany, elite sentiment accepted that some sort of intervention in Greece was inevitable. Public sentiment overwhelmingly opposed intervention, however. The political elite moved into tension with the financial elite under public pressure. In Greece, a similar crisis emerged between an elite that accepted that foreign discipline would have to be introduced and a public that saw this discipline as a betrayal of its interests and national sovereignty.

Europe thus has a double crisis. As in the United States, there is a crisis between the financial and political systems. This crisis is not as intense as in the United States because of a deeper tradition of integration between the two systems in Europe. But the tension between masses and elites is every bit as intense. The second part of the crisis is the crisis of the European Union and growing sense that the European Union is the problem and not the solution. As in the United States, there is a growing movement to distrust not only national arrangements but also multinational arrangements.

The United States and Europe are far from the only areas of the world facing crises of legitimacy. In China, for example, the growing suppression of all dissent derives from serious questions as to whom the financial expansion of the past 30 years benefits, and who will pay for the downturns. It is also interesting to note that Russia is suffering much less from this crisis, having lived through its own crisis before. The global crisis of legitimacy has many aspects worth considering at some point.

But for now, the important thing is to understand that both Europe and the United States are facing fundamental challenges to the legitimacy of, if not the regime, then at least the manner in which the regime has handled itself. The geopolitical significance of this crisis is obvious. If the Americans and Europeans both enter a period in which managing the internal balance becomes more pressing than managing the global balance, then other powers will have enhanced windows of opportunities to redefine their regional balances.

In the United States, we see a predictable process. With the unease over elites intensifying, the political elite is trying to stabilize the situation by attacking the financial elite. It is doing this to both demonstrate that the political elite is distinct from the financial elite and to impose the consequences on the financial elite that the impersonal system was unable to do. There is precedent for this, and it will likely achieve its desired end: greater control over the financial system by the state and an acceptable moral tale for the public.

The European process is much less clear. The lack of clarity comes from the fact that this is a test for the European Union. This is not simply a crisis within national elites, but within the multinational elite that created the European Union. If this leads to the de-legitimization of the EU, then we are really in uncharted territory.

But the most important point is that almost two years since a normal financial panic, the polity has still not managed to absorb the consequences of that event. The politically contrived corporation, and particularly the financial corporations, stands accused of undermining the wealth of nations. As Adam Smith understood, markets are not natural entities but the result of political decisions, as is the political system that creates the allocation of risk that allows markets to function. When that system appears to fail, the consequences go far beyond the particular financials of that event. They have political consequences and, in due course, geopolitical consequences.

The Making of a Greek Tragedy

John Mauldin — Mon, 26 Apr 2010 22:09:00 GMT

Back and recovering from my Strategic Investment Conference this weekend (where I decided to give myself permission not to write my usual letter, but I promise I will be back at it this next Friday!) I have spent some time pondering what we learned. It was a fabulous conference. Lacy Hunt, Dr. Gary Shilling, David Rosenberg, Niall Ferguson, Paul McCulley, George Friedman, former Fed Senior Economist Jason Cummins (who is now Chief Economist for Brevan Howard, the largest European hedge fund, and who was quite impressive), Jon Sundt of Altegris, and your humble analyst were all in top form. I must admit with a little pride that I think this is the finest speaker lineup for ANY investment conference anywhere. We were given a lot to think about.

Let me give you a few key points as an intro to this week's Outside the Box. First, there is a bubble building and it is in sovereign debt. It threatens to be a worse bubble than subprime or the credit crisis. Second, at one panel where we were asked what is our main worry, Paul McCulley said "Europe," which triggered an intense discussion, both in the panel and later that night over dinner. I agreed, of course, as I have written that very thing.

Both Paul and Niall think the consequences of a euro breakup could be severe, not only for Europe but for the world. I agree. That is why I have focused so much space in my writing and in Outside the Box on the European and especially the Greek situation. Everyone is hopeful that a major breakup can be avoided, but the problems the Mediterranean countries face are serious. I got the sense that most everyone expects the euro to fall further over the coming years.

In my opinion, there is little hope that Greece can resolve its fiscal crisis in a way that is less than draconian. I see almost no way out without a default of some kind. There will be band-aids and other measures to postpone the day of reckoning, but not to avoid it. They have just gone too far down a road of bad decisions.

Today we look at two short essays on Greece, one from Stratfor (George Friedman was in rare form this weekend) and the other from my friends Eric Sprott and David Franklin of Sprott Asset Management. Sprott gives us some details on a brewing Greek banking crisis and then closes with some thoughts on sovereign debt. He throws this little bon mot at us:

" ... [the US Government Accounting Office] goes on to state, however, that using reasonable assumptions, 'roughly 93 cents of every dollar of federal revenue will be spent on the major entitlement programs and net interest costs by 2020.'"

That is an example of the economic truism that if something can't happen, then it won't. Long before we get to 2020, massive change will be forced upon the US. The question is, do we do it willingly or do we become Greece?

And before I turn you over to the capable hands of Stratfor and Sprott, I have to end with what I think was the best one-liner of the conference (and there were so many). Paul McCulley noted that the debt crisis (the shadow banking system, subprime mortgages, SIVs, etc.) was the equivalent of an under-age drinking party with the rating agencies handing out fake IDs.

Have a good week. (And a special thanks to Lee Stein and David Malcolm for being so generous with their homes and wine cellars, respectively.)

Your feeling like I was drinking information through a fire hose analyst,

John Mauldin, Editor
Outside the Box

The Making of a Greek Tragedy

From Stratfor

Greece has not had many good days in 2010, but Thursday was a particularly bad day. First, Europe's statistical office (Eurostat) revised up the Greek 2009 budget deficit, which placed Athens' accounting shenanigans in the spotlight again. The bottom line is that the situation is even worse than previously thought, and the budget deficit may very well be adjusted up as more Greek accounting malfeasance comes to light. Following the announcement, credit rating agency Moody' s dropped Greece's credit rating one notch, immediately prompting a rise in Greek government bond yields, thus increasing Athens' borrowing costs.

The yield on a Greek 10-year bond shot above nine percent, while a two-year bond rose above 11 percent, both record highs since Greece joined the eurozone. Particularly daunting is the fact that short-term debt financing is now more expensive than long-term funding. This situation is referred to as an "inverted yield curve," and it is generally considered a harbinger of financial doom. This means that investors are sensing that Athens is more likely to experience problems sooner rather than later.

Higher yields mean that Greece is facing increasingly larger interest payments on an increasingly larger stock of debt. This all but confirms that Athens' claim that its stock of public debt will peak at 120 percent of gross domestic product (GDP) is simply wishful thinking. Worse still, Greece is also facing continued economic recession, induced in part by Athens' austerity measures designed to reduce its budget deficit. Given this vicious dynamic, we cannot see how Greece's debt level will stabilize at anything below 150 percent of GDP range.

The point is that the financial writing is now on the proverbial wall; some form of default is simply unavoidable. Exactly how the Greek default will unfold is unclear, but the bottom line is that the question now is not "if" but "when." Under "normal" circumstances, when the IMF becomes involved with a country in a situation similar to Greece's, the standard procedure is to devalue the local currency. By lowering the relative prices within the economy, the devaluation increases the competitiveness of the country's export sector and helps to reorient the economy toward external demand. Devaluation is also politically expedient because regaining competitiveness does not require employers to slash employees' wages, as the devaluation adjusts the relative costs silently and discreetly.

However, Greece does not have the option of devaluation because it is locked into a monetary union. The eurozone's monetary policy is controlled by the Frankfurt-based European Central Bank. The fact that Greece is locked in the "euro straitjacket" raises two questions, the first being how the Greek debt crisis will play out.

Without the option of devaluation, the Greeks will have to implement and endure draconian austerity measures - in addition to the ones it has already enacted - similar to what Latvia and Argentina endured as part of their IMF programs. Argentina in 2000 and Latvia in 2008 also could not go the currency devaluation route because neither country controlled its monetary policy. In Argentina' s case, the austerity measures were so severe that they caused considerable social unrest - including a brief period of outright anarchy in late 2001, which saw the country go through five heads of government in about two weeks - ultimately culminating in the country's partial debt default in 2002. To this day, Argentina is still dealing with the fallout of that financial calamity.

Latvia is a case of more recent vintage. In late 2008, Latvia agreed to what the IMF itself has called one of the most severe austerity programs since the 1970s. To accomplish it, Latvia has done everything from slashing public sector wages by 25 to 40 percent, increasing taxes, reducing unemployment and maternity benefits and cutting the defense budget. The crisis has already cost the Latvian prime minister his job and stoked social unrest. Despite all of that, the budget deficit has not budged much, remaining around eight percent of the GDP mark. Spending has been cut to the bone, but Latvia is simply too small of an economy to emerge from recession on its own.

Since the broader European economic recovery remains moribund at best, less government spending has translated directly to less growth. Less growth means less tax income, and less tax income means that the country' s budget deficit remains stubbornly high. Latvia has essentially become a ward of the IMF, and will remain so until either the broader European economic recovery is more robust or the Baltic state is fast-tracked into the eurozone itself.

An EU-IMF bailout of Greece would ultimately give Athens the choice of becoming either an Argentina or a Latvia. A financial assistance program that does not involve substantial structural reform on Greece's part would lead to a default a la Argentina. A bailout that forces Greece to get serious about reforms would mean Greece becomes an IMF-ward like Latvia, with default still a serious possibility down the line. In either case, Greece will essentially lose control over its destiny.

The next question is what the rest of Europe will look like, and there is no shortage of impacts. Europe, and Germany in particular, must decide whether and to what extent it should "bail out" the Greeks. How that might happen is now the topic of the day in Europe. Driving the urgency is this simple fact: In the absence of substantial (and subsidized) financial assistance, Greece will inevitably default on its debts, thus generating write-downs for all those who hold Greek government debt (mostly European banks).

The Greek default therefore is no longer an isolated problem, but a problem that threatens to aggravate an already weakened European banking sector. One of the most misunderstood facts of the international financial world is that even at the peak of the U.S. subprime crisis, in the dark hours when American hedge funds seemed to be snapping like matchsticks, Europe's banks were in even worse shape. As the Americans stabilized, so did their banks. But Europe never cleaned house, and now a Greek tsunami is poised to wash over the whole mess. [emphasis mine - JM]

Weakness Begets Weakness: from Banks to Sovereigns to Banks

By: Eric Sprott & David Franklin
Sprott Asset Management

The Greek debt situation has been an interesting case study for students of the sovereign bond markets. If there's a lesson to be learned from Greece's experience thus far it's that sovereign bailouts are far more complicated than bank bailouts. They require more sophisticated negotiations and proposals and involve an extra layer of diplomacy that makes them especially difficult to accomplish. As we write this, the European Union has recently announced new lending terms to support the Greek government, with great efforts made to assure the markets that these new terms do not constitute a 'bailout'. The problem with the Greek situation is that an actual bailout would involve an almost impossible coordination among all the major powers within the EU. It would require the unanimous pre-approval of all the EU heads of state. It would involve the European Commission, the European Central Bank and the International Monetary Fund (IMF) all visiting Greece to perform financial assessments. And finally, it would involve at least seven EU countries affirming support through parliamentary votes - all of this before a single euro is spent.

A true bailout involves an almost impossible number of hurdles that essentially guarantee nothing will happen until all other avenues of rescue are exhausted. However, judging by the recent increase in yields on 10-year Greek bonds, Greece may soon need more than a loan package proposal to solve its fiscal problems.

One aspect of the Greek situation that has been obscured by all the recent political wrangling is the crisis' impact on the Greek banks. Although the banks were supposed to be rock solid after all the government-injected capital they received (not to mention zero-percent interest rates and generous lending terms from the European Central Bank), data shows that Greek bank deposits have fallen 8.4 billion euros, or 3.6 percent, in two months since December 2009. With no restraints on capital flows within the European Union, Greek savers are free to transfer their assets elsewhere. Given that bank deposit guarantees in Greece are the responsibility of the national government rather than the European Central Bank, we suspect Greek citizens are pulling money out of their banks because they question their government's ability to honour its domestic deposit guarantees. We envision Greek depositors asking themselves how a government that can't raise enough money to stay solvent can then turn around and guarantee their bank deposits? It's a fair question to ask.

The Greek bank stocks have been thoroughly punished throughout the crisis. Chart A plots an index consisting of the four largest Greek bank stocks and shows an average decline of 47% since November 2009. The deposit withdrawals from these banks have been so damaging to their respective balance sheets (remember bank leverage?) that the Greek banks have asked to borrow 17 billion euros left over from a 28 billion euro support program launched in 2008.3 You see the connection here? Greece experienced a financial crisis, followed by a sovereign crisis, followed by another financial crisis. There is no doubt that the Greek crisis has helped drive the gold spot price to its recent all time high in euros. Gold is a prudent asset to own in times of crisis, and it's possible that a portion of the Greek deposit withdrawals were reinvested into the precious metal. The fact remains, however, that if the Greek government cannot stem the outflows of deposits soon, the EU will have no other choice but to undertake a real sovereign bailout with all its bells, whistles and arduous protocols.

It's a vicious spiral from financial crisis to sovereign debt crisis to banking crisis, and there is no reason it can't spread to other European countries suffering from similar fiscal imbalances. With Spain and Portugal next in line with their own sovereign debt issues, we can expect depositors in these countries to make similar runs to the bank for their cash. "Guaranteed by Government" is truly beginning to lose its potency in this environment. The International Monetary Fund (IMF) seems to be preparing for such a scenario with its recent announcement of a tenfold increase in its emergency lending facility. The IMF's New Arrangements to Borrow (NAB) facility is designed to prevent the "impairment of the international monetary system or to deal with an exceptional situation that poses a threat to the stability of that system." The NAB facility has grown from US$50 billion to US$550 billion with the mere stroke of a pen. Does the IMF know something that the market doesn't? Is this a pre-emptive measure to repel an attack by bond vigilantes' on Europe's fiscally-weakened countries?

Sovereign Debt

In our examination of the Greek situation this past month, we kept coming across various sovereign credit ratings. In an effort to better understand the Greek situation, we decided to look at how the ratings agencies generate their actual rankings and built our own model to determine a country's credit risk.5 We used common metrics such as GDP per Capita, Government Budget Deficits, Gross Government and Contingent Liabilities, the inflation rate and incorporated a simple debt sustainability metric in order to generate our own sovereign ratings. What we discovered in the process was quite puzzling.

It should first be noted that the rating agencies are in the business of offering their 'opinions' about the creditworthiness of bonds that have been issued by various kinds of entities: corporations, governments, and (most recently) the packagers of mortgages and other debt obligations. These opinions come in the form of 'ratings' which are expressed in a letter grade. The best-known scale is that used by Standard & Poor's ("S&P") which uses AAA for the highest rated debt, and AA, A, BBB, BB, for debt of descending credit quality.

In our opinion, as they relate to sovereign debt, the ratings provided by the agencies are highly suspect. While these agencies claim to provide ratings that consider the business credit cycle, there appears to be very little forward-looking information actually factored into their credit models. In some cases, the agency ratings end up looking absurdly optimistic. This of course should come as no surprise - we all remember the subprime mortgages that were rated AAA that are now worth pennies on the dollar.

While there were some similarities in our rankings (for example, our model ascribed AAA ratings to the local currency debt of Australia, Canada, Finland, Sweden, New Zealand which matched the ratings given by S&P), we found some glaring inconsistencies in the rating results for less fiscally prudent countries that left us scratching our heads. A good example is South Africa. The agencies currently rate South Africa an A+ entity, while our model calculated a 'BBB-' rating for its debt using our estimates. 'BBB-' is the lowest 'investment grade' rating for local currency sovereign debt - one level above junk. We arrived at this rating without having factored in South Africa's resource endowment. A significant contributor to South African GDP is derived from mining, particularly gold mining. While South Africa has been the largest producer of gold until very recently, their below-ground reserves have not been revised since 2001 when the country held 36,000 tonnes of gold (or about 40% of the global total). Recent stats from the United States Geological Survey (USGS) estimate that South Africa now has only 6,000 tonnes worth of economic gold reserves remaining. Further review by Chris Hartnady, a former associate professor at the University of Cape Town, using similar techniques to those of M. King Hubbert (the Peak Oil theorist), suggests that South Africa could have only half of the gold reserves estimated by the USGS.7 If these new estimates are correct, South Africa could have 90% less gold than claimed - and it's not even factored into our BBB- rating! So what's South African debt really worth? An 'A+' from the ratings agencies seems far too generous based on our cursory review of the country's fundamentals.

The rating agencies' ranking of the United States is even more disconnected from reality. To believe that the US sets the benchmark for sovereign debt credit ratings is preposterous. While we have written ad nauseam about the excessive debt issuance by the United States, we found a recent update written by United States Government Accountability Office (GAO) to be particularly instructive. The update noted the US's budget deficit equivalent to 9.9% of GDP in 2009 - the largest 10 since 1945 - and stated that without significant policy changes the US government would soon face an "unsustainable growth in debt".

This was not news to us. It goes on to state, however, that using reasonable assumptions, "roughly 93 cents of every dollar of federal revenue will be spent on the major entitlement programs and net interest costs by 2020." This is news! In less than ten years, using reasonable assumptions, there will essentially be no money left to run the US government - 93% of all tax revenues the US government collects will go to pay social security, Medicare, Medicaid and the interest costs on their national debt. This implies no money left over for defense, homeland security, welfare, unemployment benefits, education or anything else we associate with the normal business of government. And the US government is rated AAA!?

The historian Niall Ferguson recently wrote that, "US government debt is a safe haven the way Pearl Harbor was a safe haven in 1941." It's hard not to agree given the foregoing statements by the GAO. The risk inherent to investors, of course, is what happens when the bond market begins to realize and react to this new level of risk. In a speech earlier this month, Jürgen Stark, who is a member of the board of the European Central Bank, stated, "We may already have entered into the next phase of the crisis: a sovereign debt crisis following on the financial and economic crisis."

The activities of the IMF would confirm this statement. The question we must now ask ourselves is whether "backed by government" actually means anything anymore. In the depths of the 2008 crisis it was the governments that stepped in to provide a guarantee on financial assets. It was the governments that backed our savings accounts, money market funds, day-to-day business banking accounts, as well as debt issued by US banks. But what happens when confidence in the government guarantee begins to erode? We've seen what happened to Greece. Leverage inherent in the banking system elevated a bank run, equivalent to a mere 3.6 percent of deposits, into another full blown banking crisis. In our view it's time for investors to acknowledge sovereign risk. The ratings agencies can opine all they want, but it seems clear to us that the only true AAA asset to protect your wealth is gold.

April 2010AGEMENT LP

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.

Obama's Strategy and the Summits

John Mauldin — Thu, 09 Apr 2009 16:30:00 GMT

Dear Friends:

A long-time religious land bridge between the Islamic and Western worlds, Turkey now finds itself an economic gatekeeper, a US-backed contender for the EU and the only key that could unlock Europe from dependence on Russian resources. The value of your dollar is intrinsically linked to last week’s summits—the most important multinational summits in history.

I’d like to share with you an article by my friend George Friedman at STRATFOR. It delves into the Summits (G20, NATO, bilaterals) and explores the connections between finance and geopolitics. In this case, it boils down to two string-holding puppeteers: Germany and Russia. Germany, the largest exporter in the world, is happy to up its production while the US spreads its dollar paper-thin by contributing to an IMF fund that will bail out countries who will in turn spend their money in Germany’s already tremendous export sector. Russia, the largest supplier of natural gas to Europe, too stands to benefit from US contributions to the IMF pot, as their slice of the pie gets bigger with the pan—as long as Turkey keeps her pipes closed.

The decisions made and policies enacted at the Summits trickle down to you and me. To make sense of it all, I encourage you to read STRATFOR. George has arranged a special offer for my readers: click here to take advantage of a 2-for-1 deal; you get a 2-year Membership for the 1-year price of $349. STRATFOR is the best global intelligence service in the world, and their unbiased coverage of the G20, NATO, and other extracurricular summits is unmatched by anyone else.

Yours,
John Mauldin

Obama's Strategy and the Summits

By George Friedman
April 6, 2009

The weeklong extravaganza of G-20, NATO, EU, U.S. and Turkey meetings has almost ended. The spin emerging from the meetings, echoed in most of the media, sought to portray the meetings as a success and as reflecting a re-emergence of trans-Atlantic unity.

The reality, however, is that the meetings ended in apparent unity because the United States accepted European unwillingness to compromise on key issues. U.S. President Barack Obama wanted the week to appear successful, and therefore backed off on key issues; the Europeans did the same. Moreover, Obama appears to have set a process in motion that bypasses Europe to focus on his last stop: Turkey.

Berlin, Washington and the G-20

Let's begin with the G-20 meeting, which focused on the global financial crisis. As we said last year, there were many European positions, but the United States was reacting to Germany's. Not only is Germany the largest economy in Europe, it is the largest exporter in the world. Any agreement that did not include Germany would be useless, whereas an agreement excluding the rest of Europe but including Germany would still be useful.

Two fundamental issues divided the United States and Germany. The first was whether Germany would match or come close to the U.S. stimulus package. The United States wanted Germany to stimulate its own domestic demand. Obama feared that if the United States put a stimulus plan into place, Germany would use increased demand in the U.S. market to expand its exports. The United States would wind up with massive deficits while the Germans took advantage of U.S. spending, thus letting Berlin enjoy the best of both worlds. Washington felt it had to stimulate its economy, and that this would inevitably benefit the rest of the world. But Washington wanted burden sharing. Berlin, quite rationally, did not. Even before the meetings, the United States dropped the demand — Germany was not going to cooperate.

The second issue was the financing of the bailout of the Central European banking system, heavily controlled by eurozone banks and part of the EU financial system. The Germans did not want an EU effort to bail out the banks. They wanted the International Monetary Fund (IMF) to bail out a substantial part of the EU financial system instead. The reason was simple: The IMF receives loans from the United States, as well as China and Japan, meaning the Europeans would be joined by others in underwriting the bailout. The United States has signaled it would be willing to contribute $100 billion to the IMF, of which a substantial portion would go to Central Europe. (Of the current loans given by the IMF, roughly 80 percent have gone to the struggling economies in Central Europe.) The United States therefore essentially has agreed to the German position.

Later at the NATO meeting, the Europeans — including Germany — declined to send substantial forces to Afghanistan. Instead, they designated a token force of 5,000, most of whom are scheduled to be in Afghanistan only until the August elections there, and few of whom actually would be engaged in combat operations. This is far below what Obama had been hoping for when he began his presidency.

Agreement was reached on collaboration in detecting international tax fraud and on further collaboration in managing the international crisis, however. But what that means remains extremely vague — as it was meant to be, since there was no consensus on what was to be done. In fact, the actual guidelines will still have to be hashed out at the G-20 finance ministers' meeting in Scotland in November. Intriguingly, after insisting on the creation of a global regulatory regime — and with the vague U.S. assent — the European Union failed to agree on European regulations. In a meeting in Prague on April 4, the United Kingdom rejected the regulatory regime being proposed by Germany and France, saying it would leave the British banking system at a disadvantage.

Overall, the G-20 and the NATO meetings did not produce significant breakthroughs. Rather than pushing hard on issues or trading concessions — such as accepting Germany's unwillingness to increase its stimulus package in return for more troops in Afghanistan — the United States failed to press or bargain. It preferred to appear as part of a consensus rather than appear isolated. The United States systematically avoided any appearance of disagreement.

The reason there was no bargaining was fairly simple: The Germans were not prepared to bargain. They came to the meetings with prepared positions, and the United States had no levers with which to move them. The only option was to withhold funding for the IMF, and that would have been a political disaster (not to mention economically rather unwise). The United States would have been seen as unwilling to participate in multilateral solutions rather than Germany being seen as trying to foist its economic problems on others. Obama has positioned himself as a multilateralist and can't afford the political consequences of deviating from this perception. Contributing to the IMF, in these days of trillion-dollar bailouts, was the lower-cost alternative. Thus, the Germans have the U.S. boxed in.

The political aspect of this should not be underestimated. George W. Bush had extremely bad relations with the Europeans (in large part because he was prepared to confront them). This was Obama's first major international foray, and he could not let it end in acrimony or wind up being seen as unable to move the Europeans after running a campaign based on his ability to manage the Western coalition. It was important that he come home having reached consensus with the Europeans. Backing off on key economic and military demands gave him that "consensus."

Turkey and Obama's Deeper Game

But it was not simply a matter of domestic politics. It is becoming clear that Obama is playing a deeper game. A couple of weeks before the meetings, when it had become obvious that the Europeans were not going to bend on the issues that concerned the United States, Obama scheduled a trip to Turkey. During the EU meetings in Prague, Obama vigorously supported the Turkish application for EU membership, which several members are blocking on grounds of concerns over human rights and the role of the military in Turkey. But the real reason is that full membership would open European borders to Turkish migration, and the Europeans do not want free Turkish migration. The United States directly confronted the Europeans on this matter.

During the NATO meeting, a key item on the agenda was the selection of a new alliance secretary-general. The favorite was former Danish Prime Minister Anders Fogh Rasmussen. Turkey opposed his candidacy because of his defense on grounds of free speech of cartoons depicting the Prophet Mohammed published in a Danish magazine. NATO operates on consensus, so any one member can block just about anything. The Turks backed off the veto, but won two key positions in NATO, including that of deputy secretary-general.

So while the Germans won their way at the meetings, it was the Turks who came back with the most. Not only did they boost their standing in NATO, they got Obama to come to a vigorous defense of the Turkish application for membership in the European Union, which of course the United States does not belong to. Obama then flew to Turkey for meetings and to attend a key international meeting that will allow him to further position the United States in relation to Islam.

The Russian Dimension

Let's diverge to another dimension of these talks, which still concerns Turkey, but also concerns the Russians. While atmospherics after the last week's meetings might have improved, there was certainly no fundamental shift in U.S.-Russian relations. The Russians have rejected the idea of pressuring Iran over its nuclear program in return for the United States abandoning its planned ballistic missile defense system in Poland and the Czech Republic. The United States simultaneously downplayed the importance of a Russian route to Afghanistan. Washington said there were sufficient supplies in Afghanistan and enough security on the Pakistani route such that the Russians weren't essential for supplying Western operations in Afghanistan. At the same time, the United States reached an agreement with Ukraine for the transshipment of supplies — a mostly symbolic gesture, but one guaranteed to infuriate the Russians at both the United States and Ukraine. Moreover, the NATO communique did not abandon the idea of Ukraine and Georgia being admitted to NATO, although the German position on unspecified delays to such membership was there as well. When Obama looks at the chessboard, the key emerging challenge remains Russia.

The Germans are not going to be joining the United States in blocking Russia. Between dependence on Russia for energy supplies and little appetite for confronting a Russia that Berlin sees as no real immediate threat to Germany, the Germans are not going to address the Russian question. At the same time, the United States does not want to push the Germans toward Russia, particularly in confrontations ultimately of secondary importance and on which Germany has no give anyway. Obama is aware that the German left is viscerally anti-American, while Merkel is only pragmatically anti-American — a small distinction, but significant enough for Washington not to press Berlin.

At the same time, an extremely important event between Turkey and Armenia looks to be on the horizon. Armenians had long held Turkey responsible for the mass murder of Armenians during and after World War I, a charge the Turks have denied. The U.S. Congress for several years has threatened to pass a resolution condemning Turkish genocide against Armenians. The Turks are extraordinarily sensitive to this charge, and passage would have meant a break with the United States. Last week, they publicly began to discuss an agreement with the Armenians, including diplomatic recognition, which essentially disarms the danger from any U.S. resolution on genocide. Although an actual agreement hasn't been signed just yet, anticipation is building on all sides.

The Turkish opening to Armenia has potentially significant implications for the balance of power in the Caucasus. The August 2008 Russo-Georgian war created an unstable situation in an area of vital importance to Russia. Russian troops remain deployed, and NATO has called for their withdrawal from the breakaway Georgian regions of South Ossetia and Abkhazia. There are Russian troops in Armenia, meaning Russia has Georgia surrounded. In addition, there is talk of an alternative natural gas pipeline network from Azerbaijan to Europe.

Turkey is the key to all of this. If Ankara collaborates with Russia, Georgia's position is precarious and Azerbaijan's route to Europe is blocked. If it cooperates with the United States and also manages to reach a stable treaty with Armenia under U.S. auspices, the Russian position in the Caucasus is weakened and an alternative route for natural gas to Europe opens up, decreasing Russian leverage against Europe.

From the American point of view, Europe is a lost cause since internally it cannot find a common position and its heavyweights are bound by their relationship with Russia. It cannot agree on economic policy, nor do its economic interests coincide with those of the United States, at least insofar as Germany is concerned. As far as Russia is concerned, Germany and Europe are locked in by their dependence on Russian natural gas. The U.S.-European relationship thus is torn apart not by personalities, but by fundamental economic and military realities. No amount of talking will solve that problem.

The key to sustaining the U.S.-German alliance is reducing Germany's dependence on Russian natural gas and putting Russia on the defensive rather than the offensive. The key to that now is Turkey, since it is one of the only routes energy from new sources can cross to get to Europe from the Middle East, Central Asia or the Caucasus. If Turkey — which has deep influence in the Caucasus, Central Asia, Ukraine, the Middle East and the Balkans — is prepared to ally with the United States, Russia is on the defensive and a long-term solution to Germany's energy problem can be found. On the other hand, if Turkey decides to take a defensive position and moves to cooperate with Russia instead, Russia retains the initiative and Germany is locked into Russian-controlled energy for a generation.

Therefore, having sat through fruitless meetings with the Europeans, Obama chose not to cause a pointless confrontation with a Europe that is out of options. Instead, Obama completed his trip by going to Turkey to discuss what the treaty with Armenia means and to try to convince the Turks to play for high stakes by challenging Russia in the Caucasus, rather than playing Russia's junior partner.

This is why Obama's most important speech in Europe was his last one, following Turkey's emergence as a major player in NATO's political structure. In that speech, he sided with the Turks against Europe, and extracted some minor concessions from the Europeans on the process for considering Turkey's accession to the European Union. Why Turkey wants to be an EU member is not always obvious to us, but they do want membership. Obama is trying to show the Turks that he can deliver for them. He reiterated — if not laid it on even more heavily — all of this in his speech in Ankara. Obama laid out the U.S. position as one that recognized the tough geopolitical position Turkey is in and the leader that Turkey is becoming, and also recognized the commonalities between Washington and Ankara. This was exactly what Turkey wanted to hear.

The Caucasus is far from the only area to discuss. Talks will be held about blocking Iran in Iraq, U.S. relations with Syria and Syrian talks with Israel, and Central Asia, where both countries have interests. But the most important message to the Europeans will be that Europe is where you go for photo opportunities, but Turkey is where you go to do the business of geopolitics. It is unlikely that the Germans and French will get it. Their sense of what is happening in the world is utterly Eurocentric. But the Central Europeans, on the frontier with Russia and feeling quite put out by the German position on their banks, certainly do get it.

Obama gave the Europeans a pass for political reasons, and because arguing with the Europeans simply won't yield benefits. But the key to the trip is what he gets out of Turkey — and whether in his speech to the civilizations, he can draw some of the venom out of the Islamic world by showing alignment with the largest economy among Muslim states, Turkey.

EU Summit: What is Not Being Talked About

John Mauldin — Thu, 18 Dec 2008 20:12:49 GMT

Dear Friends:

There are plenty of sources out there that are happy to tell you what's happening in the world, and much of it matters. But oftentimes, what's much more important is the dog that didn't bark. Remember Enron's undisclosed subsidiaries? Or the off-balance sheet holdings of just about every financial services firm?

Sherlock Holmes uses the dog that didn't bark to solve the mystery -- the dog had to know the intruder. My friend George Friedman's company, Stratfor, uses the dog that didn't bark to highlight issues that are equally critical to the global economy -- that aren't being discussed. Traditional sources let me mitigate known risks. Stratfor tells me about the risks and opportunities I might not even be aware of.

I'm including an example below: Stratfor's "EU Summit: What is Not Being Talked About." As this analysis demonstrates, normal reporting on what was discussed might be helpful, but it's the "missing topics" -- those that the media misses -- that you really need to think about.

George has arranged for a special offer on a Stratfor Membership just for my readers. Click here to join now, and you'll get Stratfor's 2009 Annual Forecast as part of your Membership. Plus George has a new book (and it's fascinating!) coming out in January which he'll send you as well. I highly encourage you to take advantage of this opportunity.

Your dogged by bear-markets analyst,

John Mauldin

EU Summit: What is Not Being Talked About

Summary

The European Union summit is being held Dec. 11-12. Climate change, the Lisbon Treaty and the EU response to the global economic crisis are high on the agenda for the meeting. Absent from the agenda are ideas on dealing with a resurgent Russia, the energy crisis that could start after Russia implements higher natural gas prices for most EU member states Jan. 1, and the institutional flaws underlying the economic crisis sweeping through the bloc.

Analysis

EU leaders are meeting for the last time in 2008 on Dec. 11-12. The three main issues on the agenda for the 27 heads of government meeting in Brussels are the EU stimulus package passed in response to the global economic crisis; the Lisbon Treaty, which has languished in limbo since its rejection in an Irish referendum in June; and Europe's climate package. Prior to the summit, German Chancellor Angela Merkel expressed "cautious optimism" that agreement could be reached on the climate package, initially a German proposal that has come under criticism from various quarters.

While a handful on its own, the agenda is more notable for the issues not being discussed -- namely, how to deal with a resurgent Russia; the potential energy crisis stemming from Russian natural gas price increases for most EU member states starting Jan. 1; and the institutional deficiencies underlying the economic crisis sweeping the continent.

Related Special Topic Pages

The issue of the climate change and energy package is notable, and any progress -- particularly in midst of the economic crisis -- would be impressive considering the uphill battle. Referred to as 20-20-20, the initiative aims to reduce the European Union's carbon emissions by 20 percent, increase its use of renewable fuels to 20 percent of total energy demand and reduce total EU energy demand by 20 percent, all by the year 2020. However, with the economic crisis in full swing, the emphasis on climate change is dubious. The Lisbon Treaty is also on the agenda, and the EU member states are expected to approve assurances to Ireland on neutrality, taxation, commissioner assignments among member states and controversial rules like abortion -- all key sticking points during the Irish referendum.

The leaders do plan to address the bloc's 200 billion euro (US$263 billion) stimulus package, but the plan is more of a face-lift than a real solution to the underlying institutional problems within the European Union. As it stands now, the stimulus plan is a patchwork of national stimulus packages that accounts for only 0.6 percent of the total EU gross domestic product (GDP), whereas the European Commission hopes member states will commit 1.5 percent to the plan. Some within the commission are calling for Germany, the most powerful European economy and one of the few with a balanced budget, to pick up the slack amounting to 0.9 percent of the bloc's GDP (which would be around $170 billion). That is most definitely not on Berlin's agenda.

The EU member states are discussing this plan mainly because the broader, institutional issues are impossible to agree on. Such questions include how to protect the exposed EU member states outside the eurozone (for example, the Baltics, Hungary, Romania and Bulgaria) against currency devaluation, or whether to create some sort of unified tax regime that would give the European Union an actual fund from which to draw large amounts of cash during a financial crisis. There are also issues of a continent-wide banking regulatory regime, and of expanding the European Central Bank's powers. These questions seem prescient in light of the lack of a coherent, unified EU response to the economic crisis.

The main obstacles to answering these questions are the historical lack of willingness to devolve powers to the bloc from the nation-state level, and Germany's resistance to any "economic government" plan that would rely on German economic might for financial backing. Germany therefore is comfortable with the current plan as long as it does not ask Berlin for any financing beyond its current commitment.

Next is the issue of Europe's relationship with Russia. EU member states are divided on how to talk to Russia about security. France and Germany lead the relatively appeasing line, while Poland, the Czech Republic, Sweden and the United Kingdom lead the group stressing a firm stance. The issue is clear for Poland and the Czech Republic: As they are likely targets of further Russian maneuvers, they believe the Russian resurgence must be countered. But France is much more interested in leaving all its diplomatic avenues open, while Germany does not want to antagonize its main source of energy imports and is historically open to independent accommodations with Russia.

Which brings us to the elephant that will be in the room with the 27 European heads of state at the summit: Russia's planned Jan. 1 natural gas price increases. EU member states depend on Russian imports for a quarter of their total natural gas needs. Russian natural gas behemoth Gazprom announced in July that it would raise the natural gas prices it charges EU member states from $420 per thousand cubic meters (tcm) to $720 per tcm. But many European countries have already notified Gazprom that they will not be able to pay the new price. The current financial crisis obviously makes such a drastic increase problematic, particularly for Central European economies that both depend on Russian natural gas for most of their energy supply and already are running huge trade deficits because of energy imports.

Gazprom announced Nov. 12 that it might consider scrapping its planned price increases, but any such move most likely will be used as a tool for political manipulation. The Kremlin has been known to use energy as a political tool in the past, and without a coherent, unified effort, the Europeans will be easy to pick off one by one.

Eyeing Opportunities in the Global Financial Crisis

John Mauldin — Wed, 03 Dec 2008 17:37:25 GMT

As various companies go hat in hand to Washington for a bailout, a recurring topic is what guaranty do the taxpayers get that they're not just throwing more money down a hole. Good question. Who wants warrants or preferred shares if the company is doomed anyway? What you're seeing take place are negotiated backstops between the US Government and pools of capital. A couple of examples:

The Big 3 may get a bailout. Financially the US taxpayer will get a stake - in what will surely be radically reshaped companies. Citibank just got a large infusion from Saudi Arabia's Prince al-Waleed bin Talal al-Saud - just days before a US government orchestrated rescue helped rocket the share price. Maybe these are just coincidental moves. Maybe not.

What we're witnessing isn't finance or investment as usual. We're watching a shift to a managed economic structure, where government officials determine who will live and who will die. It's a shift from investments to agreements, where having access to large pools of ready cash is the ultimately persuasive argument. And lacking access means doing whatever you're told.

I've long been encouraging you to read George Friedman's work at Stratfor, but it becomes more important every day. Stratfor is producing a series on Countries in Crisis, and I've enclosed the latest piece which is the exception to the rule, the Gulf Cooperation Council countries. This series is a fascinating look at how those with the gold get to make the rules. Unless you've got your own sovereign wealth fund, you'll probably want to read it...

As you're structuring your own portfolios, understanding the geopolitical drivers behind where the markets are going is now more important than ever. Because these insights are so important, I've arranged a special deal for you on a Stratfor Membership which also includes a free copy of George's new book, The Next 100 Years. Click here to take advantage of this offer today. These are the drivers for the coming year, and I encourage you to factor them in today.

Yours,
John Mauldin

GCC States: Eyeing Opportunities in the Global Financial Crisis

Editor's Note: This article is part of a series on the geopolitics of the global financial crisis. Here we examine how the global financial crisis will affect the Persian Gulf states.

One of the most influential aspects of the global financial crisis, which has taken many forms around the world, is the shrinking and increasingly risk-averse global capital pool. As investors around the world began to experience heavy losses in the wake of, and partially triggered by, the U.S. subprime crisis, capital around the world began to dry up. At the same time, those who retained access to capital became increasingly risk-averse and have, in effect, begun to hoard capital.

For the time being, this means that risky borrowers or capital-intensive projects around the world are desperately in need of loans that are nowhere to be found. The impact in the short term is that major projects -- such as Brazil's development of its massive offshore oil fields -- will have to be postponed. In the long term, this lack of willing investment will mean a slowdown in growth in the areas of the world that are dependent on foreign capital for the development of infrastructure and industry, such as Latin America, emerging Europe and the Balkans.

A secondary impact of the shortage of capital is the devastating effect it can have on banking sectors. As the capital pool shrinks, liquidity becomes a serious problem for banks as they struggle to meet reserve requirements and avoid contagion. Banks all around the world have been hit by a shortage of credit but nowhere harder than in Europe, where the banking sector is so heavily intertwined with its industrial sectors that the entire underpinning of the economy relies on a highly liquid and supportive (critics would say "too supportive") banking industry. The U.S. market, by comparison, relies primarily on securities markets for external financing needs, and the kind of reciprocal, slightly incestuous relationships between banks and industries that characterize Europe do not exist in the United States. Furthermore, the common monetary policies of the eurozone have left many European states with over-stimulated economic sectors -- such as Spain's real estate sector -- that have been pushed forward by extremely low consumer lending rates (relative to what these countries experienced prior to joining the eurozone) backed by the stability and strength of the euro.

Yet another challenge facing world economies is the global slowdown of growth, which means a decline in demand for goods and a resulting decline in manufacturing. This will mean a slowdown in the Asian countries -- particularly China -- that are home to much of the world's manufacturing. The secondary impact will be on commodity-producing states, which provide the basic materials used in the construction of manufactured goods. These states (including most of Latin America) are facing an export crisis as the markets dry up.

Financial Crisis and the GCC

Fortunately for the Persian Gulf states that constitute the Gulf Cooperation Council (GCC) -- Saudi Arabia, the United Arab Emirates (UAE), Kuwait, Bahrain, Qatar and Oman -- these financial challenges are mitigated, or entirely eliminated, by enormous oil wealth and economies that have been carefully managed.

The GCC states are largely insulated from the global credit crunch because they are the proud owners of some of the world's largest oil deposits. Saudi Arabia alone boasts the largest oil reserves in the world, at well over 250 billion barrels, and all of the GCC states -- with the exception of Bahrain -- are ranked in the top 20 of world oil producers, with Saudi Arabia and the UAE leading the pack. Saudi Arabia alone made $194 billion from oil exports in 2007, and $212 billion (in real dollars) between January and October 2008. The GCC states are so capital-rich that their usual financial management strategy involves attempting to soak up as much liquidity as possible in order to contain inflation.

Indeed, with massive current account surpluses, the six GCC states are creditor nations -- meaning they supply capital to the rest of the world. As net providers of capital, these countries remain much less vulnerable to a shrinking global capital pool than net capital importers, as they can simply let up on the outflows for a bit to recapitalize their systems.

Given that this wealth is controlled for the most part by the GCC monarchies, much of this cash flow goes first into government coffers. This granted every single one of the GCC states a budget surplus, reaching as high as Kuwait's 42 percent of gross domestic product (GDP), in 2007 (this was before the oil price spike of 2008, so while the fall in oil revenue will affect budgets in 2009, the impact will not be as drastic as it would be using 2008 as a baseline). This gives Kuwait a great deal of flexibility in dealing with financial issues as they arise. Qatar, Oman and Bahrain all have surpluses, but they were less than 7 percent of GDP in 2007, so although they do maintain flexibility, they are much more limited than Kuwait.

Despite their budget surpluses and status as net capital exporters, the GCC states do maintain external debt -- used to finance corporate projects and government functions. However, public-sector external debt amounts to less than 30 percent of GDP for most GCC states. The outlying state is Bahrain, which has a public-sector external debt of around 36 percent of GDP. While this is not an insignificant level of debt, it is far outweighed by their sources of wealth. Measures of total external debt paint a different picture, however, and both Bahrain and Qatar have net external debt (which includes both public and private foreign capital borrowing) at between 50 and 60 percent of GDP. Although the UAE does not appear to be in trouble, the Dubai emirate has incurred a massive amount of debt in the process of overheating its real estate sector. The net impact of this high level of borrowing is to put the emirate at a disadvantage when it comes to seeking short-term capital to adjust to the international financial crisis.

Much of this debt has been caused by massive infrastructure and development projects such as Qatar's liquefied natural gas facilities, Dubai's fanciful real estate explosion and Bahrain's attempts to convert itself into a financial mecca. Indeed, the GCC states have used the past several decades of oil wealth to engineer massive development projects and have become, in the process, quite reliant on foreign direct investment (FDI) and the technology and expertise that accompany it. Though Qatar and Kuwait are net exporters of FDI, the other four states are importers of FDI, from Bahrain's modest 0.51 percent of GDP to Oman's more substantial 4.67 percent of GDP.

Offsetting this debt (and just about every other problem they might encounter) are the pools of capital that the GCC states maintain. One of the most important mechanisms for this capital accumulation -- because of its political and financial implications -- is the sovereign wealth fund (SWF). These SWFs are massive investment funds that make strategic investment choices for the GCC states. GCC SWFs maintain holdings that range from Saudi Arabia's relatively modest $5.3 billion to Abu Dhabi's massive $875 billion nest egg (and Abu Dhabi has even more money socked away in other SWFs). These SWFs are invested primarily in the equity markets of developed nations, and some have taken sizable stakes in Western businesses. In addition to the SWFs, the GCC states also maintain large caches of reserves. In Saudi Arabia, the state-owned bank SAMA (in addition to the kingdom's SWF) has $365.2 billion of foreign holdings, and the elite of the al-Saud family has reportedly stashed away somewhere around $1 trillion, though exact figures are difficult to track.

These pools of capital allow the GCC states to exercise great flexibility, especially during credit crunches. Gulf oil is controlled by the monarchies that rule each state, and these strong governments not only can draw on their large reserves but also can run their yearly budgets with substantial built-in surpluses. This gives the governments a great deal of room to intervene in the local markets to compensate for the effects of the financial crisis.

Trouble Spots

There are a couple of notable exceptions to this relatively rosy picture. Saudi Arabia has postponed bids on two major refinery projects until sometime in late 2009. The projects include a $6 billion, 400,000-barrel-per-day (bpd) refinery in the Red Sea port city of Yanbu to be built by Saudi Arabia's state-owned oil company Saudi Arabian Oil Co. (Aramco) and ConocoPhillips and a $12 billion joint venture with French energy company Total for another 400,000-bpd facility in Jubail. But these projects are hardly an issue of economic survival. Instead they are a part of Saudi Arabia's effort to move up the energy supply chain -- from crude production to refined products - - and while these facilities would be nice to have, their delay will not cause any sleepless nights for Saudi Arabia.

A more serious issue for GCC states is that many of them have young banking sectors that have trembled at tightening global liquidity and disappearing capital. Bahrain, an island nation, has capitalized greatly on its location at the heart of the oil-rich Persian Gulf region and has used its proximity to massive capital flows to build a powerful banking sector. This proliferation of banks has been shaken by the financial crisis, but true crisis is not on the horizon because the GCC states have avoided incurring massive amounts of debt.

The impact of the financial crisis on the oil markets is unquestionably a concern for GCC states, and oil prices have fallen to nearly $50 a barrel after reaching highs of over $140 per barrel earlier in 2008. But their cash reserves have given the GCC states a great deal of staying power in the medium term. Saudi Arabia alone raked in more than $1 billion per day when oil prices spiked. With the global slowdown, there will certainly be a decline in the rate of cash flowing in to the GCC states, so they will have to spend what they have wisely. In some respects, this slowdown in cash inflow is a blessing. Until the financial crisis broke, the biggest financial worry for these states was high inflation, and the slowdown in growth will reduce inflationary pressure.

Among the GCC states there are a few with their own unique challenges. In the UAE, for example, there has been a rapid increase in corporate borrowing over the past two years. Most of that borrowing has been to fund massive development projects in the emirate of Dubai. These fantastical projects have included the construction of islands in the shape of palm trees and the continents of the world. Dubai has been planning to build the world's largest suspension bridge across the entire city of Dubai (connecting one suburb to another) that was to be completed in 2012. The real estate sector in Dubai, which sports the world's only seven-star hotel, has reached unprecedented heights of growth.

Its 10-year growth spurt has come to an end, however, as the heavily overheated real estate sector readjusts to something closer to reality and as bank stability is in question, although the UAE has set up a task force to address the problem. According to the head of the task force, Mohammed al-Abbar, state-owned and affiliated companies owe approximately $80 billion in debts, while the government's assets stand at $90 billion, and state-associated companies hold about $260 billion in assets. In addition to across-the-board needs for refinancing, Dubai companies have suffered huge losses in the Dubai Financial Market, which has taken the biggest hit of the GCC-state stock markets so far this year, with losses of up to 66 percent.

Qatari firms have also borrowed some $40 billion over the past two years to finance hydrocarbon projects such as the construction of natural gas liquefaction plants -- though these will certainly pay for themselves as demand for liquefied natural gas rises amid very tight market conditions. A massive outflow of equity investments sent the Doha Securities Market for a spin as it lost 22 percent in the first half of September. Though this serves to tighten Qatar's credit options, it will not have catastrophic consequences.

The massive credit expansion in Qatar and the UAE has put the banking sectors of both countries in a delicate position. Liquidity crises will, as a rule, hit first in the place where commercial banking and lending has exploded the quickest. The relatively young Qatari banking sector has been affected by this phenomenon, and the government intervened in the banking sector by offering a $5.3 billion investment package on Oct. 12. Similarly, the Abu Dhabi Central Bank has intervened with $32.7 billion to ensure the liquidity of UAE banks.

According to reports from Bahrain, the country's Islamic lending facilities appear to be faring better than interest-based lending facilities. The Central Bank of Bahrain is controlling the sector's involvement in the volatile real estate market, as a precaution, and has been adjusting interest rates to maintain liquidity, which appears to be holding. Similar moves have been made in Oman, although the kingdom appears to have weathered the storm with high levels of capitalization.

As these market fluctuations demonstrate, depending on how bad things get, the GCC states may be forced to cut back on programs -- such as Dubai's development projects and Saudi Arabia's refineries. But in the end, the massive reserves they have built up, as well as their relative financial discipline, have made the decline in commodity prices a concern but hardly a crisis. And ongoing hydrocarbon production capacity improvements in Saudi Arabia and other GCC states mean that as soon as the price of oil rises again, these states will once again be positioned to rake in stratospheric levels of oil revenue. In fact, the financial crisis for the GCC states can be viewed as an opportunity for the GCC states to exploit this moment of relative economic power, both internally and on the international stage.

Geopolitical Implications

The strongest player in the region, by far, is Saudi Arabia, and Riyadh uses its massive oil wealth to exert political pressure throughout the region and the world. The kingdom's primary objective in the region is the containment of Iran and Shiite influence as Iran tries to assert dominance over Iraq. The financial crisis has been a huge boon in this endeavor. As a major oil exporter that has failed to achieve the kinds of financial solvency that the GCC states have secured, Iran is staring down the barrel of a gun as oil prices sink. Without a buffer of cash, Iran is very poorly positioned to handle a fall in oil prices.

Though the fall in oil prices threatens Saudi Arabia as well, the Saudi budget is set for an oil price of $45 per barrel, and oil prices have not dropped to levels that would threaten Saudi stability. Saudi Arabia maintains the ability to manipulate oil prices for its own foreign policy objectives and could use them against Iran. (Saudi Arabia is poised to assume an even more powerful position when prices rise again if an ambitious $129 billion project to raise its oil production capacity to 12.5 million bpd comes through as planned in 2009.)

If Saudi Arabia chooses to pursue macro-level adjustments to oil prices in order to target Iran, it will certainly do so cautiously. Though the kingdom has a solid cushion of petrodollars, it still relies on oil for 75 percent of government income. That income is necessary to meet a variety of domestic needs and to counter Iranian moves in the region by bribing political parties and militant groups in places like Iraq and Lebanon.

After Saudi Arabia, Kuwait is perhaps the GCC state best positioned to weather the financial storm. With a SWF of $264 billion, the country is very capital-rich and the government has a huge budget surplus. There has been turmoil in Kuwait's equity markets and banking sector, which has prompted the kingdom to repatriate some $3.66 billion worth of SWF investments, but the government's resources are substantial enough to handily offset these problems. Kuwait stands to gain from the decline of Iranian influence in the region, in terms of limiting both the influence of its own Shiite minorities and Iran's entrenchment in neighboring Iraq. Kuwait's foreign policy goals are thus in line with Saudi Arabia's, and Kuwait will follow the Saudi lead.

Abu Dhabi, the largest emirate of the UAE, is the wealthiest and most tightly run ship in the country. The UAE's problems lie in Dubai and its excessive real estate boom of the past decade. Dubai's financial indiscretions have put it in a position where it will need to be underwritten (to a certain extent) by Abu Dhabi. This presents a strategic opportunity for Abu Dhabi to rein in the political power and excesses of the al-Maktoum family, which rules Dubai and holds the UAE prime ministerial post. Dubai has so far remained staunchly uninterested in Abu Dhabi's offers of aid, declaring that there are no negotiations between the emirates.

Though Qatar has found itself mildly vulnerable to the international financial crisis because of its large debt burden, it is still in a reasonably safe financial position. Qatar's regional and global goals are quite ambitious, as it seeks to increase its holdings overseas and serve as a diplomatic hub for the Middle East. Qatar has already made moves toward acquiring major stakes in companies overseas -- including Citibank -- and these kinds of activities will likely continue. For Qatar, the danger may be in overextending itself in a time of depressed markets and relatively little competition.

For Bahrain and Oman, the smallest of the GCC states, their ability to take advantage of the financial crisis is relatively limited. Bahrain is constrained by domestic political factors as it seeks to balance the needs of active opposition elements with its economic outlook. This will limit Bahrain's ability to use the economic crisis as a stepping-stone toward a larger geopolitical role in the region. Oman, for its part, maintains a very low profile in the region and is very unlikely to make any moves at this time.

For all of the GCC states, the global slowdown offers investment opportunities the world over. On the political stage, the Western states are crying out for capital injections as their economies slow down. In fact, on a tour of the region, Deputy U.S. Treasury Secretary Robert Kimmitt called on the Persian Gulf Arab states to continue investing in the United States to help restore financial stability. This represents an excellent opportunity for GCC states to charge to the rescue -- with hefty expectations for future cooperation, of course.

The United Kingdom has also asked the GCC states to help the International Monetary Fund (IMF) assist countries in desperate need of a bailout. Herein lies an opportunity for the GCC states to engage in long-term financial positioning. By giving money to the IMF, the GCC states could enhance their say in the affairs of the lending institution and, by extension, in the geopolitical arena.

For the moment, however, the GCC states have not responded enthusiastically to these pleas (although Saudi Prince Walid bin Talal did announce that he would boost his stake in Citibank just days before a U.S.-announced government bailout of the company). Countries like Saudi Arabia and Kuwait (which have other options and a variety of needs to balance) see only limited direct political benefit from bailing out the West instead of investing that money at home. This is an outlook that could change once the new U.S. administration is up and running and able to make political deals and security guarantees.

As these openings demonstrate, the GCC states are among few in the world that can view the current crisis and see potential opportunities. While there will certainly be bumps in the road as these relatively young economies settle and shift in the face of a turbulent world economy, responsible management of vast oil wealth has put the GCC states in a position to weather the financial crisis, and weather it well.

Obama's Challenge

John Mauldin — Thu, 13 Nov 2008 20:47:00 GMT

With the election of a new US President, everyone is focused on the "First 100 Days." How Obama transitions into the presidency impacts not just the U.S. but the entire global system. What happens to U.S. relations with Iraq, Iran, and Afghanistan? What's going to happen at Treasury and to all the programs addressing the financial crisis? What's going to emerge from the next G20 summit?

You need to read the analysis below, written by my good friend George Friedman at Stratfor. He details the immediate issues facing the president-elect, including one of the stickiest: Europe's desire for a global banking regulatory regimen. How will Obama respond to European pressure? George has built his company Stratfor and its reputation on forecasting the future, and I'm amazed at how often he's right -- on broad themes and specific events.

As we move into the next 100 days, George is way ahead of us with a book called The Next 100 Years: A Forecast for the 21^st Century. I've read an advance copy, and it's absolutely fascinating. In it, he maps out what geopolitical changes the world will see in the next hundred years: the rise of Mexico (and war with the U.S.!), Poland and Turkey returning to great-power status, and a second Cold War, among others. I can tell you, his arguments are as absolutely compelling as the conclusions are provocative.

George has arranged a special pre-publication offer for my readers. Click here to take advantage of a Stratfor Membership that also includes a free copy of George's new book. For insight into the next 100 days and the next 100 years, I'm relying on George Friedman and his team at Stratfor. I know you'll find as much value in George's forecasts as I do.

John Mauldin

Obama's Challenge

November 5, 2008 | 1202 GMT
By George Friedman

Obama's Agenda vs. Expanding His Base

U.S. President George W. Bush demonstrated that the inability to understand the uses and limits of power can crush a presidency very quickly. The enormous enthusiasm of Obama's followers could conceal how he -- like Bush -- is governing a deeply, and nearly evenly, divided country. Obama's first test will be simple: Can he maintain the devotion of his followers while increasing his political base? Or will he believe, as Bush and Cheney did, that he can govern without concern for the other half of the country because he controls the presidency and Congress, as Bush and Cheney did in 2001? Presidents are elected by electoral votes, but they govern through public support.

Obama and his supporters will say there is no danger of a repeat of Bush -- who believed he could carry out his agenda and build his political base at the same time, but couldn't. Building a political base requires modifying one's agenda. But when you start modifying your agenda, when you become pragmatic, you start to lose your supporters. If Obama had won with 60 percent of the popular vote, this would not be as pressing a question. But he barely won by more than Bush in 2004. Now, we will find out if Obama is as skillful a president as he was a candidate.

Obama will soon face the problem of beginning to disappoint people all over the world, a problem built into his job. The first disappointments will be minor. There are thousands of people hoping for appointments, some to Cabinet positions, others to the White House, others to federal agencies. Many will get something, but few will get as much as they hoped for. Some will feel betrayed and become bitter. During the transition process, the disappointed office seeker -- an institution in American politics -- will start leaking on background to whatever reporters are available. This will strike a small, discordant note; creating no serious problems, but serving as a harbinger of things to come.

Later, Obama will be sworn in. He will give a memorable, perhaps historic speech at his inauguration. There will be great expectations about him in the country and around the world. He will enjoy the traditional presidential honeymoon, during which all but his bitterest enemies will give him the benefit of the doubt. The press initially will adore him, but will begin writing stories about all the positions he hasn't filled, the mistakes he made in the vetting process and so on. And then, sometime in March or April, things will get interesting.

Iran and a U.S. Withdrawal From Iraq

Obama has promised to withdraw U.S. forces from Iraq, where he does not intend to leave any residual force. If he follows that course, he will open the door for the Iranians. Iran's primary national security interest is containing or dominating Iraq, with which Iran fought a long war. If the United States remains in Iraq, the Iranians will be forced to accept a neutral government in Iraq. A U.S. withdrawal will pave the way for the Iranians to use Iraqi proxies to create, at a minimum, an Iraqi government more heavily influenced by Iran.

Apart from upsetting Sunni and Kurdish allies of the United States in Iraq, the Iranian ascendancy in Iraq will disturb some major American allies -- particularly the Saudis, who fear Iranian power. The United States can't afford a scenario under which Iranian power is projected into the Saudi oil fields. While that might be an unlikely scenario, it carries catastrophic consequences. The Jordanians and possibly the Turks, also American allies, will pressure Obama not simply to withdraw. And, of course, the Israelis will want the United States to remain in place to block Iranian expansion. Resisting a coalition of Saudis and Israelis will not be easy.

This will be the point where Obama's pledge to talk to the Iranians will become crucial. If he simply withdraws from Iraq without a solid understanding with Iran, the entire American coalition in the region will come apart. Obama has pledged to build coalitions, something that will be difficult in the Middle East if he withdraws from Iraq without ironclad Iranian guarantees. He therefore will talk to the Iranians. But what can Obama offer the Iranians that would induce them to forego their primary national security interest? It is difficult to imagine a U.S.-Iranian deal that is both mutually beneficial and enforceable.

Obama will then be forced to make a decision. He can withdraw from Iraq and suffer the geopolitical consequences while coming under fire from the substantial political right in the United States that he needs at least in part to bring into his coalition. Or, he can retain some force in Iraq, thereby disappointing his supporters. If he is clumsy, he could wind up under attack from the right for negotiating with the Iranians and from his own supporters for not withdrawing all U.S. forces from Iraq. His skills in foreign policy and domestic politics will be tested on this core question, and he undoubtedly will disappoint many.

The Afghan Dilemma

Obama will need to address Afghanistan next. He has said that this is the real war, and that he will ask U.S. allies to join him in the effort. This means he will go to the Europeans and NATO, as he has said he will do. The Europeans are delighted with Obama's victory because they feel Obama will consult them and stop making demands of them. But demands are precisely what he will bring the Europeans. In particular, he will want the Europeans to provide more forces for Afghanistan.

Many European countries will be inclined to provide some support, if for no other reason than to show that they are prepared to work with Obama. But European public opinion is not about to support a major deployment in Afghanistan, and the Europeans don't have the force to deploy there anyway. In fact, as the global financial crisis begins to have a more dire impact in Europe than in the United States, many European countries are actively reducing their deployments in Afghanistan to save money. Expanding operations is the last thing on European minds.

Obama's Afghan solution of building a coalition centered on the Europeans will thus meet a divided Europe with little inclination to send troops and with few troops to send in any event. That will force him into a confrontation with the Europeans in spring 2009, and then into a decision. The United States and its allies collectively lack the force to stabilize Afghanistan and defeat the Taliban. They certainly lack the force to make a significant move into Pakistan -- something Obama has floated on several occasions that might be a good idea if force were in fact available.

He will have to make a hard decision on Afghanistan. Obama can continue the war as it is currently being fought, without hope of anything but a long holding action, but this risks defining his presidency around a hopeless war. He can choose to withdraw, in effect reinstating the Taliban, going back on his commitment and drawing heavy fire from the right. Or he can do what we have suggested is the inevitable outcome, namely, negotiate -- and reach a political accord -- with the Taliban. Unlike Bush, however, withdrawal or negotiation with the Taliban will increase the pressure on Obama from the right. And if this is coupled with a decision to delay withdrawal from Iraq, Obama's own supporters will become restive. His 52 percent Election Day support could deteriorate with remarkable speed.

The Russian Question

At the same time, Obama will face the Russian question. The morning after Obama's election, Russian President Dmitri Medvedev announced that Russia was deploying missiles in its European exclave of Kaliningrad in response to the U.S. deployment of ballistic missile defense systems in Poland. Obama opposed the Russians on their August intervention in Georgia, but he has never enunciated a clear Russia policy. We expect Ukraine will have shifted its political alignment toward Russia, and Moscow will be rapidly moving to create a sphere of influence before Obama can bring his attention -- and U.S. power -- to bear.

Obama will again turn to the Europeans to create a coalition to resist the Russians. But the Europeans will again be divided. The Germans can't afford to alienate the Russians because of German energy dependence on Russia and because Germany does not want to fight another Cold War. The British and French may be more inclined to address the question, but certainly not to the point of resurrecting NATO as a major military force. The Russians will be prepared to talk, and will want to talk a great deal, all the while pursuing their own national interest of increasing their power in what they call their "near abroad."

Obama will have many options on domestic policy given his majorities in Congress. But his Achilles' heel, as it was for Bush and for many presidents, will be foreign policy. He has made what appear to be three guarantees. First, he will withdraw from Iraq. Second, he will focus on Afghanistan. Third, he will oppose Russian expansionism. To deliver on the first promise, he must deal with the Iranians. To deliver on the second, he must deal with the Taliban. To deliver on the third, he must deal with the Europeans.

Global Finance and the European Problem

The Europeans will pose another critical problem, as they want a second Bretton Woods agreement. Some European states appear to desire a set of international regulations for the financial system. There are three problems with this.

First, unless Obama wants to change course dramatically, the U.S. and European positions differ over the degree to which governments will regulate interbank transactions. The Europeans want much more intrusion than the Americans. They are far less averse to direct government controls than the Americans have been. Obama has the power to shift American policy, but doing that will make it harder to expand his base.

Second, the creation of an international regulatory body that has authority over American banks would create a system where U.S. financial management was subordinated to European financial management.

And third, the Europeans themselves have no common understanding of things. Obama could thus quickly be drawn into complex EU policy issues that could tie his hands in the United States. These could quickly turn into painful negotiations, in which Obama's allure to the Europeans will evaporate.

One of the foundations of Obama's foreign policy -- and one of the reasons the Europeans have celebrated his election -- was the perception that Obama is prepared to work closely with the Europeans. He is in fact prepared to do so, but his problem will be the same one Bush had: The Europeans are in no position to give the things that Obama will need from them -- namely, troops, a revived NATO to confront the Russians and a global financial system that doesn't subordinate American financial authority to an international bureaucracy.

The Hard Road Ahead

Like any politician, Obama will face the challenge of having made a set of promises that are not mutually supportive. Much of his challenge boils down to problems that he needs to solve and that he wants European help on, but the Europeans are not prepared to provide the type and amount of help he needs. This, plus the fact that a U.S. withdrawal from Iraq requires an agreement with Iran -- something hard to imagine without a continued U.S. presence in Iraq -- gives Obama a difficult road to move on.

As with all American presidents (who face midterm elections with astonishing speed), Obama's foreign policy moves will be framed by his political support. Institutionally, he will be powerful. In terms of popular support, he begins knowing that almost half the country voted against him, and that he must increase his base. He must exploit the honeymoon period, when his support will expand, to bring another 5 percent or 10 percent of the public into his coalition. These people voted against him; now he needs to convince them to support him. But these are precisely the people who would regard talks with the Taliban or Iran with deep distrust. And if negotiations with the Iranians cause him to keep forces in Iraq, he will alienate his base without necessarily winning over his opponents.

And there is always the unknown. There could be a terrorist attack, the Russians could start pressuring the Baltic states, the Mexican situation could deteriorate. The unknown by definition cannot be anticipated. And many foreign leaders know it takes an administration months to settle in, something some will try to take advantage of. On top of that, there is now nearly a three-month window in which the old president is not yet out and the new president not yet in.

Obama must deal with extraordinarily difficult foreign policy issues in the context of an alliance failing not because of rough behavior among friends but because the allies' interests have diverged. He must deal with this in the context of foreign policy positions difficult to sustain and reconcile, all against the backdrop of almost half an electorate that voted against him versus supporters who have enormous hopes vested in him. Obama knows all of this, of course, as he indicated in his victory speech.

We will now find out if Obama understands the exercise of political power as well as he understands the pursuit of that power. You really can't know that until after the fact. There is no reason to think he can't finesse these problems. Doing so will take cunning, trickery and the ability to make his supporters forget the promises he made while keeping their support. It will also require the ability to make some of his opponents embrace him despite the path he will have to take. In other words, he will have to be cunning and ruthless without appearing to be cunning and ruthless. That's what successful presidents do.

In the meantime, he should enjoy the transition. It's frequently the best part of a presidency.

Fourth Quarter Forecast 2008

John Mauldin — Thu, 30 Oct 2008 17:57:08 GMT

Really hear what I'm about to tell you. The center of gravity of the world economic system has moved from New York to Washington. Let me illustrate what I mean so you understand just how profound this is. Banks used to compete against banks. US carmakers competed against each other and the Japanese. And the New York financial markets told you how they're doing against each other.

Understand what's happening now. The US Treasury has become the only "customer" that matters. The Treasury is now the customer—and investor -- with the $750+ billion checkbook. The Treasury is now the "investment banker" of last resort, arranging and financing mergers. Banks are competing against insurance companies for their slice of the bailout pie. Chrysler and GM (and the Michigan Congressional delegation) are looking to Washington, not Goldman or Merrill, to facilitate a merger. This is a seismic shift.

As investors, we have to start looking at the world in a completely different way, and getting our information from different sources. A company's 10-K is almost irrelevant if all it includes is financial statements and market outlooks. What matters now are the "exogenous" factors: government guarantees of the commercial paper market, currency interventions, direct capital infusions, etc. And how does a company describe in its Management Outlook that "Yes, our company is too big to fail."

In this environment, it's more important than ever to read unbiased geopolitical intelligence and analysis of government moves, and that's what my friend George Friedman at Stratfor offers. I'm enclosing below his team's Fourth Quarter Forecast. George's team analyzes US government policy as well as the moves that are being taken by central banks and governments around the world as the private sector gets taken public all across the globe. You will not be able to understand market moves if you don't understand who the real movers are now.

I'm sending you Stratfor's Fourth Quarter Forecast, and I strongly encourage you to join Stratfor and get access to all their daily intelligence. George has arranged a special offer on a Stratfor Membership for my readers: click here to take advantage of this opportunity. In this new era, I use Stratfor daily to give me a wide-lens, global view of politics and economics. I know you'll gain as much from reading Stratfor as I do.

John Mauldin

Fourth Quarter Forecast 2008

October 23, 2008 | 1502 GMT

Three issues will dominate the final quarter of 2008: the global financial crisis, U.S. self-absorption and the Russian resurgence.

The financial crisis has its roots in an American liquidity meltdown. But as the days flow by, it will become obvious that the crisis is evolving as it spreads to the rest of the world, and its impact will be harsher and require more time for recovery elsewhere. For in the United States, actions have already been taken to rectify the liquidity imbalances, and although plenty can still go wrong and a recession is probably inevitable, the system is beginning to mend. In Europe, however, the liquidity shortage has unearthed a deep banking debacle.

Remediation is only now being started, and the problem is only now being identified, much less evaluated. The American recession will probably be over by year's end, but Europe's will likely stretch through most of 2009. And in East Asia, where the problem is neither liquidity nor banking but loss of export demand, recovery cannot even begin until the West begins demanding Asian goods en masse. The United States might have set the crisis running, but it will be Europe and Asia that really give it its legs.

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In the midst of a presidential election, a lame-duck administration, a recession and ongoing efforts to stabilize Iraq, Washington is essentially in lockdown. It has neither the capacity for nor the interest in dealing with anything that is not on a very short list of topics. Mitigating the recession is now at the top of that list, with Iraq second in line. In Iraq, U.S. policy has mutated somewhat. Until now, Washington was forced to deal with Iran, as Iran maintained the ability to scuttle any progress in Iraq. But now Iran, for various reasons, has largely moved away from its policy of stoking militia fires in Iraq. It would be a stretch to say that all concern about Iran's ability to set Iraq on fire has evaporated, but Washington certainly feels it can shape Iraq into more or less whatever it wishes so long as it does not flagrantly cross any red lines. This does not mean for a second that things are easy; creating a functional state out of the Shiite, Sunni and Kurdish populations is a lengthy and possibly fruitless task. However, Iran's apparent inability to create chaos in Iraq has drawn some of the desperation out of U.S. policy.

Finally, and to a certain degree integrated into the financial crisis and American preoccupation, comes the issue of Russia's rise. In the third quarter Russia proved that it remains capable -- militarily and politically -- of invading a neighbor, the former Soviet state of Georgia. While not immune to global financial chaos, Russia is far better prepared than most states to weather the storm; even after massive investment outflows, Russia still holds more than $700 billion in reserve funds and a fat budget surplus. Moscow has a limited window in which to act before the United States withdraws from Iraq and turns its attention northward, so Russia will be using the time to sow as many problems for the United States as possible. Russian plans are already in the works for Latin America, the Middle East and Africa, in that order. And to keep the pressure on and the momentum going, Russia is expected to make a new thrust -- more political and economic than military -- in Ukraine. Under the cover of the financial crisis (which is hitting Europe much harder than the United States) and American preoccupation, the chances of Russia successfully expanding its influence definitely qualify as betting odds.

Note to readers: Our fourth-quarter forecast is intended to be a supplement to our annual forecast and third-quarter forecast. Within each section of this quarterly we have extracted the critical trends identified in our previous forecasts and indicated where we have been right or wrong and what is coming in the next three months. We have also examined new trends that have evolved from regional developments, independent of the earlier forecasts.

Global Economy

Ultimately, Stratfor delayed the release of our fourth-quarter forecast due to the winds of change ripping through the U.S. financial industry. With so much uncertainty, it was impossible to peer minutes, much less months, into the future. But now, though the dust is far from settled, the outlines are in place for an American-led financial rescue package that puts the crisis into a context that allows for forecasting.

This section will not serve as an overview on how the crisis came about (we have written a history and tactical forecast on the financial crisis elsewhere), but it will outline the broad picture Stratfor sees in the weeks going forward.

Regional trend: The United States is in a liquidity crisis, but the fundamentals of the U.S. economy remain strong. Overwhelming state intervention will ensure that the United States recovers quickly from an impending, and probably inevitable, recession.

In the United States, the crisis is ultimately one of liquidity. Underneath all the froth, the American banking system remains stable. Yes, there are some questionable assets that have initiated panic, but on the whole American banks are solid. Before the political process in Washington took over the system and in essence made it impossible for banks to close, only 13 banks had gone under. During the recession of the early 1980s, several hundred went bust per year.

Liquidity crises are relatively -- and we emphasize the word "relatively" -- easy to fix. They "only" require injections of capital into the system, which the U.S. government has done on a mammoth scale, in order to restart lending and thus normal economic activity. At the time of this writing, banks have already increased their lending rates from the crisis lows, and we see the panic beginning to lift within weeks. For the United States, there will almost certainly be a short recession, but the way out has already been sketched.

Regional trend: With Europe dealing with a deeply entrenched banking crisis and Asia facing a plunge in exports, the financial contagion will be more deeply felt outside the United States than within.

When the U.S. liquidity crisis slammed into Europe it had identical impacts -- at first. But within a few days, it became apparent that Europe has other problems. Unlike the United States, Europe has a banking system with many portions that are not very healthy. Austrian, Swedish and Italian banks are overexposed to Central Europe, which is now in a credit hangover. German banks' corporatist links have left them with questionable assets far greater in value than anything American subprime practices generated. Irish and Spanish banks face much deeper subprime problems relative to their economic size than American banks. And the list goes on and on. So while the United States has a liquidity crisis that can be addressed "relatively" easily, Europe faces a banking debacle that has been uncovered by the liquidity crisis -- and dealing with that banking debacle is likely to take more than a year.

These crises have not really affected Asia directly, for Asian states are built upon massive and artificial flows of liquidity. States routinely funnel more liquidity into their systems than even the U.S. Federal Reserve is doing with its record-breaking operations to combat the American liquidity crisis. So even with the United States and Europe struggling, there are very few liquidity problems in China or Japan.

The Asian problem will be neither liquidity nor banking, but exports. The United States faces a short recession and the Europeans likely a long one. For Asian economies, the problem will be a plunge in Western demand for Asian exports that will hit these economies at their most sensitive point: employment. China and Japan keep their systems flush with liquidity in order to ensure maximum employment regardless of profitability. As Western growth slows, demand for Asian goods will drop, and the Asians will have to either shut factories down or subsidize them to keep operations active. Luckily -- and we are not sure that "luckily" is the correct word -- this will take some time. We do not expect East Asia to really slide into crisis mode until late in the fourth quarter, but the crisis will strike the region to its very core.

Regional trend: Inflation is on the rise on a global scale.

High inflation was the primary economic issue for countries across the globe for the first nine months of 2008. Overextension, combined with a deepening economic crunch, will finally turn this trend on its head in the final quarter. Across the developed world, demand is dropping, and that cannot help but put a cap on commodity prices.

Regional trend: The global financial crisis' contagion will contribute to a significant decline in the price of oil and defuse much of the "geopolitical heat" in the markets.

Let us close this section with a few words on oil. Stratfor has been saying for some time that the high oil prices of the last three years are not rooted in fundamentals or even in reality in general, so we stopped forecasting any specific prices. In our last quarterly forecast, we said the price of oil would drop (and it did), but we were focused more on causes rooted in geopolitical risk rather than the effects of the financial crisis. At present, much of the speculative froth and fervor that had built up prices has been dying down. In its place is a growing realization that the United States and Europe are in recession, while East Asia is about to slip into recession. With the world's three largest economies using less energy, prices are certain to slide. This realization is dawning only now, when prices have already dropped from their highs by 50 percent. The hype is mostly gone; all that remain are universally bearish fundamentals. The price drop to date is just the beginning -- and several countries, including Venezuela and Russia, stand to lose a lot from a precipitous drop in oil prices.

Former Soviet Union

Regional trend: Russia is re-emerging and will take advantage of the imbalance in U.S. power that has resulted from the wars in Iraq and Afghanistan.

Russia's third quarter was dominated by the war with Georgia, which was Moscow's coming-out party to prove that it could dominate and/or crush its neighbor unless the United States rushed to the smaller country's aid. The Kremlin had been making technical preparations for such a war for years, but timing was an issue. Moscow was forced to act in the third quarter because of the possibility that the United States might be freed from its entanglements with Iran and in Iraq. Since the war in August, the ripple effects of Russia's bold move have been felt throughout the world, but they are most defined in Russia's periphery. As each country re-examines its relations with Russia, Moscow is taking stock of the levers it has carefully placed in its periphery and around the world and considering who it can pressure, or even break.

Regional trend: Following the Russo-Georgian war, each former Soviet state -- and much of the rest of the world -- is redefining its relationship with or perception of Russia. Moscow will next turn its focus to Ukraine, which will become the center of the Kremlin's universe in the fourth quarter.

The center of Russia's focus for the fourth quarter is Ukraine, which Moscow sees as the cornerstone of its ability to reach into Europe and protect itself from Western encroachment. Since the 2004 Orange Revolution, Ukraine has been unstable and chaotic in its attempts to push away from its former master, Russia, and toward the West. Moscow has encouraged Ukraine's instability as a means of preventing the former Soviet state from aligning fully with the West, but now is the time to pull Kiev firmly back into the Russian fold.

Russia will use countless levers to influence Ukraine's inner dynamics, including: the Russian security services' high degree of infiltration in Ukraine; the country's complete dependence on Russian energy; Ukraine's financial and economic turmoil; Russia's control over most of the Ukrainian oligarchs; the interconnection between the two countries' organized crime systems; Russian military forces on Ukraine's soil; and the mere fact that approximately half the Ukrainian population considers itself beholden to Russia.

But the largest opportunity for Moscow will come in the December snap elections, scheduled after the Ukrainian government collapsed (again) in October. Elections in Ukraine are never certain to take place, but the dynamic surrounding possible elections in the country will remain whether or not the polls actually take place. The pro-Western Orange Coalition has already broken up over Kiev's relationship with Russia, and those coalition partners who are leaning back toward Moscow, along with the pro-Russia parties, are in a healthy lead in public opinion polls. Ukraine has never been predictable, but it also has never seen an election or governmental shift while Russia's full focus is on ensuring that Ukraine stays as far away from the West as possible.

A few other former Soviet states are on Moscow's agenda, though they are not as high-priority as Ukraine. Georgia's government is still seeing the fallout from the war, and Georgian President Mikhail Saakashvili's future is unclear. Russia has allowed Saakashvili to remain in office because he is a spent force, but the Kremlin has a line of political forces in place to remove him should he gain strength. Russia and Belarus spent much of the third quarter arguing over energy prices, bank credits, missile defense and Minsk's delay in recognizing the independence of Georgian breakaway regions Abkhazia and South Ossetia. The fourth quarter will be a test for Belarus as it decides whether to bend to Moscow's will or risk reaching out to the West and being crushed by Russia in the process.

Russia is also active in the Baltic states. An upcoming election is likely to leave Lithuania with a government more amenable to Moscow, but it remains to be seen how this new government will fit in with Lithuania's historical allies -- Poland, Estonia and Latvia, which are all vehemently anti-Russian -- and how Moscow can use the new government to divide that allied bloc. Azerbaijan is weighing its future relations with Moscow, since Russia has proven it can cut off the country's energy flow, which in turn cuts off its cash source. Baku will work to balance its desire to maintain good relations with Moscow and its desire to keep Western cash flowing in.

Regional trend: The global financial crisis is ripping through Russia, but it is not crippling the country. Rather, the Kremlin is using the situation to assert more control over regulations, banks, businesses and the oligarchs inside Russia while looking for opportunities abroad.

Market economies do not work in general in a country like Russia. Since the Russo-Georgian war, the Russian stock markets have been on a wild roller-coaster ride, and Russian companies have seen massive foreign investment flight. This has left those companies and their oligarchs looking for funding in their own pockets or from the state. But unlike most countries, Russia is not in danger of collapsing financially, because it sits on massive amounts of foreign currency reserves, built up over the past decade from soaring energy prices.

Instead, the Kremlin is using the unstable financial situation to reassert the primacy of the Russian state by weeding out small- and medium-sized institutions that were never really under government control. The Kremlin is also using the situation to force the oligarchs to pour their own cash -- which they had stored abroad, far from the Kremlin's grasp -- into the system in order to keep the markets stable and the oligarchs' companies afloat.

This proves just how much control Russian Prime Minister Vladimir Putin has over this class of billionaires, and it bodes an end to the oligarchic tradition that ruled Russia during most of the 1990s and well into the following decade. The oligarchs are no longer independent power brokers, but simply another tool -- and a very wealthy one -- for Putin and the Kremlin. The fourth quarter will start revealing who can keep up with the Kremlin's demands and who will fall. A massive realignment inside Russia's business sector is under way, though the Kremlin is orchestrating all of it in order to strengthen and prove its power within the country -- and over those who thought they could keep their cash outside the motherland.

Russia can now also meddle in, prop up, buy or influence financial systems around the world. It is reaching out with its vast amounts of cash to "help" other countries hit hard by the financial meltdown -- though in typical Kremlin style, Moscow is extending aid to states it considers politically valuable. In the past, the Kremlin used oligarchs' cash to do this covertly, but since that cash is needed at home, the government is openly targeting other countries' institutions. Russia is getting involved in the financial situations in Iceland, the United Kingdom, Ukraine, Kazakhstan and Georgia, to name a few. But the Kremlin must balance this desire to take advantage of financial tremors around the world with its need to keep the domestic situation stable and plan for the future of Russia's resurgence, amid concerns that its cash flow could soon dry up as energy prices tumble.

Regional trend: As Russia reasserts itself against the West, it has many levers with which to counter the United States in regions such as the Middle East and Latin America. However, Russia's ability to divide the United States' allies in Europe will give it the most success.

Since the war with Georgia, Russia has shown that it is interested in countering the United States' status as global hegemon by strengthening its relationships throughout the world. Moscow has also proved to Washington that it has levers in place to erode the United States' position in the Middle East (which is Washington's primary focus) and in Latin America (which is in the United States' backyard). But Russia will not push its ability to meddle with Middle Eastern countries like Iran too far; Moscow does not want a strong Tehran in the long run, and Washington could seriously lash back at the Russians. Moscow also knows that its actions in Latin America are mainly symbolic in that the efforts needed for real military, energy, grassroots or political moves would be enormous and would not benefit Russia much. However, this does not mean Moscow's friendship is not incredibly important to those in Latin America looking for their own leverage against Washington.

It is in Europe where Russia's moves against the West will be felt the most. In short, the Europeans are splitting apart and much of it has to do with Russia -- a situation Moscow is trying to magnify. Russia is already using Europe's economic instability to pit the countries against each other. But Moscow is also undermining NATO, a fact that will be highlighted when the alliance meets in December to discuss Russia and the possibility of extending membership action plans to Georgia and Ukraine. Germany has already staunchly come out against this Washington-initiated plan and is also discussing the possibility of a private security agreement with Russia, a major shift toward Berlin's usual role when Europe is split. But Russia also has its customary levers, like energy, to use in Europe; energy deals with Germany, the Czech Republic, Lithuania and Ukraine will still be up in the air in the next quarter.

Middle East

Regional trend: The United States has successfully forced the countries that made al Qaeda possible into the American alliance structure. It will now use that structure to clamp down on those still resisting American power. In doing so, it might inadvertently trigger tensions with Israel.

Regional trend: The Russo-Georgian war interrupted a window of opportunity for the Iranians and the United States to make headway in their negotiations over Iraq. With a U.S. political transition approaching, these negotiations will remain in limbo through the next quarter.

In writing our third-quarter forecast, Stratfor had many reasons to be optimistic about several major trends in the Middle East. We calculated that as the U.S. election season wound down, the United States and Iran would be approaching the endgame in their negotiations over Iraq. After all, Iran's supreme interest in consolidating Shiite control over Iraq, the United States' strategic interest in freeing up its forces from Iraq, and the winding down of violence in Iraq over the past year -- made possible in part by Iran's cooperation in taming its Shiite militant proxies -- laid the foundation for the United States and Iran to reach a rapprochement sooner rather than later.

For our fourth-quarter forecast, however, we are far less optimistic about the United States and Iran coming to any sort of final understanding, at least in the short term. Following the Russo-Georgian war that took place in the third quarter, the United States more urgently wants to end the war in Iraq in order to free up U.S. forces for more pressing concerns in Eurasia and the Pakistan/Afghanistan theater. The Iranians, on the other hand, have all the more reason to stall in talks with Washington. Iran knows that in the face of a resurgent Russia, the United States will worry about Moscow using the Middle East as another theater for challenging the West, namely by providing advanced weapons systems to a country like Iran. With the added leverage of Russian backing, the Iranians could push for a better deal with the Americans.

But while Iran stalls, the United States is losing interest. It appears that Washington does not feel nearly as pressured as it previously did to deal with the Iranians over Iraq, and the political and military reality in Iraq has shifted substantially over the past two years. In October 2006, a month prior to U.S. congressional elections, Iran significantly escalated Shiite militia attacks in Iraq in an attempt to force a U.S. withdrawal, and it could have used its Shiite militant proxies to trigger a civil war. Now, however, these militias either have been fully integrated into the Iraqi security apparatus (as in the case of the Badr Brigade) or have disintegrated to the point where they are no longer an effective force (as in the case of the Mehdi Army). Much of Iran's current ability to wield influence in Iraq comes through its political and economic links as well as from small groups of well-trained special operations units, such as Hezbollah in Iraq.

While the United States still has a strategic interest in reaching some level of understanding with the Iranians over Iraq, it no longer faces an immediate threat of Iran triggering civil war in the country. This gives Washington a lot more leverage in dealing with Iran, as well as more time and space to concentrate on other, more pressing issues.

In the coming quarter, Iran will not be the United States' main focus in Iraq; Washington will be too preoccupied with its own political transition, and the Iranians will need some time to work out their next steps in Iraq with a new U.S. administration. Instead, the United States will be heavily involved in the internal Iraqi political scene, working to undermine Iranian influence in Baghdad by exploiting deep rifts within the Shiite political community and reasserting Sunni political strength in provincial elections, which are to be held before Jan. 31, 2009. The surrounding Arab states, for the most part, will be in lockstep with the United States in pursuing this strategy.

Iran will use its remaining militant proxies to try and influence the results of the upcoming elections, mainly through bribes and assassination attempts against select candidates. Infighting among Shiite parties, particularly in the south, is expected to flare as Iran tries to accuse the United States of destabilizing Iraq -- a move meant to bolster Iraqi opposition to the Status of Forces Agreement (SOFA), which would provide the legal basis for U.S. troop presence beyond December, when a U.N. mandate runs out. With Iraqi politicians holding out for political and security guarantees from the incoming U.S. administration, it will be difficult for the United States to get the SOFA signed by the December deadline. But Washington is still on course to maintain a military presence in Iraq that is large enough to counterbalance Iran for at least the medium term.

While Iran will be looking to boost its leverage in relation to the West this quarter, it is unlikely to find a dependable ally in Moscow. The Russians have signaled in several different ways that they could step up arms deals and covert operations in the Middle East to undermine Western interests. But with the Israelis and the Turks playing defense and Moscow exhibiting more of a cautious attitude in its actions against the United States in this region, we expect Russian activity in the Middle East this quarter to be more talk than action.

Regional trend: Syria has found a role in the tightening Arab-U.S. alliance, and it will take concrete steps toward a peace deal with Israel that will both reassert Syrian influence in Lebanon and defang Hezbollah.

In our previous quarterly forecast, we anticipated rapid progress in Syria-Israel peace negotiations. The talks were moving at a healthy pace in the first part of the quarter, but paused after the Russo-Georgian war as Syria saw the opportunity to boost its negotiating leverage by reaching out to the Russians. Syria will continue to flirt with Moscow, but Israel and Turkey (which is mediating the peace talks) have been holding their own negotiations with the Russians and have so far kept the Russians at bay. Syria is still in many ways committed to these peace talks, but any major progress is unlikely until Israel puts its political house in order this quarter. Israeli political horse-trading is in full swing, and early elections could still be called, but Stratfor's bet is that Kadima leader Tzipi Livni will form a coalition and stave off early elections to prevent a political comeback by the far-right Likud party, allowing for progress later in the quarter on the Israel-Syria talks.

While Israel sorts out these issues, the Syrian regime will move ahead in its plans to reassert its hegemony over Lebanon. Any peace deal with Israel would inevitably include a guarantee of Syrian domination over Lebanon in exchange for the dismantling of Hezbollah's military arm to secure the Israeli northern frontier. Though the peace talks with Israel are currently in flux, the Syrians are wasting no time laying the groundwork for a possible military intervention in Lebanon by instigating attacks through militant proxies. Syria will take its time in implementing this strategy. Attacks on both sides of the Lebanese-Syrian border are likely to escalate, but the Syrians are unlikely to make any overt moves in Lebanon this quarter. Syria will also be on guard for Iranian attempts to destabilize the Syrian regime as Iran's main militant proxy, Hezbollah, gets backed into a corner.

Regional trend: Turkey is emerging as a major regional power and in 2008 will begin to exert influence throughout its periphery -- most notably in northern Iraq.

Our annual forecast on Turkey's regional expansion is on track and was reinforced this past quarter by Russia's actions in Georgia. Turkey is a traditional stakeholder in the Caucasus and does not like the idea of the Russians throwing punches in this region, especially when doing so threatens Turkey's economic standing as the main energy hub for Europe. The Turks, therefore, are in a diplomatic frenzy to reassert their influence in the Caucasus, even going so far as to kick-start the normalization process with longtime foe Armenia. Using adroit diplomacy, Turkey will work aggressively this quarter to block Russian destabilizing actions in the Middle East and hold its ground against Moscow in the Caucasus. Turkey is not looking for a fight with Moscow, but it wants to show that it will not be toothless in the face of further Russian aggression. (Indeed, Turkey is the state with the most tools to counteract Russian expansionism.)

Energy diplomacy will be a big theme this quarter, as the Turks will use their relations with Azerbaijan, Iran and even Armenia to promote themselves as the alternative to Russia in the Caucasus. Both Armenia and Iran will be tempted by the idea of establishing potentially lucrative energy links with Turkey to access the European market, though any such deals would face substantial political obstacles.

In northern Iraq, Turkey will become more aggressive in pursuing Kurdish rebels and implementing an informal buffer zone along the Turkish-Iraqi border. Turkish actions in northern Iraq will serve more than Ankara's internal security interests; Turkey also has deep political interests in keeping Iraqi Kurdistan and the Kirkuk issue in check as negotiations in Baghdad intensify this quarter.

Europe

Regional trend: After exactly 60 years of trying to reshape itself under the aegis of the European Union, Europe in 2008 will return to an earlier geopolitical arrangement: the Concert of Powers.

The decade-long Stratfor forecast that the European Union will slowly evolve from a Pan-Continental government to a glorified free trade zone is on track. Europe has indeed returned to an arrangement more reminiscent of the Concert of Powers, with France and Germany squabbling over leadership, newcomer Poland rising in status as the next leader and the traditional power of the United Kingdom missing in action. This has played out on all levels, both within the European Union and in foreign relations. Russia has seized the opportunity to magnify the cracks in the European Union, while the United States is now locked into alliances with actors that are constantly disagreeing, weakening Washington's ability to rally forces around any particular agenda -- particularly in dealing with the Russians.

Regional trend: As the traditional geopolitical arrangement similar to the Concert of Powers returns, Europe is being wrecked domestically, economically, institutionally and internationally. This trend in the fourth quarter is caused partly by the return of the old relationships, but also by the global financial crisis and a resurgent Russia.

Regional Trend: The financial crisis will continue to shatter Europe economically, as each state fends for itself in the absence of a Pan-EU decision.

Nearly every European country entered the fourth quarter in a recession, and this situation will not change through at least the end of the year. The European Central Bank (ECB) has done a decent job thus far, but it cannot regulate banks in Europe, so each state will have to come up with its own rules -- further undermining the ECB and the European Union. An EU-wide plan is simply impossible, because there is no institution able to enforce such a decision and each state is primarily concerned with itself.

Bailouts have become routine in Europe, but the fourth quarter will be about European governments attempting to prevent banks from actually failing, which could break the entire system. The less economically and financially advanced countries, which happen to be mainly on the eastern side of the Continent, are most at risk. Central and Eastern Europe are highly dependent on foreign banks and capital -- capital that will be called home, mainly to Western Europe, to help stabilize its native banking systems. The countries most vulnerable to economic crashes are Estonia, Latvia, Lithuania, Slovenia, Bulgaria, Hungary, Croatia, Slovakia, Romania and Serbia. France and Italy are also vulnerable but are better able to handle the crisis due to the sheer size of their economies.

In the fourth quarter, many countries will be reassessing the benefits and drawbacks to being part of the European Union, and nations that are considering joining the eurozone will weigh their priorities as well. European countries will also be reassessing their budgets, with many cuts in programs and funding on the table. This could lead to even more political and social volatility in all European countries. These potential cuts and thin wallets are coming in the most financially stressful season for Europe, as energy costs are high due to cold weather and Europe's largest energy supplier, Russia, is preparing to raise energy prices at the end of the year. European leaders are facing many very difficult and dangerous decisions that will shape not only the fourth quarter, but the years to come.

Regional trend: Europe is divided -- politically, economically and regarding security -- on how to respond to a resurging Russia.

The topic of Russia, and particularly how to respond to Moscow after the Russo-Georgian war, is dividing Europe even further. Politically, many Western European countries have been looking for ways to neutralize the Russian threat. Some nations, like the Czech Republic, Poland and the Baltic states (though Lithuania could soon reverse its opinion on Russia), are preparing to confront Moscow, while others are strengthening their ties with Russia in order to avoid becoming casualties of Moscow's next moves.

Economically, Europe is divided because the squeeze it is feeling from the global financial crisis is being compounded by Russian moves in the financial sector. Moscow has moved its cash around in a bid to influence financial institutions in certain strategic countries. Russia is also in negotiations with much of Central and Eastern Europe over energy supplies and prices for the next year, and Moscow has told most countries to prepare for excruciatingly steep price hikes. This puts Moscow in a position of great strength from which to negotiate with the countries that need lower energy prices during the current financial crisis.

The Europeans are also divided over how their security alliances should respond to a resurging Russia. The West (especially Washington) failed to respond meaningfully to the Russo-Georgian war -- a fact that Moscow hopes to use to prove the inherent weakness of the West's security club, NATO. Berlin and Paris have already publicly recognized the weakness and believe that this is not the time to stand up to Russia, as NATO is entrenched in Afghanistan and the United States has the additional burden of Iraq. These two European heavyweights are leading the resistance against Washington over extending NATO membership plans to the former Soviet states of Georgia and Ukraine. Countries like Poland and the Baltics are still behind the U.S. plans, but going into the December summit, NATO members -- especially those in Europe -- are anything but in agreement.

Latin America

Regional trend: Aiming to sow instability in the U.S. backyard, Russia will focus much of its attention on Latin America, where a number of Cold War-era tactics are likely to come into play.

The Russian invasion of Georgia in the third quarter was a wake-up call to the West that Russia was resurging. Shortly after the war, Russia arrived on the scene in Latin America. Having promised at least $1 billion in arms aid to Venezuela and reopened dialogue with Cuba over a return to Cold War-era alliances, Russia clearly intends to direct Washington's attention toward the U.S. southern flank. No longer constrained by a need to promote an international communist ideology to gain a foothold in the region, Russia will focus more on generating instability in Latin America -- a pastime that could lead to a resurgence of Soviet-era militias.

Several Latin American states, including Venezuela, Nicaragua, Bolivia and Ecuador, show promise as Russian allies. States that are vulnerable to Russian maneuvering include, at the very least, Colombia, Peru and Mexico. With economic troubles on the rise across the region, this list could expand, and with a lame-duck administration and no clear Latin America policy to begin with, the U.S. government will be slow to respond this quarter.

Cuba is critical to the question of Russian resurgence not just for its historical relations with Russia, but also for its strategic location at the mouth of the Caribbean. Cuba is trying to both encourage the United States to lift the trade embargo as well as urge Russia to actually put its money where its mouth is in promised investments. Which way Cuba swings will depend on whether the incoming U.S. administration gives any indication that the embargo could be lifted. Otherwise, the Russians will have a greater political opening in Cuba to exploit. For the fourth quarter, however, Cuba will mostly spend its time feeling out Washington's and Moscow's intentions without making any big moves.

Regional trend: The U.S. financial crisis will contribute to a long-term economic downturn in Latin America.

The impact of the global financial crisis on Latin America boils down to two basic factors: the shrinking credit market and falling commodity prices. Latin America is largely dependent on foreign capital for the infrastructural and industrial development that allows the region to produce the primary materials it relies on for income. The relative boom of the past decade rode high on the back of increased industrial production the world over, which created higher demand for Latin American minerals, and on rising food prices, which injected cash into agriculture-dominated economies such as Argentina's.

But as the global economy slows in the wake of the financial crisis, there will be lowered demand for primary materials. This will have a combined effect. For importer states, lower commodity prices, especially on food, are welcome news. But for major commodity producers, such as Venezuela (oil) and Argentina (agriculture), this spells disaster for local economies and government budgets. Though the region is less exposed to the U.S. financial crisis than either Europe or Asia, Latin America is facing an overall economic slowdown. Though widespread financial collapse is unlikely to occur in the fourth quarter, the strains will become apparent.

Regional trend: Brazil is rising as the continental hegemon of South America.

With more oil and natural gas discoveries announced in the past quarter, Brazil is still on track to become a regional superpower in the coming decade, but it will face some challenges in this upcoming quarter. Though blessed with substantial monetary reserves, Brazil faces a slowdown along with the rest of Latin America as the global economy shrinks and access to international credit withers.

Regional trend: Crises are brewing in Latin America's left-wing bloc.

This trend continued unabated in the third quarter, although the only state in which tensions came to a head was Bolivia. The evolution of Bolivian lowland pro-autonomy groups toward a more activist role will be defined next quarter. Though they could be willing to make peace with Bolivian President Evo Morales' government, the odds are not good. In the fourth quarter, Morales will try to push through the enactment of a constitutional referendum that would cement his socialist policies. The opposition will use this opportunity to stage further unrest.

In Argentina, the economy is suffering under President Cristina Fernandez de Kirchner's administration. A lifting of price controls on the edges of the economy could continue, but comprehensive reform is unlikely. Over the next quarter, the agricultural sector will ratchet up pressure on the government to reduce price caps so that it can operate profitably. But falling commodity prices, while helping to contain rising inflation, cut into government income, making it all the more difficult for Buenos Aires to adequately address its economic ailments. The credit crunch has already led Argentina to call off its initial offer to pay back debt to the Paris Club. Other signs of fiscal strain will become evident over the next quarter, bringing Argentina closer to a day when it will once again no longer be able to service its debt or prevent an economic crisis.

Meanwhile, in Venezuela, municipal and state-level elections are slated for Nov. 23. While domestic opposition against Venezuelan President Hugo Chavez is strengthening, the president has already taken action -- by barring more than 200 opposition politicians -- to ensure he makes it through these elections in one piece. Once the elections are over, economic issues will come to the fore. We will likely see a grasping at straws for energy, but this will become increasingly difficult, if not impossible, as credit shrinks and oil prices continue to fall. Although the economy will probably hold for the next quarter, the cracks will be evident. The Russians will remain active in Venezuela, particularly in military cooperation, and signs that Chavez is a conduit for Russian arms transfers to the rest of the region could also come to light.

Regional trend: Mexico is facing a moment of truth in the government's war against the drug cartels.

Mexico's security situation is deteriorating. The third quarter showed an emerging trend of public opinion turning against the violence -- although not necessarily against Mexican President Felipe Calderon. As violence rises, and particularly if civilian casualties become more prevalent, public outcry will increase over the next quarter. For now, the public's discontent is working in the government's favor. But there is a slight possibility that Mexico's citizens will decide the war has failed and start pressuring Calderon. This could erode Mexico's ability to use all its forces against the cartels for fear of backlash. In the past quarter, we did not see any indications that Mexico City felt pressured enough to strike a truce with the cartels to save the country's territorial core, nor any evidence of the cartels striking a truce with each other to place the government on the defensive. But these scenarios are not impossible as the security situation continues spiraling out of control.

Mexico is also particularly vulnerable to Russian covert activity. If the Russians become more active in Mexico, organized criminal activity is likely to increase, though this will be difficult to distinguish from ongoing cartel activity. We will be watching for any signs of an uptick in organizational capacity or tempo of operations in groups like the Popular Revolutionary Army, as the potential exists for Russia to tap into such left-wing organizations to create security problems on the southern U.S. border.

South Asia

Regional trend: The Pakistani army/state will hold together even as confusion and distractions in Islamabad greatly reduce the government's ability (and willingness) to rein in jihadists. Pakistan will be forced to decide whether it is more afraid of NATO forces or of its own militants. It will opt to target the militants, however halfheartedly, rather than make a stand against NATO's incursions into territory that is nominally under Islamabad's writ.

As the jihadist insurgency spread deeper into the Pakistani interior, U.S.-Pakistani relations came to a head in the third quarter, with Pakistani forces taking direct shots at U.S. forces along the Pakistani-Afghan border. But as we expected, the Pakistanis could not go too far in pushing back U.S. forces. Toward the end of the quarter, it became clear that the Pakistani political and military leadership was at least making some attempt to comply with U.S. demands and purge Pakistan's intelligence apparatus, the Inter-Services Intelligence, of jihadist sympathizers while committing more firmly to military operations against al Qaeda and Taliban forces in the tribal areas.

But there is still a lot more work to be done in this theater. With U.S. Gen. David Petraeus now at the helm of Central Command, the evolving U.S. strategy for Pakistan and Afghanistan will likely entail devoting more U.S. forces to Afghanistan and engaging in complex political negotiations with certain Taliban factions, similar to the U.S. policy pursued in Iraq.

For the next quarter, however, little is expected to change on the ground militarily. The United States simply will not have sufficient forces to make a meaningful difference in the Pakistan/Afghanistan theater in the short term. While U.S. forces can escalate cross-border operations into Pakistan, the levels of intrusion will not grow if the United States lacks the forces to back them up. The region also will be entering the winter months, when the fighting on both sides is expected to drop significantly, giving the Taliban and al Qaeda more time to recuperate. Though the United States has announced its intention to continue conducting offensive operations through the winter, the operations will still be limited in scale.

During the winter lull, the bigger focus will be on working toward a negotiated settlement with select factions of the Taliban. Talks involving the Taliban, the Karzai government, the Tajik-dominated opposition, Saudi Arabia, Pakistan, Iran, NATO and the United States will intensify in coming months. This process will be about identifying elements within the Taliban movement that would be willing to do business at a time when the Taliban feels it has the upper hand and thus is not under significant pressure to negotiate. Nonetheless, the mere idea of negotiations taking place will cause existing rifts within the jihadist insurgency to widen. The United States will rely heavily on Saudi Arabia to use its political and financial clout with the Taliban to ensure progress on the negotiating front.

The Pakistanis, on the other hand, will be too consumed with domestic ailments to contribute in any significant way to U.S. efforts in fighting the insurgency. Pakistan's civilian government is caught between fighting anti-Islamabad jihadist forces and working with pro-Islamabad Afghan Taliban. Continued unilateral cross-border U.S. strikes against al Qaeda and its Pashtun allies in Pakistan will further constrain Islamabad's options as domestic dissent continues to rise. Compounding matters is the fact that Pakistan is sliding toward bankruptcy and is now dependent on bailouts and bartering tactics to make it through this quarter without collapsing financially. Pressure from the insurgency and the deteriorating economic situation will further threaten Pakistan's internal stability and raise the potential for a rift to emerge between the civilian government and the army. Overall, Pakistan will institutionally remain in disarray, and fragmentation of the state will worsen in the coming quarter.

Regional trend: India's roller-coaster policies on everything from tax regimes to special economic zones to basic infrastructure are proving that the idea of "Shining India" is a myth and will lead to waning foreign investment.

The global financial crisis that spread in the third quarter only reinforced our forecast that India's attractiveness to foreign investors would significantly wane this year. Though India's banking sector is fairly insulated and not as vulnerable to the financial crisis as those of other Asian countries, it is more than likely to experience a drop in capital inflows and foreign direct investment in the medium to longer term as foreign companies, particularly those based in the United States, are forced to cut back on their overseas operations.

Though India is unlikely to feel a devastating economic impact in the short term, its problems stemming from the financial crisis will be mainly political. Rising inflationary pressures will only add to the opposition's strength in stifling the ruling Congress party at a time when India is also dealing with heightened religious tension and increasingly frequent, albeit low intensity, attacks by more localized Islamist militant cells. On the foreign policy front, India also will be largely politically hamstrung. Securing the civilian nuclear deal with the United States was a huge feat for India's Congress in addressing the country's energy security, and it puts India on a path toward greater strategic cooperation with the global superpower. At the same time, New Delhi cannot politically afford to take any big or overt steps in line with U.S. foreign policy for some time, though it will be closely watching for signs of a complete security and economic meltdown in Pakistan in search of both threats and opportunities.

India also will be keeping its eye on Bangladesh, where national elections are supposed to be held Dec. 18. With the Bangladeshi military tightening its grip over the government, the country's two main rival political leaders have threatened to boycott the polls, raising the potential for the elections to be delayed. Without the participation of these two leaders, there is a high probability of Bangladesh returning to its usual state of political violence and chaos ahead of the polls.

India also has security concerns to its south in Sri Lanka, where the military has made significant advances in its war of attrition against Liberation Tigers of Tamil Eelam rebels in the north. While the military's successes are often exaggerated, it stands a decent chance of overtaking Tiger strongholds in the strategic Jaffna Peninsula to the north. The Tigers will be cornered at that point, but they will not be a vanquished force. The Sri Lankan military has made comparable advances into Tiger-held territory in the past, only to see the Tigers make a significant comeback after several years. As they continue to get beaten in the north, the Tigers will make a stronger attempt to carry out attacks inside Colombo in an attempt to prove to their constituency that they are still viable.

East Asia

Regional trend: The Chinese government postponed any key reforms in 2008 until after the Olympics in August, but as Beijing now begins tackling these issues, it is confronted by a global financial crisis that will convolute all its reform plans.

Thus far, the Olympics have dominated 2008 in China, with Beijing consumed with quashing any disruptions or embarrassments that would cast a shadow over the country during its time in the global spotlight. While Beijing was distracted, issues like economic and social disparity, corruption and rising domestic frustrations festered. Beijing was convinced that as soon as the Olympics were over, it could finally address these issues with full force. But the reforms China makes will not necessarily be the ones it originally planned, as the global economic slowdown will interfere.

Many key debates are raging behind the scenes of China's central government over issues like rural development, informal and state banking, the central bank's short- and long-term lending rates, the yuan's exchange, price controls, the growth of small- to medium-sized businesses, international trade and the export sector, and energy supply and policy. These debates have put a dangerous amount of stress on the Communist Party of China and the country's top leadership.

The largest debate has been over to what degree to redistribute wealth, particularly between the wealthy coastlands and the much poorer internal regions of the country. The divide between China's mostly poor rural masses and its wealthier urban elite has generated considerable tension, causing worry among the nation's leaders about social stability and sustainable economic growth. Attempts at massive renovations and development projects in the interior, meant to boost agriculture's role in the Chinese economy, were supposed to trigger a series of policy actions that would play out through the end of the year.

But the global financial crisis will force Beijing to focus on ensuring internal stability, employment, business operations and the ability to hold onto its own cash, and this means Beijing must turn its attention back to the coast, the country's moneymaker. China is in a conundrum: It needs to redistribute wealth to guarantee internal stability, but it cannot do that if the wealth is not coming in. The financial meltdown's effects in the West are impacting China's export sector and putting at risk China's businesses (which are already seeing thin profit margins) and laborers (who are on the brink of financial ruin and unemployment). China will have to basically run in place; the economy might look like it is growing, but the trickle-down effect will be barely sustainable.

China will respond by promoting growth through cheap credit and big public spending, as it is afraid of unemployment getting out of control. It will be more important for China to use its reserves to contain the internal situation than to contribute funds to other countries, including the United States. China needs all the excess liquidity in its system to go toward appeasing the social groups most likely to be affected negatively by the economic slowdown.

Regional trend: The global financial crisis will also hit East Asia's other two economic powerhouses, Japan and South Korea, along with the smaller Southeast Asian states -- though the major effects will not be seen until the end of the year.

Japan and South Korea are both powerful economies, and both are in dire economic trouble. Japan has massive reserves, but its debt is enormous, its exports are faltering, and now the yen is rising rapidly as the carry trade unwinds, further damaging the export sector. Japan will print money frantically to slow the yen's rise, but will only see moderate success because the crisis is already far too deep. Japan is facing a major recession -- if not the disastrous economic dislocation that awaits it if it proves incapable of reforming its system.

South Korea is also in dire straits. Its economy is hurting because of the won's rapid loss of value as investors withdraw from risky assets. The weakened won will hurt South Korean businesses that are struggling to manage costs while exports fall. Market uncertainty, inflation, poor consumer sentiment and a declining currency will cause South Korean businesses to suffer unless the country is willing to repeatedly dip into its foreign currency reserves to combat the slowdown.

Most of the Asian states have plenty of liquidity due to the nature of their financial systems. The Southeast Asian countries are nervous about their fates but are not thoroughly linked to the outside world, so their economic troubles will have little impact on the rest of the globe. But these nations have not become the hotbed of economic growth they were expected to be; some never recovered from 1997 crisis, while others, like Vietnam, will not see money influxes now. Southeast Asian countries are also highly interlinked through their supply lines and trade, so when one or two economies struggle or slow, the others are hit as well. The credit crunch is causing cash and investment to flow away from them, and their export sectors are flagging. Two states that will be hit hard by this are Singapore and Malaysia, both of which have re-exports making up a large chunk of their exports. This means that even if their strong exports continue, these countries' dependence on others to use them as a subprocessing hub could sting them when other exporters' activities slow. Southeast Asian nations are expected to feel the crush of loss of credit -- just not to the extent of Japan or China. But the ripples of this crisis will likely cause economic slowdowns that could exacerbate social tensions in the region, making for a lot of noise in the fourth quarter.

Africa

Regional trend: In contrast to previous years, there will be little direct involvement from the major outside (or even inside) players in Africa. The one exception will be if Russia has any capacity to meddle in Africa this next quarter. However, Africa is not high on Moscow's list of priorities.

The second- and third-quarter forecasts for Africa predicted that the continent would not see any meaningful direct involvement from the traditional players, whether from the continent or beyond. This situation will continue through the end of the year (though for different reasons than before), with only one possible exception. Most of the big foreign players in Africa -- the United States, France, China, India and Japan -- are completely entangled in the global financial crisis and do not really have the wherewithal to handle any new engagements in Africa.

Moreover, the portfolio investment that Africa recently attracted as a "frontier market" will be constrained as global investors seek to stabilize their investment returns. Startup and junior mining interests will find it difficult to secure financing for mining projects, and while major mining companies will be able to find sufficient financing, slowing demand for commodities will mean that African economies will slow -- or, more to the point, there will be less money for the governments to keep. Interest in Africa's energy and mining sectors will remain high, but cost factors will make investors more selective.

The one possible exception to this trend could be Russia. During the Soviet days, Russia supported liberation movements and governments in Africa (as in Latin America), which it used as proxies against U.S. interests. Thus, Russia already has access to a deep set of networks constructed in Africa during the Cold War. Russia began moving in on Africa during the third quarter, when it began negotiations with the Somalian government on providing military and technical assistance and decided to send a naval vessel to strengthen maritime security off Somalia's piracy-plagued coast. African countries that cooperated with the Soviets during the Cold War did so less out of ideology and more to acquire weaponry, funding and training to fight their own battles. These conflicts and tensions are ongoing in several countries besides Somalia (such Guinea, Mali and Angola) and could help Russia renew both overt and covert relationships in Africa.

Within Africa, the major players are too busy with internal politics to get involved in issues between countries on the continent. Nigeria is still trying to manage the Niger Delta, South Africa is busy laying the groundwork for elections, and in Angola the government is concerned with consolidating its grip on power at home and either co-opting or silencing its opponents.

In Nigeria, the 2007 pact that gave the Ijaw tribe in the Niger Delta the vice presidency and led to a decrease in attacks against the region's energy infrastructure will be tested -- but not overturned -- in the fourth quarter. Northern-backed President Umaru Yaradua will move to consolidate his position in Abuja by naming a new Cabinet and purging his government of ministers appointed by his predecessor, Olusegun Obasanjo. Yaradua's moves will catch the attention of the Ijaw in the south, however, and should they believe they have lost their gains in Abuja -- for instance, if Vice President Goodluck Jonathan loses his influence -- all bets for energy security in the Niger Delta are off.

The wild card is Yaradua's frail health. If it forces him to step down, a struggle over succession will ensue, and the Ijaw will use their key weapon -- militant proxies that launch attacks in the Niger Delta energy sector -- to secure their interests in Abuja. A battle threatening all energy production throughout the Niger Delta would also raise the stakes higher than they were in 2007, demanding a military solution rather than a combination of diplomacy and economic incentives. The carnage that would result from Abuja trying to impose a military solution in the Niger Delta would be extensive.

In South Africa, the transfer of power from former President Thabo Mbeki to African National Congress President Jacob Zuma will accelerate, though elections likely will not be held early. (National elections are due by mid-2009, when Zuma most likely will push to re-establish South Africa's regional influence.) Until then, it is just regular politicking and electioneering in the country, and this will not significantly alter South Africa's policies or its relative quietude on the continent.

Angola faces more immediate concerns, including lingering tensions with the National Union for the Total Independence of Angola (UNITA) political party and rebels in its oil-rich Cabinda province. Angola will try to stamp out these rebels in the fourth quarter, following the ruling party's authoritative victory in recent parliamentary elections. The country must also be prepared to face a hostile regime in the neighboring Democratic Republic of the Congo (DRC). The United States could move to counter a possible Russian resurgence in south-central Africa by supporting the Rwandan-backed insurgency in the DRC, which in turn could move to topple the pro-Angolan government of President Joseph Kabila in Kinshasa. Installing a pro-U.S. government in the DRC could then allow the insurgents to use DRC territory to destabilize the pro-Russian Angolan government. Should the Russian arms dealers come calling, they could enflame such a conflict, embroiling Angola, the DRC and Rwanda.

The International Economic Crisis and Stratfor's Methodology

John Mauldin — Thu, 16 Oct 2008 18:08:48 GMT

Dear Friends:

Exhale for a moment, forget your losses for the time being, and try to appreciate the fact that you're living through the single most important development in global finance since Bretton Woods. This is a "tell the grandkids about it" moment, when governments all around the world have essentially decided in unison that it's time to rewrite the rules, the very framework, in which financial transactions take place. Stock trading, interbank lending, commercial paper, the very concept of private sector ownership are all up in the air right now.

The only thing I can tell you with certainty is that if you try to evaluate your investments using the same metrics you've always relied on - P/E ratios, market share, interest rates, etc. - you're going to be as successful as a football-turned-baseball coach evaluating a pitcher by the number of touchdowns he throws. The rules are changing, gentle reader, changing at least for awhile from market-driven inputs to government-driven inputs. If you try to apply what you know from the "old game" without understanding that you're playing a "new game," the rules might not make sense.

I'm sending you today a piece from my friend George Friedman on how his company Stratfor looks at economics. More precisely, this piece explains how they look at Political Economy. And from here on out, it's political economy that's going to be driving markets. If the old rule was "Never fight the Fed." It's now, "Never fight the Fed. And the Treasury. And the ECB. And the Bank of England. And the Bank of Japan...." You get my point.

George has very kindly arranged for a special offer on a Stratfor Membership for my readers. I strongly encourage you to click here to take advantage of this offer. Now more than ever, you need the kinds of insights that you can't get from traditional finance sources. You need a wider lens, and there's no one better than George and his team at Stratfor at this kind of analysis. I know you'll find them as valuable as I do.

Your Taking-It-All-In Analyst,
John Mauldin

The International Economic Crisis and Stratfor's Methodology

By George Friedman

Stratfor's focus is on geopolitics. That means that it focuses on the behavior of human societies organized into complex, geographically defined systems. In our time, that means that we study nation-states. In order to understand the behavior of nation-states, it is necessary to focus on three major dimensions: economics, war and politics. The nation has to be studied in terms of producing wealth, defending (and stealing) wealth, and the internal and external relations by which humans shape their lives.

Economics, war and politics are not separate spheres. They are a single entity together constituting the reality of the nation-state. There are those who argue that economic life should be left alone, not interfered with by political or military power. We won't engage in that argument. What we know, empirically, is that political and military power constantly impinge on economic life, and vice versa. It is impossible to imagine war without taking into account politics and economics. It is impossible to think of domestic or foreign policy without considering economic and military issues. By the same token, it is also impossible to think about economics without thinking about military and political matters. If it can be made otherwise, then someone will do so and then we will change our opinion. Until then, we cannot think of the free market as a meaningful independent reality. It is always shaped by other factors. Perhaps it should be otherwise. It isn't.

An integrated approach to social reality requires that these distinctions, so important in the organization of a university or a newspaper, be overcome. They were created in order to organize human activities into manageable pieces. Our argument is that in so doing, reality is only apparently made more manageable, and in fact is falsified. The standard approach to these issues creates distinctions that don't exist and complexities that conceal rather than reveal the nature of the problem at hand. A general who tries to wage war without consideration of political ends and economic means is going to fail. An economist who tries to understand and predict the behavior of the economy without a comprehensive understanding of the political and military realities which shape the economy will not do particularly well.

Geopolitics is in one sense also an abstraction, but it has the virtue of not creating artificial distinctions. The price that the geopolitician pays for a comprehensive view of reality is a forced simplification: there is just too much happening to state it comprehensively. Geopolitics is the search for the center of gravity of reality, those overwhelming forces that drive the system in the direction it is going to take. These forces are never solely political, military or economic in nature. Usually, they are in plain sight and are overlooked because, being simple, they appear insufficient. Indeed, they may be insufficient, but others can add the details. Our goal is to lay bare the essentials and identify the general direction in which things are moving.

Take, for example, our recent analysis of the Russo-Georgian war. It derived from this central reality: Russia by the 19th century had achieved the borders essentially held by the Soviet Union. In 1992 it had collapsed to a position in which it had not been since perhaps the 17th century. That condition was untenable. Either Russia would implode or it would reassert itself fairly quickly. By early 2000s, it was our view that it would choose to assert itself. When the United States tried to make an ally of Ukraine, which Russia sees as crucial for its economic, military and political well-being, we became certain that Russia would push back. As the Americans got bogged down in Iraq and Afghanistan, a window of opportunity opened up and the Russians began the process of reassertion.

There are, obviously, endless things left out of this analysis. People of every discipline could rip it apart as being insufficiently sophisticated. In one sense they would be right. By avoiding the complexity of sophistication, we could see the fundamental shape of things -- which was that the Russian collapse, if halted, would have to reverse itself for economic, military and political reasons. There were obviously many details we could not predict and some we didn't know. But we captured the essential geopolitical condition of Russia in order to understand what it had to do. We left it to others to do the important work of mapping the complexity. Our task was to capture the simplicity.

In our analysis of the current financial crisis in the United States -- and the world as a whole -- we have sought the center of gravity of the problem. We approached that simply by asking one question: is what is going on simply another inflection point in the business cycles that have occurred since World War II, or does it represent a systemic failure such as that which happened during the Great Depression? This struck us as the urgent issue.

We noted that in the Great Depression, the U.S. gross domestic product (GDP) contracted by nearly 50 percent over three years. It was an unprecedented calamity. Bearing this in mind, we compared the current situation to other events since World War II to see if there was a framework for measuring it. We found that framework in the Savings and Loan crisis of 1989, when an entire sector of the U.S. financial system collapsed and the federal government intervened -- essentially guaranteeing or purchasing commercial real estate, whose price decline had triggered the crisis. We noted that the total amount allocated by the federal government in that crisis was about 6.5 percent of the GDP (and the amount actually spent, before recouping of costs via sales, was less than 3 percent). We noted also that in the current crisis another sector of the financial system -- the investment banks -- were devastated, and that the federal government intervened, this time at about 5 percent of GDP. Meanwhile, the equity markets had not declined as much as they did in 2000-2001, and as of the second quarter of this year the economy was still growing by more than 2 percent. From this we concluded that the U.S. economy was moving into a recession but that the recession would not break the framework of the postwar economy, although clearly the degree of government intervention will reshape the financial markets.

From the point of view of many Russian experts in 2001, our analysis of the future of Russia was seen as simplistic and naïve. From the standpoint of professional economists and traders in the markets, the same is being said of our current analysis. But just as our critics among Russian experts failed to see the main thrust of Russian history, many economists fail to see the main thrust of what is now happening. The United States is a $14 trillion economy with a potential problem amounting to $1-2 trillion (and probably far less than that). If the government intervenes, it will create inequities and imbalances in the system. But between the size of the economy and the government printing press, the problem will be managed -- particularly because there are underlying assets -- houses -- that can be monetized in the long run. The gridlock in the financial system will undoubtedly create a recession, but there hasn't been one for seven years and it's high time.

One can like or dislike the outcome, and we certainly agree that this will cause long-term dislocations and imbalances. But we also know that America as a nation-state has the resources to manage its way through this crisis if the government intervenes. And that intervention is as hard-wired into the American political-economic-military system as the law of supply and demand.

We do not speak the language of economics. There are numerous economists who can do that. And we certainly don't speak the language of the financial markets. We speak our own language, designed to reveal the elegant essence of the problem rather than its enormous complexity. Certainly, if our analysis is wrong because we failed to identify a crucial problem, then we haven't identified the center of gravity properly. And we will be wrong, which is far worse. But as in February 2000, when we published a piece called "Recession Time?" which forecast the market collapse that happened a few weeks later and the recession that followed it, we will be criticized for not understanding some essential point -- in 2000 it was that we had no understanding of the impact of increased productivity on the business cycle. They were right. We didn't understand it and we were right not to. The complexities of productivity did not trump the obvious, which was that the NASDAQ had reached unsupportable levels and there had been no recession in nine years and that was way too long.

So, too, we are criticized for our failure to understand the spread between T-Bills and LIBOR or myriad other things. But we do understand this: The political reality is that the size of the American economy, deployed by the state, trumps the financial problems created by the fall of the housing markets. It will be ugly and painful for some and there will be a recession, but things are always ugly and painful when there is a recession.

This series is about the economic problem, therefore, but is not written about the economy and certainly not by economists. Their work is valuable but it differs from ours. Rather this is about geopolitics and therefore about the different regions and nation-states of the world. It is a geopolitical analysis subsuming economics, politics and military affairs in a single system. And it is designed to extract the obvious rather than drill into the complexity.

We hope this series has some value to our readers in clarifying the current moment. That is its intention: to highlight the main tendency, not to detail the complexity. Understanding the trees has value, but seeing the forest clearly has value as well.