John Mauldin's Outside the Box : Geopolitics, Recession

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 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.

Second Quarter Forecast 2009: Global Trends

John Mauldin — Thu, 23 Apr 2009 13:31:00 GMT

I've been in this business a long time. Some days it feels like a very long time. But never in all the years that I've been in the financial markets have I felt like business per se has less impact on my investment decisions. Let me explain.

GM shares have gone from being a claim on earnings from car sales to being a call option on whether the US government will extend another lifeline. Banks' capital structures have gone from being the province of Boards of Directors and CFOs to the "expertise" of Congressional committees and appointed regulators. Used to be when I thought about Financial Centers New York and London came to mind. Instead now I have to think about Washington and Brussels.

My friend George Friedman and his team at STRATFOR are where I turn when I need help thinking about these new realities. George's team provides me context and understanding of the environment in which financial developments are going to take place. I may tweak him about his ties, but if you saw George speak at my conference in La Jolla, you know that he's an absolutely compelling speaker. And it's small wonder that his latest book spent those weeks on the New York Times bestseller list too.

Below you'll find STRATFOR's 2Q Forecast. I hope you find it as helpful as I do in formulating my plans. What I can tell you with certainty is that if you're not taking into account the impact of geopolitical events on the markets, it's no different than trading agricultural futures without a weather forecast. George and his team provide their Members - myself included - with forecasts and on-going analysis that's invaluable in understanding the seachange in the global economy. And in exchange for me not teasing him any more, he's offering my readers a special rate on a STRATFOR Membership. Click here to join STRATFOR at this special rate and get access to a full year of the same geopolitical intelligence I use in my strategic planning. You'll be glad you did.

Yours, John Mauldin
Editor, Outside the Box

Second Quarter Forecast 2009: Global Trends

Editor’s note: STRATFOR arranges its primary forecasts — in this case the document below — topically rather than geographically. Thus, the entirety of our South Asia and Global Economy coverage for the quarterly is included in this primary forecast. Those portions of the Middle East and Eurasia forecasts that are not included in this forecast have been appended with the other regional sections.

Executive Summary

STRATFOR’s 2009 annual forecast focused on three broad trends: the global recession, the Russian resurgence and the evolution of the jihadist war.

There are number of indications that the U.S. economy is showing signs of life, but it will be weeks — if not months — before these glimmers may assemble into a firm recovery. At that point, it would be a minimum of an additional three months before a U.S. recovery could foster a global recovery. This means that for the second quarter, STRATFOR is able to take a pass on this part of our forecast. Either this quarter will be the dark before the dawn, or it will be the dark before midnight. Either way, it will be dark. A noticeable recovery will have to wait until the third quarter.

In the first quarter, Russia was convinced that it had the new U.S. president and his administration right where it wanted them: so obsessed with the Afghan war that Russia could demand anything it wanted in exchange for allowing military supplies to enter Afghanistan from the north. Russia miscalculated. It seems the Obama administration puts something above fighting the Afghan war on its priority list: limiting Russia’s resurgence. The second quarter will be Russia’s time to consolidate the advances it has made over the course of the past four years, before the Americans can gain any capacity from their planned Iraqi drawdown. Washington will be looking for ways to bolster allies against Moscow, with a somewhat ambivalent Turkey taking center stage.

Finally there is the jihadist war itself. The U.S. divide-and-conquer strategy has worked reasonably well in Iraq: Some Sunni militants, rather than shooting at U.S. forces, are now being integrated (after a fashion) into the fragile yet strengthening Iraqi federal government. This is allowing the United States to remove some forces from Iraq, and thus to surge some into Afghanistan. The American intent is to rework the divide-and-conquer trick on the Taliban. However, this tactic is not likely to be replicable for a mixture of historical, demographic and geographic reasons. The most likely reason for the plan to not succeed is because in Iraq, the “good” Sunnis the Americans courted were locals — nationalists under pressure from Shiite Iran — while the “bad” Sunnis were foreign Islamists. In Afghanistan, there is no neat factional split within the Taliban. So for the Americans, the next three months will be about trying to force a square peg into a round hole. There will be little if any progress, and the Pakistani government’s lack of enthusiasm for the conflict will allow the region’s militants to expand the scope of the war.

Primary Forecast

Global trend: The Economy

Undoubtedly, there is plenty of bad news — stock market surges tend to be the first major sign that the U.S. economy is healing, but the stock market cannot seem to find its feet, and employment remains well off ideal levels. Yet in the latter half of the first quarter, there were several developments indicating that the credit chokehold that caused the American recession to go global has begun to slacken. The availability of credit is the critical issue when evaluating this recession. Until firms and consumers can reliably borrow, economic growth cannot recover.

There are limited signs that credit is indeed loosening, and that some life is creeping back into the U.S. economy. Recent changes in accounting rules in the United States and Europe should grant banks the confidence they need to resume lending, independent of anything the governments might attempt. The Obama stimulus package — albeit far from perfect for actually stimulating the economy — is beginning to take effect. Retail sales have been surprisingly buoyant and since consumer spending comprises 70 percent of the American economy, this is a critical factor. Even more important is the fact that the stock of inventories has dropped for six consecutive months (September 2008 to February 2009, the latest month for which data is available) in the steepest decline on record. With inventories low, producers will soon be getting orders. That is how economic recoveries begin. There are even flickers of activity in the most moribund U.S. economic sector: housing.

But even if the United States economy is indeed showing signs of life, four caveats must kept in mind.

First, even a robust resumption in U.S. growth will not begin on any specific date. Instead, there will be increasingly bright glimmers of light here and there that will not be fully recognized until six months after the fact. It appears that the second quarter may be a transition quarter for the United States, with the more noticeable growth happening later in the year.

Second, the future of the American automotive industry his shifted from bleak to dark, with General Motors Corp. in particular planning for imminent bankruptcy (and GM is not the worst off of the Detroit Three). The dislocations caused by this industry’s implosion will be felt far and wide and even if they somehow do not delay the recovery, they are certain to have a material impact on how serious the average American views the recession as being.

Third, a resumption in growth in the United States historically does not mean an immediate rebound in either income or employment figures — both tend to be lagging indicators — particularly if the automotive industry breaks apart. Therefore, even if the recession does let up in the second quarter and growth turns nominally positive, that does not mean that most Americans will feel like the situation has improved. Bear in mind that it did not become conventional wisdom that the United States’ 2001 recession — which actually ended in October 2001 — had ended until 2004. Dispelling Americans’ mental gloom required more than two years of strong and sustained growth.

Fourth, while STRATFOR is certain that the U.S. economy will lead the world out of recession — the roughly $10 trillion American consumer market will demand products from, and thus generate growth in, Asia and Europe — STRATFOR is equally certain that there will be a lag of one to three quarters between a U.S. recovery and a global recovery. Most of Asia has suffered export plunges of at least 50 percent, and industrial output is down by a third the world over. Even if the Americans already have eaten through existing inventory, it will take some time for foreign suppliers to spin their industrial bases back up. The global system does not turn on a dime.

This means in the quarter ahead STRATFOR actually gets to opt out of taking a hard stance on this issue. If the United States does not recover, the world will remain mired in recession. If the United States begins to recover, the world will remain mired in recession and will begin pulling out later in the year. Either way, the second quarter is not going to be a comfortable time; it just might be slightly less uncomfortable for the Americans.

Internationally, there will be only one force aside from the U.S. economy to watch: the International Monetary Fund (IMF), which was recapitalized at the April G-20 summit to handle the growing need for bailouts. The IMF’s assistance programs can be split into two parts. First, traditional structural adjustment programs will provide funds to states that have made poor economic decisions. These states then fall under the IMF’s tutelage, and they must make often-wrenching changes to how their systems are run. States tapping this sort of loan program include Ukraine, Hungary, Iceland, Sri Lanka and Pakistan. These states in essence are on a sort of life support while undergoing economic surgery.

The second kind of program — introduced in March — is a bridge loan for states that have been doing a decent job of economic management but are affected by factors related to the recession that lie utterly beyond their control. This second type of program does not require any meaningful changes to a state’s economic management as (in the IMF’s eyes) they have not done anything wrong, and could perhaps be extended to countries like South Korea, Brazil, Mexico and Poland. It is this second sort of program that will have a deeper effect on the system in the short run as it will allow larger states to maintain economic activity independent of the United States, somewhat blunting the effects of the recession without threatening social stability. It is also going to absorb the lion’s share of the IMF’s funding; the first program negotiated under this system — a $40 billion line of credit to Mexico — is two-thirds as large as the combined total of the more traditional loans granted since the crisis began.

Global trend: The Russian resurgence

In STRATFOR’s 2009 annual forecast, we outlined how a dominant issue for the year would be Russia’s effort to force the United States to make a strategic bargain: Russia would grant U.S. forces a northern supply route into Afghanistan in exchange for an expunging of Western influence from the former Soviet space. At a series of summits in the first week of April, the Obama administration broadly rebuffed Russia’s demands, and the two states are sliding quickly into confrontational stances.

From the U.S. point of view, Russia has overreached and has failed to consolidate its position in the key former Soviet spheres it assumed were under its control. From the Russian point of view, the U.S. refusal to accept Russia’s superior position has forced Moscow to redouble its consolidation efforts in order to erode Washington’s confidence and limit Washington’s future options inside the former Soviet sphere.

Russia will make three major consolidation efforts during the next three months. First and most important, Moscow will try to manipulate Ukraine to remove pro-Western elements such as Ukrainian President Viktor Yushchenko from power. Second, Moscow will undermine the Georgian government to destabilize pro-Western elements there. Georgia, unlike Ukraine, is solidly pro-Western, so Russia is satisfied simply to destabilize or neutralize it rather than transform it into something useful to Moscow. The deck is stacked in the Kremlin’s favor in both states due to Russia’s overwhelming energy, intelligence, political, economic and cultural influence, as well as geographic proximity.

But it is the third consolidation attempt where things will get tricky: Armenia.

Turkey and Russia’s spheres of influence overlap in many regions, including the Caucasus. Not only is Russia very active in Georgia, but Turkey — as part of its efforts to relaunch long-dormant geopolitical ambitions — is trying to normalize relations with Armenia. Turkey ended relations with Armenia in 1993 after Armenia began its war with neighboring Azerbaijan over the secessionist Armenian region of Nagorno-Karabakh located inside Azerbaijan — and the Turkish-Azerbaijani relationship has only strengthened (especially against Armenia) since then.

However, the normalization of relations between Turkey and Armenia would open the Caucasus to a flood of Turkish political and economic influence. Until now, Moscow has actually facilitated this process, thinking that a grateful Turkey would not side with Europe and particularly the United States in containing Russian influence. Now that U.S. President Barack Obama has personally forged a partnership with the Turks, the Kremlin is not so sure.

The restoration of ties between Turkey and Armenia was rumored to occur in the first week of April, though now dates for the event range from May to October. Russia has many levers, including energy, which it can use to counter Turkey’s orientation toward the Americans, including Moscow’s power to decide whether its protectorate of Armenia will go forward with any deal with Ankara.

The wild card in talks between Turkey and Armenia is Azerbaijan. Baku — which considers Yerevan its worst enemy — feels that its close ally Turkey has abandoned it and wants to ensure its interests are not overlooked in any deal between Turkey and Armenia. Baku is considering two means of scuttling the talks, both with the intent of severing growing Turkish-Armenian ties: appealing to Russia (the logic being that Turkey does not wish to simply trade energy-rich Azerbaijan for energy-poor Armenia), or directly attacking Armenian-held territory (triggering a war in which Turkey would feel forced to take sides).

Global trend: The U.S.-jihadist war

While STRATFOR maintains that the overall strategic threat posed by the transnational jihadist movement continues to wane, the U.S.-jihadist war, which stretches from Iraq to the Indian subcontinent, remains a dominant theme for 2009.

The United States has no choice but to wrap up the war in Iraq so that it can devote more resources to the war in Afghanistan, but the transition from the Middle East to South Asia will not be easy. A fragile power-sharing deal among the Shiite, Sunni and Kurdish power groups remains intact, and violence levels are still low. Yet, as STRATFOR expected, the United States is facing difficulties ensuring that the Shiite-dominated Iraqi government is integrating into the security apparatus members of the Sunni militia forces that split off from al Qaeda and allied with the United States. Shiite-Sunni tensions will continue to simmer. Al Qaeda in Iraq (AQI), while a much-weakened force, may still appeal to dissident Sunnis — which may allow AQI to regain space and carry out more attacks.

Kurdish-Arab tensions are also likely to escalate over the next several months. Kurdish claims to the oil-rich city of Kirkuk and constant political maneuvering among Sunnis, Kurds and Shia (most notably involving the Iraqi prime minister) could ignite the dispute over Kirkuk’s future for political gain. In addition, political infighting within the Patriotic Union of Kurdistan (PUK) is likely to worsen as PUK leader and Iraqi President Jalal Talabani prepares for his succession.

The United States will try to improve its chances of holding Iraq together internally by laying the groundwork for a more constructive relationship with Iraq’s Persian neighbors. On the surface, the U.S.-Iranian relationship is improving: Obama has made clear his intent to engage Iran; his administration has agreed to direct, multilateral talks with the Iranians on the nuclear issue; and Iran is participating in U.S.-led summits on Afghanistan. But beyond the rhetoric, little has changed between Tehran and Washington. Iran is more likely to ratchet up ambiguity and Western anxiety over its nuclear program than make concessions to Washington. Like AQI, Iran’s influence may have slipped, but it has not evaporated: Iran’s influence with Shiite militants remains strong enough to upset the delicate Sunni-Shiite balance the Americans are counting on holding.

Iran is also unhappy with the developing U.S. strategy in Afghanistan that calls for engaging with “moderate” members of the Taliban — a radical Sunni force that Tehran regards as a strategic threat. Tehran will keep up appearances in the diplomatic sphere but will continue to keep its distance from Washington on any issues of substance in the near term. Iranian presidential elections will be held in June, but regardless of which camp the winner comes from — hard-line, moderate or reformist — Iran’s foreign policy goals and concerns are unlikely to shift significantly.

Meanwhile, Washington will shift its focus to South Asia even though there are evidently many loose ends to tie up in the Middle East. The developing U.S. strategy for this region will focus on bolstering the U.S. forces in Afghanistan, negotiating with moderate Taliban and diversifying supply routes to deny Pakistan some of the leverage it holds in this war. However, this plan suffers from a number of strategic flaws.

The second quarter will be a trying one for U.S. forces in Afghanistan. The initial surge of 21,000 troops into Afghanistan will not be in place until summer’s end. Though European NATO members have contributed additional forces to help secure the country for elections in August, most are temporary commitments and do little to alter the overall U.S. and NATO force structure being directed at a native guerrilla force with superior local knowledge and intelligence. This puts NATO on its heels in combating Taliban and al Qaeda forces, which will use this spring fighting season to shape the battlefield, carrying out operations in the countryside that aim to expand their territorial control and launching complex attacks in urban centers that aim to degrade the confidence of Afghan civilians and security forces.

American attempts to elicit cooperation from Pakistan through aid packages are unlikely to affect Pakistani behavior significantly in the near term. Though Pakistan is threatened by a separate Taliban insurgency at home, it prefers negotiations over force on its side of the border. This gap between U.S. and Pakistani policy in managing the insurgency will become more evident in the coming weeks and months as Pakistan fends off U.S. attempts to overhaul the Pakistani intelligence apparatus and makes agreements that undermine the writ of the Pakistani state in its northwest periphery. Pakistan’s preference to avoid combat will allow Taliban forces to concentrate their attacks on the U.S. and NATO supply routes that originate in the port of Karachi.

The United States had attempted to diversify its supply lines by opening up a northern route that enters Afghanistan through Russian-dominated Central Asia, but talks have frozen as U.S.-Russian relations deteriorate. The United States is now almost completely dependent on Pakistan; the logistical burden is rising with support for the troop surge, and the militants feel emboldened as Pakistan feels it can use a lighter touch in combating them.

India’s concerns will rise as little progress is made in the war.

As STRATFOR forecasted in the 2009 annual, New Delhi has refrained from taking overt military action against Pakistan after the November 2008 Mumbai attacks for fear of destabilizing Pakistan further and giving regional jihadists an excuse to focus their attention on India. Yet the gradual unraveling of command and control within the Pakistani military establishment has enabled many more of Islamabad’s Islamist militant proxies operating in Pakistan and India to team up with transnational jihadists to carry out deadlier and more strategically targeted attacks. Though the timing is uncertain, India is likely to witness another large-scale Islamist militant attack on its soil that will once again escalate cross-border tensions on the subcontinent.

India has thus far stayed on the sidelines of U.S. dealings with Pakistan and Afghanistan. Its involvement is largely limited to two items: first, making clear to Washington that Kashmir is not up for debate as Washington attempts to rehabilitate Pakistan, and second, increasing its presence in Afghanistan, devoting effort to reconstruction projects and perhaps providing covert support to anti-Taliban groups in the north (in part to counter a U.S. strategy to engage “pragmatic” Taliban). Much like the Iranians and the Russians, India has no interest in engaging Taliban forces who share a Pashtun link with the Pakistanis.

India is currently in the midst of a general election that will conclude in mid-May. No party is likely to win a clear majority, and it will be up to the incumbent Congress party and the main opposition Hindu nationalist Bharatiya Janata Party (BJP) to cobble together a ruling coalition of smaller regional parties. STRATFOR will not attempt to predict the outcome of this uncertain election, which will largely be based on the populist votes of India’s lower classes, but should the BJP manage to overcome its setbacks and take the lead, Indian restraint against Pakistan would not be assured in the event of another large-scale militant attack.

Part Two: Second Quarter Forecast 2009: Regional Breakouts

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

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

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

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

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

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

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

Yours,
John Mauldin

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

November 17, 2008 | 1840 GMT

By George Friedman

From Financial Crisis to Cyclical Recession

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

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

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

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

Economic Restructuring vs. Stability

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

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

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

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

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

Recession and the U.S. Auto Industry

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

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

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

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

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

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

The Recession in Context

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

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

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

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

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

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

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

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

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

The 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.