John Mauldin's Outside the Box : Global Economy

The China Files (Special Project): Real Estate

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

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

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

John Mauldin
Editor, Outside the Box

The China Files (Special Project): Real Estate

October 13, 2009 | 1149 GMT

Summary

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

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

Analysis

Origins of the Bubble

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

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

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

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

The Recovery Bubble

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

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

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

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

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

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

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

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

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

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

The Recession in Central Europe, Part 2: Country by Country

John Mauldin — Thu, 06 Aug 2009 20:25:00 GMT

This week I'd like to address the topic of currency. Flip through any business journal and speculation runs deep, though the ups and downs are far from predictable. A year ago everyone who thought they had half a brain and a pile of money comparable to Uncle Scrooge was threatening to transform all of their wealth into the seemingly unstoppable Yuan. Travel agents were pushing dirt-cheap excursions taking advantage of the near-worthless Icelandic krona to suburbanites with inquiries about sunny beaches and palm trees. And this year, if you're looking for a destination that won't hurt your pocket book, one might suggest Central Europe for that romantic second honeymoon.

In the long run though, currency speculation is a serious business that takes patience and an overall understanding of a nation, country or union. IMF reports and debt calculators are a good indicator, but they can be flawed and don't take into account the grand scheme of things. I've said it before and I'll say it again, the bigger picture is the one you want, and nothing prepares you for this kind of commitment than the intelligence you get from my friend George Friedman at STRATFOR. I'm sending you a piece that considers the recession in Central Europe, country by country. I encourage you to read and consider it in your portfolios. Click here to check out STRATFOR as well, as my readers get a special offer.

The Recession in Central Europe, Part 2: Country by Country

August 5, 2009 | 1146 GMT

Summary

No region has been affected by the global financial crisis quite like Central Europe, where a heavy burden of foreign debt, accumulated during the boom years of the 2000s, must be repaid in 2009. Not all Central European states are burdened by the same external debt load, but most face cutting social welfare expenditures as they sign on for relief from the International Monetary Fund and the European Union. Administrations old and new will have a tough time protecting their currencies and stimulating growth at the same time.

Editor's Note: This is part of an ongoing series on the global recession and signs indicating how and when the economic recovery will begin.

Analysis

Related Special Topic Pages

Special Series: The Recession Revisited

Related Links

The Recession in Europe

The Recession in Central Europe, Part 1: Armageddon Averted?

Central Europe is at the epicenter of the global financial crisis. The region became the top destination for foreign capital in 2002, overtaking East Asia; but since September 2008, it has experienced a massive outflow of foreign capital that threatens to crash the region's currencies. The region founded its growth largely on the influx of foreign loans that are now in danger of appreciating in real value as domestic currencies depreciate.

Part 1 of this two-part analysis looked at the problems and policy options faced by Central Europe as a whole; Part 2 examines the economic and political situations unique to each country. For the purposes of this analysis, Central Europe is defined as Bosnia, Bulgaria, Croatia, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania and Serbia. We exclude Austria, Slovakia and Greece because those countries are in the eurozone.

Bosnia

Bosnia's gross domestic product (GDP) is expected to contract by 3 percent in 2009, after nearly 6 percent growth in 2008, with the unemployment rate above 40 percent. A 1.2 billion euro ($1.7 billion) loan from the International Monetary Fund (IMF) will help stabilize the budget, but the austerity measures required by the IMF are sure to increase social tensions. The IMF requires 10 percent cuts in social welfare programs and governmental salaries, and considering that government expenditures in Bosnia total 44 percent of GDP, the IMF cuts will be substantial and have significant social impact. Indeed, the financial crisis already has threatened to reignite old ethnic and political tensions in the country, which has never truly recovered from its brutal 1992-1995 civil war.

Bulgaria

Bulgarian GDP is set to contract by around 6 percent in 2009. This, combined with an expected budget deficit of 2.5 percent of GDP, contributes to some worrisome numbers, although not as dramatic as figures elsewhere in the region.

However, Bulgaria does not have sufficient foreign currency reserves to cover its extremely high external debt coming to maturity in 2009. The problem for Bulgaria is not necessarily foreign currency-denominated lending (household-sector foreign currency-denominated lending is actually quite low), but rather years of high current-account deficits that required trade financing and corporate lending. According to Fitch Ratings, Bulgaria has $26.2 billion of debt coming due in 2009, equal to 64 percent of GDP. Therefore, despite recent assertions by newly elected Prime Minister Boyko Borisov that no IMF loan will be necessary, Sofia may be forced to consider outside funding as the second half of 2009 gets under way. This will put political pressure on the new administration very early on.

Croatia

Croatian GDP is set to plunge by about 5 percent of GDP in 2009, with unemployment expected to reach double digits (10.5 percent) following a rate of 8.4 percent in 2008. This will present new Prime Minister Jadranka Kosor with the unenviable task of picking up the pieces left by her predecessor, Ivo Sanader, who resigned unexpectedly in July.

Most pressing is the need to cut social welfare expenditures, which actually increased more than 10 percent year-on-year in the first quarter of 2009 due to an absolute increase in unemployment benefits. Croatia is also facing considerable private foreign-debt pressures, with the total external debt coming due in 2009 almost twice that of Zagreb's available currency reserves. Also worrisome for Croatia is the high percent of foreign currency-denominated lending, which at 62 percent of total lending is one of the highest percentages in the region.

While Zagreb has not asked the IMF for a loan yet — and the government for the most part is vociferously denying that it needs one — Croatia is on STRATFOR's short list of Central European countries likely to seek one in the second half of 2009. With Sanader's resignation offering a release valve for social angst in the short term, Kosor may have some political room to maneuver in order to implement the IMF's stringent austerity measures.

Czech Republic

Throughout the 2000s, the Czech Republic has been prudent enough to contain external debt, keep inflation low and maintain low interest rates. This has meant that foreign currency lending has not been as popular in the Czech Republic as it has been in other countries in Europe. In fact, lending to Czech households in foreign currency is nonexistent, with consumers perfectly content to borrow cheap koruna instead of euros.

Nonetheless, the Czech Republic will be hit by the economic crisis just as the rest of Central Europe will be hit, with an expected 3.2 percent decline in GDP in 2009. The key issue for the Czech Republic is the return of external demand for its manufactured products, particularly automobiles, which account for 18.96 percent of total Czech industrial output. With 76 percent of its GDP dependent on exports, the Czech Republic is at the mercy of its export markets in Western Europe (particularly Germany, to which it exports more than 30 percent of its goods).

Click image to enlarge

Meanwhile, the imbroglio that is Czech politics continues following the March 24 resignation of Prime Minister Mirek Topolanek, with elections called for October. The Czech Republic has a tendency to produce extremely weak governments that depend on minor parties for a majority in the parliament. Such an arrangement during a recession would severely impair the government from making the difficult decisions that are needed to get the economy back on its feet.

The Baltics (Estonia, Latvia, Lithuania)

Of the three Baltic states, Latvia has thus far suffered the most from the financial crisis. However, in terms of macroeconomic indicators, Estonia is not much different than Latvia. Estonia's gross external debt, most of which is privately held, is 116 percent of GDP, compared to Latvia's 124.6 percent. Furthermore, Estonia and Latvia both have a very high percentage of foreign currency-denominated loans in their loan portfolios (86 percent and 90 percent, respectively). Were Latvia to abandon its currency peg to the euro, Estonia's kroon would likely devalue as well because of investor pressures on the region as a whole.

Meanwhile, unemployment in Latvia is soaring, reaching 17.2 percent in June, compared to 7.5 percent in 2008. With one prime minister ousted in February, the current four-party coalition is looking shaky, especially as it attempts to implement the rigid austerity measures of the IMF.

Lithuania is not doing any better, with a 22.4 percent-of-GDP decline in the second quarter. Lithuania does have less of a reliance on foreign currency lending — 66 percent of total lending is in foreign currency — but it still has enough that a serious currency depreciation caused by a devaluation in Latvia would hurt many consumers and businesses.

The Baltics remain the most volatile region in Central Europe and the most likely flash point for social angst over austerity measures and the effects of the recession. One should not discount the possibility that Lithuania and Estonia could ask for an IMF loan or that further political changes are in store.

Hungary

Hungary is the only country in the region, aside from Poland, with a considerable amount of external public debt (53.2 percent of GDP) — the result of years of overspending in a politically contentious atmosphere between the main right and left wing parties. This is in addition to a considerable level of private debt (39.5 percent), most of which was fueled by foreign currency lending. The IMF and EU 20 billion euro ($28.8 billion) loan has forced Budapest to start cutting into the chronically high budget deficit, but at the cost of reducing social spending that the populace grew used to in the free-spending 2000s.

The ruling Socialists are attempting to hold on to power following the resignation of Prime Minister Ferenc Gyurcsany, with the center-right party Fidesz looking to capitalize on the crisis and come to power in the 2010 parliamentary elections (or earlier if elections could be forced sooner). Much as other countries in the region, Hungary is struggling to protect its currency from depreciation (so as not to appreciate the value of foreign currency loans) and stimulate growth at the same time.

Poland

Despite its high public and private indebtedness, Poland has thus far been remarkably resilient during the crisis. In 2009, Poland has actually experienced positive GDP growth (0.8 percent year-on-year), surpassed only by Cyprus in the European Union, and is expected to have grown (albeit at a slower pace) in the second quarter. The reason for Poland's resilience is the fact that, unlike the other Central European economies, it has a robust internal market with exports accounting for just 40 percent of its GDP (compared to 76 percent of GDP in the neighboring Czech Republic, 80 percent in Hungary, 55 percent in Lithuania and 86 percent in Slovakia). Poland can therefore depend on consumption to spur growth and is not so much at the mercy of demand from neighboring Western Europe for its recovery.

Click image to enlarge

With consumption holding steady, Poland has been able to weather the recession on the back of its $400 billion economy. While high levels of foreign debt are definitely a cause of concern, Poland serves as an instructive example of a Central European country that has not had to depend on Western Europe for both capital and export markets. Two quarters of minimal growth in 2009 at a time when most countries in the region are far worse will also provide Poland relative political stability.

Romania

Romania is another Central European economy that is far too indebted abroad, has relied on foreign currency lending for too much of its domestic credit and is looking at a serious budget deficit. It secured a 20 billion euro ($28.8 billion) IMF standby loan in March, part of which was used to keep the leu stable so as not to allow the real value of foreign loans to appreciate.

Unlike Poland, which is an example of a Central European economy with a robust local market, Romania is the exact opposite. Its trade deficit in 2008 stood at 14 percent of GDP, indicating that not only did it borrow foreign money but also that it used the money mainly to buy foreign products.

Serbia

The Serbian economy is forecast to contract by nearly 5 percent in 2009, with unemployment crossing 20 percent (from around 18 percent in both 2007 and 2008). Because of the crisis, Serbia has been forced to take a 3 billion euro ($4.3 billion) IMF loan and sell a vital part of its infrastructure — state-owned energy company NIS — to Russian energy giant Gazprom at below market value.

The fundamental problem with Serbia is that, because of political instability and tenuous governments that have plagued the post-Slobodan Milosevic era, the country has never been able to cut its expenditures, particularly in public-sector employment. Numerous multiparty coalitions have had to cater to parties looking to advance their interests, while the government essentially raises money through the privatization of state-owned enterprises. Furthermore, the fundamental Central European problem of borrowing abroad to finance expensive Western imports is true of Serbia as well. Foreign currency-denominated loans have made up 68 percent of total loans in 2009, mainly due to the traditional instability (and high inflation) of the dinar.

The U.S.-Russian Summit Turns Routine

John Mauldin — Thu, 09 Jul 2009 16:46:44 GMT

This week saw a 2-day summit between the United States and Russia that looks to be the first in a trend of subtle push and pull that will shape economic agendas for both states. Just as at the height of the Cold War, these two superpowers are jockeying for global attention and prospective untapped markets. But while the communication between the two is at the same volume and frequency as it was back in the days of Kennedy and Khrushchev, the tone has taken on a different level - as Obama flexes his newly appointed muscle and plants a possible seed of discontent between Medvedev and Putin concerning the future of the former USSR.

Hands-down the most important thing in Russia is energy. It's not the headline on CNN these days, but come less than 6 months from now the cold European winters will make natural gas supply lines and shipping an unavoidable talking point. Today's U.S./Russia relationship lays the groundwork for the future of global energy markets.

I'm sending you an article by my friend George Friedman at STRATFOR, a global intelligence firm, discussing what's really going on between the U.S. and Russia - at the summit and in the coming months. If energy markets matter to you - and they do, regardless of how you're invested - then you need to understand this pivotal global relationship. Also, STRATFOR is offering special rates to Outside the Box readers. Click here to read more and be sure to take advantage of these low rates for priceless intelligence to help you in your future financial planning.

John Mauldin
Editor, Outside the Box

The U.S.-Russian Summit Turns Routine

July 7, 2009

By George Friedman

The Fundamental Issues

There are dozens of contentious issues between the United States and Russia, but in our mind three issues are fundamental.

First, there is the question of whether Poland will become a base from which the United States can contain Russian power, or from the Russian point of view, threaten the former Soviet Union. The ballistic missile defense (BMD) system that the United States has slated for Poland does not directly affect that issue, though it symbolizes it. It represents the U.S. use of Polish territory for strategic purposes, and it is something the Russians oppose not so much for the system's direct or specific threat — which is minimal — but for what it symbolizes about the Americans' status in Poland. The Russians hoped to get Obama to follow the policy at the summit that he alluded to during his campaign for the U.S. presidency: namely, removing the BMD program from Poland to reduce tensions with Russia.

Second, there is the question of Iran. This is a strategic matter for the United States, perhaps even more pressing since the recent Iranian election. The United States badly needs to isolate Iran effectively, something impossible without Russian cooperation. Moscow has refused to join Washington on this issue, in part because it is so important to the United States. Given its importance to the Americans, the Russians see Iran as a lever with which they can try to control U.S. actions elsewhere. The Americans do not want to see Russian support, and particularly arms sales, to Iran. Given that, the Russians don't want to close off the possibility of supporting Iran. The United States wanted to see some Russian commitments on Iran at the summit.

And third, there is the question of U.S. relations with former Soviet countries other than Russia, and the expressed U.S. desire to see NATO expand to include Ukraine and Georgia. The Russians insist that any such expansion threatens Russian national security and understandings with previous U.S. administrations. The United States insists that no such understandings exist, that NATO expansion doesn't threaten Russia, and that the expansion will continue. The Russians were hoping the Americans would back off on this issue at the summit.

Of some importance, but not as fundamental as the previous issues, was the question of whether Russia will allow U.S. arms shipments to Afghanistan through Russian territory. This issue became important last winter when Taliban attacks on U.S. supply routes through Pakistan intensified, putting the viability of those routes in question. In recent months the Russians have accepted the transit of nonlethal materiel through Russia, but not arms.

Even before the summit, the Russians made a concession on this point, giving the United States the right to transit military equipment via Russian airspace. This was a significant policy change designed to demonstrate Russia's flexibility. At the same time, the step is not as significant as it appeared. The move cost the Russians little under the circumstances, and is easily revoked. And while the United States might use the route, the route is always subject to Russian pressure, meaning the United States is not going to allow a strategic dependence to develop. Moreover, the U.S. need is not as apparent now as it was a few months ago. And finally, a Talibanized Afghanistan is not in the Russian interest. That Russia did not grant the U.S. request last February merely reveals how bad U.S.-Russian relations were at the time. Conversely, the Russian concession on the issue signals that U.S.-Russian relations have improved. The concession was all the more significant in that it came after Obama praised Medvedev for his openness and criticized Putin as having one foot in the Cold War, clearly an attempt to play the two Russian leaders off each other.

What the Summit Produced

Much more significantly, the United States did not agree to withdraw the BMD system from Poland at the summit. Washington did not say that removal is impossible, but instead delayed that discussion until at least September, when U.S. Secretary of State Hillary Clinton will visit Moscow. A joint review of all of the world's missile capabilities was established at the summit, and this joint review will consider Iranian — and North Korean — missiles. The Polish BMD system will be addressed in that context. In other words, Washington did not concede on the point, but it did not close off discussions. The Russians accordingly did not get what they wanted on the missiles at the summit; they got even less of what they wanted in the broader strategic sense of a neutralized Poland.

The Russians in turn made no visible concessions on Iran. Apart from studying the Iranians' missile systems, the Russians made no pledge to join in sanctions on Iran, nor did they join in any criticism of the current crackdown in Iran. The United States had once offered to trade Polish BMDs for Russian cooperation on Iran, an idea rejected by the Russians since the BMD system in Poland wasn't worth the leverage Moscow has with Iran. Certainly without the Polish BMD withdrawal, there was going to be no movement on Iran.

NATO expansion is where some U.S. concession might have emerged. In his speech on Tuesday, Obama said, "State sovereignty must be a cornerstone of international order. Just as all states should have the right to choose their leaders, states must have the right to borders that are secure, and to their own foreign policies. That is why this principle must apply to all nations – including Georgia and Ukraine. America will never impose a security arrangement on another country. For either country to become a member of NATO, a majority of its people must choose to; they must undertake reforms; and they must be able to contribute to the alliance's mission. And let me be clear: NATO seeks collaboration with Russia, not confrontation."

On the surface, this reiterated the old U.S. position, which was that NATO expansion was between NATO and individual nations of the former Soviet Union, and did not — and should not — concern Moscow. The terms of expanding, reforming and contributing to NATO remained the same. But immediately after the Obama-Putin meeting, Russian sources began claiming that an understanding on NATO expansion was reached, and that the Americans conceded the point. We see some evidence for this in the speech — the U.S. public position almost never has included mention of public support or reforms.

In many ways, however, this is splitting hairs. The French and Germans have long insisted that any NATO expansion should be limited to countries with strong public support for expansion, and which meet certain military thresholds that Georgia and Ukraine clearly do not meet (and could not meet even with a decade of hard work). Since NATO expansion requires unanimous support from all members, Russia was more interested in having the United States freeze its relations with other former Soviet states at their current level. Russian sources indicate that they did indeed get reassurances of such a freeze, but it takes an eager imagination to glean that from Obama's public statement.

Therefore, we come away with the sense that the summit changed little, but that it certainly didn't cause any deterioration, which could have happened. Having a summit that causes no damage is an achievement in itself.

The Kennedy Trap

Perhaps the most important part of the summit was that Obama does not seem to have fallen into the Kennedy trap. Part of the lack of serious resolutions at the summit undoubtedly resulted from Obama's unwillingness to be excessively accommodating to the Russians. With all of the comparisons to the 1961 Kennedy-Khrushchev summit being bruited about, Obama clearly had at least one overriding goal in Moscow: to not be weak. Obama tried to show his skills even before the summit, playing Medvedev and Putin against each other. No matter how obvious and clumsy that might have been, it served a public purpose by making it clear that Obama was not in awe of either of them. Creating processes rather than solutions also was part of that strategy.

It appears, however, that the Russians did fall into the Kennedy trap a bit. The eagerness of Putin's advisers to tout U.S. concession on Ukraine and Georgia after their meeting in spite of scant public evidence of such concessions gives us the sense that Putin wanted to show that he achieved something Medvedev couldn't. There may well be a growing rivalry between Medvedev and Putin, and Obama might well have played off it.

But that is for the gossip columns. The important news from the summit was as follows: First, no one screwed up, and second, U.S.-Russian relations did not get worse — and might actually have improved.

No far-reaching strategic agreements were attained, but strategic improvements in the future were not excluded. Obama played his role without faltering, and there may be some smidgen of tension between the two personalities running Russia. As far as summits go, we have seen far worse and much better. But given the vitriol of past U.S.-Soviet/Russian relations, routine is hardly a negative outcome.

In the meantime, BMD remains under development in Poland, there is no U.S.-Russian agreement on Iran and, as far as we can confirm at present, no major shift in U.S. policy on Ukraine and Georgia has occurred. This summit will not be long remembered, but then Obama did not want the word "disastrous" attached to this summit as it had been to Kennedy's first Soviet summit.

We wish there were more exciting things to report about the summit, but sometimes there simply aren't. And sometimes the routine might turn out significant, but we doubt that in this case. The geopolitical divide between the United States and Russia is as deep as ever, even if some of the sharper edges have been rounded. Ultimately, little progress was made in finding ways to bridge the two countries' divergent interests. And the burning issues — particularly Poland and Iran — continue to burn.

A Tale of Two Depressions

John Mauldin — Mon, 22 Jun 2009 18:49:15 GMT

This week's Outside the box looks at some very interesting research done by two economic historians, Barry Eichengreen of the University of California at Berkeley and Kevin O'Rourke of Trinity College, Dublin They give us comparisons between the Great Depression and today's downturn. They continue to update their data from time to time, the link to their work is at http://www.voxeu.org/index.php?q=node/3421. I have not previously heard of www.voxeu.org, but it is a collection of the work of well regarded international economists that seems quite interesting for those who enjoy readings in the dismal science.

This week's OTB will print long, but it is primarily charts. Please note that I have re-arranged some of the new charts to cut down on space because of some duplications. Word count is not all that much and it reads well. I will be referring to their work in future letters as well. Have a great week!

John Mauldin, Editor
Outside the Box

A Tale of Two Depressions

New findings:

World industrial production continues to track closely the 1930s fall, with no clear signs of ‘green shoots'.
World stock markets have rebounded a bit since March, and world trade has stabilized, but these are still following paths far below the ones they followed in the Great Depression.
There are new charts for individual nations' industrial output. The big-4 EU nations divide north-south; today's German and British industrial output are closely tracking their rate of fall in the 1930s, while Italy and France are doing much worse.
The North Americans (US & Canada) continue to see their industrial output fall approximately in line with what happened in the 1929 crisis, with no clear signs of a turn around.
Japan's industrial output in February was 25 percentage points lower than at the equivalent stage in the Great Depression. There was however a sharp rebound in March.

The parallels between the Great Depression of the 1930s and our current Great Recession have been widely remarked upon. Paul Krugman has compared the fall in US industrial production from its mid-1929 and late-2007 peaks, showing that it has been milder this time. On this basis he refers to the current situation, with characteristic black humour, as only "half a Great Depression." The "Four Bad Bears" graph comparing the Dow in 1929-30 and S&P 500 in 2008-9 has similarly had wide circulation (Short 2009). It shows the US stock market since late 2007 falling just about as fast as in 1929-30.

Comparing the Great Depression to now for the world, not just the US

This and most other commentary contrasting the two episodes compares America then and now. This, however, is a misleading picture. The Great Depression was a global phenomenon. Even if it originated, in some sense, in the US, it was transmitted internationally by trade flows, capital flows and commodity prices. That said, different countries were affected differently. The US is not representative of their experiences.

Our Great Recession is every bit as global, earlier hopes for decoupling in Asia and Europe notwithstanding. Increasingly there is awareness that events have taken an even uglier turn outside the US, with even larger falls in manufacturing production, exports and equity prices.

In fact, when we look globally, as in Figure 1, the decline in industrial production in the last nine months has been at least as severe as in the nine months following the 1929 peak. (All graphs in this column track behaviour after the peaks in world industrial production, which occurred in June 1929 and April 2008.) Here, then, is a first illustration of how the global picture provides a very different and, indeed, more disturbing perspective than the US case considered by Krugman, which as noted earlier shows a smaller decline in manufacturing production now than then.

Updated Figure 1. World Industrial Output, Now vs Then (updated)

Source: Eichengreen and O'Rourke (2009) and IMF.

Similarly, while the fall in US stock market has tracked 1929, global stock markets are falling even faster now than in the Great Depression (Figure 2). Again this is contrary to the impression left by those who, basing their comparison on the US market alone, suggest that the current crash is no more serious than that of 1929-30.

Updated Figure 2. World Stock Markets, Now vs Then (updated)

Another area where we are "surpassing" our forbearers is in destroying trade. World trade is falling much faster now than in 1929-30 (Figure 3). This is highly alarming given the prominence attached in the historical literature to trade destruction as a factor compounding the Great Depression.

Updated Figure 3. The Volume of World Trade, Now vs Then (updated)

Sources: League of Nations Monthly Bulletin of Statistics, http://www.cpb.nl/eng/research/sector2/data/trademonitor.html

It's a Depression alright

To sum up, globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations. Focusing on the US causes one to minimise this alarming fact. The "Great Recession" label may turn out to be too optimistic. This is a Depression-sized event.

That said, we are only one year into the current crisis, whereas after 1929 the world economy continued to shrink for three successive years. What matters now is that policy makers arrest the decline. We therefore turn to the policy response.

Policy responses: Then and now

Figure 4 shows a GDP-weighted average of central bank discount rates for 7 countries. As can be seen, in both crises there was a lag of five or six months before discount rates responded to the passing of the peak, although in the present crisis rates have been cut more rapidly and from a lower level. There is more at work here than simply the difference between George Harrison and Ben Bernanke. The central bank response has differed globally.

Updated Figure 4. Central Bank Discount Rates, Now vs Then (7 country average)

Source: Bernanke and Mihov (2000); Bank of England, ECB, Bank of Japan, St. Louis Fed, National Bank of Poland, Sveriges Riksbank.

Figure 5 shows money supply for a GDP-weighted average of 19 countries accounting for more than half of world GDP in 2004. Clearly, monetary expansion was more rapid in the run-up to the 2008 crisis than during 1925-29, which is a reminder that the stage-setting events were not the same in the two cases. Moreover, the global money supply continued to grow rapidly in 2008, unlike in 1929 when it levelled off and then underwent a catastrophic decline.

Figure 5. Money Supplies, 19 Countries, Now vs Then

Source: Bordo et al. (2001), IMF International Financial Statistics, OECD Monthly Economic Indicators.

Figure 6 is the analogous picture for fiscal policy, in this case for 24 countries. The interwar measure is the fiscal surplus as a percentage of GDP. The current data include the IMF's World Economic Outlook Update forecasts for 2009 and 2010. As can be seen, fiscal deficits expanded after 1929 but only modestly. Clearly, willingness to run deficits today is considerably greater.

Figure 6. Government Budget Surpluses, Now vs Then

Source: Bordo et al. (2001), IMF World Economic Outlook, January 2009.

[They added some country data in their revision that I put here, hence the two figure 5's, but they are labeled as such on the website and I did not change their labellling – JFM]

New Figure 5. Industrial output, four big Europeans, then and now

New Figure 6. Industrial output, four Non-Europeans, then and now.

The facts for Chile, Belgium, Czechoslovakia, Poland and Sweden are displayed below;

New Figure 7: Industrial output, four small Europeans, then and now.

Conclusion

To summarise: the world is currently undergoing an economic shock every bit as big as the Great Depression shock of 1929-30. Looking just at the US leads one to overlook how alarming the current situation is even in comparison with 1929-30.

The good news, of course, is that the policy response is very different. The question now is whether that policy response will work. For the answer, stay tuned for our next column.

Fear for a Lost Decade

John Mauldin — Mon, 15 Jun 2009 19:02:56 GMT

Before we get into this week's Outside the Box, let me give you a few pieces of data that came across my desk this morning, which will help set the stage for the OTB offering.

Fitch (the ratings agency), in a downgrade of yet another 543 mortgage-backed securities of 2005-07 vintage, gives us the following side notes: "The home price declines to date have resulted in negative equity for approximately 50% of the remaining performing borrowers in the 2005-2007 vintages. In addition to continued home price deterioration, unemployment has risen significantly since the third quarter of last year, particularly in California where the unemployment rate has jumped from 7.8% to 11%... The projected losses also reflect an assumption that from the first quarter of 2009, home prices will fall an additional 12.5% nationally and 36% in California, with home prices not exhibiting stability until the second half of 2010. To date, national home prices have declined by 27%. Fitch Rating's revised peak-to-trough expectation is for prices to decline by 36% from the peak price achieved in mid-2006. The additional 9% decline represents a 12.5% decline from today's levels."

So, what does an aging population do that has seen its retirement nest egg in the form of housing and stocks go literally nowhere for 12 years? You go back to work! David Rosenberg, now with Gluskin Sheff, offers us this insight:

"What really struck us in the employment report of a few weeks ago was the fact that the only segment of the population that is gaining jobs is the 55+ age category. This group gained 224,000 net new jobs in May while the rest of the population lost 661,000. In fact, over the last year, those folks 55 and up garnered 630,000 jobs whereas the other age categories collectively lost over six million positions. This is epic." [See chart below.]

"Moreover, the number of 55 year olds and up who have two jobs or more has risen 1.1% in the last year, the only age cohort to have managed to gain any multiple jobs at all. Remarkable. These folks have seen their wealth get destroyed by two bubble-busts less than seven years apart — the Nasdaq nest egg back in 2001 and the 5,000 square foot McMansion in 2007. Both bubbles ended in tears ... and so close together."

With that as backdrop, what are we to make of the prospects for recovery over the next decade? Not much, if we listen to Professor Paul Krugman of Princeton. He suggests that the developed world could be entering a lost decade, just like Japan after their crash. Let me quickly point out that I routinely disagree with Krugman on a large number of issues. And I usually know why I disagree and believe his policy suggestions are wrong.

That being said, one purpose of Outside the Box is to look at ideas and thinkers that we may not always agree with. Krugman certainly qualifies on that front for me. However, it must be admitted that he is a very smart man. Further, his thinking is important, because it somewhat reflects the thinking of that part of the establishment that is in charge of the Fed and the Treasury. And while we are not getting gloomy long-term forecasts from either the Fed or the Treasury, I find it remarkable that Krugman is less sanguine than his peers. And there is much (certainly not all!) within this interview that I find myself in surprising agreement with. This one made me think as I read and reread it.

If he is correct, the rosy recovery assumptions built into the already bloated budget projections are going to be far too optimistic, not just for the US, but throughout Europe as well. Krugman is interviewed very capably by Will Hutton, a veteran writer and economist for the UK Guardian (a bastion of liberal politics). The direct link is http://www.guardian.co.uk/business/2009/jun/14/economics-globalrecession.

Green shoots? Really? I invite you to read and think about what this interview means for the road to recovery. I will take this up more in next Friday's missive. (Note, I did not write a letter last week. There was a new Mauldin grandchild on Friday, and I decided that some things just take precedence.) Have a great week.

John Mauldin, Editor
Outside the Box

Fear for a Lost Decade

As analysts and media hailed the tentative emergence of green shoots last week, Nobel Prize-winning economist Paul Krugman caused international shock with a prediction that the world economy would stagnate just as badly, and for just as long, as Japan's did in the 1990s. In an exclusive interview, he talks to Will Hutton about his anxiety for the future.

Will Hutton: You are warning that what happened to Japan could happen to the whole world. Japan's GDP at the end of this year will be no higher than it was in 1992 -- 17 lost years. You are saying that this is an ongoing risk, certainly for the North Atlantic economy – – maybe the world economy.

Paul Krugman: Yes. It's not that the risk of the Japan syndrome has receded very much. The risk of a full, all-out Great Depression – – utter collapse of everything – – has receded a lot in the past few months. But this first year of crisis has been far worse than anything that happened in Japan during the last decade, so in some sense we already have much worse than anything the Japanese went through. The risk for long stagnation is really high.

WH: So what is the heart of your pessimism? The bust banking system? A critic would say: "Hold on, Paul Krugman. Japan is a special case. It had an overblown export sector that had become too large for an American market it had saturated. The yen was very, very overvalued. And this interacted with a credit crunch and bust banking system. Its policy response was consistently behind the curve. That's not the story of the United States or the United Kingdom."

PK: The thing about Japan, as with all of these cases, is how much people claim to know what happened, without having any evidence. What we do know is that recessions normally end everywhere because the monetary authority cuts interest rates a lot, and that gets things moving. And what we know in Japan was that eventually they cut their interest rates to zero and that wasn't enough. And, so far, although we made the cuts faster than they did and cut them all the way to zero, it isn't enough. We've hit that lower bound the same as they did. Now, everything after that is more or less speculation.

For example, were the problems with the Japanese banks the core problem? There are some stories about credit rationing, but they are not overwhelming. Certainly, when we look at the Japanese recovery, there was not a great surge of business investment. There was primarily a surge of exports. But was fixing the banks central to export growth?

In their case, the problems had a lot to do with demography. That made them a natural capital exporter, from older savers, and also made it harder for them to have enough demand. They also had one hell of a bubble in the 1980s and the wreckage left behind by that bubble – – in their case a highly leveraged corporate sector – – was and is a drag on the economy.

The size of the shock to our systems is going to be much bigger than what happened to Japan in the 1990s. They never had a freefall in their economy – – a period when GDP declined by 3%, 4%. It is by no means clear that the underlying differences in the structure of the situation are significant. What we do know is that the zero bound is real. We know that there are situations in which ordinary monetary policy loses all traction. And we know that we're in one now.

WH: So your point is that the crisis in Japan was about excess debt, excess leverage and lack of demand – – reinforced by the fallout from the asset bubble collapsing. They didn't have credit contraction on anything like our scale, but even so, zero interest rates were just unable to turn the economy around.

PK: That's right, that's right.

WH: But an optimist would say that there are signs all around of the traction that you say doesn't exist is working. The stockmarkets in London and Wall Street – – along with most world markets – – are up a solid 20% to 25%. You've got all these improving business confidence indicators. You've got the first signs of the housing market bottoming in both the UK and the United States. This is what the optimists would tell you.

PK: But all of that points to levelling off, rather than an actual recovery. Britain's looking the best among the major European economies because it's got a PMI [purchasing managers' index, a key measure of economic sentiment] that's just above 50. In other words, Britain actually may have stopped contracting – – that's the most positive thing one can say.

Who knows if the stockmarket makes sense or not? It was pricing in the possibility of an apocalypse a few months ago. That possibility seems to have receded, so it makes sense for the markets to come up, but that's not saying that the economy is going to be great. If you do the comparison not with where they were three months ago, but where they were two years ago, then the markets still seem awfully depressed.

I hope I'm wrong but the question you always have to ask is: where do we think that this recovery's going to come from? It's not an easy story to tell.

WH: In your lectures, you drew attention to the importance of stressed balance sheets holding back consumers and business alike in their likely spending ambitions – – and thus dragging back economic activity. Is this going to be a balance-sheet-constrained recovery?

PK: It's probably true that households have been impoverished a lot by the fall of the housing and stock prices. And that it's likely that households, with all of this debt, are going to have trouble spending. And yes, the North Atlantic economy was supported quite a lot by gigantic housing booms. Here in the UK you have had the house price surge without very much construction. Economists have a well-developed theory about how balance-sheet problems can cause financial and economic crises, but we thought of it in terms of third world countries with foreign-currency debt. We didn't realise that there were lots of other ways in which that can happen.

WH: So, one way to think about it is that self-reinforcing financial crises rooted in overstretched, overborrowed companies and governments in less developed countries – – like those in Argentina and Indonesia, which were amazingly destructive in the 1990s and 2000s, but localised – – are now playing out in the developed world?

PK: There are really two stories. One is the Japan-type story where you run out of room to cut interest rates. And the other is the Indonesia- and Argentina-type story where everything falls apart because of balance-sheet problems.

WH: So in a nutshell your story is ...

PK: The "Nipponisation" of the world economy with a bunch of "Argentinafications" playing a role in the acute crisis. But even after those are over, we have the Nipponisation of the world economy. And that's really something.

WH: What was the heart of the Japanese problem? What was at the heart of their 17 years of going nowhere?

PK: Well, my guess is that it was that the balance-sheet problems took a very long time to resolve. And it is difficult to get enough demand in an economy where you have really very adverse demography ...

WH: So, which countries look closest to being Nipponised – – combining balance-sheet problems and ageing populations?

PK: Well, the US doesn't have the same combination. But in Europe, Germany and Italy look comparable. France is better and Europe as a whole is considerably better.

WH: Germany matches Japan to an uncanny degree. You talk about the Nipponisation of the world economy: I'm not so sure. But I would talk about the Nipponisation of Europe via a German economy at its centre in the grip of the same problem – – and that starts to be a global problem.

PK: Germany has huge inadequacy of domestic demand. Their economic recovery in the first seven years of this decade rested on the emergence of gigantic current account surplus.

How is it possible that Germany, which did not have a house price bubble, is having a steeper GDP fall than anyone else in the major economies?

The answer is that they depended upon exporting to the bubble regions of Europe, so they actually got side-swiped by the loss of those exports worse than the bubble regions themselves got hit.

It's Germany on a global scale that is the concern. We worry about the drag on world demand from the global savings coming out of east Asia and the Middle East, but within Europe there's a European savings glut which is coming out of Germany. And it's much bigger relative to the size of the economy.

WH: And on top there is an unique and unaddressed huge potential banking crisis. The Germans pride themselves on their three-legged banking system, but it is incredibly interlinked. The IMF warns that Germany could have to take at least $500bn of writedowns, which its banks have not begun to recognise. German banks hold a trillion dollars – – maybe more – – of maturing collateralised debt obligations that can only be refinanced by crystallising the losses. We've had RBS and you've had Citigroup. Germany's GDP will fall 6% this year – – before the banking crisis has hit it.

PK: Yeah, that's the financial view. Its important to keep track of the financial state of the banks. But one always has to keep track of the real side of the economy, too. It is a hypothesis that the problem is essentially financial. But it is by no means a hypothesis that we know is true.

WH: So even after what we've gone through, you say it's just a hypothesis that the cause of the crisis is financial?

PK: That the cause is primarily financial. Certainly, Lehman and all of that alerted us all. And it did trigger an immediate drop in demand. But the housing bust was going to happen regardless.

The fall in business investment is at least to a large degree a response to excess capacity, which is the result of falling consumer demand and the housing bust. So we don't know.

WH: I think we know more than that. The links between bank capital, loan losses, credit availability and economic activity and asset prices have never been clearer. That was why there was a threat of Depression.

PK: Clearly, re-establishing stability in the financial markets is a necessary condition for recovery. But we're not sure it's sufficient.

WH: That's very scary.

PK: Well, that is part of the reason why I am so depressed.

WH: In one of your lecture charts you seemed to be suggesting that we're 12 months into what you think could be a 36-month period of downturn, albeit at a slower rate.

PK: Easily.

WH: It's quite shocking that you think it will be that severe.

PK: If we measure the 2001 US recession by when the labour market finally started to turn around, it was a 30-month recession. It was really 30 months in before you started to see the unemployment rate come down.

WH: In Britain, there is now a new consensus forming that the government's economic forecasts, which were roundly mocked at the time of the April budget for being wildly optimistic, could be right – – that is, growth will start to resume in 2010, albeit at a very low rate.

PK: Well, the UK has achieved a lot of monetary traction in the way that no one else has through the depreciation of the pound. In effect, you've carried out a successful beggar-my-neighbour devaluation.

WH: So, the United Kingdom might actually get through this in reasonably good shape?

PK: Yeah. That's why I've been watching with an outsider's slight puzzlement, your bizarre political circus.

WH: Darling and Brown deserve more credit than they're given?

PK: If the government can hold off having an election until next year, Labour might well be able to run as "we're the people who brought Britain out of the slump".

WH: So your advice to the Labour Party is: hold steady.

PK: Probably.

WH: Probably?

PK: I don't know enough about the other aspects of politics, but I would guess that the option value is quite high that the economy might actually have turned a corner. That's unique. That's a uniquely British thing. None of the other G7 countries has anything like that.

WH: And that's a combination of our big beggar-our-neighbour devaluation, aggressive monetary policy, successfully recapitalising our banks and our fiscal policy.

PK: There hasn't been very much discretionary fiscal expansion when all's said and done.

WH: Well, there was a £20bn temporary cut in VAT.

PK: Yeah.

WH: Which is non-trivial.

PK: Non-trivial. But not much [other spending], as I understand.

WH: Well, there was bringing forward £3-4bn of capital spending. Perhaps together in a full year the stimulus was 1.5% GDP. Maybe 2% at the outside.

PK: Monetary policy has been more aggressive – – though maybe less than the Fed – – and the depreciation of the pound is a nice thing from a UK point of view.

WH: So you remain committed to the key role of fiscal policy?

PK: Yeah. Fiscal policies are best; certainly something to do to mitigate recession. People say that the Japanese fiscal policy on all that infrastructure was wasted. But it did help sustain the economy and avoid a collapse. Fiscal policy can certainly do that: it gives the credit sector time to rebuild its balance sheets. There's every reason to be expansive around the fiscal side now because even if you're not sure that it provides a long-term solution, avoiding catastrophe is a big thing to do.

WH: If you believe that, is Obama doing enough on fiscal policy?

PK: Well we have a stimulus which is a little over 5% of one year's GDP but some of it is not real – something that was going to happen anyway and not very stimulative. So it's really about 4% of GDP of genuine stimulus, but spread over two and a half years. So, it's actually quite a lot less than what I was arguing for.

WH: So, will it be sufficient?

PK: Well, sufficient to actually restore full employment would probably have to be 5% or more. More than we have would certainly be a good thing. It actually might happen. You know, the buzz I'm getting is that a second-round stimulus might well come on the agenda.

WH: Really? When you say "the buzz you're getting", have you been asked?

PK: Well, it's what you hear from people who talk to people who talk to people.

WH: Who would argue for that? Would it be Larry Summers [director of the US National Economic Council]?

PK: I think Larry. I'm not sure Tim Geithner [US treasury secretary] would be opposed to it. Nor would Chrissie [Christine Romer, director of the Council of Economic Advisers] I'm sure they would be making similar judgements. It is actually a little spooky.

WH: They're all people you know pretty well, who look at the world the same way, use the same tools and framework ...

PK: Yeah. They may be sitting where they are, having some differences. Larry's always more conventional than I am. Sometimes rightly. Sometimes wrongly. But they do operate in the same framework.

WH: How seriously do you take the argument that the growth of public debt on this scale will crowd out the spontaneous amount of growth of corporate and private debt? Is this already happening with the rise in long-term interest rates in the US?

PK: The thing about long-term interest rates is that they are a weighted average of future expected short-term interest rates. Movements in long-term rates are mostly about what people think the short rates are going to be. Look, real rates are barely up at all. What seems to have moved up is the expected rate of inflation, which is still below the Fed target. So it's more like what the markets are doing is reducing their discounting of deflationary catastrophe. WH: how do you see the politics working out in the States and in the UK now? Your praise of Gordon Brown after the banks in October were recapitalised was front-page news. Are you still as well disposed?

PK: I still think his economic policies have been pretty good. They really kind of lost their nerve on fiscal policy, but I do understand it's harder to do it here. I think the UK economy looks the best in Europe at the moment. I have no position on all of the crazy stuff. But I think the policies are intelligent. The fact of the matter is that Britain did manage to stabilise the banking situation. I'm not ecstatic, but I'm not sure I know what I could have done better.

WH: So where are you on the debate about various shape recoveries? V-shaped? L-shaped ? A W-shaped recovery?

PK: There is a possibility that we get some perk-up as the stimulus dollars start to flow and an almost mechanical bounceback in industrial production as inventories are built up. But then we slide down again. The idea that we sort of bounce along the bottom is all too easy to imagine.

WH: Is it just a story about the right dose of fiscal policy? What structural change would you advocate in the economy, to support recovery?

PK: Financial regulation. Rein in that monster. The huge increase in general private-sector leverage is at the core of how we got so vulnerable. We went for 50 years after the Great Depression without any major financial crises, and that, I think, was because we had a financial sector that didn't let people get as deeply into debt as they have now.

WH: So rein in the financial monster and give a fiscal stimulus. So you would leave the American way of doing capitalism untouched?

PK: I'm not that cosmic in this stuff. But it is true that Gordon Gekko [the anti-hero of Oliver Stone's film Wall Street, motto: Greed is Good] went hand in hand with the wave of financialisation. Corporations got more brutal and fiercer.

WH: But it is all connected. Without the leverage, there would have been no Gordon Gekkos. And leverage meant that predator companies had the firepower to launch contested hostile takeovers. The only way to fend off attack, or to make the sums work after an attack, was for companies to be more brutal and fierce – often breaking the promises to staff and suppliers that kept commitment and trust.

PK: All of that is true. I have a more mundane view about what we do. I just want a stronger welfare state and a little bit more social democracy. And some restoration of the labour movement as a counterweight.

I'm not sure – maybe I'm just not thinking about it deeply enough. I guess I've got the same attitude Keynes had, which was he was looking for almost technical fixes. You're looking for ways to fix the parts that have gone wrong rather than replace the whole thing.

You know the human cost of this crisis is vastly worse in America than it is on this side of the Atlantic. So this is a good time to push for a better US social safety net too.

WH: And lastly – you've been critical about Obama. Your view now?

PK: I'm increasingly happy with him. I was unhappy; I think they could have gotten a bigger stimulus coming out the gate. But they've become more forceful. I would have been more aggressive on the banks; we'll see if we need to re-fight that battle later on.

Healthcare is looking really good. I'm getting increasingly optimistic on healthcare reform. Climate change looks like it's going to happen. So my odds that this will in fact be the kind of New Deal I was hoping for are rising. I had my scepticism, but he is smart. He's impressive. And it is such a relief to have somebody whom you can respect in the White House.

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.

The Obama Administration and the Former Soviet Union

John Mauldin — Thu, 26 Mar 2009 15:09:23 GMT

Dear Friends:

Who's afraid of the Russian bear? As Russia makes a grab for power and influence, the rest of the world watches to see how the United States and her still-new president will react. As an investor, it's important that you're aware of global politics, as the ramifications reach beyond diplomatic relations and straight into the markets.

I've included a piece from my friend George Friedman's company, STRATFOR, on The Obama Administration and the Former Soviet Union. It's the seventh in a series that explores how key countries have interacted with the United States in the past, and how their relationships with Washington will likely be defined during the administration of U.S. President Barack Obama. It's a must-read for informed investors.

George has very kindly arranged for a special offer on a STRATFOR Membership just for my readers. I strongly encourage you to take advantage of this offer. Now more than ever, you need a wide lens on the world, as politics shapes the economy. There's no one better than George and his team at Stratfor at telling you what you need to know and why. I know you'll find them as valuable as I do.

Yours,
John Mauldin, Editor
Outside the Box

Part 7: The Obama Administration and the Former Soviet Union

Editor's Note: This is the seventh piece in a series that explores how key countries in various regions have interacted with the United States in the past, and how their relationships with Washington will likely be defined during the administration of U.S. President Barack Obama.

U.S. President Barack Obama's administration seems to be largely focused on South Asia and the Middle East. Yet one of Washington's biggest challenges will come from its old foe: Russia. Obama's team must make some major decisions regarding Russia and American influence in Eurasia — decisions that will affect not only U.S.-Russian relations but also future dynamics in Europe, the former Soviet Union and many other regions.

Russia's Geographic Position

In a nutshell, Russia is a large, untenable landmass that not only is difficult to hold together but also sees itself surrounded by enemies and other great (or potentially great) powers. The country's core — where most of its population and commerce are concentrated — actually consists of only the Moscow-St. Petersburg corridor and the surrounding European Russian regions up to the Ural Mountains. The only geographic barrier separating this core from both Europe and the Middle East is distance. The core is also disconnected from Russia's wealth of resources, which lie beyond the Ural Mountains in Siberia — making the use of Russian resources very difficult and pricey, given the costs of transport and of operating in Siberia's marshlands and frozen tundra.

Russia — the largest country in terms of landmass — has difficulty being a land power because of its sheer size. Its land and sea borders are impossible to defend effectively, leaving the country very vulnerable to invasion. Because Russia is surrounded by countless countries and superpowers, it is constantly concerned about security. Its main focus, of course, is protecting its core; its south and east are its secondary focus. In order to fully protect itself, Russia must have a buffer zone surrounding it almost entirely, keeping other powers and threats at bay. This means Russia must conquer (or at least influence) a ring of states surrounding European Russia, the Caucasus and non-European Russia. This imperative led to the organization of the Soviet Union and its Warsaw Pact bloc, and it is now driving Russia to reassert control over the former Soviet states.

Russia wants to be a world power, but it must protect itself before extending its reach beyond its immediate sphere of influence. And since the collapse of the Soviet Union, Russia has lost a lot of ground, with Western powers (particularly NATO and the European Union) expanding into its realm. Therefore, Russia faces the task of reasserting control over its former Soviet states while pushing Western influence out of those states.

The Bush Administration and Russia

At the beginning of the Bush administration, it seemed as if a new era of U.S.-Russian relations was dawning. When U.S. President George W. Bush met with Russian President Vladimir Putin, Bush said he "looked the man in the eye" and "was able to get a sense of his soul." Putin (now Russian prime minister) was the first head of state to call Bush after the 9/11 attacks in the United States, and he was quick to offer Russia's support.

But there was an inherent problem with this new friendship: Neither country truly trusted the other, no matter the rhetoric. Russia had too much work to do in order to secure its strength and its future, and the United States never wanted to see a strong Russia again. At the time, Russia was a weak, fractured and crumbling state that needed time to consolidate internally. Furthermore, once it was stronger (which would take years), Russia needed the United States to be preoccupied enough to allow Moscow to resurge onto the international scene. This opportunity would arise when the United States became too bogged down with its wars in Iraq and Afghanistan to prevent Russia from pushing back against Western influence in its border regions.

But while the Bush administration was focused on its wars, it did not allow Russia free rein in Eurasia. Bush pledged to those states in Russia's sphere — especially Poland, Ukraine and Georgia — that the United States would protect them from their former Soviet master. Under the Bush administration, Washington did much to secure these states and solidify Western influence there, but there are four moves in particular that stand out in Moscow's mind:

The Bush administration started its strategic moves into the former Soviet sphere by placing military bases in Central Asia in 2001. The bases were meant to support the U.S. effort in Afghanistan, but they also served to infiltrate a territory where the West had not had much influence. Involved in one war and about to begin another, the United States was not thinking foremost about countering a resurgent Russia. But the war in Afghanistan gave Washington an excuse to achieve its long-term goal of capping Russia's influence in Central Asia, where Russia had long been the sole power (although the West and China had dabbled in the region). Now, the United States was setting up permanent ties in the region (and military ones at that).
Next, starting in 2002, Washington entered negotiations with many Central and Eastern European states about placing ballistic missile defense (BMD) systems on their soil. Washington's rationale was that they would protect against a strike from Iran. The move would place U.S. military installations in Central Europe, essentially moving the Warsaw Pact line from Germany eastward.
In 2004, the United States ushered the three former Soviet Baltic states — Lithuania, Latvia and Estonia — into NATO. This put NATO on Russia's border and a stone's throw from St. Petersburg — a nightmare for Moscow.
The United States then demonstrated its commitment to Georgia and Ukraine after the two former Soviet states had their pro-Western revolutions (the 2003 Georgian Rose Revolution and the 2004 Ukrainian Orange Revolution). It did this by pushing for the two states to be quickly put on the path toward membership in Western organizations like NATO. The United States fiercely maintained this push despite the fact that other NATO members did not want to face Russia's ire should they agree to accept the two states as members. At present, the debate over further NATO expansion is heavily contested among its members, who allowed the Baltics to come in while Russia was still passive and weak but have had second thoughts about Georgia and Ukraine since Russia has become stronger and more assertive.

While Russia perceived them as genuine threats, these four moves actually helped Russia counter the United States. There was no question about who was behind them or whether Washington had NATO's unanimous support. Moscow knew the moves were all led by Washington, which had discounted much of NATO's concern over riling a resurgent Russia. Moscow also realized the power of fracturing the trans-Atlantic alliance into three main parts, each with its own strategic interests — the United States, Western Europe and Central/Eastern Europe. This awareness also helped Russia fracture the European Union.

From the Kremlin's point of view, the Bush administration betrayed it by heralding American-Russian friendship while making the first moves to undermine a Russian resurgence. Bush drew many lines in the sand and agitated Russia almost to the point of igniting a new Cold War — at least in Moscow's view, though it certainly contributed to the tensions by reasserting itself on the international stage. Russia understood what the Bush administration was attempting to achieve — a permanent break in Russia's influence abroad so that it could never call itself a world power again. Moscow also understood that the United States was using an old Cold War handbook to find Russia's pressure points.

Today, with the Obama administration in place, Moscow wonders if priorities have truly changed in Washington and, if they have, how it can use this transition to regain control in its near abroad and fully achieve its geopolitical goals.

Russia's Goals

Though Russia has many things it would love to demand of the new Obama administration, there are four key areas of concern: NATO's expansion and influence in former Soviet states, renegotiating the Strategic Arms Reduction Treaty (START), U.S. BMD in Europe and the U.S. presence in Central Asia. The first two issues are the most critical for Russia, which believes it must preserve its buffers and maintain nuclear parity with the United States if it intends to survive as a nation-state.

Beginning in 1999, when it accepted Poland, the Czech Republic and Hungary as new members, NATO expanded into former Warsaw Pact states. These particular states were not exactly pro-Russian and were looking for heavyweight protection against Russia. It was a NATO expansion in 2004 — when Slovenia, Slovakia, Bulgaria, Romania and the former Soviet states of Latvia, Lithuania and Estonia joined the alliance — that shook Moscow to its core.

Today, the even more critical former Soviet states of Ukraine and Georgia are on the path toward NATO membership. If either of these states actually became part of the alliance, NATO would be positioned to undermine Russia's fundamental ability to defend itself and would be able to strike at the country's core. Moscow is looking for a firm agreement from Washington that it will not expand to Ukraine or Georgia — as well as an understanding that, although the Baltic states are members of NATO, Russia still wields more influence in these three small, difficult-to-defend Eastern European countries.

One state that is not yet on NATO's agenda but may be at some point is Finland. This state has long maintained neutrality to avoid having to choose sides against Russia, its largest trading partner and with whom it shares its longest border. Finland's Scandinavian neighbor, Sweden, is considering joining NATO and, if it does, Finland could follow suit. Although Russia does not view Finland as a potential NATO threat, Moscow could move quickly to block its membership in the alliance by leveraging the many tools at its disposal (trade, energy, security) if it ever looked like it might become one.

The 1991 START treaty was a Cold War-era arms reduction treaty that was highly specific and contained rigorous declaration, inspection and verification mechanisms. Since the collapse of the Soviet Union, Washington has become disillusioned with this sort of arms agreement, concerned as it is about being locked into bilateral arrangements with one country while another — China, say — starts ramping up its nuclear arsenal. But this does not mean that the transparency of the START framework does not have value, and both the Kremlin and the White House are interested in further reductions (even beyond those called for by 2012 in the 2003 Strategic Offensive Reductions Treaty).
Russia considers arms control of central importance. With a decaying arsenal, the Kremlin relies on treaties like START to lock the Pentagon into a bilateral strategic balance. Russia simply does not have the resources (money or technical skills) to compete in another arms race. For Russia, a renegotiation of START, which expires at the end of 2009, is all about long-term survival; nuclear balance has come to play an increasingly central role in ensuring Russian sovereignty and territorial integrity.

The other two issues on Russia's agenda — U.S. BMD efforts in Europe and U.S. meddling in Central Asia — are not as critical as the first two, but they are being packaged into some sort of grand agreement in negotiations now under way between Moscow and Washington. For Russia, the BMD installations slated for Poland and the Czech Republic are more about the precedent they set for U.S. military troops on the ground in former Warsaw Pact territory than about the strategic nuclear balance.

Russia is deeply concerned about the long-term impact of BMD on the Russian nuclear deterrent, but the Polish installation with 10 interceptors would have little effect on Russian intercontinental ballistic missiles directed at the United States (which would travel over the Arctic). Nevertheless, Poland is a country with which Russia has legitimate concerns, and the BMD issue is one in which Moscow can easily appear to be the aggrieved party (it was Washington, after all, that withdrew from the 1972 Anti-Ballistic Missile Treaty). But the issue is symptomatic rather than central to the Kremlin's larger concerns.

Then there is Central Asia, where Russia wants to remove U.S. influence from its southern region. The United States no longer has a strong hold inside any Central Asian state, though it does have a base in Kyrgyzstan (as of this writing) and is currently using most of the Central Asian states as transport routes into Afghanistan — with Russia's permission. But Moscow wants it understood that Central Asia is its turf and that the United States is there with Russia's permission and can be ejected at any time. Central Asia is a tougher region for the Americans to project into, but it is becoming more important to the United States as the Obama administration reconsiders its strategy in South Asia.

Russia's Expectations and Concerns

Russia is viewing this new American administration with the same reservations it had when it viewed the old one. Moscow simply feels it was burned by Bush, and the Obama administration has come in at a time when the United States could use Russia's help. With Pakistan increasingly unreliable, the United States needs other supply routes into Afghanistan, and going through Russia and its former Soviet turf in Central Asia is the best alternative. At the same time, Russia has supported Iran in helping it develop its nuclear facilities and providing air-defense missile systems — in effect, giving Iran just the tools it needs to bargain with the United States and making Iran itself a bargaining chip for Russia to use for its own needs.

Of course, asking Russia for either concession would come with a price. It is Russia's time to place its goals on the table and ask for real actions by the new American administration in reversing or at least freezing certain Bush policies. In return, Russia would be more than happy to help the United States with its war in Afghanistan and cease supporting Iran, as long as such tactics would help Russia meet its own geopolitical objectives while keeping the United States at least partially distracted.

The Obama administration started to make overtures to Russia even before taking office, sending envoys led by former Secretary of State Henry Kissinger to Moscow for negotiations. Obama, Vice President Joe Biden and Secretary of State Hillary Clinton have said they are open to renegotiating START and possibly freezing the BMD plan, and they have already relayed to Ukraine and Georgia that NATO membership will most likely not happen. In return, Russia has allowed small shipments of supplies to start rolling from Latvia through Russia, Kazakhstan and Uzbekistan into Afghanistan, and it is helping negotiate airspace rights for the United States over Tajikistan and Turkmenistan.

But for any further commitment, Moscow wants tangible assurances from Washington that its major concerns — particularly NATO expansion and START renegotiation — will be addressed. The Kremlin does not trust the new White House and understands it can be betrayed at any moment, especially as the United States becomes less bogged down in Iraq. Russia is also concerned about how much the United States is willing to give up for its war in Afghanistan. Russia knows that, at the moment, the war in Afghanistan is a top priority for the Obama administration, but Moscow also knows that the U.S. attention span is short and that Russia's window of opportunity is correspondingly narrow.

Current negotiations will come to a head in April, when Obama sits down for the first time with Russian President Dmitri Medvedev and finally allows the Kremlin to gauge where this new administration is and where it is willing to go. Russia believes both countries are at a unique place in history: each could give a little to the other over the short term, before some future and unavoidable confrontation, or Obama could decide to take on this resurgent and stronger Russia, even if it meant sacrificing other U.S. priorities, such as Afghanistan and Iran.

Either way, the decisions facing the Kremlin and the Obama administration are ones that will shape a renewed global rivalry.

China: Exports Drop

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

Dear Friends:

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

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

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

Yours,
John Mauldin

China: Exports Drop

March 11,2009 | 1651 GMT

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

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

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

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

Reality Bites

John Mauldin — Mon, 09 Mar 2009 23:23:00 GMT

This week's writer of the Outside the Box is no stranger to long time readers. Michael Lewitt writes the HCM Market Letter and is one of my favorite writers and truly deep thinkers. He has recently decided to turn his letter into a subscription based model and is meeting with some success, as he should. So, sadly, he will no longer be a regular feature of OTB, but he did allow me to use the current letter, as I think it is one of his more provocative letters.

This is a piece you want to think through. Michael discusses the continuing series of bailouts, the consequences of the stimulus package, the various policy options and the likely response of the economy to all of the above. Plus he makes a few market calls and some interesting observations. I am truly pleased to be able to send this to you.

If you are interested in subscribing, you can to go www.hcmmarketletter.com/home.html or email info@hcmmarketletter.com.

John Mauldin, Editor
Outside the Box

Reality Bites

The HCM Market Letter by Michael E. Lewitt

"So long as risk is effectively concealed from borrowers and lenders or actually shifted to others, risk-taking will be excessive. The initial phase of excessive risk-taking will manifest itself as an economic boom, but eventually, when actual losses begin to change the perceptions of borrowers and lenders and begin to impinge upon unsuspecting others, the boom will give way to a bust....(A) market system whose credit markets involve risks that are partially concealed from the lender and partially shifted to others will be biased in the direction of excessive risk-taking. And excessive risks are converted in time into excessive losses."

Roger Garrison¹

The problem with bailouts is that you have to know what you're bailing out. But neither the U.S. government nor anybody else is capable of estimating the ultimate cost of bailing out such corporate giants as Citigroup, AIG, General Motors, Fannie Mae, and Freddie Mac (and the list goes on). There are two reasons for this. First, on a stand-alone basis, these companies are opaque and indecipherable entities. Financial innovation left transparency in the dust. Wall Street devoted much of its intellectual and political capital to concealing the risks it was creating. This concealment was deliberate; products needed to be priced inefficiently to produce profits. Second, these companies are integral parts of a networked global economy; as such, their value is completely dependent on the overall health of that network. Unless the network can be restored to health, these assets will remain severely devalued. Right now, the network is very sick. When a system is allowed to hide risk for so long, it is ill-equipped to manage that risk when it finally emerges from the shadows.

The Economic Policy Conundrum

The Obama Administration is facing a near-impossible task trying to bail the U.S. economy out of the muck of years of ill-begotten economic policies. The biggest challenge facing policymakers is not short-term recovery, however. Eventually, stimulus is likely to arrest the forces of economic collapse and stabilize matters – at least temporarily. But the real problem is sowing the seeds of long-term, sustainable, organic economic growth. This is really the crux of the policy challenge. The United States in the midst of the worst economic downturn in 80 years as the result of a panoply of extremely poor economic policy choices. Economist Roger W. Garrison draws an important distinction between "healthy economic growth, which is saving-induced (and hence sustainable), and artificial booms, which are policy-induced (and hence unsustainable)."² In other words, monetary policy that kept interest rates low for an extended period of time, tax policy that favored debt over equity, regulatory policy that allowed financial institutions to operate opaquely, and social policy that pushed home ownership regardless of affordability, all combined to create artificial economic demand that could only be financed with debt because the savings (i.e. equity) to purchase them did not exist.

Moreover, as more and more debt was created through financial engineering and policy prescription, the prices of these were bid up higher and higher. This led these products to become grossly inflated in value compared to any inherent economic worth they might possess. Once the bubble burst, their value dropped precipitously. Unfortunately, the face amount of the debt used to purchase these assets did not adjust downward at the same time. Assets that were purchased at inflated prices are now worth a fraction of what they were purchased for, leaving behind a serious dilemma for the owners of these assets and their creditors.

Following conventional economic thinking, the government believes that the solution lies in policies designed to reflate the value of these assets. The problem with this approach is that it is based on the incurrence of trillions of dollars of additional debt to create the demand needed to purchase these assets. Debt begetting more debt is a poor prescription for sustainable long-term economic growth. At best the government may be able to provide a short-term boost to the economy, but what the economy really needs is a solid, organic foundation for growth. Debt-financed government demand can't be sustained indefinitely, which is why this policy is doomed to fail in the long run. The U.S. balance sheet is not a bottomless pit, although it is increasingly coming to resemble a Black Hole. At some point, the economy will have to generate sufficient tax revenue to pay for this government spending or the country will lose its AAA rating and ultimately become a troubled credit. Economic demand will ultimately have to become savings-driven or it will again collapse.

This does not necessarily mean that the government should walk away from creating short-term demand, but it should be extremely circumspect in how it does so. This is where political reality collides with economic reality. The optimum long-term economic solution would be to allow the economy to hit bottom and then begin to rebuild demand naturally. But such a scenario would likely entail an unemployment rate on the order of 15 or 20 percent and an even worse human toll than is already being exacted by the downturn. But it would give the economy an organic base from which to rebuild. The government's job in such a scenario would be to provide the right kind of safety net (not only of financial support but also job and educational training) to see the citizenry through the crisis. What the U.S. really needs is an economic Marshall Plan to rebuild itself, with all of the sacrifice and public service that would entail. Apparently, that is asking too much in today's me-first society. Accordingly, the government finds itself compelled to follow policies that may or may not create unsustainable short-term growth and will have to be carefully targeted to promote sustainable long-term growth.

There is a profound difference between healthy, sustainable demand and unhealthy, unsustainable demand, just as we are living the unhappy lesson that there is a great difference between healthy economic activity (i.e. activity that contributes to the productive capacity of the economy) and unhealthy economic activity (i.e. speculative trading and corporate finance transactions). Propping up bad banks through a "good bank/bad bank" model would simply direct funds to the sustenance of past unhealthy economic activity. Starting a new Economic Reconstruction Bank, as HCM has recommended, could make loans available for new productive projects and direct funds into healthy long-term economic activity.

Another bout of policy-induced growth will not only repeat the mistakes of the past, but leave the economy even weaker, teetering on an unstable foundation of government support that cannot be sustained indefinitely without impairing America's balance sheet, credit rating, and ultimately its geopolitical might. Whether America's short-term political orientation can ever address this conundrum is the greatest question facing policymakers today. HCM has no hesitation in saying that much of what the government has proposed thus far to deal with the crisis won't come close to dealing with the long-term issue of creating savings-induced or organic growth. This means that any near-term relief (i.e. relief that occurs within the next five years) is most likely to give way to years of below trend growth because the economy will be lacking the organic foundation of growth it needs.

Dow 5000 Update

Year-to-date through February 27, the S&P 500 was down 18.62 percent and the Dow Jones Industrial Average was down 19.52 percent. Moreover, strategists and investors are increasingly coming around to the conclusion that corporate earnings are going to be nothing short of horrendous this year and that stocks are headed even lower, as HCM has been arguing for months (without pleasure, we hasten to add). Very recently, three of the smartest forecasters on Wall Street sharply lowered their earnings forecasts for the S&P 500.

On February 13, David Rosenberg, Bank of America's North American Economist, recently reduced his 2009 and 2010 S&P 500 operating EPS forecast to $46 (from $56) and $55.50 (from $63), respectively.ⁱ Mr. Rosenberg is now forecasting an S&P 500 low of 666 based on a 12x multiple of forward (i.e. 2010) earnings.
Francois Trahan of ISI Group dropped his S&P 500 earnings forecast from $60 to $45 on February 23. Mr. Trahan used a 13x multiple to forecast a potential market low of 585.
On February 26, Goldman Sachs' David Kostin dropped his 2009 and 2010 S&P 500 operating EPS forecast to $40 and $63, respectively, after deducting $23 and $8, respectively, for provisions and write-downs. Mr. Kostin uses a 13.2x multiple of 2010 earnings (pre-write-downs and provisions) to come up with a year-end 2009 S&P 500 target of 940.

These sharply lower forecasts are consistent with HCM's dim view of corporate earnings, but we believe that all three analysts are clinging to overly optimistic earnings multiples in predicting ultimate stock market lows. At this point, there is clearly a growing Wall Street consensus that S&P 500 earnings will come in well below $50 in 2009 and that the correct multiple on these earnings should be in the 12-13x range. HCM continues to believe that the multiple should be lower based on the fact that (a) we are in a debt deflationary spiral, and (b) government yields are artificially depressed and signal economic distress and do not signal an attractive investment alternative, and corporate yields are extremely high and offer real competition for investor funds.

Last November, HCM set 2009 price targets of 5000 on the Dow Jones Industrial Average (DJIA) and 475 on the S&P 500 based on applying a 7x multiple to Goldman Sachs' then 2009 S&P 500 earnings estimate of $65. (See The HCM Market Letter, Nov. 15, 2008, "Dow 5000") At the time, the S&P 500 was at about 850 and the DJIA was at about 8600. Our low multiple was based on our view that an environment characterized by debt deflation deserves a 6-8x multiple. Now that Mr. Kostin and others have lowered their multiple, it is only fair to raise the question whether we should be further lowering our target prices on these equity indices at this time based on applying our multiple to a lower earnings number.

For the moment, the market remains far above our previous targets. Our targets are intended to be directional in nature and we see no reason to lower them further at the current time. We have made our point, which is that the stock market is likely to head sharply lower in the months ahead. Moreover, the earnings estimates have been lowered primarily based on expectations for further write-offs by financial companies (and non-financial companies that wandered into the financial space). Investors may treat these write-offs and provisions as nonrecurring items and look to higher recurring S&P 500 earnings in pricing the market. While we continue to believe that the multiple should be in the single digits, the correct recurring earnings number remains a moving target. Accordingly, at this time it would be premature to lower our estimate further. Needless to say, we remain extremely comfortable with our prior estimates of 475 on the S&P 500 and 5000 on the DJIA.

A bear market rally is possible at any time. Investors should be aware that as the market moves lower, rallies have the potential to be extremely sharp since they are starting from compressed levels. Such rallies should be used to reduce overall equity exposure. That does not mean that equities should be abandoned totally. There are a number of stocks that are trading at well below book value (even taking into account the declining transfer value of their assets) that may be worth buying in the months ahead. The debt of these companies, which HCM is particularly active in, is even more compelling as an investment. But investors need to identify longer term changes in market behavior and the economic environment before becoming bullish again on stocks. Right now, there are no such signs, such as better employment, housing or GDP numbers, or tightening credit spreads, or improving market technicals. HCM is starting to sense that the forces of denial, as potent as they are, are starting to weaken. Accordingly, investors should structure their portfolios for further equity declines.

The "D" Word

The fourth quarter GDP loss of 6.2 percent (did anybody really believe the 3.8 percent estimate?) illustrates just how deep a hole our economy has to climb out of. The economy fell into this hole almost literally overnight, but it's going to take much longer to climb out. A quick recovery is out of the question. HCM expects first quarter GDP to be in the -6.0 to -7.0 percent range based on our reading of employment, housing and other economic data as well as the data we are seeing from the 200 or so companies in our portfolios across a wide variety of industries. Moreover, based on our view that the stimulus plan will be largely ineffective this year and that more large-scale business failures are in the works (many of them slow-motion car wrecks), we do not expect to see positive economic growth until sometime in mid-to-late 2010 (and then only modest growth).

Investors expecting a conventional bear market/bull market cycle are likely to be sorely disappointed. Over the past several decades, U.S. stock market investors have been conditioned to believe that the market will bottom and then rebound. Bear markets have been brief within the context of a long bull market that stretches back to the 1980s. But the current environment is likely going to be different. We are now experiencing a destruction of wealth on a scale that is both unprecedented and permanent because much of that wealth was built on a fragile foundation of debt; in reality, much of that wealth didn't really exist in the first place. As a result, what people believed to be economically valuable and stable was in fact nothing of the kind. In many respects, the latter stages of the bull market were little more than an illusion. Real corporate earnings and genuine productivity peaked years ago, and the economy has been operating on debt-induced fumes for years.

Accordingly, investors need to prepare themselves for a future that will not resemble the recent past. Ray Dalio, the wise man who runs Bridgewater Associates, noted in a recent Barron's interview that investors need to recognize that the current environment more resembles a depression than a recession: "Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis of the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process." (Barron's, February 9, 2009, "Recession? No, It's a D-process, and It Will Be Long," pp. 38-40.) Mr. Dalio's view is consistent with HCM's long-argued view that we are in a debt-deflationary spiral whose end is nowhere in sight.

The characteristics of our current economic situation are as follows:

Interest rates have dropped to zero.
Bank stocks have plunged by 90 percent or more.
The Federal Reserve's balance sheet has exploded.
Credit spreads have widened to historic levels.
The economy is seeing massive asset deflation.
Debt is being destroyed in record amounts.
Unemployment is increasing each month.
The financial industry is shrinking radically.
Manufacturing activity has slowed sharply.

This is not a situation that is consistent with recent American experience. HCM has previously described a depression as an economic condition in which traditional monetary and fiscal policy is rendered ineffective. For the moment, we are deeply entrenched in such a situation. The question is how long the economy will remain depressed before some of the remedies that have been proposed start to work. Unfortunately, HCM fears we may be in for an extended stay.

For these reasons, HCM believes that after the stock market bottoms, it will drift along at a depressed level for an extended period of time. The American economy will experience less-than-trend growth for a similarly prolonged period of time. The economy will have to absorb trillions of dollars of bad debts and transition its resources away from speculative activities and toward new productive endeavors. The economy has to be completely retooled, and this process will not happen overnight, particularly because such a program must be directed by a highly inefficient democratic political system that is inefficient in reaching consensus about its goals and how to achieve them. Unfortunately, the deeper involvement of the government in the financial and other sectors of the economy is likely to stifle growth, innovation and creativity and further contribute to lower growth for years to come.

Investing Today

This by no means is intended to suggest that investors will be unable to make money. It does suggest, though, that the era of bull market geniuses is probably over. Too many were paid too much for doing too little over the past several decades. Being at the right place at the right time is not going to cut it anymore. But as the debt destruction process plays out, new investment opportunities will arise in the capital structures of restructured and surviving companies.

As investors go about reallocating money to new opportunities, they may want to keep in mind something that HCM recently read in The Economist.

"Over the past 35 years it has seemed as if everyone in finance has wanted to be someone else. Hedge funds and private equity wanted to be as cool as a dotcom. Goldman Sachs wanted to be as smart as a hedge fund. The other investment banks wanted to be as profitable as Goldman Sachs. America's retail banks wanted to be as cutting-edge as investment banks. And European banks wanted to be as aggressive as American banks. They all ended up wishing they could be back precisely where they started." (The Economist, "A special report on the future of finance," January 24, 2009, p. 17.)

There are a limited number of investment opportunities that make sense in today's market, and there are a limited number of managers qualified to execute those strategies. Unfortunately, managers in out-of-favor or discredited strategies are now trying to reinvent themselves as managers of the few in-favor strategies in which they have limited or no experience. HCM is seeing this occur in the corporate credit space, where firms that have previously operated in areas peripheral to the credit markets such as private equity or mortgages are suddenly touting their expertise in corporate credit. These managers are wading into uncharted territory. Investors must insure that managers possess the expertise that is required for the strategies for which they are being hired. They have already experienced the disastrous results of private equity firms thinking that doing deals would prepare them for investing in bank loans.

Bank Nationalization

We are quickly learning the flaws of the half-baked approach to supporting the nation's banks that the Bush Administration adopted and the Obama Administration seems hell-bent on continuing. At least the Bush Administration had an excuse – the former Treasury Secretary was a career investment banker who saw the world through the eyes of Wall Street. Perhaps HCM was naïve in hoping that the new Treasury Secretary, having been a career regulator who viewed matters through the opposite end of the glass, would see things differently. We probably should have known better since Mr. Geithner participated in the Bush Administration's bailout. But the quasi-nationalization approach is clearly a disaster for all concerned (the recent article describing the hall of mirrors that used to be Citigroup is a case in point - see The Wall Street Journal, February 25, 2009, "Citigroup Chafes Under U.S. Overseers," p. A1.) There seems to be little disagreement that two of the country's major banks – Citigroup and Bank of America – are in the zone of insolvency. Their assets are worth less than their liabilities and their shareholders have been wiped out in all but name (and in the little drill-bits of stock that trade publicly as make-believe options on their long-term recovery). But the system can't seem to bring itself to admit that these banks have been effectively nationalized in all but name and that taking the final step of nationalizing them is in many respects just a matter of form over substance. The only thing worse than a banking system that has been privatized is one that has collapsed, but that is the choice we are faced with. The Rubicon has been crossed and we need to clear away tons of debris that are clogging up the river before we can cross back to the other side.

Moreover, maintaining the illusion of public ownership has enabled some of the individuals running these institutions to engage in some of the most irresponsible behavior ever seen in the history of American business. HCM is speaking specifically of the pay-out of billions of dollars of bonuses to the executives and employees of Merrill Lynch on the eve of its forced takeover by Bank of America. This act, which Bank of America's Chairman Ken Lewis claims he was powerless to stop (HCM does not believe him) and former Merrill Lynch Chairman John Thain, in what can only charitably be described as a gross breach of conscience and good judgment, somehow sanctioned, are prima facie evidence that the hybrid public/private TARP model is totally untenable and should be shelved immediately. Those banks that can repay the TARP money (or produce a believable plan to do so within three years) should be permitted to do so forthwith, and those that are teetering on the brink of insolvency should be nationalized. Otherwise, the managements of these firms are going to pay more attention to figuring out how to game government compensation limitations than maximizing the value of their troubled assets over the next several years. HCM never thought we would say that there are worse things than nationalization, but there are and we saw them when billions of dollars was paid out to the people who lost even more billions of dollars at Merrill Lynch. This has to have been one of the most brazen thefts in American history.

Let GM Go

General Motors has been insolvent for years. Yet political expediency has prevented recognition of this harsh truth. The company's unions have blocked efforts to bring the company's cost structure into line with changing economic realities. Michigan's powerful Congressional delegation has blocked efforts to improve American automobiles' fuel efficiency, creating an opening for foreign manufacturers with lower cost structures to steal the hearts and minds and pocketbooks of American consumers. Years of bad choices have now left the U.S. government with a terrible choice – whether to give GM billions of dollars of money inside or outside of bankruptcy. The correct decision, as unpalatable as it may be, is painfully obvious. All of the king's horses and all of the king's men are not going to be able put GM back together again. It is time to let this American icon declare bankruptcy in order to maximize the chances of salvaging something out of this American tragedy.

GM is still paying or accruing billions of dollars of annual interest payments on the company's more than $40 billion of debt. The company is negotiating with holders of $27.5 billion of this debt, which is unsecured, to reduce it to $9.2 billion (by exchanging stock for bonds). Yet all of this debt and stock is worthless. Instead of wasting time haggling with debt holders over exchanging a portion of their worthless claims for worthless stock, the company should declare bankruptcy so these claims can be wiped out. GM's ability to meet the government's February 17 deadline was delayed by its inability to come to an agreement its bondholders. The bondholders are institutional investors who believe they are exercising their fiduciary duty to their beneficiaries by trying to squeeze the best deal possible out of the automaker. But the sad reality is that they made a bad investment and should suffer the consequences. We need to stop trying to save everyone from the consequences of their errors or else they will keep making them.

The unions are also trying to salvage an ownership stake out of this mess. The company is negotiating to exchange half of approximately $20 billion of Voluntary Employee Benefit Association (VEBA) obligations into equity. Unfortunately, 100% of the VEBA obligations are likely worthless since GM will never be able to pay them. The VEBA was part of the bargain that the unions made with GM over the years. Workers gained generous wages, benefits and work rules that rendered the company uncompetitive. This was not a secret – the company's loss of market share and weakening financial position was apparent for years to the unions as well as to everyone else. The unions won the bargain but they lost the war. The company doesn't owe the workers anything more than what can be granted in bankruptcy, which is likely a meaningful equity stake in exchange for the VEBA and the billions of dollars of other healthcare and pension obligations owed to current and retired workers. This is undoubtedly a tragedy of enormous human dimensions, but responsibility for it is shared by all Americans who sat by while their politicians and business leaders allowed GM to sink into insolvency. Accordingly, America owes the workers a safety net when they lose their jobs and benefits. But this should be the same safety net society owes all of its displaced workers, not a special one for former GM workers.

Allowing GM to file for bankruptcy will be a blow to the American psyche. But GM has already gone bankrupt in all but name. In suggesting that it will require $125 billion in financing to undergo a bankruptcy, the company may be playing chicken with Congress but is more likely indicating just what a Black Hole of liabilities it has become over the decades. America must have the courage to deal with this reality. Bankruptcy will give the company, and the country, an ability to make the hard decisions that it refused to make before. Either way, GM's failure is going to cost taxpayers tens of billions of dollars. But until we are willing to be honest about our failures, we are never going to put ourselves in a position to avoid future ones.

Obama's Budget

President Obama's is in many respects a dramatic break with the past, although in many respects it falls short of the type of radical tax and other changes that are really needed (but may simply not be politically feasible). We just hope that Mr. Obama's reach does not exceed his grasp. Many things may have changed economically in recent years, but one thing has not: a country can't tax and spend its way into prosperity. Moreover, we are confident that the growth rate assumptions used in years 2, 3 and 4 of our new president's proposed budget are unrealistic. The economy is unlikely to grow at anything close to 3 to 4 percent in those years, and relying on that much growth to close the budget deficit by the end of Mr. Obama's first term will only lead to disappointment. This economy, which shrunk at an annual rate of 6.2 percent in the fourth quarter of 2008 and will almost certainly not show any growth at all in 2009, is not going to magically spring back to life in 2010. Mr. Obama is setting himself up for failure with these projections.

HCM was very happy to see that the Administration is prepared to rid the tax code of the egregious treatment of private equity carried interests, which we have recommended before (see The HCM Market Letter, April 1, 2008, "How to Fix It"). Now that private equity has become a loss-leader for its partners, we would caution those drafting the legislation to make sure that private equity does not gain an unintentional windfall from this legislation. This could occur if private equity partners were permitted to deduct claw-back payments (i.e. repayments of carried interests earned early in a partnership based on losses incurred later in a partnership) at the new higher tax rate if they were taxed on those original payments at the lower rate. In order to prevent such a benefit, if the original payment was taxed at 15 percent, repayment of that money should only give rise to a deduction at 15 percent, not the higher ordinary income tax rate.

We think limitations on charitable deductions are poor public policy. The argument that wealthier people should not receive a greater dollar-for-dollar benefit for charitable deductions than less affluent people is a red herring, particularly in view of the fact that the Alternative Minimum Tax already haircuts high earners' charitable gifts. We also believe that limitations on mortgage deductions would be better handled by limiting deductions for mortgages over a certain dollar amount rather than by income; such a methodology would be more effective in fighting housing speculation.

We are opposed to raising taxes on capital, but we also recognize that we are in a fiscal emergency and that raising the capital gains tax from 15 percent to 20 percent on the wealthiest Americans would not impose undue hardship and would keep the rate relatively low. We would prefer to see capital gains rates implemented on a graduated scale based on the amount of capital gains reported in a single year. Someone who earns an especially large gain could certainly afford to pay a little more in tax. We commend the plan for maintaining the 15 percent tax rate on dividends, which should not be taxed at all since they are already taxed at the corporate level and remain an extremely inefficient means of returning capital to shareholders.

The biggest problem with the budget – and with any budget, not just Mr. Obama's – is that the government just wastes so much stinking money. The reason people find higher taxes abhorrent is not because they don't want to help those less fortunate than themselves, or fund necessary government programs, but because they don't want their money to be treated like Congress's personal piggy bank. We would love to see the list of the $2 trillion of wasteful programs that Mr. Obama claimed his team has already identified for elimination. The amount of government waste is truly mindboggling, and Mr. Obama must insist on spending discipline if he is to have any chance to keep the budget deficit from exploding over the next four years.

The Coming Meltdown in Eastern Europe

By all accounts, the former Eastern Bloc countries that so successfully navigated their entry into world capitalism after the fall of communism have borrowed themselves into near oblivion and are about to inflict frightening losses on their own banks and Western European banks, their main aiders and abettors. Our good friend John Mauldin has been out front on this story, which has enormous implications for the global financial system. The ever prescient Christopher Wood has also been warning about an Asian-style banking crisis in the region, with serious ramifications for the Western European banks that loaned these institutions by some reports trillions of dollars. This is a story that needs to be followed in the coming weeks because it will have major negative consequences for world financial markets. To state the obvious, this is the last thing the world economy needs to deal with right now.

Michael E. Lewitt

Footnotes:
¹ Roger W. Garrison, Time and Money The Macroeconomic of Capital Structure (New York: Routledge, 2001), pp 111, 120.
² Garrison, p. 56.

Europe On the Ropes

John Mauldin — Mon, 02 Mar 2009 22:17:24 GMT

This week we look at the European bank markets through the eyes of my London partner Niels Jensen, head of Absolute Return Partners. I continue to believe that this is a brewing crisis which could have far more significant implications for the global economy than the Asian Crisis of 1998. In this week's Outside the Box, Niels has compiled a sobering set of data that suggests that only massive government involvement in Europe on a scale that is unprecedented will keep the wheels from coming off in Europe and the global economy.

I have worked closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work at www.arpllp.com and contact them at info@arpllp.com.

John Mauldin, Editor
Outside the Box

Europe On the Ropes

The Absolute Return Letter March 2009

"Many of today's policy proposals start from the view that "greed" and "incompetence" and "poor risk assessment" are the ultimate source of what went wrong. In fact, they were not the true cause at all. Moreover, even if they had been, it is fatuous to think that we will now create a post-crash generation of bankers and traders who are not greedy, much less a new generation of quants who will be able to assess and manage risks much better than "the idiots" who have brought us to the current abyss. Greed cannot be exorcised. Nor can the inherent inability of any quants to determine the "true" probability distributions of all-important events whose true probabilities of occurrence can never be assessed in the first place."

Woody Brock, SED Profile, December 2008

Policy mistakes 'en masse'

The last few weeks have had a profound effect on my view of politicians (as if it wasn't already dented). All this talk about capping salaries for senior bank executives is quite frankly ridiculous. It is Neanderthal politics performed by populist leaders. That Gordon Brown has fallen for it is hardly surprising but I am disappointed to see that Barack Obama couldn't resist the temptation. The mob wants blood and our leaders are delivering in spades. The stark reality is that we are all guilty of the mess we are now in. For a while we were allowed to live out our dreams and who was there to stop us? Policy mistakes – very grave mistakes – permitted the situation to spin out of control. From the U.S. Federal Reserve Bank under the stewardship of Alan Greenspan being far too generous on interest rates to the British Chancellor of the Exchequer -who now happens to be our Prime Minister - advocating 'Regulation Light'.

Policing must improve

If you really want to prevent a banking crisis of this magnitude from ever happening again, the focus should be on the way banks operate and not on how much they pay their staff. And, within that context, any discussion must start and end with how much leverage should be permitted. The French have actually caught onto that, but their narrow-mindedness has driven them to focus on hedge funds' use of leverage which is only a tiny part of the problem. It is the gung ho strategy of banks which brought us down and which must be better policed. And guess what; if banks were better policed - and leverage restricted - then profits, even at the best of times, would be much smaller and there would be no need to regulate bankers' compensation packages.

It is pathetic to watch our prime minister attacking the bonus arrangements of our banks when the UK Treasury, on his watch, spent £27 million pounds on bonuses last year as reward for delivering a public spending deficit of 4.5% of GDP at the peak of the economic cycle. Even my old mother understands that governments must deliver budget surpluses in good times, allowing them more flexibility to stimulate when the economy hits the wall. What Gordon Brown has done to UK public finances in recent years is nothing short of criminal.

So, with that in mind, let's take a closer look at the European banking industry. The following is not pretty reading. I have rarely, if ever, felt this apprehensive about the outlook. So, if the crisis has made you depressed already, don't read any further. What is about to come, will make your heart sink.

More leverage in Europe

Let's begin our journey by pointing out a regulatory 'anomaly' which has allowed European banks to take on much more leverage than their American colleagues and which now makes them far more vulnerable. In Europe, unlike in the US, it is only risk-weighted assets which matter to the regulators, not the total leverage ratio. European banks can therefore apply a lot more leverage than their US counterparties, provided they load their balance sheets with higher rated assets, and that is precisely what they have been doing.

That is fine as long as you buy what it says on the tin. But AAA is not always AAA as we have learned over the past 18 months. Asset securitisations such as CLOs proved very popular amongst European banks, partly because they offered very attractive returns and partly because Standard & Poors and Moodys were kind enough to rate many of them AAA despite the questionable quality of the underlying assets.

Now, as long as the economy chugs along, everything is dandy and the AAA-rated assets turn out to be precisely that. But we are not in dandy territory. Many asset securitisation programmes are in horse manure to their necks, so don't be at all surprised if European banks have to swallow further losses once the full effect of the recession is felt across Europe. The two largest sources of asset securitisation programmes are corporate loans and credit cards. Senior secured loans are still marked at or close to par on many balance sheets despite the fact they trade around 70 in the markets. The credit card cycle is only beginning to turn now with significant losses expected later this year and in 2010-11.

Not much of a cushion left

Citibank has calculated that it would only take a cumulative increase in bad debts of 3.8% in 2009-10 to take the core equity tier 1 ratio of the European banking industry down to the bare minimum of 4.5%¹. By comparison, bad debts rose by a cumulative 7% in Japan in 1997-98. One can only conclude that European banks are very poorly equipped to withstand a severe recession. Seeing the writing on the wall, they are left with no option but to shrink their balance sheets. Despite talking the talk, banks will use every trick at their disposal to reduce the loan book. No prize for guessing what that will do to economic activity.

The wheels are coming off

But that is not the whole story. It is not even the most worrying part of the story. For the true horror to emerge, we need to turn to Eastern Europe for a minute or two. Nowhere has the credit boom been more pronounced than in Eastern Europe. And nowhere is the pain felt more now that credit has all but dried up. One measure of the credit fuelled bonanza is the deterioration of the current account across the region. Credit Suisse has calculated that in four short years, from 2004 to 2008, Eastern Europe's current account went from +6% to -6% of GDP². That is a frightening development and is likely to cause all sorts of problems over the next few years.

Meanwhile Western European banks, eager to milk the opportunities in the East after the iron curtain came down, have acquired many of the region's banks (see chart 1). Now, with many Eastern European countries in free fall, ownership could prove disastrous for an already weakened banking industry in the West.

The problem is widespread

To make matters worse, the problems in the East are beginning to look systemic. Credit Suisse has produced an interesting scorecard where they rank a number of countries around the world on factors usually taken into consideration when assessing the credit quality of sovereign debt (see chart 2). At the top of the tree (i.e. the worst credit score) you find Iceland – hardly surprising considering their current predicament. More importantly though, of the next 14 countries on the list, 8 are Eastern European – not what you want to hear if you are an already undercapitalised European bank with huge exposure to Eastern Europe.

Swedish banks are already reeling from their exposure to the Baltic countries. Austrian banks are in even worse shape, having been the most acquisitive of any European banks. Some Italian banks could be dragged under by their Eastern European exposure and even the conservative banking sector in Switzerland doesn't look like it can escape the mayhem.

Worst of all, the problems in the East are just about to unfold at a point in time where the European banking industry is bleeding heavily from massive losses already incurred in other areas. With no access to private funding, banks find it virtually impossible to re-build their capital base with anything but tax payers' money.

US banks are better off

US banks are in less of a pickle. Unlike the subprime debacle which hit both the US and the European banks hard, US banks have little exposure to Eastern Europe. To prove my point, according to the IMF, European banks have 75% as much exposure to US toxic debt as American banks, but 90% of all cross border loans to Eastern Europe originate from Western European banks. And, to add insult to injury, European banks have been much slower than US banks in terms of recognising their losses. Write-offs now total about $750 billion in the US and only about $325 billion in Europe.

The great mortgage show

The problems in Eastern Europe begin and end with their large external debts. In recent years, ordinary people all over the region have converted their traditional mortgages to EUR- or CHF-denominated mortgages. Some have even switched to JPY mortgages. Who can possibly resist 3% mortgages? Didn't anyone inform them of the risk? As currencies across the region have fallen out of bed in recent months, these mortgages have suddenly become 30-50% more expensive. No wonder the local economy is suddenly tanking.

Credit Suisse has calculated that net foreign liabilities (as a % of GDP) have risen from 47% to 65% in recent months as a direct result of the loss of local currency values (see chart 3 – and don't ask me why Credit Suisse has included South Africa in Eastern Europe!).

Chart 4: Eastern European vs. Asian Crisis

Source: Wall Street Journal

Back in 1997-98 Asia went through a similar currency crisis. However, as you can see from chart 4, Asian current account deficits were much smaller than Eastern European deficits are now. So were debt levels. Despite that, the Asian crisis did enormous damage to the local economy. Eventually Asia came good, primarily because the devalued currencies allowed the Asian countries to export more. Eastern Europe does not share this luxury. With over 90% of the world's GDP in recession, who are they going to export to anytime soon?

Austria is in greatest trouble

According to the latest estimates from BIS, Eastern European countries currently borrow $1,656 billion from abroad, three times more than in 2005 and mostly denominated in foreign currencies (ouch!). 90% of that can be traced to Western European banks. About $350 billion must be repaid or rolled over this year. Not an easy task in these markets. Austrian banks alone have lent about $300 billion to the region, equivalent to 68% of its GDP according to the Financial Times. A default rate of 10% on its Eastern European loans is considered enough to wipe out the entire Austrian banking system. EBRD has gone on record stating that defaults in Eastern Europe could end up as high as 20%³.

An extra $250bn to the IMF

Hungary, Latvia and Ukraine have already received emergency loans from the IMF and both Serbia and Romania are reportedly considering asking for help. Meanwhile the IMF's coffers are draining quickly and it has asked leading industrial nations for new funding. At their summit a week ago, EU leaders coughed up an extra $250 billion but nobody said where the money is going to come from. Even if they find the money, it is likely to prove hopelessly inadequate. Our leaders must grow up. Measuring everything in billions is so yesterday. Trillions are the new billions, like it or not.

Conspiracy or...?

On the 11th February the Daily Telegraph's Brussels correspondent Bruno Waterfield wrote an article under the header: "European banks may need £16.3 trillion bail out, EC document warns." In the article, the reporter revealed that he has seen a secret document produced by the EU Commission which briefed the union's finance ministers on the true extent of the banking crisis. Less than 24 hours later, the article's header was changed to "European bank bail-out could push EU into crisis" and two paragraphs had mysteriously disappeared. Here they are:

"European Commission officials have estimated that "impaired assets" may amount to 44pc of EU bank balance sheets. The Commission estimates that so-called financial instruments in the 'trading book' total £12.3 trillion (13.7 trillion euros), equivalent to about 33pc of EU bank balance sheets.

In addition, so-called 'available for sale instruments' worth £4trillion (4.5 trillion euros), or 11pc of balance sheets, are also added by the Commission to arrive at the headline figure of £16.3 trillion."

Do yourself a favour - read those two paragraphs again. Newspaper editors do not change content light-heartedly. Did the Telegraph editor receive a call from Downing Street? Or Brussels? Did he have second thoughts about the avalanche that he could possibly instigate? I don't know and I probably never will. But one thing is certain. If the EU Commission's estimate of £16.3 trillion of impaired assets is correct, then the crisis is far worse than any of us could ever imagine. Not only would we have to get used to the prospects of a systemic meltdown of our banking system, but entire nations may go down as well.

Public debt to rise and rise

Even if actual losses prove to be much, much smaller (and I sincerely hope so), the banking sector cannot, in the current environment at least, raise sufficient capital to stay afloat, so more, possibly a lot more, tax payers' money will have to be put forward. This can only mean one thing. Public debt will rise and rise. The official estimate for the UK for next year is already approaching 10% of GDP, an estimate which will almost certainly rise further. We probably have to get used to running 10-15% deficits for a few years, a fact which seriously undermines the notion of government bonds being next to risk-free.

BCA Research has calculated the effect on public debt in a number of countries, as a result of further bank losses being underwritten by tax payers. Obviously, those countries with the largest banking industries (as a % of GDP) will be hit the hardest (see charts 5a and 5b).

For that very reason, and as pointed out in last month's Absolute Return Letter, there is a real risk that investors will demand much higher risk premiums on government debt. Only a few days ago, Ireland issued 3-year bonds at almost 250 basis points over corresponding Bunds. As more and more debt is transferred to sovereign balance sheets, we will likely see the spreads between good and bad paper rise further but we will also witness increasingly desperate measures being applied by the men in power. If they could prohibit short-selling of banks on the stock exchange (which didn't work), why wouldn't they consider prohibiting short-selling of government bonds? Not that it would necessarily work any better, but desperate people do desperate things.

Can Germany rescue us?

Most investors remain convinced that Germany will come to the rescue - in my opinion not as simple a solution as widely perceived given the enormity of the crisis. One possible solution which has been mentioned frequently in recent weeks is for all the eurozone nations to get together and start issuing joint bonds. This would undoubtedly help the weaker nations, but the idea was shot down by the German Finance Minister only a few days ago when he said that closer economic harmony across the eurozone would be needed before Germany would be prepared to entertain such an idea.

The most obvious trick left in the book, therefore, is to inflate us out of this mess. With the enormous amounts of public debt being created at the moment, years of deflation a la Japan would be catastrophic. You will never get a central banker to admit to it, but a healthy dose of inflation is probably our best prospect of surviving this crisis.

Given this outlook, do you really want to be long euros?

Niels C. Jensen
© 2002-2009 Absolute Return Partners LLP. All rights reserved.

Footnotes:

1 Citibank, Credit Outlook 2009

2 Ex Russia. Source: Credit Suisse Global Equity Strategy

3 "Failure to save East Europe will lead to wordwide meltdown", Daily Telegraph

Geithner, China, and the Specter of Technical Insolvency

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

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

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

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

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

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

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

John Mauldin, Editor
Outside the Box

Geithner, Obama and China

By David Kotok

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

By Nouriel Roubini and Elisa Parisi-Capone

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

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

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

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

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

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

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

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

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

Loss Estimates

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Next 100 Years

John Mauldin — Thu, 22 Jan 2009 19:19:40 GMT

Much of the world is focused on the next 100 days—what Obama is going to do. That's important. But today in a special Outside the Box from my good friend George Freidman of Stratfor We will look out a bit further George is just about to release his latest book, The Next 100 Years: A Forecast for the 21st Century. (Even pre-release it's already at #11 on Amazon's non-fiction bestseller list!) Here's my quick summary; and to cut to the chase, it's just fascinating.

What reads like a geopolitical thriller gives a thought-provoking glimpse into what the world will look like in the coming century. George's strength is his ability to take geopolitical patterns and use them to forecast future events, sometimes with startling and counterintuitive results.

For example, he forecasts:

By the middle of this century, Poland and Turkey will be major international players
Russia will be a regional power – after emerging from a second cold war
Space-based solar power will completely change the global energy dynamic
The border areas between the US and Mexico are going to be in play again, like 150 years ago
Shrinking labor pools will cause countries to compete for immigrants rather than fighting to keep them out

I confess when George first told me about these ideas, I raised an eyebrow. But after reading the book, and going through the analysis, I find myself sometimes nodding in agreement and other times not being sure what I was reading. But like all the analysis reviews I do, I pay as much attention to the methods, the logic, and the arguments as the conclusions. Do that, and what seems hard to believe all of a sudden makes sense.

Don't let short-term fears blind you to long term opportunities. George's company, Stratfor, is my source for this kind of geopolitical analysis on an on-going basis. I've included the full introduction to the book below; and I heartily recommend that you click here for a special offer on a Stratfor Membership that includes a copy of George's upcoming book.

John Mauldin, Editor
Outside the Box

The Next 100 Years

By George Friedman

OVERTURE
An Introduction to the American Age

Imagine that you were alive in the summer of 1900, living in London, then the capital of the world. Europe ruled the Eastern Hemisphere. There was hardly a place that, if not ruled directly, was not indirectly controlled from a European capital. Europe was at peace and enjoying unprecedented prosperity. Indeed, European interdependence due to trade and investment was so great that serious people were claiming that war had become impossible—and if not impossible, would end within weeks of beginning—because global financial markets couldn't withstand the strain. The future seemed fixed: a peaceful, prosperous Europe would rule the world.

Imagine yourself now in the summer of 1920. Europe had been torn apart by an agonizing war. The continent was in tatters. The Austro-Hungarian, Russian, German, and Ottoman empires were gone and millions had died in a war that lasted for years. The war ended when an American army of a million men intervened—an army that came and then just as quickly left. Communism dominated Russia, but it was not clear that it could survive. Countries that had been on the periphery of European power, like the United States and Japan, suddenly emerged as great powers. But one thing was certain—the peace treaty that had been imposed on Germany guaranteed that it would not soon reemerge.

Imagine the summer of 1940. Germany had not only reemerged but conquered France and dominated Europe. Communism had survived and the Soviet Union now was allied with Nazi Germany. Great Britain alone stood against Germany, and from the point of view of most reasonable people, the war was over. If there was not to be a thousand-year Reich, then certainly Europe's fate had been decided for a century. Germany would dominate Europe and inherit its empire.

Imagine now the summer of 1960. Germany had been crushed in the war, defeated less than five years later. Europe was occupied, split down the middle by the United States and the Soviet Union. The European empires were collapsing, and the United States and Soviet Union were competing over who would be their heir. The United States had the Soviet Union surrounded and, with an overwhelming arsenal of nuclear weapons, could annihilate it in hours. The United States had emerged as the global superpower. It dominated all of the world's oceans, and with its nuclear force could dictate terms to anyone in the world. Stalemate was the best the Soviets could hope for—unless the Soviets invaded Germany and conquered Europe. That was the war everyone was preparing for. And in the back of everyone's mind, the Maoist Chinese, seen as fanatical, were the other danger.

Now imagine the summer of 1980. The United States had been defeated in a seven-year war—not by the Soviet Union, but by communist North Vietnam. The nation was seen, and saw itself, as being in retreat. Expelled from Vietnam, it was then expelled from Iran as well, where the oil fields, which it no longer controlled, seemed about to fall into the hands of the Soviet Union. To contain the Soviet Union, the United States had formed an alliance with Maoist China—the American president and the Chinese chairman holding an amiable meeting in Beijing. Only this alliance seemed able to contain the powerful Soviet Union, which appeared to be surging.

Imagine now the summer of 2000. The Soviet Union had completely collapsed. China was still communist in name but had become capitalist in practice. NATO had advanced into Eastern Europe and even into the former Soviet Union. The world was prosperous and peaceful. Everyone knew that geopolitical considerations had become secondary to economic considerations, and the only problems were regional ones in basket cases like Haiti or Kosovo.

Then came September 11, 2001, and the world turned on its head again. At a certain level, when it comes to the future, the only thing one can be sure of is that common sense will be wrong. There is no magic twenty-year cycle; there is no simplistic force governing this pattern. It is simply that the things that appear to be so permanent and dominant at any given moment in history can change with stunning rapidity. Eras come and go. In international relations, the way the world looks right now is not at all how it will look in twenty years . . . or even less. The fall of the Soviet Union was hard to imagine, and that is exactly the point. Conventional political analysis suffers from a profound failure of imagination. It imagines passing clouds to be permanent and is blind to powerful, long- term shifts taking place in full view of the world.

If we were at the beginning of the twentieth century, it would be impossible to forecast the particular events I've just listed. But there are some things that could have been—and, in fact, were—forecast. For example, it was obvious that Germany, having united in 1871, was a major power in an insecure position (trapped between Russia and France) and wanted to redefine the European and global systems. Most of the conflicts in the first half of the twentieth century were about Germany's status in Europe. While the times and places of wars couldn't be forecast, the probability that there would be a war could be and was forecast by many Europeans.

The harder part of this equation would be forecasting that the wars would be so devastating and that after the first and second world wars were over, Europe would lose its empire. But there were those, particularly after the invention of dynamite, who predicted that war would now be catastrophic. If the forecasting on technology had been combined with the forecasting on geopolitics, the shattering of Europe might well have been predicted. Certainly the rise of the United States and Russia was predicted in the nineteenth century. Both Alexis de Tocqueville and Friedrich Nietzsche forecast the preeminence of these two countries. So, standing at the beginning of the twentieth century, it would have been possible to forecast its general outlines, with discipline and some luck.

The Twenty-First Century

Standing at the beginning of the twenty-first century, we need to identify the single pivotal event for this century, the equivalent of German unification for the twentieth century. After the debris of the European empire is cleared away, as well as what's left of the Soviet Union, one power remains standing and overwhelmingly powerful. That power is the United States. Certainly, as is usually the case, the United States currently appears to be making a mess of things around the world. But it's important not to be confused by the passing chaos. The United States is economically, militarily, and politically the most powerful country in the world, and there is no real challenger to that power. Like the Spanish-American War, a hundred years from now the war between the United States and the radical Islamists will be little remembered regardless of the prevailing sentiment of this time.

Ever since the Civil War, the United States has been on an extraordinary economic surge. It has turned from a marginal developing nation into an economy bigger than the next four countries combined. Militarily, it has gone from being an insignificant force to dominating the globe. Politically, the United States touches virtually everything, sometimes intentionally and sometimes simply because of its presence. As you read this book, it will seem that it is America- centric, written from an American point of view. That may be true, but the argument I'm making is that the world does, in fact, pivot around the United States.

This is not only due to American power. It also has to do with a fundamental shift in the way the world works. For the past five hundred years, Europe was the center of the international system, its empires creating a single global system for the first time in human history. The main highway to Europe was the North Atlantic. Whoever controlled the North Atlantic controlled access to Europe—and Europe's access to the world. The basic geography of global politics was locked into place.

Then, in the early 1980s, something remarkable happened. For the first time in history, transpacific trade equaled transatlantic trade. With Europe reduced to a collection of secondary powers after World War II, and the shift in trade patterns, the North Atlantic was no longer the single key to anything. Now whatever country controlled both the North Atlantic and the Pacific could control, if it wished, the world's trading system, and therefore the global economy. In the twenty-first century, any nation located on both oceans has a tremendous advantage.

Given the cost of building naval power and the huge cost of deploying it around the world, the power native to both oceans became the preeminent actor in the international system for the same reason that Britain dominated the nineteenth century: it lived on the sea it had to control. In this way, North America has replaced Europe as the center of gravity in the world, and whoever dominates North America is virtually assured of being the dominant global power. For the twenty-first century at least, that will be the United States.

The inherent power of the United States coupled with its geographic position makes the United States the pivotal actor of the twenty-first century. That certainly doesn't make it loved. On the contrary, its power makes it feared. The history of the twenty-first century, therefore, particularly the first half, will revolve around two opposing struggles. One will be secondary powers forming coalitions to try to contain and control the United States. The second will be the United States acting preemptively to prevent an effective coalition from forming.

If we view the beginning of the twenty-first century as the dawn of the American Age (superseding the European Age), we see that it began with a group of Muslims seeking to re- create the Caliphate—the great Islamic empire that once ran from the Atlantic to the Pacific. Inevitably, they had to strike at the United States in an attempt to draw the world's primary power into war, trying to demonstrate its weakness in order to trigger an Islamic uprising. The United States responded by invading the Islamic world. But its goal wasn't victory. It wasn't even clear what victory would mean. Its goal was simply to disrupt the Islamic world and set it against itself, so that an Islamic empire could not emerge.

The United States doesn't need to win wars. It needs to simply disrupt things so the other side can't build up sufficient strength to challenge it. On one level, the twenty-first century will see a series of confrontations involving lesser powers trying to build coalitions to control American behavior and the United States' mounting military operations to disrupt them. The twenty-first century will see even more war than the twentieth century, but the wars will be much less catastrophic, because of both technological changes and the nature of the geopolitical challenge.

As we've seen, the changes that lead to the next era are always shockingly unexpected, and the first twenty years of this new century will be no exception. The U.S.–Islamist war is already ending and the next conflict is in sight. Russia is re-creating its old sphere of influence, and that sphere of influence will inevitably challenge the United States. The Russians will be moving westward on the great northern European plain. As Russia reconstructs its power, it will encounter the U.S.-dominated NATO in the three Baltic countries—Estonia, Latvia, and Lithuania—as well as in Poland. There will be other points of friction in the early twenty-first century, but this new cold war will supply the flash points after the U.S.–Islamist war dies down.

The Russians can't avoid trying to reassert power, and the United States can't avoid trying to resist. But in the end Russia can't win. Its deep internal problems, massively declining population, and poor infrastructure ultimately make Russia's long- term survival prospects bleak. And the second cold war, less frightening and much less global than the first, will end as the first did, with the collapse of Russia.

There are many who predict that China is the next challenger to the United States, not Russia. I don't agree with that view for three reasons. First, when you look at a map of China closely, you see that it is really a very isolated country physically. With Siberia in the north, the Himalayas and jungles to the south, and most of China's population in the eastern part of the country, the Chinese aren't going to easily expand. Second, China has not been a major naval power for centuries, and building a navy requires a long time not only to build ships but to create well-trained and experienced sailors.

Third, there is a deeper reason for not worrying about China. China is inherently unstable. Whenever it opens its borders to the outside world, the coastal region becomes prosperous, but the vast majority of Chinese in the interior remain impoverished. This leads to tension, conflict, and instability. It also leads to economic decisions made for political reasons, resulting in inefficiency and corruption. This is not the first time that China has opened itself to foreign trade, and it will not be the last time that it becomes unstable as a result. Nor will it be the last time that a figure like Mao emerges to close the country off from the outside, equalize the wealth—or poverty—and begin the cycle anew. There are some who believe that the trends of the last thirty years will continue indefinitely. I believe the Chinese cycle will move to its next and inevitable phase in the coming decade. Far from being a challenger, China is a country the United States will be trying to bolster and hold together as a counterweight to the Russians. Current Chinese economic dynamism does not translate into long-term success.

In the middle of the century, other powers will emerge, countries that aren't thought of as great powers today, but that I expect will become more powerful and assertive over the next few decades. Three stand out in particular. The first is Japan. It's the second- largest economy in the world and the most vulnerable, being highly dependent on the importation of raw materials, since it has almost none of its own. With a history of militarism, Japan will not remain the marginal pacifistic power it has been. It cannot. Its own deep population problems and abhorrence of large- scale immigration will force it to look for new workers in other countries. Japan's vulnerabilities, which I've written about in the past and which the Japanese have managed better than I've expected up until this point, in the end will force a shift in policy.

Then there is Turkey, currently the seventeenth-largest economy in the world. Historically, when a major Islamic empire has emerged, it has been dominated by the Turks. The Ottomans collapsed at the end of World War I, leaving modern Turkey in its wake. But Turkey is a stable platform in the midst of chaos. The Balkans, the Caucasus, and the Arab world to the south are all unstable. As Turkey's power grows—and its economy and military are already the most powerful in the region—so will Turkish influence.

Finally there is Poland. Poland hasn't been a great power since the sixteenth century. But it once was—and, I think, will be again. Two factors make this possible. First will be the decline of Germany. Its economy is large and still growing, but it has lost the dynamism it has had for two centuries. In addition, its population is going to fall dramatically in the next fifty years, further undermining its economic power. Second, as the Russians press on the Poles from the east, the Germans won't have an appetite for a third war with Russia. The United States, however, will back Poland, providing it with massive economic and technical support. Wars—when your country isn't destroyed—stimulate economic growth, and Poland will become the leading power in a coalition of states facing the Russians.

Japan, Turkey, and Poland will each be facing a United States even more confident than it was after the second fall of the Soviet Union. That will be an explosive situation. As we will see during the course of this book, the relationships among these four countries will greatly affect the twenty-first century, leading, ultimately, to the next global war. This war will be fought differently from any in history—with weapons that are today in the realm of science fiction. But as I will try to outline, this mid-twenty-first century conflict will grow out of the dynamic forces born in the early part of the new century.

Tremendous technical advances will come out of this war, as they did out of World War II, and one of them will be especially critical. All sides will be looking for new forms of energy to substitute for hydrocarbons, for many obvious reasons. Solar power is theoretically the most efficient energy source on earth, but solar power requires massive arrays of receivers. Those receivers take up a lot of space on the earth's surface and have many negative environmental impacts—not to mention being subject to the disruptive cycles of night and day. During the coming global war, however, concepts developed prior to the war for space- based electrical generation, beamed to earth in the form of microwave radiation, will be rapidly translated from prototype to reality. Getting a free ride on the back of military space launch capability, the new energy source will be underwritten in much the same way as the Internet or the railroads were, by government support. And that will kick off a massive economic boom.

But underlying all of this will be the single most important fact of the twenty-first century: the end of the population explosion. By 2050, advanced industrial countries will be losing population at a dramatic rate. By 2100, even the most underdeveloped countries will have reached birthrates that will stabilize their populations. The entire global system has been built since 1750 on the expectation of continually expanding populations. More workers, more consumers, more soldiers—this was always the expectation. In the twenty-first century, however, that will cease to be true. The entire system of production will shift. The shift will force the world into a greater dependence on technology—particularly robots that will substitute for human labor, and intensified genetic research (not so much for the purpose of extending life but to make people productive longer).

What will be the more immediate result of a shrinking world population? Quite simply, in the first half of the century, the population bust will create a major labor shortage in advanced industrial countries. Today, developed countries see the problem as keeping immigrants out. Later in the first half of the twenty-first century, the problem will be persuading them to come. Countries will go so far as to pay people to move there. This will include the United States, which will be competing for increasingly scarce immigrants and will be doing everything it can to induce Mexicans to come to the United States—an ironic but inevitable shift.

These changes will lead to the final crisis of the twenty-first century. Mexico currently is the fifteenth-largest economy in the world. As the Europeans slip out, the Mexicans, like the Turks, will rise in the rankings until by the late twenty-first century they will be one of the major economic powers in the world. During the great migration north encouraged by the United States, the population balance in the old Mexican Cession (that is, the areas of the United States taken from Mexico in the nineteenth century) will shift dramatically until much of the region is predominantly Mexican.

The social reality will be viewed by the Mexican government simply as rectification of historical defeats. By 2080 I expect there to be a serious confrontation between the United States and an increasingly powerful and assertive Mexico. That confrontation may well have unforeseen consequences for the United States, and will likely not end by 2100.

Much of what I've said here may seem pretty hard to fathom. The idea that the twenty-first century will culminate in a confrontation between Mexico and the United States is certainly hard to imagine in 2009, as is a powerful Turkey or Poland. But go back to the beginning of this chapter, when I described how the world looked at twenty-year intervals during the twentieth century, and you can see what I'm driving at: common sense is the one thing that will certainly be wrong. Obviously, the more granular the description, the less reliable it gets. It is impossible to forecast precise details of a coming century—apart from the fact that I'll be long dead by then and won't know what mistakes I made.

But it's my contention that it is indeed possible to see the broad outlines of what is going to happen, and to try to give it some definition, however speculative that definition might be. That's what this book is about.

Forecasting a Hundred Years Ahead

Before I delve into any details of global wars, population trends, or technological shifts, it is important that I address my method—that is, precisely how I can forecast what I do. I don't intend to be taken seriously on the details of the war in 2050 that I forecast. But I do want to be taken seriously in terms of how wars will be fought then, about the centrality of American power, about the likelihood of other countries challenging that power, and about some of the countries I think will—and won't—challenge that power.

And doing that takes some justification. The idea of a U.S.–Mexican confrontation and even war will leave most reasonable people dubious, but I would like to demonstrate why and how these assertions can be made. One point I've already made is that reasonable people are incapable of anticipating the future. The old New Left slogan "Be Practical, Demand the Impossible" needs to be changed: "Be Practical, Expect the Impossible." This idea is at the heart of my method. From another, more substantial perspective, this is called geopolitics.

Geopolitics is not simply a pretentious way of saying "international relations." It is a method for thinking about the world and forecasting what will happen down the road. Economists talk about an invisible hand, in which the self-interested, short-term activities of people lead to what Adam Smith called "the wealth of nations." Geopolitics applies the concept of the invisible hand to the behavior of nations and other international actors. The pursuit of short-term self-interest by nations and by their leaders leads, if not to the wealth of nations, then at least to predictable behavior and, therefore, the ability to forecast the shape of the future international system.

Geopolitics and economics both assume that the players are rational, at least in the sense of knowing their own short-term self-interest. As rational actors, reality provides them with limited choices. It is assumed that, on the whole, people and nations will pursue their self-interest, if not flawlessly, then at least not randomly. Think of a chess game. On the surface, it appears that each player has twenty potential opening moves. In fact, there are many fewer because most of these moves are so bad that they quickly lead to defeat. The better you are at chess, the more clearly you see your options, and the fewer moves there actually are available. The better the player, the more predictable the moves. The grandmaster plays with absolute predictable precision—until that one brilliant, unexpected stroke.

Nations behave the same way. The millions or hundreds of millions of people who make up a nation are constrained by reality. They generate leaders who would not become leaders if they were irrational. Climbing to the top of millions of people is not something fools often do. Leaders understand their menu of next moves and execute them, if not flawlessly, then at least pretty well. An occasional master will come along with a stunningly unexpected and successful move, but for the most part, the act of governance is simply executing the necessary and logical next step. When politicians run a country's foreign policy, they operate the same way. If a leader dies and is replaced, another emerges and more likely than not continues what the first one was doing.

I am not arguing that political leaders are geniuses, scholars, or even gentlemen and ladies. Simply, political leaders know how to be leaders or they wouldn't have emerged as such. It is the delight of all societies to belittle their political leaders, and leaders surely do make mistakes. But the mistakes they make, when carefully examined, are rarely stupid. More likely, mistakes are forced on them by circumstance. We would all like to believe that we— or our favorite candidate—would never have acted so stupidly. It is rarely true. Geopolitics therefore does not take the individual leader very seriously, any more than economics takes the individual businessman too seriously. Both are players who know how to manage a process but are not free to break the very rigid rules of their professions.

Politicians are therefore rarely free actors. Their actions are determined by circumstances, and public policy is a response to reality. Within narrow margins, political decisions can matter. But the most brilliant leader of Iceland will never turn it into a world power, while the stupidest leader of Rome at its height could not undermine Rome's fundamental power. Geopolitics is not about the right and wrong of things, it is not about the virtues or vices of politicians, and it is not about foreign policy debates. Geopolitics is about broad impersonal forces that constrain nations and human beings and compel them to act in certain ways.

The key to understanding economics is accepting that there are always unintended consequences. Actions people take for their own good reasons have results they don't envision or intend. The same is true with geopolitics. It is doubtful that the village of Rome, when it started its expansion in the seventh century BC, had a master plan for conquering the Mediterranean world five hundred years later. But the first action its inhabitants took against neighboring villages set in motion a process that was both constrained by reality and filled with unintended consequences. Rome wasn't planned, and neither did it just happen.

Geopolitical forecasting, therefore, doesn't assume that everything is predetermined. It does mean that what people think they are doing, what they hope to achieve, and what the final outcome is are not the same things. Nations and politicians pursue their immediate ends, as constrained by reality as a grandmaster is constrained by the chessboard, the pieces, and the rules. Sometimes they increase the power of the nation. Sometimes they lead the nation to catastrophe. It is rare that the final outcome will be what they initially intended to achieve.

Geopolitics assumes two things. First, it assumes that humans organize themselves into units larger than families, and that by doing this, they must engage in politics. It also assumes that humans have a natural loyalty to the things they were born into, the people and the places. Loyalty to a tribe, a city, or a nation is natural to people. In our time, national identity matters a great deal. Geopolitics teaches that the relationship between these nations is a vital dimension of human life, and that means that war is ubiquitous. Second, geopolitics assumes that the character of a nation is determined to a great extent by geography, as is the relationship between nations. We use the term geography broadly. It includes the physical characteristics of a location, but it goes beyond that to look at the effects of a place on individuals and communities. In antiquity, the difference between Sparta and Athens was the difference between a landlocked city and a maritime empire. Athens was wealthy and cosmopolitan, while Sparta was poor, provincial, and very tough. A Spartan was very different from an Athenian in both culture and politics.

If you understand those assumptions, then it is possible to think about large numbers of human beings, linked together through natural human bonds, constrained by geography, acting in certain ways. The United States is the United States and therefore must behave in a certain way. The same goes for Japan or Turkey or Mexico. When you drill down and see the forces that are shaping nations, you can see that the menu from which they choose is limited.

The twenty-first century will be like all other centuries. There will be wars, there will be poverty, there will be triumphs and defeats. There will be tragedy and good luck. People will go to work, make money, have children, fall in love, and come to hate. That is the one thing that is not cyclical. It is the permanent human condition. But the twenty-first century will be extraordinary in two senses: it will be the beginning of a new age, and it will see a new global power astride the world. That doesn't happen very often. We are now in an America-centric age. To understand this age, we must understand the United States, not only because it is so powerful but because its culture will permeate the world and define it. Just as French culture and British culture were definitive during their times of power, so American culture, as young and barbaric as it is, will define the way the world thinks and lives. So studying the twenty-first century means studying the United States.

If there were only one argument I could make about the twenty-first century, it would be that the European Age has ended and that the North American Age has begun, and that North America will be dominated by the United States for the next hundred years. The events of the twenty-first century will pivot around the United States. That doesn't guarantee that the United States is necessarily a just or moral regime. It certainly does not mean that America has yet developed a mature civilization. It does mean that in many ways the history of the United States will be the history of the twenty-first century.

A Daily Snapshot Of Market Moving Developments

John Mauldin — Mon, 22 Dec 2008 18:21:17 GMT

Have you done your Christmas shopping yet? Research shows that more of us are putting it off in expectations of better prices. In other words deflationary expectations! The prices I have seen while out shopping the past few weeks are simply amazing. I have to admit to have made a few purchases for some items that I was not planning to buy just yet because prices were off by 60% or more. A few days ago a friend came in sporting a new black cashmere sweater top with jeweled embroidery and quite fancy. She said she got it at Saks. But the real story is that when she walked into Saks looking for a present for her kids they handed her a coupon with a 30% off any one item from whatever price it was already marked down. That top? At one point it was almost $500. She bought it for $75. I have to confess that made me worry about retail sales and future unemployment. I like low prices, but I like profitable companies and employment. I went and talked to a Saks salesperson a few weeks ago who had been there 25 years and asked if they had ever discounted like that before Christmas and he said never. It was Saturday in New York and the place looked busy. I asked why? And he said, "The store is empty during the week." And I bought a few sweaters at 60% off. Tiffani just got some presents from J Crew at over 60% off. Before Christmas! How many readers have seen the same sales? And yet shopping is down?

As a side note, this year most of the kids and in-laws are all going to get a Visa gift cards so they can take advantage of what I think are going to be even better sales after Christmas. It is not that Dad put off his shopping to the last minute (which I did) but the kids are really looking forward to finding their special items on sale. I wonder how many more are doing that?

This week we look at David Rosenberg's latest missive. While listing a number of negative data points, the thing to watch for is all the deflationary news. I have been pounding the table for YEARS that deflation is going to be the problem, and there would be massive stimulus from the Fed to fight it. We are now coming to that inflection point. Rosenberg is one of my favorite main stream economists and the North American Economist for Merrill Lynch. I would say enjoy this week's Outside the Box, but it is not enjoyable reading, but you should read it anyway.

Have a Merry Christmas. And enjoy the after Christmas sales! All the best,

John Mauldin, Editor
Outside the Box

A Daily Snapshot Of Market Moving Developments

North America: Morning Market Memo
by David A. Rosenberg

Overseas Overnight Market action Outside of Japan, which rallied 1.6% on speculation that the BoJ would buy corporate debt to ease credit risk, equity markets across Asia were weaker across the board. The Hang Seng sank 3.3%, or -505 points, to 14,622. India's Sensex was off 1.7% while China's Shanghai Composite dropped 1.5%. The Korean Kospi, however, fell just 0.1%. In Europe, equity markets are trading lower and off about 0.8% in the aggregate. US equity futures, however, are pointing to a higher open across the major indices. Bonds are trading mixed across the globe, with yields down 2-4 bps in Europe but up a bp in the US. JGBs were down a bp to 1.2%. On the commodity front, we see that gold is rallying, up $6.50 an ounce to $844.75.

On the data front

This is a truly global recession. We learned overnight that Japanese exports collapsed 26.7% year-over-year in November; that's the biggest drop on record. Shipments to the US plunged at an unprecedented 34% year-over-year rate. Meanwhile, imports into Japan sank 14.4% year-over-year in a sign of weakening domestic demand. A similar story out of Thailand, where exports dropped 18.6% in what was the biggest drop in at least 16 years. In China, interest rates were cut for the fifth time in three months. The key one-year lending rate was cut 27 bps to 5.31%. The reserve requirement was cut 50 bps to 15.5% for big banks and 13.5% for smaller ones. Chinese policymakers are trying to head off social unrest. Take a look at page A8 of today's WSJ, "China Faces Unrest as Economy Falters." For a read of how another BRIC nation has hit a wall in the face of a deepening global recession, turn to page A10 of today's WSJ, "India's Textile Industry Unravels."

Across the pond, signs of deflation abound. Germany's import price index dropped 3.4% MoM in November on top of a 3.6% drop in October. This was well below the consensus estimate, which was looking for a 2.5% decline. In France, producer prices plunged 1.9% in November on top of a 0.9% decline in October, well below the consensus, which was looking for a 0.9% drop for the month. Meanwhile, European industrial orders dropped 4.7% MoM in October on top of a downwardly revised 5.4% decline in September. This took the year-over-year rate to -15.1%, which is the the worst on record. We also see that German consumer confidence remained essentially unchanged at 2.1 in January from 2.2 in December.

The next bailout: commercial real estate

Now that the auto-makers have secured a $17 billion bailout, the next group heading to Washington for government assistance is property developers. Take a look at the front page of today's Wall Street Journal, "Developers Ask US For Bailout as Massive Debt Looms." Developers are warning policymakers that office complexes, malls, hotels and other commercial real estate are headed into default and bankruptcy. According to Foresight Analytics, some $350 billion of commercial mortgages will be due for refinancing over the next three years. And, with credit virtually unavailable, borrowers will have give up the property to lenders.

Whiffs of deflation in pharmacies

Take a look at page B3 of today's WSJ, "Pharmacies Fight Tough Battle on Generic Prices." In response to a discount prescription drug program from Wal-Mart, retail pharmacies like CVS, Caremark, Walgreen's and Rite Aid have started to aggressively promote their discount drug programs.

Breaking News Today's events

It is quiet today with no economic data released. Tomorrow, we'll get the final take on third quarter GDP, which is expected to remain at -0.5% QoQ annualized. The U of M index of consumer sentiment is due as well and expected to drop to 58.7 in December from 59.1 in November. New home sales are expected to drop again to 415,000 units annualized in November from 433,000 in October. Existing home sales are up too and expected to drop to 4.93 million units annualized in November from 4.98 million units in October. On Wednesday, we'll get the personal income and outlays report. Personal income expected to come in flat in November while spending is expected to drop 0.7% MoM in November on top of a 1% decline in October. The core PCE price index is expected to drop to 2% YoY in November from 2.1%. Durable goods round out the week and are expected to drop 3% MoM in November after a 6.9% collapse in October. Ex-transportation orders look to drop 2% too after a 5.4% plunge in October.

Making it up as he goes along

The latest news out of the Obama economics camp is that the upcoming fiscal plan will create 3 million jobs instead of the 2.5 million pledged just a few weeks ago. It begs the questions: How does the government "create" jobs anyway? What jobs? Where will they come from? Doesn't the government really help create and nurture the backdrop for the private sector to generate employment and economic growth? See "Obama Expands Recovery Plans As Outlook Dims" on the front page of the Sunday NYT. Indeed, 3 million jobs sounds good and makes for front page headlines, but it would be useful to see a line-item list of where these bodies are going to come from and whether they have the skills to build new ports, medical infrastructure, mass public transit infrastructure and expanded electricity grid and "green" technologies.

Let's do the math

We have 1.2 million unemployed construction workers. We have 123,000 unemployed architects and engineers. We have 83,000 unemployed machinery workers. We have 145,000 unemployed transportation-related workers. So that brings us to barely more than 1.5 million of a labor pool the government can tap into for all the new building activity. But the bulk of the joblessness is in financials (up to half a million), retail/wholesale (1.2 million), leisure/hospitality (1.3 million) and health/education (1.2 million). And if investment bankers, shopkeepers, bell captains and medical chart technicians have anything in common it is that they don't have much experience in shovel-ready activities.

Urban renewal in Obama's fiscal package

As an aside, we published a report two weeks ago highlighting the need for urban renewal as part of Obama's fiscal package - and it looks like somebody in Washington shares our view. See "Top Democrat Seeks to Boost Mass Transit's Share of Funding" on page A4 of the weekend WSJ. This is a secular theme. Another place we can see Obama's infrastructure program touch is the nation's levees, where repairs have lagged. See the front page of today's USA Today for more, "Most Levee Repairs Lagging."

Deflation risks are intact

Households have lost over $7 trillion in terms of net worth in the year ending 3Q, and it looks like this wealth destruction will top $10 trillion when the 4Q Fed flowof-funds data come out (that already exceeds the entire $4 trillion loss during the tech wreck). For a great synopsis, see "A Deflation Maelstrom In the Making" on page 11 of BusinessWeek. Friday's WSJ (page B1 - "Retailers Drop Prices to Avert a Flop") was filled with stories of how merchants are discounting more now than they were on Black Friday. Macy's has cut the prices of its diamond earrings from $800 a pair to $249 and the GAP just sliced another 60% off its already discounted clothing prices (as Bloomberg News reported over the weekend) and we are supposed to be consumed about deflation fear. Really? As a sign of how consumers are delaying their purchases in anticipation of even lower prices, only 47% of shoppers have completed their holiday activity versus 53% a year ago. We regard this as evidence that deflation expectations are creeping in.

And one of the conditions for deflation is, of course, wage flexibility, and everywhere we look, we see an increasing number of companies cutting back on their wage bills. FedEx is just one example - slashing wages for 35,000 employees by 5% (that is 16% of the company's workforce), including a 20% base pay cut for its Chairman and CEO (plus no company contributions to 401k plans in 2009). We also see that Nortel, Eastman Chemical, Newell Rubbermaid, Agilent Technologies, Atlas World Group, and AK Steel Holding have all cut wages and salaries in the past few weeks. According to Watson Wyatt Worldwide, another 6% of companies also plan to cut wages and benefits and 23% intend to reduce the size of their staff in 2009. Also have a look at the front page of "In Need of Cash, More Companies Cut 401(k) Match" - again, the labor market is definitely deflating. Not only that, but these cuts to 401(k) contributions are going to accelerate the process towards rising personal savings rates in coming quarters and years - again, a highly deflationary development and we are not sure that there is an appropriate response to this given that the savings rate is already at rock bottom levels of around 2%.

Moreover, the national labor market has frozen to such an extent that labor mobility has contracted significantly - see "Data Show Drop in Americans On the Move" on page 27 of the FT. Also have a look at front page of today's New York Times, "More Companies Cut Labor Costs, Without Layoffs." Companies are implementing four-day workweeks, unpaid vacations, wage freezes and pension cuts but keeping their headcount. Finally, take a look at page 13 of today's Financial Times, "Christmas Shutdown in Silicon Valley." What is usually limited to traditional manufacturing industries like auto has now hit tech. Companies across Silicon Valley are shutting down until after the holidays to cut back on spending. In spite of the forced time-off, some workers will be required to use up part of their holiday entitlement or if they don't have vacation days, take unpaid leave.

Historians may title this era GDII

As we said, historians may look back on this era and title it GDII: After all, look at how people are behaving - one of the newest fashions is renting movies about the Great Depression, or that have a similar theme like the "Grapes of Wrath" and "It's a Wonderful Life". See "Reality Can be Escaping, Too" on the front page of the Sunday NYT's Week in Review section.

Consensus still loves equities and despises bonds

See Barron's for more on the 'groupthink' theme - every single strategist surveyed (outside of us) sees the 10-year note yield backing up next year from current levels (page M12). The consensus is 3% for the end of 2009. As for equities, the Roundtable (see page 23) is at 1,045 for the S&P 500 (which would be +15 from here). Nobody is lower than 975 (Rich B's prediction) so +10% is at the low end of the entire spectrum. Health care was cited as a 'favorite sector' by 10 of the 12 pundits, and at least one of utilities/staples/telecom showed up on the top list of two-thirds of the respondents. So the view seems to be that we are going to have a bounce next year, led by ... the defensives. Interesting.

We don't understand why so many are bearish on rates

What we truly don't understand is why it is that so many folks are bearish on interest rates when in fact we need a sustained period of very low yields to help blaze the trail for the next sustainable economic expansion: After all, isn't it good news that, because of Mr. Bond's strength and resolve, we now have the benchmark 30-year fixed-rate mortgage at the lowest level in at least 37 years (5.27%)? Mortgage rates are now down 7 weeks in a row (it does the beg the question, however, as to why it is that mortgage applications for new purchases slid at a 20% annual rate in November and are off in 9 of the past 10 months). And despite the best affordability ratios in 35 years, what did we hear from Lennar last week - that its order book collapsed 46% in the past year and backlogs are down 67%. Maybe the classic affordability ratios that use conventional mortgages don't tell the complete story - because nonconventional mortgage rates have lagged with jumbo loans still costing 6.9%.

Homebuilders pressuring Washington for a bailout

As the bailouts pile up, we thought that the best read of the weekend was from the Weekend WSJ - see page W1 ("Is the Medicine Worse than the Illness?"). And now we see that the homebuilders are pressuring Washington to provide first-time homebuyers with a $22,000 tax credit. It's as if there is now a pervasive belief that there is a bottomless pit of cash ready to be put to use to correct all the excesses of the past decade from financials, to autos to builders. It's amazing that we could have let so many tech companies go belly up in the last cycle but have gone this route of accelerating rescue packages this time around. At least in the last cycle, we were running balanced budgets as opposed to trillion-dollar deficits. What does concern us is the risk to civil liberties when bankruptcy judges can alter contracts, the government can force banks to accept public capital injections (Jamie Dimon said on CNBC he didn't want or need Paulson's help), the government by fiat can bring mortgage rates down as opposed to market forces, the government tells lenders how to price their credit card business (since when did a piece of plastic become a right instead of a luxury?).

The major risks for 2009

We continue to believe that trade protectionism, competitive devaluations and military conflicts are the major risks for investors for 2009 - this is, after all, the most broadly based global recession (according to the IMF, not just us) in the post-WWII era: Ecuador defaulted on its foreign debt. Since the G20 meeting in Washington in October, five of those countries - Russia, India, Indonesia, Brazil and Argentina - have announced their intentions to raise import tariffs or otherwise restrict trade. Russia has announced plans to raise tariffs on autos; India has already lifted duties on iron, steel and soy; Brazil and Argentina are putting together a case within Mercosur for boosting external tariffs. Vietnam just raised taxes on steel imports to 12% from 8%. The EU said it may reimpose duties of 79% on a paper-binder component in retaliation against China. French President Sarkozy has established a $7.5 bln fund to invest in domestic companies so as to avoid foreign takeovers. China has reinstated export rebates and now we see that US steel, textile and paper markets intend to file complaints against Chinese imports, and did anyone notice that this auto-bailout excludes foreign companies?

It's all about self-preservation. We think that for anyone who missed it, the article on the front page of Friday's NYT is a worthwhile read ("After 30 Years, Economic Perils on China's Path"). Russia also cannot be regarded as a stable data point either as it just posted its first monthly budget deficit in November and the sovereign debt was just downgraded by S&P for the first time in a decade (Friday's WSJ reports says "public panic is one of the Kremlin's greatest fears"; the NYT reports that "as Beijing worries about strikes and mass layoffs even in some of the its most prosperous areas, official tolerance of political dissent has seemingly narrowed".) Gold will be an important hedge against policy missteps

Gold, in our opinion, is going to be important hedge against such policy missteps in 2009; and not only gold, but security of supply and government procurement policies may end up putting a floor under the beleaguered commodity complex earlier than a lot of folks think. As the chart below attests, there is a pretty good link between government spending as a share of GDP and the CRB index, because governments don't buy clothing or jewelry but they do buy "material".

And as for gold, the chart looks good against a vast majority of currencies and has broken out against Sterling. See chart below.

As we said before, the new growth engine for the economy is government spending, which is already on the rise and set to take out the prior high of over 23%. After all, when you are in trouble, you go to family members for help first. Uncle Sam.....?

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.

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.

John Mauldin's Outside the Box : Global Economy

The China Files (Special Project): Real Estate

The China Files (Special Project): Real Estate

Summary

Analysis

Origins of the Bubble

The Recovery Bubble

The Recession in Central Europe, Part 2: Country by Country

The Recession in Central Europe, Part 2: Country by Country

Bosnia

Bulgaria

Croatia

Czech Republic

The Baltics (Estonia, Latvia, Lithuania)

Hungary

Poland

Romania

Serbia

The U.S.-Russian Summit Turns Routine

The U.S.-Russian Summit Turns Routine

The Fundamental Issues

What the Summit Produced

The Kennedy Trap

A Tale of Two Depressions

A Tale of Two Depressions

Comparing the Great Depression to now for the world, not just the US

It's a Depression alright

Policy responses: Then and now

Conclusion

Fear for a Lost Decade

Fear for a Lost Decade

The Geography of Recession

The Geography of Recession

The United States and the Free Market

Russia and the State

China and Separatism

Discordant Europe

The Obama Administration and the Former Soviet Union

Part 7: The Obama Administration and the Former Soviet Union

Russia's Geographic Position

The Bush Administration and Russia

Russia's Goals

Russia's Expectations and Concerns

China: Exports Drop

China: Exports Drop

Reality Bites

Reality Bites

The Economic Policy Conundrum

Dow 5000 Update

The "D" Word

Investing Today

Bank Nationalization

Let GM Go

Obama's Budget

The Coming Meltdown in Eastern Europe

Europe On the Ropes

Europe On the Ropes

Policy mistakes 'en masse'

Policing must improve

More leverage in Europe

Not much of a cushion left

The wheels are coming off

The problem is widespread

US banks are better off

The great mortgage show

Austria is in greatest trouble

An extra $250bn to the IMF

Conspiracy or...?

Public debt to rise and rise

Can Germany rescue us?

Geithner, China, and the Specter of Technical Insolvency

Geithner, Obama and China

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

Loss Estimates

The Next 100 Years

The Next 100 Years

OVERTURE An Introduction to the American Age

The Twenty-First Century

Forecasting a Hundred Years Ahead

A Daily Snapshot Of Market Moving Developments

OVERTURE
An Introduction to the American Age