John Mauldin's Outside the Box : Global Economy

A Leaderless World

John Mauldin — Tue, 08 May 2012 06:32:48 GMT

I recently had a chance to speak at a conference where Dr. Ian Bremmer spoke after me. I was very impressed with his thought process and asked him to give me an outline of his speech to share with you for this week's Outside the Box. It's a shorter version of his powerhouse book, Every Nation for Itself: Winners and Losers in a G-Zero World. I highly recommend it.

And what, you're asking, is a "G-Zero world"? In a word, it's a leaderless world. A world in which, as Bremmer says, "Not so long ago, America, Western Europe and Japan were the world's powerhouses. Today, they're struggling to recover their dynamism…. But nor are rising powers like China, India, Brazil, Turkey, the Gulf Arabs and others ready to take up the slack…. If not the West, the rest, or the institutions where they come together, who will lead? The answer is, no one."

And that means the world's big problems won't get addressed as effectively as they should, as long as the leadership vacuum persists. Talk about Muddling Through!

This book by Bremmer is going to make a difference, and I'm not the only one who thinks so–

"Ian Bremmer combines shrewd analysis with colorful storytelling to reveal the risks and opportunities in a world without leadership. This is a fascinating and important book." –FAREED ZAKARIA

"Every Nation for Itself is a provocative and important book about what comes next. Ian Bremmer has again turned conventional wisdom on its head." –NOURIEL ROUBINI

Tonight I am in Chicago, where I spoke at the CFA conference this morning. It went well. I will try to get a link for you later. It hasn't been all work, either. David Rosenberg, Barry Ritholtz, and I all had dinner gigs, but we met up at the bar and just hung out for about three hours. Got to love O'Doul's NA beer. Not quite the same as a good chardonnay but healthier for me.

I will hit the send button as I have to get up for a breakfast meeting with Sam Zell. We have never met and I am looking forward to it. He is quite the legend. I will give you an update on the conference next weekend. The reviews are coming in quite strong. It was interesting to see the European elections after the analysis we were given. There is so much that seems up in the air. You can almost feel the changes coming. I feel like the kid in the back of the car on a long road trip: "Are we there yet?"

Your holding out for a world that works analyst,

John Mauldin, Editor
Outside the Box

Every Nation for Itself: Winners and Losers in a G-Zero World

Ian Bremmer

One beautiful fall evening in October 2011, I gave a speech on international politics to a group of Canadian business executives in Napa Valley, California. As part of the introduction, I included a few thoughts on the G20, the forum in which 19 countries plus the European Union bargain over solutions to pressing international problems. I made my case for why I believe the G20 is a dysfunctional institution that will create as many problems as it solves. The speech complete, I joined members of the audience for dinner on a beautiful terrace overlooking a vineyard. Our host, spotting an opportunity for lively conversation, seated me next to a distinguished looking gentleman I'd never met—former Canadian Prime Minister Paul Martin. This is the man who created the G20.

As Canada's finance minister (1993-2002), then prime minister (2003-2006), Martin warned that Western dominance of international financial institutions couldn't last and that the world needed a new bargaining table, one that welcomed leading emerging powers as full partners. Martin's argument fell on deaf ears in America, Europe, and Japan—until the 2008 financial crisis made his point for him.

Menus closed, Martin and I began a friendly debate. I argued that 20 negotiators never agree on anything of substance unless and until they feel threatened by the same problem at the same time and to more or less the same degree. In other words, twenty is just too many. Making matters more complicated, these twenty don't even agree on the value of multiparty democracy and free market capitalism. Martin countered that major emerging powers can't simply be excluded and that the G20 gives more countries than ever a stake in the success of the global economy and in meeting the world's greatest political and security challenges. As dessert arrived, we agreed to disagree.

Then Martin told me something I hadn't expected. He didn't put forward the G20 idea mainly to improve global governance. Instead, it was the product of his careful calculation of what was best for Canada. His country had long been a member of the G7, a privileged position. But years before the market meltdown of 2008, Paul Martin understood that the world's balance of power was changing more quickly than many realized and that the G7 was fast becoming irrelevant. He became convinced that Canada needed to exchange its first class seat on a sinking ship for a secure spot on a bigger boat. By leading the effort to build that boat, Martin believed that Canada could win valuable new friends. The G20, dysfunctional or not, is now a fixture of international politics.

As we dropped our napkins on the table and headed into the night, I replayed the conversation in my mind. I found myself thinking of an enormous poker table, one where each player minds his stack of chips, watches the 19 others, and waits for his best opportunity to play the hand he's been dealt. This is not a global order; it's a world of "every nation for itself." If the G7 no longer matters and the G20 doesn't work, then what is this world we now live in? I wrote the book to answer that question.

In short, it's a world without leadership. That's unfortunate, because at a time when so many problems transcend borders—from regional conflicts to climate change and threats to global market stability to cyber-attacks, terrorism, and the security of food and water—the need for international cooperation has never been greater. Cooperation demands leadership. Leaders have the leverage to coordinate multinational responses to transnational problems. They have the wealth and power to persuade other governments to take actions they wouldn't otherwise take. They pick up the checks that others can't afford and provide services no one else will pay for. Leaders set the agenda.

Where have the leaders gone? In the United States, a war-weary public is ever more wary of the country's mounting debt. In Europe, a more immediate debt crisis continues to undermine confidence in the future of the single currency—and of the European idea. In Japan, last year's earthquake, tsunami, and nuclear meltdown have only added to the long-term damage of two decades of political and economic malaise. Not so long ago, America, Western Europe and Japan were the world's powerhouses. Today, they're struggling to recover their dynamism.

But nor are rising powers like China, India, Brazil, Turkey, the Gulf Arabs and others ready to take up the slack. For emerging nations, emergence is a full-time job. The governments of these countries still face complex development challenges that demand too many resources and too much time, energy, attention, and money to accept major new risks and burdens abroad. China, in particular, must pass a series of enormous tests in coming years if it is to remain politically stable in something like its current form. Its leadership knows it must build a modern, middle-class country with a 21st century social safety net. It must reduce the country's reliance on exports by fueling greater domestic demand for Chinese-made products by transferring enormous amounts of wealth from state-owned companies to Chinese consumers. It must manage the environmental fallout of its enormous growth. It must absorb and redirect rising public demand for change to preserve the ruling party's monopoly hold on political power.

If not the West, the rest, or the institutions where they come together, who will lead? The answer is, no one. Neither the once-dominant G7 nor the unworkable G20. We have entered the G-Zero, a world in which, for the first time since the end of World War II, there is no single power or alliance of powers ready to take on global leadership.

The G-Zero story isn't about the decline of the West or the rise of China, because America and Europe have overcome adversity before and are well-equipped over the long run to do it again, and China faces a highly uncertain future. It's the story of a world in transition, one that's especially vulnerable to crises that appear suddenly and from unexpected directions. Nature still hates a vacuum, and the G-Zero won't last forever. But over the next decade and perhaps longer, the G-Zero will both incubate new sources of conflict, make almost all of them more difficult to manage, and push international politics toward multiple forms of turmoil. A world without leaders will undermine our ability to keep the peace, expand opportunity, reverse the impact of climate change, and feed growing populations. Its effects will have implications for our politics, business, information, communication, security, food, air and water. It will be felt in every region of the world—and even in cyberspace.

Winners and losers

Every era has its winners and losers, and the G-Zero will be no different. It is not merely strength but adaptability and resilience that are the attributes most likely to produce prosperity in a G-Zero world. Countries that have choices among political, security and commercial partners are much better able to navigate a world that generates shocks from unexpected directions. Because Brazil does big business with both China and the United States, its economy emerged with relatively little damage from the US financial market meltdown and the recession which followed. Mexico, on the other hand, which is far more dependent on the United States for its export revenue, tourism income, and remittances from workers living abroad took a much tougher hit. If you're going to rely too heavily for growth on the stability of a single economic partner, the United States is an excellent long-term option. But Brazil's diversified trade relations give its economy a resilience that Mexico can't yet match.

Turkey is a Middle East heavyweight, a NATO member and a bridge between Europe and Asia. South Africa has extensive trade relations with Europe and deepening political and economic ties with China, Russia, India and Brazil. Kazakhstan his historical ties with Russia, deepening commercial relations with both China and Germany. That's why Turkey, South Africa and Kazakhstan are "pivot states." Their flexibility is crucial for their stability and prosperity.

Like Mexico, Ukraine is what I call a "shadow state," a country that can't pivot. Much of Ukraine's population favors stronger political, economic and cultural relations with Europe, but the government of this former Soviet republic knows that for at least the next several years, it will have to protect the country's traditional ties with Russia. Why? Because Russia supplies most of Ukraine's energy and has proven more than once that it's willing to use its natural gas supplies as a weapon. In the dead of winter in 2009, Gazprom, Russia's natural gas monopoly, cut supplies to Ukraine in a dispute over pricing—and maybe to make a larger point. Moscow wants Kyiv to join a customs union that now includes Russia, Kazakhstan and Belarus, a personal priority for Vladimir Putin, and has promised gas deliveries at affordable prices to sweeten the deal. Ukraine has to take that offer seriously, because higher gas prices would force elected officials to hit voters with onerous new energy taxes.

Ukraine would love to become a pivot state, preserving relations with Russia while building new ties with Europe. In fact, Kyiv would love to sign a free trade agreement with the European Union. But the Kremlin warns that it will throw up new trade barriers if Kyiv signs a deal with Europe, and the EU says it will end trade talks with Ukraine if Kyiv joins Russia's customs union. Ukraine can't win because it can't pivot. It doesn't have the muscle or the independence to improve its bargaining position with either side. The G-Zero era won't be kind to countries like Mexico or Ukraine that remain overly reliant on a single powerful patron for security and/or market opportunities.

Diversification of partnerships and the ability to adapt to fast-changing circumstances will be crucial for companies, as well. Multinationals will have new opportunities to shift operations to places where regulatory and tax burdens are few. Some will use access to advanced technology to align with state-owned rivals, which might allow them a way in to otherwise closed markets. Other companies will offer products and services that help foreign governments achieve their development goals, for example, by investing in China's interior or by providing services to Russian companies looking for new opportunities in the Arctic. Defense firms that can help countries or companies limit the damage inflicted by regional conflicts, organized crime, or increasingly sophisticated cyber-attacks will thrive in the more volatile and less predictable G-Zero world.

What comes next?

The G-Zero is not the new normal. It can't last, because it will create too many problems that demand cooperative solutions. We have to look beyond this era of transition and to consider what will come next. Who will provide leadership in the post G-Zero world?

Don't bet against the United States. Anyone who believes that America is in some kind of irreversible decline has chosen to ignore the entire history of the US and its people. The financial crisis—and China's ability to power its way through the slowdown—have persuaded some that China's state-manipulated form of capitalism is the wave of the future. But let's not forget that, for all its well-documented failings, the free market variety of capitalism has generated a broad prosperity through booms and busts for hundreds of years. State capitalism has no history of lifting developing countries into the developed world. In part, that's because the process of "creative destruction" is not state capitalism's friend. For an authoritarian state like China's, it's a source of unrest. America's system of higher education, the durability of its democracy, its culture of innovation and entrepreneurialism, its relatively strong demographics, and a dozen other factors work in the country's favor. That said, we're very unlikely to return to some form of single superpower world. Not every emerging power will fully emerge, but only a World War II-scale cataclysm could return the world to 1945.

The shape of the post-G-Zero global order will depend on the answer to two questions. First, will relations between America and China be defined mainly by competition and conflict or by complementary interests? Second, will these two countries dominate international politics or can a variety of other states play an independent and influential global role? I see five broad scenarios:

· A G2 world in which common interests lead US and Chinese leaders mainly to collaborate

· A workable G20 order in which the G-Zero has generated so much trouble that governments are forced to work together to ensure political and economic stability

· A "Cold War 2.0" scenario in which the new order is defined by US-Chinese conflict

· Regionalization of international politics, in which America remains the only global power but in which local heavyweights call most of the shots within their respective neighborhoods

· A disintegration scenario that I call "G-Subzero" in which fragmentation within powerful countries limits the ability of national governments to govern

Fortunately, that last scenario is highly unlikely. The world that follows the G-Zero will probably be some combination of a couple of these different models, but regionalization appears the likeliest result because it's the path we're already on. This is a system in which the United States remains the world's most powerful and influential nation, but in which regional heavyweights are likely to exert extraordinary influence within their respective neighborhoods—for better and for worse.

*****

So what can America's next president, Obama or Romney, and the country's next Congress do about all this? They can accept that the world is changed, that this is not 1960, and that, at least for the time being, the architects of American foreign policy must learn to do more with less. More importantly, they can build a foreign policy that allows US policymakers, America's military, American companies, and American investors to adapt to changing circumstances, partner where necessary, and innovate at every opportunity. They must also do something that Americans don't do often enough: Invest for the longer-term future. They must rebuild the nation's strength from within so that America can afford to be indispensable for the post-G-Zero world.

And I hope that US policymakers will find the courage to bolster the nation's security by sharply reducing its debt burden. No reform that fails to trim the fat from America's sacred cows can accomplish this goal. Deficits do matter, compromise is a virtue, and even a superpower must live within its means.

Shadow over Asia

John Mauldin — Tue, 23 Nov 2010 18:15:00 GMT

This week we look over the Pacific pond to China and Japan, in an interview with my friend Vitaliy Katsenelson by David Galland, who is the managing editor of The Casey Report. Vitaliy is the chief investment officer of Investment Management Associates, Inc., and author of Active Value Investing. Profiled in Barron’s in September 2009, Vitaliy, who was born in Murmansk, Russia, and moved to the U.S. in 1991, is an adjunct faculty member at the University of Colorado at Denver’s Graduate School of Business.

Long time readers know that I just don’t get China or Japan. I think both are bubbles, but as Vitaliy notes, many bubbles can outlast the reputations of those predicting their demise. Timing is everything.

For those interested in subscribing to the Casey Report, which focuses on special situations and natural resources, you can get a risk free trial subscription by going to the following link. (http://www.caseyresearch.com/crpmkt/crpSolo.php?id=175&ppref=JMO175ED1110A) It is one of my favorite reads.

Have a great Thanksgiving week!

John Mauldin, Editor

Outside the Box

Shadow over Asia

by David Galland, Managing Editor, The Casey Report

An interview with Vitaliy Katsenelson

TCR: What our readers are looking for is a better sense of China and Japan, both of which are very important in the context of the global economy. As we have to start somewhere, let’s start with China.

Today the conventional wisdom is that somehow the Chinese economy is better managed than its competitors, very similar to how people viewed Japan in the 1970s and 1980s. Back then people were absolutely convinced that Japan was the superior country with superior policies and that its economy was unstoppable. We all know how that ended.

So, let’s start there. Is China's system better than everyone else's? Is it really possible the Chinese economy can keep steamrolling along?

VK: A few months ago, I watched a movie about Ayn Rand and it talked about how Americans in the 1930s looked at the Soviet Union’s flavor of managed economy as being superior to the American version of capitalism. At the time America was just coming out of the Great Depression, so that view made a lot of sense. So in the short run, and especially after the ugly side of creative destruction has paid us a visit, the grass of managed economy may look greener.

So when we look at China, the conventional wisdom says that the government is very, very smart, and therefore they can do a very good job in steering the economy in the right way. Chinese government may have the best intentions, its leaders may have IQs of 250 each on a bad day, but it is impossible to centrally manage an economy of China’s size.

I am a big believer that in the boxing match between a visible and an invisible hand, though the invisible hand may lose a few rounds, it will win the match every time. Last century we had the most amazing economic experiment take place when after World War II, Germany was split into two countries with different economic and political systems. But they were the same people, with the same language and culture, separated by a wall. We know how that story ended.

Of course, for a time, having government control over the levers of the economy can have advantages. For example, by taking prompt action, the Chinese government was able to pull the economy out of the recession remarkably fast, basically by fire-housing the stimulus package that was equivalent to 12% GDP. That's the advantage. The only problem is that these kinds of short-term advantages come with long-term, painful consequences.

For example, when you have a huge government presence in the economy, you also have a huge bureaucracy, and bureaucracy brings corruption. This is one of the reasons why China is rated so poorly on Transparency International’s annual corruption rating. Corruption breeds misallocation of capital, because the capital flows not to the best use, but it basically flows to whatever the political connection or whatever the bribe is directed to.

In addition, when you have a government-managed economy, it creates excesses. China has huge excesses in the industrial sector, as well as in commercial and residential real estate. We see plenty of evidence of these excesses, but they are likely to be much greater than we can measure today as they are covered up by robust economic growth. The true magnitude of these excesses will come to the surface once the economy slows down.

TCR: In essence, you’ve got a relatively small group of individuals who are making big decisions about China's economy and where production should be, in what sectors, etc. If history is any guide, that really can't last, yet many people seem to think it can. That said, China’s economy has certainly done remarkably well in the global economic crisis. In fact, according to their government, their GDP is almost back to where it was pre-crash. Why?

VK: Sure, the growth you see today in China is there, but it’s not a sustainable growth. It's not a growth that you'll see a few years from now. That is an important point for readers to understand.

TCR: Why is it not sustainable?

VK: Because the growth is being induced by government spending, by a misallocation of capital.

I'll give you an example. The vacancy rate on commercial real estate in China is fairly high, but they still keep on building new office buildings because they think they will always grow. So therefore as long as they keep building, that activity will be registered as growth, until they stop. And when they do stop, they’ll drown in overcapacity, and they won't be building new skyscrapers for a very long time.

TCR: We read that note you sent about the South China Mall, which is pretty stunning. It's the second largest mall in the world but is mostly empty.

VK: That's right. But as outrageous an example as the South China Mall is, there's an even more outrageous example – namely that the Chinese built an entire city, Ordos, in Inner Mongolia for 1.5 million residents and it is completely empty. These are classic examples of the sort of excesses going on in China.

TCR: The equivalent of building bridges to nowhere, but on a very large – Chinese – scale.

VK: Exactly. There are no shortcuts to greatness. As long as they keep building new bridges, the economic numbers will register that there is growth, but at some point the piper will have to be paid, and these projects have a negative return on capital.

TCR: It seems the Chinese are following the script Japan used to dig itself out of its postwar doldrums, deliberately keeping their currency low in order to build an economy on the back of low-cost manufacturing. But that game inevitably has to end – already we see more and more things being made in Indonesia, Pakistan, India, and so forth. If China loses the manufacturing core of their economy, won’t they be in big trouble?

VK: Well, once you move manufacturing to other countries, it’s very difficult to get it back. So you could probably argue that China will maintain its manufacturing advantage for a while.

The problem with China is pretty much the same as with any bubble. Though it may have had a solid foundation under it, it is simply a good thing taken too far. If you look at the railroad bubble in the United States, the country did need railroads, but we built too many.

The same thing happened with the technology bubble in 1998. The Internet was transformative to our economy, no question about it. But, again, it was taken too far.

There are some other countries that are lower-cost producers than China, but they probably can’t do it on the same scale that China can. But my point is that China is just a good thing taken too far, and if you add government involvement and corruption into the mix, you will get a bubble that is taken a lot further than you would normally expect.

One way of thinking about it is that the actions taken by the Chinese government, especially after the recent global recession, have basically supersized the bubble that was already forming.

TCR: Their government is sort of a holdover from a largely bygone era when many nations were communists, so isn’t it true that they need to maintain some fairly strong forward momentum, otherwise they could run into some political problems? Is that why they were so quick to unleash the massive stimulus or encourage their banks to lend an amazing amount of money? You have a chart showing those loans amounted to 29% of GDP in 2009. What kind of quality of lending can that be?

VK: Let's try to understand why the Chinese government did the things they did. As everyone knows, the Chinese economy grew at a very high rate for a long period of time. When the global economy slowed down, their economy slowed down as well (though official numbers did not show it). The Chinese government is extremely concerned about the economy slowing down because that is likely to lead to political unrest. A lot of that potential friction comes because a lot of people moved from villages to the cities. China has an almost nonexistent social safety net system. So people who lose jobs don’t complain, they riot.

So, yes, the Chinese government is afraid of political unrest, and therefore they quickly released a tremendous amount of stimulus into the economy, then followed it up with encouraging bank loans equal to 29% of GDP in 2009, a huge increase. When you infuse this much debt into an economy, it's impossible to have good capital allocation decisions. While the economy is growing, the bad debt won’t be so apparent, but it certainly will be when the economic growth slows.

A good analogy might be that when you analyze a credit card company that is growing very, very fast, and that has opened new accounts, you don’t see the bad debt because that debt is covered up by new loans. The true nature of the past lending decisions only becomes obvious when the company’s growth falls off.

One way to think about the Chinese economy is by comparing it to the bus in the movie Speed with Keanu Reeves and Dennis Hopper. In the movie, a bus was wired with explosives that would blow up if the bus’s speed dropped below 50 miles an hour.

Since China is manufacturer to the world, that manufacturing business comes with a lot of fixed costs. Factories, equipment need financing, and they are mainly financed by debt – another fixed cost. The high level of fixed costs doesn’t afford China an economic slowdown, but when it happens, the consequences will be dire. High fixed costs are great when revenues are rising as income grows at a faster rate than sales. But they are devastating to profitability when sales decline: costs decline at a slower rate than sales and you start losing money, fast.

TCR: Interestingly, there's clearly a slowdown in the U.S. and Europe, China's two biggest markets, so you would assume that China’s export industries would have suffered a fairly sharp decline since the go-go days before the crash. That has to be putting pressure on their growth. How important to the Chinese is it that the U.S. and the European economies recover and Western consumers get back into the game?

VK: I think a return of U.S. and European consumers is extremely important to the health of the Chinese economy. Some analysts think China’s internal demands can overcome the demand decline from U.S. and European consumers, and I think it is possible in the long run. But in the short run, I don’t think that's possible. Let me explain the reasons for that.

Chinese consumers represent one-third of a 5-trillion-dollar economy. If you look at the size of the U.S. and European Union together, they are equal to a 30-trillion-dollar economy, and the consumers there constitute about two-thirds of those economies.

So on the one hand, you have U.S. and European consumers representing 20 trillion dollars in purchases, versus Chinese consumers at about 2 trillion dollars. In other words, U.S. and European consumers are 10 times the size of the Chinese consumers. As a result, a very small change in consumption in the U.S. and Europe has to be overcompensated by a huge increase in consumption in China, and that is going to be very difficult to do, especially considering that the Chinese currency is kept at artificially low levels. That, of course, diminishes the purchasing power of the Chinese consumer. Over time the Chinese consumer will play a larger role in the economy, but it’s going to take a decade, not months – not even a few years.

TCR: You're pretty bearish on the outlook for China; do you have a theory about what might trip them up? What's the thing that readers should be watching for that would suggest things are starting to unravel?

VK: It’s very difficult to know exactly what's going to be the straw that breaks the camel’s back. It could be a slowdown in the Japanese economy, or a double-dip in the U.S., or some other factors that are not apparent to us today. It could be just the simple fact that the Chinese government is trying to put the brakes on the economy and mistakenly does too much.

I don’t trust government-reported statistics, thus I’d watch numbers that the Chinese government is less likely to fudge: electricity consumption, which was down during the global recession, same-store sales of American fast food restaurants in China, tonnage of goods shipped through railroads, and, though they may lag, sales by American and European companies in China.

TCR: If you look at inputs like copper imports and even copper stocks in Shanghai, by all appearances China is at least pretending that it’s business as usual. In fact, I think in August they imported 22% more refined copper than they did the year before. But if this is just to build bridges to nowhere, then it supports the idea that this is not going to be sustainable.

VK: That’s right. That is the problem with looking at this kind of data, because a lot of it is going to building things that have a negative return on capital. Therefore, you look at the data and the data does not really tell you that much – until it does. Because, basically, it’s the government's involvement that is driving a lot of the demand.

You can make the same argument that the U.S. economy was doing great in 2004, 2005, 2006, despite the obvious problems in real estate and its financial system. Likewise, a lot of people said great things about what was going on in Japan in the late ‘80s. Of course, the U.S., and Japan before it, were experiencing huge real estate bubbles that few saw as being a problem, until they were.

There was a recent article in the Wall Street Journal talking about a Chinese state-owned enterprise that operated salt mines, but now it's building office parks. Those are kind of the signs you start seeing in an economy in the late stages of a bubble, where a state-owned enterprise starts building real estate projects because it's almost like you can't lose money doing this. But one thing that makes predicting the end of this bubble very difficult is the amount of firepower the Chinese government has. The government can drive this bubble further than a rational observer would expect.

TCR: Because they’ve got so much in the way of reserves?

VK: Because they have a significant influence over the economy. Chinese government can force banks to lend and can force companies to borrow and spend (or build).

TCR: On the topic of real estate, I was speaking to a very well-off Chinese friend recently who had bought a very expensive apartment in Beijing. When I asked him about buying at bubble prices, he commented that it really didn’t matter. The money was almost irrelevant, given the status that came from having an apartment in that particular part of town. He said it was very good for his business and that he didn’t really plan on using it very much. It was an interesting perspective, how he saw real estate.

VK: In the same way that everyone in the United States decided they “must” own a house, this belief was reinforced by continuously rising house prices. You can see how big a problem this became in big cities such as Beijing and Shanghai where the affordability ratio is horrible, so the property-value-to-income ratio in Beijing is pushing 15. In Shanghai it is over 12. If you look at the national average, it is over eight times.

TCR: Can you explain that ratio to our readers?

VK: You get the ratio by taking the property value and dividing it by annual disposable income.

Basically, if you spent all your money, after you paid your taxes, just to pay off the mortgage, it would take you 14 years – which means you didn’t pay for food, electricity, etc.

This ratio is important because it helps put the scale of the Chinese real estate bubble in its proper context. In Tokyo, at the peak of the massive Japanese bubble, the ratio stood at nine times. In Beijing it's already 14 times. In Shanghai it's over 12 times. The national average for China is pushing 8.2 times right now. So housing affordability is very, very low, and the housing prices are extremely high.

Here is another interesting piece of data: property investment in China in 2009 was 10% of GDP, up from 8% in 2007. In Japan, at the peak of its bubble, it did not exceed 9%; in the U.S. it never exceeded 6%.

A recent study found that 64.5 million apartments basically don’t use electricity because they are empty. Chinese people buy those condos, and they don’t rent them. Similar to new cars in the U.S. when taken off the lot, in China an apartment is worth less once rented out. So they just keep them unoccupied with the hope to flip them, and you know how that story ends.

TCR: Yes, after Japan’s real estate bubble collapsed, prices in the major cities fell by about two-thirds and have rebounded only very little from the post-crash lows.

If a lot of Chinese lost a lot of money in real estate, one has to assume they’re going to be very unhappy. I recall a conversation with another Chinese man who lives in the States half a year and in Beijing half the year. When I asked him about the real estate bubble in China, his comment was, "Well, the government would never let it fall," and he said the same thing was true of their stock market. To put it mildly, he had an inordinate amount of faith in the Chinese government's ability to prop up bubbles.

VK: As you can tell from my accent, I was born in Russia and spent half of my life in Soviet Russia. From my direct experience, the Russian propaganda machine was very, very powerful, and so many people believed how smart the leaders were and that they could do nothing wrong.

China is not that much different from Russia in that respect. Due to the government’s control of the media, the average citizen has been brainwashed into thinking of the government with respect. They has led to an unconditional belief that the Chinese government walks on water, that the laws of economics are somehow suspended when they touch things (except they also did a fine job convincing not just their own citizens but the West as well). Sure, they have a greater control of the economy, but at the long-term cost we talked about earlier. That’s point number one.

Point number two can be understood by asking why people are buying those apartments, why are they buying this real estate? In part it is because if they put money in the bank – where the government basically sets the rates on savings accounts and the checking deposits – they are getting very little interest on their savings. Therefore they look at real estate as basically a form of savings.

Some analysts will argue that it can’t be a bubble because of the lack of leverage, given that in China you have to put 30%-40% down when you buy an apartment. It is a large down payment. But think about how much wealth will be destroyed when real estate prices decline – and that in itself could trigger a serious crisis in China because it would destroy a lot of wealth, and that could lead to political unrest. So that would be very important psychologically and for the political stability of the Chinese economy.

TCR: What would typically trigger the end of this real estate bubble?

VK: To some degree, a real estate bubble is like a Ponzi scheme. As long as there is an incremental buyer, prices keep going up, but at some point everybody who wants to buy a house has bought a house, so when an incremental buyer is not there, the prices start declining and then it becomes self-feeding. It's very difficult to time the end, but there is always an end.

TCR: What about commercial real estate?

VK: If you look at commercial real estate, it's often one subsidiary that is borrowing money from another subsidiary to put a down payment to build or buy a building. And a lot of times land is used as collateral. As land prices decline, so the loan-to-value ratio can jump through the roof very quickly when real estate prices collapse.

TCR: Talk a little about the renminbi. The Chinese government has been making noises about possibly allowing it to rise against the dollar, but from a practical standpoint, can they actually afford to let that happen?

VK: They could let it rise on a very gradual basis, but they absolutely cannot allow it to rise very rapidly because that would quickly diminish the value of the foreign reserves. But there is a conundrum. When the Chinese economy bursts, there is a very good chance the renminbi will actually depreciate, because you are going to have a flight of capital leaving China. So right now you may argue that China’s currency is too cheap, but during the crisis it's probably going to get cheaper.

TCR: What's your general sense about how much longer they can keep the game going before they collapse? And is collapse the right word?

VK: I really don’t know. In the case of Japan, their government basically ran out of chips. I think the Chinese government still has enough chips to keep the bubble going awhile longer. These bubbles usually last longer than the reputation of the person who predicts their demise.

TCR: Do you think it will occur within a decade?

VK: I think so, yes. GMO became famous for predicting the Japanese bubble collapse, but they started predicting it in 1986, so they were “wrong” for a while because it actually burst in 1989-1990. The point being, these bubbles typically last longer than you would expect, but it's going to burst.

TCR: Let’s talk for a minute about some of the potential implications of a bursting Chinese bubble. There are some fairly obvious ones, like Chinese real estate, but there are a lot of somewhat less obvious consequences, for example the hit this would cause to the Australian economy because its export sector depends heavily on China.

VK: China has been responsible for a very large portion, if not all, of incremental demand for commodities in recent years. If you're talking about copper, about oil, or pretty much all the industrial commodities, China was responsible for a very large portion of the demand. When the economy slows down and the bubble bursts, then the demand for those commodities will decline dramatically.

It's going to impact economies that benefitted tremendously from China’s ascent, so Australia will be impacted, Russia will be impacted because oil prices will decline and Russia is basically a commodity-driven nation. Brazil will be impacted. Any economy you can think of that benefitted from China's ascent will get hurt from its descent as well.

Let me clarify this. I'm not saying that China will cease to exist or that it's going back to the stone-age – I'm saying there is a bubble and it’s going to burst. It's going to go through readjustments.

TCR: But it will be a serious crisis.

VK: The bubble burst will have significant consequences.

TCR: So you'd be cautious on sort of base commodities.

VK: Yes. But also think about industrial goods. Getting commodities out of the ground, building empty shopping malls, ghost towns, and bridges to nowhere requires a lot of equipment. Industrial goods companies benefitted tremendously from Chinese demand. In the past, those were very cyclical companies, and it seems like this time they almost didn’t have a normal cycle. They declined but then came back very fast because the demand came back very fast, and a lot of that demand came from China.

TCR: And what would you invest in, are there any opportunities you see?

VK: Unless you short stocks, it's very difficult to see an opportunity in a Chinese downturn. As a portfolio manager, I look at it as a risk, and I say, all right, what can I do to immunize my portfolio from that risk. I have very little exposure to commodities and industrial stocks, and very little exposure to countries that will get hurt from China's bursting bubble – the countries we mentioned, like Australia, Brazil, Russia, etc.

TCR: Canada would have to be on that list.

VK: Yes, very true.

TCR: Let's talk briefly about Japan. Bud Conrad, our chief economist, has done a lot of looking at Japan and concludes that it's basically past the point of no return. What are your general thoughts on the implications of that country tipping back into a serious crisis? After all, it’s a very big economy, and so that would have to have a big impact on the world.

VK: Japan's story is very simple. The economy slowed down in the 1990s. To keep the economy growing, the government lowered taxes and increased government spending, sending budget deficits up. In order to finance those deficits, the amount of government debt has tripled.

The only reason they were able to finance that debt was because over 90% of the government debt was purchased internally; therefore, thanks to Japanese interest rates declining from 7.5% to 1.4%, the government was able to dramatically increase the amount of debt without the total borrowing costs going up.

Today, Japan is one of the most indebted nations in the developed world, and its population demographics are horrible because every fourth Japanese is over 65 years old. There’s no immigration into Japan, and the population is aging rapidly, and the savings rate went from the middle teens to quickly approaching zero.

TCR: So there is less demand for Japanese government bonds.

VK: Yes, exactly. With the demand for Japanese bonds declining, they are going to have to start shopping their debt outside of Japan, and the second they do, they’ll realize that no rational buyer would buy Japanese debt yielding 1.4% when they can buy U.S. debt or German debt with yields double that.

So the Japanese are going to have to start paying high interest rates, and they can't afford that, because one-quarter of the tax revenues already goes to servicing their debt. If their interest rates were to double to just 2.8%, it basically wipes out the funding for the country’s Departments of Defense and Education. So this is a situation where they go from deflation to hyperinflation, because they’re going to have to start printing money to be able to keep paying off their debt, so this is the case where they are going just from one extreme to another.

TCR: Their economy has been hugely helped by their trade surplus, but their trade surplus has been going down steadily, in no small part because China has been stealing market share.

VK: Exactly. A lot of manufacturing went to China from Japan, so that hurt the economy too.

So when you ask me about what could trigger Chinese problems, well, you know, Japan is still a big trading partner for China, so Japan's decline would impact China as well, and vice versa.

TCR: We have heard a lot about Japanese demographics. That seems to be an intractable problem.

VK: Recently I heard that the Japanese were considering trying to solve their demographic problems by allowing immigration from China to Japan. I almost fell off my chair when I heard that, because there is a lot of animosity between the two countries. They love each other as much as Armenians love Turks, so it's very difficult for me to see that happening just because of the cultural issues going on.

TCR: And it seems that the tensions are actually getting much worse.

VK: Too true. But the key point is that Japan is past the point of no return. It’s like the Titanic has already hit the iceberg and you know it’s going to sink, you just don’t know just how long it will take to go down. That's basically what is taking place in Japan.

TCR: Sticking with that metaphor, it seems like people need to begin donning life jackets and edging toward the nearest lifeboat.

So we've got some serious issues with Asia, which obviously will have some global implications. How does this tie back to the U.S.? Our take has been that – at least on a short-term basis – when things start to come unglued, it will benefit the U.S. as a purported “safe harbor,” but then people will begin to realize that if two out of three of the world’s biggest economies can fall, so can the U.S.

VK: In the short run, it may benefit the U.S. dollar because the value of currencies is relative, right? As my friend Barry Pasikov says – the U.S. dollar is valedictorian in summer school. So if people are afraid of Japan, afraid of China, they would be running towards the U.S. currency. By the way, the Japanese currency made a 15-year high recently suggesting what could be the trade of the decade.

I'm a value investor, so I generally don’t spend much time on currencies, but I think this is a case where shorting Japanese yen makes a lot of sense.

It may work against you for a while, but in the long run, I think it could turn out to be the trade of the decade.

Again, I think the U.S. dollar might benefit in the short run, but don’t overlook that China and Japan are the largest foreign holders of U.S. debt. If Japan becomes a net seller of U.S. debt and their debt starts competing with U.S. debt, then that's going to be negative for our economy because we are going to have high interest rates. If China also becomes a net seller of U.S. debt, again, it's negative for our economy.

The big question, once they start selling, is how fast will they sell their U.S. debt. If they sell it very fast, maybe because they have to, it's going to drive our interest rates higher. If it's something that develops over a long period of time, it may not drive our interest rates as much as you would think.

TCR: But ultimately, if they hit a real bump in the road, they’re going to have to start selling.

VK: Exactly. Plus, the Japanese government bonds will start competing with our bonds. In the past the Japanese people were able to consume the government debt internally, down the road the government is going to have to start selling its bonds to the same people who are buying our bonds, and instead of paying 1-2%, they’ll have to start paying 5, 6, 7%.

TCR: Which would be devastating for the Japanese economy, given the scale of their debt.

VK: Absolutely, At that point, they are going to have a very high inflation because they’ll be forced to print a lot of money.

TCR: Not a very positive outlook but I think very useful. You’ve written a book about managing a portfolio in sideways markets. What's your advice to investors at this point?

VK: I just finished a book titled The Little Book of Sideways Markets. It is a follow-up to Active Value Investing I wrote in 2007. My research leads me to believe that the U.S. markets will continue their sideways journey over the next decade, much as they did in the previous decade.

In such markets, the traditional buy-and-hold approach doesn’t really work, so you need to modify your approach, starting with the idea that you want to become a buy-and-sell investor. You want to buy stocks when they’re undervalued, but when they become fairly valued, you want to sell them.

Secondly, in the absence of good stocks to buy, you should be willing to hold more cash. I'm not an advocate of trying to time the market but rather saying that if you look at the market and you don’t see stocks that meet your criteria, just hold more cash. The opportunity cost of holding cash is a lot lower in this environment than it would be in a cyclic bull market.

Third, you want to favor stocks with a high dividend yield. You don’t want to buy stocks just because of the dividends, but if, everything else being equal, you can find stocks that have an above-average yield, that’s going to become very important in this environment because in the past dividends accounted for 90% of the return during the sideways markets.

Fourth, you basically want to increase your margin of safety. If a value investor typically looks to buy a dollar for, let's say, 70 cents, I would recommend start looking for dollars selling for 50 or even 40 cents. That's point number four, and it's extremely important.

The book walks readers through the fundamentals of investing in sideways markets, and I think it will help most investors do well in what will be an otherwise challenging environment.

TCR: When is the book out?

VK: In mid-November.

TCR: We look forward to reading it – and maybe having a separate conversation on those concepts in a future edition of The Casey Report.

VK: That would be great.

Today it is more important than ever to take a big-picture approach to investing – keeping a close eye on foreign economies, as well as U.S. politics, is now imperative for any savvy investor. In the current, post-election edition of The Casey Report, the editors analyze how the outcome of the U.S. midterm elections will affect your personal wealth going forward… and what you need to do to “recalibrate” your investing radar. Try it today – for 3 full months, with money-back guarantee. More here.

MACRO-EUROPE: The Titanic is SINKING

John Mauldin — Wed, 28 Apr 2010 21:09:00 GMT

This is a special Outside the Box. I got this letter from my good friend Greg Weldon last night and got permission to pass it on to you. I think it illustrates the problems that the world is facing from the sovereign debt crisis that is building in Europe.

There are no good solutions here, only very difficult ones. In order to get financing, Greece must willingly put itself into a multi-year depression. And borrowing more money when it cannot afford to pay back what it has will not solve the problem. 61% of Greeks now favor leaving the euro. How has Greece responded? By banning short selling on its stock market for the next two months. That should make things better. Greeks are responding by rioting and going on strike. But you truly know when a country is dysfunctional when its AIR FORCE goes on strike. Yesterday Reuters reported that hundreds of Greek pilots called in sick in protest. The response from government? The Minister of Defense said he was "profoundly disappointed." Now that had to make the pilots feel bad.

Money is flying from Greek banks, which makes sense, as how can a bankrupt Greek government guarantee Greek bank deposits? I know that Greek bankers may have a different view, but Greek depositors are voting with their feet. And Greg shows us it is not just Greece. It is fast becoming Portugal. And Spain is not far behind in my opinion.

I can well imagine there are private meetings among Greek government officials, banks and other leaders as to what must now be done. Those meetings I am sure can be tense. These things matter, as European banks hold a lot of Greek debt, as well as Portuguese and Spanish debt. European banks have not come close to dealing with their problems and are seriously over-leveraged. There is the potential for yet another banking and credit crisis stemming from European banks. Will world banks see their trust for each other (and especially European banks with large amounts of Club Med bonds) devolve as it did on August of 2008? It is something we must think about. It is possible, in my opinion. I sincerely hope it does not happen, but we must think about it. (Note, this is not something that will happen for awhile, but we should be aware of the problem.)

I want to thank Greg for letting me send this on to you. His website is www.weldononline.com. This letter is typical of his work – thorough and detailed and full of charts. He is the best slicer and dicer of data that I know.

John Mauldin, Editor
Outside the Box

WELDON'S MONEY MONITOR

Tuesday April 27, 2010

MACRO-EUROPE: The Titanic is SINKING ...

We rewind to our February 15^th Money Monitor entitled "Three Card Monty", with its focus on the 'early stages' of the now full-blown Greek debt-deficit-debacle, and we replay the quotes we spotlighted at the time ...

Greek Finance Minister George Papaconstantinou ...

... "We are basically trying to change the course of the Titanic. People think we are in a terrible mess. And we are.

We note comments from Jean-Claude Juncker, speaking on behalf of European Finance Ministers following a meeting of top EU officialdom in Brussels this afternoon ...

... "Greece is responsible for the consolidation of its public finances. It is first a Greek problem, and an internal Greek problem."

From European Central Bank President Jean-Claude Trichet ...

... "Everyone needs to respect their commitments. We have a particular Greek problem, but the other countries have their programs and they must be implemented. It is important that all of the heads of state and governments do what is necessary to guarantee the stability of the euro zone."

And from German Chancellor Angela Merkel ...

... "Germans should not pay for the consciously flawed fiscal and budgetary policies of others."

We stated, in our conclusion to that Money Monitor ...

Thinking that the problems of Greece, let alone two dozen other European debt-deficit 'offenders', will be 'solved', without PAIN, quickly ... or that they will be easily and quietly 'papered-over' ... is like playing Three Card Monty with the hustlers of Eighth Avenue in Manhattan.

It is ALWAYS a LOSING proposition.

Now, over two months later ... the Titanic is SINKING ... amid today's credit rating downgrade announced by Standard and Poor's, as it relates to Greece's sovereign debt.

Moreover, in our March 3^rd Money Monitor, "It's All Over Now, NOT !!!", we stated the following ...

In short, it is NOT, at all ... "all over now", in Europe.

And, in our April 12^th Monitor, "Three Blind Mice" ... published in the wake of the announcement of the (alleged) solution via a loan to Greece, from EU member nations, and the IMF ... we said the following ...

What happens when Italy needs a bailout, or Portugal, or Spain ...

... bailouts-that-are-not-a-bailout that would be significantly LARGER than the 45 billion EUR offered to Greece ... what then ????

Again, as we have stated repeatedly since the 4Q of last year ... Europe's fiscal debt-deficit crisis is FAR from 'over'.

Again, as we have repeatedly stated ... it will not be over, until draconian fiscal austerity measures are implemented ACROSS the region.

It will not be over ... for years to come.

Fast forward to the present ... and the announcement by Standard and Poor's wherein the credit ratings agency cut Greece's sovereign debt rating to JUNK status ... and we shine the spotlight on commentary from today's S+P 'statement' ...

... "We believe that the government's policy options are narrowing because of Greece's weakening economic growth prospects, at a time when pressures for stronger fiscal adjustment measures are rising. Moreover, in our view, medium-term financing risks related to the government's high debt burden are growing, despite the government's already sizable fiscal consolidation plans."

... "Our updated assumptions about Greece's economic and fiscal prospects lead us to conclude that the sovereign credit rating is no longer compatible with an investment grade rating."

Also ...

... "The government's multi-year fiscal consolidation program is likely to be tightened further under the new EMU-IMF agreement. This is likely to further depress Greece's medium-term economic growth."

And ...

... "The government's resolve is likely to be tested repeatedly by trade unions and other powerful domestic constituencies that will be adversely affected by the government's policy."

Adding insult to injury, Standard and Poor's also put Greece's credit 'outlook' on 'negative watch', opening the door for FURTHER downgrades ...

... "The negative outlook reflects the possibility of a further downgrade if the Greek government's ability to implement its fiscal and structural reform program materially weakens, undermined by domestic political opposition at home, or by even weaker economic conditions than we currently assume."

Indeed, the ICEBERG is HUGE ... and the unsinkable ship is sinking !!!

Evidence the rising water levels in the engine room, as represented by the 'price' of default 'protection', evidenced in the chart below plotting Greece's 5-Year Credit Default Swap Rate ... which has SOARED today, easily reaching a NEW ALL-TIME HIGH ... by FAR !!!

In fact, in our March 22^nd Money Monitor entitled "Three Card Monty, Revisited", we offered a chart perspective on the 5-Year Greek CDS. We spotlighted the downside correction that took the CDS to the med-term trend defining 100-Day EXP-MA, in line with a text-book Fibonacci retracement (between the 38% and 50% retracement levels) ... suggesting that the downside correction provided a 'buying' opportunity.

We also 'warned' about the potential for higher interest rates to significantly impact the entire fiscal environment in Greece. Thus we note additional commentary from within the Standard and Poor's statement ...

... "Pressures for more aggressive and wide-ranging fiscal retrenchment are growing, in part because of recent increases in market interest rates."

After today's parabolic rise in the 5-Year Greek Bond yield, as noted below, the word 'increases' becomes a substantial understatement.

As if this was not enough turbulence, we also note that in line with the downgrade of the Greek government credit rating, Standard and Poor's also marked down the 'rating' on the nation's largest banks ... stating that ...

... "We find that Greece's fiscal challenges are increasing pressure on the banking and corporate sectors. In particular we see continuing fiscal risks from contingent liabilities in the banking sector, which, could, in our view, total at least 5%-6% of GDP in 2010-2011."

Standard and Poor's downgraded the 'long-term counterparty credit ratings on National Bank, Eurobank, Alpha Bank, and Piraeus Bank ... causing share prices to plummet. Evidence the pair of charts on display below in which we plot Piraeus Bank ...

... and, the National Bank of Greece, both of which are breaking down technically, following a rally that mapped out another 'text-book' Fibonacci retracement correction.

Hence we turn the spotlight on the Greek stock market as a whole, represented within the chart below in which we plot the Greek ASE stock index. Indeed, we note another Fibonacci retracement, to the 33% target, followed by this week's renewed technical breakdown.

The ship ... is going DOWN.

We have been bearish on the Eurocurrency since October-November of last year, and after suffering because we were 'early' to this thematic-trade, we have been rewarded for our patience and perseverance ... as evidenced in the longer-term daily chart on display below, revealing today's decline in the EUR to a new move LOW.

Further, we spotlight the bearish technical dynamic, as defined by the negative action in the moving averages, and the slide into bearish territory by the long-term 200-Day Rate-of-Change.

While the Titanic (also known as the Eurocurrency) SINKS ... the price of Gold denominated in the Euro is SOARING, reaching a NEW ALL-TIME HIGH today, in excess of EUR 875 per ounce ...

... as observed in the long-term weekly chart seen below.

We are now watching for a 'confirming' upside breakout in the spot (USD based) price of Gold. Noting the daily chart on display below we focus on the most recent re-acceleration to the upside in the med-term trend defining 100-Day EXP-MA.

An upside violation of the April 12^th high of $1169 would constitute a full-blown med-term upside breakout.

All 'passengers' are going down with the ship ... with a downgrade to Portugal's sovereign credit rating also announced today, as Standard and Poor's marked down Portugal's rating by two notches, from A+ to A-, while placing the country on a negative outlook watch, portending more downgrades in the future.

Subsequently, Portugal's 5-Year Credit Default Swap is SOARING, as noted in the chart below, spiking to a NEW ALL-TIME HIGH ... today.

Similarly, Portugal's 5-Year Government Bond yield SOARED to a NEW HIGH, jumping by + 60 basis points today alone, capping a monstrous +215 basis point rise in the month of April, easily violating the February high of 3.95% ... as evidenced in the chart below.

Like the Titanic ... the Portuguese stock market is also ... sinking ...

... as evidenced in the daily chart on display below, replete with technical breakdown, head-and-shoulders pattern, violation of the med-term trend defining 100-Day EXP-MA ... and ... the downside reversal by the moving average itself, directionally speaking.

And finally, we have been focused on the downside price action and severe underperformance exhibited by the Spanish stock market (specifically spotlighted as recently as last Friday's ETF Playbook) ...

... and thus we note the chart on display below as Spain begins to unravel too, with the 5-Year Credit Default Swap SOARING to a NEW ALL-TIME HIGH, slicing through the (previous) double-top formed as defined by the February 17^th, 2009 high at 170 basis points, and the February 8^th, 2010 high at 173 basis points, reaching towards 200 basis points.

And, we shine the spotlight on the chart below plotting Spain's 5-Year Bond yield, which is breaking out to the upside, today, and doing so 'from' historically low levels below 2.75%, violating the February 5^th high of 3.13%.

The Titanic is sinking, and ultimately, ALL passengers will go down with the ship, including Portugal, Spain, Greece, and several other Maastricht Treaty debt-deficit offenders.

We have been anticipating this event for months.

Thus, we remain bearish on the European currencies ....

... and bullish on Gold priced in EUR.

Gregory T. Weldon ---

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Ecuador: Correa's Play for Greater Influence in the Oil Sector

John Mauldin — Thu, 22 Apr 2010 19:06:34 GMT

Today I'm sending you a piece on Ecuador's recent move to change the terms of its contracts with oil investors to keep more of the returns in the state. As we watch the world's energy market, political details like this are essential to know. The article explores the geopolitical implications of the move and the how key investors are likely to react.

This is nothing short of the real world with real consequences on the amount the meter reads to fill up your gasoline tank, your investments abroad and the overall worth of those dollar bills in your wallet right now. You don't get this kind of information on your typical media news networks. The truth is, this event is one you may not have heard about - not only do you have to keep your ears to the ground, you've got to know where to look.

For all things under the radar and overly important, my source is STRATFOR. They provide in-depth intelligence for those that need to know. Read their article, and join their email list to get weekly reports and special discounts on memberships.

John Mauldin
Editor, Outside the Box

Ecuador: Correa's Play for Greater Influence in the Oil Sector

April 21, 2010

RODRIGO BUENDIA/AFP/Getty Images
Ecuadorean President Rafael Correa (R) and Venezuelan counterpart Hugo Chavez
at a press conference in Quito, Equador, on March 26

Summary

Ecuadorean President Rafael Correa is pressuring foreign oil investors to change from production-sharing agreements to service contracts, or else face expropriation. Correa is looking to enhance the state's authority over oil revenues and thus enhance his own political security, but is making the move at the expense of Ecuador's long-term economic development.

Analysis

Foreign oil executives are making their way to Quito, Ecuador, to try to work out a compromise over oil production contracts with Ecuador's left-leaning president, Rafael Correa. The small Organization of the Petroleum Exporting Countries (OPEC) member is pressuring foreign oil investors to change the terms of their contracts with the goal of bolstering the state's authority over the oil sector. The foreign firms currently operating in Ecuador will likely acquiesce to the new terms to keep production running at a minimal rate, but these contractual changes are liable to come at the expense of Ecuador's long-term investment growth.

Correa is an economist by training who has frequently expressed his disillusion with market reforms in Latin America and believes economic power should reside within the state. He has been trying since 2007 to change foreign oil contracts from production-sharing agreements, under which the foreign producers can have partial ownership of the fields they operate, to servicing contracts, under which the producers would have to pay a production fee and then get reimbursed for the cost of their investment. In the latter scenario, the state ends up getting more revenue for itself and the producer ends up making less money overall since it can only make profits from remuneration fees - the amount per barrel that the government is willing to pay companies for producing its oil. In other words, the foreign companies incur the risk of investing resources into a project with none of the potential rewards associated with high oil prices. If the foreign oil companies do not agree to the government's terms, Correa has threatened to push for new legislation that would allow the state to expropriate the oil fields.

Naturally, the expropriation threats have spread concern among investors who have watched Ecuador expand state authority over the country's resources to beef up its coffers, and thus politically insulate the regime with populist-driven handouts to the poor. Correa will certainly benefit from having more of Ecuador's oil revenues at his disposal than in the bank accounts of foreign oil firms, but he also risks hampering the country's overall economic growth. Balancing between the benefits of short-term political capital and long-term economic risks will not be easy, particularly when the president is already struggling to revive the economy as investment flows are declining and domestic consumption remains weak. Moreover, the indigenous community that Correa claims to represent is showing stronger signs of coordinated opposition to the already politically embattled president and are now latching onto a controversial water law to corner Correa on his environmental defense policies.

Ecuador's economy depends heavily on its oil sector, which accounts for roughly a quarter of gross domestic product, 68 percent of total export earnings and 35 percent of fiscal revenues. The country is exporting about 470,000 barrels per day (bpd) of oil this year - down from an average of 503,000 bpd in 2009 - and has proven crude reserves of about 6 billion barrels. Ecuador exports a heavy sour crude called Napo and a medium-heavy, medium-sour crude called Oriente that is produced in the northeast of the country. Though Ecuadorean crude is of a better grade than Venezuela's, Ecuador has to incur a higher transport cost to ship the crude across the Andes to the Pacific coast for export. As part of its proven crude reserves, Ecuador has an estimated 900 million barrels (and 1.3 billion barrels of potential recoverable reserves) in the Ishpingo-Tapococha-Tiputini (ITT) block in the Amazon rainforest. The crude in this region, however, is a lot heavier than the country's other grades and would thus require more technical skill to extract. The Ecuadorean government would also face heavy resistance from its well-organized indigenous community regarding the environmental cost of exploiting those reserves.

The foreign companies currently operating Ecuador's oil fields in the northeast include Brazil's Petroleo Brasileiro (Petrobras), Spain's Repsol YPF, Italy's Eni and Chinese consortium Andes Petroleum (led by CNPC and Sinopec Corp). These firms produce 42 percent of Ecuador's oil, while state firms Petroecuador, Petroamazonas and Rio Napo handle the rest of production, albeit with far less technical skill. Ecuador has yet to publicize the remuneration fee it would be willing to pay the foreign firms in new service contracts, but one draft agreement calls for the state to retain at least 25 percent of gross income from extracted oil sales. The details of these negotiations are now being worked out between foreign oil executives and state officials in Quito as the threat of expropriation lingers.

Many of these companies have reason to take Correa's expropriation threats seriously. After the state took over U.S. oil company Occidental Petroleum's assets in 2006, claiming the firm's contract had expired, Correa further raised investor fears in late 2007 when he imposed a 99 percent windfall revenue tax on foreign energy firms to help make up for the state's commercial bond debt obligations. That move led to a number of arbitration suits at the World Bank's International Center for Settlement of Investment Disputes. Ecuador has also expropriated two blocks belonging to Anglo-French oil firm Perenco over tax disputes.

Now operating under the state's growing shadow, foreign oil companies that have stuck it out in Ecuador thus far are measuring the costs and benefits of their future investments. The companies that do stay will likely do so for either geopolitical purposes or basic economic need, but will not be inclined to further Ecuador's long-term oil growth.

China's Andes Petroleum consortium has a relatively simple and direct objective: It needs crude to support Chinese industrial growth, and is willing to go to the ends of the earth and into unappealing investment climates to get it. The Chinese do not bring substantial technical expertise to the table, but will be the most willing to negotiate terms with Quito so that they can continue extracting oil. Spain's Repsol, on the other hand, is a heavily state-influenced company that will often make energy decisions that give more weight to Madrid's foreign political interests than to its own economic rationale. Acting as a foreign policy arm, Repsol is likely to agree to Correa's contractual demands to allow Spain to maintain a high level of engagement in Latin America. Brazil's state-owned Petrobras sees itself as the continental energy power of the future and carries a geopolitical ambition to saturate the Latin American energy sector as a way of extending Sao Paulo's influence. Profits are thus not likely to factor as heavily into Petrobras' negotiations with Quito. Ecuador is likely to face the most resistance from Italy's Eni, a firm that is far more politically independent and will be more concerned about its bottom line in Ecuador.

The Ecuadorean government will use expropriation and extended operating contracts as the stick and carrot to try to coerce foreign firms into signing service contracts. Unless the government offers an attractive per barrel remuneration fee - and indications thus far suggest this is not the case - most firms are likely to settle reluctantly on the new contractual terms to remain in country and maintain minimal production. However, they will no longer have the incentive to invest further in exploration and deep drilling, particularly in the technically more complex fields in the Amazon. New investment will also be difficult to come by, as investors grow more skittish because of these regulatory shifts. These moves against foreign oil firms will affect the country's future economic growth, particularly as oil production declines and harder-to-tap fields need to be extracted. But as Correa says, for every minute that passes without signing the new contracts, "there are millions of dollars going to these companies." Those millions of dollars are political capital lying in wait for the Ecuadorean state.

Germany: Mitteleuropa Redux

John Mauldin — Thu, 25 Mar 2010 15:34:00 GMT

With the establishment of the euro in the 1990s, speculation was abundant on how things would play out. In the last fews months we've seen that cheap credit for the Club Med countries came at a price, and now it's time to look at who will come out on top after the current economic crisis. There is a term for this type of global analysis: geopolitical intelligence. STRATFOR, a global intelligence company, uses geography, open source data, HUMINT, and a deep understanding of global affairs to produce analysis with a geopolitical perspective.

Today I'm including their take on Germany's changing role in the EU. But it is only a small sample of all they provide, so I encourage you to sign up for their free mailing list or become a member for greater access to features including Quarterly and Annual Forecasts that will put you ahead of the game.

John Mauldin
Editor, Outside the Box

Germany: Mitteleuropa Redux

March 16, 2010

By Peter Zeihan

The global system is undergoing profound change. Three powers - Germany, Iran and China - face challenges forcing them to refashion the way they interact with their regions and the world. We will explore each of these three states in detail in our next three geopolitical weeklies, highlighting how STRATFOR's assessments of these states are evolving. We will examine Germany first.

Germany's Place in Europe

European history has been the chronicle of other European powers struggling to constrain Germany, particularly since German unification in 1871. The problem has always been geopolitical. Germany lies on the North European Plain, with France to its west and Russia to its east. If both were to attack at the same time, Germany would collapse. German strategy in 1871, 1914 and 1939 called for pre-emptive strikes on France to prevent a two-front war. (The last two attempts failed disastrously, of course.)

As much as Germany's strategy engendered mistrust in Germany's neighbors, they certainly understood Germany's needs. And so European strategy after World War II involved reshaping the regional dynamic so that Germany would never face this problem again and so would never need to be a military power again. Germany's military policy was subordinated to NATO and its economic policy to the European Economic Community (the forerunner of today's European Union). NATO solved Germany's short-run problem, while the European Union was seen as solving its long-run problem. For the Europeans - including the Germans - these structures represented the best of both worlds. They harnessed German capital and economic dynamism, submerged Germany into a larger economic entity, gave the Germans what they needed economically so they didn't have to seek it militarily, and ensured that the Germans had no reason - or ability - to strike out on their own.

This system worked particularly well after the Cold War ended. Defense threats and their associated costs were reduced. There were lingering sovereignty issues, of course, but these were not critical during the good times: Such problems easily can be dealt with or deferred while the money flows. The example of a European development that represented this money-over-sovereignty paradigm was the European Monetary Union, best represented by the European common currency, the euro.

STRATFOR has always doubted the euro would last. Having the same currency and monetary policy for rich, technocratic, capital-intensive economies like Germany as for poor, agrarian/manufacturing economies like Spain always seemed like asking for problems. Countries like Germany tend to favor high interest rates to attract investment capital. They don't mind a strong currency, since what they produce is so high up on the value-added scale that they can compete regardless. Countries like Spain, however, need a cheap currency, since there isn't anything particularly value-added about most of their exports. These states must find a way to be price competitive. Their ability to grow largely depends upon getting access to cheap credit they can direct to places the market might not appreciate.

STRATFOR figured that creating a single currency system would trigger high inflation in the poorer states as they gained access to capital they couldn't qualify for on their own merits. We figured such access would generate massive debts in those states. And we figured such debts would contribute to discontent across the currency zone as the European Central Bank (ECB) catered to the needs of some economies at the expense of others.

All this and more has happened. We saw the 2008-2009 financial crisis in Central Europe as particularly instructive. Despite their shared EU membership, the Western European members were quite reluctant to bail out their eastern partners. We became even more convinced that such inconsistencies would eventually doom the currency union, and that the euro's eventual dissolution would take the European Union with it. Now, we're not so sure.

What if, instead of the euro being designed to further contain the Germans, the Germans crafted the euro to rewire the European Union for their own purposes?

Germany and the Current Crisis

The crux of the current crisis in Europe is that most EU states, but in particular the Club Med states of Greece, Portugal, Spain and Italy (in that order), have done such a poor job of keeping their budgets under control that they are flirting with debt defaults. All have grown fat and lazy off the cheap credit the euro brought them. Instead of using that credit to trigger broad sustainable economic growth, they lived off the difference between the credit they received due to the euro and the credit they qualified for on their own merits. Social programs funded by debt exploded; after all, the cost of that debt was low as the Club Med countries coasted on the bond prices of Germany. At present, interest rates set by the ECB stand at 1 percent; in the past, on its own merits, Greece's often rose to double digits. The resulting government debt load in Greece - which now exceeds annual Greek gross domestic product - will probably result in either a default (triggered by efforts to maintain such programs) or a social revolution (triggered by an effort to cut such programs). It is entirely possible that both will happen.

What made us look at this in a new light was an interview with German Finance Minister Wolfgang Schauble on March 13 in which he essentially said that if Greece, or any other eurozone member, could not right their finances, they should be ejected from the eurozone. This really got our attention. It is not so much that there is no legal way to do this. (And there is not; Greece is a full EU member, and eurozone membership issues are clearly a category where any member can veto any major decision.) Instead, what jumped out at us is that someone of Schauble's gravitas doesn't go about casually making threats, and this is not the sort of statement made by a country that is constrained, harnessed, submerged or placated. It is not even the sort of statement made by just any EU member, but rather by the decisive member. Germany now appears prepared not just to contemplate, but to publicly contemplate, the re-engineering of Europe for its own interests. It may not do it, or it may not do it now, but it has now been said, and that will change Germany's relationship to Europe.

A closer look at the euro's effects indicates why Schauble felt confident enough to take such a bold stance.

Part of being within the same currency zone means being locked into the same market. One must compete with everyone else in that market for pretty much everything. This allows Slovaks to qualify for mortgage loans at the same interest rates the Dutch enjoy, but it also means that efficient Irish workers are actively competing with inefficient Spanish workers - or more to the issue of the day, that ultraefficient German workers are competing directly with ultrainefficient Greek workers.

The chart below measures the relative cost of labor per unit of economic output produced. It all too vividly highlights what happens when workers compete. (We have included U.S. data as a benchmark.) Those who are not as productive try to paper over the problem with credit. Since the euro was introduced, all of Germany's euro partners have found themselves becoming less and less efficient relative to Germany. Germans are at the bottom of the graph, indicating that their labor costs have barely budged. Club Med dominates the top rankings, as access to cheaper credit has made them even less, not more, efficient than they already were. Back-of-the-envelope math indicates that in the past decade, Germany has gained roughly a 25 percent cost advantage over Club Med.

(click here to enlarge image)

The implications of this are difficult to overstate. If the euro is essentially gutting the European - and again to a greater extent the Club Med - economic base, then Germany is achieving by stealth what it failed to achieve in the past thousand years of intra-European struggles. In essence, European states are borrowing money (mostly from Germany) in order to purchase imported goods (mostly from Germany) because their own workers cannot compete on price (mostly because of Germany). This is not limited to states actually within the eurozone, but also includes any state affiliated with the zone; the relative labor costs for most of the

Central European states that have not even joined the euro yet have risen by even more during this same period.

It is not so much that STRATFOR now sees the euro as workable in the long run - we still don't - it's more that our assessment of the euro is shifting from the belief that it was a straightjacket for Germany to the belief that it is Germany's springboard. In the first assessment, the euro would have broken as Germany was denied the right to chart its own destiny. Now, it might well break because Germany is becoming a bit too successful at charting its own destiny. And as it dawns on one European country after another that there was more to the euro than cheap credit, the ties that bind are almost certainly going to weaken.

The paradigm that created the European Union - that Germany would be harnessed and contained - is shifting. Germany now has not only found its voice, it is beginning to express, and hold to, its own national interest. A political consensus has emerged in Germany against bailing out Greece. Moreover, a political consensus has emerged in Germany that the rules of the eurozone are Germany's to refashion. As the European Union's anchor member, Germany has a very good point. But this was not the "union" the rest of Europe signed up for - it is the Mitteleuropa that the rest of Europe will remember well.

February Economic Report

John Mauldin — Mon, 08 Feb 2010 20:58:20 GMT

Before we get to this week's Outside the Box, a quick note about my writing on Greece in last Saturday's letter. I made the point that if Greece defaults it does not necessarily mean they have to leave the EU, any more than if Illinois defaulted they would have to leave the United States. Greece could still use the euro and life could go on. EXCEPT. The markets would no longer lend the Greek government money at anything close to a livable rate. Greece would be forced to balance its budget. Since they are part of the euro, devaluing the currency is not an option. The results of controlling their fiscal deficit would not initially be pretty and would almost insure a serious prolonged recession or depression in the Greek area, with fall out in the region. It would be a sad decade for Greece. But in the long run, it is a better option than default.

Further, and more important to the rest of Europe and the world, the results of a Greek default would be financial turmoil. 250 billion euros (and maybe 300!) of Greek debt is in international bond funds, pension and insurance companies, and above all at banks. Think German banks. Already undercapitalized banks. Also, think of all the investment banks who have been selling relatively cheap (given the apparent risk) credit default swaps on Greece, in an unregulated market, exposing their balance sheets. What should be a simple, if sad, matter for the Greeks, becomes a problem for the world, just as subprime debt in the US caused a world credit crisis. And the risk of contagion from Portugal, Spain, et al is serious. 2 trillion euros of debt could get downgraded by the bond market in very short order. It could be a replay of the last credit crisis, just with new actors as the prime problem.

Bailing out Greece without serious and credible deficit reductions by their government over the next few years would simply delay the problem, and it is not altogether clear the bond markets would go along for very long. At the end of the day, it may be the bond market which forces the Greek government and its people to take some very bitter medicine. Stay tuned. This is just the beginning of what will be a series of sovereign debt crises over the coming decade. It is important for the world that we get this one solved right, or the consequences will be quite severe.

Now, this week's Outside the Box is from my friend Simon Hunt, based in London. Simon travels to China many times a year, is an authority on copper and the Long Wave theory of cycles. When we are together, and often over emails, we have some fairly interesting debates. I generally don't follow Long Wave analysis, but Simon does make me think and check my own views carefully. And as I often write, the point of Outside the Box is not to send you material that I agree with, but ideas from smart people which make us think. So, enjoy my friend Simon's latest forecast and ideas.

John Mauldin, Editor
Outside the Box

February Economic Report

by Simon Hunt

This will be a shortened version of our usual monthly economic reports, since we have posted several short notes on the economic and financial markets.

This year is likely to be a year of surprises. Global economic growth will disappoint. The intrusion of governments into all matters financial, economic and even personal is a cause for uncertainty associated with policy risks; and markets hate uncertainty. It is these policy risks which could have the biggest impact on the potential global recovery in the economy and financial markets.

2010 should also be the year when many countries from the USA to the UK to China will experience the first moves towards policy tightening and the gradual withdrawal of financial and monetary stimulus. Moves by China to begin tightening monetary policy, even though they are only tinkering with the problem of excess liquidity, are a leading indicator to world markets of this changing environment. The consequences of this tightening are not yet visible, but could well become far reaching.

One outcome of China's fiscal and monetary largesse has been growing consumer inflation, whether fully seen in official data or not. What has been experienced on the ground by exporting companies, as we have been warning for several months, has been an increase in wages because of a shortage of skilled workers. Many never returned to their factories after last year's CNY. One factory reports (to a friend) that they are short of 17% of their normal labour force and this sort of rate is probably indicative across many coastal exporting companies.

The impact has been twofold: production has been hit and wages have had to be increased. Yesterday, Jiangsu province raised its monthly minimum wage by 13% to RMB960 (US$140). Wages for skilled labour are rising far more. This move by the province is an official recognition of what companies have been experiencing for many months.

The plight of exporting companies has consequences, too, for the RMB. China is under pressure to revalue its currency. Exporters are suffering from severe margin pressures. They are experiencing rising wages, rising raw material prices and increases in electricity and water rates etc. At the same time, credit for many of these companies remains exceptionally tight, so much so, that exporters are asking their foreign customers to open LCS, not at point of shipment, but at point of order placement.

There are a number of consequences resulting from the inflation of costs being experience by exporters. First, there will be the political result. Beijing will resist foreign pressure to revalue its currency - the earliest would be the second half of this year. Second, exporters will be raising their prices after the CNY, on average by around 10%, but for some goods substantially more. Third, buyers of Chinese goods knew well in advance that prices would be rising; they knew too that freight rates were being raised; so they have probably bunched orders up before prices rose. This dynamic together with the modest inventory replenishment being seen in the USA (though not yet evident in west coast US ports) and elsewhere has been the reason for higher level of Chinese and other Asian export business.

There is also another dynamic at work here. Across many manufacturing sectors in Asia business has been boosted by the need to replenish inventory within the supplier chain. This had been rundown to almost zero levels for balance sheet reasons in 2008's 4th quarter and last year's first quarter. This round of inventory replenishment has about now run its course. What lies behind this development will determine the course of the global economy in the first half of this year. From what we hear, the news will not be encouraging.

China's industrialisation has been nothing short of miraculous - stunning - yet there remain many pitfalls ahead. It has successfully, at least in the short-term, grown its economy whilst most of the rest of the world has suffered the pains of recession. However, by throwing so much fiscal and monetary stimulus at the economy, it risks seeing rising inflation to levels above those of official forecasts (3-4%). Inflation in the Austrian sense is already rampant. Average land prices rose by 106% last year, though even more in many large cities; the stock market exploded; investment in commodities soared, not just by merchants, but by institutions and individuals; and manufacturing, caught in this speculative frenzy, started to produce for inventory. Certainly, our observation from visits last year was that China's economy had far too much speculative froth; that too much of the fiscal stimulus and bank lending were directed into speculation and not into the real economy; and that the seeds were being sown for a nasty reaction post 2010.

We also noted, confirmed by discussions which our associate had with senior people in Beijing that economic success was breeding arrogance in the country, a theme which we have found also. In its dealings with foreign countries, China has become far more assertive, stretching from US arms sales to Taiwan, to the disputed borders between India and China, to its "obstreperous stance it took in the Copenhagen climate change conference last December", to its truculence over the alleged hacking of Google and other foreign companies and to trade issues.

The real question is whether these are tactics of divergence from the government's real problem of how to take the speculation out of the economy in order to create the foundation for sustainable growth, in other words to cause some domestic pain. We don't buy that argument. We suspect that China has grown sufficiently powerful through its trade, through the rest of the world's perception that the world depends on China's economy and because of its huge foreign exchange reserves for it to finally ditch Deng Xiaoping's words, "Keep a low profile and hide your claws" whilst building up your strength.

The West's response to China's undisputed rise in power and influence will be all-important. The history of empires suggests that America will not allow its global superpower status to be handed over willingly. There are bound to be geopolitical clashes over the coming decade, whether over the Middle East, Taiwan, Japan etc. These will be an intrinsic part of the global transition from a unilateral world to a world dominated by two powers.

In the meantime, trade will be the central issue, a theme which we have focused on for a long time, so will not express again our thinking beyond concluding that the trend is now towards manufacturing being based close to points of final consumption, rather than in some distant country or region like China and Asia.

This is both a political and economic conclusion. Pete Peterson, for instance, calls for business leaders to re-enact the non-partisan Committee for Economic Development that was formed in the midst of WW11 by folks like Paul Hoffman, Bill Benton and Marion Folsom, or something along those lines, in order to try and solve the nation's structural problems, ranging from rising budget deficits, the $60 trillion in unfunded government liabilities and promises, to the growing intrusion of government into business and finance.

Part of this coming revolution will surely be to bring back within American borders much of the manufacturing capacity needed for its own economy, rather than having that capacity located offshore. Government has begun this process by wielding a stick, threatening to curtail many of the financial benefits and tax breaks that US companies currently enjoy from their offshore operations. The next stage will be to offer the carrot - by granting tax and other incentives for US multinationals to make that move.

This relocation of capacity will not happen on its own: it will be an integral part of the US using its scientific and engineering prowess to produce state-of-the art products, whether by the development of intelligent cars, telemedicine, smart robots, artificial intelligence and other devices. In short, it will be a combination of America's power of technology and the political and economic forces pulling manufacturing back home which will revolutionaries the global economy with similar developments to be seen in Europe and Japan. It will not be just competition by price, but competition by quality and design which will allow America to reemerge as a dynamic economic power sometime by the end of the 2010s.

First, though, there must be the Schumpeterian destruction of outdated plant and the financial system which then allows a return to traditional ratios of capital structures with a focus on long-term investment. It is this destruction which always occurs in the Winter of the K-Wave, probably starting around 2012/13 in a succession of down-waves which don't terminate until circa 2018. This does not mean that the entire period is one long depression, but that recoveries are relatively short within an overall downturn.

In summary, global economic recovery will disappoint as set out below:-

Growth will slow in the first half of this year
It should recover late this year with a modest recovery likely in 2011.
The seeds of the next credit crisis have been sown by soaring government debt and monetary largesse. It may well be the need for a huge issuance of government loans that will cause the next credit crisis, starting around 2012 and reaching its apex in 2013.
A new global recession, part of the ongoing depression, will begin that year and last at least two years.
The world is unlikely to begin a new period of sustainable growth until 2018 at the earliest.
Until then markets will remain volatile and should be traded rather than now making long-term investments.

Global Bear Rally Of 2009 Will End With Japan

John Mauldin — Mon, 04 Jan 2010 21:52:00 GMT

Let me welcome you to a new year of Outside the Box. I doubt we will have trouble finding interesting commentary this year, as there are many things that could happen that demand our attention. We start with a short column by Ambrose Evans-Pritchard of the London Telegraph giving us a quick run down of the problems faced around the globe. He thinks the #1 problem is Japan, and I more or less agree. I have written about Japan many times in the past few years. In my speeches I refer to Japan as a bug in search of a windshield. I am not so sure about the timing, however, as the economic and fiscal insanity that is Japan may be able to go on for longer than many think possible. But to me it is not a question of whether there will be a crisis, but when there will be one. This year? 2011? 2012? I doubt Japan makes it to the middle of the decade with a very serious and sad day of reckoning.

The downside to the continuation of running massive deficits is that when the break does come, it will be all the more painful and difficult to deal with as the debt mounts. If there is an upside, it is for the rest of the world to see what can happen to a developed country like Japan when massive deficits are allowed to pile up one after another. It will be a morality play writ large upon the walls, which cannot be dismissed.

But as Ambrose points out, it is not just Japan. There are problems all over the developed world. He does end on the encouraging note that at some point we hit bottom and will find the buying opportunity of our lives.

This is a little darker than most of the cheery forecasts of late, but we need to think of the world at large and how we are all connected.

This Friday I write my annual forecast letter. It will be more upbeat than last year's. Until then, have a great week.

John Mauldin, Editor
Outside the Box

Global bear rally of 2009 will end as Japan's hyperinflation rips economy to pieces

By Ambrose Evans-Pritchard

The contraction of M3 money in the US and Europe over the last six months will slowly puncture economic recovery as 2010 unfolds, with the time-honoured lag of a year or so. Ben Bernanke will be caught off guard, just as he was in mid-2008 when the Fed drove straight through a red warning light with talk of imminent rate rises – the final error that triggered the implosion of Lehman, AIG, and the Western banking system.

As the great bear rally of 2009 runs into the greater Chinese Wall of excess global capacity, it will become clear that we are in the grip of a 21st Century Depression – more akin to Japan's Lost Decade than the 1840s or 1930s, but nothing like the normal cycles of the post-War era. The surplus regions (China, Japan, Germania, Gulf ) have not increased demand enough to compensate for belt-tightening in the deficit bloc (Anglo-sphere, Club Med, East Europe), and fiscal adrenalin is already fading in Europe. The vast East-West imbalances that caused the credit crisis are no better a year later, and perhaps worse. Household debt as a share of GDP sits near record levels in two-fifths of the world economy. Our long purge has barely begun. That is the elephant in the global tent.

We will be reminded too that the West's fiscal blitz – while vital to halt a self-feeding crash last year – has merely shifted the debt burden onto sovereign shoulders, where it may do more harm in the end if handled with the sort of insouciance now on display in Britain.

Yields on AAA German, French, US, and Canadian bonds will slither back down for a while in a fresh deflation scare. Exit strategies will go back into the deep freeze. Far from ending QE, the Fed will step up bond purchases. Bernanke will get religion again and ram down 10-year Treasury yields, quietly targeting 2.5pc. The funds will try to play the liquidity game yet again, piling into crude, gold, and Russian equities, but this time returns will be meagre. They will learn to respect secular deflation.

Weak sovereigns will buckle. The shocker will be Japan, our Weimar-in-waiting. This is the year when Tokyo finds it can no longer borrow at 1pc from a captive bond market, and when it must foot the bill for all those fiscal packages that seemed such a good idea at the time. Every auction of JGBs will be a news event as the public debt punches above 225pc of GDP. Finance Minister Hirohisa Fujii will become as familiar as a rock star.

Once the dam breaks, debt service costs will tear the budget to pieces. The Bank of Japan will pull the emergency lever on QE. The country will flip from deflation to incipient hyperinflation. The yen will fall out of bed, outdoing China's yuan in the beggar-thy-neighbour race to the bottom. By then China too will be in a quandary. Wild credit growth can mask the weakness of its mercantilist export model for a while, but only at the price of an asset bubble. Beijing must hit the brakes this year, or store up serious trouble. It will make as big a hash of this as Western central banks did in 2007-2008.

The European Central Bank will stick to its Wagnerian course, standing aloof as ugly loan books set off wave two of Europe's banking woes. The Bundesbank will veto proper QE until it is too late, deeming it an implicit German bail-out for Club Med.

More hedge funds will join the EMU divergence play, betting that the North-South split has gone beyond the point of no return for a currency union. This will enrage the Eurogroup. Brussels will dust down its paper exploring the legal basis for capital controls. Italy's Giulio Tremonti will suggest using EU terror legislation against "speculators".

Wage cuts will prove a self-defeating policy for Club Med, trapping them in textbook debt-deflation. The victims will start to notice this. Articles will appear in the Greek, Spanish, and Portuguese press airing doubts about EMU. Eurosceptic professors will be ungagged. Heresy will spread into mainstream parties.

Greece's Prime Minister Papandréou will balk at EMU immolation . The Hellenic Socialists will call Europe's bluff, extracting loans that gain time but solve nothing. Berlin will climb down and pay, but only once: thereafter, Zum Teufel. [which roughly means your on your own or the devil with you. Not quite sure that's polite German.]

In the end, the Euro's fate will be decided by strikes, street protest, and car bombs as the primacy of politics returns. I doubt that 2010 will see the denouement, but the mood music will be bad enough to knock the euro off its stilts.

The dollar rally will gather pace. America's economy – though sick – will shine within the even sicker OECD club. The British will need the shock of a gilts crisis to shatter their complacency. In time, the Dunkirk spirit will rise again. Mervyn King's pre-emptive QE and timely devaluation will bear fruit this year, sparing us the worst.

By mid to late 2010, we will have lanced the biggest boils of the global system. Only then, amid fear and investor revulsion, will we touch bottom. That will be the buying opportunity of our lives.

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

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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.