John Mauldin's Outside the Box : Global Economy, Europe

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 ---

Subscription Information ... eileen@weldononline.com

Or Visit www.Weldononline.com for a free trial.

PLEASE NOTE: WE OFFER A FREE THIRTY-DAY TRIAL SUBSCRIPTION, DEFINED AS A SINGLE TRIAL THAT IS LIMITED TO A ONE-TIME SIGN-UP FOR EACH INDIVIDUAL USER OR COMPANY. SIGNING UP FOR MULTIPLE TRIALS UNDER DIFFERENT NAMES, WITH FRAUDULENT CONTACT INFORMATION IS ILLEGAL, AND OFFENDERS ARE SUBJECT TO LEGAL ACTION IN FEDERAL COURT.

WE TAKE THIS VERY SERIOUSLY, AND ARE WILLING TO AGGRESSIVELY PROTECT OUR WORK, AND PURSUE LEGAL ACTION WHEN NECESSARY. BY SIGNING UP FOR A FREE TRIAL, AND BY CONTINUING TO RECEIVE OUR WORK FOR THIRTY-DAYS, YOU ARE AGREEING THAT YOU WILL NOT SIGN UP AGAIN, AND THAT YOU WILL RESPECT OUR LEGAL COPYRIGHTS.

Please note ... we do NOT offer ANY specific trading advice.

Trading is risky, and a risk-management overlay is CRITICAL to the success of any trading campaign. We do NOT focus on risk management within the scope of this informational forum.

Within our own money management philosophy, we consider the risk overlay as the single most important element of our portfolio based programs.

Hence, while our momentum based models DO provide the basis for our OWN trading decisions, we are NOT making any specific suggestions based on this alone, particularly as applies to the application of a risk overlay.

Trading securities futures contracts may not be suitable for all investors. You may lose a substantial amount of money in a very short period of time. The amount you may lose is potentially unlimited. This is because futures trading is highly leveraged. If you are uncomfortable with this risk you should not trade securities futures.

Under certain market conditions it may be difficult or impossible to liquidate a position.

All securities trading involves risk, and there is no trading strategy that can eliminate it.

The information contained herein is believed to be true, and has been secured from sources we believe to be reliable. However, Weldon Financial Publishing is NOT responsible for ANY errors, including typographical errors in printing or downloading from our spreadsheets. All material contained herein is copyrighted. We have faith that our readers will respect that fact.

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.

Europe On the Ropes

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

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

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

John Mauldin, Editor
Outside the Box

Europe On the Ropes

The Absolute Return Letter March 2009

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

Woody Brock, SED Profile, December 2008

Policy mistakes 'en masse'

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

Policing must improve

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

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

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

More leverage in Europe

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

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

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

Not much of a cushion left

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

The wheels are coming off

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

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

The problem is widespread

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

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

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

US banks are better off

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

The great mortgage show

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

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

Chart 4: Eastern European vs. Asian Crisis

Source: Wall Street Journal

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

Austria is in greatest trouble

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

An extra $250bn to the IMF

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

Conspiracy or...?

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

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

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

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

Public debt to rise and rise

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

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

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

Can Germany rescue us?

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

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

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

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

Footnotes:

1 Citibank, Credit Outlook 2009

2 Ex Russia. Source: Credit Suisse Global Equity Strategy

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

Eyeing Opportunities in the Global Financial Crisis

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

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

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

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

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

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

Yours,
John Mauldin

GCC States: Eyeing Opportunities in the Global Financial Crisis

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

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

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

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

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

Financial Crisis and the GCC

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

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

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

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

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

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

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

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

Trouble Spots

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

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

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

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

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

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

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

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

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

Geopolitical Implications

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

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

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

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

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

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

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

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

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

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

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

Obama's Challenge

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

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

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

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

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

John Mauldin

Obama's Challenge

November 5, 2008 | 1202 GMT
By George Friedman

Obama's Agenda vs. Expanding His Base

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

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

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

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

Iran and a U.S. Withdrawal From Iraq

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

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

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

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

The Afghan Dilemma

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

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

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

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

The Russian Question

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

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

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

Global Finance and the European Problem

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

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

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

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

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

The Hard Road Ahead

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

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

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

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

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

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

Fourth Quarter Forecast 2008

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

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

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

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

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

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

John Mauldin

Fourth Quarter Forecast 2008

October 23, 2008 | 1502 GMT

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

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

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

Print Version:
To download a PDF of this piece Click here.

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

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

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

Global Economy

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

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

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

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

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

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

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

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

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

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

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

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

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

Former Soviet Union

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Middle East

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Europe

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

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

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

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

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

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

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

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

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

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

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

Latin America

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

South Asia

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

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

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

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

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

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

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

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

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

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

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

East Asia

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

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

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

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

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

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

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

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

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

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

Africa

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

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

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

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

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

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

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

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

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

The International Economic Crisis and Stratfor's Methodology

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

Dear Friends:

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

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

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

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

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

The International Economic Crisis and Stratfor's Methodology

By George Friedman

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

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

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

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

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

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

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

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

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

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

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

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

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

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