John Mauldin's Outside the Box : Stratfor

Financial Markets, Politics, and the New Reality

John Mauldin — Fri, 17 Aug 2012 06:00:00 GMT

If you've been following my newsletter, you're familiar by now with my friend George Friedman and the geopolitical analysis company he founded, Stratfor. And if you've read any of George's work, you know that his entire methodology is based on the premise that the actions of leaders and nations are predictable. George starts with the constraints – what can they notdo, assuming they're rational actors – and moves forward from there. It's this methodology that allowed him to – in all seriousness and probably with an impressive amount of accuracy – write a book titled The Next 100 Years.

I've always encouraged my readers to keep up with George's work at Stratfor. His expertise is not in investing, but the understanding of global politics he provides is essential for any global investor. That said, this week George set his sights on the world of investing with a rather harsh accusation: that investors today lack both imagination and an understanding of political economy.

It's always uncomfortable, to say the least, when good thinkers turn a critical eye on your own profession. I don't necessarily agree with George's conclusions, but I respect him enough to give his ideas some careful consideration and share them with my readers. After all, my basic premise with Outside the Box is that there is little to gain by reading only the work of those with whom we agree.

If George's piece makes you think, I recommend you check out Stratfor. They offer a substantial discount on subscriptions to OTB readers, plus a complimentary copy of the aforementioned book, The Next 100 Years, for new subscribers. <<Click here to access the offer.>>

Your not so unimaginative analyst,

John Mauldin, Editor
Outside the Box

Financial Markets, Politics and the New Reality

August 7, 2012 | 0902 GMT

By George Friedman

Louis M. Bacon is the head of Moore Capital Management, one of the largest and most influential hedge funds in the world. Last week, he announced that he was returning one quarter of his largest fund, about $2 billion, to his investors. The reason he gave to The New York Times was that he had found it difficult to invest given the impossibility of predicting the European situation. He was quoted as saying, "The political involvement is so extreme – we have not seen this since the postwar era. What they are doing is trying to thwart natural market outcomes. It is amazing how important the decision-making of one person, Angela Merkel, has become to world markets."

The purpose of hedge funds is to make money, and what Bacon essentially said was that it is impossible to make money when there is heavy political involvement, because political involvement introduces unpredictability in the market. Therefore, prudent investment becomes impossible. Hedge funds have become critical to global capital allocation because their actions influence other important actors, and their unwillingness to invest and trade has significant implications for capital availability. If others follow Moore Capital's lead, as they will, there will be greater difficulty in raising the capital needed to address the problem of Europe.

But more interesting is the reasoning. In Bacon's remarks, there is the idea that political decisions are unpredictable, or less predictable than economic decisions. Instead of seeing German Chancellor Merkel as a prisoner of non-market forces that constrain her actions, conventional investors seem to feel that Europe is now subject to Merkel's whims. I would argue that political decisions are predictable and that Merkel is not making decisions as much as reflecting the impersonal forces that drive her. If you understand those impersonal forces, it is possible to predict political behaviors, as you can market behaviors. Neither is an exact science, but properly done, neither is impossible.

Political Economy

In order to do this, you must begin with two insights. The first is that politics and the markets always interact. The very foundation of the market – the limited liability corporation – is political. What many take as natural is actually a political contrivance that allows investors to limit their liability. The manner in which liability is limited is a legal issue, not a market issue, and is designed by politicians. The structure of risk in modern society revolves around the corporation, and the corporation is an artifice of politics along with risk. There is nothing natural about a nation's corporate laws, and it is those corporate laws that define the markets.

There are times when politics leave such laws unchanged and times when politics intrude. The last generation has been a unique time in which the prosperity of the markets allowed the legal structure to remain generally unchanged. After 2008, that stability was no longer possible. But active political involvement in the markets is actually the norm, not the exception. Contemporary investors have taken a dramatic exception – the last generation – and lacking a historical sense have mistaken it for the norm. This explains the inability of contemporary investors to cope with things that prior generations constantly faced.

The second insight is the recognition that thinkers such as Adam Smith and David Ricardo, who modern investors so admire, understood this perfectly. They never used the term "economics" by itself, but only in conjunction with politics; they called it political economy. The term "economy" didn't stand by itself until the 1880s when a group called the Marginalists sought to mathematize economics and cast it free from politics as a stand-alone social science discipline. The quantification of economics and finance led to a belief – never held by men like Smith – that there was an independent sphere of economics where politics didn't intrude and that mathematics allowed markets to be predictable, if only politics wouldn't interfere.

Given that politics and economics could never be separated, the mathematics were never quite as predictive as one would have thought. The hyper-quantification of market analysis, oblivious to overriding political considerations, exacerbated market swings. Economists and financiers focused on the numbers instead of the political consequences of the numbers and the political redefinitions of the rules of corporate actors, which the political system had invented in the first place.

The world is not unpredictable, and neither is Europe nor Germany. The matter at hand is neither what politicians say they want to do nor what they secretly wish to do. Indeed, it is not in understanding what they will do. Rather, the key to predicting the political process is understanding constraints – the things they can't do. Investors' view that markets are made unpredictable by politics misses two points. First, there has not been a market independent of politics since the corporation was invented. Second, politics and economics are both human endeavors, and both therefore have a degree of predictability.

Merkel's Constraints

The European Union was created for political reasons. Economic considerations were a means to an end, and that end was to stop the wars that had torn Europe apart in the first half of the 20th century. The key was linking Germany and France in an unbreakable alliance based on the promise of economic prosperity. Anyone who doesn't understand the political origins of the European Union and focuses only on its economic intent fails to understand how it works and can be taken by surprise by the actions of its politicians.

Postwar Europe evolved with Germany resuming its prewar role as a massive exporting power. For the Germans, the early versions of European unification became the foundation to the solution of the German problem, which was that Germany's productive capacity outstripped its ability to consume. Germany had to export in order to sustain its economy, and any barriers to free trade threatened German interests. The creation of a free trade zone in Europe was the fundamental imperative, and the more nations that free trade zone encompassed, the more markets were available to Germany. Therefore, Germany was aggressive in expanding the free trade zone.

Germany was also a great supporter of Europewide standards in areas such as employment policy, environmental policy and so on. These policies protect larger German companies, which are able to absorb the costs, from entrepreneurial competition from the rest of Europe. Raising the cost of entry into the marketplace was an important part of Germany's strategy.

Finally, Germany was a champion of the euro, a single currency controlled by a single bank over which Germany had influence in proportion to its importance. The single currency, with its focus on avoiding inflation, protected German creditors against European countries inflating their way out of debt. The debt was denominated in euros, the European Central Bank controlled the value of the euro, and European countries inside and outside the eurozone were trapped in this monetary policy.

So long as there was prosperity, the underlying problems of the system were hidden. But the 2008 crisis revealed the problems. First, most European countries had significant negative balances of trade with Germany. Second, European monetary policy focused on protecting the interests of Germany and, to a lesser extent, France. The regulatory regime created systemic rigidity, which protected existing large corporations.

Merkel's policy under these circumstances was imposed on her by reality. Germany was utterly dependent on its exports, and its exports in Europe were critical. She had to make certain that the free trade zone remained intact. Secondarily, she had to minimize the cost to Germany of stabilizing the system by shifting it onto other countries. She also had to convince her countrymen that the crisis was due to profligate Southern Europeans and that she would not permit them to take advantage of Germans. The truth was that the crisis was caused by Germany's using the trading system to flood markets with its goods, its limiting competition through regulations, and that for every euro carelessly borrowed, a euro was carelessly lent. Like a good politician, Merkel created the myth of the crafty Greek fooling the trusting Deutsche Bank examiner.

The rhetoric notwithstanding, Merkel's decision-making was clear. First, under no circumstances could she permit any country to leave the free trade zone of the European Union. Once that began she could not predict where it would end, save that it might end in German catastrophe. Second, for economic and political reasons she had to be as aggressive as possible with defaulting borrowers. But she could never be so aggressive as to cause them to decide that default and withdrawal made more sense than remaining in the system.

Merkel was not making decisions; she was acting out a script that had been written into the structure of the European Union and the German economy. Merkel would create crises that would shore up her domestic position, posture for the best conceivable deal without forcing withdrawal, and in the end either craft a deal that was not enforced or simply capitulate, putting the problem off until the next meeting of whatever group.

In the end, the Germans would have to absorb the cost of the crisis. Merkel, of course, knew that. She attempted to extract a new European structure in return for Germany's inevitable capitulation to Europe. Merkel understood that Europe, and one of the foundations of European prosperity, was cracking. Her solution was to propose a new structure in which European countries accepted Brussels' oversight of their domestic budgets as part of a systemic solution by the Germans. Some countries outright rejected this proposal, while others agreed, knowing it would never be implemented. Merkel's attempt to recoup by creating an even more powerful European apparatus was bound to fail for two reasons. First and most important, giving up sovereignty is not something nations do easily – especially not European nations and not to what was effectively a German structure. Second, the rest of Europe knew that it didn't have to give in because in the end Germany would either underwrite the solution (by far the most likely outcome) or the free trade zone would shatter.

If we understand the obvious, then Merkel's actions were completely understandable. Germany needed the European Union more than any other country because of its trade dependency. Germany could not allow the union to devolve into disconnected nations. Therefore, Germany would constantly bluff and back off. The entire Greek drama was the exemplar of this. It was Merkel who was trapped and, being trapped, she was predictable.

The euro question was interesting because it intersected the banking system. But in focusing on the euro, investors failed to understand that it was a secondary issue. The European Union was a political institution and European unity came first. The lenders were far more concerned about the fate of their loans than the borrowers were. And whatever the shadow play of the European Central Bank, they would wind up doing the least they could do to avert default – but they would avert default. The euro might have been what investors traded, but it was not what the game was about. The game was about the free trade zone and Franco-German unity. Merkel was not making decisions based on the euro, but on other more pressing considerations.

Modern Trading

The investors' problem is that they mistake the period between 1991 and 2008 as the norm and keep waiting for it to return. I saw it as a freakish period that could survive only until the next major financial crisis – and there always is one. While the unusual period was under way, political and trade issues subsided under the balm of prosperity. During that time, the internal cycles and shifts of the European financial system operated with minimal external turbulence, and for those schooled in profiting from these financial eddies, it was a good time to trade.

Once the 2008 crisis hit external factors that were always there but quiescent became more overt. The internal workings of the financial system became dependent on external forces. We were in the world of political economy, and the political became like a tidal wave, making the trading cycles and opportunities that traders depended on since 1991 irrelevant. And so, having lost money in 2008, they could never find their footing again. They now lived in a world where Merkel was more important than a sharp trader.

Actually, Merkel was not more important than the trader. They were both trapped within constraints about which they could do nothing. But if those constraints were understood, Merkel's behavior could be predicted. The real problem for the hedge funds was not that they didn't understand what they were doing, but the manner in which they had traded in the past simply no longer worked. Even understanding and predicting what political leaders will do is of no value if you insist on a trading model built for a world that no longer exists.

What is called high velocity trading, constantly trading on the infinitesimal movements of a calm but predictable environment, doesn't work during a political tidal wave. And investors of the last generation do not know how to trade in a tidal wave. When we recall the two world wars and the Cold War, we see that this was the norm for the century and that fortunes were made. But the latest generation of investors wants to control risk rather than take advantage of new realities.

However we feel about the performance of the financial community since 2007, there must be a system of capital allocation. That can be operated by the state, but there is empirical evidence that the state isn't very good at making investment decisions. But then, the performance of the financial community has been equally unacceptable, with more than its share of mendacity to boot. The argument for private capital allocation may be theoretically powerful, but the fact is that the empirical validation of the private model hasn't been there for several years.

A strong argument can be made – corruption and stupidity aside – that the real problem has been a failure of imagination. We have re-entered an era in which political factors will dominate economic decisions. This has been the norm for a very long time, and traders who wait for the old era to return will be disappointed. Politics can be predicted if you understand the constraints under which a politician such as Merkel acts and don't believe that it is simply random decisions. But to do that, you have to return to Adam Smith and recall the title of his greatest work, The Wealth of Nations. Note that Smith was writing about nations, about politics and economics – about political economy.

The Election, the Presidency, and Foreign Policy

John Mauldin — Thu, 02 Aug 2012 20:14:00 GMT

The closer we get to the presidential election, the more we are bombarded with facts, opinions, predictions, and the like from both ends of the political spectrum.

One thing I like about this analysis from my friend and geopolitical expert George Friedman is that he starts off with an obvious yet understated fact: you can't believe what presidential candidates say. Not because they are pathological liars, but because they must make promises that, once elected, they cannot keep, given the reality of the office.

Whether or not you buy the idea that presidents have much less power than we think, George's assessment of each candidate in terms of foreign policy is as unbiased and dispassionate as they come – definitely worth some considered thought.

If you like this piece, I suggest you check out George's company, Stratfor. They publish geopolitical analysis, and a subscription to their website and email alerts is one of the best ways to stay smart about what's going on in the world and how it might affect your investment portfolio. <<Click here to access a special discount on a 1-year subscription>>, plus get a complimentary copy of George's bestselling book, The Next Decade.

Your thinking the presidency still matters analyst,

John Mauldin
Editor, Outside the Box

Stratfor Third Quarter Forecast

The Election, the Presidency and Foreign Policy

July 31, 2012

BY GEORGE FRIEDMAN

The American presidency is designed to disappoint. Each candidate must promise things that are beyond his power to deliver. No candidate could expect to be elected by emphasizing how little power the office actually has and how voters should therefore expect little from him. So candidates promise great, transformative programs. What the winner actually can deliver depends upon what other institutions, nations and reality will allow him. Though the gap between promises and realities destroys immodest candidates, from the founding fathers' point of view, it protects the republic. They distrusted government in general and the office of the president in particular.

Congress, the Supreme Court and the Federal Reserve Board all circumscribe the president's power over domestic life. This and the authority of the states greatly limit the president's power, just as the country's founders intended. To achieve anything substantial, the president must create a coalition of political interests to shape decision-making in other branches of the government. Yet at the same time -- and this is the main paradox of American political culture -- the presidency is seen as a decisive institution and the person holding that office is seen as being of overriding importance.

Constraints in the Foreign Policy Arena

The president has somewhat more authority in foreign policy, but only marginally so. He is trapped by public opinion, congressional intrusion, and above all, by the realities of geopolitics. Thus, while during his 2000 presidential campaign George W. Bush argued vehemently against nation-building, once in office, he did just that (with precisely the consequences he had warned of on the campaign trail). And regardless of how he modeled his foreign policy during his first campaign, the 9/11 attacks defined his presidency.

Similarly, Barack Obama campaigned on a promise to redefine America's relationship with both Europe and the Islamic world. Neither happened. It has been widely and properly noted how little Obama's foreign policy in action has differed from George W. Bush's. It was not that Obama didn't intend to have a different foreign policy, but simply that what the president wants and what actually happens are very different things.

The power often ascribed to the U.S. presidency is overblown. But even so, people -- including leaders -- all over the world still take that power very seriously. They want to believe that someone is in control of what is happening. The thought that no one can control something as vast and complex as a country or the world is a frightening thought. Conspiracy theories offer this comfort, too, since they assume that while evil may govern the world, at least the world is governed. There is, of course, an alternative viewpoint, namely that while no one actually is in charge, the world is still predictable as long as you understand the impersonal forces guiding it. This is an uncomfortable and unacceptable notion to those who would make a difference in the world. For such people, the presidential race -- like political disputes the world over -- is of great significance.

Ultimately, the president does not have the power to transform U.S. foreign policy. Instead, American interests, the structure of the world and the limits of power determine foreign policy.

In the broadest sense, current U.S. foreign policy has been in place for about a century. During that period, the United States has sought to balance and rebalance the international system to contain potential threats in the Eastern Hemisphere, which has been torn by wars. The Western Hemisphere in general, and North America in particular, has not. No president could afford to risk allowing conflict to come to North America.

At one level, presidents do count: The strategy they pursue keeping the Western Hemisphere conflict-free matters. During World War I, the United States intervened after the Germans began to threaten Atlantic sea-lanes and just weeks after the fall of the czar. At this point in the war, the European system seemed about to become unbalanced, with the Germans coming to dominate it. In World War II, the United States followed a similar strategy, allowing the system in both Europe and Asia to become unbalanced before intervening. This was called isolationism, but that is a simplistic description of the strategy of relying on the balance of power to correct itself and only intervening as a last resort.

During the Cold War, the United States adopted the reverse strategy of actively maintaining the balance of power in the Eastern Hemisphere via a process of continual intervention. It should be remembered that American deaths in the Cold War were just under 100,000 (including Vietnam, Korea and lesser conflicts) versus about 116,000 U.S. deaths in World War I, showing that far from being cold, the Cold War was a violent struggle.

The decision to maintain active balancing was a response to a perceived policy failure in World War II. The argument was that prior intervention would have prevented the collapse of the European balance, perhaps blocked Japanese adventurism, and ultimately resulted in fewer deaths than the 400,000 the United States suffered in that conflict. A consensus emerged from World War II that an "internationalist" stance of active balancing was superior to allowing nature to take its course in the hope that the system would balance itself. The Cold War was fought on this strategy.

The Cold War Consensus Breaks

Between 1948 and the Vietnam War, the consensus held. During the Vietnam era, however, a viewpoint emerged in the Democratic Party that the strategy of active balancing actually destabilized the Eastern Hemisphere, causing unnecessary conflict and thereby alienating other countries. This viewpoint maintained that active balancing increased the likelihood of conflict, caused anti-American coalitions to form, and most important, overstated the risk of an unbalanced system and the consequences of imbalance. Vietnam was held up as an example of excessive balancing.

The counterargument was that while active balancing might generate some conflicts, World War I and World War II showed the consequences of allowing the balance of power to take its course. This viewpoint maintained that failing to engage in active and even violent balancing with the Soviet Union would increase the possibility of conflict on the worst terms possible for the United States. Thus, even in the case of Vietnam, active balancing prevented worse outcomes. The argument between those who want the international system to balance itself and the argument of those who want the United States to actively manage the balance has raged ever since George McGovern ran against Richard Nixon in 1972.

If we carefully examine Obama's statements during the 2008 campaign and his efforts once in office, we see that he has tried to move U.S. foreign policy away from active balancing in favor of allowing regional balances of power to maintain themselves. He did not move suddenly into this policy, as many of his supporters expected he would. Instead, he eased into it, simultaneously increasing U.S. efforts in Afghanistan while disengaging in other areas to the extent that the U.S. political system and global processes would allow.

Obama's efforts to transition away from active balancing of the system have been seen in Europe, where he has made little attempt to stabilize the economic situation, and in the Far East, where apart from limited military repositioning there have been few changes. Syria also highlights his movement toward the strategy of relying on regional balances. The survival of Syrian President Bashar al Assad's regime would unbalance the region, creating a significant Iranian sphere of influence. Obama's strategy has been not to intervene beyond providing limited covert support to the opposition, but rather to allow the regional balance to deal with the problem. Obama has expected the Saudis and Turks to block the Iranians by undermining al Assad, not because the United States asks them to do so but because it is in their interest to do so.

Obama's perspective draws on that of the critics of the Cold War strategy of active balancing, who maintained that without a major Eurasian power threatening hemispheric hegemony, U.S. intervention is more likely to generate anti-American coalitions and precisely the kind of threat the United States feared when it decided to actively balance. In other words, Obama does not believe that the lessons learned from World War I and World War II apply to the current global system, and that as in Syria, the global power should leave managing the regional balance to local powers.

Romney and Active Balancing

Romney takes the view that active balancing is necessary. In the case of Syria, Romney would argue that by letting the system address the problem, Obama has permitted Iran to probe and retreat without consequences and failed to offer a genuine solution to the core issue. That core issue is that the U.S. withdrawal from Iraq left a vacuum that Iran -- or chaos -- has filled, and that in due course the situation will become so threatening or unstable that the United States will have to intervene. To remedy this, Romney called during his visit to Israel for a decisive solution to the Iran problem, not just for Iran's containment.

Romney also disagrees with Obama's view that there is no significant Eurasian hegemon to worry about. Romney has cited the re-emergence of Russia as a potential threat to American interests that requires U.S. action on a substantial scale. He would also argue that should the United States determine that China represented a threat, the current degree of force being used to balance it would be insufficient. For Romney, the lessons of World Wars I and II and the Cold War mesh. Allowing the balance of power to take its own course only delays American intervention and raises the ultimate price. To him, the Cold War ended as it did because of active balancing by the United States, including war when necessary. Without active balancing, Romney would argue, the Cold War's outcome might have been different and the price for the United States certainly would have been higher.

I also get the sense that Romney is less sensitive to global opinion than Obama. Romney would note that Obama has failed to sway global opinion in any decisive way despite great expectations around the world for an Obama presidency. In Romney's view, this is because satisfying the wishes of the world would be impossible, since they are contradictory. For example, prior to World War II, world opinion outside the Axis powers resented the United States for not intervening. But during the Cold War and the jihadist wars, world opinion resented the United States for intervening. For Romney, global resentment cannot be a guide for U.S. foreign policy. Where Obama would argue that anti-American sentiment fuels terrorism and anti-American coalitions, Romney would argue that ideology and interest, not sentiment, cause any given country to object to the leading world power. Attempting to appease sentiment would thus divert U.S. policy from a realistic course.

Campaign Rhetoric vs. Reality

I have tried to flesh out the kinds of argument each would make if they were not caught in a political campaign, where their goal is not setting out a coherent foreign policy but simply embarrassing the other and winning votes. While nothing suggests this is an ineffective course for a presidential candidate, it forces us to look for actions and hints to determine their actual positions. Based on such actions and hints, I would argue that their disagreement on foreign policy boils down to relying on regional balances versus active balancing.

But I would not necessarily say that this is the choice the country faces. As I have argued from the outset, the American presidency is institutionally weak despite its enormous prestige. It is limited constitutionally, politically and ultimately by the actions of others. Had Japan not attacked the United States, it is unclear that Franklin Roosevelt would have had the freedom to do what he did. Had al Qaeda not attacked on 9/11, I suspect that George W. Bush's presidency would have been dramatically different.

The world shapes U.S. foreign policy. The more active the world, the fewer choices presidents have and the smaller those choices are. Obama has sought to create a space where the United States can disengage from active balancing. Doing so falls within his constitutional powers, and thus far has been politically possible, too. But whether the international system would allow him to continue along this path should he be re-elected is open to question. Jimmy Carter had a similar vision, but the Iranian Revolution and the Soviet invasion of Afghanistan wrecked it. George W. Bush saw his opposition to nation-building wrecked by 9/11 and had his presidency crushed under the weight of the main thing he wanted to avoid.

Presidents make history, but not on their own terms. They are constrained and harried on all sides by reality. In selecting a president, it is important to remember that candidates will say what they need to say to be elected, but even when they say what they mean, they will not necessarily be able to pursue their goals. The choice to do so simply isn't up to them. There are two fairly clear foreign policy outlooks in this election. The degree to which the winner matters, however, is unclear, though knowing the inclinations of presidential candidates regardless of their ability to pursue them has some value.

In the end, though, the U.S. presidency was designed to limit the president's ability to rule. He can at most guide, and frequently he cannot even do that. Putting the presidency in perspective allows us to keep our debates in perspective as well.

Stratfor Third Quarter Forecast

John Mauldin — Thu, 19 Jul 2012 23:03:00 GMT

There are plenty of forecasts out there, but today I send you one you can trust. Stratfor, a geopolitical analysis company, has one of the most rigorous methodologies out there, and their forecasts provide excellent insight into the outcome of world events in the coming quarter.

Europe, Syria, and China are the big three to watch the next three to six months. But if you are looking for a much longer forecast, Stratfor's founder – and my friend – George Friedman has boldly written one for the entire century. Stratfor is offering a complimentary copy of George's bestseller, The Next 100 Years, to <<OTB readers who subscribe here>>. I highly recommend a subscription to their daily, forward-looking analysis of geopolitics – and the book.

Your near- and long-term analyst,

John Mauldin
Editor, Outside the Box

Third Quarter Forecast 2012

Though this may not be a quarter of dramatic changes, three evolving issues will require particularly close scrutiny: the European crisis, the Syrian conflict and China's political struggle. From Brussels to Damascus to Beijing, hard realities are setting in, threatening to dismantle decadeslong political constructs. Though the biggest cracks in the system will take time to appear, this quarter we will see Europe, Syria and China busily trying to stave off harsh but unavoidable consequences.

In Europe, an ideological attachment to a prosperous past is largely blinding the Continent to the consequences of their crisis. Meeting after meeting will be held to conjure a variety of bureaucratic treatments for the crisis, but the fundamental issue will remain: the weakening of the Franco-German relationship. Whereas the European crisis has been largely characterized to this point by a struggle between the economically stronger core and the deeply troubled periphery, the crisis is now starting to consume the core.

Most of the tensions in the Franco-German relationship will emanate from Paris. France's economic model relies mostly on internal consumption and high government spending. Since the creation of the common currency, France's trade deficit with Germany has increased dramatically. The German approach to the crisis aims to curb government spending, going against France's stimulus-oriented approach. This divergence in interests carries enormous consequences for the fate of the European Union, as the Franco-German axis forms the very foundation of a Continental effort to overcome Europe's eternal geopolitical fault lines.

In Syria, there is a growing acknowledgment that the Alawite core of the regime is holding together while the critical Sunni patronage networks surrounding that core are starting to dissolve. Even as the Alawite core endures, we are coming to a point where inner circle members of the regime, as well as foreign sponsors of the regime in Moscow and Tehran, will seriously begin planning for a post-al Assad Syria. Turkey and its NATO partners still lack the appetite for a foreign military intervention in Syria. However, this environment does raise the potential for a palace coup, in which all stakeholders — Iran and Russia on one side, the United States, Turkey and Saudi Arabia on the other — will maneuver to fashion an alternative regime that best suits their interests.

In China, the Communist Party leadership is anything but blind to history and so is working to battle the consequences of an economic slowdown coinciding with an upcoming political transition. The case of Bo Xilai was a stark reminder to the Party of the dangers of regionalism when a Mao-inspired populist tries to chart a path toward perceived economic and social stability. This quarter, we will see the Party put the Bo case to rest in a decisive and public show of Party solidarity ahead of a leadership transition later in the year. But this will likely do little to conceal a growing behind-the-scenes debate over China's economic and political direction. Once again, the Party will put off any major decisions on China's biggest challenges in hopes of preventing cracks in the system from widening.

Europe

The European Crisis

The driving issue for the third quarter remains the evolution of the Franco-German relationship. The economic performance of France and Germany will likely continue to diverge more strongly in the coming months. Though the political rise of French Socialist President Francois Hollande has accelerated the inevitable deterioration of the Franco-German relationship, a rupture is not expected this quarter.

The French economy is not yet at a breaking point: French unemployment is lower than the eurozone average and Hollande's government will be able to manage socio-political pressures. France will be under increased pressure to reduce its budget deficit. Hollande's administration plans to address the problem by increasing the taxes paid by France's largest businesses and wealthiest households. While these measures do not address France's systemic economic difficulties, they will allow Paris to skirt a harsher backlash to austerity this quarter.

As the core of Europe weakens, calls for deeper EU integration from both the core and the periphery will grow louder. The peripheral countries will call for more integration to ensure a continued flow of financial assistance, while the more economically stable northern industrial countries will call for additional integration to assert more control over member nations and to protect the common market for their exports. This model of deeper integration overlaying increasingly divergent interests is not sustainable, but it is a model that will endure for the next quarter as the European Union prepares for an October summit on EU integration proposals.

France's push against Germany for stimulus-led — as opposed to austerity-led — measures to manage the crisis will continue to provide countries in the European periphery with more political room to push back on austerity and demand more financial assistance (with negotiable conditionality) from European institutions. German intransigence on austerity will relax as Berlin continues to demonstrate a willingness to accommodate countries needing economic assistance in exchange for deeper integration efforts that provide Berlin with more EU-wide authority.

In Germany, Chancellor Angela Merkel's decisions on managing the crisis at the EU level will come under increased scrutiny from within her coalition and government bodies, particularly from the parliament and the Federal Constitutional Court. Though Germany is facing rising internal pressure, Stratfor does not expect a dramatic shift in the German policy of demanding more fiscal discipline and control before discussing forms of debt mutualization and permanent financial aid.

Spain will complete negotiations for a bailout of its banking sector but is unlikely to receive a sovereign bailout this quarter. The European Union cannot afford to cut Spain off from markets because it does not have the funds to support a Spanish bailout and deal with the contagion to other eurozone countries. Should bond yields for Spain and Italy rise to unsustainable levels as these countries issue new debt this quarter, the eurozone will use the short term financial tools at its disposal — short of a sovereign bailout — to alleviate market pressure.

Greece will not leave the eurozone this quarter. Athens will receive further financial aid, which will allow the country to keep operating. The new Greek government will begin a formal renegotiation of the bailout terms with its lenders, which will keep the Greek crisis at status quo for the third quarter.

One of the main consequences of the continued economic slowdown this quarter will be a decrease in summer employment, particularly in Southern Europe, during the tourist season. Social unrest in the form of protests will be more likely in the tourism-dependent periphery, especially in Greece, Italy and Spain.

Middle East

Ongoing Iranian-U.S. Struggle

Military posturing by both the United States and Iran will again punctuate the third quarter, but both sides will again steer clear of an actual military confrontation. Increased sanctions on Iran will have a limited effect as Iran continues to trade via falsely flagged tankers and shell companies, albeit at higher costs. Iran and the United States will maintain a dialogue behind the scenes in search of a broader accommodation, but Stratfor does not expect any negotiation breakthroughs in the lead-up to the U.S. presidential election. Israel will attempt to pressure the United States into taking more decisive action against Iran but will not risk unilateral action.

The Syrian Battleground

The main battleground between the United States and Iran this quarter will be Syria. The defection of the Tlass family — the Sunni pillar of the predominantly Alawite regime — risks unraveling the regime's Sunni patronage networks in the military and business community.

The Alawites face an existential crisis and will likely band even closer together in the face of a broader Sunni opposition threat. Even so, the psychological impact of high-level defections raises the potential for a Syrian palace coup that would eliminate the al Assads from the regime. Iran and Russia, both of which have deep intelligence links in Syria, will continue providing critical support to the regime to facilitate stronger crackdowns, but these powers will also be maneuvering behind the scenes to produce a non-al Assad alternative that would remain friendly to their interests.

The still-fractured Syrian rebel movement will engage in rounds of diplomacy abroad to build international support but is unlikely to receive much more than it is already getting, namely weapons and money primarily from the Gulf states and Turkey and verbal support and limited intelligence and command-and-control guidance from Western powers. Continued support for both the rebels and the Syrian army from their respective benefactors will result in a steady escalation of violence on both sides. The rebels will remain unable to hold and defend significant territory.

Foreign military intervention in Syria remains unlikely, as neither Turkey nor the rest of NATO is eager to deal with the consequences of military action in another fragile, sectarian regional hot spot. Turkey will maintain a strong military posture along its border with Syria, thereby raising the potential for skirmishes as Syrian forces operate near the border to deny sanctuary to Syrian rebels.

As Syrian-Turkish tensions escalate, Syria and Iran could support Kurdish militant activity in Turkey. If Turkey draws a link between Kurdistan Workers' Party attacks and Syria, Turkish domestic opinion could shift in favor of Turkey taking more decisive action against Syria, though any Turkish action in Syria will be limited without NATO reinforcement.

Turkey Recalibrating

The constraints Turkey faces regarding Syria and other foreign policy matters is motivating Ankara to resolve Turkey's domestic issues. With less attention consumed by Turkey's power struggle and the Kurdish problem, the government hopes to be able to play a more decisive role in foreign affairs. This quarter will thus see continued efforts by Turkey's ruling Justice and Development Party to reach out to its political rivals. However, the Islamist-rooted party's agenda to transform Turkey from a parliamentary to a presidential system and other contentious proposals to reform the constitution will deny the party the consensus it seeks.

The ruling party will make some progress this quarter in its Kurdish containment strategy. Turkey is investing in a pipeline connecting Turkey to energy resources in Iraq's Kurdish north, thereby undermining Baghdad's control over Kurdish export avenues while enhancing Turkey's. Ankara's accelerated moves in Iraqi Kurdistan will fuel tensions between Turkey and the Shiite-dominated government in Iraq. The project, which will be subject to Kurdish militant attacks as it progresses beyond this quarter, will also exacerbate the standoff between Turkey and Iran over the fate of Syria.

Political Accommodation in Egypt

The accommodation between the Supreme Council of the Armed Forces and the Muslim Brotherhood that Stratfor forecast last quarter will hold through to the next quarter. The military will go along with a Muslim Brotherhood presidency and the remainder of the political transition but will ensure its authority through the drafting of the constitution. The Muslim Brotherhood meanwhile will try to focus on building political consensus with a diverse Cabinet. Overall, the political instability that has characterized Egypt for much of the past year will quiet down this quarter. Occasional demonstrations will take place, especially by those left out of the grand bargain between the Muslim Brotherhood and the military, but Stratfor does not expect massive protests or clashes with the military and security forces.

Egypt-Israel relations will continue to experience strain as security in the Sinai Peninsula deteriorates further due to the distraction of the Egyptian military with the political transition and a growing influx of Salafist militants into the region. Amid these security concerns, Hamas will be cautious in how it maneuvers with Israel as the group looks to capitalize on the Muslim Brotherhood's political gains and as the Egyptian Muslim Brotherhood begins to engage directly with Israel. Hamas' worsened relationship with Syria will also more visibly orient the organization against the regime and in favor of the Syrian rebellion.

Persistent Instability in Libya

The election of a new government, officially ending the North African country's transition, will not alleviate a deepening rivalry between the hollow authority of the Tripoli-based Libyan central government and the regional city councils (especially Benghazi and Misurata). An overall increase in militant activity in Libya is likely this quarter. We will be closely watching to see if jihadists in Libya shift their campaign from rhetoric to attacks. Given the significance of oil revenues for both the central and regional governments, both will expend efforts to defend Libyan energy infrastructure from tribal and jihadist attacks.

Former Soviet Union

Russia's Domestic Challenge

The Kremlin faces internal challenges in the third quarter as it and various opposition movements prepare for regional and municipal elections in the fourth quarter. The elections will be held under a law that gives non-Kremlin groups a better chance to win gubernatorial and mayoral seats in the regions. For the first time in the past decade, the Kremlin's United Russia party will have to expend considerable effort campaigning in the regions to maintain its hold over the country.

Russia and Its Periphery

Russia will be particularly active in the Baltic states in the third quarter as it tries to rebuild its clout in the energy and security spheres there. The Baltic states will continue initiatives in energy diversification and regional security to distance themselves from Russia. Both Estonia and Lithuania already have implemented provisions under the EU Third Energy Package, which requires natural gas companies to unbundle their sales, transport and production operations, thereby undermining Russia's energy dominance in the region. Meanwhile, Finland is showing more interest in regional security groups like the Nordic Defense Cooperation. Russia may attempt to counter these moves in the third quarter by trying to exploit divisions between Poland and Lithuania and offering economic incentives to countries like Latvia and Finland. But Russia's efforts to reverse these regional initiatives will have limited effect for now.

Russia and the West

Russia's relationship with the West will continue to divide into sour relations with the United States and warmer relations with strategic European partners.

Diplomatic and trade spats will intensify between Russia and the United States in the third quarter. With European powers more concerned with their own affairs, Russia will have more room to maneuver in its efforts to keep the United States focused on the Middle East (and hence away from the Russian periphery) without harming relations with France. Russian backing of Syria through arms sales, sanctions evasion and negotiations will remain a key contentious issue between Moscow and Washington.

A recent energy deal between Russia and Germany will help Russia fortify a long-term relationship with Berlin as these two powers continue to deepen their economic ties. Other Central European states are likely to demand similar deals from Moscow, which will test Russia's ability to maintain its energy leverage in these countries.

Central Asia: Another Dynamic in Strained Relations

Central Asia will remain in a precarious state next quarter with continuing protests in Kazakhstan and the threat of a resurgence of Islamist militancy. Now that Uzbekistan has suspended its membership in the Collective Security Treaty Organization military alliance, Tashkent will be able to entertain alternative security relationships with Washington or Beijing. Russia will seek to build its security ties with Kyrgyzstan and Tajikistan in order to contain and maintain pressure on Uzbekistan.

Caucasus: Increasing Security Tensions

The Caucasus region has seen a number of developments in the past few months that will contribute to an increasingly tense security environment in the next quarter. Azerbaijan has significantly increased its security ties with Israel, signing a major defense deal with it this year. Meanwhile, Russia has been emphasizing its security ties with Armenia by signaling its intentions to increase the number of contract troops among its military presence in the country. These trends have increased tensions, spawning border skirmishes between Armenia and Azerbaijan and causing increased psychological operations between Iran and Azerbaijan —raising the potential for instability and miscalculations. Nevertheless, significant constraints will prevent a broader conflict from erupting in the region.

South Asia

U.S.-Pakistan-Taliban Negotiations

A breakthrough in U.S.-Pakistani talks in early July will allow limited movement toward broader U.S.-Pakistani negotiations over a post-NATO Afghanistan. In spite of many key differences between these two uneasy allies, shared fundamental interests are driving the two toward cooperation as the United States prepares its military exit from the region. Numerous obstacles remain, however, which will hamper these negotiations in the coming quarter.

The Afghan Taliban is a major presence in these negotiations. Stratfor expects the Afghan jihadist movement to use its militant arm during the politically sensitive period ahead of the 2012 U.S. presidential election to try to strengthen the Taliban's negotiating position. For its part, the United States will continue its battlefield operations to keep military pressure on the Taliban. And Pakistan will continue to face domestic political constraints this quarter that could undermine the negotiations. A power struggle between the government and the judiciary could pave the way for early elections before the end of the year. The broader negotiations among the United States, Pakistan and the Taliban will continue but are unlikely to see much progress this quarter.

India's Economic Reality and Foreign Policy Concerns

The slump in Indian economic growth in the last quarter of the fiscal year of 2011-12 was unavoidable. It reveals underlying stresses on the economy and served as a wake-up call for New Delhi. The Indian government cannot engage in any meaningful short-term economic measures to offset the slowdown, especially since slashing interest rates further would risk exacerbating already rising inflation. Indian policymakers will try more superficial moves that highlight the government's economic expertise in an effort to maintain the perception that Indian economic growth remains on an upward trend. Though India will remain a significant economy, the government's efforts will not hide the fact that exuberance over India's economic prospects is waning.

On the foreign policy front, India will maintain a cautious approach toward efforts in improving Indian-Pakistani ties. New Delhi will steer clear of major commitments or concessions toward Islamabad as it keeps a nervous watch on progressing U.S.-Pakistani negotiations.

East Asia

China's Economic, Political and Social Challenges

In the third quarter, the Chinese leadership will juggle three interrelated issues: Continued economic problems triggered by the global slowdown and lingering European uncertainty; social pressures arising from these economic problems; and the need to build consensus and rebuild legitimacy for the Communist Party of China ahead of the generational leadership transition through the fourth quarter of 2012 and the first quarter of 2013.

On the economic front, mounting fears of a sharp slowdown mean Beijing will continue to prioritize higher growth. Beijing will continue to push infrastructure projects, reflecting the need to use domestic investment to sustain economic activity. Large state-owned enterprises will see their profits continue to fall in the third quarter, and imbalances in commodity markets may further depress state enterprises producing steel, coal and other core materials. Activity in the real estate sector, meanwhile, will pick up, particularly amid revenue difficulties for local and provincial governments and following the latest interest rate cut. Beijing may choose to ignore rising real estate prices despite an official policy of slowing sales.

Labor protests and public protests over various infrastructure projects and social and economic grievances may bring stronger local and central government responses this quarter. Beijing will seek to maintain social stability as it manages political balances amid the final preparation for the leadership transition.

Beijing will also wrap up the Bo Xilai case in the third quarter, seeking a decisive end to domestic and international speculation over the unity of the Communist Party. The sentences for Bo and his wife will likely be harsh to signal decisiveness and confidence. Behind the scenes, however, the Party will be engaged in intense debates as Beijing seeks a cautious balance between competing economic policies and the stability of the political transition, particularly with a series of key personnel appointments to be settled in the third quarter to pave the way for the transition. In general, this means the government will not be afraid to implement short-term solutions to maintain stability, once again delaying any action on the Party's major challenges.

Rising Maritime Tensions

Regionally, the third quarter will see greater attention paid to maritime territorial disputes, raising the potential for inadvertent clashes. In mid-July, the Philippines will lift a ban on fishing in disputed waters. China will follow suit in August, leading to a rush of competing fishing vessels to parts of the South China Sea disputed by the two, followed by their respective coast guards, maritime police and navies. Competition over energy resources will also spur rhetorical, and potentially physical, confrontations. The Association of Southeast Asian Nations will seek an understanding with China on a binding code of conduct for the South China Sea ahead of the group's fourth quarter summit. The Philippines continues to try to draw the United States and others into the discussions, something China strongly opposes, so Beijing may be more inclined to work through ASEAN as opposed to China's preferred bilateral path to reduce the likelihood of U.S. involvement.

The Rise of the Japanese Regionalists

The expulsion of dozens of members of the ruling Democratic Party of Japan amid attempts to pass new tax legislation is likely going to bring an end to Japanese Prime Minister Yoshihiko Noda's government and necessitate a call for new elections in the third or fourth quarter. Although yet another government turnover is not very unusual for Japan, the election will be a bellwether for determining the status of the country's emerging regionalist parties, which could begin to challenge the political and bureaucratic status quo over the next few years if they can gain momentum.

Latin America

Building Strain on Mercosur

Trade and political tensions will continue to rise within Mercosur as Brazil and Argentina pursue protectionist policies both within Mercosur and on the international market. These measures have had a detrimental impact on the smaller Mercosur members, Paraguay and Uruguay, whose relationships with larger neighbors Brazil and Argentina will come under further strain in the third quarter. Paraguay's political isolation from Mercosur after former President Fernando Lugo's rapid impeachment will add more tension to the bloc, but Paraguay is not in a position to completely withdraw without significant bilateral economic guarantees. Uruguay will push for trade opportunities outside Mercosur to offset the effects of intrabloc protectionism. Despite increasing disunity, the Brazil-Argentina relationship at the core of Mercosur will endure as both rely on the agreement to manage bilateral economic concerns and their strategic geopolitical rivalry.

Pre-Election Tensions in Venezuela

During the third quarter, attention in Venezuela will focus on the lead-up to the Oct. 7 presidential election. Despite more than a year of conflicting rumors about Venezuelan President Hugo Chavez's health, the Venezuelan leader appears poised to stand for re-election Oct. 7. The election season is shaping up to be a relatively straightforward contest between Chavez and his chief rival, Miranda state Gov. Henrique Capriles Radonski, with Chavez likely enjoying more support. As with any Venezuelan election, there will be occasional bursts of violence between members of opposing political factions, bombastic political discourse and large-scale government spending and purchase announcements made by the Chavez administration to win support of key factions such as the military, petroleum sector workers and the urban poor.

Argentina's Search for Financing

Argentina will spend the third quarter seeking investment in oil and natural gas production in an attempt to reverse a growing energy deficit. To do so, the government will continue to use domestic pools of capital — such as private bank and Central Bank reserves — and both the central government and provincial governments will court international investment. Argentina will not fully settle its outstanding international debts in the third quarter due to restrictions on the government's ability to meet key international demands. These include revising its inflation reporting methodology, a process that would rapidly increase Argentina's national debt. Tight budgets at the national and provincial levels will drive further rent-seeking, and the mining sector will see increased pressure to increase revenue shares and investments from provincial governments similar to the pressure initially experienced by YPF ahead of its nationalization.

Mexico's Political Transition and Ongoing Violence

Mexico's politics will be in transition as President-elect Enrique Pena Nieto builds his government, tries to redevelop Institutional Revolutionary Party patronage networks and seeks backing from rival factions on issues like energy investment, tax reform and managing the drug cartels when he enters office in December.

Mexico's security situation will remain turbulent. The Sinaloa Federation and Los Zetas and their respective allies will continue to fight for territorial control in the northeast (particularly in Tamaulipas and Nuevo Leon states), while the Cartel de Jalisco Nueva Generacion will maintain its ongoing turf wars in the central and Pacific states (particularly Guerrero and Michoacan) against the Knights Templar. Los Zetas and the Cartel Pacifico Sur will continue operations against the Sinaloa Federation in Jalisco (including the state's capital, Guadalajara) and Sinaloa states.

Sub-Saharan Africa

Somalia's Battle Against al Shabaab

A pro-Somali government offensive led by African Union peacekeepers to flush al Shabaab from its remaining urban strongholds will intensify in the third quarter. A Kenyan-led military siege on Kismayo will occur around August while other African Union peacekeepers continue a steady buildup in Mogadishu. Al Shabaab reprisal attacks against soft targets in Kenya can be expected. Meanwhile, Ethiopia will maintain blocking positions in central and southwestern Somalia. U.S. financial rewards for information on the location of high-value al Shabaab leaders may facilitate the multipronged offensive. Rains that traditionally fall from September to December could hamper the intervention but will not derail it. Al Shabaab fighters will retreat to their clans in the hinterlands where they can regroup. They will not be neutralized by the end of the quarter.

Somalia will hold elections for a new federal government. On Aug. 20, it will select a new president, ending Somalia's transitional government era. With limited financial resources and no established institutional support, the new government faces tremendous challenges in reversing popular support for warlords and militancy by establishing good governance out of a deeply corrupt system. The new government will try to make slow and incremental improvements to government efficiency and service delivery while taking advantage of enhanced security from the African Union Mission in Somalia and other allied military forces.

Nigeria's Struggle with Boko Haram

The Nigerian government will continue operations against Boko Haram in the northeastern region of the country. Military and security forces will receive training and small equipment upgrades. Government and civil society leaders will attempt to split the movement through back-channel negotiations. Though these efforts will disrupt Boko Haram, they will not significantly undermine the group. Political opposition to President Goodluck Jonathan's administration will provide space in northern Nigeria for Boko Haram to operate. Clashes between government forces and Boko Haram militants and low-intensity militant attacks can thus be expected to continue in the third quarter.

Strained Negotiations Between Sudan and South Sudan

Sporadic clashes between Sudan and South Sudan will persist in the third quarter as both sides attempt to redraw the boundaries of the oil-rich borderland through military force. Military clashes will be interlaced with strained negotiations, but a decisive military or political breakthrough is unlikely. Compared to last quarter, Sudan's military offensive against South Sudan may be more tempered in the coming months as both sides confront growing political, military and economic constraints. With neither Sudan nor South Sudan in a position to shift the conflict decisively, external assistance, particularly from China and Japan, will remain limited as foreign players maintain a wait-and-see approach to the negotiations.

Economic austerity measures enacted by both Khartoum and Juba last quarter will weaken popular support for both governments. Demonstrations will persist in Sudan, but will not pose a significant threat to the regime. The austerity conditions may compel energy negotiations between Khartoum and Juba in an effort to revive oil revenue streams, but the two governments will remain focused on developing separate spheres of investment and oil development.

Islamist Militant Containment in Mali

With backing from the Economic Community of West African States, politicians in Mali will be focused on regaining political legitimacy this quarter as civilian and military authorities in Bamako engage in power-sharing negotiations to form a new national unity government. The political distractions will prevent effective coordination or deployment of resources from the capital to counter Islamist militant gains in the northern half of the country.

Militant activity will largely be contained to northern Mali this quarter due to the fractured nature of the Tuareg rebels and their common interest with al Qaeda forces to protect smuggling routes from outside intervention.

The Economic Community of West African States will engage in military operations in Mali, but these will remain limited without Western support. Contingency plans for a West African-led foreign intervention are under discussion, but Stratfor does not expect the plans to become operational so long as militant activity is contained in northern Mali. Western powers with counterterrorism interests in the region, primarily the United States and France, will rely instead on unilateral special operations forces' strikes against al Qaeda forces in the region to contain the transnational jihadist threat.

The Futility of European Elections

John Mauldin — Thu, 28 Jun 2012 19:34:00 GMT

After I sent out this week's OTB on Germany, I remembered this very intriguingly titled piece by my friend George Friedman, founder of a geopolitical analysis company called Stratfor.

The piece was written a few days ago, but when it comes to someone as ahead of the pack as George, who managed to write a book called The Next 100 Years, well, let's just say what he writes is pretty timeless.

The content of this report is as bold and thought-provoking as the title. Some nuggets:

• Greece disappointed Europe not because of the choice it made but because it was crippled with indecision.

• Germany has become the problem in the eurozone where once it was the solution.

• France is not yet leading a coalition against Germany, but it is difficult to imagine a different scenario.

If you like the piece below, consider subscribing to Stratfor. <<OTB readers can click here to access a pretty significant discount on a Stratfor subscription>>. Their coverage of Europe (and the rest of the world) provides a unique geopolitical perspective. I also know that a very in-depth report on the geopolitics of Germany is coming up in the next couple of weeks, so you may want to subscribe to access it.

Your wishing this Italy trip was also timeless analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

The Futility of European Elections

By George Friedman

Europe and the financial markets watched intently June 17 as Greece held general elections. German Chancellor Angela Merkel, French President Francois Hollande and Italian Prime Minister Mario Monti all delayed their flights to the June 18 G-20 summit in Mexico to await the results.

The two leading contenders in the elections were the center-right New Democracy Party (ND), which pledged to uphold Greece's commitments to austerity and honor the country's financial agreements with the European Union and the International Monetary Fund, and the Coalition of the Radical Left (SYRIZA), a group of far-left politicians who pledged to reject Greece's existing agreements, end austerity and maintain the country's position in the eurozone. A third major party, the center-left Panhellenic Socialist Movement (PASOK), shares the ND's position of maintaining Greece's bailout agreement. PASOK had been Greece's ruling party until it formed a unity government with the ND late in 2011.

For a while it seemed these elections would be definitive. Either Greece would reject the country's agreement with its international lenders, potentially being forced out of the eurozone, or it wouldn't. If Greece rejected austerity and forcibly or voluntarily left the eurozone, the country might set a precedent for other troubled states and precipitate a financial crisis -- a eurozone exit and default would likely go hand in hand. Europe would be tested as never before, and it would find out how resilient it is to a wider financial crisis.

But in Europe, the least likely outcome is a definitive one. ND won the election with about 29.5 percent of the vote, earning 78 seats in parliament plus another 50 seats awarded to the winning party by the Greek Constitution. SYRIZA received roughly 27.1 percent of the vote, equivalent to 72 seats, and PASOK received roughly 12.2 percent of the vote, or about 33 seats. The rest of the vote was scattered among a host of other parties. A party needs 151 seats to gain an absolute majority in parliament, but since no single party passed that threshold, a governing coalition must be formed. So the ND needs PASOK if it is going to cobble together a governing coalition, but PASOK has said it will not join a coalition without SYRIZA. It is unclear what a coalition would look like between a party that wants to respect the bailout agreement and a party that wants to reject it, but such a coalition is unlikely to happen anyway. SYRIZA wants to form a powerful opposition. Something resembling a government eventually will be assembled regardless of current rhetoric.

The Greek vote has settled nothing. In fact, it may not even lead to the formation of a government; the last election failed to produce a government and forced this election. That the European crisis most severely affected a country so politically fractious could be seen as pitiable. On the other hand, one could argue that the crisis inevitably would be most severe in the most divided country -- not because the divisions caused the crisis, but because the crisis caused the divisions.

The pressure brought on by the circumstances in Greece undermined whatever political order was in place; the choices for policymakers were so limited and so frightening that coherent responses were difficult. Greece has options, but it is unable to choose one. More than anything, Europe wants a decision on its future, whatever that decision might be. On June 17, Greece disappointed Europe not because of the choice it made but because it was crippled with indecision.

Crisis Management

Greece's indecisions are at the ground level of Europe. Another and more significant framework for indecision is emerging in Franco-German relations. The French Socialist Party won an absolute majority the same day that the Greeks entered another gridlock. This makes it possible for France's Socialists to form a government without the Greens, giving Hollande a strong and coherent platform from which to operate.

France's position on managing the sovereign debt crisis differs fundamentally from Germany's. Germany has said it will not agree to proposed solutions that would essentially turn the eurozone into a transfer union until the rest of Europe can balance their budgets through austerity measures. Germany believes this must be the first step to further EU and eurozone integration. Hollande takes a different position. He, too, wants greater European and eurozone integration. However, Hollande advocates economic stimulus alongside austerity measures as a means to rebalance the finances of European governments.

Hollande wants to grow Europe out of its financial problems. This means stimulating economies, a process that requires deficit spending. Hollande upholds a traditional Keynesian tenet that increasing demand for goods among consumers will increase economic activity and increase investment. As a Socialist with a strong leftist contingent in his party, Hollande cannot support the German position, which constrains the economy, particularly by decreasing government expenditures, thereby depressing consumption.

The difference between the French and German approaches is substantial. It reveals a dispute at the heart of the European strategy for managing the crisis. The Germans have been aggressive in demanding balanced budgets. The French are becoming equally aggressive in demanding expansionary policies. Both want to avoid defaults, but the Germans want to guarantee payments of debt by a combination of bailout and austerity. The French want to add stimulus to this, which changes the situation entirely because the stimulus would be funded in large part by German coffers.

This is not a simple matter of divergent economic theory. It is a matter of national interest. France is not as economically decrepit as Spain or Italy, let alone Greece, but nonetheless it is feeling the pressures of the financial crisis. If Europe continues on its path toward recession, France will face higher unemployment and therefore domestic political pressure under the German plan. It is not in Hollande's or France's interests to follow the German course. For its part, Germany cannot risk further government deficits in the European economic system. Germany's robust economy gives the country a financial cushion to soften the effects of deficit cuts; the rest of Europe, including France, does not have this luxury.

Interestingly, France and Germany were as one on this issue until Hollande was elected president. Indeed, the foundation and mission of European integration has been the close alignment of Germany and France. A founding principle of the union, such an alignment guaranteed stability and discouraged conflicts that had torn Europe apart. Now, Europe has lost its coherence at the highest level, albeit in a more orderly manner than in Greece.

Disharmony and Public Opinion

Of course, the situation is not that simple. What Germany says it wants differs from what it allows to happen. Germany claims to favor disciplined austerity, but more than any other country Germany needs the eurozone to stay intact. It is thus willing to compromise on austerity and on underwriting bad debts. On the other hand, Germany rejects the idea that a systematic strategy to stimulate growth is needed or likely to work. France sees no other solution, lest it face austerity itself. Both want different fiscal policies from the members and also, logically, from the European Central Bank.

From the most beleaguered members of the European Union to the relations between its strongest and most stable members, there is now profound disharmony. What drives this disharmony is public opinion. The Greek public is divided politically; therefore, Greece is paralyzed. France held an election in which Hollande, who holds serious doubts about German policy, forced out and replaced former French President Nicolas Sarkozy, who shared the German position on managing the crisis.

It is not the policymakers that are divided. Rather, the electorate is driving apart policymakers. The German solution to the problem is so unpalatable to the rest of Europe that traditional elite politicians supporting Germany's plan, such as Sarkozy and former Greek Prime Minister George Papandreou, are being replaced. Their replacements tend to reject the German position.

Indeed, political reality has constrained the actions of European lawmakers. Until about five years ago, a broad consensus governed Europe when it came to EU matters, and politicians were free to align themselves with Europe. This is no longer the case -- the solution for maintaining Europe has diverged. Most important, Germany has become the problem in the eurozone where once it was the solution.

Structural issues, such as German dependence on exports to the European Union, only partly explain the change in Germany's public perception. More accurately, German methods for managing the crisis increasingly are seen by other countries as significant threats to their well being -- there is not one anti-German coalition. Germany wants to find accommodation with France. The problem rests in how the French and German views are reconciled. France is not yet leading a coalition against Germany, but it is difficult to imagine a different scenario.

The more elections are held, the more the public will force their leaders in various directions. More often than not, this direction will eschew austerity and Germany. Over time this will solidify into a new map. While this has yet to happen, the recent elections at the least are not solving Europe's problem. In fact, they may be further dividing the Continent. And there are many elections to go.

A Conversation on Europe’s Political Economy with George Friedman and John Mauldin

John Mauldin — Thu, 14 Jun 2012 21:24:00 GMT

My travels last week took me to Austin, and I was able to stop by Stratfor to visit my friend and fellow thinker George Friedman. We had a great discussion about Europe, and luckily he had the wherewithal to video it. It is short for a discussion between George and me, but we got our points in. I think you'll enjoy hearing George's point of view on political economy versus economy,and our back and forth. I don't always agree with him ... but disagreement produces the best conversations.

Click here to watch the video.

If you're interested in more from George, you can sign up for a subscription to Stratfor. They produce some of the best geopolitical analysis out there – I read it daily. My readers get a discount, plus a free copy of George's newest book, The Next Decade.

Click here to check out the offer.

Your agreeing to disagree analyst,

John Mauldin, Editor
Outside the Box

China: Two Economic Models and the Ideological Divide in Chongqing

John Mauldin — Thu, 10 May 2012 18:27:00 GMT

There are political sides in America...and then there are political sides in the communist state of China. Here, it's a matter of the right and the left. In China, it's a matter of private enterprise and strong foreign investment versus highly centralized and debt-heavy state enterprise.

According to the geopolitical analysis company Stratfor, the left may be losing ground in China, and Beijing may be headed down an economic path that focuses on private enterprise. If the trend becomes the national strategy in the long term, this could mean greater room for private business in China.

You can see why it's important to follow events like this. Read the full article below. For those of you who aren't familiar with Stratfor, it is a company, founded by my friend George Friedman, that provides daily reports and analysis on global affairs. I read them daily and have procured a special discount on Stratfor subscriptions for OTB readers. <<Check out the offer here>> – it includes a new book on the geopolitics of the BRICS nations.

Your left hand always knows what the right hand is doing analyst,

John Mauldin, Editor
Outside the Box

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

Summary

LIU JIN/AFP/Getty Images

Bo Xilai (R) shakes hands with Chinese Vice Premier Zhang Dejiang on March 13

The new Party secretary for China's Chongqing municipality, Zhang Dejiang, has called on Chongqing to develop a more robust private sector using the "Zhejiang Experience," an economic model used in Zhejiang province, where Zhang previously served as Party secretary. Zhang's statement comes as Chongqing works to secure continued foreign and private investment in the wake of the March 15 ouster of its former Party secretary, Bo Xilai.

Zhang's statement may represent a departure from Bo's "Chongqing model," which utilized state-led investment to stimulate the economy and improve social welfare and served as a potential model for China's inland development. Given Chongqing's recent exemplification of leftist economic and political policies, abandoning the Chongqing model could signal Beijing's determination to put the country on a different economic path.

Analysis

Geographically, Chongqing is an ideal setting for economic experimentation. With 28 million residents, it is populous enough to serve as a testing ground for Beijing's policies before they are implemented nationally. However, it is sufficiently isolated such that the results of those experiments can be contained if Beijing chooses to do so.

Chongqing's ideal characteristics help explain the events that took place after Bo became Party secretary in 2007. Though Chongqing had been a key destination for state-driven growth since its separation from Sichuan province in 1997, the municipality evolved into something more under Bo's leadership: an experiment that brought centralized economic management together with a leftist social program. Bo used massive amounts of central funds to stimulate growth in Chongqing while simultaneously working to close the wealth gap. During this time, Beijing's response to the Chongqing model changed from caution to quiet endorsement to apparent rejection.

Beijing originally appointed Bo to Chongqing in part to remove him from the capital and isolate him from his power base in northeast China. But Bo used the distance and relative autonomy of Chongqing to cultivate an unorthodox populist persona that he hoped would bolster his chances of gaining a seat on the Politburo Standing Committee. In the process, he came to represent China's burgeoning neo-left, a loose grouping that gained popularity in Chinese academic and political debates in the late 1990s. Bo was an opportunist willing to use atypical methods to build his own political and financial fortunes, but for many in Chongqing and beyond, he became a symbol of a different kind of Chinese politician. He spoke out on behalf of China's ordinary people and had a conspicuous public profile in a political system where stoicism and uniformity are the rule -- for example, Bo mandated the recital of nationalist songs as part of his "red campaign."

Given the popular support for Bo's policies, Zhang's statement suggests more than a localized economic policy change. By calling on Chongqing to cultivate a more dynamic private economy of the sort that brought relative prosperity to coastal provinces like Zhejiang throughout the 1980s and 1990s, Beijing -- through Zhang -- is making a political statement: Bo's Chongqing model is on the decline. Beijing wants to replace the Chongqing model with an approach that encourages, rather than squeezes, small- and medium-sized private companies. While this approach is not unprecedented in China, the decision to publicly experiment with it in Chongqing, a major center for leftist political and economic policies in recent years, is a significant blow to Bo's state-driven economic model.

Economic Models and Ideological Division

Zhang's push for Chongqing to learn from the Zhejiang Experience and begin testing Beijing's nationwide effort to encourage private enterprise over massive state-owned enterprises (SOEs) reflects the ideological divide between China's left and right. While the Communist Party of China agrees that maintaining Party control is imperative, there has always been substantial disagreement among internal party factions over how to best preserve that control. In many ways, these divisions go back to the late 1950s, when Party leaders first began to question the limits of Mao Zedong's collectivization policies and the Soviet-style command economy. Against Mao's leftist policies, which equated social equality with a state-controlled economy, this new critique was labeled "rightist." When Mao died and Deng Xiaoping came to power in 1978, he began to redirect the country's economic course toward greater private enterprise, and what had been called the "rightist" economic and ideological model started to gain traction.

But the 1989 Tiananmen crackdown changed the way in which the Party thought of the economy. The Party realized how politically destabilizing insufficient control of private enterprise could be when coupled with the difficulties of controlling the provinces. It rapidly reconsolidated control over the economy, preparing for a centrally directed development model with two phases. The first phase, which began with the Jiang Zemin era in the 1990s, sought to use the productive powers of coastal economies while maintaining strict control of the stock exchange, financing and foreign investment. The second phase, which began with current President Hu Jintao, then co-opted the growing wealth of the coast to fund SOE-directed infrastructure development in the interior. The hope was that inland provinces would eventually rise out of poverty and participate in the private enterprise-led coastal economy.

Thus, the contemporary notions of right and left in China began to take shape in 1989 and were crystallized when Hu took power and began to shift Beijing's focus from the coast to the interior. In the Chinese context, "right" refers to economic decentralization, private enterprise and strong foreign participation in the economy, while "left" refers to highly centralized state investment-driven growth. The terms of debate derive from Chinese communist nomenclature: Right refers to those who accept some degree of social inequality as a temporary consequence of economic development. The left strives for equality, even at the expense of huge debt, wasteful SOEs and little transparency.

Chongqing represented an extreme iteration of the leftist stance. Rather than contradicting Hu, Bo took his economic policies a step further and combined them with a populist social program; and for a time, it worked. Under Bo, Chongqing's gross domestic product grew faster than China's, and the municipality became a major destination for foreign direct investment. At the same time, Bo managed to close the wealth gap somewhat, boosting rural wages even faster than the cities.

But developing Chongqing required massive fixed investment from the state at the cost of severely restricting the city's private economy. Domestic consumption was high because of Bo's social welfare initiatives, but the small- and medium-sized companies that catapulted cities like Shenzhen and Wenzhou were stifled. As Bo and the Chongqing model grew in popularity, they became less appealing to a central Party leadership faced with real consequences of unbridled government spending: debt, corruption and waste.

The Party's New Orientation

Zhang Dejiang is a strong candidate for appointment to the Politburo Standing Committee in October; his appointment as Party chief of Chongqing likely is temporary. This means that he is not in a position to make the Zhejiang Experience a reality at his new post. Rather, Beijing appointed him to alleviate growing private and foreign investor anxiety and to act as a mouthpiece for the Party. While he may not be able to accomplish much, his rhetoric is significant because it reflects the Party's orientation after Bo's departure.

Of course, neither the Zhejiang Experience nor the Chongqing model is an actual policy prescription from Beijing; they are approaches rather than concrete policies. But because Zhejiang refers to an economic strategy counter to Bo's, Zhang's invocation of Zhejiang is significant because it could signal that China's left is losing ground in the ongoing debate over the country's economic future.

The State of the World: A Framework

John Mauldin — Thu, 23 Feb 2012 18:11:00 GMT

Companies issue state of the enterprise addresses, and presidents issue state of the union addresses ... but you've got to be pretty confident to address the state of the world. Luckily for us, Stratfor founder and CEO George Friedman is just that confident – and it's well-deserved.

George is the expert in geopolitics, and his company is the best source out there for geopolitical analysis. Thus, his recent article, "The State of the World: A Framework," is well worth a thorough read. It identifies three distinct phenomena the world is facing: the European financial crisis, the Chinese export crisis, and Iran's rise to power in the Middle East.

One of his most interesting points, and one that I'm inclined to agree with, is that the most powerful country in the world– the United States – is currently unprepared to deal with this new reality. Something to keep in mind as we enter election season ...

Some of you may know that Stratfor was hacked several weeks ago. While they rebuild some infrastructure, they've got an open-house website – you can access the content that's usually only available to subscribers. You may want to take advantage of this opportunity by visiting www.stratfor.com before they lock up the house again. I particularly recommend their 2012 Annual Forecast.

Your wondering whether I'll have Greek, Chinese, or Iranian food tonight analyst,

John Mauldin, Editor
Outside the Box

The State of the World: A Framework

February 21, 2012

Editor's Note:This is the first installment of a new series on the national strategies of today's global power and other regional powers. This installment establishes a framework for understanding the current state of the world.

By George Friedman

The evolution of geopolitics is cyclical. Powers rise, fall and shift. Changes occur in every generation in an unending ballet. However, the period between 1989 and 1991 was unique in that a long cycle of human history spanning hundreds of years ended, and with it a shorter cycle also came to a close. The world is still reverberating from the events of that period.

On Dec. 25, 1991, an epoch ended. On that day the Soviet Union collapsed, and for the first time in almost 500 years no European power was a global power, meaning no European state integrated economic, military and political power on a global scale. What began in 1492 with Europe smashing its way into the world and creating a global imperial system had ended. For five centuries, one European power or another had dominated the world, whether Portugal, Spain, France, England or the Soviet Union. Even the lesser European powers at the time had some degree of global influence.

After 1991 the only global power left was the United States, which produced about 25 percent of the world's gross domestic product (GDP) each year and dominated the oceans. Never before had the United States been the dominant global power. Prior to World War II, American power had been growing from its place at the margins of the international system, but it was emerging on a multipolar stage. After World War II, it found itself in a bipolar world, facing off with the Soviet Union in a struggle in which American victory was hardly a foregone conclusion.

The United States has been the unchallenged global power for 20 years, but its ascendancy has left it off-balance for most of this time, and imbalance has been the fundamental characteristic of the global system in the past generation. Unprepared institutionally or psychologically for its position, the United States has swung from an excessive optimism in the 1990s that held that significant conflict was at an end to the wars against militant Islam after 9/11, wars that the United States could not avoid but also could not integrate into a multilayered global strategy. When the only global power becomes obsessed with a single region, the entire world is unbalanced. Imbalance remains the defining characteristic of the global system today.

While the collapse of the Soviet Union ended the European epoch, it also was the end of the era that began in 1945, and it was accompanied by a cluster of events that tend to accompany generational shifts. The 1989-1991 period marked the end of the Japanese economic miracle, the first time the world had marveled at an Asian power's sustained growth rate as the same power's financial system crumbled. The end of the Japanese miracle and the economic problem of integrating East and West Germany both changed the way the global economy worked. The 1991 Maastricht Treaty set the stage for Europe's attempt at integration and was the framework for Europe in the post-Cold War world. Tiananmen Square set the course for China in the next 20 years and was the Chinese answer to a collapsing Soviet empire. It created a structure that allowed for economic development but assured the dominance of the Communist Party. Saddam Hussein's invasion of Kuwait was designed to change the balance of power in the Persian Gulf after the Iraq-Iran war and tested the United States' willingness to go to war after the Cold War.

In 1989-1991 the world changed the way it worked, whether measured in centuries or generations. It was an extraordinary period whose significance is only now emerging. It locked into place a long-term changing of the guard, where North America replaced Europe as the center of the international system. But generations come and go, and we are now in the middle of the first generational shift since the collapse of the European powers, a shift that began in 2008 but is only now working itself out in detail.

What happened in 2008 was one of the financial panics that the global capitalist system periodically suffers. As is frequently the case, these panics first generate political crises within nations, followed by changes in the relations among nations. Of these changes, three in particular are of importance, two of which are directly linked to the 2008 crisis. The first is the European financial crisis and its transformation into a political crisis. The second is the Chinese export crisis and its consequences. The third, indirectly linked to 2008, is the shift in the balance of power in the Middle East in favor of Iran.

The European Crisis

The European crisis represents the single most significant event that followed from the financial collapse of 2008. The vision of the European Union was that an institution that would bind France and Germany together would make the wars that had raged in Europe since 1871 impossible. The vision also assumed that economic integration would both join France and Germany together and create the foundations of a prosperous Europe. Within the context of Maastricht as it evolved, the European vision assumed that the European Union would become a way to democratize and integrate the former Communist countries of Eastern Europe into a single framework.

However, embedded in the idea of the European Union was the idea that Europe could at some point transcend nationalism and emerge as a United States of Europe, a single political federation with a constitution and a unified foreign and domestic policy. It would move from a free trade zone to a unified economic system to a single currency and then to further political integration built around the European Parliament, allowing Europe to emerge as a single country.

Long before this happened, of course, people began to speak of Europe as if it were a single entity. Regardless of the modesty of formal proposals, there was a powerful vision of an integrated European polity. There were two foundations for it. One was the apparent economic and social benefits of a united Europe. The other was that this was the only way that Europe could make its influence felt in the international system. Individually, the European states were not global players, but collectively they had the ability to become just that. In the post-Cold War world, where the United States was the sole and unfettered global power, this was an attractive opportunity.

The European vision was smashed in the aftermath of 2008, when the fundamental instability of the European experiment revealed itself. That vision was built around Germany, the world's second-largest exporter, but Europe's periphery remained too weak to weather the crisis. It was not so much this particular crisis; Europe was not built to withstand any financial crisis. Sooner or later one would come and the unity of Europe would be severely strained as each nation, driven by different economic and social realities, maneuvered in its own interest rather than in the interest of Europe.

There is no question that the Europe of 2012 operates in a very different way than it did in 2007. There is an expectation in some parts that Europe will, in due course, return to its old post-Cold War state, but that is unlikely. The underlying contradictions of the European enterprise are now revealed, and while some European entity will likely survive, it probably will not resemble the Europe envisioned by Maastricht, let alone the grander visions of a United States of Europe. Thus, the only potential counterweight to the United States will not emerge in this generation.

China and the Asian Model

China was similarly struck by the 2008 crisis. Apart from the inevitably cyclical nature of all economies, the Asian model, as seen in Japan and then in 1997 in East and Southeast Asia, provides for prolonged growth followed by profound financial dislocation. Indeed, growth rates do not indicate economic health. Just as it was for Europe, the 2008 financial crisis was the trigger for China.

China's core problem is that more than a billion people live in households earning less than $6 a day, and the majority of those earn less than $3 a day. Social tensions aside, the economic consequence is that China's large industrial plant outstrips Chinese consumer demand. As a result, China must export. However, the recessions after 2008 cut heavily into China's exports, severely affecting GDP growth and threatening the stability of the political system. China confronted the problem with a massive surge in bank lending, driving new investment and supporting GDP growth but also fueling rampant inflation. Inflation created upward pressure on labor costs until China began to lose its main competitive advantage over other countries.

For a generation, Chinese growth has been the engine of the global economic system, just as Japan was in the previous generation. China is not collapsing any more than Japan did. However, it is changing its behavior, and with it the behavior of the international system.

Looking Ahead

If we look at the international system as having three major economic engines, two of them -- Europe and China -- are changing their behavior to be less assertive and less influential in the international system. The events of 2008 did not create these changes; they merely triggered processes that revealed the underlying weaknesses of these two entities.

Somewhat outside the main processes of the international system, the Middle East is undergoing a fundamental shift in its balance of power. The driver in this is not the crisis of 2008 but the consequences of the U.S. wars in the region and their termination. With the U.S. withdrawal from Iraq, Iran has emerged as the major conventional power in the Persian Gulf and the major influence over Iraq. In addition, with the continued survival of the al Assad regime in Syria through the support of Iran, there is the potential for Iranian influence to stretch from western Afghanistan to the Mediterranean Sea. Even if the al Assad regime fell, Iran would still be well-positioned to assert its claims for primacy in the Persian Gulf.

Just as the processes unleashed in 1989-1991 defined the next 20 years, so, too, will the processes that are being generated now dominate the next generation. Still powerful but acutely off-balance in its domestic and foreign policies, the United States is confronting a changing world without yet having a clear understanding of how to deal with this world or, for that matter, how the shifts in the global system will affect it. For the United States strategically, the fragmentation of Europe, the transformation of global production in the wake of the Chinese economy's climax, and the dramatically increased power of Iran appear as abstract events not directly affecting the United States.

Each of these events will create dangers and opportunities for the United States that it is unprepared to manage. The fragmentation of Europe raises the question of the future of Germany and its relationship with Russia. The movement of production to low-wage countries will create booms in countries hitherto regarded as beyond help (as China was in 1980) and potential zones of instability created by rapid and uneven growth. And, of course, the idea that the Iranian issue can be managed through sanctions is a form of denial rather than a strategy.

Three major areas of the world are in flux: Europe, China and the Persian Gulf. Every country in the world will have to devise a strategy to deal with the new reality, just as 1989-1991 required new strategies. The most important country, the United States, had no strategy after 1991 and has no strategy today. This is the single most important reality of the world. Like the Spaniards, who, in the generation after Columbus' voyage, lacked a clear sense of the reality they had created, Americans have no clear sense of the world they find themselves in. This fact continues to define how the world works.

Therefore, we next turn to American strategy in the next 20 years and consider how it will reshape itself.

The Unintended Empire

John Mauldin — Thu, 22 Dec 2011 17:17:00 GMT

A new year is almost upon us, so now seems like a perfect time to step back from the (many) crises at hand and take stock of the big picture. According to my friend & fellow thinker George Friedman, the big picture of the next 10 years is this: America will dominate, and the American president will have to figure out how to act as global emperor without admitting that's what he is.

George's newest book, The Next Decade, comes out in paperback in January; and he's graciously agreed to let me send you the first chapter, which backs up the bold statements above. We don't always agree, but I have to give George credit. He's an expert at constructing an argument.

If the first chapter whets your appetite, you can <<get a free copy of the book>> when you subscribe to STRATFOR, a geopolitical intelligence company founded and led by George. It is the publication to read if you're interested in foreign affairs. Plus, OTB readers can get a hefty discount.

Your really glad I'm not a global emperor analyst,

John Mauldin, Editor
Outside the Box

The Unintended Empire

By George Friedman, STRATFOR

The American president is the most important political leader in the world. The reason is simple: he governs a nation whose economic and military policies shape the lives of people in every country on every continent. The president can and does order invasions, embargos, and sanctions. The economic policies he shapes will resonate in billions of lives, perhaps over many generations. During the next decade, who the president is and what he (or she) chooses to do will often affect the lives of non-Americans more than the decisions of their own governments.

This was driven home to me on the night of the most recent U.S. presidential election, when I tried to phone one of my staff in Brussels and reached her at a bar filled with Belgians celebrating Barack Obama's victory. I later found that such Obama parties had taken place in dozens of cities around the world. People everywhere seemed to feel that the outcome of the American election mattered greatly to them, and many appeared personally moved by Obama's rise to power.

Before the end of Obama's first year in office, five Norwegian politicians awarded him the Nobel Peace Prize, to the consternation of many who thought that he had not yet done anything to earn it. But according to the committee's chair, Obama had immediately and dramatically changed the world's perception of the United States, and this change alone merited the prize. George W. Bush had been hated because he was seen as an imperialist bully. Obama was being celebrated because he signaled that he would not be an imperialist bully.

From the Nobel Prize committee to the bars of Singapore and São Paolo, what was being unintentionally acknowledged was the uniqueness of the American presidency itself, as well as a new reality that Americans are reluctant to admit. The new American regime mattered so much to the Norwegians and to the Belgians and to the Poles and to the Chileans and to the billions of other people around the globe because the American president is now in the sometimes awkward (and never explicitly stated) role of global emperor, a reality that the world—and the president—will struggle with in the decade to come.

The American Emperor

The American president's unique status and influence are not derived from conquest, design, or divine ordination but ipso facto are the result of the United States being the only global military power in the world. The U.S. economy is also more than three times the size of the next largest sovereign economy. These realities give the United States power that is disproportionate to its population, to its size, or, for that matter, to what many might consider just or prudent. But the United States didn't intend to become an empire. This unintentional arrangement was a consequence of events, few of them under American control.

Certainly there was talk of empire before this. Between Manifest Destiny and the Spanish American War, the nineteenth century was filled with visions of empire that were remarkably modest compared to what has emerged. The empire I am talking about has little to do with those earlier thoughts. Indeed, my argument is that the latest version emerged without planning or intention.

From World War II through the end of the Cold War, the United States inched toward this preeminence, but preeminence did not arrive until 1991, when the Soviet Union collapsed, leaving the U.S. alone as a colossus without a counterweight.

In 1796, Washington made his farewell address and announced this principle: "The great rule of conduct for us in regard to foreign nations is in extending our commercial relations, to have with them as little political connection as possible." The United States had the option of standing apart from the world at that time. It was a small country, geographically isolated. Today, no matter how much the rest of the world might wish us to be less intrusive or how tempting the prospect might seem to Americans, it is simply impossible for a nation whose economy is so vast to have commercial relations without political entanglements or consequences. Washington's anti-political impulse befitted the anti-imperialist founder of the republic. Ironically, the extraordinary success of that republic made this vision impossible.

The American economy is like a whirlpool, drawing everything into its vortex, with imperceptible eddies that can devastate small countries or enrich them. When the U.S. economy is doing well, it is the engine driving the whole machine; when it sputters, the entire machine can break down. There is no single economy that affects the world as deeply or ties it together as effectively.

When we look at the world from the standpoint of exports and imports, it is striking how many countries depend on the United States for 5 or even 10 percent of their Gross Domestic Product, a tremendous amount of interdependence. While there are bilateral economic relations and even multilateral ones that do not include the United States, there are none that are unaffected by the United States. Everyone watches and waits to see what the United States will do. Everyone tries to shape American behavior, at least a little bit, in order to gain some advantage or avoid some disadvantage.

Historically, this degree of interdependence has bred friction and even war. In the nineteenth and early twentieth centuries, France and Germany feared each other's power, so each tried to shape the other's behavior. The result was that the two countries went to war with each other three times in seventy years. Prior to World War I, the English journalist (later a member of Parliament) Norman Angell wrote a widely read book called The Great Illusion, in which he demonstrated the high degree of economic interdependence in Europe and asserted that this made war impossible. Obviously, the two World Wars proved that that wasn't the case. Advocates for free trade continue to use this argument. Yet, as we will see, a high degree of global interdependence, with the United States at the center, actually increases—rather than diminishes—the danger of war.

That the world is no longer filled with relatively equal powers easily tempted into military adventures mitigates this danger somewhat. Certainly the dominance of American military power is such that no one country can hope to use main force to fundamentally redefine its relationship with the United States. At the same time, however, we can see that resistance to American power is substantial and that wars have been frequent since 1991.

While America's imperial power might degrade, power of this magnitude does not collapse quickly except through war. German, Japanese, French, and British power declined not because of debt but because of wars that devastated those countries' economies, producing debt as one of war's many by-products. The Great Depression, which swept the world in the 1920s and 1930s, had its roots in the devastation of the German economy as a result of World War I and the disruption of trade and financial relations that ultimately spread to encompass the world. Conversely, the great prosperity of the American alliance after 1950 resulted from the economic power that the United States built up—undamaged—during World War II.

Absent a major, devastating war, any realignment of international influence based on economics will be a process that takes generations, if it happens at all. China is said to be the coming power. Perhaps so. But the U.S. economy is 3.3 times larger than China's. China must sustain an extraordinarily high growth rate for a long time in order to close its gap with the United States. In 2009, the United States accounted for 22.5 percent of all foreign direct investment in the world, which, according to the United Nations Council on Trade and Development, makes it the world's single largest source of investment. China, by comparison, accounted for 4.4 percent.

The United States also may well be the largest borrower in the world, but that indebtedness does not reduce its ability to affect the international system. Whether it stops borrowing, increases borrowing, or decreases it, the American economy constantly shapes global markets. It is the power to shape that is important. Of course, it should also be remembered that every dollar the United States borrows, others lend. If the market is to be trusted, it is saying that lending to the United States, even at currently low interest rates, is a good move.

Many countries have impacts on other countries. What makes the United States an empire is the number of countries it affects, the intensity of the impact, and the number of people in those countries affected by these economic processes and decisions.

In recent years, for instance, Americans had a rising appetite for shrimp. This ripple in the U.S. market caused fish farmers in the Mekong Delta to adjust their production to meet the new demand. When the American economy declined in 2008, luxury foods like shrimp were the first to be cut back, a retrenchment that was felt as far away as those fish farms in the Mekong Delta. Following a similar pattern, the computer maker Dell built a large facility in Ireland, but when labor costs rose there, Dell shifted operations to Poland, even at a time when Ireland was under severe economic pressure. The United States is similarly shaped by other countries, as were Britain and Rome. But the United States is at the center of the web, not on the periphery, and its economy is augmented by its military. Add to that the technological advantage and we can see the structure of America's deep power.

Empires can be formal, with a clear structure of authority, but some can be more subtle and complex. The British controlled Egypt, but Britain's formal power was less than clear. The United States has the global reach to shape the course of many other countries, but because it refuses to think of itself as an imperial power, it has not created a formal, rational structure for managing the power that it clearly has.

The fact that the United States has faced reverses in the Middle East in no way undermines the argument that it is an empire, albeit an immature one. Failure and empire are not incompatible, and in the course of imperial growth and expansion, disasters are not infrequent. Britain lost most of its North American colonies to rebellion a century before the empire reached its apex. The Romans faced civil wars in recurring cycles.

While the core of U.S. power is economic—battered though it might seem at the moment—standing behind that economic power is its military might. The purpose of the American military is to prevent any nation aggrieved by U.S. economic influence, or any coalition of such nations, from using force to redress the conditions that put it (or them) at a disadvantage. Like Rome's legions, American troops are deployed preemptively around the world, simply because the most efficient way to use military power is to disrupt emerging powers before they can become even marginally threatening.

The map below, in fact, substantially understates the American military presence. It does not, for instance, track U.S. Special Operations teams operating covertly in many regions, notably Africa. Nor does it include training missions, technical support, and similar functions. Some U.S. troops are fighting wars, some are interdicting drugs, some are protecting their host countries from potential attacks, and some are using their host countries as staging areas in case American troops are needed in another country nearby. In some cases these troops help support Americans who are involved in governing the country, directly or indirectly. In other cases, the troops are simply present, without controlling anything. Troops based in the United States are here not to protect the homeland as much as to be available for what the military calls power projection. This means that they are ready to serve anywhere the president sees fit to deploy them.

As befits a global empire, the United States aligns its economic system and its military system to stand as the guarantor of the global economy. The United States simultaneously provides technologies and other goods and services to buy, an enormous market into which to sell, and armed forces to keep the sea-lanes open. If need be, it moves in to police unruly areas, but it does this not for the benefit of other countries but for itself. Ultimately, the power of the American economy and the distribution of American military force make alignment with the United States a necessity for many countries. It is this necessity that binds countries to the United States more tightly than any formal imperial system could hope to accomplish.

Empires, the unintended consequence of power accumulated for ends far removed from dreams of empire, are usually recognized long after they have emerged. As they become self-aware, they use their momentum to consciously expand, adding an ideology of imperialism—think of Pax Romana or the British "white man's burden"—to empire's reality. An empire gets writers like Virgil and poets like Rudyard Kipling after it is well established, not before. And, as in both Rome and Britain, the celebrants of American empire coexist with those who are appalled by it and who yearn for the earlier, more authentic days.

Rome and Britain were trapped in the world of empire but learned to celebrate the trap. The United States is still at the point where it refuses to see the empire that it has become, and whenever it senses the trappings of empire, it is repelled. But the time has come to acknowledge that the president of the United States manages an empire of unprecedented power and influence, even while it may be informal and undocumented. Only then can we formulate policies over the next decade that will allow us to properly manage the world we find ourselves in charge of.

Managing the Imperial Reality

Over the past twenty years, the United States has struggled to come to grips with the reverberations of being "last man standing" after the fall of the Soviet Union. The task of the president in the next decade is to move from being reactive to having a systematic method of managing the world that he dominates, a method that faces honestly and without flinching the realities of how the world operates. This means turning the American empire from undocumented disorder into an orderly system, a Pax Americana—not because this is the president's free choice, but precisely because he has no choice.

Bringing order to empire is a necessity because even though the United States is overwhelmingly powerful, it is far from omnipotent, and having singular power creates singular dangers. The United States was attacked on September 11, 2001, for example, precisely because of its unique power. The president's task is to manage that kind of power in a way that acknowledges the risks as well as the opportunities, then minimizes the risks and maximizes the benefits.

For those who are made squeamish by any talk of empire, much less talk of bringing order to imperial control, I would point out that the realities of geopolitics do not give presidents the luxury of exercising virtue in the way we think of it when applied to ordinary citizens. Two presidents who attempted to pursue virtue directly, Jimmy Carter and George W. Bush, failed spectacularly. Conversely, other presidents, such as Richard Nixon and John F. Kennedy, who were much more ruthless, failed because their actions were not directed at and unified by any overriding moral purpose.

In bringing order to empire, I propose that future presidents follow the example of three of our most strikingly effective leaders, men who managed to be utterly ruthless in executing a strategy that was nonetheless guided by moral principle. In these cases, moral ends did in fact justify means that were not only immoral but unconstitutional.

Abraham Lincoln preserved the Union and abolished slavery by initiating a concerted program of deception and by trampling on civil liberties. To maintain the loyalty of the border states, he never owned up to his intention to abolish slavery made clear in the great debates of 1858. Instead he dissembled, claiming that while he opposed the spread of slavery beyond the South, he had no intention of abolishing the right to own slaves in states where owning them was already legal.

But Lincoln did more than prevaricate. He suspended the right to habeas corpus throughout the country and authorized the arrest of pro-secession legislators in Maryland. He made no attempt to justify these actions, except to say that if Maryland and the other border states seceded, the war would be lost and the nation would be dismembered, leaving the Constitution meaningless.

Seventy-five years later, in the midst of another grave crisis for the nation, Franklin Roosevelt also did what needed to be done while lying to hide his actions from a public that was not yet ready to follow his lead. In the late 1930s, Congress and the public wanted to maintain strict neutrality as Europe prepared for war, but Roosevelt understood that the survival of democracy itself was at stake. He secretly arranged for the sale of arms to the French and made a commitment to Winston Churchill to use the U.S. Navy to protect merchant ships taking supplies to England—a clear violation of neutrality.

Like Lincoln, Roosevelt was motivated by moral purpose, which meant a moral vision for global strategy. He was offended by Nazi Germany, and he was dedicated to the concept of democracy. Yet to preserve American interests and institutions, he formed an alliance with Stalin's Soviet Union, a regime that in moral terms was every bit as depraved as the Nazis. At home he defied a Supreme Court ruling and authorized wiretapping without warrants as well as the interception and opening of mail. Yet his most egregious violation of civil liberties was to approve the detention and relocation of ethnic Japanese, regardless of their citizenship status. Roosevelt had no illusions about what he was doing. He was ruthlessly violating rules of decency in pursuit of moral necessity.

Ronald Reagan also pursued a ruthless path toward a moral purpose. His goal was destruction of what he called the evil empire of the Soviet Union, and he pursued it—in part by ramping up the arms race, which he knew the Soviets could not afford. He then went to elaborate and devious lengths to block Soviet support for national liberation movements in the Third World. He invaded Grenada in 1983 and supported insurgents fighting the Marxist government of Nicaragua. This led to the elaborate ruse of engaging Israel to sell arms to Iran in its war with Iraq and then funneling the profits to the Nicaraguan insurgents, as a way of bypassing a law specifically designed to prevent such intervention. We should also remember Reagan's active support for Muslim jihadists in Afghanistan fighting the Soviets. As with Roosevelt and Stalin, a future enemy can be useful to defeat a current one.

The decade ahead will not be a time of great moral crusades. Instead, it will be an era of process, a time in which the realities of the world as presented by facts on the ground will be incorporated more formally into our institutions.

During the past decade, the United States has waged a passionate crusade against terrorism. In the next decade, the need will be for less passion and for more meticulous adjustments in relations with countries such as Israel and Iran. The time also calls for the creation of alliance systems to include nations such as Poland and Turkey that have newly defined relations with the United States. This is the hard and detailed work of imperial strategy. Yet the president cannot afford the illusion that the world will simply accept the reality of overwhelming American hegemony, any more than he can afford to abandon the power. He can never forget that despite his quasi-imperial status, he is president of one country and not of the world.

That is why the one word he must never use is empire. The anti-imperial ethos of America's founding continues to undergird the country's political culture. Moreover, the pretense that power is distributed more evenly is useful, not just for other countries but for the United States as well. Even so, in the decade ahead, the informal reality of America's global empire must start to take on coherent form.

Because a president must not force the public to confront directly realities that it isn't ready to confront, he must become a master at managing illusions. Slavery could not have survived much beyond the 1860s, no matter how much the South wanted it to. World War II could not have been avoided, regardless of public leanings toward isolationism. Confrontation with the Soviet Union had to take place, even if the public was frightened by those crises. In each case, a strong president created a fabric of illusions to enable him to do what was necessary without causing a huge revolt from the public. In Reagan's case, when his weapons-dealing machinations came to light as "the Iran-contra affair," complete with congressional hearings and indictments and convictions for many of the participants, his well-maintained persona as a simpleminded fellow shielded his power and his image from the fallout. The goings-on in Israel, Iran, and Nicaragua were so complex that even his critics had trouble believing that he could have been responsible.

A Global Strategy of Regions

America's fundamental interests are the physical security of the United States and a relatively untrammeled international economic system. As we will see when we turn to the current state of the world economy, this by no means implies a free trade regime in the sense that free-market ideologues might think of it. It simply means an international system that permits the vast American economy to interact with most, if not all, of the world. Whatever the regulatory regime might be, the United States needs to buy and sell, lend and borrow, be invested in and invest, with a global reach.

One quarter of the world's economy can't flourish in isolation, nor can the consequences of interaction be confined to pure economics. The American economy is built on technological and organizational innovation, up to and including what the economist Joseph A. Schumpeter called "creative destruction": the process by which the economy continually destroys and rebuilds itself, largely through the advance of disruptive technologies.

When American economic culture touches other countries, those affected have the choice of adapting or being submerged. Computers, for example, along with the companies organized around them, have had profoundly disruptive consequences on cultural life throughout the world, from Bangalore to Ireland. American culture is comfortable with this kind of flux, whereas other cultures may not be. China has taken on the additional burden of trying to adapt to a market economy while retaining the political institutions of a Communist state. Germany and France have struggled to limit the American impact, to insulate themselves from what they call "Anglo-Saxon economics." The Russians reeled from their first unbuffered exposure to this force in the 1990s and sought to find their balance in the following decade.

In response to the American whirlpool, the world's attitude, not surprisingly, is often sullen and resistant, as countries try to take advantage of or evade the consequences. President Obama sensed this resistance and capitalized on it. Domestically, he addressed the American need to be admired and liked, while overseas he addressed the need for the United States to be more conciliatory and less overbearing.

While Obama identified the problem and tried to manage it, resistance to imperial power remains a problem without a permanent solution. This is because ultimately it derives not from the policies of the United States but from the inherent nature of imperial power.

The United States has been in this position of near hegemonic power for only twenty years. The first decade of this imperial period was a giddy fantasy in which the end of the Cold War was assumed to mean the end of war itself—a delusion that surfaces at the end of every major conflict. The first years of the new century were the decade in which the American people discovered that this was still a dangerous planet and the American president led a frantic effort to produce an ad hoc response. The years from 2011 to 2021 will be the decade in which the United States begins to learn how to manage the world's hostility.

Presidents in the coming decade must craft a strategy that acknowledges that the threats that resurfaced in the past ten years were not an aberration. Al Qaeda and terrorism were one such threat, but it was actually not the most serious threat that the United States faced. The president can and should speak of foreseeing an era in which these threats don't exist, but he must not believe his own rhetoric. To the contrary, he must gradually ease the country away from the idea that threats to imperial power will ever subside, then lead it to an understanding that these threats are the price Americans pay for the wealth and power they hold. All the same, he must plan and execute the strategy without necessarily admitting that it is there.

Facing no rival for global hegemony, the president must think of the world in terms of distinct regions, and in doing so set about creating regional balances of power, along with coalition partners and contingency plans for intervention. The strategic goal must be to prevent the emergence of any power that can challenge the United States in any given corner of the world.

Whereas Roosevelt and Reagan had the luxury of playing a single integrated global hand—vast but unitary—presidents in the decade ahead will be playing multiple hands at a highly fragmented table. The time when everything revolved around one or a few global threats is over. The balance of power in Europe is not intimately connected to that of Asia and is distinct from the balance of power that maintains the peace in Latin America. So even if the world isn't as dangerous to the United States as it was during World War II or the Cold War, it is far more complicated.

American foreign policy has already fragmented regionally, of course, as reflected in the series of regional commands under which our military forces are organized. Now it is necessary to openly recognize the same fragmentation in our strategic thinking and deal with it accordingly. We must recognize that there is no global alliance supporting the United States and that the U.S. has no special historical relationships with anyone. Another quote from Washington's farewell address is useful here: "The nation which indulges towards another a habitual hatred or a habitual fondness is in some degree a slave. It is a slave to its animosity or to its affection, either of which is sufficient to lead it astray from its duty and its interest." This means that NATO no longer has unique meaning for the United States outside of the European context and that Europe cannot be regarded as more important than any other part of the world. Nostalgia for "the special relationship" notwithstanding, the simple reality today is that Europe is not more important.

Even so, President Obama ran a campaign focused on the Europeans. His travels before the 2008 election symbolized that what he meant by multilateralism was recommitting the United States to Europe, consulting Europe on U.S. actions abroad, and accepting Europe's cautions (now that they have lost their empires, Europeans always speak in terms of caution). Obama's gestures succeeded. The Europeans were wildly enthusiastic, and many Americans were pleased to be liked again. Of course, the enthusiasm dissipated rapidly as the Europeans discovered that Obama was an American president after all, pursuing American ends.

All of which brings us to the president's challenge in the decade ahead: to conduct a ruthless, unsentimental foreign policy in a nation that still has unreasonable fantasies of being loved, or at least of being left alone. He must play to the public's sentimentality while moving policy beyond it.

An unsentimental foreign policy means that in the coming decade, the president must identify with a clear and cold eye the most dangerous enemies, then create coalitions to manage them. This unsentimental approach means breaking free of the entire Cold War system of alliances and institutions, including NATO, the International Monetary Fund, and the United Nations. These Cold War relics are all insufficiently flexible to deal with the diversity of today's world, which redefined itself in 1991, making the old institutions obsolete. Some may have continuing value, but only in the context of new institutions that must emerge. These need to be regional, serving the strategic interests of the United States under the following three principles:

1. To the extent possible, to enable the balance of power in the world and in each region to consume energies and divert threats from the United States.
2. To create alliances in which the United States maneuvers other countries into bearing the major burden of confrontation or conflict, supporting these countries with economic benefits, military technology, and promises of military intervention if required.
3. To use military intervention only as a last resort, when the balance of power breaks down and allies can no longer cope with the problem.

At the height of the British Empire, Lord Palmerston said, "It is a narrow policy to suppose that this country or that is to be marked out as the eternal ally or the perpetual enemy of England. We have no eternal allies, and we have no perpetual enemies. Our interests are eternal and perpetual, and those interests it is our duty to follow." This is the kind of policy the president will need to institutionalize in the coming decade. Recognizing that the United States will generate resentment or hostility, he must harbor no illusions that he can simply persuade other nations to think better of us without surrendering interests that are essential to the United States. He must try to seduce these nations as much as possible with glittering promises, but in the end he must accept that efforts at seduction will eventually fail. Where he cannot fail is in his responsibility to guide the United States in a hostile world.

The Covert Intelligence War Against Iran

John Mauldin — Thu, 08 Dec 2011 18:35:00 GMT

Today I offer a topic that might have missed your "news-net" coverage of the eurozone crisis, US debt insanity, and a possible global recession. Folks, we may have the modern-day equivalent of the Cold War on our hands.

Go ahead and let go of the images of McCarthy at the podium, the Sputnik launch, and reel footage of schoolchildren ducking under desks; this cold war likens more to Tom Cruise's Mission: Impossible than the original with Peter Graves. I'm referring to ongoing covert operations against Iran over its quest for nuclear capabilities, and its staunch position against the existence of Israel. After the defection of nuclear officials, the Stuxnet computer worm, and a few questionable "explosions," it is becoming increasingly clear that a cold war is being waged (and has been, since at least 2007) to ensure, simply put, some level of peace in the Middle East.

Take a look at this Security Intelligence Report (a short read) from my friends over at STRATFOR. And lest you forget why these spy missions matter beyond the Mission: Impossible intrigue they offer, recall that Iran is conveniently located on the narrow Strait of Hormuz, through which passes 40% of the world's seaborne oil. So a covert mission gone wrong or an Iranian countermove could elevate the current financial crisis into something of epic proportions.

This is the kind of phenomenal information I expect from STRATFOR, and <<you can too, with their special rate, available only to OTB readers>>.

This email will not self-destruct in 5 seconds.

John Mauldin, Editor
Outside the Box

The Covert Intelligence War Against Iran

December 8, 2011 | 1725 GMT

By Scott Stewart

There has been a lot of talk in the press lately about a "cold war" being waged by the United States, Israel and other U.S. allies against Iran. Such a struggle is certainly taking place, but in order to place recent developments in perspective, it is important to recognize that the covert intelligence war against Iran (and the Iranian response to this war) is clearly not a new phenomenon.

Indeed, STRATFOR has been chronicling this struggle since early 2007. Our coverage has included analyses of events such as the defection to the West of Iranian officials with knowledge of Tehran's nuclear program; the Iranian seizure of British servicemen in the Shatt al Arab Waterway; the assassination of Iranian nuclear scientists; the use of the Stuxnet worm to cripple Iranian uranium enrichment efforts; and Iranian efforts to arm its proxies and use them as a threat to counteract Western pressure. These proxies are most visible in Iraq and Lebanon, but they also exist in Yemen, Afghanistan, Syria, the Palestinian territories, Saudi Arabia and other Gulf states.

While the covert intelligence war has been under way for many years, the tempo of events that can readily be identified as part of it has been increasing over the past few months. It is important to note that many of these events are the result of hidden processes begun months or even years previously, so while visible events may indeed be increasing, the efforts responsible for many of them began to increase much earlier. What the activities of recent months do tell us is that the covert war between Iran and its enemies will not be diminishing anytime soon. If anything, with the current withdrawal of U.S. troops from Iraq and Iranian nuclear efforts continuing,we likely will see the results of additional covert operations — and evidence of the clandestine activity required to support those operations.

Ramping Up

All eyes were on this covert intelligence war after The New York Times published an article Jan. 15 reporting that the United States and Israel worked together to create and launch Stuxnet against the Iranian nuclear program. The visible events related to the intelligence war maintained a relatively steady pace until Oct. 11, when the U.S. Department of Justice announced that two men had been charged in New York with taking part in a plot by the Iranian Quds Force to kill Saudi Arabia's ambassador to the United States, Adel al-Jubeir, on U.S. soil.

In early November, a new International Atomic Energy Agency (IAEA) report was issued detailing Iranian efforts toward a nuclear weapons program. While this report did not contain any major revelations, it did contain new specifics and was more explicit than previous IAEA reports in its conclusion that Iran was actively pursuing a nuclear weapons program. The IAEA report resulted in an Israeli-led diplomatic and public relations campaign urging more effective action against Iran, ranging from more stringent sanctions to military operations.

Then, in the early afternoon of Nov. 12, explosions occurred at an Islamic Revolutionary Guard Corps (IRGC) ballistic missile base near Tehran, killing 17 people, including a high-ranking IRGC commander who was a critical figure in Iran's ballistic missile program. Iran has insisted the blast was accidental, but speculation has since spread that the explosion could have been part of a sabotage operation carried out by Israeli intelligence. Israeli intelligence officials also have undertaken not-so-subtle efforts to ensure that outside observers believe they were responsible for the blasts.

Later on Nov. 12, the Bahraini government went public with the discovery of an alleged plot involving at least five Bahrainis traveling through Syria and Qatar to carry out attacks against government and diplomatic targets in Bahrain. Iran vehemently denied it was involved and portrayed the plot as a fabrication, just as it responded to the alleged plot against the Saudi ambassador.

The next day, the Iranian press reported that Ahmad Rezai, the son of Mohsen Rezai— who is the secretary of Iran's Expediency Council, a former IRGC commander and a presidential contender — was found dead at a hotel in Dubai. The deputy head of the Expediency Council told the Iranian press that the son's death was suspicious and caused by electric shocks, while other reports portrayed the death as a suicide.

On Nov. 20, the Los Angeles Times reported that U.S. intelligence officials confirmed the CIA had suspended its operations in Lebanon following the arrest of several of its sources due to sloppy tradecraft on the part of CIA case officers assigned to Beirut. Following this report, the Iranian government announced that it had arrested 12 CIA sources due to tradecraft mistakes. We have been unable to determine if the reports regarding Lebanon are true, merely CIA disinformation or a little of both. Certainly, the CIA would like the Iranians to believe it is no longer active in Lebanon. Even if these reports are CIA spin, they are quite interesting in light of the Oct. 11 announcement of the thwarted assassination plot in the United States and the Nov. 12 announcement of the arrests in Bahrain.

On Nov. 21, the United States and the United Kingdom launched a new wave of sanctions against Iran based on the aforementioned IAEA report. The new sanctions were designed to impact Iran's banking and energy sector. In fact, the United Kingdom took the unprecedented step of totally cutting off Iran's Central Bank from the British financial sector. The Canadian government undertook similar action against the Central Bank of Iran.

On Nov. 28, there were unconfirmed press reports of an explosion in Esfahan, one of Iran's largest cities. These reports were later echoed by a STRATFOR source in Israel, and U.S. sources have advised that explosions did occur in Esfahan and that they caused a significant amount of damage. Esfahan is home to numerous military and research and development facilities, including some relevant to Iran's nuclear efforts. We are unsure which facilities at Esfahan were damaged by the blasts and are trying to identify them.

Elsewhere on Nov. 28, Iran's Guardians Council, a clerical organization that provides oversight of legislation passed by Iran's parliament, approved a bill to expel the British ambassador and downgrade diplomatic relations between the two countries. The next day, Iranian protesters stormed the British Embassy in Tehran, along with the British Embassy's residential compound in the city. The angry — and well-orchestrated — mob was protesting the sanctions announced Nov. 21. Iranian authorities did not stop the mob from storming either facility.

On Dec. 1, the European Union approved new sanctions against some 180 Iranian individuals and companies over Iran's support of terrorism and its continued nuclear weapons program. The European Union did not approve a French proposal to impose a full embargo on Iranian oil.

In the early hours of Dec. 4, a small improvised explosive device detonated under a van parked near the British Embassy building in Manama, Bahrain. The device, which was not very powerful, caused little structural damage to the vehicle and none to the building itself.

The next day, an unnamed U.S. official confirmed Dec. 4 reports from several Iranian news outlets that Iran had recovered an RQ-170 "Sentinel" unmanned aerial vehicle (UAV) in Iranian territory. The Iranian reports claimed that Iranian forces were responsible for bringing down the Sentinel — some even said the Iranians were able to hack into the UAV's command link. U.S. officials have denied such reports, and it is highly unlikely that Iran was able to take control of a UAV and recover it intact.

Outlook

The United States is currently in the process of completing the withdrawal of its combat forces from Iraq. With the destruction of the Iraqi military in 2003, the U.S. military became the only force able to counter Iranian conventional military strength in the Persian Gulf region. Because of this, the U.S. withdrawal from Iraq will create a power vacuum that the Iranians are eager to exploit. The potential for Iran to control a sphere of influence from western Afghanistan to the Mediterranean is a prospect that not only frightens regional players such as Israel, Saudi Arabia and Turkey but also raises serious concerns in the United States.

As we have noted before, we don't believe that a military attack against Iran's nuclear facilities alone is the answer to the regional threat posed by Iran. Iran's power comes from its ability to employ its conventional forces and not nuclear weapons. Therefore, strikes against its nuclear weapons program would not impact Iran's conventional forces or its ability to interfere with the flow of oil through the Strait of Hormuz by using its conventional forces asymmetrically against U.S. naval power and commercial shipping. Indeed, any attack on Iran would have to be far broader than just a one-off attack like the June 1981 Israeli strike at Osirak, Iraq, that crippled Saddam Hussein's nuclear weapons program.

Because of this difficulty, we have seen the Israelis, Americans and their allies attacking Iran through other means. First of all, they are seeking to curb Iran's sphere of influence by working to overthrow the Syrian regime, limit Syria's influence in Iraq and control Hezbollah in Lebanon. They are also seeking to attack Iran's nuclear program by coercing officials to defect, assassinating scientists and deploying cyberwarfare weapons such as the Stuxnet worm.

It is also necessary to recognize that covert action does not occur in a vacuum. Each covert activity requires a tremendous amount of clandestine intelligence-gathering in order to plan and execute it. With so much covert action happening, the clandestine activity undertaken by all sides to support it is obviously tremendous. But as the frequency of this activity increases, so can sloppy tradecraft.

Finally, as we examine this campaign it is remarkable to note that not only are Iran's enemies using covert methods to stage attacks on Iran's nuclear program and military capabilities, they are also developing new and previously unknown methods to do so. And they have shown a willingness to allow these new covert attack capabilities to be unveiled by using them — which could render them useless for future attacks. This willingness to use, rather than safeguard, revolutionary new capabilities strongly underscores the importance of this covert campaign to Iran's adversaries. It also indicates that we will likely see other new forms of covert warfare emerge in the coming months, along with revolutionary new tactical applications of older forms.

Syria, Iran, and the Balance of Power in the Middle East

John Mauldin — Wed, 23 Nov 2011 20:58:00 GMT

Let's peel our eyes away from the eurozone disaster momentarily and take a look at another crisis – one with just as much potential to impact our global financial system.

As we've discussed in Outside the Box before, Iran's trump card is not its nuclear capability but rather its opportune location next to the very narrow, very important Strait of Hormuz ... through which no less than 40% of the world's seaborne oil passes.

As the US leaves Iraq, Iran is ready and waiting to fill the void and extend its regional influence. So where's the next turf war? A shaky Syria, where the Iranian-Saudi-US balance of power will continue to play out.

If you haven't been following the newest developing crisis in the Middle East, I recommend you spend some time with this piece by my friend George Friedman, CEO of STRATFOR. I'm also including a great background video from STRATFOR on the history of the Sunni/Shia divide. It's something you hear referenced all the time, but you may not know how it got started ... or what it really means.

If you're interested in more than the infrequent freebie from me, you should consider subscribing to their service. As an OTB reader you get a great discount and a free book when you join. There's nothing quite so enriching as getting a daily dose of what's really going on in the world. It's the intellectual equivalent of a Thanksgiving meal.

Your thinking about the turkey-mashed-potatoes-and-gravy balance of power analyst,

John Mauldin, Editor
Outside the Box

Syria, Iran, and the Balance of Power in the Middle East

November 22, 2011

By George Friedman

U.S. troops are in the process of completing their withdrawal from Iraq by the end-of-2011 deadline. We are now moving toward a reckoning with the consequences. The reckoning concerns the potential for a massive shift in the balance of power in the region, with Iran moving from a fairly marginal power to potentially a dominant power. As the process unfolds, the United States and Israel are making countermoves. We have discussed all of this extensively. Questions remain whether these countermoves will stabilize the region and whether or how far Iran will go in its response.

Iran has been preparing for the U.S. withdrawal. While it is unreasonable simply to say that Iran will dominate Iraq, it is fair to say Tehran will have tremendous influence in Baghdad to the point of being able to block Iraqi initiatives Iran opposes. This influence will increase as the U.S. withdrawal concludes and it becomes clear there will be no sudden reversal in the withdrawal policy. Iraqi politicians' calculus must account for the nearness of Iranian power and the increasing distance and irrelevance of American power.

Resisting Iran under these conditions likely would prove ineffective and dangerous. Some, like the Kurds, believe they have guarantees from the Americans and that substantial investment in Kurdish oil by American companies means those commitments will be honored. A look at the map, however, shows how difficult it would be for the United States to do so. The Baghdad regime has arrested Sunni leaders while the Shia, not all of whom are pro-Iranian by any means, know the price of overenthusiastic resistance.

Syria and Iran

The situation in Syria complicates all of this. The minority Alawite sect has dominated the Syrian government since 1970, when the current president's father — who headed the Syrian air force — staged a coup. The Alawites are a heterodox Muslim sect related to a Shiite offshoot and make up about 7 percent of the country's population, which is mostly Sunni. The new Alawite government was Nasserite in nature, meaning it was secular, socialist and built around the military. When Islam rose as a political force in the Arab world, the Syrians — alienated from the Sadat regime in Egypt — saw Iran as a bulwark. The Iranian Islamist regime gave the Syrian secular regime immunity against Shiite fundamentalists in Lebanon. The Iranians also gave Syria support in its external adventures in Lebanon, and more important, in its suppression of Syria's Sunni majority.

Syria and Iran were particularly aligned in Lebanon. In the early 1980s, after the Khomeini revolution, the Iranians sought to increase their influence in the Islamic world by supporting radical Shiite forces. Hezbollah was one of these. Syria had invaded Lebanon in 1975 on behalf of the Christians and opposed the Palestine Liberation Organization, to give you a sense of the complexity. Syria regarded Lebanon as historically part of Syria, and sought to assert its influence over it. Via Iran, Hezbollah became an instrument of Syrian power in Lebanon.

Iran and Syria, therefore, entered a long-term if not altogether stable alliance that has lasted to this day. In the current unrest in Syria, the Saudis and Turks in addition to the Americans all have been hostile to the regime of President Bashar al Assad. Iran is the one country that on the whole has remained supportive of the current Syrian government.

There is good reason for this. Prior to the uprising, the precise relationship between Syria and Iran was variable. Syria was able to act autonomously in its dealings with Iran and Iran's proxies in Lebanon. While an important backer of groups like Hezbollah, the al Assad regime in many ways checked Hezbollah's power in Lebanon, with the Syrians playing the dominant role there. The Syrian uprising has put the al Assad regime on the defensive, however, making it more interested in a firm, stable relationship with Iran. Damascus finds itself isolated in the Sunni world, with Turkey and the Arab League against it. Iran — and intriguingly, Iraqi Prime Minister Nouri al-Maliki — have constituted al Assad's exterior support.

Thus far al Assad has resisted his enemies. Though some mid- to low-ranking Sunnis have defected, his military remains largely intact; this is because the Alawites control key units. Events in Libya drove home to an embattled Syrian leadership — and even to some of its adversaries within the military — the consequences of losing. The military has held together, and an unarmed or poorly armed populace, no matter how large, cannot defeat an intact military force. The key for those who would see al Assad fall is to divide the military.

If al Assad survives — and at the moment, wishful thinking by outsiders aside, he is surviving — Iran will be the big winner. If Iraq falls under substantial Iranian influence, and the al Assad regime — isolated from most countries but supported by Tehran —survives in Syria, then Iran could emerge with a sphere of influence stretching from western Afghanistan to the Mediterranean (the latter via Hezbollah). Achieving this would not require deploying Iranian conventional forces —al Assad's survival alone would suffice. However, the prospect of a Syrian regime beholden to Iran would open up the possibility of the westward deployment of Iranian forces, and that possibility alone would have significant repercussions.

(click here to enlarge image)

Consider the map were this sphere of influence to exist. The northern borders of Saudi Arabia and Jordan would abut this sphere, as would Turkey's southern border. It remains unclear, of course, just how well Iran could manage this sphere, e.g., what type of force it could project into it. Maps alone will not provide an understanding of the problem. But they do point to the problem. And the problem is the potential — not certain — creation of a block under Iranian influence that would cut through a huge swath of strategic territory.

It should be remembered that in addition to Iran's covert network of militant proxies, Iran's conventional forces are substantial. While they could not confront U.S. armored divisions and survive, there are no U.S. armored divisions on the ground between Iran and Lebanon. Iran's ability to bring sufficient force to bear in such a sphere increases the risks to the Saudis in particular. Iran's goal is to increase the risk such that Saudi Arabia would calculate that accommodation is more prudent than resistance. Changing the map can help achieve this.

It follows that those frightened by this prospect — the United States, Israel, Saudi Arabia and Turkey —would seek to stymie it. At present, the place to block it no longer is Iraq, where Iran already has the upper hand. Instead, it is Syria. And the key move in Syria is to do everything possible to bring about al Assad's overthrow.

In the last week, the Syrian unrest appeared to take on a new dimension. Until recently, the most significant opposition activity appeared to be outside of Syria, with much of the resistance reported in the media coming from externally based opposition groups. The degree of effective opposition was never clear. Certainly, the Sunni majority opposes and hates the al Assad regime. But opposition and emotion do not bring down a regime consisting of men fighting for their lives. And it wasn't clear that the resistance was as strong as the outside propaganda claimed.

Last week, however, the Free Syrian Army — a group of Sunni defectors operating out of Turkey and Lebanon —claimed defectors carried out organized attacks on government facilities, ranging from an air force intelligence facility (a particularly sensitive point given the history of the regime) to Baath Party buildings in the greater Damascus area. These were not the first attacks claimed by the FSA, but they were heavily propagandized in the past week. Most significant about the attacks is that, while small-scale and likely exaggerated, they revealed that at least some defectors were willing to fight instead of defecting and staying in Turkey or Lebanon.

It is interesting that an apparent increase in activity from armed activists — or the introduction of new forces — occurred at the same time relations between Iran on one side and the United States and Israel on the other were deteriorating. The deterioration began with charges that an Iranian covert operation to assassinate the Saudi ambassador to the United States had been uncovered, followed by allegations by the Bahraini government of Iranian operatives organizing attacks in Bahrain. It proceeded to an International Atomic Energy Agency report on Iran's progress toward a nuclear device, followed by the Nov. 19 explosion at an Iranian missile facility that the Israelis have not-so-quietly hinted was their work. Whether any of these are true, the psychological pressure on Iran is building and appears to be orchestrated.

Of all the players in this game, Israel's position is the most complex. Israel has had a decent, albeit covert, working relationship with the Syrians going back to their mutual hostility toward Yasser Arafat. For Israel, Syria has been the devil they know. The idea of a Sunni government controlled by the Muslim Brotherhood on their northeastern frontier was frightening; they preferred al Assad. But given the shift in the regional balance of power, the Israeli view is also changing. The Sunni Islamist threat has weakened in the past decade relative to the Iranian Shiite threat. Playing things forward, the threat of a hostile Sunni force in Syria is less worrisome than an emboldened Iranian presence on Israel's northern frontier. This explains why the architects of Israel's foreign policy, such as Defense Minister Ehud Barak, have been saying that we are seeing an "acceleration toward the end of the regime." Regardless of its preferred outcome, Israel cannot influence events inside Syria. Instead, Israel is adjusting to a reality where the threat of Iran reshaping the politics of the region has become paramount.

Iran is, of course, used to psychological campaigns. We continue to believe that while Iran might be close to a nuclear device that could explode underground under carefully controlled conditions, its ability to create a stable, robust nuclear weapon that could function outside a laboratory setting (which is what an underground test is) is a ways off. This includes being able to load a fragile experimental system on a delivery vehicle and expecting it to explode. It might. It might not. It might even be intercepted and create a casus belli for a counterstrike.

The main Iranian threat is not nuclear. It might become so, but even without nuclear weapons, Iran remains a threat. The current escalation originated in the American decision to withdraw from Iraq and was intensified by events in Syria. If Iran abandoned its nuclear program tomorrow, the situation would remain as complex. Iran has the upper hand, and the United States, Israel, Turkey and Saudi Arabia all are looking at how to turn the tables.

At this point, they appear to be following a two-pronged strategy: Increase pressure on Iran to make it recalculate its vulnerability, and bring down the Syrian government to limit the consequences of Iranian influence in Iraq. Whether the Syrian regime can be brought down is problematic. Libya's Moammar Gadhafi would have survived if NATO hadn't intervened. NATO could intervene in Syria, but Syria is more complex than Libya. Moreover, a second NATO attack on an Arab state designed to change its government would have unintended consequences, no matter how much the Arabs fear the Iranians at the moment. Wars are unpredictable; they are not the first option.

Therefore the likely solution is covert support for the Sunni opposition funneled through Lebanon and possibly Turkey and Jordan. It will be interesting to see if the Turks participate. Far more interesting will be seeing whether this works. Syrian intelligence has penetrated its Sunni opposition effectively for decades. Mounting a secret campaign against the regime would be difficult, and its success by no means assured. Still, that is the next move.

But it is not the last move. To put Iran back into its box, something must be done about the Iraqi political situation. Given the U.S. withdrawal, Washington has little influence there. All of the relationships the United States built were predicated on American power protecting the relationships. With the Americans gone, the foundation of those relationships dissolves. And even with Syria, the balance of power is shifting.

The United States has three choices. Accept the evolution and try to live with what emerges. Attempt to make a deal with Iran — a very painful and costly one. Or go to war. The first assumes Washington can live with what emerges. The second depends on whether Iran is interested in dealing with the United States. The third depends on having enough power to wage a war and to absorb Iran's retaliatory strikes, particularly in the Strait of Hormuz. All are dubious, so toppling al Assad is critical. It changes the game and the momentum. But even that is enormously difficult and laden with risks.

We are now in the final act of Iraq, and it is even more painful than imagined. Laying this alongside the European crisis makes the idea of a systemic crisis in the global system very real.

Iran’s Nuclear Program and its Nuclear Option

John Mauldin — Thu, 10 Nov 2011 22:12:00 GMT

Take a minute – and maybe a deep breath too – and imagine the markets at opening bell on a hypothetical morning when live video shows burning oil tankers in the Strait of Hormuz (through which 40% of the world's seaborne oil passes). Couple that with the already shaky state of the current global economy and you get ... well, what does chaos in a mosh pit look like?

Iran is back in the headlines, and once again behaving in a less-than-cooperative fashion regarding its nuclear enrichment program. After they've failed to deliver on promise after promise, it does not appear that Iran will come clean anytime soon, and definitely not in time for the IAEA (International Atomic Energy Agency) inspection report due out any day now.

So what are our options? This week I came across a report from my friends over at STRATFOR, a geopolitical intelligence company, that fully analyzes the situation. They were nice enough to let me share the full article with Outside the Box readers, so I don't want to give too much away here. All I'll say is that there are three factors deterring any form of action against Tehran, and one of them relates to the scenario I described above.

And if you'd like more than just the occasional report from STRATFOR via yours truly, I've finagled a nice discount on a STRATFOR subscription for my readers, plus a free copy of their book on Iran. >>Click here to find out more.<<

Your still grieving Rangers fan,

John Mauldin, Editor
Outside the Box

Iran’s Nuclear Program and its Nuclear Option

STRATFOR

November 8, 2011

Details and specifics of the forthcoming International Atomic Energy Agency (IAEA) report on the Iranian nuclear program continued to leak out over the weekend, with the formal report expected later this week. The growing rhetoric about Iran — including talk from certain Israeli and American corners about an air campaign against Iran — had already begun to intensify in anticipation of the report, which will say more explicitly than previous IAEA assessments that Iran is indeed actively pursuing a nuclear weaponization program.

There is a cyclical nature to this rhetoric, and the correlation with the most harsh IAEA report on Iran to date is hard to get past. But while the latest IAEA report is certainly set to contain new, specific information about Iran’s program, there has been little serious doubt in recent years that Iran has continued to actively pursue nuclear weapons. The impending IAEA report’s overarching tenor is not news to anyone — though it provides plenty of opportunity to talk about Iran’s program, point fingers at Tehran and once again raise the specter of war— something even those mostly looking to mount pressure for more aggressive sanctions may do.

Nuclear weaponization programs by their nature require large, fixed infrastructure that must be connected to significant sources of power. The development of such programs— particularly in countries operating without access to key, export-controlled materiel — demands considerable investment over many years. Any serious movement down this path is vulnerable to detection, which is likely to lead to an attack in short order as Iraq found out in 1981 and Syria found out in 2007. Essentially, if a country desires a nuclear deterrent because it lacks any deterrent at all, then it is unlikely to be allowed the uninterrupted space and time to develop one.

The counterexamples are countries — specifically, North Korea and Iran — that already have a compelling, non-nuclear deterrent. That existent, non-nuclear deterrent discourages pre-emptive attacks against the country while its nuclear development efforts are in their most vulnerable stages. In the case of North Korea, Pyongyang has demonstrated a very sophisticated ability to escalate and de-escalate crisesyear after year, keeping itself at the center of the international agenda but not inviting physical attack. One element of this is Pyongyang’s deliberate cultivation of a perception of unpredictability — the idea the North Korean dictator may not behave rationally— which convinces international actors to give the regime a wide berth. The other is continued ambiguity. North Korea has made a career out of crossing international “red lines” and has helped soften the blow of crossing those lines by doing so ambiguously, particularly with nuclear tests that arenot overtly, demonstrably successful. Yet North Korea has a large but unknown number of conventional artillery and artillery rocket batteries within range of Seoul. North Korea’s real “nuclear” option is opening fire with those batteries before they can possibly all be destroyed. And that is what ultimately keeps the international response to North Korea’s nuclear program in check: the unwillingness to trade a difficult and uncertain military attempt to address a crude, nascent nuclear program in exchange for Seoul.

Tehran has three key deterrents. First, for years, the American troop presence in Iraq, particularly after post-surge quelling of violence, remained vulnerable to Iranian-instigated attack by Tehran’s proxies and with weapons provided by Tehran (something Iran demonstrated quite unambiguously that it had the capacity to do in the form of the explosively formed penetrator, a particularly deadly form of improvised explosive device). That dynamic will remain, after American troops depart, in the form of American diplomats and contractors, who will be protected by a small army of private security contractors. Second, Iran’s ballistic missile arsenal can target both American and Israeli targets across the region – and many missiles will likely be loosed before all their mobile launchers can be pinpointed and destroyed.

But the third deterrent is the critical factor. Iran has for decades cultivated the ability to essentially conduct guerrilla warfare in the Persian Gulf and the Strait of Hormuz.This is Iran’s real “nuclear” option. There are inherent vulnerabilities in such tight waters, in which Iran can bring to bear not just naval mines, but shore-based anti-ship missiles and small boat swarms. This threat might be manageable tactically (particularly if a massive U.S.-led air campaign surprised Iran), but even in the best-case scenario, no one can manage the markets’ reaction to even the hint of disruption to 40 percent of the world’s sea-borne crude.

This is the heart of the problem. Whether there are six key nuclear sites in Iran or 60 (and Iran presents a significant intelligence challenge in this regard), any attacker has to neutralize not just the nuclear targets and associated air defenses, but Iran’s dispersed and camouflaged military capabilities all along the Persian Gulf and Strait of Hormuz. U.S. participation was decisive in a far less sophisticated air campaign against Libya. In an Iran scenario where so much must be hit so quickly, the United States is the only country capable of even attempting to bring the necessary military strike capacity against Iran.

But even the optimistic scenario must anticipate the potential for an outcome reminiscent of the 1980s Tanker Wars. While the United States and Europe are focused on the global economic crisis (and particularly the euro crisis in Europe), they will want to avoid at all costs video of burning oil tankers in the Strait of Hormuz, which could panic already skittish markets. As long as that is the case, the prospect of a military strike on Iran is dim. And in any event, surprise is a key element for a successful strike on Iran. The moment Iran should feel the most secure is when Israeli rhetoric about war is at its peak.

The European Banking Crisis: Assessing the Damage and a Look Ahead

John Mauldin — Fri, 28 Oct 2011 02:36:00 GMT

In my letter earlier this week, our guest writer, Grant Williams, gave Europe about the same odds of escaping crisis as a pitcher throwing a perfect game in baseball. That's 40,000 to 1. Take a look at this decision tree on Europe (below) from STRATFOR, a private intelligence company. Looks like they give Europe something more like the odds of a major-league pitcher leading in home runs. Not gonna happen.

With a serious impending crisis on our hands, we need to understand it from all angles, starting with geopolitical risk. So I'm sending you this insightful two-part series from STRATFOR, written just prior to the meeting of the Eurozone Finance Ministers last Friday Oct 21. STRATFOR starts with a full assessment of the problem: sovereign debt, bank centrality, housing, foreign currency, etc. Then, Part 2 gives you a look ahead at recapitalization options and the EFSF. By the way, the Finance Ministers ended their meeting by punting the problem to no fewer than three subsequent meetings.

To get more than the occasional analysis like this that I pass along to you, I recommend you become a STRATFOR subscriber. They've got the best geopolitical coverage of global affairs I've seen. Plus, OTB readers get a <<hefty discount on subscriptions plus a free copy of their founder's bestseller, The Next Decade>>.

As I write this, the Rangers lead 3-2 ... Let's see what game six brings.

Your truly impressed with Nolan Ryan (no matter the outcome) analyst,

John Mauldin, Editor
Outside the Box

Special Series (Part 1): Assessing the Damage of the European Banking Crisis

October 20, 2011 | 1745 GMT

STRATFOR

Editor’s Note: This is the first installment in a two-part series on the European banking crisis.

Sovereign Debt: The Expected Problem

The collapse in early October of Franco-Belgian bank Dexia, a large Northern European institution whose demise necessitated a state rescue, shattered European confidence. Now, Europeans are discussing their banking sector. A meeting of eurozone ministers Oct. 21 is largely dedicated to the topic, as is the Oct. 23 summit of EU heads of government. Yet European governments continue to consider the banking sector largely only within the context of the ongoing sovereign debt crisis.

This is exemplified in Europeans’ handling of the Greek situation. The primary reason Greece has not defaulted on its nearly 400-billion euro sovereign debt is that the rest of the eurozone is not forcing Greece to fully implement its agreed-upon austerity measures. Withholding bailout funds as punishment would trigger an immediate default and a cascade of disastrous effects across Europe. Loudly condemning Greek inaction while still slipping Athens bailout checks keeps that aspect of Europe’s crisis in a holding pattern. In the European mind — especially the Northern European mind— a handful of small countries that made poor decisions are responsible for the European debt crisis, and while the ensuing crisis may spread to the banks as a consequence, the banks themselves would be fine if only the sovereigns could get their acts together.

This is an incorrect assumption. If anything, Europe’s banks are as damaged as the governments that regulate them.

When evaluating a problem of such magnitude, one might as well begin with the problem as the Europeans see it — namely, that their banks’ biggest problem is rooted in their sovereign debt exposure.

http://web.stratfor.com/images/europe/art/Europe_bank_exposure_800.jpg

STRATFOR
(click here to enlarge image)

The state-bank contagion problem is fairly straightforward within national borders. As a rule the largest purchaser of the debt of any particular European government will be banks located in the particular country. If a government goes bankrupt or is forced to partially default on its debt, its failure will trigger the failure of most of its banks. Greece does indeed provide a useful example. Until Greece joined the European Union in 1981, state-controlled institutions dominated its banking sector. These institutions’ primary reason for being was to support government financing, regardless of whether there was a political or economic rationale justifying that financing. The Greeks, however, have no monopoly on the practice of leaning on the banking sector to support state spending. In fact, this practice is the norm across Europe.

Spain’s regional banks, the cajas, have become infamous for serving as slush funds for regional governments, regardless of the government in question’s political affiliation. Were the cajas assets held to U.S. standards of what qualifies as a good or bad loan, half the cajas would be closed immediately and another third would be placed in receivership. Italian banks hold half of Italy’s 1.9 trillion euros in outstanding state debt. And lest anyone attempt to lay all the blame on Southern Europe, French and Belgian municipalities as well as the Belgian national government regularly used the aforementioned Dexia in a somewhat similar manner.

Yet much debt remains for outsiders to own, so when states crack, the damage will not be held internally. Half or more of the debt of Greece, Ireland, Portugal, Italy and Belgium is in foreign hands, but like everything else in Europe the exposure is not balanced evenly — and this time, it is Northern Europe, not Southern Europe, that is exposed. French banks are more exposed than any other national sector, holding an amount equivalent to 8.5 percent of French gross domestic product (GDP) in the debt of the most financially distressed states (Greece, Ireland, Portugal, Italy, Belgium and Spain). Belgium comes in second with an exposure of roughly 5.5 percent of GDP, although that number excludes the roughly 45 percent of GDP Belgium’s banks hold in Belgian state debt.

When Europeans speak of the need to recapitalize their banks, creating firebreaks between cross-border sovereign debt exposure dominates their thoughts — which explains why the Europeans belatedly have seized upon the IMF’s original 200 billion-euro figure. The Europeans are hoping that if they can strike a series of deals that restructure a percentage of the debt owed by the Continent’s most financially strapped states, they will be able to halt the sovereign debt crisis in its tracks.

This plan is flawed. The figure, 200 billion euros, will not cover reasonable restructurings. The 50 percent writedowns or “haircuts” for Greece under discussion as part of a revised Greek bailout — likely to be announced at the end of the upcoming Oct. 23 EU summit — would absorb more than half of that 200 billion euros. A mere 8 percent haircut on Italian debt would absorb the remainder.

Moreover, Europe’s banking problems stretch far beyond sovereign debt. Before one can understand just how deep those problems go, we must examine the role European banks play in European society.

The Centrality of European Banking

Several differences between the European and American banking sectors exist. By far the most critical difference is that European banks are much more central to the functioning of European economies than American banks are to the U.S. economy. The reason is rooted in the geography of capital.

Maritime transport is cheaper than land transport by at least an order of magnitude once the costs of constructing road and rail infrastructure is factored in. Therefore, maritime economies will always have surplus capital compared to their land transport-based equivalents. Managing such excess capital requires banks, and so nearly all of the world’s banking centers form at points on navigable rivers where capital richness is at its most extreme. For example, New York is where the Hudson meets the Atlantic Octen, Chicago is at the southernmost extremity of the Great Lakes network, Geneva is near the head of navigation of the Rhone, and Vienna is located where the Danube breaks through the Alps-Carpathian gap.

Unity differentiates the U.S. and European banking system. The American maritime network comprises the interconnected rivers of the Greater Mississippi Basin linked into the Intracoastal Waterway, which allows for easy transport from the U.S.-Mexico border on the Gulf of Mexico all the way to the Chesapeake Bay. Europe’s maritime network is neither interlinked nor evenly shared. Northern Europe is blessed with a dozen easily navigable rivers, but none of the major rivers interconnect; each river, and thus each nation, has its own financial capital. The Danube, Europe’s longest river, drains in the opposite direction but cuts through mountains twice in doing so. Some European states have multiple navigable rivers: France and Germany each have three major ones. Arid and rugged Spain and Greece, in contrast, have none.

The unity of the American transport system means that all of its banks are interlinked, and so there is a need for a single regulatory structure. The disunity of European geography generates not only competing nationalities but also competing banking systems.

Moreover, Americans are used to far-flung and impersonal capital funding their activities (such as a bank in New York funding a project in Nebraska) because of the network’s large and singular nature. Not so in Europe. There, regional competition has enshrined banks as tools of state planning. French capital is used for French projects and other sources of capital are viewed with suspicion. Consequently, Americans only use bank loans to fund 31 percent of total private credit, with bond issuances (18 percent) and stock markets (51 percent) making up the balance. In the eurozone roughly 80 percent of private credit is bank-sourced. And instead of the United States’ single central bank, single bank guarantor and fiscal authority, Europe has dozens. Banking regulation has been expressly omitted from all European treaties to this point, instead remaining a national prerogative.

As a starting point, therefore, it must be understood that European banks are more central to the functioning of the European system than American banks are to the American system. And any problems that might erupt in the world of European banks will face a far more complicated restitution effort cluttered with overlapping, conflicting authorities colored by national biases.

Demographic Limitations

European banks also face less long-term growth. The largest piece of consumer spending in any economy is done by people in their 20s and 30s. This cohort is going to college, raising children and buying houses and cars. Yet people in their 20s and 30s are the weakest in terms of earning potential. High consumption plus low earning leads invariably to borrowing, and borrowing is banks’ mainstay. In the 1990s and 2000s much of Europe enjoyed a bulge in its population structure in precisely this young demographic — particularly in Southern European states — generating a great deal of economic activity, and from it a great deal of business for Europe’s banks.

But now, this demographic has grown up. Their earning potential has increased, while their big surge of demand is largely over, sharply curtailing their need for borrowing. In Spain and Greece, the younger end of population bulge is now 30; in Italy and France it is now 35; in Austria, Germany and the Netherlands it is 40; and in Belgium it is 45. Consumer borrowing in general and mortgage activity in particular probably have peaked. The small sizes of the replacement generations suggests there will be no recoveries within the next few decades. (Children born today will not hit their prime consumptive age for another 20 to 30 years.) With the total value of new consumer loans likely to stagnate (and more likely, decline) moving forward, if anything there are now too many European banks competing for a shrinking pool of consumer loans. Europe is thus not likely to be able to grow out of any banking problems it experiences. The one potential exception is in Central Europe, where the population bulges are on average 15 years younger than in Western Europe. The younger edge of the Polish bulge, for example, is only 25. In time, these states may be able to grow out of their problems. Either way, the most lucrative years for Western European banking are over.

http://web.stratfor.com/images/europe/art/Fourplex_demographics_1600.jpg

(click here to enlarge image)

Too Much Credit

Germany has extremely high capital accumulation and extremely competent economic management. One of the many results of this pairing is extremely inexpensive capital costs. When Germans — governments, corporations or individuals — borrow money, it is accepted as a near-fact that they will pay back what they owe, on time and in full. Reflecting the high supply and low risk, German borrowing rates for governments and corporations have long been in the low to mid single digits.

The further you move from Germany the less this pattern holds. Capital availability shrivels, management falters and the attitude toward contract law (or at least as defined by the Germans) becomes far less respectful. As such, Europe’s peripheral economies — most notably its smaller peripheral economies — have normally faced higher borrowing costs. Mortgage rates in Ireland stood near 20 percent less than a generation ago. Government borrowing rates in Greece have in the past topped 30 percent.

With that sort of difference, it is not difficult to see why many European states have striven for inclusion in first, the European Union, and second, the eurozone. Each step of the European integration process has brought them closer in financial terms to the ultra-low credit costs of Germany. The closer the German association, the greater the implicit belief that German financial resources would help them in a crisis (despite the fact that EU treaties explicitly rejected this).

The dawn of the eurozone era prompted lenders and investors to take this association to an extreme. Association with Germany shifted from lower lending rates to identical lending rates. The Greek government could borrow at rates that only Germany could demand in the past. Irish borrowers were able to qualify for 130 percent mortgages at 4 percent. Compounding matters, the collapse of borrowing costs and the explosion of loan activity occurred at the same time as Southern Europe’s demographic-driven consumption boom. It was the perfect storm for explosive banking growth, and it laid the groundwork for a financial collapse of unprecedented proportions.

Drastic increases in government debt are the most publicly visible outcome, but it is far from the only one. The least visible outcome is that extraordinarily cheap credit to consumers triggers an explosion in demand that local businesses cannot hope to fill. The result is unprecedented trade deficits as money borrowed from foreigners is used to purchase foreign goods. Cyprus, Greece, Portugal, Bulgaria, Romania, Lithuania, Estonia and Spain — all states whose cheap labor when compared to the Western European core should encourage them to be massive exporters — instead have run chronic trade deficits in excess of 7 percent of GDP. Most routinely broke 10 percent. Such developments do not directly harm the banks, but as credit costs return to more rational levels —and in the ongoing debt crisis borrowing costs for most of the younger EU members have tripled and more — consumption is coming to a halt. In the few European markets that demographically may be able to generate consumption-based growth in the years ahead, credit is drying up.

Foreign Currency Risk

Much of this lending into weaker locations was carried out in foreign currencies. For the three states that successfully made the early sprint into the eurozone —Estonia, Slovenia and Slovakia — this was a nonfactor. For those that did not make the early leap into the eurozone it was a wonderful way to get something for nothing. Their association with the European Union resulted in the steady strengthening of their currencies. Since 2004, the Polish, Czech, Romanian and Hungarian currencies gained roughly one-third versus the euro, driving down the monthly payments on any euro-denominated loan. That inverted, however, in the 2008 financial crisis. Then, every regional currency but the Czech koruna (and Bulgarian lev, which is pegged to the euro) gave back their gains. For Central Europeans who had taken out loans when their currencies were at their highs, payments ballooned. More than 10 percent of Polish and Hungarian mortgages are now delinquent, largely because of currency movements.

New Banking ‘Empires’

The cheap credit of the eurozone’s first decade allowed several peripheral European states a rare opportunity to expand their network of influence, even if they were not in the eurozone themselves. They could borrow money from core European banking centers like Germany, France, Switzerland and the Netherlands and pass that money on to previously credit-starved markets. In most cases, such credit was offered without the full cost-increase that these states’ poorer and smaller statures would have justified. After all, these would-be financial centers had to undercut the more established European financial centers if they were to gain meaningful market share. This pushed far more credit into Central Europe than the region otherwise would have attracted, speeding up the development process at the cost of poor underwriting and a proliferation of questionable lending practices. The most enthusiastic crafters of new banking empires have been Sweden, Austria, Spain and Greece.

http://web.stratfor.com/images/europe/art/Europe_banking_empires_800.jpg

STRATFOR
(click here to enlarge image)

Sweden has the happiest record of any of the states that engaged in such expansionary lending. Being one of the richest countries in Europe and yet not being a member of the eurozone, Sweden did not experience a credit expansion nearly as much as other states, instead it served as a conduit for that credit — augmented by its own — to its former imperial territories. Alone among the forgers of new banking empires, Sweden’s superior financial stability has allowed it (so far) to continue financial activities in its target markets — Estonia, Latvia, Lithuania and Denmark — despite the ongoing financial crisis. But instead of lending, Swedish banks are now purchasing regional banks outright. Swedish command of the Danish banking sector, for example, has increased by 80 percent since the crisis. Through its new local subsidiaries, Swedish banks now lend more in per capita terms to Danes than they do to their own citizens, and there is no longer a domestic Estonian banking sector — it is 97 percent Swedish-owned. Such expansionary activity is likely to continue so long as Sweden can sustain it, as there is a geopolitical angle to Sweden’s effort: It is seeking to deepen its regional influence not only for economic purposes, but also to mitigate the rising role of its longtime competitor, Russia.

Austria has tapped not only eurozone credit but also taken advantage of favorable carry trades to serve as a conduit for Swiss franc credit into Central Europe. Just as Sweden is using foreign capital to re-create its historic sphere of influence in the Baltic, Austria is doing the same in the lands of the former Austro-Hungarian Empire. Now, the majority of all mortgages in Poland, Hungary, Croatia and Romania — and a sizable minority in Austria — are denominated in foreign currencies, courtesy of Austrian banking activity. With the Swiss franc now locked in at record highs, many of these mortgages are not serviceable. The Hungarian government has felt forced to abrogate the terms of many of these loans, knowing that the Austrian banks are now so overexposed to Central Europe that they have no choice but to take the losses. As the financial crisis has continued apace, Austria has found itself with more exposure, fewer domestic resources and greater vulnerability to external forces than Sweden. So instead of being able to take advantage of regional weakness, it is finding itself losing market share both at home and in its would-be financial empire to Russia.

Spain’s banking empire isn’t even in Europe. Spanish firms BBVA-Compass and Santander have used the cheap euro credit to massively expand credit to Latin America. And Spain’s expansion took a somewhat novel route: The combination of cheap lending at home and in Latin America encouraged more than a million Latin American Spanish speakers to relocate to Spain and gain citizenship. To smooth the naturalization process, Madrid mandated that the new Spaniards be granted top-notch credit, a factor that only added to an already hyperactive construction sector. Spanish banks’ nearly 500 billion-euro exposure to Latin America is, for now, holding; only time will tell its impact to Spain’s bottom line.

The Greek government used its access to cheap credit to build up debt levels that are now the subject of much discussion across Europe. But much less is made of its banks, who encouraged consumers both at home and across the southern Balkans to increase their own debt levels. Being the least experienced of the four would-be financial centers, Greek banks offered the steepest credit breaks to the countries with the weakest repayment potential. Like Spain, Greece also did not make EU membership a condition for lending; vast volumes accordingly were fed into Macedonia, Serbia and even Albania.

Housing Bubbles

Large volumes of suddenly cheap credit made available to eager consumers obviously generated a series of sizable housing bubbles.

Spain’s tapping of European credit markets also underwrote the largest housing boom in Europe. More construction projects have been completed in Spain in recent years than in Germany, France, Italy and the United Kingdom combined. The construction sector— both commercial and residential — has now collapsed and there are about 1 million homes now sitting vacant in a country with just 16.5 million families. Outstanding loans to various real estate interests total some 400 billion euros, all backed by collateral that has lost 20 percent of its value since the housing market peaked.

In relative terms, Irelandactually did more than Spain. At its peak, nearly 10 percent of Irish gross national product was dependent upon construction, with 70 percent of that purely from residences. Half of the mortgages extended during the Irish real estate boom were made at the peak of the market between 2006 and 2008. That sector remains in the midst of a fairly rapid collapse. Residential home prices have reduced by half since their peak in 2007 and are showing few signs of stabilizing. The Irish government hopes that with their eurozone bailout package, their banking sector will become functional again by 2020. Until then, Ireland in effect has no banking sector and has been financially sequestered from the rest of the eurozone.

Two other European states — the United Kingdom and Sweden — have both experienced massive increases in home price growth, and both suffered from price corrections due to the 2008 financial crisis. But prices in both markets have recovered smartly, with Sweden even bouncing back above its pre-crisis highs. Sweden, in fact, is still experiencing a massive housing boom, with annual mortgage credit still expanding at a 30 percent annualized rate.

Special Series (Part 2): Looking Ahead in the European Banking Crisis

October 20, 2011 | 1744 GMT

STRATFOR

Editor’s Note: This is the second installment in a two-part series on the European banking crisis.

Risks to Recapitalization

Because of the politicized nature of European banking, European governments often require their banks to have a smaller cash cushion than banks elsewhere in the world. For example, when the European Banking Authority ran stress tests in July to prove the banks’ stability, the banks were only required to demonstrate a capital adequacy ratio (the percentage of assets held in cash to cover operations and losses) of 5 percent — half the international standard. Even with such lax standards, eight European banks still failed the tests. Since banks need cash to engage in the business of making loans, there is very strong resistance among European banks to valuing their assets at market values. Any write-downs force them to redirect their free cash from making loans to covering losses. The lower capital requirements of Europe mean that their margin for error is always very thin.

Increasing that margin requires more cash reserves, a process known as recapitalization. Recapitalization can be done any number of ways, but most of the normal options are currently off the table for European banks. The preferred method is to issue more good loans so that profits from new business can eat away at the losses from the bad. But in a recessionary environment, new high-quality loans are hard to find. Banks also can raise money by issuing stock or selling assets. However, few in Europe, much less elsewhere, want to increase their exposure to the European banking sector, largely because of banks’ gross exposure to Europe’s sovereign debt crisis. European banks in particular, which are in the best position to know, are reluctant to become more entangled in each other’s affairs and often shy away from lending to one another, even for terms as short as overnight.

Even in good times, any serious recapitalization efforts would flood the market with stock shares and assets for sale. These are not good times. Remember that banks are the primary purchasers of European sovereign debt and Europe is already in a sovereign debt crisis. Adding more assets for banks to buy would create the near-perfect buyer’s market: rock-bottom prices. There are indeed some would-be purchasers— Sweden from within the European Union and Turkey and Russia from without — but their combined interest adds up to merely billions of euros, when hundreds of billions are needed.

Which brings us to the sheer size of the problem. The Europeans are leaning toward a new regulation that would force all European banks to have a capital adequacy ratio of 9 percent, hoping that such a change would decisively end speculation that Europe’s banks face problems. It will not.

According to the European Banking Authority, the institution that is responsible for carrying out stress tests, two-thirds of Europe’s banks are currently below the 9 percent threshold — and that assumes no past or future reduction in the value of sovereign bonds for any European governments, no new sovereign bailouts that damage investor confidence or asset values, no mortgage crisis, no new bank collapses in Europe akin to that of Franco-Belgian bank Dexia and no renewed recession. Simply increasing capital adequacy ratios to 9 percent will cost about 200 billion euros (about $270 billion). The regulation also assumes that all European banks have been scrupulously honest in their reporting; Dexia, for example, shuffled assets between its trading and banking books to generate a misleading capital adequacy ratio of 12 percent, when the reality was in the vicinity of 6 percent. Forcing the banks to have a thicker cushion is certainly a step in the right direction, but the volume is insufficient to resolve any of the problems outlined to this point, and the latest rumor out of Europe’s pre-summit negotiations is that perhaps only 80 billion euros is actually needed.

If the banks cannot recapitalize themselves, the only remaining options are state-driven recapitalization efforts. Here, again, current circumstances hobble possible actions. The European sovereign debt crisis means many governments are already facing great stresses in meeting normal financing needs — doubly so for Greece, Ireland, Portugal, Italy, Belgium and Spain. No eurozone states have the ability to quickly come up with several hundred billion euros in additional funds. Keep in mind that, unlike the United States, where the Federal Reserve plays a central role in bank regulation and remediation, the European Central Bank has no role whatsoever. The individual central banks of the various eurozone states lack the control over monetary policy to build the sort of highly liquid support mechanisms required to sequester and rehabilitate damaged banks. Such central bank actions remain in the arsenal of the non-eurozone states — the United Kingdom, for one, has been using such monetary policy tools for three years now. However, for the eurozone states, the only way to recapitalize is to come up with cash — and as Europe’s financial crises deepen, that’s becoming ever harder to do.

The EFSF

There is one other option that the eurozone states do have: the European Financial Stability Facility (EFSF), better known as the European bailout fund, which manages the Greek, Irish and Portuguese bailouts. With its recent amendments, the EFSF can now legally assist European banks as well as European governments. But even this mechanism faces three complications.

First, the EFSF has yet to bail out a bank, so it is unclear what process would be followed. The French have indicated they would like to tap the facility to recapitalize their banks because they see it as being politically attractive (and not using just their money). The Germans have indicated that should a bank tap the facility then the sovereign that regulates the bank must commit to economic reforms; the EFSF, therefore, should be a last resort. Not only is there not yet a process for EFSF bank bailouts, but there also is not yet an agreement on who should hold the process. Even if the Germans get their way on the EFSF, remediation and supervisory structures must first be built.

Second, the EFSF is a very new institution with only a handful of staff. Even if there were full eurozone agreement on the process, the EFSF is months away from being able to implement policy. And if the EFSF is going to have the ability to restructure banks, that power is, for now, directly in opposition to EU treaties that guarantee all banking authority to the member-state level.

Finally, the EFSF is fairly small in terms of funding capacity. Its total fundraising ceiling is only 440 billion euros, 268 billion of which it has already committed to the bailouts of Greece, Ireland and Portugal over the course of the next three years. Unless the facility is significantly expanded, it simply will not have enough money to serve as a credible bank-financing tool. To handle all of the challenges the Europeans are hoping the EFSF will be able to resolve, STRATFOR estimates the facility will need its capacity expanded to 2 trillion euros. Finding ways to solve that problem likely will dominate the European summits being held during the next few days.

Navigating the Eurozone Crisis and Preparing for Greece’s Failure

John Mauldin — Thu, 06 Oct 2011 17:53:00 GMT

Folks, you hear a lot about the eurozone crisis, but what you don't run across very often is a coherent idea on how to move forward. My friends at STRATFOR, a private intelligence company, have done us all the courtesy of saying out loud what everyone else shies away from: Eject Greece from the eurozone.

It's not pretty. It belies the lovely concept of a unified and prosperous Europe. And the worst part: it comes with a big fat price tag, of the 2-trillion-euro variety. But it may be the only way to steer the train before it derails completely.

Today I have the privilege of sending you two pieces from STRATFOR. If you have a couple of minutes now, <<watch this video on preparing for Greece's (inevitable) failure>>. Then check out the written piece below, a deeper dive into the crisis as a whole. If you're interested in following all of STRATFOR's geopolitical analyses, as an OTB reader you can get a hefty discount off their subscription rate, plus a free copy of the NY Times bestseller by George Friedman (my buddy, and STRATFOR's founder).

Your hoping the Rangers take it all analyst,

John Mauldin, Editor
Outside the Box

Navigating the Eurozone Crisis and Preparing for Greece’s Failure

September 28, 2011

LOUISA GOULIAMAKI/AFP/Getty Images
A protester sets fire to euro banknote copies in Athens on Sept. 17

Summary

The eurozone's financial crisis has entered its 19th month. Germany, the most powerful country in Europe currently, faces constraints in its choices for changing the European system. STRATFOR sees only one option for Berlin to rescue the eurozone: Eject Greece from the economic bloc and manage the fallout with a bailout fund.

Analysis

The eurozone's financial crisis has entered its 19th month. There are more plans to modify the European system than there are eurozone members, but most of these plans ignore constraints faced by Germany, the one country in the eurozone in a position to resolve the crisis. STRATFOR sees only one way forward that would allow the eurozone to survive.

Germany's Constraints

While Germany is by far the most powerful country in Europe, the European Union is not a German creation. It is a portion of a 1950s French vision to enhance French power on both a European and a global scale. However, since the end of the Cold War, France has lost control of Europe to a reunited and reinvigorated Germany. Berlin is now working to rewire European structures piece by piece to its liking. Germany primarily uses its financial acumen and strength to assert control. In exchange for access to its wealth, Berlin requires other European states to reform their economies along German lines — reforms that, if fully implemented, would transform most of these countries into de facto German economic colonies.

This brings us to the eurozone crisis and the various plans to modify the bloc. Most of these plans ignore that Germany's reasons for participating in the eurozone are not purely economic, and those non-economic motivations greatly limit Berlin's options for changing the eurozone.

Germany in any age is best described as vulnerable. Its coastline is split by Denmark, its three navigable rivers are not naturally connected and the mouths of two of those rivers are not under German control. Germany's people cling to regional rather than national identities. Most important, the country faces sharp competition from both east and west. Germany has never been left alone: When it is weak its neighbors shatter Germany into dozens of pieces, often ruling some of those pieces directly. When it is strong, its neighbors form a coalition to break Germany's power.

The post-Cold War era is a golden age in German history. The country was allowed to reunify after the Cold War, and its neighbors have not yet felt threatened enough to attempt to break Berlin's power. In any other era, a coalition to contain Germany would already be forming. However, the European Union's institutions, particularly the euro, have allowed Germany to participate in Continental affairs in an arena in which they are eminently competitive. Germany wants to limit European competition to the field of economics, since on the field of battle it could not prevail against a coalition of its neighbors.

This fact eliminates most of the eurozone crisis solutions under discussion. Ejecting from the eurozone states that are traditional competitors with Germany could transform them into rivals. Thus, any reform option that could end with Germany in a different currency zone than Austria, the Netherlands, France, Spain or Italy is not viable if Berlin wants to prevent a core of competition from arising.

Germany also faces mathematical constraints. The creation of a transfer union, which has been roundly debated, would regularly shift economic resources from Germany to Greece, the eurozone's weakest member. The means of such allocations —direct transfers, rolling debt restructurings, managed defaults — are irrelevant. What matters is that such a plan would establish a precedent that could be repeated for Ireland and Portugal — and eventually Italy, Belgium, Spain and France. This puts anything resembling a transfer union out of the question. Covering all the states that would benefit from the transfers would likely cost around 1 trillion euros ($1.3 trillion) annually. Even if this were a political possibility in Germany (and it is not), it is well beyond Germany's economic capacity.

These limitations leave a narrow window of possibilities for Berlin. What follows is the approximate path STRATFOR sees Germany being forced to follow if the euro is to survive. This is not necessarily Berlin's explicit plan, but if the eurozone is to avoid mass defaults and dissolution, it appears to be the sole option.

Cutting Greece Loose

Greece's domestic capacity to generate capital is highly limited, and its rugged topography comes with extremely high capital costs. Even in the best of times Greece cannot function as a developed, modern economy without hefty and regular injections of subsidized capital from abroad. (This is primarily why Greece did not exist between the 4th century B.C. and the 19th century and helps explain why the European Commission recommended against starting accession talks with Greece in the 1970s.)

After modern Greece was established in the early 1800s, those injections came from the United Kingdom, which used the newly independent Greek state as a foil against faltering Ottoman Turkey. During the Cold War the United States was Greece's external sponsor, as Washington wanted to keep the Soviets out of the Mediterranean. More recently, Greece has used its EU membership to absorb development funds, and in the 2000s its eurozone membership allowed it to borrow huge volumes of capital at far less than market rates. Unsurprisingly, during most of this period Greece boasted the highest gross domestic product (GDP) growth rates in the eurozone.

Those days have ended. No one has a geopolitical need for alliance with Greece at present, and evolutions in the eurozone have put an end to cheap euro-denominated credit. Greece is therefore left with few capital-generation possibilities and a debt approaching 150 percent of GDP. When bank debt is factored in, that number climbs higher. This debt is well beyond the ability of the Greek state and its society to pay.

Luckily for the Germans, Greece is not one of the states that traditionally has threatened Germany, so it is not a state that Germany needs to keep close. It seems that if the eurozone is to be saved, Greece needs to be disposed of.

This cannot, however, be done cleanly. Greece has more than 350 billion euros in outstanding government debt, of which roughly 75 percent is held outside of Greece. It must be assumed that if Greece were cut off financially and ejected from the eurozone, Athens would quickly default on its debts, particularly the foreign-held portions. Because of the nature of the European banking system, this would cripple Europe.

European banks are not like U.S. banks. Whereas the United States' financial system is a single unified network, the European banking system is sequestered by nationality. And whereas the general dearth of direct, constant threats to the United States has resulted in a fairly hands-off approach to the banking sector, the crowded competition in Europe has often led states to use their banks as tools of policy. Each model has benefits and drawbacks, but in the current eurozone financial crisis the structure of the European system has three critical implications.

First, because banks are regularly used to achieve national and public — as opposed to economic and private — goals, banks are often encouraged or forced to invest in ways that they otherwise would not. For example, during the early months of the eurozone crisis, eurozone governments pressured their banks to purchase prodigious volumes of Greek government debt, thinking that such demand would be sufficient to stave off a crisis. In another example, in order to further unify Spanish society, Madrid forced Spanish banks to treat some 1 million recently naturalized citizens as having prime credit despite their utter lack of credit history. This directly contributed to Spain's current real estate and construction crisis. European banks have suffered more from credit binges, carry trading and toxic assets (emanating from home or the United States) than their counterparts in the United States.

Second, banks are far more important to growth and stability in Europe than they are in the United States. Banks — as opposed to stock markets in which foreigners participate — are seen as the trusted supporters of national systems. They are the lifeblood of the European economies, on average supplying more than 70 percent of funding needs for consumers and corporations (for the United States the figure is less than 40 percent).

Third and most importantly, the banks' crucial role and their politicization mean that in Europe a sovereign debt crisis immediately becomes a banking crisis and a banking crisis immediately becomes a sovereign debt crisis. Ireland is a case in point. Irish state debt was actually extremely low going into the 2008 financial crisis, but the banks' overindulgence left the Irish government with little choice but to launch a bank bailout — the cost of which in turn required Dublin to seek a eurozone rescue package.

And since European banks are linked by a web of cross-border stock and bond holdings and the interbank market, trouble in one country's banking sector quickly spreads across borders, in both banks and sovereigns.

The 280 billion euros in Greek sovereign debt held outside the country is mostly held within the banking sectors of Portugal, Ireland, Spain and Italy — all of whose state and private banking sectors already face considerable strain. A Greek default would quickly cascade into uncontainable bank failures across these states. (German and particularly French banks are heavily exposed to Spain and Italy.) Even this scenario is somewhat optimistic, since it assumes a Greek eurozone ejection would not damage the 500 billion euros in assets held by the Greek banking sector (which is the single largest holder of Greek government debt).

Making Europe Work Without Greece

Greece needs to be cordoned off so that its failure would not collapse the European financial and monetary structure. Sequestering all foreign-held Greek sovereign debt would cost about 280 billion euros, but there is more exposure than simply that to government bonds. Greece has been in the European Union since 1981. Its companies and banks are integrated into the European whole, and since joining the eurozone in 2001 that integration has been denominated wholly in euros. If Greece is ejected that will all unwind. Add to the sovereign debt stack the cost of protecting against that process and — conservatively — the cost of a Greek firebreak rises to 400 billion euros.

That number, however, only addresses the immediate crisis of Greek default and ejection. The long-term unwinding of Europe's economic and financial integration with Greece (there will be few Greek banks willing to lend to European entities, and fewer European entities willing to lend to Greece) would trigger a series of financial mini-crises. Additionally, the ejection of a eurozone member state— even one such as Greece, which lied about its statistics in order to qualify for eurozone membership — is sure to rattle European markets to the core. Technically, Greece cannot be ejected against its will. However, since the only thing keeping the Greek economy going right now and the only thing preventing an immediate government default is the ongoing supply of bailout money, this is merely a technical rather than absolute obstacle. If Greece's credit line is cut off and it does not willingly leave the eurozone, it will become both destitute and without control over its monetary system. If it does leave, at least it will still have monetary control.

In August, International Monetary Fund (IMF) chief Christine Lagarde recommended immediately injecting 200 billion euros into European banks so that they could better deal with the next phase of the European crisis. While officials across the EU immediately decried her advice, Lagarde is in a position to know; until July 5, her job was to oversee the French banking sector as France's finance minister. Lagarde's 200 billion euro figure assumes that the recapitalization occurs before any defaults and before any market panic. Under such circumstances prices tend to balloon; using the 2008 American financial crisis as a guide, the cost of recapitalization during an actual panic would probably be in the range of 800 billion euros.

It must also be assumed that the markets would not only be evaluating the banks. Governments would come under harsher scrutiny as well. Numerous eurozone states look less than healthy, but Italy rises to the top because of its high debt and the lack of political will to tackle it. Italy's outstanding government debt is approximately 1.9 trillion euros. The formula the Europeans have used until now to determine bailout volumes has assumed that it would be necessary to cover all expected bond issuances for three years. For Italy, that comes out to about 700 billion euros using official Italian government statistics (and closer to 900 billion using third-party estimates).

All told, STRATFOR estimates that a bailout fund that can manage the fallout from a Greek ejection would need to manage roughly 2 trillion euros.

Raising 2 Trillion Euros

The European Union already has a bailout mechanism, the European Financial Stability Facility (EFSF), so the Europeans are not starting from scratch. Additionally, the Europeans would not need 2 trillion euros on hand the day a Greece ejection occurred; even in the worst-case scenario, Italy would not crash within 24 hours (and even if it did, it would need 900 billion euros over three years, not all in one day). On the day Greece were theoretically ejected from the eurozone, Europe would probably need about 700 billion euros (400 billion to combat Greek contagion and another 300 billion for the banks). The IMF could provide at least some of that, though probably no more than 150 billion euros.

The rest would come from the private bond market. The EFSF is not a traditional bailout fund that holds masses of cash and actively restructures entities it assists. Instead it is a transfer facility: eurozone member states guarantee they will back a certain volume of debt issuance. The EFSF then uses those guarantees to raise money on the bond market, subsequently passing those funds along to bailout targets. To prepare for Greece's ejection, two changes must be made to the EFSF.

First, there are some legal issues to resolve. In its original 2010 incarnation, the EFSF could only carry out state bailouts and only after European institutions approved them. This resulted in lengthy debates about the merits of bailout candidates, public airings of disagreements among eurozone states and more market angst than was necessary. A July eurozone summit strengthened the EFSF, streamlining the approval process, lowering the interest rates of the bailout loans and, most importantly, allowing the EFSF to engage in bank bailouts. These improvements have all been agreed to, but they must be ratified to take effect, and ratification faces two obstacles.

Germany's governing coalition is not united on whether German resources — even if limited to state guarantees — should be made available to bail out other EU states. The final vote in the Bundestag is supposed to occur Sept. 29. While STRATFOR finds it highly unlikely that this vote will fail, the fact that a debate is even occurring is far more than a worrying footnote. After all, the German government wrote both the original EFSF agreement and its July addendum.

The other obstacle regards smaller, solvent, eurozone states that are concerned about states' ability to repay any bailout funds. Led by Finland and supported by the Netherlands, these states are demanding collateral for any guarantees.

STRATFOR believes both of these issues are solvable. Should the Free Democrats — the junior coalition partner in the German government — vote down the EFSF changes, they will do so at a prohibitive cost to themselves. At present the Free Democrats are so unpopular that they might not even make it into parliament in new elections. And while Germany would prefer that Finland prove more pliable, the collateral issue will at most require a slightly larger German financial commitment to the bailout program.

The second EFSF problem is its size. The current facility has only 440 billion euros at its disposal — a far cry from the 2 trillion euros required to handle a Greek ejection. This means that once everyone ratifies the July 22 agreement, the 17 eurozone states have to get together again and once more modify the EFSF to quintuple the size of its fundraising capacity. Anything less would end with— at a minimum — the largest banking crisis in European history and most likely the euro's dissolution. But even this is far from certain, as numerous events could go wrong before a Greek ejection:

Enough states — including even Germany — could balk at the potential cost of the EFSF's expansion. It is easy to see why. Increasing the EFSF's capacity to 2 trillion euros represents a potential 25 percent increase by GDP of each contributing state's total debt load, a number that will rise to 30 percent of GDP should Italy need a rescue (states receiving bailouts are removed from the funding list for the EFSF). That would push the national debts of Germany and France — the eurozone heavyweights — to nearly 110 percent of GDP, in relative size more than even the United States' current bloated volume. The complications of agreeing to this at the intra-governmental level, much less selling it to skeptical and bailout-weary parliaments and publics, cannot be overstated.

If Greek authorities realize that Greece will be ejected from the eurozone anyway, they could preemptively leave the eurozone, default, or both. That would trigger an immediate sovereign and banking meltdown, before a remediation system could be established.

An unexpected government failure could prematurely trigger a general European debt meltdown. There are two leading candidates. Italy, with a national debt of 120 percent of GDP, has the highest per capita national debt in the eurozone outside Greece, and since Prime Minister Silvio Berlusconi has consistently gutted his own ruling coalition of potential successors, his political legacy appears to be coming to an end. Prosecutors have become so emboldened that Berlusconi is now scheduling meetings with top EU officials to dodge them. Belgium is also high on the danger list. Belgium has lacked a government for 17 months, and its caretaker prime minister announced his intention to quit the post Sept. 13. It is hard to implement austerity measures — much less negotiate a bailout package — without a government.

The European banking system — already the most damaged in the developed world — could prove to be in far worse shape than is already believed. A careless word from a government official, a misplaced austerity cut or an investor scare could trigger a cascade of bank collapses.

Even if Europe is able to avoid these pitfalls, the eurozone's structural, financial and organizational problems remain. This plan merely patches up the current crisis for a couple of years.

Obama’s Dilemma: U.S. Foreign Policy and Electoral Realities

John Mauldin — Thu, 22 Sep 2011 18:26:00 GMT

Folks, this piece from STRATFOR has compelled me to focus on the US for one more day before I head off to Europe. You've seen the articles and other insights I send on occasion from George Friedman, my friend and prophetic author of The Next 100 Years and The Next Decade, both bestsellers. Well, this article takes the cake. George is the founder of a geopolitical intelligence company called STRATFOR, whose focus is international affairs. But on the rare occasion when domestic politics and international affairs intersect, it's always a treat to get George's insight.

I don't even want to give away any spoilers here. It's better to let you follow first-hand, as George builds his argument and arrives at a profound final conclusion. Let me just say: In Endgame, as you know, I predict that we will deal with the deficit in a controlled manner, or face disastrous consequences. Here, we learn how the realities of the next 14 months before the presidential election present some potential global consequences of their own.

If these occasional samples (which I get special permission from George to send) aren't enough for you, my intelligent readers, I recommend you get full access as a STRATFOR subscriber. OTB readers get a<<steep discount on subscriptions and a free copy of George's latest book>>, which I mentioned above. I suggest you investigate. I read them every day myself.

John Mauldin, Editor
Outside the Box

Obama's Dilemma: U.S. Foreign Policy and Electoral Realities

September 20, 2011

By George Friedman

STRATFOR does not normally involve itself in domestic American politics. Our focus is on international affairs, and American politics, like politics everywhere, is a passionate business. The vilification from all sides that follows any mention we make of American politics is both inevitable and unpleasant. Nevertheless, it's our job to chronicle the unfolding of the international system, and the fact that the United States is moving deeply into an election cycle will affect American international behavior and therefore the international system.

The United States remains the center of gravity of the international system. The sheer size of its economy (regardless of its growth rate) and the power of its military (regardless of its current problems) make the United States unique. Even more important, no single leader of the world is as significant, for good or bad, as the American president. That makes the American presidency, in its broadest sense, a matter that cannot be ignored in studying the international system.

The American system was designed to be a phased process. By separating the selection of the legislature from the selection of the president, the founders created a system that did not allow for sudden shifts in personnel. Unlike parliamentary systems, in which the legislature and the leadership are intimately linked, the institutional and temporal uncoupling of the system in the United States was intended to control the passing passions by leaving about two-thirds of the U.S. Senate unchanged even in a presidential election year, which always coincides with the election of the House of Representatives. Coupled with senatorial rules, this makes it difficult for the president to govern on domestic affairs. Changes in the ideological tenor of the system are years in coming, and when they come they stay a long time. Mostly, however, the system is in gridlock. Thomas Jefferson said that a government that governs least is the best. The United States has a vast government that rests on a system in which significant change is not impossible but which demands a level of consensus over a period of time that rarely exists.

This is particularly true in domestic politics, where the complexity is compounded by the uncertainty of the legislative branch. Consider that the healthcare legislation passed through major compromise is still in doubt, pending court rulings that thus far have been contradictory. All of this would have delighted the founders if not the constantly trapped presidents, who frequently shrug off their limits in the domestic arena in favor of action in the international realm, where their freedom to maneuver is much greater, as the founders intended.

The Burden of the Past

The point of this is that all U.S. presidents live within the framework in which Barack Obama is now operating. First, no president begins with a clean slate. All begin with the unfinished work of the prior administration. Thus, George W. Bush began his presidency with an al Qaeda whose planning and implementation for 9/11 was already well under way. Some of the al Qaeda operatives who would die in the attack were already in the country. So, like all of his predecessors, Obama assumed the presidency with his agenda already laid out.

Obama had a unique set of problems. The first was his agenda, which focused on ending the Iraq war and reversing social policies in place since Ronald Reagan became president in 1981. By the time Obama entered office, the process of withdrawal from Iraq was under way, which gave him the option of shifting the terminal date. The historic reversal that he wanted to execute, starting with healthcare reform, confronted the realities of September 2008 and the American financial crisis. His Iraq policy was in place by Inauguration Day while his social programs were colliding with the financial crisis.

Obama's campaign was about more than particular policies. He ran on a platform that famously promised change and hope. His tremendous political achievement was in framing those concepts in such a way that they were interpreted by voters to mean precisely what they wanted them to mean without committing Obama to specific policies. To the anti-war faction it meant that the wars would end. To those concerned about unilateralism it meant that unilateralism would be replaced by multilateralism. To those worried about growing inequality it meant that he would end inequality. To those concerned about industrial jobs going overseas it meant that those jobs would stay in the United States. To those who hated Guantanamo it meant that Guantanamo would be closed.

Obama created a coalition whose expectations of what Obama would do were shaped by them and projected on Obama. In fact, Obama never quite said what his supporters thought he said. His supporters thought they heard that he was anti-war. He never said that. He simply said that he opposed Iraq and thought Afghanistan should be waged. His strategy was to allow his followers to believe what they wanted so long as they voted for him, and they obliged. Now, this is not unique to Obama. It is how presidents get elected. What was unique was how well he did it and the problems it caused once he became president.

It must first be remembered that, contrary to the excitement of the time and faulty memories today, Obama did not win an overwhelming victory. About 47 percent of the public voted for someone other than Obama. It was certainly a solid victory, but it was neither a landslide nor a mandate for his programs. But the excitement generated by his victory created the sense of victory that his numbers didn't support.

Another problem was that he had no programmatic preparation for the reality he faced. September 2008 changed everything in the sense that it created financial and economic realities that ran counter to the policies he envisioned. He shaped those policies during the primaries and after the convention, and they were based on assumptions that were no longer true after September 2008. Indeed, it could be argued that he was elected because of September 2008. Prior to the meltdown, John McCain had a small lead over Obama, who took over the lead only after the meltdown. Given that the crisis emerged on the Republicans' watch, this made perfect sense. But shifting policy priorities was hard because of political commitments and inertia and perhaps because the extremities of the crisis were not fully appreciated.

Obama's economic policies did not differ wildly from Bush's — indeed, many of the key figures had served in the Federal Reserve and elsewhere during the Bush administration. The Bush administration's solution was to print and insert money into financial institutions in order to stabilize the system. By the time Obama came into power, it was clear to his team that the amount of inserted money was insufficient and had to be increased. In addition, in order to sustain the economy, the policy that had been in place during the Bush years of maintaining low interest rates through monetary easing was extended and intensified. To a great extent, the Obama years have been the Bush years extended to their logical conclusion. Whether Bush would have gone for the stimulus package is not clear, but it is conceivable that he would have.

Obama essentially pursued the Bush strategy of stabilizing the banks in the belief that a stable banking system was indispensible and would in itself stimulate the economy by creating liquidity. Whether it did or it didn't, the strategy created the beginnings of Obama's political problem. He drew substantial support from populists on the left and suspicion from populists on the right. The latter, already hostile to Bush's policies, coalesced into the Tea Party. But this was not Obama's biggest problem. It was that his policies, which both seemed to favor the financial elite and were at odds with what Democratic populists believed the president stood for, weakened his support from the left. The division between what he actually said and what his supporters thought they heard him say began to widen. While the healthcare battle solidified his opposition among those who would oppose him anyway, his continuing response to the financial crisis both solidified opposition among Republicans and weakened support among Democrats.

A Foreign Policy Problem

This was coupled with his foreign policy problem. Among Democrats, the anti-war faction was a significant bloc. Most Democrats did not support Obama with anti-war reasons as their primary motivator, but enough did make this the priority issue that he could not win if he lost this bloc. This bloc believed two things. The first was that the war in Iraq was unjustified and harmful and the second was that it emerged from an administration that was singularly insensitive to the world at large and to the European alliance in particular. They supported Obama because they assumed not only that he would end wars — as well as stop torture and imprisonment without trial — but that he would also re-found American foreign policy on new principles.

Obama's decision to dramatically increase forces in Afghanistan while merely modifying the Bush administration's timeline for withdrawing from Iraq caused unease within the Democratic Party. But two steps that Bush took held his position. First, one of the first things Obama did after he became president was to reach out to the Europeans. It was expected that this would increase European support for U.S. foreign policy. The Europeans, of course, were enthusiastic about Obama, as the Noble Peace Prize showed. But while Obama believed that his willingness to listen to the Europeans meant they would be forthcoming with help, the Europeans believed that Obama would understand them better and not ask for help.

The relationship was no better under Obama than under Bush. It wasn't personality or ideology that mattered. It was simply that Germany, as the prime example, had different interests than the United States. This was compounded by the differing views and approaches to the global financial crisis. Whereas the Americans were still interested in Afghanistan, the Europeans considered Afghanistan a much lower priority than the financial crisis. Thus, U.S.-European relations remained frozen.

Then Obama made his speech to the Islamic world in Cairo, where his supporters heard him trying to make amends for Bush's actions and where many Muslims heard an unwillingness to break with Israel or end the wars. His supporters heard conciliation, the Islamic world heard inflexibility.

The European response to Obama the president as opposed to Obama the candidate running against George Bush slowly reverberated among his supporters. Not only had he failed to end the wars, he doubled down and surged forces into Afghanistan. And the continued hostility toward the United States from the Islamic world reverberated among those on the Democratic left who were concerned with such matters. Add to that the failure to close Guantanamo and a range of other issues concerning the war on terror and support for Obama crumbled.

A Domestic Policy Focus

His primary victory, health-care reform, was the foundation of an edifice that was never built. Indeed, the reform bill is caught in the courts, and its future is as uncertain as it was when the bill was caught in Congress. The Republicans, as expected, agree on nothing other than Obama's defeat. The Democrats will support him; the question is how enthusiastic that support will be.

Obama's support now stands at 41 percent. The failure point for a president's second term lurks around 35 percent. It is hard to come back from there. Obama is not there yet. The loss of another six points would come from his Democratic base (which is why 35 is the failure point; when you lose a chunk of your own base, you are in deep trouble). At this point, however, the president is far less interested in foreign policy than he is in holding his base together and retaking the middle. He did not win by a large enough margin to be able to lose any of his core constituencies. He may hope that his Republican challenger will alienate the center, but he can't count on that. He has to capture his center and hold his left.

That means he must first focus on domestic policy. That is where the public is focused. Even the Afghan war and the U.S. withdrawal from Iraq are not touching nerves in the center. His problem is twofold. First, it is not clear that he can get anything past Congress. He can then argue that this is Congress' fault, but the Republicans can run against Congress as well. Second, it is not clear what he would propose. The Republican right can't be redeemed, but what can Obama propose that will please the Democratic core and hold the center? The Democratic core wants taxes. The center doesn't oppose taxes (it is merely uneasy about them), but it is extremely sensitive about having the taxes eaten up by new spending — something the Democratic left supports. Obama is trapped between two groups he must have that view the world differently enough that bridging the gap is impossible.

The founders gave the United States a government that, no matter how large it gets, can't act on domestic policy without a powerful consensus. Today there is none, and therefore there can't be action. Foreign policy isn't currently resonating with the American public, so any daring initiatives in that arena will likely fail to achieve the desired domestic political end. Obama has to hold together a coalition that is inherently fragmented by many different understandings of what his presidency is about. This coalition has weakened substantially. Obama's attention must be on holding it together. He cannot resurrect the foreign policy part of it at this point. He must bet on the fact that the coalition has nowhere else to go. What he must focus on is domestic policy crafted to hold his base and center together long enough to win the election.

The world, therefore, is facing at least 14 months with the United States being at best reactive and at worst non-responsive to events. Obama has never been a foreign policy president; events and proclivity (I suspect) have always drawn him to domestic matters. But between now and the election, the political configuration of the United States and the dynamics of his presidency will force him away from foreign policy.

This at a time when the Persian Gulf is coming to terms with the U.S. withdrawal from Iraq and the power of Iran, when Palestinians and Israelis are facing another crisis over U.N. recognition, when the future of Europe is unknown, when North Africa is unstable and Syria is in crisis and when U.S. forces continue to fight in Afghanistan. All of this creates opportunities for countries to build realities that may not be in the best interests of the United States in the long run. There is a period of at least 14 months for regional powers to act with confidence without being too concerned about the United States.

The point of this analysis is to try to show the dynamics that have led the United States to this position, and to sketch the international landscape in broad strokes. The U.S. president will not be deeply engaged in the world for more than a year. Thus, he will have to cope with events pressed on him. He may undertake initiatives, such as trying to revive the Middle East peace process, but such moves would have large political components that would make it difficult to cope with realities on the ground. The rest of the world knows this, of course. The question is whether and how they take advantage of it.

Portfolio: Venezuela’s Search for Economic Security

John Mauldin — Thu, 08 Sep 2011 23:10:00 GMT

You're familiar with my thoughts on gold: I buy it regularly as insurance, not an investment. Now here's something you didn't expect: I just watched a STRATFOR video and learned that the Venezuelan president, Hugo Chavez, keeps an epic 60 percent of the nation's reserves in gold. Wow. Guess he sees it as insurance as well?

Watch the video. It covers four recent moves by the ailing leader in an attempt to drum up some cash for his social programs, which can only be interpreted as a strategy to keep his waxing and waning political support strong. It all goes to show that Venezuela is a nation to watch, for better or worse, given Chavez's illness and the absence of a strong successor.

Oh, and let's not forget that the U.S. imports about a million barrels per day of oil from Venezuela, or 8 percent of total U.S. oil imports ... not insignificant.

After you <<watch and digest the video>>, I suggest subscribing to STRATFOR to access all their geopolitical intelligence. They cover everything from Chavez to China, and all things in between, with a unique perspective. OTB readers get a whopping 63% discount off their first year, plus a free copy of The Next Decade, the forward-looking bestseller by STRATFOR CEO and founder George Friedman. Try them out. As they say, it's a golden opportunity.

Your keen on geopolitics analyst,

John Mauldin, Editor
Outside the Box

Portfolio: Venezuela’s Search for Economic Security

STRATFOR