Market Winds Stall

From the Wall Street Journal, we see that the market has given back seven months of gains in a day. Well, a day does not a correction make, but at least some cautious sentiment is taking hold.  Looking back at some recent points, what still looks concerning?

• According to Fed presidents, the labor markets remain weak, unhealthy, in flux or whatever euphemism is acceptable to the Yellen regime. [Despite the recent job numbers, and the trend of a few months nobody is willing to declare victory yet]
• The housing "recovery" has stalled, weakened, sputtered.[No change here.]
• The Fed won't tie monetary policy to rules, but some Fed Presidents feel that rates may rise sooner rather than later. [The confusion and dissonance among Presidents continues]
• Our larger, more concentrated banking sector is shelling out billions in shareholder equity to the government without admitting any crime they've committed.  Meanwhile, their fundamental businesses, with some lending growth, are lackluster.[Still in place: look at Bank of America]
• Trading revenue continues to flounder for the investment banks.[Bank of America excepted: probably a timing issue]
• Top line revenue continues to be hard to come by, and earnings gains continue to be of low quality, especially in the tech sector, where retirement plan commitments are excluded from "normal" earnings.[IBM's ninth consecutive quarter of declining revenue from core businesses and low quality EPS; the $20 per share "earnings road map" number has been dismissed as meaningless as a barometer of fundamental future prospects]

In Europe, all our points remain in place and some look worse on recent news:

• Germany's Chancellor getting ready to impose sanctions.
• Elysee Palace will impose sanctions and export restrictions, but they will not impact the export of Mistral systems to Russia.
• Sanctions will take some time to gain traction.
• Is Britain part of Europe? Jury still out.
• Daily operations at Banco Espirito Santo even worse than anyone expected.  Board and management were unaware of assets and balance sheet commitments. Inquiries underway. 
• Europe was 'cheap' and getting 'cheaper.'

The Middle East will be descending into a more complex maelstrom, which the U.S. does not understand. Israel must complete whatever action it is contemplating against Hamas soon. Sentiments pro-Israeli military action and pro-Hamas are both increasing: not a stable outlook.  

Back From India

My family and I returned from a long overdue trip to India to reconnect my children, my spouse, and myself with my family, who are all over India.  Our hubs were in Delhi, Trivandrum/Cochi/Ponkunnom in Kerala, and Bangalore.  My family are in government, private business, public business, and are operators of estates in various commodities.  The degree of change and contradiction in the Indian story are, respectively, staggering and puzzling.  I'll post over time, as I try and digest what I've observed.  There are personal pics for my friends on Facebook.

Meanwhile, the news here seems totally non-surprising, just as expected.  Missing phones, email and papers for three weeks wasn't critical after all.

Besides Its Checkbook, Russia May Not Have a Winning Plan forUkraine

A few weeks ago, Ukraine showed  signs of a thaw in tensions, as Orthodox priests kept apart protesters and armed riot police.  Concessions were made to some arrested protesters. Anger had seemingly been dissipated, but now the trends suddenly seem to have reversed themselves.

As deft as Russian President Putin seems to have been in derailing the European Union project, the current tactics will serve only to harden world opinion and to ultimately cripple the economy in Ukraine.  When the 'aid' bill comes due, Russia may find its client unable to pay.

As the Financial Times points out, popular sentiment in Russia sees Ukraine as having deep ties to Russia, and they don't regard it as a former Soviet republic that should be independent.  President Putin is reported to have made this remarkable public statement,

"Mr Putin invoked the “unity” of the Russian and Ukrainian people and said that, as joint spiritual heirs of the baptism, “in this sense we are, without doubt, one people”."

I suspect that for most citizens of Ukraine, the feeling may not be mutual.

At this point, there will be all kinds of manipulation and propaganda put out to western audiences who are viewing developments in Kiev with dismay.  These protesters suddenly seem to be a much more violent crowd than had occupied the square for weeks.  Might some of the more violent tactics be from paid agitators?  The inability of western leaders like German Chancellor Merkel to even get President Yanukovich on the phone seems like he has become a paid puppet.  Again, it was only a few weeks ago that he was said to have listened to suggestions about widening the representation in his government. No more.

If the citizens of Russia and Ukraine are, in the words of President Putin, "one people," then subjecting ordinary citizens of Ukraine to violence, public humiliation, with wanton disregard for its sovereignty is not a winning strategy that Europe and the rest of the world should sit idly by and accept.

Vatican Official Speaks at St. Thomas on Religious Freedom

Yesterday, the University of St. Thomas hosted Archbishop Francis Chullikatt, who is the Papal Nuncio and Permanent Observer of the Holy See to the United Nations, speaking on the subject of religious liberty.  In my time working at the United Nations, some Papal Nuncios chose to do their work behind the scenes, like good diplomats, and they were not often outspoken.  Archbishop Chullikatt's international experience as a diplomat and pastor, recently in Iraq, demands that he be outspoken on issues which he has experienced personally.  The auditorium's full house was in rapt attention during his remarks.

In 1987, he said that there were 1.4 million Chaldean Christians living in Iraq.  In northern Mosul, across the river from Nineveh, Chaldean Christians had long been the majority in the city.  In 2010, the Syriac Catholic Cathedral was attacked by gunmen, killing 52 men, women and children.  Children, he said, were shot in open view of their mothers before they themselves were killed.  Two priests, both personally known to Archbishop Chullikatt, were also killed.

By 2003, only 800,000 Christians remained in Iraq, and today the number is about 200,000.  A large community of Iraqi Christians has established itself in Detroit.  In May 2011, St. Mina Coptic Church was burned to the ground in Egypt while the Egyptian army stood passively and watched.  Incredibly, the Grand Mufti of Saudi Arabia, the highest religious authority in the country, called for the destruction of all Christian churches on the Arabian Peninsula. Western mainstream media stories reacting against these inflammatory remarks are curiously absent from Google searches on the subject. 

The Papal Nuncio cites persecution of Christians in Nigeria, India, Pakistan and Burma.  In Burma, he notes, Christians are portayed as carriers of Western liberalism and lax cultural mores, such as women's rights.  Burmese nationalists, who clothe themselves in Buddhist trappings without the values, focus their efforts on the Christians are representing unwanted outsiders who are enemies of the true Burma.

In our own country, Archbishop Chullikatt cited the philosopher Christopher Dawson, who said that the modern state is no longer satisfied with the "passive obedience" of the governed, but it increasingly requires its ambit to stretch out over every aspect of the lives of its citizens from cradle to the grave.  Thus, our own government's constant reference to "worship" (as opposed to religion) as being a private matter.

For a much better reflection of the Nuncio's views, here is a link to his talk at the April National Prayer Breakfast.  I am really glad to have had the opportunity to hear such an impassioned and informative talk on a subject of vital worldwide importance.

China's Future: Western Optimism and Chinese Pragmatism

Back in March, we posted about a declining phase in Chinese growth and the need for a new economic model.  Hedge funds which have made bets on a "hard landing" for China are likely to be disappointed.  The reasons are rather simple.  In Western financial markets, shocks are transmitted quickly through financial speculation, markets turn volatile and overshoot before a new equilibrium is found.

This scenario shouldn't apply to China.  Investments are controlled by the government and directed into jumbo, state run enterprises.  The government is sitting on vast hordes of liquid currencies and securities, and the currency is managed.  Financial markets are not all transparent. Numbers cannot be trusted. Look at the long running fiasco at Sino Forest, which would have collapsed within weeks on any major international exchange.  Sophisticated investors are as powerless as retail investors in a pink sheets stock. 

The Chinese landing won't be a hard landing.  It will be more like a King Air that loses both its engines.  If the Chinese government is a good pilot, the plane will continue to fly and glide to a landing, perhaps with some bumps at the end.  This isn't to say that there won't be  prices to be paid among segments of the Chinese population.  The private sector folks who have made quick fortunes on light manufacturing will be chastened by recessions in their customer countries.  Since the Chinese model is a mercantilist, managed model with humongous external balances and muted internal demand, a steady hand on the stick can bring the plane in. 

The longer run question is what happens when China continues to pursue its own nationalistic, pragmatic interests.  Isolation from the international community could be an unintended  and undesirable consequence.  We've written before about sweeping Chinese claims in Pacific waters around contested islands.  In the absence of an operative Law of the Sea Treaty, the U.S. has no basis to dispute any of these claims, except to object and refer to customary international law. 

As an example of China's thumbing its nose at Western trade management mechanisms, we have the Chinese government slapping tariffs and anti-dumping charges on SUV's exported by General Motors.

    credit: David Gray/Reuters in New York Times, 12/15/2011
Even though the Government is said to have conducted a two year study into the issue of subsidies and dumping, their results weren't shared with the Office of the US Trade Representative, even as a courtesy. 
With the already high levels of taxes and fees, GM's commitment to this potentially lucrative market is likely to yield no results in a profitable vehicle line.  Meanwhile the sight of its Buick SUV's covered in dirt and clay on a Chinese pier does nothing for the brand equity either.  Don't think that this little poke in the eye wasn't carefully orchestrated. 

Besides indignation, the U.S. has no meaningful response, except pushing papers and filing claims.  There may not be as much gold in Shangdu as hoped for GM and other US exporters.

Nord Stream Is The Big News In Europe Today

The Western press front pages were replete with Italian Prime Minister Berlusconi looking heavenward as he contemplated his announced resignation. Or was he thinking about AC Milan's recent run of form in Serie A?  There was nothing new in today's tedious play-acting in Greece and Italy. 

The news of fundamental economic importance was the opening of phase I of the Nord Stream underwater gas pipeline which links Russia's vast Siberian gas reserves with Germany.  The 1,200 km long pipeline can carry 27.5 bcm of gas, and when phase II is completed in 2012, Nord Stream can supply about 10% of the European Union's energy needs with the relatively green, fuel of choice for residential and industrial consumers. 

This is a sharp stick in the eye for Ukraine, Belarus and Poland, which had earned revenue from gas transmitted by older, overland pipelines through their territories.  Ukraine's efforts at disrupting supply in the past for political reasons are now neutralized.  Russia may eventually have from 25-33% of the EU's gas market supplied from its reserves.  As Russian President Medvedev said with some understatement, "We are going to put into operation the first stage of a new partnership with Russia and the European Union."  Gazprom OAO will own 51% of the Nord Stream venture.

We've always said that Russia's proclivities were naturally towards a stronger partnership with Europe than towards a wary partnership with America.  This massive technical and financial undertaking is a good start.  Relationships have been quietly building in other areas too, like football.  Gazprom has been a prominent uniform sponsor for Schalke 04 a great Bundesliga club with a rabid fan following. 

One curious item to note about the ribbon cutting for Nord Stream was that Chancellor Merkel was joined by the French Prime Minister Fillon and not by her erstwhile political companion of recent months, French President Sarcozy.  Germany has in principle gained access to more secure natural gas supplies through the Nord Stream joint venture, which strenghtens its economic prospects for the future, given the growing convergence of interests with Russia. 

Papendreou Agonistes: Greece Throws Down The Gauntlet

For all the hectoring that Greek Prime Minister Papendreou may soon face from the German Chancellor and French Prime Minister, his gambit of calling for a referendum seems politically and economically rational.  Under a scenario of further fiscal discipline mandated by the EU, economic growth prospects are dismal which means growing political unrest and instability in Greece.  The Greek political leadership will not be able to influence the path of future events, other than to be reacting to serial crises.

If, on the other hand, a referendum goes were to go forward and pass, Greece could resurrect the drachma, gain control over its future monetary policy and have an exchange rate to adjust for differential inflation levels with the rest of the EU and for payment imbalances.  A run on the banks would have to be forestalled, but Argentina suffered through a bank run in 2001 and reemerged healthier five years later.

Asset markets would be thrown into turmoil, but everything would eventually be remeasured, and life would go on, with limited access to the capital markets for some time.  However, from the political standpoint, Greece would be in charge of its monetary and fiscal policies, as opposed to the popular perception that the country is at the mercy of Germany and France.  Short-run economic growth prospects in this scenario shouldn't be much worse than under the current euro structure, assuming that fiscal discipline continues and revenues are eventually raised through higher taxes and better collections.

The important element for a politician is that Greece is in charge of its own destiny, even if that means being a pariah for a few years.

Back in July, we wrote about the limited options for the European Central Bank. We focused on " the fundamental problem of economic imbalances within the European Union."  Professor David Beim of the Columbia University School of Business puts forward a cogent analysis in his October 9 paper, "Can the Euro Be Saved?"

The seminal formulations of the economic and currency union idea were put forward by Robert Mundell, Roland McKinnon, Peter Kenen, Douglas Dosser and others in the 1960s.  As Beim rightly points out, these models were predicated on the countries being broadly similar, especially as regards having common or similar rates of inflation. If they were not, a currency union must inevitably end in a debt crisis, driven by persistent payments imbalances.  That's where the EU is today.

We've said from the beginning that no politician on our planet will willingly cede national sovereignty over fiscal policy, because that would be either a literal or political death sentence. We've written earlier, "we are moving, like a slow motion train wreck, towards a default of some kind, semantically within or outside the euro."

Professor Beim agrees, "Greek debt restructuring and exit from the euro needs to happen in the near future and will happen with certainty in the medium future."

Professor Beim raises a really important point, which has been glossed over in all the focus on Greece, and that is the balance sheet of the European Central Bank.  He reads the September 30, 2011 balance sheet showing 2.3 trillion euros of assets, composed of 1.14 trillion of bank loans and distressed sovereign debt!

As he says, "The ECB itself needs to be bailed out, replacing its risking assets with European Financial Stabilisation Mechanism (EFSM) euro-bonds, to the extent that this can be done at this late stage." 
This recapitalisation itself will be a Herculean undertaking.

Arab Spring's Prescursor: Algeria

I just finished John Kiser's fine book, "The Monks of Tibhirine," which provided the basis for the screenplay of Xavier Beauvois' wonderful movie, "Of Gods and Men."  Kiser's deft treatment of Christian-Muslim relations is depicted against the violent background of French colonialism in Algeria.

The Western press has romanticized the so called "Arab Spring," as a prelude to a golden age of Western democracy and modernity in Middle East nations oppressed by their own dictators.  Some of this is wearing off as the reality is showing something different. 

In Kiser's book, Ali Benhadj, a popular preacher who resonated with disaffected Algerian youth says,"For Muslims liberty is constrained by the law of God, not by the rights of others....rights change, and liberty is an illusion that can be trampled by the state.  True liberty comes from submission to God."  Benhadj wrote this in  the newspaper El Munguid ("The Deliverer") around 1988. 

So the Western concept of a secular, political democracy in which the state regulates religion to being a solely private matter, is anathema to the population in the Middle East.  It's interesting to read about the commonality of ideas and mutual respect between the local Algerian Muslim population and the Cistercian monks, who are People of the Book. 

In a speech at the Es Summa mosque in November 1989, Kiser writes that Ali Benhadj said, "They (the Algerian ruling elites) are just like the French before them.  They believe that God can be separated from life, visited perhaps once a week in a mosque.  They have adopted the so-called Enlightenment thinking of the French, which is at the root Greek, an insolent idea that man is the measure of all things.  Everything comes from God. Secular thinking separates man's spirit from God. Islam teaches that it is man's duty to be humble and to serve God in accordance with his commandments." 

The Syrian, Tunisian, Egyptian and other elites bring their own philosophical, political and economic baggage to the discussion about the future of the Arab Spring.  Reading about Algeria's history through Kiser's book was very instructive in thinking about the future of the countries which are trying to throw off the shackles of authoritarianism.  It will not be a short struggle.

One Way Out for the Eurozone?

The capital markets have Eurozone fatigue.  Day after day, hour after hour, we await the same news: an answer is forthcoming from the next meeting of EU finance ministers.  There's a Monty Python sketch in which the characters play around with an innocent question, "How big is it?"  Well pundits at the IMF conference have suggested a rescue/bailout/fiscal equalization fund of 1.4-4.0 TRILLON euros would solve the problem.  There is no answer to "How big?"

A facility of that size is out of the realm of possibility, for a union in which the strongest member has a GDP of 2.5 trillion euros.  Eventually, Germany will have to deal with the reality that its interests diverge not only from the weaker members of the union, but from those of France as well.  Then, Merkel and Sarkozy will no longer be able to pose as figurative, "Brothers in Arms." 

Greece has announced that its austerity measures will not enable it to meet its budget targets in today's WSJ. So, really we are moving, like a slow motion train wreck, towards a default of some kind, semantically within or outside the euro.  We wrote way back in June about the likely fate of the euro and about the attractiveness of Treasuries despite all of our fiscal management issues. 

A country's exchange rate is the most effective market price for adjusting imbalances in merchandise trade and external capital  accounts.  With the euro, Greece or Italy don't  have an exchange rate for the market to devalue until their economises  adjust to a new equilibrium.  Playing with tax and fiscal policies are not primary tools for these adjustments, as Greece is finding out.  Italy is waiting in the wings, and I don't believe that the Berlusconi government would have any inclination to drive itself down a path as Greeece has done. 

Thinking back to the Lehman crisis, one of the justifications for the absurd bailout concocted by Treasury was the fact that nobody could really map out the complete counter party network for Lehman/AIG/Bear Stearns and the other SIFI's, along with the amounts at risk.  Nobody knew how bad it would get and whose hands would get blown off. So we implemented a really bad deal.

Likewise, the structure of the EU and the obligations of its members were built without contemplating the alternatives we're now facing, namely an exit from the euro.  However, if one member exits, the utility of the entire common currency mechanism is mortally wounded as an economic construct. I'm not sure anyone really knows how the default//exit scenario would play out in practice.  Markets need to adjust and move one, but that means a paralyzed Europe has to come to terms with the failure of the notion of their common currency union. 

It doesn't matter how many times the finance ministers meet and where they meet, there may only be "One Way Out."

"Ain't but one way out, baby,
  Lord, I just can't go out that door.
  Ain't but one way out baby,
  Lord, I just can't go out that door.
  'Cause there's a man down there,
  Might be your man, I just don't know."
 
  (Holland/Dozier/Holland) EMI

The ECB Built the Euro On A Shaky Foundation

I found an interesting ECB press release form 1999, in which  Tomasso Padoa-Schioppa, a Member of the Executive Board of the ECB talks about the founding and construction of the European currency.  The discussion is all from a central banker's perspective, and the "primary objective assigned by the Treaty.." is "price stability."  This is to be achieved by a coordinated lowering of interest rates and target growth rate of 4.5% for M3.

What's really curious about this release is the lack of any reference to the financial markets and their role in setting the value of the euro.  The oblique reference to fiscal harmonisation presages today's issue.

"The situation (stability of prices and interest rates), however, would change if the currently perceived risks of fiscal relaxation in Europe were to materialise. The European policy mix might then become unbalanced, and market developments could adversely affect long-term interest rates and the exchange rate. These risks should be considered carefully when assessing the stance of fiscal policies. Reducing deficit and debt levels must therefore remain the objective of European governments, in particular where the public debt is large. This is a pre-condition for a balanced policy mix, one that will keep interest rates low and make the euro a stable currency. You may say that this is the traditional central banker's argument. Yes, it is; but that does not mean that it is not valid."

There never was any incentive or regulatory mechanism for member countries to keep the fiscal policy mix stable.  It was hopelessly naive to have assumed otherwise.  Governments cannot cede sovereignty over fiscal policies to bureaucrats in Brussels, so it still is huis clos.

The market's taking a hatchet last Friday to the share prices of the supposedly stronger European banks was ominous.  Again, the rating agencies went from having their faces splashed with Canoe for their bravado in taking the U.S. credit rating down, to having their faces covered in egg, as they chase the ambulance on the euro.

As we said back in June, the Greeks hold the cards in the short-term in this crisis, which is why it took until September for things to come to a head.  Now that the markets have awakened from their stupor on the euro, there is no really attractive option on the European table which is politically palatable.  In the US markets, meanwhile, it is the spectre of the 2012 elections that is forcing at least some political posturing on our own budget deficit woes. 

A Breath of Spring in Tripoli?

Scenes of exhilaration on the streets of Tripoli abound in the world press today. Fouad Ajami, a respected and knowledgeable commentator on the Middle East, is too hard on the Obama Administration's handling of support to the Libyan rebels. He dismissively calls our strategy, "leadership from the back."

I look at it a bit differently. It appears that the regime of a despotic leader who squandered "four decades of a nation's life," has been brought down through a NATO coordinated support mission, with the most important contributions coming from the U.S., and without the shedding of American blood. However it happened, this is a pretty sensible use of our resources to get a good outcome. It beats our usual, "Ready, fire, reconsider" strategies.

Going forward, probably driven by the desire to take credit for domestic political reasons, we still run the risk of putting out feet in our mouths, backing the wrong horse, and throwing money at problems which are not monetary. Let's wait and see, perhaps leading from the back again.

When Gadhafi is found and captured, let's hope that the rebels don't create an undignified and inhumane spectacle. After some photo opportunity, like pulling down a Gadhafi statue in a Tripoli square, the settlement of old scores and grudges will begin. Also, there will be a struggle for primacy among the segments of the rebels. Who will be the face and voice of the new leadership council?

We have to resist our usual tendency to select that person, perhaps because they studied at Harvard. The oil companies, none of which appear to be American, are already lining up to lead the restoration of production capacity. Our not being a leader in this effort is probably a good thing, as it frees us a bit from the accusation that we're all about the black gold.

Even though Gadhafi has robbed the national patrimony, that's now in the past and the nation has to look forward. It will need institution building, tribal power sharing, and assistance in financing and building infrastructure and supplying essential services. We should look, listen and learn as this situation unfolds, and share in the pride of Libya's setting itself free.

The Fed and the ECB: Both Out of Options

The Federal Reserve Bank once and for all showed that it's abdicated its role as a central bank versus the being the monetary arm of the executive branch. As much as I abhor Fed Speak, a certain amount of opacity in language is desirable. For example, there's the customary practice of committing to low rates "for an extended period."

Wall Street takes that language and processes it, and the markets incorporate the information content into the shape of the yield curve, for example. The Fed is not committed to any specific date and retains flexibility, as it must and should. Putting a specific date on the period of low rates is an unprecedented break with central bank practice. This is another boon to Wall Street to have at it, and does nothing about the problem of all the excess liquidity on bank balance sheets and the lack of traditional lending.

I understand that inflation could surprise, but unless something unusual happens on the global economic growth front, apart from a supply shock or natural disaster, there appears to be no fundamental underpinning for an inflationary spike.

The oil price decline is a combination of growing inventories, sharply declining demand, and a reduction in speculative focus on this market. The speculation will move elsewhere, with a Fed guarantee that it won't surpise speculators with higher rates. Gold has been levitating for a long time, but let's leave that market aside.

Turning to the ECB, it has relatively few options that will provide meaningful support to a dismal outlook in Europe. The Wall Street Journal naively suggests that the Germans, French and stronger European countries will withdraw from the European currency union and create their own "strong euro."

This is extremely unrealistic and would not solve the fundamental problem of economic imbalances within the European Union. Germany is really in the driver's seat, but it too will be reluctant to detonate the charge that destroys the empire of the Brussels bureaucrats, of which many senior ones are French. A slow, economically inefficient unwinding is probably what's in store.

What about the former Eastern Europe? There is a lot of underexploited dynamism in countries like Poland, but they never really had a primary seat at the table of the European Union. If the euro disappears and the Union falters, do they turn East or West for economic growth?

There is occasional blather about the need for European countries to increase fiscal harmonization to get out of the current mess. That was never acceptable to any EU member, and the notion of giving up some degree of national sovereignty remains anathema. Forget about this option.

Finally, in Britian we have again echoes of London Calling by the Clash. Paul Simonon sang an ominous "Guns of Brixton," and that's one of the neighborhoods being torn apart by violence and thuggery. In addition to any issues with newer immigrant groups, Londoners are finally having to acknowledge that with all the economic gains in the City of London financial district, the educational and employment situation of a few generations is dire and has been ignored.

Fiscal stimulus anyone?

South China Sea: A UN Framework Foresaw Issues

China has taken dead aim on territorial claims in the South China Sea, which run into often conflicting claims by the Phillipines, Malaysia, Vietnam, and Brunei. The Third United Nations Convention on the Law of the Sea established workable concepts for territorial seas, exclusive economic zones, and a framework for waters under international jurisdiction, including special arrangements for straits which were key for international commerce. The U.S. Coast Guard, Merchant Marine and Navy were all on board with the treaty.

Unfortunately, the foolish Republican, neo-isolationists and a handful of American multinationals, many of which are out of business now, got together and decided that the LOS treaty was not something the U.S. needed or should accept. Predictably, in the South China Sea, territorial claims to outlying islands define the outer boundary from which territorial seas and EEZ's are defined. Without a global framework agreed to by all the major powers, China has seized on the notion of signing individual side deals with the smaller ASEAN players. This is not in the interests of these players nor those of the international community, but it's difficult to see how this gets resolved now in a rational, economic way.

What's at stake here? Potentially rich resources of natural gas, for one. Although the inferred resources need quite a bit of proving out, gas resources are said to rival those of Qatar. Other potential subsea mineral deposits have also been identified in the South China Sea. Secretary of State Clinton can try the Kissinger shuttle diplomacy tack here, but we have no leverage at all. China has already taken the position that any compromise on their claims to outlying islands, which they say date back to 1947, represents an attack on their sovereignty.

Not signing the LOS treaty didn't seem like a big deal a few decades ago, but it was truly an impotant opportunity lost, and we'll eventually find out what some of the costs are in the South China Sea and in other areas.

Arab Spring: A Columbia Forecast

The Columbia University Club of Minnesota sponsored a talk on "Change in the Ruling Systems of the Middle East." Richard W. Bulliett is Professor of Middle Eastern History at Columbia University. Given that his discipline was history, Professor Bulliett's context for his outlook began in the 11th century, but I'll definitely telescope a lot of that material. He had some interesting remarks about foreign policy issues beyond the current turmoil in the Middle East.

Arab governments do not generally attack each other. In 1991, this fundamental principle was breached when several Arab states gave assistance to the U.S. coalition in invading Iraq. At the same time, Egypt made peace with Israel. Bulliett sees these events as laying the seeds for the current unrest.

In the eyes of the Arab populace, this violation also de-legitimized the ruling systems of the states that provided aid to another foreign infidel, namely the United States. The most stable ruling systems in the Middle East are those based on the "neo-Mamluk" model. The Mamuluks were the slave-soldiers of the Ottoman Empire, primarily Circassians, Kurds and Turks. In the military tradition that took hold in the Middle East, military leaders came from the lowest social and educational classes, a totally different model from the elite models of Britain and the U.S., where leaders come from Sandhurst and West Point.

Once the neo-Mamluks come into power, their goal is to tap deep roots, through appropriating assets, government monopolies, and widespread nepotism. A kleptocracy is their modus operandi. That is how, for example, the Egyptian military controls most of the prime residential and leisure real estate in Egypt. Once the neo-Mamluks are established, their ideology is very flexible. They are relatively indifferent about secularism, Islamism, socialism, capitalism, or fascism, as long as nothing affects their finances and life styles. While both U.S. political parties may long for an nineteenth century ideal of a secular democracies in the Middle East, this is not even in the political calculus of the neo-Mamluks.

Unlike our Wall Street Journal narrative, Bulliet says that Facebook and Twitter were marginal as far as their impact on the Arab street demonstrations. Good communication tools, no doubt, but they were not the axes of any real revolution.

Mubarak's fate in Egypt was determined by Egyptian generals in a smoky, Chicago-style backroom meeting, though probably in a luxurious palace. "Free and fair" elections will not occur, but rather "credible" elections in which Bulliet says that the Muslim Brotherhood may even achieve a plurality. However, they too understand the rules. Don't go overboard with any reforms that bring the eyes of the world on Egypt, take the counsel of the generals and protect their privileges.

In the many parenthetical sidebars that occur in an academic speech, Bulliet notes that U.S. foreign policy careerists, advisers, consultants, and academics have no idea what is going to transpire in Egypt, or Libya or Syria, for example. That is pretty distressing to hear. He also notes that the Israelis too have no clue what is happening, and they too were totally blindsided by the events leading to the street demonstrations and regime instabilities. This goes against the self-perpetuating mythology of the all-knowing and all-seeing Mossad.

This means that President Obama's call for fresh negotiations between the Arabs and Israelis is hopelessly misguided. Given that the Israelis have no idea what the future political map will look like, they would be ill-advised and irrational if they undertook any substantive negotiations in the current environment.

Professor Bulliet says that the Syrian regime has maintained the highest degree of legitimacy in the minds of Arab peoples, despite economic paralysis and political uncertainty. The reason is that the Syrian regime is the only that is consistently viewed as being anti-American and anti-Israeli from 1991 through the current turmoil. The younger Mr. Assad may likely survive, and then he may embark on some reforms, but nothing will effect the portfolios of the military leaders who lend him their legitimacy. He is not so optimistic about Libya, because, among other things, Mr. Quadaffi has brutally pruned his own military in order to secure his own interest and that of his chosen successor. It looks like it may not work, but what comes after no one knows.

There have been some gains in issues we like to read about, such as women's equality in places like Iran. Fifty percent of the university population in Iran are now women. Their role and power, though, will hardly have changed unless these graduates emigrate. Iranian university students have read classics of the Western canon because they have all been translated into Persian by university faculty looking for reasons to make themselves relevant during the Khomeini ascendancy. By contrast, Bulliet says that no Western works are being translated into Arabic at all, and so secondary and university students in their schools have absolutely no exposure to Western thoughts or ideas, except as filtered through propaganda sources.

So, there won't be many buds on the trees in the Arab spring, and the summer won't be lush. There won't be an outbreak of democratic, modernist states. Bulliet says it may take FIFTY years for any movement beyond the neo-Mamluke model, and even then it may not be the secular, tolerant democratic model that we crave in the West. Not great news, but it's something that our politicians, academicians, intelligence community and citizenry need to understand and study objectively, beyond the lens of the Cold War and anti-terror.

Parsing the Fed: Pass the Ouzo

I sat next to some pretty good Fed watchers at Merrill Lynch Capital Markets, and so I couldn't resist taking up my magnifying glass today, reading Louise Story's report in the New York Times. Fed Chairman Bernanke says "a disorderly default in one of those countries would no doubt roil financial markets globally." This seems like either big news or a faux pas.

Most of the press talk from the IMF, the ECB, global banks and rating agencies takes the position that any sovereign issuer default, by Greece, Ireland, Spain, or Italy, would be verboten because of the potential contagion. What Chairman Bernanke's statement says to me is that there is such a thing as an "orderly default," and that such orderly default would not roil financial markets globally. If he and others believe that, then there must be more going on behind the scenes than is public.

He continues, "It (a disorderly default) would have a big impact on credit spreads, on stock prices, and so on. ...I think the effects in the United States would be quite significant." Please hold that coffee, and get me an ouzo!

Echoing sentiments from our last post, Christopher Whalen of Institutional Risk Analyst characterizes the recent European deal announcement as "ridiculous." We then return to the world of derivatives markets, and we find Darrell Duffie of Stanford University opining that regulators "may not have adequately studied what contagion might occur among swaps holders, in the case of a Greek default." (quotation from NYT paraphrasing Duffie) Like the last crisis, it appears that we've learned nothing, and again no one seems to know what's at the end of the burning fuse.

Someone needs to come clean on this. The European Central Bank's statement that " This is much too sensitive...for us to have a conversation.." is totally inappropriate. Until then, our markets will be under downward pressure, as they are yesterday and today.

Euro Standoff: Not Good News

U.S. stocks are up this morning, after a confusing and contradictory hash of press releases from European governments, the IMF and private research groups. Germany has been calling for private bondholders to take their haircuts, for periphery governments to implement meaningful austerity, and finally for Germany to lead a bailout financed by the sovereign Euro-North and the IMF. Instead, nothing of any consequence happened this weekend.

The Centre for Economics and Business Research Ltd. forecasts the demise of the Eurozone by 2013. The IMF communiques chiding Germany's conditions for further bailouts seem wildly out of touch; they also speak to the value of having a non-European in charge of the Fund as soon as possible. The Greek establishment realizes that it many ways, it holds the cards simply because it owes so much to so many; why would investors expect meaningful action from them in light of the IMF's finding fault with the Euro-North countries for not being more accommodating?

It's virtually impossible to forecast the trajectory of a meltdown in the Euro-zone. All in all, how could it be good for the world economy and for stocks? In a perverse way, U.S. Treasuries could benefit again as a safe haven, the least bad of a lot of worse alternatives.

What Arab Spring?

I don't know who can claim coinage of the phrase "Arab Spring," but the phrase needs to be hit with weed killer because it's superficial, inappropriate and misleading. The echo of course is to "Prague Spring." But, let's take a quick trip back and remember what happened in 1968.

Alexander Dubcek became Communist Party leader in Czechoslovakia on January 1, 1968. What became the original Prague Spring began in April 1968 with an "Action Programme" of political, cultural and social liberalization. Dubcek's plans included a federalization of the Czech Republic into Czech and Slovak entities. Long moribund cafes, salons, and theater groups came alive. This looked like a long winter had indeed given over to new life. But, remember what happened next?

By late August, Soviet tanks rolled into Czechoslovakia and a very brief, Prague Spring ended! The real playing out of the historical drama took many years. Our journalists have created a narrative more akin to "Law and Order" than to 21st century politics. In a television drama, the bad guy goes to jail in 46 minutes. It didn't happen in Czechoslovakia and it won't happen in the Arab world.

Dubcek was replaced in April 1969 by Husak, the Communist Party leader to whom Vaclav Havel addressed his famous 1975 Open Letter, by which time a reform movement had started to resurface some seven years later.

In the Arab world, Tunisia and Egypt have gotten rid of their despots, and they would seem on the surface to be the states with some political, cultural, and political infrastructure to support modernization. But, in the words of Rashid Khalidi, the Edward Said Professor of Arab Studies at Columbia, "...despots have gone, but a real transformation (in Tunisia and Egypt) has barely begun."

We have no idea where the current process of sequential, out-of-phase, cycles of unrest will resolve itself. If Tunisia and Egypt have the potential to become roses, our positions in Libya and Syria may have us grasping nettles.

Shigeru Ban's Take on Japan's Rebuilding

Today's New York Times has an encouraging article about architect Shigeru Ban and his use of paper as a construction material for housing victims of natural disasters. Mr. Ban has been doing this work internationally since 1995, and his work spans locations such as Kobe and Chengdu after earthquakes.

In addition to the "poetic" (to quote the Times) quality of his materials and ideas, I liked what he had to say generally about what needs to be done to help homeless Japanese, particularly the elderly. In a response to a question about "innovative" solution for shelters, Mr. Ban says, "We don't need innovative ideas. We just need to build normal things that can be made quickly and easily." Nicely said. There's no need for commissions, multi-year studies, and comprehensive national housing plans...just get rebuilding. He also believes that private initiatives can help in the Japanese context. Let's see if the Japanese government can get going; there are plenty of creative people with experience, who can help. Here's one of them.

Cembalest and JP Morgan on Japan

Michael Cembalest is Chief Investment Officer for JP Morgan Chase Private Bank, and I always enjoy reading his global investment research bulletins. His current piece has some great insights about Japan from the geopolitical and historical sides. He shows that after the WWII, when Japanese industrial production hit its nadir in 1946, it took just six years to recover to the normalized prior high, and Japan was not advantaged like Europe by the Marshall Plan.

As economic writers have talked about "Lost Decades," and we read consistent gloom about the demographics, high savings rates, and interest on government debt being fifty percent of revenues, here is an excerpt from the recent JP Morgan Chase bulletin:

"Japan faces a lot of challenges, such as poor demographics, ongoing deflationary pressures and the worst debt dynamics in the world. However, as we wrote last August, Japan’s domestic debt market is held 93% domestically, rather than relying on the kindness of strangers (like the U.S. or parts of Europe). Japan also has the ability to mobilize the investment accounts of nationalized banks and insurance companies (Yucho, Kampo), which have accumulated over 300 trillion yen of JGBs in the last decade."

Not relying on the kindness of strangers or on their currency being a global reserve currency is a big deal. Cembalest also puts together their Middle East research to say that Japan, and the world, should not feel a secular sting from rising energy prices:

"Japan is the world’s third largest oil importer, the largest importer of thermal coal, and the largest importer of liquid natural gas (2). One would think that with 6%-7% of the electrical grid permanently offline (3) and another 7% of the non-nuclear grid temporarily affected, that energy prices would be surging across the board. But there are 3 caveats contributing to lower crude oil prices:

** First, to replace lost electricity, Japan needs ~300 thousand barrels per day of oil equivalents (mostly for diesel generators). In the context of the global oil supplies and 3.5-5.0 mm bpd of spare capacity, this should be manageable, particularly since much of Japan’s incremental energy imports will take the form of liquid natural gas
** Second, the decline in economic output associated with a disaster like this tends to depress energy demand
** Third, the Saudi Day of Rage passed without much incident, and Qaddafi has retaken most of the oil facilities. On our conference call today, Vali Nasr highlighted that this calm should not be interpreted as a broad sanction for the status quo. Saudi Arabia is still caught between what he described as 3 pincer movements of Shi’a populations (in Yemen, Bahrain and Saudi Arabia’s own Eastern Province; see chart on last page) looking for some combination of wealth, political freedoms and religious autonomy. But for now, the stability of oil exports in the Gulf region looks secure. As we discussed on the conference call today, the history of supply interruptions based on weather or geopolitical events mostly points toward a recovery in exports once the immediate event has passed. Only in the case of the double-barreled 1979 Iranian Revolution followed by the war with Iraq, did we see a country experience a sudden and unrecoverable decline in oil exports." Source: "Matter over Mind," JP Morgan Chase, Inc. ,2011.

On the philosophical side of things, there's often nothing like a crisis to bring people together. After 9/11, I always felt that one of the terrorists' misjudgements was to have planned their heinous strike on New York, which they felt to be the center of global capitalism. It is also the singular, global metropolis with a virtually unlimited well of resourcefulness, grit, fortitude, compassion and openness to working together for a common cause. When the disaster struck, petty squabbles and power grabs were forgotten; for the rest of the country, the old "let Manhattan drift out to sea" sentiments were replaced by the feeling that "we're all New Yorkers now." The images of President Bush throwing a baseball from the mound at Yankee Stadium vividly showed everyone that we had taken the blow and that, as a nation we wouldn't be overcome, even by a well conceived strike at the heart of our greatest city.

If the political leaders are up to it in Japan, a similar, great national unity and drive to rebuild can come out of the current crisis. Even as Japanese society has become secularized in the press, there are deep spiritual traditions among the populace that can provide a firm foundation for the months and years ahead. All the people will be looking for is leadership from the major parties. Emperor Akihito's remarks were of more than symbolic importance, as he is a revered figure to the Japanese; his urge to "live strong for tomorrow" is an aphorism straight out of Japanese martial arts traditions.

It certainly is in the tradition of U.S. international engagement to help a major trading partner, and Western European leaders should also follow suit. Hopefully, GE is sending their best teams of reactor engineers and scientists to learn from what went wrong with the containment vessel design and safeguards, and to also help their customers right things without looking at their lawyers for approval. There will have to be much grieving, since no one knows what the death tolls are; there's also a lot of uncertainty about the levels of continuing radiation exposure and their spread, but let's hope that this crisis and its aftermath can be a catalyst for Japan coming out of its economic desert experience, which would benefit the entire global economy.

What's Next For China?

Back in December, I posted a reflection on on the terrible track record of long-term forecasts, and it was mindless euphoria about the Chinese economic miracle that stimulated that post. David Beim of the Columbia University Graduate School of Business has written a paper for the NBER, "The Future of Chinese Growth," that brings a thoughtful eye to the consensus forecasts.

China's economy has had a thirty year run, ended 2010, where real GDP growth averaged 10% per year! This is extraordinary by any measure. Beim points out that this performance was driven by two, high octane sub-periods. The first was the explosion of Chinese entrepreneurship launched by Deng Xiao-Ping in the 1980's in which the central government subsidized and sponsored private enterprises in China's villages. These efforts distributed their benefits widely throughout the country and were domestically focused.

Beim identifies the next phase as being driven by the annexation of Hong Kong and by the political accession of politicians with Shanghai loyalties. These two forces led to the development of large, coastal-oriented enterprise clusters that were export-oriented, with mainland China supplying large, efficient production and distribution facilities and cheap provincial labor, with the Hong Kong Chinese supplying management expertise and finance. Continuing huge capital investments financed by Chinese banks fueled the export boom that has brought us to where we are today. The benefits of this phase have accrued to a new elite, and this drive was one hundred percent export oriented.

Invoking the neo-classical growth model of Solow and Swan, Beim shows that China is already experiencing diminishing returns to capital, and he suggests that Chinese banks may be ignoring balance sheet issues associated with their cowboy underwriting standards during the export-led boom. Everybody, even the popular press, has written about the need for the Chinese economy to shift to domestic consumption growth. Beim's thesis is that this will be easier said than done. If this is the case, it would seem that the bubble inside the Chinese miracle could end badly. It's definitely thinking outside the box.