The European crisis will continue regardless of the coming bailout

Markets are clearly on edge today, awaiting the next round of rumors from Europe. We're almost 20 months into this crisis. As a point of reference, the late 90s Asian financial crisis lasted about 2 years, from May 1997 to March 1999. While there's key structural differences between late 90s East Asian economies and the current beleaguered European economies, the policy response - bailouts and austerity - is very similar. The policy debate that developed during the East Asian crisis on the merits of austerity during a crisis is the same facing today's Western economies, as America is debating Obama's new jobs bill and Europe is putting together the next bailout for Greece. I would argue the austerity-for-bailouts system imposed during the East Asian crisis is inappropriate in the European crisis due to the fact that the economies in question are structurally deficit to the point where their potential GDP growth is not sufficient to pay-off debt, no matter the extent of the austerity measures.

The actors driving intellectual thought on these issues seem to have barely changed as well. Though many details of Ron Suskind's new book Confidence Men have been discredited, it's not the first time we've heard that Larry Summers is a control freak who strictly limited access to the President and dominated the Administration's intellectual thought on domestic policy. Similar allegations were made of Summers and his mentor Rob Rubin during the Clinton years. Summers clearly limited the influence of other advisers such as Joseph Stiglitz and Paul Volcker, both of whom were listed as "advisers" to the President but whose ideas on financial reform and stimulus were largely ignored by the Administration. Those offering substantially different policies from the East Asian experience, such as Stiglitz, have been marginalized.

Interestingly, the biggest change in intellectual thought on economic policy in recent years has occurred in the American right, which has recently favored low-tax and deregulation policies more extreme than those enacted during recent eras of Republican legislative leadership. This shift to the right is especially surprising considering the US' current woes are largely the result of a financial crisis caused by deregulation and a fiscal crisis partially caused by tax-cuts on the wealthy. The growth policies recommended by Republican candidates such as Rick Perry, Mitt Romney, Ron Paul and others are drastically different than those being debated in Europe, where the economic debate is focused on financial issues. At least in the US, we are focused on long-term structural problems. As long as European politicians pretend that Europe faces a confidence problem rather than a solvency problem, we will keep the cycle of ever more austerity and ever more bailouts we've seen over the last 20 months.

Is America Overstretched?

Osama bin Laden’s plan to destroy the US seems remarkably lucid for a madman. Bin Laden wrote that he wanted the US to overreach in its response to the 9/11 attacks, resulting in “long-term economic burdens, leading to further economic collapse.” Bin Laden’s words echo the works of prominent historians (most notably Paul Kennedy), who have identified imperial overstretch as one of the primary reasons for the decline of empires. Driven by a combination of hubris, disproportionately influential domestic interests, and the fear that a failure in an empire’s periphery will spread to its core, empires extend beyond their underlying capabilities and ultimately crumble under the weight of their commitments. Overstretch is the reason why empire’s rarely fail because of a defeat abroad – for example Vietnam – but rather from a deteriorating core (a phenomenon described by Fareed Zakaria as a “supernova” because there is light on the outside but darkness in the center).

With a defense budget of historic proportions, military based around the globe, active involvement in three military conflicts, and debt so momentous it is approaching 100% of GDP, the argument for American overstretch is an easy one. But a closer look reveals that the current picture is different than the overstretch that inflicted the Roman and British empires. For one, as Secretary Gates said during his farewell speech last week, the tremendous growth in US national debt is not due to our defense budget but due to an unfunded growth in entitlements (Medicare Prescription Drug and Modernization Act of 2003), unfunded tax cuts, and a devastating recession. Furthermore, military spending accounts for only 15% of our budget. The amount of national guard and reserve soldiers in Iraq and Afghanistan makes it easy to conclude the US military is stretched thin, but remember that unlike past conflicts and past empires, the US sources it’s military personnel without conscription. The 3 million Americans employed by the Department of Defense make up less than 1% of our population.

No, American power is not limited by its military, even in its current state. American power suffers from what Niall Ferguson calls an “attention deficit” problem.

America faces increasingly competing interests around the globe. During the cold war, American foreign policy was driven by one overriding interest – defeating the Soviet Union and containing communism. Since the end of the cold war, it’s more difficult to define an overarching policy objective. 9/11 allowed a brief paradigm shift to anti-terrorism but this issue was not overarching enough to cover the interests of the US in places such as the Russian periphery or Far East. George W. Bush (and now Obama in his response to the Arab Spring) toyed with a doctrine based on the promotion of democracy, but this paradigm can’t be applied to interests in Saudi Arabia, China, or Pakistan.

The result is an increasingly contradictory foreign policy beset by competing interests. Two conflicts, Arab -Israeli and Indian-Pakistani, are especially representative of the difficulty of balancing American interests in an ideologically complicated world.

As I wrote last week, Obama is attempting to balance American influence on the Arab street with a strong relationship with an Israeli leadership that has no incentive for progress on an Israel-Palestine peace process. Consider the difference in rhetoric towards key relationships in the Middle East.

Arab Street – every country has the right to democracy and self-determination
Saudi Arabia – current leadership needed for global stability
Israel – one of America’s closes allies, moral and historical right to free Jewish state

The interests outlined above are so intertwined they are theoretically impossible to address at the same time, but given their significance, America is forced to engage all at once. Not surprisingly, America’s relations with the Middle East, including Israel, are the worst they’ve been in decades.

There is a similar spaghetti bowl of interests in India and Palestine. On the one hand, strong support for India is an imperative to balance the increasing assertiveness of China, culminating in a generous military and nuclear deal under the Bush administration. But the objective of building India as a pole to counter China is extremely counter-productive to US interests in Pakistan. Pakistan will not turn on the extremist factions that support the Taliban, Al Qaeda, and Kashmir separatists. For Pakistan, these factions are a tool against its greatest enemy - India. It has become clear from Wikileaks cables that the Pakistani ISI was involved in the organization of the Mumbai attacks. Wikileaks cables also revealed how special envoy Richard Holbrooke insisted on including Kashmir in his Af-Pak mandate as he understood there could be no proper co-operation with the Pakistanis as long as this issue was outstanding (the inclusion of India ultimately failed due to strong resistance from Indian leadership).

International relations have always been complex. What’s changed is the coherence of America’s interests – ranging from national security to moral values. America is overstretched in the sense that it is attempting to advance all of its interest abroad, even when they contradict with each other. We must prioritize if we want to achieve our goals abroad.

Atul Gawande on Checklists

I was lucky enough to watch the talented Atul Gawande give the commencement at Harvard Medical School this past weekend (reprinted here). Gawande argued (as he has done in a book as well as a recent appearance on Charlie Rose) that the practice of medicine has become so complex in the last half few decades that it requires a new system to address the complexity. Doctors can no longer operate as lonesome cowboys but as a synchronized pit crew.

The core structure of medicine—how health care is organized and practiced—emerged in an era when doctors could hold all the key information patients needed in their heads and manage everything required themselves. One needed only an ethic of hard work, a prescription pad, a secretary, and a hospital willing to serve as one’s workshop, loaning a bed and nurses for a patient’s convalescence, maybe an operating room with a few basic tools. We were craftsmen. We could set the fracture, spin the blood, plate the cultures, administer the antiserum. The nature of the knowledge lent itself to prizing autonomy, independence, and self-sufficiency among our highest values, and to designing medicine accordingly. But you can’t hold all the information in your head any longer, and you can’t master all the skills.

His solution to managing the inherent complexity of medicine is simple: checklists. The aviation industry, which is also high risk and extremely complex, uses checklists as a mechanism to make sure that simple, but extremely important tasks are not overlooked, such as making sure each meter in the cockpit is working properly.

It's often said that national debate on an issue is healthy, but it's hard to see how this is true for healthcare. Healthcare is the key contributor to our future deficits. As Gawande points out, it also hinders us from investing in the primary long-term drivers of our economy - education. So if healthcare is such a complicated and high risk industry, then why has it become the object of politicians rather than technocrats? Key issues in healthcare - such as the infamous and widely misunderstood "death panels" - simply cannot be understood by the layman, leaving the system especially vulnerable to the influence of politicians more concerned with re-election and polls than policy. The blatant misportrayal of some parts of the healthcare bill is a case in point. But so is the Democratic reaction to Paul Ryan's recent budget and Medicare policy.

Israeli-Palestinian Political Posturing Carries Risks

It's amazing what a difference 6 months makes. 6 months ago, Mubarak was still in power, Netanyahu's approval rating was so low he was politically irrelevant, and the Israel-Palestine issue seemed destined to be ignored as long as Bibi and Barack are both in office. But the populism that swept Egypt and the rest of the Arab states over the last six months threatens to re-ignite the Israeli-Palestine crucible to the point where renewed conflict seems almost inevitable.

Fatah's reconciliation with Hamas indicates Palestinian rejection of the Abbas negotiations of the last few years. While Palestine's frustrations with the peace process have come to a head, the populism that fueled regime-change in Egypt continues to seep into policy decisions as Egyptian leadership must take a harder stance on Israel to satisfy public opinion. And it's not just Egypt; from now onwards, every Arab leader will need to pay more attention to the views of the Arab people as domestic peace has become an issue in even the most stalwart of countries.

In the history of the Israel-Palestine conflict, we've really seen two different types of conflicts. One is the conventional type that characterized the early wars between Arab states and Israel. We have not seen this type of conflict for decades as the Arab states developed leadership which enjoyed complete autonomy and had nothing to gain personally from a full-scale conflict. Even as Israel-Palestine has remained arguably the single most important issue to the Arab people, the leaders themselves were better off avoiding full-scale conflict. During this period, we saw the second type of conflict characterized by suicide bombs, Hezbollah, Hamas, and, more recently, rockets. I argue that the rising Arab populism, even when it doesn't lead to regime change, is leading to a third type of conflict, characterized by Tahrir-square type uprisings and diplomatic and economic skirmishes. The political awakening of the Arab spring will be manifested in ways other than the two types of conflict that characterized the previous few decades. Expect to see more UN resolutions, political pressure on Israeli allies, diplomatic isolation, engagement with Fatah/Hamas, non-violent protests and widespread demonstrations.

The US is stuck in the middle, trying to build a relationship with the awakening Arab people to protect it's non-Israel interests in the region while also maintaining its unwavering support for Israel. But it's hard to see how this "middle way" can work. So far, this strategy has angered US allies such as Saudi Arabia but not gone far enough to garner traction with the Arab street. Obama's recent speech was disappointing to most Arabs because it punted on key points of the Israel-Palestine conflict such as Jerusalem and offered no concrete support for the Arab people's struggle for dignity in countries like Libya and Syria. Netanyahu's rebuttal before Congress was really a victory lap. Not only did he boost his domestic approval by double digits, he threw into Obama's face that virtually the entire Congress supports Netanyahu's vision of a two-state solution over Obama's.

At this point, if I were either Obama or Netanyahu, I would be less concerned with the details of the peace process than the existence of one. There needs to be some sort of progress and some evidence of the start of a real process. Even though political realities make an agreement extremely unlikely, even the appearance of a process would be important given the political upheaval of the rest of the Arab world. Higher volatility means higher risk. Israel's security and peace in the region will be better served simply by the appearance of progress, even if Netanyahu, Obama, and Arab leaders privately recognize the futility of the discussions.

Is it worth it to be the global reserve currency?

The dollar's status as the world's reserve currency is not necessarily the exorbitant privilege it's often described, especially not when facing growth-threatening fiscal deficits and sluggish industrial growth. When one looks at the dramatic need for growth in the US, the status as world reserve currency becomes much more expensive.

Recent news in China and the US underscores the difficulties of the current system, which even after an economic crisis is still structurally the same as before. In China, inflation is increasing (see for example China's recent fine of Unilever) while in the US, GDP growth has slowed to 1.8%. The difference between now and the last cycle is that US consumers have been sucked dry. The US consumer can no longer drive demand. The good news is that the middle class in China, India, Brazil, etc. is growing incredibly fast, driving increases in consumerism and urbanization. The bad news is that as long as the Dollar is the world reserve-currency it will be difficult to realize the full potential of this enormous opportunity. The valuation premium enjoyed by the Dollar due to its unique status is a constant downward drag on US exports as well as Chinese consumption.

But what is the cost of losing the reserve currency? To those with significant dollar-denominated fortunes, the costs are significant. The outflow of capital from US financial markets would significantly raise the cost of capital for US corporations, governments, municipalities, and consumers. It would effectively transfer wealth from the haves to the have-nots, as job growth would increase but the value of dollar-denominated portfolios would decrease. Though it is never a good idea to describe a policy decision as a wealth transfer, that is effectively what has happened in the US since China's entry into the WTO, and a reversal is necessary for the global economy to rebalance.

Ultimately, the "wealth transfer" angle to this policy makes it almost impossible to enact. This is not a new story. The role of Pound Sterling decreased throughout the 1900s as the British Empire declined. Much of British hegemony abroad was focused on the role of Sterling in trade and the great benefits enjoyed by the City as a result. The decline of the British Empire as well as the decline of Sterling were completely unplanned and unmanaged. The transition is simply impossible to manage. Britain, just like the the US now, fights to maintain this status for its currency, with force if necessary. Part of the problem is the disporportionate power of elites in these societies. These factions have the most to lose from a paradigm shift- it takes substantial political change to overcome the inertia of present policies.

Risk pull-back

Oil is down 7% today. Gas is down 6%. Silver is down almost 9%. Rates are about 3 bps lower. Stocks are down 50 bps.

Something is happening in commodities. There are certainly reasons to be bearish. Prices are extremely high. Inventories are generally above their long-term average. Demand is pulling back. Most recent economic news has disappointed- from NFPs to ISM to GDP growth. So a pull-back is justified, but the change in commodities is far more extreme than the de-risking that is occurring in rates and equities. Why is that?

Bill Gross' new investment outlook reiterates his short treasuries thesis, this time relying on evidence from a recent paper by Carmen Reinhart and M. Belen Sbrancia. This paper describes how governments delever by setting treasury yields below real interest rates. It's a fascinating study and a valuable perspective. The last time the US faced an indebtedness comparable to today was during World War II, when total debt exceeded 100% of GDP. It's often assumed that we overcame the massive fiscal debt through 2 decades of substantial growth. But Gross, Reinhart, and Sbrancia remind us that yields on government debt were below real interest rates post WWII, thus effectively deleveraging the balance sheet over time. I've mentioned before the role of the Fed in supporting the government bond market during and after WWI and WWII. Milton Friedman describes the conflict between the Treasury and Fed after WWII, as the Treasury effectively forced the Fed to keep yields low for almost a decade after the end of the war (see Monetary History of the United States).

If Gross is correct and we are living in a world of negative real interest rates for savers, what is the outlook for inflation? Today's move in commodities says a lot. When the government is effectively deleveraging by keeping government debt yields below real interest rates, economic growth becomes the difference between hyperinflation and something more normal. That leaves commodities as the asset class the most leveraged to economic growth. As Gross points out, holders of Treasuries will get burned as yields stay below real rates. But with weaker growth than expected, commodities will no longer capture the yield being stolen by the Fed.

Bits and pieces... 5/3/11

WSJ has an obituary on Bin Laden. I was unaware that Bin Laden wrote shortly after 9/11 to a Taliban leader that his plan was to force the U.S. to overreach in its reaction to al Qaeda attacks as the Soviets had overreached in Afghanistan in the 1980s, ultimately resulting in "long-term economic burdens, leading to further economic collapse." I always assumed Bin Laden's goals were destruction for the sake of destruction. In that context, it's chilling to think of where we are now vs. 10 years ago. With active military conflicts in Libya, Iraq, and Afghanistan, it's tough to argue we're not overextended. Facing a momentous deficit and seemingly insurmountable amount of debt, we certainly are faced with "long-term economic burdens" which restrict our imperial power - consider for example the resurgence of Russian influence in Eastern Europe and Central Asia. But this is correlation, not causation. Bin Laden failed. Our financial troubles we face today are due mainly to reckless and myopic policies such as tax cuts and entitlement expansions. One thing history should teach us is that empires are rarely destroyed by exogenous forces, but are consumed from within by gluttony and hubris.

NYMag profile on Krugman ("What's Left of the Left"): really interesting discussion of a meeting Obama had with leading "liberal" academics (Stiglitz, Sachs, Krugman, Alan Blinder, Larry Mishel) underscores one of the reasons liberals have been ineffective in driving policy in America over the last 30 years- policy recommendations are too disparate from one another and discussions focus too much on esoteric policy. The article includes an insightful quote from Ezra Klein: “On the right, there’s something of a cultural underlay to the worldview: We are the real Americans, and they are not. Liberals want to say, We are correct on the evidence, and they are not.” If you think about it, a lot of conservative rhetoric is based on the underlying idea that Obama is not legitimate and not representative of what they see as true America, either due to the location of his birth or "socialist" political views. The left on the other hand, criticizes policy more than personality.

According to Bloomberg, silver futures fell 13% yesterday as the CME raised margin requirements by (coincidentally) 13%. It's ridiculous how much leverage must be in that market to warrant such a pull back. Another Bloomberg article reports: "Funds held a net 1.49 million futures and options in 18 commodities by April 26, 57 percent more than a year earlier." I've written before on the strong correlation between oil price volatility and the amount of non-commercial market participants. It's a pity that the financial crisis has overshadowed the necessity of studying speculation in commodity markets and the relationship between financial and physical markets. It's also a pity that Congress is cutting the EIA's budget to the point where it has to drop some of its projects, such as the study of the linkages between physical energy markets and financial trading.