Red Alert: The G-7 -- Geopolitics, Politics and the Financial Crisis

October 11, 2008

The finance ministers of the G-7 countries are meeting in Washington. The first announcements on the meetings will come this weekend. It is not too extreme to say that the outcome of these meetings could redefine how the financial markets work, certainly for months and perhaps for a generation. The Americans are arguing that the regime of intervention and bailouts be allowed to continue. Others, like the British, are arguing for what in effect would be the nationalization of financial markets on a global scale. It is not clear what will be decided, but it is clear that this meeting matters.

The meetings will extend through the weekend to include members of the G-20 countries, which together account for about 90 percent of the global economy. This meeting was called because previous steps have not freed up lending between financial institutions, and the financial problem has increasingly become an economic one, affecting production and consumption in the global economy. The political leadership of these countries is under extreme pressure from the public to do something to solve — or at least alleviate — the problem.

Underlying this political pressure is a sense that the financial class, people who run global financial institutions, have failed to behave responsibly and effectively, and have therefore lost their legitimacy. The expectation, reasonable or not, is that the political system will now supplant these managers and impose at least a temporary solution. The finance ministers therefore have a political mandate, almost global in scope, to act decisively. The question is what they will do?

That question then divides further into two parts. The first is whether they will try to craft a single, global, integrated solution. The second is the degree to which they will take control of the financial system — and inter-financial institution lending in particular. (A primary reason for the credit crunch is that banks are currently afraid to lend — even to each other.) Thus far, attempts at solutions on the whole have been national rather than international. In addition, they have been built around incentivizing certain action and increasing the available money in the system.

So far, this hasn’t worked. The first problem is that financial institutions have not increased interbank lending significantly because they are concerned about the unknowns in the borrower’s balance sheet, and about the borrowers’ ability to repay the loans. With even large institutions failing, the fear is that other institutions will fail, but since the identity of the ones that will fail is unknown, lending on any terms — with or without government money — is imprudent. There is more lending to non-financial corporations than to financial ones because fewer unknowns are involved. Therefore, in the United States, infusions and promises of infusion of funds have not solved the basic problem: the uncertain solvency of the borrower.

The second problem is the international character of the crisis. An example from the Icelandic meltdown is relevant. The government of Iceland promised to repay Icelandic depositors in the island country’s failed banks. They did not extend the guarantee to non-Icelandic depositors. Partly they simply didn’t have the cash, but partly the view has been that taking care of one’s own takes priority. Countries do not want to bail out foreigners, and different governments do not want to assume the liabilities of other nations. The nature of political solutions is always that politicians respond to their own constituencies, not to people who can’t vote for them.

This weekend some basic decisions have to be made. The first is whether to give the bailouts time to work, to increase the packages or to accept that they have failed and move to the next step. The next step is for governments and central banks to take over decision making from financial institutions, and cause them to lend. This can be done in one of two ways. The first is to guarantee the loans made between financial institutions so that solvency is not an issue and risk is eliminated. The second is to directly take over the lending process, with the state dictating how much is lent to whom. In a real sense, the distinction between the two is not as significant as it appears. The market is abolished and wealth is distributed through mechanisms created by the state, with risk eliminated from the system, or more precisely, transferred from the lender to the taxing authority of the state.

The more complex issue is how to manage this on an international scale. For example, American banks lend to European banks. If the United States comes up with a plan which guarantees loans to U.S. banks but not European banks, and Europeans lend to Europe and not the United States, the integration of the global economy will very quickly shatter, leading to significant limitations on international trade, currency convertibility and so on. You will nationalize economies that can’t stand being purely national.

At the same time, there is no global mechanism for managing radical solutions. In taking over lending or guarantees, the administrative structure is everything. Managing the interbank-lending of the global economy is something for which there is no institution. And even with coordination, finance ministries and central banks would find it difficult to bear the burden — not to mention managing the system’s Herculean size and labyrinthine complexity. But if the G-7 in effect nationalize global financial systems and do it without international understandings and coordination, the consequences will be immediate and serious.

The G-7 is looking hard for a solution that will not require this level of intrusion, both because they don’t want to abolish markets even temporarily, and more important, because they have no idea how to manage this on a global scale. They very much want to have the problem solved with liquidity injections and bailouts. Their inclination is to give the current regime some more time. The problem is that the global equity markets are destroying value at extremely high rates and declines are approaching historic levels.

In other words, a crisis in the financial system is becoming an economic problem — and that means public pressure will surge, not decline. Therefore, it is plausible that they might choose to ask for what FDR did in 1933, a bank holiday, which in this case would be the suspension of trading on equity markets globally for several days while administrative solutions are reached. We have no information whatsoever that they are thinking of this, but in starting to grapple with a problem of this magnitude — and searching for solutions on this scale — it is totally understandable that they might like to buy some time.

It is not clear what they will decide. Fundamental issues to watch for are whether they move from manipulating markets through government intrusions that leave the markets fundamentally free, or do they abandon free markets at least temporarily.

Another such issue is whether they can find a way to do this globally or whether it will be done nationally. If they do go international and suspending markets, the question is how they will unwind this situation. It will be easier to start this than to end it and state-controlled markets are usually not very attractive in the long run. But then again, neither is where we are now.

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Sarkozy supports Russian security pact idea

ELITSA VUCHEVA

08.10.2008 @ 17:52 CET

EUOBSERVER / BRUSSELS – French President Nicolas Sarkozy on Wednesday (8 October) expressed readiness to discuss Russian plans for a "European Security Treaty," which would provide security guarantees for European and Atlantic states as well as a new framework of rules to govern relations.

Mr Sarkozy - who is also the EU's current president-in-office - met Russian president Dmitry Medvedev in Evian, France, for an international conference organised by the French Institute of International Relations (IFRI).

Mr Sarkozy (l) is ready to discuss the Russian idea (Photo: kremlin.ru)

"I heard president Medvedev present his ideas for a new security pact which would run from Vancouver to Vladivostok. We are ready to discuss it," Mr Sarkozy was reported as saying by Reuters.

The French leader proposed a summit of the Organization for Security and Co-operation in Europe countries to be held at the end of 2009 to "discuss [the Russian] proposals and those of the European Union for new concepts of a pan-European defence," according to German news agency DPA.

Mr Medvedev also called for a "special forum" to be convened, at which "the leaders of all European states and the leaders of key organisations in the Euro-Atlantic area could take part."

Prior to the meeting with the French president, the Russian president outlined in a speech his ideas for a pact that would include Russia, the EU and NATO countries and would contribute to crating "a unified and reliable system of comprehensive security."

Main ideas of the pact

A "Euro-Atlantic space" that would give powers to all members instead of favouring a US-led unipolar world would be the best option, Mr Medvedev argued.

The European Security Treaty would be based on "conscientious fulfilment of international commitments; respect for the sovereignty, territorial integrity and political independence of states [and] respect for all other principles that flow from the UN charter," he said.

It would contain "a clear affirmation of the inadmissibility of the use of force - or the threat of force - in international relations," as well as "guarantees of equal security."

The pact should also state that "no single state or international organisation may have the exclusive right to maintain peace and stability in the region. This applies fully to Russia too."

Finally, it would contain "basic parameters for arms control and reasonable sufficiency in military construction," and boost co-operation in areas such as terrorism and drug trafficking.

No to Sovietology

Russia had earlier this year already raised the idea of a European Security Treaty as a tool to overarch the EU and NATO, to which it does not belong. But its invasion of Georgia in August had up to now overshadowed debate on future institution-building.

On Wednesday, Mr Medvedev also reiterated Russia's opposition to the enlargement of the North Atlantic alliance, in particular to the east, stressing that his country was not interested in confrontations and calling on the US to stop accusing Moscow of conducting a Soviet-driven foreign policy.

"[Sovietology] belongs to the past … Sovietology, like paranoia, is a very dangerous disease, and it is a pity that part of the US administration still suffers from it," he said. "One should study the new Russia rather than reviving the ghosts of the Soviet Union."

Midnight deadline

To back his statement, Mr Medvedev said Russia would withdraw its "peacekeeping contingent" from security zones around Georgia's breakaway provinces of South Ossetia and Abkhazia "by midnight tonight" - ahead of a 10 October deadline stipulated in earlier peace accords.

The move would "pave the way for the resumption of negotiations on an ambitious framework agreement, both in terms of the scope and intensity of cooperation," Mr Sarkozy said, AFP reports, referring to stalled talks on an EU-Russia partnership pact.

Lithuania has threatened to block the talks unless Russia leaves South Ossetia and Abkhazia proper as well, the ELTA news agency said, citing a "senior diplomat."

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Beyond the Post-9/11 World

October 8, 2008

By Reva Bhalla

One day after 9/11, U.S. President George W. Bush declared a global “war on terror.” Al Qaeda had first reared its head years before in the 1993 World Trade Center bombing, the 1998 U.S. Embassy attacks in East Africa and the 2000 USS Cole bombing, but it was not until the World Trade Center towers came crashing down that the global international security community became almost completely consumed with battling global jihadism. Professors of political Islam came out of the woodwork, Osama bin Laden became a household name, university students started pouring into Arabic language courses and, for the first time, terrorism became a national security priority. This era became known as the “post-9/11 world.”

As we discussed last week, a great deal of debate continues within the international security community over the strength of the al Qaeda organization now as compared to seven years ago, with much of the U.S. intelligence community under the impression that al Qaeda is now stronger than it was before Sept. 11, 2001. Stratfor, on the other hand, has long maintained that the al Qaeda core — the tight group of individuals under the leadership of bin Laden and Ayman al-Zawahiri that masterminded the 9/11 attacks — has seen its leadership and operational capability significantly decline over the past seven years.

A strategic threat to the U.S. homeland on the scale of 9/11 requires things like a transnational financial network to wire funds, highly trained operatives disciplined in operational security, undetected preoperational surveillance of targets, and safe-haven territory that is not constantly being bombarded with airstrikes, among other essentials. While al Qaeda prime is busy dodging missiles and making videos, al Qaeda franchises are by and large struggling to stay relevant in their theaters of operation (e.g., Iraq) or are shifting over to a more active area of operation (e.g., Afghanistan).

This is not to say, however, that terrorism is dead. The jihadist movement has decentralized into smaller, largely uncoordinated organizations capable of carrying out attacks in such notably lawless hotspots as Pakistan, Afghanistan, Yemen, Iraq and Algeria. In addition, the threat of al Qaeda grassroots cells in the West with the limited capability of pulling off small-scale attacks remains, though advances by Western security agencies since 9/11 have largely hampered such groups’ efforts.

A Look Back at Cold War Terrorism

Scattered jihadist insurgencies will continue to erode stability in areas of the Middle East and South Asia for some time to come. But a larger terrorism threat is looming on the horizon, one that poses a more lethal threat to Western interests across the globe: the revival of state-sponsored terrorism.

This new phase of terrorism is developing in the context of growing state-to-state conflict between Russia and the West, for which Russian intelligence has long been preparing. Since the Russo-Georgian war in August, there have been a number of indications that Russia is looking to revive some of its Cold War contacts in places such as Cuba, Venezuela, Nicaragua, Syria, Lebanon and the Horn of Africa, among others.

Recent Russian activity in these areas invokes memories of the Cold War, when
the Soviets backed numerous left-wing militant groups in third-party countries, including the Palestine Liberation Organization, Germany’s Red Army Faction, Italy’s Red Brigades, the Japanese Red Army, the Sandinista National Liberation Front, the Revolutionary Armed Forces of Colombia, the Popular Movement for the Liberation of Angola and dozens of others. With Soviet assistance, training camps for militant groups were set up in such places as Libya, Iraq, Syria, East Germany, Bulgaria, Czechoslovakia and elsewhere. Through a Soviet ideology that emphasized the socialist perspective of class struggle, these groups were given the funds, training, weaponry and ideological ammunition to wreak havoc across the globe.

Back then, the United States lacked a comprehensive counterterrorism strategy for dealing with these state-sponsored terrorist groups. Though terrorism was rampant at that time, it was still difficult to prove the Soviet hand in many of the terrorist groups active then. (Many used a variety of pseudonyms to confuse Western intelligence agencies.) Inside the United States, the FBI handled KGB-sponsored militant activity as a purely law enforcement problem. Overseas, the CIA would work with liaison intelligence services to combat insurgent and terrorist groups and to undermine Soviet proxy regimes, attempting covert operations such as coups in Latin America.

Overall, the focus was still on state-to-state conflict, not on developing a counterterrorism strategy for specific groups. Once Soviet funding finally dried up with the fall of the U.S.S.R., the vast majority of these left-wing militant groups crumbled, and terrorism remained low on the priority list for U.S. national security — that is, until 9/11.

Learning to Cope with Nonstate Actors

When the terrorists struck on Sept. 11, 2001, the first logical step was to take out al Qaeda’s state sponsors. Going to war in Afghanistan to deprive al Qaeda of its primary state sponsor — the Taliban regime — was a relatively easy political decision for the United States. From there, however, things got complicated. While justifying a war in Iraq was difficult for the United States, Washington succeeded in compelling surrounding Arab regimes such as Saudi Arabia and Libya to give their full cooperation in stamping out al Qaeda. Pakistan’s security apparatus had deep relations with the very jihadists the United States was fighting, but carrying the war to a nuclear-armed Pakistan was a less attractive option than entering into a tenuous security alliance with Islamabad in hopes of eroding the jihadists’ support base.

As the jihadists’ list of state sponsors got shorter, the threat they posed became more diffuse. Though overall the jihadist threat had become less lethal, it had also become more difficult to stamp out in places like London, where grassroots cells had taken root. As a result, counterterrorism agencies are still grappling with the idea of waging a battle of ideas against jihadism and devoting more military resources to stability operations to deprive these groups of their support networks.

Looking Forward

While more work has to be done to further degrade the threat of jihadism, counterterrorism agencies need to anticipate a revival of state-sponsored terrorism. State sponsorship is capable of transforming a small, largely ineffective group into a serious threat. With state sponsorship, a militant group that previously was capable of only popping off trash can bombs in Manila can access difficult-to-obtain materials (such as blasting caps and explosives) via the state sponsor’s diplomatic pouch. State sponsors can then train these groups to develop superior tradecraft in improvised explosive device construction for larger, deadlier attacks.

Militant groups with state backing also benefit from training in target surveillance and operational security — essential skills for avoiding scrutiny from hostile intelligence agencies. For militants always on the run, state sponsorship can provide a group with havens for planning and training purposes. Finally, state sponsors can prove essential in giving logistical support to militants who need funding and travel documents to move around with greater ease.

But having a state sponsor can also place limits on militants. A state sponsor is more likely to keep tabs on the activities of its militant proxies, keeping such things as weapons of mass destruction (WMDs) out of militant hands for fear of attacks on the sponsor’s own soil. With a state sponsor, a militant group will have less autonomy and thus less inclination to acquire nonconventional weapons. By contrast, more autonomous nonstate actors like al Qaeda are more likely to work to acquire WMDs — though their chance of success remains low.

The Russian Agenda

Russia is not the great power it was during the Cold War, but Moscow plans to reassert Russian prowess vis-a-vis the West, particularly as the U.S. military is still bogged down in fighting the jihadist war.

The Russia of today is not constrained by the need to wage an ideological war in the name of communism. Instead, potential Russian covert activity in regions such as Latin America, the Middle East and Africa would be focused more on generating chaos, thereby creating enough headaches for the West to keep the United States preoccupied while Russia works on consolidating its influence along the former Soviet periphery. To this end, disaffected Palestinian groups, beaten-down Kurdish militants in Turkey, Bolivarian Leftist movements across Latin America and separatist movements in Africa are all fair game for the Russians.

While the world has seen better economic days, the Russians still have ample petrodollars to support terrorist campaigns in parts of the world where Moscow has a strategic interest in undermining the West. Terrorism, relatively speaking, is cheap. For example, the FBI estimates that the 9/11 attacks only cost al Qaeda between $175,000 and $250,000 for flight training, travel and other expenses for the hijackers. The Russians, who have long been deep in the global arms trade, could even potentially turn a profit via arms sales to rebel groups in Latin America, the Middle East and Africa.

The extent to which Russia would re-engage in such terrorist campaigns depends on a number of factors, including the potential risk versus opportunity in supporting certain groups, the resources of the Russian SVR, the amount Russia is willing to invest in terrorism campaigns and the geographical areas where the Russians are more likely to find cooperative allies. For example, Russia has complex relations with Israel and Turkey to worry about, and it is now more or less lacking a Libya equivalent to export a terrorist agenda in the Middle East. Latin America, in contrast, offers a much lower risk opportunity for the Russians to sow instability in the U.S. backyard.

The potential revival of Russian state-sponsored terrorism is most likely still early in its development. But one should not forget that after the Cold War, many experts proclaimed a “New World Order” in which terrorism had become a thing of the past — and U.S. intelligence capabilities atrophied as a result. About a decade later, the 9/11 attacks caught the United States off guard and brought into being a new era of Islamist terrorism that is only now declining. With state-sponsored terrorism back on the horizon, the time has come to recognize the changing face of terrorism beyond the post-9/11 world.

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The ECB must act now to prevent deflation

In the US during the Great Depression, prices fell throughout the 1930s and despite FDR's public works programs, the US economy only recovered when it went on a wartime footing.

GEORGE IRVIN

01.10.2008 @ 18:12 CET

EUOBSERVER / COMMENT - The US and Europe are caught on a financial roller coaster. Each day brings a new twist to the ongoing financial turmoil.

First there was the collapse or takeover of some of the most respected banks in Wall Street and the City of London. Now we have the quasi-nationalisation of Fortis Bank in Benelux and the bailout of Hypo Real Estate in Germany, and for the moment much uncertainty surrounds US treasury secretary Henry Paulson's $700bn bailout plan, defeated by the country's Congress.

The European Central Bank needs to start focusing on the threat of deflation. (Photo: European Central Bank).

Just over a year ago, the sub-prime mortgage crisis appeared at best a financial blip, and at worse the harbinger of a serious if manageable downturn.

But today, there is a real danger that - to use George Bush's folksy turn of phrase - this sucker is goin' down. Not just the US but the EU as well. Look at the way in which Eurozone bank shares have been falling: Dexia in Belgium (with assets greater than Belgium's GDP), Aareal, HRE and Commerzbank in Germany, Natixis in France and Anglo-Irish Bank in Ireland. The euro has given the Eurozone shelter from currency attacks, but not from financial contagion.

Of course, as the financial turmoil has worsened, so too has populist moralising to the tune of "It's all due to greedy bankers" and "Those responsible for the mess must pay". This is easy rhetoric, but no solution.

So what is the solution? Are we facing a banking crisis, a credit meltdown or the early stages of a new Great Depression?

In truth, we are facing all three.

Financial meltdown

Assuming that the free-market crazies in Congress don't veto the Paulson bailout again, there should be relative calm in the markets by the week's end.

But don't expect the calm to last. Even if €700 billion worth of non-performing assets were replaced by treasury bonds in the next fortnight, sentiment is now so volatile that a few more bank failures could send a tsunami of panic cascading through the world's markets. Moreover, there is a limit to the number of bailouts that can be organised within a much-weakened US banking sector and, as the negotiations prior to Lehman Bothers collapse showed, even big sovereign wealth funds are reluctant to buy shaky banks.

That leaves nationalisation of the US banking sector - in whole or in part - as the ultimate option.

The advantage of nationalisation is that the state would acquire both assets and the liabilities (as in the case of Freddie and Fanny), but things will have to get very much worse before Mr Paulson supports such an alternative. And of course, where would that leave the US public borrowing requirement? The US is already the world's largest debtor, financing some $700 billion in current consumption by overseas borrowing - mainly from the Middle East, Russia and China.

If further financial weakness were to precipitate a run on the dollar, well, let's not even think about it.

The real economy

The reason we've not yet seen widespread pain is that the financial crisis is only just starting to work its way through to the real economy.

The credit crunch has already hit the worker whose house is being repossessed, and the rate of house repossessions in the US and the UK is climbing precipitously. Next will be the small businesses to whom the local bank will cut off new credit, not to mention the jobs and livelihoods to be lost as the recessionary spiral deepens.

And what about the ordinary Joe whose final salary pension has disappeared and who will never qualify for a mortgage on a decent house? Or the German or Italian export producer caught between a stronger euro and a weakening world market?

Many leading economists in the US have been critical of the Paulson bailout because it fails to address the underlying weakness of the real economy.

Why give $700bn to the bankers when one could bail out the mortgage defaulters instead, thus addressing the cause of the sub-prime problem and not just shoring up bankers' balance sheets?

It's a good question.

The proximate answer is that had the Democrats voted against Paulson, thus increasing financial chaos, Barrack Obama's electoral campaign would be toast. But politics aside, the real economy is where the sickness lies, and the Fed must cut interest rates soon - and so must the ECB!

The Japanese precedent

The current crisis looks very much like what happened in the late 1980s in Japan when a few square kilometres in central Tokyo was said to be worth more than the whole state of California. When the property bubble burst in 1989, the Bank of Japan (BoJ) dithered for months before cutting interest rates.

As Keynes argued in the dark days of the 1930s, the antidote to a financial crisis and impending economic depression is to flood the market with cheap credit in order to prevent the general price level from falling (i.e., deflation). If deflation can be kept at bay, fiscal expansion can help put people back to work and stimulate a rise in national income.

But once deflation sets in, consumers postpone consumption even longer. In the US during the Great Depression, prices fell throughout the 1930s and despite FDR's public works programmes, the US economy only recovered when it went on a wartime footing. Japan has experienced two decades of stagnation and deflation from which it has still not recovered.

The true danger in Europe

While the EU's banking system may be better regulated than that of the Anglo-Saxon countries, Europe is not immune to financial contagion - as we are seeing at present - or to recession. Germany and France are already experiencing negative growth, and the barely positive growth projections issued by Brussels a fortnight ago will now almost certainly need to be revised downwards. The last time the core Eurozone economies were technically in recession was only four years ago, and ECB monetary policy was looser then than it is today.

The Eurozone is less well equipped than the US to combat deflation, in part because the ECB is obsessed with inflation and in part because of its self-imposed constraint on fiscal policy. The current financial crisis is highly deflationary.

If the ECB continues to sit on its hands over monetary policy and politicians in Brussels continue to believe neo-liberal dogma about self regulating markets and automatic stabilizers, expect things to get far, far worse.

The author is Professorial Research Fellow at the University of London, SOAS

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