22/02/2011: Bernanke succeeds where Bush failed

It is now more than two months since the self-immolation of a young Tunisian street vendor, Mohammed Bouazizi, triggered a chain reaction that has so far ousted entrenched authoritarian regimes in Tunisia and Egypt and sparked mass protests and revolts in Libya, Bahrain, Yemen, Algeria, Djibouti, etc. Dominoes, anyone? The image is irresistible.

Actually, the domino theory is a vintage Cold War concept employed to justify America's intervention in Vietnam. If Saigon fell to the communists, the rest of Southeast Asia would soon follow.

An all-purpose response to any perceived threat, the image of tumbling dominoes was revived to justify America's invasion of Iraq in 2003, only this time in reverse. While other pretexts were cited – Iraq's alleged weapons of mass destruction, ties to international terrorism and non-compliance with various UN resolutions – US President George W. Bush offered his own domino theory as part of what became known as the "Bush doctrine" as a moral justification for the war.

In a speech to the conservative American Enterprise Institute just prior invading Iraq, Mr. Bush proclaimed, "A new regime in Iraq would serve as a dramatic and inspiring example of freedom for other nations in the region." Thus, the "reverse domino" theory of democracy spreading across the Middle East. Obviously, few if any in the region shared his vision; and today's occupied, terror-riddled and barely functional Iraq can hardly be seen as a role model for any country.

So, no democratic dominoes were set in motion by Mr. Bush eight years ago. Nonetheless, that process now seems to have started in earnest, if for very different reasons.

Paraphrasing Lenin, as quoted by Keynes, the best way to destroy a nation is to debauch its currency. While the origin of this remark is disputed, I think it neatly summarizes one of the real causes of the turmoil today in the Middle East and North Africa.

Counterfeit money has often been used to destabilize enemy regimes during wars, triggering prices increases and sending inflation out of control. However, it was not a forged currency that sent the people of Tunisia out into the streets in January, with all the dramatic consequences that are still unfolding. Rather, it was America's ultra-expansive monetary policy.

The US Federal Reserve's quantitative easing has flooded the world with liquidity, which in turn has fueled prices increases of many assets, agricultural commodities among them. While drought and forest fires in Russia and floods in Australia certainly contributed to surging food prices, the main driver, in my view, is the deluge of money spilling out from US printing presses.

Countries whose currencies are pegged or closely aligned with the US dollar, like many of those in North Africa and the Middle East, took the biggest hits as food prices climbed. To be clear, I am not arguing that US monetary policy is the sole cause of the far-reaching events now unfolding in these countries, but it is certainly a major trigger.

Seeking phantom weapons of mass destruction, George W. Bush tried and failed to set the region's dominoes of democracy in motion by brute force. Today, probably inadvertently, Fed President Ben Bernanke accomplished this miracle with weapons of monetary destruction. Who could have imagined it?

10/02/2011: Angry Greeks in the mezzanine - Why the euro is still in crisis

No, the euro crisis is not over yet. The recent turbulence has certainly subsided, but far too many imponderables lie ahead for us to sound an all-clear signal.
Twenty-eight basis points, 0.28%: that was the paper-thin margin on 12 January between tranquility and havoc on European markets. But the invisible hand of the market formed a thumbs-up and Portugal managed to place its 10-year government bonds at 6.72%.
Had the threshold of 7% been reached, Lisbon would have very likely needed support from the European Financial Stability Fund (EFSF), raising the curtain for another act in the European sovereign debt drama. And that act would have closed with Spain, whose financial intermediaries are closely interlinked with those of its Iberian neighbor, quivering fearfully in spotlights. Fortunately, this didn’t happen.
More good news came on 25 January, when the EFSF’s debut issue of a five-year, AAA-rated EUR 5bn bond was successful, and even several times oversubscribed, at 2.89%. Those two events led many pundits to conclude the Euro crisis was over. I remain skeptical.
Despite several colleagues patiently explaining to me that a liquidity premium may account for it, I find it dubious that the 5-year AAA bond from the EFSF can yield 0.5% more than a 5-year AAA bond from the German government. Is the EFSF bond really as triple-A safe as Germany’s bond? And isn’t this exactly the sort of question many failed to ask in the wake ofß prior to? the last financial crisis?
Technicalities aside, I think sounding an all-clear on the euro crisis may momentarily recast it as a tedious but manageable economic problem but dangerously ignores the vital and far less manageable political dimension. Wishful thinkers on the euro cite some implausible reasons for their optimism.
Yes, as they argue, Germany could easily underwrite Greece’s entire sovereign debt – which amounts to roughly 4% of Germany’s GDP. And why not toss in Ireland and Portugal’s debts as well? Sorry, but I seriously doubt the German constitutional courts and the German public would agree to this philanthropic gesture.
And granted, the latest data shows Spain starting to increase its competitiveness. But chipping away at its 30% gap in unit labor costs with Germany will be a long and painful process for Madrid, especially with unemployment at over 20%.
Agreed, Greece has begun to implement harsh austerity measures. However, it is meeting grassroots resistance, for example, some people are refusing to pay health and transportation fees. A tax boycott is certainly thinkable in Greece. And who could blame the Greek populace for rejecting such deep sacrifices to rescue such a broken system?
Ireland will probably kick out the sitting government when it votes on 25 February, and the new government may not pursue all the policies the old one has agreed to. Meanwhile, the situation in Belgium is utterly confusing. The country has had no government for eight months now. If it would split into two linguistic entities – a rather ugly reminder that a political union is never forever – who would be responsible for the Belgian government’s immense debt?
Stabilizing the Eurozone with the EFSF can work as long as only the smaller countries need help. But this construct would be sorely tested if, for example, Spain were to falter.
Alternatives like the proposed Eurobond should also be viewed skeptically. We know since the financial crisis that the alchemy of mixing AAA and sub-investment grade debt cannot magically yield a new shiny AAA bond, with Germany as the super-senior tranche and Greece in the mezzanine.
In our view, the only way to relieve the chronic sovereign debt crisis at the Eurozone’s periphery is to mimic the Americans’ approach to US subprime debt: the European Central Bank will have to buy that “toxic” sovereign debt from European financial intermediaries until the balance sheets of the latter are considered stable enough to allow some European peripheral countries to default and reshuffle their debt without triggering a banking crisis in Europe’s core.Of course, this scenario will not please Germany, since monetization of European peripheral debt will ultimately lead to more inflation. But if European politicians vow, like French President Nicolas Sarkozy in Davos last month, “Never will we abandon the euro,” inflation is the price that must be paid.

03/02/2011: Winds of change sweep across the Arab world

A mighty Reeh El Sahara, or desert wind, is sweeping though the Arab world. Politicians and "experts" have been overtaken by events in Tunisia and Egypt. While we cannot foretell any specific outcomes, we see compelling reasons for these kinds of episode to recur.

I am not a geopolitical expert but, then again, who is? No one – no intelligence service, no embassy, none of the many think tanks and public pundits – predicted the spark that started in Tunisia and is currently enflaming Egypt.

Is it a geopolitical black swan, an unknowable turn of events, impossible to forecast because it exceeds our knowledge and imagination? I doubt it. In my view, like the latest financial crisis, it is another case of what radical philosopher Slavoj Žižek has called the "unknown known" – something lying in plain sight and completely obvious in retrospect, but willfully ignored because it doesn’t suit our view of the world.

Could it be that besides venal kleptocracies and fanatical theocracies, there might be another vision for Arab societies, one that promotes social justice and the rule of law? Given the velocity of recent events, it is obviously too early to answer this question, and it is probably naïve to bet on a purely positive outcome. But we have at least been granted a glimpse of this idealistic vision, which lay unseen by leaders and opinion makers, and we believe it is not merely a feverish desert mirage

Again, I am just an economist and given the dismal recent forecasting track record of my profession, I would not presume to criticize those who failed to see this historical turn coming. But looking to the future, as an economist, I see four elements that convince me such assertive public demonstrations will flare up again. The elements relate to economic equality, food prices, demographics and technology.

Equality is a much disputed theme in economic theory. This is not only because the term itself is elusive, but also because its analysis fails to yield clear, quantifiable messages. In economic terms, in a completely equal society, special talent would not be specially compensated. Hence, there would be no economic incentive to develop and use talent. And in a completely unequal society, where the uppermost stratum is unattainable through merit, the disincentives are the same. The regimes in the Arab world, and in many emerging markets as well, offer severely limited prospects for individual development and expression. What they do offer, however, is fertile ground for discontent.

Throughout history, high food prices have been a trigger for popular revolutions. Today, the pressures stemming from demographics and from development (through changes in food habits) in many emerging markets have sent food prices sharply higher. Add to that the increased acreage devoted to cultivating biofuels, plus clean water's increasing scarcity, and we have a recipe for rising food prices in the years ahead. With their oil wealth, Saudi Arabia and some of the Gulf States could divert some income to subsidizing food. Other, less well-endowed, countries will likely face the wrath of hungry crowds.

The most important source of political instability today and tomorrow , in my view, is demographics. The looming cost explosion facing the aging developed economies, and also China, is widely recognized. But there is an equally large demographic bubble, as we now must finally acknowledge. According to the UN, the median age of the population in the Arab world – that is, half of the population is at or below this age, half above – ranges between 24 and 30. In the US, the median age is 37, 42 in Western Europe and a ripe, old 45 in Japan. Obviously, if they can find no meaningful work, there will be plenty of frustrated, angry young men and women in the Arab states for years to come.

Add technology, in the form of the communication tools we all carry in our pockets and the social networks to link people together, and our picture is complete. Whatever the preliminary outcomes may be, we think it is safe to assume that Tunisia and Egypt are only the beginning of a hot wind of change sweeping through the Arab world.