« July 2008 | Main | October 2008 »

September 29, 2008

Financial crisis world-wide

The last few weeks have been in economic and even ideological terms, highly dramatic. The collapse of the sub-prime mortgage market in the United States, a market that specializes in lending money for house purchases to high-risk clients, as a result of collapsing house prices sparked off problems that have swept around the world. The problem arose in the United States as interest rates rose from 1% to 5% and more. Low interest rates sucked all sorts of people into house purchases and encouraged a high volume of speculative building. Rising rates caused lower sales and rises in defaults. The market, and perhaps even the regulators, seems to have overlooked the fact that when interest rates are at 1%, they can only go up! This led to falling house prices and increased rate of default on repayments. High-risk institutions in the sub-prime market had sold some of the debt to other institutions (banks; investment banks) domestically and internationally and this interconnected debt is what has given rise to the problems. This debt was made up of packages of mortages and so it was difficult for the rating agencies to be sure of the risks. There are suggestions that the SEC was not as careful as it should be in investigating the developments. Banks and mortgage institutions are in trouble nearly everywhere as stock markets and even private depositors took fright. The irony of the situation is that the regulatory authorities in the United States, the US Federal Reserve and the SEC, presided over the financial services industry as it was creating this problem and now the Federal Reserve is presiding over the attempts to rescue the financial sector and hence save the US and world economy from a deep and highly disruptive recession. How did this worldwide situation come about? What are the regulatory issues and other implications?

The level of government involvement in the bail-out of financial institutions is unprecedented in the developed world. The long-debate, initiated by Adam Smith in 1776, over what governments can do and what markets can do has dramatically shifted towards governments yet governments, through the agency of their central banks, have also presided over the regulation of the financial sectors during the period that led up to this mess. It is no good going on, at least for the moment, about who to blame for the situation. Action was required and the typical action is, everywhere, to try and relieve the credit restrictions as banks, in an effort to preserve their own situation, refuse to lend to other banks or are only willing to do so at very high rates of interest. In August 2007, the Federal Reserve cut its rate to the banking system as lender of last resort. Intervention also took place in other countries, notably in Europe, Canada and Japan. The crisis had begun. It became headline news in the UK with the failure of Northern Rock, a building society that borrowed on the markets to invest and hence was easily caught out. Shortly afterwards, US institutions start announcing investment losses. Coordinated international action was necessary and the Federal Reserve worked cooperatively with central banks in other countries to stave off the credit crisis.

The crisis continued to spread from the money markets to the bond markets and then to the bond insurance markets (another means of supposedly spreading risk). The rot was spreading and in the spring another big US institution (Bear Stearns) was in trouble leading to a buy-out with Federal funding support. In the UK a significant number of mortgage scheme were withdrawn as house prices there continued to fall. The three-hundred year-old, Royal Bank of Scotland had to seek funding from shareholders and has suspended dividend payments, issuing share certificates instead. The FBI started fraud investigations against individuals in the financial sector in the United States. The Federal government has to step in and rescue the two key housing market institutions in the United States, Fannie may and Freddie Mac. In the UK HBOS, heavily engaged in mortgage debt is sold to Lloyd’s. The huge HSBC announces a dramatic lower of its profits. Merrill Lynch is bought by Bank of America and Lehman Brothers collapses. The collapse of AIG prompted a rethink on policy and the federal authorities started to search for a system-wide solution rather than watch institutions collapse one after another. Only broadly-based financial institutions with a balanced set of assets can survive in this context. Anyone over-exposed to sub-prime debt and to mortgages more widely is likely to be in trouble. Bradford and Bingley Building Society (a mortgage leader) in the UK will now be taken over by the Spanish bank, Santander.

It is any further spread of insecurity and the consequence on the real economy that the Federal authorities are trying to avert by the $700billon rescue package. The Federal funding is to be used to buy-up ‘toxic debt’ from the sub-prime market. Mass failures in the financial sectors around the world would lead to a collapse of international trading and misery for many ordinary people as bank-guarantee schemes would be unable to cope with the demands for compensation. Declining trade and production would signal a world recession perhaps reminiscent of the problems of the 1930s. This is why the rescue package is seen as essential. But the outcome is not guaranteed and the scheme has many critics, especially from the political right. The right argues that inappropriate regulation got the system into this mess and that inappropriate intervention will simply extend the crisis and dull its beneficial edge. The beneficial edge in this argument is the reallocation of resources in the real economy. The "philosophical" right argues that what is required is not more intervention but overall less. Certainly this is a massive input along the lines of Keynesian economy policy that has tended to be relatively discredited in the United States in recent times. That this propsed package it is not proving popular with voters and hence with the Legislature is probably due more to the feeling that Wall Street is corrupt. The intervention in the US would have been supported by intervention by other central banks in other contexts. The international fiancial system is capitalism's Achille's heel. The Federal Reserve to some extent intended to act as lender of last resort to the international system. Maybe this would have been enough to save the world from a significant depression, though trade and domestic economies will turn down, and also save countless savers from financial stress. We have not heard the last of this discussion. It is not just Wall Street nor the middle-class that are at risk.

September 11, 2008

Continuity and change in Pakistan.

The reign of the unpopular Pervez Musharaf is over. He left office towards the end of August and was replaced as President of Pakistan by Asif Zardari, the late Benazir Bhutto’s husband. Whatever Zardari’s faults, he has been elected to the Presidency by a democratic process. Stable and representative leadership is essential in Pakistan given the country’s significance to the West and to the United States in particular. Mushraf was unpopular for a number of reasons, including, among the middle-class, for his treatment of judges and lawyers. He was also unpopular because of the close relationship with the United States. What, if anything, has changed as a result of Zardari becoming President?

Pakistan is a country used to turbulence and political shocks. It is currently facing economic problems in part prompted by the changes in the oil price and food prices and partly by domestic fiscal irresponsibility. This situation makes citizens jumpy. At the same time ordinary people in Pakistan are not convinced that Pakistan needs do America’s bidding with respect to the Taliban. It is suspected that many in the army are sympathetic to the movement. Since 9/11 the United States has seen Pakistan as one of the front-lines in the “war on terror?. It has pumped money into the military when Pakistan desperately needs to tackle the issues of poverty and economic development. Poverty is the soil in which the Taliban takes root. A different investment strategy is required.

Zardari, elected by a significant margin in voting in the Provincial Assemblies and in Parliament, has not fundamentally changed the role of the President as created by Musharaf. He still maintains the kind of powers that Musharaf gathered to his office in order to deal with the internal turbulence that seems to be endemic in Pakistan’s political life as a result of both internal and external factors. At the same time as a democratically-elected President, he needs to reflect and adjust policy to the needs of the people as expressed through their representatives. Democracy is the weapon that Benazir Bhutto, who saw the link between the suppression of democracy and the rise of the militants, claimed would defeat the Taliban. The government must deliver the benefits of democracy, inlcuding the benefits of stability and economic growth.

The United States has made it very clear to the new President that it expects a robust approach to the problems with separatists and those who support the Taliban. This expectation has been demonstrated both by words (September 9th) and by deeds (an independent US air strike in the tribal areas, the first for a number of years). The most recent attack by the United States against targets in Pakistan brought criticism from the Pakistan army chief, General Kayani. Kayani’s criticism was supported by the Prime Minster and ally of Zardari, Yousaf Gilani. The United States by promoting independent action in Pakistan has offended not only the government and the military but masses of ordinary citizens. Despite the reception given to Gilani earlier this summer in Washington, the government of Pakistan feels that to the people of Pakistan it looks as if “the government of Pakistan has surrendered to whatever the Americans want to do in the tribal areas? (Guardian, September 11, 2008). The United States frustrated with slow progress along the Pakistan border and growing problems in Afghanistan may have pushed too hard. Having supported Musharaf, the United States seems to be making life difficult for the new government. Given that Zardari is against terrorism, after all he lost his wife to a terrorist bomb attack, a better form of engagement with Pakistan would seem to be required. A military strategy in the Tribal Areas is viewed in Pakistan as likely to be counter-productive and simply not enough.

September 9, 2008

A credible policy towards Russia.

Russia is still smarting from its experiences of the collapse of the Soviet Union. It has not yet found a new role in the world. It has a choice: authoritarian mercantilism or European type liberalism with coordinated inter-state action. The Georgian invasion looks like a mistake in the light of its economic ambitions. What policies are needed towards Russia in the light of the invasion of Georgia?

There can be little doubt that existing policy towards Georgia and even towards the Ukraine by the United States and the EU is no longer tenable. Russia is a country which could go either way. It can become more like a free-market democracy or it can swing back to its authoritarian roots, whether these be Soviet or Russian Imperial roots. This issue is unresolved in Moscow though the trouble of the rouble and the stock-market over Georgia may have helped to give pause for thought.

Western Europe is a highly significant but essentially small landmass stuck on to Russia. If Russia is to change, it needs the West. The EU has a long history now of assisting the development of political and social frameworks for the operation of a market-type economy in areas where such economic arrangements have been stifled. If Europe is to survive as an area of peaceful economic and political cooperation it needs to build ties with Russia. It also needs to recognize Russian sensitivities. European, but more especially, United States ambitions in Georgia were never particularly realistic, the more so given that Saakashvili is unpredictable. The Russians did not go much beyond the areas in which they could express a legitimate interest nor did they force the overthrow of Saakashvile, though it is clear that they would rather see the back of him. Some Europeans may feel the same. The EU, in the talks over the Russia withdrawal from non-separatist territory, is expected to guarantee that Saakashvili does not again resort to force. United States and European aid will prevent Russia from ruining Georgia’s economic future, and help keep pipe lines open, but this will not be the last of the issues with respect to the stability of Georgia and the Russian influence upon it.

The Ukraine is the next issue. President Sarkozy of France, current rotating president of the EU, who has been very active in the diplomatic engagement with Russia, sees no desire on the part of the Russians to shift its borders with the Ukraine. Sarkozy is clear that the EU wishes to avoid a new Cold War and that economic and strategic cooperation is essential. The trouble is that NATO membership is potentially on offer to the Ukraine as it was potentially to Georgia. It does not seem a very useful way of sustaining the independent political future of the Ukraine and Georgia to deal with the issue through a military alliance that is based on joint defense. The EU must seek cooperation in the longer run whilst cooling relations in the short run. Both entities need to talk both in the short run (in the manner of Sarkozy) and in the longer term. Ukraine needs to be boudn economically to the EU. Europe will find an accommodation quicker, I sense, that the United States so long as the present attitude in the administration lasts.

Russia has not yet embraced its post-imperial future. In Britain it took the Suez Crisis before any significant psychological adjustment took place to its practical status as a post-imperial power. In France it took the Algerian War. In the end both countries developed a more realistic approach to international political life without the benefit of empire. Russia, bloated with oil and gas monies, and still smarting from the humiliation of the spectacular fall of the Soviet Union, is not in the mood to adjust. Maybe the international odium will sink in and this invasion seen as a turning point away from authoritarian solutions towards negotiation and exchange. Putin may not think this, but the impact of the flight of capital for Russia continues and the banking system is contracting lending as a result. The invasion of Georgia has won Russia few friends and is set to disrupt relations with the United States for some time to come. Yet, if Russia wishes to sustain its economic development, find new export markets and modernize its economic governance, it needs strong cooperation with the European Union. The EU is aware of this and needs to strengthen its good neighbor policies and forget about Ukrainian and Georgian membership of NATO. That Europe has taken a lead with respect to the Georgian crisis is a hopeful sign.

September 5, 2008

European news that you may have missed.

Some snippets from the news as reported in Europe that you may have missed. The news as reported here has been compiled mainly but not uniquely from the feeder service provided by www.openeurope.org and any additional comment is supplied by the author of this blog.

It has been reported the EUobserver that the Turkish President, Abdullah Gul is to visit Armenia on Saturday. This will be an historic visit and one that is to be seen in the context of the dispute over the genocide of the dispute over the Armenian genocide. This visit has been welcomed by the EU in the hope that it will be a significant step in restoring good relations between the two countries. This is positive news for the region in the wake of the Russian “imperial? activities in Georgia. It also illustrates that Turkey is refocusing its regional policy in the light of the changing prospects for full membership of the EU.

Russia is paying a short-term economic price for its invasion of Georgia. According to the Financial Times (London) some $21 billion of foreign capital has been withdrawn from Russia as a result of the invasion of Georgian sovereign territory. This has meant that the monetary authorities in Russia had to intervene in the foreign exchange markets to support the rouble. If Russia were more integrated into world markets, there would be more chance of economic factors influencing foreign policy decisions. The world community is not pleased with Russia but Russia, flushed with oil and gas money, is at the moment still crowing about the restoration of national pride and assertiveness. Meanwhile Newsweek has argued that the Russian action has united European and United States policy and galvanized support in Poland and the Ukraine for the missile defense shield (Poland) and association with the EU (Ukraine). It would seem that whilst the Russian leadership is still immune from international criticism, it has underestimated the political cost of its intervention. It remains to be seen when the leadership, described by the journalist Fareed Zakaria, in Newsweek, as “drunk on high oil prices? will wake up to the consequence of their actions. Russia may yet feel the need for a “good neighbor? policy such as is pursued by the EU. Russian national pride comes at a very high price.

The Irish Times has reported that the French President, Nicholas Sarkozy, has warned during a visit to Damascus that Israel would bomb Iran if the Iranians persist in enriching uranium. Sarkoyz is quoted as saying that “Iran is taking a major risk by continuing the process of obtaining nuclear weapons?. The French have always claimed a special relationship with the Arab world and Sarkozy is keen to build on this claim as part of his revamped approach to the development and execution of French foreign policy. His visit to Damascus is an attempt to encourage useful discussion between Israel and Syria. It seems clear that the issue of “bombing Iran? is still a possibility in a complex situation. The idea has gone up and down in discussion in the United States. Sarkozy clearly hopes that such an eventuality can be avoided.