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“If government is “for the people”, then it needs to do its job. And in case anyone in the government has forgotten why they went to Washington, I will give you a news flash – your real job isn’t to feed us when we are on the bread lines, but to keep us off of them in the first place.”

– Brown Man Thinking Hard

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By George Friedman ~ Honorary Political Season Contributor

Three weeks after the U.S. presidential election, we are getting the first signs of how President-elect Barack Obama will govern. That now goes well beyond the question of what is conventionally considered U.S. foreign policy — and thus beyond Stratfor’s domain. At this moment in history, however, in the face of the global financial crisis, U.S. domestic policy is intimately bound to foreign policy. How the United States deals with its own internal financial and economic problems will directly affect the rest of the world.

One thing the financial crisis has demonstrated is that the world is very much America-centric, in fact and not just in theory. When the United States runs into trouble, so does the rest of the globe. It follows then that the U.S. response to the problem affects the rest of the world as well. Therefore, Obama’s plans are in many ways more important to countries around the world than whatever their own governments might be planning.

Over the past two weeks, Obama has begun to reveal his appointments. It will be Hillary Clinton at State and Timothy Geithner at Treasury. According to persistent rumors, current Defense Secretary Robert Gates might be asked to stay on. The national security adviser has not been announced, but rumors have the post going to former Clinton administration appointees or to former military people. Interestingly and revealingly, it was made very public that Obama has met with Brent Scowcroft to discuss foreign policy. Scowcroft was national security adviser under President George H.W. Bush, and while a critic of the younger Bush’s policies in Iraq from the beginning, he is very much part of the foreign policy establishment and on the non-neoconservative right. That Obama met with Scowcroft, and that this was deliberately publicized, is a signal — and Obama understands political signals — that he will be conducting foreign policy from the center.

Consider Clinton and Geithner. Clinton voted to authorize the Iraq war — a major bone of contention between Obama and her during the primaries. She is also a committed free trade advocate, as was her husband, and strongly supports continuity in U.S. policy toward Israel and Iran. Geithner comes from the Federal Reserve Bank of New York, where he participated in crafting the strategies currently being implemented by U.S. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson. Everything Obama is doing with his appointments is signaling continuity in U.S. policy.

This does not surprise us. As we have written previously, when Obama’s precise statements and position papers were examined with care, the distance between his policies and John McCain’s actually was minimal. McCain tacked with the Bush administration’s position on Iraq — which had shifted, by the summer of this year, to withdrawal at the earliest possible moment but without a public guarantee of the date. Obama’s position was a complete withdrawal by the summer of 2010, with the proviso that unexpected changes in the situation on the ground could make that date flexible.

Obama supporters believed that Obama’s position on Iraq was profoundly at odds with the Bush administration’s. We could never clearly locate the difference. The brilliance of Obama’s presidential campaign was that he convinced his hard-core supporters that he intended to make a radical shift in policies across the board, without ever specifying what policies he was planning to shift, and never locking out the possibility of a flexible interpretation of his commitments. His supporters heard what they wanted to hear while a careful reading of the language, written and spoken, gave Obama extensive room for maneuver. Obama’s campaign was a master class on mobilizing support in an election without locking oneself into specific policies.

As soon as the election results were in, Obama understood that he was in a difficult political situation. Institutionally, the Democrats had won substantial victories, both in Congress and the presidency. Personally, Obama had won two very narrow victories. He had won the Democratic nomination by a very thin margin, and then won the general election by a fairly thin margin in the popular vote, despite a wide victory in the electoral college.

Many people have pointed out that Obama won more decisively than any president since George H.W. Bush in 1988. That is certainly true. Bill Clinton always had more people voting against him than for him, because of the presence of Ross Perot on the ballot in 1992 and 1996. George W. Bush actually lost the popular vote by a tiny margin in 2000; he won it in 2004 with nearly 51 percent of the vote but had more than 49 percent of the electorate voting against him. Obama did a little better than that, with about 53 percent of voters supporting him and 47 percent opposing, but he did not change the basic architecture of American politics. He still had won the presidency with a deeply divided electorate, with almost as many people opposed to him as for him.

Presidents are not as powerful as they are often imagined to be. Apart from institutional constraints, presidents must constantly deal with public opinion. Congress is watching the polls, as all of the representatives and a third of the senators will be running for re-election in two years. No matter how many Democrats are in Congress, their first loyalty is to their own careers, and collapsing public opinion polls for a Democratic president can destroy them. Knowing this, they have a strong incentive to oppose an unpopular president — even one from their own party — or they might be replaced with others who will oppose him. If Obama wants to be powerful, he must keep Congress on his side, and that means he must keep his numbers up. He is undoubtedly getting the honeymoon bounce now. He needs to hold that.

Obama appears to understand this problem clearly. It would take a very small shift in public opinion polls after the election to put him on the defensive, and any substantial mistakes could sink his approval rating into the low 40s. George W. Bush’s basic political mistake in 2004 was not understanding how thin his margin was. He took his election as vindication of his Iraq policy, without understanding how rapidly his mandate could transform itself in a profound reversal of public opinion. Having very little margin in his public opinion polls, Bush doubled down on his Iraq policy. When that failed to pay off, he ended up with a failed presidency.

Bush was not expecting that to happen, and Obama does not expect it for himself. Obama, however, has drawn the obvious conclusion that what he expects and what might happen are two different things. Therefore, unlike Bush, he appears to be trying to expand his approval ratings as his first priority, in order to give himself room for maneuver later. Everything we see in his first two weeks of shaping his presidency seems to be designed two do two things: increase his standing in the Democratic Party, and try to bring some of those who voted against him into his coalition.

In looking at Obama’s supporters, we can divide them into two blocs. The first and largest comprises those who were won over by his persona; they supported Obama because of who he was, rather than because of any particular policy position or because of his ideology in anything more than a general sense. There was then a smaller group of supporters who backed Obama for ideological reasons, built around specific policies they believed he advocated. Obama seems to think, reasonably in our view, that the first group will remain faithful for an extended period of time so long as he maintains the aura he cultivated during his campaign, regardless of his early policy moves. The second group, as is usually the case with the ideological/policy faction in a party, will stay with Obama because they have nowhere else to go — or if they turn away, they will not be able to form a faction that threatens his position.

What Obama needs to do politically, then, is protect and strengthen the right wing of his coalition: independents and republicans who voted for him because they had come to oppose Bush and, by extension, McCain. Second, he needs to persuade at least 5 percent of the electorate who voted for McCain that their fears of an Obama presidency were misplaced. Obama needs to build a positive rating at least into the mid-to-high 50s to give him a firm base for governing, and leave himself room to make the mistakes that all presidents make in due course.

With the example of Bush’s failure before him, as well as Bill Clinton’s disastrous experience in the 1994 mid-term election, Obama is under significant constraints in shaping his presidency. His selection of Hillary Clinton is meant to nail down the rightward wing of his supporters in general, and Clinton supporters in particular. His appointment of Geithner at the Treasury and the rumored re-appointment of Gates as secretary of defense are designed to reassure the leftward wing of McCain supporters that he is not going off on a radical tear. Obama’s gamble is that (to select some arbitrary numbers), for every alienated ideological liberal, he will win over two lukewarm McCain supporters.

To those who celebrate Obama as a conciliator, these appointments will resonate. For those supporters who saw him as a fellow ideologue, he can point to position papers far more moderate and nuanced than what those supporters believed they were hearing (and were meant to hear). One of the political uses of rhetoric is to persuade followers that you believe what they do without locking yourself down.

His appointments match the evolving realities. On the financial bailout, Obama has not at all challenged the general strategy of Paulson and Bernanke, and therefore of the Bush administration. Obama’s position on Iraq has fairly well merged with the pending Status of Forces Agreement in Iraq. On Afghanistan, Central Command chief Gen. David Petraeus has suggested negotiations with the Taliban — while, in moves that would not have been made unless they were in accord with Bush administration policies, Afghan President Hamid Karzai has offered to talk with Taliban leader Mullah Omar, and the Saudis reportedly have offered him asylum. Tensions with Iran have declined, and the Israelis have even said they would not object to negotiations with Tehran. What were radical positions in the opening days of Obama’s campaign have become consensus positions. That means he is not entering the White House in a combat posture, facing a disciplined opposition waiting to bring him down. Rather, his most important positions have become, if not noncontroversial, then certainly not as controversial as they once were.

Instead, the most important issue facing Obama is one on which he really had no position during his campaign: how to deal with the economic crisis. His solution, which has begun to emerge over the last two weeks, is a massive stimulus package as an addition — not an alternative — to the financial bailout the Bush administration crafted. This new stimulus package is not intended to deal with the financial crisis but with the recession, and it is a classic Democratic strategy designed to generate economic activity through federal programs. What is not clear is where this leaves Obama’s tax policy. We suspect, some recent suggestions by his aides not withstanding, that he will have a tax cut for middle- and lower-income individuals while increasing tax rates on higher income brackets in order to try to limit deficits.

What is fascinating to see is how the policies Obama advocated during the campaign have become relatively unimportant, while the issues he will have to deal with as president really were not discussed in the campaign until September, and then without any clear insight as to his intentions. One point we have made repeatedly is that a presidential candidate’s positions during a campaign matter relatively little, because there is only a minimal connection between the issues a president thinks he will face in office and the ones that he actually has to deal with. George W. Bush thought he would be dealing primarily with domestic politics, but his presidency turned out to be all about the U.S.-jihadist war, something he never anticipated. Obama began his campaign by strongly opposing the Iraq war — something that has now be come far less important than the financial crisis, which he didn’t anticipate dealing with at all.

So, regardless of what Obama might have thought his presidency would look like, it is being shaped not by his wishes, but by his response to external factors. He must increase his political base — and he will do that by reassuring skeptical Democrats that he can work with Hillary Clinton, and by showing soft McCain supporters that he is not as radical as they thought. Each of Obama’s appointments is designed to increase his base of political support, because he has little choice if he wants to accomplish anything else.

As for policies, they come and go. As George W. Bush demonstrated, an inflexible president is a failed president. He can call it principle, but if his principles result in failure, he will be judged by his failure and not by his principles. Obama has clearly learned this lesson. He understands that a president can’t pursue his principles if he has lost the ability to govern. To keep that ability, he must build his coalition. Then he must deal with the unexpected. And later, if he is lucky, he can return to his principles, if there is time for it, and if those principles have any relevance to what is going on around him. History makes presidents. Presidents rarely make history.

By George Friedman – Honorary Political Season Contributor

In 1989, the global system pivoted when the Soviet Union retreated from Eastern Europe and began the process of disintegration that culminated in its collapse. In 2001, the system pivoted again when al Qaeda attacked targets in the United States on Sept. 11, triggering a conflict that defined the international system until the summer of 2008. The pivot of 2008 turned on two dates, Aug. 7 and Oct. 11.

On Aug. 7, Georgian troops attacked the country’s breakaway region of South Ossetia. On Aug. 8, Russian troops responded by invading Georgia. The Western response was primarily rhetorical. On the weekend of Oct. 11, the G-7 met in Washington to plan a joint response to the global financial crisis. Rather than defining a joint plan, the decision — by default — was that each nation would act to save its own financial system with a series of broadly agreed upon guidelines.

The Aug. 7 and Oct. 11 events are connected only in their consequences. Each showed the weakness of international institutions and confirmed the primacy of the nation-state, or more precisely, the nation and the state. (A nation is a collection of people who share an ethnicity. A state is the entity that rules a piece of land. A nation-state — the foundation of the modern international order — is what is formed when the nation and state overlap.) Together, the two events posed challenges that overwhelmed the global significance of the Iraqi and Afghan wars.

The Conflict in Georgia

In and of itself, Russia’s attack on Georgia was not globally significant. Georgia is a small country in the Caucasus, and its fate ultimately does not affect the world. But Georgia was aligned with the United States and with Europe, and it had been seen by some as a candidate for membership in NATO. Thus, what was important about the Russian attack was that it occurred at all, and that the West did not respond to it beyond rhetoric.

Part of the problem was that the countries that could have intervened on Georgia’s behalf lacked the ability to do so. The Americans were bogged down in the Islamic world, and the Europeans had let their military forces atrophy. But even if military force had been available, it is clear that NATO, as the military expression of the Western alliance, was incapable of any unified action. There was no unified understanding of NATO’s obligation and, more importantly, no collective understanding of what a unified strategy might be.

The tension was not only between the United States and Europe, but also among the European countries. This was particularly pronounced in the different view of the situation Germany took compared to that of the United States and many other countries. Very soon after the Russo-Georgian war had ended, the Germans made clear that they opposed the expansion of NATO to Georgia and Ukraine. A major reason for this is Germany’s heavy dependence on Russian natural gas, which means Berlin cannot afford to alienate Moscow. But there was a deeper reason: Germany had been in the front line of the first Cold War and had no desire to participate in a second.

The range of European responses to Russia was fascinating. The British were livid. The French were livid but wanted to mediate. The Germans were cautious, and Chancellor Angela Merkel traveled to St. Petersburg to hold a joint press conference with Russian President Dmitri Medvedev, aligning Germany with Russia — for all practical purposes — on the Georgian and Ukrainian issues.

The single most important effect of Russia’s attack on Georgia was that it showed clearly how deeply divided — and for that matter, how weak — NATO is in general and the Europeans are in particular. Had they been united, they would not have been able to do much. But they avoided that challenge by being utterly fragmented. NATO can only work when there is a consensus, and the war revealed how far from consensus NATO was. It can’t be said that NATO collapsed after Georgia. It is still there, and NATO officials hold meetings and press conferences. But the alliance is devoid of both common purpose and resources, except in very specific and limited areas. Some Europeans are working through NATO in Afghanistan, for example, but not most, and not in a decisive fashion.

The Russo-Georgian war raised profound questions about the future of the multinational military alliance. Each member consulted its own national interest and conducted its own foreign policy. At this point, splits between the Europeans and Americans are taken for granted, but the splits among the Europeans are profound. If it was no longer possible to say that NATO functioned, it was also unclear after Aug. 8 in what sense the Europeans existed, except as individual nation-states.

The Global Financial Crisis

What was demonstrated in politico-military terms in Georgia was then demonstrated in economic terms in the financial crisis. All of the multinational systems created after World War II failed during the crisis — or more precisely, the crisis went well beyond their briefs and resources. None of the systems could cope, and many broke down. On Oct. 11, it became clear that the G-7 could cooperate, but not through unified action. On Oct. 12, when the Europeans held their eurozone summit, it became clear that they would only act as individual nations.

As with the aftermath of the Georgian war, the most significant developments after Oct. 11 happened in Europe. The European Union is first and foremost an arrangement for managing Europe’s economy. Its bureaucracy in Brussels has increased its authority and effectiveness throughout the last decade. The problem with the European Union is that it was an institution designed to manage prosperity. When it confronted serious adversity, however, it froze, devolving power to the component states.

Consider the European Central Bank (ECB), an institution created for managing the euro. Its primary charge — and only real authority — is to work to limit inflation. But limiting inflation is a problem that needs to be addressed when economies are otherwise functioning well. The financial crisis is a case where the European system is malfunctioning. The ECB was not created to deal with that. It has managed, with the agreement of member governments, to expand its function beyond inflation control, but it ultimately lacks the staff or the mindset to do all the things that other central banks were doing. To be more precise, it is a central bank without a single finance ministry to work with. Unlike other central banks, whose authority coincides with the nations they serve, the ECB serves multiple nations with multiple interests and finance ministries. By its nature, its power is limited.

In the end, power did not reside with Europe, but rather with its individual countries. It wasn’t Brussels that was implementing decisions made in Strasbourg; the centers of power were in Paris, London, Rome, Berlin and the other capitals of Europe and the world. Power devolved back to the states that governed nations. Or, to be more precise, the twin crises revealed that power had never left there.

Between the events in Georgia and the financial crisis, what we saw was the breakdown of multinational entities. This was particularly marked in Europe, in large part because the Europeans were the most invested in multilateralism and because they were in the crosshairs of both crises. The Russian resurgence affected them the most, and the fallout of the U.S. financial crisis hit them the hardest. They had to improvise the most, being multilateral but imperfectly developed, to say the least. In a sense, the Europeans were the laboratory of multilateralism and its intersection with crisis.

But it was not a European problem in the end. What we saw was a global phenomenon in which individual nations struggled to cope with the effects of the financial crisis and of Russia. Since the fall of the Soviet Union, there has been a tendency to view the world in terms of global institutions, from the United Nations to the World Trade Organization. In the summer of 2008, none of these functioned. The only things that did function effectively were national institutions.

Since 2001, the assumption has been that subnational groups like al Qaeda would define the politico-military environment. In U.S. Defense Department jargon, the assumption was that peer-to-peer conflict was no longer an issue and that it was all about small terrorist groups. The summer of 2008 demonstrated that while terrorism by subnational groups is not insignificant by any means, the dynamics of nation-states have hardly become archaic.

The Importance of the State

Clearly, the world has pivoted toward the nation-state as the prime actor and away from transnational and subnational groups. The financial crisis could be solved by monetizing the net assets of societies to correct financial imbalances. The only institution that could do that was the state, which could use its sovereign power and credibility, based on its ability to tax the economy, to underwrite the financial system.

Around the world, states did just that. They did it in very national ways. Many European states did it primarily by guaranteeing interbank loans, thereby essentially nationalizing the heart of the financial system. If states guarantee loans, the risk declines to near zero. In that case, the rationing of money through market mechanisms collapses. The state must take over rationing. This massively increases the power of the state — and raises questions about how the Europeans back out of this position.

The Americans took a different approach, less focused on interbank guarantees than on reshaping the balance sheets of financial institutions by investing in them. It was a more indirect approach and less efficient in the short run, but the Americans were more interested than the Europeans in trying to create mechanisms that would allow the state to back out of control of the financial system.

But what is most important is to see the manner in which state power surged in the summer and fall of 2008. The balance of power between business and the state, always dynamic, underwent a profound change, with the power of the state surging and the power of business contracting. Power was not in the hands of Lehman Brothers or Barclays. It was in the hands of Washington and London. At the same time, the power of the nation surged as the importance of multilateral organizations and subnational groups declined. The nation-state roared back to life after it had seemed to be drifting into irrelevance.

The year 1989 did not quite end the Cold War, but it created a world that bypassed it. The year 2001 did not end the post-Cold War world, but it overlaid it with an additional and overwhelming dynamic: that of the U.S.-jihadist war. The year 2008 did not end the U.S.-jihadist war, but it overlaid it with far more immediate and urgent issues. The financial crisis, of course, was one. The future of Russian power was another. We should point out that the importance of Russian power is this: As soon as Russia dominates the center of the Eurasian land mass, its force intrudes on Europe. Russia united with the rest of Europe is an overwhelming global force. Europe resisting Russia defines the global system. Russia fragmented opens the door for other geopolitical issues. Russia united and powerful usurps the global stage.

The year 2008 has therefore seen two things. First, and probably most important, it resurrected the nation-state and shifted the global balance between the state and business. Second, it redefined the global geopolitical system, opening the door to a resurgence of Russian power and revealing the underlying fragmentation of Europe and weaknesses of NATO.

The most important manifestation of this is Europe. In the face of Russian power, there is no united European position. In the face of the financial crisis, the Europeans coordinate, but they do not act as one. After the summer of 2008, it is no longer fair to talk about Europe as a single entity, about NATO as a fully functioning alliance, or about a world in which the nation-state is obsolete. The nation-state was the only institution that worked.

This is far more important than either of the immediate issues. The fate of Georgia is of minor consequence to the world. The financial crisis will pass into history, joining Brady bonds, the Resolution Trust Corp. and the bailout of New York City as a historical oddity. What will remain is a new international system in which the Russian question — followed by the German question — is once again at the center of things, and in which states act with confidence in shaping the economic and business environment for better or worse.

The world is a very different place from what it was in the spring of 2008. Or, to be more precise, it is a much more traditional place than many thought. It is a world of nations pursuing their own interests and collaborating where they choose. Those interests are economic, political and military, and they are part of a single fabric. The illusion of multilateralism was not put to rest — it will never die — but it was certainly put to bed. It is a world we can readily recognize from history.

By George Friedman ~ Honorary Political Season Contributor

A complex sequence of meetings addressing the international financial crisis took place this weekend. The weekend began with meetings among the finance ministers of the G-7 leading industrialized nations. It was followed by a meeting of finance ministers from the G-20, the group of industrial and emerging powers that together constitute 90 percent of the world’s economy. There were also meetings with the International Monetary Fund (IMF) and World Bank. The meetings concluded on Sunday with a summit of the eurozone, those European Union countries that use the euro as their currency. Along with these meetings, there were endless bilateral meetings far too numerous to catalog.

The weekend was essentially about this: the global political system is seeking to utilize the assets of the global economy (by taxing or printing money) in order to take control of the global financial system. The premise is that the chaos in the financial system is such that the markets cannot correct the situation themselves, and certainly not in an acceptable period of time; and that if the situation were to go on, the net result would be not just financial chaos but potentially economic disaster. Therefore, governments decided to use the resources of the economy to solve the problem. Put somewhat more simply, the various governments of the world were going to nationalize portions of the global financial system in order to stave off disaster. The assumption was that the resources of the economy, mobilized by the state, could manage — and ultimately repair — the imbalances of the financial system.

That is the simple version of what is going on in the United States and Europe — and it is only the United States and Europe that really matter right now. Japan and China — while involved in the talks — are really in different places structurally. The United States and Europe face liquidity issues, but the Asian economies are a different beast, predicated upon the concept of a flood of liquidity at all times. Damage to them will be from reduced export demand, and that will take a few weeks or months to manifest in a damning way. It will happen, but for now the crisis is a Euro-American issue.

The actual version of what happened this weekend in the financial talks is, of course, somewhat more complex. The United States and the Europeans agreed that something dramatic had to be done, but could not agree on precisely what they were going to do. The problem both are trying to solve is not technically a liquidity problem, in the sense of a lack of money in the system — the U.S. Federal Reserve, the European Central Bank and their smaller cousins have been pumping money into the system for weeks. Rather, the problem has been the reluctance of financial institutions to lend, particularly to other financial institutions. The money is there, it is just not getting to borrowers. Until that situation is rectified, economic growth is pretty much impos sible. Indeed, economic contraction is inevitable.

After the failures of so many financial institutions, many unexpected or seemingly so, financial institutions with cash were loath to lend money out of fear that invisible balance-sheet problems would suddenly destroy their borrowers, leaving lenders with worthless paper. All lending is driven by some appetite for risk, but the level of distrust — certainly after many were trapped in the Lehman Brothers meltdown — has meant that there is no appetite for risk whatsoever.

There is an interesting subtext to this discussion. Accounting rules have required that assets be “marked to market,” that is, evaluated according to their current market value — which in the current environment is not very generous, to say the least. Many want to abolish “mark to market” valuation and replace it with something based on the underlying value of the asset, which would be more generous. The problem with this theory is that, while it might create healthier balance sheets, financial institutions don’t trust anyone’s balance sheet at the moment. Revaluing assets on paper will not comfort anyone. Trust is in very short supply, and there are no bookkeeping tricks to get people to lend to borrowers they don’t trust. No one is going to say once the balance sheet is revalued, “well, you sure are better off than yesterday, here is a hundred million dollars.”

The question therefore is how to get financial institutions to trust each other again when they feel they have no reason to do so. The solution is to have someone trustworthy guarantee the loan. The eurozone solution announced Oct. 12 was straightforward. They intended to have governments directly guarantee loans between financial institutions. Given the sovereign power to tax and to print money, the assumption was — reasonable in our mind — that it would take risk out of lending, and motivate financial institutions to make loans.

The problem with this, of course, is that there are a lot of institutions who will want to borrow a lot of money. With the government guaranteeing the loans, financial institutions will be insensitive to the risk of the borrower. If there is no risk in the loan whatsoever, then banks will lend to anyone, knowing full well that they cannot lose a loan. Under these circumstances, the market would go completely haywire and the opportunities for corruption would be unprecedented.

Therefore, as part of the eurozone plan, there has to be a government process for the approval and disapproval of loans. Since the market is no longer functioning, the decision on who gets to borrow how much at what rate — with a government guarantee — becomes a government decision.

There are two problems with this. First, governments are terrible at allocating capital. Politics will rapidly intrude to shape decisions. Even if the government could be trusted to make every decision with maximum efficiency, no government has the administrative ability to manage the entire financial sector so directly. Second, having taken control of interbank finance, how do you maintain a free market in the rest of the financial system? Will the government jump into guaranteeing non-interbank loans to ensure that banks actually lend money to those who need it? Otherwise the banking system could be liquid, but the rest of the economy might remain in crisis. Once the foundation of the financial system is nationalized, the entire edifice rests on the nationalized system.

The prime virtue of this plan is that it ought to work, at least in the short run. Financial institutions should start lending to each other, at whatever rate and in whatever amounts the government dictates and the gridlock should dissolve. The government will have to dive in to regulate the system for a while but hopefully — and this is the bet — in due course the government can unwind its involvement and ease the system back to some sort of market. The tentative date for that unwinding is the end of 2009. The risk is that the distortions of the system could become so intense after a few months that unwinding would become impossible. But that is a problem for later; the crisis needs to be addressed now.

The United States seems to dislike the eurozone approach, at least for the moment. It will be interesting to see if Washington stays with this position. U.S. Treasury Secretary Henry Paulson, who appears to be making the decisions for the United States, did not want to obliterate the market completely, preferring a more indirect approach that would leave the essence of the financial markets intact.

Paulson’s approach was threefold. First, Washington would provide indirect aid to the interbank market by buying distressed mortgage-related assets from financial institutions; this would free up the lenders’ assets in a way that also provided cash, and would reduce their fears of hidden nightmares in each others’ balance sheets. Second, it would allow the Treasury to buy a limited stake in financial institutions that would be healthy if not for the fact that their assets are currently undervalued by the market; the idea being that the government takes a temporary share, in exchange for cash that will recapitalize the bank and reduce its need for access to the interbank market. Finally — and this emerged at 2 a.m. on Monday — the government would jump into the interbank market directly. The Federal Reserve promised to lend any amount of dollars to any bank so long as the borrower has some collateral that the Fed will accept (and these days the Fed accepts just about anything). The major central banks of Europe have already agreed to act as the Fed’s proxies in this regard.

The United States did not want to wind up in the position of micromanaging transactions between financial institutions. Washington felt that an intrusive but still indirect approach would keep the market functioning even as the government intervened. The Europeans feared that the indirect approach wouldn’t work fast enough and had too much risk attached to it (although the Fed’s 2 a.m. decision may take the air out of that belief). They also believed Washington’s attempt to preserve the market was an illusion. With the government buying distressed paper and investing in banks, they felt, what was left of the market wasn’t worth the risk or the time.

There is also an ideological dimension. The United States is committed to free-market economics as a cultural matter. Recent events have shown, if a demonstration was needed, that reality trumps ideology, but Paulson still retains a visceral commitment to the market for its own sake. The Europeans don’t. For them, the state is the center of society, not the market. Thus, the Europeans were ready to abandon the market much faster than the Americans.

Yet the Europeans and the Americans both had to intervene in some way, and now they face exactly the same problem: having decided to make the pig fly, there remains the small matter of how to build a flying pig. The problem is administrative. It is all very well to say that the government will buy paper or stock in companies, or that it will guarantee loans between banks. The problem is that no institutions exist to do this. There are no offices filled with officials empowered to do any of these things, no rules on how these things are to be done, no bank accounts on which to draw — not even a decision on who has to sign the checks. The faster they try to set up these institutions, the more inefficient, error-prone and even corrupt they will turn out to be. We can assure you that some bright lads are already thinking dreamily of ways to scam the system, and the faster it is set up, the fewer controls there will be.

But even if all of that is thrown aside, and it is determined that failure, error and corruption are an acceptable price to pay to avoid economic crisis, it will still take weeks to set up either plan (with the possible exception of the Fed’s announcement to jump into the interbank market directly). Some symbolic transactions can take place within days — and they will undoubtedly be important. But the infrastructure for processing tens of thousands of transactions simply takes time to build.

This, of course, is known to the eurozone finance ministers. Indeed, the Europeans will hold an EU-wide summit on the topic this week, while the Americans are going to be working very hard to clarify their own processes in the next few days. The financial institutions will need to have guarantees to start lending — or some sort of retroactive guarantee — but the bet is that the stock markets will stop falling long enough to give the finance ministries time to get organized. It might work.

We need to add to this another dimension we find very interesting. We have discussed elsewhere the axes on which this decision will be made: one is the degree of government intervention, the other is the degree of international collaboration. Clearly, governments are going to play the pivotal role. What is interesting is the degree to which genuine international collaboration is missing. Certainly there is voluntary collaboration — but there is not an integrated global strategy, there is not an integrated global institution administering the strategy, nor is there an irrevocable commitment on the part of governments to subordinate their sovereignty to relevant global institutions.

The Americans and Europeans seem to be diverging in their approaches, with Paulson delivering a warning about the consequences of protectionism. But the European Union is also now being split between members of the eurozone and EU members who have their own currencies (primarily the United Kingdom). Indeed, even within the eurozone, the solutions will be national. Germany, France, Italy and the rest are all pursuing their own bailouts of their own institutions. They have pledged to operate on certain principles and to coordinate — as have the United States and Europe — but the fact is that each state is going to execute a national policy through national institutions with its own money and bureaucracies.

What is most interesting in the long run is the fact the Europeans, even in the eurozone, have not attempted a European solution. Nationalism is very much alive in Europe and has emerged, as one would expect, in a time of crisis. And this raises a crucial question. Some countries have greater exposure and fewer resources than others. Will the stronger members of the eurozone help the weaker? At present it seems any such help would be simply coincidental. This is a global question as well. The Europeans have pointed out that the contagion started in the United States. It is true that the Americans sold the paper. But it is also true that the Europeans bought it readily. If ever there was a systemic failure it was this one.

However, it has always been our view that the state ultimately trumps the economy and the nation trumps multinational institutions. We are strong believers in the durability of the nation-state. It seems to us that we are seeing here the failure of multinational institutions and the re-emergence of national power. The IMF, the World Bank, the Bank for International Settlements, the European Union and the rest have all failed to function either to prevent the crisis or to contain it. The reason is not their inadequacy. Rather it is that, when push comes to shove, nation-states are not prepared to surrender their sovereignty to multinational entities or to other countries if they don’t have to. What we saw this weekend was the devolution of power to the state. All the summits notwithstanding, Berlin, Rome, Paris and London are looking out for the Germans, I talians, French and British. Globalism and the idea of “Europe” became a lot less applicable to the real world this weekend.

It is difficult to say that this weekend became a defining moment, simply because there is so much left unknown and undone. Above all it is unclear whether the equity markets will give governments the time they need to organize the nationalization (temporary we assume) of the financial system. No matter what happens this week, we simply don’t yet know the answer. The markets have not fallen enough yet to pose an overwhelming danger to the system, but at the moment, that is the biggest threat. If the governments do not have enough credibility to cause the market to believe that a solution is at hand, the government will either have to throw in the towel or begin thinking even more radically. And things have already gotten pretty radical.

hat tip Race42008
“worst of all worlds he let Paulson and Bush drive bailout story for a week, then show up at a national security debate and have America think of him as the out of touch guy still hung up on the Surge. Now he is a leader, seeking to achieve bipartisan consensus to avoid catastrophe. He neutralizes Obama’s advantage because Obama has to fall in line behind the bailout Dodd will no-doubt drive through congress. Now economy is moot as they both support the same deal, only McCain is seen as a leader and Obama a follower. Debates resume next week, and McCain not seen as out of touch.”

An Analysis of the Mortgage Crisis from my colleague David Dworkin at Affiniti Network Strategies

If you’ve been waiting for the mortgage crisis to hit bottom, get yourself a couple of good books, because it’s going to be a while, well into 2009 or 2010 at least. Count on it getting a lot worse before it gets better, and even that may be a rosy scenario if Congress passes bad legislation in an election-year panic.

Recent studies estimate over 1 million additional families will lose their homes over the next six years, due solely to subprime mortgages made between 2004-2006. And every time a home goes into foreclosure, the other homes on their block depreciate an average of $5000. To complete the viscous cycle, for every 1 percent reduction in home value, twice as many homes will fall into a negative equity position, where the mortgage is for more money than the house is worth and 70,000 of them will go into foreclosure. (source: First American CoreLogic, Inc. http://www.corelogic.com/)

Like all crises, everyone wants to know four things:

  1. Who’s to blame?
  2. When is it going to end?
  3. How did we get in this mess?
  4. How do we get out of this mess?

In the next two entries in The Leading Edge, I’ll try to answer three of these questions in plain English. I will not try to assign blame. It is human nature to identify responsibility when something bad happens. This reassures us somehow that justice has been done and we are safe from more bad things happening to us. A crisis of this scope requires lots of cooperation. While there are many truly innocent victims, there are many more who went into this with their eyes wide shut. Take your pick: lenders (including mortgage banks, commercial banks, S&L’s and mortgage brokers), rating agencies, the Administration and Congress, GSE’s, and consumers as well.

Homeownership is tremendously important and has broad community benefits, but only when it is done responsibly. The perception that everyone should be a homeowner runs into trouble when nearly everyone who should be a homeowner is one. By 2004, the national homeownership rate was over 69 percent. Interest rates were low and the entire economy benefited as the technology boom of the 1990’s was replaced by the housing boom. No one had any interest in downshifting. Besides, housing had become a critical part of the overall national economy and a lot of the new home equity generated by rising home values was being spent to support it. Slowing down the housing market became synonymous with slowing down the nation.

To keep the mortgage market and housing machines running, mortgage underwriting (the rules that help ensure we buy homes we can afford), became a useful tool to expand historic growth even further. Loosen up on the rules, and more people can get on for the ride. The balloon metaphor is useful because the same air that fills up a balloon and makes it functional can also burst it. And that’s exactly what happened with mortgage underwriting standards. Books will be written about the many “exotic” and “hybrid” mortgage products that contributed to this crisis, but the one product that has done the most harm is the “2-28”.

A typical mortgage is a contract to repay a debt over 30 years. Most mortgages in the US are 30 year “fixed rate” mortgages. That means that you pay the same “fixed” interest rate every year, and your payment is the same every month. An adjustable rate mortgage, more common in the rest of the world, adjusts the mortgage interest payment to the market rate on an annual and sometimes monthly basis.

The difference comes down to who is taking the risk that interest rates will go up and down. In an adjustable mortgage, the consumer takes most of the interest rate risk because the mortgage payment changes with the market. When rates go down, the payment is less. When rates go up, the payment is more. With a fixed rate mortgage, the payment stays the same when rates go up, and they can refinance into a new mortgage when rates go down. An adjustable rate is better for banks, but only as long as most consumers are able to afford their mortgage when rates rise.

As a result of this risk imbalance between the two choices, the market usually makes adjustable rate mortgages cheaper than fixed-rate mortgages. From time to time, complicated factors reverse this trend, and the rates are pretty similar or even the reverse. But this time, lenders who made a lot of adjustable rate mortgages, which are more profitable for them, made some key changes to how the interest is calculated and how buyers were qualified.

Borrowers are qualified on their ability to make the first payment, not the 25th payment. So lenders began offering mortgages with “teaser” or introductory rates that were a lot less than the interest rate that would be paid after the two year teaser period ended. In some cases, the teaser rate ended in a few months, but the payment stayed the same for two years while the shortfall (the difference between what the payment was and what the payment should be) was paid by the borrower in home equity – the small part of the home they actually owned. Teaser rates were sometimes less than 2% in a 6% market. Homeowners were qualified based on this rate, even though it would adjust after two years to a much higher rate.

That’s why many lenders privately referred to these loans as lender crack. They knew these loans would kill them eventually, but they couldn’t stop because they were addicted to the revenue and volume they generated. How much volume? Between 2003 and 2006, lenders originated 1.12 million loans with initial interest rates of less than 2 percent – $431 billion in credit. But these are just the worst of the worst. Nearly 60% of all adjustable rate mortgages originated in 2004-2006 will have payments reset more than 25% of their original amount. For a $300,000 mortgage with a 1% teaser rate, that means a payment increase from $965 per month to $1896 per month at the prevailing interest rate of 6.5%. (source: First American CoreLogic)

For low- and moderate-income consumers, this mortgage almost guarantees foreclosure. If you have plenty of cash, and have high yield investments, this kind of a mortgage may be a good deal. But for first time homebuyers, or those on limited or fixed incomes, it’s financial Russian roulette with five rounds in the chamber. A low- or moderate-income homebuyer, who can’t afford the increased interest rate now, is not going to be able to afford it in two years. When the biggest raise you’ve ever received was 10% and your mortgage payment goes up 50%, you’re going to lose your home.

And that brings us to when this crisis is going to end. If you’re an optimist, late 2009 is probably a good target. If you’re a pessimist, tack on another year or two. Until then, if you see any light at the end of the tunnel step aside, because it’s probably another train.

Foreclosures will continue to increase as more of the 2-28’s reset. When resets peak in March of 2008, we will be approaching the beginning of the end. But remember, those homeowners will just be starting the process of getting behind on the payments. They won’t loose their homes for another 6-12 months, depending on the state in which they live. That means that the real estate market in most states will be glutted in the spring of 2009. As that inventory is absorbed (or in the case of some urban neighborhoods, demolished), the market will finally bottom out. Personally, I don’t know how much value my home will lose, but I am quite sure it won’t appreciate another dollar until 2010.

An Analysis of the Mortgage Crisis from my colleague David Dworkin at Affiniti Network Strategies

If you’ve been waiting for the mortgage crisis to hit bottom, get yourself a couple of good books, because it’s going to be a while, well into 2009 or 2010 at least. Count on it getting a lot worse before it gets better, and even that may be a rosy scenario if Congress passes bad legislation in an election-year panic.

Recent studies estimate over 1 million additional families will lose their homes over the next six years, due solely to subprime mortgages made between 2004-2006. And every time a home goes into foreclosure, the other homes on their block depreciate an average of $5000. To complete the viscous cycle, for every 1 percent reduction in home value, twice as many homes will fall into a negative equity position, where the mortgage is for more money than the house is worth and 70,000 of them will go into foreclosure. (source: First American CoreLogic, Inc. http://www.corelogic.com/)

Like all crises, everyone wants to know four things:

  1. Who’s to blame?
  2. When is it going to end?
  3. How did we get in this mess?
  4. How do we get out of this mess?

In the next two entries in The Leading Edge, I’ll try to answer three of these questions in plain English. I will not try to assign blame. It is human nature to identify responsibility when something bad happens. This reassures us somehow that justice has been done and we are safe from more bad things happening to us. A crisis of this scope requires lots of cooperation. While there are many truly innocent victims, there are many more who went into this with their eyes wide shut. Take your pick: lenders (including mortgage banks, commercial banks, S&L’s and mortgage brokers), rating agencies, the Administration and Congress, GSE’s, and consumers as well.

Homeownership is tremendously important and has broad community benefits, but only when it is done responsibly. The perception that everyone should be a homeowner runs into trouble when nearly everyone who should be a homeowner is one. By 2004, the national homeownership rate was over 69 percent. Interest rates were low and the entire economy benefited as the technology boom of the 1990’s was replaced by the housing boom. No one had any interest in downshifting. Besides, housing had become a critical part of the overall national economy and a lot of the new home equity generated by rising home values was being spent to support it. Slowing down the housing market became synonymous with slowing down the nation.

To keep the mortgage market and housing machines running, mortgage underwriting (the rules that help ensure we buy homes we can afford), became a useful tool to expand historic growth even further. Loosen up on the rules, and more people can get on for the ride. The balloon metaphor is useful because the same air that fills up a balloon and makes it functional can also burst it. And that’s exactly what happened with mortgage underwriting standards. Books will be written about the many “exotic” and “hybrid” mortgage products that contributed to this crisis, but the one product that has done the most harm is the “2-28”.

A typical mortgage is a contract to repay a debt over 30 years. Most mortgages in the US are 30 year “fixed rate” mortgages. That means that you pay the same “fixed” interest rate every year, and your payment is the same every month. An adjustable rate mortgage, more common in the rest of the world, adjusts the mortgage interest payment to the market rate on an annual and sometimes monthly basis.

The difference comes down to who is taking the risk that interest rates will go up and down. In an adjustable mortgage, the consumer takes most of the interest rate risk because the mortgage payment changes with the market. When rates go down, the payment is less. When rates go up, the payment is more. With a fixed rate mortgage, the payment stays the same when rates go up, and they can refinance into a new mortgage when rates go down. An adjustable rate is better for banks, but only as long as most consumers are able to afford their mortgage when rates rise.

As a result of this risk imbalance between the two choices, the market usually makes adjustable rate mortgages cheaper than fixed-rate mortgages. From time to time, complicated factors reverse this trend, and the rates are pretty similar or even the reverse. But this time, lenders who made a lot of adjustable rate mortgages, which are more profitable for them, made some key changes to how the interest is calculated and how buyers were qualified.

Borrowers are qualified on their ability to make the first payment, not the 25th payment. So lenders began offering mortgages with “teaser” or introductory rates that were a lot less than the interest rate that would be paid after the two year teaser period ended. In some cases, the teaser rate ended in a few months, but the payment stayed the same for two years while the shortfall (the difference between what the payment was and what the payment should be) was paid by the borrower in home equity – the small part of the home they actually owned. Teaser rates were sometimes less than 2% in a 6% market. Homeowners were qualified based on this rate, even though it would adjust after two years to a much higher rate.

That’s why many lenders privately referred to these loans as lender crack. They knew these loans would kill them eventually, but they couldn’t stop because they were addicted to the revenue and volume they generated. How much volume? Between 2003 and 2006, lenders originated 1.12 million loans with initial interest rates of less than 2 percent – $431 billion in credit. But these are just the worst of the worst. Nearly 60% of all adjustable rate mortgages originated in 2004-2006 will have payments reset more than 25% of their original amount. For a $300,000 mortgage with a 1% teaser rate, that means a payment increase from $965 per month to $1896 per month at the prevailing interest rate of 6.5%. (source: First American CoreLogic)

For low- and moderate-income consumers, this mortgage almost guarantees foreclosure. If you have plenty of cash, and have high yield investments, this kind of a mortgage may be a good deal. But for first time homebuyers, or those on limited or fixed incomes, it’s financial Russian roulette with five rounds in the chamber. A low- or moderate-income homebuyer, who can’t afford the increased interest rate now, is not going to be able to afford it in two years. When the biggest raise you’ve ever received was 10% and your mortgage payment goes up 50%, you’re going to lose your home.

And that brings us to when this crisis is going to end. If you’re an optimist, late 2009 is probably a good target. If you’re a pessimist, tack on another year or two. Until then, if you see any light at the end of the tunnel step aside, because it’s probably another train.

Foreclosures will continue to increase as more of the 2-28’s reset. When resets peak in March of 2008, we will be approaching the beginning of the end. But remember, those homeowners will just be starting the process of getting behind on the payments. They won’t loose their homes for another 6-12 months, depending on the state in which they live. That means that the real estate market in most states will be glutted in the spring of 2009. As that inventory is absorbed (or in the case of some urban neighborhoods, demolished), the market will finally bottom out. Personally, I don’t know how much value my home will lose, but I am quite sure it won’t appreciate another dollar until 2010.