Latin America's insertion into the global economy. Source: Google Images

A decoupling of emerging markets from the struggling developed world is a myth, as we saw in 2011 when euro and US shocks caused a sell-off in EM currencies, including in Latin America. Next year could be rough as global growth slows. Countries from Brazil to China are rushing to reverse their earlier policy tightening. Softening Chinese demand should result in flat to softer commodity prices, affecting most countries in Latin America. The big wild card for growth will be the euro zone again. On this, it is challenging to be optimistic. Latin Americans borrow substantially from European banks, and so access to capital may be muted.

So, which countries in Latin America are best able to weather what’s coming in 2012? Countries with strong external balance sheets, macro policy flexibility, sizable domestic markets, and stable politics. Brazil generally passes this test, but its ongoing slide into stagflation — inflation above target and growth below 3% — suggests some limit to policy flexibility. Watch out for the Venezuelan election because no one knows what a post-Chavez world will look like. Mexico’s seems well-positioned for 2012, given a competitive exchange rate and rising exports, some dynamism north of the border, policy flexibility, and what looks to be a fairly quiet electoral season on the horizon. Yet Mexico is vulnerable to just the sort of developed market crisis that beckons toward year-end 2012: namely, a sell-off in the US dollar that could result from America’s inability to solve its government debt problem.

The Union of South American Nations

Will the Union of South American Nations (Unasur) and its monetary fund, Banco del Sur, be successful?

It has been difficult for emerging markets to diversify their sources of balance of payments (BOP) support. During the 1997-98 Asian crisis, the shame such Asian nations as Korea, Thailand, and Indonesia felt (their leaders and peoples, that is), when they had to go hat in hand to the IMF and accept harsh reforms for BOP support, led to calls for an Asian Monetary Fund to supplant the IMF as the lender of last resort. This fund took over ten years to establish; still, these days many Asian nations have ample fx reserves to weather a global slowdown on their own.

Such is the case with many South American nations. Brazil (with over US$ 350 billion in reserves) and Peru (with nearly $50 billion) are exemplary. Due to Chinese demand and the boom in commodity prices, most South American countries are in pretty good shape in terms of fx reserves. But, such countries with heterodox (read: unsound) economic policies as Argentina, Ecuador, Bolivia and Venezuela could see themselves under fiscal and perhaps BOP pressure. These governments follow policies at odds with IMF standards and would be prime candidates for Banco del Sur funds. Yet South American governments are a long way from agreeing on what policy conditions Banco del Sur would condition disbursements. Most countries would probably adhere to an approach not too dissimilar from the IMF’s. Finally, given the infancy of Unasur’s institutions, bilateral central bank swap facilities would be the preferable option to help countries in need.

The following post is an edited version of an article that appeared in the Jerusalem Post earlier this month by Pinchas Landau, author of The Landau Report, a newsletter and consultancy service addressing the needs of foreign firms and financial institutions active in Israel and the Middle East.

“Domestic fury, and fierce civil strife
Shall cumber all the parts of Italy…”

Julius Caesar Act III, Scene 1

As it happens, Italy was not the scene of domestic fury, let alone of fierce civil strife. Instead, the Italian government and parliament – at the urgent prodding of its lecherous leader Berlusconi – rushed through more and tougher austerity measures, in an effort to persuade the financial markets that Italy is not a basket case and to convince the European Central Bank to continue buying Italian government bonds. The ECB, seemingly encouraged by this display of political determination by the Italians – although over the firm objections of the German members of its governing council, did step up to the plate and buy both Italian and Spanish bonds, thereby preventing a total rout in the markets.

However, even with this support from the ECB, the Italian and Spanish stock markets lurched from one low to another over the week. This came as the markets were swept daily and almost hourly by rumors of liquidity problems at leading Italian banks and, far worse, major French banks as well. So while the Italian domino trembled – but did not (yet) fall – the next domino down the line, namely France, began to shake. Here, too, the response was seemingly firm: not only did the ratings agencies confirm that they had no problem with FrAAAnce’s triple A rating – despite having knocked the USA down a notch – but President Sarkozy summoned his senior ministers and instructed them to prepare further austerity measures for discussion and approval later this month. Here, too, the aim is to demonstrate that the political determination exists to do whatever it takes to stabilise the economy.

Formidable. But there is a problem with tough economic policies. They are great when you see the Powerpoint slides and Excel spreadsheets that show how expenses will be reduced and the deficit trimmed, so that key debt ratios improve over time. But if these fierce austerity measures are legislated and implemented as planned, they cause serious hardship to many people and engender major social dislocation. Economists will explain, rightly, that the alternative is worse – eventual breakdown of government and total collapse – but that sensible line still doesn’t play well among the people who actually bear the brunt of the budget cuts, the public sector firings, the elimination of welfare programs, etc.

Just how problematic it is to impose severe and prolonged austerity on a large country became abundantly, painfully, shockingly, clear in the UK this week. The Conservative- LibDem coalition that came to power last year had a mandate to cut government spending and raise taxes, so as to prevent Britain reaching the parlous financial state that Italy, France et al are now facing. The Cameron government has gone ahead with massive cuts in public spending. These measures have been fiercely opposed, as might have been expected. There have been major demonstrations by students and others, and some of these have turned very violent and very nasty. But that was to be expected – in Athens the austerity measures were worse and the intensity of the opposition was greater.

Yet the protests and demonstrations seen hitherto in the UK were in no way similar to, nor did they in any way prepare people for, the events of the last week. These were not demonstrations, or protests against anything specific. Instead, there has been a wave of wanton vandalism, perpetrated for the most part by kids.

Fortunately, this wave of violence has not cost lives, except for one incident in Birmingham. Unfortunately for its perpetrators and would-be imitators, it did something even worse, in the British scale of values. It attacked property. If, in earlier times, it could be said that “an Englishman’s home is his castle”, in the current secular age in which real-estate is the national religion, his home is also his church and sanctuary – and shopping centers are the social cathedrals. By attacking and burning shops and homes, the stupid, greedy kids have declared war on the middle class – and will pay dearly for their mistake.

They are smart enough to know that playing the role of disadvantaged victim – “you shouldn’t ignore us”, as some of the thugs explained – is the politically correct path to a rap on the knuckles, rather than a prison sentence. But they are not smart enough to realize that they have just helped consign that liberal mindset to the garbage can of history. Britain is now facing up to the consequences of five decades of social engineering and family collapse – in the developed country with the highest rate of teenage pregnancies, how many of the vandals have two parents, let alone functioning ones? – perpetrated by left-liberal ideologies, and three decades of economic Darwinism perpetrated by right-wing ideologies. These consequences are not abstract concepts, they are the “feral rats” (as a middle-class lady in Croydon termed them) that emerged into full view this week.

But as the rest of Europe is forced to rapidly dismantle its welfare state in an attempt to avoid bankruptcy, it will expose itself to the same consequences. Each country has its own brand of poisonous racial/ ethnic/ religious/ national/ class hatreds bubbling beneath the surface. As the crisis deepens these will spill over into domestic fury, fierce civil strife and the rest of Mark Anthony’s terrible prophecy.

China and the U.S.: Who’s winning?

The IMF is much publicized as saying earlier this year that China will have a larger economy than the US in 2016.  That statement is true depending on two factors — how you value a country’s output or GDP and what your forecasts for GDP growth are.  If China’s economy is valued at today’s market exchange rates and at the costs and prices currently prevailing in the different economies, its economy is much smaller than America’s and will not surpass it for many years to come.

In 2010, US GDP was about $14.7 trillion and China’s was about $5.9 trillion.  BUT, valued at what economists call Purchasing Power Parity, that is a dollar buys the same basket of goods in the US and in China (which would mean we would have to increase China’s undervalued currency, kept low to increase exports, and correct for some price and cost differences), then China’s GDP suddenly becomes over $9 trillion while US GDP remains roughly the same.

The second factor is what is your growth forecast for these economies.  Well, China has been growing at 8-11% per year for many years now and the US economy cranks along at about 2-3% growth, not bad but not stellar for a developed economy.  So, many economists straight-line out that growth record for the years to come and, say, okay, China’s economy will be larger than the ever fearsome US economy in 2016.  It may well be, but history has shown us that economic success stories turn sour and sluggish economic dogs transform into race-winning greyhounds.  Witness, poorly growing Brazil’s and Peru’s transformation into fairly robustly growing economies and “peripheral” Europe’s turn to bust in recent years.

And, watch out for China’s potential property price bubble, its huge, opaque and state-directed financial system, and considerable political risk in the Middle Kingdom.  As for the US, it has proven “declinists” wrong before — remember Paul Kennedy’s book in the 1980s about the decline of the US?  He didn’t foresee the tech boom of the late 1990s when America grew by nearly 5% per year.  Likewise, those predicting the decline of the US economy today — with its labor market flexibility, dynamism, highly developed financial markets, relatively nimble political system (that’s right, compare it to Japan’s) and technological prowess — may be proven wrong again.

And what about power?  Political scientists discuss power in relative rather than absolute terms.  That is, even if the US economy grows nicely, emerging market economies are likely to grow more rapidly.  Thus, the US economy will decline in relative terms.  It must.  It can’t maintain its wealth gap forever as long as EM economies continue to appropriate technology and know-how from the developed world.  So, since a nation’s economy is the underpinning of its power — in political and military terms, US power will decline relatively.

Power has other dimensions too, including alliances, and it seems implausible that a hostile power could erect in the near term an alternative coalition to really challenge US-led alliances worldwide.  Finally, it all depends on whether you are a foreign policy realist, believing we live in a dog-eat-dog world, or a foreign policy liberal, believing we have erected effective multilateral institutions with broad participation, including nations that could be possible adversaries, such as China, India and Russia.  If you believe in the latter, then the relative decline of US power may not yield the insecurity and threats realists would have you worry about. China, India and Russia (and others) would have too much to lose.

What should the US do about all this, policy wonks?  For starters, cut the fiscal deficit and develop a medium-term plan to reduce entitlement spending and get government debt to GDP down to a moderate level.  That said, the government should invest in infrastructure and education and perhaps in basic research, maybe by freeing up funds through closing tax loopholes and cutting subsidies to farmers and others.  And, once the economy rebounds, let’s put the Tea Party back in the Lipton Tea box, so that we can raise America’s comparatively low tax burden and fix these roads and bridges and educate these kids.

On the defense front, the US should begin to wield military power more effectively, like Les Gelb recommended in a Foreign Affairs article last year, by avoiding costly land wars and instead leveraging alliances and employing more “surgical” tactics.  President Obama’s happily successful (and lucky?) foray into the Libyan conflict, whereby the US played a leading role, but left much of the dirty work to France and Britain, may be a case study.

Illustration by Edel Rodriguez (Source: www.thedailybeast.com)

With America’s latest market crash, the debt debate seems so ‘last week’ (hey, it was last week!), there is still much to learn from the tumultuous process. Niall Ferguson attempts to provide an outside perspective on the whole debt limit battle. It’s a pretty important outside perspective too; China:

Viewed from Beijing, it looked very different. Indeed, it’s hard to imagine what more we could have done to vindicate the Chinese Communist Party’s position that Western democracy is a form of institutionalized chaos to be avoided by all sane Asians….

The antics of American legislators take on a new significance when you realize how our leading creditor interprets them. As Beijing sees it, the last three months have furnished ample evidence that—regardless of what the American rating agencies may say—the United States is no longer creditworthy. Even if Congress has pulled back from the brink of outright default, many in China view the debt deal as at best a temporary fix. As the Xinhua News Agency put it, the 11th-hour deal has “failed to defuse Washington’s debt bomb for good, only delaying an immediate detonation by making the fuse an inch longer.” Meanwhile, the unspoken intention of the Federal Reserve is to debase the dollar through “quantitative easing,” which translates into Mandarin as “printing money.”

We all know that China is not just a spectator in America’s budget battles, but a key constituency. Ferguson details China’s skin in our game:

According to official figures, mainland China holds $1.1 trillion in U.S.-government debt instruments. But it’s an open secret that the Chinese authorities also like to buy Treasuries via intermediaries in London, Hong Kong, and elsewhere. Add the U.K. and Hong Kong figures and the total is closer to $1.6 trillion—about 17 percent of the federal debt in public hands. And if you include nongovernmental securities held in China’s international reserves, the U.S. debt to China rises to more than $2 trillion.

In that math one can see a rising power. In this math, provided by Robert Samuelson, can be seen a troubled, possibly falling power:

Europe represents about one-fifth of the world economy and buys about a quarter of American exports. While Europe’s debt crisis was confined to a few small countries, they could be rescued; other European countries supplied loans to substitute for the credit denied by private lending markets. In 2010, Greek, Irish and Portuguese government debt totaled about 640 billion euros (about $910 billion), less than 7 percent of the 9.8 trillion euros of debt of all members of the European Union.

 With Spain, Italy and possibly France now under financial assault, the situation changes dramatically. There are more debtor nations and more debt at risk. In 2010, Italy’s debt was 1.8 trillion euros; Spain’s 639 billion euros; and France’s 1.6 trillion euros. But there are fewer countries that can support a rescue; and some of them have heavy debts. Even Germany’s ratio of debt-to-gross domestic product (GDP), a measure of debt in relation to its economy, was a hefty 83 percent last year, similar to France’s. (The big difference between France and Germany is that Germany’s economy is growing faster.)

The United States and most of Europe’s finances are hemorrhaging and both are showing rather pathetic attempts to get their houses in order. Unless their trajectories change quickly, they, particularly Europe, may be forced to answer a final question, posed by Samuelson, in the affirmative:

Would China contemplate bailing out Europe? If it did, there would be a stunning transfer of geopolitical power and prestige to China.

The debt and deficit crises driving a 2000 point decline in US Markets over the last two weeks and a credit downgrade lies at the heart of the Western financial and political system goes way beyond the debt & deficit woes currently gripping the Western world; it strikes at the very heart of the way the global economy has been run for over two decades. In short, we are seeing the emergence of a new era of Global leadership. After relying on globalization defined by the Washington consensus to deliver years of growth, lift millions from poverty, keep living standards rising and citizens happy, Western nation states now seem to have lost control of globalization. In the short term, that leaves policymakers looking impotent in the face of fast-moving markets and other uncontrolled and perhaps uncontrollable systems — undermining their authority and potentially helping fuel a wider backlash, social unrest and the emergence of  new centers of leadership and influence.

As I have written here before, the emerging economies have already begun creating alternative global policy-making bodies. The progress of South-South trade is one of the biggest challenges facing the WTO and its Western benefactors. To add insult to injury, in the face of S&Ps downgrade of US credit-worthiness, talk of an alternative global currency to replace the Greenback is accelerating in highly influential quarters — from the IMF to OPEC, from the United Nations to the G-8. In the long run, there are already signs the world could repeat the mistakes of the 1930s and retreat into protectionism and political polarization – witness the present political rankling in Washington & the Euro-zone. There are few obvious solutions, and some of the underlying problems have been building for a long time. “In times of economic recession, countries tend to become isolationist and retrench from globalization,” says Celina Realuyo, assistant professor of National Security affairs at the US National Defense University in Washington DC. “Given the increased number of stakeholders on any issue — climate change, the global financial system, cyber security — it is unclear how traditional nation states can lead on any issue, let alone build consensus globally,” she added.

The financial system, the internet and even the supply chains for natural resources have quietly slipped beyond effective forms of state control. These instruments of globalization have delivered huge wealth and kept economies moving with arguably greater efficiency, but can also swiftly turn on those in authority. Just as Egyptian President Hosni Mubarak discovered that shutting down the internet was not enough to prevent social-media fueled protest from overthrowing him, the world’s most powerful nation states are confronting their helplessness in controlling markets and financial flows.

Technology and deregulation allow both information and assets to be transferred around the world faster than ever before — perhaps faster than states can possibly control, even with sophisticated laws, censorship and other controls. The broad consensus at the 2009 London G20 meeting has already been replaced by a much uglier tone of polarization and mutual recrimination at both domestic and international levels. Where once they would have lobbied quietly, Russia and China now loudly, publicly and angrily criticize the US, with Russian Prime Minister Vladimir Putin recently describing America as an economic “parasite” pulling down the global economy.

Tea Party: the lunatic fringe

In the US and Europe, right-wing lunatic fringe groups, like the Tea Party, Euro-skeptics and xenophobic nationalist groups seem to be on the rise, a potential obstacle to sensible financial reform and effective policy making. On the left, calls for greater regulatory controls on unfettered markets and populist uprisings, as in London presently. Over the past year, global currency valuations wars have become the source of new international tensions as major states accuse each other of “competitive devaluation” to boost exports. In cyberspace, nations worry powerful computer attacks on essential systems could one day spark war, with conflicts over cyber-spying already fueling mutual distrust among major powers.

It’s unlikely that nations can genuinely pull back from globalized systems on which they have become reliant. “The Net sees censorship as damage and routes around it,” computer science guru John Gilmore said in 1993. In the modern, high-speed globalized system, one could say the same of attempts at financial and economic restrictions. Many areas of the global economy have also become effectively “ungoverned space” into which a host of actors — from criminals to international firms such as Google and Goldman Sachs, to countless other individuals and groups — have enthusiastically jumped. Transnational corporations and global billionaires move money… Read more here.

Source:   Reuters, FT, NY Times                                 Cartoon:   Bill Day/MSNBC.com

Let’s face what we all know by now: the Republicans have fallen off the deep end. In the Republican-controlled House of Representatives, an idea once confined to the conservative ‘wingnut’ fringe of the Republican party has morphed into the party’s mainstream – the belief that intentionally allowing a Federal default on paying the National debt might be an acceptable price to pay to make a political point by forcing the Obama administration to assume ownership of a fiscal mess created by the previous Republican president. Just to be clear that I am not simply being partisan or shifting blame here, the national debt DOUBLED under George W. Bush from $5Tn when he took office to $10Trn when he left. That means it took George Bush just five years to spend, what it took all previous presidents 200 years to do.  See for yourself, here, and here.

And increasingly Republicans – some say for cynical partisan reasons – are rejecting President Obama’s  $4.4 Trn Debt Reduction Plan and its dire predictions of economic “catastrophe” if the debt limit is not increased. They argue a period of technical default can be managed without plunging markets into chaos. But judging by the dire economic catastrophe in states that are controlled by Republicans such as Wisconsin, Ohio, Arizona and Texas – Rick Perry’s ‘Texas Miracle,’ really wasn’t – Americans should think carefully about the consequences to our way of living, and what happens when Republicans implement their draconian economic schemes — something George H.W. Bush(41) called ‘voodoo economics’ — that give unecessary tax cuts to the wealthy, billion-dollar bailouts to Wall Street and Big Oil, and tax loopholes to corporations that ship good-paying American jobs overseas, while ordinary working and middle-class Americans suffer. See more on Republican economics here.

WSJ: Moody’s Warns on US Debt

Establishment Republicans including Tim Pawlenty, the former Minnesota governor who announced his presidential candidacy last month, are backing a short-term default if it leads to deep, immediate spending cuts. Jeff Sessions and Paul Ryan, the top Republicans on the Senate and House Budget Committees, have also said failure to raise the debt limit would not trigger immediate catastrophe. Republican Senator Pat Toomey has even introduced legislation directing the Treasury to prioritize debt service over other payments if the debt limit is not raised. It has 22 Republican co-sponsors in the Senate and 98 in the House of Representatives, although no members of the Republican leadership have backed it.  David Frum, a former speechwriter for President George W. Bush and a Republican advocate for raising the debt limit, said he holds regular question-and-answer sessions with Republican congressman over a beer.

“I have yet to meet one Republican who actually says a failure to raise the debt limit scares them,” Frum said. “It is deeply, deeply troubling the number of Republicans I now talk to — and I include the mainstream — who think a technical default is manageable. Many on Wall Street disagree – myself included. And so does Donald Trump, See the video below…

Source: Reuters, WSJ                           Cartoon: Newsday/UPS by Wes Handelsman

President Barack Obama arrived in Europe this week beginning a six-day trip that seeks more resources to promote and support the pro-democracy movements in the Middle East and North Africa that has emerged as a priority on the international agenda. President Obama began in Ireland where he visited the birthplace of his great-great-great-grandfather in Moneygall, a town with a population of about 300. He  delivered remarks at Trinity College in Dublin and met with Irish President Mary McAleese and Prime Minister Enda Kenny on Monday.  The six-day trip is anchored by President Obama’s official State visit hosted by the Brits, and an address to the UK Parliament on Wednesday, May 25 in where the president will seek to reaffirm and refine the trans-Atlantic alliance amid economic and political upheaval. The president’s remarks to Parliament will seek to ‘reframe’ the US-European relationship, said Heather Conley, director of Europe Program at the Center for Strategic and International Studies in Washington.

He also will attend a meeting of leaders from the Group of Eight (G-8) nations in Deauville, France at which the battle over IMF succession, and turmoil in the Middle East and North Africa will be a prime topic. On the IMF succession issues, France’s finance minster, Christine LeGarde is the front runner. However, several emerging nation candidates have also been suggested central bank governors such as Mexico’s Agustin Carstens; South Africa’s Trevor Manuel; and China’s Zhou Xiaochuan. Also at the top of the agenda are plans for accommodating and integrating Africa into the global economic framework.  Sub-Saharan Africa is home to 1 billion people, and according to the United Nations, that number is estimated to increase to 1.8 billion and account for 20% of the world’s population by 2050.  Along with China’s recent interest in the ‘Dark Continent’, this impending growth has stimulated greater Western interest in Africa’s emerging markets and governance. The 2011 G8 discussion will focus on opportunities in Africa and explore means to encourage the development of the private sector.  With the US as a primary investor, and half of its investment portfolio in Africa, the Millennium Challenge Corporation (MCC) is an important voice in this week’s G-8 conversation.  The MCC is building capac­ity, strengthening relationships, improving the business environment, and creating opportunities for increased bilateral trade with these emerging African economies.  “This is a very important trip for the president to reaffirm our core alliances in the world,” Ben Rhodes, deputy national security adviser, told reporters in a May 20 preview of the president’s trip. Europe and the US are “bound by a set of values” that have resonance “at a time when we see people reaching for those values around the world,” he said.

Interactive Media: Live Updated Coverage of the Deauville G-8 Summit

Another goal of the G-8 summit in Deauville, France, on May 26- 27 will be an expected agreement drawing from the president’s address last week which framed US policy in the wake of pro-democracy movements sweeping through the Mid-East region, said Michael Froman, Obama’s deputy national security adviser for international economic affairs. The president will ask G-8 member countries to support “financial stabilization, modernization and reform of the economies in the region,” he said.  President Obama has proposed $2 bn in US assistance for Egypt, $1 bn in loan guarantees through the Overseas Private Investment Corp (OPIC), and cancellation of $1 bn in debt, about a third of what Egypt owes the US. The administration plans to work with Congress to create “enterprise funds” to invest in Tunisia and Egypt, modeled on similar funds that supported democratic transitions in Eastern Europe.

The US also is asking the World Bank (WB) and International Monetary Fund (IMF) to present a plan at the G-8 summit for what needs to be done to stabilize the economies of Egypt and Tunisia, Obama said. He also wants the European Bank for Reconstruction and Development to refocus on aiding the region and for the US and European Union to promote increased trade opportunities.

The trip comes on the heals of President Obama’s address to AIPAC – a pro-Israel lobby interest with a disproportionate influence on US foreign policy – where he repeated a pre-existing US policy that long-stalled peace talks should start on the basis of the Israel’s 1967 borders, an assertion that had infuriated Israeli leaders, exposed a rift between the two allies although this was a reiteration of pre-existing US policy under two previous administrations.

But President Obama’s speech to Washington’s powerful pro-Israel lobbying group on Sunday seemed to soothe contrived ‘tensions’ with Jewish voters. The president stressed that he expected the two sides to eventually reach an accord that included land swaps that would take into account the “new demographic realities on the ground,” signaling that Israel should be allowed to keep some Jewish settlements built on occupied land in exchange for land swaps. He also pressed Israel to “make the hard choices” for peace. An aide to Palestinian President Mahmoud Abbas said: “We appreciate President Obama’s stated position regarding a state on the 1967 borders, it is a step in the right direction.”

On Sunday, the President reiterated the “principles” he outlined on Thursday in a speech on Middle East upheaval. At issue is Obama’s explicit statement of previous administration’s Israeli policy. The proposal would call for negotiated land swaps for Israel to retain some large settlements in the West Bank. The President chided those who he said had “misrepresented” his position, a slap at Netanyahu, who had seized on the notion that he was being asked to return to 1967 lines while ignoring the president’s stipulation there would be land exchanges. “By definition, it means that the parties themselves – Israelis and Palestinians — will negotiate a border that is different than the one that existed on June 4, 1967. That’s what mutually agreed upon swaps means,” Obama said. “It allows the parties themselves to account for the changes that have taken place over the last forty-four years. … to take account of those changes including the new demographic realities on the ground.”

President Obama’s Israeli policy outline is consistent with policies by former Presidents George W. Bush in 2004; and Bill Clinton in 1999 saying it was “unrealistic” for Israel to return to old borders and suggesting it may keep settlement blocs under any peace pact by trading adjacent Israeli land tracts. Despite that, the president’s stress on pre-1967 borders put the United States formally on record as endorsing the old boundaries as a starting point, something the US embraced privately dating back to the Clinton administration. President Obama’s aim was to draw Palestinians back to the table and head off their UN statehood drive, after US brokered peace talks collapsed late last year when Netanyahu refused to extend a moratorium on settlement building in the West Bank.

Sources: Bloomberg, Reuters  Videos: Reuters, AP, WhiteHouse.gov

A power shift at the International Monetary Fund (IMF) in favor of Emerging Market nations has now set the stage for a fierce international battle over who should succeed Dominique Strauss-Kahn (DSK) as he battles well-publicized allegations of sexual assault in New York. The outcome of this struggle and may threaten the ‘gentlemen’s agreement’ between Western powers of Europe’s claim to the top post at IMF, while the US lays claim to the top post of the World Bank.  It has been an ‘understood’ arrangement since 1944. Christopher Swann of Reuters News Worldwide has written a brilliant synopsis of the fracas, here.

However, in an op-ed piece in the Financial Times of London, the noted Global investment strategist and PIMCO Co-CEO Mohamed El-Erian, argues that this ‘feudal system must be changed; and now is the time to do it. Without a credible and quickly-recovering IMF, Europe will face even more uncertain prospects, progress on structural reforms in advanced economies will recede, and the world will find it more difficult to integrate the rapidly growing emerging economies’ which are leading the World in global economic recovery. He makes a valid point.

This fracas lept unexpectedly into the spotlight with DSK’s arrest in New York on sexual assault charges, which has fueled speculation of his imminent resignation; while the current acting IMF Director, No. 2 man, John Lipsky – deeply steeped in IMF culture and in Wall Street banking – is unlikely to retain the top post beyond his 2012 tenure as the power struggle ensues.

Among Strauss-Kahn’s reforms he has instituted since his selection in 2007 as IMF Managing Director, has been major structural changes in voting & Board representation within the organization that has elevated China to No. 3 in voting power and given countries such as India, Russia and Brazil a greater voice.  Some IMF board officials, according to Reuters, say there is a push by some countries for a speedy resolution to DSK’s role — which would favor another European – while others cautioned against judging too soon, and in the interim work to implement a more transparent, though time-consuming, process. Strauss-Kahn, who was denied bail on Monday, and plans to fight the charges and allegations, which may stretch-out over months.  “No matter how it plays out, it is going to be very difficult for Strauss-Kahn to be an effective leader of the IMF,” said Eswar Prasad, a former IMF official now at the Brookings Institute, a think tank in Washington. In the US, the IMF’s biggest shareholder, officials said Strauss-Kahn was unable to carry on being chief of the global lender from a jail cell, whatever the legal outcome. US Treasury Secretary Timothy Geithner has called for an interim chief to be named, saying Strauss-Kahn “is obviously not in a position to run the IMF.” While Chilean Central Bank President, Jose De Gregorio, weighed in, telling the Financial Times in an interview published on the paper’s website that Strauss-Kahn should leave his post as IMF managing director.

LATEST DEVELOPMENTS

The IMF, whose shareholders are 187 member countries, has two choices in replacing DSK quickly: (a) Retain its feudalistic approach led by economies who no longer have the economic clout they once did, or (b) implement an open, representative, merit-based selection process based on clear criteria and a transparent process, with greater say by emerging economies which are more relevant in today’s global economy. German Chancellor Angela Merkel said on Monday that while it was not yet time to discuss succession, there was a good case for a European to be in the job. Germany pointed to the debt crisis that has engulfed Ireland, Greece and Portugal in pressing its argument that a European could bring a fuller understanding of one of the world’s most pressing economic problems.  Strauss-Kahn has been deeply involved in talks over European Union and IMF bailouts for debt-strapped countries.  In fact, one of his signature achievements has been reforming the IMF’s voting structure to give emerging market economies more power.  In the past, emerging economies had not been unified enough to put forward a consensus candidate. Some think this time could be different.

As a result of the prospect of tensions between developed and emerging economies in the IMF Board structure, some have recently floated PIMCO’s Mohamed El-Erian, as a possible appeasement. However, El-Erian  this week said he has no desire to head the IMF if its managing director, Dominique Strauss-Khan, resigns over the sex assault allegations.  El-Erian says the  selection process of a new IMF chief has to change now or the fund won’t have the credibility to help Europe overcome its problems. If the fund wants to gain legitimacy among emerging economies, he continued, the IMF needs to be more representative and reflect the current nature & composition of the global economy of nation’s the position has to be open to candidates of all nationalities, more transparent, and a merit-based selection process for the new IMF chief. Stay tuned…

Source: Reuters, FT                                        Video:

The world’s three major credit rating agencies won a HUGE legal decision by the dismissal of lawsuits seeking to hold them responsible as ‘underwriters’ for aiding & abetting investment firms to structure and assign false ratings, then sell the same securities to unwitting investors that were not worth the ‘AAA’ ratings they were assigned.  Wednesday’s ruling by the Federal Court of Appeals, 2^nd Circuit in New York was a victory for McGraw-Hill Co’s (MHP.N) Standard & Poor’s, Moody’s Corp’s (MCO.N) Moody’s Investors Service and Fimalac SA’s (LBCP.PA) Fitch Ratings. The decision was also previously upheld by three lower-Court decisions.

Rating agencies have been widely faulted – including by the US Congress – for contributing to the Global financial crises that began in 2007 by issuing high ratings on junk debt securities, such as credit default swaps (CDS) that proved risky, and which the noted investor, Warren Buffett, called ‘financial weapons of mass destruction.’ The ratings agencies have come up with an ingenious defense by arguing their ratings were ‘opinion’ protected by free speech protections of the First Amendment.

In Wednesday’s case, plaintiffs including public & private pension funds who invested the retirement assets of workers all over the United States, State treasurers and other investors had between 2005 and 2007 bought more than $155 billion of mortgage-backed and other securities, including many with the highest “triple-A” ratings, that lost value when they were later downgraded. This ruling is a set-back for ordinary working Americans, the Middle-class, and individual investors everywhere.  Read more here.

Source:  Reuters                               Cartoon:  Washington Post

Secretary of State Hillary Clinton and US Treasury Secretary Tim Geithner play host this week to the third round of a newly formed bi-lateral talks between the US and China. This is the first time the so-called US-China Strategic and Economic Dialogue (SE&D) is being held in the US.  The purpose of the talks, Geithner said in his opening comments on Monday, is to look for opportunities to build closer economic ties between the World’s two leading economic powers. The two sides will also “address areas of concern” and to ” share perspectives on the major challenges facing each of [our two countries] at home as well as in the broader global economy,” Geithner added. “I believe we are making significant progress in strengthening our economic relationship.”  The two-day S&ED is co-chaired by Chinese Vice Premier Wang Qishan, State Councilor Dai Bingguo; and representing the US, Secretary of State Hillary Clinton and Treasury Secretary Timothy Geithner.  Geithner said that the key challenge that the US economy is facing remains the high unemployment, currently at 9.0%.

Interactive Media:  Jim Rogers, Founder/CEO – Quantum Fund

“Even after a year and a half of positive economic growth and more than two million private sector jobs created — unemployment is still very high, and we still have a lot of work to do in repairing the damage caused by the crisis,” Geithner noted in his remarks at the joint opening session of the S&ED. “Our challenge is to strengthen the foundations for future economic growth. This requires a sustained effort to improve education and improve incentives for innovation and investment, even as we put in place the long term fiscal reforms that force us once again to live within our means as a nation.” Geithner noted that cooperation between the US and China contributed in “no small part” to the global recovery. And the continuing effort of working together will benefit the sustaining growth of the world.

China is our nation’s second-largest trading partner and its third-largest export market, with bilateral trade totaling about $457 Bn (US) in 2010, with China carrying a $273 Bn surplus over the US, according to the Commerce Department.

According to a Brookings Institute analysis, Expectations for the US-China Strategic & Economic Dialogue meeting are muted – a good sign that reveals a maturing US-China relationship. The focus has shifted to making methodical progress on issues between the two nations, rather than on resolving major conflicts or arriving at dramatic breakthroughs. There are of course differences in the objectives of the two sides and different perceptions of what constitutes progress. This enhances the value of the S&ED dialogue even if there are few high-profile successes. The sometimes bellicose rhetoric between these two vital economic powers has ratcheted down as progress has been made on some of the most visible points of tension. The currency issue continues to fester but recent developments have transformed this into a problem for the rest of the world rather than just between the US and China. However, there are storm clouds gathering on the horizon as more fundamental and contentious issues, with high stakes on both sides, come to the fore. For the US, concerns over China’s manipulation of its currency, human rights violation, copyright infringement & piracy, and the “imbalance” between the US and China evidenced by a huge trade surplus, and US concerns over the leverage China holds in World Markets with almost $2 Trn in US Treasury reserves.

For China, they are pushing for greater access to US technology products & expertise, freer access to US Markets for Chinese FDI, formalized in a bi-lateral investment treaty between the two nations, their concerns that tepid US economic policy & financial regulatory reforms could worsen the sluggish global recovery, and China’s desire to be recognized as a ‘Market economy’ by the US in order to gain greater WTO liberalized trade preferences with member nations. See Geithner Q&A video here.

The Global Markets reaction to the news about the capture and killing of Osama bin Laden (OBL) last week, was a momentary blip over concerns about spikes in oil & commodity price, and the oft-quoted “uncertainty” about terrorist Blowback in Western centers about his killing. But I found especially prescient a piece I saw in Time magazine, posted below, and written by the noted Global Market Strategist and PIMCO Co-CEO, Mohamed El Erian — someone whom  I’ve written about here on a number of occasions.  See here, and see video here.   In it, El-Erian argues that the capture and killing of OBL certainly doesn’t mean an immediate end to the terrorist threat, but rather it will lead to an abatement of the threat. Which in turn means we can draw down in Afghanistan, and turn more time, attention and resources to fixing the sluggard American economy. I agree with him.  See more below…

‘One of the most notable outcomes of the dramatic news that Osama bin Laden has been killed is the feeling of unity across the American political and social spectrums. The event has triggered a shared sense of achievement, pride and common purpose. It is a mood that the U.S. has not felt for years as increasingly polarized political debates, on both serious and trivial issues, gradually gutted the operational middle of the country’s political system.

Interactive Media:  Photo Gallery of Americans Celebrating OBL Killing.

After initial excitement, this moment of unity has largely been shrugged off by global markets as investors worry about the immediate risk of terrorist backlash and, more generally, the continued sense of malaise in the American economy. Yet bin Laden’s death has the potential to become a turning point for the country, and for President Barack Obama in particular, if the spirit of cooperation can be translated into broad-based, bipartisan progress on economic issues that are central to the long-term well-being of the country and the world. (See TIME’s video “Inside the Raid to Kill Osama bin Laden.”)

Unemployment remains stubbornly high. Youth joblessness is at alarming levels, with too many of the country’s teenagers getting close to the point where they go from being unemployed to being unemployable. Various budget constraints have limited the scope for easy solutions, even if these were desirable. The debt and deficit dynamics are bad and deteriorating at both state and federal levels. A major rating agency, Standard & Poor’s, has already taken the previously unthinkable step of placing the country’s AAA credit rating on negative outlook. And Americans can no longer rely on their central bank for yet another round of imaginative pump priming to buy them time, options and flexibility.

Interactive Media: The Economist – ‘What’s Wrong With America’s Economy..??‘

In effect, America can’t buy itself out of its economic problems, nor can it again kick the can down the road for much longer. Meanwhile, the rest of the world continues to outpace the U.S. in growth, competitiveness and wealth creation.

These structural problems were years in the making, and they require structural solutions that will need to be implemented steadfastly for a number of years. Read more here.

Source: Time magazine, The Guardian (UK), Financial Times of London

Video:  Time.com, CharlieRose.com, ABCNews.com

The United States Dollar became the global reserve currency of choice via the Bretton Woods agreement after WWII. However, when Republican President Richard M. Nixon took the United States off the Gold Standard in 1971, the US Dollar – the Greenback – became a ‘fiat’ currency; that it is, it was backed only by the “full faith & credit” of the US Governments implied “promise” to repay.  But the mighty US Dollar doesn’t have much clout these days; and I’ve written as much on many occasions here on the Global Markets blog. The Greenback has lost nearly 15% of its value against foreign currencies since the precipitation of the global financial crisis in 2008, and almost 5% since the end of last year. As a result, in 2010, Central Banks around the World became net buyers of Gold reserves for the first time in two decades, adding 87 metric tons of gold in government purchases by countries such as Saudi Arabia, Brazil, Cuba, South Korea, Bolivia, India, Russia and Nigeria, according to World Gold Council data. Interestingly, OPEC which denominates its oil reserves in US Dollars, has recently floated the notion of ditching the Greenback in favor of either the Euro or Gold as an alternative reserve denomination. Consequently, as the value of the US Dollar continues to slide, the World is bullish on Gold.  China, with more than $3 Trn in foreign currency reserves, plans to set up new sovereign funds to invest in precious metals.  Russia alone bought 8 tons of gold in 1^st Q 2011.  As developing countries accelerate purchases, gold may reach $2,000 per ounce this year, compared with a record of $1,569.80 at Friday’s close in New York said Robert McEwen, the CEO of US Gold Corp.  “China is out to have more gold than America, and Russia is aspiring to the same,” McEwen said last week in an interview at a Bloomberg Link conference in New York. “When you have debt, you don’t have a lot of flexibility. China wants to show its currency has more backing than the U.S.”  Likewise, Euro Pacific Capital’s Michael Pento, who correctly predicted gold’s highs for the past two years, forecasts a 2011 high of $1,600 per troy ounce.  Gold prices reached record highs 15 times last month on demand from investors seeking an alternative to the US Dollar  after the currency slumped to its lowest levels since 2009, U.S. debt widened, and the Federal Reserve signaled April 27 that borrowing costs will remain near zero percent for an extended period.  Comparatively, China’s economy, the largest foreign holder of US Treasury notes, grew 9.7% in 1^st Q 2011.

Meanwhile, Economists in every quarter are debating the end of the era of the dollar, while news organizations paint the Greenback as a 98-pound weakling – wet! Our so-called ‘fiat’ currency, backed only by the full faith and credit of the government, no longer commands respect, as Republican lawmakers threaten intentional default, and Congress debates whether to raise the national debt limit in order to avoid payment default on our outstanding debt as of July 8, 2011.

Interactive Media:  World Gold Reserves vs US Dollar

There are other consequences, however, that we’re missing in the debate over all this red ink. Our budget deficit, as well as the Federal Reserve’s ballooning lending programs and other financial obligations, will accelerate a process already well underway — a changing role for the U.S. dollar in the global economy. The domino effect is straightforward: Higher deficits spark market concerns over future inflation; concerns of inflation contribute to a weaker dollar; and both come together to undermine the greenback’s role as a reliable store of value around the world.  So if the World boots the US Dollar, how would that affect our average daily lives as Americans..?? How do we hedge against fluctuations in the Greenback..?? Barry Eichengreen of the Washngton Post wrote an interesting analysis on that question. You can read more on that here.

Similarly, the Economist magazine’s latest cover issue is titled, ‘What’s Wrong With America’s Economy?’ and it’s a brilliant synopsis from an outsider’s perspective of what’s wrong, and what needs to be done to fix it. Among several issues raised that I found prescient is the propensity across the nation to incarcerate a large – and a racially disparate – segment of its citizens, which among other things drives the influx of illegal immigration, which has an increasingly burdensome impact on government spending at all levels.  You can read more on that here.

As I’ve been prognosticating for several years now – many of my clients still recall I was touting ‘Buy Gold!’ beginning back in 2001 when I was with Morgan Stanley and gold was selling at $374/oz – the era of the US Dollar as the global reserve currency of choice is over. Like it or not, out of the ashes of this national fiscal debacle, a new, more stable global reserve system is emerging. And for the world as a whole, as well as for the US, this could be a good thing. It would lead to a more stable worldwide financial system and stronger global economic growth. The current system entails developing countries putting aside hundreds of billions of dollars a year in currency reserves (US Treasury notes) that can be better spent on their infrastructure and economic development. But doing so only weakens global demand – often for US products – and contributing to our economic difficulties. And just ethically, there is something a little unseemly about poor and developing countries countries lending us trillions of dollars, that stunts their growth; and now at an rate of return close to zero.

Discussions on the design of a new system are already underway. The United Nations’ Commission of Experts on Reforms of the International Monetary and Financial System – a body chaired by my former Columbia professor and Nobel-winning economist Joseph Stiglitz, and which included economists, former and current government officials, financial sector participants, central bankers, and business leaders from Asia, Europe, the US, Africa, and Latin America – has argued that a new global reserve currency system may be the most important reform to ensure the long-term health of the global economy; it also suggested how to design an orderly transition from the dollar-based system.

In its interim report in June, the commission described a number of alternatives. Some involve building on the International Monetary Fund’s “special drawing rights,” or SDRs – a currency whose valuation would be based on a “basket” or index of several World currencies, a kind of “IMF money” – but making the issuance of this global reserve money annual and more predictable. (Currently, issuances of SDRs are small and irregular.) Other proposed reforms are more complex and ambitious, such as using China’s Renmenbi or the Swiss Krona as an alternative to the Greenback.

The US has resisted these changes, but change will come inevitably, and it’s better for us to participate in the construction of a new system than have it happen without us. We have seen many benefits and great advantages with the dollar as the world’s reserve currency of choice, particularly the ability to borrow at low interest rates seemingly without limit. But we haven’t seen the costs & consequences as clearly: inevitable trade deficits, susceptibility to foreign interests (eg, China), the economic instability, monetary policy & currency wars (eg, Quantitative Easing), huge global imbalances (eg, China vs. US economic recovery), etc. The benefits to us as Americans are likely to shrink, and rapidly so, as global central banks shift their reserves away from the Greenback and toward, for now, Gold stockpiles. It is happening already, and the process is likely to accelerate. Chinese authorities, for example, have openly expressed concerns about the value of the country’s vast dollar reserves. Not surprisingly, China, Japan, Australia, Brazil and other nations holding lots of US debt (Treasury notes) are leading the efforts in the appropriate global forums to build a new system.

In my view, we should show leadership in helping to shape this new structure and managing the transition, rather than a reactionary resistance to what is inevitable. We may have preferred to keep the old system, in which the Greenback reigned supreme, but by the greed and irresponsibility of few, we have abdicated the throne. That’s how I see it: what do you think..??

Source: Economist, Washington Post, Bloomberg, Fire Dog Lake    Chart: WGC.com