June 29, 2011 11:01 pm

Germany is the loser from Greece’s wriggle

By Derek Scott


Wednesday’s vote in Greece may have gained the leaders of the European Union a bit more time, but it has certainly put up the eventual cost of the crisis, not least to Germany. More than 20 years ago, Nicholas Ridley was forced to resign from the British cabinet for describing economic and monetary union as a “German racket”. The assertion was unfair to Germany but, even today, there is a consensus that it reaps huge benefits from Emu. This was only ever partially true; it is no longer true at all.


German manufacturing has certainly benefited from Emu and earlier from the exchange rate mechanism, both of which were used to maintain the competitiveness of its manufactures. However, this was at the expense of German consumers and taxpayers. In so far as Mr Ridley’s “racket” had substance, it reflected an implicit collusion between German manufacturers, bankers and politicians. Certainly, outside Emu, the likely appreciation of the Deutschmark would have made German manufacturers less competitive, but this would have stimulated the expansion of other (underdeveloped) sectors of the economy, raising economic growth and living standards.


German export success is reflected in its current account surplus, but this has been recycled into other countries within Emu, including Greece. Emu replaced exchange rate risk with credit risk but, encouraged by pro-Emu disinformation markets, mispriced credit risk. Emu was, above everything, a credit bubble. Well, the credit bubble burst and, when that happens, usually creditors get hurt – but not within Emu where taxpayers are, in effect, bailing out German and other EU banks.


At some stage the creditors will pay: it is a matter of how and when. None of the proffered solutions to the Emu crisis will work because they do not address the nub of the problem. It is not primarily a crisis of deficits and debts but rather centres on the problems created when countries lose competitiveness within a monetary union. The Emu prescription is, in effect, two-thirds of a traditional IMF package – reduced expenditure and increased taxation – without the final third – currency depreciation. This only makes things worse.


Bail-outs, however large, will not work since they do not address the loss of competitiveness (though they do make possible the transfer of risk from banks to taxpayers). Nor does debt restructuring or rescheduling or asset sales, which provide only marginal relief (since the single benefit is the differential income stream from assets being transferred from public to private sectors).


Economic reform is no “solution” either. Economic reforms are necessary in several of the countries in crisis. However, the initial impact of economic reform often appears to make things worse as unproductive capital is closed down and labour is shed, and this needs to be offset by slacker monetary policy. However, as the benefits of reform come through, monetary policy needs to adjust to the rise in anticipated rates of return. In Emu, it is not possible for an individual country to adjust its monetary policy in order to reap the benefits of reform.


Holding the current Emu together requires transfers (“gifts”) from the current account surplus countries to those with deficits, so the latter are spared the cost of attempting to restore competitiveness through deflation. In effect, this means transfers in perpetuity from Germany, not dissimilar to the transfers to East Germany but on a far larger scale. This would wreck Germany’s economy and its public finances.


Germany’s politicians seem blind to the implications of its policies: more “austerity” and “more lending”. The former will make things worse and the latter just postpones the reckoning. The cost to Germany of default now and rescuing its banking system is certainly less than after further depression and later default by Greece and other peripheral nations. Political turmoil in Greece is one thing, but when the German people understand the cul-de-sac into which their leaders have taken them in the name of “Europe” the repercussions will be more serious. Emu is a disaster for Europe and Germany.


The writer was economic adviser to Tony Blair from 1997-2003 and is vice-chairman of Open Europe
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Copyright The Financial Times Limited 2011.

REVIEW & OUTLOOK

JUNE 30, 2011.

The French Deception


Europe's latest Greek debt scheme is one more political evasion. 


If it's Thursday it must mean that Europe is out with another scheme to delay its eventual reckoning with Greek insolvency. This one comes courtesy of France and is, no surprise, tailor-made to help French and German banks. Unfortunately it leaves Greece in a worse fiscal position and increases risk to European taxpayers and other investors in Greek debt.


The ratio of Greek debt to GDP is now 155% and is slated to peak at 170% next year, which is another way of saying that this is too big a problem to grow out of. Even with the European Union and International Monetary Fund plowing billions into Greek coffers and Greek politicians cutting budgets in the midst of a sharp economic contraction, the prospects for avoiding default are slim to none.


The best path to recovery for Greece and the EU would be to recognize that Athens is broke, to restructure the debt to levels that Greece can realistically pay, and then let markets punish Greek profligacy by denying the government access to capital at good rates until it accomplishes the necessary reforms.


French President Nicolas Sarkozy is resisting this path—for reasons that we will get to in a minute. Instead he wants to offer bond holders the chance to voluntarily roll debt maturing between 2011 and 2014 into 30-year paper. Under the only scenario that investors are likely to accept, a little more than half of the face-value of a €100 bond would be redeemed for cash and a triple-A, sovereign, zero-coupon bond. The rest (€49) would be reinvested in a 30-year Greek bond with a coupon that is higher than what they now receive and is tied to GDP growth. As an example, new bonds would pay an average effective interest rate of 10% if Greece grows at 2% a year.

Creditors who accept the plan will instantly reduce their exposure to Greece by more than 50% and almost double their return even with very low growth rates. (What's French for "a gimme"?) Yet neither Greeks, nor European taxpayers nor other bond holders will fare so well.


Let's start with what happens to Greece: It gets more debt. Because the new bonds will replace bonds with an interest rate of 4.5%-5% annually, the cost of servicing the new debt will double. This interest rate differential means that over the 30-year life of the new bonds, the burden of this debt doubles. Trying to understand why the EU would want to take an unsustainable debt burden and make it worse is, well, Greek to us. This week's riots and yesterday's narrow victory in Athens for another austerity package shows where this will lead.


But Greeks are not the only losers. The bond holders of other maturities will also suffer because the probability that Greece will eventually default will go up, as will the odds of a lower recovery value on the bonds. Meanwhile, European taxpayers, along with the IMF, will be asked to continue shoveling money into Greece, on the premise that it can dig itself out of a hopelessly deep hole.


Neither France nor Germany can defend this plan on grounds that a Greek default would destroy their banks. Of the €285 billion total bonds outstanding, French and German banks are estimated to hold a combined €28 billion. That's the most of any banking system outside of Greece. Still, even a 50% write-down would not destroy these banks. BNP Paribas is the largest private holder of Greek debt outside of Greece, and in May CEO Baudouin Prot said that a 30% write-down of its Greek holdings would reduce its earnings per share by only 3%.


So why not let Greece fail so it can recover faster? One answer lies in the French and European Central Bank conviction that a Greek restructuring would drive contagion. Portugal and Ireland will next ask to give their creditors haircuts, the theory goes, causing large losses for Spanish banks that will have to be recapitalized by the Spanish government.

If that bankrupts Madrid, huge losses will ripple across the European financial system. Then French and German taxpayers might have to recapitalize their banks—an unhappy prospect for Mr. Sarkozy with elections in the offing.


These are reasonable concerns but far from certain, and they are containable if European leaders had the wit and will to work out loss-sharing debt accords for Ireland, Spain and the rest. It also isn't clear how raising the cost of Greek debt alleviates the problem. Instead, this proposal appears to be a political bargain. Germany and the Netherlands have been insisting that private creditors shoulder some of the burden. With its proposal, France can say it has included private creditors toward what it calls a solution.


But perhaps someone can tell us how creditors are sharing any pain when they take out half of their investment and double their return on the remainder?


Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved

June 29, 2011 11:24 pm

China can yet avoid a middle-income trap

By George Magnus
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The Chinese Communist party will celebrate its 90th anniversary on July 1 with a pride that testifies to the pragmatism it has shown since Deng Xiaoping determined to lift the nation out of poverty some 30 years ago, and set a course to make China what it is today. But the party also faces three huge challenges that should make us wonder what the country will be like when the centenary comes round.


First, China will this decade make the transition from a borderline to a fully fledged middle-income country, with per capita income rising more than three times to about $13,000. This will be a quite different experience from the trebling of per capita income that has occurred since Deng, because richer, more complex economies need high-quality institutions, especially in the legal arena, to sustain human development. This is far more important than national output, steel production or any other metric.


In their absence, countries get stuck in a middle-income trap – as evidenced by Argentina, Venezuela and the former Soviet Union. The Fraser Institute ranks China’s institutional quality 82nd in a group of 141 countries. While it scores well in size and efficiency of government, it is weak in other areas, particularly regarding the rule of law and neutral legal institutions. The problem with reform in this area is that it clashes directly with the primacy of the CCP party over both the state and the judiciary.


Second, China is in the throes of a leadership change which, while carefully orchestrated, is exposing political and ideological struggles, not least for membership of the State Council. The revival of Maoism by some of the “princelings”, the revolutionaries’ children, is significant.


Uncertainty is already apparent in foreign and domestic policies that sometimes reflect an assertiveness that derives from economic power, and sometimes a latent sense of insecurity that speaks to angst about both the party’s own legitimacy and rising social tensions. The escalation of the latter has resulted in a sharp crackdown on human rights activists and lawyers. Meanwhile, internal rivalries lie behind an intrusion of the military, state-owned enterprises and regional party elites into many areas of policymaking that is heightening political uncertainty.


In the international security arena, a more truculent China has already emerged over the past two years. Posturing to Japan, South Korea and the US, complex relations with North Korea and Iran, and the courting of Pakistan – plus, to India’s chagrin, the construction of naval facilities – all have a sharper edge nowadays and point to tensions that detract from a crucial domestic agenda.

Third, China is at a crucial economic juncture. It has to attend to rising inflation in goods and property prices, rooted in the sharp rise in recourse to credit, sometimes of questionable quality, to finance high investment and growth. The political will to attack the underlying causes of inflation is weak, however, and there is no desire to use market mechanisms to set interest rates and the appropriate price of capital.


China must also press on with rebalancing; that is, the move away from an investment-centric growth model to one based on consumption and services. This is a complex task, liable to lead to pronounced economic volatility – and it is also intensely political. It entails redistributing power from those who have benefited to date – companies, coastal regions, the military and provincial party elites – to those left behind, including consumers, migrant workers and the countryside, on which 780m citizens still depend for their livelihoods.


In line with the Chinese proverb about crossing the river by feeling the stones, economic and financial policies change slowly. But, contrary to recent assuring statements from Wen Jiabao in this column, inflation is not yet beaten, and there is little evidence that successful rebalancing is occurring. If anything, investment is holding up too well, while households are compromised by rising inflation and financial repression. More than 40 per cent of household wealth is held as bank deposits, on which the real interest rate stands currently at -2.3 per cent.


Incremental change, however, will not substitute for institutional change and this is the CCP’s greatest challenge for the coming years. It has pulled China out of poverty with unprecedented speed and success by being smart and flexible. But in steering it to become a middle-income nation, it will need far more of the latter quality if, in aspiring to high-income status and global leadership, it is not to fall at what we might call a Bric wall.


The writer is senior economic adviser at UBS and author of Uprising: will emerging markets shape or shake the world economy?


Copyright The Financial Times Limited 2011.

06/30/2011

Deal in Sight

German Banks Agree to Billions in Greek Debt Relief

The Seattle Plot: Jihadists Shifting Away From Civilian Targets?

Created Jun 30 2011 - 03:53

By Scott Stewart

On June 22 in a Seattle warehouse, Abu Khalid Abdul-Latif pulled an unloaded M16 rifle to his shoulder, aimed it, and pulled the trigger repeatedly as he imagined himself gunning down young U.S. military recruits. His longtime friend Walli Mujahidh did likewise with an identical rifle, assuming a kneeling position as he engaged his notional targets. The two men had come to the warehouse with another man to inspect the firearms the latter had purchased with money Abdul-Latif had provided him. The rifles and a small number of hand grenades were to be used in an upcoming mission: an attack on a U.S. Military Entrance Processing Station (MEPS) in an industrial area south of downtown Seattle.


After confirming that the rifles were capable of automatic fire and discussing the capacity of the magazines they had purchased, the men placed the rifles back into a storage bag intending to transport them to a temporary cache location. As they prepared to leave the warehouse, they were suddenly swarmed by a large number of FBI agents and other law enforcement officers and quickly arrested. Their plan to conduct a terrorist attack inside the United States had been discovered when the man they had invited to join their plot (the man who had allegedly purchased the weapons for them) reported the plot to the Seattle Police Department, which in turn reported it to the FBI. According to the federal criminal complaint filed in the case, the third unidentified man had an extensive criminal record and had known Abdul-Latif for several years, but he had not been willing to undertake such a terrorist attack.


While the behavior of Abdul-Latif and Mujahidh in this plot demonstrates that they were amateur “wannabe” jihadists rather than seasoned terrorist operatives, their plot could have ended very differently if they had found a kindred spirit in the man they approached for help instead of someone who turned them into the authorities. This case also illustrates some important trends in jihadist terrorism that we have been watching for the past few years as well as a possible shift in mindset within the jihadist movement.


Trends


First, Abu-Khalid Abdul-Latif and Walli Mujahidh, both American converts to Islam, are prime examples of what we refer to as grassroots jihadists. They are individuals who were inspired by the al Qaeda movement but who had no known connection to the al Qaeda core or one of its franchise groups. In late 2009, in response to the success of the U.S. government and its allies in preventing jihadist attacks in the West, al Qaeda in the Arabian Peninsula (AQAP) began a campaign to encourage jihadists living in the West to conduct simple attacks using readily available items, rather than travel abroad for military and terrorism training with jihadist groups. After successes such as the November 2009 Fort Hood shooting, this theme of encouraging grassroots attacks was adopted by the core al Qaeda group.


While the grassroots approach does present a challenge to law enforcement and intelligence agencies in that attackers can seemingly appear out of nowhere with no prior warning, the paradox presented by grassroots operatives is that they are also far less skilled than trained terrorist operatives. In other words, while they are hard to detect, they frequently lack the skill to conduct large, complex attacks and frequently make mistakes that expose them to detection in smaller plots.


And that is what we saw in the Seattle plot. Abdul-Latif had originally wanted to hit U.S. Joint Base Lewis-McChord (formerly known as Fort Lewis and McChord Air Force Base), which is located some 70 kilometers (44 miles) south of Seattle, but later decided against that plan since he considered the military base to be too hardened a target. While Abdul-Latif and Mujahidh were amateurs, they seem to have reached a reasonable assessment of their own abilities and which targets were beyond their abilities to strike.


Another trend we noted in this case was that the attack plan called for the use of firearms and hand grenades in an armed assault, rather than the use of an improvised explosive device (IED). There have been a number of botched IED attacks, such as the May 2010 Times Square attack and Najibullah Zazi’s plot to attack the New York subway system.


These were some of the failures that caused jihadist leaders such as AQAP’s Nasir al-Wahayshi to encourage grassroots jihadists to undertake simple attacks. Indeed, the most successful jihadist attacks in the West in recent years, such as the Fort Hood shooting, the June 2009 attack on a military recruitment center in Little Rock, Ark., and the March 2011 attack on U.S. troops at a civilian airport in Frankfurt, Germany, involved the use of firearms rather than IEDs. When combined with the thwarted plot in New York in May 2011, these incidents support the trend we identified in May 2010 of grassroots jihadist conducting more armed assaults and fewer attacks involving IEDs.


Another interesting aspect of the Seattle case was that Abdul-Latif was an admirer of AQAP ideologue Anwar al-Awlaki. Unlike the Fort Hood case, where U.S. Army Maj. Nidal Malik Hasan had been in email contact with al-Awlaki, it does not appear that Abdul-Latif had been in contact with the AQAP preacher. However, from video statements and comments Abdul-Latif himself posted on the Internet, he appears to have had a high opinion of al-Awlaki and to have been influenced by his preaching. It does not appear that Abdul-Latif, who was known as Joseph Anthony Davis before his conversion to Islam, or Mujahidh, whose pre-conversion name was Frederick Domingue Jr., spoke Arabic. This underscores the importance of al-Awlaki’s role within AQAP as its primary spokesman to the English-speaking world and his mission of radicalizing English-speaking Muslims and encouraging them to conduct terrorist attacks in the West.


Vulnerabilities


Once again, in the Seattle case, the attack on the MEPS was not thwarted by some CIA source in Yemen, an intercept by the National Security Agency or an intentional FBI undercover operation. Rather, the attack was thwarted by a Muslim who was approached by Abdul-Latif and asked to participate in the attack. The man then went to the Seattle Police Department, which brought the man to the attention of the FBI. This is what we refer to as grassroots counterterrorism, that is, local cops and citizens bringing things to the attention of federal authorities. As the jihadist threat has become more diffuse and harder to detect, grassroots defenders have become an even more critical component of international counterterrorism efforts. This is especially true for Muslims, many of whom consider themselves engaged in a struggle to defend their faith (and their sons) from the threat of jihadism.


But, even if the third man had chosen to participate in the attack rather than report it to the authorities, the group would have been vulnerable to detection. First, there were the various statements Abdul-Latif made on the Internet in support of attacks against the United States. Second, any Muslim convert who chooses a name such as Mujahidh (holy warrior) for himself must certainly anticipate the possibility that it will bring him to the attention of the authorities. Abdul-Latif and Mujahidh were also somewhat cavalier in their telephone conversations, although those conversations do not appear to have brought them to the attention of the authorities.


Perhaps their most significant vulnerability to detection, aside from their desire to obtain automatic weapons and hand grenades, would have been their need to conduct preoperational surveillance of their intended target. After conducting some preliminary research using the Internet, Abdul-Latif quickly realized that they needed more detailed intelligence. He then briefly conducted physical surveillance of the exterior of the MEPS to see what it looked like in person. Despite the technological advances it represents, the Internet cannot replace the physical surveillance process, which is a critical requirement for terrorist planners. Indeed, after the external surveillance of the building, Abdul-Latif asked the informant to return to the building under a ruse in order to enter it and obtain a detailed floor plan of the facility for use in planning the attack.


In this case, the informant was able to obtain the information he needed from his FBI handlers, but had he been a genuine participant in the plot, he would have had to have exposed himself to detection by entering the MEPS facility after conducting surveillance of the building’s exterior. If some sort of surveillance detection program was in place, it likely would have flagged him as a person of interest for follow-up investigation, which could have led authorities back to the other conspirators in the attack.


A New Twist


One aspect of this plot that was different from many other recent plots was that Abdul-Latif insisted that he wanted to target the U.S. military and did not want to kill people he considered innocents. Certainly he had no problem with the idea of killing the armed civilian security guards at the MEPS — the plan called for the attackers to kill them first, or the unarmed still-civilian recruits being screened at the facility, then to kill as many other military personnel as possible before being neutralized by the responding authorities. However, even in the limited conversations documented in the federal criminal complaint, Abdul-Latif repeated several times that he did not want to kill innocents. This stands in stark contrast to the actions of previous attackers and plotters such as John Allen Mohammed, the so-called D.C. sniper, or Faisal Shahzad, who planned the failed Times Square attack.


Abdul-Latif’s reluctance to attack civilians may be a reflection of the debate we are seeing among jihadists in places like Afghanistan, Pakistan and even Algeria over the killing of those they consider innocents. This debate is also raging on many of the English-language jihadist message boards Abdul-Latif frequented. Most recently, this tension was seen in the defection of a Tehrik-i-Taliban Pakistan faction in Pakistan’s Kurram agency.


If this sentiment begins to take wider hold in the jihadist movement, and especially the English-speaking jihadist community in the West, it could have an impact on the target-selection process for future attacks by grassroots operatives in the West. It could also mean that commonly attacked targets such as subway systems, civilian aircraft, hotels and public spaces will be seen as less desirable than comparably soft military targets. Given the limitations of grassroots jihadists, and their tendency to focus on soft targets, such a shift would result in a much smaller universe of potential targets for such attacks — the softer military targets such as recruit-processing stations and troops in transit that have been targeted in recent months.


Removing some of the most vulnerable targets from the potential-target list is not something that militants do lightly. If this is indeed happening, it could be an indication that some important shifts are under way on the ideological battlefield and that jihadists may be concerned about losing their popular support. It is still too early to know if this is a trend and not merely the idiosyncrasy of one attack planner — and it is contrary to the target sets laid out in recent messages from AQAP and the al Qaeda core — but when viewed in light of the Little Rock, Fort Hood and Frankfurt shootings, it is definitely a concept worth further examination.