Disaster Can Wait

Barry Eichengreen


SHANGHAI – Nowadays there is no shortage of pundits, economic or otherwise, warning of impending disaster. If right, they are hailed as seers; if wrong, chances are that no one will remember. So here’s a forecast: there will be no shortage of predictions that 2012 is shaping up as a disastrous year.

My view is different: 2012 will not be a year of crisis, but nor will it bring an end to our current economic troubles. Rather, it will be a year of muddling through.

Many people think that 2012 will be the make-or-break year for Europe – either a quantum leap in European integration, with the creation of a fiscal union and the issuance of Eurobonds, or the eurozone’s disintegration, igniting the mother of all financial crises.

In fact, neither scenario is plausible. The collapse of the eurozone would, of course, be an economic and financial calamity. But that is precisely why the European Central Bank will overcome its reluctance and intervene in the Italian and Spanish bond markets, and why the Italian and Spanish governments will, in the end, use that breathing space to complete the reforms that the ECB requires as a quid pro quo.

To be sure, Europe will not be spared the pain of a recession. A botched bank-recapitalization plan and the cloud of uncertainty hanging over the euro mean that recession is already baked in. Moreover, the pro-growth reforms needed in countries like Italy will almost certainly make things worse before they make them better. The initial effect of reducing hiring and firing costs, for example, will be layoffs of redundant workers. But investors look ahead, so reforms that promise an eventual return to growth should reassure them.

While the eurozone is unlikely to collapse in 2012, there will be no definitive answer to the question of whether the euro will survive, because there will be no quantum leap in European integration. Treaty revisions take time to draft – and more time to ratify. Efforts to strengthen Europe’s fiscal rules, for example, will take the form of bilateral agreements between governments, rather than changes in the European Union’s Lisbon Treaty.

It is a sad state of affairs when a recession qualifies as muddling through. But such is the European condition.

Consider next the United States. While recent data suggest that the economy is doing better all signs are that GDP will have expanded at a 3% annual rate in the fourth quarter of 2011 – it is important not get carried away.

Fiscal support for the expansion will continue to be withdrawn. And, while the housing market shows some signs of stabilizing, prices will remain weighed down by the large shadow inventory of homes in foreclosure and held by banks.

These considerations suggest that the acceleration of US growth that began in the third quarter of 2011 is unlikely to be sustained. At the same time, if growth slows significantly, the US Federal Reserve will undoubtedly respond with another round of quantitative easingQE3 by another name. Thus, while growth next year is likely to fall well short of 3%, the US should be able to avoid a double-dip recession.

Finally, China should grow by 7.5-8% in 2012. This is muddling through, Chinese styleconsiderably slower growth than the double-digit rates of the past, but not the hard landing that purveyors of doom and gloom warn is inevitable.

I am more pessimistic than institutions like the World Bank and International Monetary Fund, which anticipate Chinese growth in 2012 of 8.5-9%forecasts that do not take into account the sharp cooling of China’s housing market. Although weakening housing demand has not yet shown up in lower prices, the volume of transactions has fallen off dramatically. And where volumes lead, prices eventually follow.

Fortunately, China is still enough of a planned economy that officials can mobilize policies to cushion the impact. If construction plummets, for example, the authorities can reduce reserve requirements, as they recently did, thereby encouraging banks to lend to other sectors. And, if the European and US economies avoid the worst, Chinese exports will hold up.

Thus, if all of the global economy’s largest pieces fall into place, there is no reason why 2012 should be a disaster. But muddling through cannot continue forever. Europe needs to draw a line under its crisis and figure out how to grow. The US needs to overcome its political polarization and policy gridlock. And China needs to rebalance its economy shifting from construction and exports to household consumption as the main engine of growth – while it still has time.

Of course, if none of this happens – or if not enough of it does2013 could turn out to be the annus horribilis of the perma-bears’ dreams.

Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley. His most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar.

Copyright: Project Syndicate, 2011.

The Covert Intelligence War Against Iran

December 8, 2011 | 0952 GMT

By Scott Stewart

There has been a lot of talk in the press lately about a “cold war” being waged by the United States, Israel and other U.S. allies against Iran. Such a struggle is certainly taking place, but in order to place recent developments in perspective, it is important to recognize that the covert intelligence war against Iran (and the Iranian response to this war) is clearly not a new phenomenon.

Indeed, STRATFOR has been chronicling this struggle since early 2007. Our coverage has included analyses of events such as the defection to the West of Iranian officials with knowledge of Tehran’s nuclear program; the Iranian seizure of British servicemen in the Shatt al Arab Waterway; the assassination of Iranian nuclear scientists; the use of the Stuxnet worm to cripple Iranian uranium enrichment efforts; and Iranian efforts to arm its proxies and use them as a threat to counteract Western pressure. These proxies are most visible in Iraq and Lebanon, but they also exist in Yemen, Afghanistan, Syria, the Palestinian territories, Saudi Arabia and other Gulf states.

While the covert intelligence war has been under way for many years, the tempo of events that can readily be identified as part of it has been increasing over the past few months. It is important to note that many of these events are the result of hidden processes begun months or even years previously, so while visible events may indeed be increasing, the efforts responsible for many of them began to increase much earlier. What the activities of recent months do tell us is that the covert war between Iran and its enemies will not be diminishing anytime soon. If anything, with the current withdrawal of U.S. troops from Iraq and Iranian nuclear efforts continuing, we likely will see the results of additional covert operations — and evidence of the clandestine activity required to support those operations.

Ramping Up

All eyes were on this covert intelligence war after The New York Times published an article Jan. 15 reporting that the United States and Israel worked together to create and launch Stuxnet against the Iranian nuclear program.
The visible events related to the intelligence war maintained a relatively steady pace until Oct. 11, when the U.S. Department of Justice announced that two men had been charged in New York with taking part in a plot by the Iranian Quds Force to kill Saudi Arabia’s ambassador to the United States, Adel al-Jubeir, on U.S. soil.

In early November, a new International Atomic Energy Agency (IAEA) report was issued detailing Iranian efforts toward a nuclear weapons program. While this report did not contain any major revelations, it did contain new specifics and was more explicit than previous IAEA reports in its conclusion that Iran was actively pursuing a nuclear weapons program. The IAEA report resulted in an Israeli-led diplomatic and public relations campaign urging more effective action against Iran, ranging from more stringent sanctions to military operations.

Then, in the early afternoon of Nov. 12, explosions occurred at an Islamic Revolutionary Guard Corps (IRGC) ballistic missile base near Tehran, killing 17 people, including a high-ranking IRGC commander who was a critical figure in Iran’s ballistic missile program. Iran has insisted the blast was accidental, but speculation has since spread that the explosion could have been part of a sabotage operation carried out by Israeli intelligence. Israeli intelligence officials also have undertaken not-so-subtle efforts to ensure that outside observers believe they were responsible for the blasts.

Later on Nov. 12, the Bahraini government went public with the discovery of an alleged plot involving at least five Bahrainis traveling through Syria and Qatar to carry out attacks against government and diplomatic targets in Bahrain. Iran vehemently denied it was involved and portrayed the plot as a fabrication, just as it responded to the alleged plot against the Saudi ambassador.

The next day, the Iranian press reported that Ahmad Rezai, the son of Mohsen Rezai — who is the secretary of Iran’s Expediency Council, a former IRGC commander and a presidential contender — was found dead at a hotel in Dubai. The deputy head of the Expediency Council told the Iranian press that the son’s death was suspicious and caused by electric shocks, while other reports portrayed the death as a suicide.

On Nov. 20, the Los Angeles Times reported that U.S. intelligence officials confirmed the CIA had suspended its operations in Lebanon following the arrest of several of its sources due to sloppy tradecraft on the part of CIA case officers assigned to Beirut. Following this report, the Iranian government announced that it had arrested 12 CIA sources due to tradecraft mistakes. We have been unable to determine if the reports regarding Lebanon are true, merely CIA disinformation or a little of both. Certainly, the CIA would like the Iranians to believe it is no longer active in Lebanon. Even if these reports are CIA spin, they are quite interesting in light of the Oct. 11 announcement of the thwarted assassination plot in the United States and the Nov. 12 announcement of the arrests in Bahrain.

On Nov. 21, the United States and the United Kingdom launched a new wave of sanctions against Iran based on the aforementioned IAEA report. The new sanctions were designed to impact Iran’s banking and energy sector. In fact, the United Kingdom took the unprecedented step of totally cutting off Iran’s Central Bank from the British financial sector. The Canadian government undertook similar action against the Central Bank of Iran.

On Nov. 28, there were unconfirmed press reports of  an explosion in Esfahan, one of Iran’s largest cities. These reports were later echoed by a STRATFOR source in Israel, and U.S. sources have advised that explosions did occur in Esfahan and that they caused a significant amount of damage. Esfahan is home to numerous military and research and development facilities, including some relevant to Iran’s nuclear efforts. We are unsure which facilities at Esfahan were damaged by the blasts and are trying to identify them.

Elsewhere on Nov. 28, Iran’s Guardians Council, a clerical organization that provides oversight of legislation passed by Iran’s parliament, approved a bill to expel the British ambassador and downgrade diplomatic relations between the two countries. The next day, Iranian protesters stormed the British Embassy in Tehran, along with the British Embassy’s residential compound in the city. The angry — and well-orchestratedmob was protesting the sanctions announced Nov. 21. Iranian authorities did not stop the mob from storming either facility.

On Dec. 1, the European Union approved new sanctions against some 180 Iranian individuals and companies over Iran’s support of terrorism and its continued nuclear weapons program. The European Union did not approve a French proposal to impose a full embargo on Iranian oil.

In the early hours of Dec. 4, a small improvised explosive device detonated under a van parked near the British Embassy building in Manama, Bahrain. The device, which was not very powerful, caused little structural damage to the vehicle and none to the building itself.

The next day, an unnamed U.S. official confirmed Dec. 4 reports from several Iranian news outlets that Iran had recovered an RQ-170Sentinelunmanned aerial vehicle (UAV) in Iranian territory. The Iranian reports claimed that Iranian forces were responsible for bringing down the Sentinelsome even said the Iranians were able to hack into the UAV’s command link. U.S. officials have denied such reports, and it is highly unlikely that Iran was able to take control of a UAV and recover it intact.


The United States is currently in the process of completing the withdrawal of its combat forces from Iraq. With the destruction of the Iraqi military in 2003, the U.S. military became the only force able to counter Iranian conventional military strength in the Persian Gulf region. Because of this, the U.S. withdrawal from Iraq will create a power vacuum that the Iranians are eager to exploit. The potential for Iran to control a sphere of influence from western Afghanistan to the Mediterranean is a prospect that not only frightens regional players such as Israel, Saudi Arabia and Turkey but also raises serious concerns in the United States.

As we have noted before, we don’t believe that a military attack against Iran’s nuclear facilities alone is the answer to the regional threat posed by Iran. Iran’s power comes from its ability to employ its conventional forces and not nuclear weapons.

Therefore, strikes against its nuclear weapons program would not impact Iran’s conventional forces or its ability to interfere with the flow of oil through the Strait of Hormuz by using its conventional forces asymmetrically against U.S. naval power and commercial shipping. Indeed, any attack on Iran would have to be far broader than just a one-off attack like the June 1981 Israeli strike at Osirak, Iraq, that crippled Saddam Hussein’s nuclear weapons program.

Because of this difficulty, we have seen the Israelis, Americans and their allies attacking Iran through other means. First of all, they are seeking to curb Iran’s sphere of influence by working to overthrow the Syrian regime, limit Iran’s influence in Iraq and control Hezbollah in Lebanon. They are also seeking to attack Iran’s nuclear program by coercing officials to defect, assassinating scientists and deploying cyberwarfare weapons such as the Stuxnet worm.

It is also necessary to recognize that covert action does not occur in a vacuum. Each covert activity requires a tremendous amount of clandestine intelligence-gathering in order to plan and execute it. With so much covert action happening, the clandestine activity undertaken by all sides to support it is obviously tremendous. But as the frequency of this activity increases, so can sloppy tradecraft.

Finally, as we examine this campaign it is remarkable to note that not only are Iran’s enemies using covert methods to stage attacks on Iran’s nuclear program and military capabilities, they are also developing new and previously unknown methods to do so. And they have shown a willingness to allow these new covert attack capabilities to be unveiled by using them — which could render them useless for future attacks. This willingness to use, rather than safeguard, revolutionary new capabilities strongly underscores the importance of this covert campaign to Iran’s adversaries. It also indicates that we will likely see other new forms of covert warfare emerge in the coming months, along with revolutionary new tactical applications of older forms.


DECEMBER 10, 2011

Making the Next Bailout the Last

Ben Bernanke is worried about whether the Fed has the political capital to do it all again.


The European debt crisis isn't over, and may indeed get a lot worse if the new strategy (as appeared on Friday) is to let European banks borrow unlimited funds from the European Central Bank to cycle back into the bonds of spendthrift governments. If the stock market seems happy, it's only because the meltdown has been postponed.

Since another bailout of the U.S. financial system may yet be needed as a result of the European mess, it behooves us to ask what we learned from the last one. Happily there was plenty of news this week to help us.

Financial pros were buzzing about a Bloomberg News story that had then-Treasury secretary Henry Paulson, on July 21, 2008, stopping by a hedge fund and musing about wiping out Fannie Mae and Freddie Mac's shareholders and placing the mortgage lenders under government conservatorship, as he did seven weeks later.

On most lips was the question: Did Mr. Paulson tip his hand in a way that let shortsellers make a fortune betting against Fannie and Freddie? Our concern is different. The Bloomberg revelations should also be profoundly irritating to anyone who heard and believed Mr. Paulson's public pronouncements at the time, suggesting Fannie and Freddie were properly capitalized and indicating that their shareholders would be protected.

We're thinking of people like fund managers Bill Miller and Eddie Lampert, who were holders of Fannie and Freddie stock, as they later made known, partly on Mr. Paulson's say-so.

Their subsequent grief was featured in a column here, in which they argued that this double cross led directly to the collapse of equity values across the financial system. Erased along the way was the Bush administration's frantic hope at the time of recruiting private investors to recapitalize the banking system so taxpayers wouldn't have to.

Getty Images

This might be water under the bridge if the cycle of self-defeat hadn't continued under the new administration. Early on, in order to declare the crisis solved, Team Obama produced "stress tests" purporting to show that the banks' future earnings would be sufficient to cover their future long-term losses. Investors took this as a sign to buy bank shares. Then Washington proceeded to bombard the banks with regulatory actions, lawsuits and vilifying rhetoric that destroyed all over again the market confidence so expensively bought.

Today, the biggest banks are even bigger. Yet look at their miserable stock prices. One consequence is that there's no chancezero—of private capital stepping in to help the banks handle losses from a European meltdown.

Which brings us to the second relevant news item of the week. Washington, and the Federal Reserve especially, intervened heavily after the Lehman collapse to quell an immediate liquidity panic. Whatever the utility of that bailout, it didn't solve any long-term problem, leaving us a handful of supergiant banks limping along the edge of a confidence meltdown. It also left us with a public deeply distrustful of financial regulators.

In an unusual and lengthy letter to Congress this week, Fed Chief Ben Bernanke complained about certain unnamed press outlets and labored to rebut the idea that Fed actions in 2008-2009 had merely stuffed taxpayer money into the pockets of undeserving bankers. Did the Fed save us from another Great Depression? We'll never know. But Mr. Bernanke is clearly worried that his and Washington's political capital may not be up to doing it a second time.

Here's where the loop gets closed. All the more important, then, for future policy, and for getting us off the bubble-and-bust cycle, is the following question: Were the banks smoking in bed or were they victims of a fire started elsewhere? Everybody knows the answer. Yet shockingly little progress has been made in reducing the incentive of the banking system to smoke in bed.

There are answers wherever you look. Reform the deposit insurance system. Require banks to take on a class of creditor who would be legally obligated to ante up if a bank needs recapitalization because of excessive losses.

Correct a regulatory strategy that works by incentivizing banks to treat certain assets—mortgages, Greek debt, Italian debt—as risk-free. This, inevitably, leads to the overproduction of these assets until the system blows up.

Unfortunately, government, having empowered itself in the crisis, is doing what government does. It is taking more, not less, control in telling banks what assets to invest in. Dodd-Frank didn't so much cure too-big-to-fail as institutionalize it. The Corzine fiasco is being turned into yet another miseducational moment in which investors are encouraged to believe that it's the job of government to protect them from losses.

Down this road lies financial crises without end, assuming we survive the current one.

 Holman W. Jenkins Jr. is a member of the editorial board of The Wall Street Journal. He writes editorials and the weekly "Business World" column that appears on the paper's op-ed page on Wednesdays, and he edits OpinionJournal's premium e-mail newsletter, "Political Diary."

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

Fund of Information


No Easy—or Cheap—Remedy for Volatility


Lots of new funds promise to remove uncomfortable price changes from your portfolio, but most are unproven and could be bad for your financial health.

The only thing more alarming than this year's market volatility has been some of the unsolicited advice given to investors who don't even understand the problem.

Several mainstream publications and television pundits have casually —and clearly without the benefit of much researchrecommended that investors wary of market volatility try an array of expensive and unproven products. Among them: inversely correlated funds, which aim to provide the opposite return of a benchmark like the Standard & Poor's 500 Index volatility funds, which use a variety of options strategies to profit from volatility; and long/short and market-neutral funds, which (sometimes) attempt to limit losses due to volatility.

Perhaps the best indication that these strategies are growing increasingly faddish is the slew of new exchange-traded funds that have been launched in the past few months, including the iShares family of low-volatility ETFs, and Russell's low-volatility and low-beta offerings.

Volatility is certainly something investors need to be aware of. But first, you need to understand exactly what it is, and then you can decide what, if anything, you want to do about itminimize it, capitalize on it, or ignore it altogether.

Standard deviation is perhaps the most commonly cited measure of a fund's volatility. Mathematically speaking, standard deviation measures the dispersion of a set of data from its mean. For mutual funds, the standard deviation measures how often a fund's returns have diverged from its average return. The larger the dispersion, the higher the standard deviation, and the more volatile a fund is considered to be. Like the returns themselves, you can compare a fund's standard deviation with that of the S&P 500 Index or other relevant benchmark.

But that doesn't tell the whole story. "Risk and volatility are not synonymous," says Shannon Zimmerman, Morningstar's associate director of fund analysis. "Some funds are more volatile than the broad market, but are actually less risky."

One good example: Oakmark Select (ticker: OAKLX). Manager Bill Nygren is a veteran value investor; he's interested only in stocks that are trading 40% below their intrinsic value. That leads to a pretty concentrated, blended portfolio of 20 growth and value stocks. The fund's three-year standard deviation is 22.21, higher than the S&P 500's 18.97, indicating it's more a volatile option when compared with, say, any given S&P index fund.

But take a look at the fund's upside and downside capture ratios, which, along with standard deviation, can be found on Morningstar's Website (under the "ratings and risks" tab). An upside/downside capture ratio measures how much a fund has outperformed (gained more than or lost less than) a benchmark. An upside or downside ratio of 100 indicates that the fund moved in lockstep with the benchmark. So its upside ratio of 128.61 for the past three years shows that when the market has been up, Oakmark Select has been up considerably more. The downside ratio of 105.26 in the same period indicates that while performance has lagged a bit when the market was down, it didn't lag by nearly as much as it outperformed in good times. In fact, Oakmark Select's three-year return is 22.31%, substantially ahead of the S&P's 13.16% return in the same period.

"CONCENTRATED FUNDS are generally more volatile than the broad market," Zimmerman says. "But if you overlay a good stock-picking strategy, like Bill Nygren's strict valuation criteria, it mitigates the risk, if not the volatility." Other funds whose standard deviations would indicate greater volatility, but that generally employ valuation strategies that dramatically mitigate risk and improve performance, include BBH Core Select (BBTRX), which invests in less risky blue-chip companies, and Leuthold Core Investment (LCORX), a quasi-quantitative fund that uses 179 qualitative and quantitative factors to compare the prospects of various asset classes with the risk-free returns of U.S. Treasury bonds.

"We're all overexposed to the immediacy of information, but too many people are suffering from recency bias," says Adam Bold, president of the Mutual Fund Store, an independent investment advisory firm. "A year and a half ago, every move in the market was attributable to the BP oil spill. When was the last time you thought about that in relation to your portfolio?"

Capitalizing on volatility has proven very difficult, as evidenced by the lackluster returns of both hedge and mutual funds that have tried. What's more, seemingly similar alternative funds can be quite different in investing philosophy. Not all long/short funds, for instance, are run with an eye towards minimizing volatility. Craig Callahan, president of ICON Advisers and manager of its ICON Long/Short Fund (ISTAX), says it's currently just 4% short. "We only short to make money, and we're not seeing enough overpriced stocks," he says. "We don't short to reduce volatility. It costs way too much. Volatility is caused by news events and emotions that show up in the market. You can't control any of that. And trying to control things you can't just ends up costing a lot."

Cash Track

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