September 18, 2012 7:52 pm

Bernanke makes an historic choice

Ben Bernanke illustration©Niall Ferguson




Ben Bernanke, chairman of the Federal Reserve, has persuaded his colleagues to make a bold decision. By a majority of 11 to one, they decided last week to undertake a monthly programme of asset purchases aimed at the labour market. Is this riskless? No. Does it make sense? Yes, because the results of doing nothing would be far worse.
 
 
 
 
As the press release of the open market committee stated: “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.” This is also “consistent with its statutory mandate”, to fostermaximum employment and price stability”.
 
 
 
Click to enlarge
 
 
 
Mr Bernanke elaborated the argument for such action in the speech he delivered last month at the symposium at Jackson Hole, Wyoming, organised by the Federal Reserve Bank of Kansas City. This contained an extraordinary sentence: “The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last many years.” I congratulate Mr Bernanke for this ethical response. I applaud him for recognising that the Fed not only can but should do something about this dire situation.
 
 
 

The September economic projections of members of the Federal Reserve Board and Federal Reserve Bank presidents reveal why people who think like Mr Bernanke about the evils of elevated unemployment should favour action. The “central tendency” of these projections is for an unemployment rate of 6.7 to 7.3 per cent even in 2014. Worse, the collapse in the employment rate that occurred in 2008 shows no sign of reversal. (See charts.)


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In the Fed’s view, the explanation for persistently high unemployment and low employment is inadequate demand. Thus, joblessness will stay high until growth accelerates. In the words of the press statement, “without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labour market conditions”.
 
 
 
 
Significantly, a paper presented at the Jackson Hole symposium entitled “The United States Labour Market: Status Quo or A New Normal”, co-authored by Edward Lazear, a well-known conservative economist, provides support for the Fed’s view. It conclude that no structural changes can explain changes in unemployment over recent years. The pattern is consistent with exceptionally high cyclical unemployment. “It is the demand, stupid.” This cannot be surprising. Between 1990 and 2007, nominal US GDP – also a measure of aggregate demand grew at a trend annual rate of 5.4 per cent. It then went over a cliff: in the second quarter of 2012, it was as much as 14 per cent below its pre-2008 trend. Worse, the gap between trend and actual levels has continued to grow. All this suggests a prolonged and disturbing weakness in aggregate demand.
 
 
 
 
The Fed’s plan is to buy mortgage-backed securities of the government-sponsored agencies, Fannie Mae and Freddie Mac, at a rate of $40bn a month. It will continue to lengthen the maturity of its assets and reinvest the principal repayments from its holdings of agency debt and mortgage-backed securities in yet more agency securities. These actions will raise the Fed’s holdings by about $85bn a month and so should, it argues, put downward pressure on long-term interest rates, support mortgage markets and help to make broader financial conditions more accommodative. Above all, the Fed is committed to continuing with this policy until the labour market improves substantially.
 
 
 
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Predictably, the Republican party is outraged. Mitt Romney, the Republican presidential candidate, reacted at once by stating that the third iteration of “quantitative easing” would merely provide a “sugar high”. This response is no surprise: Republicans have consistently opposed any and all attempts to use fiscal or monetary policies to ameliorate the recession. I do not know whether they believe in their liquidationist views or have sought to deny Barack Obama’s administration any success in reviving the economy. A part of me wishes they had enjoyed the chance to apply their liquidationist philosophy. The results would surely have matched those of the early 1930s: an economic catastrophe with long-lasting political results. So the wiser part of me is grateful that the people in charge were far more responsible. Quite properly, the Fed has sought to mitigate the results of the financial collapse of 2008 and the subsequent private deleveraging.
 
 
 
Will the Fed’s new approach work? On this, there must be questions. The Fed has been running ultra-loose monetary policies since late 2008 and interest rates on long-term bonds are already extremely low. Mr Bernanke argues that the Fed’s asset purchase programmes have raised output by almost 3 per cent and private employment by more than 2m jobs above what they would otherwise have been. Yet, since interest rates are already so low, the new action is unlikely to achieve as much again. It is far more likely to be helpful than transformative.
 
 
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In a lengthy discussion of monetary policy “at the interest-rate lower bound”, also given at Jackson Hole, Michael Woodford of Columbia University argues for an explicit nominal GDP target, for fiscal stimulus and for close co-ordination of monetary and fiscal policies. But tighter co-ordination is inconceivable in the US. If the Fed did announce a plan to get nominal GDP back to its 1990-2007 trend by, say, the fourth quarter of 2016, it would need to deliver a 45 per cent increase from the second quarter of this year. That is an indicator of the scale of the demand shortfall. Needless to say, such a target is hugely unlikely.
 
 
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Critics argue that the new Fed policy will not only fail to work as hoped, which is likely, but will do vast damage, which is far less so. Many have been prophesying hyperinflation for years. This fear is misguided. Unconventional policies do indeed create costs and risks. But the costs and risks of deficient demand are far greater. The Fed has decided to err on the side of expansion. That is surely right. It is, in truth, more likely to achieve too little of what it seeks than too much.
 
 
 
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Copyright The Financial Times Limited 2012.



September 18, 2012, 9:32 am
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An Enigma in the Mortgage Market That Elevates Rates
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By PETER EAVIS


Imagine a 30-year mortgage on which you only pay 2.8 percent in interest a year.


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Such a mortgage could already exist, but something in the banking system is holding it back. And right now, few agree on what that "something" is.




Getting to the bottom of this enigma could help determine whether mortgage lenders are dysfunctional, greedy or simply trying to do their job in a sensible way.




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Right now, borrowers are paying around 3.55 percent for a 30-year fixed rate mortgage that qualifies for a government guarantee of repayment. That's down from 4.1 percent a year ago, and 5.06 percent three years ago.




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Mortgage rates have declined as the Federal Reserve has bought trillions of dollars of bonds, a policy that aims to stimulate the economy. Last week, the Fed said it would make new purchases, focusing on bonds backed by mortgages.




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The big question is whether those purchases lead to even lower mortgage rates, as the Fed chairman, Ben S. Bernanke, hopes.



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But mortgage rates may not decline substantially from here. Something weird has happened. Pricing in the mortgage market appears to have gotten stuck. This can be seen in a crucial mortgage metric.





Banks make mortgages, but since the 2008 crisis, they have sold most of them into the bond market, attaching a government guarantee of repayment in the process.





The metric effectively encapsulates the size of the gain that banks make on those sales. In September 2011, banks were making mortgages with an interest rate of 4.1 percent. They were then selling those mortgages into the market in bonds that were trading with an interest rate, or yield, of 3.36 percent, according to a Bloomberg index.






The metric captures the difference between the bond and mortgage rates; in this case it was 0.74 percentage points. The bigger the "spread," the bigger the financial gain for the banks selling the mortgages. That 0.74 percentage point "spread" was close to the 0.77 percentage point average since the end of 2007. Banks were taking roughly the same cut on the sales as they were in previous years.






But something strange has happened over the last 12 months. That spread has widened significantly, and is now more than 1.4 percentage points. The cause: bond yields have fallen a lot more than the mortgage rates banks are charging borrowers.




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Put another way, the banks aren't fully passing on the low rates in the bond market to borrowers. Instead, they are taking bigger gains, and increasing the size of their cut.





So where might mortgage rates be if the old spread were maintained? At 2.83 percent - that's the current bond yield plus the 0.75 percentage point spread that existed a year ago.



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It's important to examine why the tight relationship between bond yields and mortgage rates becomes unglued.




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One explanation, mentioned in a Financial Times story on Sunday, is that the banks are overwhelmed by the demand for new mortgages and their pipeline has become backlogged. When demand outstrips supply for a product, it's less likely that its price -- in this case, the mortgage's interest rate -- will fall. There are in fact different versions of this theory.



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One holds that bank mortgage operations are still poorly run, and therefore it's no surprise they can't handle an inundation of new applications. Another says banks deliberately keep rates from falling further as a way of controlling the flow of mortgage applications into their pipeline.




If mortgages were offered at 2.8 percent, they wouldn't be able to handle the business, so they ration through price, according to this theory.





Another backlog camp likes to point the finger at Fannie Mae and Freddie Mac, the government-controlled entities that actually guarantee the mortgages. The theory is that these two are demanding that borrowers fulfill overly strict conditions to get mortgages. Banks fear that if they don't ensure compliance with these requirements, they'll have to take mortgages back once they've sold them, a move that can saddle them with losses.




As a result, the banks have every incentive to slow things down to make sure mortgages are in full compliance, which can add to the backlog. Once this so-called put-back threat is decreased, or the banks get better at meeting requirements, supply should ease.
But there is a weakness to the backlog theories.




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The banks have handled two huge waves of mortgage refinancing since the 2008 financial crisis. During those, the spread between mortgage and bond rates did increase. But not anywhere near as much as it has recently. And the spread has stayed wide for much longer this time around.



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For instance, $1.84 trillion of mortgages were originated in 2009, a big year for refinancing, according to data from Inside Mortgage Finance, a trade publication. In that year, the average spread between bonds and loans was 0.89 percentage points. And the banking sector was in a far worse state, which would in theory make the backlog problem worse.




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Today, the sector is in better shape, with more mortgage lenders back on their feet. But the spread between loans and bonds is considerably wider. In the last 12 months, when mortgage origination has been close to 2009 levels, it has averaged 1.1 percentage points. This suggests that it's more than just a backlog problem.


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Some mortgage banks seem to be having little trouble adapting to the higher demand. U.S. Bancorp originated $21.7 billion of mortgages in the second quarter of this year, 168 percent more than in the second quarter of last year.



 
Wells Fargo is currently the nation's biggest mortgage lender, originating 31 percent of all mortgages in the 12 months through the end of June. In a conference call with analysts in July, the bank's executives seemed unfazed about the challenge of meeting mounting customer demand.


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"We've ramped up our team members in mortgage to be able to move the pipeline through as quickly as possible," said Timothy J. Sloan, Wells Fargo's chief financial officer. He also said that the bank had increased its full time employees in consumer real estate by 19 percent in the prior 12 months. Not exactly the picture of a bank struggling to expand capacity.


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But if banks are readily adding capacity, why aren't mortgage rates falling further, closing the spread between bond yields? Perhaps a new equilibrium has descended on the market that favors the banks' bottom lines.


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The drop in rates draws in many more borrowers. The banks add more origination capacity, but not quite enough to bring the spread between bonds and loans back to its recent average.


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The banks don't care because mortgage revenue is ballooning. But it all means that the 2.8 percent mortgage may never materialize.



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Copyright 2012 The New York Times Company




Last updated:September 17, 2012 6:38 pm
 
How to cut the US deficit by fixing tax
 

One of the few issues on which Barack Obama and Mitt Romney agree is the need for tax reform. Since the last overhaul in 1986, loophole after loophole has been added, producing a tax system that is complex, unfair, inefficient and detrimental to growth. Today, tax reform must also address three major challenges: escalating federal debt, rising income inequality and intensifying global competition.



Addressing the long-run deficit and stabilising the debt will require more revenue. Even after the economy recovers, current tax policies will not generate enough revenue to cover future spending on social security, health, defence and debt interest, let alone basic government operations and investments. In 2012, federal tax revenues are likely to be less than 16 per cent of gross domestic product, compared with an average of more than 18 per cent in the 20 years before the crisis hit in 2008.
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When the US economy is operating near capacity, total tax revenuesfederal, state and local – are much smaller as a share of GDP than in other developed countries. And there is scant evidence that taxes as a share of GDP and economic growth are negatively correlated. Indeed, there is a small positive correlation between income per capita and tax revenue as a share of GDP.



Special tax rates and allowances are a major reason why tax revenues are comparatively low in the US. So-called tax expenditures amount to about 7 per cent of GDP; more than what the federal government spends individually on defence, health and social security. Reducing the number and limiting the size of tax expenditures would simplify the tax code, remove distorting incentives and raise revenue. Mr Obama proposes to use some of the revenue from reforming tax expenditures for deficit reduction; Mr Romney would use all of it to cut tax rates, with disproportionate benefits to high-income taxpayers.
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But tax reform should not come at the expense of progressivity. Income inequality is greater in the US than in the other developed countries of the OECD. The US tax system is considerably less progressive than it was a few decades ago and it does less to counteract pre-tax income inequality than other OECD systems.



Widening inequality is reflected in opportunity gaps between children born into different income groups and a decline in intergenerational mobility: an American child’s future income is more dependent on his or her parents’ income than in most other OECD nations. Mr Obama’s plan counters these trends. The Romney-Ryan plan exacerbates them.
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Proponents of greater progressivity often call for an increase in corporate taxes but this would lead to slower growth and fewer jobs. The US has the highest statutory corporate tax rate in the developed world. Even after tax expenditures are included, its effective marginal corporate tax rate is one of the highest in the world. Business decisions about where to locate investments are responsive to differences in taxes and have become more sensitive over time. Of all taxes, corporate income taxes do the most harm to economic growth.



Both Mr Obama and Mr Romney advocate corporate tax reform that lowers the rate and broadens the base. The economic benefits could be significant. The current system has large unjustifiable differences in effective tax rates that influence business choices about what to invest in, how to finance an investment, where to produce and even what form of organisation to adopt. These differences distort capital allocation, add complexity, increase compliance costs and reduce corporate tax revenues.
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A lower rate would stimulate investment, narrow the tax preference for debt over equity financing and weaken the incentives for international companies to move production to lower-tax locations. But lowering the corporate tax rate is expensive each percentage point reduction would cut revenues by about $120bn over 10 years. Scaling back the three largest corporate tax expenditures to pay for a cut could increase the cost of capital, thereby reducing investment and growth.
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A more efficient and progressive way to pay for a lower corporate tax rate would be to increase taxes on dividends and capital gains. This would shift more of the burden towards capital owners and away from labour, which bears the burden in the form of fewer jobs and lower wages. Mr Obama proposes to raise rates on capital gains and dividends for the top 2 per cent of taxpayers. Most capital gains and dividends go to this group. Mr Romney would leave these rates unchanged for this group.
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The US economy needs efficient and progressive tax reform and it needs more revenues for deficit reduction. Revenue increases have been a significant component of all major deficit-reduction packages enacted over the past 30 years. This must be the case now, too. Additional revenues as part of a credible long-run deficit-reduction plan and supported by progressive tax reforms will boost economic growth and job creation.



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The writer is a professor at the Haas School of Business at the University of California at Berkeley and former chair of the Council of Economic Advisers under President Bill Clinton


 
Copyright The Financial Times Limited 2012.



Armada of international naval power massing in the Gulf as Israel prepares an Iran strike

An armada of US and British naval power is massing in the Persian Gulf in the belief that Israel is considering a pre-emptive strike against Iran’s suspected nuclear weapons programme.

By Sean Rayment, Defence Correspondent

10:00PM BST 15 Sep 2012
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Armada of British naval power massing in the Gulf as Israel prepares an Iran strike
The Strait of Hormuz is only 21 miles wide at its narrowest point Photo: ALAMY
 




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Western leaders are convinced that Iran will retaliate to any attack by attempting to mine or blockade the shipping lane through which passes around 18 million barrels of oil every day, approximately 35 per cent of the world’s oil traded by sea.

 
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A blockade would have a catastrophic effect on the fragile economies of Britain, Europe the United States and Japan, all of which rely heavily on oil and gas supplies from the Gulf.


 
The Strait of Hormuz is one of the world’s most congested international waterways. It is only 21 miles wide at its narrowest point and is bordered by the Iranian coast to the north and the Oman to the south.


 
In preparation for any pre-emptive or retaliatory action by Iran, warships from more than 25 countries, including the United States, Britain, France, Saudi Arabia and the UAE, will today begin an annual 12-day exercise.
 
The war games are the largest ever undertaken in the region.


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They will practise tactics in how to breach an Iranian blockade of the strait and the force will also undertake counter-mining drills.


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The multi-national naval force in the Gulf includes three US Nimitz class carrier groups, each of which has more aircraft than the entire complement of the Iranian air force.
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The carriers are supported by at least 12 battleships, including ballistic missile cruisers, frigates, destroyers and assault ships carrying thousand of US Marines and special forces.



The British component consists of four British minesweepers and the Royal Fleet Auxiliary Cardigan Bay, a logistics vessel. HMS Diamond, a brand-new £1billion Type 45 destroyer, one of the most powerful ships in the British fleet, will also be operating in the region.
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In addition, commanders will also simulate destroying Iranian combat jets, ships and coastal missile batteries.



In the event of war, the main threat to the multi-national force will come from the Islamic Revolutionary Guards Corps navy, which is expected to adopt an “access-denial strategy in the wake of an attack, by directly targeting US warships, attacking merchant shipping and mining vital maritime chokepoints in the Persian Gulf.



Defence sources say that although Iran’s capability may not be technologically sophisticated, it could deliver a series of lethal blows against British and US ships using mini-subs, fast attack boats, mines and shore-based anti-ship missile batteries.
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Next month, Iran will stage massive military manoeuvres of its own, to show that it is prepared to defend its nuclear installations against the threat of aerial bombardment.



The exercise is being showcased as the biggest air defence war game in the Islamic Republic’s history, and will be its most visible response yet to the prospect of an Israeli military strike.
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Using surface-to-air missiles, unmanned drones and state-of-the-art radar, Iran’s Revolutionary Guards and air force will combine to test the defences of 3,600 sensitive locations throughout the country, including oil refineries and uranium enrichment facilities.




Brigadier General Farzad Esmaili, commander of the Khatam al-Anbiya air defence base, told a conference this month that the manoeuvres would “identify vulnerabilities, try out new tactics and practise old ones”.
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At the same time as the Western manoeuvres in the Gulf, the British Response Task Forces Group — which includes the carrier HMS Illustrious, equipped with Apache attack helicopters, along with the French aircraft carrier Charles de Gaulle - will be conducting a naval exercise in the eastern Mediterranean. The task force could easily be diverted to the Gulf region via the Suez Canal within a week of being ordered to do so.
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The main naval exercise comes as President Barack Obama is scheduled to meet Benjamin Netanyahu, the Israeli prime minister, today to discuss the Iranian crisis.



Many within the Obama administration believe that Israel will launch a pre-emptive strike against Iran’s nuclear facilities before the US presidential elections, an act which would signal the failure of one of Washington’s key foreign policy objectives.
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Both Downing Street and Washington hope that the show of force will demonstrate to Iran that Nato and the West will not allow President Mahmoud Ahmadinejad, the Iranian leader, to develop a nuclear armoury or close Hormuz.



Sir John Sawers, the head of MI6, the Secret Intelligence Service, reportedly met the Israeli prime minister and Ehud Barak, his defence secretary, two weeks ago in an attempt to avert military action against Iran.
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But just last week Mr Netanyahu signalled that time for a negotiated settlement was running out when he said: “The world tells Israel 'Wait, there’s still time.’ And I say, 'Wait for what? Wait until when?’



Those in the international community who refuse to put red lines before Iran don’t have a moral right to place a red light before Israel.”
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The crisis hinges on Iran’s nuclear enrichment programme, which Israel believes is designed to build an atomic weapon. Tehran has long argued that the programme is for civil use only and says it has no plans to an build a nuclear bomb, but that claim has been disputed by the West, with even the head of MI6 stating that the Islamic Republic is on course to develop atomic weapons by 2014.




The Strait of Hormuz has long been disputed territory, with the Iranians claiming control of the region and the entire Persian Gulf.
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Rear Admiral Ali Fadavi of the Iranian Revolutionary Guard Corps recently boasted that “any plots of enemies” would be foiled and a heavy price exacted, adding: “We determine the rules of military conflict in the Persian Gulf and the Strait of Hormuz.”



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But Leon Panetta, the US defence secretary, warned that Iranian attempts to exercise control over the Strait of Hormuz could be met with force.




He said: “The Iranians need to understand that the United States and the international community are going to hold them directly responsible for any disruption of shipping in that region — by Iran or, for that matter, by its surrogates.”
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Mr Panetta said that the United States was “fully prepared for all contingencies” and added: “We’ve invested in capabilities to ensure that the Iranian attempt to close down shipping in the Gulf is something that we are going to be able to defeat if they make that decision.”


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That announcement was supported by Philip Hammond, the Defence Secretary, who added: “We are determined to work as part of the international community effort to ensure freedom of passage in the international waters of the Strait of Hormuz.”



One defence source told The Sunday Telegraph last night: “If it came to war, there would be carnage. The Iranian casualties would be huge but they would be able to inflict severe blows against the US and British.



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“The Iranian Republican Guard are well versed in asymmetrical warfare and would use swarm attacks to sink or seriously damage ships. This is a conflict nobody wants, but the rhetoric from Israel is unrelenting.”