February 2, 2015 7:39 pm

Battle for Ukraine: How the west lost Putin

 
 
After more than 40 telephone calls and countless hours of meetings over the past six months, Angela Merkel braced herself for one last push. It was past 10pm and the German chancellor was sitting in a Hilton hotel conference room in Brisbane, Australia. Her interlocutor was the implacable Vladimir Putin.

For nearly two hours, the Russian president reeled off a litany of resentments. The west had proclaimed victory in the cold war. It had cheated Moscow by expanding the EU and Nato right to Russia’s borders. It had ignored international rules to pursue reckless policies in Iraq, Afghanistan and Libya.

The chancellor steered the conversation back to eastern Ukraine, where Russian-backed separatists were engaged in a bloody struggle against the western-backed government in Kiev, according to a person familiar with the meeting. Since the crisis began, Ms Merkel had worked hard to extract some sense from Mr Putin of what he wanted — something she could use to construct an agreement. When he finally offered a solution, she was shocked. Mr Putin declared Kiev should deal with the rebels the way he had dealt with Russia’s breakaway Chechnya region: by buying them off with autonomy and money. A reasonable idea, perhaps, to an ex-KGB colonel. But for an East German pastor’s daughter, with a deeply-ingrained sense of fairness, this was unacceptable.
 
Vladimir Putin is the master destabiliser. A black belt in judo, he is an expert at keeping opponents off-balance. He alternates between the friendly gesture and the menacing glance.
 
Throughout the crisis in Ukraine, the most serious threat to security in Europe since the end of the cold war, Mr Putin has succeeded in wrongfooting western leaders. They know he wants to restore Russia’s influence and keep Ukraine within his orbit, but are at a loss to divine how he intends to achieve his aims.
 
Ms Merkel had asked her closest advisers to stay outside during the Brisbane meeting, on November 15 last year. “She wanted to be alone . . . to test whether she could get Putin to be more open about what he really wants,” says someone briefed on the conversation. “But he wouldn’t say what his strategy is, because he doesn’t know.”

When the hotel meeting broke up at about 2am, Chancellor Merkel and President Putin were in dark moods. Hours later, the Russian leader would fly home, missing the second day of the G20 summit and fuming about snubs from other world leaders. Ms Merkel, according to two people briefed on the outcome, left convinced there would be no quick end to the crisis.

She fretted, too, that Mr Putin’s ambitions to reassert Russian influence stretched beyond Ukraine.

The next day in Sydney, she cast aside her usual caution. “Who would have thought it possible that 25 years after the fall of the Berlin Wall . . . something like this could happen in the middle of Europe?” she said in a speech. Mr Putin’s escapades in Ukraine called “the whole of the European peaceful order into question”. She also added a new warning — that Russia might come to threaten not just Ukraine, but Georgia or the Balkans.

For Moscow, too, something snapped. Weeks later, a Kremlin official dismissed the notion, often cited in diplomatic circles, that there had ever been a “special relationship” between the two leaders.

“Putin and Merkel could never stand each other,” he told the Financial Times. “Of course, they are professionals, so they tried to make the best of it for a long time. But that seems to have changed now.”

A tale of betrayal

The Merkel-Putin encounter in Australia marked a turning point. After a year of crisis, the west realised that it had been pursuing an illusion: for all its post-communist tribulations, Russia was always seen to be on an inexorable path of convergence with Europe and the west — what a senior German official calls the notion that “in the end, they’ll all become like us”.
 
“Now it’s about acknowledging the differences,” he says. The failure of months of diplomacy left the two sides on the brink of a new cold war. No further Merkel-Putin meetings have taken place since Brisbane, though she still speaks to him by telephone. And as Russian-backed rebels step up the offensive again in eastern Ukraine, the Minsk agreement — the ceasefire signed in September — is in tatters. The fate of Ukraine, an industrialised and agriculturally rich country of 45m people straddling east and west, hangs in the balance. The risks of the conflict escalating remain high.
 
After interviews with ministers, top EU leaders, diplomats, officials and intelligence officers from more than 10 countries, the FT has reconstructed the months where the diplomacy finally broke down. It is a tale of miscalculations by both sides; of western underestimations of just how far Mr Putin was prepared to go to defend what he presents as Russia’s fundamental interests; and above all, of two sides talking past each other, locked into entirely different narratives.

Anti-government demonstrators stand among the smoke of burning barricades during clashes with riot police in Kiev on February 18, 2014. Opposition leader Vitali Klitschko on February 18 urged women and children to leave the opposition's main protest camp on Kiev's Independence Square, known as Maidan, as riot police massed nearby. "We ask women and children to quit Maidan as we cannot rule out the possibility that they will storm (the camp)," the former heavyweight boxing champion told protestors on the square. AFP PHOTO / SANDRO MADDALENA (Photo credit should read SANDRO MADDALENA/AFP/Getty Images)©AFP
Maidan protesters among the barricades last February

From Ukraine’s perspective, it is also a tale of betrayal. During the protests that broke out in early 2014 — and ultimately brought down the pro-Moscow government of Viktor Yanukovich — it became the first country in Europe to watch protesters die holding EU flags. The west, many in Kiev believe, has failed Ukraine.

According to officials in Kiev and hardline Russia critics, the west’s greatest failure was the admission it was not prepared to use military force to defend Ukraine against its nuclear-armed neighbour — or even supply it with arms. This hamstrung western policy from the start, leaving economic sanctions as the only credible tool. Some say it left the west with no real policy at all.
 
But while the EU and US have not managed to bring peace or change Mr Putin’s behaviour, they have scored some successes — in achieving unity on sanctions and the ratification of the EU’s treaty with Kiev. That unity will be tested in the coming months: EU consensus is needed to renew its swingeing economic sanctions against Russia when they are due to expire in June.
 
So far, the sanctions have acted as what one US official calls an “accelerant” to the unexpected plunge in oil prices, pushing Russia into a deep economic crisis. The rouble has tumbled, leaving Russia facing recession and spiralling inflation, challenging its ability to fund its costly stealth war in Ukraine (where the Kremlin insists there are no Russian soldiers on the ground, despite ample evidence to the contrary).
 
Ms Merkel has commanded centre stage during the crisis, not merely as Europe’s most senior leader — she took office in 2005 — but also because she has a unique grasp of the forces that shape Mr Putin’s psychology. At 62, he is just two years older than she; both remember the cold war well. Her command of Russian is an advantage, too. Her conversations with Mr Putin, who learned German as a KGB operative in Dresden, often begin in German. But people briefed on their talks say Mr Putin switches to Russian when things “get complicated”.
 
During a tense meeting in Milan in October, when European leaders struggled, but failed, to hold Mr Putin to the terms of the Minsk agreement, the chancellor broke into an argument in Russian between Mr Putin and Ukrainian President Petro Poroshenko. As the two leaders tussled over a key detail of the accord covering elections in rebel-held territory, she firmly corrected Mr Putin in his native language.

As in the eurozone crisis, Ms Merkel has assumed a leadership role for Germany in international affairs for the first time since the second world war. In her words, Ukraine poses a “test of resolve” for the west, seeing it as a challenge to peace in Europe itself. “Merkel was clear from the very beginning that it’s . . . not a fringe event,” says Norbert Röttgen, head of Germany’s parliamentary foreign affairs committee. The ever-cautious chancellor might have preferred Germany’s main allies to take the lead on Ukraine. But the US, the UK and France were stretched by the turmoil in the Middle East. An EU diplomat says: “Merkel grabbed this and we have been happy for her to grab it.”

The US was happy for her to grab it, too. According to a senior Washington official, Mr Poroshenko, the oligarch elected Ukraine’s president in May, was anxious to hold face-to-face meetings with Mr Putin. But he wanted other leaders in the room capable of holding Mr Putin to commitments. Ms Merkel was the obvious choice. “The administration’s view is that she’s the best interlocutor that we have in the west with Putin,” says an ex-US diplomat.

Obama takes the back-seat

US President Barack Obama has held his own share of calls with Mr Putin, but he has largely taken a back seat. US insiders say the president feels Mr Putin was unresponsive to efforts to build a relationship. “Obama sees the world in win-win terms, Putin sees it in zero-sum terms,” says the ex-diplomat. The two have a visible lack of chemistry. In Mr Obama’s words, Mr Putin has a “kind of slouch, looking like the bored kid in the back of the classroom”.

Ms Merkel is familiar with Mr Putin’s psychological operations. In 2007, he played on her well-known fear of dogs by allowing his black Labrador, Koni, into a meeting with her in his summer residence in Sochi. Photos show her tight-lipped as the Labrador buried its head in her lap.

Berlin officials say the chancellor does not allow Mr Putin to get to her through such displays or, for example, by turning up hours late for a meeting, as he did the night before the summit in Milan.

Instead, she turns it to her advantage, treating the Kremlin chief’s bad manners as a sign of weakness.

Russian President Vladimir Putin speaks during his visit to the Crimean port of Sevastopol on May 9, 2014. Putin's visit to Crimea, which was annexed by Moscow in March, is a "flagrant violation" of Ukraine's sovereignty, authorities in Kiev said today.AFP PHOTO/ YURI KADOBNOV (Photo credit should read YURI KADOBNOV/AFP/Getty Images)©AFP
Putin in Crimea in May last year after its annexation


But Ms Merkel is persistent. For her, talking to Mr Putin is not just about trying to change his behaviour but making sure he understands how Russia’s actions are perceived in the west. Diplomats suspect Mr Putin is surrounded by yes-men afraid to give him the unvarnished truth. They suggest, for example, that he has been surprised by the strength of EU unity over sanctions.

“She’s one of the few who on a regular basis gives him a mirror of his actions,” says a Berlin insider.

She prepares meticulously, studying maps of eastern Ukraine and poring over them in meetings and phone calls with Mr Putin. “There are maps and charts, with roads and checkpoints,” says a European diplomat. “She has these details. She knows about them.”

Ms Merkel used to see Mr Putin as a difficult partner, but one who she could do business with.

But the Ukraine crisis has changed her mind. She realised Mr Putin was not telling the truth in their conversations — for example, in his denials that Russian troops were directly involved in the takeover of Crimea and, later, in eastern Ukraine. In public, Ms Merkel has not said Mr Putin has lied, but she has in private. “‘He’s lying,’ that’s what she says to all the other leaders,” says the EU diplomat.

Almost as big a challenge as dealing with Mr Putin has been maintaining unity between the EU and the US, whose ties were severely strained by the Iraq war a decade earlier. Each side has also suffered from internal divisions. In Washington, different arms of the US administration have split, with some state department officials taking a more hawkish stance than the White House.

Within the EU, Poland and the Baltic states are taking a harder line against Russia than countries such as Italy. Ms Merkel has had to persuade a sceptical German business community, wary of damaging ties with Russia, of the need for robust action.

Frank-Walter Steinmeier, German foreign minister, was a long-time proponent of the need to do a deal with Mr Putin over Ukraine. But Ms Merkel has slowly made him realise this may be impossible. In Brisbane, she secured an invite for Mr Steinmier to meet the Russian leader in Moscow because she felt the necessity to “disillusion” him, says a person familiar with the meeting.

Initially, the EU’s sanctions were weaker than those passed by the US — even though the moves were synchronised. But one event in the middle of July bridged all of these gaps, uniting the west in anger at Russia’s aggression: the downing of flight MH17.

It was July 17, Angela Merkel’s 60th birthday. By the time her 650 guests began to arrive at the sleek Konrad Adenauer House in central Berlin, the news from eastern Ukraine was out: a Malaysia Airlines Boeing 777 had crashed, probably shot down. Since the flight was from Amsterdam to Kuala Lumpur, Germans — and many other Europeans — were almost certainly among the 298 passengers and crew presumed dead.

Ms Merkel put out a statement expressing shock and demanding a full investigation. A partygoer close to Ms Merkel recalls her saying little about the disaster. “The chancellor doesn’t like to speak about something until she is sure of her facts. But she was shaken. It was horrendous.”

In Washington, Mr Obama heard the news from Mr Putin. Towards the end of a call arranged to discuss sanctions the US and EU had imposed the day before, Mr Putin mentioned reports of a plane “crashing” in eastern Ukraine. There was no reference to the possibility that it might have been shot down.

By the end of the day, intelligence pointed to rebels in eastern Ukraine as having downed flight MH17 using a Buk ground-to-air missile supplied by Russia, apparently mistaking it for a Ukrainian military plane. Speaking in Detroit, US vice-president Joe Biden said the Boeing had been “shot down, not an accident. Blown out of the sky”.

Unifying moment

The downing of MH17 was a turning point, brutally awakening the western public to how virulent the fighting in eastern Ukraine had become — or, in the words of one senior US official, “the complete Mad Max quality of it all”. What had seemed a low-level, contained conflict had mushroomed into a real war, capable of claiming the lives of innocent civilians who lived hundreds or thousands of miles away.

Yet the danger of such an incident had been mounting for weeks — partly because Ukrainian forces had gained the upper hand militarily over the rebels. A 10-day ceasefire announced by Mr Poroshenko, which had been repeatedly breached, had been called off on July 1. Within days, Ukrainian forces had recaptured Slavyansk, the rebels’ military stronghold. Russia had begun sending heavy weaponry across the border — including anti-aircraft missiles aimed at weakening Ukraine’s air force.

As evidence solidified that the Buk launcher had been supplied by Russia, the incident brought home how much the conflict had become a “proxy” war between Russia and Ukraine — even between Russia and the west.
 
Ukraine map


Some western diplomats thought the incident might provide an opportunity for Mr Putin to make a face-saving exit from the conflict.

“[People thought] perhaps there is a chance that [Moscow will] see it’s getting out of control and start taking weapons out of there,” says an EU foreign minister. “But it was a clear surprise that they continued to arm, that they didn’t back down.”

Ms Merkel was horrified by reports from the crash site that bodies were being looted and rebels were denying investigators proper access. “The chancellor decided that a clear signal must be sent after the shooting down of the civilian plane,” said Philip Missfelder, the Christian Democratic Union’s parliamentary foreign policy spokesman. “We in Germany have the feeling that it made a qualitative difference that civilians were killed.”

Mr Putin was out of view. On Saturday July 19, Ms Merkel became the first western leader since the crash to speak to him, insisting that the separatists aid the recovery of the bodies and allow an investigation. When he protested, as often before, that he had no control over the rebels, she warned that inaction would result in economic consequences.

Ms Merkel also spoke to Mr Obama. She could see that Mr Putin’s responsibility for the missile-firing was unclear. But failing to secure the crash site wasa “chance not taken by the Russian authorities”, said a Berlin observer close to the chancellor.

On Sunday, the US was confident enough of its intelligence to give a detailed account of what it believed had befallen MH17. John Kerry, secretary of state, announced the US knew the missle’s trajectory — and that it came from separatist-held territory.

Within hours, Mr Putin made his first public appearance since the plane was shot down — in a video posted on the Kremlin’s website at 1.40am Moscow time. Looking sweaty with dark bags under his eyes, Mr Putin spoke of the “terrible tragedy” but acknowledged no responsibility on the part of the rebels, or Russia. Instead, he implied Kiev bore moral responsibility after it called off a ceasefire in June: “I believe that if military operations had not resumed in eastern Ukraine . . . this tragedy probably could have been avoided.”

Western officials who had hoped that Moscow might attempt to calm tensions were disappointed. Russia’s defence ministry presented a narrative entirely at odds with the west’s, claiming that Russian radar had spotted a Ukrainian fighter not far from the jet shortly before the crash.

Some long-serving western diplomats were reminded of Moscow’s response in 1983, when a Soviet fighter downed a Korean airliner that had strayed into its airspace. “It was the same tactic. Lies, throw up chaff,” says one.

But MH17 took place in the era of smartphones and social media. Photos and videos quickly emerged online of a Buk launcher arriving in east Ukraine, then departing minus one missile.

Many of the initial conclusions have been borne out by official investigations.

After months of propaganda from Russian state media presenting an entirely different version of the Ukraine crisis, US officials felt they were in a race to get their information about MH17 out quickly.

Some Moscow officials and western analysts sympathetic to Russia say the rush to finger-point was a miscalculation by the west. Asked why Mr Putin did not turn MH17 into an opportunity for reconciliation, a former senior Kremlin official said: “Because he was insulted. He acted emotionally.

Because your side came out before anything was clear, accusing him of all sorts of things.”

No one outside the Kremlin knows whether there was ever any real possibility of Mr Putin taking a different approach. What is clear, however, is that outrage over MH17 gave the west a newfound sense of unity.

The EU and US took aim at entire sectors of the Russian economy, imposing new sanctions on state-owned banks and oil companies. Along with the unexpected slide in oil prices, these have exacerbated Russia’s financial crisis. The “atmosphere had changed fundamentally” after MH17, an EU foreign minister said.

During a meeting on the sanctions, Poland’s hawkish parliamentary speaker Radoslaw Sikorski, noted to a colleague: “It seems only [Russia critics] are here. I didn’t have to say anything. They have made our points for us.”
 
Soon enough, Mr Putin would deliver his response.

‘At war with Russia’

In the days around Ukraine’s independence anniversary, August 24, three Russian operational battle groups totalling about 4,000 Russian soldiers crossed the border, with unmarked tanks, armoured personnel carriers and heavy weapons, western officials say.

Russian special forces and military intelligence officers had been in eastern Ukraine since pro-Russian rebels first began seizing towns in April, say Kiev and western intelligence officials. But the entry of regular Russian forces marked a perilous escalation.

“At that point we were no longer talking of an antiterrorist operation,” as Kiev termed its fight against the separatists, says a Poroshenko adviser. “We were at war with Russia.”

Western officials still struggle to understand what Mr Putin’s objectives are. Does he want to restore Novorossiya, the Black Sea territory conquered by Catherine the Great stretching from Donetsk to Odessa? Is he determined to break the Nato alliance? Whatever his objective, one thing became clear in August: Mr Putin was determined not to “lose” in Ukraine.

Western officials had feared such a retaliation for weeks as Ukrainian forces continued to gain the upper hand over the rebels. Reports that rebels were positioning themselves near kindergartens and hospitals prompted a warning call to Mr Poroshenko from Mr Biden, his most frequent US contact.

“[There were] calls from the vice-president that there was not a military solution, and you should be careful about doing things that could provoke a Russian response,” says a White House official. “Our assessment was that Putin was not going to let the separatists lose.”

Ms Merkel echoed the message. “She was holding him back from a military push,” says a person close to the chancellor. “She was saying, don’t underestimate Russia and how Russia will react.”

But there were splits in the US and Europe over how far Ukraine should push its military campaign.

“There were some here saying that, if one of Donetsk or Lugansk falls, that will provoke Putin into a massive attack, from which [the Ukrainians] will never recover,” this official says.

“Others were saying they should take one of those towns and then sue for peace, to prove to [Putin] that he can’t win.”

In the event, Russian forces entered before Ukraine could retake either city — and rapidly turned the tables. Ukrainian forces had been better armed and disciplined than the rebels. But they were outmatched by the well-organised, heavily-armed Russian forces.

Russian weaponry included Uragan rockets, which can fire shrapnel on a target in precision strikes from 35km away. Ukrainian soldiers “never saw the enemy”, says the adviser to Mr Poroshenko. “It was like a meat-grinder.”

As the carnage mounted, Ukraine’s president realised he had no choice but to push for a ceasefire.


Reporting team: Neil Buckley, Stefan Wagstyl, Peter Spiegel, Roman Olearchyk, Kathrin Hille, Sam Jones, Roula Khalaf, Geoff Dyer and James Politi

A Greek Morality Tale

Joseph E. Stiglitz

FEB 3, 2015

Greece debt chains banker
  NEW YORK – When the euro crisis began a half-decade ago, Keynesian economists predicted that the austerity that was being imposed on Greece and the other crisis countries would fail. It would stifle growth and increase unemployment – and even fail to decrease the debt-to-GDP ratio. Others – in the European Commission, the European Central Bank, and a few universities – talked of expansionary contractions. But even the International Monetary Fund argued that contractions, such as cutbacks in government spending, were just that – contractionary.
 
We hardly needed another test. Austerity had failed repeatedly, from its early use under US President Herbert Hoover, which turned the stock-market crash into the Great Depression, to the IMF “programs” imposed on East Asia and Latin America in recent decades. And yet when Greece got into trouble, it was tried again.
 
Greece largely succeeded in following the dictate set by the “troika” (the European Commission the ECB, and the IMF): it converted a primary budget deficit into a primary surplus. But the contraction in government spending has been predictably devastating: 25% unemployment, a 22% fall in GDP since 2009, and a 35% increase in the debt-to-GDP ratio. And now, with the anti-austerity Syriza party’s overwhelming election victory, Greek voters have declared that they have had enough.
 
So, what is to be done? First, let us be clear: Greece could be blamed for its troubles if it were the only country where the troika’s medicine failed miserably. But Spain had a surplus and a low debt ratio before the crisis, and it, too, is in depression. What is needed is not structural reform within Greece and Spain so much as structural reform of the eurozone’s design and a fundamental rethinking of the policy frameworks that have resulted in the monetary union’s spectacularly bad performance.
 
Greece has also once again reminded us of how badly the world needs a debt-restructuring framework. Excessive debt caused not only the 2008 crisis, but also the East Asia crisis in the 1990s and the Latin American crisis in the 1980s. It continues to cause untold suffering in the US, where millions of homeowners have lost their homes, and is now threatening millions more in Poland and elsewhere who took out loans in Swiss francs.
 
Given the amount of distress brought about by excessive debt, one might well ask why individuals and countries have repeatedly put themselves into this situation. After all, such debts are contracts – that is, voluntary agreements – so creditors are just as responsible for them as debtors. In fact, creditors arguably are more responsible: typically, they are sophisticated financial institutions, whereas borrowers frequently are far less attuned to market vicissitudes and the risks associated with different contractual arrangements. Indeed, we know that US banks actually preyed on their borrowers, taking advantage of their lack of financial sophistication.
 
Every (advanced) country has realized that making capitalism work requires giving individuals a fresh start. The debtors’ prisons of the nineteenth century were a failure – inhumane and not exactly helping to ensure repayment. What did help was to provide better incentives for good lending, by making creditors more responsible for the consequences of their decisions.
 
At the international level, we have not yet created an orderly process for giving countries a fresh start. Since even before the 2008 crisis, the United Nations, with the support of almost all of the developing and emerging countries, has been seeking to create such a framework. But the US has been adamantly opposed; perhaps it wants to reinstitute debtor prisons for over indebted countries’ officials (if so, space may be opening up at Guantánamo Bay).
 
The idea of bringing back debtors’ prisons may seem far-fetched, but it resonates with current talk of moral hazard and accountability. There is a fear that if Greece is allowed to restructure its debt, it will simply get itself into trouble again, as will others.
 
This is sheer nonsense. Does anyone in their right mind think that any country would willingly put itself through what Greece has gone through, just to get a free ride from its creditors? If there is a moral hazard, it is on the part of the lenders – especially in the private sector – who have been bailed out repeatedly. If Europe has allowed these debts to move from the private sector to the public sector – a well-established pattern over the past half-century – it is Europe, not Greece, that should bear the consequences. Indeed, Greece’s current plight, including the massive run-up in the debt ratio, is largely the fault of the misguided troika programs foisted on it.
 
So it is not debt restructuring, but its absence, that is “immoral.” There is nothing particularly special about the dilemmas that Greece faces today; many countries have been in the same position. What makes Greece’s problems more difficult to address is the structure of the eurozone: monetary union implies that member states cannot devalue their way out of trouble, yet the modicum of European solidarity that must accompany this loss of policy flexibility simply is not there.
 
Seventy years ago, at the end of World II, the Allies recognized that Germany must be given a fresh start. They understood that Hitler’s rise had much to do with the unemployment (not the inflation) that resulted from imposing more debt on Germany at the end of World War I. The Allies did not take into account the foolishness with which the debts had been accumulated or talk about the costs that Germany had imposed on others. Instead, they not only forgave the debts; they actually provided aid, and the Allied troops stationed in Germany provided a further fiscal stimulus.
 
When companies go bankrupt, a debt-equity swap is a fair and efficient solution. The analogous approach for Greece is to convert its current bonds into GDP-linked bonds. If Greece does well, its creditors will receive more of their money; if it does not, they will get less. Both sides would then have a powerful incentive to pursue pro-growth policies.
 
Seldom do democratic elections give as clear a message as that in Greece. If Europe says no to Greek voters’ demand for a change of course, it is saying that democracy is of no importance, at least when it comes to economics. Why not just shut down democracy, as Newfoundland effectively did when it entered into receivership before World War II?
 
One hopes that those who understand the economics of debt and austerity, and who believe in democracy and humane values, will prevail. Whether they will remains to be seen.
 
 

Read more at http://www.project-syndicate.org/commentary/greece-eurozone-austerity-reform-by-joseph-e--stiglitz-2015-02#UaDyrSLVloLmhjHU.99

Review & Outlook 

Obama Unchained

The budget promises a revenue increase of 11% for the political class.

Feb. 2, 2015 7:45 p.m. ET


President Obama ’s allies are cheering the fiscal 2016 budget he released on Monday as an expression of his liberated liberal self. We’re trying to recall when he wasn’t so liberated. But the exercise is still useful as a warning about the tax-and-spending trajectory of liberal governance absent reform or Congressional restraint.

Mr. Obama’s guiding principle seems to be “never enough.” The White House budget office expects federal outlays and revenues to rise to altitudes well above historical norms, yet the average estimated deficit over 10 years of $567 billion is higher than in any Administration since World War II. Mr. Obama has to keep raising taxes because it’s the only way he can keep the deficit from exploding given his spending demands.

The budget shop predicts revenues will boom in 2016 to a new federal record of $3.53 trillion, which is a 16.7% increase over $3.02 trillion in 2014 and 67.5% (!) more than 2009. The one-year revenue increase alone is 11%. How many people do you know who are getting an 11% raise this year? Mr. Obama wants that much more for the political class to redistribute. 

As a share of the economy, tax receipts will climb to 18.7% of GDP in 2016 from 17.5% in 2014 and then settle in at a 19.3% average through 2025. That’s two percentage points above the 30-year average of 17.2%.

Mr. Obama needs all this cash because he is proposing to spend $3.99 trillion in 2016. The budget gnomes must have been told that, whatever you do, keep the top line below $4 trillion.

The $3.99 trillion is a 7% increase from 2014 and about $1 trillion more than the feds spent in 2008. Outlays would be 20.9% of GDP and jump to 22.2% by 2025, again outstripping the 30-year average of 20.4%.

Mr. Obama’s immediate goal is to reverse the modicum of restraint enforced by the post-Pelosi GOP House. The document derides as “mindless austerity” the statutory spending caps—which he proposed and then signed—of the Budget Control Act of 2011, and proposes to burst through them for both defense and domestic discretionary spending.

For the Pentagon, Mr. Obama’s budget of $612 billion represents a 4.5% increase over 2015.

This boost is overdue in a world of proliferating national-security threats from the Islamic State to Vladimir Putin to China.

But the President is bidding for that classic Washington compromise in which Democrats spend more on social welfare in return for Republicans spending more on defense. Mr. Obama’s implicit threat is that if the GOP won’t let him spend more on domestic accounts, he’ll further weaken U.S. security. Thank you, Commander in Chief.

Mr. Obama’s domestic priorities include new “investments” ranging from more cash for non-fossil fuel energy to a free community college entitlement to a new $478 billion program for public works. He also favors more spending through the tax code, featuring the refundable tax transfer payments that are the core of his new pitch for “middle-class economics.”

Mr. Obama is also trying to entice Republicans with an opening bid on taxing corporate foreign profits, suggesting that the $2.12 trillion U.S. companies currently have parked overseas could be repatriated at a 14% rate, and 19% on future overseas profits. That’s an improvement on the 35% statutory rate if Apple or Intel bring those profits home.

This net tax increase is supposed to be an overture to Republicans like Rand Paul who support a one-time overseas corporate tax holiday to fund roads and bridges. But such a temporary fix would do little to change the long-term incentives to keep profits abroad or help U.S. tax competitiveness. The revenue windfall would be better used to support a larger corporate tax reform that permanently lowers rates.

The great unmentionables in Mr. Obama’s budget are entitlements, which roll on largely untouched. The share of the budget that is “mandatory”—not part of annual appropriations—is 15.1% of GDP in 2016 and jumps to 16.6% by 2020, gradually crowding out everything else the government is supposed to do.

Medicaid spending will nearly double to $567 billion in 2025 from $301 billion in 2014. Most of that is ObamaCare. Meanwhile, the Social Security “off-budget surplus” that has long financed current spending on everything except retirement is shrinking and goes negative in 2017. This means senior benefits will soon have to be paid out of general tax revenues.

***

These trends explain why deficits are lower for now but start to widen after 2018 despite Mr. Obama’s tax increases and economic growth projections of 2.6% on average for the next five years. The Congressional Budget Office predicts 2.4% growth, which means even less revenue.

Oh, and even with lower deficits, debt held by the public will be 75% of GDP this year, the highest level since 1950, and up from only 39.3% as recently as 2008.

Mr. Obama’s previous budgets at least pretended to care about these long-term fiscal problems, so in that sense this effort is more honest. Republicans can block Mr. Obama’s revival of tax and spend politics, but they still need his signature to arrest America’s coming fiscal crackup. On the evidence of this budget, they’re unlikely to get even the back of his hand.

Gold Is Beginning to Lose Less Badly Against the US Dollar

By Henry Bonner


At around $1,230 per ounce as of February 6, 2015, gold is slightly positive with a 0.4% increase over 12 months. The positive number comes thanks to an up-move in gold in January 2015, which took gold briefly above $1,300 on January 22nd.1

Why has gold stopped falling in the last 12-month period? And will it continue to hold above its lows?

In Sprott US Chairman Rick Rule’s latest call (available here), he explained why, if the ‘recovery’ narrative is real, he will be entering precious metals and commodities more aggressively.

While commodity prices have been weak, and oil prices in particular dropping off over the last three quarters, the general US stock market has performed well. The S&P 500 returned around 20% over the last 12 months.2

This reflects bullishness on the US economy overall, and if it’s justified, we should see “higher wages, higher auto sales, increasing sales of durable consumer goods, and, importantly, increasing capital investment in American industry.” Higher production of durable goods, more housing starts and automobile purchases should boost demand for commodities like copper or iron ore, which have been weak over the last several years.

Precious metals should also rise in a recovery scenario because “demand pull inflation (from increased spending) tends to raise prices faster than any single other factor,” says Rick.

With that in mind, the oil price decline could help the global economy.

“Households and businesses have more money left over to spend, which should be a good boost to the economies of many countries,” said Rick. It’s especially good for large mining companies, he explained, because energy is one of their main input costs. Still, it’s not likely to matter on its own for most mining stocks, which are much more dependent on the prices of the metals they produce.

Overall, the oil price drop should be good for investors in precious and base metals.

The likelihood that an oil price slump could precipitate a global economic crisis is low, says Rick. “There’s been speculation that the amount of oil field debt outstanding (estimated at around $500 billion for the US3) could precipitate another debt crisis, similar to 2008. The energy sector only constitutes 2 or 3% of the US economy, so even if a third of outstanding oil debt is impaired, it’s not the stuff of a global economic crisis like housing prices were.

Absent a real economic recovery, what does the future look like for gold?

Rick says that important moves in gold originate from deep changes in the global monetary and financial system.

Too many investors, he warns, focus on headlines such as the Swiss Franc’s departure from the Euro peg, or crises in the Middle East.

Instead, gold’s performance will depend on the outcome of its ongoing ‘war’ with the US dollar for the faith of investors and savers worldwide. In a recent interview with Sprott’s Tekoa Da Silva, Rick said:

“From my point of view, we’re simply locked in a war with the U.S. 10 year note. If the dollar strengthens, it weakens gold. If the dollar weakens it strengthens gold.”

You can see the US dollar hegemony from the fact that interest rates are so low; the 10-year US Treasury pays around 1.8% per year4 as of February 6.

Now, the official inflation rate actually dropped substantially in 2014 to 0.8% annualized, thanks in part to cheaper gas prices – so perhaps 1.8% doesn’t seem so bad. Still, leaving food and fuel aside, the official inflation rate was 1.6%.5And as of early 2010 the interest rate on 10-year Treasuries was around twice as high.This tells you the power of the US dollar – represented by the US Treasury -- right now.

Over the last few years, gold has simply been losing the war against the US dollar, says Rick. Now gold’s price is stabilizing, but Rick noted in his recent call that gold’s struggle against the US dollar is uphill, and that the dollar still has a strong upper hand:


Procter & Gamble, the Strong Dollar, and Pepto Bismol

Tony Sagami

February 3, 2015


 
Applied Materials. Boeing. Coach. Ford. Intel. McDonald’s. Nike. Pfizer.
 

What do those household-name companies have in common? Not much, other than that a huge part of the sales come from outside the US.
 

Really, really huge.
 

Collectively, the 500 companies in the S&P 500 get 46% of their sales and roughly 50% of their profits from outside the US. They are truly multinational giants.
 

Expanding your customer base is always a good thing, but doing business overseas is not without peril, and one of the underappreciated perils is the impact of currency movements. A stronger dollar can hurt companies that do a large share of their business overseas because sales in other countries translate back into fewer dollars.
 

Just ask Procter & Gamble, which reported their Q4 results last week.
 
 
 
P&G sold $20.16 billion of toothpaste, laundry detergent, diapers, toilet paper, and razor blades last quarter, but that was a 4% decline from the same period a year ago.
 

Worse yet, profits plunged by 31% to $1.06 per share, which was not only well below the $1.13 per share Wall Street was expecting but also a horrible 31% year-over-year drop. That’s bad.
 

What’s behind those terrible numbers? The US dollar.
 

“The October-December 2014 quarter was a challenging one with unprecedented currency devaluations,” said CEO A.G. Lafley.
 

The US Dollar Index was up 13% in 2014 and is now near a 9-year high. That strong dollar is a big millstone around the neck of US exporters, whose products are now more expensive for foreign buyers as well as negatively affecting profits once those foreign sales are converted back into US dollars.
 
 
 
Worse yet, Lafley said the environment will “remain challenging” in 2015.
 

The US dollar is now at a 9-year high and threatening to go higher. Much, much higher.
 

By historical standards, the US dollar is still cheap and expected to go higher by many observers, including Procter & Gamble.
 

P&G warned Wall Street that its 2015 sales will fall by another 5% and its 2015 profits will shrink by another 12%.
 

Think about those two numbers: 5% lower sales and 12% lower profits.
 

The strong dollar is a big problem for P&G because it gets roughly two-thirds of its revenues from outside the US, so it’s more affected by the strong US dollar than most companies, but P&G is far from alone when it comes to currency woes.
 

The line of companies that have warned that the strong dollar is hurting their profits is getting longer and longer.
 

Microsoft, Pfizer, McDonald’s, Caterpillar, United Technologies, Emerson Electric, 3M, and even Walmart have warned that the rising dollar is depressing their profits.
 

What does this mean to you? That a LOT more companies are going to report lower-than-expected sales and profits in 2015 and those that do will see their stock get hammered, just like P&G.
 

The problem is that Wall Street is blind to this profit-crushing trend.
 

In 2014, the S&P 500 companies collectively earned $117.02, and the median forecast of Wall Street strategists for 2015 S&P 500 earnings is $126, which is an optimistic 7.6% growth in earnings.
 

Unless you think that Procter & Gamble is an isolated island of trouble (and it’s not), you should be very worried that Wall Street is grossly underestimating the profit-crushing impact of the strong dollar as well as grossly overestimating corporate America’s earnings growth.
 
 
That massive disconnect between reality and the Wall Street dream world is going to translate into some very tough times for stock market investors. If you haven’t added some defense to your portfolio… you may need lots and lots of a popular Procter & Gamble product: Pepto Bismol.