Mining in Latin America

From conflict to co-operation

Big miners have a better record than their critics claim. But it is up to governments to balance the interests of diggers, locals and the nation

COCACHACRA, PERU
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A COUPLE of hours drive south of Arequipa, Peru’s second city, the Pan-American highway drops down from the high desert of the La Joya plain and threads its way through tight defiles patrolled by turkey vultures before reaching the green braid of the valley of the river Tambo.

The river burbles past fields of rice, potatoes and sugar cane. It is a tranquil, bucolic scene. The only hint of anything untoward is the five armed policemen guarding the bridge at the town of Cocachacra.

Last April the valley was the scene of a month-long “strike” that saw pitched battles between the police and hooded protesters hurling stones from catapults (see picture). Two protesters and a policeman were killed; 150 police and 54 civilians were hurt. The protest was over a plan by Southern Peru Copper Corporation, a Mexican-owned company, for a $1.4 billion copper and gold mine, called Tía María, on the desert bluffs overlooking the valley. Southern, as Peruvians know the firm, says the mine would generate 3,000 construction jobs and 650 well-paid permanent posts and would add more than $500m a year to Peru’s exports. Local farmers insist it would kill their livelihoods by polluting the river. The company denies this: after a previous round of protests in 2011 in which three people died, it redesigned the project to include a $95m desalination plant as a way to avoid drawing water from the river.

So far the farmers are winning. Because of the protests, Southern suspended the project. Although his government approved Tía María, Ollanta Humala, Peru’s president, gave it only lukewarm support. Southern is waiting for a new government to take office in July. Even then it will be difficult to win local consent. “The conditions will never exist for the company to operate,” declares Jesús Cornejo, the president of the water-users’ committee in Cocachacra.

Nearly all the houses in the valley are adorned with flags saying “Farming Yes, No to the Mine”.

Tía María is just one of many conflicts in Peru between mining, hydrocarbons and infrastructure companies and communities. In September three people were killed in a protest over last-minute changes to the design of Las Bambas, a giant copper mine bought in 2014 for $7 billion by MMG, a Chinese group, from Glencore, a Swiss commodities company, and which began production last month. In February 2015 in Pichanaki, in the eastern Andean foothills, one person was killed and 32 were injured when police opened fire on a mob opposed to natural-gas exploration by Pluspetrol, an Argentine firm. In 2012 protests halted Conga, a copper and gold mine in which an American-Peruvian consortium had invested $1.5 billion.

In all 53 people have been killed and almost 1,500 injured in social conflicts in Peru, mostly related to extractive industries, since Mr Humala took office in 2011. Peru has foregone investment of $8.5 billion in mining projects blocked by such conflict over the past 15 years, according to Semana Economica, a magazine.

Battles over the exploitation of natural resources have become common throughout Latin America. The Observatory of Mining Conflicts in Latin America, a coalition of NGOs, logged 215 of them in 19 countries in 2014, led by Mexico, Peru and Chile (see map). In 2013 Chile’s Supreme Court suspended Pascua-Lama, a gold mine straddling the border with Argentina, over fears that it would pollute rivers; Barrick Gold, its Canadian developer, had already spent $5 billion on the mine.

Colombia’s Constitutional Court has blocked exploration of a copper and gold deposit at Mandé Norte, north of Medellín, at the request of Embera Indians and Afro-Colombians in the area.

Oil drilling, too, has sparked protests in Ecuador and Peru; so have big infrastructure projects such as hydroelectric dams in Brazil and a proposed road through a nature reserve in Bolivia.

But it is mining that has become the biggest source of strife.

Slicing off the mountain tops
 
In the 1990s Andean countries opened their economies to private investment. The result was a boom, featuring vast open-cast mines. These often involve slicing the tops off mountains or drying up lakes. In the past people in the Andes tended to welcome mining; disputes were over labour relations. Modern projects have met growing resistance, partly because democracy has taken root in the region. People are more conscious of the projects’ impact on their environment, of the big money that is at stake and of their rights.

Opponents of mining often claim it brings no benefit to Latin America, just “poverty…serious environmental harm and…human-rights violations”, as a report by a group of Canadian NGOs put it. Some left-wingers argue that Latin America should abandon large-scale extractive industries altogether, saying they are inimical to development.

Modern mining is capital-intensive and generates relatively few jobs (though these tend to be skilled and well-paid). Yet the reality is much more nuanced than critics allow. By providing foreign exchange, tax revenues and investment, mining has helped to speed economic growth and poverty reduction in several South American countries over the past 15 years. In Peru, for example, where poverty fell from 49% in 2005 to 23% in 2014, mining exports amounted to $27.4 billion at their peak in 2011, or 59% of the total. In Chile and (to a lesser extent) in Peru, industries have sprung up to supply mines with equipment, spare parts, software and other services. Tellingly, left-wing governments in Bolivia and Ecuador have backed mining and hydrocarbons projects, in the latter case riding roughshod over opposition.

The latest conflicts come as the mining boom has turned to bust. Faced with plunging prices and profits, miners are slashing investment and suspending projects. That in turn has contributed to an economic slowdown in the region.

Despite the slump, it remains vital for Latin American countries to find ways of reconciling the interests of diggers, local people and the nation as a whole. This is not easy. Unlike in the United States, minerals in Latin America belong to the state, rather than the private owners of the land under which they lie buried. The state grants mining concessions to companies, which must then reach agreement with the communities whose lives will be disrupted. Most of the benefits accrue to the nation; many of the costs, such as pollution, are borne locally.

There is a huge asymmetry of power, resources and information between big miners and peasant farmers and herders high in the Andes. Expectations, which may be unrealistic, are aroused. Modern mines often operate as near-enclaves: local people lack the skills to work there and the scale to supply food and other provisions.

Disputes can arise over land purchases, relocation of the population and compensation payments. Water is increasingly a flashpoint. Mines insist that they clean up waste water—and this is usually true. But sometimes things can go badly wrong. In Brazil in November 17 people were killed and thousands of tonnes of mud released into the river Doce when a tailings dam burst at an iron-ore mine that is a joint venture between Vale and BHP Billiton. In Mexico in 2014, 40m litres of copper sulphate from a mine owned by Southern’s parent company leaked into a river.

In remote areas of the Andes, companies have come under pressure to supply basic services that the state fails to, such as electricity, schools and clinics. Outside actors, such as political movements and NGOs, may fan conflicts—or help to resolve them.

Over the past two decades the balance of power has shifted in favour of local populations.

Fourteen Latin American countries are among only 22 to have signed the International Labour Organisation’s Convention 169 on the rights of indigenous and tribal peoples. This requires governments to ensure that these groups are consulted about projects or laws that may affect them. Many governments did not foresee the impact the convention would have, says Carlos Andrés Baquero of Dejusticia, a think-tank in Bogotá. Several countries, including Chile, Colombia and Peru, have written the requirement of prior consultation into law.

There is debate as to whether this gives locals a right of veto. In Colombia mining bosses complain that prior consultation has become a means to extort money from companies. Peru has decided that it doesn’t confer a veto, and has applied the law only to Amazonian tribes and not to Quechua-speaking people in the Andes. There the new system has worked to prevent conflicts in most, though not all, of the oil and gas projects over which it has been invoked. The convention has encouraged people to self-identity as indigenous. But many conflicts involve mestizos.

The second big change is in regulation. In Peru and Chile all projects are required to submit an environmental impact assessment (EIA). In Peru, this was supervised by the Ministry of Energy and Mines, whose main job is promote investment. “People don’t believe in the rigour of EIAs,” says José de Echave of CooperAcción, an NGO that works with communities affected by mining. Only this year has an autonomous environmental certification agency begun work.

Peru devolves half a mine’s corporate income tax to regional and local governments in the area.

This has showered some mining districts with more money than they can spend, often fostering corruption.

Third, spurred by activists in their home countries as well as by changes in host-country laws and politics, some multinational miners nowadays take environmental and social responsibilities much more seriously than in the past. In many cases mutually beneficial agreements can be struck between miners and communities, provided there is trust and goodwill. Communities “are not necessarily against mining but they are very concerned that their decision-making capacity about their land not be taken away from them,” says Tim Beale of Revelo Resources, a Vancouver-based exploration company. If the mining firm understands that, “it will have a much bigger chance of success.”

One example is Gold Fields, a South African company, which developed a medium-sized gold mine in Hualgayoc in northern Peru. The circumstances seemed unpropitious: the project began in 2004, just when mass protests stalled an expansion by Yanacocha, a big gold mine nearby. Gold Fields began by holding many meetings with local people, at which managers explained the project and listened to concerns. The company promised to employ some locals and train others to use the money they received from the sale of their land to set up service businesses. It brought in an NGO to work with herders to improve pastures, dairy cattle and cheese production. It worked with local mayors to install electricity and drinking wáter.

Shut up and listen
 
People protest “because they want things rapidly, they fear missing a golden opportunity,” says Miguel Incháustegui, a Gold Fields manager. He says the keys to achieving social consent were to listen more than talk and to ensure that living standards improve for people in the surrounding area.

Mitigating social and environmental risks is not expensive: it typically adds about 1% to a company’s total costs, estimates Janine Ferretti, head of the Inter-American Development Bank’s environment division. But that is not always true. At the Quellaveco copper project in Peru, Anglo American, a British firm, made an expensive offer to pay upfront to restore a river to its original course after the mine closed. The project is now in limbo.

Some miners find it hard to change. They see their strengths as understanding geology and managing projects, not engaging in grassroots politics. Others apply best practice in some countries but not in others, notes Mr Beale.

Southern seems to be in that group. Pinned to the wall of Mr Cornejo’s office in Cocachacra is a decree issued by Peru’s government in 1967 that gave Southern six months to halt emissions of sulphur dioxide from its nearby smelter and compensate local residents for air pollution.

Only in 2007 did it stop the emissions. Tía María is not a stereotypical conflict: Cocachacra is one of the 300 least poor of Peru’s nearly 2,000 districts; it has basic services; and its people are mestizo commercial farmers, not indigenous peasants. Guillermo Fajardo, Southern’s manager for the project, blames outsiders for the violence. Nobody in the area agrees. Certainly, the community is divided, and those who support the mine have faced intimidation; the opponents have the support of a far-left party.

The underlying problem is a lack of trust. “The company might be right but the population feels unprotected,” says Helar Valencia, the mayor of Cocachacra. Tía María only has a chance of going ahead if local peoples’ concerns are addressed “with concrete confidence-building measures” such as the government building a reservoir to ease water shortages, says Yamila Osorio, the regional governor.

Despite the headlines, more mines go ahead than don’t in Peru, points out Anthony Bebbington, a geography professor at Clark University in Massachusetts. Mainly because it has cheap energy and high-grade ores, many of Peru’s mines are competitive even at today’s prices.

Thanks to Las Bambas and other new mines, the country’s copper output is forecast to rise from 1.7m tonnes in 2015 to 2.5m tonnes this year, second only to Chile’s.

Ironically, the end of the boom may increase both government and public support for mining.

In Arequipa, for example, the regional government’s revenue from mining will fall this year to a tenth of its peak, says Ms Osorio. Although low prices have halted some projects, they potentially offer more time for consultations.

Reconciling the national benefits and local costs of mining is ultimately a problem of democracy. The days when big mines could simply be imposed are over. In that regard, something has been learned from the conflicts of the past two decades. Complaints about pollution are “a means of demanding a better state presence”, argues Vladimir Gil, a Peruvian anthropologist, in a study of Antamina, a big copper mine developed in the 1990s. The opposition such projects arouse can be seen “as a petition to achieve greater participation in national affairs”. In some areas governments might reasonably decide that big mining should not be allowed because of its impact on the environment or on farming. That is what Costa Rica has decided; El Salvador is close to doing so.

When a project does serve the national interest, it is important that the government backs it.

That does not always happen. Carlos Gálvez, the president of SNMPE, a mining-industry lobby in Peru, points out that after this year’s new copper mines and one other project, the pipeline is now empty. To remedy that, he says the next president should defend mining more robustly.

Mining is a long-term business. Exploration can take ten years, development of a project another five and construction from three to five, says Mr Galvéz. The minerals bust is a reminder that governments should invest the windfall gains from extractive industries in areas such as infrastructure and education to try to develop less cyclical economic activities. But it is not a reason to put off the institutional changes needed to give mining a sustainable future in Latin America. 

viernes, febrero 12, 2016

HERE COMES $20 OIL / BARRON´S MAGAZINE

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Barron's Cover

Here Comes $20 Oil

Oil could fall as low as $20 a barrel in the first half of this year, recovering to $55 by year end. That could help drive stocks, which have closely followed oil prices, much higher.

By Gene Epstein                

 
Oil bulls, take heart. The last leg of the bear market that began in mid-2014 is probably in sight, as marginal producers fall by the wayside. Supply cutbacks should bring a rebound in the price of crude by the second half of 2016.
 
But before a rebound, West Texas Intermediate crude will probably continue to fall, perhaps as low as $20 a barrel, before vaulting to the mid-$50s by year end.
 
Stock market investors can also take heart. The stock indexes have been closely correlated with oil of late, moving up or (mostly) down, as the price of crude has gyrated. This perverse pattern has persisted even though the overwhelming majority of global companies benefit from cheaper crude, since they buy the refined products to help run their operations.
 
It’s true that many oil exporters are in emerging market economies, and low oil prices have slowed their economic growth and put a dent in their sovereign wealth funds. Beyond this, stock traders may be subscribing to the misguided belief that low oil prices are signaling imminent global recession.
Our expected recovery in crude by the second half of this year will, therefore, probably bring a recovery in equities. And perhaps even before then, stock traders might wake up to the fact that the bear market in oil has mainly been reflecting a world awash in black gold.
 
While global weakness on the demand side has played a part in the buildup of excess supply, it has been weakness in the rate of growth, not an outright economic contraction. A further slowdown in global growth, especially from China, will also play a role, but here again, the supply side will dominate, as cutbacks in production bring a rebound in prices.
 
Barron’s predicted $75 oil in late March of 2014, when crude was trading above $100. But the market soon overshot our contrarian forecast, as the slowdown in global growth curbed the growth in demand. We followed up on that story repeatedly, lowering our sights to $20 a barrel a year ago (see chart below).

                                  
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WORLD CONSUMPTION OF OIL has held up relatively well. It rose in 2014 to 92.8 million barrels a day from 2013’s 91.9 million, a below-par increase of just 0.9 million barrels. Consumption in 2015 rose to 94.5 million, for a relatively substantial rise from 2014. But, of course, that was due mainly to the price plunge that made oil dirt cheap.
 
For 2016, in no small part because of the expected economic slowdown in China, Citigroup’s senior energy analyst Eric Lee projects below-par oil demand growth of one million barrels a day, to 95.5 million.
 
The supply side, then, has been the main driver of the oversupply that has wrought the bear market.
 
And nowhere has the supply-side revolution been more dramatic than in the U.S. As recently as 2010, the U.S. produced 5.5 million barrels a day of oil. Due to the advent of hydraulic fracturing, or fracking—the extraction of oil from shale—production jumped to 8.7 million by 2014. In 2015, production set another record, at 9.7 million.
 
Meanwhile, Saudi Arabia, long the Organization of Petroleum Exporting Countries’ swing producer, has recognized that it is powerless to control the market, and has simply produced at full tilt, with the aim of earning as much as it can. Russia, too, was able to increase production last year, in part because the collapse of the ruble against the dollar meant that it earned more rubles by selling oil for dollars, despite the collapse in the dollar-denominated oil price.
 
The worldwide oversupply of oil is evident from the buildup of inventories. Storage-tank capacity outside the U.S. is virtually exhausted. Edward Morse, head of global commodity research at Citigroup, who was cited in our first story, says that warm weather in December caused a buildup of heating-oil supplies in Europe that is being stored on ships, since there’s nowhere else to put the stuff.
 
The U.S. is virtually the only nation remaining with storage space left. And even here, as the Energy Information Administration reported last week, “at 502.7 million barrels, U.S. crude-oil inventories remain near levels not seen for this time of year in at least the last 80 years.” That figure of more than 500 million excludes the crude held by the U.S. government in its Strategic Petroleum Reserve, at nearly 700 million barrels.
 
The Strategic Petroleum Reserve is an anachronistic throwback to a time when energy insecurity might have been justified. Also anachronistic: federal restrictions that were long imposed on the U.S. export of oil.
 
This is no time to start selling the Strategic Reserve, however nonstrategic it has become, but export restrictions were finally lifted by Congress in December. That’s a sensible move, although one that should bear fruit only over the long run. For the time being, the market abroad for crude would seem to be close to saturated.
 
The chart above page reflects the likely trajectory, as seen by Citigroup’s Morse and Lee. As fundamental analysts, they project the price in quarterly averages; Barron’s has interpolated monthly prices that are consistent with these averages.
 
Also providing key insight: Steve Briese, publisher and writer of the Bullish Review of Commodity Insiders newsletter, who has frequently been cited by Barron’s.
 
The price decline in January to an average of $31.70 from $37.20 in December—punctuated by a low of $26.68 touched on Jan. 20—resulted from four factors: clear signals from China that growth of this powerhouse economy was slowing, thus curbing demand; mild winter weather, which caused a huge buildup of heating-oil stocks that the Europeans had to store on ships; investors shorting the market on the expected lifting of sanctions on Iranian exports; and the usual seasonal pullback in January of refinery utilization after the seasonal drawdown in December.
 
As Morse points out, “The only entities in the world that actually consume crude oil are refineries.” A price rebound in February and March is expected, due to the return of refinery demand and to the typical winter pattern of prices rising with the colder weather in February and March.
 
Briese cites a key indicator that affirms this constructive view of the next two months. He pays close attention to the Commitments of Traders Report released weekly by the Commodity Futures Trading Commission. The report tracks the long and short positions in futures and options on WTI traded on the New York Mercantile Exchange. This derivatives market is used by refiners that would naturally take long positions to hedge against a price rise, and producers who would take short positions to hedge against a price decline.
 
Briese long ago found strong evidence that in this, as in most other commodity futures and options markets, “commercials” as a group do not hedge by rote. Rather, they trade strategically—generally against the price trend.
 
As of Feb. 2, the most recent date for which figures are available, the net-short position—longs minus shorts—was 270,008 contracts. Since commercials as a group are almost always net short, the key point for Briese is this net-short position was at the low end of the historical range. For example, in June 2014, at the market’s last price peak, the commercials’ net-short position came to 512,853.
 
The fact that, at 270,008, the net-short position of the commercials was relatively low is a signal for Briese that the “smart money” is optimistic on the oil price—but only mildly positive. For example, in December 2008, at the market’s last price bottom, the commercials’ net-short position was even lower, at 99,753 contracts, which signaled an even bigger vote for a price rebound.
 
For the second quarter, Morse anticipates a return to price weakness based on two key factors: a larger refinery-maintenance period worldwide, particularly in the U.S., and especially in April, which will bring a pullback in demand, and the expectation that by April, Iranian production will have a noticeable effect on supply.
 
From Briese’s perspective, this could set the stage for the $20 capitulation low he has long been expecting, and which Barron’s has cited several times. As of Feb. 2, the large speculators held a huge long-only position of 579,266 contracts, nearly 36% of all the open positions in crude held on Nymex. As the fundamentals start to weigh on the price, forced liquidation of this long position could briefly push the price as low as $20.
 
Citigroup’s Lee also foresees an interim scenario for $20 oil driven by supply/demand fundamentals.
 
As he points out, if storage supplies build up to the point that no capacity is left, even in the U.S., then any production that comes on-stream would have to be sold immediately. Such distress sales could mean that prices briefly drop below $20.
 
BUT BY THE SECOND HALF, the bull market will return. “We think,” says Morse, “that the world is poised to lose a lot of oil production in the U.S., Colombia, Mexico, Venezuela, China, and then potentially in Russia, Brazil, and the United Kingdom sector of the North Sea.”
 
Russia is in a bind, he explains. The government has a dwindling amount of hard-currency reserves. So unless it decides to spend those reserves down to nothing, it will need to raise taxes, and likely targets are the oil and gas companies. The companies will therefore be forced to reduce their production, thus partially killing the golden goose that has been Russia’s main source of hard currency. And because of financial sanctions on Russia, the companies have no ability to borrow.
 
Morse projects a $50 average price in the fourth quarter, from which Barron’s extrapolates $55 by December. As a sign of how much the environment has changed, note that when we predicted $75 oil in March 2014, it was an outrageously bearish prediction. A $55 prediction now looks quite bullish.

As the nearby chart shows, the price of crude really does influence the price of gasoline, although not one-for-one, since the price of the refined product has other costs built into it that are relatively fixed, especially labor costs. When the WTI price was at $105 per barrel, the gasoline price averaged $3.70 a gallon; at $55, the price at the pump should run $2.50 a gallon.

As noted in our first bearish story predicting $75 oil, over the past five years, the world has found a trillion extra barrels of oil—the equivalent of 30 years of extra supply—with a third of it coming from shale, a third from deep water, and a third from oil sands. Over the past year, the costs of recovery from these sources has noticeably fallen. A return to triple-digit prices on crude oil is unlikely for the foreseeable future. 



Trump, Sanders and American rage


The yearning for leaders from the fringes will have profound implications for the US and the world
 
Daniel Pudles illustration©Daniel Pudles
 
 
For those who are worried that Donald Trump is a new Mussolini in the making, I have reassuring news. Based on his performance at a weekend rally in Plymouth, New Hampshire, Mr Trump is far too boring a speaker to make a convincing fascist dictator.

His long, rambling discourse — sprinkled with complaints about how long it had taken him to drive to the venue in the north of the state — left his audience yawning, with some leaving early to get to Super Bowl parties. Even Mr Trump’s traditional crowd-pleasers about “building the wall” with Mexico received only tepid ovations.
 
Yet, despite his manifest flaws as a speaker and as a human being, Mr Trump has succeeded in dominating the run-up to the US presidential election for months. His success in the Republican race — and that of Bernie Sanders, a self-described socialist, on the Democratic side — testifies to how the political establishment has lost the trust of voters.
 
Many Americans seem to have concluded that the political system is so corrupt and dysfunctional that only a total outsider can be trusted to take charge. The point was driven home to me while talking to a potential Trump voter on the fringes of the Plymouth rally. This man, a prosperous-looking lawyer, told me that if he did not vote for Mr Trump he would opt for Mr Sanders.
 
The Trump and Sanders pitches to the voters have certain strong similarities. Both lambast all mainstream politicians as in hock to corrupt special interests and lobbyists. Mr Trump, a billionaire, makes a virtue of the fact that his campaign is self-financed — making him immune, he says, to the pressures brought to bear on all the other Republicans by their donors. Mr Sanders has raised most of his campaign money from small donations and has put Hillary Clinton on the back foot by pointing to the hundreds of thousands of dollars she has accepted in speaking fees from the likes of Goldman Sachs.
 
Mr Sanders’ argument that “the business model of Wall Street is fraud” is finding an audience. Indeed, if anybody has said a good word about Wall Street in this election, I must have missed it. The most that Mrs Clinton will do is to suggest tentatively that “greed” in high finance, while bad, is not the only pressing problem facing the US.

In her speeches, Mrs Clinton consistently displays her impressive grasp of detail and public policy. Yet her campaign’s argument that she would be “ready on day one” to be president emphasises her status as a consummate member of the political establishment. That seems risky when large parts of the US public seem to detest the political elite.
 
By contrast, both Mr Trump and Mr Sanders are running from the fringes of their parties.

Both have said things that would be regarded as political suicide in a normal year. Mr Trump is probably the most openly racist candidate since George Wallace, the segregationist, in 1972.

Mr Sanders calls himself a “democratic socialist” — in a country that has always rejected socialism.

Yet the fact that both men are happy to smash rhetorical taboos has strengthened their respective claims to be genuine outsiders. That seems to be what voters are looking for.

Both men go into Tuesday’s New Hampshire primaries as strong favourites to win. The conventional wisdom remains that they will trip up later in the campaign. But, then again, a year ago the idea that Messrs Trump and Sanders could be the winners to emerge from New Hampshire would itself have been regarded as absurd. So who knows?
 
What is already clear, however, is that America’s political class is only beginning to grasp the depth of the anti-establishment mood that is gripping the US. Almost eight years after the financial crisis, this mood seems to be growing in strength, not weakening. President Barack Obama’s announcement last week that the US unemployment rate is now below 5 per cent barely registered on the campaign trail.
 
Instead, all the talk is of students reeling under unpayable debts; and of parents having to work at two or three low-paid jobs to make ends meet. The idea that the economy is “rigged” in favour of insiders is now embraced, in some form, by most of the candidates in both the Republican and Democratic parties.

Yet almost all the candidates running in New Hampshire make unconvincing populists. The very fact that they are running for president is a strong indication that these people are successful members of the American elite. Even Senator Ted Cruz of Texas, who casts himself as the ultimate outsider, is a former Princeton debater married to a Goldman Sachs banker.
 
That kind of dissembling only increases popular cynicism about politics — and facilitates the rise of apparent iconoclasts.
 
If America’s yearning for anti-establishment leaders from the political fringes continues, the implications will be profound — for the US and for the world. The system, dominated by the Democrats and Republicans, has always rejected the political extremes. That means that, behind the day-to-day dramas, the nation has benefited from a deep political stability, which has contributed greatly to its economic strength and global power. If America’s immunity to extremism is ending, the whole world will feel the consequences.


The Limits of German Power

Volker Perthes

 Darts with French, German, and British flag designs 
BERLIN – In the two years since Germany’s president, foreign minister, and defense minister signaled that their country would take on a larger role in international affairs, the country’s leaders have received a crash course in geopolitical realism. The challenges Germany has had to face include Russia’s annexation of Crimea, the conflict in eastern Ukraine, the explosion of Syria, terrorist attacks in Europe, and an unprecedented influx of refugees.
 
These crises have greatly increased Germany’s international profile. And yet the country’s reemergence as a major player on the world stage must be tempered with the recognition that its power depends on cooperation with its partners and the development of a strong, unified European foreign and security policy.
 
Germany’s embrace of a more active global role has taken place within a rapidly changing geopolitical landscape – one in which German and other European leaders have had to accept that most of the rest of the world does not share their preference for multilateral decision-making. They have also had to come to terms with the fact that the United States is no longer prepared to take the lead in every crisis, and that rising global powers – such as China, India, and Brazil – are not yet prepared to contribute effectively to maintaining a stable global order.
 
Meanwhile, the dividing lines between domestic and international affairs have become increasingly blurred. The refugee crisis, for example, demands policy interventions in areas as diverse as defense, development aid, European integration, domestic security, and social-welfare policy.
 
Increasingly, the challenges Germany is facing have become intertwined; terrorism, the Syrian civil war, Russian aggression, and refugee flows are interacting in dangerous and unpredictable ways. Nor are any of these crises likely to be easily contained or quickly resolved; each will have to be managed over the long term.
 
And given its high degree of integration into the global economy, Germany is vulnerable even to distant developments. For example, preventing military conflict and maintaining maritime freedom in the South China Sea is clearly in Germany’s interest.
 
To their credit, Germany’s leaders, recognizing the important role their country can play, have taken the diplomatic lead with Russia over its intervention in Ukraine. Moreover, Germany was a key participant in the nuclear negotiations with Iran, and it has been deeply involved in the effort to find a political solution to the Syrian civil war. Germany also assumed the 2016 presidency of the Organization for Security and Cooperation in Europe.
 
On the military front, Germany has beefed up its contribution to NATO measures to bolster defenses in the Baltic region and Central Europe, and it has become increasingly open to contributing military forces to interventions in crises outside the alliance’s area. It has participated in United Nations peacekeeping efforts in Mali, prolonged its engagement in Afghanistan, supplied weapons and training to forces in northern Iraq, and provided reconnaissance flights and other assistance to French military strikes against the Islamic State in Syria.
 
German policymakers are aware that their international partners expect this type of leadership to become the norm, and they have demonstrated an interest in expanding Germany’s rising influence. As a medium-size power however, Germany cannot be present everywhere; maintaining a broader international footprint will require cooperation with allies and partners around the world.
 
Indeed, the more Germany leads, the more dependent it becomes on other international actors – most notably its European Union partners – and the more exposed it becomes to fluctuations in the geopolitical environment. For example, China’s regional posture and its strategic relationship with the US will influence German efforts to find multilateral solutions to global challenges like climate change or cyber threats.
 
As Germany continues to lean forward internationally, it can be expected to increase spending on foreign policy and international security. To be sure, Berlin has yet to meet NATO’s target of 2% of GDP for defense spending. Like most other states, it has also failed to meet the internationally agreed commitment to spend 0.7% of GDP on official development assistance.
 
But, unlike some of its partners, Germany has not slashed its defense budget, and it has substantially increased funding for diplomacy.
 
Nonetheless, even as it has increased its capacity to provide military forces for UN, NATO, or EU operations, Germany has made clear that it does not view itself as a military power.
 
German policymakers continue to believe that political and economic means of influence are more effective than violence, implying further development of soft-power tools, including digital diplomacy. They are also eager to develop more “networked” national and European foreign policies that take into account the activities and possible contributions of non-state actors.
 
For the time being, Germany’s main foreign policy priorities are likely to remain the EU and the continent’s eastern and southern neighbors – from which immediate security risks are most likely to emanate. This would be a wise choice. Germany and its EU partners will be most effective when managing conflicts, stabilizing governments, or supporting economic and political transitions in their immediate neighborhood.
 
Furthermore, given today’s extraordinarily turbulent geopolitical environment, Germany has a fundamental interest in championing the development of the EU’s foreign policy and security institutions. As much as German policymakers might enjoy the growing demand for their contributions to international politics, the country’s membership in the EU remains its most potent source of power and security.
 
 


Erdogan’s Foreign Policy Is in Ruins

Just a few short years ago, Turkey was heralded as one of the region's rising powers. What happened?

By Henri J. Barkey
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Erdogan’s Foreign Policy Is in Ruins


It wasn’t long ago that Turkish foreign policy was the talk of the town. Defined by the catchy phrase of “zero problems with the neighbors,” Turkey aimed to both improve relations with its neighborhood and slowly emerge as the dominant regional power. It was a classic case of enhancing soft power through democratization and economic reforms at home, coupled with shrewd diplomacy aimed at establishing Ankara as a mediator in the region’s conflicts.

This policy lies in ruins today. It is the victim of the unpredictable turnabout in the Arab Spring, especially in Syria; hubris; and miscalculations in domestic and foreign policy. With the exception of the Kurdistan Regional Government in northern Iraq, Turkey’s relations with almost all of its neighbors have soured. At the same time, tensions with the United States, European Union, and Russia have all dramatically increased. If Ankara has any sway today, it is mostly because of its geography — which gives it proximity to Syria and the refugee calamity — and its willingness to use strong-arm tactics in diplomatic transactions.

So how did Turkey’s international ambitions fall apart? It’s a question with multiple answers.

President Recep Tayyip Erdogan’s grandiose ideas of his role in the world, his desire to transform Turkey into a strong presidential system, and the collapse of the Kurdish peace process, itself a casualty of the Syrian crisis, all have contributed to damaging Ankara’s once-promising foreign policy.

Turkey and the Arab Spring

Even before the Arab Spring, there were signs that Turkish foreign policy was faltering. In 2009, after almost seven years of conservative rule, Turkey’s accomplishments were noteworthy: rapid economic growth, the transformation of Istanbul into an international hub, democratization at home, and the domestication of the powerful military establishment. Erdogan’s Justice and Development Party (AKP) went from electoral victory to electoral victory, as ordinary citizens were seduced by his accomplishments and turned off by a hapless opposition.

Having consolidated his position at home, especially after the 2007 elections, Erdogan became more of a risk-taker. He initiated a calculated public showdown with Israeli President Shimon Peres at the 2009 World Economic Forum, in which he angrily castigated Israel’s policy in Gaza, which threw relations between the two countries into a tailspin. However, it also paid off tremendous dividends in the Arab world, as Erdogan and Turkey’s popularity skyrocketed, and Arabs flocked to Turkey for tourism and in search of investment opportunities. This was followed by a pro-AKP Turkish NGO’s decision to charter a boat and sail to challenge the Israeli blockade of Gaza and the disastrous Israeli response, which ended with the deaths of nine Turks and saw relations with Israel collapse further.

The advent of the Arab Spring also pushed the United States and Turkey to work together closely. They appeared to synchronize their public statements on Egyptian President Hosni Mubarak in an effort to push him out and later worked together on supplying arms and supplies to the Free Syrian Army. Turkey once again emerged as a regional model country that had successfully married Islam and democracy in the person of Erdogan and his AKP.
As early as 2010, Obama declared Turkey to be a “great Muslim democracy” and “a critically important model for other Muslim countries in the region”; in 2012, he even named Erdogan among the top five leaders with whom he had forged a close relationship.
Turkey, however, wanted to be more than a model. The rise in Egypt, Tunisia, and Syria of the Muslim Brotherhood, with which the AKP leadership had had close relations, opened the possibility of an active role for Ankara as the movement’s most powerful regional ally. The Arab Spring in effect allowed for the Turkish leadership to imagine itself as the region’s leading power: As then-Foreign Minister Ahmet Davutoglu put it, Turkey “will lead the winds of change in the Middle East … not just as a friend but as a country which is seen as one articulating the ideas of change and of the new order.”

Turkey’s moment had arrived. But it wouldn’t last long: Davutoglu’s hoped-for “new order” was dealt a setback when Egypt’s Muslim Brotherhood-led government was overthrown by a combination of public protests and the army, and Erdogan’s relations with the new military-led regime disintegrated rapidly. But it was in Syria, where Bashar al-Assad’s regime stubbornly persisted in the face of an insurgency that Turkey helped support, where Turkish foreign-policy objectives were ultimately upended.

How Syria changed everything

Before the 2011 uprising, Syria had been the ultimate successful example of Turkey’s “zero problems” foreign policy. Soon after the AKP’s rise to power, Syrian strongman Bashar al-Assad and Erdogan established a close working and even personal relationship. This was a remarkable turnabout, considering that in 1998, Turkey threatened Syria militarily due to its support of the Kurdistan Workers’ Party (PKK), which was then waging an insurgency against the Turkish state.

Erdogan helped launch indirect negotiations between Israel and Syria, and went on to support the Baathist regime against a U.N. effort, led by the United States and France, to pressure Syrian troops to leave Lebanon.

When the peaceful protests started in Syria, Erdogan at first maneuvered to prevent Assad from succumbing to the same fate as the Egyptian and Tunisian leaders. He counseled Assad to introduce reforms — in fact, he reportedly suggested that these did not have to be very profound — but to no avail.  As Assad gave a free rein to his military to crush the protests, Erdogan turned on his former ally and friend.
A number of factors contributed to Erdogan’s decision: anger that Assad would not heed his counsel, the common perception that Assad would not survive anyway, the belief that he could shape the new Syria, and finally the dramatic escalation of violence during the holy month of Ramadan in 2011 on what Erdogan saw as Sunni protestors. He called for Assad’s removal and publicly proclaimed that the Syrian dictator had only months left in power. Soon, he said in September 2012, “we will be going to Damascus and pray freely with our brothers at the Ummayad Mosque.”

Assad, however, would not fall so easily. The divergence between Erdogan’s wishes to see Assad replaced by a friendly Sunni-based alliance and the reality of the Syrian dictator’s stubborn hold on power frustrated the Turkish leader and pushed him toward a go-it-alone policy. Deep splits started to emerge with the United States, as Erdogan expressed disappointment in Obama’s unwillingness to enter the fray despite massive civilian casualties at the hand of regime forces.

Erdogan’s break with Assad also heralded the beginning of a sectarian Sunni policy that became more pronounced as the Syrian regime endured. Turkey’s policy of encouraging foreign fighters to flow across its border into northern Syria has also helped radicalize the opposition and has raised tensions with Ankara’s U.S. and European partners. The Turkish government knew that many of these foreign fighters would join jihadi militias, such as the al Qaeda-affiliated al-Nusra Front, but allowed them to do so because the homegrown “moderate” rebels had proved unsuccessful in bringing about the demise of the Assad regime. Jihadi fighters, some of whom were battle-hardened and more willing to die for the cause, would presumably complete the task that other Syrian rebels could not.

The unintended consequences of tens of thousands of foreign fighters converging on Syria soon became apparent. Many of the foreign fighters gravitated toward the Islamic State, helping it become the power it is today. In May 2013, during a visit to Washington, Obama urged Erdogan to stop supporting jihadi elements, specifically al-Nusra Front, and prevent their access through the Turkish border. But by then, a jihadi infrastructure within Turkey had materialized that bedevils Turkish security officials to this day.

The prime beneficiary of the loose border controls has been the Islamic State. The infrastructure in Turkey that developed to support the jihadis would ultimately be used to strike against Turkish towns, starting with Diyarbakir, Suruc, Ankara, and lastly Istanbul. The first three bombings targeted Kurds and leftists, leaving more than 135 dead, and the last attack in Istanbul’s tourism district killed 11 German tourists. The Islamic State has also executed its Syrian opponents inside Turkey with impunity and set up exchanges for Syrians and others to ransom their loved ones held by the Islamic State on Turkish soil.

The Kurdish Question

The empowerment of the Syrian Kurds has been the most important consequence of Syria’s spiral into chaos. Disenfranchised and repressed by successive Syrian regimes, the Kurds were able to take advantage of the country’s fracturing to lay claim to territory where they constituted a majority. They soon found a powerful ally in the United States: When the Islamic State advanced on the Kurdish-held town of Kobani in October 2014, the U.S. Air Force pounded the jihadi group, launching an extraordinary and successful relationship that has proved to be the most successful effort at dislodging the Islamic State from territory it has conquered.

But this deepening alliance came at the expense of the Turkish government. The dominant Syrian Kurdish movement, the Democratic Union Party (PYD), is a close ally if not a subsidiary organization of the PKK, which trained and nurtured it, making it into a formidable fighting force.

Washington has made it clear that it distinguishes between the PKK and the PYD, despite the umbilical relationship between these two organizations. From a legal perspective, while the PKK is on the U.S. terrorism list, the PYD is not — and has been the recipient of American military support in its war against the Islamic State. As the United States has deepened its relationship with the PYD, Washington’s only concession to Ankara has been to give in to Turkish ultimatums not to invite the PYD to participate in recent Syria peace talks in Geneva.

In retrospect, the Syrian Kurds’ victory in Kobani proved to be the deathblow for Turkey’s domestic peace process with its Kurdish population. At the time, Erdogan was harshly critical of the American intervention in Kobani as he and his party perceive the PYD to be a greater scourge than the Islamic State. In February 2015, he repudiated the agreement his lieutenants had negotiated with the pro-Kurdish Peoples’ Democratic Party and the PKK. New documents suggest that the breaking point was his fear that Syrian Kurds would duplicate the Iraqi Kurdish experiment of creating an autonomous region on Turkey’s southern border.

By last summer, the war by and against the PKK at home had resumed with a vengeance. Since the June 7 election, some 256 security personnel have been killed; the casualties on the side of the PKK, while harder to pin down, have also been high. The destruction in Kurdish towns such as Silopi, Cizre, and the Sur district of Diyarbakir, where Turkish tanks have fired on homes and the youth wing of the PKK has decided to put up stiff resistance, has also been devastating.

Erdogan correctly understood that the Kobani siege represented a possible turning point for the Kurds’ fortunes in the region.
He had two choices, co-optation or suppression. He chose the latter.
Even as the Kurds undermined Erdogan’s domestic and international position, the Turkish president found his hands tied even further in Syria by the Russian intervention on behalf of Assad. In a careless move, Turkish fighters in November 2015 shot down a Russian bomber that had briefly intruded into Turkish airspace, an action that triggered a rash of costly economic, political, and military actions in retaliation by Russian President Vladimir Putin.

Erdogan had misjudged Putin: The shoot-down was born in the frustrations emanating from his failures in Syria and from watching the Russians and Iranians succeed in bolstering the much-battered Syrian army against Turkey’s allies in the country.

The ripple effects from Syria have put Turkey at odds with Iran. From the beginning of the Syrian conflict until the end of 2015, when the Russians intervened directly and the role of Iran’s Quds Force became more obvious, Turkey and Iran had agreed to disagree on this issue.

The extensive business ties between Erdogan’s government, including large-scale gold sales, Turkey’s dependence on Iranian gas, and Iran’s need for the foreign exchange revenues created by these exports have helped the two countries avoid a public shouting match. This is in the process of changing because the confluence of forces on the ground has turned the tide in favor of Assad.

Erdogan has not given up on his dream of Turkish influence in the region. Ankara recently announced that Turkey would open up a naval base in Qatar and set up training facilities in Somalia. When convenient, the Turkish president also has proved capable of altering his policies at a moment’s notice — most recently by warming relations with Israel. A rapprochement with Jerusalem opens the lucrative possibility of constructing gas pipelines from the eastern Mediterranean fields through Cyprus to Turkey.

What’s next for Erdogan

Erdogan faces three interlinked challenges. He is relentlessly pursuing a constitutional change that would allow him to centralize executive powers in the presidency, allowing him to run the country unconstrained by its institutions; the escalating conflict with the Kurds threatens to lead to their complete break with the Turkish state; and the deterioration of the Syrian situation promises not only to exacerbate the Kurdish conflict at home but also weaken relations with the United States, as Washington strengthens its ties with the Syrian Kurds.

Erdogan may well get his way on some of these issues — particularly the creation of a presidential system — but the price will be even greater divisions within Turkish society, and between Turkey and its traditional allies. Erdogan is confident that his approach toward the Kurds is succeeding and is banking on the disillusionment of some in the Kurdish community, especially the more pious elements, to turn on the PKK. In the meantime, however, the suffering in Kurdish-majority cities is likely to have an indelible impact on the Kurdish community. Changing international conditions, primarily in Iraq and Syria, suggest that a military victory now may turn out to be a Pyrrhic one.

As for Syria, there is clearly a major divergence in priorities between Turkey and the United States and Europe. For Turkey’s Western partners, the No. 1 priority is to defeat the Islamic State — whereas in Ankara, the overthrow of the Assad regime and the prevention of a Kurdish autonomous region in Syria are the overriding concerns. The continuation of the Kurdish strife at home will further push Ankara away from its allies on Syria.

The crux of the matter is this: Turkish foreign policy is no longer about Turkey but about Erdogan. Floundering at home and abroad, the Turkish president has embarked on an illiberal course at home undermining what are admittedly flawed institutions and reconstituting them in his image. His omnipresence and unchallenged position mean that foreign policy is the product of his worldview, whims, and preferences. There is no one who can challenge him. The systematic approach of the early years has given way to indulgence; this more than anything explains the ups and downs of Turkish foreign policy.
 
 
ADEM ALTAN/AFP/Getty Images


Oil Dictator Dominos

Bill Emmott

Dominoes
LONDON – Price movements as large and rapid as those that have upended oil markets since June 2014 are sure to cause pain to some and benefit others. Though the pain tends to capture the most attention, the benefit is just as important – if not more so. The 70% drop in the price of a barrel of crude represents a colossal transfer of $3 trillion in annual income from oil producers to oil consumers.

 
As a result, while sliding equity markets and a further decline in oil (and other commodity) prices have sparked much talk of another global recession, dire predictions are likely to prove overly gloomy and misdirected. To be sure, the dramatic drop in the price of oil will produce winners and losers. But the biggest dangers will be political, not economic.
 
The shift in fortunes can perhaps best be seen on the boarding passes of International Monetary Fund officials. Rather than going to Athens, they are now heading for Baku. Indeed, Central Asia’s oil-producing dictatorships, including Azerbaijan, have been among the countries hardest hit by the drop in prices – especially because, as ex-Soviet states, they remain heavily dependent on trade with Russia, another oil producer.
 
The biggest beneficiaries of the price slump will be the highly indebted, oil-importing countries of the eurozone: Greece, Italy, and Spain (Germany, too, is likely to benefit). Their export markets in emerging economies will suffer, damping hopes of a trade-led recovery, but that negative effect stands to be more than offset by the windfall from a big drop in energy costs.
 
Growth in the eurozone will be based on the resulting increase in domestic demand, rather than exports.
 
The United States and the United Kingdom are simultaneously energy producers and importers, so the impact on their economics is likely to be more complicated. In 2013 and 2014, energy firms dominated business investment, and cutbacks in the sector will translate into lost jobs and dropping demand for the manufacturers and service companies supplying the industry.
 
On the other hand, consumer spending in both countries stands to rise. While US consumers have so far saved a large proportion of the windfall they have received through cheaper gasoline prices, the gains for households are starting to translate into higher levels of spending.
 
Economists are likely to spend months puzzling over why the effect of low oil prices has proved slow to emerge in the consumption statistics. But, ultimately, emerge they will, as they have every time such a large fall has occurred. The more important question is one for political scientists: Which governments will collapse this year, and with what consequences?
 
It is no coincidence that the last emerging-markets crisis, in 1997-1998, was also associated with a dramatic fall in oil prices. In that case, the two biggest victims were a dictator in Indonesia and a fragile democrat in Russia. In May 1998, nine months after the beginning of East Asia’s financial crisis, Indonesian President Suharto resigned after 31 years in office. A few months later, Russia defaulted on its sovereign debt as its currency collapsed. On December 31, 1999, President Boris Yeltsin resigned, leaving the country in the hands of his recently appointed prime minister, Vladimir Putin.
 
In attempting to predict which governments might face a similar fate this time, the basic criteria – in addition to the oil slump’s financial impact – are resilience and flexibility. Does a regime have the financial reserves with which to cushion the shock and buy time to adjust?
 
Does a country have a robust banking system? Can its political system contain growing popular frustration or channel it through existing institutions? Oil-dependent regimes that fail to meet these criteria are in trouble.
 
This analytical framework yields surprising insights. As much as pundits like to predict the collapse of the Saudi Arabian monarchy, they are likely to be disappointed once again. The country is the world’s lowest-cost oil producer; and, though its political rigidity is beyond question, it is showing economic flexibility by cutting its budget and introducing wide-ranging reforms.
 
Russia, however, for all its bluster, may prove less fortunate. Its political robustness is not matched by financial and economic resilience. Putin will try to mask the pain, but at some point it is likely to become debilitating.
 
The potential victims are many, with worrying implications for geopolitical stability worldwide.

Venezuela has been in financial crisis since long before the oil crunch, and Nigeria is looking a lot like Russia in 1998 – a fragile democracy facing a currency crisis.
 
As to who might become the next Suharto in the coming months, my best guess is one or more of the Central Asian oil autocrats in Azerbaijan, Kazakhstan, and Turkmenistan. In any case, this year promises to be interesting – and harrowing, if you happen to be a dictator clinging to power in an oil-exporting country.
 


Capitalism Is Grinding To A Halt

by: Shareholders Unite


Debt has exploded almost everywhere.

Combined with low inflation and low growth, it risks ratcheting up further, greatly increasing the risk of debt-deflationary cycles.

Debt deflation and other forces are threatening the long-term dynamism of economies, not a conducive environment for investors.
 
Debt + deflation = disaster
 
Debt is everywhere, and almost everywhere it is either at record levels and growing, or both.

This holds for private debt and public debt alike.
 
 
How did it ever come to this, and what are the implications?
 
Public debts have several origins, like:
  • Baumol's disease
  • Shifting preferences
  • Recessions
  • Political compromise
  • Demographics
Not everybody will be familiar with the first reason, Baumol's disease. This explains the automatic increase in size of the public sector because productivity gains are more difficult in services compared to industry.
 
As the public sector is almost all services, the productivity lag will cause either public sector wages to lag the private sector, or it will automatically increase the cost of the public sector.
 
It is simply difficult to raise productivity in big swathes of the public sector, like defense, general administration, healthcare and education.
 
Healthcare is especially problematic. Populations are getting older, new and often more expensive treatments become available and it's difficult to increase productivity.
 
This is why healthcare is almost everywhere the main threat to the sustainability of public finances, there is little reason to assume its relentless rise as a percentage of GDP is about to halt.
 
ICT holds some promise (electronic health records, online education, eGovernment, etc.), but this is a very long and protracted process.

Shifting preferences also automatically increases the size of the public sector, when populations become richer, people tend to place more importance on a safe environment, on healthy products, on a cleaner environment, better schools for their children, better healthcare, etc.
 
All of this makes a disproportionate claims on the public sector (through regulation, justice, law enforcement or direct government involvement).
 
Recessions are usually a big drain on public finances, outlays increase (unemployment benefits, etc.) while wages, profits and expenditures grow slower or decline, seriously denting tax revenues. More often than not, these effects are compounded by pro-cyclical policy reactions, cutting spending and raising taxes in the midst of a recession, which tend to prolong it.
 
The public sector faces many demands, and public preferences are often contradictory (many people are against cutting expenditures, but they're also against raising taxes). The resulting political compromise also has a habit of shifting the cost to the future.
 
Demographics plays an important role in many countries, as it tends to decrease the tax base whilst simultaneously increasing outlays on pensions and healthcare especially. Japan, with its rapidly shrinking population and its 200%+ public sector debt, comes to mind as a textbook case.
 
All this explains why public debts have tended to ratchet upwards in so many countries, with recessions especially marked.
 
Private sector debt
 
Numerous trends tend to increase private sector debt, in no particular order of importance:
  • Increased leverage
  • Increased inequality
  • Greatly reduced interest rates
  • Global savings glut
  • Demographics
  • Cost of capital goods
Without even trying to be anywhere near exhaustive, all kinds of financial innovation and wizardry increased leveraged possibilities, increased inequality led to a lot of borrowing (especially in the US where median wages haven't gone up in decades, this was a way to share in the increased wealth).
 
Since the 1980s, central banks in developed countries have managed to basically conquer inflation, leading to greatly reduced interest rates.

The latter trend has been reinforced by a global savings glut brought on, in part, by demographic developments and falling cost of capital goods.
 
The risks
 
Public sector debt isn't a serious problem unless a substantial amount of that debt is owned abroad, or (even worse) is denominated in a foreign currency.
 
This is why Japan, despite people betting against Japanese bonds for over a decade, hasn't experienced any immediate crisis, although the level of public debt has reached a point (200%+ of GDP) where serious concerns about its sustainability are warranted.
 
But one should not lose sight of the fact that almost all Japanese public debt is in the hands of the Japanese themselves (who will inherit not only the debt, but also the bonds), and it's dominated in yen, which the Japanese central bank can print in copious amounts.
 
Basically, the Japanese owe the debt to themselves, and rather than 'stealing' from future generations, these will inherit the bonds as well.
 
Risks are much more severe for countries that borrow abroad, especially those that borrow in foreign currency. Any devaluation of their own currency immediately increases the debt, and this is how many developing countries experienced financial crises.
 
Private sector debt has also been rising fast nearly everywhere and this has been responsible for financial crises as well:
 
 
 
The graph above gives the public and private debt for 17 advanced countries, one sees a marked trend increase in private debt from the 1960s. This matters, as:
History demonstrates that excessive private-sector borrowing plays a greater role than fiscal profligacy in generating financial instability. However, when the credit boom collapses, the government's capacity to alleviate the downturn is limited by the prevailing level of public debt. [Jordà et. al.]

And:
In an update of work on debt and deleveraging, McKinsey notes that between 2000 and 2007, household debt rose as a proportion of income by one-third or more in the US, the UK, Spain, Ireland and Portugal. All of these countries subsequently experienced financial crises. [Martin Wolf, FT]
But the accumulation of public and private debt is very serious even in the absence of a financial crisis for a number of reasons:
  • The declining ability of debt to spur growth.
  • The accumulation of debt itself can slow growth, a sort of world deleveraging process.
  • The accumulation of bad debts can tighten credit standards of banks and other financial institutions.
  • High outstanding debt ratios reduce the effectiveness of monetary policy.
  • These processes can be self-reinforcing.
The first is most obvious in China, where growth is slowing whilst debt has kept on rising (by 124 percentage points in the debt-to-GDP ratio between 2007 and 2014).
 
It is obvious that at a certain level of indebtedness, households and institutions start worrying about the health of their balance sheets and their capacity for financing these debts.
 
This is likely to first result in a reduction of new credit demand, and ultimately, in increased savings and reduced spending, paying off old debts rather than taking on new debt in order to restore the health of balance sheets.
 
It will be clear from this that monetary policy effectiveness can be seriously compromised if more debtors tighten their belt to pay off old debts.
 
According to Richard Koo from Nomura, this effect can become so strong as to render monetary policy completely powerless, hence the term balance sheet recession.
 
Banks can reinforce this process by tightening credit standards, which they might very well do when they become worried about their own balance sheets due to the level of non-performing loans.
 
This not only can push certain creditors over the edge, it also leads to further declines in credit creation, slowing economic growth.
 
The slowing economic growth from reduced credit demand and supply, and the ineffectiveness of monetary policy to revive these, can easily worsen balance sheets by reducing incomes and asset values which underpin debts and debt service capabilities.

This, on its turn, can increase bad debts and reinforce the cycle. This doesn't necessarily lead to a so called Minsky moment in which the integrity of the whole system collapses after a tipping point is reached, producing widespread failures and bankruptcies.
 
If not aggressively dealt with, it can lead to a sort of lingering zombie economy where indebted institutions, companies and households linger on as interest rates collapse and economic growth and inflation slow to a crawl.
 
Japan has some experience with this, especially in the 1990s.
 
How to deal with the debt?
 
There are simply just three ways:
  • Boost economic growth.
  • Boost inflation eating away the real value of the outstanding debt.
  • Write-offs, restructurings and bankruptcies.
A combination of growth and mild inflation used to be the way rich countries dealt with previous debt binges, like the one that resulted from financing WWII.
 
However, as we explained above, the accumulation of debt and the pervasive effect on balance sheets everywhere is slowing growth and inflation everywhere and this is turning into a self-reinforcing cycle.
 
Surprising as it may be, the US has done relatively well in this area, at least much better than either the eurozone or Japan, although the latter two each have structural disadvantages that the US doesn't suffer from.
 
The eurozone is greatly hampered by the inbuilt deflationary bias through the working of the monetary union, which basically functions like the gold standard in the 1930s.
 
Japan, despite heroic efforts the last couple of years with Abenomics, is simply suffering from ingrained deflation and a strong demographic headwind.
 
It will also be clear that the resulting investment climate isn't ideal. Low growth isn't conducive to top-line growth, lowflation doesn't give companies a whole lot of pricing power (unless they have a near unassailable competitive advantage for products and/or services that are relatively price inelastic).
 
The way companies deal with this is to increase the payout ratio, together with buybacks this is over 90%.

This in itself only reinforces the trend of low growth and low inflation, as this shifts income from those with a low propensity to save to those with a high propensity to sabe.
 
Basically, the economy is slowly moving towards a model where many households and institutions are nurturing weak balance sheets and are spendthrift as a result.
 
Others are happy to collect relatively meager returns from bonds and/or dividends. There is still a fair amount of entrepreneurial activity, but the formation of new companies seems to have slowed down, as well as productivity growth.
 
Economies face serious challenges escaping debt-deflationary cycles and hysteresis effects, whilst at the same time trying to revive economic dynamism. Unless these challenges are met, these are not times conducive to producing great stock returns.