02/14/2015 04:30 PM

The War Next Door

Can Merkel's Diplomacy Save Europe?


 Photo Gallery: Long Night in Minsk                      
Chancellor Angela Merkel has often been accused of hesitancy. But in Minsk this week, she committed herself to helping find a way to quiet the weapons in Ukraine. The result was a cease-fire. But it is fragile and may ultimately be disadvantageous for Ukraine.

The problem has four syllables: Debaltseve. German Chancellor Angela Merkel can now pronounce it without difficulties, as can French President François Hollande. Debaltseve proved to be one of the thorniest issues during the negotiations in Minsk on Wednesday night and into Thursday. Indeed, the talks almost completely collapsed because of Debaltseve.

Ultimately, Debaltseve may end up torpedoing the deal that was worked out in the end.

Debaltseve is a small town in eastern Ukraine, held by 6,000 government troops, or perhaps 8,000. Nobody wants to say for sure. It is the heart of an army that can only put 30,000 soldiers into the field, a weak heart. Until Sunday of last week, that heart was largely encircled by pro-Russian separatists and the troops could only be supplied by way of highway M03. Then, Monday came.

Separatist fighters began advancing across snowy fields towards the village of Lohvynove, a tiny settlement of 30 houses hugging the M03. The separatists stormed an army checkpoint and killed a few officers. They then dug in -- and the heart of the Ukrainian army was surrounded.

The situation in Debaltseve plunged the Ukrainian army into a desperate, almost hopeless, position, as the negotiators in Minsk well knew. Indeed, it was the reason the talks were so urgently necessary.

Debaltseve was one of the reasons Merkel and Hollande launched their most recent diplomatic offensive nine days ago. The other reason was the American discussion over the delivery of weapons to the struggling Ukrainian army.

Debaltseve and the weapons debate had pushed Europe to the brink of a dangerous escalation -- and the fears of a broader war were growing rapidly. A well-armed proxy war between Russia and the West in Ukraine was becoming a very real possibility. A conflict which began with the failure of the EU-Ukraine Association Agreement and the protests on Maidan Square in Kiev, and one which escalated with Russian President Vladimir Putin's annexation of the Crimea Peninsula, has long since become the most dangerous stand-off Europe has seen in several decades. It is possible that it could ultimately involve the US and Russia facing each other across a line of demarcation.

A Success

Given the intensity of the situation, Germany and France together took the initiative and forced the Wednesday night summit in Minsk, Belarus. The long night of talks, which extended deep into Thursday morning, was the apex of eight days of shuttle diplomacy between Moscow, Kiev, Washington and Munich. With intense focus during dozens of hours of telephone conversations and negotiations across the globe, the German chancellor helped wrest a cease-fire from the belligerents. It is a fragile deal full of question marks, one which can only succeed if all parties dedicate themselves to adhering to it. Whether that will be the case is doubtful. The Minsk deal is brief respite. Nothing more. But it is a success nonetheless.

During the 17 hours in Minsk's Palace of Independence, there was much at stake. First and foremost, the focus was on demarcation lines and local elections, it was on ending the killing in eastern Ukraine. But there were several larger questions on the table as well, questions focusing on Russia's relationship with Europe and whether it will be possible to avoid an extended conflict with Vladimir Putin's Russia. They were questions focusing on how to deal with an aggressor: Is it wise to make concessions to Putin? And at what point does compromise become appeasement?

Above all were questions of international diplomacy: What is diplomacy capable of? Is the threat of violence necessary to make diplomacy work? What is the correct path: American weapons deliveries or European diplomacy? And, perhaps most crucial of all, the focus was on European emancipation: Is Europe able to solve its own conflicts without help from the United States?

The exertions of Chancellor Merkel and Foreign Minister Frank-Walter Steinmeier make it clear that Germany has recognized its responsibility in Europe and in the world. One year ago, German President Joachim Gauck demanded that German foreign policy become more assertive in addressing international conflicts. It is a plea that Merkel and Steinmeier have answered in recent weeks.

The Ukraine crisis has changed German politics and it has changed Merkel as well. The German leader used to dither in the face of tough decisions, but now she is making moves she would have avoided in the past. She has taken the initiative and, contrary to her preferred modus operandi, has embarked on a mission with an uncertain outcome. Her style has also changed. Never before has the chancellor seemed as emotionally engaged as she has in recent days. Her political arguments have rarely been so personal. The Ukraine crisis has changed Merkel's view of reality. Her foreign policy address delivered at the Munich Security Conference earlier this month was a fierce commitment to realpolitik. The foreign policy idealism she used to purvey was nowhere to be seen.

Polemical Battle of Words

The low point of the Minsk negotiations was reached on Thursday morning. At 8 a.m. local time, Organization for Security and Cooperation in Europe (OSCE) special envoy Heidi Tagliavini climbed into a car at Vajskovy Street 4 to deliver a piece of bad news. The street is located in the heart of the Belarussian capital, just behind Gorky Park, and is home to the event center Dipservice Hall. Tagliavini had been meeting there with the so-called "Contact Group," which includes representatives from Russia, Ukraine and the OSCE. The leaders of the eastern Ukrainian rebel republics Donetsk and Luhansk were also present.

Tagliavini drove to the Palace of Independence, located on Victory Prospect, where Merkel, Vladimir Putin, François Hollande and Ukrainian President Petro Poroshenko had spent the entire night negotiating. The news that Tagliavini had to tell the leaders essentially destroyed the results of the last 14 hours of negotiations: The rebels no longer wanted to sign the closing document.

The leaders and their delegations had been engaged in talks in the 200-square-meter (2,150-square-foot) ceremonial hall since 6:30 p.m. the evening before. Following their arrival in Minsk, the German and French delegations initially holed up in the German Embassy before then coordinating with the Ukrainians. It is the same pattern that had been followed in the previous days' talks: total consensus between Germany and France followed by close accord with Ukraine before beginning talks with the Russian side.

Talks continued through the entire night, without a break. At times, one of the participants would nod off, head on the table. There was plenty of alcohol available, but Merkel didn't touch it. Participants said that the tone was measured. At one point, it did become loud, with Putin and Poroshenko becoming involved in a polemical battle of words, but they quickly calmed down again. They would occasionally stand up to talk through a particularly thorny issue privately, before coming back and continuing the talks. The personal relationship between the two is a good one and they address each other with the familiar form of "you."

Large groups, smaller groups, two leaders whispering in the corner, coffee, snacks: It went on like that through the entire night. Everyone knew what was at stake and they all, participants reported, seemed to want to reach an agreement.

Protecting the Ukrainians

The Russians took a tough line. They saw themselves as being in a position of strength, partly because of the situation in Debaltseve. The Europeans, for their part, insisted on an immediate cease-fire out of concern for the volatile situation facing the Ukrainian military. The separatists, not surprisingly, wanted to delay the beginning of the cease-fire for as long as possible so as to give themselves time to completely conquer Debaltseve. Poroshenko, too, seemed to prefer a delayed cease-fire -- apparently not fully understanding the situation facing his military. The Europeans were trying to protect the Ukrainians from themselves.

The European duo had already pried an important concession out of the Russian president in Moscow during the week prior to Minsk: The elections in the separatist areas will only be held within those areas behind last September's demarcation line. The hundreds of square kilometers separatists have since taken will not be considered as part of their territory. Kiev managed to assert itself on another issue as well: Direct talks with the separatists, as Moscow had been demanding, will not take place.

Putin, though, got the upper hand in a different area: The border between Russia and the separatist-held regions in eastern Ukraine will be observed neither by the Ukrainians nor by international forces. This issue will only be revisited after the elections, if at all.

Even before the arrival of Tagliavini, the talks had already twice threatened to collapse. Particularly contentious is the withdrawal of heavy weaponry. In the end, agreement was reached that all heavy weapons would be withdrawn from the firing lines. For the Ukrainians, the firing line refers to the front where it now stands. For the rebels, it is the front line from last September. The result is a broad buffer zone, a zone that broadens to 140 kilometers (87 miles) for heavy rocket launchers. That means that the separatists will have to withdraw their equipment deep into the territories they hold, in some cases almost to the Russian border.

That is the deal that was presented to the separatists in Dipservice Hall early in the morning. Not long later, Tagliavini returned with their rejection of the agreement. Were the talks all for naught?

The negotiators refused to give up. They returned to the vast hall inside the Palace of Independence and continued talking. Merkel, Hollande, Poroshenko and Putin retired to a smaller room off the main hall, where Putin was informed that everything now depended on him. It was a point at which the collapse of the talks was a very real possibility. Putin withdraws to an office that had been set up especially for him on the third floor of the palace to telephone with the separatist leaders waiting in Dipservice Hall. The Germans and French did not learn what exactly he said to the two -- Igor Plotnitsky of the Luhansk Republic and Alexander Zakharchenko of the Donetsk Republic. But two hours later, the pair agreed to the cease-fire. At 11 a.m. local time, the marathon negotiations came to an end.

Two documents were prepared. The first was a declaration from the national leaders present. The other was the Contact Group paper regarding the implementation of the first Minsk Agreement, which was signed five months ago. Even the name of the document was the object of extended and bitter debate. Kiev and the Europeans insisted that it make reference to the first Minsk deal reached last September.

Once the talks were finished, there was no press conference held. Just before noon, Merkel, Hollande, Putin and Poroshenko left the Minsk palace. "We are hopeful," is all the German chancellor would say of the result of the long night of talks.

Indeed, there is nothing left for the world to do but hope that the cease-fire really does take effect along the entire front. The world must hope that this deal lasts longer than the first Minsk agreement did -- forever if possible. The world must hope that the government troops trapped in Debaltseve really do lay down their weapons and don't try to fight their way free.

The world must hope that free elections are held in the separatist areas and that the elected politicians negotiate a fair autonomy agreement with Kiev, one that re-establishes Ukraine's unity.

Buying Time

Should both sides adhere to the cease-fire, time will be won. That isn't much, but it is a far cry from nothing. Everyone can get together and work to ensure that the hopes listed above become facts in the near future -- for the people of Ukraine but also for the rest of the world.

Overshadowing everything, after all, is a possible conflict between the US and Russia, both nuclear powers.

The Minsk deal also bought valuable time for US President Barack Obama. He recently stood up to the hawks in Washington and rejected the idea of delivering weapons to Ukraine. But during Merkel's visit to the American capital on Monday, he told her that were the Minsk talks to fail, he would no longer be able to contain the weapons delivery discussion. It came across almost as an ultimatum.

Internally, Vice President Joe Biden had previously thrown his support behind supplying Ukraine with weapons, as had Secretary of State John Kerry. Plans for such military assistance had also long since been developed. During a visit to Kiev two weeks ago by Obama advisors, Poroshenko's people presented a list of equipment they wanted, including surface-to-air missiles, radar units and medical equipment. The American NATO General Philip Breedlove believes that missile defense systems are absolutely essential to defend against Russian artillery and also believes Ukraine should be provided with drones.

But the Ukrainians are currently unable to operate such high-tech equipment. They would have to receive extensive training from American advisers. That, though, would essentially make the US a party to the conflict, as Obama well knows. Which is why he was hesitant following his talks with Merkel, saying only that which American presidents always say in such moments: "What I've asked my team to do is to look at all options."

On Wednesday evening, Obama spoke with Putin by phone for 90 minutes. "That really helped," say Merkel's people, adding that they believe it was important to Putin to have the US president take such an interest in the issue.

'Captured Loot'

American weapons deliveries, on the other hand, don't impress Putin one bit. On the contrary: Were US weapons and military trainers to turn up in Ukraine, the Russian people, 85 percent of whom already support Putin, would unanimously stand behind their president, one Kremlin insider, who does not belong to the hawkish camp, says. "Plus, we would be happy to see American weapons quickly fall into the hands of the separatists as captured loot."

Putin, the Kremlin insider says, believes he is in a strong position. "The later the Western states and the Ukraine are prepared to agree to a really stable compromise, the weaker their negotiating position will be," the insider says.

That analysis might not be far off. Ukraine government troops could indeed collapse if the fighting continues. Morale within the army is not nearly as strong as it is among the separatists.

The Ukrainian army was unprepared for the war in the east. Whereas Russia completely modernized its military recently, Ukraine scrapped or sold off much of the equipment it had inherited when the Soviet Union collapsed and radically reduced the size of its military, dismissing two-thirds of its soldiers. The weapons now being used by Ukrainian troops fighting in the east are far inferior to those possessed by the separatists.

At the beginning of the war, the Ukrainian army had some 130,000 troops according to the most optimistic estimates, with half of them fulfilling their compulsory military service. Now, many young men are doing their best to avoid conscription altogether by heading overseas. The National Guard has a further 35,000 men in uniform. They mostly man checkpoints and guard infrastructure.

President Poroshenko is thus dependent on the help of militias, those voluntary units that fight in the service of oligarchs or out of their own interests. But they often don't follow orders from Kiev, making them difficult to control and unfit for use in strategic operations.

According to a report delivered recently to the Chancellery in Berlin by Germany's foreign intelligence service, the BND, the Ukrainian army is slowly disintegrating, demoralized by the separatist advances and short on personnel. Even arms deliveries from the West, the BND believes, would be more likely to overwhelm the Ukrainian army than it would to make it a more effective fighting force.

Increasingly Unsettled

Furthermore, the grim state of the country's economy threatens to destabilize Poroshenko's government. The Ukrainian currency, the hryvnia, fell to a new historic low on Wednesday. Just a few weeks ago, the rate was 18 hryvnia to the euro, now it is 30. The country is increasingly unsettled.

The chief public prosecutor has already fallen. He proved unable to recover the billions of dollars that former President Viktor Yanukovych smuggled out of the country to Switzerland, Luxembourg and the US. Furthermore, reform programs for the judiciary and public administration are making little progress. Frustration among the public at large is growing with some in Kiev even talking about a "new Maidan," a reference to the protests that drove Yanukovych out of office (and out of the country) one year ago. "If nothing changes in Ukraine, then everything will explode in four to six months," says Mikheil Saakashvili, the former president of Georgia and supporter of the new Kiev leadership.

Aid from the International Monetary Fund and other donors is aimed at preventing such an explosion from taking place. In the next four years, Ukraine is to receive around €40 billion euros -- but the program includes "extremely strict conditions," say senior Berlin officials with concern. Among them is an increase in gas prices for private consumers as well as an unpopular pension reform aimed at cutting government spending. Berlin is worried that support for the government could rapidly disappear should too much be demanded too quickly. Chancellor Merkel has thus charged her economic policy advisor Lars-Hendrik Röller with encouraging the IMF to exercise political caution.

"The aid program cannot be allowed to destabilize Ukraine domestically," said one government official in Berlin.

Russia has likely already achieved its minimum goal, that of preventing Ukraine from joining NATO or the European Union. The deal agreed to in Minsk includes a kind of veto right for separatist areas in eastern Ukraine on important fundamental issues. That right would apply to membership in military alliances and to membership in economic blocks such as the EU or Putin's Eurasian Economic Union. Furthermore, the constitutional reform, as called for by the Minsk deal, can only be undertaken with the agreement of the pro-Russian secessionist areas.

Russia is also hopeful that the agreement reached in Minsk will put an end to the spiral of sanctions that have been imposed on the country by the West. Just on Monday, the EU agreed to intensify the penal measures once again by adding more names to the list of those forbidden from entering the EU and more accounts to the list of those that have been frozen. That idea, though, has now been shelved for the time being. "The Minsk agreement gives us an opportunity to not impose new sanctions," said Luxembourg Foreign Minister Jean Asselborn. He said that removal of sanctions already in place will only be addressed once the cease-fire has proven to be stable and Moscow does in fact withdraw its heavy weaponry.

Global Importance

Indeed, only then will we know if Chancellor Merkel has landed an important diplomatic coup. For her, Thursday morning in Minsk marked the end of eight days during which her diplomatic talent was tested its fullest. They were eight days with little sleep and trips to eight cities: Kiev, Moscow, Munich, Washington, Ottawa, Berlin, Minsk and Brussels. That may sound like global politics, but it was really a last-ditch effort to maintain order in Europe, a mission of global importance.

Last Saturday saw Merkel holding a speech in Munich's Bayerische Hof hotel at the Security Conference. The topic was, of course, Ukraine. Her talk was frequently interrupted by applause -- her skepticism of arms deliveries to Ukraine was particularly well received. One person in the audience, though, didn't clap. He sat in the first row with a dour expression on his face, empty eyes and his hands clasped in his lap. It was Ukrainian President Petro Poroshenko.

While his country was being torn apart by war and his soldiers were dying, the German chancellor was explaining to the world why nothing could be done. At least not with force of arms. "I cannot imagine a single scenario in which better equipment for the Ukrainian army would lead President Putin to be so impressed to believe that he might lose militarily," she said. That, she added, was reality.

Reality is a word that Merkel used often while in Munich. Putin's superiority is a reality, she said, and Syrian President Bashar Assad is a reality as well. "You have to deal with reality as it is," Merkel said.

It was a commitment to absolute realpolitik. Merkel has long been considered the queen of pragmatism and she has often been accused of lacking convictions and being willing to sacrifice long-term goals for short-term opportunities and power tactics. But that didn't apply to foreign policy. In that field, people have long said that she was a real idealist. Her commitment to freedom and to a "values-guided foreign policy" seemed credible given that she grew up behind the Iron Curtain.

But in the Ukraine crisis, Merkel is infusing her biography with completely new meaning. She is now drawing parallels between Ukraine and the construction of the Berlin Wall. Until recently, East Germany served as justification for her commitment to freedom and human rights -- a commitment that had to be defended on the battlefield at times. Now, though, East Germany is serving as an illustration that there are situations where nothing can or should be done. Even the Americans weren't prepared to use military means to protect the people of East Germany in 1961, Merkel said in Munich. "I don't blame them," she added. It was simply realistic.

Last Resort

The path from the Merkel who, as leader of the opposition, cited the Western community of values in justifying her support for George W. Bush's Iraq invasion to the Merkel who refuses to supply arms to Ukraine because, as she says, the conflict cannot be solved militarily, is a long one. Merkel's "values-guided foreign policy" also meant that the use of military means as a last resort could not, and should not, be excluded.

"Anyone who rejects military action as a last resort weakens the pressure that needs to be maintained on dictators and consequently makes a war not less but more likely," Merkel wrote in a 2003 contribution for the Washington Post, that ran under the headline, "Schröder Doesn't Speak for All Germans." "Responsible political leadership must on no account trade the genuine peace of the future for the deceptive peace of the present."

Now, she is calling for patience and political stamina. Sometimes, her logic would seem to hold, you have to accept present injustices, remain true to your principles and hope for a better future. "Nobody knew when the Cold War was going to end," she said. East Germans had to wait 28 years after the construction of the Berlin Wall for better times to come.

Realpolitik focuses on power and powerlessness. It's about realizing what you can achieve with what means and when it might be smarter to admit your own lack of power. Realpolitik has no illusions, it is bitter and, sometimes, it is brutal.

Some see Merkel as being weak. US Senators in particular have voiced criticism of her approach, even uttering the unflattering word "appeasement," a reference to the Munich Agreement of 1938, which handed part of Czechoslovakia to Adolf Hitler's Nazis. Those who want to avoid war at all costs, make a war not less, but more likely. Merkel's response was the Berlin Wall -- history versus history.

On Monday, Merkel met in Washington with Barack Obama and her message could be summed up in a single word, one which is also a crucial element of realpolitik: patience. She wanted the US to show patience before intervening in the conflict in eastern Ukraine, with arms shipments, for example. You have to keep "trying again and again" with Putin, she said. "That's why we're politicians," she said. And she sounded passionate.

She is afraid of a proxy war over Ukraine between the nuclear powers of US and Russia. To prevent that, she has divided up the conflict into a multitude of technical details, with each appearing grotesquely minimal in comparison with what could ultimately happen. "Where there is a complete lack of trust, you can fight to the death about anything," one of her advisors said during the US trip. Merkel's answer is: Then you have to find a solution to each point of conflict, one after the other.

Taking a Chance

Obama wasn't of a mind to reject her approach. If at all, he only wanted to deliver arms in the eventuality that the Minsk summit failed. Obama told Merkel that he is happy about every problem that doesn't land on his desk. Indeed, he is a president who gives Merkel room, and a chance, to make her own foreign policy, a European foreign policy.

"We Europeans have to take risks sometimes too," she told a small group of reporters during the hectic week. It was, she noted, primarily the Americans who brought the wars in the Balkans to an end, by force of arms.

In Ottawa, Merkel spoke with the Canadian prime minister. Then she flew back to Berlin for the funeral of ex-German President Richard von Weizsäcker, continuing on to Minsk for all-night talks and then to Brussels. Where does she now stand after this week of traveling and talking? She took a chance, she tried something. That, already, is something. She wanted to prevent the war in eastern Ukraine from further escalating. And she resisted American calls for arming the Ukrainian army.

Had the talks in Minsk failed completely, Merkel would not have looked good, particularly from the American perspective. Many in the US would have smiled wryly and said that the Europeans simply can't hack it and that they need their big brother to solve the problem.

After Minsk, though, such a reaction would be out of place, even though things could look very different in a couple of days. For the moment, though, Merkel can celebrate a small success. The weapons are to fall silent.

The Merkel who spent much of last week in the air was a different Merkel from the one who can often be seen here in Germany. It was a Merkel who forges ahead and who risks failure. It was also a Merkel who did exactly what Germans expect from her: Fight for peace, search for compromise with the Russians and resist the Americans. All of that conforms nicely to the present mood in Germany.

Along the way, she also patched up relations with France, restoring the German-French axis by including Hollande. That is good for Europe.

Skill and Persistence

Merkel and Hollande laid the cornerstone for their diplomatic initiative at the end of January in Strasbourg, where they dined together in the restaurant Zuem Ysehuet. They spent over three hours together, over lamb and venison, and spoke about the tradition of German-French friendship, about Ukraine and about new Greek Prime Minister Alexis Tsipras. Their host at the dinner was European Parliament President Martin Schulz.

The idea for a joint Ukraine mission came from Merkel, but she knew that she could only exert enough pressure on Putin if Hollande joined as well. Still, the world will likely see it as her success. Or her failure.

But the price of the chancellor's realpolitik is a high one, and Ukraine is paying it. Merkel already told the Ukrainian president weeks ago that the West wasn't prepared to go to war for the country. Now, though, it has become clear that the West is willing to accept Ukraine's partition. Ukraine hasn't just lost the Crimean Peninsula, it has now also lost territories in the east.

Officially, Merkel has continued repeating two mantras: The first is that there is no military solution. The second is that Ukraine's territorial integrity will not be sacrificed. They are both lovely sentences, but they are unfortunately not reconcilable. If the West doesn't intend to protect Ukraine's territorial integrity with military means, then that integrity exists only on paper.

The Chancellery has continued to insist that a modern-day Yalta conference -- whereby Ukraine is divided up between Russia and the West -- is not in the cards. And it was conspicuous that Merkel's file folder that she had with her during the negotiations didn't contain a single map. The chancellor, Berlin officials say, is uninterested in taking part in negotiations over the precise route of the demarcation line between the separatist areas and those areas under Kiev's control. But no matter where the line ultimately runs, it will divide a region ruled by Kiev and one under the influence of Moscow. The West will accept that Moscow will define at least part of Ukraine as being within its sphere of influence.

It is always good when the weapons go quiet, but Merkel has achieved little beyond that. Separatist leaders along with a determined Putin, who knows that the West is not prepared to spill the blood of its soldiers to defend Ukraine's integrity, have shown her the limits of her influence. But the European order is not constructed in Berlin alone. What was achieved in Minsk has little to do with Merkel's power. It has more to do with her political skill and her persistence.

By Nikolaus Blome, Matthias Gebauer, Christiane Hoffmann, Dirk Kurbjuweit, Christian Neef, René Pfister, Matthias Schepp, Christoph Schult and Holger Stark

Mamas, Don’t Let Your Babies Grow Up to Be Pension Fund Managers

By John Mauldin

Feb 15, 2015

We do not have to look to Greece to find massively underfunded obligations. Here in the US we can find hundreds of examples, willingly created by politicians and businessmen who proclaim they are working for the public good. We call them pension funds, but they’re just another form of unfunded debt. A sovereign bond is a promise to pay a certain amount of money over time. A defined-benefit pension fund is a promise to pay a certain amount of income over time. The value of either is determined by the ability of the government or the pension fund (or its sponsor) to pay.

I am in the Cayman Islands as I write this letter, to speak at an alternative investment conference attended by the management of some of the largest pension funds in the US and Europe, both public and private. Being here has motivated me to write this week’s letter on the problems that pension funds face. The pension fund managers I have talked with take their fiduciary obligations seriously, and they face some serious challenges.

I was on the stage with Nouriel Roubini (who makes me come off as the optimist), and we were talking about macroeconomic risks. I was asked what other sorts of risks people should be thinking about, and I cited a recent report about how pension fund obligations had dramatically increased because of a small change in mortality tables.

There has been a very steady increase in life expectancy over the last almost 100 years. It is a fairly well-defined trend. The actuarial accountants whose responsibility it is to track these things updated the life expectancy tables for a 65-year-old male, who can now expect to live an additional 21.6 years, two years longer than in the old table. I pointed out that this trend toward longevity is very well established and is likely to accelerate as new technologies and medicines become available, which means that underfunded pension plans are even more underfunded than we think.

I pointed out that while living longer is a very high-quality personal problem to deal with, if your pension plan doesn’t live as long as you do, that could be an issue.

Some pension plan managers approached me afterwards to talk about this issue, and it is apparent that others are confronting it head on. Matt Botein, global co-head and CIO, BlackRock Alternative Investors, later talked about how he helped pension funds to hedge their “mortality risk” (the odds that pensioners will live longer) by buying a large life insurance company. The value and profits of a life insurance company will rise if the people they have insured live longer. That is a very creative way to deal with the exposure that pension funds have to the obligations imposed by longer lifespans.

Mamas, Don’t Let Your Babies Grow Up to Be
Pension Fund Managers

Today we briefly look at four very large problems facing pension funds. With a nod to Willie Nelson, I’m not sure I want my babies to grow up to be pension fund managers. It’s going to be a very challenging occupation, given all the headwinds they face. Not that the ones I know don’t seem relatively happy and well-adjusted, but they do face a Sisyphean task.

Expected Returns, Realistic Expectations

Most public and private pension funds project returns of between 7½ and 8% on their investment portfolios. Let’s analyze how realistic that is.

First, if you look back over the last six years, pension funds actually returned 6.8%.

Not bad until you consider that we’ve been in a roaring bull market for the entirety of those six years. The average return for the largest public pension funds in the US in the recent decade was closer to 3.2%, and the overall average return for all US pension funds was 5.5%. Pension fund returns are highly correlated to stock market indexes, which is not surprising when you look at the typical allocation pattern of pension funds. This survey is from publicfundsurvey.org.

Note that hedge funds have recently underperformed equities; but on average they do somewhat better over the long term, depending, of course, upon which funds you are in. Accounting for the equity-like returns that many hedge funds achieve and the fixed-income returns that many real estate portfolios yield, the typical public pension fund portfolio looks like 55 to 60% equities, 30% fixed-income, and 10 to 15% alternatives.

As every prospectus states, and as I remind readers all the time, past performance is not indicative of future results. Jeremy Grantham at GMO has given us a forecast for seven-year real returns of various asset classes. This chart is as of December 31, 2014. Note that the long-term real return for US equities has been 6.5% (for newbies, when we say “real” return we mean net adjusted for inflation. Got it?)

Such forecasts are made in various ways but are generally based on how a particular asset class performed at a given level of valuation. It is well understood that if stocks at the beginning of a period have a lower valuation (there are several different ways to measure valuation, but generally we think of the price-to-earnings ratio), then their longer-term returns are going to be higher, often significantly higher, than the returns when equity valuations are high at the beginning of a period. Equity valuations are generally in the high range today (though not in historical nosebleed range – there is room for them to go higher).

Thus GMO’s forecasts are not very optimistic in terms of equity returns. And neither do they expect much from bonds.

This does not bode well for pension funds, which are heavily weighted to US equities. Given that the 10-year US Treasury is yielding under 2% and that some of us feel it may approach 1% before the end of the decade, the probability that any fund will be able to obtain 7-8% total returns over the next seven years doesn’t seem very high. Even hoping to get 4% might be stretching it.

If this all sounds pessimistic, I suggest you go to www.CrestmontResearch.com and look at historical returns on the equity and bond markets for the last 100 years. There were periods when US equity returns were negative for 20 years.

Further, it has been almost seven years since the last recession. Given that the longest we’ve gone without a recession is close to 10 years, it seems likely that we will see a recession within the next five years. The average stock market correction in a recession is in the 40% range, and recessions almost always mean that interest rates go even lower, which makes the challenge of achieving even 4% over the next seven years even more daunting.

The difference between compounding at 4% and 8% is huge. You can go to various websites that will help you calculate compound interest rates on your assets over time. I went to money-rates.com. The difference between compounding at 4% and 8% for 10 years is impressive: $1,000 grows to $1,480 at 4% and to $2,159 at 8%.

$1000 grows to $2,191 at 4% in 20 years and to $4,661 at 8%. At 4% you barely double your money in 20 years, but at 8% you double and then more than double again.

Okay, we all know the power of compounding. And it stands to reason that if a pension fund compounds at half the rate they expect to, they’ll have a problem in the future. But it’s actually worse than that, because some pension funds are not adequately funded today. Obviously, if a pension fund doesn’t have the money in its fund that it should have, then that money is not available to compound.

As it turns out, the largest portion of future assets from which pension funds will be able to pay out future benefits comes from the magic of compounding. If a government or company fails to fund its pension plan today, then either more money will have to be provided in the future, or there will be fewer benefits.

Pension funds, and especially public pension funds, are massively underfunded. How much is a matter for debate, but it’s a debate we should briefly look at. Since the level of future assets depends on the rate at which the portfolio will increase, a pension fund’s projection of that potential growth will determine whether the fund is overfunded or underfunded today. That projected growth rate is called the cap rate.

Dude, Where’s My $4 Trillion?

Even assuming the 7-8% returns that most pension funds use to calculate the contributions required to fund promised benefits, the funding shortfall is still in the high hundreds of billions of dollars nationwide. But what if you assume a cap rate similar to the return on the 15-year bond? That return was about 3.25% a couple of years ago when a group called State Budget Solutions did a study on the underfunding of public pensions. Using that 3.25% cap rate, they estimate that public pension funds are underfunded to the tune of $4.1 trillion. I should point out that their study included just 250 state-level defined-benefit plans and omitted many smaller county and municipal plans, so the shortfall across all plans is in all likelihood much worse.

I should note that you can find other studies that will say the underfunding is “only” $890 billion or $1.5 trillion or – pick a number. But I have not found one study that says there is not an underfunding problem.

You can click on the link above to see how your state is doing, but let’s pick on California. Back in 2013 their state pension plans had $459 billion in assets and a projected liability of $1.1 trillion (at the lower, 3.25% cap rate), for a funding shortfall of $640 billion.

The State of California itself assumes a higher cap rate, but even then the state admits it will need to inject $5 billion a year annually into the state’s second-largest pension fund, the California State Teachers’ Retirement System, or CalSTRS. For complex statutory reasons, CalSTRS is dependent on the legislature to backfill any losses, while CalPERS (California’s largest fund) can simply raise its contribution rates for participating cities.

Let’s look at the situation as described by Steven Greenhut in an article called “California Faces Death by Pension”:

It became clear that CalSTRS would go belly up in thirty years if the legislature didn’t start sending another $5 billion or so its way annually. So [Governor Jerry] Brown and company concocted another plan to ratchet up state contributions. But it, too, was largely phony. Under the plan, the state sends a pittance extra each year to CalSTRS, with the really large bumps in contributions pledged to take place years from now when it will be someone else’s problem. 

This offers a teaching moment. The annual $5 billion (which the state is apparently not actually funding) would get the pension plan back into compliance, but only if you accept the validity of CalSTRS’ assumed return of 7½%. If you take the far more conservative (and maybe too conservative) estimate of State Budget Solutions, California would need to invest roughly $30 billion annually. That would obviously eat up a huge chunk of the $100 billion state budget and is politically impossible.

That leaves the poor pension fund manager with a political dilemma. If he lowers his projected rate of returns, then the people (teachers, firemen etc.) covered by the plan will have to make higher annual contributions. Given how tight budgets are, no politician or union leader wants to be forced to allocate more money to current pension funding, no matter how wise it might be to do so. It would mean cutting somebody else’s budget or raising taxes, and neither are easy tasks.

Yet setting a higher goal for returns almost forces pension fund managers to move out the risk curve in the search for yield. But pension funds are supposed to be conservative money. Balancing that mandate is not easy.

Where Can You Find Yield?

And that brings up a third challenge that pension fund managers face: yields all across the board, almost everywhere in the world, are down because of monetary policy. It is not just yields on corporate bonds that are down. Returns from private equity are also down, as more money chases fewer deals. The prices for the better-rated opportunities rise because of the lower interest rates. And deals get done that shouldn’t because money is almost free.

This is the inverse problem of the cap-rate issue. Because interest rates are so low, the same dollar amount of leverage provides a larger potential return. And the larger potential return increases the price, bringing returns back to whatever is normal for the time. And in today’s environment, returns are low.

I talk with hedge fund managers and fixed-income managers all the time. If you are willing to take a nontraditional approach to fixed-income investing, you can find yields in the high single digits and even the low double digits. But the emphasis here is on “nontraditional.” And there are certainly not enough deals to go around for all of the tens of trillions of dollars of investment funds around the world that are looking for such deals.

A pension fund manager has to deal with his board of trustees. That’s something they constantly talk about: “the governance issue.” Some boards have very sophisticated members, and others, well, not so much. In fact, my experience with boards of trustees is not very heartening. What often happens is that they look for advice from outside consultants. These consultants come in and tell them how much return they can expect to get and give them “political cover” for making decisions, when the suggested decision is pretty much the same old same old. Which is why pension fund returns tend not to vary that much across the spectrum of funds.

(Please note there are some very real exceptions to that generalized statement I just made. There are some boards composed of such experienced investors that I would feel uncomfortable sitting at the same table. Why would they need my advice?)

So in addition to the problems of potentially lower market returns, a pension fund manager may have to deal with an inexperienced board that looks to consultants to tell it what to do and looks over the shoulder of the pension fund manager, keeping him from taking advantage of his experience. But the board of trustees needs to make sure it has some way to protect itself from liability if things don’t work out as planned. And being able to point the finger at consultants and outside counsel is one way to mitigate risk exposure.

A High-Order Problem

And then there is the problem that I mentioned at the beginning of the letter: people are living longer, which means pensions are even more seriously underfunded. But that is a very high-order problem. I don’t think my generation is going to volunteer to die “on time” just to make pension managers happy. The Society of Actuaries started with actual data from numerous pension plans and looked at 220,000 deaths from 2000 until 2009 (involving 10½ million life-years). What they found out was that during that period people were living two years longer than they had been in the past. This corresponds to the roughly one year of increased life expectancy for every passing four years of the last century.

This has real-world implications. As Bloomberg Business reports:

If retirees on average live three years longer than expected – a typical margin of error in the past – a global pension bill estimated at up to $25 trillion could swell by $3 trillion, according to a 2013 report by the Bank for International Settlements’ Joint Forum, a global body of insurance, banking and securities regulators….

The typical corporate pension plan already is underfunded. In aggregate, plans maintained by the 411 companies in the Fortune 1000 that sponsor defined-benefit plans – where retirees receive a guaranteed payout depending upon years of service – are 80 percent funded, according to Towers Watson. [I note that this is a much higher funding level than public pension plans achieve, but it can be a drain on profits for corporations.]

That extra $3 trillion that will have to be found because people are living longer? In another eight years it will be additional $3 trillion, as actuaries are surprised to find that people keep insisting on living longer. And inflation and underfunding problems will make the number still larger.

There are those who argue that longevity is not going to continue to increase as it has over the last century, because we have found all the “low-hanging fruit.” Basic hygiene, antibiotics, modern medicine, and so on have taken us about as far as we are going to go, they say.

And while I would agree that we have harvested the low-hanging fruit, I think the biotech revolution is creating fruit ladders that will let us reach far higher.

The baby boomer generation is going to be the first generation in the last 150 years that will break the deal that is implicitly made with previous generations. Each generation heretofore has agreed of die in an actuarially definable period of time. That way pensions get funded and wealth is transferred on.

I think there is every likelihood that it won’t happen this time. The boomer generation is going to live far longer and use more resources in doing so than any previous generation has done. 

Patrick Cox, my colleague over at Transformational Technologies, has been documenting the rapid evolution of age-extending medicines and therapies for some time now. He and I are both taking some rather new nutraceuticals that seem to be having positive effects. While I can’t say for sure whether it is any one of them or a combination of several that is improving my physical well-being, something has me feeling better than I have in a very long time. Perhaps it is just a different trainer who pushes me more than anyone in the past 40 years has (though I don’t think so), but I am setting lifetime highs in bench presses and other measures of strength. Both Pat and I are in our 60s (I’m 65), and we are both experiencing these lifetime highs in our physical activity. People don’t typically expect to do that in their 60s.

There are technologies and therapies that are just around the corner that, I promise you, I will be close to the front of the line to participate in. And a bit further down the road, but no more than 10 years out, we’re going to see cures for most major diseases. That seems a radical statement, I know, but I’m talking to the doctors and scientists who are doing it.

Healthcare as we know it is changing. I talked to two healthcare executives here in the Cayman Islands. A doctor from India has built a very modern hospital here in Cayman that is doing open-heart surgery for a flat $22,000 per surgery (25% of US costs), inclusive of any complications that you might have. That is an all-in price. Their hospital infection rate, a big problem in the US, is a small fraction of what we see in the US. Their success rate is higher. They are simply using different procedures and controls than we find in the US. The doctors are actually far more skilled than most, as together they do dozens more surgeries per week than similar groups of US doctors do. And they are doing this across multiple disciplines, like orthopedic surgery, cancer treatment, etc. Their vision is to drive the cost of healthcare down and improve outcomes in doing so. As costs come down, more of us will be able to afford access to healthcare and thus extend our lives.

My doctor, Mike Roizen of the Cleveland Clinic, points to a study they did that estimates the US could save 20% of its healthcare costs if the American people just changed the way they behave. One of the primary reasons Europeans spend less on healthcare than Americans is that we’re just not as healthy. We eat a lot of bad food, smoke, don’t exercise, and even worse, don’t take prescribed medicines. Thirty percent of Americans are now defined as obese. The correlation between obesity and health is well known.

In less than 10 years therapies will exist to bring that obesity epidemic under control, which will extend both lifespans and healthspans. There are multiple paths that Patrick and I are watching today for the development of such therapies. It is a very interesting race to watch, and if you pick the right horse it could be very profitable.

Let me make a suggestion. You should go to http://www.mauldineconomics.com/tech and subscribe to Patrick’s free weekly letter, where he talks about a lot of the new advances being made in biotech and medicine each week. Whether or not you ever intend to subscribe to his investment letter, you should be aware of the breakthrough developments that are happening today. In his latest issue he talks in detail about the nutraceuticals that he and I are taking, so you and your healthcare team have a starting point for deciding whether you should consider taking them, too. We are not in the pill business, but I would really like my subscribers to live longer with me. We are not interested just in helping you have a longer life, but also in helping you have a healthier life, too.

Healthspans are more important than lifespans. I am watching my mother come to the end of her life. She was active up until a few years ago but has now become bedridden at 97; and frankly, it is not a very pleasant prospect that in 30 years’ time that person in the bed could be me unless there are some major advances in healthcare.

After that little walk down the rabbit trail, let’s come back to the original point. People who are counting on their pension funds for retirement are going to live longer than pension fund managers have been expecting them to. This reality is going to make it even more difficult to ensure that everybody has enough money to get them through to the end of their longer lives.

If you don’t have a pension but are going to have to live off your savings, then it is very important that you understand that you need add five to ten years – at least – to whatever you think your life expectancy is today. We need to rethink retirement and rethink Social Security. Because, yes, the additional costs for Social Security, the largest pension fund in the US, are going to be staggering.

For a start, we need to be aggressively increasing the retirement age for Social Security. When Social Security was introduced during the presidency of Franklin Roosevelt, the age at which you could claim benefits was 65. But the average lifespan for a male at that time was around 57. If lifespans and eligibility for Social Security had moved in lockstep, today eligibility for Social Security would be somewhere in the upper 80s. And while no one would suggest that should be the case, it does help frame the question of what the eligibility age for Social Security should be.

Dallas, Florida, Switzerland, and New York

I want to thank my hosts at the Cayman Alternative Investment Summit. They really went out of the way to make sure we had a good time and to make us feel special. And I actually did get a few hours here and there at the beach and in the gym. The Ritz Carlton resort here is very nice.

I am back in Dallas and will speak this Thursday at an open forum for financial advisors sponsored by S&P and called “Managing Risk and the Future of Factor-Based Strategies.” If you are an investment professional, you can register at this link.

At the beginning of March, I will be in Orlando to do a keynote presentation for the American Banking Association and to share a dinner with my old friend Greg Weldon. A few weeks later I fly to Geneva and Zürich, where I have a very packed schedule. In addition to speaking, I’m particularly looking forward to being with Dylan Grice, plus lots of other friends, and meeting Bill White for the first time. I’m sure I will be staggered by the cost of everything in Switzerland, but the train ride from Geneva to Zürich is worth every penny. On a side note, Bill White was smart enough to negotiate his speaking fee in Swiss francs, while I’m getting dollars for mine. That probably tells you all you need to know about whose advice you should listen to.

I have some other speeches in Dallas and will then head to New York at the end of March.

I’m finishing the letter while still in Cayman, and I think it’s time to hit the send button, because the beach is calling. And while I don’t sit in the direct sun very long, there are plenty of umbrellas under which to hang out with my iPad and finish a book or two. I will probably be a bit more casual than Al Pacino. The conference arranged for him speak on Thursday, and Friday morning he was out by the pool lying in a lounge chair, wearing his standard black long-sleeved shirt and pants. I’m thinking my swimsuit and an old T-shirt might be more appropriate. Hu-wa. You have a great week!

Your not even thinking of retiring analyst,

John Mauldin

Fiscal Austerity Versus European Society
Kemal Derviş
FEB 16, 2015 .

House of cards

WASHINGTON, DC – Over the last five years, the eurozone has, without explicit popular consent, maintained a strict policy focus on fiscal austerity and structural reforms – despite serious social repercussions, not only in the Mediterranean periphery and Ireland, but even in a “core" European Union country like France. Unless eurozone leaders rethink their approach, the radical Syriza party's success in Greece's recent general election could turn out to be just one more step toward a future of social fragmentation and political instability in Europe. Or it could mark the beginning of a realistic and beneficial re-orientation of Europe's economic strategy.
Of course, fiscal sustainability is vital to prevent a disruptive debt refinancing and inspire confidence among investors and consumers. But there is no denying that it is much easier to support fiscal austerity when one is wealthy enough not to rely on public services or be at serious risk of becoming mired in long-term unemployment. (The wealthy also remain largely in control of the media, the public discourse, and cross-border capital flows.)
For the millions of workers – and especially young people – with no job prospects, fiscal sustainability simply cannot be the only priority. When unemployment benefits are slashed, they are the ones who suffer. And when budget cuts extend to education, it is their children who are unable to gain the skills they need to reach their future potential.
Austerity-induced suffering is particularly extreme in Greece. Severe pension cuts are preventing the elderly from living out their lives with dignity. A large burden has been placed on those who actually pay their taxes, while many – often the wealthiest, who long ago stashed their money abroad – continue to evade their obligations. Health care has lapsed, with many cancer patients losing access to life-saving treatment. Suicides are on the rise.
Yet Greece's creditors have continued to ignore these developments. This is clearly not sustainable – a point that former Director of the International Monetary Fund's Europe Department Reza Moghadam recognized when he recently called for writing off half of Greece's debt, provided an agreement can be reached on credible growth-enhancing structural reforms.
Social sustainability is essential for long-term economic success. A country cannot prosper if its educational system lacks the resources and capacity to prepare its children to thrive in the digital economy. Likewise, a reform program cannot be implemented if inequality, poverty, and social frustration strengthen extremist political parties, such as Greece's overtly fascist Golden Dawn party or France's far-right, anti-Europe National Front, which now boasts 25% electoral support.
When times are tough, immigrants and minorities become easy targets. As Joseph Stiglitz recently pointed out, it is unlikely that Hitler would have come to power in Germany if the unemployment rate was not 30% at the time. It does not help when some of those trapped in the poor ghettos surrounding major cities – however small a minority – become tempted by violence and fall prey to terrorist recruiters.
Regardless of what today's corporate profit reports and stock indices may show, a country cannot achieve inclusive, sustainable success – in economic or human terms – if these fundamental social issues are not adequately addressed. Of course, fiscal caution cannot be abandoned; after all, if governments or the private sector were to spend borrowed or newly minted money freely, the result would simply be more crises, which would hurt the poor most. But social sustainability must be an integral part of a country's economic program, not an afterthought.
The persistent tendency to pay lip service to social sustainability, while implementing economic programs focused on unrelenting austerity, is a leading cause of political instability in Europe. Though reform programs aimed at building viable macroeconomic frameworks remain essential, they must include strong provisions for countercyclical policies to offset the “paradox of thrift" (the tendency to save more during a recession, undermining economic growth). When aggregate demand falls short of aggregate supply, governments must increase public spending.
Moreover, governments that are now focused narrowly on microeconomic issues need to devote the same level of attention and commitment to designing and implementing social policies that focus explicitly on ensuring the livelihoods, health, education, and housing of the most vulnerable segments of the population. And, using new technology to analyze large amounts of data, they should boost the efficiency of social programs, while encouraging the active participation of concerned citizens.
The European Commission and the IMF have admitted their errors – not only the inaccurate macroeconomic forecasts on which the Greek program was based, but also the decision not to account for social sustainability – and have acknowledged that the program has not produced the expected results. Yet, for some reason, Greece's creditors refuse to negotiate with the new government (which enjoys strong domestic support) to develop a new program that incorporates debt relief, a lower fiscal surplus, and structural reforms that support growth and promote social cohesion.
 This must not continue.
The last five years have underscored the challenge of achieving financial stability. But political and social stability have proved to be even more elusive. Policymakers must direct just as much effort and resources toward realizing social sustainability as they do toward getting the Basel III financial reforms right. Europe's future prosperity – and its global role – depends on it.

Oil’s Black Swans on the Horizon

Saudi Arabia May Be Targeting Oil Producers, Not Just Rival Producers

By Liam Denning
Feb. 16, 2015 12:33 p.m. ET

Next week sees the one-year anniversary of Uber’s ride-sharing service arriving in Riyadh.

Disruption is creeping up on Saudi Arabia and the global oil market on which it relies. So far, this has centered on supply: North America’s shale boom has upended expectations of ever-increasing dependence on Middle Eastern crude.

But Saudi Arabia’s oil minister, Ali al-Naimi, is also worried about the other side of the equation. At a conference last month, he asked: “Is there a black swan that we don’t know about which will come by 2050 and we will have no demand?”

Against the backdrop of oil’s recent plunge, Mr. al-Naimi was thinking of potentially disruptive trends including new technology and efforts to cut carbon emissions.

This might seem overdone. Last week, the International Energy Agency released medium-term forecasts showing global oil consumption rising by 6.6 million barrels a day by 2020.

Beneath the headline, though, the story is changing. Compared with 2014’s forecast, the agency cut one million barrels a day on average from estimates for the next five years. That may not sound like much, but consider that excess supply weighing heavily on prices now is estimated to be only around 1.5 million barrels a day.

Perhaps more importantly, the mix of demand is changing, too.

Three years ago, the IEA projected global demand would grow by 3.86 million barrels a day between 2015 and 2017. Of that, 79% came from so-called BRIC countries—Brazil, Russia, India and China—and the Middle East. The latest forecast cut that growth estimate and now only 63% is set to come from those regions.

The IEA sees the U.S. playing a bigger role. From 2008 through 2014, its annual medium-term forecasts always projected a five-year decline in U.S. oil consumption. Now, U.S. demand is seen rising by 380,000 barrels a day by 2019.

This makes sense given a recovering U.S. economy and Americans’ predilection for bigger vehicles when gas is cheaper. Meanwhile, a cooling Chinese economy and the impact of lower oil prices on the economies of oil-producing countries eats into growth from emerging markets.

The shift should worry oil producers. The U.S. response to lower gas prices won’t match that of the late 1980s and 1990s. Then, the prime working- and driving-age population was still growing strongly and hybrid and electric vehicles were largely unavailable.

The IEA still expects U.S. demand to peak in 2019. Oil intensity in terms of barrels per dollar of gross domestic product is set to continue falling in the U.S., and at an even faster pace in China.

At 1.16%, compound annual growth of global demand in the IEA’s latest medium-term forecast is the weakest since 2009.

Big Oil struggles to conceive of a world where demand growth slows to a trickle or stops. Exxon Mobil sees global demand hitting about 117 million barrels a day in 2040. Yet back in 2007 it saw that level being reached in 2030. And even Exxon can be blindsided. Its strategy in this century’s first decade implicitly assumed relatively cheap oil and the U.S. needing ever-rising imports of oil and natural gas. That turned out to be utterly wrong.

Similarly, prevailing assumptions such as improvements in batteries for electric vehicles advancing very slowly or that everyone in emerging markets will own a gas guzzler (rather than, say, using something like Uber) may prove myopic. New technologies, whether mobile phones, flat-screen televisions, or even shale fracking, are nascent until, suddenly, they aren’t and rapidly replace what came before. Multidecade oil projects requiring high break-even prices—such as Canada’s oil sands—look especially vulnerable if demand patterns change.

Oil’s sheer volatility, along with its geopolitical and environmental baggage, provides powerful incentives to use less of it. Saudi Arabia’s current strategy appears aimed at making rival producers sweat. Equally, it may represent a concerted effort to court consumers faced with a small but rapidly growing set of alternative choices.

February 15, 2015 2:36 pm

Athens must stand firm against the eurozone’s failed policies

Wolfgang Münchau

One of the riskiest options would be a formal exit from the currency unión

In this photo Illustration, paper money of Old Greek Drahama and Euros are crunched up as they are displayed on January 12, 2015 in Athens, Greece©Getty
Drachma vs euro: Syriza, Greece’s anti-austerity party, leads in the polls
The Greek finance minister can expect a frosty reception on Monday where he will confront his eurozone colleagues in another ‘high noon’ European showdown. My advice to Yanis Varoufakis would be to ignore the exasperated looks and veiled threats and stand firm. He is a member of the first government in the eurozone with a democratic mandate to stand up to an utterly dysfunctional policy regime that has proved economically illiterate and politically unsustainable. For the eurozone to survive with the current geographic remit, this regime needs to go.
Of course, for Greece to stand up to the EU policy elites is risky. The consequences of a failure to agree a deal have to be well understood. Greece might risk a financial collapse, and with it a forced exit from the eurozone. The concrete issue under discussion is a new loan to Athens to cover its funding needs for the next few months. The argument is not really about the money. It would only take a couple of economists in a pub with a pencil and a few beer mats to do the sums.

The dispute is about the packaging. The Greeks want a simple bridging loan combined with an implicit acknowledgment that the previous support programmes have failed. Others disagree. The Germans support austerity on ideological grounds. The Portuguese oppose any deal for Greece as they have taken their austerity medicine and did not stage an insurrection. And the Lithuanians are saying: we are even poorer than you are. Why should we bail you out? And so on.

So what should the Greek government do? They should stick with their position not to accept a continuation of the existing financial support programme. By doing this they would no longer be bound by self-defeating policy targets such as the contractual requirement to run a primary budget surplus of 3 per cent of gross domestic product. For a country with mass unemployment, such a target is insane. It would, of course, be better for this nonsense to stop while Greece remains in the eurozone. But the most important thing is that it has to stop.

If this is not feasible, Athens would need to prepare a Plan B. This does not necessarily mean a formal exit from the eurozone, which would be one of the riskiest options. There are smarter choices to pursue first.

The most sensible one is the introduction of a parallel currency — not necessarily paper money, more like a government-issued debt instrument that can be used for certain purposes. A number of economists have been thinking along these lines. Robert Parenteau, a US economist, has proposed what he called “tax anticipation notes”. These are IOUs backed by future tax revenue. Such instruments exist in the US at state level. They act as a tax credit that allows governments to run a fiscal deficit until the economy recovers. With such an instrument Greece could abandon austerity without abandoning the euro.

John Cochrane, a conservative economist at the University of Chicago, also wants the Greek government to print IOUs. They would be electronic money, not necessarily cash and would be used to pay pensions and other transfer payments. The IOUs would fulfil one of the core functions of money — a medium of exchange. You can use them to buy food in the grocery store or to recapitalise parts of your banking systems.

And what no one is saying — at least not in polite company — is that once this system is in place, you can default on the official European creditors. What can they do? They cannot eject you from the eurozone. They have no legal means to do so. They cannot kick you out of the EU either. They still need your assent for treaty change, or any policy requiring unanimity, such as the renewal of the sanctions against Russia.

The riskier alternative would be a hard exit — Grexit. This is an option Greece should try to avoid because it is hugely disruptive. But the scale of the downside of this, at least for Greece, depends on how it is managed. Grexit would be potentially more dangerous for the eurozone itself because it could be a seen as a template for others, especially in the absence of an economic Armageddon in Greece. Yet, while not desirable, Grexit would still be preferable than the status quo.

The worst-case scenario would be for the Greek government to blink first, and accept defeat. If Syriza were to be co-opted into the policy consensus, the only political party left to oppose these policies would be Golden Dawn, a neo-Nazi party.

My preference would be for the eurozone as a whole to abandon the failed policies of the past five years, and move on. If that proves politically impossible, the second best option, for Greece at least, would be a semi-exit with a parallel currency and a default on official creditors only. Either way, they will need to stand their ground on Monday.