Face off

Donald Trump may be bluffing over a pre-emptive strike on North Korea

But do not count on it

THE last time that America almost risked a pre-emptive strike on North Korea the gamble offered a spectacular pay-off. Ashton Carter, a leading architect of that plan, recalls that his scheme for bombing the Yongbyon nuclear facility in 1994 assumed that in one or two days the entirety of the regime’s nuclear programme could be levelled and entombed in rubble. Mr Carter, who went on to become defence secretary in the Obama administration, now thinks that an American first strike would only put “a significant dent” in North Korea’s arsenal of nuclear devices and bombmaking sites. “The difference today is that the North Koreans are very good at hiding, burying and moving around their nuclear infrastructure,” says Mr Carter, now at Harvard University.

If the potential upsides of a strike have shrunk, the risks have grown hugely. The crisis of 1994 saw Kim Il Sung thwart international inspections and threaten to put plutonium from Yongbyon into half a dozen primitive bombs. Since then power passed to the despot’s son and in 2011 to his grandson, Kim Jong Un, a young man in a hurry who has to date never met a foreign leader, even from China, the closest his all-but-friendless kingdom has to an ally. North Korea has tested six nuclear devices between 2006 and 2017, including what appeared to be a hydrogen bomb, and produced enough plutonium and uranium for possibly dozens more warheads. Its missiles credibly threaten American territory in Guam, Hawaii or even the continental United States, even if officials do not believe a North Korean nuclear-tipped rocket can yet reach an American city.

Just because war in Korea would be unspeakably dangerous does not mean that it will not happen. Sober officials with long careers in Asia policy talk of being more fearful than at any time in recent memory. America is governed by Donald Trump, who revels in matching North Korea in bluster. He has called Mr Kim “Little Rocket Man” and a “sick puppy”, and promised that continued North Korean threats to America “will be met with fire and fury like the world has never seen”. Mr Trump has at times called diplomacy with the Kim regime “a waste of time”. He is also scornful of allies and alliances, causing one Japanese expert to identify a grave concern: “that Trump will come up with a military option and not take the costs seriously.” It is not just Mr Trump. The generals seen as a steadying influence on the president have given warnings that the Kim regime cannot be permitted to build weapons that threaten American territory.

General Joseph Dunford, chairman of the joint chiefs of staff and a man who wields his influence discreetly, last year chided anyone who thinks it unimaginable that America might use force to check a North Korean nuclear menace. “What’s unimaginable to me is allowing a capability that would allow a nuclear weapon to land in Denver, Colorado,” he said. In August 2017 H.R. McMaster, a lieutenant-general who is national security adviser to Mr Trump, scolded an Obama-era predecessor, Susan Rice, for suggesting that their country could contain and deter a nuclear-armed North Korea, as it did the Soviet Union. “She’s not right,” chided Mr McMaster, asking how “classical deterrence theory” could apply to so brutal a regime.

On manoeuvres

Even the defence secretary, James Mattis, a cerebral former Marine general who says his job is to “buy time for our diplomats” to solve the North Korean crisis, has weighed in. Put on the spot by reporters in September 2017, he insisted that there are military options that would not imperil Seoul, the South Korean capital, though its 10m inhabitants live within range of the North’s artillery and missiles. Such options exist, he said, “but I will not go into details.”

Others sound less certain. Mr Carter notes—with tact—that retaliating against a foreign attack is the standing policy of the North Korean armed forces. “If the US and South Korea decided to initiate a strike, we would have to make sure that we were thoroughly prepared for a full-on conflict,” he says. Invited to contemplate military options that would not put Seoul in harm’s way Abraham Denmark, a Pentagon official during the Obama era who worked on Korea policy, answers simply: “I can’t imagine what those could be.”

Discussions of Korea strategy quickly drift into seemingly impossible tangles, involving deadly Stalinist court politics and fantastical perils. Official reports detail the North’s nuclear, biological and chemical arsenals, and artillery pieces in hardened bunkers just north of the demilitarised zone (DMZ) that divides the two Koreas, which some analysts estimate can fire 10,000 rounds a minute at Seoul. A Pentagon report of 2015 talks of North Korean drones, midget-submarines and of commandos who may attack targets in South Korea “via suspected underground, cross-DMZ tunnels”. Mr Mattis has said a Korean conflict “would probably be the worst kind of fighting in most people’s lifetimes”.

Still, responding to presidential demands for more and better options, officials are debating possible “preventive” strikes, a term denoting actions taken earlier than “pre-emptive” attacks in response to an imminent threat, like a missile being readied for launch.

Untangled logic

At root, however, debates about Korea strategy turn on two starkly straightforward questions, spelled out in interviews with serving and former defence and national-security officials, diplomats and spies, including several with personal experience of negotiating with North Korea. First, will China ever break decisively with North Korea, its infuriating neighbour but valued buffer against the world? Second, can Mr Kim be deterred? For if he cannot, then any responsible American president must contemplate a strike, risking what the Japanese expert summarises as “tens of thousands of casualties today to prevent millions tomorrow”.

Aides to Mr Trump boast that the president’s resolve explains China’s support for UN Security Council sanctions of unprecedented severity, including curbs on North Korean exports of coal and textiles and on flows of oil and refined petroleum from China. A senior State Department official recalls Mr Trump’s order to strike Syria with Tomahawk cruise missiles in April 2017, during dinner with the Chinese president, Xi Jinping, at Mar-a-Lago, his Florida estate. That strike, enforcing a red line over Syria’s use of chemical weapons, “put military action back into our diplomacy”, says the official. “It was an important data point that China internalised.”

In fact China has yet to abandon a long-standing hierarchy of Korean horror in which a nuclear-armed North ranks second. For China, it is pipped by the prospect of a chaotic fall of the Kim regime, followed by a reunification of the two Koreas on Western terms, lining China’s border with American allies and high-powered American radars (or worse, hulking GIs in Oakley sunglasses).

Team Trump has tried sweet reason. Rex Tillerson, the secretary of state, joined Mr Mattis in assuring China publicly that as it pursues the denuclearisation of the Korean peninsula, America has no interest in regime change or accelerated reunification, seeks no excuse to garrison troops north of the DMZ and has no desire to harm the “long-suffering North Korean people”, as distinct from their rulers.

Revealing a once closely held secret, Mr Tillerson told the Atlantic Council, a Washington think-tank, last December about “conversations” with China about how the two countries might secure loose nuclear weapons should North Korea fall into chaos. This included assurances that American forces would retreat south of the DMZ when conditions allowed. Less sweetly, the senior official at the State Department says that when Mr Tillerson first met his Chinese counterparts, Yang Jiechi and Wang Yi, in March 2017, he told them that “we are out of time” and to drop their long-standing view of North Korea as an asset that keeps America usefully tied up.

Mr Tillerson told China that it can help America do more “the easy way or the hard way”, with the hard way meaning secondary sanctions on Chinese entities that trade with North Korea, and credible threats that Mr Trump is “serious about the military option if we cannot resolve this diplomatically”. Addressing that hierarchy of horror, the aim is to convince Chinese leaders that the very thing they fear most—instability next door, followed by an Asian nuclear-arms race—will be brought about by continued toleration of America’s worst fear, namely North Korean nukes.

Put that way, the Korean dilemma arguably revolves around a single question: is Mr Trump bluffing? Should North Korea, China and the wider world believe that America will use force to prevent Mr Kim from building a nuclear missile that can strike Washington, DC, or Los Angeles?

Team Trump is at pains to explain why the boss is not bluffing, and why 2018 is, in the words of one senior administration official, “a very dangerous year”. That official pointedly praises Israel for twice launching air strikes against suspected nuclear weapons sites, once in 1981 against the Osirak reactor being built by Iraq, and in 2007 against a reactor in Syria allegedly under construction with North Korean help.

Strike one, strike two…

The official calls those strikes “textbook cases” of preventive action. He draws attention to a Trump tweet in late December, linking to a television interview that Mr Trump gave as a private businessman in 1999, urging America to “negotiate like crazy” with North Korea but, if talks failed, to “do something now” before warheads are aimed at New York and other cities.

Strikingly, though, when asked point blank whether Mr Trump has already set red lines that North Korea may not cross, officials will only reply that as a general rule, they are very careful about drawing red lines. Though news outlets have reported debates about giving North Korea a “bloody nose”, an official calls that phrase “a fiction of the press”.

Insiders deny that the Trump administration is dividing into camps of hawks and doves, with each taking a different view of the utility of talks. A clearer divide turns on relative optimism or pessimism about Mr Kim’s intentions, with Mr McMaster a leading voice of doom (he has compared this moment of geopolitical peril to 1914). In particular, pessimists doubt North Korea’s claim that it wants nuclear weapons that can hit America for self-defence.


Logic, and Mr Kim’s own words, point to a nuclear programme with grander ambitions, perhaps to “drive the US from the peninsula” or reunify Korea under the North’s flag, argues the senior administration official. “Why should a regime starve a couple of million of its own people to death, expose itself to punishing sanctions, [and] allow itself to be isolated by all its friends, merely to gain a deterrent that they already had for 60 years, from artillery pieces pointed at Seoul?”

Several officials and ex-officials who see the value of frightening Mr Kim to the negotiating table hope privately that Mr Trump is bluffing, believing that a limited strike would risk massive retaliation. Even narrowly-focused operations North of the border are deemed risky. In late 2016 Mr Obama’s National Security Council organised a war game, asking military, diplomatic and intelligence officials to simulate a mission to secure nuclear weapons in a North Korea tumbling into instability.

Participants call the exercise deeply sobering, with so many American troops needed to secure the large number of nuclear sites that it could take months to build them up, losing any element of surprise, and raising seemingly insuperable questions about when to evacuate Americans from the region without triggering chaos. An unclassified letter sent by the Pentagon to Congress in November 2017 offered the assessment that only a ground invasion could find and secure all weapons sites.

A senior American official recalls being asked by foreign counterparts why Mr Kim could not simply be killed. In reply he would point to the outside world’s dangerous lack of knowledge about what orders the leader’s death might trigger: “We seriously don’t know that there isn’t some sort of automatic doomsday process that pulls down the pillars of the temple.” The same official asked military colleagues for “horse’s head on the pillow” options that would terrify Mr Kim without triggering a full-scale response. “Nobody I spoke to in the military had an idea that could reliably thread the needle,” he says.

Scenarios for limited strikes could include the shooting down of a North Korean ballistic missile test. But a failure would damage the credibility of American defences. There is also a dangerous paradox attached to any action launched on the grounds that North Korea is deemed deaf to reason, notes Joseph DeTrani, a former intelligence officer and commentator for “The Cipher Brief”, a national-security website, who is also a semi-official envoy entrusted with meeting senior North Korean diplomats.

If trust vanishes, North Koreans “may see an imminent threat coming to them that is not an imminent threat”, disbelieving assurances that a strike is limited. In his experience, the country’s diplomats are professional and informed about the world. But that only helps if their advice reaches core leaders, who also hear from “hardliners in North Korea [whom] we do not know,” cautions Mr DeTrani. He disagrees with colleagues (and there are many) who call Mr Trump’s tweets unhelpful. On balance it is positive for North Koreans to hear directly from the president, he says. They understand bombast.

Optimists note that America has real points of leverage, even without force. Mr Carter urges step-by-step “coercive diplomacy”, setting out specific sticks and carrots for discrete North Korean actions, from missile tests to underground nuclear tests. If China proves incapable of playing a positive role, he recommends it is “sidelined”.

Several officials say that China’s willingness to toughen sanctions is mostly about managing America, which is seen as one of two irresponsible powers, alongside North Korea, distracting Chinese leaders from their domestic priorities. “The Chinese are more upset with the North Koreans for waking the American giant,” says an American official.

China is now enforcing UN trade embargoes on North Korea more strictly, in part to ward off American sanctions targeting specific Chinese banks and oil traders, though diplomats still deplore Chinese “salami-slicing” of each new sanctions plan. By a process of elimination, China now backs “pressure that will placate the Americans without being strong enough to [make the Kim regime] collapse,” says the official. Meanwhile, China continues to argue for America to freeze military exercises and curb deployments of advanced weapons in Asia. China is always “willing to bargain away the American military footprint”, growls a second official.

A final camp combines scepticism about North Korea’s motives—dismissing Mr Kim’s claims to need nuclear weapons as a deterrent—with (relative) optimism about sanctions. A Western diplomat says that North Korea believes that, if it can become the only nation with a long-range nuclear capability other than America, Britain, China, France and Russia, it will be welcomed to an “elite club”, free of all sanctions, “which is pie in the sky”.

This camp would use North Korea’s ambitions against it. Daniel Russel, former assistant secretary of state for East Asian and Pacific affairs during the Obama era, shares the pessimists’ belief that North Korea does not need nuclear weapons for deterrence, securing its safety with its ability to bombard Seoul. Nor does it need missiles—it can already detonate a nuclear device smuggled into South Korea, even if that would be suicidal.

Mr Russel argues that the North’s goal is money and other concessions. If through sustained sanctions “North Korea is denied the pay-off, the ransom it is seeking, it hasn’t actually achieved the [right] return on investment on the nuclear programme,” says Mr Russel, now at the Asia Society. A sense of being squeezed without reward is spreading discontent among the elites, he says. “The ability to limit Kim’s ability to govern, via sanctions, is the best leverage we have.”

Ironically, given all the focus in Washington on Mr Trump’s impulsive ways, insiders worry most about a crisis that is thrust upon him. They fear that China and North Korea are both waiting Mr Trump out, hoping that he loses the White House or become distracted by other crises.

Mutual incomprehension

Mr Denmark speaks for several officials when expressing dread about Mr Kim misjudging some fresh provocation. In 2010 the North sank the Cheonan, a South Korean patrol ship, killing 46 sailors. He fears Mr Kim trying a similar act today, thinking that America will not respond. The North might overreact to American demonstrations of will, such as bomber flights off the coast, says Mr Denmark. “What’s to stop the North Koreans thinking that’s the beginning of an attack? That keeps me up. Who has launch authority on the North Korean side in the middle of the night?”

On the other side stands Mr Trump, a wild card who may soon face risks he deems intolerable while lacking any good options. “The president may be forced to take action,” a US official says. “The potential for conflict is very high.”

The Bank of Japan’s Moment of Truth

Takatoshi Ito  

Governor of the Bank of Japan Haruhiko Kuroda

TOKYO – The Japanese economy has enjoyed seven consecutive quarters of positive growth, with the average annual rate reaching 1.9%. With aggregate demand exceeding potential output by 1%, the country’s “GDP gap” is now positive. Unemployment is down to 2.7%, the lowest level since 1993, and the job-opening-to-application ratio is 1.56, its highest level since 1974, resulting in acute labor shortages in several sectors, including construction, retail, and package delivery. And in January this year, the Nikkei Stock Average rose above ¥24,000 ($216), its highest level since 1991.

But, while these indicators suggest that Japan is finally out of the woods of more than two decades of stagnation, deflation, and economic insecurity, the headline inflation rate, at just 0.6%, remains far below the Bank of Japan’s 2% target. And, notably, while the BOJ had been attributing low inflation to falling energy prices, energy is now contributing positively to inflation. When fresh food is excluded from the price index, the rate rises to 0.9%, but falls to 0.3% when also excluding energy.

Considering the current labor shortages, why Japan has not experienced a healthy wage-inflation spiral remains a mystery. To be sure, inflation is also missing in the United States and Europe. But the Japanese case is particularly striking. Japan’s real economy has been supported for years by fiscal deficits as high as 6% of GDP, and by extraordinary quantitative easing (QE), which BOJ Governor Haruhiko Kuroda introduced in April 2013. The debt-to-GDP ratio has since risen to 230%, and the BOJ has assumed ownership of more than 40% of outstanding government bonds (JGBs).

The BOJ has maintained its negative policy rate and 0% ten-year-bond rate by purchasing annually ¥80 trillion in JGBs and ¥6 trillion in equities. But, more recently, it has kept the ten-year-bond rate at 0.0-0.1%, while reducing the pace of new purchases of JGBs to around ¥50 trillion, in what some regard as a stealth tapering.

With Kuroda’s term ending in early April, two camps of critics have become increasingly vocal. The first camp, arguing that the real economy is what matters, wants the BOJ to stop providing stimulus and start worrying about its bloated balance sheet.

When the inflation rate moves closer to the target, the BOJ will have to start raising its policy and long-term rates without adjusting the size of its balance sheet – which is exactly what the US Federal Reserve is already doing. Given the low average coupon rate of asset-side long-term bonds, the upward shift of the yield curve will result in a loss for the BOJ (“negative seigniorage”), at least temporarily. In the worst-case scenario, the BOJ could exhaust its capital and require a fiscal injection, which could jeopardize its Independence.

Accordingly, the first camp believes the inflation target should be lowered to 1%. Inflation would then be on target, and the BOJ could wind down its QE program. The major drawback of this approach is that it would cause the yen to appreciate sharply, striking a blow to the real economy.

The second camp believes that more stimulus is needed, and that increasing the consumption-tax (VAT) rate in April 2014 was a huge mistake, as is stealth tapering. Instead, QE and expansionary fiscal policies should remain at full throttle until the 2% inflation target is reached. That means more government expenditure through more JGB issues, to be purchased by the BOJ – also known as “helicopter money.” The problem is that intentionally blowing up the budget deficit will increase the risk of a fiscal crisis down the road, without helping the real economy.

When the BOJ held its latest policy-setting meeting on January 22-23, it maintained the approach it has followed for more than a year. Kuroda and his deputy governors are probably hoping that the real economy’s strong performance will translate into higher inflation soon. But will it?

Generally, three keys to higher inflation are wage increases, resulting from labor scarcity; expectations of higher future inflation among the public; and a favorable external environment.

With respect to wages, Japanese Prime Minister Shinzo Abe’s government has been pressuring major corporations to raise wages by 3% or more. That should be manageable, considering that many corporations are enjoying record profits. And yet unions in Japan remain timid, and workers remain traumatized from 15 years of deflation. As a result, many choose job security over pay hikes. Demanding higher wages, they fear, would give companies an excuse to move operations abroad or adopt labor-replacing technologies.

As for the second ingredient, the BOJ has admitted that it underestimated the difficulty of influencing inflation expectations when it introduced its QE program in April 2013. In Japan, the expected inflation rate, however it is measured, tends to track the actual inflation rate, albeit with some lag. This helps to explain why simply announcing a 2% target has not anchored the public’s expectations, as it has in the US.

At the same time, the external environment is promising. Almost every other advanced economy is experiencing steady, synchronized growth. And emerging economies, especially China, have also regained strength. At the level of the global economy at least, the stars seem to be aligned for inflation to reach the 2% target rate in Japan, the US, and the eurozone.

In Japan, the Phillips curve tends to be L-shaped. Right now, the economy is very close to the kink in the “L,” the point known as the non-accelerating inflation rate of unemployment (NAIRU). Any sign of a vertical move (implying higher inflation with an unemployment rate at NAIRU), rather than a horizontal one (a lower unemployment rate without CPI inflation), will be welcomed by the BOJ, and good for the economy at large.

Takatoshi Ito, a former Japanese deputy minister of finance, is Professor of Economics at the School of International and Public Affairs, Columbia University, and Senior Professor at the National Graduate Institute for Policy Studies, Tokyo University.

Bitcoin freeloads on institutions’ trust, warns BIS

Cryptocurrency is ‘a Ponzi scheme and an environmental disaster’ says Agustín Carstens

Martin Arnold, Banking Editor

Agustín Carstens, general manager of the Bank for International Settlements, condemned bitcoin as 'a bubble' © AFP

Central banks must clamp down on bitcoin and stop such cryptocurrencies “piggybacking” on mainstream institutions and becoming a “threat to financial stability”, the head of the Bank for International Settlements has warned.

Agustín Carstens, general manager of the BIS — known as the bank for central banks because it is where they hold accounts — condemned bitcoin as “a combination of a bubble, a Ponzi scheme and an environmental disaster”.

His comments came as growing signs of a backlash against cryptocurrencies by mainstream financial institutions contributed to another steep fall in the price of bitcoin, which means it has lost almost two-thirds of its market value in a month.

“To date, many judge that, given cryptocurrencies’ small size and limited interconnectedness, concerns about them do not rise to a systemic level,” said Mr Carsten in a speech at Goethe University in Germany on Tuesday morning.

“But if authorities do not act pre-emptively, cryptocurrencies could become more interconnected with the main financial system and become a threat to financial stability.”‘

Cryptocurrencies exploded in number and value during 2017, hitting a combined market capitalisation of $830bn in early January before a market sell-off knocked nearly 70 per cent off that value.

But most banks refuse to touch cryptocurrencies as they raise anti-money laundering concerns because of their anonymity.

UK lenders, for instance, have even declined to provide mortgages to people who have funded their deposits by selling cryptocurrencies, which means their money cannot be traced. Many US and UK banks have also blocked customers from buying cryptocurrencies using their credit cards.

But there are already signs of the crypto-asset class permeating Wall Street, such as the creation of bitcoin futures contracts by two big US exchanges in December — the CME and Cboe. Goldman Sachs and Morgan Stanley are clearing these contracts for customers while steering clear of directly trading cryptocurrencies or holding them in custody for clients.

Meanwhile, investor interest is surging in cryptocurrencies and the initial coin offerings that finance blockchain-based start-ups, which last year raised more than $3.4bn in an almost completely unregulated market.

Mr Carstens, the former head of Mexico’s central bank, conceded that many of the world’s main central banks have closely examined the potential to transform their own operations using blockchain, or distributed ledger technology (DLT), which underpins cryptocurrencies.

But he said: “In practice, central bank experiments show that DLT-based systems are very expensive to run and slower and much less efficient to operate than conventional payment and settlement systems.”

His comments came a day after Mario Draghi, president of the European Central Bank, warned that cryptocurrencies were “very risky assets” and said the ECB’s bank supervision arm was working “to identify potential prudential risks that these digital assets could pose to supervised institutions”.

Pointing out that the “mining” process to create new bitcoins uses the same amount of electricity as Singapore each day, Mr Carstens said “the current fascination with these cryptocurrencies seems to have more to do with speculative mania than any use as a form of electronic payment, except for illegal activities”.Cryptocurrencies – investing or gambling?

“Accordingly, authorities are edging closer and closer to clamping down to contain the risks related to cryptocurrencies,” he said, pointing out that it was “alarming that some banks have advertised ‘bitcoin ATMs’ where you can buy or sell bitcoins”.

“If the only ‘business case’ is use for illicit or illegal transactions, central banks cannot allow such tokens to rely on much of the same institutional infrastructure that serves the overall financial system and freeload on the trust that it provides,” he added.

Hulbert on Markets 

Gold: Don’t Make This Critical Mistake

By Mark Hulbert

      Photo: Dmitry Beliakov/Bloomberg News 

Many who invest in gold think the most important issue they face is timing—when to be in the asset class and when to be out.

They’re wrong.

Just as important, if not more so, is how they get their exposure to the gold market.

Not all gold and gold-related investments perform even remotely similarly, according to a study forthcoming in the Financial Analysts Journal titled “All That’s Gold Does Not Glitter.” Its authors are Robert Johnson, president and CEO of the American College of Financial Services, and Gerald Jensen and Kenneth Washer, both professors of finance at Creighton University.

Take the past decade. Over the 10 years ended Jan. 22, according to FactSet, the iShares Gold Trust exchange-traded fund (ticker: IAU) gained 45.1%, while the VanEck Vectors Gold Miners ETF (GDX) lost 49.3%. That’s a huge spread.

In this regard, gold is far different than equities. “If you’re going to put together a diversified equity portfolio, then the market-timing decision is far more important than the choice of individual stocks to put in that portfolio,” Johnson explained in an interview. With gold, by contrast, “the choice of vehicle is just as important, if not more so, than the market-timing decision.”

What factors should you take into account when choosing a particular gold-related investment?

Two Ways to Play Gold

How the iShares Gold Trust ETF and the VanEck Vectors Gold Miners ETF have performed over the past decade.
Source: FactSet

One is leverage. Many gold investors look to ETFs and funds that invest in gold-mining companies as a leveraged way of exploiting a rise in gold’s price. And, sure enough, the researchers found gold-related betas of between 1.5 and 1.8 for many of those funds (calculated when focusing on weekly volatility). That means that those funds are expected to gain or lose between 1.5 and 1.8 times as much as gold bullion in a given week.

Those high betas are attractive to aggressive speculators interested in getting more bang for their buck when investing in gold. But there’s an easier way of achieving the same result: Increase your allocation to gold bullion itself. If you otherwise were allocating 10% to gold, for example, allocating 15% instead would have the same effect on your bottom line as investing 10% in a gold-oriented investment leveraged with a gold-related beta of 1.5.

Another factor to keep in mind when choosing a gold investment is how good a job it does hedging against stock-market declines. The researchers report that the ETFs and funds that invest in gold-mining companies are far more correlated with the stock market than you’d expect. Gold bullion, in contrast, is not.

One revealing statistic is the correlation coefficient, which measures the extent to which gyrations in one asset are correlated with those of another; a coefficient of 1.0 would mean perfect correlation, while a zero reading would mean there is no detectable correlation. In contrast to a correlation coefficient of just 0.03 between gold bullion and the Standard & Poor’s 500 index, which is essentially zero, the gold-mining company funds had significant coefficients ranging from 0.3 to 0.7.

Yet another factor is one the gold-mining funds have in their favor—their ability to hedge against inflation. Confirming earlier reports, the researchers found that bullion itself is essentially uncorrelated with changes in inflation. The correlation coefficients with inflation for the gold mining company funds the researchers analyzed, in contrast, range from 0.2 to 0.4. Note carefully, however, that even though such coefficients are statistically significant, they nevertheless are still far from the 1.0 level that would indicate perfect correlation.

Regardless of where you come down on the bullion-versus-gold-mining-company-shares decision, the researchers’ broader point remains: A lot is riding on your choice, since in the future there is likely to be a wide dispersion of returns among the different investment vehicles traditionally used by investors to gain exposure to gold.

As Johnson and his co-authors conclude, investors should not be treating “precious metals as a largely homogenous asset class.”

How Violence in Mexico Shapes Relations With the US 



Violence in Mexico is on the rise, multiple reports show, stoking alarm both inside and outside the country. Though violence doesn’t have inherent geopolitical significance, it becomes significant when it has the potential to fundamentally alter a country’s economic trajectory, political system and international relations. In the case of Mexico, reports of increasing violence, particularly organized crime-related violence, merit a closer look because Mexico is an emerging market and harbors ambitions to get out from under the thumb of the United States.

The violence in Mexico also raises the issue of the potential for spillover into the U.S., since this would likely lead to a redefinition of the bilateral relationship. Other places in the world have higher rates of violence than Mexico, but greater scrutiny is placed on Mexico because of its proximity to the U.S. and the impact violence may have on Mexico’s emergence as an economic power.

Rising Violence and Drug Trafficking

To understand the potential impact, we must first understand the types of violence in Mexico. Media reports focus on intentional homicides as well as kidnappings, extortion and armed robberies. In tracking homicides, Mexico distinguishes between homicides in which the perpetrator intentionally seeks the death of the victim and homicides that result from reckless or negligent behavior without the intention of causing death.

Intentional homicides set a new record last year. The previous record of 22,409 was set in 2011. The number of intentional homicides had declined each year since then, but the trend reversed in 2015. In 2017, there were 25,339 intentional homicides, a 23 percent increase from the previous year and 13 percent higher than the old record.

Drug trafficking organizations are often blamed for the rise in violence in Mexico. The official statistics do not differentiate between drug- or organized crime-related killings and other homicides, but some types of homicides are characteristic of the criminal and drug trafficking organizations, or DTOs, in Mexico. Homicides involving guns – which was about two-thirds of the homicides in 2017 – have a high probability of being related to organized crime or drug traffickers. Extortion and kidnapping, along with human trafficking and sales of stolen cars, are also associated with DTOs. It is not a coincidence that the states with the most homicides and kidnappings per month and the greatest increases in homicides per month are those with a strong presence of drug trafficking activity. The high-profile victims are typically journalists and politicians, who are attractive targets for organized crime groups. Further, anecdotal evidence of mass graves, dismembered bodies, decapitations and bodies found with narco messaging all point to the work of DTOs.

Homicides in Mexico do not occur uniformly across the large territory. Baja California, Guerrero, Mexico state, Veracruz and Chihuahua rank as the most violent states with the highest incidents of intentional homicide. Other states with high homicide totals are Sinaloa, Michoacan and Jalisco. In other states, such as Colima, the number of registered homicides are low, but they have a dramatic effect due to the small population. Colima registered 93.6 deaths per 100,000 people in 2017. Baja California Sur ranks second with 69.1 deaths per 100,000 people. For perspective, the national homicide rate in Mexico is about 20.8 per 100,000 people. Other states that have lower homicide rates have noted a faster increase in those rates. Last year, intentional homicide cases rose 550 percent in Nayarit, 116 percent in Aguascalientes and 118 percent in Quintana Roo. Overall, 26 of Mexico’s 32 states recorded an increase in homicide rates in 2017.

As for kidnappings and extortion, the number of reported incidents has increased in the past two years, but not as quickly as homicides. Both peaked in 2013, with 1,688 kidnappings and 8,213 extortion cases, and then dropped significantly over the next two years. However, since 2015, the number of reported incidents has slowly increased. In 2017 there were 1,484 reported kidnappings and 5,649 extortion cases, both surpassing 2016 totals. Meanwhile, local human rights organizations and other observers say there is reason to believe these incidents are under-reported. Given the nature of extortion and due to anomalies observed in the data from Mexico state, those organizations may be correct.

Drug Trafficking Organizations and Organized Crime

The main reasons for the spike in violence are the splintering, restructuring and growing competition among the DTOs and other organized crime groups in Mexico. This fragmentation had its roots in the presidency of Felipe Calderon (2006-12), who from day one adopted an aggressive stance on drug cartels. His “kingpin strategy” focused on killing or imprisoning the heads of major cartels, which followed a hierarchical model with strong familial and neighborhood ties.

Calderon’s approach led to a surge in homicide rates from 2006 to 2011 because it created power vacuums within groups and provoked turf wars and cycles of revenge killings. In addition, security operations began targeting these illegal groups. Over the past 11 years, Mexico’s military, which has more training and better equipment than local police, has become more involved in fighting organized crime.

The current criminal organization landscape is exceptionally fluid. Many groups operate more on a local cell-based level, and their association with other groups may shift with business interests. Many of these groups not only are involved in drug trafficking but also engage in other profitable crimes, including kidnapping, assassination, auto theft, prostitution, extortion, money laundering, software piracy, resource theft and human trafficking. Some criminal organizations have incorporated areas of specialization. For instance, some DTOs on the U.S. border have assumed the role of toll collectors, exacting payment from other traffickers, while other organizations specialize in sourcing cocaine from South America. Still others focus on transit routes within Mexico and other ways to either facilitate the drug trade or augment their profits through lower-risk activities.

The number of large DTOs jumped from four in 2006 to nine in 2017, and another 45 smaller organized crime groups have been identified. Their structure is more like a consortium, where groups are different sizes and specialize in various business activities. For example, La Linea and Los Aztecas are two distinct local criminal groups that fall under the umbrella of the Juarez cartel.

Though the Sinaloa cartel is the largest and most powerful DTO in Mexico, the Jalisco New Generation cartel, which broke off from the Sinaloa cartel in 2010, has become formidable over the past two years. In a short time it has grown and strengthened enough to compete for space, resources and markets. Given the increasing overlap of territories and resources, clashes with other DTOs become more frequent and intense. This is also the case for smaller groups that may act independently or fall under larger DTOs. Some of these groups stay in the drug business, while smaller, local criminal groups remain engaged in other criminal activity such as the illicit gasoline trade. When Mexico’s current president, Enrique Pena Nieto, assumed office in December 2012, security officials estimated there were 80 to 90 smaller criminal groups in operation. The latest estimates put the number at 45, which means there still are many players competing for business in the black market.

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Economic Impact

Mexico needs to address the violence of DTOs for domestic economic reasons and to maintain its relationship with the United States. Violence and crime cost Mexico approximately 18 percent of its gross domestic product, according to a 2017 report by the Institute for Economics and Peace. The figure factors in a wide range of related costs, including spending on security by the government and businesses and lost income due to a homicide in the family. In terms of government spending, the institute estimates that Mexico spends 6.8 percent of its GDP to help contain violence nationwide.

Growing violence may also discourage investment, according to the Bank of Mexico. The bank recently ranked Mexico’s security as 5.5 on a scale of 1-7, with 7 representing the greatest risk to investment. Private sector estimates indicate that investments may fall by up to 5 percent because of violence, with impacts already being noted anecdotally.

Despite those warnings, a large-scale exodus of companies from Mexico in response to violence has not occurred. Many businesses there understand the security risks and factor in those costs. The point at which violence becomes intolerable will largely depend on the companies’ ability to operate profitably over the long term. Any prolonged decline in revenue or absence of investment would, of course, hurt the economy.

Relations With the U.S.

In terms of foreign policy, the violence in Mexico will primarily affect its relationship with the United States. Besides their shared border, the U.S. is the main destination for Mexican-produced opium and for cocaine transited through Mexico, and is the source of illegal weapons for Mexico’s DTOs. Drug trafficking between the two countries dates back to the early 20th century when the first opium shipments from Sinaloa made their way into the United States. Shortly thereafter, alcohol flowed to the U.S. in the wake of the Prohibition Act of 1919. The products and tactics for doing business may have changed, but not the business of smuggling.

The Mexican DTOs are the major wholesalers of illegal drugs in the United States and are increasingly gaining control of U.S. retail-level distribution through alliances with U.S. gangs. Street gangs continue to work with Mexican DTOs in Mexico, along the southwest border, and throughout the United States. These relationships are based more on location and personal and business ties than on strict affiliations with a given gang.

Mexican DTOs conduct business with a much lower profile in the U.S. than they do in Mexico to avoid engaging with security officials. The Drug Enforcement Administration’s 2017 National Drug Assessment notes the absence of significant spillover violence in the United States. Violence that does occur is infrequent, localized on the southwest border and mostly among traffickers. Mexican DTO activity in the United States is mainly overseen by Mexican nationals or U.S. citizens of Mexican origin. Those operating in the United States often share familial ties with, or can be traced back to, the natal region of leading cartel figures in Mexico.

The U.S. and Mexico have worked closely together on border security, particularly since the Sept. 11 terrorist attacks. But current tensions surrounding trade and immigration policies between the two countries make border security cooperation less straightforward, and the ability to strengthen such cooperation is no longer a singular issue. There is minimal spillover violence right now, but any change that causes spillover violence to rise would have massive political and geopolitical effects. The U.S. government is already studying measures for increased border controls and justifying them by vilifying Mexico. An actual spillover of violence would empower those in the United States advocating tighter border security. Right now, the U.S.-Mexico border allows for the relatively easy, free flow of trade and persons. A strong, controlled border would redefine the basic structure of this bilateral relationship.

The U.S., for its part, can try to pressure Mexico to take stronger action or pursue particular security measures. The point of leverage for this would not be a wall, as President Donald Trump has urged, since that would not be effective or practical. President Richard Nixon effectively shut down the U.S. border for several weeks in September 1969 in an attempt to stem the flow of drugs. The closed border killed local business but did little to impact the drug flow.

Perhaps more effective for the U.S. would be to limit or hinder remittances. Remittances to Mexico from people in the U.S. help to sustain or augment household income nationwide. The most recent figures from the Bank of Mexico show that from January to November 2017, remittances totaled $26.1 billion, and the year is poised to see a record high. But the move could backfire. Remittances play an even more important role in households of poorer states – Michoacan, Guerrero and Oaxaca, for example – so cutting off remittances runs the risk of driving more desperate people to join criminal groups and creating controversy within the United States. Still, remittances are a powerful card to play and may be used as a tactic with other bilateral issues, such as NAFTA, that have a greater overall impact on the U.S.

Security Options

Though it is in Mexico’s interest, particularly its economic interest, to stop drug-related violence, the key question becomes: What can the Mexican government do? The short answer is: not much. There are several strategies the Mexican government could pursue, but it faces severe constraints that will limit the effectiveness of any approach.

One obvious strategy is putting an end to criminal groups’ illicit financial activities, primarily drug trafficking and other black market activities, including fuel sales and human trafficking. The problem is that these groups have many alternative routes and means of conducting their business. Shutting down one route, point of entry or source of materials is merely a logistical problem for a criminal group. Criminal organizations have many financial resources as well as experience in logistical planning. To be effective, the government would need to conduct multiple large-scale shutdown operations simultaneously. This would be an extremely costly and difficult endeavor. The government and security forces simply don’t have the manpower and resources to conduct a sustained and effective operation of this magnitude.

Extra resources would have to come from outside the country, and the country best positioned in terms of funding, skills and expertise is the United States. But Mexico cannot accept large-scale U.S. support – especially in manpower – on its own soil. History has proved to Mexico that it must be wary of any foreign presence, that of the U.S. above all others. The government cannot risk the country’s sovereignty or increased dependence on the U.S. Therefore, from Mexico’s position, cooperation with the U.S. is best limited to primarily border cooperation, along with selective training, weapons supplies and funding.

Similarly, the idea of tackling violence by eliminating corruption is a purely theoretical option since it is no secret that, generally speaking, local police and government officials are also corrupt. Prosecution is not guaranteed and is often lax when pursued. Attempts to remove corrupt members of local police departments nationwide have failed, which in part explains why the military has assumed domestic security responsibilities. Though the targeted elimination of high-profile corruption is possible, completely cleaning the system of it is impossible without totally dismantling everything and rebuilding from the ground up.

The Mexican government faces fewer constraints in crafting regulatory frameworks for tacking criminal groups. The main obstacles the government faces here are political in nature. The current government did pursue judiciary reforms and domestic security legislation to better combat criminal groups. Both measures have been severely criticized by various political and special interest groups, citing confusion in the judiciary reforms and vagaries and loopholes for abuse of power in the domestic security legislation. Though regulatory changes fall squarely within the power of the government, the public reaction and associated political costs prevent drastic changes and full enforcement.

A final possible strategy would be to focus more on quelling violence rather than eliminating or reducing criminal activity in the country. The violence Mexico currently experiences is a symptom of the competition between criminal groups. In theory, removing this competition – in a sense creating a monopoly – would eliminate the violence that competition produces. This would involve the government aligning or tacitly supporting a dominant drug trafficking group or cluster of groups, ultimately diminishing competition. This is not a novel strategy but it certainly is a highly controversial one. It compromises the government’s power over criminal groups, and there are no guarantees that the monopoly would hold. Not to mention it’s morally questionable and wouldn’t be feasible until at least 2019. Mexico holds presidential elections on July 1, and the sitting president cannot run for re-election. A new government will be inaugurated on Dec. 1. Criminal groups will have no incentive to negotiate with the outgoing government.

The rise in violence in Mexico is geopolitically significant because of its potential to affect the trajectory of Mexico’s economic development and basic framework of its relationship with the United States. Given the political and resource constraints facing the Mexican government, this level of violence will likely continue to rise in 2018. During this time, anecdotal evidence will provide a strong measure of the economic impact – as will statistics, though they inherently capture the past over the present. The United States will be closely watching for any increase in spillover violence. Though the current levels do not threaten the U.S.-Mexico relationship, a sharp rise – combined with the political climate in the U.S. and tense relations over NAFTA negotiations – would help set the stage for a strong U.S. reaction that would redefine the relationship.