Portending an Interesting Q4

Doug Nolan

"Those who do not learn history are doomed to repeat it." I'll add that those that learn the wrong lessons from Bubbles are doomed to face greater future peril. The ten-year anniversary of the financial crisis has generated interesting discussion, interviews and scores of articles. I can't help but to see much of the analysis as completely missing the critical lessons that should have been garnered from such a harrowing experience. For many, a quite complex financial breakdown essentially boils down to a single flawed policy decision: a Lehman Brothers bailout would have averted - or at least significantly mitigated - crisis dynamics.

I was interested to listen Friday (Bloomberg TV interview) to former Treasury Secretary Hank Paulson's thoughts after a decade of contemplation.

Bloomberg's David Westin: "It's been ten years, as you know, since the great financial crisis that you stepped into. Tell us the main way in which the financial system is different today than what you faced when you came into the Treasury?"

Former Treasury Secretary Hank Paulson: "Well, it's very, very different today. So, let's talk about what I faced. What I faced was a situation where going back decades the government had really failed the American people, because the financial system had not kept pace with the modern financial markets. The protections that were put in place after the Great Depression to deal with panics were focused on banks - protecting depositors with deposit insurance. Meanwhile, the financial markets changed. And when I arrived (2006), half or more of the Credit was flowing outside of the banking system. And we didn't have the oversight we needed. We didn't have the regulatory authorities to deal with a run, and this was a situation where there was a great deal of leverage. There was a great deal of risk. Today, when you look at it, we see a situation where the banks are better capitalized. We have much better regulatory oversight. I think there are fewer gaps. I think we have a better set of authorities. There is less of what I would call 'dry tinder' - there's less excesses. So, I think there is less risk, although these things are unpredictable of having any kind of a major financial crisis, on the one hand. And there are some important new authorities. But some of the things we relied very heavily on have been taken away. So, I wish we had a few more protections."

"…The thing I would be most concerned about are some of the authorities we used to stop the panic. The Exchange Stabilization Fund at Treasury we used to guarantee the money markets. Remember there was a run on the three and one-half trillion money markets, and the money markets were funding short-term borrowings for many of the biggest companies in the world. So when the money markets began to implode, the commercial paper market dried up. If these big companies started cutting back on their funding, this would have moved very quickly to their suppliers, to smaller industrial companies. It could have been disastrous. We stepped in and we used the Exchange Stabilization Fund to guarantee the money markets. We no longer have that authority."

Mr. Paulson is surely accurate in stating that the government "really failed the American people," though I doubt future historians will see this failure having concluded with the 2008 crisis. Finance had fundamentally changed, and the regulatory framework failed to adapt. As Paulson stated, Credit expansion (and finance more generally) had moved outside of traditional bank lending, but Washington had not constructed adequate safeguards and resolution mechanisms in the event of a panic.

While not inaccurate, this line of analysis misses the greater point - the critical lesson that went unheeded: It was "activist" government policy-making over an extended period that played a decisive role in the rapid expansion of non-traditional finance. Federal Reserve policymaking evolved to aggressively incentivize risk-taking and leveraged speculation. The government-sponsored enterprises (GSE) evolved from guarantors of mortgages to massive quasi-central banks, with unlimited access to cheap money market finance supporting enormous balance sheets and market backstop operations. Between the Fed and GSEs, unprecedented Washington "activism" created a backdrop conducive to a "wild west" derivatives marketplace ballooning to the hundreds of Trillions.

It is true that "we didn't have the oversight we needed." But the much greater issue was that Washington had become actively involved in promoting cheap Credit, abundant liquidity, and inflated securities and asset markets. Washington partnered with Wall Street to fundamentally and momentously change system-wide risk intermediation and resource allocation.

What's missing in the 10-year crisis anniversary dialogue is a more comprehensive discussion of several decades of serial booms and busts, including the factors behind the 1987 stock market crash; the late eighties boom and bust; the S&L crisis; the 1994 bond market rout; the 1995 Mexico collapse; the 1997 "Asian Tiger" collapse; the 1998 implosion of Russia and Long-Term Capital Management; the 2000 collapse of the "tech" Bubble; the 2001 crisis in Brazil; the 2002 U.S. corporate debt crisis; the 2002 collapse of the Argentine peso and so on.

I have for a long time now argued that "unfettered" contemporary finance is dangerously unstable. I believe it has become only more unsound - and perilous - over time. Here in the U.S., it was easy to disregard the spectacular boom and bust dynamics that were wreaking havoc throughout numerous overseas economies (heck, they worked to keep U.S. rates and market yields low!). "The Maestro" and his monetary magic had everything under control. Things, however, finally came home to roost in 2008. The mighty U.S. was not immune after all. Indeed, years of government interventions, manipulations and market backstops ensured the accumulation of excesses and structural maladjustment to the point of risking financial collapse.

To focus on Lehman as the critical factor in the crisis is to disregard the true culprit, the intoxicating amalgamation of contemporary finance and "activist" government monetary management. As always, Credit is self-reinforcing. I (among others) have argued that Credit is inherently unstable, with today's unconstrained contemporary Credit remarkably unstable. Asset inflation is the most dangerous form of inflation, as "Wall Street" market-based finance and modern central banking doctrine specifically champion rising securities and asset prices. What is more, government and central bank promotion of asset inflation guaranteed that leveraged speculation evolved into a dominant force in global finance.

For more than nine years, I've argue that responses (U.S. and international) to the 2008 crisis unleashed the "global government finance Bubble." I believe speculative leverage is a greater global issue today than even in 2008. This leveraging has become integral to global liquidity, liquidity that fueled precarious booms in China, throughout the emerging markets and even in Europe. Furthermore, this global liquidity has been "recycled" into U.S. securities Bubble markets, illustrated by the massive (Fed's Z.1) "Rest of World" flows into U.S. financial assets over the past decade.

The "global savings glut" thesis was popular back during the mortgage finance Bubble period. We were to believe a persistent surplus of "savings" over "investment" explained low market yields and overly abundant marketplace liquidity. Yet "savings" is not going to suddenly disappear. Liquidity created in the process of expanding speculative leverage, on the other hand, can evaporate almost instantly in the event of an acute bout of de-risking/deleveraging. And if this liquidity had evolved into a prevailing source of finance for the asset markets and real economy, an abrupt change in market perceptions will have profound ramifications for both financial and economic stability. Most critically, the longer speculation-related liquidity has fueled the markets and economy, the deeper the structural impact and the greater the subsequent dislocation when this liquidity source is interrupted.

It was imperative for policymakers to make fundamental post-crisis changes to their approach with incentive structures, incentives that had fomented progressively more systemic financial and economic Bubbles. That was the key lesson from the crisis - one that went unheeded. Policymakers instead moved aggressively in the opposite direction: Their market interventions and manipulations became only more extreme. The upshot has been a historic Bubble around the globe, stocks and bonds and across asset markets more generally.

The issue in 2008 was not Lehman as much as it was tens of Trillions of leveraged securities holdings and derivatives whose value had been inflated by a confluence of speculation, leverage, liquidity overabundance and market misperceptions. This self-reinforcing liquidity backdrop had not only inflated the value of mortgage-related securities, it had inflated the value of the underlying collateral (home prices). This liquidity was also being recycled through the securities markets more generally, in particular inflating the prices of U.S. equities and corporate Credit.

This powerful dynamic of liquidity excess and rising asset prices propelled an unprecedented degree of sophisticated risk intermediation and derivatives trading that worked to distort, disguise and inflate various risks. Market risk perceptions became utterly distorted. These factors fundamentally loosened mortgage Credit and system Credit Availability more generally. The resulting massive expansion of mortgage Credit, ultra-easy financial conditions and resulting asset inflation (inflated perceived wealth) stoked both spending and investment.

Importantly, the critical factors fomenting the mortgage finance Bubble were all made more powerful by post-crisis policy responses: The amount and impact of leveraged speculation and resulting liquidity excess; endemic asset inflation; derivatives-related masking and distorting of risk; deep-seated distortions to both the financial and economic structure. Similar dynamics to those that fueled previous U.S. market and economic Bubbles now encompass the world.

Bubble markets remained largely oblivious to risk heading risk into the 2008 crisis. There was no appreciation for how vulnerable the liquidity backdrop had become to abrupt change. After all, the GSEs and Fed had for years cultivated the perception of impenetrable market liquidity backstops. And this misperception incentivized risk-taking - aggressive speculation, leveraging, risk intermediation and derivative strategies - that basically ensured acute vulnerability to a bout of de-risking/deleveraging. Sure, Lehman could have been bailed out. But that would have only ensured an even more extended period of ("terminal") excess and a more perilous crisis.

I appreciate Hank Paulson's focus on the critical role played by non-bank Credit in the crisis. But when discussing how the system has become sounder post-crisis, he falls back on the standard "the banks are better capitalized." We are to have faith that system stability has benefitted from better oversight and regulation - that policymakers learned from history.

Market were blindsided in 2008. There was a complete lack of appreciation for how distortions at the "periphery" - in particular Trillions of risky mortgage loans, securities, derivatives and speculative leverage - had late in the cycle come to provide the marginal source of finance fueling increasingly maladjusted financial and economic structures. There was no understanding of how unstable finance had nurtured acute fragility - no appreciation for how the inevitable eruption of risk aversion at the "periphery" would over time come to imperil stability at the "core."

There are today ominous parallels. In 2007 and well into 2008, it was "subprime doesn't matter." Today, "EM doesn't matter. China doesn't matter. Tariffs don't matter. Debt doesn't matter." Corporate earnings, tax cuts, deregulation and technological prowess ensure the robust U.S. economy will remain immune to global financial and economic issues. The powerful "core" is invulnerable to a weak "periphery," much as the highly liquid and resilient market in "AAA" was right into the fall of 2008 perceived unaffected by faltering lower-tier securities. There is the current misperception that global "whatever it takes" ensures liquid and robust securities markets.

I have posited that the global Bubble has been pierced at the "periphery." Global financial conditions have tightened, although there is the typical ebb and flow between risk aversion and risk embracement (fear and greed). It's my view that unprecedented speculative leverage has accumulated throughout global markets and that the destabilizing process of "de-risking/deleveraging" has commenced in the emerging markets. The first phase of this process has seen faltering liquidity at the "periphery" spur additional speculative flows to the "core." Increasingly, however, I would expect global de-leveraging to have negative ramifications for risk-taking and liquidity more generally.

It's worth noting Friday's 26 bps surge in Italian 10-year yields. Italy's yields were up as much as 35 bps intraday (to a four-year high 3.26%) before settling somewhat lower. Italian bank stocks sank 3.7% in Friday trading, this after Italy's populist government appeared to agree on a 2019 budget deficit of 2.4% (above the anticipated 2.0% ceiling). Why such a forceful reaction (considering that U.S. deficits will likely soon approach 5% of GDP)?

I'm thinking back to when subprime issues began afflicting the "Alt A" (less than prime) mortgage market. Current market focus has turned to Italy - a heavily indebted sovereign borrower increasingly vulnerable to a tightening of global financial conditions; a prime beneficiary of loose finance on the upside, now at risk as a marginal borrower in a shifting liquidity backdrop. From my analytical perspective, Italy is a key player as we monitor for crisis dynamics gravitating from the "Periphery" to the "Periphery of the Core."

The ECB's "whatever it takes" policy approach has incentivized leveraged speculation, especially at the Eurozone's relatively higher-yielding periphery. A Friday Bloomberg headline: "Sovereign-Bank 'Doom Loop' Haunts Rattled Italian Markets." Italy's banks are not alone in holding leveraged bets on Italian debt. It's been too easy for the leveraged speculating community to borrow at negative rates (i.e. short German two-year debt at negative 54 bps) and profit from the spread. Italian debt has surely been one of the most popular "carry trade" speculations in the world, perhaps also financed with interest-free borrowings from Japan. Meanwhile, funds have surely flowed into Italian debt from Japan, with savers and institutions alike reaching for yields. And, now remembering back 20 years, leveraged derivatives bets on Italian debt played a role in the 1998 (Russia/LTCM) crisis.

If, as I suspect, the global risk-taking and liquidity backdrop is changing, "marginal" borrowers such as Italy will be viewed in different light. Yields are rising, which means the value of EM and Italian debt is declining. When these securities offered rising prices and stable spreads, risk embracement saw self-reinforcing speculative leveraging and attendant liquidity abundance. And as wonderful and enduring as this dynamic appears on the upside, speculative leverage is inevitably problematic on the downside. Lower bond prices (higher yields) force a reduction in leverage, which can lead to a self-reinforcing "Risk Off" contraction of marketplace liquidity.

Interestingly, the euro declined 1.2% this week, with the Swiss franc down a notable 2.3%. Key Eastern European currencies (Czech koruna, Bulgarian lev, Romanian leu and Hungarian forint) fell between 1% and 2%. The week provided a reminder of how Italian debt worries can spark worry for Italian banks, European banking, the euro and Eastern European economies.

Worries about Europe spur the U.S. dollar, with a stronger American currency reminding the world of festering EM issues. The Argentine peso sank 9.9% this week. For the most part, however, global markets ended the third quarter with a semblance of stability.

A bloody Friday in Italian debt certainly wasn't going to tarnish a big quarter for U.S. equities. The S&P500 returned 7.7% for the quarter, lagging the Nasdaq100's 8.6%. The Nasdaq Telecom index jumped 11.7%, and the Biotechs (BTK) surged 13.2%. The NYSE Healthcare Index gained 12.7%. The Dow Transports rose 10.0%, with the DJIA up 9.0%.

It may have been subtle, but there was some quarter-end market action that might just portend an interesting Q4. There was the 32 bps one-week surge in Italian yields, along with the 8.3% drop in Italian bank stocks. The European (STOXX600) Bank index was down 3.0% in the final week of the quarter, with Japan's TOPIX Bank Index dropping 2.0%. Curiously, especially with Treasury yields trading at highs for the quarter, U.S. Bank stocks (BKX) sank 4.7% this week. The Broker/Dealers were down 3.1%. There was, as well, the return of concern for tightening global dollar funding markets. The fourth quarter starts Monday, with various indicators pointing toward an important tightening of financial conditions.

As I chronicle history's greatest financial Bubble, I'll take note of this week's developments in the Judge Kavanaugh Supreme Court confirmation hearings. Thursday's hearings were nothing short of incredible - incredibly dramatic, emotional, tragic and disturbing. Our country is being torn apart - and the tearing has turned more unambiguous and heinous. Ramifications for what is unfolding in society, politics and geopolitics are as profound as they are far-reaching. But with stocks right at all-time highs, what's to fret about…

It was a week that pitted Democrats and Republicans in Washington, with vitriol and differences that appear more irreconcilable than ever before. There was also President Trump speaking at the United Nations, with world representatives either laughing "with" or "at" the leader of the free world. And it's this confluence of division, contempt and hostility in the face of an increasingly fragile global Bubble that has me deeply concerned. A global crisis in the current backdrop would make 2008 seem like a walk in the park.

I'll conclude with an astute observation from Bloomberg's David Westin:

Westin: "You lost some of the legal provisions that you described. What about political? Because one of the things you had going for you - and I know it was difficult and was not all in a straight line - but through that crisis you got Congress, you had a President, even with low approval ratings, to really back you. Do we still have that same political capital - or political competence - given what happened last time?"

Paulson: "That's really a key question…"

Why so little has changed since the financial crash

Martin Wolf on the power of vested interests in today’s rent-extracting economy

Martin Wolf

“Here I am back again in the Treasury . . . but with one great difference. In 1918 most people’s only idea was to get back to pre-1914. No one today feels like that about 1939. That will make an enormous difference when we get down to it.” John Maynard Keynes wrote this in 1942. It did make a difference. After the Great Depression and a second world war, people wanted change. They got it. France calls what followed les trentes glorieuses.

The stagflation of the 1970s brought a counter-revolution: the 1980s saw a radical change of ideas on the role of the state and markets, the goals of macroeconomic policy and the job of central banks. Again, the aim was a fundamental transformation.

So what happened after the global financial crisis? Have politicians and policymakers tried to get us back to the past or go into a different future? The answer is clear: it is the former.

Martin Wolf chart

To be fair, they have tried to go back to a better past. That is what happened in 1918. Then they had just come out of a devastating war. So the new ideas were about peace — “collective security” and a League of Nations. But they wanted to return to the prewar economy, especially the gold standard. In 1918, then, they mostly wanted to go back to a better version of the past in international relations. After the crisis of 2008, they wanted to go back to a better version of the past in financial regulation. In both cases, all else was to stay the way it was.

The chief aim of post-crisis policymaking was rescue: stabilise the financial system and restore demand. This was delivered by putting sovereign balance sheets behind the collapsing financial system, cutting interest rates, allowing fiscal deficits to soar in the short run while limiting discretionary fiscal expansion, and introducing complex new financial regulations. This prevented economic collapse, unlike in the 1930s, and brought a (weak) recovery.

Martin Wolf chart

Note how closely these actions hewed to the pre-crisis policy consensus. Central banks acted as lenders of last resort, as they should. They also played the dominant role in macroeconomic stabilisation, as pre-crisis thought suggested. Their principal instrument remained interest rates, though they included long rates this time, because short rates reached zero. Shortly after the worst of the crisis had passed, fiscal policy turned towards austerity. The financial system is much as before, albeit with somewhat lower leverage, higher liquidity requirements and tighter regulation. Efforts to lower debt in the private sector were modest. (See charts.)

The financial crisis was a devastating failure of the free market that followed a period of rising inequality within many countries. Yet, contrary to what happened in the 1970s, policymakers have barely questioned the relative roles of government and markets. Conventional wisdom still considers “structural reform” largely synonymous with lower taxes and de-regulation of labour markets. Concern is expressed over inequality, but little has actually been done. Policymakers have mostly failed to notice the dangerous dependence of demand on ever-rising debt.

Monopoly and “zero-sum” activities are pervasive. Few question the value of the vast quantities of financial sector activity we continue to have, or recognise the risks of further big financial crises.

Martin Wolf chart

It is little wonder populists are so popular, given this inertia, not to mention the miserable experience of so many citizens since the crisis and, in important cases, before that. Politics abhors a vacuum. Ideas as dangerous and divisive as those of US president Donald Trump or Matteo Salvini, Italy’s deputy prime minister, are bound to fill it. One cannot beat something with nothing.

The persistent fealty to so much of the pre-crisis conventional wisdom is astonishing. The failure of Keynesianism in the 1970s was significant but certainly no greater than the combination of slow economic growth with macroeconomic instability produced by the pre-crisis orthodoxy. What makes this even more shocking is that there is so little confidence that we could (or would) deal effectively with another big recession, let alone yet another big crisis.

What explains the complacency? One reason might be the absence of good ideas. The economist Nicholas Gruen argues just that in a provocative article. Yet there are some perfectly good ones.

Martin Wolf chart

Some have argued for a shift from debt to equity finance of house purchases. Others have called for the elimination of the tax deductibility of debt interest. Some note the perverse impact of executive incentives. Some argue convincingly for higher equity requirements on banks, rejecting the argument that this would halt growth. Others ask why only banks have accounts at central banks. Why should every citizen not be able to do so? Some wonder why we cannot use central banks to escape dependence on debt-fuelled growth.  
Martin Wolf chart

Beyond finance, it seems ever clearer that protection of intellectual property has gone too far.

Also, why not shift taxation on to land? Why are we letting the taxation of capital collapse?

And why are we not trying to revitalise antitrust?

An all-embracing new ideology may be unavailable today. That is probably a good thing. But good ideas do exist. A more likely cause of inertia is the power of vested interests. Today’s rent-extracting economy, masquerading as a free market, is, after all, hugely rewarding to politically influential insiders.

Martin Wolf chart

Yet the centre’s complacency invites extremist rage. If those who believe in the market economy and liberal democracy do not come up with superior policies, demagogues will sweep them away.

A better version of the pre-2008 world will just not do. People do not want a better past; they want a better future.

A Bigger Game in North Korea

More important countries are compelling the U.S. to move forward.

By Phillip Orchard        

The denuclearization process with North Korea is going nowhere fast. Last week, U.S. Defense Secretary James Mattis said the U.S. has no plans to suspend any more major military exercises with South Korea. Mattis also said that smaller-scale exercises in the South would continue, lending credence to the North’s accusation that a nuclear submarine recently dropped off a fresh contingent of U.S. special operations forces at the Jinhae naval base for training. Halting these kinds of exercises was Washington’s portion of the tacit “freeze for freeze” agreement the United States and North Korea appeared to have reached a few months ago.

Also last week, U.S. President Donald Trump abruptly canceled a long-planned visit to Pyongyang by Secretary of State Mike Pompeo, just days after Pompeo finally named a special envoy to spearhead working-level negotiations with the North. Trump’s decision was reportedly motivated by a letter he received the same day from Kim Jong Un’s spy chief, Kim Yong Chol, who warned that negotiations may fall apart if the White House fails to take steps toward negotiating a peace treaty with the North.

There’s no reason to believe North Korea is holding up its end of the bargain either. Most available evidence suggests Pyongyang continues to develop its ballistic missiles and its enrichment capabilities.

North Korea never pledged to denuclearize on the timeline the White House said it would, of course, and since Singapore, it has stymied the diplomatic process over largely symbolic issues. The two sides are at an impasse over how to move forward. The White House wants full denuclearization. Full denuclearization is a non-starter for Pyongyang. Surrendering its nuclear program would only invite an attack. A partial handover is possible, but the U.S. won’t abide by an agreement that simply allows the North to rebuild what it just gave away. A peace treaty is possible, but the North would demand that the U.S. withdraw its 28,000 troops from the peninsula – a nonstarter without full denuclearization. And even if Washington signed a peace treaty, it would be sacrificing its one source of leverage over the North.


The issue is simple, if not easy. Unless the U.S. is willing to address North Korea’s nuclear program by force, the White House doesn’t have much leverage to induce capitulation. Washington can try to influence the size and shape of the North’s nuclear and missile arsenals, as well as its behavior as a nuclear power, and it could tolerate a nuclear North Korea for many of the same reasons it’s learned to live with a nuclear Pakistan: Islamabad doesn’t have the long-range missile technology needed to strike the U.S., and the alternative would be an exceedingly costly war. But it doesn’t exactly have much leverage for these lesser aims, either. International sanctions pressure has been gradually weakening, and South Korea has been busy pursuing its own reconciliation with the North in ways that are likely to further ease international pressure on Pyongyang. The U.S. has already played its military exercises card, and it won’t pull U.S. forces from the peninsula – at least not right now. It has promised economic investment to appeal to Kim’s designs on economic development, but Kim can’t do so without threatening his regime’s continued rule. And with Trump having declared in June that North Korea was no longer a nuclear threat, there’s political pressure on the White House to show results. Time is on the North’s side.

The U.S. is now attempting to regain some of the leverage it lost. It’s why the U.S. is threatening to restart military exercises that Pyongyang believes are a rehearsal for invasion. It’s also why the U.S. has tried to reinvigorate the sanctions regime. Yet it’s hard to see military drills or sanctions doing much to break the impasse. They haven’t yet – not even when international pressure peaked in 2017. That means the U.S. likely has bigger issues in mind in crafting its North Korea strategy — namely, China and Russia, the two countries most responsible for keeping the Kim regime afloat.

Over the past month, for example, the U.S. (unsuccessfully) sought a U.N. Security Council resolution to halt shipments of refined petroleum products to the North. It also slapped new penalties on Russian banks accused of laundering money on behalf of North Korean front companies (one of them based in China) and on a pair of Russian shipping firms accused of conducting ship-to-ship oil transfers with sanctioned North Korean ships. Last week, Vox reported that the U.S. is considering new secondary sanctions targeting Chinese and Russian banks and firms. The recent sanctions were too small to hurt much, but the sanctions could be read as warning shots of worse things to come. Given the fragility of the Russian and Chinese economies, it’s doubtful that either government missed the message.

The White House and the U.S. State Department, meanwhile, have both singled out China and Russia in their statements on North Korea. It’s safe to assume that they shifted the blame for political reasons, but China and Russia have always been bigger strategic threats than North Korea. The U.S. may not be able to resolve the North Korea nuclear crisis, but it can certainly weaponize it against its enemies. (In fact, it already has. Trump said Pompeo’s visit may not be rescheduled until after U.S.-China relations are repaired, suggesting the White House is eager to bind the two issues together.)

To be clear, neither Russia nor China are interested in a nuclear North Korea. It’s just that the threat it poses to them is subordinate to the threat the U.S. poses. North Korea, then, is just a bargaining chip. Moscow has sustained low-level economic support to Pyongyang as a way to bolster its image as global power-broker and seek concessions from the U.S. on, say, Ukraine and Syria. China supported the U.N. sanctions to forestall a war that might end with U.S. forces back on its border, but it continued to play ball because it thought doing so would keep the U.S. satisfied on trade.

In other words, every party to the Korean crisis – except for the two Koreas – is once again playing a bigger game. This is a familiar role for North Korea, which has long served as a pawn between outside powers. That’s why the North went nuclear in the first place. And in three weeks, Kim will celebrate the 70th anniversary of his country’s founding (reportedly with an envoy from Chinese President Xi Jinping) with Pyongyang in the rare of position of being able to bend this game to its advantage.

The Catholic Church Is a Dysfunctional Workplace

The ferocity of the Vatican’s civil war has less to do with theology or justice than petty office politics.

By Andrew Brown
Pope Emeritus Benedict XVI is greeted by Pope Francis during the Ordinary Public Consistory at St. Peter's Basilica on February 14, 2015 in Vatican City, Vatican. (Franco Origlia/Getty Images)
Pope Emeritus Benedict XVI is greeted by Pope Francis during the Ordinary Public Consistory at St. Peter's Basilica on February 14, 2015 in Vatican City, Vatican. (Franco Origlia/Getty Images)

The present scandal in the Catholic Church in the United States has no obvious precedent. Demands that a sitting pope resign have been unknown since the crises of the late 14th century, when rival popes reigned in Rome and Avignon, and they would have been unthinkable in modern times until 2012, when Pope Benedict XVI shocked the world by resigning. Before then, one would have no recourse but to hope that a pope with whom one disagreed should die. In fact, one British priest who hates Pope Francis assured me last year that the group of priests who oppose him “pray for him to die every day” but that forcing him to resign was out of the bounds of possibility.

So the demand by Archbishop Carlo Maria Viganò, formerly the Vatican’s ambassador to Washington, that Francis resign was a significant escalation of the culture wars now convulsing the U.S. church. The ostensible reason is that Viganò claims that in 2013 Francis restored to favor Cardinal Theodore McCarrick, who had, in retirement, been secretly sanctioned by Benedict for his liaisons with seminarians. The problem with this accusation is that the sanctions, if they existed, were so secret that the outside world did not know of their existence and McCarrick ignored them entirely. 
Viganò’s letter follows the attempt by four retired cardinals last year to convict the pope of heresy over his line on divorced and remarried people, one that Francis eloquently ignored. In terms of U.S. politics, it pits the right-wing firebrand Steve Bannon against the Democratic upstart Alexandria Ocasio-Cortez. It is a battle for the soul of the Catholic Church in the United States, between the conservative culture warriors in one camp and the pastoralists in the other. It has potentially global implications about the way in which the leadership of the church and the way it tackles migration, the environment, sexuality, and capitalism. The hammering of the right-wing Catholic media on this scandal is reminiscent of the way the Fox News axis worked on the Benghazi attack and its aftermath, Hillary Clinton’s emails, and Whitewater in the past. The pope himself has used the powers of his office ruthlessly (as all popes tend to do), not least in sacking Viganò.

But reading the archbishop’s 7,000-word denunciation of the pope and his allies reminds me most of all of the greatest poison pen letter I have ever been sent as a journalist. In the spring of 2013, as the pontificate of Benedict was drawing to an end, I received at my desk at the Guardian a four-page single spaced letter, posted from Bavaria, with a covering note in English that said: “The enclosed secret letter was sent to all German cardinals and bishops, as well as to the most eminent personalities of the Vatican in October 2013. Everybody knows that what was written is true. Yet nothing happened. Therefore we have decided to go public about it.”

There followed an indecipherable signature. The letter was headed: “The homosexual network in the Vatican. Prelate GG and the homosexual society behind the back of Pope Benedict XVI.” I’m ashamed to say that I put it aside for a couple of months. Not that I doubted the Vatican was full of gay men—nor even that Benedict himself and his personal secretary, Archbishop Georg Gänswein, might be among them (though the writer of the letter didn’t broach this possibility, portraying the conservative pope instead as the victim of a sexualized cabal). Such possibilities are assumed by anyone seriously interested in Vatican affairs. But there is no good reason to associate either with scandal at any stage in their careers. If both are celibate, their conduct is perfectly in line with Catholic teaching. There wasn’t any kind of printable story there.

Nonetheless, when I finally read the letter through, I was entirely fascinated. Most of the characters in it were referred to only by initials, but the network described—of gay men all busily intriguing for high office in the Vatican—stretched from Rome to Vienna to Berlin. I was possessed by the need to discover whom these initials belonged to and, above all, who had written the letter. Over the course of a fortnight, and with the invaluable help of a friend, a former British intelligence officer well-versed in German Catholic affairs, I unpicked the skein of pseudonyms until I tracked the author down to the cathedral of a small city in Bavaria, where he had been exiled after his diplomatic career had ended for alleged sexual indiscretions.

I flew to Munich, hired a car, and, accompanied by the Berlin correspondent, met the sleek and stately cleric in his chapter house. We introduced ourselves and asked him straight out if he had written the letter. An innocent man would have replied, “What letter?” This man just looked at us through his steel-framed spectacles. A flicker of surprise jumped across his face, and then he smiled. He said, still smiling, that he had no idea what we were talking about and that journalists from respectable newspapers didn’t do this kind of thing. Then he shut the door and retired within. The story was dead, as he knew it would be.

Viganò’s letter differs from the one I received in that neither its author nor its subjects are anonymous. It is also aimed directly at the pope, rather than appealing to him against the misdeeds of his subordinates. But the tone of a mafioso shocked—shocked!—to discover that there are bodies buried in the foundations of a bridge he has been trying to sell is very much the same. The Vatican’s ambassador—a papal nuncio—will have been present at many of the burials because his job is twofold. He is not just a representative of the Vatican to the host country but also to the host church, where he acts as a political commissar and alternative source of information to the Vatican for the local bishops.

What gives the Viganò letter its force is the enormous tension in the U.S. Catholic Church that started under Pope John Paul II and has widened ever since. The roots of that potential schism go back at least as far as the reforms of the Second Vatican Council in the early 1960s, which broke up the fortifications of the Counter-Reformation church, which had endured since the 17th century. Latin in the Mass was out; the church’s traditional anti-Semitism was purged; nuns shook off their habits; a thousand flowers were set to bloom. Some turned out to be weeds: The plurality of child abuse cases later identified were perpetrated in the 1970s by priests born in the 1940s who lost their moral compass in the sudden storm of freedom.

Some people, predominantly intellectuals who had joined the church precisely because it stood against the modern world, were aghast at these developments. For them, the election of John Paul was literally a godsend. He restored church discipline and maintained a fiercely anti-communist position. In Latin America, he moved the church away from its alliance with left-wingers—or tried to. In the United States, he was enthusiastically supported by neoconservative intellectuals, including many of the most influential converts from Protestantism.

But John Paul had a very poor record on sexual abuse, as has become apparent in recent years.
He protected and indeed encouraged the charismatic Mexican priest Marcial Maciel, who was a brilliant fundraiser. In the United States, he promoted another charismatic fundraiser and promoter of vocations, “Uncle Ted” McCarrick, to be a cardinal and archbishop of Washington. We learned from Viganò’s letter that the then-nuncio had warned Rome against promoting him in 2000 but was overruled. It now seems that McCarrick was widely known to be gay and believed to be only intermittently celibate, but his activities were not thought to be criminal. And once he had been promoted, any public punishment would have been an occasion of scandal and a huge blow to the reputation of the pope who had promoted him.

State Capitalism 2.0

Alissa Amico

Saudi Arabia oil refinery

GENEVA – The fall of the Berlin Wall almost 30 years ago represented a high-water mark in the retreat of the state from the global economy, signaling a defeat of socialist economics virtually worldwide. From dirigiste France to communist China, countries with widely divergent economic models began to adopt a more laissez-faire policymaking approach, predicated on the idea that the less state intervention, the better.

Amid this global rollback of statist and socialist economics, some state-owned enterprises (SOEs) were privatized outright. But the vast majority of “crown jewels” remained partly in the hands of governments, with a strategic private partner or private investors acquiring stakes through capital markets. Whatever its form, privatization did not just express a philosophical direction; it also had wide-ranging economic consequences, not least on stock exchanges, which were revitalized through SOE listings in countries as different as Italy and Egypt.

With the turn of the millennium, however, the retreat of the state from the economy stopped in its tracks. The success of economies such as China, which is driving economic development through its SOEs, and the United Arab Emirates, which is driving economic diversification through its sovereign wealth funds (SWFs), has raised potent questions about the efficacy of private-sector-led growth.

A number of governments have sought to replicate China’s experiment with its SOEs and Singapore’s experience with its SWF, Temasek. In the Middle East, for example, a quiet state-driven economic revolution has been unfolding in recent years, epitomized by Dubai’s emergence as the world’s largest hub for international air travel, recently surpassing London’s Heathrow.

While the potential floating of shares of Saudi Aramco, Saudi Arabia’s state-owned oil company, seems to suggest that privatization has not been completely jettisoned, there is a wider and potentially more important trend. Rather than privatizing, governments around the world are increasingly looking for ways to address their SOEs’ perennial weaknesses, including their lagging corporate governance, low productivity, and subpar innovation.

To that end, the structure of sovereign wealth is evolving from a legacy model of passive state ownership to one that recognizes that SOEs’ survival hinges on their ability to compete internationally. An SOE’s monopolistic or oligopolistic position at home no longer ensures its competitiveness, particularly in the context of disruptive new technologies that cross borders. In the long term, government protection will not help a state-owned telecom fend off the likes of Skype, WhatsApp, and Viber.

In response to this challenge, governments are focusing less on privatization than on modernization. Many SOEs and SWFs have recently established venture capital arms to target high-tech companies producing innovation that can underpin their core businesses. Saudi Telecom, for example, has launched STC Ventures to invest the company’s cash as well as pursue opportunities in cutting-edge technologies. Similarly, the Investment Corporation of Dubai, one of the Emirati SWFs, has invested $47 million in Indigo, a Boston-based farming technology start-up.

Still, SOEs and SWFs have limited experience in the tech sector, and their corporate culture is rather rigid compared to the companies they are targeting. Overseeing the governance of high-tech firms requires a fundamentally different skill set than managing joint ventures with foreign partners, a craft that SOEs and SWFs have recently perfected. Hence, to secure the necessary expertise, the Saudi Public Investment Fund has formed a partnership with Japan’s Softbank, and Abu Dhabi’s Mubadala Investment Company has entered into an agreement with the French state-backed investment vehicles CDC International Capital and Bpifrance.

Yet even with the know-how in place, the governance of high-tech companies such as Facebook and Snapchat can pose additional challenges, because both tech company founders and sovereign investors tend to prefer a high level of operational control. Beyond the matter of control, the acquisition of technology companies also requires SOEs and SWFs to take a different approach to risk management, owing to the unstable nature of valuations in this sector.

In this regard, emerging-market sovereign investors have much to learn from China, where SOEs have been actively acquiring technology firms worldwide. Following a few problematic episodes in recent years, China’s finance ministry has now issued guidelines to mitigate the risks for SOEs pursuing foreign acquisitions.

Even if many emerging-market sovereign funds would prefer to remain quiet, non-voting investors with passive stakes in foreign companies, the tech-sector acquisition spree that is currently underway demands that they gain a better understanding of their rights as shareholders. It also requires that they equip their teams with more investment expertise and coordinate closely with other domestic investors so that their acquisitions can have a multiplier effect on their respective national economies.

With private-equity activity having declined in the Middle East and indeed elsewhere in recent years, owing to the fallout from the Abraaj Capital saga, SOEs and SWFs in the region will likely continue to establish their own private equity vehicles. Through sovereign investments in high-tech firms, policymakers can produce positive multiplier effects, including on the capital markets that were previously developed through privatization.

For example, SOEs may be able to list private-equity funds that they establish, while grooming domestic high-tech firms in which they invest for potential listings of their own. This would benefit the local equity markets as much as – or perhaps even more than – the listing of the SOEs themselves, given that exchanges now include specific listing segments geared toward luring innovative firms.

In any case, to focus solely on the privatization of large SOEs is to give a false impression of the direction of state capitalism in emerging markets. State capitalism 2.0 is not premised on the dilution of government ownership, but rather on its realignment with the future of the world economy. This shift is fundamental to the survival of state ownership, and it requires that sovereign investors rethink their traditional governance paradigm. If SOEs are not to go the way of the dinosaurs, they will need to learn not only to waltz with foreign partners, but also to breakdance, fall, get up, and try out new moves.

Alissa Amico is Managing Director of GOVERN, the Economic and Corporate Governance Center.