By Eric Vandenbroeck and co-workers
Today European states are manoeuvring
aggressively with and against each other to seek out their national interests.
Here is a handful of examples: splits between Europe’s southern and northern
states over the strength of the euro and the independence of the European
Central Bank (ECB), Poland’s refusal to authorize trade negotiations with
Russia despite a change in government, France’s attempts to politically isolate
Germany within Europe’s decision-making structure and splits in opinion over
the expansion of NATO into the Russian frontier. All these and more are far
more reminiscent of the structure of European relations in 1910 than in 2000.
Looking forward, Europe already is buzzing about Paris ’ six-month turn
at the EU helm in the last half of 2008. While formally the presidency is about
advancing some common EU goals, France ’s primary concerns — immigration
control, reining in the independence of the ECB and limiting German capabilities
— are more about serving French national interests.
Regional trend: Should it occur over Russian objections, Kosovar
independence would deliver a massive blow to Russian credibility. Thus, Kosovo
will serve as the litmus test for either the return of Russian power or a surge
in the West’s expansion.
Kosovo’s Feb. 17 independence has so far not been met with any dramatic
shifts in Russian positions, much less any serious push back against Western
influence. In fact, the only thing Russia has done is attempted to band
together the Commonwealth of Independent States more tightly. Such tactical and
defensive moves will do little to convince the West that Russia ’s positions
should be taken seriously, much less address the West’s cooperation and coherence
in reducing Russia ’s influence in its periphery.
It is in this context that the April 2-4 NATO summit occurred. Even as
the return of the Concert of Powers weakens the solidarity of the European
Union, NATO coherence is moving in the other direction. In part this is because
France, which will fully rejoin the alliance by year’s end, wishes to hedge its
bets against a strengthening Germany . In part it is because many European
states recognize that NATO, not the European Union, allows the greatest likelihood
for Europe punching above its weight on the international stage. In part it is
because the Europeans are alternatively scared of or not impressed with Russian
power. So expanding NATO into the Balkans — and even flirting with membership
talks with Georgia and Ukraine — is either the equivalent of an insurance
policy or kicking Russia while it is down. In the weeks ahead a similar logic
will seal up deals on ballistic missill defense.
Russia is in the most threatened position it has been in since 1998
when the financial crisis crippled it economically and Western unilateral
actions in then-Yugoslavia made a mockery of Russian political and military
power. For Eurasia , therefore, the second quarter hinges on Russian President
Vladimir Putin’s ability to respond to his country’s newfound isolation.
Putin’s task is a difficult one. While Russia is hardly a weakling, the
West is not sitting idle. While at the NATO summit Russia was fully focused on
limiting NATO membership expansion, Washington formalized a process for hooking
NATO members into its missile defense system. While Russia claims it won the
victory at the summit, that victory will be short-lived. NATO appears to have
set itself up for larger and more long-term moves to constrain Russia ’s power.
Regional trend: Russia ’s internal power struggles will hamper Moscow
’s ability to pursue its international agenda.
But despite obvious desires, the Kremlin is very unlikely to strike
back in the near term. In the second quarter, Dmitri Medvedev will assume the
presidency while Putin steps into the prime minister’s position. This
transition — while more in form than in substance — has sufficiently shaken the
Kremlin power structure so that the second quarter will be one of seething and
seeking in Moscow as various power groups scheme and strike against each other.
The group that bears the most watching is the Federal Security Service
(FSB). A central pillar of Putin’s control of the Russian system these past
eight years has been regular reorganizations to keep the various power players
at each others’ throats so that they do not have the
freedom to conspire against him. But in order to strengthen Russia ’s international
position, there has been one exception: the intelligence services. Rather than
shatter them, Putin has instead consolidated them almost exclusively under the
FSB. And now the FSB is a robust political force in and of itself — and it
believes that one of its own should succeed Putin as president. The risk of a
coup or something like it — while not high — is certainly on many minds.
In the end, we expect Putin to successfully migrate his personal
position as Russia ’s central power broker to his new office, but that will
take time. Additionally, Putin will be forced — at a minimum — to spend the
second quarter establishing his successor in the factions’ minds as a
non-negotiable fact, while seeking a new balance of power among the
institutions and factions that compose the inner workings of the Kremlin.
Success in this latter task is not guaranteed by a long shot.
But even in the unlikely scenario of a coup against Medvedev and/or
Putin , Russia ’s geopolitical imperative to seek to roll back Western advances
by reasserting Russian influence throughout the former Soviet space remains.
The question is how much energy Russia can expend on that goal — which in the
second quarter will be nil — not what the policy preference will be.
New regional trend: Serbian elections will end Belgrade ’s position in
geopolitical no-man’s-land — one way or the other.
As discussed above, Kosovar independence has deeply affected
Western-Russian relations not on the merits of the case, but for what it means
for Russian credibility. On the merits, however, it will affect developments in
the former Yugoslavia just as deeply.
Serbian elections, to be held May 11, will be the region’s only
important vote in the second quarter. In that vote, Serbs must choose between
locking themselves to a prison of anti-Western sentiment (Serbia is now
landlocked and bordered on all sides by NATO and EU members, applicants and
protectorates) or breaking with its schizophrenic and nationalist past and
throwing in its lot with the very West that has so humiliated it. Either way, this
is Serbia ’s moment of truth.
Regional trend: The Chinese government intends for the year 2008 to be
China ’s day in the sun, with the Olympics showcasing how advanced and stable
the country has become. This requires Beijing to act pre-emptively to prevent
anyone with an interest in marring China ’s image from disrupting the Olympics.
Beijing continues taking pre-emptive measures against threats to the
Olympic Games — limiting public protests, censoring both foreign and domestic
media, and tightening Internet controls. It has even gone so far as to
overstate threats to prepare the Han population for whatever crackdowns might
be needed.
But there are plenty of real examples of others seeking to use the
Olympics to cast China in an unfavourable light.
Tibetan protests in March would not have been nearly so violent if not for the
run-up to the Olympics. Likewise, outgoing Taiwanese President Chen Shui-bian
tried to rattle Beijing by pushing a referendum to seek U.N. membership while
looking to purchase F-16s from Washington.
We expect seemingly disparate activist campaigns (such as Save Darfur
and Free Tibet) to coordinate their anti-Beijing activities in the hopes of
linking many different regional and topical issues. To counter, Beijing will
undermine such activities by lobbying foreign governments and personalities to
both reduce their reception for these groups and prepare the world for
crackdowns on them.
Regional trend: In order to tighten its grip on an often unstable and chaotic
economy and Communist Party, the Chinese Central Committee is reshuffling the
bureaucracy, with an eye to creating energy, aviation and finance super
ministries directly under its control.
The March National People’s Congress formally launched the process of
selecting the next generation of leadership and consolidating the Central
Committee’s authority. The selection process is now mostly concluded, with Xi
Jinping all but certain to take the top spot when President Hu Jintao resigns
and Li Keqiang likely becomes prime minister.
But the top leadership is not of one mind on the issue of
organizational consolidation, and players across the various institutions
jealously guard their policy independence (and the profits that flow from it).
The reshuffling process will dominate what little of the government’s attention
is not held by Olympic preparations for the next several months — which means
that this trend is largely boxed up until the Olympics conclude.
Regional trend: The U.S. alliance structure in Asia is being readjusted
as states feel out both bilateral and multilateral relationships in order to
maximize their influence in an evolving world.
The first quarter saw the defeat of the proposed successor to Taiwanese
President Chen Shui-bian, the return of former Thai Prime Minister Thaksin
Shinawatra to Bangkok and success for South Korean conservatives. The first
event heralds a Taipei far more capable of holding a civil discussion with
China , thus removing a large perennial headache and smoothing over at least
one problem in presenting Beijing ’s Olympic image. The second heralds some
form of normality in Thailand (which will thrill businesses). While tensions
are still running high, the election results and Thaksin’s return signal some
sort of compromise between the military and new government in shaping Thailand
’s future.
In both cases — and in the case with the new South Korean government —
the United States is now involved in a liberal round of alliance management. It
is not so much that the changes in governments have given rise to anti-American
forces, but with change comes the need for a regrounding
on one hand, and adjustment as the Asian states feel out new bilateral
relationships with their neighbours on the other.
Similar activities are in progress with the Australian and Japanese
governments.
Regional trend: The Pakistani army/state will hold together even as
confusion and distractions in Islamabad greatly reduce the Pakistani
government’s ability (and willingness) to rein in jihadists.
February elections were peaceful and successful, and President Pervez
Musharraf’s forces were decisively trounced. The reason for such a clean break
—was simple: The army abandoned the president and soon could usher him from
power in the event of a clash between him and Parliament.
The new order will be a weak, hybridized coalition government moving
toward a parliamentary system complete with checks and balances, albeit heavily
influenced by the country’s military. The most significant geopolitical result
of these internal machinations will be an assertive review of the country’s
terrorism policies, effectively ending Islamabad ’s reputation as a one-stop
shop for U.S. security concerns. These changes will complicate U.S. operations
just as militant activity along the Afghan-Pakistani border goes through its
normal spring up tick, which means the insurgency will strike into Pakistan
harder, deeper and more often.
Regional trend: India ’s schizophrenic policies regarding everything
from tax regimes to special economic zones to basic infrastructure are proving
that the idea of “Shining India ” is a myth and will lead to a waning in
foreign investment.
This is a trend in progress. As of the end of the first quarter,
foreign investors have not run for the door, but Indian politics are certainly
not going to bolster anyone’s confidence in the second quarter. While
parliamentary elections do not have to be held until May of 2009, India tends
to have elections early and the campaigning has already unofficially begun.
Campaigns in India are often accompanied by gridlock, violence and the utter
non-responsiveness of government as all attention is directed toward
re-election. Add in rising tensions throughout India ’s myriad secessionist
regions, and there will be little joy for anyone relying upon India for their
bottom lines.
Meanwhile, the ongoing tug-of-war between Russia and the United States
over India will continue, with Moscow relying heavily on energy and defence incentives to scupper Washington ’s attempts to
secure New Delhi ’s commitment as its strategic proxy in the Indian Ocean
basin. India ’s domestic political squabbles will guarantee that little to no
progress will be made toward the U.S.-India civilian nuclear deal, much to
Russia ’s content.
Regional trend: The rest of South Asia will be consumed with domestic
issues.
This prediction is, if anything, an understatement. The stalemate
between the Sri Lankan government and the Tamil rebels is continuing, while
Bangladeshi elections, which were supposed to occur in 2008, are now almost
certain to be postponed another year. Nepal will have its elections in April as
the country’s Maoists argue among themselves over how deeply they should enmesh
themselves in the political system after years of rebellion. Unwilling to get
cut out of the political negotiations, a Madhesi insurgency in the Terai region
of Nepal will intensify. All three states will remain mired in their own
troubles, only tangentially aware of what occurs beyond their borders.
That just leaves Afghanistan. While talks between Western forces
protecting the central government in Kabul and elements of the Taliban
continue, the bottom line is that little progress is being made on the
battlefield. A surge in Western troop levels has allowed international forces
to hold more ground, but even now there are fewer than half the number of
troops in-country than the Soviets stationed during their 1980-1989 war. The
best international forces can hope for — a strategic stalemate punctuated by
regular attacks by both sides — is indeed the current situation on the ground.
Neither side is capable of winning or — while both sides’ nerves hold — of
losing. As a result, there will be an increased clamour
in the West for dialogue with pragmatic elements within the Taliban movement.
Regional trend: Latin America is coming of age and beginning to look
internally to address problems, rather than depending upon action from beyond
the region (action that only rarely materializes).
Mexican President Felipe Calderon’s tax reforms have moved ahead with
impressive speed, but his efforts to liberalize the energy sector have stalled
in the face of Congressional protest from both of the opposition parties. Some
limited progress might be made in the second quarter in terms of legalizing
joint ventures in the U.S. border region — where some legal gymnastics might
make foreign investment possible — and offshore with Brazilian state firm Petroleo Brasileiro, whose
presence would not trigger the same level of nationalist outcry that other oil
firms’ would.
A spat between Venezuela and Colombia over a Colombian foray into
Ecuador in pursuit of Revolutionary Armed Forces of Colombia (FARC) members in
February was solved entirely in house, with neither side appealing to even
mediation from beyond their immediate neighbours.
Colombia ’s efforts to remove one of its rebel groups — the National Liberation
Army — from the military equation continue without any international mediation.
Even Argentina — whose indulgence in populism has brought forth high
inflation, distribution failures, chronic strikes and energy vulnerability —
shows not even a hint of a tendency to seek outside assistance. Very soon the
government will need to either buckle down and do the painful reforms necessary
to stabilize the economy or risk an economic breakdown. We expect that in time
the government will choose the former. But, then again, it seems that such a
decision would have already been made — yet the populist policies continue to
flow.
Regional trend: Only one Latin American state will rebut the trend to
seek self-sufficiency: Bolivia.
In essence, Bolivia is flirting with civil war.
The richer but less populated lowlands have been resisting the rising
power of President Evo Morales — whose support base is among the poor,
indigenous highlanders — as he attempts to consolidate power in this
notoriously fractured state. The lowlanders are now exporting their products in
ways to eliminate tax-taking by the central government. The clash between the
two regions — which is often higher in drama than octane — will accelerate in May
when the lowlands vote in an independence referendum, despite a federal court
ruling that has already declared it unconstitutional.
This will throw down the gauntlet to Morales and force him to consider
military action, an arena in which he holds the upper hand — the lowlands, used
to holding political control, do not have a history of militancy. But, even in
the best-case scenario for the president, a military resolution will not happen
easily or quickly — and is unlikely to happen until all political options are
exhausted.
Regional trend: Brazil is rising as the continental hegemon of South
America.
Via state-linked energy firm Petrobras , Brazil is steadily deepening
its ownership of energy infrastructure in Bolivia , Paraguay and Uruguay — a
policy that will soon be extended into Argentina as that country’s situation
degrades. While all these decisions make economic sense on their own merits,
the investments serve another purpose: extending de facto Brazilian control
throughout the Southern Cone.
Brazilian influence is not only spreading south. President Luiz Inacio “Lula” da Silva has already manoeuvred
Brazil to be the central power in determining the future of post-Castro Cuba .
Brazil took advantage of the Colombian-Venezuelan disagreements in March to
insert itself as the central mediator in the continent’s security conflicts.
Brasilia will spend much of the second quarter leveraging its already
impressive economic power in an effort to force the region to recognize it as
the region’s political leader under the aegis of the South American “Security
Council” — a group that Brasilia envisions as a Brazil-led forum for dealing
with regional issues.
Regional trend: Venezuela ’s Hugo Chavez faces the greatest challenges
to his rule in his 10 years as president, largely due to the rising unity of
the country’s notoriously fractured opposition.
In the first quarter, Chavez acted as a man under extreme pressure when
he picked a fight with Colombia that he had no hope of waging, much less
winning, in order to stir up nationalist sentiment. He is similarly engaged in
a legal tussle with ExxonMobil, which could cost Venezuela dearly in terms of
cash and assets.
Ten years of populist policies have fundamentally damaged the
Venezuelan economy, resulting in surging inflation and food shortages —
developments that often sound the death knell for Latin American governments.
To address these issues in the second quarter, Chavez will move against select
foreign energy interests to scrape together more financial resources, attempt
to force domestic food producers to increase output (or simply confiscate
property) and rally to the FARC’s defence in an
effort to maintain nationalistic support.
The common thread in all of these reactive policies is Chavez’s fear of
the country’s steadily uniting opposition. But after visiting remarkable
defeats upon Chavez in 2007, opposition efforts have largely stalled so far in
2008. If Chavez can shift from reaction to crackdown, he will be able to
alleviate the sense of desperation that currently pervades the government and
break the opposition’s back.
Regional trend: In contrast to previous years, there will be little
direct involvement of the major outside — or even inside — players. The one
exception will be Angola , which will enjoy a rare day in the sun as the
continent’s up-and-comer.
If anything, this has proved to be an understatement. China is obsessed
with the Olympics, Russia with NATO expansion, India with elections and the
United States with the Middle East . Of the major global powers only Europe is
playing in the African sandbox in any real way, and that is largely limited to
the French-led stabilization force it is dispatching to Chad — a force that
will desperately try to keep its head down.
Even within the continent, local players are locked down in internal
affairs. Nigeria is attempting to put its stamp of authority on the restive
Niger Delta, an effort we expect will prove reasonably successful now that
someone from that region — Goodluck Jonathan — holds the vice presidency. The
result will dial back violence and oil disruption issues to lower levels than
have been seen over the past three years.
In South Africa , President Thabo Mbeki is slowly being edged out of
governance by his almost-certain replacement, Jacob Zuma. The combination of
the political transition and a chronic electricity crisis eliminates all
bandwidth in Pretoria for international adventurism.
Elsewhere, African developments are reverting to a steady state. In
Somalia , neither the Ethiopians nor the Somalian Islamists are positioned well
to win the war. The Ethiopia-Eritrea stalemate will continue, with war not
particularly likely. In Kenya , the tribal splits exacerbated by elections that
occurred at the very end of 2007 are here to stay, but urban politicians have
already divvied up the political spoils, so any violence should fall to
background levels and be restricted to the countryside, largely in the western
part of the country.
Even in Angola — the one country we highlighted in our annual as being
in a position to push out — introspection is sinking in. The government is busy
ensuring that it will be able to decisively win September parliamentary
elections (the country’s first since 2002, and an event that will lay the
groundwork for presidential elections to be held, possibly in 2009). Luanda
also is making sure rebel groups in the country — including the National Union
for the Total Independence of Angola in the country’s central highlands and
rebels in the country’s oil-rich Cabinda province — lack the capacity to
threaten the ruling regime’s grip over the major urban regions and the
country’s two critical bases of wealth: its oil and its diamonds. But uniquely
among the various African states, Angola — gorged on its newfound oil wealth — does
have the bandwidth to deal with any threats or opportunities that arise. It
just will not be particularly watchful for the next three months.
The first quarter of 2008 witnessed American successes at
leveraging the U.S. Sunni alliance structure. Specifically, jihadist activity
in Iraq is near its lowest level since it began in the summer of 2003, a few
months after the ouster of the Baathist regime, and the Iraqi government has
consolidated sufficiently to begin cracking down on dissident Shiite groups in
southern Iraq . At the time of this writing, it appears Iran knows what is
coming and instead of stirring up Shiite militias to secure more leverage in
negotiations with Washington , Tehran is smoothing differences of opinion with
the Americans to not risk losing its position in Iraq . Iran has not given up
its influence — far from it. Rather, as Iraq ’s Sunnis and Kurds become more
willing to work with the United States , Iran ’s willingness to turn the Shia
loose begins threatening Iranian interests as well. The more the Shia fight
among themselves, the weaker Iran ’s hold on the country.
That makes the second quarter (or perhaps third) the most likely one in
which a final deal could be struck. The timing makes sense. Iran — having
learned from Ronald Reagan what it means to wait to deal with the next U.S.
president — would like an agreement before U.S. elections in November. So too
(obviously) would the Bush administration. The two items left to deal on are
what Iran’s final price is for not setting Iraq on fire, and how to break it to
the people of the United States and Iran that the Great Satan is working with a
charter member of the Axis of Evil. As the days roll by, the first of these items
is becoming less of an issue as the pieces steadily fall into place while the
second issue is becoming more prominent.
As Iran and the United States slide toward alignment, Syria is getting
left out in the cold. Despite Damascus ’ best efforts, it has been unable to
capture American attention as anything other than an adjunct to Iran —
something of minimal value should Tehran and Washington come to an agreement.
Syria ’s two keys to relevance are achieving an end to international isolation
and securing its position in Lebanon . Syria has little to offer on the first
point — indeed, much of the Arab world boycotted the Syrian-hosted Arab League
summit in March.
On the second, the West sees no need to allow Syria any concessions on
the topic. The result is a regime shorn of options and searching for a new
strategy. Damascus has the most wiggle room in Lebanon, where it can resort to
an array of intimidation tactics to attempt to manipulate local politics in its
favour, but it will also search for cards to play
along its border with Israel with an aggressive aim to demonstrate to Israel
and the United States the costs of leaving Syria out in the diplomatic cold.
The last major player opposed to U.S. interests in the region is the
Lebanese-based militant group Hezbollah. While Hezbollah desperately wishes to
seek revenge for the assassination of operations chief Imad Mughniyah,
it is afraid that Israel could achieve in 2008 what it failed to do in the
2006: severely degrade Hezbollah’s military capability. This leaves Hezbollah
playing its cards conservatively to avoid triggering a confrontation — a
confrontation that Tehran and Washington , engrossed in their negotiations over
Iraq , also would prefer to avoid.
For its part, Israel is itching for a fight — but between Iranian,
American and Hezbollah desires for calm, it would take a major miscalculation
for one to break out.
Regional trend: Turkey is emerging as a major regional power and in
2008 will begin to exert influence throughout its periphery — most notably in
northern Iraq
Turkey launched regular military interventions across the Iraqi border
to hobble Kurdish ambitions. And anything shy of a strong centralized Iraqi
government — which is simply not in the cards — will prevent future such
interventions. (However, Turkey ’s long-standing identity crisis over the
definition of secularism will complicate this trajectory.) Turkey is feeling
strong not only in northern Iraq, but also in the nearby Balkans and Caucasus,
where it is seeking to mentor newly independent Kosovo and a newly oil-rich
Azerbaijan.
But internally all is not solid in Turkey. The guardians of Turkey ’s
secular state have challenged the Islamist-rooted ruling Justice and
Development (AK) party, seeking a Constitutional Court ruling that would
disband the party and likely the government. The second quarter will see this
drama play out as the two sides literally struggle for the future of the
government.
While the AK party enjoys strong public support and holds the
parliament and the presidency, the secularists control the court that will be
making the decision on the ban (which could result in the Parliament’s
dissolution and the president’s dismissal). In the end, odds are the AK party —
or the political force that the party represents — will end up on top, but it
will not be an easy, quick or clean victory. The court decision might not come
in the second quarter, and even if it does a ruling against the AK party would
likely force fresh elections. This domestic situation could disrupt Turkey ’s
economic growth and detract from its focus on northern Iraq.
Economy
Regional trend: Oil prices will soften in 2008 due to the fading of
geopolitical risks in key locations.
Obviously prices have risen — not fallen — in the first quarter of
2008. Yet many of the geopolitical factors that led to the 2007 price surge —
violence in Nigeria , Iraqi instability and the possibility of an
American-Iranian confrontation — are all cycling down. We look to the second —
and more likely third — quarter of 2008 for this prediction to come true. If
the global economy cools somewhat (see below), that too should take some of the
shine off of oil prices.
Regional trend: Countries the world over will pull their energy sectors
back from the free market in order to stave off social instability and/or
maximize profit.
On the supply side, Venezuela will tinker with fresh nationalizations
as well as another windfall tax on foreign producers. Russia will launch its
effort to bring private producer TNK-BP under state control. States ranging
from Kazakhstan to Angola to Libya to even the United States are changing their
tax laws to increase the state’s tax take.
On the flip side, many states are asserting more control over their
networks to protect sacred cows. Many European states are fighting the European
Commission’s plans to break up monopolistic holdings in energy transport and
distribution. China is gathering its various energy firms and agencies into a
single super ministry for reasons political as well as economic. And states the
world over — doubly so in South and East Asia — are paying through the nose to
maintain energy subsidies and thus contain social unrest.
Even in the country where there are efforts to alter such a state of
affairs — Mexico — the heavy hand of the state retains its grip, as energy
reforms will remain mired in congressional opposition.
Regional trend: Despite much talk to the contrary, the United States
will enjoy strong economic performance. In part, this is because of the massive
inflow of money into the United States from Asian and Arabian states.
A good rule of thumb is that when the dominant financial publications
are screaming about blood in the streets, an economic recovery is under way.
The U.S. economic system is such that adjustments are made very early in
crises, as Americans tend to overreact. We believe the worst of the current
slowdown — in part triggered by the subprime mortgage issue — hit in the final
quarter of 2007. It is worth noting that preliminary government statistics
indicate that growth for that quarter still came in at 0.6 percent — not great,
but still clearly in positive territory.
There certainly was fallout in the first quarter of 2008, but so far
that activity has largely been limited to the housing and financial sectors.
The first was badly in need of a reality check, and the second was responsible
for financing the first. Moreover, the worst of the housing problems exploded
in very discrete overleveraged and overbuilt markets — some regional recessions
are certainly possible, even inevitable — but the underlying national economic
bedrock remains stable. We see the current situation as market punishment
for poor decision-makers. The worst has past for the
United States; there are certainly some inflation concerns, but we believe
inflation will affect the developing world more than the developed world (see
below).
What we find most illuminating is the split between market rhetoric and
market performance. Wall Street appears convinced that the end is nigh, yet at
the time of this writing, the S&P500 was only about 15 percent off of its
peak. In most recessions, the major markets shed 25 percent or more of their
value. We do not do not intend to not forecast markets, but the
markets forecast future economic performance rather accurately.
Much angst and hand-wringing will remain as the financial carnage runs
its course. But what is most notable about the first quarter is what did not
happen: long-term interest rates did not increase (therefore, any liquidity
crunch is both limited and temporary), and the markets did not crash. We
see no weakness in American economic fundamentals, and the stage appears set
for a return to moderately strong growth. The one danger we are watching like a
hawk is consumer confidence, which dipped at the tail end of the first quarter.
In election years, politicians challenging the system –- and, remember, there
are no incumbents running for the presidency — tend to talk down the economy.
In the 2000 and 1992 elections, such talk contributed to mild recessions. If
the subprime slowdown is to become worse, that will be why.
New regional trend: Inflation is on the rise on a global scale.
The current inflation has three causes. First, broad and deep economic
growth globally has increased demand for everything from T-shirts to titanium
in both the developed and the developing world — in the world of economics,
this is called demand-pull inflation. Second, a variety of geopolitical
disruptions — including populist policies in Argentina, snowstorms in China,
energy muscle-flexing in Russia and, of course, oil north of $100 a barrel —
have driven prices higher for reasons that have little to do with economic
fundamentals (cost-push inflation).
Finally, the process of U.S. and global financial institutions
digesting the subprime housing crisis requires that they re-evaluate the risk
of their portfolios of assets more accurately. Until they are confident that
they have the numbers right, they will be less likely to make new loans. This
has a mixed impact on inflation, reducing the ability of consumers to make
purchases (actually a deflationary trend because it threatens to create a glut
of goods) while also limiting the ability of producers to produce goods (a
textbook inflationary impact).
The combination of high demand, restricted supply and reduced
availability of credit (although we expect this last item to reverse at some
point this quarter) is not simply a recipe for inflation, but also for slowed
economic activity. This is doubly the case in the weaker portions of the
developing world where growth is tightly linked to production, as opposed to
the developed world where services are far more important. That, in turn, is
stoking fears of social unrest, especially in countries where the poor (usually
hit first by increases in the price of basic necessities) make up the bulk of the
population.
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