Market Advisory Features
Trade: Will There Ever be a Breakthrough?
American Economic Policy: Taxing Times
Investment: In Search of Those Elusive Returns
Neighbors: Trouble on the Doorstep
Donald Rumsfeld: The Not-so-quiet American
Finance and Economics: Bank Regulation
Re-ordering the World
The President at War: His Father's Shadow
Trouble on the doorstep
MORE than a week into the American-led war against Iraq, its neighbours have not yet suffered the dire consequences that they and others had predicted. There have been no floods of Iraqi refugees across their borders. None has been attacked by Iraq except Kuwait, and even there Saddam Hussein’s missiles have done little damage. Nor have Iraq’s neighbours yet been sucked into a “war within a war” over the Kurds’ aspirations to independence. But across the region there have been big street protests against the war, causing concern among its mostly authoritarian rulers—some of whom are backing America, overtly or otherwise.
On Friday, fears that the conflict might spread across the region increased when Donald Rumsfeld, America’s defence secretary, told Syria to stop supplying Iraqi forces with military equipment, which he said included night-vision goggles. “We consider such trafficking as hostile acts and will hold the Syrian government accountable,” Mr Rumsfeld added. He also said he would hold Iran responsible for the hundreds of Iranian-armed Iraqi Shias whom he said Iran had allowed to cross into Iraq. America would treat them as “combatants” if they interfered with its military operations, he said. Iran denied interfering in the war in Iraq and said there were no military links between the Iraqi Shias and its own forces.
The rulers of Iran and many other Middle Eastern countries have been trying to avoid taking a strong stand over the war, saying they would like the fighting to stop but avoiding going too far in criticising America. However, the region's press has been full of harsh words about American aggression and pictures of the civilian victims that Iraq has put on display, whipping the public into a fury, both at the war itself and at their own governments’ failure to take a tougher line.
Egypt’s security forces have been using harsh repression and mass arrests to try to contain growing demonstrations in its cities but Iran's authorities seem to have decided that the best tactic is to put themselves at the head of the protests, perhaps hoping that this will make it easier to contain them and prevent them turning into a focus for anti-government dissent. Iran’s leaders have been insisting on their “active neutrality” between America—the Great Satan—and Saddam, who waged a long and bloody war against Iran in 1980-88. But, after several independent anti-war rallies in recent days, Iran's leaders decided to invite the population to take part in a big, official protest on March 28th. Tens of thousands heeded the call.
Iran’s rulers, like others, have given warnings that the war will lead to a rise in extremism, fuelled by resentment against the United States, especially if there are heavy civilian casualties. However, the creation of a host of new Osama bin Ladens is some way down the list of war-related worries for the region’s rulers. The principal ones are:
Who’s next for regime change? Several of Iraq’s neighbours fear that once America has finished with Saddam, they will be the next target. Mr Rumsfeld's warnings are bound to increase those worries. Iran is already on America's “axis of evil” list and, besides its suspicions that Iran is backing Shia guerrillas against it in Iraq, America suspects that Iran is developing nuclear weapons. Syria and Saudi Arabia both backed America against Iraq in the first Gulf war in 1991 but both are suspected by America of sponsoring terrorism and thus their leaders also fear they are on George Bush’s list.
A democratic, pro-American Iraq, if this is the war’s outcome, might encourage the public in neighbouring countries to demand more freedoms from their autocratic rulers. Iran now has democratic, nominally pro-western Afghanistan on its flanks, as well as Turkey, and if Iraq liberalises, it will feel surrounded. As will Syria. Though the current demonstrations on Middle Eastern streets are directed against America, once Saddam is deposed they could conceivably mutate into protests against the corruption, repression and general incompetence of the authorities at home.
Alternatively, a rise in Islamic fundamentalism may be the result if the Middle Eastern public turns on its governments for being “lackeys” of America. The press, and Muslim clerics in many parts of the region, are busy stirring up such sentiments. Syria's leader, Bashar Assad, has declared that while being America’s enemy these days may be dangerous, being its friend could be fatal. Jordan is a big recipient of American aid and is hosting around 6,000 of its troops. But, amid big protests in Islamist strongholds in the south of the country, King Abdullah has been telling his people that he shares their anger over the war. Egypt’s president, Hosni Mubarak, facing rising protests at home, has complained to Mr Assad about being called pro-American by street protestors in Damascus.
Troublesome minorities might also use the war as a pretext to cause problems for the region’s rulers. Besides the sizeable Kurdish minorities in Turkey, Syria and Iran, who might be emboldened by any move to independence among their brethren in Iraq, there are the Shia Muslims in Sunni-ruled countries such as Bahrain, Saudi Arabia and Kuwait. They might start demanding more freedoms if their co-religionists in Iraq were to win them as a result of Saddam’s downfall.
Economic fall-out from the war is another big worry. Most of the region’s economies are already in deep trouble. Egypt’s has been depressed for five years, and now its tourism industry faces a collapse in bookings. Syria’s troubled economy may soon be hit by the loss of the cheap oil it has been getting from Saddam, and by the end of its profits from smuggling Iraqi oil in contravention of UN sanctions. War worries are also hanging over Israel’s crippled economy. However, if criticism of the war prompts America to press for an Israeli-Palestinian peace settlement, there could be a positive outcome: the Bank of Israel reckons that the Palestinian uprising cost Israel up to $3.6 billion last year, due to a fall in tourism and a decline in trade with the Palestinian territories. The region’s desperate need for bail-outs provides America with a powerful lever with which to keep its governments on side, or at least restrained in their criticism of the war. Mr Bush’s war budget, sent to Congress on March 25th, included $1 billion for Israel, $1.1 billion for Jordan, $1 billion for Turkey, $300m for Egypt, and lesser sums for everyone from Oman to Djibouti.
Saddam might still attack. Since, unlike in 1991, there have been no Scud missiles launched at Israel so far, its citizens have put aside their gas masks. But the government is urging them to remain vigilant, in case a desperate Saddam lashes out. Turkey has continued to receive NATO’s Patriot anti-missile batteries, in case it is targeted in the same way as Kuwait has been.
Likewise, refugees might yet begin flooding across Iraq’s borders if the war gets bloodier, or if afterwards the allies struggle to hold Iraq together. Iran, like other neighbouring countries, is trying to seal its borders, but it says it fears getting up to 1.2m refugees. Turkey had about half a million Iraqis crossing its frontiers at the end of the last Gulf war, after the failure of an uprising against Saddam, and has sent its troops to create a buffer zone.
Faced with so many worries, and the contradictory pressures to placate their angry public by opposing the war while not going too far to upset America, Middle Eastern leaders have opted for half-hearted condemnation of the invasion, empty rhetoric about proposing a ceasefire, and a short-lived attempt to reconvene the UN Security Council. As Qatar’s foreign minister, Hamad bin Jassem Al-Thani, admitted on March 24th, most of the regional summits held to discuss motions condemning the war have been held simply to appease public opinion. As Iraqi vice-president Taha Yassin Ramadan put it, his country’s neighbours come in three types: those who collude openly with America, those who do so secretly, and those who avoid deciding while unleashing their police to suppress popular rage against the war. Few of them are fans of Saddam. But few of them are as sure as Mr Bush that getting rid of him is bound to be good news for the whole region.
Trade: Will There Ever be a Breakthrough?
Agriculture is at the heart of the Doha round’s difficulties, and it is the deadline for establishing an agreed framework for detailed farm-trade negotiations that will slip by on March 31st. Although a final draft text will not be published until then, nobody thinks there is any prospect of it securing the agreement of the participants. As deadlines come and go, so the prospect of making substantive headway fades. Already, the agenda for a key ministerial meeting in September in Cancun, Mexico, is becoming unmanageably crowded. The stalemate on agriculture will make things much worse.
The battle lines are clear—and they are uncomfortably reminiscent of the transatlantic dispute about policy on Iraq. America wants to see agricultural export subsidies scrapped over a five-year period, to cut domestic subsidies to 5% of the value of farm production and to cap tariffs at no more than 25%. Such sweeping cuts horrify the European Union. Europe is ready to cut subsidies, but by nothing like as much as America would like to see. Efforts to bridge the gap have so far failed: compromise proposals have been rejected by America as being too weak and by Europe as going too far.
There is no disguising the depth of transatlantic differences. But it is not just the Americans and Europeans who are at odds with each other. There is no doubt that the EU is deeply attached to its notoriously expensive Common Agricultural Policy (CAP) and no doubt either about the lengths to which France, in particular, will go to protect it. The French president, Jacques Chirac, stitched up a deal with his German counterpart, Gerhard Schröder, last October to ensure that the CAP would be protected for years to come. But several other countries, including Japan, also provide generous support to their farmers and tend to hide behind European intransigence. And America’s attachment to abolishing farm support sits oddly with the farm bill which President George Bush signed last year and which provides for massive new subsidies for farmers. Mr Bush’s trade negotiator, Robert Zoellick, argues nevertheless that America is ready to slash subsidies if those countries with higher levels of support cut back proportionately more, to produce a level playing field.
The divide over agriculture threatens to undermine Doha because the developing countries, which object most strongly to the trade-distorting subsidies provided to farmers in the industrial world, were such reluctant participants in the first place. Many poor countries felt they got a raw deal from the earlier Uruguay round and were not convinced that they had much to gain from a new round. They were persuaded to go along with Doha because the rich countries held out the prospect of significant concessions in several areas, including agriculture.
So far, the poor countries’ initial scepticism appears justified. The promised changes to existing trade agreements, aimed at helping developing countries, have yet to materialise—even though the deadline was the end of last year. A deal to improve poor countries’ access to cheap medicines was also due to have been concluded by the end of 2002: America’s refusal to go along with the deal agreed by everyone else scuppered that. Now it is clear that, for the time being, talks on farm trade are going nowhere.
In the current international climate it is hard to see how all these issues could be resolved at the September meeting. The Doha round was launched in November 2001, just weeks after the terrorist attacks on America. There seemed at the time a genuine desire on the part of rich and poor countries alike to strengthen international co-operation on a broad range of issues; and a recognition in the industrial world of the importance of ensuring that developing countries participate fully in the global economy.
Since then, of course, the atmosphere has soured: the war in Iraq, and the events that led up to it, have opened up fresh divisions, not least among the rich countries themselves. So far there have been relatively few attempts to link economic- and foreign-policy issues by the key transatlantic participants. But that might change, especially after the news of the WTO’s preliminary ruling on American steel tariffs.
When Mr Bush imposed the duties to protect the American steel industry last year, he sparked protests from just about every steel-exporting country—all were outraged by what they saw as a flagrant breach of international trade rules. America has since made a large number of concessions—many products have been excluded, and many countries, including the poorest, exempted. But a WTO ruling on March 26th found in favour of those countries that have filed formal complaints, including Europe, Japan and China.
If confirmed, the WTO’s finding will set the scene for yet another row. Some American lawmakers have already reacted angrily to the ruling and started to argue that the WTO is exceeding its authority. Talk of America leaving the WTO is likely to follow, even if it comes from a small minority. All this could, in turn, revive other bilateral disputes, subdued during the Doha talks: about unlawful tax concessions for American companies and about the EU’s refusal to import genetically modified crops. It is hardly the context in which to encourage hopes of a breakthrough on agriculture.
American Economic Policy: Taxing Times
The vote was nevertheless a significant setback for the president at a time when American troops are heavily engaged in Iraq. For a start, it came as something of a surprise—at the end of last week a similar proposal had been defeated, and the Senate had, in the end, voted to reduce the proposed $726 billion tax cut by $100 billion, intended to cover the cost of the war in Iraq. Many in Congress had been irritated by the Bush administration’s refusal to come up with any estimate of the cost of the war. So the timing of the latest vote was particularly unfortunate for the White House. It came only hours after Mr Bush had finally sent Congress a specific request for extra money to pay for the war—just under $75 billion.
Mr Bush and his team have been working hard to sell the huge tax cut as part of the president’s plan to stimulate the faltering American economy. The president has not forgotten the bitter lesson learned by his father, who failed to win re-election in 1992 despite winning the Gulf war of 1991. American voters blamed Mr Bush senior for poor economic performance on his watch. The current president, who faces re-election next year, is determined to avoid that.
Since Mr Bush’s Republican Party now controls both houses of Congress, he might have expected his budgetary plans to sail through without serious challenge. But members of Congress often have very different interests and agendas from the president of the day—even when they belong to his party. Many on Capitol Hill doubt the wisdom of passing such large cuts in taxes at a time when the country is engaged in an expensive war and when the government has swung rapidly back into deficit. Gone are the large projected budget surpluses that Mr Bush inherited a little over two years ago.
Since then, of course, the economy has been in recession and has subsequently recovered more slowly than anticipated. And Mr Bush has already secured congressional approval—within months of taking office—for one large tax cut. Now, with the government accounts a sea of red ink for the foreseeable future, the president wants another.
Economists are divided about the wisdom of slashing taxes in this way, without trying to balance the books. Last month, around 450 economists, including ten Nobel laureates, openly criticised the tax-cut plan: in response, the White House quickly marshalled support from economists who took a different view. Mr Bush has been arguing that his tax cut will itself have a beneficial impact on economic growth, and that as a result the deficits projected under current methods will turn out to be overly pessimistic. The Congressional Budget Office is embarking on a series of studies, using what is called dynamic forecasting, to try to take account of the economic impact of the tax plans. The administration no doubt hopes this will help play down the deficit implications.
But even some of those inclined to be sympathetic to the president’s tax-cutting aims have been urging caution. When Alan Greenspan, the influential chairman of the Federal Reserve, testified to Congress last month, he supported one of the central elements of the Bush plan—abolishing tax on dividend income—in principle. But he voiced disquiet about doing so in a way that significantly raised future budget deficits. And Mr Greenspan also argued that it was too soon to be sure that further economic stimulus was needed. Better to wait until the geopolitical uncertainties had cleared, when the economic recovery might gather momentum without further government help.
The uncertainties to which Mr Greenspan alluded are certainly having an economic impact. With the war under way, and no sign yet that it will be a short affair, businesses and consumers are nervous. The latest survey of consumer confidence in America, published on March 25th, showed it to be at the lowest level for nine years. Stockmarkets around the world are jittery. A sharp rise in share prices last week, triggered by hopes of a brief conflict, was partially reversed as it became clear that the war would not necessarily be over quickly or painlessly.
Amid all this global uncertainty, it is difficult to see what short-term measures could soothe fears and send people rushing back to the shops, or persuade companies to make long-term investment decisions. On March 27th, the International Monetary Fund warned that even a relatively quick end to the conflict might not end the uncertainties which discourage investors because of “continued geopolitical instability and tangible threats of terrorism”.
Hence Mr Greenspan’s own uncertainty. In spite of all the short-term gloom, the American economy is still growing faster than most other big industrial countries. Unnecessary stimulus with serious long-term consequences—Mr Greenspan and others worry that budget deficits will crowd out private investment and force up interest rates—would only add to the structural imbalances in the American economy. The current-account deficit, now around 5% of GDP, has reached levels which alarm some economists.
Such concerns are, essentially, on hold until the war is over. Depending on the outcome, though, they may then become urgent. The Senate’s vote might be no more than a shot across the president’s bows, for now. But it has sent a clear message about the post-war domestic agenda—and one which Mr Bush will not like.
Finance and Economics: Bank Regulation
The Basel Committee on Banking Supervision, which is drawing up the rules, is pleased with the results of its third (and supposedly last) impact study. The study suggests that the complex new risk weightings to be applied to different types of asset will produce appropriate levels of capital for most of the world's banks.
Getting this far has taken a lot of sweat and horse-trading. American bankers and regulators have been at the forefront. American financial institutions have debated the rule changes as keenly as anybody. And Bill McDonough, head of the Federal Reserve Bank of New York, has cracked the whip as chairman of the Basel committee.
Imagine, therefore, the consternation of other committee members on learning how America plans to treat the new rulebook. Some American bankers and legislators are arguing that the proposed capital charge for operational risk—a fundamental part of Basel 2—needs to be completely rethought. Worse, American regulators intend to apply the new rules to fewer than a dozen of their banks. At a congressional hearing last month, they made it clear that the thousands of other American banks would continue to use the less complex existing rulebook, Basel 1. In fact, Basel 1 is little different from the lowest of Basel 2's three grades of sophistication. Nevertheless, the regulators believe that even this slight change would be a waste of money for America's smaller banks.
This is a choker for European regulators, who see Basel 2, like Basel 1, as a global standard to be applied to all banks. Granted, the Federal Reserve has always said that it would apply Basel 2 only to “internationally active” banks. The surprise is that this means so few. It seems that banks as big as State Street, Mellon Financial Corporation, and perhaps even Bank of New York, which all have huge international payments and securities operations, will escape. State Street and Mellon have been lobbying hard, arguing that the Basel 2 charge for operational risk is too formulaic. They say that operational risk—the risk of loss from systems failures, external events, fraud etc—is impossible to quantify. It would be better if supervisors monitored banks' efforts to mitigate these risks and then set a subjective capital charge. But this is anathema to European regulators.
In Europe, a version of Basel 2 is to be incorporated into European Union law and applied to all banks and investment firms, not just internationally active banks. To this end, the European Commission hopes to publish a draft directive in June. No wonder rulemakers in both Basel and Brussels are furious with the Americans.
As things now look, different standards will apply to American and European banks, giving the Americans a theoretically lower cost of making loans. Karen Petrou of Federal Financial Analytics in Washington fears that the American regulators' narrow application will allow some quite big American banks to side-step realistic capital charges, by using the old Basel 1 loopholes. “The whole point of Basel 2 is to get rid of regulatory arbitrage,” she comments.
However, members of the European Parliament (MEPs) might also try to reshape the new rules—just as American congressmen have already tried. Alexander Radwan, a German MEP who will report to the parliament on Basel 2, has several concerns. He thinks that capital charges that are more sensitive to credit risk could curb lending to small companies, a fear previously expressed also by the German government. And he dislikes the idea of bank-supervision rules being drawn up and amended by unelected experts (such as the Basel committee) outside the purview of politicians.
The Europeans also have some bargaining chips, which may yet produce a compromise with the Americans. American banks cannot operate in Europe under non-EU capital rules or supervision unless these are judged to be of “equivalent” standard. American banks may find that Basel 1 will not be deemed equivalent within the EU after 2006, when the commission's promised directive is due to take effect. Moreover, some American investment banks may be caught by another EU directive on financial conglomerates, which comes into force in 2005. They may have to seek out a consolidated supervisor with stronger oversight than their current one, the Securities and Exchange Commission: an EU committee will decide next year.
Alternatively, European regulators could follow the American lead, and simply reduce the scope of Basel 2 in Europe, along American lines. That might not be a bad outcome. Initially, a few big banks conforming to Basel 2 would set a standard to which other banks could aspire. The incentive to aspire would come not from regulatory pressure but from the market, which might judge compliant banks to be safer and better-run.
Nice, but improbable. So much effort has been put into Basel 2, and so many European banks are braced for the future directive, that there is no turning back now. So it looks more likely that American and European banks and their regulators will end up playing by different rules.
It was not always so. Before the terrorist attacks on the twin towers and the Pentagon, Mr Rumsfeld looked like an extinct volcano. On September 7th 2001 the Washington Post ran an article speculating on possible successors. But from the moment he raced out of his office to tend to the wounded he was transformed into a national hero. His straight talk and steely confidence proved to be just the tonic the country needed. His press conferences became compulsory viewing. A man who has seen only two films in years—“Saving Private Ryan” and “Black Hawk Down”—found himself treated as a matinée idol.
The articulator-in-chief has been just as active in shaping long-term strategy. From the first he pushed for an all-out war on terrorism rather than just a surgical strike on al-Qaeda. He had been pointing for years to the dangers that could come from explosive dictatorships such as Iraq and from the spread of weapons of mass destruction. September 11th confirmed his Hobbesian view of the world.
Why has Mr Rumsfeld proved so successful in rallying Washington behind his vision? It is tempting to argue that he owes it all to Jacques Chirac. French intransigence helped to confirm George Bush's worst suspicions about the United Nations. Even now, the entente discordiale continues: if anybody is doing more than Rummy to keep the UN out of rebuilding Iraq, it is Jacques. But most of it comes down to Mr Rumsfeld himself.
Begin with his talents, which include an extraordinary combativeness (he was once the All-Navy Wrestling Champion) and a wealth of experience. Elected to Congress in 1962, he was ambassador to NATO under Richard Nixon, and then chief of staff and defence secretary under Gerald Ford, and has held grand-sounding jobs ever since (including meeting Saddam Hussein as Ronald Reagan's special envoy to the Middle East). He is both the youngest and oldest secretary of defence in American history. Henry Kissinger—no mean draftsman in the darker arts of politics—described the young Rumsfeld as “a skilled full-time politician-bureaucrat in whom ambition, ability and substance fuse seamlessly.” An operator, in other words.
But the deeper reason for Mr Rumsfeld's influence in the White House is ideological. He is “one of us” in a way that Colin Powell could never be. Mr Rumsfeld is one of the most conservative members of a conservative club. His congressional voting record received a 100% rating from conservatives and a 4% rating from liberals. He is also a CEO in a club of CEOs. As chief executive of G.D. Searle in the early 1980s, he quintupled the drug company's share price by pioneering techniques that other Bush cabinet members were promptly happy to copy: downsizing, delayering and selling off non-core businesses. Mr Rumsfeld is particularly close to his fellow ex-CEO and one-time protégé, Dick Cheney, who succeeded him as President Ford's chief of staff.
No one can doubt Mr Rumsfeld's success in amassing power. But how successfully has he wielded it? The accusations against him have been launched in two waves. The longstanding barrage—mainly dispatched from doveish quarters—is that he has wilfully antagonised allies and sabotaged diplomacy. The fresher assault, which comes from generals as much as politicians, is that he has underestimated the difficulty of removing Saddam Hussein. Mr Rumsfeld, they whisper, is a classic victim of “sun-king syndrome”—a near universal malady among bosses of all sorts that leads them to overestimate their own abilities and underestimate everybody else's.
The diplomatic charge is, to put it politely, hard to rebut. Mr Rumsfeld may be right that America's policies should dictate its coalitions rather than the other way round, but his fondness for throwing rhetorical hand grenades such as that crack about “old Europe”, accurate though history may find it, has hardly helped the collecting of allies. His forthright style has reinforced latent fears of American imperialism, maybe to the cost of his troops now. The current war would have been easier if Turkey had given America permission to use its ground bases.
What about Rummy the war leader? His relationship with the armed forces may be better characterised as “creative tension” than sun-king arrogance. In Afghanistan he was largely right to push Tommy Franks to make bolder use of air power and special forces (though more ground troops might have made it easier to capture al-Qaeda's leaders). In Iraq the jury is still out, but the argument between Mr Rumsfeld and the generals may well have produced a sensible compromise. Mr Rumsfeld eventually accepted the generals' assessment that a war on Saddam needed 250,000 troops in the region; General Franks agreed to a much bolder attack than he had originally intended.
Mr Rumsfeld likes management maxims. One of “Rumsfeld's rules” is: “Don't divide the world into ‘them' and ‘us'.” He has clearly failed on that. Another is: “Visit with your predecessors from previous administrations. Try to make original mistakes, rather than needlessly repeating theirs.” Which leads us back to Mr McNamara, another ex-CEO with a boundless ego and a taste for slicked-back hair, rimless glasses and high-tech warfare. Whether Mr Rumsfeld is breaking yet another of his rules, and needlessly repeating Mr McNamara's mistakes in Vietnam all those years ago, we shall soon discover.
Re-ordering the world
IT IS always easy, at times of great international turmoil, to spot a turning point that is not there. For many people, the war in Iraq, and the anxious months leading up to it, seem to represent the most dangerous period in their lifetimes. For those young enough to have only vague memories, if any, of the Gulf war of 1991 or the cold war, let alone the Cuban missile crisis of more than 40 years ago or the Korean war of the early 1950s, their perception might be right. But set Iraq in the context of even relatively recent world history, and it is clear that it is much too soon to gauge what sort of turning point, if any, the current war will be. Is a new world order taking shape? And if it is, what will it look like?
For now, nobody can be certain of the answers. But it is possible to see what issues will determine the shape of international relations in the war’s aftermath. Most important will be the United Nations. America, Britain and others blame the UN Security Council—and especially French intransigence—for its failure to endorse an invasion of Iraq to disarm Saddam Hussein. Those countries that wanted to avoid war argue that America simply wanted backing for actions it planned to take whatever the UN said. There is talk that the UN might now be a busted flush, just in the way the League of Nations was after its failure to stop Italy invading Abyssinia in 1935.
That is possible, but does not yet seem probable. Crucial to the UN’s future will be the way that transatlantic relations develop after the bitter recriminations that have characterised the dialogue in Washington, Paris, Berlin and London in recent months. Will both sides bear grudges, or seek to repair bruised relationships? Bridges will need rebuilding amongst Europeans, too, of course—relations between Britain and France in particular are as frosty as even grey-haired diplomats can remember. For now, the idea of a common European Union defence and foreign policy is hard to take seriously, as even its most ardent supporters glumly realise. That might be why France, Germany and Belgium have decided to meet next month to discuss closer defence integration among themselves.
Some of those anxious about American intentions worry that Iraq is simply the start of a prolonged American campaign against countries which President George Bush has declared to be part of an axis of evil, and that he will turn his attention to Iran or North Korea next. There is no evidence for this yet; it is certainly hard to see Mr Bush winning much European support for such a strategy. If Britain’s prime minister, Tony Blair, were to continue to support America in such circumstances, relations among member states within the EU would deteriorate still further.
Much hinges on the progress of the war itself. A short, successful and relatively bloodless conflict that resulted in regime change in Iraq, replacing Saddam Hussein with something resembling democratic government, would strengthen the case for intervention put forward by America and its allies. So too would a readiness to put the UN at the centre of efforts to reconstruct Iraq. This is something that all EU members, including Britain, are keen to see. American reluctance to relinquish tight control at the transitional stage could exacerbate instead of ease tensions.
A prolonged and bloody war would have very different consequences. For a start, both Mr Bush and Mr Blair would find themselves, at best, in a very uncomfortable political position at home. Mr Bush faces re-election next year and the outcome of war could have a big influence on his prospects. Mr Blair has already seen a large number of his own backbenchers oppose the war. He could find himself vulnerable if the military operation proves far more difficult than anticipated. In such circumstances, though, emollient words between countries which have long been allies would be even more important. The prospect of an isolationist American superpower, which European countries fear, would have far-reaching consequences.
Ultimately, of course, international relations are about power, and it is America’s unrivalled power which troubles some Europeans. Even before Iraq, some had doubts about what they saw as the Bush administration’s unilateralist approach: the refusal to sign up to the Kyoto treaty on climate change and the International Criminal Court are frequently cited examples. France is perhaps the most enthusiastic supporter of a common European foreign policy because of the counterweight which the French believe Europe could then exercise in the face of American power. But the divisions over Iraq make that seem a utopian ambition. Long ago, Henry Kissinger, Richard Nixon’s secretary of state, used to complain that when he picked up the telephone to Europe he never knew who to call. Even Mr Kissinger might be thrown by the bitterness that has split Europe’s leaders. And Javier Solana, the EU's foreign-policy representative, who should in theory at least be the first port of call, has been almost invisible during the Iraq crisis. He is a man with a job title but, apparently, no job.
European impotence derives in part from its inability to shape a common world view, but it also reflects economic weakness. Germany, for instance, once the dominant economy in Europe, is in a mess: on the brink of yet another recession and, some think, deflation—and with the present government of Gerhard Schröder apparently incapable of delivering radical economic reforms. Far from progressing towards its aim of being the most competitive region on the planet by 2010, Europe is returning to the sclerosis of the 1970s. With Japan in apparently terminal decline, America remains the dominant world economic power.
Is reconciliation impossible, whatever happens in Iraq? Probably not. Since the conflict started, America has made much of the fact that more than 35 countries are involved, in some way, in what Mr Bush calls the coalition of the willing (though the war’s stauncher opponents have dubbed it the coalition of the bullied). Even France, not a member of this coalition, has allowed British and American planes to use its airspace. It is always possible to repair relationships if those involved want to: and, for once, linkage might prove useful in rebuilding transatlantic bridges. Were the Europeans to table a more acceptable proposal on farm trade in the Doha round of trade negotiations, America—along with Australia and many developing countries—might start to take a more charitable view of Europe. On this issue, though, time is short. The Doha timetable has set a deadline of March 31st for establishing a negotiating framework on agricultural trade.
Equally, an American readiness to involve the UN in the postwar reconstruction process would ease fears that it was no longer prepared to invest effort in multilateral diplomacy. The signs are mixed. “In a post-Saddam Iraq,” said Mr Bush after the Azores summit on March 16th, “the UN will definitely need to have a role.” In that, though, the relief agencies are likely to loom larger than the Security Council, which was probably the institution he had in mind when he said, more ominously: “We hope tomorrow the UN will do its job. If not, all of us need to step back and try to figure out how to make the UN work better.” It is the result of those calculations that will ultimately determine the future of international relations.
president at war
His father's shadow
IT WAS certain, after September 11th 2001, that Afghanistan would not be the only military campaign in the war against terror. The president's stress on states that sponsor terrorism, and on the threat posed by their acquisition of weapons of mass destruction, guaranteed that. It was also likely, if not certain, that Iraq would be the next target. Its connection with terrorists is a matter of dispute. But its pursuit of weapons of mass destruction made it hard for the president to ignore.
So, on the night of March 19th, Mr Bush went on national television to announce that the disarmament of Iraq had begun. In doing so, he abandoned the arguments he had been using to justify for months an attack. At the United Nations, he had said that Iraq should be disarmed to enforce Security Council resolutions. In a speech to a think-tank in Washington, he had suggested Saddam should be overthrown to spread democracy in the Middle East.
But now he restated the argument he first used after the attacks in New York and Washington: Iraq's pursuit of weapons of mass destruction, and the danger that Saddam might co-operate with terrorists to use them, constitute a threat to America itself. “We will meet that threat now,” he told the nation, “so that we do not have to meet it later...on the streets of our cities.” He had said almost exactly the same thing two days earlier, as he gave Mr Hussein a 48-hour ultimatium to leave Iraq. “The United States”, he said, “has the sovereign authority to use force in assuring its own national security.”
In other words, the president is justifying war with Iraq through the doctrine of pre-emption—the idea that preventive war is sometimes necessary in a world where terrorists can kill 3,000—or 300,000—people at a stroke. This claim, put forward last June in a speech to the military cadets at West Point, has been heard infrequently since. As America's UN diplomacy has failed, it has resurfaced. At his televised press conference about Iraq on March 6th, President Bush mentioned al-Qaeda five times.
The re-appearance of pre-emption as a justification for military action may deepen divisions between supporters and opponents of war (if that is possible). The doctrine of pre-emption probably scares more people outside America than almost any other Bush policy. So compared with his father on the eve of the first Gulf war, the son is entering conflict with fewer international allies.
The State Department has just published a list of 33 supporting countries, plus 15 that want to remain anonymous. But around 100 countries backed the first conflict. By chance, the Pew Global Attitudes Project, a respected international pollster, released a study this week of European opinion. It found unprecedented levels of antagonism towards America. Big majorities view the country unfavourably: 84% in Turkey, 74% in Spain, 71% in Germany, 68% in Russia, 67% in France. Britain was the only place where a plurality liked America.
Yet at home Mr Bush's position is stronger than his father's was. Public support is rising fast as Americans rally round the flag. That happened before the first Gulf war. But six weeks before conflict, the difference was great: in December 1990, half of all Americans supported war; this February, the figure was two-thirds. This war is more popular.
And there has been less political division over it. Before the first Gulf war, Congress passed a resolution narrowly approving force along partisan lines (the vote was 52-47 in the Senate, 250-183 in the House of Representatives). Last October, the votes were 77-23 in the Senate, 296-133 in the House. All the Democratic presidential hopefuls voted in favour.
That does not mean Democrats will not criticise the president if the campaign goes less well than expected (and expectations of a swift war run high). But it may put the younger Mr Bush into a better political position than his father. The elder Bush's fate is a classic example of success in war bringing no benefit at election time. But the younger Bush starts from a stronger domestic position and has already shown, in the 2002 mid-term elections, that he can use national security as a vote-winner.
George Bush has often been described as a gambler—on taxes, on the mid-term vote, and on Iraq, the biggest gamble of his career (far greater than the war against the Taliban, which was forced upon him). This gamble could reshape not only the world, but America's domestic policy. But such a transformation may happen in different ways. On the world stage, repercussions will flow in part from the strength of opposition to the president's strategy. At home, they may well flow from the strength of his support.
EARLY this week the markets were telling themselves that the second Gulf war was as good as won. Equities rallied; bond and oil prices fell; gold hardly flickered. But that did not help investors, such as insurance companies and pension-fund managers, with their thorny conundrum: how to allocate their assets over the long term?
The accepted wisdom, that equities offer superior returns in the long run, has recently looked a little hollow (see chart). Forecasts for the so-called equity risk premium (the return in excess of the yield on government bonds demanded by investors to compensate for the extra risk of holding equities) range from a traditional 5% to as little as 2.4% a year. Such a thin premium may look on the low side to many investors, given that share prices could tumble again and that more corporate misbehaviour may be uncovered.
Yet most of the alternatives to pure equities—bonds issued by governments (in developed or emerging markets), municipalities or companies; asset-backed securities; funds of hedge funds; bonds indexed to equities or to credit risks—all seem loaded with their own mixture of downside risk and lacklustre returns. What can an asset manager do, apart from hiding under the duvet?
There is plenty of advice available. For example, the amazing foresight of the pension fund of Boots, a British retailer, which moved all its assets into bonds in 2001 to miss the worst of the equity slump, is now inviting criticism. “Why sacrifice around 3% a year so that trustees can sleep peacefully at night? That's a lot of money compounded over 25 years,” argues someone who thinks he knows better.
The reason is that, for some pundits, equities have lost so much value that they are beginning to look cheap. In some cases the dividends paid on shares, divided by share prices, are even outstripping the yield on bonds issued by the same company. This makes no sense. The share price has no theoretical ceiling, while the bonds pay a fixed amount.
A handful of academic works on the equity risk premium, published in the past year, far from gathering dust on university bookshelves, have become the stuff of hot debate in investment banks and company boardrooms, and among the trustees of pension funds and even university endowments. Why? Because popular assumptions about long-term investment returns have been overturned. A year ago Robert Arnott, chairman of First Quadrant, an investment firm, and Peter Bernstein, an investment adviser, estimated that the equity risk premium should be as low as 2.4%. They argued that accidents of history, survivor bias, changes in corporate culture and many other factors had made equity returns look higher than they really were over the past 75 years. And they concluded that the outlook for equity and bond returns in the short term was about the same: between 2% and 4%.
Sobering conclusions have also come from academics at the London Business School, whose analysis of equity returns since 1900 shows that, before the last bull run, only two decades, the 1950s and 1960s, had produced real rates of return of over 10%. The authors, Elroy Dimson and others, note that returns were low in 1900, but that investors became used to higher returns over the next century. Now, perhaps, shareholders will have to accept lower rewards once again.
Bill Gross, a fixed-income champion at Pimco, an American asset-management firm, predicted last September that bond returns will outstrip equities until share prices fall to their fair value, that is, until the Dow Jones Industrial Average is at 5,000 rather than today's 8,000-odd. However, those with an equity bias, such as Chris Johns, chief economist at ABN Amro Securities, continue to argue for at least a 60% equity weighting over the long term. “We're near to the wrong point of the cycle to go into bonds,” he says.
The debate is even causing ideological rifts within the same financial institution, says Mr Dimson of the London Business School. Corporate financiers are quoting one equity risk premium to companies creating incentive plans for their employees; fund managers pick another rate for asset allocation; those advising utilities use another to negotiate with governments on funding; universities worry about how much of their endowments they can spend each year. Then there are the aggregate—often wildly optimistic—returns forecast by equity analysts. “These are very hot issues,” says Mr Dimson, “since the equity risk premium drives decisions on asset allocation and company investments.”
Institutional investors know they cannot stay out of the market forever. Some dived into equities this week as stockmarkets rose. But they are also being tempted into so-called alternative investments. Hedge funds are attracting a growing proportion of institutional assets: they have been able to achieve above-average absolute returns in aggregate. But many investors will be disappointed, because fewer hedge funds are likely to outperform in future and the fees they charge are high.
Jerome Booth of Ashmore Investment Management sings the virtues of sovereign debt in emerging countries. Since a crisis in 1998, these markets have become less volatile, he says; the investor base has become more institutional and less speculative; and there is less risk of contagion between countries. Rating agencies have consistently underrated sovereign bonds because the risk is hard to quantify, says Mr Booth. He boasts over 25% average returns for his funds in the past decade.
But even he cautions investors against putting more than 5% of their assets into such bonds, at least to start. What about the rest? Many investors have sought higher yields in corporate-credit markets, from single-name corporate bonds, credit default swaps, or packages of securities backed by pools of corporate names.
The recent high levels of defaults and ratings downgrades have taken the shine off that market. There may, therefore, be little alternative to a cautious return to equities. Messrs Arnott and Bernstein recommend that investors accustom themselves to much lower returns than they have enjoyed in the past. “It's naive to expect earnings and dividends to grow faster than the economy,” says Mr Arnott.
That translates roughly into higher pension contributions, a longer working life and less rosy retirement all round. Or you can take a punt. Recently, Jonathan Compton of Bedlam Asset Management said he was buying his 18-year-old daughter shares in one company, BP: “One of the great opportunities this side of Mars,” he was quoted as saying. This week BP's shares dipped when a $3.4 billion shortfall appeared in its pension fund.