Market Advisory Features

Economics focus

To have and to hold

Can people learn to be as rational as economic theory supposes?

FOR several years now, a battle has been raging among economists. On one side are the traditional, “neoclassical” theorists, who believe that people should be thought of as rational economic agents. On the other are the upstart “behaviouralists”, who do not accept that people always get their complicated sums right (maximising utility subject to a budget constraint, and all that), or even act as if they do.

A top behaviouralist, Daniel Kahneman, won last year's Nobel prize in economics for pointing out the differences between Homo sapiens and H. economicus. Real people tend to judge their well-being relative to others, not in absolute terms; their actions depend on the way choices are presented; they fear loss more than they crave gain. Such insights form the core of what is known as “prospect theory”. Some economists think that prospect theory can overthrow two centuries of neoclassical thought. Others say that it only gives credence to the idea that people repeatedly make daft mistakes. Is there a way of settling the dispute?

Some recent work should at least help. It explores the “endowment effect”, one of the chief tenets of prospect theory. Put simply, this means that people place an extra value on things they already own. Think of a favourite sweater, or your house: would you swap either for something of equal market value? Over the past decade, prospect theorists have found support for the endowment effect in scores of experiments. In one of the best-known, researchers at Cornell University began by giving university students either a coffee mug or a chocolate bar, each with identical market values. First the experimenters confirmed that roughly half the students preferred each good. After the goodies were handed out, they let the students trade: those who had wanted mugs but got chocolate (or vice versa) could swap.

With barely 10% of students opting to trade, the endowment effect seemed established (you would expect 50% to have swapped, given the random allocation of gifts). Even after a short time with things of little value, ownership had overwhelmed the students' prior tastes. Dozens of other tests have produced similar results, and have produced a wave of criticism of neoclassical economics.

The criticism has been taken seriously, as it should be: if the endowment effect is real, people's economic decisions are fundamentally different from what economists have assumed. The implications of this are profound. To take one example, the Coase theorem, which argues that initial allocations of wealth do not matter as long as markets allow people to trade their stakes—the rationale for government auctions of everything from radio spectrum to mobile-telephone licences—would no longer be valid. To take another, although economists have shown that you need only a few sharp traders for prices in financial (and other) markets to become efficient, the volume of trade with an endowment effect will be below what it might be without one.

John List, an economist at the University of Maryland, recently tested the existence of the endowment effect in a new way. Instead of using callow students, he went to a real market with traders of varying degrees of experience: a sports-card exchange, one of many such, where Americans trade pictures of their favourite athletes. There, traders dealing in hundreds of cards mix with browsers who might buy only one.

In one experiment*, Mr List took aside a group of card fans and gave them an assortment of other, less familiar, sporting memorabilia, such as autographs, badges and so forth. He then let them trade. The less card-trading experience a subject had, the less likely he was to trade, even when a good deal was on offer. More experienced traders were less prone to the endowment effect, and traded as keenly as neoclassical theory predicts.

Although consistent with an endowment effect, this was not proof of one. Novice traders could simply be wary of dealing with those who might get the better of them. To rule this out, Mr List concocted another experiment along the lines of the Cornell study†. He gave a similar cross-section of fans chocolate and coffee mugs, whose values are well-known even to the most inexperienced bargainers, and let them trade. Again, Mr List found evidence for an endowment effect—but also that long experience as a card trader spilled over into his experimental mug-and-chocolate market. Only novices, like the students in earlier experiments, tended to be swayed by what they had been given.

This implies that prospect theory can capture the behaviour of inexperienced people, of which the world has many in all sorts of markets. But experienced buyers or sellers in well-established markets get over their psychological “flaws”. They can even transfer their trading skills from one market to another. The neoclassicals, it seems, have scored a point.

Mr List notes that sellers seem to learn how to trade faster than buyers do. What might this imply for, say, stockmarkets? The green investors who discovered shares only when markets boomed in the 1990s had been slower than others to part with their cash and join in. But once in, were they afflicted by the endowment effect? Owning Amazon shares bought for $400 each made it hard to sell until much higher prices came along (they didn't). Sophisticated traders, especially the sell sides of investment banks, had no such baggage, and sold. The bear market, however, should have proved as good a learning experience as novice investors are likely to get.

Buttonwood

Reading China’s tea leaves

Will China float the yuan, revalue it up a bit, or neither?

FORECASTING exchange rates is rather like peering at tea leaves: many clever people get it wrong more than is the norm in financial markets, where the standard is high. The analogy is especially appropriate at the moment. Many pundits think it only a matter of time before China revalues its currency, the yuan, up; some even think it will let its currency float. Speculators (hedge funds and banks) are out in force. The reason has less to do with domestic considerations in China than with strong-arming from America, which thinks that the Middle Kingdom is competing unfairly by keeping its currency pegged low to the dollar, and is therefore flooding the world with cheap goods which exacerbate deflationary pressures. They make things a lot cheaper in China.

Actually, American politicians don’t care much about the rest of the world, but they do worry about the ill effects of cheap imports on their own manufacturers, who are griping mightily. These cares are already being voiced, but the complaints are becoming louder: next week John Snow, America’s treasury secretary, is to visit Beijing. They are likely to get even louder ahead of next year’s elections in America. And not just because of America’s trade deficit with China. The latter is a powerful symbol of America’s apparent problems with Asia as a whole, since the region accounts for half of its current-account deficit. All Asian countries run more or less managed exchange rates, which is why their foreign-exchange reserves have swollen by $285 billion over the past year or so. China’s foreign-exchange reserves rose by $10 billion last month alone, to $356 billion. China has replaced Japan as America’s whipping boy in Asia in part because its trade surplus is now bigger, and because it carries more clout in the region.

As foolhardy as currency predictions are, Buttonwood nonetheless has his two yuan to offer. At the risk of China revaluing as soon as this sentence is published, as is usually the way, the country is unlikely to float its currency for many, many months, perhaps years, though it might tweak it up a touch, just to show willing. China has shown itself fairly immune to outside pressure over the years, unless action is forced upon it, or because it is in its interests. Perhaps it is not worth roiling America overly, but there are scant domestic reasons for opening up its capital account and floating its currency, or even revaluing it up much.

Opening up the capital account would attract a lot of hot, speculative money, just as it did in the rest of Asia in the early 1990s. That is the last thing that China needs. The country’s banks are already saddled with mountains of bad loans. These would eventually rise further, perhaps a lot further, were the country to open up its capital account without first having a political and economic system with more transparency, less corruption, and some notion of sound lending practices.

Nor is there much by way of domestic economic or political impetus. Booming exports means lots of jobs, a fact not lost on the Communist party, with an eye to political stability. Nor is there much worry about a potential nasty side-effect of a booming current-account surplus: rising inflation. The mechanics of such a rise in prices work as follows. The dollars earned by exporters must be converted into yuan, which the central bank simply prints. Unless this extra domestic currency is mopped up in some way, the money supply rises, banks ramp up their lending, and inflation can take off (which would increase the real exchange rate—ie, taking inflation into account—and reduce competitiveness).

The money supply is certainly going up at a fair lick (M2 rose by 21% in the year to the end of June), but broad inflationary pressures are subdued; China, lest we forget, has only recently emerged from a period of deflation. There are, it is true, pockets of inflationary pressure (in property, for example) but the authorities can cope with a bit of this: the central bank has just increased the reserve requirements for banks to rein in their lending. At some point, these pressures will be sufficient to force China to do something. But not yet.

Another way of looking at China’s current-account surplus with America is that in exchange for selling lots of cheap shoes and fridges to American consumers, China receives little by way of return except IOUs in the form of American Treasuries. In effect, Mr Snow and his colleagues are asking the Chinese to accept fewer dollars when these IOUs come due. This makes little financial sense, except for America, which has an awful lot outstanding, and which ought as a result to be careful about the threats it makes. China does not have to hold so much of its reserves in dollars. Time for a switch into euros?

More importantly, Japan this month recorded its sixth successive quarter of growth, with GDP rising 2.3% at an annual rate in the second quarter. This comfortably surpassed expectations and nearly matched America’s surprisingly speedy growth over the same period. The second half of the year looks equally promising: the Organisation for Economic Co-operation and Development (OECD) says its leading indicator for Japan has risen for two consecutive months.

Previous bounces have been driven by government spending or export demand, but this one seems broader. Spending by Japanese businesses rose by 1.3% in the second quarter, and even private consumption was up by 0.3%. Japan’s Cabinet Office has watched the recovery spread throughout those economic activities that normally lead the cycle, registering 81.8 on its “diffusion” index in June. (A figure above 50 shows that more sectors are expanding than contracting.)

The economy is growing, but prices are still falling. Deflation was 2.1% in the second quarter, less than in the previous three months but fast enough to ensure that Japan’s economy is still shrinking in nominal terms: output is rising, but the yen value of that output is falling. By some estimates, the recovery will have to last up to two years to eliminate Japan’s excess capacity and bring deflation to a halt.

With prices continuing to fall, and nominal interest rates around zero, Japan remains caught in its long-standing liquidity trap. People hold money, which gains in value as long as prices fall, rather than spending it or investing it in anything riskier or less liquid. Until people believe that prices will rise, conventional monetary policy is as ineffectual as “pushing on a piece of string” (to quote Keynes’s famous phrase). But the string-pushers at the Bank of Japan may finally be exerting some pull over the economy. Under instructions from the Ministry of Finance, they have succeeded in holding the yen down this year by buying up $74 billion of foreign currency, mostly dollars.

The central bank can pay for these dollars either by selling some of the bonds it owns or by printing money. In the past, it has always sold bonds. Economists call this “sterilised” intervention: the bank changes the value of the yen without changing the money supply. But now, according to the Financial Times, the bank has stopped sterilising its purchases of dollars. It is, in effect, buying dollars with freshly printed money, keeping the yen competitive while also boosting the money supply. Some economists, such as Allan Meltzer of Carnegie Mellon University, have been urging the Bank of Japan to do this for years. Mr Meltzer points out that America escaped from a liquidity trap of its own in 1938 by letting the monetary base grow as foreign exchange (and gold) flowed in.

Japan’s escape may still be some way off. Meanwhile, Junichiro Koizumi, Japan’s prime minister, must stand for re-election next month as leader of the Liberal Democratic Party (LDP). Mr Koizumi’s approval ratings in the country at large are a respectable 50%, but it is the party, not the public, that will vote on September 20th. Mr Koizumi wants to retain his popularity with the people while also mending fences with rival party factions. He may not be able to do both.

One point of contention is spending on “public works”. In its efforts to stimulate the economy, Japan has run up a public debt of 140% of GDP with little to show for it. Mr Koizumi has promised to restrain this spending. One of his potential rivals for the LDP leadership, Shizuka Kamei, wants to keep the gold-plated taps running. But outlays on infrastructure suffer from diminishing returns. Keynes, again, recognised the problem: “Two pyramids, two masses for the dead, are twice as good as one; but not so two railways from London to York.” Japan now has three bridges to Shikoku (to cite a favourite example of Robert Alan Feldman at Morgan Stanley). Mr Koizumi thinks this enough. Mr Kamei, it seems, would build a fourth.

In truth, neither Mr Koizumi nor Mr Kamei offers a convincing way out of Japan’s fiscal-policy dilemma. Japan’s debt is worryingly high, and to keep adding to it by splurging on public works of questionable value may be counter-productive. More spending means higher debt. If Japanese households expect future taxes to rise to service that debt, they will save more, neutralising any fiscal stimulus. But fiscal retrenchment might also backfire. One of Mr Koizumi’s predecessors helped to kill off a fledgling recovery in 1997 with an ill-timed hike in the consumption tax. Adam Posen, an economist at the Institute for International Economics in Washington, reckons that Japan’s public debt has grown mainly because of falling revenues, not higher spending. Anything that jeopardises the present recovery will also jeopardise the public finances.

Japan needs a more creative approach to fiscal policy. Several economists have suggested cutting the consumption tax now while promising to raise it steeply in the future. That would encourage consumers to spend now, while also reassuring them that Japan’s public finances will be repaired in due course. Alternatively, Mr Koizumi needs to persuade Toshihiko Fukui, governor of the Bank of Japan, to finance tax cuts directly by printing money.

Mr Koizumi and Mr Fukui cannot rely on the fragile recovery to do their work for them. The danger is that a few bits of good economic news will make the case for decisive and creative policy less pressing. But without a sustained fiscal and monetary push, the recovery is likely to fizzle out as quickly as the recoveries of 1996-7 and 2000. Japan’s “lost decade” might yet stretch into a lost generation.

As in most regimes built on crony capitalism, the two have become indistinguishable.

Buttonwood

The price of uncertainty

But it has been replaced by a related and equally interesting paradox. The sharp rise in the yields of Treasuries seems to have had no effect whatsoever on equities. Or to put it another way: the rise in the volatility of long-term interest rates to record levels, and almost twice their normal rate, has left the stockmarket completely unmoved. The Chicago Board Option Exchange’s VIX, an index of volatility on the S&P 100 stockmarket index, closed yesterday at 19.28%—right at the bottom of its trading range of the past few years, the merest sniff above its recent low in July 1999, and less than half the 50% that it reached in August last year.

This is odd, to put it mildly. Normally, high interest-rate volatility leads to high equity volatility (though not necessarily the other way round, because when equities are having a tough time, investors flock to Treasuries, which tends to depress volatility). There are good reasons for this: think of the effects volatile interest rates have on borrowing; on planning; on equity-valuation models that plug in interest rates; and on banks’ risk-management models, which force them to dump positions—wherever they may be—when losses mount and volatility rises in one part of their trading business. Oh, and then there are the systemic concerns and rumours about this or that investment bank or hedge fund getting into trouble when markets move sharply. In recent years the VIX, widely used as a proxy for systemic concerns, has spiked sharply at such times. This time, it has fallen.

Perhaps the Treasury market is now at one with the equity market: higher rates simply reflect a healing economy and higher demand for capital. On this view, as the economy recovers—and the evidence that it is enjoying at least a short-term fillip grows by the week—so the demand for capital and its price (interest rates) rises. But this does not ring true. American companies still have a lot of excess capacity at home, and thus demand for money for new investment is still weak. And it also neglects the extent to which the equity and bond markets seem to be ignoring each other. If history is any guide, there should have been at least some systemic flutters, if for no other reason than it is highly likely that a big institution somewhere has lost bags of money, and because the mortgage-backed securities market has tended to fall apart at such times. It certainly did in 1994.

Or perhaps the equity market has studiously ignored what the bond market has been up to for the good reason that the latter's recent gyrations have been only tangentially connected with what is happening to the real economy and short-term rates. In 1994, the Fed was in the process of doubling interest rates; this time, whatever your view about its communication skills (and there are many bond traders who might wish they were better), it has hinted repeatedly that it will leave rates at 1% for a long time to come.

Long-term rates have perhaps been having a wild time over the past few months for other reasons. In May, foreign central banks, especially those from Asia, bought more than $100 billion of Treasuries, largely to stop their currencies appreciating against the dollar. All that new money pushed down yields. Of late, demand from those same central banks has all but evaporated. Then there are the activities of Fannie Mae and Freddie Mac , the two American government-sponsored mortgage giants, which Buttonwood mused on last week (see article), and whose hedging activities have hugely exacerbated the moves in the Treasury market, both up and down. They have had to sell an awful lot of Treasuries lately to hedge their positions.

The provenance of the biggest players in the Treasury market is important. When bond markets have fallen apart in recent years, with consequent reverberations in the equity market, it has often been because the participants have been leveraged and, more important, marked their positions to the market price. Central banks apart, this time they are only leveraged. Together, banks and Fannie and Freddie own half the mortgage market and do not have to mark their positions to market daily for the benefit of their lenders and regulators. They have thus not had to sell these mortgage portfolios, and the spread of mortgage-backed securities has remained remarkably constant; it is the price of the hedge—Treasuries—that has whipsawed. Whatever their financial position, few seriously think that Fannie and Freddie are likely to go bust, though it still seems odd that almost nobody in the equity market entertains the prospect that they, or anyone else for that matter, might be in trouble.

WHAT is the greatest technological advance of the past 100 years? That was the question considered recently by America's National Academy of Engineering. Some said the light bulb or the television; others the telephone, the computer or perhaps the internet. In fact, the experts picked an achievement without which those other marvels would be useless: North America's power grid.

The academy gushed that “widespread electrification gave us power for our cities, factories, farms, and homes—and forever changed our lives...from street lights to supercomputers, electric power makes our lives safer, healthier, and more convenient.” Try telling that to the millions of people in the north-eastern United States and Canada who were plunged into darkness on August 14th, when the greatest engineering achievement of the 20th century suddenly fell apart.

In what seemed like an instant, street lights, lifts and air conditioners stopped working. As minutes grew to hours, it became clear that this was no blip. In Cleveland, Ohio, the sudden cut shut down pumping stations, leaving many without water. In Manhattan, several million people walked cheek-by-jowl for hours through dark streets and across packed bridges to get home. They were the lucky ones: others had to sleep in railway stations, on office chairs or even on the pavements. The blackout caused Ontario's 12m residents even more grief, for Toronto's subway trains were out of operation for the whole weekend after the blackout.

The good news is that this massive power cut resulted in very few injuries or deaths. If it had happened in winter, or on a much hotter day in summer, it might have been worse. It also did not provoke the sort of bloody rioting and looting that was seen in New York during the blackout of 1977. On the contrary, the much-maligned residents of that city proved—as they had after the attacks of September 11th 2001—to be calm, resourceful, patient and even selfless at times. Yet now that the electricity is back, those let down by the worst power failure in North American history are demanding answers.

This will not be easy, given the complexity of the electrical system. Getting to the bottom of things will require answers to three simple questions. What exactly happened? Why did it happen? And how can it be prevented in future? And answering these questions points to a troubling but inescapable conclusion: unlike other countries that are modernising their power industries successfully, America is muddling along with an approach to electricity reform that is deeply flawed. If future blackouts are to be avoided, it must fix these problems quickly and decisively.

It might sound straightforward to work out what it was that shut down such a large swathe of the North American grid. Indeed, early on, plenty of explanations were touted: lightning strikes, trees bringing down power lines, a fire shutting down a power plant, control-room operators snoozing through alarm bells, even computer-virus attacks. George Bush and other American officials rushed to make clear that this was not a terrorist incident—though some fingers did point north.

That is because few things move more seamlessly between America and Canada than electricity. Ontario is an integral part of the North American power grid (which is subdivided into two main, quasi-independent grids serving the eastern and western halves of the continent, plus a third grid for Texas). When the blackout occurred, American generating stations were supplying about 7% of the electricity in Ontario. In the event, this amicable arrangement gave way to bitter rancour: Canadian officials talked of problems in America, while the Americans blamed Canada.

Actually, nobody had the facts necessary to make any confident claims at all. The leading theory now is that the blackout began with the sudden failure of several transmission lines in Ohio controlled by First Energy. For reasons that are not yet clear, the company was unable to contain the damage or, it is claimed, to warn neighbouring grid operators in time for them to take precautionary action. As a result, a little local difficulty cascaded into a regional problem and ultimately a national crisis, as one part of the grid after another automatically shut down to prevent the permanent damage that might result from a huge and unexpected surge in power.

It could take investigators weeks to finish their technical report on this blackout, but it does not need so long to answer the second question, why it happened. One possible explanation is that this was a freak occurrence; if that were true, there would be no reason to blame anybody and no reason to rethink basic assumptions about grid safety and reliability. If this were merely an electrical version of a storm of the century, it would be foolish to “goldplate” assets to prevent a repeat.

Sadly, the signs are that America's grid was ripe for a blackout. Peter Smits, head of the power-transmission division at ABB, a European engineering giant, insists that “this was not a once-in-100-years event.” He points out that various parts of America's grid have seen smaller blackouts in recent years—something “that would not happen in Germany”. Studies by industry associations, technical experts and America's Energy Department have all highlighted the fragile state of America's grid. Granger Morgan of Carnegie Mellon University goes further, concluding that “this blackout took 50m people by surprise, but for most folks that look at the grid the only surprise is that it didn't happen before.”

The reason that the experts are not surprised is that they have seen the demands placed on America's grid grow rapidly, but have yet to see improvements in infrastructure to meet them (see chart 1). Was a lack of money to blame? After the blackout, several pundits claimed that it would cost $50 billion or more to fix America's grid. Yet although that seems quite a lot, it is not when seen over a 30-year time horizon in an industry that takes $300 billion a year in retail revenues in the United States alone. Transmission costs make up some 7% of the cost of delivered power, while generation makes up perhaps three-quarters. Shortage of money is not the real issue.

Another plausible explanation might be that the necessary technologies are not available. Yet a glance at the more reliable grid in Europe suggests this is not true. So does the fact that much of America's grid uses technology designed in the 1950s and 1960s. In fact, explains ABB's Mr Smits, there are plenty of modern technologies that would greatly improve the reliability of America's grid. He points to the example of high voltage direct-current cables, an innovative means of delivering electricity over long distances. China is using this technology to deliver the power generated at its Three Gorges dam to Shanghai; Brazil uses it to get Amazon power to São Paulo.

Yet consider the travails that ABB has met in America with this technology. The firm completed a project laying high-voltage cable from Connecticut to energy-starved Long Island, New York, a year ago. But objections from greens and bureaucratic delays stopped it from becoming operational. When the lights went out on August 14th, Spencer Abraham, Mr Bush's energy secretary, ordered that the cable be activated immediately. “Without it,” says Mr Smits, “I can say with confidence that Long Island would not have received power on August 15th.” That sorry tale suggests that the real explanation for America's power woes lies in mucky politics.

The way the country has deregulated power has left investors and utilities confused, with little incentive to invest in upgrading transmission. Paul Joskow, an economist at the Massachusetts Institute of Technology, says that “the wrangling between pro- and anti-competition forces, jurisdictional disputes between federal and state policymakers, and plenty of ignorance have led our electric-power system to become stuck somewhere between the old system of regulated monopoly and a new system that relies more on competitive power markets. If we remain stuck here, there will be much more trouble with electricity down the road.”

That grim analysis suggests that the third question—how to prevent future blackouts?—is pressing. And to judge by the sound and fury coming from Washington, Ottawa and New York, politicians and utility bosses are taking it seriously. The North American Electricity Reliability Council, the group responsible for grid reliability, has a big investigation under way. Canada and the United States are co-operating on a joint one. And congressional staffers are tinkering with proposals in the big energy bill that both the House and Senate will take up after the August recess.

In the end, fixing the grid's problems will require Congress to fix America's energy laws in several ways. The most important is to enhance the role of the Federal Energy Regulatory Commission (FERC). America's federal system gives a lot of authority over the transmission and distribution system to states. Mr Joskow insists that the federal government “needs to be given primary regulatory and policy jurisdiction over the high-voltage transmission facilities owned by private, public and cooperative utilities”, just as it has jurisdiction over interstate natural-gas pipelines. He also wants to see the crazy patchwork of local transmission operators consolidated into a few regional organisations.

Although the FERC deserves some blame for snoozing as power marketers such as Enron manipulated the wholesale market for power, it has come roaring back to life under the leadership of Pat Wood. Mr Wood was appointed to the FERC by Mr Bush, whom he got to know when he was the top energy regulator in Texas. He has proposed changes to bolster the FERC and advance deregulation. He has put forward a promising if imperfect plan to clarify aspects of deregulation, and another to force the many grid companies to unite into a few, manageable regional giants. He is right to call for more federal control over power. But the administration is, for the moment, afraid to anger powerful and generous regional utility monopolies.

Asked about objections from states'- rights advocates, he defends his plans thus: “I'm from Texas, a great advocate of states' rights! Even so, I truly believe that more federal control makes sense. After all, if there's any commodity that deserves to be treated as interstate commerce—and therefore under federal jurisdiction—it has to be one that moves across state and even national boundaries at the speed of light.”

That notion also points to the final area of hope for fixing the grid: technology. Once the disincentive to invest is removed, the industry seems sure to see a rash of innovation of the sort seen in telecoms after the break-up of AT&T. In particular, advances seem likely in two areas: upgrading the grid to expand capacity, and bypassing it with micropower plants that generate power close to consumers.

Some worry that expanding the grid's capacity will mean laying more transmission lines. Actually, it need not. Thanks to advances in materials technologies and superconducting cables, more power can be shipped down the same rights of way if decades-old wire is simply replaced. Just as important is sophisticated new communications and monitoring hardware and software that will allow grid controllers to assess flows of power more easily.

Roger Anderson of Columbia University, whose warnings of this summer's impending power crisis went unheeded, hopes to build, with colleagues from Houston's Rice University , the “smart electric grid of the future” in Texas. He is not alone. T.J. Glauthier of E2I, a group affiliated with the Electric Power Research Institute (the research arm of the American power industry), wonders if the blackout could have been averted had First Energy had at its disposal powerful tools to analyse the grid's problems in real time. His group is working with Lucent and GE to develop the “open architecture for a self-healing, intelligent grid” equipped with microprocessors and sophisticated software for communications and control.

E2I and EPRI are also working with United Technologies to develop “plug and play” software that could make it as easy to connect a micropower plant to the grid as it is to connect a printer to a computer. That would do much to boost the fortunes of small, super-clean generators such as fuel cells and microturbines. Researchers at Carnegie Mellon have run elaborate simulations and tests, and have concluded that a system with more distributed generation would be more robust than today's grid.

If that sounds far-fetched, consider one last question: where was the safest place in New York during the worst blackout in American history? It may have been the middle of Central Park. That is because the police station in the park uses fuel cells. With the rest of the city in darkness, super-clean “micropower” plants carried on unaffected: New York's finest had all the power and light they needed. If only 1,000 such flowers were allowed to bloom, the world might shed a grid conceived long ago in favour of an energy internet worthy of the 21st century.

IT IS, both literally and figuratively, a big deal. The ¥260 billion ($2.2 billion) leveraged-buyout (LBO) of Japan Telecom's fixed-line business by Ripplewood Holdings, announced on August 21st, is the biggest purchase yet by a private-equity fund in Japan. Such funds have been making inroads in Japan over the past few years and Ripplewood, an American firm, has been the keenest buyer of Japanese businesses. But the nature of this deal differs sharply from the LBOs that made headlines in America during the 1980s. This LBO shows that, far from being a barbarian banging threateningly on Japan's gates, Ripplewood is already inside them—and increasingly welcome to roam about.

That Japan Telecom is already owned by another foreign investor, Britain's Vodafone, has no doubt helped to muffle nationalist complaints about the deal. It would be a mistake, however, to assume that no local interests will be threatened by the transaction. If it succeeds with its business plan, Ripplewood will turn Japan's third-biggest fixed-line operator into a tougher competitor to NTT, the former state telecoms monopoly, which still packs a political punch. Yet since Ripplewood plans to achieve this by finding new revenue sources and building up the business—Vodafone, which will keep Japan Telecom's mobile business, has already made most of the potential fixed-line cost savings—it would be hard for local critics of the deal to make nasty labels stick.

Moreover, despite being skewered in the local press after its first few acquisitions, Ripplewood seems to be winning the support of important decision-makers in Japan. The financing of this week's deal is a good sign. Japan's four biggest banks are joining half a dozen foreign institutions to provide most of the loans. High fees are not their only reason to be involved. Ripplewood is one of the few outfits in Japan that has shown a knack for deploying capital wisely. More importantly, this being Japan, it has also made itself a socially acceptable business partner by showing that it is more interested in building businesses up than in tearing them apart to sell piecemeal.

Ripplewood took some heat as one of the buyers of a troubled nationalised bank in 2000 (since renamed Shinsei Bank), and proceeded to get tough on unprofitable borrowers. But many of its successes came from adding to the Japanese businesses it bought. After acquiring Denon, which makes high-end audio electronics, it expanded the business dramatically, first merging it with Marantz, another firm owned by Philips, a big Dutch firm, then adding several foreign consumer-electronics firms to the newly formed D&M stable. It took a similar tack after buying Niles Parts, which makes car switches and sensors, acquiring a low-end American switchmaker to help expand the business.

Although it has often had to cut labour costs, Ripplewood has also tapped its Japanese businesses' labour groups for ideas about better growth strategies. Tim Collins, Ripplewood's chief executive, praises the labour groups he has worked with as “having a more enlightened sense of self-interest than most managers, anywhere in the world”. If it avoids big labour showdowns, Ripplewood can expect a growing number of Japanese executives—a socially cautious breed—to feel relaxed about selling their businesses to it. If so, this week's big deal will not be the last.

US industrial production perks up

Mark Tran
Friday August 15, 2003

The US economy showed glimmers of revival as industrial production jumped in July, the Federal Reserve reported today.

Production at US factories, mines and utilities increased 0.5% last month, the biggest gain this year, after being unchanged in June. The proportion of industrial capacity in use rose to 74.5% from June's 74.2%.

The rise in industrial production for June was more than double the 0.2% increase forecast by economists and followed other signs of a pickup in economic activity.

Business investment has perked up with the commerce department last month reporting that purchases of equipment and software rose at a 7.5% annual rate from April to June, the biggest quarterly increase in three years.

Earlier this week, the Federal Reserve pledged to keep rates at a historical low of 1% as long as needed in order to boost growth. The US economy grew at a surprisingly strong 2.4% in the second quarter - thanks mainly to a huge rise in defence spending - and analysts have pencilled in growth of 3.6% for the second half of this year.

The US, the world's largest economy, came out of recession in November 2001, but recovery has been patchy with growth not robust enough to absorb new workers coming on to the market. In fact, the private sector has lost 2.5 million jobs in the past two years and the unemployment rate remains stuck above 6%.

Despite recent gains in industrial production, the industrial output index is still at 109.7 (with the 1997 level being equal to 100) and is 1.4% lower than a year ago. Industrial capacity in use - at 74.5% - is still 6.8% below the 1972-2002 average.

Businesses are still reluctant to start hiring until they see an improvement in profits and are convinced that recovery has really taken off. The fundamental problem for the US economy remains the legacy of the boom years, with American companies still coming to terms with the amount of overinvestment in the past decade.

The rise in industrial production in June came from gains in cars, electronics and computers, and a jump in demand for utilities. With retail sales showing the biggest gain in four months in July and inventories near record lows compared with sales, companies are having to raise production.

President George Bush has ordered an inquiry into a massive power failure affecting up to 60m North Americans. Whatever the immediate cause, an overloaded transmission system and poor regulation may be the real culprits

SO THIS is what happens when two of the first world’s richest countries suffer a third-world blackout. On Thursday August 14th, a massive power failure switched off lights and shut down factories across a large swathe of the north-eastern United States and southern Canada. The outage affected some of the world’s biggest and busiest cities, including New York, Detroit, Cleveland and Toronto, leaving up to 60m people without electricity, equivalent to the entire population of France or Britain.

So severe was the disruption in New York state that its governor, George Pataki, declared a state of emergency. The centre of New York became gridlocked as traffic signals failed. Confused workers spilled on to the streets, while thousands more were trapped for hours in lifts and hot, crowded subway trains. Hordes of stranded commuters ended up having to spend Thursday night in the city's parks and plazas. Thieves in Brooklyn in New York, and in Canada’s capital, Ottawa, took advantage of the absence of streetlights and burglar alarms, and went on a looting spree. Officials were taken aback by the speed at which the chaos unfolded. The blackout spread in a matter of seconds, tripping circuit breakers installed to protect electrical installations from sudden, potentially damaging power jolts. A nonplussed President George Bush described the incident as a “massive national problem” and promised a full investigation into what caused it.

That is still a matter of some debate. At first, naturally, there were fears of terrorist involvement, but this was quickly ruled out. However, officials were left arguing about what had actually happened. The office of Canada’s prime minister, Jean Chrétien, said that a severe outage at a nuclear-power plant in Pennsylvania may have been the cause. Earlier, American and Canadian officials had said a fire or perhaps lightning had hit a power plant near Niagara Falls in New York state. By Friday morning, investigations were focusing on plants in northern Ohio.

What is clear is that this was the biggest power failure ever to strike North America. In total, more than 20 power plants were temporarily shut down, including nine nuclear reactors in four American states. This makes it even more disruptive than the “Great Blackout of 1965”, which affected about 30m people in America and Canada. That outage was triggered by a single circuit-breaker tripping on one power line, again near Niagara Falls. This overloaded other transmission lines, triggering their circuit-breakers and thereby isolating some power plants, setting off a chain reaction that, within five minutes, had blacked out much of the north-eastern United States and part of the Canadian province of Ontario.

Like Mr Bush, Lyndon Johnson, America’s president at the time of the 1965 blackout, demanded a full investigation. He called in the defence ministry and the Federal Bureau of Investigation to take part in the inquiry. One of its main outcomes was the creation of the North American Electric Reliability Council, a New Jersey-based industry group that works to ensure reliable service on the 500,000 miles of high-voltage power lines across North America. But as demand for electricity has grown, the council has found it increasingly hard to maintain the transmission system. Indeed, industry experts have been warning for some years that it is creaking under the weight of ever-heavier power loads. And the problem continues to get worse: the Electric Power Research Institute, based in Palo Alto, California, estimates that demand for power in America has grown at twice the rate at which transmission capacity has increased in the past decade. The rapid growth of power-thirsty air conditioning systems has played a big part. “We’re a superpower with a third-world grid. We need a new grid,” Bill Richardson, the governor of New Mexico and a former federal energy secretary, told CNN. “The problem is that nobody is building enough transmission capacity.”

But there are obstacles in the way of building new capacity. Attempts to upgrade the electricity system usually face strong opposition in local communities, which want access to all the electricity they can use but are loth to have power plants and transmission towers on their doorstep. Industry watchers say that since the power-transmission business is so tightly regulated, companies do not have enough incentive to invest in beefing up the network. As with California’s energy crisis in 2000-01, poor regulation of the energy market is likely to be among the underlying causes of the latest east-coast blackout.

Plenty of companies outside the power industry will also have something to say about the blackout. On Friday morning, oil prices rose on fears that the temporary closure of refineries would lead to fuel shortages. Late trading on America’s financial markets on Thursday was hit by the outages, which shut dealing rooms across the region. But the New York Stock Exchange and Nasdaq opened on Friday morning as usual, and most big Wall Street firms said contingency plans were working well and emergency power generators were running smoothly (though many bankers and brokers could not get into work). Seven big airports were affected for several hours and hundreds of flights delayed or cancelled. By Friday morning, though, the Federal Aviation Administration had lifted its temporary ban on flights into New York and some Canadian airports.

With Detroit losing power, the heart of North America’s car industry was caught in the blackout. At one point, 23 of Ford’s 44 North American plants were down, and nine of DaimlerChrysler’s 13 vehicle-assembly plants. Some of these were planning to reopen on Friday, while others may have to stay shut until the weekend or Monday. It is not yet clear how much this will cost the industry. An unplanned plant shutdown can hit profits directly, since some carmakers book revenues when a vehicle is built, although short interruptions can usually be made up through overtime.

North America’s electricity systems are more closely interconnected than they were when the 1965 blackout struck. Most of the vast area between the Atlantic and the Rocky Mountains is now plugged together in one massive electricity grid, with thousands of generating plants pumping energy in and hundreds of millions of electricity users drawing it out: the grid has been called “the biggest machine in the world”. When it works, this hugely complex contraption is highly economic because, at any given moment, the demand for electricity can be matched with the cheapest set of power sources available at that time across the entire region. But when this monster machine malfunctions, as tens of millions of North Americans have just found out, the consequences can be spectacular.

Europe and America have presented a plan on agriculture, the main sticking point in the Doha trade talks. But other members of the World Trade Organisation are unimpressed

LATE on Tuesday night, bleary-eyed trade negotiators from the European Union and the United States claimed to have sealed a pact for reforming agricultural trade. Not before time. The World Trade Organisation meets in Cancún, Mexico in less than four weeks to try and salvage the Doha round of world trade talks. Failure to reach a deal on farm subsidies and Doha would be done for.

Trade theory is elegant; trade negotiations are not. Any issue that cannot be resolved can always be obscured. But the text of this latest deal is a classic of the genre, full of fuzzy language, fussy jargon and fudged commitments. It calls for reforms, cuts and caps without putting figures on almost any of them.

Take the contentious issue of subsidising exports, for example. The text offers a commitment to eliminate subsidies, over time, on those products of “particular interest” to poor countries. Which products, exactly? It doesn’t say. And how long before the subsidies are eliminated? Again, we are left to fill in the blanks ourselves. All that can be known from the text is that export credits, which America favours, will be phased out just as quickly (or slowly) as the export subsidies the EU so cherishes.

The pact’s “commitments” on import tariffs are even more opaque. The EU and America will try to improve access to their markets in not one but three different ways, blending these measures by some secret formula they do not see fit to divulge. Some tariffs will be cut, although the pact does not say by how much. Some product lines will even be duty-free. Still others will be “subject to a Swiss formula coefficient”. That’s clear then.

Besides promoting exports and discouraging imports, the EU and America also spend a lot of money supporting their farmers, either by keeping their prices artificially high or by giving them money directly, based on such things as the number of livestock they keep or acres they reap. Tuesday's pact acknowledges that these “domestic support” measures do in fact distort trade. It promises to reduce the measures that most distort trade and to put a cap on direct payments to producers. This time the agreement even provides a number: spending on direct payments will be limited to 5% of the value of agricultural production.

This pact is not so much a trade deal as it is a signal that the EU and the United States are not yet willing to give up on the Doha round. After the American farm bill last year, and the EU’s anaemic efforts to reform its common agricultural policy, the Doha round had looked set to fail. Don’t cancel your tickets to Cancún just yet, is the unstated but substantive message of this pact.

Even the EU ambassador to the WTO admitted it was only an “agreement in principle”. An agreement in practice still looks a long way off. The 15 member states of the EU have yet to approve the text’s words, even without any numbers. Oh, and the other 130 members of the WTO will have a thing or two to say as well.

The transatlantic deal “will be good for Cancún,” one EU official told Reuters, “but it will probably infuriate the Cairns Group.” Right on cue, a spokesman for the group, which includes big agricultural exporters such as Brazil, Canada and Australia, complained that the proposals were both inadequate and vague. The passage promising to cut export subsidies, for example, could mean everything or nothing to a country like Brazil. It all depends on whether products like sugar, soya and cotton are included on the list. India (not a member of the Cairns Group but an influential player nonetheless) has already seen enough of the deal to dismiss it as “not feasible”.

The original January 2005 deadline for completing the Doha round will almost certainly be missed. But the Indians, and other hold-outs, may still be talked round eventually. Some commentators talk of completing a deal by 2007. Let's hope so. That is the year that the American president's “fast track” trade negotiating authority expires. If it is not renewed, any deal he makes can be amended by Congress. If persuading the 15 members of the EU is going to be difficult, and winning agreement among all 147 members of the WTO still harder, then persuading the 535 members of Congress to keep their hands off a trade bill will be all but impossible.

America, it is said, is the world's latest imperial power. Don't believe it

WHAT is the shelf-life of an idea? Just a few short months ago, the talk—and not just in Washington, DC—was of empire, America's that is. Even before the invasion of Iraq, pundits of all stripes were casting aside their coyness to proclaim that America was the latest imperial power to bestride the world. Today, with tribulations besetting the new Romans in both Afghanistan and Iraq, their most recent conquests, the chorus has died down, but the idea is far from dead. Too many people have invested too much in it.

For several years, after all, commentators have been announcing the discovery of an American empire. Books and articles have poured forth, professors and pundits have pondered the implications— and a surprising number have welcomed the new role. “No need to run away from the label,” argues Max Boot, a fellow at the Council on Foreign Relations in New York: “America's destiny is to police the world.”

Behind the claim lies a conjunction of circumstances. First is the sheer scale of America's power. While the sole superpower remains more than ready to put its technological prowess to military use, its western allies, wearied by centuries of fighting, have been quick to cash in their post-cold-war peace dividends and turn to more pacific pursuits. Russia is diminished. China still lags behind. America's pre-eminence in the skies, at sea and on land is thus unchallenged. In terms of both brute force and gee-whizz gadgetry, it leaves even its nearest competitors standing, or rather quaking.

Matching this military might, runs the argument, is an unrivalled degree of economic power. Throw together all the output from Hollywood and Silicon Valley to Wall Street and Tin Pan Alley, and you have a commercial empire that would have been the envy of the British East India Company or Cecil Rhodes. And with “hard” power and “soft” power combined, you have influence on a scale never seen before. The polite term for it is hegemony, but in reality, as Mr Boot says, it is Globocop. What other country divides the world up into five military commands with four-star generals to match, keeps several hundred thousand of its legionaries on active duty in 137 countries—and is now unafraid to use them? For, stung by the events of September 11th, America is no longer shy about spilling blood, even its own. Weren't the Afghan and Iraqi wars largely designed to show just that?

To power and global reach can therefore be added another imperial characteristic: an actual desire to sally forth and act. Even before Americans were attacked on September 11th 2001, influential voices were calling for a more activist foreign policy. Some were what Ivo Daalder, a fellow at the Brookings Institution in Washington, DC, calls “assertive nationalists”, some were “democratic imperialists”. Both groups were impatient with the constraints imposed by treaties, multilateral action and America's membership of international clubs like the UN. Both wanted to see America hit back when attacked. Both thought the Clinton administration had been timid, if not craven, in defence of American interests.

If, before September 11th, George Bush belonged to either of these groups, it was to the assertive nationalists—along with men like Dick Cheney, his vice-president, and Donald Rumsfeld, his secretary of defence. The president's instincts were to take robust action if necessary, but to avoid foreign entanglements. In particular, even as a candidate, he had been hostile to the idea of “nation-building” (correctly, state-building) abroad, an ambition more closely identified with the democratic imperialists, also known as neoconservatives. Later, though, Mr Bush started to come round to that idea. September 11th, he was to say a year after the event, “taught us that weak states, like Afghanistan, can pose as great a danger to our national interests as strong states.” Accordingly, “We will extend the peace by encouraging free and open societies on every continent.”

So there it is. The American empire passes the duck test: it not only looks like a duck and walks like a duck, it also quacks like a duck. And, unfashionable as the idea may seem, it has been given a remarkably warm reception. Even non-Americans seem well-disposed. Over a year ago Robert Cooper, a British diplomat, called for “a new kind of imperialism”, albeit one that would be provided by the “post-modern European Union”. Michael Ignatieff, a Canadian now at Harvard, has also been ready to argue that “imperialism doesn't stop being necessary just because it is politically incorrect,” though not for him another European imperium. Doubtful as he is about the enterprise, he can see no alternative to American leadership.

Many like Mr Ignatieff are ready to lend support to the idea of an American empire, moved by a desire to bring people living in failed states out of their disorder and misery, and believing that only America can run such an empire. Others are more concerned to deny terrorists a base from which to launch attacks on what was once the inviolable fortress of the West. All take succour from recent, generally favourable reassessments of the British empire, notably the one offered in a book (and television series) by Niall Ferguson, a Scottish historian now at New York University. “What the British empire proved”, writes Mr Ferguson, “is that empire is a form of international government that can work—and not just for the benefit of the ruling power.” The British empire, he suggests, “though not without blemish”, may have been the least bloody path to modernity for its subjects.

Such thoughts are still too controversial for senior members of the Bush administration to utter aloud. “We don't seek an empire,” avers Mr Bush himself. “Our nation is committed to freedom for ourselves and for others.” With equal vigour, Mr Rumsfeld insists: “We're not imperialistic.” But after one regime-changing war in Afghanistan and another in Iraq, the administration seems to be gathering the wool of empire, and doing so with a civilising mission that sounds pretty imperial.

If Mr Bush does not state the aims explicitly, the neocons feel no such embarrassment. For them, Afghanistan and Iraq are just the start. The transformation of the entire Middle East—Iran, Syria, Saudi Arabia, the lot—must now ensue. In logic, once that is democratised under American tutelage, other regions will have to follow. The United States has long felt free to intervene in Latin America; even before September 11th it was being drawn into Colombia. The Balkans, after a more direct intervention, are benefiting from even starker American supervision (or indirect rule, to use the imperial term, via the EU and UN). Can parts of Asia and Africa be far behind?

Perhaps they can. It depends, of course, on what is meant by empire, and therefore on what counts as a constituent part. In one sense, America has had an empire for years. In pursuit of its “manifest destiny”, which would have been called Lebensraum (room to grow in) in 1930s Germany, 19th-century American expansionists laid claim to most of their continent. Some parts, such as Alaska and the huge swathe of land between the Rockies and the Mississippi that came with the Louisiana Purchase, were bought. Others were acquired more traditionally: California, Nevada, Utah, New Mexico, Arizona and parts of Colorado and Wyoming all fell into America's lap at the end of the 1846-48 war that President James Polk had baited Mexico into fighting, chiefly to obtain California.

A second imperial phase came after the Spanish-American war of 1898. This “splendid little war”, in the words of the secretary of state, John Hay, delivered Cuba, Puerto Rico, Guam and the Philippines. The expansionist impulse continued under Teddy Roosevelt, whose big stick (carry one, while talking softly, he advised) and amendments to the Monroe Doctrine (his corollary proclaimed the United States' right to intervene anywhere in Latin America to prevent the Europeans doing so) have helped to make him a hero in today's Washington. A man of pre-emptive action—grab Hawaii, or see it threaten America's west coast, he argued—Roosevelt is Mr Bush's favourite president, and hugely admired by Mr Rumsfeld too.

But soon America was drawing back, first under Roosevelt himself and then under Woodrow Wilson, whose “14 points” set out an idealistic programme for a just peace after the first world war, based on collective security and national self-determination. Yet by the end of the next world war, America, the only country to emerge unambiguously strengthened, had entered a third imperial phase. It was formally in occupation in West Germany and Japan, and it was the de facto power in a variety of places from Dutch Indonesia to the Belgian Congo, from most of Latin America to much of Indochina.

If these earlier imperiums were empires, then perhaps America has indeed acquired a new one. But if the imperial attribution is to mean anything, an empire has to have at least two characteristics besides those of huge might and a willingness to use it. An empire must also be a hierarchical system, in which ultimate control resides at the centre, in this case Washington, DC, and all the colonies, client states, satrapies, sepoys, slaves and helots must understand that. And it must be enduring. True, territories can be acquired one by one for a series of different reasons, as Britain's first colonies were. But, as Adam Smith said, “every empire aims at immortality.” In other words, running colonies collectively as an empire requires the intention of either continuous control or, more likely, some sort of transformation, which is where state-building comes in, ideally laced with a bit of missionary zeal. The thrills of empire are not those of the one-night stand.

In short, the empire now proclaimed in America's name is at best a dull duck, at worst a dead duck, unless it is to be a big strong drake that intends to throw its weight around for quite a while. And this in turn raises two difficulties for the concept of a new American empire. One is that the subjects won't like it. The other is that Americans won't either.

For the truth of the first proposition, take a look at Iraq. Four months after the fall of Baghdad, America still faces what one of its own top generals has called “war, however you describe it”. Even at the outset, the happy natives failed to greet their liberators quite as joyfully as some had so obviously hoped. Yes, Saddam Hussein was loathed; no, the Iraqis would not die for him in any numbers; but now, please leave us to get on with our own affairs. No matter that the Iraqis are in no position to run their own affairs. They still do not want their country run for them. Resistance is encouraged by the emperor's failure to fix the plumbing, stop the looting and get the lights back on, never mind the constant indignities that go with running an empire: arrests, roadblocks and house-to-house searches that offend the modesty of devout Muslim women. The combination of cock-up and hostility has not only cost the new administration its first boss, Jay Garner. It has also led America to reverse its plans to start cutting the number of its occupying troops. A constitution and free elections are promised for next year, but the progress towards democracy has been much slower than was at first hoped.

Just a few teething troubles? Up to a point, certainly. But Afghanistan, too, suggests that the imperial role is neither popular nor easy. Nearly two years after a singularly successful toppling of the Taliban, the country is still largely in the hands of warlords of dubious allegiance, each with his own militia (see article). They pay nominal obeisance to the proconsul, President Hamid Karzai, but pay him his dues either grudgingly or not at all, preferring to keep the revenues they collect for their own militias. The 5,000 or so peacekeepers, the emperor's proxy army, scarcely dare leave the capital, Kabul, though they are now under NATO command. In the provinces, meanwhile, anything may be going on. The UN has just said that it is suspending work in the south after a series of attacks, and the Taliban are talking of new offensives in the north.

All this is grist to the mill of the true believers in America's imperial mission. It just goes to show that an early exit after a quick war solves nothing. If the peace is to endure, if the rule of law is to be established, if democratic institutions are to take root, you had better be prepared for a lengthy undertaking, with men, money and limitless patience. Such has been the lesson of Bosnia, Kosovo and Northern Ireland—a lesson yet to be learnt perhaps in Congo, Sierra Leone and countless other hell-holes less pressing on the western conscience. The neo-imperialists have logic on their side when they argue that regime change alone is not enough, and, to their credit, they say they are ready for the long haul. Mr Boot, one of their foremost advocates, believes America is too. The price is affordable, he argues, and, in its containment of the Soviet Union and other policies, America has shown it can sustain a commitment over long decades.

It is a beguiling argument. But a contradiction lies at the heart of the imperialists' concept. Imperialism and democracy are at odds with each other. The one implies hierarchy and subordination, the other equality and freedom of choice. People nowadays are not willing to bow down before an emperor, even a benevolent one, in order to be democratised. They will protest, and the ensuing pain will be felt by the imperial power as well as by its subjects. For Americans, the pain will not be just a matter of budget deficits and body bags; it will also be a blow to the very heart of what makes them American—their constitutional belief in freedom. Freedom is in their blood; it is integral to their sense of themselves. It binds them together as nothing else does, neither ethnicity, nor religion, nor language. And it is rooted in hostility to imperialism—the imperial rule of George III. Americans know that empires lack democratic legitimacy. Indeed, they once had a tea party to prove it.

Some imperialists may be untroubled by such thoughts. Throughout their imperial history, the British, a rather steak-and-kidney sort of people, not much interested in constitutional concepts, would generally fight to defend their own freedom but did not feel obliged to introduce it in their colonies so long as democracy was in prospect for their subjects one distant day. They were helped in this happy procrastination by powerful practical interests (they exported both settlers and capital to their colonies), by a degree of racism, and by a sustained sense of semi-religious mission. And despite the many hardships, those who ran it also had fun with their empire (lots of dressing up with funny hats, playing polo and shooting tigers); and it was a commercial enterprise (“Trade follows the flag,” noted Rhodes).

Little, if any of this applies to Americans. The neocons may have the missionary zeal, but even this is likely to pall in the face of setbacks. There is certainly no zeal to bear the financial burden: Mr Bush's latest budget was drawn up without any money at all for Afghanistan, and the costs are rising in Iraq (to nearly $4 billion a month, just for the soldiery), even as Mr Rumsfeld says more troops may be needed. Unlike most empires of old, the United States is an importer, these days, both of capital and of migrants.

America has changed since September 11th. The new mood allows for more nationalism, more assertiveness, less patience with allies, a greater readiness to go it alone. But there is no appetite to spend a lifetime in a sweaty country in the service of a noble cause. The memories of Vietnam, where every effort to withdraw or hand over to the locals seemed to lead to further entanglement, have not departed. And though the rhetorical heat may now be turned on Iran and Syria, Mr Rumsfeld and his fellow fire-eaters know full well that Americans are not ready for another invasion. Even if, hallelujah, regime change in such countries could be effected peacefully, would the United States really be prepared to shoulder the white man's burden across the Middle East?

It is unlikely, to say the least; the imperial idea is a big exaggeration, like previous fads. It was fashionable, after all, to declare history at a close not so long ago. The new battlegrounds would be markets, said some pundits. Commerce, ideas and information were the weapons of the modern world; military might was for the pterodactyls. To be sure, America is now going through an imperial phase, but this one has more in common with its earlier imperial phases than with the imperial eras of Britain, Byzantium or Rome. If the assertive nationalists and the democratic imperialists have come together over Iraq, that does not mean the administration has signed up for the entire neocon agenda. And as for the foreign-policy pundits, in time they will move on to a new idea.

That does not mean Mr Bush is wrong to think that democracy is the best hope for the world, though it will surely have to take different forms in different places. He is right. But he is also right in disavowing any imperial intentions. America will have to promote its aims some other way, probably by leading multilateral action. Empire is simply not the American way. If the United States has to intervene in places like Afghanistan and Iraq, and then stay on, it will not enjoy the experience. Running the place, it will discover, is nasty and brutish, so it had better also be short. Good or bad, that is not what most people mean by an imperium.

THE bond market has had a torrid time of it while Buttonwood was sunning himself in Sark, a small island in the English Channel with no cars but two banks. In his absence, the yield on ten-year Treasuries popped up to almost 4.5%—some 140 basis points (bps, or hundredths of a percentage point) above their lows in June. This move has been both big and fast: bigger and faster, indeed, than the infamous rout in early 1994, when the market took twice as long to fall a similar amount. The market recovered a bit last week, but was still decidedly nervous even after the Federal Reserve left rates unchanged on Tuesday August 12th. Treasury yields are more volatile than they have ever been.

This is a bit odd in some ways, since nobody expected the Fed to do anything anyway, and very few (the Fed included) entertain the prospect of its putting up short-term rates from their present 1% for the foreseeable future. In 1994, the economy was motoring and the Fed ended up doubling rates, to 6%. This time, the recovery, if any, will be weak. Inflation is not a problem, though deflation still might be. Perhaps bond yields had fallen a bit rapidly at the beginning of June and deflationary fears were overdone. Since then, the evidence has mounted that the economy is recovering somewhat. But real yields—ie, taking prospective inflation into account—were not particularly low at the beginning of June and by historical standards are now decidedly fetching.

What, then, has turned a small correction into a sharp sell-off? The biggest cause seems to have been the hedging activities of holders of mortgage-backed securities (securitised bundles of mortgages, which this column warned about a few weeks ago, see article). In particular, this means the activities of Fannie Mae and Freddie Mac , two quasi-government-guaranteed agencies which are the biggest holders of mortgage-backed securities, a bigger market now than the Treasury market. When Treasury yields fall, the duration of mortgage-backed portfolios also falls because homeowners swap old mortgages for new, cheaper ones. To hedge against this, fund managers buy Treasuries. Conversely, when yields rise, they sell Treasuries. As in 1994, this recently turned into a vicious circle of rising yields and more hedging.

Further evidence that the mortgage giants were mostly responsible for the sharp rise in yields can be found in the interest-rate swaps market. Swap-market participants exchange fixed rates for floating ones. If more people want to pay a fixed rate in exchange for a floating rate than want to receive a fixed rate, the swap spread—the fixed interest—rises compared with Treasury yields. And paying or receiving fixed in the swaps market is another much-used tool with which the two agencies hedge their mortgage portfolios. In 1994, the swap spread rose to a then record level of 116bps. This time, too, it rose dramatically. At one point, the ten-year swap spread reached 71.5bps, though it has fallen sharply since then.

If Treasury yields rise further, mortgage hedgers will exacerbate the trend. Also adding to volatility in Treasuries are banks, which have increasingly substituted Treasuries for corporate loans as loan growth has slowed. Since they are leveraged institutions (they have a small amount of capital backing lots of assets), with nowadays more or less mechanical risk-management systems that in effect force them to sell when losses mount, this probably also increases volatility.

But the recent turmoil notwithstanding, the outlook for Treasuries remains good. The strategists at CSFB, who think that Treasury yields could fall to 2-2.5% over the next couple of years, recently wrote a research note which explains why and which rubbishes the notion that low Treasury yields earlier this year were evidence of another bubble. Put simply, after an equity bubble bursts, it takes years, decades even, for investment, inflation and risk appetite to recover. All of which is ample reason for bond yields to fall a lot and means that they have further to fall.

In bubbles investors lose a shedload, not just a lot: look, for example at the losses borne by investors after the 1929 crash in America or the recent Japanese experience. The chances of bond investors losing anything like that are very slim. Bond investors have lost comparable sums only as a result of big wars or big inflations or both (such as during and after the first world war, or between the second world war and 1981, when real bond returns fell by 66%). The only time when cyclical recoveries have produced low returns has been when nominal bond yields were even lower than they fell in June. In comparison with the past couple of hundred years, when bond yields were 3-6%, present bond yields look cheap.

The economic environment after the popping of an equity bubble makes them doubly so. The experience of Japan since 1990 suggests that short-term rates can stay very low for much longer than people expect. In Japan, as elsewhere, the downward trend in bond yields has been punctuated by savage though short-lived sell-offs (indeed, the path of bond yields in Japan since 1990 and America since 2000 looks eerily similar). In America in the 1930s, Treasury bills yielded less than 0.5% for most of the decade, yet America’s economic rebound over that period was one of the strongest-ever peacetime expansions—and Treasury yields drifted lower.

The US is starting a nuclear fight that will be hard to stop

The hawks are gunning for a showdown with North Korea and Iran

Simon Tisdall
Saturday August 9, 2003
The Guardian

John Bolton might be termed an old hand. The US under-secretary of state for arms control and international security, a Yale-educated lawyer, has held a string of senior posts in the state and justice departments. By any yardstick, he is an experienced if conservative-minded diplomat of some gravitas who, it must be assumed, knows what he is doing. But according to an official North Korean statement this week, Bolton is "human scum".

Even by Pyongyang's astringent rhetorical standards, this is strong stuff. It constituted a reply in kind to a stunningly splenetic tirade delivered by Bolton in Seoul three days earlier that amounted to a fierce, personal attack on Kim Jong-il.

North Korea's leader was a tyrannical despot and extortionist who "lives like royalty", Bolton said, while hundreds of thousands of his people were locked up and millions more endured a life of "hellish nightmare... scrounging the ground for food in abject poverty". For good measure, Bolton also attacked the UN for not facing up to its responsibilities - a familiar theme for students of the Iraq crisis.

The curious thing about this exchange is not so much its intensity as its timing. Bolton went nuclear, verbally speaking, only hours before North Korea finally acceded to longstanding US demands for multilateral talks on its nuclear arms ambitions. South Korean officials were relieved that the North had not used Bolton's broadside as an excuse for further prevarication. But like the rest of us, they were left wondering whether Bolton had launched a deliberate pre-emptive strike against the nascent diplomatic process.

This raises a key question, as America's twin confrontations with North Korea and Iran over nuclear arms accelerate towards a crunch in the next few weeks. In a nutshell, peaceful, internationally supportable, diplomatic solutions to both disputes are available. Their outlines may be clearly discerned; the mechanisms by which they can be achieved are more or less in place. But does the US actually want to cut a deal?

The ambiguities clouding US policy towards North Korea date back to the early days of the administration, when George Bush put a damper on former South Korean president Kim Dae-jung's "sunshine policy" of detente with the North. Since 9/11 and Bush's "axis of evil" speech, matters have just gone from bad to worse.

The planned talks in China, also involving South Korea, Japan and Russia, are viewed in the region and beyond as a crucial opportunity to arrest this apparently inexorable downward spiral. The UN secretary-general, Kofi Annan, and others have suggested that North Korea might initially freeze its nuclear arms programmes in return for a sort of US non-aggression pact.

But such compromises may not suit the likes of Bolton, Paul Wolfowitz and Douglas Feith at the Pentagon, and other hardliners, including perhaps Bush himself - who has professed personal loathing for Pyongyang's communist leader. For them, it seems, nothing less than Kim's overthrow will ultimately suffice, although it may have to wait until a second Bush term.

A former US envoy, James Goodby, warns that Washington must beware of over-reaching itself. "Many in the Bush administration want regime change in North Korea and think that slow strangulation might do it," Goodby wrote in the New York Times. But security assurances and economic incentives were what was really needed. "Improving the lot of the North Korean people should be a fundamental aim."

Such common-sense advice risks being drowned out by the beat of Washington's ideological war drums. That discord will strain ties with US regional allies, encourage North Korean paranoia and miscalculation, and could yet shipwreck any talks on a reef of mutual distrust, bad faith and hidden agendas.

As usual, secretary of state Colin Powell takes a softer line, insisting for now at least that the US is not intent on regime change and rejecting Wolfowitz's claim that the North is teetering on the edge of economic collapse.

Such assurances may again strike students of the Iraq crisis as unhappily familiar. Powell is not yet a lame duck but he is definitely limping after the latest spate of speculation that he will quit at the 2004 election. Powell may be getting tired of trying to restrain neo-con knee-jerkers. He surely does not relish four more years of being stabbed in the back.

The strange, treacherous ways of American diplomacy are also complicating that other nuclear stand-off, with Iran. A September deadline now looms, by which time Tehran is told it must accept "challenge" inspections of its nuclear facilities. If not, the US may seek UN sanctions and step up unilateral pressure; military options are not entirely ruled out. Following Washington's line, and egged on by Israel, Tony Blair is turning the screw, too, threatening to block an EU trade deal and highlighting human rights issues.

Like North Korea, the Iranian government is fully aware that US tactics do not stem from worries about WMD proliferation alone. But nor does it totally dismiss western concerns. In fact, Tehran has developed a series of not inflexible negotiating positions. The question, once again, is whether the US is really interested in finding solutions.

On the nuclear issue, Iran might swallow the International Atomic Energy Agency's "additional protocol" if article four of the non-proliferation treaty, entitling it to acquire "equipment, materials and scientific and technological information for the peaceful uses of nuclear energy", were honoured. On the issue of al-Qaida, Iran is ready to surrender suspected members if the US will exchange the Mujahedeen terrorists it is harbouring in Iraq. Even on Palestine, there is just a hint of a future accommodation. Iran says it supports Iraq's new governing council and is not involved in attacks on US troops there (for which the US has indeed produced no evidence). As an earnest of its intentions, it has offered to supply much-needed electricity to Iraq - an offer made three weeks ago and to which it has had no response.

Although, like the Bush administration, Iran speaks with many voices, it knows it must improve relations with the west if it is to succeed in building its economy and if the aspirations of its younger generations are to be met without more trouble on the streets.

But this, of course, is exactly why some in Washington think that by hanging tough and raising the stakes, they can eventually have it all. By continuing and possibly escalating disputes, US hawks hope not merely to tame the mullahs but to topple them.

This is a potentially disastrous miscalculation, a recipe for intensifying internal and external strife. It has little to do with arms control or encouraging civil reform from within, and a lot to do with imposing the US world view from without. This is why Iran's heated debate over UN inspections has acquired a symbolic quality. This is why, as in North Korea, some in Iran oppose anything that smacks of concessions.

They call it a trap. But we should call it Bolton's first law of international power politics: keep the other guy guessing; wear him down. When he gives a little, demand a whole lot more. Then zap him anyway.

America's labour productivity is soaring, but its labour market is stagnant. The economy—“new” or otherwise—is working well below its full potential

WHEN Alan Greenspan hailed America’s productivity miracle in the late 1990s, it raised the happy prospect of growth without inflation. On Thursday August 7th, the Bureau of Labour Statistics offered the latest evidence of America’s productivity revival: output per worker soared by 5.7% in the second quarter, at an annualised rate. Miraculous? Maybe. But the figure has raised the unhappy prospect of growth without job creation.

When productivity grows, the economy is able to produce more with the same number of workers. This raises the potential output of a fully employed economy. Unfortunately, the economy does not always live up to its potential. Surprisingly strong figures for GDP last quarter and for services last month, not to mention rising yields in the bond market, had raised hopes that the economy was returning to form and beginning to punch its weight. But the latest productivity figures show that it is still performing well within itself. There may be more slack in the economy that many commentators, and certainly many bond-market investors, had thought.

If that is true, it may be bad news for the labour market. Higher productivity means that firms can make more stuff without hiring more workers to do it, or the same amount of stuff with fewer workers. Back in the 1960s, Arthur Okun, an American economist, showed that employment would fall, even if the economy were growing, if an “output gap” opens up between actual output and the economy's long-term “potential” output. Okun’s razor appears to be at work in the American economy today, shaving payrolls in the non-farm sector by 44,000 in July.

If demand continues to lag behind productivity, inflation as well as employment might fall again. In a prescient speech last month, Ben Bernanke, a governor at the Federal Reserve, warned that a growing economy might still be vulnerable to disinflation, or even deflation, if the recovery is not strong enough to take up any slack capacity. A predicament of this kind—the mirror image of stagflation—would not be unprecedented. The late 19th century saw over two decades of mild deflation, during which time many economies grew respectably. China routinely combines growth rates of 6% or 7% with near zero inflation.

All of the chatter about America's recovery or relapse should not disguise the more important long-term question: is the much-hyped “new economy” for real? Output has dipped and climbed, but has the trend rate of growth risen? Economists are still far from a consensus. Productivity, wrote Robert Solow, a nobel laureate in economics, is “a remote and slow-moving part of the macroeconomic equation”. Certainly, America’s productivity figures were slow to register any gains from the information technology revolution that so excited equity investors and technophiles in the 1990s. When the productivity figures did pick up in the second half of the 1990s, all of the assorted gurus, bulls and nerds claimed vindication. Even Mr Greenspan became a cheerleader for the new economy, albeit a rather taciturn and oblique one.

The cheers faded as the stockmarket bubble burst and the economy went into recession. But the collapse in share prices does not itself disprove the notion of a new economy. The bears can be right without the nerds being wrong, because technological revolutions do not always pay off for the people who bought stocks in them. The railroad investors of the late 19th century, for example, made no money from their stakes in America’s rail companies, but most agree that the economy as a whole benefited. Productivity gains can be real, without showing up in your dividend payments. The gains might go to workers, in the form of higher wages, or they might show up in the creation of new companies rather than new profits for old companies.

If the bear market and the recession do not refute the productivity optimists, Thursday's productivity announcement does not vindicate them either. Quarterly productivity measurements tend to jump about over the course of the cycle, because employment always lags behind output. Firms are slow to fire workers when sales fall—leading to declines in measured productivity—and they are equally hesitant to hire workers as sales start rising—leading to big gains in productivity at the start of a recovery. As Robert Gordon, a professor at Northwestern University , points out, the recoveries of early 1975, late 1982 and early 1991 were all accompanied by dramatic surges in productivity that quickly petered out over the subsequent two years.

While the academics debate the size of the output gap, both the Fed and the bond markets have to act on it. The latest productivity figures suggest the recovery has some way to go before it brings the economy back to its full potential, stirring inflationary pressures and inviting higher interest rates from the Fed.

THEY could hardly believe it. Five Britons, long imprisoned in Saudi Arabia for their alleged roles in a string of bombings there in 2000 and 2001, were suddenly released and sent home on Friday August 8th. Two of them had been sentenced to death by beheading, while the other rest faced up to 18 years in prison. Up until the moment the Saudi government offered the men “royal clemency”, it had insisted that they were behind the attacks, which, the government said, had been about settling scores in a turf war among expatriate criminals. Despite having confessed on television, the Britons maintained their innocence, saying that the confessions had been coerced.

What prompted this rare show of Saudi magnanimity? The need for a good showing in foreign relations, most likely. In the nearly two years since the September 11th terrorist attacks on New York and Washington, the Saudis’ relations with America and Britain have been turbulent. Fifteen of the 19 hijackers were Saudi nationals. This painful issue has resurfaced of late: last month, a 900-page report on the terror attacks released by America’s Congress in effect accused some of the kingdom’s rulers of funnelling money to Islamist charities that supported the hijackers, as well as providing more direct aid to some of the hijackers themselves. The report’s 28 pages on Saudi Arabia’'s involvement remain classified, but its uncomplimentary conclusions were leaked. The Saudi foreign minister pleaded directly with President George Bush to declassify the information, to allow the government to respond to the charges. Mr Bush, citing security reasons, refused.

By releasing the Britons, the Saudis may hope to show a gentler face to the world. But the kingdom has far to go on this score. Saudi Arabia will be one of the biggest obstacles to America’s apparent determination to bring democracy to the Middle East. The country is an absolute monarchy in which political parties are banned. Nor is there much sign of political or economic reform (despite the creation last month of a Centre for National Dialogue). The current king, Fahd, who acceded to the throne in 1982, heads a council of ministers, but illness has forced him to grant more responsibility to Crown Prince Abdullah bin Abdul-Aziz. Unrest is growing because of the vast economic divide between the country’s 5,000 al-Saud princes and the rest of its 20m people, many of whom are young and face rising unemployment. Despite its alliance with America, the royal family clings to a strict Islamic strain, called Wahhabism, which America believes has helped to stir up Muslim discontent with the West. The Sunni-dominated country also has a restive minority in the Shia Muslims, who account for 5-10% of the population.

Terrorism, and the battle against it, has caused changes. In the past the Saudis have been reluctant to admit that they harbour homegrown terrorists. Their instinctive reaction has been to blame terrorism on foreigners, such as the Britons released this week. (The prisoners' supporters suggested that the bombings blamed on them may in fact have been carried out by Islamic fundamentalists angry about Saudi Arabia's ties with America and Britain.) The Saudis also initially claimed that the attacks on New York and Washington bore the marks of a foreign feud or criminal gang. But terror at home has forced them to face up to militancy on their doorstep. The suicide bombings in an expatriate district of Riyadh this May, which killed 35 people, were a wake-up call in this respect.

Besides forcing the Saudis to admit that extremist groups such as al-Qaeda were in their midst, the Riyadh bombings also caused the local population to rethink their view of fundamentalist militancy. Many no longer see Osama bin Laden as a hero. This domestic swing, combined with pressure from America, has encouraged the Saudi government to launch a crackdown, leading to around 250 arrests. In the past week, following the congressional report, America has also demanded—and been granted—the right to interrogate Omar al-Bayoumi, a Saudi national said to have aided two of the September 11th hijackers.

As America increasingly takes the war on terror to Saudi soil, Saudi Arabia’s rulers face tough choices. They will want to preserve their alliance with America, which is the biggest buyer of Saudi oil and has traditionally protected the country from threatening neighbours, such as Iran and Iraq. There are concerns in the royal family that with America now invested in Iraq, putting down military bases and getting Iraq’s oil pumping, Saudi Arabia could lose out. (Indeed, America announced in May that it would pull its 5,000 troops out of Saudi, though it said this was because they were no longer needed to patrol the no-fly zone in Iraq, and denied that it was downgrading its relationship with Saudi Arabia.) But appealing too much to America brings its own internal perils. Ordinary Saudis are no fans of the superpower, owing to its support of Israel, its invasions of Afghanistan and Iraq and its perceived prejudice against Muslims. All of which leaves Saudi Arabia's rulers between a rock and a hard place. The released Britons can only be thankful that they are no longer there with them.

WHEN a car bomb exploded at the American-run Marriott Hotel in the Indonesian capital, Jakarta, on Tuesday August 5th, killing at least ten people and injuring about 150, suspicion instantly fell on Jemaah Islamiah (JI), a Muslim militant group believed to have links with al-Qaeda. Some of JI’s alleged leaders and operatives are on trial over a series of terrorist attacks in the country, including the bombing last October of a nightclub in Bali which killed 202 people, mostly foreign tourists. On Thursday, Amrozi bin Nurhasyim, the “smiling bomber”, who was photographed laughing after his arrest and later admitted involvement in the Bali attack, was found guilty and sentenced to execution. Despite boasting during his trial that he was ready to die a “martyr's death”, on Friday his lawyers said he would appeal against the death sentence.

Police said on Friday they were closer to concluding that JI was indeed responsible for the hotel bombing: they have identified the suicide bomber who carried it out; and two suspected terrorists already under arrest have admitted that they recruited him. The explosives and methods used in the hotel blast were similar to those in the Bali bombing. Singapore's Straits Times reported on Wednesday that JI had admitted responsibility for the attack in Jakarta and threatened others if its leaders are sentenced to death.

Addressing a meeting of diplomats from the Association of South-East Asian Nations on Friday, Indonesia’s president, Megawati Sukarnoputri, said that the regional body's plans for fighting terrorism had been shown up as inadequate. She called for “a global coalition involving all nations, all societies, religions and cultures to defeat this threat”. Speaking to parliamentarians a few days before, Miss Megawati had said that although the terrorists responsible for the attacks claimed to be fighting for Islam, they had nothing to do with the religion or with Muslims in general. In the wake of the bombing, moderate Muslim leaders have called for “strong action” against the bombers and for death sentences handed down to terrorists to be carried out swiftly.

Most of the hotel’s guests were foreign visitors. It had recently hosted a reception held by the American embassy; and Australia’s prime minister, John Howard, stayed there earlier this year. However, it is believed that most of those killed were Indonesians. Last week, the American government issued a warning that al-Qaeda was believed to be planning further attacks in America and other countries. And a witness in the trial of one of the Bali bombing suspects said that he believed al-Qaeda was financing JI’s bombings. Wan Min Wan Mat, a militant imprisoned in Malaysia, spoke by video link to the trial of Ali Ghufron (also known as Mukhlas), who is accused of being JI’s head of operations. Mr Wan Min said he had passed on to Mr Ghufron more than $35,000, which he was told had come from al-Qaeda to finance terror attacks in Indonesia, though he did not know if this money was used for the Bali bombing. A radical Muslim cleric, Abu Bakar Basyir, is on trial accused of being JI’s leader. He denies this and claims that the group does not exist.

The Bali bombing and Mr Amrozi’s lack of remorse over it have turned many Indonesians against the militants and against Mr Basyir in particular, and the Indonesian authorities have arrested more than 30 suspected militants over the Bali bombing. However, Indonesia has continued to suffer terrorist attacks. And a recent series of arrests across South-East Asia shows that, besides its links with other terrorist groups, JI appears to have active cells of its own in much of the region. In the past few months, police in the Philippines, Cambodia, Thailand and Singapore have arrested suspected JI members. Bomb-making materials have been seized in Thailand and Malaysia. Until recently, Thailand’s prime minister, Thaksin Shinawatra, ridiculed those who suggested there were terrorists lurking within his country. But on his recent trip to America he announced that Thailand had arrested three suspected JI members. Despite all these arrests, though, “the bulk of Jemaah Islamiah remains at large”, says Andrew Tan of the Institute of Defence and Strategic Studies in Singapore.

Though Mr Basyir’s prosecutors have struggled to prove that JI does indeed exist, the testimony of various witnesses at his trial shows there clearly is an elaborate and active terrorist network in the region, whatever its name and whoever its leader. One witness said he had trained in the Philippines at a camp of the Moro Islamic Liberation Front (MILF), a local Muslim secessionist group, before bombing a McDonald’s restaurant in Indonesia. In another terrorism trial in the Philippines, a MILF member testified that he had helped JI to bomb a railway station in Manila, the capital.

The MILF announced this week that its leader, Salamat Hashim, had died of a heart attack last month, soon after he had denounced terrorism and promised to eradicate any terrorists from his movement. The progress of the armed forces’ campaign against the MILF has forced the militant group to agree a ceasefire and peace talks. The separatist war waged for the past 31 years by the MILF and other Muslim rebels on the Philippine island of Mindanao has caused around 120,000 deaths. Nevertheless, the 300-odd military officers and troops who staged a short, unsuccessful mutiny in Manila on July 27th accused senior defence officials of orchestrating two bombings this year in Mindanao that together killed 38 people; they had done it, the mutineers claimed, in the hope of persuading America to give more money towards the Philippines’ war on terrorism.

Jemaah Islamiah, whose name means “Islamic community”, has its roots in radical Muslim movements of the 1940s and 1950s that sought to create an Islamic superstate in South-East Asia. The militant groups survived various crackdowns by the Indonesian authorities and resurged after the fall of the country’s long-time autocratic ruler, President Suharto, in 1998. Since Miss Megawati became president, in 2001, following the impeachment of her predecessor, Abdurrahman Wahid, her administration has been inept and tainted by scandal; and her secular views have made her vulnerable to criticism from conservative Muslim leaders. Only since the Bali bombing has she appeared to have the resolve to take on the militants.

The concerted action that Indonesia and its neighbours are now starting to take against the threat of Islamist terrorism is welcome. But not so the all-out attack that Miss Megawati has sent the armed forces to launch against separatists in the devoutly Muslim province of Aceh, with the aim of wiping out the rebels’ Free Aceh Movement (GAM). The operation, launched in May, continues with no end in sight. The security forces say that, so far, more than 50 of their troops and more than 600 rebels have been killed. On Friday, police said they had arrested two GAM members suspected of planting a bomb that caused minor damage at the Indonesian parliament building last month. They said the two were also suspected of planting a bomb at Jakarta airport in April, injuring 11 people.

Until now, the armed forces have operated with impunity, often being accused of complicity in killings of suspected separatists in the sprawling country’s breakaway provinces. Many officers accused of involvement in the bloodshed during East Timor’s vote for independence from Indonesia in 1999 have been acquitted or given lenient sentences. On Tuesday, however, Adam Damiri, the army’s regional commander at the time of these killings, was found guilty of crimes against humanity and jailed for three years.

THE past year is widely perceived as a dry time for deal-making on Wall Street. This is patently wrong. The Street's leading firms have sewn up one deal after another—with prosecutors. The most recent, on July 28th, was struck between local and federal officials and two of America's largest banks, Citigroup and J.P. Morgan Chase. It covered their involvement with Enron and, in Citi's case, with Dynegy , another troubled (but not as troubled) Texan energy company.

Fines, “disgorgement” of profits and what-not brought the combined price tag to $308m. This is a lot, but it is small in comparison with Citi's profits ($4.3 billion in the second quarter) or with what Morgan might make in good times. According to the prosecutors, the two banks had provided ingenious financial structures and a vast quantity of credit, $8.3 billion, to Enron solely to obscure its true financial condition. The process was helped by the use of shell companies in offshore jurisdictions with strict secrecy laws. This practice, says Manhattan's district attorney, Robert Morgenthau, should be banned.

Nobody really knows whether the punishment fits the crime. As one regulator acknowledges, the fines (like those levied in the broader Wall Street settlement in April) were based on no particular economic logic. In routine criminal matters, fines are often double the illicit gains. But by some reckonings, Morgan lost money on its dealings with Enron, while Citi came out ahead only because it dumped its exposure on to unwary customers. These may now take revenge through civil litigation.

Nor does any clear principle apply to the allocation of the money. The New York district attorney's office gets $3m towards the cost of the investigation. In addition, New York City and New York state cop $25m apiece. The rest is earmarked for compensating investors. It can, however, be put towards the cost of private civil litigation over Enron. All this money and more will almost certainly be needed.

For the banks, the deal removes an important distraction from business. And because no individuals will be prosecuted, shareholders, not executives, will bear the costs. Yet the banks have suffered still more damage to their reputations. In settling, they have also conceded two legal points that they had long resisted.

The first is that, even though every element of a transaction they structured could be legal, the whole could be misleading enough to violate the law. The second, just as worrying, is that banks are responsible for how their clients use the fancy financial structures they create. This is consistent both with the Sarbanes-Oxley act, now a year old, and with rulings on Enron made by a federal court in Houston.

In another era, the banks might have prolonged the legal battle over these points. But after Enron's meltdown and other scandals, why risk even worse headlines? The share prices of both banks have been strong lately, maybe because regulatory threats have been receding. That said, the shares dipped a bit after the settlement was announced. Unexpectedly, both Citi and Morgan wrote letters promising excellent behaviour in the future. Perhaps that has rattled investors' confidence.

An ocean apart

SO MUCH for the Iraq war being a dead weight on America’s growth prospects. On Thursday July 31st, the Commerce Department announced that America’s economy grew at a 2.4% annual rate in the second quarter, the fastest rate since the third quarter last year, and handily beating Wall Street’s expectations of around 1.5%. The rise owes much to defence spending, which was up nearly 45% in the second quarter (the fastest pace at which it has grown since the early 1950s), as well as continued spending by America’s redoubtable consumers. Claims by jobless Americans, published on Thursday in a separate report, also fell for the third straight week. President George Bush, whose father was ousted from the presidency by an upstart Democrat proclaiming “It’s the economy, stupid”, must be giddy with relief.

Across the Atlantic, the figures are bleaker. The euro area is expected to muster growth of just 0.6% this year, a fall from last year’s unimpressive 0.8%, according to Eurostat. A report released on Thursday by the Organisation for Economic Co-operation and Development (OECD) predicted that this year’s “subdued” euro-area performance would improve to growth of 2% next year—a downward revision from 2.4% forecast in April. This is far short of America, whose bullish treasury secretary, John Snow, said this week that the economy is “spring loaded” to grow by more than 4% next year. Still, this week has also brought hopeful signs that a European recovery may at last be underway, especially in Germany, the continent’s biggest economy. The Ifo barometer, a measure of business confidence in Germany, rose in July for the third month running. The Reuters/NTC purchasing managers index (PMI) also rose for Germany from June to July, but remains below 50%, the level that signals an expansion.

Why is America apparently surging ahead, while Europe continues to lag? Part of the answer surely lies with the differing actions of central banks. In America, the Federal Reserve has aggressively cut interest rates to 1%, their lowest level in 45 years, in an effort to spur growth. The European Central Bank (ECB) too has brought interest rates down, to 2%, but it has acted more slowly, partly due to worries about inflation. Critics accuse the ECB of failing to provide the sort of short-term stimulus that countries like Germany desperately need. On Thursday, the ECB's governing council met to discuss interest rates and chose to hold them steady. The OECD expects the bank to keep them on hold until next year.

Another crucial difference between America and Europe is fiscal policy. America’s healthy second-quarter figures owe much to the stimulus provided by spending on the Iraq war, with the occupation currently costing an estimated $3.9 billion each month (before reconstruction costs). Bush administration officials also claim that their tax-cut package—worth some $2 trillion over the next ten years—has buoyed consumer spending. European countries, by contrast, cannot resort to such measures because they are bound by the stability and growth pact, which is designed to limit their budget deficits to 3% of GDP (America’s deficit, projected at $455 billion this year, is 4.2% of GDP). Germany and France have recently breached this limit, and Italy is close. Nonetheless Germany, desperate to shake off its economic sluggishness, is proceeding with a big tax-cut package. Germany and France risk hefty fines if they fail to bring their deficits back below 3%—though in reality there is little the European Commission can do if they refuse to pay.

America’s strong showing may help pull Europe along. The European Union is America’s largest trading partner—so as America gathers momentum, its appetite for European goods will increase, despite the euro's recent rise against the dollar, which makes European products more expensive for American importers. But continental Europe’s economies, being structurally more rigid than America's, may simply be unable to keep up. As the OECD report points out, Europe urgently needs to implement reforms such as boosting labour-market mobility and lowering barriers to internal trade.

But nor are all the signs positive in America, whose consumers save too little and have too much debt, and whose current-account deficit is generally considered to be unsustainable. The employment picture, a key indicator of recovery, is not as rosy as politicians would want. America’s unemployment rate fell in July for the first time in over a year, to 6.2%, according to Labour Department statistics released on Friday—but the drop was caused by people leaving the workforce (some presumably despairing of finding a job anytime soon) since businesses remain hesitant to hire. Better times for America are likely on the way—but Mr Snow and Mr Bush must hope that “spring loaded” growth will extend to the labour market as well.