This was a slow week as many Washington think tanks went into summer hibernation, while many of their analysts went on vacation. This can be expected to continue for the next few weeks, until after Labor Day weekend.
The Monitor Analysis looks at the collapse of the financial markets during the last week. Although many see rising stock prices over the last few days as a sign that the crisis is past, we see a set of structural problems that will bedevil the US and other nations in the future.
Think Tanks Activity Summary
The Carnegie Endowment looks at the diplomacy surrounding Syria and its civil war. They note, “Despite public references to Syria, much of the political activity by the main external powers relates to their own agendas and priorities. Iranian Foreign Minister Jawad Zarif visited Damascus in early August, where he also met Hizbullah leader Hasan Nasrallah, but the fact that he does not manage the Syria file in Iran and that he next went to Pakistani capital Islamabad suggests that his primary role was to clarify the implications for regional counterparts of his country’s comprehensive nuclear deal. Zarif reportedly discussed a peace plan for Syria, but this is simply a revised version of the four-point proposal originally put on the table by Iran in late 2012. More significant is Iranian interest in starting a formal dialogue with the Gulf Cooperation Council, building on a supposed initiative by Oman with the support of Qatar.”
The Washington Institute looks at the Sinai Multinational Force of Observers (MFO) and calls to withdraw the US observers. They warn, “The administration should keep in mind the dangers of changing the MFO’s deployment anytime soon. First, any decrease in the MFO’s strength risks weakening a multinational institution that has not only verified the 1979 treaty’s enforcement, but also encouraged the unprecedented Egyptian-Israeli strategic coordination that exists today. This coordination is not inevitable: bilateral relations nearly collapsed in September 2011, when an Egyptian mob attacked the Israeli embassy in Giza three weeks after Israeli forces accidentally killed six Egyptian soldiers while chasing jihadists back across the border. Later, Muslim Brotherhood president Mohamed Morsi downgraded diplomatic relations with Israel during his year in office. Throughout this uncertain period, the MFO facilitated bilateral cooperation and, in the face of a burgeoning Sinai insurgency, even secured Israel’s permission for Egyptian troop deployments that exceeded the treaty’s limitations. If anything, today’s robust strategic coordination is an argument for the MFO’s importance, not its superfluousness.”
The CSIS argues that rather than focusing on congressional passage of the Iran deal, the US should focus on implementation of the agreement. They provide several suggestions and conclude, “No agreement is ever better than the way it is put into practice, and this is clearly a case where the U.S. must verify and enforce, rather than trust. It is also a case where U.S. public credibility will be critical, and U.S. ability to persuade other states – including key allies – that the U.S. is providing an objective assessment, can be trusted if it says it encounters problems and violations, and will only move towards snap back under these conditions is critical. The U.S. has a mixed record in strategic communications at best, and it needs to do far better if JCPOA ever has to be enforced.”
The German Marshal Fund looks at the relationship between Turkey’s newly discovered war on terrorism and the Iran nuclear deal and see a historical conflict between these two long time Middle Eastern powers. They conclude, “The revival of the Turkish–Persian balance of power — a narrative that dominated the Middle East for centuries — is just the first ripple caused by the Iran deal, and should deeply concern U.S. officials. By minimally satisfying American needs for the sake of their own, competing regional goals, both states are undermining U.S. strategy. Can Washington turn the dispute between Ankara and Tehran into an opportunity to develop a coherent Syria strategy? The odds are slim. But now more than ever the United States must be aware of these cross-purposes and factor them into its broader regional calculations.”
The Foreign Policy Research Institute looks at the foreign policy views of the Democratic candidates for president.
America’s Deteriorating Financial System
More than just a threat to banks
For about a century, America’s financial system has been the capitalist model to emulate by rest of capitalist world and a major center of economic activity. It was the center of new capitalist phenomenon, where the majority of American households who had money invested in Wall Street – either directly or through retirement funds.
Today that dream is gone as real investors have been pushed to the side. Today’s American financial system is an unstable collaboration of central banks, merchant banks, and computer trading systems that may hold onto a share of stock for a couple of minutes.
The complete breakdown of the system was evident the last two weeks as American investors tried to access their accounts to execute buy and sell orders, only to find that they were unable to execute orders as central banks, major banking funds, and computers played ping pong with the market.
When many of these investors were finally able to execute an order, it was to sell. The American investor, which built Wall Street, was taking his money out and not looking at buying stock in the near future.
What happened? It’s not China’s fault. Nor is it the total fault of the current administration, although Obama’s economic policies did contribute mightily to the instability that lead to the events of the last week.
It’s a complicated story that goes back decades. It includes central banks unwilling to make the tough decisions that might lead to a recession, but would help the economy remain healthy, which led to major central bank intervention in previously private financial markets. It included major merchant banks using their political pull to make major profits. And, it included the advent of automated computer trading (algorithm trades), which led to major instability instead of more liquidity.
Central Banks have always intervened in some financial markets. A century ago they would intervene in gold markets in order to support their currency’s value. That ended in 1971, when the US ended the gold standard and the world went to fiat money – money with no backing but debt. Using paper money meant that central banks had to intervene in financial markets since there was no natural monetary backing (gold) to support the system.
In the 1980s, the US Federal Reserve created what was to be called the Plunge Protection Team (officially known as the Working Group on Financial Markets). Its job was, “enhancing the integrity, efficiency, orderliness, and competitiveness of our Nation’s financial markets and maintaining investor confidence.” This meant that in case of a market crash, it was to pump money into the market to keep prices up.
The Plunge Protection Team has intervened in markets regularly in the past three decades – and quite frequently in the past few months (even more so in the last few days). Other major nations also have equivalent teams to stem financial collapses. While they have propped up the markets, they have added trillions in liquidity to the financial system, while slowly taking over control of the financial systems from individual investors.
As it stands now, much of American industry is owned by central banks – banks that are more interested in market stability than sound economic growth. The central bank of Switzerland, the Swiss National Bank, purchased 3,300,000 shares of Apple stock in the first quarter of this year, adding 500,000 shares in the second quarter. This was a time when “smart money” was selling, not buying.
It turns out that the Swiss central bank, in addition to its Apple stock, holds very large equity positions, ranging from $250,000,000 to $637,000,000, in numerous US corporations — Exxon Mobil, Microsoft, Google, Johnson & Johnson, General Electric, Procter & Gamble, Verizon, AT&T, Pfizer, Chevron, Merck, Facebook, Pepsico, Coca Cola, Disney, Valeant, IBM, Gilead, Amazon.
Among this list of the Swiss central bank’s holdings are stocks which are responsible for more than 100% of the year-to-date rise in the S&P 500 prior to the latest sell-off. Since the US Federal Reserve is prohibited from directly owning US stock, many observers think that the Swiss purchases were actually at the Fed’s behest.
The problem is that central banks aren’t perfect and they are liable to political pressure. The result can be catastrophic. Nobel prize-winner Milton Friedman and Anna Schwartz established that the Great Depression was the consequence of the failure of the Federal Reserve to expand monetary policy sufficiently to offset the restriction of the money supply due to bank failure. When a bank failed in the pre-deposit insurance era, the money supply would shrink by the amount of the bank’s deposits. During the Great Depression, thousands of banks failed, wiping out the purchasing power of millions of Americans and the credit creating power of thousands of banks.
In this case, the opposite is true – the Federal Reserve is pumping too much money into the system.
That’s the problem. Overreliance on excess liquidity has actually hindered capital investment.
The New Corporate Strategy
In the past, companies would borrow money to invest in new, profit making capital investment. Today, that has changed in America.
Most American Chief Executive Officers are compensated on the value of the company’s stock or earnings per share, not real economic growth. This has led many company presidents to use the glut of liquidity to borrow money at low rates and then buy back company stock – a tactic that raises the price of the stock and artificially makes the earning per share grow. However, although it makes the stock share price look good, Marketwatch said, “the fact remains that buybacks are one of the most dubious tricks on Wall Street.”
In the first quarter of 2015, companies in the S&P 500 index returned more money to shareholders than they earned. The last time that happened was in the fourth quarter of 2008, when the entire S&P 500 reported a slight loss for the quarter but still spent $110 billion on dividends and buybacks.
For instance, heavy machinery producer Caterpillar announced that the company repurchased $4.2 billion worth of stock in 2014, even though it had made less than that.
Clearly, not only had the liquidity pumped into the system by the central banks damaged the financial markets, they have changed corporate strategy from one of producing and making profits to one of making stock prices more attractive – a guaranteed way to destroy an economic system.
The Individual American Investor
The American financial system was based on individual American investors. This not only allowed them to share in American growth, it also contributed to political stability as the average citizen saw themselves as part of the system, not an outsider who couldn’t profit from America’s growth. This prevented the typical “rich elite versus the poor masses” fault lines seen in many other nations.
However, the average American investor has been crowded out today. The Wall Street Journal noted many stories of trapped American investors this week, including this one: “The painter from Phoenix was one of millions of Americans who watched in horror as the U.S. stock market sank like a boulder Monday morning, a plunge that topped more than 1,000 points before many investors had finished their breakfast cereal.
Ms. Elizabeth, 31 years old, tried in vain to sell at least some of the shares in her TD Ameritrade Holding Corp. account, but was unable to log in amid a crush of others rushing to do the same. By the time she was able to access the site, she was down $6,000.
“It might not be a lot of money to some people,” said Ms. Elizabeth, “but as a young artist trying to get somewhere, this hurt a lot.”
“It makes me wonder if a guy like me has a fair chance or not,” said Igore Hernandez, a lawyer in Casa Grande, AZ told the Washington Post. He was unable to log on to his online broker.
These investors aren’t likely to move back into the market anytime in the near future.
Much of the liquidity created by the central banks has flowed into the accounts of major banks and other trading institutions. This has increased the divide between the American rich and American middle class. It has also given the banking sector a major impact on American politics as the major campaign contributors to candidates are frequently in the banking industry.
Needless to say those contributions come with strings. That’s why many major banks that failed in 2008 weren’t allowed to fail and were propped up with Federal Reserve liquidity.
This was succinctly phrased by economist Michael Hudson, president of the Institute for the Study of Long-Term Economic Trends, a Wall Street financial analyst and distinguished research professor of economics at the University of Missouri, Kansas City.
Hudson said, “The real problem is that we’re still in the aftermath of when the bubble burst in 2008, that all of the growth in the economy has only been in the financial sector, in the monopolies—only for the 1 percent. And it’s as if there are two economies, and the 99 percent has not grown. So the real problem is, stocks have doubled in price since 2008, and the economy, for most people, certainly who listen to your show, hasn’t grown at all.”
He also commented on the tie between banks and politics. He said, “Both parties are basically run by Wall Street. The Democratic Party, ever since Bill Clinton, was run by Robert Rubin. And all of the secretaries of the treasury, the officials, have basically come from Goldman Sachs, especially Tim Geithner.”
On two Republican presidential candidates – Jeb Bush and John Kasich, he said, “Both worked for Lehman Brothers, Kasich after he ran for—after he was a congressman; Jeb Bush, according to The Wall Street Journal, Bush signed on with Lehman after leaving the Florida Governor’s Mansion, making it clear he wanted to work as a hands-on investment banker. I believe he made something like $14 million working for Lehman and then Barclays.”
It appears that the banks are running the government instead of the other way around.
The Impact of the Current Financial Situation
The ramifications of the current financial crisis are great – both inside the US and internationally.
The drastic fall of the Chinese markets have had a major impact on that nation, there could be political ramifications. A Chinese government that has been embarrassed might be more willing to engage in a risky move internationally in order to reassure its citizens that China is still a major international player and to show other nations that it shouldn’t be taken likely.
In this case, the hot spot could be the South China Sea, which has seen the growth of a Chinese military presence, especially on man made islands. Although there is a great chance of a confrontation with the US, China may feel that a confrontation – especially one that causes the US to back down – would be a way to regain prestige.
Another area of concern is the GCC region, where oil is the lifeblood of the economy. As oil process crash in the current crisis, it limits the ability of the GCC nations to continue their current military expansion.
There is also the political situation, where GCC residents are used to liberal government spending – in return for a more autocratic government. Should spending drop, the chances of political unrest in the region also grow.
Finally, there is the US. Although the current financial crisis will not destroy the system, it has shown some of the fault lines inside the country.
First, there are the fundamentals. Is this one of many bear markets that happens as the financial markets readjust? Or is this one different?
There is mounting evidence that the current decline might just be sending a signal that there is more going on here than just an “overdue correction in a bull market.” The reality is that leverage of this magnitude is ‘gasoline waiting for a match.’ When an event eventually occurs, that creates a rush to sell in the markets; the decline in prices will reach a point that triggers an initial round of margin calls. This forced sale of assets will reduce the value of the collateral further triggering further margin calls. Those margin calls will trigger more selling forcing more margin calls, so forth and so on. And, given the high level of debt, this could make the crash of the last week seem small.
Then there is the issue of civil and political stability that Wall Street has provided Americans for the last century. America’s strength has been in its broadly based economic investment – one that hasn’t rested in the hands of a few elite. That has changed.
As we have reported in the past two years, these cracks are growing. There was the “Occupy Wall Street” protests and “Black Lives Matter” on one side. There has been the Bundy Ranch Standoff and the Tea Party protests on the other side of the political spectrum. All of these show a serious distrust of the ruling class in Washington.
This has also shown itself in the 2016 presidential campaign, where the two candidates generating the largest, most enthusiastic crowds are campaigning against Washington and those in charge – Donald Trump and Bernie Sanders. Although they offer differing solutions, they both see the same problems.
Meanwhile, the two candidates seen as closest to the ruling class, Jeb Bush and Hillary Clinton are lagging behind in crowds and enthusiasm.
This financial crisis has brought to light some of the issues bothering the majority of American voters – that the US is governed by a ruling class of elite rich families, who look out only for themselves.
Unless the concern can be addressed by both Democratic and Republican parties, more unrest can be expected in America in the next few years.
The Iran Nuclear Agreement: The Need for a Full U.S. Implementation Plan
By Anthony H. Cordesman
Center for Strategic and International Studies
August 24, 2015
The U.S. focus on whether the Congress can get 60 votes against the agreement, and then 67 votes to override a veto, presents the potential danger that the U.S. does not prepare properly for what happens if they can’t block the agreement and the Joint Comprehensive Plan of Action (JCPOA) actually goes into force. The implementation process will be extremely complex. It requires a wide range of actions by the IAEA, and the creation of new institutions to support the agreement. It requires the U.S. to be ready to independently verify and deal with any possible problems in each step in Iran’s compliance with the agreement as Iran moves toward Implementation Day at some point in 2016. It will then require a constant U.S. effort to monitor compliance with the agreement and to put that compliance in a broader security context.
Syria’s Fog of Diplomacy
By Yezid Sayigh
August 20, 2015
The flurry of contacts and visits among key external powers involved in the Syrian conflict over the past few weeks has sparked speculation that a rare opportunity to end the war may be opening up. The spate of diplomatic activism is impressive, and almost unprecedented since publication of the “Geneva-1” communique in 2012 in encompassing key actors on both sides of the divide. But although the prospect of ending Syria’s tragedy is tantalizing, it remains unlikely. The key external powers have in fact given little sign of changing their basic positions. Instead, when it comes to Syria they seem to be engaged in little more than positioning and public relations.
A Quick Guide to the Foreign Policy Views of the Democratic Presidential Candidates
By Brandon George Whitehill
Foreign Policy Research Institute
As of this writing, five Democrats are running for their party’s nomination for President of the United States: Hillary Clinton, Bernie Sanders, Jim Webb, Martin O’Malley, and Lincoln Chafee. Of these candidates for president, three (Sanders, Clinton, Chafee) were members of Congress during 9/11 and the votes on Afghanistan and Iraq Wars; two (Clinton, Webb) served on the Senate Armed Services Committee, two (Webb, Sanders) on the Veterans Affairs Committee, one (Webb) on the Foreign Relations Committee, and one (Chafee) on the Homeland Security Committee; one (Webb) was the Assistant Secretary of Defense, Secretary of the Navy, and a Marine Captain; and one (Clinton) was the nation’s top diplomat as Secretary of State. Among the Democrats, Webb, Sanders, O’Malley, and Chafee opposed the 2003 Iraq War from the beginning (initially supported by Clinton) and the 2011 intervention in Libya (supported vigorously by then-Secretary Clinton). Webb stands alone in his opposition to the current deal with Iran. Sanders opposed the Gulf War in 1991 in which the US and its allies ousted Iraq from Kuwait; he also opposed Obama’s troop surge in Afghanistan in 2009.
Is Turkey’s War on Terror a Consequence of the Iran Deal?
By Joshua W. Walker
German Marshall Fund
Aug 25, 2015
The deal negotiated by the P5+1 with Iran on its nuclear program has been heralded by supporters as a historic agreement and regional game-changer. Much of the international criticism thus far has centered on Israeli and Gulf Arab skepticism about the deal. Overlooked in these discussions, however, is the significant impact the Iran deal is already having on other regional disputes, including Iran’s relationship with its traditional competitor, Turkey. Operating with a caretaker government since its June 7 national elections and now heading to early elections on November 1, Turkey has opened a two-front war against the so-called Islamic State and its traditional foe, the Kurdistan Worker’s Party (PKK). Most analysts have pointed to the July 20 terror attack in Suruc and the subsequent killings of two Turkish police officers as the spark that triggered Ankara’s strategic shift. However, the fact that these events transpired immediately following the end of negotiations with Iran was not an accident. The broader trend of increased Iranian–Turkish competition is playing out regionally as Tehran’s support for the Kurds further antagonizes Ankara.
Securing the Sinai MFO Without a U.S. Drawdown
By Eric Trager
August 26, 2015
In the wake of a June 9 jihadist rocket attack on the Multinational Force of Observers (MFO) and other dangerous incidents, the U.S. government is reviewing the future of its military deployment in the Sinai Peninsula. While Washington does not appear to have any near-term plans to substantially alter, let alone end, its MFO deployment, the ongoing deliberations about force protection have led some outside the government — including the New York Times — to call for a U.S. troop withdrawal. Whether or not these calls are answered, the current situation bolsters the narrative that America is withdrawing from the Middle East and undermines Washington’s ongoing efforts to reassure regional allies about the Iran nuclear deal.