Sean Gallup/Getty Images
Merkel at the Reichstag.

Why can't German leader Angela Merkel abide her own peers? She bristles at Nicolas Sarkozy, protests Gordon Brown's widely praised economic-stimulus plan as a "pointless race to spend billions," and appears immune to the charm of U.S. President Barack Obama, whom most other Germans seem to love.

Merkel's standoffish manner is the outgrowth of a German foreign policy that has, since the end of the Cold War, grown increasingly independent of American influence and focused on German self-interest, whether in military adventures in the Balkans, Iraq, or Afghanistan or in handling the global economic crisis. And unlike her recent predecessors, Helmut Kohl and Gerhard Schröder, Merkel grew up outside the political mainstream, as a physicist in East Germany. As a result, her style is more businesslike, less backslapping. She is "Ms. Cautious," and growing more so as elections approach in September, says Thomas Kleine-Brockhoff of the German Marshall Fund. "She's not just jumping onto a global hype."

Thus, she has remained silent on whether Tony Blair (or anyone else) should become the first president of the European Council, if the powerful post is created as planned. Her relationship with Sarkozy is limited by his spontaneity and her disdain for it. And her initial coolness to Obama suggests neither dislike nor disregard, but rather a sizing up of a young leader and a straightforward respect for seniority; she sees herself as sen-ior to Obama, just as she saw herself as junior to George W. Bush when she became chancellor in 2005, says one Merkel watcher.

The ties to Obama, at least, could warm over time. In contrast to Brown and Sarkozy, the American and German leaders are popular at home, with approval ratings of 60 percent or more. Both are realists who recognize that their countries' different national interests may lead to disagreements on issues like handling the economic crisis and Afghanistan. And both are known for their unsentimental personal styles, suggesting that a meeting of the minds, if not the hearts, is possible.

You might have heard about a little report from New York Attorney General Andrew Cuomo this morning. With all the subtlety of a sledgehammer--it's titled No Rhyme or Reason: The 'Heads I Win, Tails You Lose' Bank Bonus Culture, for chrissakes--it gives the most detailed accounting to date of the Wall Street bonus fiasco, showing that, as they were losing billions, a whopping 4,793 lucky folks took home bonuses of $1 million or more last year.

It's grist for the rage mill, to be sure, but is it a game changer? To find out, I checked in with another man making noise about regulation these days: Eliot Spitzer, once known as "Lord High Executioner" among the Wall Street crowd. Here's what he had to say about the matter:

So I take it you’ve heard about this Cuomo report?
Is that the one about the poor investment bankers struggling to pay their bills?

That’s it. It’s a sad tale.
Yeah, like Dickens.

My basic question is: after all this, why is it still so hard to regulate these guys?
Setting pay is a quintessential private sector activity. The question is, how do you do it properly and fairly? Whose voice should be heard? Take the public bailout out of the equation for a moment, because let’s hope that’s not a permanent fixture. These are bigger issues. Why have compensation committees failed so utterly? Why have shareholders never been able to reign this in?

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Political infighting in Iran heated up yesterday when some of President Mahmoud Ahmadinejad’s conservative supporters warned him that he might not get a second term in office if he doesn’t start towing the line. The warnings came off the back of a tiff over the last couple of weeks between Iran’s Supreme Leader Ali Khamenei and Ahmadinejad, in which the former warned the president to get rid of his right hand man, Esfandiar Rahim Mashaie, who was perceived as being a bit too friendly towards Israel. The president ultimately bagged his number two, but only after taking his own sweet time – a slight to Khamenei.

While the conflict is portrayed as a relatively recent event off the back of the election turmoil, the fact is that Ahmadinejad has been increasingly on the outs with conservatives in Iran for many months now, and not because of Israel but because of the economy, which he has notoriously mismanaged. His ill-thought out energy and monetary policies as well as runaway public subsidies have resulted in double digit inflation, rising unemployment, and blackouts. Under Ahmadinejad’s watch (and the highest oil prices in decades) the country has become a net gas importer, despite its vast natural resource wealth.

A faltering economy was a key issue in the June 12th elections, but the problems go back farther than that. In January, as the price of oil was falling, the Supreme Leader announced that Iran’s new five year development plan, set to come into effect next year, would funnel 20 percent of the country’s oil and gas revenues into a new development fund separate from the Oil Stabilization Fund, which, according to many analysts, Ahmadinejad has plundered wildly. “There should be tens of billions of dollars left in the fund, and it’s not at all clear that there are,” says Alireza Nader, an Iran analyst at the RAND Corporation. “What is clear is that Ahmadinejad gave a lot of the oil money earned in the boom days to friends in the Revolutionary Guard, and to companies started by former Guard officers, often in the form of loans and no-bid state contracts.” RAND estimates that such companies, while typically corrupt and inefficient, are now the biggest economic players in Iran, with far-reaching influence in key sectors like manufacturing, construction, and banking.

Analysts inside and outside of Iran say that the creation of the separate fund is proof that the Supreme Leader was beginning to sideline the President, or at least stop him from wreaking more economic havoc, months ago. Now, the political fault lines in Tehran are growing ever more apparent, and that will likely make the country even tougher to govern in the coming months. The implication for markets, according to Eurasia Group Director Cliff Kupchan is “an even further reduced chance that diplomacy with the U.S. will be successful.” That means investors will be less likely to want to put much needed investment into Iran, and that could further destabilize the economy, regional trade, and possibly even oil exports. If that happens, the effects would reach far beyond Tehran.

Blair's new popularity lies in a changing Europe. In the past, the EU has filled top posts with mediocre candidates, chosen after months of horse-trading between member states. But the new president will be Europe's chief spokesman and mediator, and will need all the charisma that Blair exudes. Besides, Blair has some handy credentials: He speaks French. He's a socialist--a useful gesture to the left--yet his pro-market sympathies mean he won't offend conservatives. Paradoxically, his strongest qualification could be his nationality. How better to allay British skepticism of Europe than by putting a Brit at its head?

Cathal McNaughton/Reuters-Landov
A pig farmer in Ireland.

By Andrew Bast

During swine flu’s first months, the World Health Organization broke down the numbers of new cases by country to show where the virus was spreading. Then, in July, the WHO quietly announced that it was abandoning its count. While this may seem alarming, counting cases has long been counterintuitive. The problem with an exploding epidemic—Britain’s chief medical officer says 100,000 people caught the swine flu in a week—is that the resources it takes to count it grow just as fast. “You can’t devote . . . resources to just surveillance,” says Marc Lipsitch, a Harvard professor of epidemiology. So what can authorities do? Track trends—specifically, how the virus is mutating (U.S. officials recently spotted young swine-flu patients having seizures). By last Friday, the pandemic had spread to nearly every country. From now on, understanding swine flu no longer means asking how many. But instead, what kind?

Caption contest, anyone?

From StefanoScalia via Anonymous Arabist

 
Mustafa Ozer/AFP-Getty Images

For 86 years, since modern Turkey was founded by an Ottoman general, the Army has been the country’s most trusted institution. It has launched four coups in the past four decades, each with broad popular support. Now, fol-lowing charges against top brass for plotting a coup and organizing death squads against Kurdish activists, the honeymoon is over. A recent poll by the Ankara-based MetroPOLL Social Research Center shows 65 percent of Turks do not want the military involved in politics, even as commentators; nearly 40 percent say former top general Kenan Evren should face trial for his role in a 1980 coup. The shift in opinion is a shock for the Army, which sees itself as the people’s protector against corrupt politicians. Yet memos leaked last month appear to show Turkish officers working to subvert the Islamist-rooted AK Party government—despite its large democratic mandate. The papers reveal plans to orchestrate press smears against AK, and to invent a fake terrorist organization linked to an exiled Islamic scholar who is close to AK Party leaders. The memos may even be an elaborate fake, but they place the Army and the AK Party on a collision course. The party is fighting back by restricting the powers of military courts, and strengthening the capacity of civilian courts to prosecute military suspects. The age of the untouchable Turkish Army, and the popular coup, may be closing.

Hilary Clinton, Tim Geithner and their Chinese counterparts are busy in D.C. at the first ever China-US Economic and Strategic Dialogue, a high level pow-wow in which the world’s 800 pound gorillas will try and smooth over issues like China’s supposed currency manipulation, trade conflict, disagreements over climate change and worries about the future of the dollar. As president Obama put it yesterday when opening the session: “We can’t predict with certainty what the future will bring, but we can be certain about the issues that will define our times. And we also know this: The relationship between the United States and China will shape the 21st century, which makes it as important as any bilateral relationship in the world. That really must underpin our partnership. That is the responsibility that together we bear.”

The relationship between China and the US is often portrayed as an edgy powder keg of misaligned interests that will inevitably explode at some point when China tries to buy the next big energy company or the U.S. institutes some ill-thought out trade protectionism. I think this is wrong. I actually believe that China and the U.S. are going to become much closer in the years ahead, and that many of the supposed conflicts will never come to pass. Cases in point:

1. The Chinese won’t sell off T-bills. I get so annoyed when TV pundits posit this idea that China is going to someday suddenly dump the $1 trillion in T-bills that it is holding and crash the U.S. economy. Guys, listen up – if they ever did this, their own economy would be the first to tank. What’s more, even if they started moving out of T-bills and towards, say, euros (which they aren’t doing right now), it would take decades for the two currencies to reach parity, during which time all the economies in question would adjust to the new reality. The dollar is going to be less important as a global currency in the LONG run. But the Chinese are in a co-dependant economic relationship with us – if we go down, so do they.
2. The Chinese won’t start a major war over energy. Yes, their demand for natural resources like oil, minerals, water and farmland is increasing rapidly (which has been a very good thing for commodities prices). And yes, some of their recent attempts to buy Western commodities companies (like Rio Tinto, or Unocal a few years back) have been contentious. But let’s get real – the Chinese now have modern, multinational companies that are simply trying to do business by the rules that we set up – they want to acquire companies to meet their growth needs just like anyone else. It’s quite possible that Chinese energy demands will help fuel continuing civil war in places like Africa, where various factions fight for control of natural resources. But those would have happened anyway – commodities nations are simply more prone to conflict no matter who the buyers are. Ultimately, China, the US and other major resources consumers will realize it’s in their best interests to cut joint deals rather than go to war over resources.
3. There won’t be a trade war between the U.S. and China. We heard a lot about “Buy America” a few months ago, but then it sort of went away. Then, a month ago, the Chinese instituted a “Buy China” clause. At first, this ruffled a lot of feathers, but its impact will be negligible. The Chinese might be able to offer subsidies to consumers to buy their own cheap electronics and white goods, but they still need to import all the complex machinery and natural resources to run their factories, and the middle classes would much rather consume upscale retail products made in the US and Europe than buy no-name home brands (at least right now). What’s more, the Chinese know that they’ll suffer most in any trade war – the US and Europe are their biggest trade partners.

While I don’t expect any major economic news to come out of the summit – just more of the same noises we’ve been hearing (say no to protectionism, manage the fall of the dollar and the rise of the yuan, etc), I do think it will be interesting to see how the Chinese-US political relationship develops going forward. Historically, Japan has been the major ally in the Asia-Pacific region. The Obama administration has made it clear that they’d like China to play that role in the future. What kind of a best friend will they be? Watch this space.

The government is ramping up the pressure on employers to prove the legal status of their workforce. Is this good or bad for the economy?

Charles Foster
BAD. This takes an overly heavy stick to business. It doesn't remove any undocumented workers from the U.S. and drives them further into the cash economy, where they're not paying taxes or paying for health benefits. This makes it more likely that as uninsured people, they'll increase the burden on an already overworked health-care system.

Mark Krikorian
GOOD. The business community says it's never a good time to enforce immigration laws, but this is truly the best time to do it. With 10 percent unemployment, there are a lot of Americans who need jobs, so businesses will have an easier time replacing their illegal labor force. This would be excellent for American workers, and the U.S. economy.

Our Verdict
It's unlikely that employment gains would outweigh the big costs imposed on already strapped businesses. To minimize them, employers should only have to reverify the status of new hires, not their whole workforce.

Foster is chair of Americans for Immigration Reform. Krikorian is Executive Director of the Center for Immigration Studies.

By Andrew Bast

Somalia has become synonymous with the term “failed state.” Even now, after nearly two decades of civil war and a dismaying string of failed foreign interventions, the end of the country’s long humanitarian catastrophe seems no closer. Recently, Western security experts have begun to warn that the capital city, Mogadishu, could be overrun by Al-Shabab, an armed Islamic extremist group the U.S. government says has ties to Al Qaeda. In the past two months, more than 200,000 people have fled fighting between Al-Shabab and a 4,300-strong African Union peacekeeping force. Last week Al-Shabab gunmen overran a U.N. compound in the city of Baidoa, expelling the international agencies there, including aid workers. Alarmed, Washington recently sent $5 million worth of munitions to help the badly outmatched blue helmets. Now various groups inside and outside the country are calling for more foreign assistance.

I want to respond to a reader who commented on yesterday’s post about the possibility that the U.S. dollar might be replaced by a new type of currency known as an “SDR”:

Reader: "[You suggest in your post that] 'Americans won’t be able to live quite as large as they have in the past.’ This is a vague statement. What exactly does it mean?  Does it mean that the value of the dollar is going to drop?   Maybe the author is purposefully being vague, because she is uncertain about the implications of issuing more SDRs?"

Apologies for sounding vague, but in fact, I can be quite specific about what would happen if the dollar was no longer the world’s major reserve currency. For starters, yes, the value of the dollar would drop, thus dimishing the wealth of the average American. But that’s going to happen anyway. The value of any currency tends to be correlated with the underlying strength of its economy. It’s been clear for sometime that the American government and the American consumer are carrying too much debt. Ultimately, that’s not good for either the U.S., or all the many countries that hold dollars as their main reserve, because endless amounts of American debt will eventually result in inflation that will devalue dollar assets.

The idea behind the SDRs is to break the dysfunctional economic relationship between the U.S. and the big export nations like China. Americans are encouraged to keep spending themselves into oblivion because it’s so cheap for them to do so, since the dollar is artificially buoyed by the rest of the world, in particular Asian exporters like China which would do a lot better to spend their surpluses on improving the lives of their own people rather than buying lots of dollars and burying them in the ground.

Theoretically, using a basket of currencies as the world’s reserve would bring more stability to the global economy by breaking this cycle. That could, eventually, help the dollar rebound (though probably not to its record highs). But first, as I said in yesterday’s post, the SDRs would have to be widely traded – and that’s not going to happen overnight. Hope this clears things up.  

The global arms race is slowing for only one major contestant, Europe, with potentially long-range implications for its status as a big power. Despite the worldwide recession, global arms sales rose 4 percent last year, with the U.S. and China leading the pack at $607 billion and $85 billion, respectively. Russia, too, has been bumping up its defense budget, now at $58.6 billion, in hopes of regaining its Soviet Union-level capabilities. But in Europe, cash-strapped governments are slashing defense budgets in favor of propping up popular social programs. 

Already this year, Italy has downsized its defense spending by about 7 percent and Spain has cut about 4 percent. Analysts are predicting that Britain's roughly $60 billion annual defense budget could face cuts as high as 25 percent in coming years. And top military and civilian officials, including Lord Paddy Ashdown, are calling for a new defense posture that fits leaner times. That could mean abandoning plans to shell out more than $38 billion to replace Britain's fleet of Trident nuclear submarines, and building only one (or neither) of an $8 billion pair of aircraft carriers, which ceremonially began construction last week.

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Mac Margolis wrote last week about how the reliable democracies of Latin America have stood idly by while their more volatile neighbors eroded democratic institutions like legislatures and constitutions. Here, Ecuador's man in Washington responds:

There once was a time in the United States when only land-owning white men were allowed to vote. At the time it was called a democracy, although most citizens were excluded. 

Your correspondent Mac Margolis seems to long for such a time. Clearly he fears majority rule in Central and South America and disapproves of leaders who "exacerbate the region's class and race pathologies" by encouraging poor and indigenous people to vote and participate in their government.

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Generally speaking, the UN gets low points for shock value on the Arab Human Development report it released today, the gist of which can be reduced to war = insecurity = bad for business. But Chapter 5, the economy section, deserves a look for two big reasons.

Reason A: The GDP Rollercoaster Ride

UNDP Arab Human Development Report 2009

 

If there were ever any question as to the extent of the MENA region's volatility, this should pretty much clear it up. After all the intense ups and downs of the multi-decade roller coaster ride, the region's per capita economic growth has hardly changed at all since 1980.

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Some interesting news today on the currency front. Remember all the hoopla a few months ago about how the dollar was going to be replaced by a wacky new IMF backed currency that went by the acronym “SDR” – or special drawing rights? China was calling for the new system, and U.S. Treasury Secretary Tim Geithner didn't rule it out. Well, the IMF is now on the verge of taking a big leap towards this new system, with a proposal to increase the supply of these SDRs (which are basically just a bundle of several currencies including the dollar, yen, sterling, and the euro) by eightfold. The IMF will vote on the measure on August 7^th and would start issuing the new currency by the end of the month.

If it passes, this would be the first time the IMF would have increased the number of SDRs since 1981 – a pretty substantial shift. It doesn’t mean the dollar is going away – it still makes up 44 percent of the composite of the SDRs. But it does mean that the world is taking a big step away from the dollar as the de-facto global reserve currency. “The decision could mark a watershed moment in the evolution of global monetary relations,” say the folks at Capital Economics in London, who put out a smart note on the topic this morning. But for that to happen, many more parties would have to hold and trade the SDRs. Right now, only central banks and big government institutions can trade them.

What does all this mean for you? Ultimately, it means Americans won’t be able to live quite as large as they have in the past, since the dollar will become less important. But it also means that other countries around the world (who could potentially exchange SDRs for their local currencies) could live larger. That could be good for purchasing power, but could also fuel inflation and create a lot of volatility in currency markets. Which, of course, also means investment opportunities. Stay tuned.

The Ben Bernanke sweepstakes is heating up. Sometime over the next few months, President Obama will decide whether to reappoint the Federal Reserve chairman to a second four-year term. The betting now is that Bernanke will be back, and he almost certainly helped himself on Tuesday with his Humphrey-Hawkins testimony before the House Financial Services Committee. In his prepared remarks, along with an op-ed in the Wall Street Journal, Bernanke answered the most strident questions posed by his critics. He does, in fact, have "an exit strategy" from the Fed's expanded balance sheet and loose monetary policy, he said. He's prepared to wield a wide array of tools to make that happen. "The extraordinary policy measures we have taken in response to the financial crisis and the recession can be withdrawn in a smooth and timely manner as needed," Bernanke said -- in other words, of course I can deal with future inflation, it's just not going to be now. Compared to some past performances, Bernanke sailed through the day.

Still, there were a few signs of tension with the Obama administration, which could bode ill for Gentle Ben. Bernanke indirectly raised questions about the administration's fiscal policy, saying current spending is unsustainable, and he appeared to differ with Treasury Secretary Tim Geithner when he called for an activist counsel of advisors to oversee systemic risk. Perhaps that too was in answer to his critics, among them Anna Schwartz, the 93-year-old scholar who earned herself a permanent place in economic history when she co-authored, with Milton Friedman, the "Monetary History of the United States." In an interview, Schwartz accused Bernanke of being "very much influenced by the Treasury." Others, however, would say it is Bernanke that has pushed the Treasury. And even if Obama has reason not to want to reappoint Bernanke, he risks political disaster if he opts for his chief economic advisor, Larry Summers, as his replacement. Summers, at this stage, would be perceived as an Obamaite infringement on the Fed's independence, not to mention an confirmation nightmare.

All in all, it's looking as if Bernanke is making the case that he's got too many balls in the air right now to be shoved aside. And he may be right.  

The iPhone has apps for reading the news, checking bank accounts, and streaming music. Now it's got one for exacting revenge on overpaid CEOs and Ponzi schemers.

Squash the $treet, a creation of Last Legion Games, lets you "watch the shady bankers, creepy fraudsters, and corrupt CEOs flee their gilded offices, sprinting for the nearest escape vehicle," as the creators put it. Once they're out on the street, in the "festering heart of the city where all the thievery and greed began," you can "squash and flick the snarky scoundrels."

The app is a testament to the status of videogames─and iPhone apps in particular─as pieces of cultural criticism.

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Readers will be forgiven for not feeling like the economy is in recovery─American trade is down, unemployment is nearing 10 percent (closer to 20 in some parts of the country, if you count people who’ve stopped looking for work), and housing foreclosures are higher this year than last. Yet the global economy recovery is upon us, according to the number crunchers. The IMF just raised their projections for global growth to 2.5 percent from 2 percent─the first upward tick since the crisis began.

What’s really interesting to me is that U.S. is actually leading the recovery, in part off the back of our corporate profits, which are at record highs, despite the financial crisis. Of course, this again might not feel great to most folks. Why should bankers at “Golden Sachs” be taking home loot again so soon after a bailout? Yet the fact that at least some of the big banks appear to be back on their feet is actually good news for the larger economy. And in many ways, it speaks to how much better American policymakers handled this crisis than their European counterparts, despite stumbles along the way. Europeans are still doing stimulus in dribs and drabs and hoping the whole problem will go away.

Unfortunately for them, things will likely get worse in Europe before they get better. I spoke today with Chris Willliamson, chief economist for Markit, a global financial market research firm, who told me that rates of economic decline in Germany, Italy, and Spain are still comparable to the post 9/11 period. Things are not stabilizing in these countries─Spain is in the midst of a real-estate crash, Italy is risking sovereign default, and German consumers have their wallets zipped up tight, thanks to the fact that their big export businesses are in major decline. The French are holding steady, but only just. The entire eurozone is flat, as the U.S. and U.K. move ahead.

This is just the opposite of what folks were predicting six months ago. So much for the triumph of the Continental model of capitalism.

For more on the shape of the recovery in the U.S. and the rest of the world, check out our packages in next week's print editions.

SOURCE: JONES LANG LASALLE

Alexander F. Yuan/AP
At a Chinese auto show. 

when a little-known Chinese company agreed to purchase Hummer from General Motors in June, the deal was initially seen as another symbol of a rising China's might. But recent murmurs from Beijing suggest that authorities might nix the acquisition by Sichuan Tengzhong Heavy Industrial Machinery; state media are reporting that Hummer's environment-crushing reputation doesn't fit with China's new drive to go green. Yet environmental concerns are just a public excuse. According to officials, Beijing's real worries are much more hard-nosed: Should Tengzhong fail to restructure the ailing SUV maker, it would damage China's image in the international marketplace. And Beijing has good reason to believe some of its domestic auto companies aren't ready to drive a foreign brand. The eager buyer is unknown even in China, and its expertise lies mainly in dump trucks and cement mixers. The past is sobering: when China's biggest carmaker, SAIC, bought a stake in South Korea's Ssangyong Motor Co. in 2004, it ran afoul of Korean labor unions, which obstructed the hoped-for turnaround. Foreign assets are "hard to digest," says Eduardo Morcillo, an M&A expert with InterChina Consulting. Still, Ssangyong was barely known outside Asia. Failing with an international brand like Hummer would cause far sharper stomach pains.

Top White House economic aide Larry Summers gave a major policy speech at the Peterson Institute for International Economics today, but it had more to do with public relations than economics. The central message: WE DID IT! In other words, the U.S. economy has stepped back from the "abyss" of a second Great Depression, and we can thank President Obama's economic policies for turning the tide.

Summers' speech may mark the beginning of a major political struggle over who or what should get credit for an economic recovery, assuming that one gets under way later this year. Summers suggested that's what will happen, but Summers notwithstanding, it isn't necessarily clear that it will.

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Yesterday was one of those days where so many people on the Internet were wrong that I almost couldn't sleep because of it.

I'll restrain myself to just one example: Mark Gimein's defense of Goldman Sachs in The Big Money. (Disclosure: Newsweek and The Big Money are owned by The Washington Post Company.) 

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These last couple of days, my inbox has been filling up with news alerts announcing glistening second-quarter profits at the banks everyone loves to hate: $3.4 billion at Goldman Sachs, $2.7 billion at JP Morgan, $3.2 billion at BofA.

I like a good economic recovery as much as the next guy, but it seems a little too good to be true, doesn't it? Where's this money coming from? How are the banks doing so swell when they haven't come close to clearing out all the trash inventory that sank them in the first place?

Viral Acharya, a finance professor at the New York University Stern School of Business, has some thoughts:

A large number of banks borrowed government debt in October or November of last year. It basically allowed the banks to borrow at a low fee, so effectively the banks became riskless. Once they got the large capital injections, suddenly the issue of them failing in the short term was gone. The bank earnings now seem a lot rosier. I'm happy for the banks, but I'm cautious in saying that this does not necessarily mean that banks are back to being profitable.

There's more on TARP issues and profit-imitating trading strategies in the rest of Nancy Cook's interview with Acharya. It's an important read.

How can we predict the next bubble? That’s the $64,000 question, and while nobody has an answer, Goldman Sachs made some interesting observations in a research paper they put out this week entitled “The Twilight Zone.” This is what the bank is calling the most sensitive period in the economic cycle, the one that comes right between a boom and a bust.

Previously, economic cycles were basically thought to have just two parts─theoretical models that the rocket scientists in major banks use to try and forecast the future generally have a “boom” line and a “bust” line. But the Goldman paper posits another period─the Twilight Zone period─which generally lasts between a few months to a year. It’s during this tipping-point period that investors can find clues to the next bust.

But which of the many hundreds of commonly tracked economic figures should investors be looking at to predict the next crash? Probably whatever data point that was most important to supporting the boom in the first place. For example, the 1920s boom in America was supported by a credit expansion that led to a huge increase in consumer spending (sound familiar?). But several months before the stock market crash, factory outputs of things like cars had started to decline sharply─a sure sign that consumers had stopped spending, and black clouds were on the horizon.

The same thing goes for other crashes, like the Latin American debt crisis, in which capital flight began a year prior to the various sovereign defaults, and the Asian crisis, which investors might have foreseen had they been looking at the sharp fall in external reserves in Thailand (which had attracted some of the hot money fueling the region’s boom).

Of course, hindsight is 20/20. But this report serves as a reminder that where you see smoking hot assets, you may very well soon see fire.

Even Dr. Doom seemed to be all sunshine and lollipops yesterday. Nouriel Roubini, one of the few economists to accurately predict the magnitude of the economic crisis, told a Chilean investors’ conference in New York that "the freefall of the economy” is over. “There is light at the end of the tunnel," he said. "And the light at the end of the tunnel for once is not the one of an incoming train.”

You can probably guess what happened from there. As Wall Street whooped with joy, stocks promptly rallied. But before long, Dr. Doom was clearly agitated again. He put out a statement last night refuting overly hopeful media reports on his remarks:

“It has been widely reported today that I have stated that the recession will be over 'this year'” and that I have 'improved' my economic outlook. Despite those reports─however─my views expressed today are no different than the views I have expressed previously. If anything my views were taken out of context.

“I have said on numerous occasions that the recession would last roughly 24 months. Therefore, we are 19 months into that recession. If as I predicted the recession is over by year end, it will have lasted 24 months with a recovery only beginning in 2010. Simply put I am not forecasting economic growth before year’s end."

Still, whether he thinks the recession will end in December or January, it's significant that even Roubini is helping to solidify the shaky consensus that we might be looking at a bottom.

But read the entire release before you reach for the champagne. He also thinks a W-shaped recession is possible, which means we'd be dipping back down again in short order. What's more, he's emphatic that the recovery─no matter when the recession ends─ going to be long, slow, jobless, and generally miserable. So much for sunshine and lollipops.

(From Longorshortcapital.com and, indirectly, from Matt Taibbi.)

California is $26 billion in the red and handing out IOUs. The solution is likely to include both tax hikes and spending cuts.

Which should lawmakers do more of?

Tad Dehaven: Cut spending. This mess is the direct result of years of excessive spending. If, since 1990, California had just spent at the rate of inflation and population growth, it would have a $15 billion surplus. Taxes are already high in California. Raising them any higher would be about the worst thing it could do; it would kill whatever growth is out there.

Nick Johnson: Increase taxes. It’s Econ 101 to say that spending cuts exacerbate a recession and cost more jobs than tax increases do. California could lay off every single state employee and still not balance its budget. The worst thing is to cut services families rely on. Obviously, cuts in spending are inevitable, but tax increases have to be a bigger part of the solution.

Our Verdict
Voters already rejected a mishmash of proposed tax increases, and Arnold is dead set against any more, having already raised them by $12 billion. Hiking cigarette taxes by $1.50 makes sense, but more cuts seem inevitable.

Dehaven is a budget analyst with The Cato Institute. Johnson is director of the State Fiscal Project at the center on Budget Policy and Priorities.

Check out this very interesting article from GlobalPost about how the financial crisis has led to a spike in conflict and violence around the world this year. As the author, Thomas Mucha, notes, "economics matters." Don't we know it.

By the way, one other point on this topic that I would draw out: natural-resource prices have been as volatile as they've ever been over the last 12 months. Given that the majority of conflict happens in commodities-rich areas, that's probably a key catalyst for the growing violence as well.

Could the next bubbles already be brewing, this early in a recovery? That’s what a number of sources I speak with have been saying in the past few weeks. Economists are worried about the price of oil, minerals, and other commodities─even though they’ve taken a slight dip in the past few days, they are still at prices far higher than usual at this point in the economic cycle. Ditto U.S. and European stocks, and especially emerging-market equities, which are really booming as everyone continues to dream of the days of double-digit returns. Even real estate is spiking again in places like China, Hong Kong, and a handful of other big cities in developing countries.

What’s driving this? An excess of spare cash around the world. Despite the downturn, there are still plenty of people holding lots of money on the sidelines, and they are itching to find a place to put it. If I had to pick the most worrisome bubble of the moment, I’d probably look east to China. Since last December, Chinese banks have given close to a trillion dollars in loans to help companies expand (year-on-year lending was up an unbelievable 1,000 percent at the start of this year). When I was in China in May, even bankers at state- run institutions were starting to worry that not all of this money was making its way into the real economy, and that much of it was being recycled into the stock markets and housing, possibly setting the stage for the next big painful bubbles there.

Policymakers in China and elsewhere are going to be reluctant to take any action around brewing bubbles right now, because the recovery isn’t yet entrenched. This is worrisome, because it could set the stage for yet another boom-bust cycle (more on that in a future cover story from our Morgan Stanley columnist, Ruchir Sharma). I wonder when we might once again enter the period that Goldman Sachs chief economist Jim O’Neill calls “the Twilight Zone”─a delicate time between boom and bust. This is when “the economic fundamentals that support a boom begin to break apart, but a future bust also becomes more likely.” This period must be managed with care by politicians. Tomorrow, I’ll blog more on the Twilight Zone and how we might make our way out of it unscathed in the future. 

CIT is definitely not too big to fail. At least for now. Maybe the company's CEO, Jeffrey Peek, will find a more receptive audience in the Administration as bankruptcy nears, but for now, its $80 billion in assets was deemed sufficiently small enough to squeeze through the bankruptcy process.

Or, looked at another way, perhaps Peek and his employees just didn't give enough money to the Democrats.

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Get ready for 10 percent unemployment. That's the message from the Fed.

Every quarter, the five members of the Federal Reserve Board and the presidents of the 12 regional Federal Reserve Banks give their best guesses about the economic outlook. The latest batch of numbers--released July 15--indicate that the Fed's gotten both more optimistic and more pessimistic. How could that be?

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The White House put out a release this morning announcing that Larry Summers will take to the stage at the Peterson Institute for International Economics this Friday to deliver a progress report on the economic crisis. Given how many waves Friday press conferences have been known to cause, should we expect high drama?

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The big financial news this week is that CIT, a century-old bank, might be next in line for a government bailout.

As Bloomberg notes, since 2003 the finance firm has been run by Jeffrey Peek, formerly a top executive at Merrill Lynch. Peek revamped CIT's loan portfolio, which used to be concentrated on financing for small businesses, and moved the firm into new, high-yield areas like -- you guessed it -- subprime mortgages. Since 2007, the company has reported eight straight quarters of losses, and its debt is now rated as junk. The company has to pay back $1 billion to lenders next month, and it looks like it needs Treasury's help to do so.

But the real story isn't whether CIT sinks or swims, but what it implies for the financial system if it does indeed get a government bailout.

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It seems so. For the first time since June 2007, growth forecasts for the world’s rich nations are being revised upward, according to the latest OECD data. Also, some new figures from the IMF show that predictions of world GDP growth for 2010 are up by half a percentage point, to 2.5 percent. OK, that’s about half of what it was in the heyday, but we should still be thankful.

Despite all our problems, the U.S. is driving all this. We’re still the biggest kid on the block, with the most liquid currency. The U.K. and Japan are in recovery too, but the euro zone isn’t─growth there is still lagging, and things could very well get worse before they get better, given that German banks are exploding left and right, as is debt in most of the major economies.

But, as Martin Wolf notes in his very smart FT op-ed piece today, this recovery isn’t going to feel much like one. He makes the important point that the moral-hazard problem in banking has only gotten worse, given the huge bailouts. I’m personally very curious about just how Goldman Sachs managed to get those great profit numbers yesterday.

The other thing that worries me is that while this upswing is clearly great for companies─a number of global blue chips are awash in profits─it’s not good for labor. As most of us know, labor’s share of the global wealth pie has been decreasing relative to corporates’ since the 1970s. It looks like this recession may have sped up that trend. Jobless recovery, indeed. For more on what the recovery means everywhere, check out our package in next week's print issue.

But in China, it seems, a few hundred people are saying something. A 39-year-old Uighar scholar named Ilham Tohti vanished from his home last week after officials accused his website, Uighar Online, of serving as a platform to stir up civil unrest. Now, reports are emerging that Chinese intellectuals are rallying around his cause, even while officials refuse to acknowledge whether or not they are actually holding him.

Mr. Tohti has certainly been critical of Beijing in the past; he defiantly told Radio Free Asia in March that unemployment among Uighars is among the highest in the world, and that he will continue saying so "no matter what." But inciting riots? It's hardly a scientific survey, but here are some screen grabs of the offending website's homepage, with some crude Google-supplied translations (click on the pics for full-size views):

Source: Uigharbiz.net

Goldman Sachs announced its second-quarter results today, and they were impressive. Here's a bit of fun math to illustrate just how impressive: GS set aside $6.6 billion this quarter to pay employee bonuses at the end of year. GS has 29,400 employees. That works out to an average bonus of $224,000 per employee -- for the second quarter alone. Annualized, that works out to a yearly bonus just shy of $900,000. Not bad for a year in which the rest of the world is debating whether we're in the early stages of a new Great Depression or just a very severe recession.

Over the last few days, I’ve been talking with our Rio correspondent, Mac Margolis, about the future of Brazil, which has been one of the winners in the global financial crisis. As Mac reports for an upcoming Scope item in the international magazine, the country has weathered the downturn much better than most; not a single bank went under, its debt is low and is predicted to fall rather than rise significantly in coming years, and the Treasury is still sitting on $208 billion in hard currency reserves. While the Dow, the DAX, and the Nikkei have tanked, the Sao Paulo stock exchange is up 31 percent since January and most economists are expecting Brazilian GDP growth to grow strongly again by next year.

But the fact that Brazil is so flush is also a risk.

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photo credit: Nir Elias--Reuters-Landov

In Sunday's Washington Post, George F. Will takes a swat at Obama, arguing that his pro-government policies are "diminish[ing] America's competitive advantages." He writes:

Let's guess: Will a person or institution looking for a place to invest $1 billion seek opportunities in the United States, where policy decisions are deliberately increasing taxes, debt, regulations and the cost of energy, and soon will increase the cost of borrowing and hiring? Or will the investor look at, say, India. It is the least urbanized major country -- 70 percent of Indians live in rural areas, 50 percent on farms -- so the modernizing and productivity-enhancing movement from the countryside to the city is in its infancy. This nation of 1.2 billion people has a savings rate of 25 to 30 percent, and fewer than 20 million credit cards. Which nation, India or the United States, is apt to have the higher economic growth over the next decade? 

Luckily, we don't have to guess! The United Nations actually tracks foreign direct investment, a measure of one country's investment in another. Buying a factory or stake in a foreign company contributes to FDI, and signals an implicit vote of confidence in the future prospects of that country.

So how does the U.S. fare against India?

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As both Rana and Barrett have written in the past few days, there are plenty of good reasons to keep an eye on the Uighar protests in China. At the top of our list is the hunch that political unrest, even in an economically isolated area like western China, can have a delayed but distinct ripple effect on a country's economic stability. In that spirit, I'd like to direct your attention over to Kenya's sex trade.

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After reading a review copy, which was delightful and provocative throughout, I asked Tyler a few follow-up questions by email 

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McKinsey today came out with the latest version of its annual "Power Brokers" report, looking at the rise of four key players on the global financial scene: Asian sovereign wealth funds, petrostates, hedge funds, and private equity. This paper is chockablock with statistics that international investors will find interesting, but the key takeaway is this—power and money are shifting south and east much faster than we thought possible. Consider this, from the report:

"Although oil exporters and Asian sovereign investors were shaken by the crisis, they remain power brokers and are poised for future growth. In 2008, oil exporters and Asian sovereign investors invested $1.7 trillion in global capital markets, an average of $4.5 billion per day. Financial power will continue to disperse and shift from the West to other parts of the world, with the assets of oil exporters and Asian sovereign investors projected to grow twice as fast as those of other institutional investors through 2013 under a base-case scenario that assumes global GDP growth resumes in 2010. For policymakers and business leaders, these projections present a serious challenge: how to ensure that this surplus capital is invested in productive opportunities that will raise living standards, rather than contribute to future asset bubbles."

Hedge funds, meanwhile, are completely underwater (assets under management are down 25 percent from '07 to '08), and private equity is flat. If you had any doubt that the Asian century is upon us, this report should clear it up.

As Rana noted yesterday, investors (and anyone concerned about the future of China) should watch the Uighur unrest carefully, even though it's happening in an economically isolated, far western province of the sprawling country. She drew a link between autocracy and growth. Here's another reason to pay attention: Mexico. It was, after all, the 1994 Chiapas uprising that caused foreigners to pull their money out of the country, leading to a painful currency devaluation and a severe recession. The effect wasn't immediate. As the Latin America expert Andres Oppenheimer writes in his book on modern Mexico, Bordering on Chaos, the Chiapas situation simmered for a bit until an emerging-markets investor from San Francisco visited San Cristobal, decided she didn't like what she saw, and recommended pulling money out of the country. That was the first domino that led to an international collapse.

China is, of course, in a much better macroeconomic position than Mexico was in 1994, and has strict controls on capital flows into and out of the country. China's weaknesses, as Rana explains, are in the political sphere. Beijing has gotten better at controlling the occasional ethnic clashes, and is even making a concerted international PR effort, but there could one day soon be a conflagration that erupts into something Beijing can't control.

Today in graphics that should make your palms sweat: Nate Silver, the 538.com numbers nerd who brought the world minute-by-minute election coverage, is now delivering a detailed vision of global climate-induced dystopia.

The back story: The American Scene is home to an ongoing debate over the costs and benefits of Waxman-Markey, the climate change bill that recently passed in the House and is now headed for the Senate. In arguing against it, commentator Jim Manzi points to the Intergovernmental Panel on Climate Change estimate that warming would decrease global GDP by 5 percent, saying that's pretty marginal compared to the economic impact of the proposed legislation. But a good portion of the world's countries register mere blips on counts of total global GDP, even though they account for much of its population. How much, exactly? Into the fray jumps Mr. Silver and his map:

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That’s pronounced “Wee-gur,” just so you know. By now you’ve probably read about this Muslim minority in China, who are clashing with Han Chinese in the country’s remote Xinjiang province. While this is mainly a political story about Chinese repression of ethnic minorities, it has some important economic lessons. For starters, Xinjiang is an area rich in oil and minerals--not incidental to the fact that the Chinese authorities are eager to make sure it stays part of China. But second and more importantly, the ethnic violence reflects what may be the biggest deterrent to Chinese growth--autocracy. I recently saw a very interesting study by the Carnegie Endowment looking at the connection between political freedom and economic growth within society. The link is strong. The study found that countries like China, Iran, Venezuela, and the like, which have become more repressive over the last few years, have also experienced sharp decreases in consumption. Basically, if people don’t feel secure, they don’t spend, and economies don’t grow as fast.

China has so far been able to offset this effect with its massive exports. But with Western economies in decline, that era is coming to an end. And there are many economists who believe that the treatment of the Uighers, as well as China’s stance toward Tibet, and its general repression of its entire population, are a growing economic risk factor. Yesterday, I got a report from Capital Economics in London entitled “Is political stability assured in China?” Their answer was no. While China has so far done well in terms of political stability relative to its neighbors with similar per capita GDPs, Capital noted that past performance was a poor indicator for the future given that Chinese leadership is so opaque. “The form that any institutional change could take is as hard to predict as the timing,” notes the report. What’s more, there’s an assumption that a more democratic China would continue to support economic reform. Not necessarily so. If the Chinese could all vote, the rural population would rule--and they may be much less supportive of the industry-led model that has made the coasts (and many Western investors) rich over the last two decades. The upshot: China may well be less politically stable, and thus less economically secure, than we think.

GoldmanGate is certainly bringing out the inner spook in people. Over at Cryptogon, a blog I had never heard of with a penchant for conspiracy theories, the author set up a honey trap to lure web surfers trying to find the top-secret trading algorithm stolen from Goldman Sachs. By cleverly toying with his headlines and text, he set up one of his blog posts so that it would appear in Google results as a link to the stolen trading platform. When seekers click on the link and visit his site, he finds out a smidgen of information about the seeker, often including the place of employment.

So who's hunting around for the illicit code?

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Academic journals don't usually generate the kind of buzz that has readers counting down the days to the publication date. But there's an intriguing exception on the horizon. On September 1, the American Institute for Economic Research's Econ Journal Watch will publish a symposium of economic "notes from the underground": essays written by guilt-ridden economists confessing instances of "moral or intellectual compromise" in their work. Qualifying sins may include:

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It is often a difficult task to make finance seem sexy and interesting, but there's a financial story now unraveling that effortlessly rivals the best James Bond or Jason Bourne novel.

Sergey Aleynikov, a former vice president at Goldman Sachs, was arrested at the airport in Newark, N.J., on July 3, about a month after he left the globe-spanning investment bank. At Goldman, Aleynikov, a competitive ballroom dancer, computer programmer, and Russian emigrant, had been in charge of the development of a "distributed real-time co-located high-frequency trading (HFT) platform," according to his LinkedIn profile.

The platform, according to informed speculation, is Goldman's "secret sauce." It's a highly sophisticated piece of code that absorbs market data and, within microseconds, makes trades based on that data. It's basically a black box of financial Kryptonite. According to numbers released by the New York Stock Exchange, Goldman dominates the realm of automated trading, and it is likely due in no small part to this platform. 

And according to federal charges, Aleynikov stole Goldman's black box, uploaded it to a German server, and then tried to hide his trail, wiping the record of his keystrokes. Goldman's network stored a backup, so the company was able to check it after alarm bells were triggered by Aleynikov's 32-megabyte upload. 

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There was a glorious time between the mid-1980s and 2007 when inflation was low, economies boomed, and recessions were short and infrequent. In general, the business cycle -- an economics term that refers to the cycle of growth, contraction, and recovery that's a feature of every normal economy -- was subdued. When the economy slowed, it didn't slow for long.

Economists have wracked their brains trying to explain this period of time. Some attribute it to the rise of China and India, which fed the world with low-cost goods. Others say it was Alan Greenspan's skilled manipulation of interest rates. Others think it was just blind luck. Now, two economists at the Minneapolis Federal Reserve say we have baby boomers to thank.

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You can’t hold a good banker back, it seems. I had to laugh when I read the cover of the FT this morning, with a story on how Goldman Sachs, Barclays and others are finding ways to soften the burden of the new capital requirements being imposed on them in the wake of the financial crisis. One of the ways they are doing it, apparently, is by splicing and dicing together assets from several different clients into a single security, which, as the FT notes, “can be sold to other investors and rated by a credit rating agency, potentially reducing the capital allocated against the assets by between 10 percent and 50 percent.”

It’s complex securitization. Sound familiar? It should – it’s what started the financial crisis to begin with!

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No U.S. metropolitan area has been immune from the financial crisis, but the impact has been highly uneven: some cities are already starting to show signs of recovery; others--notably in Florida, California, and Ohio--are still mired in the downturn. 

5.1  Percentage unemployment rate in Provo, Utah, the country's lowest.
17.5  Percentage unemployment rate in Modesto, California, the country's highest.
25  Percentage of the "Strongest 20 metro areas" that lie in Texas, with Austin, Dallas, and El Paso in the top five. 
70  Percentage of the "Weakest 20 metro areas" that lie in California and Florida, with Tampa; Stockton, California; and Sacramento, California, all in the bottom five.

It's still up in the air whether the worst of the financial crisis has passed. In the here and now, the undeniable--and more immediate--question is over how to strengthen the lax financial regulations that toppled the first domino.

Economists say when recovery eventually comes, the resulting growth will likely be a product of a new regulatory structure devised by the world's governments. But the world's a big place. Government leaders may generally agree on a broad global framework of investing and trade restrictions, but getting each national government to play ball in actually setting and enforcing the regulations makes for tricky business.

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Our Beijing bureau chief, Melinda Liu, is in town and mentioned to me yesterday that the Chinese authorities are cracking down on "virtual" currencies. What's a virtual currency, you ask? In online multiplayer games like World of Warcraft, players collect loot in order to buy weapons and armor for their characters, and to advance through the game. For many, this is a very, very serious pastttime -- as evidenced by this teen's reaction when his mother canceled his WoW account.

Some players are so serious, in fact, that they'll pay real-life cash for the virtual gold. When clever entrepreneurs figured this out, they started hiring people to work in "virtual sweatshops," playing WoW and similar games for hours at a time, collecting loot to later sell on virtual currency exchanges. This has started to worry Chinese officials, says The New York Times:

The coin of fantasy realms have already moved markets here. So-called QQ coins — a form of currency produced by the Chinese Internet giant Tencent — have sometimes risen sharply in value against China’s official currency, the renminbi, alarming officials at the nation’s Central Bank.

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For years, American educators have been touting the rise of the "knowledge economy" and shifting focus away from the manual trades, encouraging teens onto the four-year college track in preparation for our supposedly postindustrial society. Meanwhile, cubicle jobs are increasingly going the route of manufacturing work as corporations outsource any task that can be delivered over a wireless connection. And thanks to the financial crisis, that drain is only likely to accelerate. So perhaps it's time to reconsider where the future of work is headed as the century unfolds. It's a subject that's starting to gain traction, first in the writings of Princeton economist Alan Blinder and most recently in a clever book called Shop Class as Soulcraft, by philosopher (and motorcycle repairman) Matthew Crawford.

The Idea: American elites tend to harbor ambivalent feelings about manual labor and the blue-collar trades, which are increasingly identified as jobs of the past, only suitable for low-skilled or immigrant laborers. However, manual trades (construction, repair, and maintenance) are among the few jobs that have proved resilient to global outsourcing. Moreover, as Crawford argues, working with one's hands can potentially be more lucrative and intellectually satisfying than being a low-level cubicle worker.  

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