The Destruction of the Irish Economy

by Jeremy James

The Wright report on the review of the performance of the Department of Finance
in the 10 years to end-2010 has just been published on the Department's website.
For anyone who is genuinely concerned about the way this country's economy has
been torn asunder over the past few years, this report is a shameless and mind-
numbingly pointless exercise. It does not give a single convincing insight into the
real reasons the Department stood back from its statutory responsibilities, from
2004 if not earlier, and allowed an utterly unprincipled and unscrupulous
'government' to do appalling damage to our economy and the fabric of our nation.
The Department was the organisation best equipped to call a halt to the maverick
schemes and cynical exploitation of the outgoing 'government', but it did
absolutely nothing of substance to prevent this catastrophe. Its spineless attitude
beggars belief.

If you want the viewpoint of a former longserving member of the Department's

middle management cadre, please see the attached submission which Robert Pye
made to the review group on 10 October 2010 (which fact is recorded in the
official report).

Be warned, the exploitation of the Irish people is far from over. In addition to
further draconian budgets which will do even more economic damage than the
last one, we can expect to see a sizeable portion of our public assets pass into
foreign ownership over the next few years. These will probably include ESB,
Bord na Mona, Coillte, RTE and a host of other state-owned companies.
Remember, the members of the incoming 'government' sat complacently in the
Dail during the past 10 years while their outgoing counterparts went on the
rampage. The sharks and jackals who control the international banking system
will face no real opposition to their goal of stealing what remains of our wealth
and completing the final destruction of our sovereignty.

Such are the needs of the New World Order.

[The submission which Robert Pye made to the review committee on 10 October
2010 follows below.]

4 March 2011

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TO: Mr Rob Wright, Chairman of the Review Panel established by the
Minister for Finance to conduct an Independent Review of the
Department of Finance

- Review of the Department of Finance -

Submission by Robert Pye, employee of the Department 1979-2010

Disclaimer
At the outset I would like to state that none of the comments and opinions expressed
in this submission should be taken as a reference to any individual civil or public
servant, whether past or current. They should be interpreted as referring exclusively to
(a) the Department (or other relevant organisation, as appropriate) as a corporate
entity, or (b) the senior management cadre, broadly conceived. This is not to imply
that individual civil and public servants did not make very serious mistakes in the run
up to, and in the aftermath of, the fiscal and banking crises, but merely to clarify that
this submission makes no pronouncement – good, bad or indifferent – in relation to
any individual.
Key Players
The key players in the fiscal/banking débâcle are those normally identified in public
and media discussion of the issues in recent months, plus one group which is
ordinarily never mentioned, as follows:
The Ruling Elite: This is not the cartel of bankers and developers, nor
even a combination of the cartel and other influential interests, but the
quasi-dynastic consortium which has ruled Ireland for generations.
Credentials
Even though I was an Assistant Principal in the Department for 26 years (1984-2010)
– a rank which does not normally have close regular contact with senior management
– I enjoyed exceptional proximity to the higher management tiers of the Department
since 1994 when I was assigned, firstly to the programme of reform of the public
service, and then to strategic management co-ordination within the Department. I was
also secretary during that time to both the Assistant Secretary Group and the Principal
Officer Group, as well as the Departmental Partnership Committee. I was thus
unusually well placed over a period of fifteen years to observe the inner workings of
the Department, its management dynamics, its decision-making processes and its
changing organisational structure.

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I was responsible for co-ordinating the preparation of all Statements of Strategy
published by the Department since 1997, as well as all Progress Reports thereon, the
Department’s official Risk Management Strategy, its framework of assignments of
responsibility for all officers at Principal level and above, and all progress reports on
change management developments and initiatives across the Department. I was also
responsible for co-ordinating the preparation of the Department’s Annual Output
Statement which was used by the Oireachtas Finance and Public Service Committee
in its annual meeting with the Minister as the basis for its review of the progress or
otherwise made by the Department in achieving its strategic objectives. I organised
the Department’s annual conferences in the period 2000-2007 and participated in a
drafting and advisory capacity in the major Organisational Review of the Department
in 1995, as well as in a lesser review in 2000. I also attended occasional meetings of
the Management Advisory Committee (MAC) between 1994 and 2008.
I greatly enjoyed my work and found it both challenging and rewarding. I was
allowed a high degree of autonomy and, for the most part, there was a clear
willingness on the part of management to both hear what I had to say and to give it
due consideration. Many of my ideas and suggestions over the years were
implemented. I enjoyed a good working relationship with virtually all managers at
Director level and above and got to know many of them on a more personal level.
I feel it is important to provide this career-related information in order to establish that
I am well qualified to comment on the Department, its workings and its management.
As it transpired, very few people would have had such a broad overview of the
Department or such regular contact with the top three layers of management over such
a long period.
I also have extensive experience of organisational and systems issues within the civil
service as a whole through my work on computerization. For example, I was the sole
author of the ESRI report, An Overview of Civil Service Computerization 1960-1990,
which was published in 1992, and spent six years with the Department’s IT strategic
planning function (1988-1993).
I also served in the Department’s Economics Unit in 1994-1995 and as deputy Gilt
Dealer for the Department in 1987-1988, which included oversight of the Stock
Exchange.
For the record I would point out that I did not accept three or more offers of
promotion to Principal level in the period 2000-2008, partly for family reasons, but
also because I had long been concerned at the extent to which the Department is
influenced, if not controlled, by the political system.

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General Comment on the Department’s Management
In my experience, the Department has always had a strong management team and has
always striven to promote a high level of professionalism. Like most organisations, it
may have one or two weak performers in some areas but, broadly speaking, these
have never been a serious impediment to the achievement of its objectives. In the
main, the Department’s managers (PO level and above) are hard working and
committed. Many have acquired a good deal of experience in various sections, as well
as in other Departments, and have a high standard of educational attainment. On the
whole, in my experience, its managers take real satisfaction in delivering a high
quality service.
The introduction of a formal MAC structure in 1994 (which superseded the less
structured approach which had operated hitherto), along with the creation of the
Assistant Secretary Group in 1997 and the Principal Officer Group in 1999 [dates
approximate], greatly improved the strategic management process and raised aware-
ness across Divisions of the goals being pursued by other senior managers and
facilitated the identification of common issues and concerns. As a result senior
managers have had more direct contact with one another over the past ten years and a
better understanding of their respective roles in the overall management of the
Department.
While the Department could not be regarded as a perfect administrative machine, it
was definitely not dysfunctional. In my opinion, the principal causes of the
fiscal/banking débâcle cannot be traced to structural or systemic weaknesses within
the Department. Neither can they be attributed, in any realistic sense, to skill
deficiencies among its senior managers.
The real problems lay elsewhere, as I shall shortly demonstrate.
No one wants to hear bad news
My first real acquaintance with a major flaw in the Department’s modus operandi
came in 2004. My wife had inherited a small sum of money which she wanted me to
invest on her behalf. So I studied the markets to determine which sectors were most
likely to perform well during the next 10-15 years. Perhaps being an amateur
economist has its advantages because, after 3-4 months of reading and analysis, I
came to a conclusion which was widely at variance with that of my colleagues,
namely, that the world economy was set for a major dive in the very near future.
In fact, my analysis suggested that, given the serious imbalances in Ireland’s
economic profile, a major global shock could have a devastating impact on both our
fiscal position and our banking system. So I wrote a series of papers which I
circulated internally on a personal basis to a number of senior managers.

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I wrote as a private individual for two reasons. Firstly, I was ‘trespassing’ on the work
of other sections (which is a major taboo in the Department) and, secondly, there
would be no onus on the Department to disclose any of my papers under Freedom of
Information since they were written and received in a personal capacity (I did all of
my research, analysis and writing in my own time). The scenario I was describing in
my papers was very different from the official view being taken by the Department
and promoted widely by politicians. I also published in a private capacity to prevent
the Department from placing an embargo on the release of my papers at a later date.
Appendix A attached lists the grades of those officers who received one or more of
my papers, as well as the papers supplied in each case (I have not named any of the
individuals concerned but the reader can be assured that most of them were very well
placed).
Appendix B attached comprises all 7 papers, plus a draft article which I wrote for
submission to The Irish Times in January 2007 (which was officially blocked by the
Department.)
The response to my first paper was very disappointing. So I tried again. Struck by the
validity of my arguments, one officer (at PO level) was prepared to hold a workshop
to discuss the issues. However, he was promoted to Assistant Secretary rank outside
the Department a couple of weeks later. Please note that he was the ONLY person
who at any time called for a wider discussion of the issues in any of my papers. The
ONLY person.
I persisted and managed to get a meeting with 3 well-placed Assistant Secretaries.
The meeting, which took place on 13 October 2004, lasted about 40 minutes. They
agreed that the risks I had identified were legitimate but not with the high rating I had
ascribed to them or with my overall conclusions. They argued that one of my main
recommendations – that the state should run a large budget surplus for several years –
was simply untenable on political grounds. (A large surplus could have been placed in
a sinking fund and used to reflate the economy after the tsunami struck. It would also
have greatly reduced the rate of growth in public expenditure and thus lessened the
severity of the impact.)
I continued to write papers until end-2005 when I finally gave up. Despite repeated
efforts to spark a debate, I got absolutely nowhere. Apart from the brief, unproductive
meeting of 13 October 2004, I had no serious feedback from anyone to any of my
seven papers. While three recipients gave some very informal feedback (two POs and
one Assistant Secretary) and were broadly in agreement with my analysis, they
showed no willingness to express their opinion more openly within the Department.
I made one final attempt to raise the alarm in January 2007 when I wrote a long article
for submission to The Irish Times. Given my position within the Department, I felt I
was obliged (rightly or wrongly) to first submit it to the Department for ‘approval’ to
send it (but not to endorse its contents). However I received an official written
notification from the head of Corporate Services Division informing me that I could
not send it.

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The entire experience was extremely exasperating. I was confronted with a side of the
Department that was utterly baffling. It was patently obvious to me that no one
wanted to raise the possibility that the so-called ‘soft landing’ would turn out to be a
calamitous crash. Such a spectre was politically unacceptable and could not be
debated.
The Seven Papers and the proposed Irish Times article
The arguments sets out in my seven papers were fairly straightforward. Instead of
taking a purely domestic stance on the Irish economy, they focused on the geopolitical
factors which would have the greatest bearing on its development in the years ahead. I
could see that there would be no point in highlighting the potentially devastating
property bubble or the unconscionable growth in household and developer debt –
these factors were already receiving attention in the media. Besides, if I commented
too much on the Irish economy I would be accused of second-guessing the work of
another section of the Department – which is severely frowned upon. So I focused
instead on geopolitical analysis, partly because it was not being conducted in a
systematic fashion anywhere in the Department and partly because it added a whole
new dimension to the debate. Overall the geopolitical angle gave me all the space I
needed to sound the alarm.
I won’t try to summarise my arguments except to note that they correctly predicted
each of the following:
- the global credit crunch of 2008;
- the Wall Street banking crisis;
- the calamitous damage caused by financial derivatives;
- the extent to which the international financial system was being
operated in a fraudulent manner;
- the sharp collapse in the Irish stock market in 2008;
- the potential collapse of the Irish banking system in 2008/9;
- a major fiscal shock to the Irish economy in 2008/9;
- the very significant increase in pension fund deficits;
- the price of oil at end-2007 (two years in advance);
- the progressive destabilisation of the Middle East;
- the continued marked deterioration in US budget and trade deficits;
- the substantial increase in commodities and precious metals;
- the abysmal response by G20 and OECD leaders to the crisis;
- the very significant deepening of US indebtedness.
We have yet to see the collapse of the US dollar, but this cannot be far off. Neither
have we seen the huge burst of inflation predicted in my papers, but this will come if,
as expected, Europe and the US print fiat money on a grand scale to pay for the so-
called stimulus and bail-out packages. (This used to be described as recklessness in
the UK and elsewhere, but today it is known as Quantitative Easing.)

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So what went wrong in Ireland?
Before we can establish what went wrong in the Department, we need to examine the
forces that were shaping the Irish economy in the period 2000-2008.
When a serious crime has been committed one must ask Cui Bono? The debate in the
media to date in this regard has been very poor. Over 50 billion euro (and counting)
has been transferred from the Irish people to a relatively small number of unknown
beneficiaries. This is being described as a necessary expedient to protect both
international bond holders and the Irish banking system. However, whether it is
justified or not – and I am firmly of the view that it is hideously misconceived –
when considered purely as a system of intervention it is completely lacking in
transparency.
The Irish people are still not being told who the ultimate beneficiaries of this
gargantuan transfer of wealth really are. Not one euro has been ‘lost’ in the débâcle.
Not one. Instead there has been a massive transfer of wealth between the Irish middle
class and an elite group of insiders. When a mother of two defaults on a loan of €2000
from her local credit union, it is described as a crime and the woman is put in prison
for a few months, but when €50 billion goes missing, and powerful vested interests
are involved, it is described as an unfortunate occurrence.
There is really no point in examining the conduct of the Department of Finance during
this period (2000-2008) unless this central reality is acknowledged. A theft of this
magnitude does not occur without the deliberate connivance and planning of a number
of people in key positions, both in Ireland and abroad.
At this point I should state categorically that I don’t believe the Department was
wittingly complicit in this crime. As far as the Department is concerned, the central
question is not its complicity but its failure to recognise the gravity of what was
happening and to raise the alarm. We will now look at the reasons for this.
Why the Department failed in its responsibility
The attitude taken to my seven papers, and the deliberate frustration of my attempts
(such as they were) to carry the debate to a wider audience, is itself a significant
indicator of the attitude prevailing within the Department. But what exactly was that
attitude?
It might help to compare it with the attitude taken to another public policy issue –
Decentralisation. This ‘scheme’ was foisted on the civil service without debate,
planning or analysis of any kind. It was purely a political initiative to garner votes in
provincial areas and generate large capital projects (through the construction of office
accommodation) for well-connected developers. At a stroke it dealt a nasty blow to
the Public Service Modernisation programme which was predicated on many
principles which Decentralisation contravened – one size fits all, segregation of staff,
reduced mobility, communication bottlenecks, empire building, over-specialisation,
the proliferation of administrative overheads, the duplication of functions,
organisational inflexibility, etc.

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While some Departments already had a species of decentralisation under way, it was
being carried out strictly in line with their specific needs, in support of their strategic
objectives, and in accordance with their own timetable and business requirements.
What is more, the Decentralisation scheme ran completely counter to another
important government policy, the National Spatial Strategy, which sought to optimise
the distribution of national resources and infrastructure across regional locations,
using agreed criteria and planning parameters – all of which were ignored by the
Decentralisation scheme.
So if any Government or Ministerial initiative deserved to ‘resisted’ by the
Department, this was it. How exactly such ‘resistance’ might have been exercised is a
matter of conjecture, but the question never arose since the attitude of management
during this period was one of unquestioning obedience. When the logic of the
Decentralisation scheme was challenged at a meeting of the Departmental Partnership
Committee in 2003/2004, in circumstances which could not be regarded as either
unreasonable or disrespectful, the officers concerned were swiftly rebuked. They were
told in no uncertain terms by a very senior manager that the role of the Department
was to advise the Government on policy matters and, once the Government had made
a decision, it was the Department’s statutory duty to implement it without question.
No vacillation or second-guessing of any kind would be tolerated.
This was not a once-off incident. It was the prevailing attitude, hammered home again
and again by senior management. We might advise the Government that white was
white, but if the Government decided that white was black, then the Department was
deemed ‘legally’ required to preach the same message to all and sundry – without
question.
This may seem somewhat comical, but for the Irish taxpayer it was far from amusing.
The Government which came to power in 1997 quickly realised that it could get the
Department to do virtually anything it wanted, without any significant resistance. And
the more it got its own way, the more brazen it became.
Let me give a number of examples to illustrate this. Please consider each of them very
carefully since they paint a very bleak picture indeed and highlight the disturbing
inability of the Department to exercise a moderating influence on some of the more
eccentric, partisan and irresponsible policies pursued by the Government (It is not
known whether any senior civil servant stood his ground with the Minister during this
period, but it is generally believed that at least one did, a very capable and widely
respected individual – but he was abruptly transferred outside the Department ):
o The feverish expansion of expenditure in the Health Sector, despite the
well-known structural difficulties in that sector, the fragmented and
unconvincing nature of its management, the serious lack of systems to
ensure the effective allocation of resources, and the startling absence
of any evidence that the increases already made were having any
effect.

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o The introduction of a series of dangerously pro-cyclical Budgets from
2001 which stoked inflation and undermined competitiveness.
o The introduction at great cost of a state-subsidised scheme (SSIAs) to
encourage saving when no such encouragement was needed and no
clear strategic objective was being achieved.
o The Decentralisation Scheme [which we have already discussed].
o The uncritical pursuit of major infrastructural projects at costs far in
excess of the norm in other countries. The state was probably paying a
premium of 30-40 per cent minimum on every euro it spent on such
projects. For example the LUAS project – a mere 16 miles of track –
cost €780m when projects of a similar size in most other European
countries would, as widely reported, have cost somewhere between
€250m and €400m.
o The complete failure to identify the cartel being operated by a number
of construction companies whereby each tendered for a public contract
at a grossly inflated price and a pre-selected under-bidder, also a
member of the cartel, secured the contract – also at a greatly inflated
price. According to media reports in 2008 (I believe) the fair market
price for all large public construction contracts was being inflated by
this cartel by 30-40 percent. Of even greater concern is the apparent
failure by the Government to publish information about the companies
concerned or to explain the steps, if any, being taken to recover the
over-payments or impose meaningful financial penalties.
o The Tribunal gravy train is one of the most outrageous misuses of
public funds that one could possibly devise. Fee structures (which are
already excessive) were applied on a semi-permanent basis to a
situation for which they were never designed. Well over half of public
expenditure on the legal costs of Tribunals over the past 15 years has
been a complete waste. The abuse was so brazen and so flagrant that it
is truly astonishing that the Irish public (or the Department) could have
allowed it to continue.
o The Department has a central role in formulating policies that support
price stability and competitiveness. This gives it a direct interest in the
pricing practices employed in such major sectors of the economy as
the retail grocery trade and the sale of pharmaceuticals. However, as
consumers have long argued, and as the experts have finally admitted,
both of these sectors were over-charging by 25%-30% during most of
the boom and yet no effective action was taken to rein them in.

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 o Another obvious abuse, which should also have drawn considerable ire
from the public, was the Benchmarking scheme. Instead of having one
system of pay determination, public servants now had two – and each
operated without any obvious regard to the other. If the standard
Partnership arrangement was fair, then there was no justification for
Benchmarking. On the other hand, if the standard Partnership
arrangement was unfair, then workers in the private sector were being
deceived by the state. One cannot have it both ways.
To crown it all, the papers relating to Benchmarking were withheld
from the public. This ensured that the entire exercise and the spurious
principles which underpinned it were hidden from objective scrutiny.
It is unclear how strenuously the Department argued against the
Benchmarking scheme, if at all. However if it did its efforts were
singularly unsuccessful. The scheme added billions to the public
service pay bill and did enormous damage to Ireland’s competitive-
ness.
Further disturbing examples could be given of Government policies which should
have drawn a powerful response from the Department, but these should suffice.
Other major players
Before proceeding to examine the property bubble and its toxic effects, we should
pause for a moment to consider the role of other major players in the débâcle. Any
assessment of the Department should have regard to the concomitant failures by
bodies which were meant to be supporting it in the stewardship of the economy.
The Central Bank should have taken radical action as early as 2004. While flagging
the possibility that the ever-expanding bubble could trigger a banking crisis, it did
virtually nothing to address the explosive growth in credit, the cavalier borrowing
policies of the major banks, their indiscriminate liberality in relation to a small circle
of developers, or their unbelievable reluctance to implement responsible lending
criteria. Its failure in this regard could well amount to criminal negligence. (I can
recall a Sunday newspaper article in 1992/1993 by Mr Cathal Guiomard, a former
employee of the Central Bank. I believe it took the form of a letter to the Governor. In
the article he tore the Central Bank to shreds, citing a ream of evidence which seemed
to support his lacerating appraisal of its many defects. If even half of his criticisms
were well founded, it was a seriously dysfunctional organisation even then.)
The role played by the office of the Financial Regulator was so negligent that it is
difficult to even talk about this organisation without exploding in fury. Let that
comment suffice.

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And then we have the NTMA, which manages a major international investment
portfolio on behalf of the state and is thus obliged to monitor and forecast significant
geopolitical risks. What warning did it give the Department? What steps did it take to
alert key figures in the Department to the gathering storm clouds? If it was aware of
the impending international crisis, why didn’t it ensure the Department was fully
apprised of its intelligence? And if it was not aware, why was it managing an
international investment portfolio of over €20 billion?
Next we have the ESRI, whose Quarterly Reports are meant to reflect the harsh
realities of the market place. Why was its analysis so wide of the mark? It has about
fifteen ‘Professors’ who are meant to be leaders in the field. Most enjoy a rank and
remuneration above that of Assistant Secretary. What is more they are not as
hampered as civil servants by the need to couch their pronouncements in politically
anodyne language. The Institute should have been sounding the alarm continually and
in no uncertain terms from 2004. Instead it too lacked the moral courage to state
plainly what was actually happening and propose radical remedial action.
Among academics, it would appear that only Morgan Kelly of UCD had a true grasp
of developments. His articles in The Irish Times were both cogent and informative
and should have spurred a number of economists to snap out of their complacency.
The fact that they did not is further evidence of the depressing herd mentality which
affects the vast majority of Irish economists.
The Department’s response to the growing crisis
The inflation in property prices throughout the period 2000-2008 was perhaps the
most obvious sign that a major economic crisis was building up. Even the dogs in the
street knew that if this bubble burst – which is normally what bubbles do – then the
consequences for the economy were potentially catastrophic. The Government
response was abysmal. The three so-called Bacon Reports would have little or no
impact on the problem – and just about everybody in the Department knew this. As
long as cheap credit was freely available, prices would inevitably go up. In order to
slow property price inflation, it would be necessary to severely tighten the availability
of credit. One didn’t need advanced skills in economics to see this.
The bubble yielded huge revenue increases in VAT, income tax and stamp duty. The
Government’s appetite for cash was simply voracious. However virtually every senior
manager in the Department knew – of should have known – that its conduct was
economic recklessness of the highest order. What is more, it was impacting directly
and in a very punitive form on members of society who were too gulled by media
propaganda to recognise what was happening. For example, a family of four which
wished to move to a home with an extra bedroom could end up paying over €60,000
in stamp duty, virtually all of which it would have to borrow. This was on top of the
extra money it would have to borrow to buy the larger property. Thus the Government
was forcing middle income families to increase their borrowings significantly in order
to make a massive lump sum donation to the state. And when the state got its hands
on the money, it immediately spent it. Frankly, this was economic madness of the
worst kind, and yet the Department stood by and let it happen.

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The Government had no incentive whatever to take corrective action. It was reaping a
colossal revenue windfall, most of which it then channelled into current expenditure.
As an egregious violation of the most basic principles of economics, this is probably
impossible to beat.
Many commentators bleat about the need for greater specialist skills in economics and
financial management in the Department, but this is nonsense. The mistakes which
were made had nothing to do with skills. They were due rather to the appalling
inability of the Department to impress upon the Government the sheer recklessness of
its policies.
It has also been suggested that the Department was in some sense ‘weakened’ by the
enlarged role played by the Department of the Taoiseach in the past ten years or so.
This too is a red herring. The Department of Finance suffered no statutory diminution
of any kind in its responsibilities. It was just as ‘powerful’ in the period 2000-2008 as
it had been at any time in its history. The question really is whether it was prepared to
exercise that power in the interests of the Irish people or to roll over like a compliant
poodle and let a ruthless cartel of international bankers and investors extort billions
from the Irish taxpayer.
The Department could not come to grips with the fact that it would have to confront
the Government and fight furiously to defend both the banking system and the public
finances. Instead it simply contented itself with “advising the Government” and
including the occasional cautionary comment in its Memorandums. If papers released
to date under FOI are any indication, these cautionary comments were no more than
spineless academic observations at a time when a series of thundering rebukes were
absolutely essential. By end-2006 the Department should have been in open revolt
against the patently insane policies being pursued by the Government.
During this period (2000-2008) I had the opportunity to observe the Assistant
Secretary Group in action. This comprises all managers at Director and Assistant
Secretary level across all Divisions (about 14 in all). These individuals also get an
opportunity to attend the weekly meetings of the MAC on a rotating basis (3-4 at a
time). The public has a right to ask whether and to what extent this group of well paid
senior civil servants addressed the unfolding crisis over this period. What recommen-
dations did it make? What steps did it take to alert top management to the calamity
that was then unfolding? The answer, sadly, is very little (and I’m being kind here –
the correct answer is probably “none at all”.)
In other words there was little if any recognition within the Department that a truly
major crisis was brewing. Most accepted the conventional view that a “soft landing”
was the most likely outcome. This seemed to be predicated on the belief that as long
as cheap and ample credit was available from the international money markets, the
banks could continue to find the necessary liquidity to sustain their operations and
could gradually tighten their lending policies as soon as the property market reached a
natural plateau. This was not just wishful thinking of the worst kind by the banks but
a serious criminal violation of their legal requirement to avoid any activity that might
threaten their solvency or long-term viability.

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In my seven papers I concentrated on trying to show that the international money
market itself was on the brink of a major crisis. So, just at the point where the Irish
banking system was most over-stretched, its supply of cheap liquidity would be
severely reduced, if not cut off completely. No one in the Department wanted to hear
this message.
[The Department already had good reason to keep a close watchful eye on at least one
major bank. AIB almost destroyed itself in 1985 when it bought ICI – an incredible
blunder by any reckoning – and had to be bailed out by the state at considerable cost.
Then, in the course of the 1990s, it deliberately defrauded the Exchequer of hundreds
of millions in taxation revenue by encouraging thousands of its clients to open illegal
off-shore accounts. Furthermore, it knew full well that the ethical standards applying
in Anglo-Irish Bank were even lower than those of AIB.]
The perception that the international financial system was sufficiently robust to
withstand a major shock was reinforced by the absence of a section or unit within the
Department to monitor and analyse geopolitical risks. It was not that such risks were
being ignored, but their potential impact on the Irish economy was not being analysed
in a convincing or systematic way. Instead the Department was content to adopt a
standard textbook approach, factoring in geopolitical factors where they appeared to
be relevant in a given context, but otherwise failing analyse the global environment in
its own right, with particular reference to the United States. Had they done so they
would have seen that most of the opinions published in The Economist, The Wall
Street Journal and The Financial Times were just that, opinions.
If a person like myself, with no formal qualification in economics, could see the huge
inconsistencies and incongruities in the Government’s policies and the shock that
would shortly explode on the international stage, there is no reason why the many
skilled and capable managers within the Department could not have done likewise.
The attitude to my papers
This leads inevitably to the question – why were my papers ignored? Why didn’t the
Department host a workshop to explore these issues? Why was there no debate
whatever on the questions raised in my papers?
The answer? – I don’t know.
Perhaps I was speaking above my station, or treading on people’s toes. Or perhaps
people were just too busy to take on another burden. Or perhaps I was raising issues
which were too sensitive politically. Why did some senior managers agree with me in
private but took care never to voice this view across the Department? Why did the
Department block my proposed submission to The Irish Times?

13
I believe the same attitude of supine resignation which gripped the Department and
rendered it unable to confront out-of-control politicians, also made it unable to debate
or even acknowledge the validity of the issues raised in my papers. After all I was
recommending a series of budgetary surpluses at a time when the Government was
arrogantly proclaiming its intention to Spend Spend Spend. I was also recommending
a major shift in the investment strategy being pursued by the NTMA in relation to the
National Pension Reserve Fund. No one in the Department appeared to be willing to
take on a challenge like that.
In fairness, I must stress that most managers at Assistant Secretary and Director levels
were putting in long hours during this time. Most were dealing with matters which
were politically sensitive and very time-consuming to address. I can safely say that, in
my experience, all officers at that level were pulling their weight and many were
going the extra mile to deliver results. However none of this excuses their role in the
calamity that ensured.
Conclusion
So what went wrong? The answer ought to be obvious. We were allowed to think
outside the box, but under no circumstances could we speak outside the box. If the
Government said black was white, then black was white. The Department simply
lacked the moral courage to confront politicians whose policies were plainly
ludicrous. It was not helped by a political system in which one party ruled without
restraint for over ten years, with virtually no opposition of any kind. A senior civil
servant, even a tough person with a lot of experience, would find it difficult to
confront a Minister who was not facing any meaningful resistance in the Dail.
The Department also tried to justify its stance by interpreting its legislative remit far
too narrowly. It is not enough to say that the Department is statutorily required only to
provide advice to the Government and then implement its decisions. This is not what
the legislation says. There is a statutory duty of care on the Department to act
only in the public interest and to defend the public finances and the banking
system in all circumstances. Its failure to do this in the lead up to the
fiscal/banking débâcle is inexcusable, while its failure thereafter to preserve the
integrity of the public finances raises extremely serious questions about its own
independence and integrity.
This devastating failure must be balanced against the sinister strategy adopted by the
by the Ruling Elite who, deliberately and systematically, siphoned off (and continue
to siphon off) vast sums of money from the Irish middle class. This is by far and away
the most serious crime ever committed in modern Irish history. It is doubtful whether
the Department realised, until it was too late, just how cynical and venal the enemy
really is. Indeed, I believe it still does not understand the role and influence of the
Ruling Elite or their stunning disregard for the welfare of the Irish people.

14
This group is working hand in hand with its counterparts abroad to establish a New
World Order, which entails the destruction of independent sovereign states and the
creation of a system of global governance controlled by the international banking
cartel. They are using systematic economic sabotage to bring this about. Iceland was
first. Next come Greece, Ireland and Portugal, to be followed, presumably, by Spain,
Hungary and the Baltic states. The Department, alas, appears to have no
understanding of this agenda or its pernicious implications for our country, our
independence and the welfare of future generations.

Robert Pye
Greystones
10 October 2010

15
 APPENDIX A

Recipients of Economic Shock papers

June July Sept Feb May Aug Nov

2004 2004 2004 2005 2005 2005 2005
Second Sec Gen x x x x x
A/Sec #1 x x x x x x
A/Sec #2 x x x x x
A/Sec #3 x x x x x x x
A/Sec #4 x x x x
A/Sec #5 x x x x x x x
A/Sec #6 x x x x x x x
A/Sec #7 x x x
PO #1 x x x x x x x
PO #2 x x x x
PO #3 x x x x x x x
PO #4 x x x x x x x
PO #5 x x x x x x
PO #6 x x
PO #7 x x x x x x x
PO #8 x x x x x x
PO #9 x x x
AP x x x

The grade listed is that obtaining at the time the individual received
his/her first paper. Several were promoted over this period and
some are now at Secretary General rank.

16
 APPENDIX B

Papers prepared in my own time and circulated

privately to the individuals listed in Appendix A

#1: Preparing for the Coming Economic Shock and its Aftermath (June 2004)

#2: Preparing for Turbulence on the World Markets (July 2004)

#3: The Imminent Tsunami: Why the World Economy is on the

Threshold a Major Recession (September 2004)

#4: Countdown to a Global Economic Shock (February 2005)

#5: The World Economy: A House of Cards (May 2005)

#6: Ask not for Whom the (Lutine) Bell Tolls (August 2005)

#7: Eight Reasons why a Global Economic Shock is

Inevitable by end-2008 (November 2005)

Article drafted for submission to The Irish Times (January 2007)

(which was blocked by the Department):

#8 Why a Global Economic Shock is Now Looking Inevitable

17
 Discussion Paper for limited circulation,
by Robert Pye, Greystones, Co Wicklow.

Preparing for the Coming Economic Shock and its Aftermath

The principal economic shocks of the past forty years have been oil related, 1973 (the
Yom Kippur War) and 1979 (the collapse of the Iranian regime). Other shocks,
though significant, did not have nearly the same impact on the world economy –
Black Monday (1987), the Sterling Crisis of 1992, the Asian crisis of 1997, the Dot
Com bubble of 2000 and the Twin Towers attack in 2001. These lesser shocks were
largely the result of systemic errors or irrational, and essentially reversible, episodes
in the markets.

The oil crises of 1973 and 1979 had a fundamental and enduring effect on the world
economy, even though only one commodity was involved and no major cost-
increasing crisis developed in tandem. Their impact on both national economies and
international markets was both sharp and severe. Appendix A shows the impact on
key economic indicators in Ireland in the year following both events, while Appendix
B shows the severity of the movements in key market indices.

It should be clear from these statistics that, despite the reduction in dependency on oil
in most major economies since 1979, the impact of another oil shock of comparable
magnitude would be very significant.

The 1973 shock saw oil prices jump from $15.01 to $23.87 a barrel, an increase of
63%. The corresponding figures for 1979 were $29.83 and $44.89 (66%). It should
be noted that neither increase was accompanied by an interruption in the supply of
oil.

The questions one must now ask are:

(a) Is another oil crisis looming?

(b) If so, what impact will it have?

(c) What steps could reasonably be taken at this juncture to mitigate the effects?

Is Another Oil Crisis Looming?

The answer to the first question is almost certainly yes. In fact the evidence for this is
far stronger than the evidence available before the two previous shocks. The
geopolitical climate is remarkably stormy in comparison to that prevailing in 1973
and 1979. While there is a wealth of evidence to support this view, the main
indicators are as follows:

18
 (i) The war in Iraq has escalated out of control. It has now become a guerrilla
war for which the Islamic extremists have prepared. Protracted guerrilla wars
are virtually unwinnable without the use of overwhelming force. Even then,
the high operational costs and disturbing casualty rates limit the extent the
which this option can be pursued. The possibility of restoring equilibrium,
according to many commentators, is virtually nil. The plan to establish
“democracy” in Iraq is misconceived since it implies rule by the majority, who
in Iraq are the Sh’ites. Neither the Sunni minority nor the Kurds would allow
this. Furthermore, the Kurds see the current unrest as a golden opportunity to
create a Kurdish state. This is a further destabilising factor that could even
draw Turkey into the conflict.
.
(ii) The success of the strategy adopted by the Islamic extremists in Iraq will
embolden their colleagues in other countries, notably Saudi Arabia. Repeated
attacks on oil infrastructure and personnel, notably engineers, will at some
point make military intervention by the US inevitable. There are several
million foreign workers in Saudi, many of whom will leave the country if the
abductions and executions continue (The UK have recently allowed non-
essential diplomatic staff to leave). Military intervention will enjoy strong
popular support among the US electorate, at least initially.

(iii) There are strong doubts internationally whether Saudi internal security is
completely reliable. Al Qaeda subversives and sympathisers may already be
employed unwittingly by the security forces and members of the royal family.
This means a co-ordinated strike could have sudden and dramatic
consequences.

(iv) The existing US government has consistently stated that it will not allow
extremists to undermine its foreign interests and that it will take whatever
action it considers necessary to defend those interests. It has already
intervened militarily in two Islamic countries where the stakes were much
lower than they are in Saudi. Also, as early as 1998, the neoconservatives
were calling for the use of pre-emptive military intervention in the Middle
East.

(v) The option of invading Saudi Arabia was actively considered by the US in
1973, according to a British intelligence memorandum released at end-2003.
Seizure of the oil fields, the memo says, was “the possibility uppermost in
American thinking [and] has been reflected, we believe, in their contingency
planning.” (Washington Post, 1 January 2004). Commenting on the same
disclosure, the International Herald Tribune said, “Many Saudis, who believe
America invaded Iraq to secure access to its oil, say they cannot exclude the
possibility that their country will be next.” (8 January 2004).

19
Few commentators seem willing to refer to the possibility of military intervention in
Saudi by the US. The most telling observation that I can find is by Irwin Stelzer,
director of economic policy studies at the Hudson Institute: “A final lesson for
policymakers: prepare for the day when Osama Bin Laden and his associates are in a
position to topple the Saudi regime and withhold supplies of oil, causing an economic
trauma in industrialised countries and a humanitarian catastrophe in the undeveloped
world...The invasion of Iraq was not about oil. But the next American intervention in
the Middle East may well be.” [Sunday Times, 20 June 2004].

What impact will the coming oil crisis have?

Given the statistics in Appendices A and B, there is every reason to believe the
coming oil crisis will be just as disruptive as its predecessors. While world
dependency on oil has fallen somewhat since 1973, it still constitutes a primary input
to economic activity. It also affects all countries, so there is no reserve economy to
drag the rest out of recession.

As Stelzer suggests in the above quotation, the aim of Al Qaeda is to deny America
access to Saudi oil, not simply to push up the price. This would suggest that the
resulting demand around the world, including the growing demand by China, could
push the price close to $100 a barrel.

There is another major factor will may well make this oil crisis even more disruptive
than the first one. The US was winding down its campaign in Vietnam at that time
and was able to pump more resources into the economy. This time the reverse will
happen. The ongoing cost of the war in the Middle East (Iraq, Saudi and possibly
some of the smaller neighbouring countries) will be a very significant drag on the US
economy.

Even without the coming escalation in military costs, the US economy is not in very
good shape. The budget deficit is running at record levels and showed little sign of
abating even before the entry of America into Iraq. There are also indications that the
true cost of the war in Iraq is not being factored in, so that the underlying deficit is
probably much higher than the official figure. The trade deficit is also historically
high, and growing.

The current recovery is being fuelled by a weak dollar policy, tax rebates and
historically low interest rates. None of these will be available once the crisis erupts.

Americans also have a very high level of personal debt and a great dependency on the
stock market and buoyant property prices to fund their retirement plans. Economic
growth in the past 25 years also means that the amount of money in the various
markets, both US and global, is substantially greater than it was in 1979.
Consequently the shock to the markets, when it comes, could have a correspondingly
greater effect.

20
These developments – the growing budget and trade deficits, a significant increase in
the price of oil, the substantial ongoing cost of financing the war, and the shock to the
markets – will frighten those Asian economies which are currently propping up the
deficit by buying Treasury Bills. If they are to continue funding the deficit, they will
expect a higher rate of return and compensation for the falling dollar. Thus higher
interest rates appear inevitable.

There will be a further reason for higher interest rates. The cost of the war for the US
will be funded only in part through taxation and borrowing. The bulk of the cost will
be covered by a substantial increase in the money supply. This will lead to high and
sustained inflation.

The resulting global recession will be deep and enduring.

What steps could reasonably be taken at this juncture to mitigate the effects?
There is nothing that can be done to avoid the crisis, but it may be possible to take
certain steps to mitigate its effects. These include:

o Aiming for a budget surplus for the next 5-6 years. This will leave more room
for a stimulus to the economy when it needs it most.

o Denominating a greater proportion of the national debt in the currencies which

are likely to be weakest after the crisis hits, in particular the US dollar, and
switch as much as possible out of Swiss Franc (which will appreciate strongly
against the euro).

o Introduce amending legislation to enable the annual contribution to the

national pensions reserve fund to be invested in infrastructure until 2010.
Also enable a significant proportion of the accumulated reserve to be used for
the same purpose.

o Review price control legislation and identify further statutory safeguards.

o Consider a possible strategy for discussion with the social partners for
compensating workers for rising inflation. The threat of wage driven inflation
is a serious one. Some mechanism will be needed to contain wage demands.

o Greatly curtail the availability of credit to domestic borrowers. Many home

owners will be caught for an extended period with negative equity.

o Encourage the major financial institutions to shorten their positions in those

sectors of the market which will be most exposed when the crisis hits.

o Be prepared to factor in the increased cost of national security and the loss of
revenue from a significant fall in tourism.

21
Signs of an imminent invasion
While it is unclear when the US will move into Saudi, whether 2005, 2006, or 2007,
there are a series of signs which ought to mark a step closer to that event:

(i) The election of Bush in November. (The election of Kerry, while not ruling
out an invasion, would widen the range of options.)

(ii) A significant increase in the American defence budgets for 2005 and 2006.

(iii) A further significant increase in the terror premium on the price of oil. This is
currently around $10 a barrel. If it goes to around $30, bringing the price of
oil to $60 a barrel, then big business will expect, or even demand, military
intervention in Saudi.

(iv) Introduction of compulsory military service. Given the extent to which US

forces in Iraq are already over-stretched, the draft appears inevitable. The
timing of its introduction will likely reflect the general time-scale being
adopted by the US government.

(v) A sharp rise in military stocks will be a clear sign that investors expect an
invasion. Since there is a loose correlation between investor sentiment in the
US and public opinion, the Government will likely take this as a sign that the
public will not oppose an invasion.

Some closing remarks

I have kept this paper as brief as possible. Naturally, a great more could be said about
the likelihood and timing of the impending crisis, the factors which appear to make it
inevitable, and the best way of dealing with the effects. Indeed, the effects
themselves are not so easy to pin down since much depends on the political response
of a wide range of players. For example, would Russia guarantee cheap oil to
America in return for support in dealing with the growing crisis around its own
southern borders? Will America offer Middle Eastern oil under its control only to
those countries who assist it in conducting the war? Will the availability of portable
nuclear devices, and the real possibility that they may be used in a western city, lead
to pressure for a withdrawal by the US?

Some readers may be take comfort in the possibility that the Democratic candidate
will win the Presidency in November. However, this is unlikely. Al Qaeda will want
to retain the existing regime and can be expected to take whatever steps may be
necessary to sway American opinion in that direction. There is also growing
evidence, in the US media and elsewhere, that a large proportion of Americans see the
current conflict as a religious one. If so, then they are more likely to stay with the
existing regime.

22
Conclusion
Western economies should pursue a budgetary and economic strategy over the next
5-6 years which takes due account of the emerging oil crisis and its significant
adverse consequences.

____________
28 June 2004

23
Bibliography:

Peter Bernstein The Power of Gold

Noam Chomsky World Orders Old and New

Fernando De Soto The Mystery of Capital

Bill Emmott 20:21 Vision

Samuel Huntington The Clash of Civilisations

Paul Krugman The Great Unravelling

Richard Maybury The Thousand Year War

Karl Popper The Open Society and Its Enemies

George Soros The Bubble of American Supremacy

Joseph Stiglitz Globalisation and Its Discontents

24
 APPENDIX A

Inflation
CPI average 1971-1973: 9.7%
CPI average 1974-1976: 18.7%

CPI average 1977-1979: 11.5%

CPI average 1980-1982: 18.7%

Growth
GNP (constant 1995 prices)
1972 21,548
1973 22,487
1974 23,305
1975 23,496
1976 23,836

1979 27,447
1980 27,916
1981 28,487
1982 28,001
1983 27,667

Interest Rates
(3 month interbank rate)
1971 6.61
1972 7.05
1973 12.14
1974 14.60

1978 9.86
1979 16.02
1980 16.30
1981 16.66

25
 APPENDIX B

Gold
Average gold price 1973: $97
Average gold price 1974 $159

Average gold price 1979: $306

Average gold price 1980: $612

Oil
Crude Oil Prices (inflation adjusted)
1972: $13.89
1973: $15.01
1974: $23.87
1975: $24.42

1978: $23.65
1979: $29.83
1980: $44.89
1981: $59.88

Dow
Dow IA (monthly average in January)
1972 902
1973 999
1974 855
1975 703

1979 839
1980 875
1981 947
1982 871

26
 Discussion Paper by Robert Pye, Greystones, Co Wicklow.

Preparing for Turbulence on the World Markets

It is impossible to predict how a national economy will develop over a period of years
without also making a number of assumptions about how the global economy will
develop over the same period. This is particularly true of Ireland, an extremely open
economy, not just in terms of trade but in terms of its dependence on FDI and the
global factors which determine international fixed capital investment.

This paper looks at the international situation and attempts to answer a central
question: What particular action should the Irish authorities take to mitigate the
effects of a major global economic shock sometime in the next few years?

To answer this question satisfactorily we must look, firstly, at the reasons for
believing that a major shock is on the way and, secondly, if it is coming, the likely
depth and duration of its aftermath.

Is a major economic shock on the way?

Many commentators believe that the combined effect of major imbalances in the
markets and the evolving political situation in the Middle East make a major shock
inevitable. The various factors cited are discussed below.

The US National Debt

The US national debt has been growing at a faster rate than at any time in history. It
took off during the Reagan years, rising from 900 billion, when Reagan took office, to
2600 billion at the end of his second term. During this short period, it almost trebled.
Four years later, at the end of the Bush (Sn) presidency, it had jumped to 4077 billion,
an increase of 56% or thereabouts in just four years. After moderating somewhat
during the Clinton administration, it took off again when another Republican
President took office in 2001. Today it stands at 7260 billion (about 68% of GDP).

A total national debt of 68% of GDP is not necessarily excessive by international

standards, but it is a cause of concern. As the world reserve currency, the stability of
the currency must be measured by more rigorous standards than those applying to
other countries. In that context, a national debt of 68% of GDP – and rising – is a
matter of concern.

27
The US Budget Deficit
It is not just the absolute size of the national debt that matters, but its expected rate of
increase. As we have seen, the three Republican Presidents since 1980 have all taken
a very profligate approach to budgetary matters. The current administration has made
it clear that this policy will continue if, in their estimation, the economy appears to
warrant it. For example, in the 3-year period 1999-2001, the budget had an average
surplus of 163 billion, while in the period 2002-2004, it had an average deficit of 351
billion. This swing is also without precedent and far in excess of what the markets
had expected.

The apparent weak dollar policy

The current administration appears to be boosting production by allowing the dollar to
weaken, making exports more attractive. This runs counter to the stated policy of
most previous administrations in recent decades, who sought to maintain a strong
dollar and make the US markets attractive to investors. The US dollar strengthened in
the nineties as capital flight from the currency crises (starting with Brazil in 1992,
then Mexico, Japan, South East Asia, Russia, Argentina, Europe, Turkey and Brazil,
again) created demand for the US dollar.

A continuation of the weak dollar policy will make it harder to entice other countries
to continue buying Treasury bonds to prop up the budget deficit. At present foreign
players make up around 40% of the deficit, mainly China, Taiwan, South Korea and
the UK. They have also been funding a sizeable proportion of FNMA borrowing.
They see benefit in doing this at the moment since it holds down their currencies and
helps exports.

There is also a wider and more long-term concern. Ever since the Bretton Woods
Agreement in 1944, the US dollar has been the world reserve currency Globalisation
would have been impossible without a high level of international confidence in the
dollar and the fundamentals underpinning it. If the US authorities are no longer seen
to have a strategic interest in this role, then the resulting increase in risk will add
further upward pressure on global interest rates, a pressure that would not abate for
many years.

Under Bretton Woods, all major currencies were fixed against the dollar, which in
turn was supported by gold. The US held about three quarters of the world stock of
gold at that time. Up to 1971 it was possible for anyone to enter a US bank and
exchange dollars for gold. In effect, gold was the primary currency. Inflationary
pressures forced the US off the gold standard in 1971. Since then the world has relied
on fiat money, backed only by the promises of central bankers to protect the value of
their currencies. In the view of many, the Federal Reserve is no longer fulfilling this
role and the current administration seems to be prepared to print fiat money as
required.

28
Personal and corporate indebtedness
Both personal and corporate indebtedness are at an all-time high. Home owners
borrowed on the rising value of their properties in an attempt to exploit the very low
rates of interest. Corporations also tried to take advantage of the low rates of interest
to borrow for investment and, in many cases, to speculate. Increased interest rates
will hit both, leaving little room for further consumption or investment to offset an
economic shock.

Trade deficit
The trade deficit is also running at a very high level. Americans are importing far
more than they are exporting, even though the dollar has fallen significantly against
other currencies over the past year or two (The deficit of course is also helping to
drive down the dollar). The increased borrowing by home owners is probably a major
factor in this imbalance. While this is likely to correct itself as interest rates rise,
there is still evidence that cheaper imports will continue to fuel a significant deficit,
especially if the yuan remains fixed against the dollar. A continuing high deficit will
weaken the dollar further and add weight to the argument that the US authorities no
longer wish to maintain its role as the main reserve currency.

Significant expansion in money supply

The US money supply has grown significantly in the past few years – see Table A.
The authorities appeared to allow this to happen to dampen the risk of deflation.
Whatever the arguments in favour of this policy, it has had the effect of greatly
increasing the risk of general price inflation. Two other markets have already inflated
significantly – the stock market and the property market. There is no scope therefore
for the increase in M3 being absorbed by either of these markets. This means it will
very likely flow into general prices over the next year or two, unless interest rates
move upward. Even then, there is a limit to how far they can go without hurting the
economy.
Table A
M3 ($bn)
Seasonally adjusted
May 2004 9212
Nov 2003 8842
May 2003 8725
Nov 2002 8479
May 2002 8169
Nov 2001 7956
May 2001 7554
Nov 2000 7034
May 2000 6770
Nov 1999 6457
May 1999 6193
Nov 1998 6003
May 1998 5679
Nov 1997 5411
May 1997 5139
Nov 1996 4939
May 1996 4783

29
The expansion of the money supply has been extraordinary. During a period when
GDP grew by 50%, M3 grew by 93% (GDP was 7,694 in 1996 and is estimated to
achieve 11,525 in 2004) . No statistic in this paper is more revealing.

Social Security and Medicare

For much of the Clinton presidency efforts were made to come up with a better
system for containing the ever-increasing cost of Medicare, but without success.
Meanwhile costs have continued to climb. The US social security system, which
operates on a pay-as-you-go basis, is also very expensive. The Baby Boomers are
retiring and the combined cost of these two schemes is expected to rise rapidly in the
coming years. Since many depend on both schemes to foot a significant part of the
cost of their retirement, there will be a general expectation that the Federal
Government will continue to fund them. However, the current administration is
trying to set up a separately funded scheme to cover some or all of the cost of social
security. Many commentators, including Paul Krugman (a), believe that this is
financially unsound and will only lead to further uncertainty among investors.

A hike in interest rates

The above scenario makes a hike in interest rates inevitable. This will have several
very obvious effects: a fall in the stock market, a slowdown in the economy, falling
tax revenue, reduced investment, and higher debt service costs for consumers who
borrowed on the strength of their greater stock wealth (prior to 2001) and rising home
property values. There is also a possibility that interest rates will not be able to rise
high enough to offset the rise in inflation, leading to negative rates of return. This
will hurt pensioners and the Baby Boomers coming up to retirement who are relying
on interest income to support their lifestyles.

Reaction by investors
The threat of rising interest rates, inflationary pressures, a weakening of the dollar, a
fall in the stock market, and an unsustainable budget deficit could cause investors to
panic. This is particularly true of small investors who are looking for a steady income
stream in retirement. Many could be expected to move their investments abroad. The
large investment institutions may get the same idea. If this happens, the authorities
may have to introduce exchange controls. This will be a very visible sign to the
international community that something is seriously amiss with the US economy.

Investors will also be very concerned by any indication from the Government that
their accrued Social Security and Medicare entitlements, which they will need in
retirement, may not be met in full. Given life expectancy at age 60 and the standard
of living that people have grown to expect, this could be a very unsettling discovery
and lead to further disenchantment with the financial system, loss of confidence in the
administration and general unrest.

30
Market sentiment
Recent experience has shown how vulnerable the markets are to adverse news of any
kind. Many were hurt by the Dot Com bubble and are anxious not to suffer another
hit. As Stiglitz observed, "For all the talk of the New Economy ending the business
cycle, the changes of the Roaring Nineties actually may have increased our economic
vulnerability, by making the economy more sensitive, more responsive to shocks." (b)

The recession of 2002 was, according to The Economist, "one of the shallowest on
record", which would lead one to believe that the lessons have not been learned. The
same lack of realism which fed the Dot Com bubble is still around. This would
suggest that the bad news, when it comes, will lead to considerable volatility in the
markets. This could cause problems for the banking sector, who are already greatly
exposed on foot of the remortgage boom fuelled by the property bubble. If that
bubble were to burst at the same time, and there is reason to believe it would, it could
lead to a number of bank failures and a marked contraction in lending.

The rush to commodities

There is a vast amount of investment money in the US markets which, when disturbed
by a stock market contraction, will seek value somewhere else. As mentioned above,
some investors will try to move their investments abroad, but the scope for this is
likely to be restricted by currency controls. Since the money will have to go
somewhere, many analysts believe there will be a rush to commodities. There are
several reasons for this:

o The commodities market has been in a bear phase for about two decades. All
the interest has been in the stock market. Since bull cycles in commodities
have occurred at intervals in the past, another one can reasonably be expected.

o There has been a significant increase in demand for commodities from the
growing economies of China and India. This has not yet fed through very
strongly into prices but is expected to do so.

o Investment in commodity production has not kept pace with potential demand.
This will lead to shortages in some sectors and drive up prices.

o The world demand for oil will reinforce the view that other commodities may
be running out or, at least, proving more expensive to extract. Also, global
climate changes may affect perishable commodities.

It is worth quoting Jim Rogers on this (Rogers was the co-founder with George Soros
of the Quantum Fund). In a recent interview in The Guardian he is quoted as saying:

"The American dollar is a flawed currency and will collapse in value before
the end of the decade, taking with it the prosperity of the American nation.
Investors should be buying commodities – platinum, lead, wheat, sugar, oil,
the sort of assets that haven't been fashionable for a quarter of a century or
more." He went on to say, "The US owes the world $8 trillion. We are the
world's largest debtor nation by a factor of many times and our foreign debts
are increasing by $1 trillion every 21 months. That's terrifying." (c)

31
Rogers is not alone in taking such a pessimistic view. Warren Buffett has Berkshire
Hathaway sitting on a cash pile of $36 billion because he is unable to find value in the
market, $12 billion of which is in foreign currencies. (d)

George Soros is also intensely critical of the Bush administration, primarily because
of what he perceives as its gravely mistaken economic strategy and its neglect of the
international financial system. As evidence of this he is committing some $15 million
in 2004 to back the Democratic candidate (e). He has also railed against the dangers
posed for the world financial system by the Neo-conservative ideology in his book,
The Bubble of American Supremacy (2003).

When leading experts such as Rogers, Buffett, and Soros – who, it should be noted,
are all active players in the market, not analysts sitting on the sidelines – are
concerned that a major economic shock is on the way, we ought to be listening.

What happened to the 30 year bond?

In 2001 the Treasury announced that it would no longer be issuing a 30-year bond and
has since redeemed all outstanding 30 year bonds. This took the markets by surprise.
It might be taken as a sign that the authorities recognised that the long-run rate of
inflation would prove greater than projected and that the cost of compensating buyers
for this risk was simply too great. In other words, confidence in the performance of
the economy in the longer term had diminished.

Bond yields generally are giving a similar picture. The long term historical average
for the yield curve is 1.35 percentage points (i.e. long maturity bonds attract 1.35%
more interest than short maturity bonds). Long term interest rates are driven by
expectations of future inflation and expectations of future growth. The yield curve at
the moment is very steep (4.1%), so either investors expect significant future growth
or significant future inflation (The difference is even more pronounced in historical
terms if the higher rate (5.24) is taken as a multiple of the lower (1.14)). Given the
fundamentals at the moment, it is hardly credible that expectations of future growth
are significant, therefore a sizeable chunk of the investment community must believe
that inflation is set to rise fairly sharply.

The fragility of the financial system

The fragility of the world financial system has long been noted. A structure designed
in the Sixties and Seventies is now expected to handle colossal movements in capital,
in a vast array of instruments and derivatives. Hedge funds, which hardly existed in
the Sixties, now exert an influence out of all proportion to their productive usefulness.
A handful of players can bring down a currency or distort a market in ways
unimagined in the Sixties. There is a growing disparity in almost all markets between
the nominal value of an asset and its real underlying value. The system itself
promotes this by providing no incentive to the large financial institutions and
brokerages, who make enormous profits from commission and transaction costs, to
narrow the disparity. Extensive deregulation in the US has not helped (Enron,
WorldCom, Anderson, etc).

32
The real Government debt, according to its own economists, was $44 trillion in 2002.
This includes the national debt, social security and medicare liabilities. This is far in
excess of the national debt proper, which we have already discussed. A White House
spokesman confirmed the $44 trillion estimate and said, "There is no question that
Social Security and Medicare are going to present [future] generations with a crushing
debt burden unless policymakers work seriously to reform these programmes." (f)

It is sometimes argued that debt is not a net liability in the true sense since each
debtor is often a creditor. This is valid to an extent in a small system, but as the
system expands and the numbers of players increases, the associated risk grows
exponentially. Take a circle of ten people, each owing a million dollars to the person
on their right. The total nominal debt (which will show in the statistics) is 10 million,
but the net indebtedness of the group as a whole is zero. However, if one person
defaults all ten suffer. If we increase the circle to 100, and one person defaults, then
100 suffer. In other words, the larger the circle the greater damage done if just one
player defaults.

The collapse in 1998 of Long Term Capital Management, a major hedge fund, was a
vivid demonstration of this risk. If the Federal Reserve had not stepped in and
guaranteed its liabilities, a long string of major financial institutions would have
collapsed along with it. What is more, the time available for successful intervention
was extremely tight (about a day). The faster the financial markets operate, the more
complex and less transparent they become, the greater the risk that the next LCTM-
type collapse will spread through the system before corrective action can be taken.

Increased military spending

On top of the many adverse factors described above is a new and especially
worrisome development – the growth in military spending.

As stated in an earlier paper (g), the war in Iraq is out of control. If the US pull out,
the region will collapse into civil war, with the risk of destabilising neighbouring
countries, including Saudi Arabia. This would almost certainly jeopardise oil supplies
and send western economies into turmoil. So the American military are stuck in Iraq
for 10 or 15 years. This will be eat up the peace dividend that came at the end of the
Cold War and saved the US taxpayer around 2% of GDP per annum (This was a
major factor in promoting economic growth during the Nineties). The American
public can now expect to spend an additional 2% or more of GDP every year for the
foreseeable future to fund the Iraq war as well as the ongoing campaign in
Afghanistan. This does not take account of the crisis that could emerge if Saudi
becomes unstable in the wake of increasing terrorist activity and the US is obliged to
maintain an active military presence in the Arabian peninsula as well.

As Huntington (h) observed the modern Islamist movement is taking advantage of the
large increase in the population of Moslem countries over the past two decades.
There is now a substantial cadre of young, unemployed men in these countries, filled
with militant religious ideals, who will be more than willing to participate in a general
campaign against US intervention in the Middle East and its support for Israel.

33
It is almost impossible, therefore, to see the US budget deficit falling below 500
billion anytime over the next ten years. It may even hit a trillion. There is every
reason to believe that this will be unsustainable by conventional means – raising taxes
and/or borrowing – and that the authorities will allow the money supply to expand
even further. It is possible to see why Rogers says the dollar will "collapse in value
before the end of the decade".

In this context, it is worth citing a revealing excerpt from the preface (2003) to the
English translation of 'After the Empire' by Emmanuel Todd, a researcher at the
French National Institute for Demographics Studies in Paris (Todd gained renown for
predicting the collapse of the Soviet empire in his book, 'The Final Fall: An Essay on
the Decomposition of the Soviet Sphere' (1976):

The domestic and foreign deficits of the United States are skyrocketing.
Indeed leaders around the world are wondering more and more if the central
regulating power of the world economy is not heading toward a sheer
abandonment of the basic rules of capitalist reasoning. Its adventurism is not
just military, it is also financial. One can predict that in the years or months to
come financial institutions in Europe and Asia with heavy investments in the
United States will lose a lot of money – the fall of the stock market being only
the first stage in the disappearance of foreign holdings in the United States.
The dollar is dropping, but no economic model allows one to predict how low
it will go since its very status as reserve currency is becoming uncertain. (i)

A possible scenario five years from now

In light of the above analysis, which is based mainly on undisputed data, it is worth
asking where the world economy will be in five years time. It is difficult to envisage
a sanguine scenario. There are too many factors militating against a happy outcome.
The world economy will likely slip into recession within two years and several
economies, including the US, may slide further into a depression. (Here we define
these terms in the usual way: A recession as at least two consecutive quarters of
decline in gross domestic product. If it lasts more than a few quarters and is
associated with rising unemployment, a general decline in prices and a loss of
purchasing power, it becomes a depression.)

The stock market will suffer, interest rates will rise, and investment will fall. At
present, most large economies are either sluggish or moribund. China, the only one
that has been doing well up to now, is slowing down, so there will be no large
economy in a sufficiently fit state to help pull the others out of recession. In addition,
the growing loss of confidence in the dollar will hamper international trade and
investment. Other large economies will also suffer as the US exports its own
inflation. Both the loss of confidence in the dollar and the gradual increase in global
inflation will put other currencies under pressure, promoting speculation and
increasing the risk of capital flight from more vulnerable economies.

As noted earlier, these developments are very likely to generate a rush to

commodities. Oil will soar in price, not just in response to speculation and demand,
but as a result of the growing uncertainty in the Middle East and the possible
interruption in supplies.

34
The US may put considerable pressure on other countries to help it fund its military
campaign in the Middle East or to supply troops. This will lead to discord and
hamper efforts to develop a coherent strategy to address the growing international
crisis.

It should be noted that none of this analysis takes into account the effects of possible
terrorist attacks on western assets or centres of population. Neither does it take
account of a major destablisation of the Middle East which could arise from a military
incursion by Israel into Islamic territory (eg bombing of Iranian nuclear facilities).

How will these developments affect Ireland?

It is hardly necessary to spell out in detail how these developments will affect the
Irish economy. However, there are a few factors which ought to be highlighted since
they could impact significantly on budgetary and industrial policy.

The euro
The euro should benefit from the weakening of the dollar. Increasingly reserve funds
are moving out of dollars and into the euro. This trend will accelerate. However, it
will do harm to both Irish and EU exports to the American market. The turbulence in
the markets will also discourage the UK from adopting the euro. It could also be
expected to dissuade the ECB from admitting any of the ten new member states.

FDI
A weakened dollar could also be expected to reduce the volume of FDI from the US.
It is unclear what effect the introduction of exchange controls might have. There is a
strong possibility however that existing US firms in Ireland will be content to stay put
and perhaps even to expand their operations here, circumstances permitting. Foreign
earnings will be more attractive in the new environment. The IDA might even be able
to persuade US firms with manufacturing bases in other countries (such as Indonesia
and Malaysia) to relocate some or all of their operations to Ireland on the grounds that
it offers a more stable political environment.

National Pensions Reserve Fund

As a state, Ireland is uniquely poised to take advantage of the coming rush to
commodities via the NPRF. At end 2003, the fund had assets equivalent to 8.7% of
GNP, with shareholdings in 1286 companies across 23 markets. The NPRF
Commission should be asked to review its strategy in this area and consider the scope
for switching a large portion of its assets from shares to commodities (It is unclear
what proportion is already in commodities). This would yield a double bonus –
avoiding the big losses that would be incurred by keeping a major portion of its assets
in shares and reaping the gains from a bull market in commodities. The windfall
could then be used to mitigate the effects of the global downturn (This would
necessitate legislative change, preferably with all-party agreement).

National Debt
It would make sense to denominate as much of our national debt as possible in US
dollars. Any small increase in debt service costs due to rising US interest rates
relative to euro-zone rates would be more than offset by the fall in the dollar. An
opportunity like this should not be missed.

35
Attracting skilled migrants
The coming US draft will be a matter of great concern to most American citizens and
their families. Many skilled workers of Irish extraction may wish to relocate from the
US to another country. This could represent a significant amount of human capital for
a small economy like Ireland. The policies pursued in various sectors should be
geared towards attracting these migrants and their assets.

Pay inflation
It is generally accepted that, once pay-driven inflation takes hold, it is very difficult to
bring under control. The existing system of pay determination, based largely on
partnership, has evolved in recent years in a climate where the general economic
outlook has been exceptionally good. The advent of benchmarking in the public
service has reinforced the expectation that everyone should enjoy the proceeds of
growth, in full and with minimum delay. In addition, the public service unions have a
disproportionate influence on the entire wage determination process, both public and
private. This means that the inability-to-pay concept has been all but forgotten. As
demonstrated by recent events, workers will expect immediate compensation for any
general increase in inflation, both current and expected.

The existing system of pay determination will need to be re-examined and suitable
mechanisms introduced to slow the pace at which inflation feeds into pay. This is not
an easy problem to solve, but is potentially one of great importance to the economy as
whole.

___________
18 July 2004

Notes

(a) The Great Unravelling (2004), Paul Krugman

(b) The Roaring Nineties (2003), Joseph Stiglitz, p.200.
(c) The Guardian, 3 July 2004
(d) The Economist, 13 March 2004
(e) The Guardian, 12 November 2003
(f) Financial Times, 30 May 2003 [cited in (j)]
(g) Preparing for the Coming Economic Shock and its Aftermath, R Pye, 28 June 2004
(h) The Clash of Civilisations (1996), Samuel Huntington
(i) After the Empire (2002/2003), Emmanuel Todd
(j) Hegemony or Survival (2003), Noam Chomsky

Copyright 2004, R Pye.

36
 Discussion Paper for limited circulation,
by Robert Pye, Greystones, Co Wicklow.

The Imminent Tsunami: Why the World Economy is on the

Threshold a Major Recession

Background
In two earlier papers (1) (2) I set out reasons why I believe the world is heading toward
a major economic shock. The factors behind this centre mainly on the worsening
condition of the US economy and the obvious reluctance by the current administration
to take the necessary evasive action. The US current and trade deficits are
unsustainable, the federal debt is growing at an alarming rate, the implicit liabilities
(social security and medicare) are grossly underfunded, and the war in the Middle
East – and its associated costs – is escalating out of control.

The response to the two earlier papers has been muted. Some readers have said that
the depth of the US economy is such that it can quite easily rally in the face of such
pressures and that a small hike in income tax would quickly bring matters under
control. This attitude seems to be fairly widespread but in my view, and the view of
many economists, this attitude is gravely mistaken. I will attempt to set out below the
reasons for this assessment and why the Irish authorities have time to make some
significant changes in policy to mitigate the impact of this tsunami before it strikes.

What some commentators are saying

In my earlier papers I cited the words and actions of Jim Rogers, George Soros, Paul
Krugman and Warren Buffett, all of whom expressed real concern at the direction the
US economy is taking. Rogers sees the dollar taking a major dive in the next 4-5
years, Soros is highly critical of the failure of the current administration to support the
world financial system, Krugman is of the view (which is stated very strongly in his
New York Times column) that the industrial elite are deliberately steering national
policy toward their own commercial ends, while Buffett has clearly stated that the
stock market is greatly inflated and is sitting on a cash pile of $36 billion, one third of
which is not in US dollars.

Ken Rogoff
The Irish press is finally giving vent to this view. In The Irish Times, 24 September
2004, economist Jim O'Leary (3) said that the US dollar is heading for a major
correction. Referring to the massive US budget deficit, which is funded mainly by
east Asian central banks (China and Japan), he says: “If you have formed the
impression that this is not a sustainable situation, you are not alone. Some of the
world’s foremost economists are convinced that a major and potentially very painful
correction must occur.” He refers approvingly to a paper by Ken Rogoff (4), ‘The
Unsustainable US Current Account Position Revisited’, July 2004 (http://emlab.
berkeley.edu/users/obstfeld/ca_v2.pdf). Rogoff, who is chief economist at the IMF
and a professor at Harvard, is not given to making radical predictions. Along with his
co-author, Maurice Obstfeld, he argues that the dollar must depreciate by 20% to 40%
to get the American economy back into balance, and says:

37
 "The real question is not whether there needs to be a big exchange rate
adjustment when the US current account closes up. For most plausible
shocks leading to global rebalancing, this is a given. The real question is
how drastic the real effects are likely to be. This is an open
question...[but]...The rest of the world is not going to have an easy time
adjusting to a massive dollar depreciation. It is also the case that world
derivative markets have exponentially expanded in comparison with
even ten years ago. With little reliable data on counterparty risk, there
has to be concern that a massive dollar movement could lead to
significant financial problems that are going to be difficult to see before
they unfold (e.g. along the lines of the collapse of Long Term Capital
Management in 1998)."

They also argue that the unfolding crisis with the dollar is more akin to that of the
1970s than the 1980s. The decline at the end of the 1980s, when the Reagan era
current account deficit closed up, was "relatively benign". However, the 1970s saw
many of the conditions that exist today – large budget deficits, soft monetary policy,
open-ended security costs (Vietnam) and pressure on oil. For this reason they
conclude that "the outcome could be much more severe than it seemed during the
1980s dollar collapse." This is far removed from the benign scenario envisaged by
Greenspan.

Ferguson
Another commentator who has taken a pessimistic view is Niall Ferguson, the
economic historian. In his book, 'Colossus: The Price of America's Empire' (2004),
he states (5):

“So vast is America’s looming fiscal crisis that it is tempting to talk about
the fiscal equivalent of the perfect storm – or the perfect earthquake, if you
prefer...the dynamics of fiscal overstretch really do have much in common
with the dynamics of natural disasters. We can know only that, like a
really big earthquake, a big fiscal crisis will happen. What we cannot
know is when it will strike, or the size of the shock.” [p.276]

“Here, then, is one possible scenario. Bondholders will start to sell off as
soon as a critical mass of them recognise that the government’s implicit
[Social Security and Medicare] and explicit liabilities are too much for it
to handle with conventional fiscal policy and conclude that the only way
the government will be able to pay its bills is by printing money, leading
to higher inflation.” [p.277]

“...the magnitude of the problem is such that most Americans, including

those who consider themselves well informed about the nation’s finances,
find it quite simply incredible. Indeed, the main reason why America’s
fiscal crisis remains latent is precisely that people refuse to believe in its
existence. And they are able to do this because the United States has
imperceptibly come to rely on East Asian capital to stabilize its
unbalanced budgets.” [p.262]

38
The threat of Islamic fundamentalism
The really interesting aspect of the conclusions reached by both Rogoff and Ferguson
is that they both attach relatively little significance to the growing crisis in the Middle
East. They both expect the ongoing wars in Iraq and Afghanistan to impose a fairly
constant strain on the US economy. However, neither presents any argument to
justify this assumption.

One of the leading analysts on Islamic fundamentalism, Jason Burke, makes the
following telling observation in his book, 'Al-Qaeda' (2003) (6):

“The ousting of Saddam Hussein is widely seen throughout the Islamic

world as a strategic move to secure oil – Allah’s gift to the Muslims – and
protect Israel. This perception that a belligerent West is set on the
humiliation, division and eventual conquest of the Islamic world is as
much a root cause of Muslim violence as relative poverty or government
repression. The militants believe they are fighting a last-ditch battle for
the survival of their society, culture, religion and way of life. They
believe that the Crusades never ended and that they are now fighting in a
desperate war of self-defence. They understand, as we in the West also
believe, that self-defence can justify using all sorts of tactics that might be
frowned on in other circumstances. They believe, as we think too, that
they are fighting to preserve their lives, societies and culture.” [p.288]

In other words, the US is embroiled in a war in the Middle East which is set to
escalate further, at considerable additional cost to the US economy. To date the
Americans have lost 1060 men under arms in Iraq. This is a very large number for a
zone which is meant to be under tight military control. The number of Iraqi civilian
deaths is also extremely high. Reliable estimates put it somewhere between 15,000
and 30,000. Despite recent comments by US Defence Secretary Rumsfeld, there is no
possibility that the US will withdraw from the region. If it did, the conflict would
quickly turn into civil war and spill into neighbouring regions. The damage this
would do to American (and global) oil interests would be immeasurable.

So, if the war is getting worse and America is committed to a conflict lasting 10-15
years, then one must assume that the costs of containment will continue to increase.
So far the US has been fighting with minimal manpower and conventional
technology. If Bush gets a second term (which he is almost certain to secure) the
Neoconservatives will do what they have always said they would do and expand the
theatre of operations, primarily to subjugate Iran.

Israel has also said that it would not tolerate the continuation of the Iranian nuclear
weapons programme. Analysts are predicting a major military strike by Israel or the
US to destroy this programme and make it impossible for Iran to either develop a
nuclear capability or retain the material needed to produce a number of dirty
radioactive bombs which could be used against US or Israeli cities. It is important to
note that the use of such bombs by terrorist groups would make it very difficult for the
US to identify the country or regime that ultimately sponsored the attack. Therefore,
the reasoning goes, they must do all they can to prevent such a programme from
developing further.

39
It must also be remembered that the fall of Iran in 1979 was a major shock to the US.
The Neoconservatives are determined not to let this happen again to their "interests"
in the Middle East, especially Saudi Arabia.

Huntington (7) draws attention to the huge expansion in the Muslim population in the
Middle East in the past 20 years or so. This means there is now a vast number of
unemployed young men to swell the ranks of the fundamentalist insurgents. What
future do they see for themselves in a land wracked by war? Add the
uncompromising message of the fundamentalists and the steady flow of funds from
regimes opposed to the US and you have an ever-worsening situation.

The increasing tension in the area and interruption to supplies will continue to push up
the price of oil. The recurring spikes of the past few months can be expected to
translate into a permanent increase in the baseline price of oil from around $35 a
barrel at the start of the 2004 to $50 or more by end-2004 and a good deal more by
end-2005.

Bond holders
International bond holders are playing a canny game. They are continuing to
concentrate on short Treasuries to ensure that, when the crash comes, the US
government cannot inflate itself out of debt at their expense by printing more money.
The 30-year bond has gone since bond holders were demanding too high a yield to
justify selling it. These are further signs that many players in the market believe a
major correction is on the way.

The only pillar holding up the market is the continued willingness of the East Asian
central banks to buy federal debt. They are trying to keep their currencies down vis-a-
vis the dollar to support their exports. Naturally, both the US government and the
East Asian economies have an interest in maintaining this mutually beneficial cycle.
But a slide in the dollar, which depends on many factors beyond the control of the US
government and the East Asian economies, would wipe billions off the foreign
reserves held by the latter. This could hit the fragile banking system in China and
precipitate a crisis.

What would the impact on the dollar be if the East Asian economies stopped buying
US Government debt? The Economist, 13 December 2003, quoted the answer given
to this question by Jim O’Neill, Chief Economist at Goldman Sachs – "Potentially
catastrophic.”

Expansion of derivative markets

In the quotation given above, Rogoff notes with concern "that world derivative
markets have exponentially expanded in comparison with even ten years ago." He
suggests that this could give rise to unpredictable adverse effects. Look, for example,
at the growth in hedge funds in the past decade, from 1500 funds managing $200bn in
1993 to 6000 funds managing $850bn in 2003. These are sometimes viewed as
massive international casinos, capable of causing serious instability in the markets.
As The Economist recently stated, there is reason to be concerned about this,
especially with more and more banks setting up hedge funds of their own in an
attempt to increase earnings.

40
Those who are sceptical about the risk of a major international economic crisis
sometimes cite the depth and integration of the world capital markets as the principal
reason for believing that any serious imbalances can be managed in a controlled way.
For example, Rogoff refers to a talk given by Greenspan at end-2003 in which he puts
forward this view. However, since hedge funds are an ever-expanding feature of the
markets which Greenspan and others expect to behave in a rational and mutually
supportive (albeit self-serving) way in a crisis, it is very difficult to be sanguine about
the scenario that is now emerging.

Denominating oil in dollars

After OPEC decided in the early 70s to price oil in dollars, the currency entered a
kind of 'oil standard'. This helped to make the dollar the world reserve currency,
increased demand for dollars, and attracted huge amounts of capital into the US
economy. The US is therefore hotly opposed to any attempt by oil-producing
countries to switch the denomination of this commodity into another currency. As
soon as Iraq switched to the euro, it was invaded. Iran has been threatening to switch,
as has Chavez in Venezuela. It has been speculated that the invasion of Iraq and the
attempt to topple Chavez were driven, at least in part, by the desire to prevent the
switch.

If it ceased to be the denominating currency for oil, the dollar would quickly
depreciate and the vast amount of petro-dollars currently circulating outside the US
would make their way back into the US economy and cause both serious inflationary
problems and consternation in the banking system.

Implications for Ireland

The tsunami is coming and there is nothing the Irish authorities can do about it. The
impact on the world financial system will cause investors to flee the stock market and
put their money into the traditional safe havens, notably gold and other precious
metals. A bull market in commodities can be expected. What is more, it will likely
continue for many years as both the stock market and the bond market take a
hammering.

Two golden opportunities

These developments give rise to two major opportunities which hardly arise even
once in a generation:

(1) to transfer the greater part of the NPRF into commodities

(precious metals, industrial metals, oil, etc)

(2) to convert the greater part of the national debt into dollars.

The risks behind these initiatives are very small, while the potential benefits are
enormous, perhaps as much as €10 billion by 2015.

41
Banking system
The level of mortgage lending in recent years has been running at record levels.
Borrowers will be exposed to a substantial hike in interest rates as the international
crisis develops and property prices enter a downward spiral. Since the level of
exposure by Irish banks in this market is very high, there is a real risk that the collapse
in asset values could cause one of them to go under. The Central Bank actually hinted
at this possibility in a recent report.

Inflation
The thirst for capital by the US government will push up interest rates to painful
levels, but this will not be enough to contain the inflationary effects of oil price
increases. The US government will also resort to printing money to finance its war in
the Middle East and cover the ever-growing cost of social security and medicare.
This can be expected to feed into the world economy and promote global inflation.

In light of this, the Irish authorities will need to have some way of containing pay
expectations. The existing two-tier system of public service pay determination,
involving both general round increases and benchmarking, may prove very unsuited
to the containment of pay pressures in this changed environment. The power of the
public service unions in the overall pay determination process may also prove a
significant barrier to containment.

Growth and Exports

There is no doubt that, as Rogoff notes, a major depreciation in the dollar will be bad
news for the EU. Growth can be expected to stagnate for several years and economies
with overly generous social benefit systems, such as Italy, may run into serious
difficulties.

Timing
The really big question is when this crisis in the world economy will occur, followed
by its daunting list of adverse effects. It could commence with either the predicted
dollar slide or with a major collapse in the stock market which takes the dollar down
with it. Most commentators are reluctant to fix a time line for this but there is good
reason to believe it will get rolling during the latter half of the next Bush presidency
(c 2007) – the tax giveaway at that stage, in anticipation of the Presidential race in
2008, would be enough to cause panic amongst bondholders. A major terrorist strike
on a Western target, especially an American city, could accelerate this.

It is worth noting that many investment firms in the US are advising their small
clients to switch their dollars into euro in anticipation of the coming depreciation. If
this trend gathers pace and larger players get involved, it alone could act as the
trigger.

42
Conclusion
The reader is referred to the earlier paper of 18 July (2) for a more detailed
examination of the Irish options. However one looks at the problem, the coming
tsunami will necessitate a re-think in several major areas of public policy, including
pay, financial regulation, debt management, pension funding, capital investment,
budgetary policy and taxation.

28 September 2004

References

(1) Robert Pye, Preparing for the Coming Economic Shock and its Aftermath, 28
June 2004

(2) Robert Pye, Preparing for Turbulence on the World Markets, 18 July 2004

(3) Jim O’Leary, Inflated Dollar Facing Painful Correction, The Irish Times, 24
September 2004

(4) Ken Rogoff and Maurice Obstfeld, The Unsustainable US Current Account
Position Revisited, July 2004 (http://emlab.berkeley.edu/obstfeld/ca_v2.pdf)

(5) Niall Ferguson, Colossus: The Price of America’s Empire, 2004

(6) Jason Burke, Al-Qaeda, 2003

(7) Samuel Huntington, The Clash of Civilisations, 1996.

Copyright 2004, R Pye.

43
 Discussion paper for limited circulation

Countdown to a Global Economic Shock

by Robert Pye, Greystones, Co Wicklow

“Nobody can say when the fall will come or whether it will turn into a
crash, but when even Alan Greenspan, the chairman of the US Federal
Reserve, says there is a 75 per cent chance of a dollar crisis in the next
five years, be sure trouble lies ahead.”
- Will Hutton, The Observer, 14 November 2004

Introduction
The first three papers in this series stated that a major economic shock is coming, that it
will be deep and painful, and that steps should be taken wherever possible in an Irish
economic context to mitigate its effects. (1) (2) (3)

This paper, seven months after the first, states that the factors giving rise to the shock
continue to worsen and that, in essence, the tsunami is getting closer. The purpose of
this paper is to highlight the main indicators and show how their cumulative adverse
effect is rapidly pushing the global economy toward a major crisis.

Fundamental cause
The fundamental cause of this crisis is the massive misallocation of capital both within
and between the major economies. The US is living way beyond its means. Since it is
the major world economy by far, accounting for about one third of global output, and
custodian of the world reserve currency, the necessary correction, when it comes, will
have a strong negative impact on the markets.

Most economic commentators accept that a correction is necessary and that it should
take the form of a managed depreciation of the dollar. However, there is no indication
that a managed or phased depreciation is possible. This worked when it was last tried –
the famous Plaza accord of 1985, when the leading economies co-operated to produce a
depreciation in the dollar that was acceptable to the markets. It can be argued, however,
that even the Plaza accord was flawed and that it was one of the main factors behind the
shock of 1987.

This time there is virtually no co-operation between the US administration and its main
counterparts. For example, the highest profile American at Davos was a Hollywood
actress. There is no public sign that the US administration is trying to negotiate a
solution with China, or that it even recognises the need to do so.

44
The Geopolitical Climate
A seismic shift is taking place in the balance between the world powers. The Bush
administration acknowledged this when, in 2002, it stated the following in its National
Security Strategy:

Our forces will be strong enough to dissuade potential adversaries from pursuing a
military build-up in hopes of surpassing, or equalling, the power of the
United States. (4)

While it might be reasonable to imagine that the US government would pursue such a
strategy in a covert manner, its willingness to state its intent in such a public manner is
the mark of an administration that does not see much point in negotiated solutions.

The current situation is like the realignment of tectonic plates, of which there are five:
the US, China and the main Asian economies, Europe, Russia, and the Middle East.
The key question for the first three is: Where will it source its oil in the decades ahead?
The last two hold the answer.

In a shrewd piece of analysis in The Sunday Times, economic analyst and

neoconservative sympathiser, Irwin Stelzer, sketched out the following scenario (5):

o Governments have taken control of the world’s oil and gas industry from
traditional commercial enterprises.

o These governments have interests hostile to America’s.

o China is forging closer economic ties with Iran, Venezuela and Canada to
protect its future supply of oil.

o Russia is courting Germany, Japan and China with a view to securing its longer
term strategic objectives in exchange for oil and gas.

Stelzer concludes: “Add the emerging relationship of China and Russia, and you have
something for American planners to worry about.”

One might add a further point not noted by Stelzer, namely that Japan will increasingly
see its future with China, not the US.

At no time in its history has the US been so vulnerable to its enemies. It is increasingly
apparent that Russia and China, acting in concert, have the power to inflict real
economic damage on the US by restricting its access to oil. This is why the US entered
Iraq and why it has no intention of leaving. It also why there is every reason to believe
it will pre-empt any interruption to its supply of Saudi oil by intervening militarily in
that country sometime in the next five years.

45
The escalation of tensions between the US and the Islamic world was underlined by the
recent public declaration by both Bush and Rumsfeld that either the US or Israel may
find it necessary to use military force against Iran to neutralise its growing nuclear
capability. Since China is already courting Iran and is in a position to fill any gaps in
Iran’s nuclear programme, the US threat is directed at a wider audience.

In light of these developments, in conjunction with the stated aims of the

neoconservatives, it is clear that the US policy of pre-emptive intervention will continue
and that the scope for achieving high-level international co-operation to resolve the
growing economic crisis is very restricted indeed. It is further complicated by the fact
that China has succeeded in amassing a huge quantity of US dollars in its foreign
reserves which, if converted into another currency, would deal a serious blow to the
American economy, albeit at cost to itself.

The prevailing mindset

The prevailing mindset is incredibly rigid. Many commentators continue to assume that
the Asian economies will continue to buy American dollars and prop up the alarming
US budget deficit, purely to ensure that their own currencies continue to be competitive.
This assessment takes no account of the geopolitical climate sketched out above or of
the speed with which massive quantities of capital can move between markets, whether
in response to an international incident or in hope of speculative gain. Neither does it
take any account of the growing cost of American involvement in Iraq. The latest
estimate of the cost to date is €300 billion, around double what had been expected. This
is roughly €150 billion a year and rising. Given that military experts believe no
progress can be made without at least doubling the number of military personnel in Iraq
(from 150,000 to over 300,000) the cost is bound to grow significantly. (There is also
talk of establishing permanent military bases in the region, which will push the cost
even higher.)

The popular mindset in America, as projected by the media and accepted by the
majority of its population, is that democratic stability can be achieved in Iraq, that
Middle Eastern oil is secure, and that the cost of the war is containable. Not one of
these assumptions stands up to critical scrutiny. The Sunni minority will never accept
Shia control, the main sources of American oil are in deeply unstable zones, and the
cost of military intervention is set to increase even further. When a critical mass of
American investors wake up to these facts, the markets will be in crisis.

When the first paper in this series was written the price of oil was around $40 a barrel.
It has since risen to €50 a barrel and is expected by many commentators to hit €60 by
the end of 2005. Increased demand, interruptions in supply, and speculative movements
in the markets are expected to push the price even higher, perhaps to €100 a barrel by
end-2008.

46
Depth and elasticity of the markets
For several years capital has been too readily available to virtually anyone, at
unsustainably low rates. This has led to a huge misallocation of capital, both within and
between national economies – inflated currencies, bubbles in several markets, and huge
trade imbalances. As stated earlier, this misallocation is the chief cause of the coming
crash.

It has been argued that the depth and elasticity of the markets will be enough to absorb
the waves created by the necessary correction, but there is a flaw in this reasoning.
Markets are only elastic when prices can adjust with reasonable fluency to reflect real
underlying values. It has been over eight years since this could seriously be asserted.
The key price, the price of money, is far too low and as a result it is distorting all other
prices. The bond market, the equity market and the property market are all significantly
over-valued.

The depth of the markets can only be relied upon when the major players, especially the
main financial institutions, are confident that the necessary capital can be found at short
notice and at low cost to defend their positions. This implies minimum levels of
transparency, liquidity and confidence. Financial derivatives now play such a big role
in most markets that it is almost impossible to be confident that no indefensible
exposures can arise.

As one well-known commentator has said, “Global laissez-faire may break down in an
unmanageable crisis of the world’s stock markets and financial institutions. The
enormous, practically unknowable virtual economy of financial derivatives enhances
the risks of a systemic crash." (6)

It is this lack of confidence ("nervousness") on the part of the major players that could
trigger a rush that would destabilise the markets.

It has also been argued that the US economy has been here before and came away
unscathed. However, the context has changed in two very significant respects, as The
Economist noted:

"For almost two decades, economists have worried about America's

current-account deficit and predicted a plunge in the dollar and a hard
landing for the economy. The dollar did indeed fall sharply in the late
1980s, but with few ill effects on the economy. So why worry more now?
One good reason is that the current-account deficit, currently running at
close to 6% of GDP, is almost twice as big as at its peak in the late 1980s,
and on current policies it will keep widening. Second, in the 1980s
America was still a net foreign creditor. Today it has net foreign liabilities
and these are expected to reach $3.3 trillion, or 28% of GDP, by the end of
2004." (7)

47
Greenspan and other factors
The head of the Federal Reserve, Alan Greenspan, is scheduled to retire in 2006. For
reasons that are probably not justified, the markets appear to have confidence in his
stewardship. Since all the principal appointments by the current administration in
recent months have been highly conservative, there is a growing concern that
Greenspan’s replacement will be nothing more than a mouthpiece for the White House.
This alone could trigger a selling spree.

Greenspan also tried to 'talk down' the dollar recently, a clear sign that the Federal
Reserve is very concerned about the state of the US economy. It is extraordinary that
the principal spokesman for the world's reserve currency should find it necessary to
make a pronouncement of this kind. The re-appointment of John Snow as Treasury
Secretary is a further indication that the current administration has no real intention of
defending the currency.

There is also concern that Congress may decide to place all blame for the mounting
economic woes on the self-serving stance adopted by other economies, notably China,
Japan and the EU, and push through a series of protectionist policies in response. Since
labour costs in China are ridiculously low in comparison with the US, and since they
are likely to remain so for many years to come, considerable damage could be incurred
by the US economy if and when China moves into these areas of industry where it does
not currently have a presence, notably the manufacturing of cars, trucks, computers, and
airplanes. Europe’s Airbus has already overtaken Boeing, so there is no reason why,
with current rates of technological transfer, China could not compete successfully in
these markets within a few years.

The reported growth in output and employment in the US may be exaggerated. If

Chrysler or General motors builds and sells an extra car, that's a real increase in output.
If Microsoft run off an extra 1000 copies of Word or Access, that too counts as a similar
increase in output, even though virtually nothing has been produced. In other words,
‘old style’ economic growth reflected a more substantial enrichment of infrastructure
and a more widespread distribution of benefits than that produced by the ‘new
economy’. Each extra job created in 1980, say, when the US manufacturing base was
about 40% greater than it is today, was more economically productive than each extra
job created in 2004, many of which are temporary, part-time, or service-based.

Stephen Roche of Morgan Stanley, by far the most vociferous champion of the view
that a major global crisis is imminent, has argued that a currency correction will not, of
itself, relieve the pressure. The contraction in the US manufacturing base over the past
20 years (since the Plaza accord) means that a major fall in the currency will not deliver
the export-led windfall that might formerly have been expected. In his view, unless
American consumers cut back significantly on imports and save far more than they
currently do, the problem will only get worse.

48
The pensions funding shortfall
The increasing recognition in both the US and the EU that many pension funds will be
unable to meet their liabilities, particularly as large numbers of them are switching from
'defined benefits' to 'defined contributions', is making the baby boomers very
uncomfortable. This is not helped by the threat in the US to privatise social insurance.
This will make matters worse by diverting tax revenue to pay existing pensions which
would otherwise be funded from social welfare contributions. The fear is that the
administration will use this device to reduce the level of benefits. This could induce
persons approaching retirement to switch their existing assets out of US dollars to
compensate.

Another problem with the baby boomers is that they have probably been the single
greatest factor behind the stock market boom of recent years. It is fairly well accepted
that the principal investors are those in the 45-60 age bracket with an income surplus to
invest. This cohort is due to contract significantly in the next ten years, with a
corresponding contractionary impact on the markets.

It should be noted that the foregoing concerns about pension costs take no account of
the significant additional expense that increased longevity is bound to entail.

The debt bubble

The average American has been borrowing heavily to support a high level of
consumption over the past several years. This has led to yet another bubble, perhaps the
most volatile of all – a debt bubble. The level of personal saving is virtually zero.
Credit card debt has doubled since 1990. If interest rates continue to rise, as they will,
consumers will be hurt and domestic demand will contract, with implications for
growth, tax revenue and social security.

Inflation as a solution
With a debt portfolio of almost €8 trillion to service, rising interest rates, a massive
budget deficit, increasing costs in Iraq, and a large cohort of baby boomers on the brink
of retirement, there is real concern that the current administration is planning to inflate
its way out of debt. In his book, Colossus, Niall Ferguson stated that this expedient will
not work as well as it did in the 1970s, for the following reasons:

“First, much of the government’s tradeable debt is of short maturity; indeed,

fully a third of it has a maturity of one year or less. That makes it much
harder to inflate away because any increase in inflationary expectations
forces the government to pay higher interest rates when it seeks to renew
these short-dated bonds. Secondly, Social Security benefits are protected
against inflation through an annual inflation adjustment. Medicare benefits
are also effectively inflation-proof because the government unquestioningly
pays whatever bills it receives. Thirdly, government workers are not likely
to sit idly and watch prices outpace their wages. For all these reasons, a
rerun of the 1970s would not in fact solve the federal government’s fiscal
problems.” (8)

49
However, he goes on to note that the government could default, not on its tradeable
liabilities but on its non-tradeable, implicit liabilities such as Social Insurance. It could
also remove the three obstacles listed by Ferguson by (i) issuing fewer short maturity
bonds, (ii) removing inflation-proofing from social security, and (iii) introducing
legislation to freeze public service pay and prevent industrial action.

The growing Islamist threat

The threat from Islamic insurgents and terrorists is growing stronger. The longer Iraq is
in turmoil, the more disaffected young men will be drawn to the ranks of the insurgents.
The demographic bulge in Islamic countries will ensure a strong supply of males in the
16-30 age bracket for many years to come. The same leaders and political activists who
fought furiously for nine years to throw the Russians out of Afghanistan will be just as
committed to throwing the US out of Iraq.

An ex-CIA operative reported some months ago that Bin-Laden sought approval from a
senior Muslim cleric to inflict major casualties on the US mainland. The cleric is
understood to have approved four million fatalities and eight million displaced persons.
This would suggest that the terrorists possess or are confident of obtaining portable
nuclear devices.

The Islamic world also possesses a major weapon which is hardly ever adverted to in
the media, namely, the Grand Ayatollahs. Shia Islam has seven. These possess
extraordinary influence over the general population. Their word is law. It is not
inconceivable that one or more of these senior clerics will at some point issue an order
to expel the infidel. If that happens, the whole population will rise up.

Kondratieff cycles
While predictions based on theoretical models are often flawed, usually because they
ignore or fail to take proper account of changing circumstances, there is strong evidence
to suggest that capital markets go through a cycle lasting five or six decades in which
debt imbalances accumulate to the point where a major correction is needed and a new
cycle begins. The best known of these is the Kondratieff cycle. While none of the
analysis in this series of papers depends on the theory of Kondratieff cycles, it is
nonetheless worth noting that the theory does predict a major collapse in the markets
over the next 2-3 years.

Some statistics
The table in Appendix A gives some telling statistics about the US economy. Perhaps
more important than the statistics are the underlying trends. The picture they give is of
an economy that is way out of balance. America's enemies on the world stage can be
expected to exploit this situation to their advantage and to engineer circumstances that
will strain its economy even more.

50
Conclusion
There has been no improvement in the global economic situation since the first paper
(June 2004). If anything, it has only got worse. The trend depicted in Appendix A is
very depressing. The US authorities appear to have no strategy for dealing with the
problems confronting them. What is worse, they are not prepared to acknowledge their
potential severity. Commentators outside the US appear to be far more concerned about
the emerging situation than those within the US.

The resulting shock, or perhaps series of shocks, will almost certainly result in a global
depression. The Japanese slowdown that began in 1990 was triggered by high levels of
corporate debt, croneyism in the banking and financial sectors, and a collapsing
property market. It persisted for 15 years because Japanese consumers refused to
consume, despite numerous attempts by the authorities to induce them to part with their
savings. This is a foretaste of the way global consumers are likely to behave after the
tsunami strikes. People will look for a secure means of saving to protect their long term
interests. The price of commodities and precious metals will soar.

The implications for public policy in Ireland, as well as some suggested ways of
mitigating the impact of the coming shock, are set out in earlier papers.

2 February 2005

References

(1) Preparing for the Coming Economic Shock and its Aftermath, R Pye, 28
June 2004

(2) Preparing for Turbulence on the World Markets, R Pye, 18 July 2004

(3) The Imminent Tsunami: Why the World Economy is on the Threshold a
Major Recession, R Pye, 28 September 2004

(4) The National Security Strategy of the United States of America, The White
House, 17 September 2002.

(5) America Stymied as Governments Bid to Control Oil, Irwin Stelzer, The
Sunday Times, 30 January 2005.

(6) False Dawn, John Gray, Granta Books, 1998

(7) Special Report: The Future of the Dollar, The Economist, 4 December 2004.

(8) Colossus: The Price of America’s Empire, Niall Ferguson, Penguin Press,
2004.

Copyright 2005, R Pye.

51
 APPENDIX A

Indicator Comment
Budget deficit 4.3% of GDP increasing 3.7% in 2003
($412bn) in 2004

Trade deficit set to exceed $600bn increasing $496bn in 2003

in 2004

Inflation 3.26% increasing 1.88% in Dec 2003

(Dec 2004)

Exchange rate 1.3569 (against euro falling 1.2582 on 1/1/04

on 1/1/05)

National debt $7.633 trillion increasing $7.009 trillion 31/1/04

Gold $421 increasing $400 on 01/02/04

(on 01/02/05)

Oil $48.20 increasing $33.05 on 31/01/04

on 31/01/05 [West Texas Intermediate]

Growth 3.8% in 2005 slowing 4.4% in 2004

Personal saving rate 0.2% approx. falling 4.0% at start 1999

[Nov 2004] 2.0% approx mid-2003

Consumer credit, $9.3 trillion increasing $7 trillion

mortgage and other debt (April 2003) (January 2000)

Refinancing of $125bn unsustainable $86bn in 2001

family property in 2004

Military fatalities 1400+ increasing Far in excess of what was expected

in Iraq in 2003

Cost per annum $150 bn increasing Original projections were half this rate
of Iraq

Note: This table does not include several other significant indicators,
including the non-funding of social security and medicare (an estimated
liability of $45 trillion), the extra costs implicit in increased longevity, and
the real rate of interest (which has been negative for several years).

52
 Discussion paper for limited circulation

The World Economy: A House of Cards

by Robert Pye, Greystones, Co Wicklow

"Central banks are supposedly the guardians of money. Yet between

them they may have created the biggest liquidity bubble in history."

- The Economist, 26 February 2005

Introduction
The first four articles in this series were devoted to a simple proposition, namely that
the world economy is heading for a major crash sometime in the next 3-5 years,
followed by a long-lasting and painful contraction. This article takes up some of the
earlier arguments in light of recent global developments.

Dependence on oil
It is frequently argued that world dependence on oil is far less than it was in 1973 and
1979 and that, therefore, the impact of an oil shock will be correspondingly smaller.
This argument fails to take into account two vital factors: (i) the world economy still
has no alternative to oil for a significant proportion of its economic activities and (ii)
the price of oil is no longer determined in the way it had been up to about 2000 (see
next section). The shock to date has been muted by the fall in the dollar relative to the
euro, thereby disguising the full extent of what has been happening. The real shock
will come when speculation, hoarding, increased world demand, limited refining
capacity, and interruptions in supply all conspire to generate huge spikes in the price.
This will continue to drive up the baseline price. This situation will not be helped by
the fact that many of the key players have a vested interest in pushing up the price. In
addition, competition among speculators will only add to the pressure, with banks and
pension funds getting into the game. In short, the price of oil in say, 5 years time, will
be significantly above its current level. Even without a major terrorist incident, it
could hit €100 a barrel before end-2008.

OPEC and the price of oil

The price of oil in the past was controlled by OPEC, but this is no longer the case.
OPEC is virtually powerless. There is practically no elasticity in supply. Even a
significant new find would make little impression on the price. The markets also
appear to be working on the basis that traditional commodity pricing mechanisms are
no longer applicable to the world oil market. The price of a commodity that every
economy needs, especially one in short supply, will not necessarily follow a linear
progression. They know it is worth whatever the buyer is prepared to pay and that it
is in the interest of financial stakeholders to keep pushing the price up. In short, the
price of oil over the past 30 years gives no indication whatever of the direction it will
take in the future.

53
Look at Japan
Greenspan and others have been trying to paint an upbeat scenario, where the depth
and liquidity of the world capital markets will maintain enough buoyancy to keep the
world economy afloat for years to come. This seems rather naïve when one looks at
the economy of a country like Japan. In a booming international environment, with
low interest rates, high domestic savings, low national debt, and significant demand
for its exports, it has been largely moribund for about 15 years. Not even the leading
pessimists in the early 90s predicted this outcome.

If the main engine of the world economy, the US, were to falter, most other
economies would be faced with a situation even worse than that faced by Japan over
the past 15 years. How would countries such as Germany, France, Italy, Korea, or
Indonesia fare, given that their existing fiscal position and economic profile is
significantly weaker than that of Japan in 1990?

Worsening double deficits in US

The twin deficits in the US continue to worsen. The trend in each case is even more
unnerving than the absolute amount. The US economy needs to import €2bn a day to
just stay where it is. Many of its economic indicators are being massaged by the
authorities to give the impression than the underlying position is healthy and
sustainable. For example, increases in employment are being heralded as strong
growth signals, when in reality they fall far below what could be expected at this point
in the cycle and, to a greater extent than ever before, comprise jobs that are
temporary, part-time, low-paid and non-industrial. Talk about low interest rates and
low inflation ignore the fact that real interest rates have been negative or close to zero
for several years. This is a very unhealthy sign in an economy that is meant to
underpin global performance.

The low rates of interest have also fuelled a property bubble, not just in the US but in
most major economies (Germany seems to be the exception). This means that when
interest rates rise, as they will, they will impact severely on domestic demand and
damage world trade.

There is a further problem whose magnitude is not generally recognised. The extent
to which the US relies on profits from financial firms has grown ten-fold in the last
twenty years or so, from 4 per cent of overall profits in 1982 to more than 40 per cent.
The increase in other large economies has not been nearly as great. As a whole, the
financial sector makes up nearly a quarter of America’s overall stockmarket
capitalisation, up from 5 per cent in the 1970s. This changing pattern would suggest
that when it hits the shock will cause a great deal of pain.

Developments in China
China is in a bind. It depends heavily on the US as a consumer of its exports. To
keep this stream flowing, it must continue to buy US treasury bonds and, in the
process, accumulate a huge surplus in dollar reserves. This surplus is then used to
bolster the fragile Chinese banking system. If the dollar were to fall significantly, the
Chinese banking system would take a hard knock. But if China tries to get out of
dollars before this happens, it could trigger the very problem it is trying to avoid.

54
According to many commentators, the only way around this is to allow the Renminbi
to gradually appreciate against the dollar, preferably by fixing it against a basket of
currencies. However, this does not appear to be attractive to the Chinese authorities
who will still witness a fall, albeit a gradual one, in both their exports and their
foreign reserves. It also fails to take account of a major strategic factor, namely that
the Chinese are seeking to usurp the US on the world stage over the coming decades
and that an outcome that hurts the US may be just as attractive as one that helps
China.

M3 and institutional weaknesses

The purpose of a central bank is to control the money supply. M3 among all the
major economies has increased substantially over the past 15 years, outstripping GNP
growth by a long distance. So far this massive increase in liquidity has not translated
into inflation because it was soaked up, firstly by an equity bubble (which has not
completely burst) and later by a global property bubble. When interest rates hit a
critical level, they will trigger a collapse in the latter, releasing a huge flood of money
that will feed partly into general prices and partly into commodities.

The Economist had some revealing comments to make about global liquidity in its
issue of 26 February 2005:

...global liquidity has been expanding at its fastest pace for at least 30
years. This deluge largely reflects the combined effects of American
and Asian monetary policies. Our measure of "global liquidity"
consists of the sum of America's monetary base (notes and coins plus
banks' reserves held at the Federal Reserve) and foreign exchange
reserves held by central banks around the world. In both 2003 and
2004 this rose at annual rates of more than 20%. In no other 2-year
period since 1975 has liquidity increased by so much...Central banks
are supposedly the guardians of money. Yet between them they may
have created the biggest liquidity bubble in history.

Institutional controls over the world financial markets are weak. There is no
international consensus on either the problems or the possible solutions. The level of
distrust between the major economies seems to be lower than it has been at any time
since the 1930s. The attitude that gave rise to Bretton Woods and the Marshall Plan is
nowhere in evidence. There is a high level of cynicism regarding the goals of key
institutions like the IMF, the World Bank and the WTO. Even apparently
independent institutions like the ECB are seen to operate within a framework
determined largely by political considerations. On the other hand, the power of the
unregulated sector – hedge funds, international investment funds, multinational
companies – has increased enormously.

For better or worse, the perception exists that the world economy is not being
properly managed and, of greater concern, that a co-ordinated response to a global
shock will not be forthcoming.

55
No one in control
The sense that there is no one is control is nowhere more evident than in the US. A
flavour of the situation that now prevails may be found in a recent article from The
Economist, Not exactly major league (19 March 2005):

“Mr Bush generally prefers businessmen and true believers to

academics and Wall Street types. It is hard to claim that economists
guarantee success: witness, for instance, the Clintons’ economist-
packed health-care plan. All the same, Mr Bush is plainly chancing it
– especially if an economic crisis of some sort were to happen…

What would Mr Bush’s team do if there was some sort of international

economic crisis, such as a dollar crash?

…given the lack of strength within the administration, the risks now
are surely higher [than in 1987]. Mr Bush should be crossing his
fingers that nothing goes wrong.”

It is telling that a major periodical on world financial matters should speak so frankly,
not just about the quality of economic leadership in the US, but about the real
possibility of a global economic crisis.

Threat of terrorism
The threat of terrorism should be kept under constant review and factored into the
way world interest rates are likely to evolve. Interest rates, as the cost of renting
capital, include a risk premium to reflect the possibility that the capital may not be
repaid in full. Thus economic terrorism alone may force up the cost of capital. For
example, the Sunday Times (8 May 2005) stated that one of its reporters succeeded in
getting agreement from an international arms dealer to supply him with 3 rockets with
a range of 8 miles and a radioactive warhead containing 400 grms of caesium-137 and
strontium-90 at a cost of $500,000. It is reasonable to assume that one or more
international terrorist organisations have already obtained such weapons. They are
easy to prime and operate since no knowledge of nuclear fission is required. As a
‘dirty’ bomb it would cause very few deaths, but would contaminate an area of
several square miles and render it uninhabitable for a year at least. If one of these was
detonated over a major commercial centre, such as the Square Mile or Wall street, the
interruption to business and the loss of rental income would cause major economic
damage. The prospect of further attacks would add significantly to the cost of doing
business in major commercial centres around the world.

56
Iraq and Iran
The invasion of Iraq is increasingly been seen as a disastrous venture by the US. The
so-called Iraqi government has taken over three months to form and is hardly more
than a loose coalition of conflicting ethnic interests. The insurgency is as strong as
ever, fuelled by an extreme ideology that will not rest until the US is driven out of the
Middle East. The presence of the US military in Muslim territory is only serving to
radicalise more and more of the local population. This is a war the US cannot win.
Costs will mount, as will the death toll. Eventually the insurgents will be sufficiently
organised to hit oil infrastructure. When this happens, the real cost of the war will
become apparent.

The Iranian nuclear development programme is also a growing cause of concern to

both Israel and the US. Since China is known to have links with Iran, international
and regional tensions can only increase further.

Dollar slide
Given the many factors outlined above and in earlier articles, a significant slide in the
dollar is inevitable. Depending on how this happens, it can be expected to set off a
painful chain of events.

One effect of a fall in the dollar will be a significant drop in foreign competition,
allowing indigenous US firms to push up their prices, thus fuelling inflation even
more.

World trade will take a severe knock and growth will fall, very likely to recessionary
levels. The US authorities will have to push up interest rates to support the dollar and
curb inflation. This will hit consumers and slow growth even further. The real
damage will come when the equity markets take a hit and pension fund managers see
an escalation in their liabilities.

The first central bank to rush to the door and convert its dollars holdings into another
currency will also set a match to a pile of dry tinder.

The real question then will be, Who will invest and where? Everyone will rush to
commodities and precious metals. This is probably why the National Pensions
Reserve Fund recently changed its strategy and has begun to invest for the first time
in these assets.

What preparations can be made?

The world economy is a house of cards. There is nothing a small member of the EU
can do to influence these coming events. However, there are a few simple measures
which, if taken now, could help to reduce the damage when the house of cards takes a
tumble:

57
 (a) Denominate a significant proportion of the national debt in US currency to
exploit the coming collapse in its value.

(b) Put a far greater proportion of the National Pension Reserve fund into
commodities and precious metals. (The proportion being converted by the
NPRF managers is far too low and the projected time scale much too long.)

(c) Modify the existing pay determination structures, which are possibly too
responsive to worker demands, to reduce the risk of a wage price spiral.

(d) Aim as far as possible to accrue an annual budget surplus which could be used
to boost the economy in a troubled post-shock environment.

12 May 2005

*****************

Previous articles in this series:

- 28 June 2004
- 18 July 2004
- 28 September 2004
- 2 February 2005

Copyright 2005, R Pye.

58
 Discussion paper for limited circulation

Ask not for Whom the (Lutine) Bell Tolls

by Robert Pye, Greystones, Co Wicklow

“...by avoiding deflation [through loose monetary policy], central banks

have allowed private sector debts to grow even more, in the US and UK
at least. That has made the scale of the potential problem even greater.
When things do go wrong, they will be very nasty indeed.”

– Philip Coggan, Financial Times, 2 July 2005

This paper is less an analysis of specific factors contributing to the impending crisis in
the global economy than a survey of the general pattern of risk that has emerged and
which continues to worsen.

Volcker
Let’s start with comments made by Paul Volcker, the chairman of the Federal Reserve
from 1979 to 1987, in The Washington Post on 10 April 2005. Volcker is known for
his objectivity, his sober judgement, and his deep knowledge of financial markets.
Referring to the arrangement that currently exists, whereby the US feeds its voracious
appetite for capital by borrowing on a grand scale from China and other Asian
economies, he says:

The difficulty is that this seemingly comfortable pattern can't go on

indefinitely. I don't know of any country that has managed to
consume and invest 6 percent more than it produces for long. The
United States is absorbing about 80 percent of the net flow of
international capital. And at some point, both central banks and
private institutions will have their fill of dollars.

I don't know whether change will come with a bang or a whimper,

whether sooner or later. But as things stand, it is more likely than not
that it will be financial crises rather than policy foresight that will
force the change.

He raises the possibility of a solution based on a concerted policy response

comprising a substantial appreciation of the yuan, a significant increase in
EU consumption (along with major structural reform), and the introduction
of measures to “forcibly” increase the US rate of internal saving. He goes
on to say:

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But can we, with any degree of confidence today, look forward to any one of
these policies being put in place any time soon, much less a
combination of all?

The answer is no. So I think we are skating on increasingly thin ice.

On the present trajectory, the deficits and imbalances will increase.
At some point, the sense of confidence in capital markets that today
so benignly supports the flow of funds to the United States and the
growing world economy could fade. Then some event, or
combination of events, could come along to disturb markets, with
damaging volatility in both exchange markets and interest rates. We
had a taste of that in the stagflation of the 1970s -- a volatile and
depressed dollar, inflationary pressures, a sudden increase in interest
rates and a couple of big recessions.

Volcker clearly does not see a managed response to the growing crisis. At some point
an event or “combination of events” (such as an event similar to 9/11) will trigger a
major slide in the markets, with long and painful repercussions across the global
economy. The outcome he sees emerging is broadly the same as that cited in earlier
papers in this series – a significant fall in the dollar, strong inflation internationally, a
major hike in interest rates, and a deep recession.

China
The first risk factor is China. The extremely high level of investment in that economy
in recent years is underpinned by a fragile banking system. A sharp slowdown in the
world economy could reveal the weaknesses in that system – high exposure to default
by creditors, a high concentration of foreign reserves in the US dollar, little depth in
domestic consumption, and only modest experience in managing a major financial
crisis. There is also a high level of cronyism in the Chinese business system, a strong
command-economy ethos, and a less than transparent method of recording financial
liabilities.

The recent adoption of a managed floating exchange rate has done nothing to date to
bring about the degree of appreciation in the yuan that is needed to address US
concerns.

China is still a one party state, with no adequate means for rival factions to give vent
to their views. This means that internal political pressures can develop suddenly and
in ways that are difficult to predict. The Americans have never demonstrated a
convincing ability to read the strategic intentions of foreign powers. A failure to
understand what is happening in China during a crisis – whether economic, military or
political – could have very unpleasant consequences. For example, just how far are
the Chinese prepared to go in pursuit of their strategic objectives in relation to Taiwan
or the South China Sea, or in opposing US attempts to widen its sphere of influence in
the Middle East, in particular Iran? Would US intervention in Iran be taken by the
Chinese as an opportunity to assume control over Taiwan?

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China is currently exposed to two major environmental risks, either of which could
precipitate the kind of large scale social disturbances that would facilitate the seizure
of power by hawks and hardliners. The first is the risk of famine brought on by a
prolonged drought. As the celebrated scientist E O Wilson observed in a study of
biodiversity in a global environment (2002):

“...the groundwater of the northern plains [which supports two-thirds of

China’s agriculture] has dropped precipitously, reaching an average 1.5
metres (5 feet) per year by the mid-1990s. Between 1965 and 1995 the
water table fell 37 metres (121 feet) beneath Beijing itself....The
extremity of China’s condition makes it vulnerable to the wild cards of
history. A war, internal political turmoil, extended droughts, or crop
disease can kick the economy into a downspin. Its enormous population
makes rescue by other countries impracticable.”

The second environmental risk is the growing likelihood of an avian flu pandemic
(H5N1) that could affect the human population. Many medical experts give this risk a
high rating.

Nuclear
The next major risk is that of nuclear terrorism.

Iran has long been concerned that either the US or the Israelis could carry out a
military strike on its nuclear development sites. The reality of this threat was
demonstrated recently when the UK, France and Germany offered to ‘protect’ Iran
against the possibility of (US) military intervention if it promised to put its nuclear
plans on hold.

Iranian determination to press ahead with its nuclear programme has only increased
with the election of Ahmadinejad, a known hardliner, as president.

Given the intensity of terrorist activity in Iraq in recent months, it is increasingly clear
that the Sunni minority, who ruled the country under Saddam Hussein, are prepared to
provoke a civil war with the Shia majority in order to secure a permanent power base
in the region. Since Iran is mainly Shia, and since the Kurds are also pressing for a
homeland in northern Iraq, the resulting conflict could well destabilise the entire
region.

Bush recently made a major strategic decision when he authorised the sale of civil
nuclear technology to India, a country which has never signed (and shows no
intention of ever signing) the nuclear non-proliferation treaty. This runs completely
against longstanding American policy, which has always opposed the release of
nuclear technology or materials to countries that had not signed the treaty. Clearly,
America wants a nuclear ally in the region to balance Pakistan on one side and China
on the other. This shortsighted decision will only encourage the Iranians to continue
with their own nuclear programme.

61
Pakistan is ruled by a military junta. Any semblance of democracy in that country is
an illusion. General Musharraf and his cronies live in fear that the terrorists will
target them at some stage. It is believed that they have tolerated a strong Al Qaeda
presence in the northern province in return for a temporary entente. When it no
longer suits Al Qaeda to continue with this arrangement, a major heave against
Musharraf is inevitable, especially when nuclear missiles are part of the spoils.

Economic indicators
The main global economic indicators all continue to worsen. In the US, the trade and
budget deficits show no sign of moving away from their general downward trend,
while the national debt, which takes no account of implicit liabilities (such as
pensions and medicare), is growing steadily. Some economists reckon that the trade
deficit, which is already drifting toward 7 per cent of GDP, will reach 8 per cent by
2010. The improvement in the dollar, from 1.35 to 1.22 against the euro, says more
about Europe than it does about the US economy. The property bubble continues to
expand, representing the biggest financial bubble in history, according to The
Economist. Real incomes in the US have shown little increase over the past 10 years,
and household savings are virtually nil. Domestic consumption is being fuelled by
asset-price appreciation and related high levels of household borrowing, which is at
an all-time high. Real interest rates are close to zero, while increases in employment
are well below those normally seen at this point in the cycle. The influence of the
unregulated or loosely regulated sector – hedge funds and investment consortia – on
the stability of the financial markets continues to increase. Investors are borrowing to
invest in order to take maximum advantage of the low interest rate, thereby distorting
equity prices and leaving themselves exposed to interest rate increases. Many
corporate investors are much more highly leveraged than in the past, and therefore
more vulnerable to volatility and sudden movements in the markets. Oil is now over
$65 a barrel, compared to $40 a year ago, while, tellingly, oil futures with a maturity
of 5 years are also selling at €65. Domestic demand in almost all markets outside the
US is muted. A sudden fall in equities would add greatly to the strain already felt by
pension funds, who are faced with increased demographic longevity, significant
underfunding, and the imminent retirement of baby boomers. Many high profile
industrial investments, such as General Motors and Ford, are at or close to junk bond
status. Demographics also show that the proportion of the population in the 45-60 age
bracket, which is the group that has been investing most in the stock market in the
past decade, is set to fall sharply over the next few years. There also strong signs that
Chavez in Venezuela will continue to take an anti-American line, both in relation to
oil supply and in relation to foreign policy in the Latin American zone.

The only ray of sunshine is the introduction by China of a floating exchange rate
mechanism. However, given that this alone is unlikely to lead to a significant
appreciation of the yuan relative to the dollar, it is a very tiny ray indeed.

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Financial system
The world financial system itself is far from stable. Not only is it much larger that it
was, say, 15 years ago, but it contains much greater and faster transnational flows of
capital (which caused the Asian crisis of 1997), and a variety of risks that that are not
properly understood, mainly due to a lack of transparency and the role of contagion in
transmitting problems from one market to another in ways that are difficult to predict.
As Andrew Large, Deputy Governor of the Bank of England, said in November 2004,
“the search for yield” in an environment of low interest rates is encouraging investors,
banks, and hedge funds to converge on similar trading strategies, raising “the prospect
of one-way markets developing and market liquidity evaporating in response to a
shock.”

The situation is not helped by the fact that net US overseas liabilities has risen steeply
to around 25 per cent of GDP. In other words, when all financial flows into and out
of the country are taken into account, the US owes the world one quarter of all output.
If current trends continue, and there is no indication whatever that they will not, then
the US current account deficit could reach 8 per cent of GDP by 2010, pushing net
external liabilities to around 90 per cent according to one estimate. One can expect
the markets to panic before that happens, if only because the increased strain on the
dollar will increase the cost of supporting the budget deficit and generate an
unsustainable feedback loop.

In the words of Warren Buffett (March 2005), the US is fast changing from an
'ownership society' to a 'sharecropper society', paying substantial rent annually to a
third party in order to operate.

Lessons from history

Every decade throws up a fresh wave of economic commentators who are convinced
that the old rules no longer apply. The ‘new economy’ gave us the Dot Com bubble,
a bout of wholesale irrationality which drew little cautionary comment from
institutions, such as the Federal Reserve, which ought to have dampened enthusiasm
before the crisis became unstoppable. The same institutions are now ignoring the
crisis that is rapidly coming down the tracks.

Niall Ferguson, professor of history at Harvard University, has drawn attention to the
parallels between the existing situation and the years leading up to the Second World
War. Both moments in history were preceded by a long period of globalisation, huge
international movements of capital and commodities, major technological advances,
and an international financial system almost wholly dependent on the economic health
of a single hegemonic super-power. There is a major difference on this occasion
though. The UK was a net exporter of capital in the period 1870 to 1914, while the
US today is a net importer. Unless the rest of the world can continue to feed its
incredible appetite for capital, its currency will collapse, with dreadful implications
for the global economy.

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As Ferguson observed, “Today no one can be sure how stable the international
monetary system is, but one thing is certain: it is no more stable than the system
which preceded World War I.” In fact, we could go further and assert that it is less
stable. At least the world financial system prior to WWI sought to maintain stability
among the major currencies through the operation of the gold standard. Today, the
bewildering capacity to create fiat money, even by the world’s reserve currency,
stands in marked contrast to this earlier, more robust arrangement.

Just as Britain tried to stem German expansion in 1914, with disastrous consequences,
the current regime in the US has stated that it will act to impede Chinese expansion.
For Balkan terrorism, we now have Korean, Iranian and Pakistani nuclear ambitions,
plus a major global insurgency among Islamic militants. This insurgency has stated
that its chief aim is to drive the US out of the Middle East by undermining its
economy. One of the principal ways it will do this is by attacking global oil refining
and distribution infrastructure. A motor boat packed with high explosives could
cripple an oil tanker. A small plane packed with high explosives could cripple an oil
refinery. A band of school boys with high explosives could cripple a pipeline. Given
that standards of living in Saudi have been falling consistently over the past 15 years,
while the proportion of unemployed and disaffected youth has swollen significantly,
the internal stability of that country is even worse than that of Iran prior to its collapse
in 1979. For these reasons, US intervention in Saudi Arabia and other parts of the
Middle East appears inevitable.

Sentiment
So why aren’t investors being more cautious? One can only suppose that the main
driver is sentiment, much as it has always been. The fundamentals are only important
when the majority of investment decisions are informed by reason and logic. While
the average US investor (and consumer) continues to buy the line peddled by
Greenspan and others (which seems to ignore geopolitical factors entirely), then one
can expect the aggregate assessment to be bullish, or at least upbeat. The real
problem will start when the majority of investors wake up to the scale of the
impending crisis and everyone rushes for the door. As Volcker noted (see excerpt
above), this awakening could be accelerated by a major international incident.

Stephen Roach of Morgan Stanley, whose pronouncements over the past year or two
have been consistently negative, made the following statement on 15 August 2005
about the ability and willingness of the American consumer to keep on spending:

"Over the years, I’ve learned to be wary of betting against the

American consumer. But the history of energy shocks argues to the
contrary. Moreover, today’s saving-short, asset-dependent, overly-
indebted consumer is far more vulnerable than in the past. After years
of such warnings, investors, of course, have all but given up on that
possibility. That’s precisely the time to worry the most."

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Conclusion
The global risk profile is even worse than it was this time last year. What is more the
underlying trends show no signs of improving; so, even as the markets continue to
'prosper' for another 12 months, we can expect the situation this time next year to be
much closer to meltdown.

15 August 2005

*****************

References

Buffett, W Annual report to shareholders of Berkshire Hathaway, March 2005.

Coggan, P. “It’s pretty calm now. But just wait for the storm...”, Financial Times, 2 July 2005

Ferguson, N. “Sinking Globalisation”, Foreign Affairs, March/April 2005

Large, A. "Why we should worry about liquidity", Financial Times, 11 November 2004

Roach, S. "Beneath the Surface", Morgan Stanley web report, 15 August 2005.

Volcker, P. “An Economy on Thin Ice”, The Washington Post, 10 April, 2005

Wilson, E.O. The Future of Life, Little Brown, New York, 2002.

Previous articles in this series

28 June 2004: "Preparing for the Coming Economic Shock and Its Aftermath"
18 July 2004: "Preparing for Turbulence on the World Markets"
28 September 2004: "The Imminent Tsunami"
2 February 2005: "Countdown to a Global Economic Shock"
12 May 2005: "The World Economy: A House of Cards"

Copyright 2005, R Pye.

65
 Discussion paper for limited circulation

Eight Reasons why a Global Economic Shock

is inevitable by end-2008

by Robert Pye, Greystones, Co Wicklow

...the present [US trade] deficit is excessive and dangerous.

Left alone, it could end in a global recession, rampant
protectionism, and even a disastrous financial crash.

- The Economist, 24 September 2005

The world is on course for a major economic shock. There are eight reasons, all inter-
related, which suggest that this is almost certain to occur before end-2008. In random
order, they are:

1. The US budget deficit

2. The US trade deficit
3. The US federal debt
4. The instability of the world financial system
5. The rising price of oil
6. Pension fund deficits
7. Growing geopolitical tensions
8. A failure of leadership

Reason No.1: US Budget Deficit

The US budget deficit is slipping out of control. The existing situation, and the
underlying trend, is even less acceptable in an economy that is meant to underpin the
world reserve currency. The position from 2000 to 2009 (projected by the US Office
of Management & Budget) is set out in Table A.
Table A

Budget Deficit
Year (Surplus +) % of GDP
US$ billion
2000 +236 2.4
2001 +127 1.3
2002 158 -1.5
2003 375 -3.5
2004 412 -3.4
2005 319 est -2.6
2006 268 est -2.1
2007 241 est -1.8
2008 240 est -1.7
2009 237 est -1.6
Data source: US OMB [table compiled by author]

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Some commentators do not place a great deal of credence in the projections from
2005 to 2009, which are very optimistic in light of the trend over recent years, the
commitments made post-Katrina, the increasing cost of the war in the Middle East,
and the cost of paying for additional retirements as the baby boomers leave the work
force.

As stated in the last paper in this series (August 2005), the key concern is not the
absolute amount of the budget deficit but the emerging trend. The swing of 5.8 per
cent of GDP over the 5-year period 2000-2004 is without precedent over the last 60
years.

Compare this with the Sixties, when the federal government funded a major war in
Vietnam, the NASA moon project, and the Great Society programme. The average
budget deficit for the period 1966-1970 was 0.9 per cent, and yet it is commonly
argued that the huge increase in federal spending during the Sixties forced the US to
drop its commitment to Bretton Woods in 1971. If an average budgetary imbalance
of 0.9 per cent could form the background to a major shift in policy, what reason have
we to believe that the pressures exerted today will not have a corresponding effect?

Reason No.2: US Trade Deficit

The trade deficit is also getting worse – see Table B. At the start of 2000 it stood at
$300bn. By end-2004 it had jumped to $668bn, while developments to date in 2005
are far from encouraging.

Table B

Trade deficit $bn GDP $000bn %

1995 113670 7522 1.51
1996 124894 8000 1.56
1997 140906 8471 1.66
1998 214064 8953 2.39
1999 300060 9519 3.15
2000 415999 9953 4.18
2001 389456 10226 3.81
2002 475211 10591 4.49
2003 519679 11236 4.63
2004 668074 11995 5.57
Data source: US Bureau of Economic Analysis [table compiled by author]

The deficit in the first 8 months of 2004 was $396bn, while in the first 8 months of
this year it has already climbed to $463bn, an increase of almost 17 per cent.

So, as with the budget deficit, it is not just the absolute figures that are a cause of
concern but the underlying trend.

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The currencies of many developing countries collapsed when their international
transactions fell this far out of balance. The normal solution, a carefully managed
devaluation of the currency, is not being pursued. Perhaps the authorities fear that a
move in that direction could trigger a slide. Also, an orderly devaluation would
require a co-ordinated international effort, which in turn would require the full co-
operation of China, a major rival of the US on the world stage.

The Plaza Accord of 1985 achieved a 'successful' devaluation of the dollar, but many
commentators believe it led to the stock market crash of October 1987. Also, the
Plaza accord did not require the co-operation of an aggressive economic competitor.
China is a major rival to the US on the world stage and, unlike Japan and the EU
member states, would welcome a long-term weakening of the US economy.

The Plaza Accord was necessary in part because interest rates had been exceptionally
high for several years and had caused the dollar to become overvalued. But it was
also prompted by a ‘high’ trade deficit – 2.34 per cent in 1984 and 2.73 per cent in
1985!

The US is acting as world consumer of last resort, fuelled by a property bubble. Over
the past 4 years, consumption and residential investment together accounted for over
90 per cent of the rise in America’s GDP. Even more striking, 40 per cent of all new
private-sector jobs have been in construction, mortgage-broking and other areas
related to housing. Unless its economy switches form such a high concentration in
non-tradables, it will be unable to produce the exports needed to correct its burgeon-
ing trade deficit. It will be more difficult to do this given the contraction in its
manufacturing base which in 1980 was about 40% greater than it is today.

A significant component of the risk posed by the trade deficit is protectionism. If US

industry is unable to reverse the imbalance, and there is every indication this could
take some time to correct without an orderly depreciation of the dollar, politicians and
captains of industry will increasingly call for the introduction of protectionist
measures such as quotas and tariffs. This will stop globalization in its tracks and give
rise to a whole new batch of economic problems. Depending on how the Asian
economies react, it could trigger the very financial crisis it was designed to avoid.

Reason No.3: US Federal Debt

By itself, the current level of US federal debt would not be a matter of major concern.
However, when other indicators are faltering, the federal debt assumes a greater
significance. The projected level for 2006 is $8726 billion or 69 per cent of GDP, the
highest it's been since 1960. For example, during the Seventies, when the economy
had to bear the brunt of the first oil crisis, it averaged only 35.6 per cent of GDP

68
Table C

Federal Debt
% of GDP
$bn
2000 5628 58.0
2001 5769 57.5
2002 6198 59.8
2003 6760 62.4
2004 7486 est 65.3
2005 8132 est 67.5
2006 8726 est 69.0
Data source: US Bureau of the Public Debt [table compiled by author]

As with the twin deficits, the underlying trend is disquieting. The debt has grown
from 57.5 per cent of GDP to 67.5 per cent in only 5 years, a very large increase for
the world's most powerful economy and bastion of the world's reserve currency. This
could really start to hurt when interest rates rise, either in response to inflationary
pressures or to demands by foreign lenders for the greater risk they are taking on.

It has been argued that inflation is being kept down by globalisation, where low
labour costs in Asian economies and the more competitive pricing of internationally
traded goods and services have held back the general increase in prices that might
otherwise have occurred. But this argument ignores the dampening effect of the
housing bubble, where asset price inflation has helped to hide the effects of loose
monetary policy. When the housing bubble bursts, one can expect the inflationary
wave to work its way into consumer prices. This will require further interest rate rises
which in turn will increase the relative burden of the federal debt.

Monetary policy under Greenspan has been incredibly loose – see Table D. The large
increase in M3 in recent years has not yet found its way into core inflation but it is
very difficult to see how this can be avoided over the next couple of years without a
painful increase in interest rates.

Table D

[September] M3 $bn GDP $bn %

1996 4885 8000 61.1
1997 5332 8471 62.9
1998 5882 8953 65.7
1999 6323 9519 66.4
2000 7003 9953 70.4
2001 7850 10226 76.8
2002 8334 10591 78.7
2003 8909 11236 79.3
2004 9359 11995 78.0
2005 9977
Data source: US Federal Reserve [table compiled by author]

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At this juncture, it is worth comparing the US economy as it stands today, under each
of the above indicators, with the corresponding figures for 1980 when the last oil
crisis struck – see Table E

Table E

Trade Balance Budget Deficit Federal Debt M3

as % of GDP as % of GDP as % of GDP as % of GDP
1980 + 0.79 - 2.7 33.4 66.4

2004 - 5.57 - 3.4 65.3 78.0

[table compiled by author]

It is clear from Table E that the US economy is far less equipped to deal with an
economic shock than it was in 1980. When one considers the inflation caused by that
shock and the level of interest rates required to bring it under control, we can get
some idea of the problems that are building up. (The average Federal Funds interest
rate over the period 1975-1978 was 6.01%, while for the period 1979-1982 it was
13.3%.)

Reason No. 4: The instability of the world financial system

Since the last paper in this series we have witnessed the use of a hedge fund to hide
losses of $430m incurred by a NY futures brokerage (Refco). This does not appear to
have had a serious impact on the financial markets but it serves as a chastening
reminder that the opacity of hedge fund operations provides ample opportunity for
crimes of this kind. While there are doubtless large numbers of honest brokers in the
market, there are also bound to be a fair share of unethical players who will use
whatever means they can to push for higher returns or to conceal losses. The problem
with concealment is that a lot of damage can be done before the authorities can
intervene to stabilise the market.

Refco was subjected to due diligence by Goldman Sachs before it was floated on the
stock market – just two months before it collapsed! If a major financial institution,
with access to business records, cannot spot a gaping hole in the accounts of such a
company, what reason have we to believe that many other black holes are not already
extant throughout the financial system?

The hedge fund market has grown rapidly. Funds under management in Europe alone
have trebled in less than 3 years and now stand at $279bn. Worldwide there are over
8,000 funds managing more than a trillion dollars. Some of these funds are very
large. About 250 in the US and Europe have assets of more than $1bn. While such
funds represent about 5 per cent of assets under management worldwide, they are
estimated to account for between a third and a half of all daily trading on the London
and New York stock exchanges.

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The Bank for International Settlements made some stinging remarks in its latest
annual report (June 2005) about the increased instability in the world financial
system, mainly due to the "explosive growth" in credit derivatives. Despite the
limited fall-out from the collapse in value of credit notes issued by General Motors
and Ford, the BIS believes that

"the robustness of these new markets has not been fully tested...The strong
credit conditions that have fostered the development of these markets may
not continue into the future. One concern is the impact of highly
leveraged positions on the balance sheets of financial institutions when
markets turn. Another is the nature of the systemic role played by highly
leveraged institutions such as hedge funds in affecting market liquidity;
two-way markets could conceivably disappear as protection sellers exit at
precisely those times when default insurance is needed most."

While it is unlikely that any hedge fund today would indulge in the level of borrowing
that brought down Long Term Capital Management in 1998, there is a good chance
that the risk identified by the BIS could result in many of them being caught out at the
same time, with no counterparty to soften the blow. The impact on the world
financial system could be very painful indeed.

The world financial system is underpinned by staggering levels of debt. Non-financial

corporate-sector debt in the US comes to around $7 trillion, while accumulated
household debt is in the region of $10 trillion. Mortgage and credit card debt in the
UK recently passed the £1 trillion mark. The low interest rate policy pursued by the
Federal Reserve since 2001 has caused overall indebtedness, not just in the US but
around the world, to expand enormously.

The sophisticated use of credit derivatives has allowed this debt to be securitized in so
many ways that it has infiltrated just about every type of investment portfolio. It is
argued that this spreads the risk, but it also serves to hide it. The more securitized
debt is taken on by counterparties, the greater the instability in the system.

Credit card debt has grown at an extremely fast rate in the past ten years. Since a
large proportion of consumers depend on this form of credit, which attracts a punitive
rate of interest, the continuing increase in interest rates will eventually have a sharply
negative effect on consumer confidence. This is especially true of the US, the engine
of the world economy, where the personal saving rate is close to zero.

Reason No.5: The rising price of oil

The first paper in this series (June 2004) predicted that the price of oil would jump
from $40 a barrel (as it was then) to $60 by end-2005. However, it hit that figure by
start-2005 and has since spiked to $70 or thereabouts. The current baseline price is
still above $60 and is not expected to fall.

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It can't be stressed strongly enough that oil is not just a major commodity. It is the
commodity, the sine qua non of all economic activity. The slightest suggestion that
supply could be interrupted or curtailed sends jitters through the markets. US foreign
policy for the past sixty years or more has been based chiefly on ensuring that this
never happens. The rise of Al Qaeda and increased demand, mainly from China, has
added considerably to the problem. There are also real concerns that reserves are
running down faster than expected and that infrastructure is not being upgraded.
Taken together, these factors strongly suggest that the price of oil will continue to rise
for many years to come. Given past experience, this will have major implications for
consumer confidence, growth, inflation, interest rates and industrial policy.

Al Qaeda cannot defeat the US militarily, but they can do it considerable economic
damage. With two-thirds of world oil reserves in just five Islamic countries (Saudi
Arabia, Iraq, Iran, Kuwait and the UAE), they will have ample opportunity to pursue
this agenda.

The US entered Iraq for just one reason – oil. And it is staying for the same reason.
The Bush regime would appear to have decided, in line with stated Neoconservative
policy, that Middle Eastern / Caspian oil is vital to America’s long-term strategic
interests and that it will do whatever is necessary to protect it. Al Qaeda on the other
hand will do all it can to promote civil unrest across the entire region. Military
equipment for the insurgency will not be in short supply since the enemies of the US –
Iran, Russia, and China – will continue to ensure that the Islamic insurgency remains
a bitter thorn in the side of US foreign policy.

China has been making overtures to all the world’s major oil-producing countries and
is known to be particularly interested in securing a reliable supply of oil from one or
more middle eastern countries. To this end it has been supplying military technology
and other inducements to regimes in various countries, including Iran, Kazakhstan
and Saudi Arabia, to win favour and exercise a greater measure of strategic influence
in the region.

In short, both the reigning world super-power and its main rival are competing in the
same region for the same resource. What is more, even though Russia has ample oil
and gas reserves, it cannot afford to be pushed aside as the US and China vie for
resources in sensitive regions along its southern border.

According to one study, total world oil production would have to grow by 60 per cent
between 1999 and 2020 to satisfy anticipated world consumption, while total US oil
consumption is expected to increase by 44 per cent between 2001 and 2025. With
reserves falling, demand rising, growing civil unrest in many oil-producing countries,
and increasing terrorist activity designed to interrupt supply, the price of oil is bound
to rise significantly in the coming years. $100 a barrel by end-2007 is not out of the
question.

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It should also be remembered that the US economy benefits significantly from the fact
that world oil prices are denominated in US dollars. To buy oil you must first buy US
dollars. Any threat to depart from this arrangement is a threat to the well-being of the
US economy. For example, Chavez could well decide to land a blow against
perceived American imperialism by denominating Venezuelan oil in euro rather than
dollars. This means that, to buy Venezuelan oil, the US would have to sell dollars to
buy euro! Even Putin reminded the US of this possibility when in October 2003, in
response to a question at a news conference with Gerhard Schroeder about the
possibility of denominating Russian oil in euro, he said, "We do not rule out that it is
possible. That would be interesting for our European partners."

Reason No.6: Pension Deficits

A pensions crisis is brewing. Funds worldwide are in deficit, and they are falling
further into deficit as longevity increases. The UK government actuary has recently
stated that he will no longer adhere to the ‘limit to life hypothesis’, namely the
assumption that there must be a limit to longevity increases. This policy revision has
added a further 4 months to the life expectancy of a 65-year-old man, taking it to 19.4
years, and one month to the expectancy of a 65-year-old woman. This means that in
just two years, the official estimates of life expectancy for 65-year-olds has jumped
from 17.8 years to 19.4 years for men and from 20.6 years to 22.1 years for women.

The net of effect of this is to push pension funds further into deficit and to raise the
prospect of further life expectancy adjustments in the coming years.

The impact of the pension crisis in the US has been receiving greater attention with
the collapse of Delphi, the auto parts manufacturer, which was one of the biggest in
US history. A large chunk of its pension deficit will be assumed by the Pension
Benefit Guaranty Corporation (PBGC), a federal insurance agency which allows
corporate entities to insure their pension liabilities by contributing regular premiums.
The collapse of Delphi has helped to highlight just how rapidly the funding shortfall
at the PBGC is growing. The total underfunding of US pension plans increased from
less than $20bn in 2000 to over $350bn by September 2004, while the direct deficit at
the PBGC stood at over $23bn on the same date.

Some of major airlines in the US, by filing for receivership under Chapter 11, have
successfully passed their pension liabilities to the PBGC. The very existence of the
PBGC is thus proving to be a moral hazard, providing an incentive to large
corporations to offload their pension liabilities by filing under Chapter 11. The fact
that the corporations pay premiums to the PBGC is not very comforting, for two
reasons. Firstly, the scope for increasing the premiums to underwrite the shortfall is
both very restricted and politically sensitive. Secondly, the PBGC invests the bulk of
its assets in US Treasuries. This means that future taxpayers, and not a self-sustaining
investment portfolio, will be paying for the future aggregate deficit across the entire
pensions industry. Since future taxpayers will also be paying for social security
pensions, medicare and medicaid, this is a very grim prospect indeed.

Even if more companies switch from defined benefits to defined contributions, where
the individual carries the investment risk, adverse market conditions will still give rise
to a significant fall in personal income and thus in domestic consumption.

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Reason No.7: Growing geopolitical tensions
A major weakness with modern economic theory is that it does not incorporate a
measure or an indicator of geopolitical tension (GPT). Given the increase in
globalization over the past 20 years or so, this omission is surprising. Of course, an
accurate measure could hardly be expected, but some method of recognising such
tensions should figure in any global economic model. If such a yardstick existed, its
historical data would almost certainly show that geopolitical tensions today are far
greater than they were when Iran fell in 1979 or when oil prices quadrupled in 1973.
The fall of the Soviet Union, the rise of Islamic insurgency and the proliferation of
nuclear capability have caused GPT to escalate. It seems unrealistic to take world
GDP at face value when GPT is being ignored.

It would be unthinkable 15 years ago that a nuclear device could be smuggled into Tel
Aviv. But this is a real prospect today. Only a few years ago citizens of Delhi were
faced with the possibility, during a very tense two-week period, that Pakistan would
direct a nuclear device at their city. Former US Senator Sam Nunn has repeatedly
warned that the threat of a nuclear device being exploded in a large American city is a
very real one. Al Qaeda have stated that their main weapon against the US is
economic. A major terrorist attack in a financial centre such as Wall Street or the
Square Mile could have a catastrophic impact on the world financial system. It is
clear from many expert commentaries – such as Clarke’s Against All Enemies,
Scheuer’s Imperial Hubris or Johnson's Blowback – that outcomes of this magnitude
can no longer be considered improbable.

Even if Ahmadinejad’s threat that Israel “should be wiped off the face of the earth”
through the use of a nuclear weapon is largely rhetorical, it is similar to the rhetoric
that Ayatollah Ruhollah Khomeini broadcast regularly from Paris in the 1970s, before
he overthrew the Shah. The Israelis see the current Iranian regime as posing no less a
threat to the security of their state than did Saddam Hussein in 1981 when they
destroyed his nuclear reactor in Osirak near Baghdad. Iran sponsors two major
terrorist organisations, Hamas and Hezbollah, whose main aim is to destroy Israel.
Iraq did not have the same strategic commitment to the destruction of Israel in 1981,
yet its nuclear capability was demolished anyway. A proper GPT analysis of the
world economy should therefore be asking what kind of fall-out can be expected
when, and not if, Israel carries out a similar strike inside Iran.

Too many historians and self-appointed experts have been gushing indiscriminately
about the ‘end of history’, claiming that democratic, free-market capitalism has
triumphed and that citizens of every nationality are bound to adopt the American
model in the decades ahead. This kind of nonsense is blinding many world leaders
and economic commentators to the fact that major tectonic plates are moving faster
than they have for sixty years, with potentially disastrous consequences for the very
system they revere if they do not act quickly.

This brings us to the last factor, the quality of world leadership.

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Reason No.8: A failure of leadership
As The Economist recently stated in a detailed survey of the world economy, where it
highlighted the growing dangers, “If the first step towards finding a solution is to
agree on the problem, the world’s policymakers are still a long way from solving the
global imbalances.”

US fiscal and monetary policy since 2001 has consistently made the problem worse,
while the failure of the current administration to engage in meaningful dialogue with
the leading economies and establish a co-ordinated response is deplorable. G8
summits without China are virtually meaningless. Apparently no attempt is being
made to encourage the oil-rich countries to use the huge windfall garnered on foot of
recent price increases to bolster the world economy.

Unless two or more world leaders draw public attention to the massive misallocation
of capital across the world financial system and the need to adopt a concerted
approach to correct it, there is little likelihood that existing consultative structures will
have any effect. In fact, their continued silence will only reinforce the common
assumption that the invisible hand of the market will keep everything on an even keel.

In The Fog of War, former US Defense Secretary Robert McNamara gave a candid
account of the duplicity and arrogance that pervaded the US administration in the
1960s, when countless military mistakes were made and one strategic blunder led to
another. Given that McNamara was a leading player in this appalling failure of
leadership, and that neoconservative policies today mirror many of those pursued by
McNamara and his cronies, the documentary holds many lessons for the 21st century.

The calibre of leadership on the world stage is abysmal. Bush and Blair waltzed into
Iraq without proper regard to the consequences. Chirac is ill. Schroeder was weak
and Merkel will be even weaker. Few people could name the President of the
European Commission. The Japanese premier, Kozumi, has never been an influential
voice on the world stage, while the governments of the main Asian economies will
not say anything without the implicit approval of Beijing. Putin is heard only by
those who covet Russian oil and gas. Both the IMF and the World Bank are in thrall
to Washington, while the OECD is too lightweight to make any difference, even if it
did have the temerity to speak out. Trichet has been trying to highlight some of the
difficulties but seems reluctant to challenge the main players. Greenspan has been
one of the main architects of the coming fiasco, while his successor, who blames a
global savings glut for the existing imbalances, is unlikely to act decisively.

Conclusion
The risk table in the attached appendix speaks for itself.

6 November 2005

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 *****************

References

- A Survey of the World Economy, The Economist, 24 September

2005

- Bank for International Settlements, Annual Report, June 2005

Clarke, R Against All Enemies: Inside Americ'a War on Terror, Free Press,
USA: 2004

Connon, H Is a new disaster hiding in Refco's hedge?, The Observer,

16 October 2005

Galbraith, G K The Great Crash 1929, Penguin, UK: 1955

Johnson, C Blowback: The Costs and Consequences of American Empire,

Metropolitan Books, USA: 2000

Klare, M Blood and Oil, Metropolitan Books, USA: 2004

Mellon, J Wake Up: Survive and Prosper in the Coming Economic

& Al Chalabi Turmoil, Wiley, UK: 2005

Morris, E (dir) The Fog of War [documentary], USA: 2003

Scheuer, M Imperial Hubris: Why the West is Losing the War on Terror, Potomac
Books, USA: 2004

Previous articles in this series

1. 28 June 2004: 'Preparing for the Coming Economic Shock and Its Aftermath'
2. 18 July 2004: 'Preparing for Turbulence on the World Markets'
3. 28 September 2004: 'The Imminent Tsunami'
4. 2 February 2005: 'Countdown to a Global Economic Shock
5. 12 May 2005: 'The World Economy: A House of Cards'
6. 15 August 2005 'Ask not for Whom the (Lutine) Bell Tolls'

Copyright 2005, R Pye.

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 APPENDIX

Table of Global Risks

static risk synergised risk
US budget deficit 10 12
US trade deficit 10 12
US federal debt 7 9
Instability of financial system 10 12
Rising price of oil 15 17
Pension fund deficits 8 10
GPT 15 17
Leadership failure 5 7
TOTAL 80 96
[compiled by author]

This table sets out an estimate of the risk in question triggering a world economic
crisis sometime in the next 3 years, where 1 is a 1% chance and 100 is 100%. The
‘static risk’ column ignores the estimated values attaching to the other risks, while the
‘synergistic risk’ column attempts to factor in the cumulative impact of the other risks
listed above. While the table is entirely subjective, the values in each case are fairly
conservative. For example, few economic commentators would contest the assertion
that there is a 10% chance that the US budget deficit could trigger a world economic
crisis sometime in the next 3 years.

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 Article written for The Irish Times (January 2007) but officially
blocked by the Department of Finance

Why a Global Economic Shock is Now Looking Inevitable

by Robert Pye

The world economy is poised on the edge of a precipice, and yet, oddly enough, few
international commentators are alerting the public to the turmoil that lies ahead.

Before examining the situation facing us today, let's look first at the global situation in
July 1914. The world economy was poised on the edge of a precipice then also. Like
today, few market commentators saw what lay ahead. The world had enjoyed over
four decades of relative peace and increasing prosperity. Markets everywhere had
expanded steadily, international investment had grown significantly, and globalization
in the modern sense was well established. Communication and co-operation between
the major economies was well developed, the world banking system was fairly robust,
the gold standard gave stability to the major currencies, and the leading world
economy – Britain – was a net exporter of capital. Living standards across Europe
had improved dramatically and the middle class in most economies was growing
substantially.

While tensions between the great powers were well recognised, it was generally
accepted that everyone had too much to lose by embarking on a military adventure
against a major rival, especially one that might escalate into a grand confrontation.
Among those with the most to lose, and with the greatest investment in the status quo,
were the major bond holders in the main economies. These institutions, as well as
wealthy individuals, could have been expected to monitor their portfolio of risks on an
ongoing basis and to be sensitive to adverse developments on the world stage. And
yet they failed completely to detect the tsunami that was about to sweep away a large
portion of their wealth. The assassination of Archduke Franz Ferdinand in Sarajevo
on 28 June 1914 is generally viewed as the spark which ignited World War I, but the
bond markets at the time did not react. As the weeks passed, there was no indication
that the leading financial houses grasped the magnitude of what was happening. Their
methods of risk assessment were neither broad enough nor sensitive enough to detect
the seismic shift that was about to occur.

The same holds today. The world economy is extremely out of balance and
geopolitical tensions have grown considerably in the past five years, yet the markets
continue to operate as though nothing untoward was happening. Investors are
assuming, just as their predecessors did in 1914, that the benefits accruing from the
existing arrangement are so great, so transparently obvious, that no nation state or
ethnic group would dare to destabilise it.

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This perception is so sadly at odds with the underlying geopolitical reality that it is
difficult to fathom, but it is consistent with the myopia shown by previous
generations. Market analysts focus on fine detail. That's what they're paid to do. But
in doing so they often fail to take account of the wider picture, the broad geopolitical
environment in which their assumptions are embedded. Sudden changes in that
environment can have unsettling consequences.

So just how stable is today's global economy and how well does it reflect the sharp
rise in geopolitical tensions? A small number of leading investors and market
analysts, including the sage of Omaha, Warren Buffett, are convinced that a major
correction is on the way. The world economy as a whole is driven, for better or
worse, by developments in the US economy, which comprises about one third of
global output. That economy is very heavily indebted. As we noted earlier, the
world's largest economy in 1914 – Britain – was a net exporter of capital, but the US
economy today is dangerously dependent on a continuing supply of capital from the
world at large. It requires an inflow of roughly $2bn a day just to stay afloat. Most of
this is supplied by Asian central banks who continue to buy US treasury bills (federal
debt) to prevent their own currencies from appreciating against the dollar. They thus
possess a mountain of dollar-denominated assets that will collapse in value if the
dollar starts to slide. For this reason it is argued that both the US authorities and the
Asian banks have too much to gain from the existing arrangement to let it fall
asunder. But this kind of optimism is no more sustainable today than it was in 1914.

For a start, the American consumer must continue to consume. Unless he or she
continues to buy masses of Asian imports, the cycle will come to a halt. The buying
spree of the past few years was fuelled in large part by the sharp increase in property
prices. On foot of this perceived increase in wealth, property owners withdrew equity
from their homes to finance their additional spending. Personal savings rates dropped
close to zero and credit card debt rose prodigiously. As a result a large proportion of
US consumers are living so far beyond their means that a sharp contraction in
domestic consumption is bound to occur at some point.

Historically low interest rates also induced many firms to borrow more than they had
planned and certainly more than would be prudent in a less benign environment. If
interest rates rise and domestic consumption falls, these firms will be unable to
contribute through further investment to an economic recovery. On top of this, state
and federal indebtedness have been rising excessively. While the total US federal
debt – $8.7 trillion – is lower than, say, that of Germany as a percentage of GDP, it is
historically high for a currency that is meant to function as the world reserve
currency.

Furthermore, this debt figure represents official federal debt only, not the huge
unfunded liabilities generated by social assistance commitments (pensions, medical
cover, etc) which are variously estimated to lie somewhere between $45 trillion and
$57 trillion – more than 4 times US GDP! In other words, the burden of debt being
passed from one generation to the next is incredible. The level of future taxation
needed to fund it would be punitive – assuming the federal and state authorities do not
default on their obligations.

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There are two other major problems that make the situation a whole lot worse. The
first is the fiat status of the US dollar. Up to 1971, the dollar was underwritten by a
formal link to gold. This made it difficult to expand the money supply ("print
money") without first meeting certain sound economic criteria. With the lapse of
these criteria, the US authorities (like those of other countries) can print money at
their discretion. The production of money in this way, known as fiat money, is only
stable over the long term if the money supply expands in step with economic growth.
If it is allowed to outstrip growth, it can for a while create the illusion of prosperity –
but a day of reckoning must come as prices readjust to reflect the over-supply of
money.

There are strong signs that the US money supply has been expanding too rapidly and
that the authorities are not disposed, at least for the moment, to bring it under control.
One indication of this was the termination by the Federal Reserve in March 2006 of
the publication of M3 money supply figures for the US economy. Every developed
economy publishes these as a matter of course. While the US money supply can be
extrapolated from other published figures, the refusal to release a standard headline
indicator like M3 is a matter of concern. It lends credence to the view expressed by
many critics that the US government is allowing money supply to expand at an
excessive rate in order to fund the ever-rising cost of the war in Iraq.

This has not as yet hit the value of the dollar, at least to a degree that could trigger
international concern. One reason for this is that the dollar has been enjoying a kind
of proxy gold standard over the past thirty years or so. Since oil is denominated in
dollars, all major economies are obliged to buy dollars to pay for their oil imports.
While this accounts for only a fraction of the dollars bought by foreigners, it has
nevertheless played an important role in sustaining the centrality of the dollar in world
trade. Significantly, it has also meant that oil exporting countries have a direct
interest in maintaining the value of the dollar, primarily by recycling a large portion
of their oil-generated earnings back into the US economy.

What if a major oil-exporting country threatened to denominate its oil in a currency

other than dollars? Chavez of Venezuela has adverted to this possibility, as has Putin
of Russia. Both know the harm this would do to the dollar. Interestingly, shortly
after Saddam Hussein threatened to do so, Iraq was invaded.

The other major problem is the risk posed by the ever-growing – and unregulated –
market in financial derivatives. These are debt instruments designed to pass the
underlying risk to the party best equipped to take it on. Many are so complicated that
only a handful of experts in the leading investment institutions understand them.
They are a sensible way of diversifying risk, but only if the risks concerned are
transparent. Their amazing proliferation in recent years has given rise to legitimate
concerns that buyers are increasingly unable to evaluate the underlying risk
effectively. As the volume and speed of transactions increase, and as financial
derivatives become more complex, the chances that untenable risks will accumulate in
certain sectors are bound to increase. The web of derivatives is so pervasive that a
market failure in one sector could spread fairly rapidly into others and cause a major
shock to the financial system. This came close to happening in 1998 when a large
hedge fund, Long Term Capital Management, collapsed. Only the timely intervention

80
by the US authorities prevented a calamity. The real concern today is that a large
institution or hedge fund could collapse before the authorities had time to intervene
and underwrite its liabilities.

To get a better idea of the systemic risk posed by the collapse of a single institution,
picture a circle of one hundred institutions, each owing $100m to the institution on its
right. The net debt within the circle as a whole is zero. But consider the implications
for the remaining 99 if one of them goes under. Each of them will forfeit $100m, and
the circle as a whole will show an accounting deficit of $10bn. Not a happy scenario.
This is why timely intervention is so critical. If the authorities can take on the
liabilities of the institution that failed, and do so in good time, it can prevent the
collapse of the other 99. However, there is no guarantee that the failure will come to
light in time or that sufficient liquidity can be assembled to plug the hole before the
others go under. One has only to look at the criminal accounting practices employed
by fairly straightforward institutions like Enron to see how easily major losses can be
disguised.

If these were the only problems facing the world economy, there might be reason to
believe that concerted action by leading participants – assuming they could reach a
consensus – would lead to a satisfactory solution. But this ignores the huge frictions
that have arisen from the conflicting ambitions of four major powers, namely the US
itself, Russia, China and the Islamic bloc. The latter three regard the US as, at best a
rival and, at worst, an enemy. This has been exacerbated by the policy of unilateral
intervention pursued by the current Bush administration.

As far as the Islamic insurgents are concerned, before the US can be defeated
militarily, it must be weakened economically. Thus they have a major incentive to
exploit the existing problems with the US economy by creating further terror along
the lines of 9/11, possibly by deploying portable nuclear devices or other instruments
of destruction. A high death toll, especially if achieved through a series of
simultaneous strikes, would cause a collapse in the stock market and deliver a
catastrophic blow to the world financial system.

Putin's Russia is fast turning into a modern fascist state, where habeas corpus and the
rule of law have no meaning. A humbling blow to the US economy would suit it
admirably, as would a further increase in tensions in the Middle East between Shia
and Sunni factions. By providing aid to the Iranian nuclear programme, it is gradually
stoking the fire that it hopes will cut off western access to Middle Eastern oil. Once
this happens it will enjoy a geopolitical influence that the Tsars of old would have
envied.

China must continue to expand economically if it is to remain internally stable. To do

this it needs a reliable source of oil. It has been working hard in recent years to forge
closer ties with oil-exporting countries like Venezuela, Sudan, Canada and...Iran. The
latter is geographically close, an enemy of the US and anxious to retain the covert
support of another major power.

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In addition to these major sources of geopolitical tension, there are three wild cards in
the pack: Israel, Saudi Arabia and Pakistan. The first two are alarmed by the prospect
of a nuclear-armed Iran. Israel is unlikely to let Iran reach the stage where its nuclear
capability becomes militarily viable. It would rather provoke a confrontation on its
own terms than allow Iran to dictate the course of events. The best it can hope for is a
change of regime in Tehran, though the scope for this seems rather slim.

Saudi Arabia, a Wahabi-led Sunni state, is known to be very unhappy with the
destabilisation of Iraq and the threat posed to its regime by a resurgent Shia
movement led by Iran.

Western commentators tend to forget that another unstable Islamic state, namely
Pakistan, already has a healthy nuclear arsenal. Its northern province is a known Al
Qaeda stronghold and Musharraf's grip on power is tenuous at best. Through the
agency of Abdul Qadir Khan, a leading scientist, it has also supplied nuclear
technology and know-how to North Korea, among others. It is very unlikely that this
occurred without the approval of senior power brokers in Pakistani political circles.

Putting all these pieces together, the outlook is grim indeed. Taken as isolated
phenomena, they are fairly forbidding, even from a global perspective. But
considered as related phenomena, strung together and reinforced by some common
themes – a reaction by the great powers to American supremacy, hostility to Western
intervention in Islamic countries, both recently and historically, and systemic
weaknesses in the world financial system – they present a far darker picture.

Why is such a disturbing matter not discussed more openly in the media? I think that
this is due in part to the fact that, generally speaking, economists do not study history
and historians do not study economics. A major confrontation seems far too
improbable to a generation with little direct experience of the pain and tragedy of
large scale war. Even the younger generation of Americans see the Vietnam War as a
distant, rather oblique event. The 'end of history' brigade have also lulled many into
believing that the main problems of social organisation have been solved, that a
paradigm for unlimited economic growth has been developed, and that reason will
always prevail. It is difficult for anyone accustomed to such comforting assumptions
to see that the conditions for a third world war are well and truly in place and that all
that is required is an incident of sufficient magnitude to set it in motion.

When the shock occurs, the price of oil will go through the roof and industrial output
will decline markedly. Economic growth in the west will stall for decades,
unemployment will rise significantly and standards of living will fall. The stock
market crash and the slide in the dollar will destroy wealth on a grand scale, leaving
tens of millions without adequate pensions or health care.

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Most level-headed readers will argue that this scenario is far from inevitable, that the
most pessimistic assumptions are being lumped together to produce a sensational
outcome. Three years ago I would have said much the same, but once you see the
pattern taking shape and weigh it against the lessons of history, it is not a question of
whether this will happen but when. Three months or three years from now? Who
knows. All I suggest is that you give the matter some thought and draw your own
conclusions.

-----

[Mr Pye is author of An Overview of Civil Service Computerisation, 1960-1990

published by the ESRI in 1992. The views expressed herein are personal and do not
purport to represent those of any other person, group or organisation.]

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