The Political Importance of Financial Reform

Today at 2:00pm ET, exactly 2 years after the collapse of Bear Stearns in March 2008, Senate Banking Committee Chairman Chris Dodd will unveil his financial reform bill. This bill promises to bring sweeping change to all major US banks. Even Morgan Stanley and Goldman Sachs will not be spared as the bill is said to contain a provision that hinders these firms from revoking their bank holding company charter they adopted during the financial crisis.

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Netanyahu's Political Attack on Obama

I firmly believe the Obama administration cannot react strongly enough to right-wing Israelis' recent "insult" against American leadership in the Middle East. I am referring, of course, to Israel's settlements announcement during Biden's visit last week. This is not the first time Netanyahu has pulled something like this:

Right-wing governments in Israel have regularly embarrassed high-level U.S. officials by making announcements about new settlement activity during or just after their visits. But it usually happens to secretaries of state. It infuriated James Baker, confounded Condoleezza Rice, and appalled Madeleine Albright. When I [Martin Indyk, former Ambassador to Israel] served as Albright's ambassador in Israel, during Bibi Netanyahu's first term as Prime Minister, he announced a major extension to an existing West Bank settlement as she departed Israel after one of her efforts to move the peace process forward. When she heard the news, she called me on an open line and shouted: "You tell Bibi that he needs to stop worrying about his right wing and start worrying about the United States."

But this time is more significant than when Albright was Secretary of State during the Clinton years. This announcement directly attacks Obama's basic foreign policy -- that engaging diplomatically is more fruitful than the unilateralism of the Bush years. By undercutting Obama's pending diplomatic achievements and fueling domestic criticism of Obama as a weak leader, Netanyahu's actions are much more damaging to Obama today than they were to Clinton in the 1990s.

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Obama in China

At first, it seemed like Obama's visit to China might actually be fruitful after the People's Bank of China issued a report promising an improvement in the yuan's exchange rate mechanism a few days before Obama's arrival. But this move was posturing, an attempt to lessen discussion on this topic and not a sign of coming compromise.

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Obama's Commitment to Palestine and the Stark Realities of Geopolitics

US rhetoric on Israeli settlements has shifted dramatically since President Obama's inauguration. In the first few months after January 20, Obama courted the world, successfully promoting an image of a cooperative, benevolent US. A key part of this was a sterner approach to Israel. Obama demonstrated this by unexpectedly demanding a halt to settlements during his first meeting with Netanyahu. Indeed, Obama mentioned multiple times during his campaign that he advocated a more balanced approach to Israel-Palestine. Six months after inauguration, Obama's Palestine strategy has converged with Bush's.

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Assessing the President

Historically, there is no statistically significant relationship between stock prices and presidential approval ratings. In fact, Richard Brody shows in his classic study of public opinion, Assessing the President, that even macroeconomic performance is more often than not an inadequate predictor of public opinion.* However, for the Obama administration there has been an unusual inverse relationship between the economy and public approval.

From today to the inauguration, the correlation between the S&P 500 and total approval of the president is -0.794. This strong relationship is the result of one of the strongest equity rallies in history and the quick end of Obama's honeymoon period.

Another interesting correlation is that between the US Dollar and Obama's approval. The correlation since inauguration is a positive .822. There is mounting political pressure in the US for a stronger dollar (the GOP has started using the dollar's weakness to attack the President), even though a weak dollar is in many ways in Obama's interest. If the weak dollar policy ends up creating jobs, we will likely see the dollar-approval correlation turn negative.


Though the relationship between the dollar, stocks, and Obama's approval rating is statistically significant (a regression indicates stocks and the dollar have a 71.6% predictive power with p-values <.0001), there is no reason to think this is a causal relationship. (If anything, I'd think higher stocks are having a positive effect on Obama's approval rating because it indicates his policies are working. Apparently this doesn't seem obvious to everyone, such as Jim Cramer, who argued Obama's low approval rating are bringing up stock prices because investors believe a weaker Obama is better for business.)

However, once in a blue moon, these correlations are significant and explanatory. The stock market crash following the collapse of Lehman Brothers was one of the main reasons Obama was elected president (which says a lot about how the American public views Obama). Gallup charted opinion of Obama during fall 2008 versus negative views of the economy:

If you look at the chart above, you see Obama only took the lead after the collapse of Lehman Brothers on Sept. 15 when negativity surged. Also, Obama's lead spiked October 8, during the Dow's most dramatic decline of the crash:


The high negative correlation between stock prices and Obama's approval rating is likely a coincidence. But there are real implications to this correlation. As stocks go up, the severity of the financial crisis declines. As the intensity of crisis decreases, the harder it becomes to push through effective reform. During the Great Depression, it took five years of misery before Congress pushed through meaningful reforms. In a previous post, I discussed how, from the perspective of some markets, this crisis looks very similar to past crises (1987) that ended up with no material reform. In electing Obama, the electorate voted for change. Now that in retrospect the crisis seems less dangerous than it was, the need for change becomes less apparent. Obama won the election more narrowly than people remember. It took one of the most unstable economic moments in US history to grant Obama his narrow lead. We really shouldn't be surprised that the public responded dramatically to Obama's ambitious changes. The response to Healthcare reform would likely have been much different had markets not recovered so fast.


* On a side note, one of Brody's findings in Assessing the President is that approval of a Democratic president increases as unemployment grows and falls as unemployment shrinks. However, the relationship between inflation and a democratic president's approval rating is negative, meaning approval falls when inflation rises. For Republicans on the other hand, inflation is positively correlated with approval while unemployment is negatively correlated (as one would expect). This might reflect the different expectations voters have for democratic and republican presidents. Therefore, when a democrat curbs inflation, he is rewarded with higher approval than a republican might otherwise get, because it is unexpected.

Iran Incongruities

As the world inches closer to official and non-official deadlines given to Iran on nuclear negotiations, something in the international equation just doesn’t add up.

The relevant players here are the P5+1 (the permanent five members of the UN Security Council plus Germany), Israel, the Sunni gulf states, and Iran. It’s worth evaluating their interests one by one, since a composite view of the situation will involve an intersection of these interests with their respective capabilities.

China—not thrilled about the prospective of nuclear proliferation, but even less thrilled about the prospect of interruptions in its energy supplies. China imports almost 60% of its oil from the Persian Gulf, and its largest trading partner is Iran. This means that the odds of China agreeing to the only sanctions that would really hit home in Iran—a gasoline embargo—are slim to none, since economic weakness directly translates to innerpolitical turmoil and trouble for the Communist Party. The only worse prospect is armed conflict, which would almost certainly close off the Straits of Hormuz entirely.

France—Sarkozy has been clear that France will not tolerate a nuclear-armed Tehran. Iran’s numerous and continuing infringements against UN resolutions give the administration a legal basis to an increasingly militant posture.

The UK—in line with France and the US. Will not tolerate a nuclear-armed Iran, but like both countries, would prefer to avoid commitment of armed forces (for obvious reasons of economic and political costs and risks).

Germany—Germany is in a much more conflicted position than some of the government’s rhetoric would lead one to believe. For one, Germany (and close relative Austria) has substantial commercial interests in Iran. Secondly, although people and government are publicly very anti-nuclear-proliferation, both distrust US leadership, and have absolutely zero appetite for any type of conflict anywhere in the world, let alone in the neighborhood of Iraq, which is widely viewed as a symbol for All That is Wrong With America. The Germans have a tendency to view all conflict as fundamentally driven by self-interest, which is therefore intrinsically immoral (unless Germany’s own interests are at stake). Finally, Germany’s increasingly cozy relationship with Russia, borne both from energy dependence and diverging interests with the US, means that Germany is unlikely to form a united front with the rest of the West to exert pressure on the other stakeholders in the brewing conflict.

Russia—Russia already has extensive commercial ties with Iran, specifically in two sensitive and lucrative sectors: nuclear technology (the Buschehr plant) and armaments (particularly SU-300 SAMs). The country therefore has a vested interest in business-as-usual, except that the alternative (strict sanctions or war) have a potential to be even better for the Kremlin’s bottom line. A closing of the Straits of Hormuz would lead to an explosion in oil prices, and gasoline sanctions would allow Russia to make a killing exporting fuel overland to Iran at inflated prices. Even more importantly, Russia would like to see nothing more than to see the Middle East suck in American resources even further, since this would allow it to continue reasserting control over its sphere of influence in the former Soviet Union (particularly Ukraine and the Caucasus). The only balancing aspects are that Russia is also interested in a stable Afghanistan, meaning that a shift in US combat capabilities out of the country would require added expenses by the Kremlin to secure that border; and secondly, a nuclear-armed Iran will likely further push US ballistic missile defense system proliferation in Eastern Europe. News that the US has shelved these plans, whether true or not or for whatever reason, do not change that long-term reality. Overall, though, between its oil export capability, potential to disrupt American air attacks by the dissemination of air defense systems, and even nuclear support, Russia can make a difficult situation just that much worse.

The US—the US doesn’t really want war, and can’t afford it. The latter is not just a matter of defense appropriations and budget deficits, but also opportunity costs and the deep socioeconomic malaise that would follow the inevitable rise in crude prices following Persian Gulf action. However, the US cannot tolerate a nuclear-armed Iran, for the following reasons: 1) it is illegal under the NPT and would weaken the international state system, 2) it would constitute an existential threat to all US allies in the region, particularly Israel; 3) it could very well lead to an arms race in the Middle East that harbors immense fat-tail risks. Finally, Obama is seen internationally as young, untested, and possibly weak, and he is a Democrat, which means that at the domestic level he must constantly prove his foreign-policy steel. He cannot afford to appear even slightly weak here.

The Gulf States—America’s Sunni allies in the Persian Gulf, and chiefly Saudi Arabia, are extremely concerned about the prospect of nuclear armament in the region and its potential to shift the balance of power. Many battle with social issues around the integration of Shiite minorities within their own borders. The question, as always, is not only one of capability, but of political will—how to balance their populations’ antipathy to everything Israeli with the confluence in national interest? As is the case with Palestinian support, rhetoric will sharply diverge from policy.

Israel—has made its position abundantly clear: Iran will not be allowed to acquire nuclear weapons. Netanyahu is playing a complicated political game balancing domestic and international politics (best shown in settlements ‘freeze’). In recent weeks, he has tried to buy the Russians, cajole the Americans, intimidate the Iranians, and ratchet up the pressure as much as possible. To mount an attack across Iraqi/ American airspace, Jerusalem needs Washington’s approval. But the wild card here is Obama’s perceived coolness to the Israeli cause—if the Israelis do not predict help as forthcoming, they may feel freed to undertake radical action themselves.

Iran—is playing the usual games. They are attempting (and succeeding) and changing the debate from revolving around nuclear issues, to revolving around the debate itself. They have done this by proclaiming first that nuclear issues are not on the table during the upcoming negotiations (scoring domestic political points and adding another hurdle for foreign diplomats), then proposing Tehran as the negotiation site (which is impossible, since negotiations are at head-of-state level, but would be a major victory if agreed upon), by making small meaningless concessions. (such as letting inspectors back into an enrichment plan), and finally, by releasing a position paper. The last bit allows the more recalcitrant participants (Germany, Russia, China) to claim that diplomacy is making progress and thus oppose stricter sanctions, when really the situation has not changed at all. The hoped-for outcome is that, after a year of meetings, all players go home exhausted, and with even fewer options than before.

The point is, everyone has very different priorities, and everyone is trying to push the situation as far as possible thinking no one else will act. For example, no one thinks Israel will act without US support, and no one thinks the US will (or can) act at all; but these assumptions don’t necessarily hold true. Expecting a few months of negotiation with no tangible outcome simply does not make sense when some players simply cannot afford to let that happen at almost any cost (particularly Israel and the Arabs). Also, Obama is thinking of Kennedy and the Cuban missile crisis, and has a strong incentive to move fast. With so many miscalculations and moving pieces, the situation could escalate rather quickly.

There are a few possible accommodations that could be made to change the constellation of players. The most intriguing is a Grand Bargain between Russia and the US (of which the recent US scrapping of missile defense systems may well have been the starting gun). It would really cost the US, above all in credibility, since it would basically have to withdraw support from Georgia, the pro-western sections of Ukraine, and even to some extent Poland, and lessen its presence in Central Asia; but policymakers might well decide that this is worth it since n the long-term, these losses can be regained. If the West were truly unified—Germany being the problem here, not France—then this would be more easily achievable, since Russia would both see a bigger stick waving and could be offered more carrots.

Another possibility is a massive change in US strategy. It would take a while to implement because of the formidable logistical obstacles, but the US could shift forces right back out of Afghanistan into the Gulf region, abandon the Afghan effort altogether (thereby creating a liability for Russians), to ratchet up pressure on Iran and signal a willingness to fight.

A wild-card here, ignored in most discussions, is China. How would the Middle Kingdom react to military action in the Gulf that reduces oil imports or raises their price? For that matter, could the country be convinced to support sanctions if the only alternative is war (which would be even worse economically)? The Chinese talk like a superpower, but haven’t paid the costs yet—maybe they will begin to here?

In any case, no matter what pattern of escalation follows between Iran and the West, or Russia and the US, or whichever constellation of powers, nuclear war is not the risk. But the odds of an economic disruption of some sort are rising with every day that there is not a realignment of the interests described above. And thus, it might well make sense for investors to hedge what could be a substantial fat-tail risk. In almost any scenario, crude oil and Russian indices should do well, and the US (and most of the rest of the global economy) should do relatively worse. Alternative energies would get a boost. And given that the popular media coverage of the situation has been muted thus far, this kind of protection should still be affordable.

Special thanks to my brother (who knows much more about geopolitics than I) for his input into this article. This article is a product of a long phone conversation with him, and the ideas in it should be considered his more than mine.

Perspectives on Obama's Tire Tariff

Pres. Obama's recent 35% tax (on top of an existing 4% tariff) on tires imported from China has generally been denounced as a protectionist move motivated by domestic political factors. Bill Witherill of Cumberland Advisors called it a "cynical and dangerous move" because the US tire manufacturing industry is internationally uncompetitive anyway. Some have speculated the tariff will lead to another Smoot-Hawley effect on the world economy. With the lessons from the Great Depression hanging heavy over everyone's head, the recent trend of trade retaliation (such as competing Buy America and Buy China policies) is certainly alarming.

But while the tariff may seem ominous from an economic perspective, from a geopolitical perspective the tariff makes more sense. A recent article from Stratfor (which is unfortunately not public) argues the moves of both countries were politically motivated and are unlikely to escalate. I don't agree, but it's an interesting argument. First they point out this is not a normal WTO case, because Obama never even mentioned any unfair trade practices. Obama did it because he can. In the 2001 Chinese WTO accession agreement, Clinton insisted on including a particular section 421, which basically allows the US to sanction any product without making a case for trade violations until the end of 2013. For that reason, China cannot react in any way that will actually hurt the US, because it could provoke Obama to use section 421 again, completely legally. We have yet to see any meaningful retaliation. China declared it would probe "unfair practices" in US chicken and auto products, but that's it.

But why would Obama do this for domestic political reasons as the FT, WSJ, Stratfor, and others have claimed? Sure he's having trouble with healthcare, but why would he trade a small boost in his base for further complications in Iran? As Stratfor points out, China could easily retaliate by refusing to cooperate with sanctions or stonewalling negotiations. But this would make Obama look terrible. Obama has a lot of political capital riding on Iran. His criticism of Bush's unipolar attitude and unwillingness to negotiate was one of his main foreign policy selling points during the campaign. I think its more likely Obama enacted the duty to remind China of its economic leverage before the P5+1 negotiations with Iran. China is not enthused about sanctioning its third-largest supplier of oil.

Obama said on Wall Street this Monday,

"Make no mistake, this administration is committed to pursuing expanded trade and new trade agreements. It is absolutely essential to our economic system. But no trading system will work if we fail to enforce our trade agreements. So when, as happened this weekend, we invoke provisions of existing agreements, we do so not to be provocative or to promote self-defeating protectionism. We do so because enforcing trade agreements is part and parcel of maintaining an open and free trading system."

These words imply the US sees its ability to tariff-at-will as a right in return for opening up trade with China. While his choice of industry might have been politically motivated, his decision to raise tariffs in the first place was likely a geopolitical one. It will be interesting to see how the trade and Iran issues evolve alongside each other.

Negotiating with Iran

In a press conference yesterday, Iranian President Ahmadinejad ruled out compromising on Iran's "undeniable right" to a nuclear program but stated he is open for discussion with Pres. Obama. This statement indicates the challenges facing President Obama's Iranian policy. Obama campaigned on the premise that he could talk to antagonistic leaders without preconditions and achieve multipolar solutions. But that is virtually impossible as long as Ahmadinejad is president of Iran.

As long as Obama follows a multi-polar strategy, Iran will be able to delay by playing members of the engagement against each other. Consider the deadline set by Obama for Iran to come to the negotiating table, which is less than three weeks away. If Iran refuses to talk, the G-8 has promised "crippling sanctions." The delegation that will negotiate with Iran consists of the UN security council plus Germany (US, UK, France, Germany, Russia, and China). The UK, France, and Germany can be expected to follow Obama's lead. But Russia and China care much less about a nuclear Iran than the US. Moreover, Russia and China have a significant stake in keeping Iran stable and gain nothing from sanctions. It is in Russia's interest to keep the US occupied in the Middle East and away from its periphery. Russia also trades with Iran and will want to protect this. China depends on Iran for commodities. As long as Iran is China's third largest oil supplier, China will not be willing to get tough on Iran while Iran maintains a semblance of co-operation.

Ahmadinejad has taken advantage of this division. His recent statements were vague enough for Russia and China to claim Iran is willing to negotiate, drawing the process out further. Ahmadinejad also notably invited leaders from these countries to Tehran, something Obama is unlikely to do for domestic political reasons. If parties can't degree on where to meet to negotiate, the negotiations are likely to be just as unproductive.

On the other hand, Obama has no alternative to a multi-polar strategy. Sanctions can only be effective if Russia and China participate. The US simply has little leverage over Iran, having exhausted most of its options in the past. Whatever happens in Iran will ultimately depend on Russia and China.

Unemployment Risk

I wrote in my last post about the reversing of the expectations cycle. The expectations cycle is an interesting topic intellectually and also an incredibly useful investment tool. I wrote two weeks ago I expected an imminent reversal of optimism as economic data would come in worse than expected. No indicator demonstrates this better than the new unemployment figures from last week.

The unemployment rate is now up to 9.5% and looks set to break 10% for the first time since the early 80s recession. This data was worse than expected in the same way the May unemployment figures were better than expected. In May, unemployment was 100,000 people less than expected, sending markets higher into June. June's unemployment was 100,000 people more than expected. Ever since that data was released in early July, equities have fallen by about 1% a day. Most interesting however is the effect on commodities, especially oil. Commodity prices have decreased across the board and oil is down to $60 today (already a -3.4% change just for the day). (Oil was also affected by an announcement by the CFTC that it might place limits on positions for some market participants.) The decline in commodities is indicative of greater risk-aversion and negativity on the economy. Most of the upward pressure on commodities came from reasoning that an economic recovery would demand more raw materials and re-inflate commodity prices. In that sense, commodities can be seen as a call option on economic recovery. A good indicator of the new negativity is the marketpsych fear index (the line represents investor fear):


The rise in unemployment has significant political risk for the economy. As unemployment increases, policymakers will be under more pressure to stimulate the economy, especially since Obama said the stimulus package would keep unemployment at 8%. As unemployment surges, Obama will be under additional pressure to enact policies that can really mess things up in the long-run. A large part of this pressure comes from the fact that public opinion of Obama depends almost completely on a recovery. It is hard to imagine how Obama could be re-elected with unemployment above 10%. (A WashPost article from today titled "Obama Stands to Be Judged By the Economic Recovery" argues just that.)

Increasing the budget deficit is a grave risk, especially if you believe Morgan Stanley chief economist Richard Berner, who declared "America’s long-awaited fiscal train wreck is now under way."

"Depending on policy actions taken now and over the next few years, federal deficits will likely average as much as 6 percent of [the gross domestic product] through 2019, contributing to a jump in debt held by the public to as high as 82 percent of GDP by then — a doubling over the next decade,” Berner writes on Morgan Stanley’s online Global Economic Forum.

"Worse, barring aggressive policy actions, deficits and debt will rise even more sharply thereafter as entitlement spending accelerates relative to GDP. Keeping entitlement promises would require unsustainable borrowing, taxes or both, severely testing the credibility of our policies and hurting our long-term ability to finance investment and sustain growth," he adds. "And soaring debt will force up real interest rates, reducing capital and productivity and boosting debt service."

"Not only will those factors steadily lower our standard of living," Berner concludes, "but they will imperil economic and financial stability."

We have already heard talk about a stimulus II. Another stimulus would have more long-term negative repercussions than its worth. Sometimes, one simply has to buckle down and take the pain.

Bevin's Dilemma and Obama's Soft Power

If Zionists had a list of the most evil people in history, the British Foreign Secretary after WWII, Ernest Bevin, would be close to the top of the list, right under Hitler. The reason for this is that Bevin oppossed Jewish emigration to Palestine after WWII. Furthermore, he opposed the creation of a Jewish state. One has to agree denying Jews a home after the Holocaust isn't a praiseworthy act.

But, there is a different perspective. Bevin and the (flailing) British Empire had a strong interest in keeping Palestine peaceful. The Middle East was seen as the new future for the Empire, especially with mounting nationalism in India. Not only did Palestine have a crucial geopolitical position right by the Suez Canal, but relations with Arabs were key to maintaining British power over Kuwait, Qatar, Iraq, Iran, Bahrain, and Aden (Yemen). Keeping even levels of population was a necessity for stability in Palestine, much like it is in Lebanon today. In general, when one looks back on the Arab-Israeli conflict, much of it stems from population differences. For example, in the 80s there was relative peace in Israel. Peace lasted until the fall of the Soviet Union brought a huge wave of Jewish immigrants to the region.

When one considers the enormous pressure on Bevin to maintain a crumbling empire and the negative implications of Jewish immigration for British interests, Bevin's position becomes more understandable. We can at least empathize that Bevin was in a very difficult position.Bevin's side of the story has been forgotten for too long. But, it seems Obama understands Bevin's dilemma. In fact, Obama might have found the perfect middle way between supporting Israel and pleasing the Arabs. Geopolitically, Obama's position is similar to Bevin's. Obama faces significant pressure to cede to Israel's demands; though like Bevin, giving in to these demands would mean a weaker position among Arabs. Also, much like Bevin, Obama has a much greater stake in being friends with the Middle East than previous presidents—a result of high oil prices and terrorism.

Giddeon Rachman wrote in the FT today that Obama is "a soft power president. But the world keeps asking him hard power questions." That may be true for cases like Afghanistan and North Korea, but the Israeli-Palestine conflict is a pure soft power play. I wrote in an earlier post that Obama's soft power efforts would yet bear dividends and I think that moment is near in the Middle East. With his highly anticipated speech in Cairo tomorrow (as well as his order to Netranyahu to stop settlements), Obama will set the course to achieve what Bevin could not: a balance of Arab pride and Israeli ambitions. Historians' most potent criticism of Bevin is not that he was anti-semetic, just very undiplomatic—what a difference soft power makes.