Failing States Or It's The Money Stupid

Not California. Although California is failing. The States I'm going to discuss are Muslim States affected by the world wide financial crisis. Spengler is taking his usual jaundiced look at the world.

Financial crises, like epidemics, kill the unhealthy first. The present crisis is painful for most of the world but deadly for many Muslim countries, and especially so for the most populous ones. Policy makers have not begun to assess the damage.

Spengler wrote this in December of 2008 and half a year later the policy makers are no further along.

Moderate Islam was the El Dorado of the diplomatic consensus. It might have been the case that Pakistan could be tethered to Western interests, or that Iran could be engaged peacefully, or that Turkey would incubate a moderate form of Islam. I considered all of this delusional, but the truth is that we shall never know. The financial crisis will sort them out first.

As I commented in the late autumn, the world is not flat, but flattened (see Asia Times Online, October 28, 2008), leaving the economies of the largest Muslim countries in ruins. It is hard to forecast the political fallout, for when each available choice leads to a failed state, it is a matter of indifference which one you adopt. As state finances crumble, states will become less important, and freebooters will seize the stage. Think of the Mumbai terrorists as a political cognate of the Somali pirates, and the character of a Middle East made up of failed states comes into focus.

Iran's President Mahmud Ahmadinejad controls Iran through a kleptocracy of Central African proportions, dissipating the country's oil windfall into payoffs to an "entire class of hangers-on of the Islamic revolution", as I wrote in June (see Worst of times for Iran, Asia Times Online, June 24, 2008), when oil still sold at US$135 a barrel. What will Ahmadinejad do now that the oil price has collapsed? According to my Iranian sources, the answer is: Exactly the same thing, but without the money.

Iran is a State that depends on oil socialism. And the problem with all socialisms is that they eventually run out of other people's money. Did I mention California? I do believe I did. First thing too. Surprisingly California has oil which they do not intend to drill for. It's the ecology don't you know.

The point of the joke is that Iran's regime cannot reduce subsidies or raise taxes without losing control of the constituencies that brought it to power. They are the peasants and the urban poor who barely afford shelter and food as matters stand. Despite the oil-price collapse, the government has not reduced energy subsidies that the International Monetary Fund (IMF) puts at more than a fifth of gross domestic product (GDP). A proposed value-added tax was withdrawn last October after strikes in the bazaars, starting in Isfahan and other provincial towns and spreading to the capital Tehran. Iran is eating through its $60 billion of foreign exchange reserves, unable to adjust to a collapse of its only significant revenue source.

Iran must break down, I argued last June, or break out, through a military adventure. The sand is slipping out of the hour glass, and the regime must decide what to do within a few months. If it does nothing, the default position, as it were, is Pakistan.

Pakistan has a couple of ways to reduce its dependent population. A civil war - which appears to be underway or foreign adventures which have as yet not seriously materialized.

Iran's Ahmadinejad rules through massive subsidies. Pakistan's President Asif Ali Zardari does the same thing, but without the money. Pakistan ran out of foreign exchange reserves in November and obtained emergency financing from the IMF. Its current account deficit was running at an alarming 14% of GDP, or about $20 billion a year, a small sum, but an important one for a country two-thirds of whose 175 million people subsist on less than $2 a day.

Pakistan received just $7.6 billion from the IMF, covering a third of its current account deficit, which means that imports must be reduced drastically (although lower oil prices may help a bit). Inflation is running at 25% a year.

Pakistan has one of the world's youngest populations and an enormous capital requirement. Young people borrow from old people, and countries with young populations should import capital from countries with aging populations. That is out of the question, for the world markets have turned Pakistan into a pariah. The cost of credit protection on Pakistani sovereign debt
is now more than 3,000 points (or 30%) above the benchmark London Interbank Offered Rate (LIBOR), reflecting a complete shutout from capital markets.

A 30+% rate implies that Pakistan can't last more than three years as a country. I believe that in this case the market is underestimating the risk. Where have we seen that before? The US housing market? Evidently a clue stick is insufficient to get the world wide money boys to wake up. Perhaps a clue bomb is required. It is coming.

Pakistan was at least able to raise a modicum of official support. What will Iran do if its reserves run out? The same thing as Pakistan, but without the money, for Iran is a geopolitical pariah without access to official aid.

The Muslim risk premium has become so pervasive that investors are looking cross-eyed at Saudi Arabia. The cost of credit protection on the Kingdom of Saudi Arabia has jumped since August, and now is considerably higher than Israel's.

But what about all that oil? Israel has none and the Kingdom of Saudi Arabia is awash in it. Evidently a barrel of oil doesn't carry you as far, money wise, as it used to.

Turkey has been able to keep afloat through the crisis, but barely so. The Turkish currency has fallen by a third, its stock market has fallen by nearly 80% in dollar terms, and the central bank must keep interest rates at a punishing 20% to prevent money from fleeing the country. Turkey has a real economy with a few first-rate manufacturing companies, unlike Iran and Pakistan, so the comparison is not quite fair. Nonetheless, Turkey relied heavily on short-term interbank borrowings to finance its balance of trade deficit, and the crisis has pulled the carpet out from under its economy. In August, before the crisis erupted in force, Turkey had 10% unemployment. It will get much worse.

Turkey was the poster-child for the so-called carry trade, in which hedge funds and other investors borrowed in low-interest currencies, for example the Japanese yen, and lent the money in high-interest currencies, of which Turkey's lira was the highest. The carry trade was the main source of money for Turkish business. What will Turkey do now that the credit crisis has made the "carry trade" a painful memory? The same thing, but without the money.

Pakistan is about to become a failed state, and Iran and Turkey will be close behind. As I commented to Chan Akya's report of December 2 on this site (see The
hottest place in the world), Pakistan's military-age population is far greater than those of other Muslim military powers in the region. With about 20 million men of military age, Pakistan today has as much manpower as Turkey and Iran combined, and by 2035 it will have half again as many.

Spengler goes on with more grim details and finishes with:

The lights are going out across the Middle East; states are failing, and it is not in the power of the West to make them whole again. All the strategic calculations that busied policy analysts and diplomats are changing, and the West has a very short time to learn the rules of a new and terrible game.

So the question is this: can Obama and Company raise their game? My personal opinion is that they are not up to the job. America is currently short of carrots and Obama, unlike Bush, is not big on sticks. My prediction: a crisis (financial) carried Obama into office, a crisis (military) will carry him out of office. Ah for the good old days of FDR. He was no better than the Obama crew relative to economics but, from his tenure as Secretary of the Navy, he knew how to fight.

Cross Posted at Classical Values