The new world order, established after the fall of communism in Russia and eastern Europe, is set to shatter. Global leadership by the US confronting the USSR was succeeded by US leadership flying solo. Now comes fragmentation. The US might be the most powerful nation but over the next few years its role will be contested by China, the EU, South Korea and even Japan. This implies a much higher risk premium for financial assets.
Any US victory in Iraq will be followed by a failure to win the peace. The Middle East will be destabilized. The US will waste lives and money. The Saudi regime will fall within five years. Energy prices will stay high but will act as a tax on global consumption rather than becoming a source of inflation.
A short-lived rally
So any equity rally on the outcome of the war will be short lived. There will be no lift-off because the US consumer will be paralyzed for at least five years because of gradual deflation of US debt and housing bubbles, and the erosion of wage power by Asian competition.
It’s not just Iraq investors need to grapple with. Optimists argue that North Korea’s Kim Jong Il is only after money to prop up his regime and is using the Iraq crisis to gain maximum leverage. Once he does, he will give up nuclear weapons and quieten down.
This is wishful thinking. The best way Kim can preserve his crumbling regime for his lifetime is to guard against external attack. He needs more money – to pay his clique of fellow criminals, not feed his people – and reckons he will get more for each nuke he owns. The US is signalling exactly that today, with the inconsistency of its approach to nuclear North Korea and non-nuclear Iraq.
So there is a real possibility before the year is out that the US will be forced to bomb Kim’s nuclear and military installations, acting unilaterally. That will be the start of another war. The yen will go into free fall. Even octogenarian Japanese will export savings when that happens. All reform (there isn’t much) in Japan will come to a screeching halt.
Already one of the results of US unilateralism and European political divisions has been to kill off Nato. The US has signalled its irrelevance by being prepared to bypass it.
The EU is now split on one level and united on another. Some European leaders support the US on Iraq. That increases their vulnerability if the venture misfires.
The US attempt to replace France and Germany at the core of the EU is futile. It may be correct to call them “old” economically. Indeed, the whole of Europe is old, rich and risk-averse compared with the US. But it is impossible to move the EU core at US behest. France and Germany are the axis about which the EU is constructed and will remain so.
For decades, the friendship between Germany and France depended on mutually compatible weaknesses: the French were militarily strong but economically weak; the Germans were an economic powerhouse yet politically divided by the Cold War and dependent on US protection. This limited the natural anti-Americanism of Gaullist France. France’s ambition then, as now, was to lead a French-dominated, independent EU, made up of nation states whose collective identity was defined by their anti-Americanism as much as by their own multifarious cultures.
The end of the Cold War meant united Germany no longer had any reason to defer to France, and the French had few instruments to keep the Germans in check. But the Germans stuck with an outmoded economic model. Economic eclipse drives political eclipse. So Germany has become Europe’s political pigmy. France is now continental Europe’s most powerful state.
So there has been no reform of the Common Agricultural Policy and there won’t be. Expect many more reverses of this kind. The general anti-American mood will complicate Europe’s dealings with the US on a whole host of other subjects, such as international trade. Again, US and EU unilateralism will reduce the efficiency of international trade liberalization and increase the risk of outright protectionism.
The terrible prospect is that the EU and the US will remain alienated and EU members will become hopelessly divided. The UK will drift further away from integration into the EU and overall European integration will slow dramatically. Japan, South Korea and China will become alienated from the US too. This will make further economic reform and trade liberalization difficult.
A wholesale return to protectionism is unlikely when there are so many intricate global supply chains. The protectionist response is more likely to be piecemeal and messy. Friction and inefficiency at the margin are what the new protectionism will be about. It’s not a recipe for booming financial markets.
