Policy Tensor

A Terrible, Very Bad, No Good Idea

In World Affairs on July 26, 2014 at 6:35 pm

The United States is pursuing a strategy in Ukraine that it will come to regret. The White House has leaked a proposal to give precise, real-time locations of surface-to-air missiles in eastern Ukraine to the government in Kiev. Such an information pipeline has an extremely high military value to the government fighting Russian-backed rebels in the east. The rebels’ anti-air capabilities have been critical to holding back the central government’s advance. They have brought down a significant number of Ukrainian warplanes, including at least five in the past 10 days. That the government in Kiev is seeking ways to counter these capabilities is, thus, not surprising. What is surprising is that the United States is considering providing high-value, actionable military intelligence to it. It would constitute a major escalation in the proxy war. It is plain to demonstrate that Moscow would have no choice but to respond by escalating its own support for the rebellion. If push came to shove, Moscow will send in a military force to secure its perimeter. The West has simply no way to counter that. A more counter-productive policy is hard to imagine.

The Ukrainian government’s counter-offensive has achieved a moderate degree of success over the past few weeks. Government forces have recaptured a number of towns in recent fighting, including the city of Lysychansk. These developments prompted Russia to escalate the flow of arms to the rebels. Putin is acting out of fear of losing in eastern Ukraine; not out of inborn imperial ambitions, despite claims in a certain well-respected Western newspaper to the contrary. The demonization of Herr Putin in Western media is a bad sign. Not because Putin is a great guy. Whatever his personal qualities, he is simply trying to shore up Russia’s security, just as any responsible Russian leader would. The reason why it is a bad sign is because, while such a moralizing tone may be useful to mobilize Western public opinion, it is inconsistent with a dispassionate evaluation of realities that bear on actual decision-making.

Any serious analysis of the situation has to begin with the observation that Ukraine is squarely in Russia’s backyard. A Western-allied government in Ukraine is inconsistent with Russia’s security interests. The eastward expansion of Nato by the Clinton administration was ill-considered. It did not seem especially stupid in 1991-1998, when Russia was weak and the US could impose its will in Russia’s backyard. But it ought to have been foreseen that Russia would inevitably regain at least some of its former strength. And when that happened, the United States’ marginal interests in the region would undermine the credibility of its extended deterrence.

The US has continued to meddle in Russia’s backyard. This has predictably backfired. The first to crumble was the American penetration of the Caspian Sea region. The realignment of the region’s major polities was effected without violence in the mid-2000s. Russia managed to arm-twist the post-Soviet republics to scuttle plans for a pipeline to the EU that would bypass Russian territory. Georgia wasn’t so lucky. Believing that Washington had its back, the small state foolishly confronted the Kremlin over break-away provinces of South Ossetia and Abkhazia. Russian military intervention in 2008 ensured that the provinces would never return to Georgian control, and reestablished Russia as the regional hegemon in the Caucasus. There wasn’t much Washington could do about it except issue diplomatic protests. Washington’s meddling in the Ukraine eventually convinced a faction of Ukrainian oligarchs that the time was ripe to reorient the country to the west. US diplomats and intelligence services played a key role in destabilizing the Ukrainian polity. Just as in the Caspian Sea region and the Caucasus, Russia responded to the heightened threat by responding aggressively.

A peaceful resolution of the Ukrainian crises is impossible without Western recognition of Russia’s security interests. While the United States can support and arm the western oriented central government in Kiev, it does not have sufficient interests at stake to militarily counter a Russian military intervention. The best it can do is create trouble for Russia. For now, Washington seems to have doubled down on its meddling. This is very bad news for the Ukrainian people. It is also a bad strategy for the United States. A much more conflictual relationship with Moscow precludes cooperation in Syria and Iraq, and over Iran’s nuclear ambitions. Much more threateningly, it pushes Moscow closer to Beijing. If Russia bandwagons with China—as it will if Washington doesn’t stop meddling in Russia’s backyard—it will make balancing China considerably harder. In that scenario, China will not have to worry about its western perimeter, freeing up power resources to confront US primacy in the maritime zone. China is not the Soviet Union. It has the potential to be stronger than the United States. And the US has never before faced an opponent that was potentially stronger than itself. Let’s not make this any harder than it has to be, shall we? Washington can start on a much more prudent policy by scuttling the proposal to supply actionable military intelligence to Russia’s troubled neighbour.

Fighting in the Shadows

In Realism on July 17, 2014 at 5:30 pm


You know you are old when they start making period dramas about a decade when you were alive. One of the policy tensor’s guilty pleasures is watching a late Cold War-era espionage drama called The Americans. To someone with my interests, all that great power intrigue is irresistible; more so than usual because it is quite credible. It got me thinking about the following question: how does a state deter hostile covert actions by a great power adversary? And more generally, how does the balance of power operate in the shadows?

As far as I can tell, this question has not been investigated by scholars. It is not entirely impossible that theoretical work on this question is classified. That may explain why there is no open source paper on the subject. Although I reckon that it is extremely unlikely to be the case since even more sensitive questions are routinely discussed in academic journals. For instance, the closely related question of congressional oversight of intelligence agencies is the subject of considerable debate. This lacunae is perplexing, to say the least. Perhaps scholars have simply overlooked this question so far. This short essay is just a first pass at the issues at stake.

How does deterrence work against covert operations by rival powers? The central problem is, of course, uncertainty and deniability. Let’s say one of your key scientists working on a promising military technology is assassinated in a car bombing. The most important question that needs to be answered is: who ordered the strike? Even in a bipolar system the answer may not be the obvious one. For instance, during the Cold War, if the target were American, it would be difficult for the US government to be certain that it was a KGB operation and not, say, the handiwork of Islamist terrorists or the Iranians. How, then, can the United States deter the Soviet Union from wreaking havoc in the shadows?

The most obvious response by states faced with covert threats is to enhance their espionage and counterintelligence capabilities. Careful analysis can provide some insight about the origin of covert strikes. For instance, terrorists with revolutionary aims are quite unlikely to not claim responsibility since their primary aim is to broadcast their message. Similarly, the choice of targets could point directly to separatists and others who may have an incentive to destabilize the target state. The sophistication of the operation may rule out all but the most capable intelligence agencies. Covert attacks sometimes carry telltale signatures. Non-state actors have very limited capabilities: they can successfully carry out only certain kinds of operations and not others. Forensic analysis can provide vital clues to solve the puzzle. Yet, such efforts may be largely unsuccessful in identifying the perpetrators. The most likely outcome of such investigation is that some potential sources of trouble may be ruled out, whilst leaving a fairly large number of adversaries in suspicion.

Targeted states can choose to retaliate-in-kind. If the origin of the strike or the source of the threat can be identified with some certainty, states can respond by deploying their own assets against the adversary. This requires the acquisition of offensive covert capabilities. European great powers, especially Great Britain, had been playing this game for a very long time of course. The scale of the Soviet operation itself grew up in response to western efforts after 1917 to destabilize the nascent revolutionary state. Until World War II, the United States’ intelligence apparatus was rudimentary. During the war, covert operations of the Western allies were run by the British. It was quite late in the war, when the extensive covert operations of the Soviet Union came to light, that the United States significantly stepped up its own efforts in the shadows. Initially, these were mostly intelligence gathering operations. Listening posts close to Soviet territory and other aspects of signal intelligence were the first to develop.

Offensive US covert capabilities were quickly developed thereafter to counter existing Soviet capabilities. The Soviets soon responded by stepping up their own efforts. The dynamic of the escalating ‘arms race’ in the shadows was in this respect very similar to the conventional and nuclear arms race between the two adversaries in the Cold War. But the similarities between the three spheres end there. Whereas mutual nuclear deterrence works with near certainty and conventional deterrence works well under certain conditions, the prospects for deterrence in the shadows are much bleaker. Not only is it hard to determine who ordered covert operations, even knowing who did it may not be of much help if retaliatory capabilities don’t exist. If retaliation-in-kind is not viable or seen to be insufficient to deter, a state fearing hostile covert action can threaten to escalate. In that case, successful deterrence depends on the military balance between the adversaries.

If the state enjoys conventional superiority against the adversary, it can punish the adversary by limited military action. After the bombing of a discotheque in Berlin by Libyan intelligence in 1986, the US carried out medium-scale airstrikes against Libya. Similarly, responding to the alleged Iraqi plot to assassinate former President George HW Bush in 1993, the Clinton administration launched punitive airstrikes against the headquarters of Iraqi intelligence. If the state does not enjoy conventional military superiority against the adversary, the threat to carry out punitive military action may not be credible. Iran threatened to respond aggressively to the assassination of Iranian nuclear scientists by Mossad. Given the balance of power between Israel and Iran, the threat wasn’t credible and failed to deter Israel, which continued to carry on with its assassination program.

Even if the state enjoys conventional superiority, nuclear deterrence may make threats to escalate non-credible. Following the terrorist attacks on the Indian Parliament by militants alleged to be on the payroll of Pakistani intelligence, India amassed 700,000 troops on the Pakistani border; to no avail. Given the balance of terror, India’s threat to escalate was not credible. Note that this is due entirely to the compactness of Pakistani territory. Since the Pakistani capital is merely two hundred miles from the Indian border, even a small border incursion is a strategic threat to Pakistan, and a nuclear response always remains a real possibility. Contrast that with India’s northeast: China can take over the region by a limited military incursion without triggering a nuclear response from India.

The options against peer competitors are much narrower. Threats to escalate are not be credible under conditions of military parity and nuclear stalemate. This means that great powers locked in cold wars with each other need to expend more and more resources on espionage and counterespionage capabilities. With war banished from the center of international politics by the rise of nuclear weapons, all the action moves to the shadows. As the cold war periodically heats up and cools down, the rise and fall in temperature will be felt most immediately in the covert sphere. Cold War intrigue was, in this sense, the natural counterpart to the stability of the bipolar world.

A Fool’s Game

In Markets on July 8, 2014 at 4:30 pm

The Dow Jones Industrial Average surpassed 17,000 for the first time in its history last week. The S&P 500 is at an all time high as well. Only the Nasdaq hasn’t surpassed its tech-bubble peak. And its not just the stock market—real estate, high-yield bonds, emerging markets, government debt, fine art—you name an asset and I promise you it’s booming. The latest craze is frontier debt. That is, bonds of dicey governments such as those in sub-Saharan Africa. Credit spreads—the differential in borrowing costs faced by investment-grade and lower-rated firms—are at an all-time low. Overall market volatility has almost never been lower. It looks like the good times are here. Except, they most decidedly are not.

The economic recovery is, in fact, tepid. The US economy is expected to grow a mere 2.1 per cent this year. In the first quarter, it actually shrank by 2.9 per cent. Yes, the unemployment rate has fallen to 6.1 per cent, exactly where it was on the eve of the financial crisis in December 2007. But, as of June 2014, 2.7 per cent of adults who wanted a job were not actively looking for work. Another 3 per cent of the population in working part-time because they can’t find full-time work. Counting the underemployed and the discouraged, the labor market shortfall is 15 per cent. Not that the pre-recession era was all that swell. In December 2007, this shortfall was 12 per cent. 

At $2.1 trillion, corporate profits are higher than ever; accounting for an eighth of US GDP, tying the previous record that was set by the 1942 war economy. The effective corporate tax rate back then was 55 per cent, compared to 20 per cent now. No wonder corporate profits after tax accounted for a tenth of GDP; a new record. Meanwhile, the share of wages and salaries in 2013 was 42.5 per cent; another record low. One could assume that with the going so good for the masters, at least the sky-high equity valuations would be justified. One would be wrong. The Shiller P/E ratio, at 26, is back to pre-recession levels. The forward price/earnings ratio is also back to the pre-crisis bubble years. Amazon, the darling of the stock market, is trading at more than five hundred times its earning per share. The risk premium demanded by investors to compensate them for holding riskier assets is back right down to levels last seen in 2004-2006. Amidst a weak economic recovery, we are witnessing nothing short of a financial boom.

This isn’t quite Tulip mania. Investors—at least the clear-eyed ones—know that assets are overpriced. Yet, they are in no hurry to sell. This is because the financial boom is a foster child of the United States Federal Reserve. And as every child knows, you’d be a fool to fight the Fed. The markets are simply dancing to the Fed’s tune. 

The Fed has followed an extraordinarily accommodative monetary policy for nearly six years. The policy rate has been zero since December 2008. Soon after hitting the zero lower bound (ZLB), the Fed embarked on non-standard measures proposed by Ben Bernanke in 2004. This policy has three components: (1) Forward Guidance: declaration by the Federal Open Market Committee (FOMC) to influence the expectations of market participants; (2) Expanding the Fed’s balance sheet beyond what is required to maintain rates at the ZLB: what’s called Quantitative Easing (QE); and (3) Outright Asset Purchases: intervention in markets of distressed debt and toxic assets to prop up prices in order to prevent banking crises. The Fed’s balance sheet has grown from a few hundred billion dollars to $4.3 trillion. It is now in the process of “tapering”—that is, slowing down the expansion of its balance sheet, which will continue to grow through this fall. Fed officials are mulling what to do with that giant pile in the long run. They reckon they’ll have to keep it. The highly-unusual intervention in various distressed assets, what purists would call “price administration,” has stabilized financial markets. Forward Guidance has been unexpectedly effective. Bernanke’s “taper tantrum” last year prompted a large-scale sell-off of emerging market funds and led to a sharp spike in market volatility generally. The Fed’s clarification calmed the markets and the market response to the actual taper has been quite tame.

BIS figures

Such extraordinary intervention has pushed down the entire yield curve on government bonds, precisely as the Fed intended. Investors’ search of yield has pushed up prices of assets across the board, thereby depressing yields on all assets. The decline of volatility and inflation expectations have increased the risk appetite of investors. The elevated risk appetite of investors has in turn buoyed up demand for lower-rated debt. US firms have increasingly tapped capital markets to exploit record low yields, at a time when many banks have been restricting credit. Gross issuance in the high-yield bond market alone soared to $90 billion per quarter in 2013 from a pre-crisis quarterly average of $30 billion. Since cheap credit has enabled troubled firms to refinance easily, corporate default rates have declined. The depressed default rates have in turn justified tighter credit spreads. Firms are using cheap credit to pay higher dividends, buy back shares and engage in mergers and acquisitions. This has allowed very many troubled firms to look quite dandy. Remarkably, despite the vanishing costs of finance, nonresidential fixed investment by nonfinancial firms is flat; perhaps in light of the economy’s actual prospects. 

It’s clear that the Fed’s bubble economics is causing a major misallocation of capital resources. The notion of price discovery has disappeared from asset and credit markets as prices increasing diverge from fundamentals. Perhaps more importantly, the risk of a major financial bust as the Fed tries to implement an exit from its extraordinarily accommodative monetary policy is getting more and more serious. Based on these considerations, the Bank of International Settlements (BIS) issued a stern warning against delaying policy normalization. Fed Chair Janet Yellen has dismissed such concerns. Krugman is still making fun of bond market vigilantes. The IMF considers the baseline scenario to be a smooth exit. Right, we’ll see about that.

Basically, everyone caught on the floor when the music stops playing is going to pay dearly. This is why smart money has moved into a conservative capital preservation strategy. For instance, the cash component of JP Morgan’s fixed income fund, the world’s largest, is now no less than three-fifths. 

The Fed has painted itself into a corner. There is no smooth exit now. The Fed simply cannot normalize policy without dislocating world markets. And the longer it takes to reverse policy, the worse the dislocation.


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