‘THE MAGINOT LINE ILLUSION, ‘ by Peter Boone & Simon Johnson at baselinescenario .com.

The Maginot Line Illusion

By Peter Boone and Simon Johnson

Many commentators suggest Spain is now the euro zone’s Maginot line.  The argument is clear:  Spain, with GDP over $1.3 trillion (8th largest in the world; 5th largest in Europe) and its large outstanding bank and public debt, is simply too big to fail without causing irreparable harm to the euro zone financial system.  If we dig in here, the reasoning goes, eurozone market upheavals can be stopped.

Just as Germany did in 1940, in past weeks global market forces circumvented this new Maginot line without serious resistance.  The events that shook equity markets were not just in Spain; they were everywhere in the world.  The cost of protecting against default on India’s largest private bank rose 79BP, or 44%, and the cost of protecting against major Korean banks’ default similarly rose 45%.  Oil prices collapsed and emerging markets found their access to credit markets dried up.  The interest rate for lending between banks in US dollars (LIBOR) shot up, and investors piled funds into their currently perceived “safe-havens” driving down the yields of German, French, and US bonds.

This pattern reflects the core problem facing world markets today.  Investors have already begun to extrapolate from eurozone problems to understand that the world remains a highly dangerous place.  The latent dangers include our overreliance on rapid Asian growth that might falter, the pressure for sharp fiscal tightening in nations with high deficits (other than in the world’s “safe havens”), and highly leveraged banks that continue to own toxic real estate, weak sovereign debt, and other assets.  If world financial markets once again decide their risk appetite is again low, there are many unsustainable leveraged institutions and governments that are in for a tough ride.

Spain’s role in this possible calamity is more that of a sideshow than a frontline.  Spain has a fighting chance for survival without serious economic disruption, but only if the world economy remains at the least benign.  To get out of its difficulties, the Spanish government needs to be far more determined than the light approach taken by the Irish and Portuguese (which face far worse problems than Spain).

To be clear, Spain has a better chance of avoiding sovereign and massive bank defaults compared to Greece, which is in intensive care – with a doubtful prognosis and a permanent resource infusion from the European Central Bank.  In this regard the announcements in the last few weeks from Spain were helpful, for example when the government chose resolution authority over religious authority in taking legal control of a troubled savings bank (CajaSur) from the Catholic Church.

Spain’s savings banks, often owned by local authorities, the church, and other civic groups are generally a bastion of moral hazard due to the implicit belief that no political leader would let the relevant creditors fail.  The CajaSur takeover did not impose losses on creditors, but it did establish that the managers of failed banks can at least lose their jobs.

The highly unpopular budget reforms announced by Prime Minister Zapatero further demonstrate some resolve – and the fact they just passed a legislative hurdle is encouraging.  According to optimistic forecasts, Spain’s budget deficit will fall to 5.3% of GDP next year (although the European Commission still has this projected at 9.8%).  If Spain can get anywhere near this level, despite 20% unemployment, then financial markets will probably go easy on them.  Spain’s high unemployment is partly the result of a more liberalized labor market that made it easier for employers not renew term contracts.  This has made Spain one of the worst nations in Europe in terms of employment loss, but it also means jobs could rebound quickly.

So the question is not whether Spain can remain solvent, but rather whether world markets will be patient enough – and risk tolerant enough – for a much wider range of nations to have enough time to make the needed adjustments.

The Achilles heel for Spain, and for others in Europe, are private credit markets – loose banking regulations and (in some countries) lax fiscal policy during the boom of the 2000s have placed serious countries at the mercy of bond markets.  We now know the European Central Bank will refinance sovereign debt for a long time, but there are 22 trillion euros of credits provided by the euro zone banking system largely to the private sector (with total eurozone GDP around 9 trillion euros, this makes euroland highly dependent on credit).  If the banking system decides it needs to tighten up on risk-taking, some of this credit will be cut off – thus further slowing growth in the region.

The first and greatest cuts under such a scenario would be for debtors in Portugal-Ireland-Italy-Greece-and-Spain (still lumped together by markets).  There are 2 trillion euros of external private credits to Spain, Greece, and Portugal alone – any modest attempt to contract this amount will set off a new round of lower asset prices as enterprises and households try to sell off what they can in order to repay loans, while banks march in to foreclose on property and cut their exposures.

In the United States such a credit contraction would be met with the Federal Reserve pouring out liquidity and helping bail out many creditors.  This would not solve the underlying problem – and stores up serious moral hazard issues for creditors in the future – but it at least gives time for the debtors to make payments.  The US will also remain a safe haven, as least for a while, and that gives a cushion for the government to run budget deficits and avoid fiscal cuts driven by nervous bond markets.

For Europe it is much harder to predict how events will evolve over the same time frame.  The recently announced 750bn euro package actually implies that the troubled nations (definitely Greece and Ireland, likely Portugal and perhaps Spain) must make large fiscal cuts.  Bond market vigilantes reign supreme if their actions force fiscal cuts – sadly, this is where the eurozone periphery finds itself.  At the moment Germany and France are the safe havens.  Bond yields in France fell sharply the last two weeks, while Spain’s yields rose, and would have increased much more were it not for ECB purchases.

But who is really safe in Europe?  With France running an 8% GDP budget deficit (for 2010) and a debt/GDP ratio of 83.6%, should we be confident they are safe while Spain is not (with debt/GDP at 65%)?  France’s thirty years of budget deficits do not bode well for anyone expecting an immediate strong fiscal response.  In many ways Spain appears better placed to take tough actions than France.

If investors decide that risk taking is no longer the right mode, many nations will be in trouble; there may be Maginot Lines but they are worth nothing.  If recent market sentiment signals a coming global downturn rather than continued world growth, investors will soon question whether even the safest havens are safe

‘FLOTILLAS & THE WARS OF PUBLIC OPINION, by George Friedman at Stratfor via John Mauldin at Investor Insight.

Flotillas and the Wars of Public Opinion

May 31, 2010

By George Friedman

On Sunday, Israeli naval forces intercepted the ships of a Turkish nongovernmental organization (NGO) delivering humanitarian supplies to Gaza. Israel had demanded that the vessels not go directly to Gaza but instead dock in Israeli ports, where the supplies would be offloaded and delivered to Gaza. The Turkish NGO refused, insisting on going directly to Gaza. Gunfire ensued when Israeli naval personnel boarded one of the vessels, and a significant number of the passengers and crew on the ship were killed or wounded.

Israeli Deputy Foreign Minister Danny Ayalon charged that the mission was simply an attempt to provoke the Israelis. That was certainly the case. The mission was designed to demonstrate that the Israelis were unreasonable and brutal. The hope was that Israel would be provoked to extreme action, further alienating Israel from the global community and possibly driving a wedge between Israel and the United States. The operation’s planners also hoped this would trigger a political crisis in Israel.

A logical Israeli response would have been avoiding falling into the provocation trap and suffering the political repercussions the Turkish NGO was trying to trigger. Instead, the Israelis decided to make a show of force. The Israelis appear to have reasoned that backing down would demonstrate weakness and encourage further flotillas to Gaza, unraveling the Israeli position vis-à-vis Hamas. In this thinking, a violent interception was a superior strategy to accommodation regardless of political consequences. Thus, the Israelis accepted the bait and were provoked.

The ‘Exodus’ Scenario

In the 1950s, an author named Leon Uris published a book called “Exodus.” Later made into a major motion picture, Exodus told the story of a Zionist provocation against the British. In the wake of World War II, the British – who controlled Palestine, as it was then known – maintained limits on Jewish immigration there. Would-be immigrants captured trying to run the blockade were detained in camps in Cyprus. In the book and movie, Zionists planned a propaganda exercise involving a breakout of Jews – mostly children – from the camp, who would then board a ship renamed the Exodus. When the Royal Navy intercepted the ship, the passengers would mount a hunger strike. The goal was to portray the British as brutes finishing the work of the Nazis. The image of children potentially dying of hunger would force the British to permit the ship to go to Palestine, to reconsider British policy on immigration, and ultimately to decide to abandon Palestine and turn the matter over to the United Nations.

There was in fact a ship called Exodus, but the affair did not play out precisely as portrayed by Uris, who used an amalgam of incidents to display the propaganda war waged by the Jews. Those carrying out this war had two goals. The first was to create sympathy in Britain and throughout the world for Jews who, just a couple of years after German concentration camps, were now being held in British camps. Second, they sought to portray their struggle as being against the British. The British were portrayed as continuing Nazi policies toward the Jews in order to maintain their empire. The Jews were portrayed as anti-imperialists, fighting the British much as the Americans had.

It was a brilliant strategy. By focusing on Jewish victimhood and on the British, the Zionists defined the battle as being against the British, with the Arabs playing the role of people trying to create the second phase of the Holocaust. The British were portrayed as pro-Arab for economic and imperial reasons, indifferent at best to the survivors of the Holocaust. Rather than restraining the Arabs, the British were arming them. The goal was not to vilify the Arabs but to villify the British, and to position the Jews with other nationalist groups whether in India or Egypt rising against the British.

The precise truth or falsehood of this portrayal didn’t particularly matter. For most of the world, the Palestine issue was poorly understood and not a matter of immediate concern. The Zionists intended to shape the perceptions of a global public with limited interest in or understanding of the issues, filling in the blanks with their own narrative. And they succeeded.

The success was rooted in a political reality. Where knowledge is limited, and the desire to learn the complex reality doesn’t exist, public opinion can be shaped by whoever generates the most powerful symbols. And on a matter of only tangential interest, governments tend to follow their publics’ wishes, however they originate. There is little to be gained for governments in resisting public opinion and much to be gained by giving in. By shaping the battlefield of public perception, it is thus possible to get governments to change positions.

In this way, the Zionists’ ability to shape global public perceptions of what was happening in Palestine – to demonize the British and turn the question of Palestine into a Jewish-British issue – shaped the political decisions of a range of governments. It was not the truth or falsehood of the narrative that mattered. What mattered was the ability to identify the victim and victimizer such that global opinion caused both London and governments not directly involved in the issue to adopt political stances advantageous to the Zionists. It is in this context that we need to view the Turkish flotilla.

The Turkish Flotilla to Gaza

The Palestinians have long argued that they are the victims of Israel, an invention of British and American imperialism. Since 1967, they have focused not so much on the existence of the state of Israel (at least in messages geared toward the West) as on the oppression of Palestinians in the occupied territories. Since the split between Hamas and Fatah and the Gaza War, the focus has been on the plight of the citizens of Gaza, who have been portrayed as the dispossessed victims of Israeli violence.

The bid to shape global perceptions by portraying the Palestinians as victims of Israel was the first prong of a longtime two-part campaign. The second part of this campaign involved armed resistance against the Israelis. The way this resistance was carried out, from airplane hijackings to stone-throwing children to suicide bombers, interfered with the first part of the campaign, however. The Israelis could point to suicide bombings or the use of children against soldiers as symbols of Palestinian inhumanity. This in turn was used to justify conditions in Gaza. While the Palestinians had made significant inroads in placing Israel on the defensive in global public opinion, they thus consistently gave the Israelis the opportunity to turn the tables. And this is where the flotilla comes in.

The Turkish flotilla aimed to replicate the Exodus story or, more precisely, to define the global image of Israel in the same way the Zionists defined the image that they wanted to project. As with the Zionist portrayal of the situation in 1947, the Gaza situation is far more complicated than as portrayed by the Palestinians. The moral question is also far more ambiguous. But as in 1947, when the Zionist portrayal was not intended to be a scholarly analysis of the situation but a political weapon designed to define perceptions, the Turkish flotilla was not designed to carry out a moral inquest.

Instead, the flotilla was designed to achieve two ends. The first is to divide Israel and Western governments by shifting public opinion against Israel. The second is to create a political crisis inside Israel between those who feel that Israel’s increasing isolation over the Gaza issue is dangerous versus those who think any weakening of resolve is dangerous.

The Geopolitical Fallout for Israel

It is vital that the Israelis succeed in portraying the flotilla as an extremist plot. Whether extremist or not, the plot has generated an image of Israel quite damaging to Israeli political interests. Israel is increasingly isolated internationally, with heavy pressure on its relationship with Europe and the United States.

In all of these countries, politicians are extremely sensitive to public opinion. It is difficult to imagine circumstances under which public opinion will see Israel as the victim. The general response in the Western public is likely to be that the Israelis probably should have allowed the ships to go to Gaza and offload rather than to precipitate bloodshed. Israel’s enemies will fan these flames by arguing that the Israelis prefer bloodshed to reasonable accommodation. And as Western public opinion shifts against Israel, Western political leaders will track with this shift.

The incident also wrecks Israeli relations with Turkey, historically an Israeli ally in the Muslim world with longstanding military cooperation with Israel. The Turkish government undoubtedly has wanted to move away from this relationship, but it faced resistance within the Turkish military and among secularists. The new Israeli action makes a break with Israel easy, and indeed almost necessary for Ankara.

With roughly the population of Houston, Texas, Israel is just not large enough to withstand extended isolation, meaning this event has profound geopolitical implications.

Public opinion matters where issues are not of fundamental interest to a nation. Israel is not a fundamental interest to other nations. The ability to generate public antipathy to Israel can therefore reshape Israeli relations with countries critical to Israel. For example, a redefinition of U.S.-Israeli relations will have much less effect on the United States than on Israel. The Obama administration, already irritated by the Israelis, might now see a shift in U.S. public opinion that will open the way to a new U.S.-Israeli relationship disadvantageous to Israel.

The Israelis will argue that this is all unfair, as they were provoked. Like the British, they seem to think that the issue is whose logic is correct. But the issue actually is, whose logic will be heard? As with a tank battle or an airstrike, this sort of warfare has nothing to do with fairness. It has to do with controlling public perception and using that public perception to shape foreign policy around the world. In this case, the issue will be whether the deaths were necessary. The Israeli argument of provocation will have limited traction.

Internationally, there is little doubt that the incident will generate a firestorm. Certainly, Turkey will break cooperation with Israel. Opinion in Europe will likely harden. And public opinion in the United States – by far the most important in the equation – might shift to a “plague-on-both-your-houses” position.

While the international reaction is predictable, the interesting question is whether this evolution will cause a political crisis in Israel. Those in Israel who feel that international isolation is preferable to accommodation with the Palestinians are in control now. Many in the opposition see Israel’s isolation as a strategic threat. Economically and militarily, they argue, Israel cannot survive in isolation. The current regime will respond that there will be no isolation. The flotilla aimed to generate what the government has said would not happen.

The tougher Israel is, the more the flotilla’s narrative takes hold. As the Zionists knew in 1947 and the Palestinians are learning, controlling public opinion requires subtlety, a selective narrative and cynicism. As they also knew, losing the battle can be catastrophic. It cost Britain the Mandate and allowed Israel to survive. Israel’s enemies are now turning the tables. This maneuver was far more effective than suicide bombings or the Intifada in challenging Israel’s public perception and therefore its geopolitical position (though if the Palestinians return to some of their more distasteful tactics like suicide bombing, the Turkish strategy of portraying Israel as the instigator of violence will be undermined).

Israel is now in uncharted waters. It does not know how to respond. It is not clear that the Palestinians know how to take full advantage of the situation, either. But even so, this places the battle on a new field, far more fluid and uncontrollable than what went before. The next steps will involve calls for sanctions against Israel. The Israeli threats against Iran will be seen in a different context, and Israeli portrayal of Iran will hold less sway over the world.

And this will cause a political crisis in Israel. If this government survives, then Israel is locked into a course that gives it freedom of action but international isolation. If the government falls, then Israel enters a period of domestic uncertainty. In either case, the flotilla achieved its strategic mission. It got Israel to take violent action against it. In doing so, Israel ran into its own fist.