The dragon comes calling

Sep 2nd 2005
From The Economist print edition

No bilateral relationship is more important than America's and China's. Yet as George Bush and Hu Jintao prepare to meet, it is in a fractious state

IN 1979 China's late leader, Deng Xiaoping, impressed many Americans by donning a Stetson at a rodeo in Texas. The impromptu gesture was taken as a sign that China was at last ditching Maoism and fervent anti-Americanism, including distaste for its “bourgeois” line in hats. America was to be its new friend in the cold war with the Soviet Union. In Washington next week, on his first visit since he took over as Communist Party chief in 2002, President Hu Jintao will try to convince Americans that China is still a friend and that its growing economic and military power is nothing to worry about. He will have a far tougher time of it.

Some of Mr Hu's handicaps are personal. Foreign affairs are still a bit of a maze to him, and he knew little of them before he assumed the leadership. Nor does he seem to have hit it off with President George Bush, though they have met several times elsewhere. He remains an enigmatic figure, with none of Deng's crowd-pleasing ways. Diplomats say he prefers to stick closely to his brief.

Relations, besides, are so tricky just now that the two sides cannot even agree on how to describe the visit. Rather than accept Mr Bush's invitation to hold informal talks at his ranch in Crawford, Texas, Mr Hu chose a more formal reception at the White House, presumably hoping it would boost his image as a statesman at home. But the Americans have refused to glorify the trip by calling it a “state visit”, the term Chinese officials use. Mr Hu will get a 21-gun salute, but not a state dinner in the evening. These niceties may sound inconsequential, but they send a clear signal that all is not well.

And the reasons are not hard to see. In recent months, China-bashers have emerged all across the American political spectrum. On the left, the unions think that China's harsh labour conditions are a form of unfair competition that destroys American jobs. On the right, defence hawks feel threatened by China's accelerating military build-up, not to mention its record of supplying arms to pariahs. Congress recently assumed that a Chinese bid for a middling American oil firm might mark the beginning of an attempt to “buy up America” and imperil its security. Mr Bush's Christian supporters look askance at an atheist dictatorship that persecutes Christians. And it would be hard to find an American who is not repelled by, for example, Chinese officials' habit of persecuting those who exceed birth quotas.

As China sees it, America's current Sinophobia is beginning to rival its preoccupation with terrorism. Bush administration hawks who had fallen silent on China—of whom the defence secretary, Donald Rumsfeld, looms largest in Chinese minds—are beginning to take up the cudgels again. China now frets that its professed willingness to help fight global terrorism and resolve the nuclear crisis in North Korea is of limited value in keeping Americans happy. America's trade deficit with China, which has almost doubled in the past four years (see chart below), has compounded the problem. China's fear is that tensions could grow, jeopardising its access to its biggest overseas market and fuelling military rivalry, too. Small wonder that Mr Hu will not be treated to White House consommé and crystalware.

The great free-trade war

On the trade front, the two countries' interests are mostly identical. Both would benefit from free trade. But China exports six times as much to America as it imports from it. After many years of American hammering for better access to China's market, it is now the Chinese who are on the free-trade offensive.

Talks in Beijing this week between American and Chinese officials produced no progress in their dispute over a massive surge in China's textile exports to America. On Thursday September 1st, America decided to restrict imports of Chinese-made bras and some synthetic fabrics. Chinese textile imports have risen by 97% in the six months since quotas were lifted, in January. An editorial this week in the official China Daily newspaper declared that America's textile industry, instead of seeking protectionist measures, should instead embrace “restructuring”—for which read the further migration of manufacturing to countries such as China.

Many Americans assume that the Chinese are not playing fair. In fact, China's economy is relatively open by developing-country standards. For a long time, the yuan was undervalued in what seemed, to American officials, a deliberate attempt by China to make its exports more competitive. After persistent complaints from both America and Europe, China adjusted its currency-exchange policy in July, allowing the yuan to strengthen by 2%. But the adjustment is still too small to make much of a dent in the deficit, and the Americans want more. Minxin Pei of the Carnegie Endowment for International Peace, a think-tank, predicts that “things will get ugly next year”. And although Mr Hu will ask Mr Bush to treat China as a market economy under American trade law, which would make it harder to slap anti-dumping measures on Chinese goods, his request is unlikely to be granted.

There are some brighter spots. In Seattle, where Mr Hu is due to meet business leaders, there will be praise for China's confirmation in August of a $5 billion order for 42 Boeing 787 Dreamliner jets. This was a big show of support for the new model, which is being made in Seattle and is seen by Boeing as crucial to the company's future development. But China's common tactic of winning friends abroad with aircraft orders will not impress America's disgruntled workers, at least outside the north-west.

Another hot economic issue is China's galloping demand for energy, which is one reason why oil prices are so high. (The other big one is American demand.) Because petrol is so lightly taxed in America, motorists there are hurt more by oil-price rises. They want someone to blame, and they may have heard that China is scouring the world to lock up oil supplies for its own “energy security”.

In June, CNOOC, a Chinese state-controlled corporation, tried to buy Unocal, a mid-sized American oil firm. Security hawks were horrified that such a strategic asset might fall into potentially hostile hands. So were 73% of the American public, according to one poll, and the House of Representatives, which voted 398 to 15 to urge a presidential “review” of the bid. CNOOC took the hint and withdrew.

Free-traders were outraged. James Dorn of the Cato Institute, a libertarian think-tank, scoffed at the idea that the bid for Unocal, whose American oil wells account for only 1% of American consumption, might affect national security. Others noted that China might reasonably conclude from the episode that it cannot rely on global trade rules to secure its energy supplies, and should look instead to mercantilist or even military means to do so. Mr Bush will try to convince Mr Hu that this is not true, but Congress has undermined his case.

General Zhu's bombshell

American defence planners also view China's rise with apprehension. Here is a nasty authoritarian regime with a rapidly modernising army far larger than its defensive needs require. As China gets richer, it can pay for more and smarter weapons, some of the scariest of which (more than 700 short-range ballistic missiles) it is placing near the Taiwan strait. A recent Pentagon review noted that “China does not now face a direct threat from another nation. Yet, it continues to invest heavily in its military, particularly in programmes designed to improve power projection.” The review added that current trends in military modernisation could pose “a credible threat to modern militaries operating in the region”. Such as America's.

A flurry of books and magazine articles boast titles such as “China: The Gathering Threat” and “How We Would Fight China”. Several weeks ago, a Chinese general, Zhu Chenghu, threatened that China would lob nuclear weapons at “hundreds” of American cities if the two countries came to blows over Taiwan. Chinese generals often make such incendiary remarks, and are rarely punished for it.

In fact, war between China and America is neither imminent nor likely. General Zhu's nuclear bombshell does not reflect official policy, as the Chinese foreign ministry stressed shortly after he dropped it. Tensions over Taiwan have cooled since last December's legislative elections there, and Mr Bush will reassure Mr Hu that America still has a “one China” policy. But America is also committed to helping Taiwan defend itself if it is attacked by the mainland, and China this week issued a warning that “relevant countries” should not think of protecting Taiwan with a missile-defence system. Mr Hu and other Chinese leaders believe that stronger Chinese armed forces, with a capability to attack American forces if necessary, are essential to deterring Taiwan from moving to formal independence.

Both sides, wary of the other's strength, are seeking to strengthen regional alliances: America by schmoozing India and persuading Japan to be more assertive, China by cosying up to Russia and the Central Asian states.

In August, Russia and China staged their first joint military manoeuvres. They strenuously denied that these were aimed at any third country, and tactfully called the 10,000-man exercise in eastern China an anti-terrorist operation. But it is hard to believe that a message to America was not implied. Both countries are members of the Shanghai Co-operation Organisation, a grouping of Central Asian nations that both China and Russia have been nurturing (with limited success) as a counterbalance to America's influence in the region.

The Americans are unlikely to be unduly worried. They know that Russia has its own anxieties about China's rising power, and that China and Russia both regard their ties with America as considerably more important than China-Russia relations. More disturbing to the Americans are Russia's efforts to profit from China's demand for sophisticated arms. Russia is China's biggest foreign arms supplier. At the recent exercises it deployed strategic bombers, which military experts say China would like to buy as part of its preparations for possible conflict with America over Taiwan.

America and China are in harmony on one subject: both agree that North Korea is a menace. The two governments are working together to try to persuade Kim Jong Il, the North Korean despot, to give up the nuclear weapons that he claims—and most observers believe—he has. An American official close to the stop-go six-party talks (including America, China, both Koreas, Russia and Japan) on this issue says that China has been “very helpful”.

But China and America have different priorities. For America, disarming North Korea is the top goal. For China, that comes second to making sure that North Korea does not collapse and unleash even more refugees into China than it has already done. This is perhaps why the government in Beijing has not used all the levers at its disposal. Although it could shut off North Korea's oil supplies, it has only done so once, for three days in 2003.

Almost every aspect of Sino-American relations is complicated by the fact that only one of the two powers is a democracy. To take a small example, America is holding a handful of Uighurs it captured in Afghanistan. It wants to release them, but cannot hand them over to China. The Uighurs, Muslim separatists in the far western province of Xinjiang, are often involved in violence against the Chinese state. Chinese officials are already furious about the establishment last year in America of a Uighur government-in-exile. For all these reasons, as well as China's rickety justice system, there is no hope that the Uighur prisoners would get a fair trial there.

Mr Hu is not about to give ground on any human-rights issues. He has shown no eagerness to promote political reforms at a time of growing social turbulence caused by rapid economic change. Chinese officials have accused the Americans of instigating the revolutions in Georgia, Ukraine and, most worryingly for China, neighbouring Kirgizstan during the past two years. Mr Hu will dismiss out of hand any suggestion by his American hosts that China should embrace democracy too.

Since last year, China has refused to talk to America about human rights, in protest against America's decision to sponsor an abortive attempt to have China censured at the UN Human Rights Commission in Geneva. In December China's top policeman, Zhou Yongkang, gave warning of growing social unrest and urged police officers to put a stop to any organised dissent. He accused foreign religious groups, including American Christians, of stepping up their activities in China, including a “new trend” of “infiltrating” universities and government departments.

China doubtless feels secure in its belief that the Bush administration, like others before it, will not allow human rights to make or break the relationship. To defuse tensions over this and the host of other contentious issues, Mr Hu is likely to use his public appearances—including a speech at Mr Bush's alma mater, Yale—to put a positive spin on the relationship. The message, according to a Chinese diplomat, will be that “China is a force for peace and that China's development is peaceful in nature”. Such protestations will be greeted with scepticism.

Grounds for hope

The biggest danger to the relationship is not so much the lack of warmth between Mr Bush and Mr Hu. Both governments, despite misgivings about each other's policies, appear to recognise that they have enormous stakes in each other's continuing prosperity. Reluctant though it is to say so publicly, China even sees certain benefits in a Pax Americana, particularly in north-east Asia, where it worries about a resurgence of Japanese military power if the Americans retreat.

But China's economic rise has been accompanied by the growth of an increasingly vocal, occasionally virulent, nationalism. Mr Hu sometimes feels obliged to make concessions to this, as when the leadership tolerated, for a time, the widespread anti-Japanese protests earlier this year. The control of China by an authoritarian and secretive Communist Party (attributes which Mr Hu unwisely fosters) fuels this xenophobia in China, as well as American wariness.

Chinese officials, confused by the change of American mood from the rodeo-and-Stetson days, like to see the problem as one of presentation. During a visit to America in 2003, China's prime minister, Wen Jiabao, used the term “peaceful rise” to describe China's growth. But Chinese leaders later backed away from the phrase. Hardliners felt it limited China's options for handling Taiwan, and liberals felt that even the word “rise” was too provocative. Jia Qingguo of Peking University says both governments need to encourage positive thinking among their publics. But he cautions that “China can only do so much. Americans have to reassure themselves.”

How might they do so? In the long term, there are three reasons why the “China threat” may be overstated. One is that, unlike the American government, Osama bin Laden or the old Soviet Union, China's ruling party is not trying to spread an ideology. It has none to spread.

In a narrow sense, of course, it offers a rival to the American-sponsored liberal-democratic model; China has shown that a country can prosper, at least in the short term, by allowing economic freedom but not the political sort. And its needs for energy and raw materials can prompt it, Soviet-style, to back pariah states such as Sudan and Iran. But for all the talk of revolutionary solidarity, China's leaders recently decided not to extend a regime-saving loan package to Zimbabwe's tyrant, Robert Mugabe, for the pragmatic reason that he has a terrible credit history.

The second reason for calm is that, as Adam Segal of the Council on Foreign Relations puts it, China's economic reforms may spur democratic ones. There is plenty of domestic pressure for change, though only at low levels: the Chinese government counted 74,000 protests last year, mostly against local misrule. A more democratic China might not be nicer: it could be unpleasantly nationalist. “Ultimately China will find its own way politically,” says a senior American official. “How it does so will depend in part on how we shape them. The consensus is we need to be engaged. We want them to grow in a rules-based way.”

The third reason not to panic is that China's economic explosion cannot continue for ever, not least because the one-child policy has probably doomed China to grow old before it gets rich. A hard landing for the Chinese economy would harm the rest of the world in many ways, but it would ease fears that the next superpower will be a dictatorship.

America has agonised before over the emergence of an Asian rival whose unfair trade practices, gluttony for raw materials and ruthless nationalism were thrusting the two countries towards a collision. That was the argument of “The Coming War with Japan”, a book that was taken seriously when it was published in 1991. The unstoppable Japanese economic juggernaut, you may recall, stalled around the time “The Coming War” came out. In a decade or two, will the widespread current fear of China seem as laughable as the Japanophobia of yore?

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Oil and troubled waters

Sep 6th 2005
From The Economist Global Agenda

The economic effects of Hurricane Katrina, like the human costs, are hard to predict. But the disaster is already putting upward pressure on oil prices at a time of strong demand, tight supply and refining bottlenecks

OVER the past week, a shaken nation has watched a Hobbesian nightmare unfold on its television sets. Americans have begun asking their officials pointed questions about who let this happen, but they are also questioning themselves, discarding their faith that the terrorist attacks of September 11th 2001 had finally taught Americans how to pull together in a crisis. Long after the looting has stopped and the refugees have been resettled, the reverberations of the Hurricane Katrina disaster will be felt in the American psyche.

But these are not the only effects that will reach beyond the flooded streets in time and space. Economists are already hard at work, rewriting their forecasts to account for the toll that Katrina may yet take on the nation’s economy. The affected area’s ports move a large fraction of America’s imports—including critical oil and gas supplies—as well as roughly half its grain exports. Action Economics, a market-analysis firm, has already nudged its forecast for GDP growth down to 4.4% from 4.6%, at an annualised rate, for the current (third) quarter.

While big hurricanes like Katrina destroy wealth, they sometimes lead to a temporary surge in GDP as the downturn immediately after the storm is made up for by the burst of economic activity that takes place when the rebuilding begins. In the case of Katrina, however, any output boost will be balanced by the effect on the area's energy infrastructure. In a research report from Merrill Lynch, David Rosenberg says that while rebuilding could add $40 billion to America's GDP, disruptions to energy supplies could raise prices enough to claw back $30 billion of that gain.

The Gulf of Mexico provides about a tenth of all the crude oil consumed in America; and almost half of the petrol produced in the country comes from refineries in the states along the Gulf's shores. Though some pipelines have begun operating again at reduced capacity, some three-quarters of the region's natural gas production, and over 90% of oil output, are still shut down, and the Department of Energy reported last Thursday that ten refineries, processing 1.9m barrels per day, were out of action. Twelve more refineries have been forced to cut production owing to supply shortages.

This is bad news considering that refineries had been running flat out in recent months to keep up with high demand. The government is doing what it can to ease the bottlenecks: oil has begun to flow from the national Strategic Petroleum Reserve to refiners caught short; the administration has lifted restrictions on foreign ships making deliveries between American ports; and the Environmental Protection Agency has temporarily relaxed some fuel regulations until September 15th, which will prevent differences in petroleum standards among American states from causing local shortages. Other countries have also responded: Europe has offered petrol from its reserves (America stockpiles only crude oil). Nonetheless, average petrol prices nationwide hit $3 for the first time on Monday September 5th, the Labour Day holiday. In southern states such as Georgia, some retailers have been charging more than $5 a gallon.

The real concern, however, is not how high prices will go, but how long they will remain there. After the American Petroleum Institute said last week that the effect of Katrina on oil and gas production would be “significant and protracted”, oil rose towards the record $70.85 it had hit earlier in the week; by Tuesday, it had fallen back again to just under $67. Though in real (inflation-adjusted) terms prices are still lower than in the wake of the Iranian hostage crisis in 1979, that reassuring mantra has worn thinner in recent months as real prices have edged closer to those historical highs. Furthermore, while much of the recent oil-price increase was demand-driven, and thus expected to have relatively benign economic effects, any sizeable outages owing to Katrina could cause a supply shock similar to those that repeatedly battered the world economy in the 1970s.

Those fears may be overdone. But $70 oil and petrol futures at double the level of a year ago raise the possibility of lingering economic effects, particularly if the region’s oil infrastructure takes months to get back online. Though America’s economy has recently posted enviable growth rates, these have been kept up by consumers who have run down savings and taken on debt in order to keep spending growing faster than their income. With consumers stretched thin and interest rates rising, a prolonged period of high petrol prices might well force households to retrench, at least temporarily. Mr Rosenberg calculates that every one-cent rise in the price of a gallon of petrol takes $1.3 billion out of consumers’ pockets, which could trim as much as a full percentage point off consumer spending this winter. Speculation is growing that the Federal Reserve will temporarily halt its steady tightening of the money supply at its next meeting, on September 20th.

Already there are calls for policy changes to fix the flaws in America’s energy infrastructure exposed by Katrina: its tight refining capacity, its dependence on offshore drilling in the hurricane-prone Gulf, its love affair with big, inefficient cars. The Senate committee on energy has scheduled a hearing for Tuesday to explore some of these issues.

But oil and gas are not the only industries to be affected. While construction companies and their suppliers are no doubt gearing up for a bumper season when the waters recede, agricultural exporters are busy looking for alternative shipping routes if Gulf ports do not re-open soon. Particularly hard-hit will be the corn harvest, which started last week, but all farmers will suffer from higher energy prices. Insurers, of course, will take a nasty hit to earnings from claims that may run as high as $25 billion. And the combination of cancelled flights and higher jet-fuel prices threatens to push more airlines into bankruptcy.

Innocents abroad

The ripples will spread even beyond America’s shores. Many other nations, particularly in Asia, are heavily dependent on robust American demand for their exports; and some are already feeling the pain of high oil prices. Indonesia's central bank was forced to raise interest rates sharply last week to stem a near-10% drop in the rupiah. Partly thanks to lavish fuel subsidies, Indonesia’s oil imports, financed in dollars, have touched off fears of a balance-of-payments crisis, driving the currency sharply downwards. While rich countries are much less dependent on oil than they used to be, thanks to increases in fuel efficiency and a shift from manufacturing to services, middle-income countries are still big energy guzzlers: India and South Korea use more oil per dollar of GDP today than they did in the 1970s.

Even in less-thirsty Europe, there are fears that economic recovery could be choked off in its infancy by the steady upward march of prices for petrol and heating oil. That would weaken another of Asian exporters’ main markets and leave the world economy looking vulnerable. If the damage Katrina has done to the Gulf's oil-pumping capacity forces Americans to shop abroad for more fuel to feed their appetites, it could be a long cold winter for everyone.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Deeply difficult times for the Big Easy

Sep 2nd 2005
From The Economist Global Agenda

The people of New Orleans are finally getting the help they need after several days of chaos in the wake of Hurricane Katrina. Angry questions are being asked about the stuttering relief effort, and about past decisions that made the disaster more painful than it had to be

NEW ORLEANS’S nickname, the Big Easy, was well earned. Residents and visitors have long loved the place for its don’t-think-about-tomorrow attitude. Though everyone knew that the low-lying city was vulnerable to tempests and flooding, many who had lived there for years had experienced hurricane scares and smaller floods, and had come to view the risk of disaster with a sort of cheery aplomb. In the physical devastation and appalling lawlessness that has followed Hurricane Katrina, many are now wondering whether someone, at the local, state or national level, should have thought about tomorrow a little harder.

Since the breaching of the city’s levees—which protect it from the Mississippi River to the south and Lake Ponchartrain to the north—on the morning of Tuesday August 30th, things have gone from bad to worse to nightmarish. Water levels have stopped rising, but most of the city remains under water. Perhaps 100,000 people either could not or would not leave the city on Sunday, when the mayor announced that they must. Tens of thousands ended up at the city’s official shelter at the Superdome stadium for days, turning it into a sink of hot and smelly misery. When thousands of these unfortunates were evacuated on buses to Houston, others quickly took their place. Not far away, other homeless people made their way to the city’s convention centre, which quickly became a second giant shelter. Conditions there were said to be worse than at the Superdome—until Friday, when hefty supplies of food, water and medicines finally arrived.

Meanwhile, looters have been roaming the streets, stealing food and water in desperation but also computers and sporting equipment in opportunism. Looters cleaned out the guns at a giant Wal-Mart, and one of them gloated that policemen had helped themselves to the shelves’ contents as well. Rapes and car-jackings have been reported, and there have been angry confrontations between roving thugs and the few shop- and homeowners who have stayed, both sides often brandishing guns. To add to the city’s woes, gas leaks have bubbled through the surface of the water, sometimes catching fire, and a number of fires and explosions have sent huge plumes of smoke across town.

While Katrina was a powerful storm—which also devastated the coasts of Mississippi and Alabama—the extent of the chaos and suffering in New Orleans in her wake has nonetheless been surprising. America has dealt with ferocious hurricanes before. And New Orleans’s vulnerabilities were well known. Thus many are starting to point fingers in relation to both the short-term response and long-term policy failures.

Ray Nagin, the city’s mayor, has shown increasing frustration throughout the week, especially with the federal government’s response and its press conferences: “They're feeding the people a line of bull, and they are spinning and people are dying…Get off your asses and let’s do something.” The police superintendent has also complained, bemoaning the lack of national guardsmen who might have established order earlier. (Under American law, regular soldiers may not take part in law enforcement.) On Friday a large contingent of guardsmen finally arrived, and Kathleen Blanco, the governor of Louisiana, gave warning that “they know how to shoot to kill.”

Many of the immediate difficulties are understandable. As Michael Chertoff, the secretary of homeland security, pointed out, the disaster has in fact been a double one. The hurricane’s winds flattened homes on the Gulf coast, and shortly thereafter the rains burst the levees, the latter creating a “dynamic” situation while authorities responded to the former. Plugging a hundred-metre hole in a levee while waters rush through is a huge challenge for engineers. Impassable roads have made delivery of supplies difficult. Still, an under-pressure President George Bush criticised the relief effort on Friday morning, calling it “not acceptable”, before flying to the region to see the damage.

Some are pointing the finger at Mr Bush himself, on the grounds that some of his administration's longer-term policy decisions have made the response to the disaster more difficult. The war in Iraq, it has been noted, has depleted the number of available national guardsmen by a third or more in Louisiana, Mississippi and Alabama; many of those serving in Iraq are trained emergency personnel. Others allege that the war has squeezed the budget, causing a postponement last year of projects to improve the levees. But it is far from clear that these could have been completed in time to stop the flooding after Katrina.

Other criticisms might have more political bite. America is already feeling the pain of high oil prices, though these have yet to dent economic growth significantly. Katrina sent prices higher still, at least for a time. Mr Bush’s decision to lend nearly 1m barrels of oil a day from America’s strategic reserve to its oil companies has eased temporary supply fears. But neither the war in Iraq nor Mr Bush’s energy policy has done much to make the country less vulnerable to oil shocks.

Some critics put the blame for the disaster on the president’s policy on climate change. Here they are on shakier ground. Temperature increases may have some effect on the intensity of hurricanes, but there is no obvious reason to believe that if Mr Bush had signed the Kyoto Protocol on becoming president in 2001 Katrina would not have breached New Orleans’s levees. Nonetheless, any natural disaster with a possible connection to environmental policy, however tenuous, could hurt Mr Bush politically—especially as opinion polls show that voters see the environment as being one of his weakest points.

Even if some failures can be attributed to the Bush administration, the most important reasons for Katrina’s deadliness may lie in decisions that predate the current president, from Jean Baptiste le Moyne de Bienville’s decision to found the city in its precarious location, in 1718, to the more recent “improvements” in the area’s maritime navigability that have damaged south-eastern Louisiana’s wetlands. For much of the 20th century the federal government tampered with the Mississippi, to help shipping and—ironically—prevent floods. In the process it destroyed large swathes of coastal marshland around New Orleans—something which suited property developers, but removed much of the city’s natural protection against flooding. Support may now grow for a multi-billion-dollar plan to restore the wetlands, though a similar project in Florida has proved difficult.

It is an uncomfortable fact that millions of Americans have made the decision to live in areas prone to this kind of disaster. Though Congress has authorised an immediate $10.5 billion relief package, Denny Hastert, the speaker of the House of Representatives, has expressed doubt that large dollops of money should be spent on reconstruction in a location as exposed as New Orleans (though he later backpeddled). But there remain important questions to be asked at both the local and national level about the failures that led to Katrina’s destruction and chaos. It has provided yet another reminder that decisions made without due regard for the consequences can prove painful indeed later on.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Measure for measure

Buttonwood

Aug 30th 2005
From The Economist Global Agenda

Investors are mad for risk-appetite indices. What do they actually tell us?

IT CAN now be revealed that Buttonwood has not always been a fan of cricket. Brought up in the robust and marginally faster-moving world of baseball, she has long found the appeal of five-day contests involving leg-spinners and silly mid-offs inexplicable. Until this brilliant holiday weekend, that is, when The Economist trounced the Spectator and, in a slightly more publicised match, England edged past Australia.

In much the same way, America’s stockmarket edged past news on Monday August 29th that Hurricane Katrina was set to become the world’s costliest storm ever for insurers, helping to push oil above $70 a barrel: share prices moved up within half an hour of the market’s opening, though they fell again the next day. It was certainly not the first time that investors had bought stocks when the news was bad, like a pitcher shaking off his catcher’s signals. Were investors cleverly re-assessing economic fundamentals (basically solid growth and still-good prospects for corporate earnings) and upping their rational valuation of shares? Or were they just irrepressible exuberants on a tear?

This question, it turns out, is at the centre of one of the big divides in financial theory. Those who believe in efficient markets think that prices reflect all known information about future returns. If an investor happens to feel irrationally feisty when he rolls out of bed in the morning, no matter: smart money will move in and arbitrage away the difference between the price he paid for the share and the price that correctly reflects the discounted value of expected cash flows.

Advocates of behavioural finance, on the other hand, reckon markets are imperfect. Sophisticated investors are often unable or unwilling to offset sentiment traders entirely, especially when there are constraints to arbitrage (it is not always possible to short a stock, for example). For many, “investor sentiment” does matter.

Which is just as well, as there are an awful lot of people measuring it. Take last week. On August 22nd, the UBS/Gallup Index of Investor Optimism said the slow but steady rebound of investor confidence since April had continued in August. On August 23rd, State Street Global Markets’ Investor Confidence Index also showed improvement since the recent low point in May. CSFB’s Risk-Appetite Index, which only in March was reflecting “euphoria” before the big plunge in April and May, shows another sharp fall in risk appetite over the past two weeks or so.

The divergences among these measures are perhaps less surprising than their congruencies, for they are constructed along different lines with different variables. UBS polls qualifying American investors about their expectations for financial markets. CSFB looks not at what people say but at what prices suggest they are actually doing, evaluating returns on 65 asset classes around the world to see whether riskier ones are outperforming safer ones. State Street concentrates on quantity rather than price. Drawing information from the $9.5 trillion in global assets that it holds in custody, the bank analyses periodic changes in this pool to determine whether institutional investors are assuming more or less risk.

How well do the different indices capture investor sentiment? The authors of an article in the Bank of Canada’s June Financial System Review put ten of them under the microscope. They chose five recent episodes in which markets reacted extremely and indices might have been expected to reflect unambiguous investor sentiment: the Russian debt default in 1998, the peak of the dotcom-fuelled bull market, the beginning of the 2000-2002 bear market, the terrorist attacks of September 11th 2001 and the beginning of the 2003 bull market. The chart below shows the results, with CSFB’s index best capturing the moment.

There are literally dozens—maybe hundreds—of other measures of investor sentiment, ranging from official versions, such as those the International Monetary Fund and the Bank of England have for surveillance purposes, to private-sector models, many but not all of which purport to give a trading advantage. They are branching out fast. Yale’s School of Management, which already has a much-watched index based on a poll of institutional and retail investors, and tracks investor sentiment in Japan, is launching similar indices in a number of new countries, beginning with India next week. And State Street is planning to break down its global index to show risk appetite specifically in North America, Europe and Asia.

Assuming that these indices do actually reflect what they are supposed to, what do they tell us that is of practical use? Do they predict future returns? If not, why are investors prepared to pay an arm and a leg for some of them? After all, the Chicago Board Options Exchange's VIX contract, which tracks implied volatility in the S&P 500 share index, is known as the “investor fear gauge”—though it has come unglued of late.

Academic journals are stuffed with articles about how to measure investor confidence and what to do with it once you have measured it. Most suggest that sentiment is not a reliable predictor of long-term future returns in general. But it may help to predict returns on certain kinds of shares, says Malcolm Baker of the Harvard Business School, whose research with Jeffrey Wurgler, of New York University’s Stern School of Business, will be published soon in the Journal of Finance. Shares in new, small, non-dividend-paying firms—basically, those without much of a track record and whose shares are hard to arbitrage—are more likely to outperform when investor sentiment is pessimistic at the start of the period being studied.

“I love to see those academic studies saying that sentiment doesn’t matter,” says Jason Goepfert, chief executive of Sundial Capital Research in Minnesota. “That means it’ll work all the better. We’ve looked at all sorts of indicators—fundamental, technical. It’s not that investor sentiment doesn’t fail, but it fails less often.”

Sundial’s sentimenTrader.com offers a variety of confidence indices to subscribers, both institutional (including hedge funds) and individual. Mr Goepfert points to one real-money gauge in particular: the Rydex fund family, one of the few to make its asset data readily available and in the past a good indicator of sentiment. Allocations are close to their all-time most bearish now, with loads parked in the money markets and a leveraged short position that is greater even than last April, when most sentiment indicators dived. This suggests that returns are set to rise over the coming weeks.

Investor sentiment seems to be most predictive when it is near historical extremes, and then only in the short term. In the longer run it has less to say, for returns should reflect the business cycle and corporate earnings. The big question now is what the impact of sharply higher oil prices will be. If they act as a brake on global economic growth, as seems likely, it will knock investor sentiment and returns, both short-term and long-term, for six.

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Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

The fallout from Katrina

Sep 2nd 2005
From The Economist Global Agenda

As New Orleans slips into lawlessness after Hurricane Katrina struck the Gulf of Mexico coast, officials say they can still only guess at the death toll of the disaster—though it is likely to be in the thousands. Many survivors are still waiting for help

THE natural catastrophe is past, but the human catastrophe in the wake of Hurricane Katrina seems to be worsening still. Around four-fifths of New Orleans was still under water on Thursday September 1st, three days after the storm slammed into Louisiana, with winds roaring up to 140mph. Much of the city is below sea level and its ageing levees—a system of flood walls, earthworks and pumping stations designed to hold the waters back—could not resist Katrina's might.

As the hurricane travelled on across Mississippi, Tennessee and Alabama, it left a trail of death and devastation there too. Officials say it is impossible to know how many people have been killed, but the official count has already moved into the hundreds; at least 30 died in a single catastrophic collapse of a seaside apartment building in Biloxi, Mississippi. In New Orleans, reports of bodies floating in the floodwaters herald a dreadful accounting to come; the mayor has said that the final death toll may be in the thousands. With many roads blocked by the floods and fallen trees, rescue workers and volunteers are working round the clock to reach the uncounted number in need of food, medical attention and uncontaminated drinking water.

But while catastrophes often bring out the best in people, in this case it has brought out some of the worst, too. Looters and armed gangs stalk New Orleans, fires started by arsonists rage as desperate refugees clamour for rescue, and CNN has reported shots fired at medical convoys evacuating the sick and helpless. On Thursday, more troops were sent in to quell the lawlessness. In the early hours of Friday, the waterfront area was rocked by a series of massive blasts that sent clouds of acrid smoke drifting across the city. It was not clear what had caused the explosions, which, according to early reports, may have come from a chemical plant.

Some are warning that it could be a matter of weeks, or even months, before electricity is restored to all of the millions who lost it in the wake of the storm. The army's chief engineer says it could take up to 30 days to remove the water, and New Orleans officials have said it could be several months before those who fled before Katrina hit are able to return.

Though most of the city's residents left before the storm, huge efforts are now being made to rescue and evacuate those who remained behind to care for pets or ageing relatives and neighbours, or simply because they had nowhere else to go. The Superdome, a downtown sports arena, was a temporary home for at least 20,000, but heat, humidity, failed plumbing and a lack of supplies have turned it into a festering nightmare. Buses are now being brought in to transport the refugees to a stadium in Houston, but violence and the overwhelming number of the needy have slowed this and other evacuation efforts. Reports have emerged of people dying in the crowds waiting for buses to take them to safety.

More worrisome still is the toll of disease on those who are trying to wade to safety. The floodwaters are now a toxic stew of raw sewage, household and industrial chemicals, and the rotting corpses of the people and pets who drowned as the waters rose. Doctors worry that this may mean an increase in the sorts of gastrointestinal diseases commonly seen only in the poorest countries. The water is also an excellent breeding ground for mosquitoes, particularly in the warm, wet climate of the Gulf Coast, which could mean a spike in mosquito-borne illnesses such as West Nile virus.

Once the floodwaters have been pumped out of the city—which may take weeks—insurers expect a deluge of claims. Estimates of the losses range from $9 billion to $25 billion. The high end of this range would make Katrina the most expensive natural disaster in America’s history for underwriters, topping the $21 billion paid out after Hurricane Andrew in 1992.

To the insurers’ losses must be added the cost to the government of rescue operations, plus many uninsured losses that will ultimately be met by private individuals or the taxpayers. For instance, homeowners’ insurance typically does not include flood coverage, which is underwritten by the federal government, and business-interruption insurance may not cover losses from looting. There will undoubtedly be wrangling between insurance adjusters, homeowners and the feds over what water damage was due to the storm, and what is attributable to the rising flood.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

An Iraqi tragedy raises sectarian tension

Aug 31st 2005
From The Economist Global Agenda

In the most deadly incident since America’s invasion of Iraq, an estimated 1,000 Shias have died in a stampede in Baghdad, which Sunni insurgents are suspected of causing. Like the row over the draft constitution, the tragedy will worsen sectarian tension

AROUND a million of Iraq’s Shia Muslims were making their annual pilgrimage to the north Baghdad shrine of an 8th-century saint on Wednesday August 31st, when pandemonium broke out. Panicking at rumours that a suicide-bomber was trying to blow himself up in their midst, thousands of pilgrims stampeded across a bridge over the Tigris that leads to the shrine. Many were trampled underfoot; others drowned after jumping from, or being pushed off, the bridge. The Iraqi authorities say as many as 1,000 may have died, most of them women and children.

Catastrophes causing heavy loss of life have become almost an everyday event in Iraq since the American-led invasion to topple Saddam Hussein in early 2003. But no single incident since then has been anything like this deadly. In a sense, the gathering of such a multitude in a restricted space was an accident waiting to happen. Indeed, great crowds at Muslim shrines have turned into deadly crushes before, sometimes with no obvious cause. But some Iraqi government officials and Shia politicians swiftly blamed the tragedy on Sunni Muslim insurgents who, while incessant in their attacks on American and Iraqi forces, have increasingly targeted Shia civilians too. Their apparent aim is to foment a civil war, making the country even more ungovernable than now and forcing American troops to make an ignominious exit.

Iraq’s interior minister, Bayan Jabor, accused insurgents of deliberately triggering the stampede by spreading the suicide-bombing rumour. Ammar al-Hakim, a leader of the Supreme Council for Islamic Revolution in Iraq (SCIRI), the dominant party in the Shia-led governing coalition, blamed “terrorists, Saddamists and radical extremists”. The defence minister, Saadoun al-Dulaimi, a Sunni, disagreed, insisting the tragedy was nothing to do with sectarian tensions. However, there were several apparently sectarian attacks on the pilgrims earlier in the day: at least seven people were killed in three separate mortar attacks on the Shias as they marched to the shrine, for instance.

Whether the stampede was a tragic accident or the result of a deliberate attack may never be known for sure. What may matter most is whether Shias conclude that it was sectarian—and whether they decide to react. It would certainly not be the first time the insurgents have attacked a Shia religious festival. In March last year, more than 180 people were killed when suicide-bombers attacked worshippers at the same Baghdad shrine and at another, even more important one in Karbala. More recently, Shia gatherings of all sorts—weddings, funerals and crowds milling around outside mosques—have become vulnerable.

In response, the killings of Sunni leaders and clergy have increased. However, given the level of provocation it is remarkable that the various heavily armed Shia militias have so far resisted the temptation to launch massive reprisals against ordinary Sunnis. Grand Ayatollah Ali al-Sistani, Iraq’s most influential Shia cleric, has restrained the hands of the most militant of the armed Shia groups, such as Muqtada al-Sadr’s Mahdi Army. But the huge toll from the stampede will make this much harder. Even if the tragedy does not trigger an all-out conflict between Iraq’s religious and ethnic groups, some say that a low-level civil war is already brewing. Attacks, or threats of them, have forced Shias and Sunnis living in districts where they are a minority to begin moving out.

The proposed Iraqi constitution, which will be put to a referendum in October despite its rejection by Sunni negotiators, seeks to ease the underlying fears of rival communities and thereby prevent a descent into civil war. Its guarantees of democracy should reassure the majority Shias (about 60% of the population) that they will no longer be dominated by the Sunnis (20% of Iraqis), as they were until the fall of Saddam. The Kurds (also 20%) are guaranteed continuing autonomy in their northern homelands. The Sunnis, based predominantly in Iraq’s central and western regions, are promised that oil and gas revenues will be shared between provinces largely on the basis of population—and not grabbed by the Shia south and the Kurdish north, where most of the reserves are.

In practice, however, achieving this equitable division of oil wealth will depend on negotiations between central and provincial governments; and Sunnis are worried that the constitution allows the southern Shias to form a powerful super-region similar to that of the northern Kurds, with its own security forces, based on existing militias. Thus a weak central government may find it hard to persuade the Kurds and Shias to hand over the Sunnis’ fair share of oil earnings, whatever the constitution says.

Some sort of deal may yet be reached to bring on board enough leading Sunnis to secure a credible yes vote for the constitution. The fresh general election which is set to follow such a vote might then attract more Sunni candidates and voters, finally giving the country a government that all its main groups recognise as legitimate. But it is also quite possible that widespread rejection by Sunnis will undermine all attempts to reach a political accommodation. If so, the insurgency will continue and the slide towards civil war may become ever more unstoppable.

It’s not Vietnam…it’s worse

Whatever the Bush administration may say publicly, it must increasingly be hoping for a period of relative calm in Iraq so that it can declare victory and bring the troops home—even though Iraq’s security forces are still far from ready to maintain order without American help. For all George Bush’s talk about staying the course, the pressure to cut and run is growing. An ABC News/Washington Post poll on Tuesday showed the president’s approval ratings at an all-time low of 45%, owing to concerns over the Iraq war and soaring oil prices.

In a report released on Wednesday, the Institute for Policy Studies and Foreign Policy in Focus, two think-tanks critical of the war, estimated that operations in Iraq were now costing American taxpayers $5.6 billion a month. Adjusting for inflation, they reckon this is about 10% higher than the average military cost of the Vietnam war in the 1960s and 1970s. But pulling the troops out at this stage would be a crushing defeat for America, as well as a spectacular victory for the insurgents and their al-Qaeda allies. Iraq might collapse into a religious and ethnic war far more bloody than the conflict has been up to now—and might break up altogether. There is still a chance that such a terrible outcome can be avoided. But whoever it was whose rumour-mongering triggered the deadly stampede has done his best to make it happen.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Crunch time for UN reform

Aug 31st 2005
From The Economist Global Agenda

America has requested extensive last-minute changes to a draft agreement on reforming and modernising the United Nations. Painful negotiations lie ahead of next month’s summit of world leaders

IF THERE was still any question that America is taking a new line with the United Nations, the answer now seems clear. Next month, 175 world leaders will gather in New York to consider a raft of reforms for the world body. But just weeks before the summit is to begin, America has asked for extensive changes to the draft “outcome document” that many other negotiators felt was almost finished. Many detect the hand of John Bolton, America’s controversial new ambassador to the UN, who offered the proposed changes on Wednesday August 24th. But Mr Bolton is probably more symptom than cause—George Bush sent him to the UN as a signal that business-as-usual would no longer be acceptable.

There is talk of crisis in many of the media reports about America’s proposed changes. The Washington Post reported that 750 such edits had been made to the draft outcome document. In truth, the majority of these are nitpicking wording changes that have little effect on the content. But some of them would change the declaration considerably, particularly regarding development efforts and intervention to stop human-rights catastrophes.

September’s summit, billed by the UN as the biggest gathering of world leaders in history, was originally to be a five-year review of the 2000 Millennium Summit, the most notable product of which was the Millennium Development Goals (MDGs). These include worthy aims such as halving abject poverty and achieving universal primary education by 2015. As desirable as these goals are, there seems little hope of achieving the panoply of policy objectives embedded in the MDGs; the UN itself is already complaining about the lack of progress.

The proposed American edits to the document remove nearly all references to the MDGs, referring instead to more vaguely worded “internationally agreed development goals”. In place of the MDGs, America wants to put more emphasis on the “Monterrey Consensus”, the result of a 2002 summit in Mexico which concluded that developing countries need to take more responsibility for their own growth by fighting corruption, improving their investment climates and making their countries generally more hospitable to economic activity.

Such market-friendly ideas have become the vogue not only in America but among the non-governmental organisations fighting poverty around the world. They have belatedly recognised that tens of billions of dollars in aid over recent decades have failed to curb extreme poverty in much of the world, especially Africa. Those countries that have made the greatest strides against poverty, most notably India and China, but also countries like South Korea and Taiwan, have done so largely by making their own economies suitable for investment and growth.

But developing countries, as well as many UN officials and rich-world governments, believe that substantial aid is required too. For reasons of geography and history, they argue, Africa is in a “poverty trap” that no amount of internal reforms will solve without aid. Thus the draft summit document included a call for rich countries to aim to give 0.7% of their GDP in assistance.

It is this kind of language that America wants removed. In a slightly defensive letter to other ambassadors sent on Friday, Mr Bolton said that despite its deletion of every reference to the MDGs, America did in fact support them, so long as they were taken to mean outcomes (eg, halving poverty) and not inputs (such as the aid target, which America never agreed to). The blizzard of negative publicity last week may have put some pressure even on America’s fierce ambassador.

The diplomatic problem is that the countries of the developing world, represented by the “G77” group, see a strong focus on aid and the MDGs as their price for agreeing to the rich world’s—especially America’s—agenda. That agenda includes an overhaul of management and oversight within the UN’s own house, to prevent, for example, fraud like the recent and humiliating oil-for-food scandal. The developing countries may only agree to proposed American reforms like this if tempted by a promise of sizeable and predictable aid flows. If the Americans are going to propose 750 amendments, the G77 might respond in kind.

Am I my brother’s peacekeeper?

Besides the shift in language on development, the edited American draft significantly weakens a section on the so-called “responsibility to protect”. Following the genocide in Rwanda and the NATO-led intervention in Kosovo, international lawyers have sought to secure language promoting humanitarian intervention to stop atrocities. The original draft called on states to acknowledge their responsibility to prevent such crimes against humanity, and to aid the UN in establishing an “early-warning” system to halt disasters-in-the-making. When states fail in this duty to protect their citizens, the drafters declared that the rest of the world “has the obligation” to act, and invited permanent members of the Security Council not to veto any such intervention.

In the first set of changes to the draft document, all this langauge was cut by American editors—State Department lawyers trying to avoid legal commitments and Pentagon strategists fearing some kind of automatic requirement of American arms to stop catastrophes. Instead, the American version simply said that outside countries should be “prepared to act”. The superpower’s critics quickly noted that it had once again lined up alongside a rogue's gallery of badly behaved states to oppose a human-rights agreement: in this case Pakistan, Egypt, Cuba, Iran and Syria.

But as with the development clauses, the American position has since softened somewhat. A letter from Mr Bolton this week suggests inserting language that the world has a “moral responsibility” to act to stop large-scale crimes against humanity. But the American ambassador remains opposed to creating a legal responsibility, which could, he argues, inappropriately predetermine the means to be used. In any case, his letter points out, the Security Council already has the power to authorise intervention. In a further concession, America has re-inserted support for a new UN-based “early-warning system” into its proposed text.

So even though many still worry that this section of the draft has been fatally weakened, the vaguer American version of "responsibility to protect" would be the first-ever clear international agreement that outside countries should be willing to act to stop atrocities in a country whose government cannot or will not stop them itself. This could form the political basis for a future intervention, possibly even military intervention, should the Security Council be presented with a case like the slaughter in Sudan's Darfur region.

The atmosphere is therefore not as bad as some of the more breathless talk of crisis indicates. Nonetheless, America has annoyed many with some seemingly needless niggling points—cutting “respect for nature” from a legally meaningless laundry-list of the world’s basic values, for example. Critics say that the deletion is emblematic: America is taking an overly lawyerly approach to a non-binding political document on which all have made compromises. An American spokesman responds that “mumbo-jumbo” does no one any good, and that America may support a shorter statement instead of the current 36-page draft.

Time is now limited. A document must be substantially complete before national leaders show up on September 14th, and there remains procedural wrangling about which countries (approximately 30) should be in a core group negotiating these last-minute changes. Diplomats are firing up their coffee pots, preparing to work through nights and weekends. It will be a long and harrowing two weeks. But everyone agrees that the UN needs reform. Failure to achieve consensus in September would be a sadly wasted opportunity for all concerned.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Iraq, still divided after three deadlines

Aug 29th 2005
From The Economist Global Agenda

Iraq's draft constitution has been finished and will be put to the voters in October. Sunni Arabs continue to object strenuously to the document, and say it could provoke a civil war

AFTER three deadlines and painful negotiations, Iraq finally has a draft constitution, endorsed by leaders of Iraq's Kurds and Shias. Iraq's president, Jalal Talabani (a Kurd), said in a ceremony on Sunday August 28th that only the Koran is perfect, but the constitution was “the first of its kind, written by representatives of important Iraqi factions”. But Sunni Arab leaders, who object to crucial provisions in the constitution, said the document was a failure and could provoke civil war.

Officially, the draft had been due on Thursday. But the negotiators took several more days to try—ultimately unsuccessfully—to reach consensus. Thursday night’s deadline came after a three-day extension the drafters had given themselves on Monday. And Monday’s deadline was itself an extension from the previous Monday. All of this delaying was in an attempt to get the Sunnis, who dominated Iraq under Saddam Hussein, on board. Many of the contentious issues had been settled by Thursday. For example, Islam is to be “a basic source” of Iraqi law, reflecting a compromise between religious Shias who wanted it to be the main source, and secular Iraqis (including most of the Kurds) who preferred to have weaker references to Islam.
Clerics will be allowed to serve on the supreme court, but they will not constitute a majority.

But while the religion issue has been settled, provisions in the constitution for a federal system of government remain unacceptable to the Sunnis. The draft hands considerable powers to the provinces. It also allows provinces to join together into regions. The Kurds have controlled an enclave in northern Iraq since the first Gulf War in 1991. The Sunnis accept that they will continue to do so, but they are much less relaxed about the potential ambitions of the Shias, who are the biggest ethnic group in Iraq by some way. Sunnis fear an Iraq dominated by a Shia super-region.

But since the Shias are a majority in Iraq, they would dominate any centralised government. So why are many Shias for federalism and many Sunnis for centralisation? One reason is oil revenues. The Kurdish-dominated north and the Shia-heavy south sit on nearly all of Iraq’s known oil and gas. Some Sunnis feared that federalism would cut them out of a fair share of this. Here, the Shias and Kurds compromised. The constitution calls for revenues from the country’s existing oilfields to be shared according to the population of each province. Revenue from new discoveries would belong to the province under which the oil lies. This was seen as the best possible split between the haves and the have-nots.

But Sunnis—and some of the Shias that follow Muqtada al-Sadr, a radical cleric—see other problems with federalism. Sunnis despise the Badr Forces, a militia allied to the Supreme Council for Islamic Revolution in Iraq (SCIRI), one of the two main Shia parties in the current government. SCIRI is close to Iran; many of its leaders spent much of the Saddam era in the Islamic Republic next door. And the Badr Forces fought alongside Iran during the long Iran-Iraq war in the 1980s. Some observers worry that a Shia super-region in southern Iraq would be a foothold for Iranian influence.

So the constitutional deal struck between the Shias and Kurds has left the Sunni Arabs feeling coerced. “The streets will rise up,” predicted Salih Mutlak, one of their negotiators, over the proposed federal system. Indeed, on Friday thousands of Sunnis marched in Baquba against the constitution (as did thousands of Mr Sadr's Shia followers in eight cities including Baghdad).

A referendum on the constitution is expected to take place in October, in advance of general elections in December. If two-thirds of voters in at least three provinces reject the document, it will fail, and the general election will produce another transitional government, tasked with picking up the pieces and pushing through a new version. Sunni leaders are encouraging their followers to come to the polls—and more surprisingly, several militia groups, both Shia and Sunni, have been urging their supporters to do the same. This apparent willingness to fight the constitution at the ballot box, rather than with bombs, is a step in the right direction.

Sunnis are thought to have a majority in four provinces, but it is not clear whether they can achieve the necessary two-thirds majority in three. The Sunni provinces are also home to much of the current violence. If this prevents voters from turning out, the constitution will appear even more to the Sunnis like a product made almost entirely without their input. This would remove one of the rationales—pushed by the Bush administration—for setting the August deadline for drafting the document: that it would sap the Sunni insurgency that continues to take a toll on American troops and, in far greater numbers still, Iraqis.

With American nerves fraying, George Bush has his eye on the home front as well as Iraq itself. Just 34% of those answering a recent Newsweek poll approve of the president’s handling of the war. And a CBS poll found that 59% thought Iraq was not worth the loss of so many American lives. Even Mr Bush’s supporters are starting to wonder. “By any standard, we’re not winning [in Iraq],” said Chuck Hagel, a Republican senator believed to be nursing presidential ambitions.
The current constitutional exercise will be one of the key determinants of overall success or failure. If it works, Iraq may set a hopeful precedent for the entire Middle East, marking a big step forward in Mr Bush's campaign to spread democracy to the region. If it fails, it could mark the complete collapse of America's Iraqi experiment.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Economist.com Cities Guide: London Briefing - August 2005

News this month

Trigger happy

Leaked documents and video footage have suggested that a young Brazilian man shot dead by police on July 22nd, the morning after the failed, second set of bomb attacks on London, may have been killed in cold blood. Previous reports said that Jean Charles Menezes was chased by police into Stockwell tube station, where he was shot during a struggle. It was said that police wrongly assumed that Mr Menezes’s heavy clothing concealed a suicide-bomb.

But new evidence, seemingly leaked from the Independent Police Complaints Commission, paints a different picture. Not only does it reveal that Mr Menezes was not chased, but also that he was not wearing any heavy clothing. It also seems the 27-year-old was not positively identified as a suspect and had already been restrained when he was shot eight times.

Mr Menezes’s family has called for a full judicial inquiry into the killing and for the suspension of the “shoot-to-kill” policy for terrorist suspects used by London’s police. Figures released by the British Transport Police, meanwhile, showed that people of Asian appearance were five times more likely to be stopped and searched than other passengers, in the month after the first bomb attacks.

Going nowhere

An unofficial strike at Heathrow Airport affected tens of thousands of travellers in early August. The dispute began when Gate Gourmet, a caterer supplying British Airways (BA), sacked 670 of its workers in a row over pay and conditions. Members of the carrier’s ground staff then went on strike in sympathy, forcing the airline to cancel hundreds of flights. An estimated 70,000 passengers were affected over the weekend, with hundreds forced to spend an uncomfortable night at the airport.

The row couldn’t have come at a worse time for Britain’s tourism industry, which is struggling in the wake of the London bombings. It has also damaged BA’s reputation and may cost up to £40m ($72m) in lost revenues. But, as usual, the biggest losers could be the inconvenienced passengers. Despite new European Union laws that have beefed up protection for travellers, it seems the strike could be deemed an “extraordinary circumstance”, which would exempt BA from paying compensation.

Last orders

London’s vibrant bar and pub scene is set for a shake-up when the Licensing Act takes effect on November 23rd. The government is hoping a move to longer, “continental-style” drinking hours will curb binge drinking and its associated social problems. But this view is not shared by senior judges and policemen, who warned in August of the potential for increased law-breaking.

In central London, where hundreds of pubs and bars already stay open into the small hours, it’s hard to see what difference the act will make. But it’s another story in mainly residential areas. There, fears about increased disorder have led to a number of high-profile campaigns to stop local boozers from extending their hours. Local councils will have great flexibility in choosing how to grant these licences, but some doubt whether they will use these powers effectively.

Sky's the limit

Despite the ravages of the Blitz and a spasm of tower-block building in the 1970s, London’s distinctive low-rise skyline is still recognisably similar to Canaletto’s 18th-century paintings. But plans for new high-rise developments are raising fears that the capital could be transformed into an architectural pin-cushion. Fuelling the debate was a controversial government decision in late July to grant planning approval for a 49-storey block of flats at the southern end of Vauxhall Bridge. In doing so, the government twice overruled planning inspectors and ignored protests from conservation groups.

The tower’s backers—among them Ken Livingstone, the mayor—argue that high-rise buildings will help solve London’s shortage of affordable housing. But in this case, most of the flats will be for rich people. Critics, one of whom branded the government’s decision “epic in its dumbness”, also point out there is plenty of land suitable for high-density, low-rise building in other parts of the city. But they and other protestors face an uphill struggle: one thing this battle has shown is that London’s famous views have scant legal protection.

Aussie rules?

The long-running takeover battle for the London Stock Exchange (LSE) took another turn on August 15th when an Australian investment bank announced it was considering a joint bid. Macquarie Bank, which has expanded aggressively overseas in recent years, said its bid would probably be in cash and be part of a consortium. News of the bank’s interest caused shares in the LSE to jump by nearly 4% to £5.73.

Bids from two European exchange groups, Deutsche Börse and Euronext, were meanwhile dealt a blow by Britain’s Competition Commission. On July 29th it said that “remedies” would be needed if either group were to buy the LSE: most likely, the acquirer would have to sever its trading and clearing and settlement activities. The Commission’s final verdict is expected in November. Newspapers are also reporting that Sweden’s main exchange, OMX, which unsuccessfully bid for the LSE in 2000, could join the line of suitors.

Catch if you can

September 2005

“The President of an Empty Room” and “Mary Stuart”

Until August 27th 2005 and September 3rd 2005 respectively
Two plays are demanding attention this late August. "The President of an Empty Room", a new play by Steven Knight at the National Theatre, takes place over the course of one day in a Cuban cigar factory. The finest cigar-roller is a young heroin addict, played by Paul Hilton, who finds himself in charge of the factory the day after his girlfriend has left him. Voodoo, dancing, music, cigar smoke and talk of democracy fuel the play. The stalls are arranged around the stage, which makes for a vibrant audience experience.

Meanwhile, across the river, “Mary Stuart” at the Donmar Warehouse depicts an earlier time of terror and religious war, when the political leadership of England must decide whether to suspend the rule of law. Friedrich Schiller, who wrote the original play, can be ponderous, but Peter Oswald's new version never is. The wonderful performances, contrasted by the set's intense austerity, make this the best London play this season. Advance tickets are sold out, but ten seats and about 20 standing places are available each morning. Arrive at about 8am and you'll probably get a seat, or check the website for last-minute, single tickets. Your patience will be well rewarded.

Royal National Theatre, South Bank, London, SE1. Tube: Waterloo. For tickets call +44 (0)20 7452-3000 or see the theatre's website.

Donmar Warehouse, 41 Earlham St, London WC2H. Tube: Covent Garden. See the theatre's website. For tickets call +44 (0)870 060 6624 or visit Ticketmaster's website.

More from the London cultural calendar

Economist.com Cities Guide: Sydney Briefing - August 2005

News this month

Run out of town

Though they have cooled a little recently, Sydney's house prices remain stratospheric by Australian standards. They are over-valued by 37%, compared with 22% for Australia as a whole, according to J.P. Morgan, an investment bank. Consequently, on August 12th, Ian Macfarlane, governor of the Reserve Bank of Australia, the country's central bank, told a federal parliamentary committee that young Sydneysiders should consider moving out of the city.

It seems his advice is being heeded: Brisbane, capital of Queensland, where house prices are more reasonable, is attracting a higher population growth than Sydney. The prices are widely considered to be the reason for New South Wales, of which Sydney is capital, having the slowest job growth in 2004-2005 of any Australian state, as companies seek cheaper locations elsewhere.

The light at the end

After two years under construction, Sydney’s latest bid to improve its clogged roads, a traffic tunnel 50 metres below the city centre, will open on August 28th. The Cross City Tunnel runs from Darling Harbour, at the western edge of central Sydney, to Rushcutters Bay, at the east. It will eliminate 16 sets of traffic lights and cut the average journey time from 20 minutes to two. The A$680m ($525m) cost of the project will be met by a toll of A$3.50, paid via an electronic tag attached to cars.

The tunnel should shorten journey times to Sydney's airport from the west and provide a seamless crossing of Sydney Harbour from the east. Its capacity to relocate 90,000 cars a day from the central business district will be a relief for central residents and workers—but not for those in the inner west. They, and the area's many tourists, will be forced to inhale the tunnel's fumes through ventilation stacks in the middle of Darling Harbour.

Chauvel trouble

A campaign is under way to save one of Sydney's few remaining arthouse cinemas. Housed in the old Paddington Town Hall, the Chauvel Cinema, named after Charles and Elsa Chauvel, two pioneering Australian film-makers, has shown quality films and documentaries that would never find a commercial release, as well as Sydney’s only regular programme of classic world cinema. But a feasibility study commissioned by the Australian Film Institute (AFI), which runs the Chauvel, found that the cinema was likely to lose around A$30,000 a month in the current climate, so the AFI decided to close the cinema by the end of September. The Valhalla, a similar venue, closed in early August.

Resistance from film buffs is strong: a meeting of almost 300 people on August 11th called on the New South Wales state government and the Sydney City Council, the cinema's landlord, to step in until a survival strategy can be devised. Early signs are optimistic: Morris Iemma, the new state premier, not previously known to have artistic inclinations, says he is considering the proposal.

Turned off

The fallout from the London bombings in July has reached Sydney, with the cancellation of a lecture visit by Abdur Raheem Green, a British-born Muslim preacher. Mr Green had been due to speak during the week of August 15th. But he changed his plans after the Australian authorities said it would take “some time” for him to gain permission to land in Sydney.

Mr Green is on the Australian immigration department’s “alert list” of people considered to pose a risk to national security. Though he has visited the country before, the department says his visa application is under “thorough review”. Mr Green wrote a pamphlet on jihad in 1994 in response, he said, to an article in The Economist, but now claims to condemn terrorism. Meanwhile, John Howard, Australia's prime minister, is planning to hold a meeting with local Muslim leaders to discuss tightening counter-terrorism measures.

Island life

Reflecting the growing dependence of the Pacific's island nations on aid and investment from their richer neighbours, the Asian Development Bank (ADB) opened an office in Sydney on August 3rd. The office will oversee the bank’s work in the island nations of Vanuatu, Nauru, Kiribati and the Solomon Islands. It is the fourth office the bank has established in the Pacific region in the past year.

Sydney was chosen because of the city’s role as a business hub and its access to private-sector investment, which the ADB says is as vital as aid for attacking poverty in the Pacific. The Manila-based ADB provided $5.3 billion in loans for the region in 2004. Haruhiko Kuroda, the ADB’s president, told Economist.com that further economic integration between Australia and East Asia, such as free-trade agreements, should be encouraged, to stimulate growth and reduce income disparities in the region.

Catch if you can

September 2005

Sydney Symphony Orchestra: August-September season

Until September 12th 2005

Australia’s leading symphony orchestra has chosen two impressive programmes for its August-September season on its home stage at the Sydney Opera House concert hall. The first features Stephen Kovacevich (pictured), a renowned concert pianist, performing Mozart’s Piano Concerto No. 24 in a programme that also includes Bruckner’s Symphony No. 8. Yannick Nezet-Seguin, a French-Canadian, will conduct. This will be followed by Marin Alsop, a leading American conductor, in a separate programme of music by the American composers Leonard Bernstein, Aaron Copeland and Erich Korngold. Both programmes promise to be highlights in the Sydney Symphony Orchestra’s busy year.

Mozart and Bruckner: August 24th-27th; “American Visions”: September 8th, 10th and 12th. Sydney Opera House, Bennelong Point, Sydney. Tel: +61 (02) 9250 7777. See the orchestra's website.

More from the Sydney cultural calendar

Economist.com Cities Guide: Brussels Briefing - September 2005

News this month

Suez crisis

Belgium was awakened from its summer snooze on August 9th by a bid for Electrabel, a Belgian energy company, from Suez, a French utilities group. The €11.2 billion ($13.7 billion) bid was not a complete surprise: Suez already owns 49.9% of Electrabel, and market observers had long expected the debt-saddled business to seek benefits from Electrabel’s success. (Electrabel is Suez's most valuable asset.) Yet many Belgians see the news as a blow to national pride. Electrabel, Belgium’s third-largest company by market value, seems to be the latest in a series of Belgian companies to succumb to a foreign takeover.

On August 24th, Electrabel's board—half of whom were appointed by Suez—approved the bid by 17 votes to one. But there could be complications. Suez’s chief executive, Gérard Mastrallet, has promised Belgium's prime minister, Guy Verhofstadt, that a new Franco-Belgian company will be created and that shares will be traded in Brussels. Members of Mr Verhofstadt’s coalition government say these promises should be made legally binding.

Beach bummer

It has been a summer of contrasting fortunes for two of Belgium’s better-known beaches. Bruxelles-les-Bains, an artificial beach created in Brussels beside a canal, failed to draw the same crowds as in previous years. Modelled on Paris Plage, the Parisian beach beside the Seine, Brussels's version attracted over 500,000 visitors in 2003, its first year, and 600,000 visitors in 2004. But this year, despite an investment of €500,000, there were fewer than 250,000 visitors. Freddy Thielemans, the mayor of Brussels, blamed the poor weather, noting that in the month the beach was open there were only two days of sunshine. He is considering providing covered areas on the beach next year.

By contrast, a nudist beach established in 2001 at Bredene, on the Belgian coast, has proved so popular that the mayor of that town wants its width extended by 200 metres to 650 metres.

Going off the rails

All is not well at SNCB, Belgium’s national railway company. On August 24th, a strike held by staff at the city’s south station disrupted the morning rush-hour traffic. The employees were protesting against new staffing regulations that take effect in September. SNCB is aiming to reduce staff by 3,000 by the end of the year, but is still launching a campaign to recruit 235 drivers and 129 guards. This muddle over staffing is a result of the SNCB's early-retirement terms, negotiated as part of a restructuring package. The terms are so attractive that management fears it may lose more staff than it can afford to.

Building for Europe

Brussels’s Euroquarter resembles a big building site, as the European Parliament’s base in the city extends to keep pace with the enlargement of the EU. Work on the extension, which encroaches on the neighbouring railway station, is ahead of schedule, but will not finish until next year. Meanwhile, a new building is taking shape on Rue de la Loi, 45 metres from the European Commission’s Berlaymont headquarters. When it is finished at the end of 2006, it will be home to the translation services of the Council of Ministers.

Commercial excess

Away from the buoyant Euroquarter and the city centre, Brussels has a surfeit of commercial property on its outskirts, according to a survey published by De Tijd, a Flemish business newspaper. Despite an economic recovery that started in 2003, rental prices for office space in the outlying eastern suburbs have not picked up. In 2002, the average price was €150 per square metre; now the price in some areas is below €70. Some landlords are offering sweeteners to would-be tenants, such as lengthy, rent-free periods. In one industrial zone near Zaventem, home to the city’s airport, about one-third of office space is unoccupied.

Catch if you can

September 2005

Opera at La Monnaie

From September 1st 2005

Despite a rather subdued start (just seven performances in September and October), the new season at Brussels’s opera house, in a corner of the cobbled Place de la Monnaie, is filled with gems. The season opens with Mozart’s “Die Zauberflöte”, followed by the world premiere of “Thyeste”, with music by Jan van Vlijmen, a Dutch composer who died last December, and lyrics by Hugo Claus, a Belgian poet and novelist. Looking further ahead, highlights include new productions of Wagner’s “The Flying Dutchman” in December, Mozart’s “Così fan tutte” in January and February, and Mussorgsky’s “Boris Godunov” in April and May. Book well ahead.

La Monnaie, 4 Place de la Monnaie, Brussels 1000. Tel: +32 70 23 39 39. Visit the theatre's website for further details.

More from the Brussels cultural calendar

Palocci's value

Brazil's economy

Aug 25th 2005 SÃO PAULO
From The Economist print edition

Worries about the finance minister

“NO ONE is indispensable,” declared Brazil's finance minister, Antonio Palocci, in the course of a two-hour press conference called to rebut allegations of corruption against him. A scandal over illegal payments to legislators and irregular party financing has already toppled leaders of government, Congress and the ruling Workers' Party (PT), to which Mr Palocci belongs. On August 19th it reached Mr Palocci himself. A former aide who became a manager of a rubbish-collection firm accused him of taking a monthly pay-off from the company (and passing it on to the PT) when he was mayor of Riberão Preto, a city in São Paulo state. For the first time since the corruption scandal began in May, speculators panicked, dumping Brazilian bonds, shares and the real.

The aide offered his testimony as part of a plea-bargain, and Mr Palocci's self-defence was spirited. That initially calmed markets down, but then the edginess returned. Although the economy is fairly sound, the scandal could yet shake it. Mr Palocci has been the government's champion of tight fiscal and monetary policies. These have saddled Brazil with the world's highest real interest rates and exporters with an uncomfortably strong currency. Yet they have also held down inflation and public debt—a big reason why the political crisis has not been accompanied by an economic one.

So far, Mr Palocci has managed to combine stability with moderate growth. In 2004 the economy grew 4.9%. Growth is likely to slow to 3% this year before picking up again in 2006. Even with the strong real, exports are booming. The trade surplus is heading for a record $40 billion this year, which makes foreign debt more manageable and helps shield the economy from financial panics. Domestic credit is buoyant, thanks partly to government wheezes such as bank loans repaid from workers' paycheques. Lending to households is rising sharply, helping sales of white goods, notes Mario Mesquita, an economist at ABN Amro, a bank.

Investment, though, has lagged. Although sales of machinery and equipment are growing strongly, construction, which accounts for two-thirds of investment, is weak partly because of high interest rates. Inflation is edging down towards the central bank's target of 5.1%, which ought to allow a long-awaited easing of monetary policy. That will not happen if markets lose faith in the government's commitment to stability.

Mr Palocci insisted that his policies would survive even if he is forced out. That is probably true. Brazil's president, Luiz Inácio Lula da Silva, has backed him staunchly, in part because abandoning austerity would be unpopular. According to IPSOS, a polling firm, voters are unwilling to sacrifice low inflation for faster growth. Were Mr Palocci to go, Lula would probably replace him with a like-minded technocrat, such as one of his aides. But there would be a cost.
Next to Lula, Mr Palocci is the PT's weightiest politician in the government and the ablest defender of austerity and economic reform. His exit would demoralise an embattled president. A successor with the same ideas might have more difficulty realising them.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

Different this time?

Buttonwood

Aug 23rd 2005
From The Economist Global Agenda

Foreigners are again pouring cash into emerging markets. What will happen when they stop?

BUTTONWOOD was in the wilds of Guadalajara (Spain’s, not Mexico’s) last week, trying to keep teenage bikinis within the bounds of decency, when the latest twist in Brazil’s long-running corruption tale hit the press. The Spanish have more than a passing interest in Latin America, even the Portuguese-speaking bits. So coverage of allegations that Antonio Palocci, Brazil’s finance minister, had been on the take in a previous political incarnation was full and frank.

The resulting sell-off of the Brazilian market hit assets all around Latin America. Brazilian bonds have the heaviest weighting in J.P. Morgan’s Emerging Market Bond Index Plus (EMBI+)—the benchmark for many money managers—and any problem Brazil has makes itself felt. The spread on the index—ie, the premium that investors demand for holding an allegedly riskier security than American Treasuries—had fallen from 3.6 percentage points at the beginning of the year to 2.9. On August 19th, it widened back out to 2.95 points. But Mr Palocci effectively denied the charges over the weekend and appeared to have the confidence of his president.
Brazil bounced back, and by close of play on August 22nd the spread on the EMBI+ was down to 2.92 percentage points.

The speed of the rebound in Brazil is a sign of just how keen investors are to see the upside in emerging markets. This is borne out by the latest figures from Emerging Portfolio Fund Research, which tracks funds with assets totalling more than $4 trillion. Between the beginning of June and the week ending August 17th, emerging-market equity funds took in a net $6.94 billion. That brings the year’s total to $8.74 billion, nearly three times 2004’s level and more than the previous high of $8.6 billion for all of 2003. Bond funds tell the same story, with total net inflows this year of $4.74 billion, a record.

Emerging assets have been making more money for their owners than developed countries’ for a while. The return on emerging-market debt so far this year has been 5.6%, higher than on Treasuries, for example. Equities in weird and wonderful places have done better, too: the Morgan Stanley Capital International index of share prices in emerging markets is up by almost 13% so far this year, compared with less than 3% for markets in rich countries. Many emerging countries’ currencies are strengthening or expected to do so soon.

All well and good. But Buttonwood had a formative experience when she moved to Jakarta in 1997 to live the Asian Miracle and caught instead the Thai baht in freefall, soon followed by the rest of South-East Asia. And one has to say that the global environment has been exceptionally kind to emerging markets lately. Interest and inflation rates are low; demand (in America, parts of Europe and the developing world) has been strong; commodity prices have been booming; risk aversion is in retreat. If any of the above stops, or if investors decide that they have run up emerging-asset prices far enough, will we see a repeat of the 1997-98 crisis?

In theory, no. Most of the important emerging countries have gone straight, we are told, and are thus better able to withstand a sharp reduction in foreign investment than before. Current-account deficits have been reduced or converted to surpluses. Fiscal policy is more prudent. Net new borrowing has been limited and the outstanding stock of debt in most places is dwindling. Inflation has fallen.

In a study released last week, Christian Stracke of CreditSights, a research firm, compares emerging economies’ dependence on portfolio inflows now and eight years ago. (Portfolio investment—as opposed to foreign direct investment—is generally fast and easy to liquidate, and so includes the sort of “hot money” that travels fast and upsettingly.) Looking at 25 countries, he finds that dependence is generally much lower, but patchily so.

As the table shows, portfolio liabilities in the 18 months to June 2005 for the group as a whole were $118.5 billion, far less than the $170.7 billion that came in before June 1997. This averages out some very different experiences: both Argentina and Brazil have seen liabilities decrease sharply, while India, Poland and Hungary have had just the reverse. What is more, the “hotter” sort of portfolio investment—debt securities—has fallen most (from $116.6 billion to $66.7 billion) while equity investment has stayed almost the same.

On another measure, the ratio of foreign-exchange reserves to recent inflows, things look sturdier still. In June 2005, the median emerging country had enough reserves to cover 529% of the past 18 months’ portfolio inflows, compared with just 222% in June 1997. This average again masks some big differences: oil-rich Russia’s reserves are a staggering 2,093% of flows, while Turkey has either 161% or 249%, depending on how one treats the bulky “errors and omissions” category of its current-account figures.

One can quibble with these figures. Most of the 2005 numbers go up only to the first quarter, for instance, and portfolio flows picked up sharply from June. And while it makes sense to look at foreign portfolio liabilities in isolation—as this is the footloose stuff that leaves—the parallel existence of foreign portfolio assets is not totally irrelevant, nor is the size and trend in foreign direct investment. The broad picture is nonetheless revealing, and, within limits, encouraging: a sell-off rather than a rout may be the worst that happens if foreign investors turn tail.

But it would not take much to produce that—higher real interest rates in America, for a start (and rate rises look likely to continue). The impact of dearer oil is harder to judge. High oil prices should be a plus for emerging producers such as Russia and Venezuela, while heavy importers such as South Korea have enough other attractions to get away with it. But money managers are beginning to look askance at emerging-market guzzlers who have subsidised energy use and may no longer be able to afford it.

Paradoxically, globalisation may also dim the appeal of emerging markets by increasing the correlation between developed and developing assets. Mexico, some say, is beginning to pay the price for its lockstep with the United States. A sharp increase in risk aversion would make that matter more: at the moment, investors ask only to be led to the next frontier, but a few more terrorist attacks in big financial centres could change that.

At the end of the day, a bare-knuckled corruption scandal bringing an important government to its knees—Brazil?—might not be the pase de la muerte that we holidaying hackettes would have seen had we spent more time at the bullring and less on the beach. But it could well do the weakening work of the picadores.

Send comments on this article to Buttonwood (Please state whether you are happy for your comments to be published)

Read more Buttonwood columns at www.economist.com/buttonwood

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.

The sick cope best with labour pains

Aug 24th 2005
From The Economist Global Agenda

America’s Northwest Airlines and British Airways are both feeling the effects of strike action. Ironically, struggling Northwest is coping reasonably well without its striking mechanics, while buoyant BA is still recovering from a one-day stoppage by some ground staff. When dealing with unions, it helps to have little to lose

THE last time a big strike hit Northwest Airlines (NWA), in 1998, the American carrier was paralysed for two weeks and the pilots who caused the stoppage walked away with handsome pay increases. This time, the effects have been far less painful. Despite a walkout by 4,500 mechanics and cleaners last week, Northwest says that it has run nearly all of its scheduled services—though with some delays—after bringing in new staff to cover the work of the striking employees. Oddly, the main factor in the airline’s favour this time is the deteriorating fortunes of full-service carriers in America (and around the world). Northwest, America’s fourth-biggest airline, has gone from a successful money-making venture, unable to resist the power of the unions, to a financially troubled one that has little to lose from taking on disgruntled staff.

The contrast with the situation at another strike-hit airline, British Airways (BA), underlines this point. BA is recovering from a blow to its reputation and finances caused by a brief stoppage. On August 11th, around 1,000 ground staff walked out in sympathy with 670 fellow union members who had been sacked by Gate Gourmet, a catering firm that supplies BA and which used to belong to the airline. The industrial action stranded around 70,000 flyers, some for several days. The dispute is a direct consequence of BA’s largely successful efforts to recover from the troubles afflicting airlines over the past few years. Ironically, its position of relative strength makes it more vulnerable to the flexing of muscles by its workers, who complain that the airline continues to look for ways to cut costs despite being profitable. BA has suffered strike action in the busy holiday period in each of the past few years.

There is no doubt that BA is in much better shape than most American airlines. Since the terrorist attacks of September 11th 2001, America’s big carriers have amassed losses of over $30 billion between them. But the cause of the slump predates the New York atrocity. Airlines suffered a steep drop in demand from lucrative business-class customers after the bursting of the dotcom bubble. Meanwhile, the older carriers, with heavily unionised workforces, high running costs and a legacy of crippling pension and health-care commitments, faced mounting competition from low-cost competitors (which now have 30% of the market compared with 7% in 1990). On top of this, the soaring oil price has forced up fuel costs.

The big airlines’ reaction to these threats has been to shed employees, cut pay and pensions, and outsource operations to cheaper providers. Since 2000, around 100,000 airline employees have gone, and carriers have secured billions of dollars in cost savings using Chapter 11 bankruptcy—or the threat of it—to persuade workers to make concessions. Under bankruptcy protection the courts can relieve a company of its debts and rescind contracts that make it difficult to continue in business. US Airways, America’s sixth-largest airline, has used the provisions of Chapter 11 to force annual cost cuts from workers of $1 billion. United Airlines, the second largest, has used them to save more than $3 billion, through job cuts and changes to its pension rules.

The mere threat of Chapter 11 has also proved a useful weapon, albeit less potent. Delta Airlines, America’s third-largest carrier, said this week that it would seek savings in addition to the $1 billion it negotiated last November, as its cash position has deteriorated considerably since then. Many observers think Delta will file for bankruptcy later this year, perhaps before October 17th when the rules governing Chapter 11 are changed to limit the time companies can spend restructuring under its protection. Northwest may join it before the rules are tightened.

No wonder, then, that America’s cash-strapped airlines are more willing to take on their unions these days. Doing so requires careful planning as well as pugnaciousness. Northwest, for instance, long expecting a strike, made elaborate contingency plans that were helped by the restructuring the industry had undergone. It rapidly replaced the 4,500 striking staff with just 1,900 temporary workers (and is training another 400) drawn from the pool of staff laid off by other airlines.

Furthermore, other unionised employees at Northwest refused to back the striking mechanics, perhaps sensing that it would hasten the airline’s tail-spin into Chapter 11 and a full-scale restructuring that would see many more jobs go. The divisions in America’s labour movement burst into the open last month, when several large unions representing over a third of its membership withdrew from the AFL-CIO, America’s trade-union federation.

BA must be wishing that its unions were just as divided. Britain’s flag-carrier has clawed its way back by shedding more than 13,000 jobs since 2001 and cutting costs by £1 billion ($1.8 billion) a year. Much of this saving came through outsourcing the preparation of its in-flight food. But this also left BA at the mercy of Gate Gourmet—the only catering firm in the Heathrow area in a position to serve the airline. It did not help that BA had no contingency plan.

BA’s own employees may have felt emboldened to strike (illegally) in support of former colleagues at the catering firm in order to set a marker for the battles to come as BA moves to the new, fifth terminal at Heathrow. The changes in working practices that the airline hopes to introduce with the move are sure to arouse union ire. BA wants another £300m squeezed from running costs in the next couple of years.

The airline industry, more than most others, is vulnerable to strikes. In the current harsh operating environment, a small number of cabin crew, mechanics or catering staff can bring a carrier to its knees within weeks—especially if they cannot easily be replaced. But the lesson from recent experience in America and Britain seems to be this: if you want to get the better of your unions, it helps to be on your knees from the start.

Copyright © 2005 The Economist Newspaper and The Economist Group. All rights reserved.