I recently got hold of the first 50 million prime numbers and decided to play around with this dataset.Yiting Zhang’s recent work on the distribution of primes piqued my interest in visualising the consecutive differences between primes.

I decided to use a random walk procedure where the initialising direction is randomly chosen from a unit vector selection of {left, right, up or down}. The first step is then randomly chosen from one of the two directions orthogonal to this initialising vector. The magnitude is determined by the prime difference at each step.

Below are some figures for different numbers of prime differences:

2D random walk for (1 million - 1) prime differences

2D random walk for (1 million – 1) prime differences

2D random walk for (20 million - 1) prime differences

2D random walk for (20 million – 1) prime differences

2D random walk for (50 million - 1) prime differences

2D random walk for (50 million – 1) prime differences

Here’s the R code for the random walk procedure:

step = matrix(c(0,1,0,-1,1,0,-1,0),nrow=2,ncol=4)

x_pos = rep(0, length(primeVec))
y_pos = rep(0, length(primeVec))
move_initial = step[,sample(c(1,2,3,4),size=1)]
for(i in 2:length(primeVec)){
	index = which(move_initial%*%step==0)
	move_new = step[,sample(index,size=1)]	
	dx = move_new[1]*diff[i-1]
	dy = move_new[2]*diff[i-1]
	x_pos[i] = x_pos[i-1] + dx
	y_pos[i] = y_pos[i-1] + dy
	move_initial = move_new
}
time = Sys.time()
plot(x_pos,y_pos,type='l')
legend("topright",col=1,lty=1,legend=time,bty="n",cex=0.8)

The figures above are all quite unique and this increases as the number of steps taken increases. I’ve decided to time-stamp each of the three figures as it is highly unlikely that these exact figures are to appear again. More concretely the probability of each individual sequence occurring is 0.25x(0.5)^(n-1) where n is the number of prime differences.

At a higher level, the highly stochastic nature of these random walks draws some very interesting parallels with the indeterminate nature of human life. The everyday and mundane (work routine, observations on way to get coffee) that we take for granted may not be so when you consider that they may not appear in that exact form again in your lifetime.

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Fragility

The economic history of the last century has been marked by sinusoidal swings between government fine tuning of the economy and free markets. The triumph of war time planning had brought Keynesian economics on to the world stage. Today we see a re-emergence of Keynesian ideas, though with markedly different outcomes.

The trusted tools of conventional monetary policy that have been used for over 70 have seemingly had very little effect. Lowering interest rates decreases the cost of borrowing for agents in the economy and in practice does stimulate growth, however such policies may have limited effects for highly leveraged countries. A 2009 paper published by Rogoff and Reinhart found that empirically, countries with a debt to GDP ratio of greater 90% face a 1% lower median growth rate. Clearly the circumstance under which debt is accumulated is critical to understanding the effectiveness of fiscal and monetary policies.

Central bank balance sheet as a percentage of GDP

Central bank balance sheet as a percentage of GDP

War-time debts are less problematic given the transfer of organized labour to the civilian economy and the cessation of war spending as hostilities cease. Excessive debt accumulated under peace time can be harmful to long term growth prospects. The Federal Reserve, Bank of England, ECB and the Bank of Japan have significantly increased their balance sheets since the summer of 2007. Whilst a large amount of the initial balance sheet increase was attributed to direct investments in companies and the purchase of toxic assets, the recent growth of the balance sheet is primarily from the use of unconventional monetary policies devised to work around the zero bound on nominal interest rates. Credit easing, quantitative easing, and signaling are the new tools which central bankers are using to bring life back to the global economy. In theory the outright purchase of long dated securities to flatten the yield curve should promote savers to investment their cash into the economy.

To date it is arguable how effective these policies have been. Whilst major global equity indices have rallied back to their pre-crisis levels, there is a disconnect between financial asset performance and the real economy. Unemployment in the U.S. has remained stagnant below the 8% mark (refer to previous page chart), while the situation is far worse in Eurozone. This disconnect could be indicative of either an investor preference to allocate cash to financial markets versus traditional job generating investments in hard assets, or the limited effects of monetary policy given a series of debt related crises around the world. I believe it is a mix of both of these factors which have stunted the effects of expansionary monetary policy. Central bank balance sheets and national debt levels have grown to such an extent that they pose very credible long term dangers to the global economy.

Major global indices have recovered; different story with unemployment

Major global indices have recovered; different story with unemployment

In an environment where asset prices have been inflated due to record low interest rates, there are very few asset classes which remain undervalued. Moreover, the notion of being long in an asset that is undervalued will become increasingly difficult to justify. If anything, the dangers of advanced economy leverage poses more risk to inflated asset prices. In this environment, it is much easier to look for the low hanging fruit which run contrarian to recent market trends. A very attractive asset class which offers asymmetric payoffs is credit protection and more specifically, Japanese credit default swaps (CDS)

Japan has for years accumulated significant debts in an attempt to stimulate its economy through both fiscal and monetary policy. From 1990 to fiscal 2013 outstanding government debt grew from 166 trillion to 750 trillion yen (excluding FILP bonds ). This represents an annual growth of approximately 7%.

Outstanding JGB and interest payments as a percentage of government tax revenue

Outstanding JGB and interest payments as a percentage of government tax revenue

Meanwhile, government tax revenue has fallen sharply from their peak in 1990 of 60.1 trillion to 42.6 trillion yen as of 2012. Whilst interest payments remained largely stable in the 1990s and dropped during the first decade of the new millennium, this was largely due to the successive lowering of official cash rates which allowed the Japanese government to refinance its debt. As of January 31st 2013, the year 10Y Japanese Government Bond (JGB) yield stood at 76.3 basis points. Shorter tenure bonds such as the five year JGB yielded 15.2 basis points.

JGB 10Y spot yield

JGB 10Y spot yield

While monetary policy has allowed Japan to refinance its government debt at historically low rates, its interest to tax ratio has slowly increased over the last two years. When more than 20% of expected government tax revenue is to be spent on servicing debt there should be serious concerns over the sustainability of adding additional debt. When a country has reached such a high level of debt, the answer to growth is not to add on debt, but either growth to eliminate it or a sovereign restructuring. Unfortunately for Japan, it is also facing an uphill battle in terms of its ability to grow.

Japan faces a rapidly aging population as the baby-boomer generation go into retirement. Population growth for the country has steadily declined since the mid-1970s and is today barely above 0% per annum. What this implies for the economy is an increasing amount of pension obligations and laborers exiting the workforce with a much smaller force of young workers coming in to fill the gaps. Add to this a racially homogeneous country which despite increasing average annual immigration in the last decade has seen net migration of less than half a million between 2005 and 2010. The demographic trends for Japan highlight an obvious issue with mounting pension obligations and a lack of young workers to grow the economy.

Proportion of population over 65 (LHS) and net population growth rate (RHS)

Proportion of population over 65 (LHS) and net population growth rate (RHS)

Immigration (LHS) and net immigration (RHS)

Immigration (LHS) and net immigration (RHS)

On top of all these fundamental issues that still plague the Japanese economy, the latest move by the Bank of Japan to adopt a 2% inflation target as well as a commitment monthly purchases of 13 trillion yen of financial assets poses additional dangers to an already fragile Japanese economy. The reason being the signaling effect that such a measure should in theory have in the bond market and secondly the further growth of the Bank of Japan’s balance sheet.

Since 2009, Japan has experienced average annual deflation which has given JGB holders a higher real interest rate. The issue with raising inflation expectations to 2% is that in theory bondholders should demand a higher cash coupon on new JGB issuances to compensate for the inflation. While this has phenomena has yet to occur in the JGB market, the BOJ’s announcement has had significant effects in devaluing the yen.

A further look into the ownership structure of outstanding JGBs reveals some technical factors which may have hindered a rise in yields in the JGB market, but which also point to additional concerns. As of Q3 2012, foreign owners of JGB stood at only 9.1%, whilst domestic banks, life insurance companies and pension funds owned more than 70% of the outstanding JGB stock. The huge domestic ownership has allowed the Japanese government to continue monetizing its deficit without too much concern for capital flight. This however has created a very dangerous feedback loop for the government to continue piling on debt.

Outstanding JGB holdings

Outstanding JGB holdings

Should the Abe government attempt to inflate away its debt obligations, it will run into serious issues with future deficit financing. While the average maturity of newly issued JGBs have steadily increased in the last three years, the Japanese government runs the risk of lowering average JGB issuance maturity due to the inflation risk posed by its policies. Moreover the delicate balance held together by domestic JGB holders will not last forever. Domestic pension and insurance companies will run into financing issues when their nominal income from their JGB holdings will not be able to meet inflated pension and claims payouts.

Average JGB issuance maturity

Average JGB issuance maturity

It is perhaps surprising that Japanese five year CDS spreads have in fact tightened since February 2012. Assuming a 60% default recovery rate, Deutsche Bank data suggests an implied annual default probability 1.7% as of Feb 6th 2013, which is significantly lower the same period a year ago despite continued debt accumulation and low growth prospects.

JGB 5Y CDS spread (LHS) & implied default (RHS)

JGB 5Y CDS spread (LHS) & implied default (RHS)

In this era of unprecedented central bank easing, asset inflation has caused a disconnect between financial markets and the real economy. Less talked about are the dangerous levels of debt being accumulated by the major advanced economies. Japan is an example of the limitations of Keynesian expansionary policies and Japanese CDS represent a greatly undervalued instrument given the country’s leverage and growth outlook.

San Francisco mapped through geotagging

Internet Through The Ages

The launch of the Mosaic browser by Marc Andreessen in 1993 paved the way for Netscape which announced its browser in late 1994. The World Wide Web would fundamentally change the way global information was structured and accessed. Credit Suisse saw early on the benefits of the internet in changing the way retail clients brought and sold shares. The incorporation of Donaldson, Lufkin & Jenrette’s online brokerage business DLJDirect was a sign of the ways in which traditional financial brokerage functions were going online and become electronic.

The fundamental difference between Web 1.0 and today’s Web 2.0 era is the establishment of social media platforms that have allowed for user generated content and greater online social interaction. The internet today is not just seen as a research tool for one to access information, but has also become a place for the dissemination of user generated content. Thus, in the absolute the biggest change that web 2.0 social has brought is a key decentralization in the ways in which information is generated and shared. This distributed internet architecture today has led to an explosion of user data, which holds immense opportunities to revolutionize the core businesses for various aspects of the financial services industry.

Data Explosion

Today’s social media platforms have benefitted from network effects derived from two structural changes in internet usage. Growing penetration of high speed internet in developed and developing countries have increased exponentially in the last decade and this trend has been complemented by an increased willingness to put authentic personal information online. According to the Cisco VNI index, monthly internet traffic will expand fourfold globally from 2010 to 2015, while the number of smartphones globally could well hit five billion by 2015 according to Marc Andreessen. Growth of the internet from the first internet bubble to today has been immense and remains strong going into the remainder of this decade.

The result of these two structural shifts in internet usage combined with smartphone penetration has led to an explosion of personal data. Social media sites like Facebook or Twitter have been immensely powerful in convincing people to willingly hand over their personal information, friendship associations, interests, as well visual identifications of themselves and friends. This treasure trove of data is immensely valuable.

As heavier regulation comes down on more risky securities businesses, core commercial lending businesses will take on more importance in revenue contribution for universal and commercial banks. Better Bayesian prior updates have the potential to revolutionize the traditionally rigid commercial banking services to customized services for more nuanced customer segments. Hunting for signals of particular customer needs can now be done through large scale data mining on social media portals. For instance, a client tweets a photos of an apartment that she has inspected for purchase to ask for feedback. This information once picked up can be used for targeted marketing of home loan services to this particular client.

The realization that social media is an intelligence platform for financial institutions is crucial. Better intelligence gathering leads to more robust competitive strategies, but also leads to quicker product feedback. Setting up social media profiles is one step, but machine learning and data science specialists must be employed to fully capture the richness of personal information and opinions disseminated through social media.

Data Driven Decision Making

As proprietary trading is being clamped down for universal and investment banks, flow trading for clients will become increasingly important. The distributed architecture of the internet today means that a lot more people can become citizen journalists reporting on events around them. The sheer size of the global social graph means that this information has the ability to reach a wide variety of people and companies – including trading desks.

The ability now for everyday citizens to disseminate information has to some extent been very disruptive to traditional media which have relied on a limited number of journalists to cover a wide range of events. Oftentimes, natural disasters or unexpected events are more quickly reported by direct witnesses through social media platforms like Facebook or Twitter. A notable example of such social media use was during the Egyptian revolution of 2011, where citizens were able to paint a clearer picture of the unrest through localized social media reporting. This information when aggregated can be of immense value to flow trading desks. For instance, a hypothetical confrontation in the Strait of Hormuz reported by eyewitnesses on Twitter could hit the internet quicker than the reporting from various news agencies. Given the electronic execution of today’s trading desks, an integrated social media listening tool could be utilized to gain an information advantage and thus execute trades for clients on more favorable market terms.

Similarly, such an information advantage could also be exploited to generate trading signals for investment managers. The concept of using the immense amount of information available is not unfamiliar to investment banks. For instance, UBS has used satellite images of Wal-Mart store parking lots to get a more accurate estimate on quarterly earnings. An obvious extension of such intelligence gathering techniques is to the realm of social media. A string of time-stamped Twitter updates on a new product launch could be aggregated to get an idea of the perception of a new product amongst a diverse group people. This information could then be used to make a decision on the position to take for the given company. This is especially relevant given that more people are covering events via Twitter. Social media thus provides in some cases an information advantage, but also interesting signals that could be utilized by sell-side flow trading desks, but also independent proprietary desks at hedge funds and asset managers.

Crowdfunding – The Future?

For every day citizens, the capital raising process is something very esoteric and relegated to the ranks of financial services firms and institutional investors. The distributed internet architecture has made the prospect of crowdfunding large private or government projects a possibility.

As developed cities face an increasing financial strain to repair or build new infrastructure, crowdfunded solutions could be the solution. Rather than raise taxes, small infrastructure repairs or upgrades could be hosted on a crowdfunding site owned by a securities firm. This solution provides inherently more clarity in the end use of a constituent’s capital contribution versus paying taxes to the city or state government. A hypothetical scenario would be the ability for citizens to upload visual images of derelict sites in their neighborhood to a crowdfunding platform. Citizens whom share a similar interest in the infrastructure overhaul could contribute online to such a project, where the pooled funds are overseen by a securities firm which then transfers this crowdfunded pool of capital to the city council to implement the necessary repairs. This is one example of possible crowdfunding in the public finance space, there may be other very interesting applications. The key takeaway is that as these low hanging infrastructure projects and repairs are moved to the crowdfunding platform, city planners can focus on allocating capital to bigger projects given their tighter budgets.

In the U.S., the JOBS Act is a bill that could potentially open up even large scale statewide projects to citizen investors who will be allowed to invest up to 10,000 USD online. Though initially for startup funding, it is conceivable that infrastructure projects could soon be allowed to be partially funded through such a platform.

Though crowdfunding sites like Kickstarter or Indiegogo exist, the backing of a global financial adds credibility. The entrance of financial services firms to crowdfunding is a complement to existing donation based sites and would provide their institutional clients a new source of potential investors.

Reserve currency war?

The 2008 Financial Crisis marked a major turning point for the global economy but also a challenge to the economic hegemony which the United States has enjoyed since the end of the Cold War. Today, the United States is experiencing both a financial weakness, but also a steady decline in its image as a global superpower given its foreign policy actions in the past decade. Though originally touted as a viable successor to the USD, the Euro has lost such considerations in the face of the ongoing European debt crisis.

A reserve currency is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. If we look back historically, no one currency is immune to be dethroned as the global reserve currency. The British Pound faced a gradual decline after World War I and a complete replacement by the USD after World War II. The Cold War’s polarization of nations around the world around ideological lines provided a great platform for the United States to extend its influence around the world under the guise of combating Communism. With this greater influence came the political and economic alignment from allied nations with the United States. Thus, it is clear that the rise of the USD was very much connected with the United States’ foreign policy during the Cold War era. With the Soviet Union disbanded, the spread of capitalism became truly global and we entered into a new era of globalization which has also shown the complexities of large financial flows to destabilize economies.

In much the same way that the Bretton Woods agreement sealed the fate of the British Pound as a reserve currency, the 2008 Financial Crisis represented a similar unforeseen but large disturbance in the global political and economic landscape. We are now beginning to see China gradually chipping away at the economic hegemony of the United States, with its own diverse set of soft power tactics. China’s large reserve of over three trillion USD has been a potent weapon in its bid to expand its global reach. Outbound Chinese M&A activity such as Lenovo’s acquisition of IBM in 2005 demonstrate the subtle but continued Chinese strategy of appropriating its pent up reserves globally to increase its power projection. More recently, China’s heavy investment globally in an attempt to secure its energy future has put significant Chinese presence in countries such as Angola or Venezuela. Though these countries represent more of ideological allies with the Chinese Communist government, China’s recent offer to purchase Greek bonds is again a sign of their gradual build-up of their foreign power base. If we were to compare this phenomenon in the absolute with the United States’ policies of aiding countries fighting against Communism, then we see some striking similarities which would suggest that China is well on its way to establishing the global influence needed for the widespread use of the RMB.

In the context of China, the political situation is very unlike that of the United States or the United Kingdom at the time of their respective currency ascendency. Though China possesses aspects of a modern market economy, it is today a unique mix of ideological communist governance with the economic benefits of its liberalized economic policies. However one key aspect of its growth model which in its current will limit the adoption of the RMB is its fixed exchange and stringent capital controls imposed by the Chinese government. Though, the People’s Bank of China has over the past decade has let the RMB appreciate on several instances against the USD, the topic of the fixed RMB exchange rate is still a contentious issue today. For the RMB to be a true reserve currency, its exchange rate would have to be allowed to float against other major currencies. Though this is unlikely within the next decade given that such a move would considerably undermine the competitiveness of Chinese exports, there are some fundamental changes in the Chinese economy which hint that the importance of keeping the RMB fixed is waning in the eyes of Chinese policy makers.

Over the past decade we have seen a gradual transition from the export-driven model to the production of higher value-add products, but also the development of a service economy domestically as rising incomes facilitate the demand for luxury goods and services. The Chinese economy has been able to facilitate the development of more high tech manufacturing such as solar cells and the active development of domestic Chinese companies in the technology space (Lenovo, Haier) demonstrates a desire on the part of the central government for China to gradually switch to a consumption economy like that of the United States. Another factor which could curtail the dominance of Chinese manufacturing is the large relative increases in wage rates for workers in manufacturing. It is conceivable that China could have less of a role in global manufacturing as other developing nations like Vietnam come in to take up Chinese output with its cheaper labor. Given these broad economic trends within the Chinese economy, the importance of the RMB fixed exchange rate could significantly diminish in the coming decades thus allowing for a liquid global market for RMB.

Exchange rate aside, the Chinese government has made significant efforts to increase the volume of RMB traded globally and facilitate the creation of markets for RMB denominated securities. Recent efforts to popularize the use of the RMB though ‘dim-sum’ bonds which are corporate bonds denominated in RMB have grown exponentially. China has also negotiated with Brazil to settle trades in RMB. In addition to these steps there have been recent measures to develop Chinese financial markets with the launch of Chinese options and futures markets. The recent innovations in Chinese financial markets demonstrate a gradual sophistication of the Chinese financial system and it is likely that over time, a large market for RMB denominated securities will emerge. This process however will be slow and may likely take decades.

Though trends in the central government’s stance towards establishing freer financial markets for the RMB have been promising, there is a big but less obvious setback for the RMB and this involves both China’s political relations going forward with its major trade partners, but also general concerns around governance and stability. Since its economic reforms, China has steadily built its relations with the developed West, however this relationship can be characterized as being more along trade than any political or cultural lines. Issues around human rights, corruption and fake products are some of the sensitive political issues which have caused tension between China and the United States. Furthermore, provincial rioting and the lack of free speech lead to concerns over further domestic tension which may undermine stability. Unlike the Bretton Woods agreement, which was more or less a transfer of reserve currency status among allies in WWII, the rise of China is a phenomena which has caused political unease in the established West. It remains to be seen if countries such as the United States or United Kingdom will readily adopt the RMB as a reserve currency given their undercurrent of political tension with China. An alleviation of such contentious issues would require a drastic reform of the central government and thus is the greatest challenge to the RMB achieving reserve currency status. Assuming continued growth and the promotion of the RMB, it is likely that the central government will gradually reform to stay in power and maintain stability.

There has been much talk of the rise of China as a challenger to the United States. In actuality this is to some extent an exaggeration given the many domestic political and economic problems which the Chinese leadership must address. History has shown that a change in the reserve currency is gradual and takes place over decades. The United States today is financially weak and arguably in a decline, thus it is conceivable a new currency may take the USD’s reserve currency status. The RMB has the potential to achieve this status given China’s extensive trade relations and its active efforts to project soft power globally. The obvious hurdles of fixed exchange rate and limited financial markets are issues which are already being addressed and will likely change in decades as the Chinese economy adjusts its growth model. The more serious hurdle is the political tension and perception which hold China back as a benevolent global power and hence also the global adoption of the RMB. It is however plausible that the Chinese government will undergo a gradual form of reform in the coming decades to allow the RMB to become the world’s next reserve currency.

I’ve always pondered the significance of unfolding global events and its relevance in the grand narrative of defining an era. For me the following events in history have really caused a cataclysmic shift in global geopolitics and power dynamics:

Berlin Wall (1989)

Berlin Wall 1989

Important here for its symbolism of bridging a divided Europe ever since the end of WW2. The fall of the Berlin Wall signaled a sea change in the Cold War.

USSR Dissolution

Kremlin Coup

The binary opposition of political and economic ideology was to be no more after the dissolution of the U.S.S.R. The world entered into an era of increased globalisation as capitalism spread across the world. There was a profound new sense of global cooperation as coalition forces fought to free Kuwait in the first Gulf War, which was to be followed by interventions Somalia and Bosnia.

Asian Financial Crisis (Global Contagion)

Hong Kong Skyline

The truly interconnected nature of global economies was to be felt with the onset of the 1997 Asian Financial Crisis. An economic crisis that originated in Thailand was to set off the default of Russia in August 1998 and the downfall of Long Term Capital Management. This crisis exposed the truly fragile nature of the new global economic paradigm.

September 11, 2001

911 Memorial

An unforgettable day which would lead to two conflicts and exorbitant spending on the part of the U.S. government.

Lehman Brothers, September 15, 2008

Lehman Brothers NY HQ

Though Bear Stearns went down in March 2008, the collapse of Lehman was truly momentous for it set off a wave of panic across global financial markets. Marc Andreessen mentioned in CS 183 class the scarring effects of the 2000 internet crash on industry people. One has to wonder how the 2008 Financial Crisis has affected those who were old enough to discern the implications of such a momentous time in history. Only time will tell.

I do not necessarily see the current European debt crisis nor the public backlash against Wall St. as a zeitgeist moment for this new decade. Rather these events in aggregate are the derivative of what unfolded in 2008, with the Lehman HQ image being the symbolic image of the Financial Crisis.

The new age we have entered into is one which is fundamentally indeterminate. I say indeterminate due to the seemingly indecisive nature of global governments to settle upon an economic philosophy and to proceed with it. After 2008, one had a real sense that the unfettered free market capitalism advocated by the likes of Milton Friedman, Ronald Reagan and Larry Summers was coming to an end and that Keynesian policies were making a comeback. It is true that the capital injection aspect of Keynesian economics has made a comeback, but there is also a real sense of inconsistency in some of the policies that have been implemented.

The unfolding European debt crisis is a prime example of inconsistent policies, where fiscal austerity as a way out has now been challenged by rival Keynesianesque policies of government spending. It is this back and forth indecision which has to some extent dragged on and escalated the debt crisis that originated out of Greece. Now almost four years since Lehman, there is a real sense that governments around the world are broken, indecision and infighting almost brought the U.S. to the brink of default in August 2011.

There is a very real sense that the global economic and political power has been fragmented since Lehman. China has steadily chipped away at the economic hegemony of the U.S. and is now in a position to provide capital to debt laden developed countries. We are living through a very interesting age of global power dynamics shifts. It will be interesting to see what the next zeitgeist moment is.

Smart defence: a call for further NATO integration

The establishment of the EU in 1993 marked a major step towards greater European integration. In the wake of the 2008 Financial Crisis and the ongoing European Debt Crisis, EU nations have more than ever been constrained by dwindling fiscal budgets for military spending. As a means of greater fiscal consolidation, NATO nations must seek greater integration of their defence capabilities to avoid unnecessary duplication and cost overruns.

In a world where there is increasingly fragmented power, NATO is no longer facing the imminent threats it faced during the Cold War. The fall of the Soviet Union marked a transition from mass-scale warfare through the Fulda Pass to more localized conflicts. The interconnected nature of the global economy means that it is very unlikely that NATO will face a similar threat like it did with the Soviet Union. It is time for NATO to adapt to evolving threats it is currently facing and its tighter fiscal situation.
Instead of the replication of capabilities by individual nations, it is far more cost efficient for countries to specialize on their own areas of immediate need and skillsets. For instance, Bulgaria which is largely landlocked and has only naval access through the Black Sea contributed a frigate to the Libyan naval blockade in early 2011. It can be argued that given its geographic location and the small scale of its existent navy, that it would be far more cost efficient for Bulgaria to allocate its defence budget to more tangible ground forces. Bulgaria’s navy is a clear example of unnecessary defence expenditure in outdated equipment which would not standup to threats faced by more advanced adversaries. A more pertinent example of deadweight loss in defence spending is in Greece, whose Elli Class frigates do not have the capabilities possessed by the more advanced frigates of the English and French navies. It is unlikely that the naval capabilities of Greece or Bulgaria would be able to confront the threats faced by more advanced adversaries. The examples outlined above demonstrate that such capabilities are no more useful than to maintain a false sense of strategic security for a nation.

Specialisation of capabilities is very necessary given the tighter budget constraints faced by NATO members in the ongoing European Financial Crisis. In order for NATO members to move away from a diverse set of capabilities there must be agreements set in place for members to specialize and deploy their capabilities in a regional role. For instance, in order for Greece to scale back its outdated navy, a larger NATO member such as France may have to step in to guarantee regional protection for the Mediterranean. NATO members must familiarize themselves to the concept of a regional defence network as opposed to a defence limited by a member nation’s boundary. In giving up some capabilities, member states will become more tightly integrated given the need to coordinate different military assets in a regional defence scheme.

In order for a regional defence system to be coordinated, a follow on action must be a more uniform adoption of military equipment. In the past, the introduction of the NATO 5.56mm round marked a great step forward in unifying ammunition on the battlefield. More of such integration is necessary with other military capabilities such as fighter jets and ground forces. The joint development of the Eurofighter was another great development in further integration, but member states still possess different fighters in their existing fleets which make munitions sharing difficult for a truly regional defence network to be set up. Though there are economic arguments for defence manufacturers to come up with their own designs such as the French Rafale, more collaboration and joint ventures would forego this need to develop off the shelf designs as a revenue source. A broad mandate for the common adoption of newly developed fighters through defence contractor joint ventures would one allow better integration of munitions sharing and refueling capabilities. Secondly, the purchase of NATO produced equipment would keep more spending circulating amongst EU defence contractors. A notable example of defence outflows was with the Danish and Dutch purchase of F-16 fighters. Further integration will require clear mandates for NATO members to adopt common equipment such as the Eurofighter when they replace their existing aircraft fleet. Similar strategies can be implemented with ground vehicles.

In conclusion, greater NATO integration requires the establishment of a regional defence mindset. Member states must be willing to retire capabilities that are no longer competitive and specialize in areas of their strength. Secondly, there must be more joint NATO developed weapon systems and mandated adoption for member states as they begin to rollover their older military hardware. These measures will ensure a more effective NATO force in these lean times, whilst also promoting further integration and peace across the region.

Butterfly effect

Election Year: Best Response Strategy for Obama

The escalation of the Iranian nuclear standoff this year with Western sanctions and the threat of an Israeli preemptive strike on Iranian nuclear facilities. Amid the politics and rhetoric it is interesting to see how the United States’ collective action with the EU to impose an embargo on Iranian has put it in a reactionary role to Israeli foreign policy.

Wanting to gain a deeper understanding of the perspectives of Turkey and Israel in this standoff, I recently reached out to Bloomberg Op-Ed Efrain Inbar, Soli Ozel and Dmitry Trenin to get a feel for the ways in which this crisis can be resolved. It is interesting to see here two contrasting views on how to deal with Iran. Whereas the United States has looked at preventing Iran obtaining nuclear weapons in the absolute, the Russian and Turkish approach has been based on the idea that Iran will eventually obtain a nuclear weapon no matter how many setbacks they face and hence it is better to integrate into the global community as opposed to shutting it out. Israel on the other hand has had a history of covert strikes against nuclear programs, with one on Iraq in 1981 and more recently in Syria back in 2007. Clearly Israel has shown its propensity to preemptively remove threats from its hemisphere of influence before. The Israeli mentality towards a strike on Iran is not so much a question of whether or not to strike, but at what cost to strike. It would appear that risk calculus has now tipped in favor of a preemptive strike. All this puts the United States and particularly president Obama in a tight spot given that its election year.

Though Obama has gained some political capital with the killing of Bin Laden in 2011, the more than decade long U.S. military involvement in Iraq and Afghanistan is not far from the voter’s mind. Having pulled troops out of Iraq last year, the prospect of another U.S. Middle East conflict causing more U.S. spending and costing U.S. lives is not something most voters would like to deal with. Yet on the other hand, the incumbent President is also at risk of appearing soft on U.S. foreign policy in front of Republican attack. Obama is thus truly between a rock and a hard place in terms of the Iranian nuclear standoff. He must appear strong in U.S. policy denouncing Iranian nuclear ambitions, yet also not go far enough to give some illusion to Israel that U.S. would launch a joint effort to preemptively strike Iran.

Israel Calling The Shots

Given Obama’s predicament, it would appear that the U.S. for the time being has switched to a reactionary posture towards Israeli foreign policy. Israel could be argued to be the lynch-pin in this entire situation.

Let us conduct a little thought experiment here on how this chess game will unfold should Israel attack. A preemptive strike whether successful or not would likely prompt Iranian retaliation as a means of saving face, but also the closure of the Strait of Hormuz (again to follow through on the bluff). An Iranian counterattack would most likely materialize in the form of long range missile bombardment, Israel’s response is really anyone’s guess. But more importantly though, an Iranian closure of the Strait of Hormuz would more than likely draw the United States into direct contact with Iranian forces on the premise of global energy security.

If we go back in history, the ‘Tanker Wars’ of the Iran-Iraq conflict drew the Soviet Union and the United States into an escort role in the Persian Gulf. Given the structural change (Chinese demand) in global energy demand these days, it would appear that the United States would be even more inclined to protect a vital waterway for the world’s crude oil supply. Nonetheless, a direct confrontation would be won by the United States, but at what cost?

Impact On Oil Markets

Though the collapse of the Soviet Union has enabled the development of large reserves in the Central Asian countries of Kazakhstan, Azerbaijan and Turkmenistan, oil from the Gulf Region still represents a sizable portion of global daily demand. In 2011, an average of 14 tankers carrying 17 million barrels per day passed through the Strait of Hormuz. That’s a huge amount of oil that would be removed from the global markets! The bigger issue today with oil trading is the rise of paper and electronic trading, which has made oil a truly fungible commodity. Thus, the rise of global oil markets has also brought about the risk of market overreaction to supply disruptions, as we saw in 2008. Thus any such disruptions in supply would be reflected in a dramatic increase in spot prices. With that being said it is most likely we see Dubai Crude exhibit pricing deviations with Brent and WTI prices.

Though the U.S. Strategic Petroleum Reserve has the ability to some extent ease prices, the dual impact of high oil prices in a weak U.S. economy and the uncertainties of the duration of a U.S. conflict with Iran do not bode well for the incumbent President in election year. It is extremely fascinating to see how minor action could have such wide reaching effects around the world.