- John Kemp is a Reuters columnist. The views expressed are his own --

As hopes for reaching a binding agreement to cut greenhouse gas emissions at the Copenhagen summit die, climate negotiators could learn useful lessons on how to structure the negotiations from the multiple rounds of trade talks within the GATT/WTO framework.

Climate negotiations are about limiting carbon dioxide emissions, but the negotiators are also hammering out a complex economic instrument that will define the distribution of production, energy use and income in the next few decades. It is the agreement's profound economic effects that are making it so hard to reach a final deal.

While the stalled negotiations on the Doha Round might make it seem likely an unlikely role model, the GATT/WTO process has successfully created a legal framework for liberalising world trade through eight successive rounds of increasingly complex negotiations, as well as a dispute settlement system accepted by all major countries.

In the process, negotiators have already had to resolve many of the difficult issues bedevilling attempts to reach an emissions deal:

* How to obtain treaty commitments from a huge range of countries at different stages of economic development.

* How to handle negotiations with the United States, given the peculiar nature of that country's constitutional arrangements.

* How to ensure countries live up to their commitments and resolve subsequent disputes about treaty implementation.

Climate negotiators could usefully apply many of these lessons to their own agreement. As Copenhagen falters, they may need to rethink the "road map" for talks to improve the chance of bringing them to a successful conclusion.

FRAMEWORK AND DETAILED SCHEDULES

The 1947 General Agreement on Tariff and Trade (GATT) established a legal framework and general principles for trade liberalisation. But detailed tariff reductions as well as commitments on subsidies, dumping and technical barriers were left to a later series of trade rounds. These commitments were then turned into schedules of concessions for each member country and incorporated by reference into the central treaty.

Negotiations started with a series of limited tariff reductions that were gradually made more ambitious. Part IV of the GATT, added in 1966, guaranteed developing countries "special and differential treatment" to encourage them to become involved in the tariff-reduction process and make their own binding commitments.

For each round, political leaders set broad objectives at the outset, but the detailed exchange of "concessions" was handled by lower-level officials in a Trade Negotiations Committee (TNC).

Something similar is needed for the climate talks. President Barack Obama has already backed a "two-step" process. Political leaders would aim for an "operational agreement" at next month's summit while leaving a legally binding agreement until 2010 or later. [ID:nSP280582] The aim is to ensure agreement on the big issues is not held hostage to myriad disputes over the details.

It might make sense to separate an agreement on the broad framework (including establishment and review of targets, trading emissions allowances, technology transfer, funding, and dispute settlement) from the details (including specific reduction targets and how much developed countries pay their developing counterparts to help mitigate the costs of technology upgrades).

It might also make sense to agree fairly easy reductions in the first round, then hold further negotiations in coming years to make targets more ambitious, using salami-slicing tactics rather than a big-bang approach. This would also allow developing countries to adopt modest emissions cuts in round one, with the aim of toughening them further in subsequent talks.

But for a two-step process to work, political leaders must give clear instructions to lower-level officials responsible for detailed negotiations (including clear scope for eventual concessions). If not agreement will become bogged down over relatively small differences in percentage reductions, as the Doha Round has become stalled over farm subsidies and tariff cuts for developing countries.

THE PROBLEM OF SENATE RATIFICATION

Trade negotiators are already used to the idea that an agreement is subject to a "double lock." Deals require approval at international level and by the U.S. Congress (either by a two-thirds majority in the U.S. Senate if the deal is presented as a treaty, or a simple majority in both houses if the deal is presented as ordinary legislation).

The existence of this double lock confers an advantage on the United States since other countries have to negotiate twice -- once with the administration and then again with Congress. Having given one set of concessions to the president's officials to secure a deal, other countries may have to make even more concessions to get the deal approved by U.S. legislators.

To encourage countries to make meaningful concessions without fear the final deal will be re-opened, U.S. presidents have often been required to obtain "fast-track" negotiating authority binding Congress to a straight up-or-down vote within a set time on the results of a trade round.

Negotiations are usually structured as a "single undertaking" in which every commitment or concession is part of a whole and indivisible package and cannot be agreed separately: "nothing is agreed until everything is agreed."

In terms of sequencing, trade negotiators have usually sought to reach an international agreement first and then presented the deal for congressional approval.

Until now, the climate negotiations have been using the opposite approach. The Obama administration has sought to obtain an ambitious climate bill including cap-and-trade from Congress (HR 2454, S 1733) and then use this to persuade developing countries such as China to offer significant emissions reductions at the international level.

But experience with trade negotiations suggests that an international deal precedes U.S. action, and does not come after it. It is unlikely Congress will agree to stringent targets without some assurance other countries will follow suit, including large future emitters such as China and India. So the international track may need to move first, or at least in parallel.

The Obama administration needs to harvest a number of provisional commitments from its international partners to have any hope of getting a climate bill through the Senate. If it is structured as a single undertaking, the various parties would offer tentative commitments. Once a deal is done, it would be taken back to the Senate to be incorporated into U.S. law.

The only question is whether the president would need to obtain some sort of fast-track authority. This is probably not necessary as long as the president's Democratic Party controls both houses of Congress with comfortable majorities.

But it does set a deadline for a deal. Negotiators would need to reach agreement by next summer, well ahead of the 2010 mid-term elections, unless the Democratic Party appears on course to retain comfortable majorities, in which case negotiations could take longer and still reach a successful conclusion.

DISPUTES, NULLIFICATION, IMPAIRMENT

U.S. lawmakers are already suspicious that other countries will not adopt meaningful targets or will cheat on those they do agree. So any climate deal will need a mechanism for settling disputes. If not, countries are likely to retaliate unilaterally against partners they believe are not living up to their commitments, which could unravel the whole system.

From the beginning, GATT Article XXIII allowed a country to request formal consultations with another treaty member if it believed expected benefits under the agreement were being "nullified or impaired," and this has been worked up into an increasingly formal and effective dispute settlement system.

If emission targets and aid packages are structured as part of a mutual exchange of concessions among treaty signatories, so one country's targets are conditioned on other countries meeting their own, the climate treaty will need a similar dispute mechanism.

Rather than attempt to create one from scratch, it would probably be better to use the WTO system as a template and modify it to take account of the climate accord's unique characteristics.

– John Kemp is a Reuters columnist. The views expressed are his own —

Both Goldman Sachs and Morgan Stanley reduced the size of their commodity trading books during the third quarter, according to their latest filings on Form Y-9C (”Consolidated Financial Statements for Bank Holding Companies“):
While the gross fair value of physical commodity inventories held on their balance sheets rose — sharply in Goldman’s case — the gross fair value of the commodity contracts was down.

Most of the shrinkage came from smaller positions in exchange-traded futures contracts, as well as a reduction in over-the-counter (OTC) options. OTC swap positions also fell.

But the gross notional value of forwards was little changed.

– John Kemp is a Reuters columnist. The views expressed are his own –

Resounding defeats for Democratic Party gubernatorial candidates in Virginia and New Jersey on November 3 have killed any lingering hope Congress will enact climate change legislation this year, and may doom the prospect of passing a cap-and-trade bill this side of the 2010 mid-term elections.

Prospects for eventually passing legislation may now depend on winning Republican support with nuclear loan guarantees and more offshore drilling.

While the president remains personally popular, with high approval ratings, and does not need to face the voters again for another three years, 16 Democratic senators and 256 Democratic members of the House of Representatives will be on the ballot in November 2010.

The Virginia and New Jersey off-cycle elections are often idiosyncratic. But crushing defeats for Democrats at the top of the ticket in both states are already sparking a bout of soul-searching over the lessons that need to be learned if the party is to retain firm control of both houses of Congress next year.

What worries many Democrats is that turnout among the young voters who helped propel them to victory last year fell away sharply, self-identified independents broke heavily for the Republican candidates; and voters overwhelmingly cited the economy and jobs rather than healthcare or climate change as their major concern in exit polls.

Democrats face the classic dilemma for any party after a defeat — press ahead trying to enact a difficult agenda or pull back, re-focus on simpler and less controversial measures.

The White House insists both defeats were due to local factors (a poor candidate in Virginia, a souring economy in New Jersey) and will not change the president’s determination to press ahead with an ambitious domestic agenda centered on healthcare reform and climate change.

But the party’s congressional wing is divided. Liberals (mostly from safe seats at little risk next year) argue the administration and party should press ahead; voters will rally behind a record of accomplishment next year. Moderates and conservatives (mostly from swing seats or those carried by John McCain in 2008 or George W Bush in 2004) as well as those from heavy industrial states are pressing to scale-back and refocus on cutting unemployment.

In this context, it seems unlikely the administration can find the 60 predominantly Democratic votes it needs to pass a climate bill on the floor of the Senate; hammer out a compromise between the differing House and Senate versions in conference; then secure simple majorities in both houses to pass the agreed bill into law.

Even before this week’s election results, the prospects for passing climate change legislation this year were dimming rapidly. But the arithmetic, already challenging, has now become very tricky as the administration loses momentum.

60-VOTE DOUBT IN SENATE

In the Senate, only two Democrats are up for re-election in Republican-leaning states carried by John McCain (North Dakota’s Byron Dorgan and Arkansas’s Blanche Lincoln).

Both have already taken a cautious approach to climate legislation. Both broke ranks with the majority of their colleagues earlier this year to vote for a Republican amendment preventing the budget reconciliation process being used to push through cap-and-trade on a 51-vote straight majority rather than the 60-vote super-majority normally needed to end a filibuster.

But the party remains ambivalent over cap-and-trade, split between liberals from coastal states who want a commitment to tough emissions reduction objectives, and senators representing industrial areas or conservative states anxious about supporting anything that could be portrayed as a costly, job-killing energy tax by their opponents at election time.

In theory, the Democratic Party (together with its independent allies) has the 60 votes needed to push a climate bill through despite almost uniform Republican opposition. In practice, the party broke 26-31 in favor of the Republican amendment to the budget resolution earlier this year, in what many saw as a straw poll on cap-and-trade.

Some Democrats have fallen into line since then, and the administration may be able to pick up one or two Republican votes such as South Carolina’s Lindsey Graham with the promise of loan guarantees and other government help for the nuclear power industry.

With several Democrats harbouring concerns, though, there are not yet 60 votes for an ambitious climate bill.

The bill will not be openly defeated on the Senate floor. If it dies or gets delayed it will be in the cloakroom. Majority Leader Harry Reid will not bring it up for a vote unless and until 60 firm votes are in his pocket. So Democrats with doubts will be able to delay the bill indefinitely by holding out and asking for more concessions, without having to come out explicitly against it.

RISK OF REVERSAL IN HOUSE

The arithmetic looks as daunting in the House of Representatives. While the lower chamber has already approved its own climate bill (HR 2454) legislators will have to vote again to pass the consolidated version if and when it is agreed in conference.

There is nothing to stop congressmen changing their minds. As the election draws closer and the already bitter partisanship in the chamber intensifies, some of the bill’s earlier supporters may withdraw.

The original bill passed only by the narrowest of margins (219-212), with 44 Democrats voting “No.”

A total of 84 Democrats represent Republican-leaning districts carried by John McCain or George W Bush in 2004. It will take only a handful of further defections to sink the measure if it returns from conference.

If the consolidated bill has been toughened in line with the Senate version (S 1733), congressmen will have a ready-made excuse to claim it has gone too far.

Parties controlling the White House usually lose seats at the mid-term elections, so pressure on Democrats in Republican-leaning areas will be immense.

The party’s heavy losses in Virginia and New Jersey this week will make them very cautious.

CROWDED AGENDA, LOSING MOMENTUM

Arguably, the president has tried to push through too many ambitious reform proposals and stretched his political capital too thinly.

At the best of times, it would be difficult to get either healthcare reform or climate change through Congress when the president’s majority is an uneasy coalition of liberals and centrists. But when the president is having to deal with a recession, financial regulation, and whether to increase the military commitment to Afghanistan, it has proved impossible to rally support for them both at the same time.

Hopes that healthcare and climate change legislation could be rammed through early in the year, long before the mid-term elections, while the Republican Party was still consumed by infighting after losing heavily in 2008, have evaporated.

Climate change has become a second-order priority. The political capital needed to assemble winning coalitions for a bill in both chambers is being deployed elsewhere.

The best option for the administration may be seeking to broaden its coalition, buying more Republican support through a combination of nuclear financing guarantees and greater access to offshore drilling.

But if an agreed climate bill does not go through before the year end, its prospects next year, when legislators will be fixated on the looming elections, are no better.

(John Kemp is a Reuters columnist. The views expressed are his own)

Warren Buffett’s acquisition of the remaining 77.4 percent of Burlington Northern Santa Fe (BNSF) railroad his Berkshire Hathaway does not already own looks like a strategic bet that America’s future energy needs will be met, in large part, through a massive expansion in coal-fired power generation coupled with carbon capture and storage (CCS).

Coal is the most important item moved on BNSF’s railroads. It accounted for almost half the tonnage moved by BNSF in the first nine months of the 2009 (214 billion revenue ton miles out of a total of 444 billion) and a quarter of the company’s revenues ($2.7 billion out of a total of $10.4 billion).

BNSF’s track and rights of way are perfectly positioned to benefit from a massive expansion of the country’s coal-fired output in the next 20 years, coupled with CCS technology to curb the carbon-dioxide emissions.

BNSF controls the crucial rails linking the massive domestic reserves of the Powder River Basin, the Northern Great Plains, the Western Interior Basin and the Illinois Basin east to the main industrial centres of the Midwest and west to the major electricity demand centres in southern California.

* http://pubs.usgs.gov/of/1996/of96-092/Comp/main.gif
* http://www.eia.doe.gov/cneaf/coal/reserves/chapter1.html#fig1
* http://www.bnsf.com/tools/reference/division_maps/?menu=5&submenu=0
* http://graphics.thomsonreuters.com/109/US_ENRGY1009.gif

– John Kemp is a Reuters columnist. The views expressed are his own –

The Bank of England’s decision to continue with its asset purchase programme, or quantitative easing (QE), at the rate of 50 billion pounds per quarter in Oct-Dec, unchanged from Jul-Sep, shows bank officials are more worried about ending support for the recovery too soon than about risking inflation by leaving it too late.

The problem with QE is that you have to keep buying the same amount of assets each month to maintain the same monetary stance. With interest rates, the Bank can cut them and they stay cut. If asset prices drop with QE, it represents a tightening of monetary policy.

The Bank initially bought 75 billion pounds in the first 3 months (Apr-Jun) and then tapered this to 50 billion in the second three months (Jul-Sep) as the crisis engulfing the banking system and the rest of the economy eased. A cautious approach might have tapered the QE programme again to 25 billion in the final three months of the year before ending it entirely at the start of 2010. But the Bank opted to stick at 50 billion.

Critics point out that the programme has not achieved its announced objective of increasing bank credit and the amount of money in circulation. The rate of growth in M4, the broadest money supply measure, has risen only marginally. But that ignores the counterfactual of what would have happened to M4 in the absence of the programme — it might have fallen sharply.

Growth in the monetary aggregates is, in any event, mostly endogenous. It depends on demand for credit. In the current environment, where many households and businesses have little or no collateral, credit is impaired, and most are focused on paying down debt rather than adding to it, limited growth in M4 is not surprising. Trying to make it grow faster is like force feeding a duck to make foie gras — possible but unnatural.

QE has always been as much about restoring confidence, dispelling fears about deflation and ensuring a ready market for the safer securities banks hold as much as growing the money supply. On most of these measures it must be considered a qualified, if expensive, success. A full judgement will only be possible when the Bank has proved it can withdraw the excess liquidity in a timely manner to prevent an upsurge in inflation.

In the end, the decision to press on is driven by fears about the fragility of the current recovery, and the risk that if QE ends too soon, effectively tightening policy, whatever green shoots have emerged over the summer will be killed off by an autumn frost.

All recoveries are fragile and weak early on. While the rebuilding of inventories along the supply chain, often provides the initial boost, this must eventually be replaced by a more sustained increase in household and business expenditure.

But with their new focus on the experience of the 1930s, central bank officials worldwide are more worried than normal about doing anything to stall the recovery.

Looming over the debate is the experience of 1937, when the Federal Reserve responded to concerns about the amount of “excess liquidity” in the banking system and sharp rises in the price of some commodities, especially steel, by doubling reserve requirements on banks in the space of nine months. It effectively converted previously “excess” reserves against which the banks could lend into “required” reserves against which they could not.

The four-year old recovery (1933-1937) promptly collapsed amid tightening bank credit, and the United States suffered the second deep recession in a decade, with output not fully recovering until the onset of war in 1940-41 (https://customers.reuters.com/d/graphics/DSTMIRROR.pdf).

Anxious to avoid a repeat, it is no wonder that the Bank of England is in no hurry to tighten policy. While this level of QE must eventually generate inflationary pressures, the Bank judges, probably correctly, that it still has some time before policy needs to move to a more restrictive setting.

-- John Kemp is a Reuters columnist. The views expressed are his own --

Like Archbishop Thomas Cranmer before he was burned at the stake for heresy, the U.S. Commodity Futures Trading Commission (CFTC) seems about to make a dramatic recantation.

Later today, the Commission will hold the first of three public hearings to discuss whether to impose tougher position limits in energy markets and restrict the availability of hedging exemptions. But it is already preparing to release a report that will accuse speculators of playing a significant role in last year's oil price spike, according to a report in the Wall Street Journal.

While it might seem a minor shift in emphasis, it is a radical reversal of the Commission's previously stated view that there was "no evidence" that investment flows had a material impact on prices. Commission staff have doggedly maintained that physical supply and demand factors could explain all the observed volatility in oil and other commodity prices over the past two years.

The position was stated most forcefully by CFTC Chief Economist Jeffrey Harris in testimony to the House of Representatives' Agriculture Committee in May 2008 (http://www.cftc.gov/stellent/groups/public/@newsroom/documents/speechandtestimony/harris-fenton051508.pdf).

It was repeated in September 2008 in the CFTC's "Staff Report on Swap Dealers and Index Traders" and again this year in a joint report with the United Kingdom's Financial Services Authority (FSA) on commodity regulation for the International Organisation of Securities Organisations (IOSCO).

The Commission's view has come under pressure from sceptical legislators as the scale of speculative positions in commodity markets and the number of exemptions the Commission and exchanges have granted have been revealed. Congressional anger threatened to derail Gensler's confirmation. The price of allowing him to take office seems to have been a promise to take a tougher approach.

The CFTC's position had become politically unsustainable. The climbdown was foreshadowed earlier this year when incoming CFTC Chairman Gary Gensler admitted in a pre-confirmation letter that "rapid growth in commodity index funds was a contributing factor to a bubble in commodities prices that peaked in mid-2008" and "the expanding number of hedge funds and other investors who were increasing asset allocations to commodities ... also put upward pressure on prices".

But most observers expected it to announce a shift only after the three public hearings planned for July and August, giving the futures industry an opportunity to water-down the conclusions. The Commission's early move suggests it does not intend to be side-tracked from determined reform by vested interests.

The shift is significant because it changes the question from "whether" to limit the impact of investment money on commodity markets to one of "how". The Commission has issued a set of questions for the hearings that include a strong presumption the outcome will be some form of tougher and more comprehensive position limits (http://www.cftc.gov/newsroom/generalpressreleases/2009/pr5681-09.html).

The move leaves the FSA increasingly exposed. It has not accepted there is a problem in the commodity markets it regulates, let alone agreed that the solution is tougher limits and more stringent regulation. The FSA's line is still that there is "no evidence" speculation has influenced prices. If the CFTC abandons that position, however, the FSA's could become intellectually indefensible, and London's sleepy regulator may come under strong pressure to fall into line.

- John Kemp is a Reuters columnist. The views expressed are his own. -

Reports that China has asked for a discussion about reserve currencies at next week's expanded Group of Eight summit in Italy has added to confusion about whether the country wants to dethrone the dollar from its status as the world's sole reserve currency. But the very fact the issue has been pushed onto the agenda suggests that a fundamental shift is underway.

Given the U.S. government's enormous borrowing requirements over the next decade to cover the bank bailout, fiscal stimulus and deficits in Social Security and Medicare, the dollar's reserve status depends on emerging markets' continued willingness to accumulate U.S. liabilities rather than switching to other stores of value, such as the euro or the IMF's Special Drawing Right (SDR).

As the largest buyer of U.S. Treasury securities, China can break the dollar's reserve currency status any time it wants. But it would risk large losses on the stock of U.S. debt that it has bought already. The resulting unstable stability is the foreign exchange version of the Cold War stalemate based on "mutually assured destruction".

Senior Chinese officials have given off mixed signals about their intentions.

When pressed, officials have indicated China will continue to stand by the dollar in the short term and denied the country has begun to diversify its official holdings. But that has not stopped People's Bank of China (PBOC) Governor Zhou Xiaochuan floating the idea of shifting to a super-sovereign currency based around the SDR.

Zhou's call for diversification was repeated last week in the central bank's annual stability report, which noted that "an international monetary system dominated by a single sovereign currency has intensified the concentration of risk and spread of the crisis". It went on to urge the IMF to exercise closer supervision of the economic and financial policies of major reserve-issuing countries.

Chinese officials have bluntly expressed concern about U.S. fiscal and monetary policies that appear to contemplate inflation and devaluation as a way out of the debt crisis, or at least accept it with weary resignation.

China has started backing a variety of small projects designed to encourage greater "internationalisation" of its currency (such as an active RMB market in Hong Kong and bilateral discussions with Latin American countries on the use of RMB to settle trade transactions).

The question is whether China is preparing to deliver the "coup de grace".

Pressing for a reserve currency discussion at the expanded G8 summit (which will also be attended by India, Brazil, Mexico, South Africa and Egypt) suggests China's leaders are serious. They must have known that just pushing the issue onto the agenda would rekindle market fears about the dollar's value.

But it could also be an attempt to create leverage and seize the initiative as part of wider efforts to shape the international financial agenda.

In the past, G8 summits have been structured as a monologue from the advanced industrial economies to the developing world. But following the debt crisis, the leading emerging markets are in no mood to be lectured.

By putting the dollar into play, China's government may hope to pre-empt pressure from western countries for a revaluation of the RMB, and take exchange rate discussions off the table entirely.
It is also a sign China is ready to begin flexing its financial muscle and will have to be treated as an equal alongside the United States, EU and Japan, shaping as much as responding to the policy debate.

The dollar's reserve status has become highly conditional, one of a number of items to be bargained over as part of the international financial agenda. Past experience suggests that when reserve currencies become highly contingent in this way, it marks the beginning of the end.

The dollar will not lose its reserve status completely. But it is set to become less "special". In future it will have to share its reserve status with the euro, the yen and perhaps even in time the yuan.

– John Kemp is a Reuters columnist. The opinions expressed are his own —

Perhaps the most frustrating aspect of much western comment on the unfolding crisis in Iran has been its over-simplification and lack of historical awareness. Perspectives are shaped by a single issue (western concerns about whether Iran is pursuing a nuclear weapons program) and the desire to draw a simple Manichean distinction between good guys (liberal-democrats) and bad ones (clerical-authoritarians).

The reality is far more complicated.

Part of the problem is a truncated sense of history. For most western commentators, the history of Iran’s troubled relations with the west starts in 1979 with the triumphant return of the glowering Ayatollah Ruhollah Khomeini at the head of the revolution which swept away Shah Reza Pahlavi’s western-backed regime and replaced it with a new Islamic Republic.

Western anxiety was compounded by the 444-day American hostage crisis that helped destroy the presidency of Jimmy Carter, and humiliated a United States still reeling from defeat in Vietnam and the Watergate crisis. Iran and the United States soon became embroiled in a series of proxy conflicts fought in Iraq, Lebanon, and via terrorist attacks on U.S. targets.

But for many Iranians the country’s troubled relations with the west can be dated further back — to at least the CIA-backed coup against Prime Minister Mohammed Mossadegh in 1953.

It marked a crucial turning point in Iranian history, something a bit like the Prague Spring, in which a popular, reforming and democratizing but also nationalist prime minister, who believed Iran should control the exploitation of its own petroleum resources, was removed by western intelligence agencies anxious to protect their countries’ interest in the oilfields.

The Pahlavist regime which replaced Mossadegh may have been modernizing and reforming, but it was also absolutist, dissolute and corrupt, and the Shah’s secret police, the SAVAK, ruthlessly hunted down and murdered opponents at home and abroad. While Pahlavist exiles abroad promote the memory of a modernizing golden age, there is no enthusiasm for monarchist restoration at home, and the Shah went into exile largely unmourned.

Criticism of the Shah’s regime was never confined just to religious conservatives. Even liberals were critical of the excesses of the Peacock Throne.

Iran therefore has no reason to love the western powers.

Subsequent events have deepened the mutual suspicion. When Iraqi President Saddam Hussein launched an unprovoked aerial attack on Tehran in 1980 and sent the Iraqi army across the Shatt al-Arab in a brutal war of aggression designed to exploit the turmoil and internal weakness of the fledgling Islamic Republic, the western powers stood aside.

Iraqi forces occupied the oil-rich and strategically vital province of Khuzestan, Iran’s cultural cradle, and captured the half-million strong city of Khorramshahr — and the west did nothing.

When Iran’s regular army and the volunteer forces of the Revolutionary Guard and the basij (the same groups now being used to suppress the protests) drove Iraqi forces back across the border and then moved into the al-Faw peninsula and began to threaten Iraq’s second city of Basra, Iraq resorted to chemical weapons — first the nerve gas sarin and then, when Iranian soldiers were given atropine-filled syringes as an antidote, switching to mustard gas.

Still the west did nothing. In fact, western companies were busy supplying the precursors Iraq needed to make its chemical arsenal and breach the Geneva Protocol. Meanwhile, western intelligence agencies were supplying Iraq with satellite reconnaissance photographs to aid the war effort.  Funding was catalyzed from friendly regional regimes to support Iraq’s faltering war effort and avert the risk of an outright Iranian victory.

To counter Iran’s successes on the ground, Iraq’s air force began strategic bombing of Iran’s cities, then switched to missile attacks on Tehran using Scuds, as Iran suffered its own version of the blitz.

None of this is to suggest Iran did not commit atrocities of its own, or to take Iran’s side over Iraq.

But when western leaders condemn Iran’s alleged quest for “weapons of mass destruction” and fulminate against Iran’s missile program, they betray a startling lack of perspective.

Some estimates put the number of Iranian soldiers who fell victim to chemical weapons as high as 100,000. Total casualties (killed or wounded) are put as high as 1 million. When Iran accepted a UN-mediated ceasefire proposal in 1988, Khomeini not unreasonably likened it to drinking a cup of poison.

Given this history, western leaders are in no position to deliver credible moral lectures, and it is hardly surprising that Iran’s leaders and media mutter darkly about western interference. Nor is it surprising that the Obama administration, seeking to improve relations, has been anxious to avoid the impression of meddling.

– John Kemp is a Reuters columnist. The views expressed are his own –

Economic history is the only field of human endeavor where the past changes as much if not more than the present and the future. Policymakers and practitioners struggle to define and write a “narrative” of the past as a means to control how policy responds to current and future problems.

The debate now over financial reform is a case in point. Even though the banking system has only just emerged from the most severe shock since the 1930s, the battle over how to define the events of the last 18 months, and what they should mean for investors and regulators in future, is already well underway.

Contrasting speeches last week by Federal Reserve Governor Kevin Warsh and Bank of England Governor Mervyn King illustrate the two extremes around which the debate is polarizing:

* Warsh speech

* King speech PDF

The financial sector will exploit these differences to derail any fundamental overhaul of regulation.

Warsh’s speech characterized the crisis as the “panic of 2008″ and set it in the context of the previous two decades of rapid non-inflationary growth, implying the crisis was an irrational aberration in an otherwise well-functioning economic and financial system.

In effect, Warsh reprised a philosophy associated with former Fed Chairman Alan Greenspan: occasional, wrenching crises are a price worth paying for an innovative, dynamic and wealth-generating form of capitalism. Policy should focus on ameliorating the after-effects rather than risk stifling growth by aiming to prevent crises altogether.

In contrast, King made the case for fundamental reform. He highlighted the real costs which a crisis that originated in the financial system is imposing on the real economy, as well as the more intangible but no less profound impact on attitudes towards wealth-creation, reward and regulation.

While noting there was no support for “excessively bureaucratic regulation”, King made clear “change to the structure, regulation and indeed culture of the banking system is necessary. Blaming individuals is no substitute for acknowledging the failure of a system, of a certain type of banking.”

STABILITY VERSUS GROWTH

King’s speech echoes the famous analysis set out in Hyman Minsky’s “Stabilising the Unstable Economy”. Minsky made a compelling case that periodic crises were an essential part of a financial-capitalist system in which massive long-term investment projects were financed by issuing large volumes of debt. By breeding over-confidence and increasingly risky capital structures, periods of stability laid the seeds of their own destruction.

But unlike Greenspan, Minsky argued such crises were not a “price worth paying”. Appropriate regulation was both necessary and desirable to constrain risk-taking to an acceptable level, and could be achieved without sacrificing growth. King’s speech appears to be advocating something similar.

Warsh is re-fighting an old debate between “stability-first” and “growth-first”. It is a false choice, as a closer look at the historical record suggests.

The problem with his speech is its truncated view of history. He notes U.S. output (measured by real GDP) grew at an average rate of more than 3 percent a year between the mid-1980s and 2007, and was significantly less volatile than in earlier periods. Unemployment averaged less than 5.75 percent, a full percentage point lower than in the previous 15 years.

But this is a tendentious use of dates. Warsh has picked the start and ends points to support a pre-determined conclusion. It specifically excludes the last two years of underperformance (2008 and 2009) from the period of the Great Moderation (as if the current problems had nothing to do with the policies pursued in the preceding years).

And by choosing the start point as the mid-1980s, then going back 15 years, it lumps both the Volcker recession of 1980-1982 and the oil shock of 1973 into the same base period for adverse comparison. With a selective use of statistics like this, it is possible to prove anything.

It is worth looking further back, in a more neutral manner. The attached PDF chart shows annual GDP growth since 1930 and the average rates for 20-year periods (1930-1949, 1950-1969, 1970-89 and 1990-2009).

While annual GDP growth was certainly less volatile during the most recent period, the average growth rate (2.5 percent) was not especially high compared with the previous 20 years (3.2 percent) or the two decades of the 1950s and 1960s (4.3 percent).

Warsh focuses on the undoubted benefits that openness to trade and rapid financial innovation delivered during the 1990s and the first part of the current decade, describing them as the principal achievement of the Great Moderation. Minsky’s own golden era was the 1950s and 1960s, when relatively conservative bank balance sheets and strict regulation appeared to tame the violent boom-bust cycle of the pre-war years while still enabling brisk growth and unprecedented prosperity.

But it is not obvious from the historical record whether macroeconomic management has been superior over the last 20 years to the 1950s and 1960s. Nor is it obvious policymakers have to choose between financial stability and economic growth. It is possible to have respectable growth and stronger financial supervision.

KEEPING OPTIONS OPEN

Minsky attributed the stability of the 1950s and 1960s to the impact of wartime finance, which had swapped a large part of the private securities on bank balance sheets for government debt, increasingly their liquidity, coupled with the development of a more extensive system of lender-of-last-resort, deposit protection and bank regulation.

Much of that framework of prudential oversight and conservative balance-sheet management has been swept away in the last 20 years as policymakers have relied more heavily on “market discipline”. The debate is how far to go in trying to recreate it.

Bank of England Deputy Governor Paul Tucker has already suggested banks should be forced to hold a greater cushion of highly liquid assets (for which read government debt) to reduce liquidity risks. In his speech, King reiterated the point.

He went on to suggest it was unsustainable that banks could take highly risky investment strategies while backed by an implicit (and free) state guarantee. Either regulation must be tightened, banks must pay for the guarantee, or it must be restricted to a range of “narrow banks” performing utility-like payments and basic lending services.

Rather than a set of detailed and perhaps politically unrealistic policy prescriptions, King’s speech should be seen as a plea to keep the debate and options open, not close them down prematurely and revert to business as usual.

King is right to try to encourage a deeper examination of the origins of the crisis. But radical reform seems unlikely. Wall Street and the City of London are already fielding an army of well-paid, silver-tongued lobbyists to deflect it. And as the divisions between King and Warsh reveal, regulators are too ham-strung by disagreements among themselves to force fundamental restructuring on a reluctant the industry.

– John Kemp is a Reuters columnist. The views expressed are his own –

Steady improvement in manufacturing surveys, payroll data and freight movements all indicate the U.S. economy is approaching the low point in the business cycle and should hit the bottom within the next one to four months. But that does not necessarily imply a strong and sustained expansion is about to get underway.

It is possible to be optimistic that the worst of the downturn is now over (or nearly so), while remaining cautious about prospects for strong and sustained recovery once the cyclical turning point is passed.

The slow and fitful recovery from the last recession is one reason to be careful. The National Bureau of Economic Research (NBER), the traditional arbiter of the U.S. business cycle, dates the last trough to November 2001 (eight months after the expansion peaked in March 2001 and just two months after the attack on the World Trade Centre). But signs of a strong and sustained recovery did not emerge for more than two years.

Fitful expansion in 2002 and 2003 is one reason the Fed kept interest rates so low for so long. While many commentators now see this is a significant error that contributed to subsequent bubbles in the bond and real estate markets, at the time the slow recovery caused officials, led by then-Governor Ben Bernanke, to worry more about the risk of deflation taking hold.

The Fed was still cutting interest rates to 1.00 percent as late as June 2003, an insurance policy against falling prices. It did not feel emboldened to begin raising them from this ultra-low level until June 2004.

Uncertainty caused by impending war between the United States and Iraq was certainly one factor overshadowing the recovery, but not the only one. Widespread pessimism and a cautious approach to new investment and hiring all helped ensure recovery was very slow. It failed to become clearly self-sustaining for almost three years.

The same could easily happen again.

RESTOCKING AND FINAL DEMAND

Headline increases in gross domestic product (GDP) can be separated into growth from final demand (consumption, business investment, government spending and exports); and increases in the level of inventories held by manufacturers, distributors and retailers along the supply chain (including raw materials, work in progress and stocks of finished but unsold items).

Sustainable increases come from final demand. Inventories are more volatile. Large changes in either direction tend to be quickly reversed within a quarter or two. A large build up in one quarter is usually followed by an equally large reduction in the following one.

The attached chartbook shows quarterly growth rates for GDP, final sales and inventories since 1948, and how the U.S. economy behaved in the first four quarters after each recession ended. Click here for PDF.

Headline GDP and final sales have proved much more stable than inventories. GDP and final sales have been negative in 37 and 35 quarters respectively out of a total of 245 since 1948. In contrast, inventory changes subtracted from GDP about half the time (119 quarters) and added to it roughly as often (126 quarters).

Recessions since 1948 can be divided into two very distinct groups:

(1) Severe recessions characterised by declines in final demand for at least two consecutive quarters. There have been four of these severe recessions (ending in 1954, 1974, 1982 and 1991).

(2) Other, inventory-driven recessions where final demand remained positive (most of the time) but the attempt to liquidate excess inventories by cutting production below final consumption pushed the economy into recession (defined as two quarters of negative overall GDP growth). There have been five of these “other recessions” or “inventory recessions” (ending in 1949, 1958, 1960, 1970 and 2001).

Past experience suggests the early stages of recovery are very different depending on whether the economy is emerging from a severe recession or an inventory-driven one.

In the case of deep recessions, recovery has been led by final demand. Inventory changes continued to subtract from GDP growth in the first quarter after recession ended and did not begin to make a substantial positive contribution until the third quarter (six to nine months later).

The pattern after inventory-driven recessions has been very different. Growth in final demand was much less important, with inventory rebuilding supplying most of the initial impetus for expansion.

In four of the five inventory recessions since 1948 inventories made a positive contribution to GDP from the first quarter after the downturn ended. The exception was the anaemic recovery after the 2001 recession. The lack of a stronger inventory response in this instance may have contributed to the failure to achieve a self-sustaining recovery in this case. But in every case, the inventory-driven recovery fell away somewhat in the second quarter after the recession ended before surging again in the fourth.

From the charts, it is clear that the current downturn looks much more like a severe recession than an inventory de-stocking one (with sharp falls in final demand in both Q4 2008 and Q1 2009).

If this is the correct characterisation, inventory rebuilding may play only a limited role in the early months of the recovery. Assuming the cyclical trough occurs during Q3 (between July and September) re-stocking might not make a significant positive contribution to growth until Q1 or even Q2 2010.

Analysts hoping for inventory rebuilding to provide much of the impetus for recovery in the second half of 2009 may be disappointed. Any expansion in the final months of 2009 is likely to be much slower and more uncertain.