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Lorenzo Bini Smaghi, a member of the ECB Executive Board, penned an op-ed in the FT today entitled "It is better to have explicit rules for bail-outs." Given the relative simplicity and directness of such a title, one would expect the piece to lay out the logic behind such a statement. Instead, what follows is largely nonsense,and self-contradictory blather.

Let's begin:

"One of the many lessons we can draw from the financial crisis... is that economic agents do not always behave rationally, especially when they take decisions affecting others. Research has shown in particular that agents are not only motivated by self-interest, as economists are keen to believe, but also by considerations of fairness."

A strong start - I'm with you so far, Lorenzo.

"Such attitudes make it difficult for governments to act consistently in times of crisis, especially when elections are close. This was notably the case in September 2008, shortly before the US presidential election, when Congress, despite the gravity of the situation, rejected the government's bail-out plan until Lehman Brothers' failure made it apparent that the risk of financial collapse would have devastating effects for all."

Mmmkay - not the best example. Congress rejected the government's bail-out plan not out of considerations of fairness, but because the Democrats tried to ram it down the throats of Republicans too blinded by ideology and obstructionist predispositions. Maybe our author is trying to be polite.

Regardless, he believes that democratic governments cannot be relied upon to react swiftly to address crises:

"Systems and institutions with specific crisis-resolution mandates thus need to be established to permit rapid responses."

Therefore: clearly established, fixed procedures for bailing out (woops, "resolving") an institution in crisis to prevent contagion is the way forward. Would this not create moral hazard? Would not this not allow the clever folks at large banks, investment firms, and hedge funds to find ways around the fixed rules, just as they have consistently done in the past? Would it not be better to provide regulatory bodies with resolution powers that are both broad and ambiguous enough to create uncertainty for financial actors as to when/how they might get bailed out in the future? Would this not go some distance to preventing them from gaming the system just as they have consistently done in the past?

Lorenzo's argument seems to be that elected officials should not be trusted to solve problems in the heat of the moment. There is some truth to this: it's messy and leaves you vulnerable to political cycles and populism. Ad hoc crises resolution efforts at the national level can also make things worse at the international level - we saw this with Ireland's unconditional guarantee of bank liabilities back when the crisis was as its worst.

But it does not follow that iron-clad rules need to be laid out in all cases. Fixed rules based on the last crisis are almost certainly not going to be well-suited for the next one - we do not want to train our generals to fight the last war. Smaghi does not seem to have grasped this fundamental lesson from history at all:

"Moral hazard should ... be addressed by establishing institutions and procedures that allow for incentive-compatible solutions (carrots as well as sticks). This means, in particular, that financial assistance, if needed to avert a major systemic crisis, can be granted on strict conditions that aim to prevent any recurrence of the problem."

Really? Any recurrence of the problem? Please don't insult your readers with this drivel. Finally:

"[M]oral hazard cannot be tackled simply by assuming that crises will not occur. Nor can it be assumed that letting an institution or a country fail is always and everywhere the most desirable solution, as the post-Lehman experience has shown. Decision-makers in both the public and private sectors must thus be ready to deal with worst-case scenarios and make sure that they are not prevented from delivering the appropriate decisions."

Aside from stating the blindingly obvious, I read this last paragraph undermining Smaghi's argument entirely. Given the fact that the next crisis will not be identical to the previous one, flexibility is key. "Explicit rules for bailouts" is not flexibility, and is certainly not going to equip decision-makers with the capacity to deal with worst-case scenarios. Indeed, explicit rules may very well prevent them from delivering appropriate decisions.

*deep breath*

Flexibility essentially means power. The debate that we should be having is over how much power financial regulators should have/are able to use effectively. How much should we be able to rely on this power? Will it dampen the inherent moral hazard of future government bailouts?

Smaghi's argument is not so much an argument but rather a vague collection of statements that are tenously linked together, not particularly convincing, and seemingly self-contradictory. He has contributed nothing but confusion.

-George Soros on Greece and the Eurozone's inherent flaws.

-Kenneth Rogoff sees a wave of sovereign defaults in the years ahead (they tend to follow banking crises).

-There is an interesting debate at Free Exchange on the need for a European Monetary Fund.

-We cite Paul Krugman a lot of these pages; The New Yorker profiles the man and his politics.

-In the wake of another coup in Africa (Niger, this time), FP Passport asks, 'Why are coups always led by colonels?'

-In Olympics news other than US Hockey's epic beatdown of Team Canada (sorry, Dave), the NYT has an interesting analysis of the controversial (for Russians, at least) men's figure skating competition, explaining why American Evan Lysacek didn't need a quad to win gold.

I'm about a third of the way through Charles Kindleberger's Manias, Panics, and Crashes - a historical examination of financial crises over the past few centuries. It's an interesting read, and Kindleberger regularly sprinkles in some real gems. For instance, in discussing some of the causes of over-zealous investment during a financial bubble, he opines that "There is nothing so disturbing to one's well-being and judgment as to see a friend get rich." The same can be said of our financial institutions.

Here's another: "For historians, each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways. History is particular; economics is general."

Kindleberger tries to weave his way through the particulars to arrive at some general conclusions about crises, and it's sobering stuff. We're used to hearing about the Great Depression, but things pretty much drop off for anything prior. But let me tell you, there were crises galore in the 18th and 19th centuries. The worst part? Although the particulars differ, they tend to bear remarkable similarities to our latest meltdown.

In fact, many of the debates back then echo to the debates being waged today. Writing in the post-WWII period, Chicago economist Henry Simon was arguing that it was not the money supply, not government policy, but rather the instability of credit markets that created a fragile financial system: "He was concerned about the speculative temper of the community and the ease with which short-term nonbank borrowing and lending made society vulnerable to changes in business confidence." Again, the details have changed, but the collapse in confidence in uninsured non-bank lending was a major component of the credit crunch that fed our latest meltdown.

It's something to ponder as practitioners, regulators and policymakers pick up their socks and attempt to try again. How long before the lessons from mortgage-backed securities fade away and the unintended consequences of the latest policy decisions set the stage for the next crisis?

I have been mulling a thorough post on the developing Eurozone sovereign debt crisis for the past two days, thinking of ways I could adequately present the necessary context, theoretical arguments and implications to the global economy. But in reading through Simon Johnson's coverage of the developments in Europe, I realized something: I can't possibly deliver a better analysis than he has. So instead of trying in vain to duplicate his efforts, I point you towards The Baseline Scenario:

-Johnson's first look at the situation asked whether US policymakers, specifically Tim Geithner, understood the risks posed by a European sovereign debt crisis to America and the global economy

-Over the weekend, Johnson looked at the likelihood of IMF involvement in Greece, the irrelevance of the G7 and the implications of European policymakers' dithering

-Today, Johnson, Peter Boone and James Kwak released their Revised Baseline Scenario for 2010, which includes a great treatment of the Eurozone's sovereign debt woes and its broader implications. This is a long post, but I recommend reading it in full for their 2010 outlook.

Markets rallied yesterday on signs the European big boys would step in and back Greece. ECB President Trichet rushed back from a trip abroad and there were rumors circulating that Germany, the only Eurozone country that really has the balance sheet and power to step in at this point, was constructing a 'firewall' of sorts that would stem any contagion from the Greek crisis. But Germany later denied any plans were in the works, which rattled investors again.

I suspect we'll get some official statements out of the ECB and Commission by the end of the day, hopefully laying out some concrete steps to resolve the situation. But if you believe Simon Johnson, it may all be too late.

Paul Krugman deconstructs the Spanish case and shows why: a) it's different from Greece, and b) how it reflects the Eurozone's broader problems.

I apologize for the light posting of late. I've been preoccupied with some pretty heavy work-related stuff. But I want to devote much of this week to the developing eurozone crisis. A backgrounder will follow shortly, but to give you an idea of how serious the situation in Europe is, traders have taken over $8bn in short positions against the euro, the largest bet ever against the common currency.

That's massive, almost equal to the $10bn bet against sterling made by George Soros that 'broke' the bank of England in 1992 and ejected sterling from the European Exchange-Rate Mechanism.

The euro was supposed to be one of the big winners of the financial crisis; for the 'safety' it provided countries like Slovakia, for the credible external commitment its accession criteria provided countries like Hungary and Poland, and for its rise as a viable reserve alternative to the dollar. But all of the sudden the euro is confronted with its biggest crisis and I sense that policymakers will soon encounter a stark choice: explicitly back countries like Greece and Portugal or eject them from the common currency.

Stay tuned.

Ukraine is awaiting a run-off in its presidential election to be held on February 7th between leader of the opposition Viktor Yanukovych and current Prime Minister Yulia Tymoshenko. The winner will succeed President Viktor Yuschenko, who is leaving office with an approval rating in the low single digits, a dramatic fall from grace for the leader of the Orange Revolution. His successor will inherit a country in crisis: economically, financially and existentially. This election could not be more important for Ukraine's future.

Yuschenko's presidency was an utter failure. Granted, he had little domestic support, as his current prime minister (Tymoshenko) is also his fiercest political rival. But his economic record has been dismal in response to the Ukraine's crisis, sacrificing his early achievements in attracting FDI and cutting unemployment. While he has succeeded in turning Ukraine away from Russia and set the country on a path towards European integration (WTO accession, a promise of future NATO membership and negotiations over an FTA with Brussels), he has also presided over near-annual gas wars with Russia that threaten Europe's supplies, a total economic deterioration (GDP contracted about 15% in 2009) and non-observance of key conditions to Ukraine's $16.4 billion IMF program. This led the IMF to suspend its fourth disbursement or $3.8 billion, leaving Ukraine on the brink of default. Yuschenko also managed to swing public opinion decisively against NATO and EU accession, undermining his key foreign policy successes.

Conventional wisdom therefore interprets the current election as a repudiation of Yuschenko's pro-Western agenda, with the two leading candidates representing a more Russia-oriented foreign policy in the years ahead. But according to Samuel Charap's recent article in Foreign Policy, this assumption overstates the degree to which either Yanukovych or Tymoshenko will turn to Russia. Neither candidate is a 'pro-Russian stooge,' even Yanukovych, who according to Charap did little to endear himself to the Kremlin during his stint as prime minister, even if he was the Kremlin's 'preferred' candidate the last time around. Further, the interests that back Yanukovych are heavily invested in EU trade, so one can expect a lot of pressure on the potential president to deepen Ukraine's economic integration into Europe. This is far more critical to Ukraine's future than the immediate prospects for NATO accession.

Tymoshenko's presidency would hold the most promise, as she is likely to fashion a commanding political majority that would leave her free to enact key economic policy reforms, most importantly the 2010 budget and energy sector reform, that would unlock the remaining IMF funds and set Ukraine on a path to recovery. She would also prioritize Ukraine's relationship with Russia, but in the interest of rapprochement, which is as important to Europe (see: gas) as it is to Russia. Thus, both candidates are likely to conduct a more balanced foreign policy, which would be in the interest of all parties. But economics will determine Ukraine's future, and neither candidate can afford to ignore the pressing challenges at home. Both the EU and Russia have a role to play in stabilizing Ukraine's economy.

One of the fundamental insights of IPE is that domestic politics matter as much in the international arena as they do internally. They either enable or constrain foreign policy decisions, and Ukraine's current situation highlights this perfectly. The EU/Russia dichotomy that Yuschenko spent so much time constructing has clouded our perspective on the current candidates and their impact on Ukraine's future, as Charap's article illustrates. Their presidencies will be dominated by jobs, energy and trade. Rapprochement with Russia is likely and welcome, but there are powerful interest groups in favor of further economic integration with the EU. This will check any drift eastward.

There are probably very few activities which are shared by both schoolchildren and our fiscal & monetary policymakers, but blowing bubbles is one of them. The difference being that the kids' bubbles usually consist of soap, are far more entertaining, and cannot cause ruin to entire economies when they pop. But it's the metaphorical asset bubbles that I am more interested in.

Metaphorical bubbles and their non-metaphorical problems
Which brings us to the lead story in last week's The Economist. The editorial worries that the loose monetary policies adopted by major economies (printing money; very low interest rates) has created an environment vulnerable to further asset bubbles. In the short term, the side-effect of cheap money on asset prices is being welcomed by many: the profits are helping the market rebound from its earlier downward spiral and firms' balance sheets are being strengthened as a result.

But there are longer-run issues to be concerned about. As the articles explains, "The problem for [investors] is not just that valuations look high by historic standards. It is also that the current combination of high asset prices, low interest rates and massive fiscal deficits is unsustainable." Eventually the cheap money is going to run out when governments scale back their extraordinary measures - this is not a secret. What is not known, however, is whether the process of scaling back is going to be smooth or volatile. History suggests that we cannot assume a smooth transition.

Carry Trade 2009-?
Not all the evidence points to asset bubbles - see The Economist's other article - at least not for the wealthiest economies. Emerging markets, however, are the destination of a lot of this cheap money, which creates its own challenges. To understand why this is so, let's look back to Nouriel Roubini's November editorial about the Mother of All Carry Trades that began in 2009. The "carry trade" is the practice of borrowing in a cheap currency (the USD, with a near-zero - and sometimes negative - interest rate) and investing in risky assets with higher return. Here's Roubini:

"Let's sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March [2009]....
Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight... By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets.

Does that bolded sentence sound familiar? It should if you've been following the financial crisis at all. The perception of decreasing risk due to lower volatility can be misleading.

Bear in mind that this carry trade is contingent on cheap borrowing. When (not if) borrowing in USD becomes more expensive, this effect will have to reverse itself or shift to a new currency, like the Yen. If this happens suddenly, Roubini believes there will be a stampede "as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments."

So maybe this bubble will pop, as Roubini argues it will. Maybe it will simply deflate. The fact is that nobody can say for certain - but the risk is there. Remember the story of Icelandic people blowing up their Land Rovers to avoid paying them off after the krona tanked? That's a dramatic but useful illustration of what happens when the carry trade reverses itself rapidly.

In the meantime, as I alluded to above, the consequences of cheap money flowing to emerging markets are being felt in a number of areas. I'll look at some of the implications in the next installment.

The FT's profile this weekend of Jim O'Neill, the Goldman Sachs economist who coined the now ubiquitous acronym 'BRICS,' got me thinking about one of my main objectives for IPE Journal: a dedicated focus on the 'rise of the rest.' In looking back over the history of my posts, I realized that the financial crisis, perhaps inevitably, distracted me from this emphasis as my coverage became far more US-centric than I anticipated or desired. That is partly a reflection of the US' role in the crisis and the overwhelming media coverage of the US financial sector over the past year, partly my own engrained anglo-saxon bias in choice of literature and media outlets, and partly a recognition that the majority of our readers are in fact based in North America.

But the pace with which countries like China, Brazil and Indonesia have emerged from the Great Recession has crystalized the importance of the emerging economies to not just my own worldview, but I suspect those of our readers as well. So the following links represent a shift back to the emerging markets and issues that are likely to play a defining role in the years ahead. That is not to say my coverage of US banks or Gordon Brown will cease entirely, but expect a much smaller role for Lord Mandy in the months ahead. This is, after all, a blog on International Political Economy. But I do love Mandelson.

-Via Free Exchange, The Economist looks at a McKinsey study on deleveraging that partly demonstrates why the big emerging markets have emerged far quicker from the crisis than the major economies (Russia aside). If you follow the links to the actual article, I found it interesting that when viewed through the prism of crises, countries like the US and Spain currently look a lot like emerging markets have historically in the aftermath of such episodes.

-China finally takes its foot off the gas by raising reserve requirements on lenders and reimposing a sales tax on certain home sales, fearing that the economy is overheating (asset bubbles and inflation). Conventional wisdom six months ago held that China was likely to allow a gradual depreciation of the renminbi to export its way out of the economic slowdown. Six months later, is a gradual appreciation more likely in 2010?

-A constitutional crisis looms in Nigeria, threatening a recovery in oil output and social/political stability.

-Chile continues the resurgence of the right in the Americas. With Venezuela plunging quite literally into darkness and (hyper)inflation, the 'Bolivarian Revolution' that swept the region looks less-than-promising ten years on.

-Finally, and contrary to the first link, the future may be bright for the emerging economies, but are investors touched by a bit of irrational enthusiasm at the moment?

-A leadership challenge to Gordon Brown has once again thrown Labour into disarray, just as the party managed to reverse the Tory poll momentum. Who knew British politics could be so fun! (Update: he has survived, again...)

-The president of Iceland, a country on a fast-track to EU accession, has refused to sign off on legislation that would have repaid the UK and Netherlands some $5.5 bn lost in failed 'Icesave' accounts. He has instead decided to put the matter to a referendum. The move seriously jeopardizes Iceland's EU prospects and threatens to further isolate the tiny nation. The economy minister says the referendum decision has effectively put on hold both the country's IMF program and any decision to lift capital controls. Ouch.

-Argentina's president has fired the president of the central bank over his refusal to back a government plan to tap the country's $48 billion reserves to pay off $6.6 bn in debt this year. One problem: Martin Redrado says he won't go! He says the power to fire the central bank chief rests with Congress and he has no plans on going. Further, the man tapped by Fernandez de Kirchner to replace Redrado, former central bank president Mario Blejer, has declined the offer. Blejer resigned in 2002 due to government interference in the bank's independence. Argentina has finally been making progress in negotiations with defaulted creditors who refused the previous government's offer to renegotiate their portion of the $95 bn 2001 debt default, and was aiming to return to international markets this year for the first time in nearly a decade. The president's intervention does little to bolster the confidence Argentina has taken so long to recover.

As we kick off our look back at 2009, here's a list by Joshua Keating, associate editor at Foreign Policy, of the 10 Worst Predictions for 2009. The predictions are paraphrased below, the comments are my own:

1. Obama to sign energy bill by end of the year- Rahm Emanuel on 19 April (White House chief of staff)
Not even close. Health care, health care, health care.

2. Bernnake to step down after first term, Summers replaces him at Fed- Business Week on 2 January (magazine)
Tough confirmation hearings, but Bernanke enjoys the confidence of the president and is soon to be entering his second term. Far from basking in the glory of a depression averted, Bernanke has been charged with unwinding his extraordinary response to the crisis.

3. Swine Flu to kill hundreds of thousands in the US- Report to the President on US Preparations for the 2009-H1N1 Influenza on 7 August (President's Council of Advisors on Science and Technology)
Um, no. But this was enough to scare me into getting vaccinated.

4. No end in sight to US economic freefall- George Soros on 20 February (billionaire investor and activist)
To be fair, Soros hedged his comments, but the pace of recovery in both the financial markets and real economy has undoubtedly been surprising. The US stimulus package may not have done enough, but it seems to have done just enough to avert catastrophe. That tricky unemployment rate remains...

5. No Afghan surge for Obama, Gen. McChrystal to resign- Charles Krauthammer on 27 September (right-wing columnist/commentator)
Obama succumbed to the COIN camp against, I suspect, his instincts. McChrystal saw the back of Obama's hand following his public intervention into the Afghan surge debate, but in the end got 3/4 of the troops he was looking for.

6. Gordon Brown will 'certainly' step down within three days- Martin Kettle on 5 June (associate editor at The Guardian)
The train wreck that was the Brown premiership reached its inglorious nader over this week in June when the Labour backbench revolt burst into the open with public calls to resign. Somewhat remarkably, Brown fights on (thanks in no small part to Lord Mandy) and has even narrowed the Tory lead in the run-up to likely elections in March.

7. Breakthrough agreement, Zelaya returning to office, democracy lives in Honduras!- Hillary Clinton on 30 October (US secretary of state)
Zelaya has spent quite a bit of time the Brazilian embassy, presiding over nothing but his cowboy hat, and Honduran democracy is shaky at best.

8. Israel will likely strike Iran between US election and Obama's inauguration...Israel will likely strike Iran before end of 2009- John Bolton on 22 June 2008 and 28 July 2009 (former US ambassador to UN and epic moron)
John Bolton calls on Israel to bomb Iran as often as the sun rises. It still hasn't happened. You get the impression that Bolton believes if you wish for something hard enough it will just happen. I really loathe this guy on so many levels.

9. G7 finance ministers have unleashed inflationary hell, world markets to collapse under chaos- Jim Rogers on 10 October 2008 (billionaire investor)
I would argue that entering 2010 deflation remains a bigger risk than inflation in the major economies.

10. China will take over Panama and choke the US via the canal- Rep. Dana Rohrabacher on 7 December 1999 (US representative)
Ten years later and the cargo flows.

-An enterprising reader of The Guardian has answered the newspaper's call to untangle the complicated web of Tony Blair's finances. Usually I would say that the business of an ex-leader is none of my business, but with Blair the scrutiny would seem appropriate, given his still notionally official role as a Middle East envoy and near-presidency of the EU.

-The FT looks at the retreat of the siloviki under the Medvedev presidency.

-Yegor Gaidar, first finance minister of post-Soviet Russia and one of the architects of the country's transition to a market-based economy, died this week at 53. Gaidar's reforms, legacy and reputation are a complex mix of historic achievement, failure and resentment. The intellectual merits and legacy of the 'shock-therapy' administered by people like Gaidar in Russia or Jeffrey Sachs (for our younger readers, yes, that one) in Poland will be debated in academic and policy circles for generations.

-One of the cultural truisms of the crisis is that wealth is out, modesty is in. The ostentatious displays of the nouveau riche (think: oligarchs and investment bankers) are not only remnants of an era passed, but universally held in bad taste. However, an aspirational lifestyle has been fundamental to the consumer-driven, middle-class wealth-creation of the western world over the past century, and with swelling middle-classes in countries like the US and England due to decades of declining real wages and wealth destruction in the crisis (think houses and mutual funds), symbols of old-money status and wealth should enjoy a renaissance as the masses yearn for a taste of the good life. In an interesting article, The Guardian looks at 'Tory Chic: the return of poshness.'

-The financial impact of Tiger Woods' indiscretions is massive, not just for the golfer, but the game he plays.

- "We have not yet achieved self-reinforcing recovery... We are on a government support system, both in the financial markets and in the economy." Paul Volcker is interviewed by Der Speigel.

- The Catholic Church gets all up in Berlusconi's face. The Economist explains.

- The award for healthiest teeth in the OECD goes to the British. The British!?

- The rate of return on cancer research: looks good. Now if only we had some numbers like this for green technology...

As an addendum to Dave's post below, if you are interested in learning about the current debate/questions surrounding sovereign ratings, have a look at the case of Mexico.

Fitch downgraded Mexico on November 23rd following the Congress' approval of the 2010 budget, which relied too heavily on borrowing and higher oil exports. Mexico's medium-term outlook is under scrutiny, in part, due to the country's over-reliance on a collapsing oil sector (output has declined by about a quarter since 2004, while the sector accounts for almost 40% of state revenue) and failure to sufficiently address the root causes of a widening fiscal deficit, including over-reliance of oil revenues and a small non-oil tax base. JPMorgan has estimated the budget deficit will swell to its widest margin in two decades.

Highlighting the current debate over sovereign ratings, however, is the fact that not everyone agreed with the downgrade. Goldman Sachs' chief Latin American economist Paulo Leme has called the downgrade 'unnecessary roughness' because it overlooks what is still a deficit equivalent to just under 2% of GDP in a recessionary economy. While each country's conditions are different, as a generic measurement a deficit under 4-5% of GDP is widely considered sustainable, especially within the context of a 7.5% annual decline in GDP. I can think of a few countries who would welcome such a small gap. Further, while Leme concedes the Congress could have done far more with the 2010 budget, he feels the downgrade overlooks the value of tax increases included in the bill. The political environment in Mexico is hardly conducive to reform, as Fitch cited as a major factor in its decision, so in this context the tax increases should be viewed as a positive development.

In my opinion, the medium-term concerns centered on the inability of the Calderon government to win Congress' approval for the restructuring of the oil sector are valid, and until this is achieved the country will remain under just scrutiny. But with respect to Mexico's ratings, this assessment places too great an emphasis on medium-term policy considerations, while overlooking the fairly stable near-term profile. Fitch correctly highlights Mexico's vulnerability to future oil-price shocks- relative to its peers Mexico's external debt-to-GDP and debt-to-revenue ratios are high- and limited room for counter-cyclical expansion. But when judged independent of its peers, a downgrade is likely a step too harsh given Mexico's 'healthy banking sector, resilient external accounts, the sovereign's manageable external debt amortization profile, as well as its ability to tap the IMF Flexible Credit Line (FCL) in case of a significant worsening of external financial conditions.' In fact, both the peso and Mexico's bonds rallied following the downgrade, perhaps reflecting a general skepticism amongst market participants.

The case of Mexico illustrates the tricky business of rating sovereign debt and fiscal sustainability, particularly in the post-crisis environment (i.e. widening fiscal deficits amidst tighter borrowing conditions.) While any credit rating agency will tell you that ratings criteria, however objective, are measured within a local context, it seems that in the current environment countries are being painted with rather broad strokes. The spike in CDS spreads for Gulf states following Dubai's announcement is one such example that wholly ignored the unique characteristics of the Dubai situation. The expansionary response of many governments to the crisis has been almost universally credited with averting a total collapse of the global economy. In fact, both the IMF and UN have recently warned against withdrawing this stimulus too soon, lest we manufacture a double-dip recession. While these policies ultimately raise important questions over the medium-term sustainability of imbalances, a clear assessment of a country's ability to exit this response and address larger deficits in the medium-term should control the outlook for a country when, like Mexico, that country is comfortably financing their deficits in the near-term. That picture isn't always clear in the current environment and ratings agencies should thus reserve their judgement until government's are sufficiently confident that growth is sustainable (which they aren't) and have been able to clearly outline their exit strategies (which they haven't.)

In a live appearance on Russian television, Russian PM Vladimir Putin said he will 'think about' reclaiming the presidency in 2012.

Asked about Putin's comments, President Dmitry Medvedev repeated the line that he and the prime minister would come to an agreement on who would run so as to avoid 'elbowing one another.' He very eloquently, however, said 'if Putin doesn't rule out running, neither do I rule myself out.' Medvedev must have studied under the Rumsfeldian school of evasion.

This is setting up a potentially explosive confrontation, less between the two men than between their two camps: the liberals around Medvedev and the silvoki clan Putin heads. Vested interests can be tricky politics.

Further, pay attention to how the story around last week's train bombing develops. The political implications are unclear at the moment, but terrorism obviously plays to Putin's strengths (See: 1999 apartment block bombings.) An economy (Medvedev) v. security (Putin) election narrative would be interesting.

FT Alphaville charts the return of risk as the dust from Dubai settles.

Regular readers will note that I predicted on Friday that Dubai would be an isolated incident and the markets would return to calm this week as the information/communication out of the government improved.

Hand pats own back.

When the judging the systemic implications of Dubai World's default, it is helpful to keep everything in context. FP Passport does just that.

A final thought on Dubai: don't discount the city-state's long-term prospects too much. Service-based economies with weak domestic demand (or in Dubai's case almost no indigenous population) are destined to be pro-cyclical. The vision to become a financial, services, transport and residential hub in a region with limited integrated infrastructure and service capacity, as well as tremendous development potential, seems a sound one. If the new silk road will be paved with microchips, euros and renminbi, Dubai could very well become the great marketplace connecting east and west.

It is a holiday week here in the US, so I have been only passively following the developments of the past few days. But as the global reaction to the Dubai Government's request for a six-month restructuring and standstill on Dubai World's, and its subsidiary Nakheel's, debt makes its way to the US markets this morning (the US was closed for the Thanksgiving holiday yesterday), I have been thinking about the implications of the decision over my morning espresso (or 5 to be exact).

Briefly, a few thoughts on the decision:

-Legalese aside, this is a default and the markets are treating it as such. S&P has said that under its default criteria, Dubai World's restructuring may be considered a sovereign default, that is the failure of the sovereign to provide timely financial support to a 'core government-related entity.' The Dubai Ministry of Finance's bogus assertion that they are simply asking creditors to 'wait until May' is ludicrous.

-You can view the risk of contagion from two angles. One perspective would have us shaking in our trading smocks, worried that much like South East Asia in the late nineties, the bursting of a property bubble backed by the sovereign in an opaque legal and financial environment would quickly spread to other, similarly fragile economies. Just look at the spike in borrowing costs over the past 48 hours for not just Dubai, but regional peers like Abu Dhabi, not to mention emerging markets more globally. Compounding this fear is the still fragile state of the international financial system. On the other hand, and this is the perspective I have come to hold over this morning's coffee, Dubai is a unique beast, and its fallout should be fairly small. It is a property-driven bust with no economic muscle to speak of besides construction and services. It was always destined to burst in spectacular fashion amidst the global financial crisis. Its development model fundamentally relied on cheap borrowing costs, conspicuous consumption and financial services. Unlike its regional peers, it holds no natural resource wealth or, to my knowledge, potential, which is why it staked its future on becoming a global financial center. The implicit guarantee that the Dubai government, or even Abu Dhabi, would back Dubai World's obligations was a miscalculation, and now creditors are left uninformed and, until Monday at least, out in the cold. Its regional peers hold massive forex reserves, recovering oil and gas revenue and sovereign wealth funds that back most of their government-owned entities (companies similar to Dubai World.) The prospect of a similar situation developing in Abu Dhabi is highly unlikely. This is why, once markets settle next week, the contagion should be minimal.

-But the prospect of contagion, and current panic over Dubai's position, highlights the critical importance of information to the functioning of financial markets. Dubai World's fragile position has been apparent for months, and as I mention above, the assumption was that it was fully backed by the government. But in an opaque political and financial environment, this assumption was really a matter of faith. It was never clear that the government would fully back Dubai World's debt: that's why, as Willem Buiter points out, private creditors demand and earn higher risk premiums on property developers than they do on sovereign debt. I think this will raise interesting questions about, and perhaps greater scrutiny of, sovereign enterprises and wealth funds worldwide. Limited liability extends to the owners of these firms (that is probably a gross generalization), even if the owner is the state itself. As Buiter says, creditors will have to manage this risk the way they always do: hope for the best. Greater transparency will allow investors to more accurately price this risk. Finally, the current anxiety is compounded by the lack of information coming out of the Ministry of Finance. This is partly a matter of poor timing, with some markets closed for holidays in the Middle East and US. The government of Dubai has essentially told investors to wait until Monday, which to globally interconnected financial markets can be a lifetime. Even in an opaque environment, a timely and transparent response can go a long way towards stabilizing market expectations and limiting the contagion.

On Monday, Gillian Tett wrote an article in the FT speculating on whether the latest asset bubble is sovereign debt. Since the onset of the financial crisis, financial institutions have been flooding to (and indeed have been encouraged to) government bonds because they are 'safe' and 'low-risk' assets. That they are perceived to be safe and low-risk is also reflected in their prices. But as Gillian explains, this sense of safety may be misleading:

[C]ould this flight to the "safety" of government bonds in itself be creating subtle new dangers? Government debt, after all, has soared to levels not seen in peacetime for centuries, if ever, in many countries, not least the US and UK. Fiscal deficits are swelling across the western world. And the level of political commitment to curbing those deficits remains uncertain - not least because with yields currently so low there is less pressure on politicians to push through reform.... it is easy to imagine that some countries will end up eroding the value of their bonds by debasing their currencies in the coming years, printing money and stoking inflation.

Gillian's concerns reflect the main message of a book I am currently reading: This Time is Different, by Carmen Reinhart and Ken Rogoff. With a tag-line reading "Eight centuries of financial folly," the book uses a wealth of data to demonstrate just how frequently countries default on their domestic and external loans. The answer is: often.

One of the trends they identify is that banking crises are usually a precursor to sovereign debt crises. This is particularly true for emerging market economies, regardless of whether the banking crisis occurred in their country/region or the rich world, because of their reliance on funds from external sources. Since the rich world just went through a banking crisis (as part of the wider financial crisis), and levels of global trade have collapsed, this is something to watch out for.

But Gillian isn't talking about emerging markets: she's talking about large, wealthy countries like the US and the UK. Rich countries are very unlikely to default straight up. But there are other ways to partially-default on your loans, like inflation (as noted above). This works particularly well when both your domestic and external debt is denominated in your own currency (as it is in with the US).

The problem boils down to this: financial institutions just spent a lot of time & taxpayer money replacing now-worthless financial products like CDOs and commercial paper with government bonds. Now the value of those government bonds is at risk due to the huge sums of money governments spent bailing out those very same financial institutions. Unless governments (or more specifically, the wider public) are willing to make difficult spending choices to tackle national debt problems, we risk repeating this cycle a few years down the road.

And in case there's any doubt that governments have been loading up on debt, I will again point to the Economist's global debt calculator. Add to this the short-term costs of lost productivity from the financial crisis and the long-term costs of a massive demographic change in Western countries, and it's a sobering picture indeed.