Regional Security Implications of the Global Financial Crisis

1. Regional Security Implicationsof the Global Financial Crisis Council for Security Cooperation in the Asia Pacific 7th General Conference, Jakarta 16-18 November 2009 Charles Wolf, Jr.

2. Roadmap • Global Financial Crisis (GFC): Sources, Consequences, Remedies • Regional Security Effects and Implications: • Macroeconomic conditions and security • Defense budgets • Development budgets • Foreign assistance and foreign investment • Proliferation • Terrorism, piracy, threats to law and order • Regional security organizations • Concluding Remarks

3. GFC (1): Processes, Participants, Scale; Sub-Prime Mortgages, Lending, Securitizing, Debt Ratings, “Undue Diligence,” Credit Tightening, and Consequences (1) (2) (3) (4) (5) (6) Motivation of “ownership society”, Freddie Mac, Fannie Mae, loose monetary policy, low rates, diluted quality of borrowers and of mortgages Rating agencies (Moody’s, Fitch’s, S&P), insurers (AIG, Prudential, etc.) Lending practices of mortgagers, promotional efforts and weak credit scrutiny by lenders, further erosion of mortgage quality Packaging, “slicing and dicing,”derivatives through mixing and matching sub-prime and prime mortgages; collateralizing, securitization of CDOs/SIVs by issuers Marketers, distributors;leveraging (30:1),and leveraged sellers Leveraged buyers Processes & participants 102, banks, AAA ratings, conflicts of interest (i.e., “clients” are rated!), inadequate analytic ability and inherent difficulty of risk assess-ments 105, banks, investment banks, foreign and U.S. banks, e.g., UBS, Deutsche Bank, Merrill, Citigroup, Goldman 106, U.S. and global banks, central banks, SWF’s, “band-wagon” effects 106, banks, investment banks, Bear Stearns, Merrill, Lehman Bros, Citigroup, erroneous and omitted balance sheet entries due to AAA-ratings, lax FASB rules 107, mainly in U.S., some other countries 104, Countrywide, Home Equity, commercial banks, S&Ls, laxity of credit scrutiny Numbers & questions

4. GFC (2): Principal Sources and Contributors (Culprits ?) • Macroeconomic policies and imbalances: • Monetary policy (US): loose, permissive • Structural imbalances: US (I>S), China (S>I) • Ineffectual regulation in US: • Too little regulation? too much? wrong and confused? • Between 2000-2008, full-time US government financial regulatory staffgrew by 26%, regulatory budgets by 21% ($2.3 billion) !

5. GFC (3):Principal Contributors • Politically-mandated, subsidized (“sub-prime”) housing mortgages • Securitization, complex derivatives (credit default swaps, “moral hazard”) • Rating agencies • Leveraging (30-40 times!) • Ineffective corporate governance )

6. GFC: Consequences and Remedies • “Coupling” between crises in US, Europe, Asia-Pacific • GFC emanating from US, reinforcement by financial institutions, businesses, governments in Europe, Japan, China, & ROW • Is coupling generally close, loose, moderate? • Factors boosting coupling: trade, foreign investment, equity markets • Factors diminishing it: expanded domestic markets, transaction costs, protectionism • Regulatory reform: more, less, or different? • Efficient markets require ample, transparent, timely information • Important to reduce information asymmetries • Corporate governance: boards, disclosures, procedures • Redefining Tier I capital (from 4% to 8%, perhaps with further boost for “too-big-to-fail” banks?) • Should regulatory focus be national, regional, or international? (IMF, BIS, World Bank, G-8, G-20. G-77)?

7. Roadmap • Global Financial Crisis (GFC): Sources, Consequences, Remedies • Regional Security Effects and Implications: • Macroeconomic conditions and security • Defense budgets • Development budgets • Foreign assistance and foreign investment • Proliferation • Terrorism, piracy, threats to law and order • Regional security organizations • Concluding Remarks

8. Regional Security Effects(1):Macroeconomics and Security • Extensive (inconclusive) literature on relations between economic conditions and internal/external security (e.g., Marx, Tocqueville, Machiavelli, Hoffer, Deng, Huntington; “realists” vs.”idealists”) • Relevant variables include poverty,economic levels and growth, unemployment, inequality, expectations, informational access, etc. • One familiar model: instability/insecurity likely to increase if/as economy contracts, unemployment and inequality rise • GFC adversely affects some/all of these variables

9. Regional Security Effects (2):External Assistance & Investment • Foreign aid likely reduced: slower growth in donor countries, larger debt burdens and other fiscal claims: “stimulus” outlays, health and energy programs,etc. • Foreign investment flows uncertain: entrepreneurial incentives vs. asset protectionism; resource investments vs. technology investments --China’s investors (e.g. CIC, CITIC, CNOOC, other banks and companies),likely to be very active for “resource security”, high tech, other needs • Trade effects also uncertain: protectionism, short- vs. mid-term effects

10. Regional Security Effects(3): Proliferation • Heightened risks: • Potential sources may be deliberate or inadvertent (e.g., DPRK, Iran, Pakistan??) • Potential buyers may be in Asia, or Middle East • Dangers from possible links between piracy and proliferation; between proliferation and terrorism • Proliferation Security Initiative: 94 participating countries, whether to strengthen and how?

11. Regional Security Effects(4): Defense Budgets • Asia-Pacific defense budgets: under pressure from GFC • But likely different effects within region: • China: +18% (2009), 2010 (?) • Japan: 0% change (‘09). ‘10 (DPJ uncertainty) • Indonesia: -15% (2008), decrease in ‘09, 2010?? • South Korea: +4% (2008), +4% (‘09), 2010 (?) • Australia: + 5% (2008), uncertain ‘09, ‘10 • GFC effects and A-P political/security conditions

12. Regional Security Effects(5): Development Effects • Mixed results from preliminary examination of 2008-2010 health, education, infrastructure budgets of China, Japan, Indonesia, South Korea, Australia • Aggregate government revenues decreased or barely constant (“coupling” effects) • But “stimulus” packages in all 5 countries exceed decreases of development outlays • China’s stimulus 13% of GDP ! • Japan’s stimulus 3.1% GDP • Korea, Australia, Indonesia 1-3% GDP

13. Regional Security Effects (6):Multilateral Security Organizations • ARF, CSCAP, SCO, 6-Party Talks, EAS, bilateral/trilateral links (US-Japan-Korea, US-Indonesia) • Is there a useful role for overarching regional organization? G-20, or subset?

14. Roadmap • Global Financial Crisis (GFC): Sources, Consequences, Remedies • Regional Security Effects and Implications: • Macroeconomic conditions and security • Defense budgets • Development budgets • Foreign assistance and foreign investment • Proliferation • Terrorism, piracy, threats to law and order • Regional security organizations • Concluding Remarks

15. Concluding Remarks (1) • “Game-changing” global trends will affect regional security • Enhanced political-economic-security roles of China, India, Indonesia, Brazil, South Korea, other countries: a “pluralistic” (rather than “multipolar’) world • US role perhaps diminished (relatively), but still largest power center (e.g. largest global market, but with likely smaller net imports) • Japan with DPJ may be more active in A-P, (or less? or unchanged?) • Europe’s role may be diminished, but perhaps enhanced if viewed as “balancer”?

16. Concluding Remarks (2) • These “game-changers” perhaps imply that effective solutions/management of specific regional security issues (preceding charts), will depend more on A-P institutions, and ad hoc coalitions possessing two characteristics: ---motivation based on priority national interests ---willingness to share burdens (costs) along with decision making • “Smart Power” as collective, prudent combinations of “soft” and “hard” power