The world has been slow to realize that we are living this year in the shadow of one of the greatest economic catastrophes of modern history. But now that the man in the street has become aware of what is happening, he, not knowing the why and wherefore, is as full to-day of what may prove excessive fears as, previously, when the trouble was first coming on, he was lacking in what would have been a reasonable anxiety. He begins to doubt the future. Is he now awakening from a pleasant dream to face the darkness of facts? Or dropping off into a nightmare which will pass away?

He need not be doubtful. The other was not a dream. This is a nightmare, which will pass away with the morning. For the resources of nature and men’s devices are just as fertile and productive as they were. The rate of our progress towards solving the material problems of life is not less rapid. We are as capable as before of affording for everyone a high standard of life—high, I mean, compared with, say, twenty years ago—and will soon learn to afford a standard higher still. We were not previously deceived. But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time—perhaps for a long time.

John Maynard Keynes – The Great Slump of 1930.

The restoration of confidence was undeniably needed. After all, Mr McDaniels’s company it was that gave triple-A ratings to thousands of the sub-prime mortgage loans whose deterioration triggered the global recession. Triple-A, it should be noted, means a bond has less than a 1 in 10,000 chance of defaulting – in Moody’s’ estimation, as Michael Lewis points out in The Big Short, the sub-prime loans were as safe as US Treasury bonds (83 per cent of the triple-A ratings his firm gave to mortgage bonds in 2006 were subsequently degraded). McDaniels’s company, too, was still awarding triple-A ratings to Bear Stearns, Lehman Brothers and AIG shortly before – in part because they believed the ratings and invested heavily in sub-prime bonds – they all went bust and almost brought the whole financial system down with them. Mr McDaniels, as Lewis reports, told an investor in 2007: ‘I truly believe our ratings will be accurate.’

A restoration of confidence is also needed in light of the congressional Financial Crisis Inquiry Commission’s damning verdict on the ratings industry, published in January. The rating agencies, the Commission concluded, ‘abysmally failed in their central mission to provide quality ratings on securities for the benefit of investors…The rating agencies placed market share and profit considerations above the quality and integrity of their ratings.’ The Commission selected Moody’s as its case study for bad practice in the industry.

The sheer ineptness of the companies is documented in embarrassing detail in The Big Short. In one of many examples of their incompetence, Lewis shows how they rated floating-rate mortgages, whereby borrowers would spend two years on a low, “teaser” rate before the rate rose sharply for the rest of the term, more highly than steadier fixed-rate loans. The ratings remained the same even when the interest payable on the loans soared: ‘The rating agencies simply assumed that the borrower would be just as likely to make his payments when the interest rate on the loan was 12 per cent as when it was 8 per cent.’

That floating-rate loans received higher ratings meant that more people were able to take them out – the proportion of US sub-prime mortgages with floating rates rose from 40 to 80 per cent in the five years to 2007. Buoyed by the lively trade in mortgage securities, lenders persuaded tens of thousands of people who could not afford it to saddle themselves with these loans. As Lewis notes, ‘sub-prime borrowers tended to be one broken refrigerator away from default – few, if any, should be running the risk of their interest rate spiking up,’ but Moody’s couldn’t get the loan ratings out of the door quickly enough: the agency went from spending six weeks assessing the credit-rating of a single security to issuing thirty new triple-A ratings on mortgage bonds every day (the Commission called the company a “Triple-A factory”).

But it was not just stupidity that threatened the system; it was also a complete – and sometimes suspicious – lack of transparency. Another passage from The Big Short relates what happened when two investors, Danny and Vinny, went to meet a woman from Moody’s to ask how she went about rating sub-prime bonds:

The woman from Moody’s was surprisingly frank. She told [the investors] that even though she was responsible for evaluating subprime mortgage bonds, she wasn’t allowed by her bosses simply to downgrade the ones she thought deserved to be downgraded. She submitted a list of the bonds she wished to downgrade to her superiors and received back a list of what she was permitted to downgrade. “She said she’d submit a list of a hundred bonds and get back a list with twenty-five bonds on it, with no explanation of why,” said Danny.

…

“Here’s what I don’t understand,” said Vinny, hand on chin. “You have two bonds that seem identical. How is one of them Triple-A and the other one not?”

“I’m not the one who makes those decisions,” said the woman from Moody’s, but she was clearly uneasy.

“Here’s another thing I don’t understand,” said Vinny. “How could you rate any portion of a bond made up exclusively of subprime mortgages Triple-A?”

“That’s a very good question.”

It’s a question the ratings agencies prefer to duck. Ray McDaniel, of course, is not alone in benefiting from the mess he helped cause – most of the heads of the investment banks that conned or bullied the agencies into upgrading sub-prime ratings (Moody’s complied not just because it didn’t understand the complex bond packages but because of the threat that the banks would go to its rival, S&P, if the rating wasn’t high enough to sell the securities on to pension funds and insurance firms), or that bet on the dodgy bonds themselves, are still in their jobs, and still raking in obscene bonuses.

Those banks are again making profits, thanks to being bailed out by the US taxpayers they had already shafted once. Moody’s net annual profit, on the other hand – despite the alleged restoration of confidence in the company – was 10% lower in 2010 than it was in 2005 when McDaniels took the helm. During that time, according to El País, the salaries of top staff have doubled. Why there hasn’t been a revolt against these people (not least from the shareholders who are so obviously being taken for a ride) is a mystery, but as with the Middle Eastern dictators they resemble, who are finally being punished after years of pillaging their countries, the day of judgement is surely only deferred.

The conflict had several immediate results.

Already fraught relations between Moscow and Tbilisi plunged to new depths and diplomatic relations were severed.

Russia and three other countries recognised the independence of the breakaway Georgian regions of South Ossetia and Abkhazia.

And relations between Russia and the West – the US and the EU – deteriorated to their worst level since the collapse of the USSR – there was even talk of a new Cold War from western politicians.

The Cold War analogies led some commentators to argue Russian foreign policy had taken a decisive anti-western turn and things could and/or should never be the same again

Two years later, the one thing that seems unlikely to ever be the same again is the shape and size of Georgia. If recognition from Russia was not enough, the recent International Court of Justice opinion that Kosovo’s unilateral declaration of independence was not against international law, makes it even less probable Tibilsi could regain control of its lost regions.

But otherwise those predictions and talk of a new Cold War couldn’t appear more misplaced.

Russian relations with Georgia remain hostile. Although the border has reopened in places and some business links survive, ties look set to remain frosty as long as Prime Minister Putin and President Saakashvili remain in office, given their dispute now has a personal animus that goes beyond the geo-political.

But when it comes to relations with the western powers, over the past year things have improved significantly.

One of President Obama’s most successful foreign policy initiatives to date has been the ‘reset’ of relations with Russia that has led to a new nuclear arms control agreement, START 2, but Washington appears to have been pushing at an open door. Though the talks over START took a bit longer than expected and the Russians bargained hard, President Medvedev genuinely seemed to want to do a deal.

When it comes to Europe, the Russians were reaching out to their arch rivals, the Poles, even before the tragic air crash in Russia that killed the Polish President and many of the country’s elite in April. Mr Putin, who has a reputation for playing hardball, handled the consequences of the disaster with a sensitivity that surprised many and Poland has reciprocated.

Russia knows Poland is now an important player in the EU and the overtures to Warsaw show Moscow wants to improve relations with the wider EU, damaged in the past few years by disputes from the disruption of gas supplies via Ukraine, to the killing of the former Russian agent, Alexander Litvinienko, in London.

What lies behind this change of policy in Moscow?

The reasons for the change of approach from Russia were outlined in a leaked Foreign Ministry paper in May  and they appear to be highly pragmatic.

The economic crisis came as huge shock to Russia’s leaders as the economy shrank by up to 10%. The fall in global economic activity led to a big fall in the price of oil on which Russia depends for much of its GDP.

The penny seems to have dropped in Moscow  that the oil and gas industry need to be much more efficient and the country needs to diversify away from reliance on the energy sector. So President Medvedev and Prime Minister Putin want to modernise the Russian economy, and they have decided they need good relations with the western economies to get access to investment and technology.

Last month, Russian Foreign Minister, Sergei Lavrov, wrote a significant essay in Russia in Global Affairs explaining the policy change in more depth

So is Moscow turning  westwards, rather than to its new partners in the BRIC bloc – China, India and Brazil – when it really needs help?.

Well this change could be a sign that the talk of the shifting balance of power in the world is overblown.

Equally, it could well be a sign that the emergence of new powers, alongside the presence of the traditional western powers, has given all states more options in foreign policy – and a country like Russia, which sees national interest through the lens of realpolitik, can pick its horses for courses in the global arena.

The World Tonight is broadcast at 22.00 UK time on BBC Radio 4 and online

Delivering the annual lecture at The Ditchley Foundation last week, Strobe Talbott suggested that the “promise” of the Obama Presidency – both in the domestic and the international arenas – is now “at risk”. “[W]hatever fate is in store for the current president of the United States”, Talbott argued,

“one thing is for sure.  His success in tackling the major issues of our time will depend on his establishing a degree of common purpose with his partners in national governance at the other end of Pennsylvania Avenue and with his partners in global governance around the world.”

- Elsewhere, over at The Cable, Josh Rogin reports on the slow progress of reviews into US development policy – the Presidential Study Directive on Global Development and the Quadrennial Diplomacy and Development Review.  The Economist, meanwhile, highlights Brazil’s growing identity as a significant aid donor.

- Finally, the head of the UK Financial Services Authority, Adair Turner, cautions against the default acceptance of prevailing economic ideology, suggesting that policymakers would do well to draw on a diversity of economic opinion. Joseph Stiglitz, meanwhile, explores the Keynesian prescription for the global economy.

Michael Pomerleano explains the need for a new institution with the necessary legitimacy to provide global financial stability, arguing that “[n]ational public policies can no longer be independent of global collective-action problems”. Amartya Sen, meanwhile, explores the continuing significance of the 18^th Century ideas of Adam Smith to contemporary global economic troubles.

- Elsewhere, in an interview with The Christian Science Monitor, Henry Kissinger offers his views on Obama’s recent nuclear initiatives, US-China relations, and coherence among the BRICs. Over at World Politics Review, Nikolas Gvosdev reports on the lack of support forthcoming among BRIC countries for strict sanctions on Iran and highlights some of the other options open to the US administration in dealing with Tehran. Jonathan Holslag, meanwhile, assesses China’s recent diplomatic “charm offensive”, concluding that this will yield little over the long-term if words aren’t backed up by meaningful action.

- Finally, two television debates and nearly three weeks into the British general election campaign, David Marquand explains why this is “a moment for careful historical reconnaissance”. Assessing the rise of Nick Clegg and the Liberal Democrats, he explores comparisons with the three-party politics of Britain in the early 1920s. The FT’s Philip Stephens, meanwhile, assesses the impact of the debates and the implications of a hung parliament for the British electoral system.

It’s commonplace to describe the financial crisis as a once-in-a-century event, but I question whether that is the case. Perhaps we’re not in the midst of a short-lived financial shock, but a long crisis that stretches back into the 1990s.

Here’s Paul Blustein on Alan Greenspan:

The Fed chief told the G-7 that in almost fifty years of watching the U.S. economy, he had never witnessed anything like the drying up of markets in the previous days and weeks.

Greenspan wasn’t speaking in Autumn 2008 when Lehman’s collapsed, however, but ten years’ earlier in the wake of the spectacular blow-up of Long-Term Capital Management, which lost $4.5 billion almost overnight in what the fund’s principals post-rationalised as a 100-year flood.

Long-Term (with its superbly hubristic name) was brought low by derivatives, just as Lehman’s would be a decade later.

(Robert Rubin, Clinton’s Treasury Secretary, was one of those left picking up the pieces – part of ‘the committee to save the world’, with Greenspan and Larry Summers. Rubin went on to preside over Citigroup as it needed a succession of massively expensive bailouts, when its derivatives tanked in the subprime crisis.)

The proximate cause of Long-Term’s failure was Russia’s Rouble crisis, when the country defaulted on its debt after the IMF refused to mount a second bailout.

The Russian crisis itself came in the midst of a long series of dramatic economic failures that hits the world between 1997 and 1999, mostly in East Asia (Thailand, South Korea, Indonesia etc), but which also battered Brazil and would devastate Argentina in 2002. Blustein again:

Time and again, panics in financial markets proved impervious to the ministrations of the people responsible for global economic policymaking.

IMF bailouts fell flat in one crisis-stricken country after another, with the announcements of enormous international loan packages followed by crashes in currencies and sever economic setbacks that the rescues were supposed to avert.

Greenspan believed that the crisis of 1997-1999 was caused by “more investment monies flow[ing] into these economies than could be profitably employed at modest risk.”

Ben Bernanke,his successor at the Fed, took a similar view. In 2005, he argued that, in response to the crisis, East Asian countries became net exporters of capital, rather than net importers. Even countries such as China, which had survived the crisis unscathed, built up reserves, in part to hedge against future financial turbulence.

In practice, these countries increased reserves through the expedient of issuing debt to their citizens, thereby mobilizing domestic saving, and then using the proceeds to buy U.S. Treasury securities and other assets.

Effectively, governments have acted as financial intermediaries, channeling domestic saving away from local uses and into international capital markets.

In the meantime, the money that had flowed into emerging markets was looking for a home. During the dot.com era, it found it in technology stocks. But they crashed in 2001, costing investors $5 trillion of losses. To restart the party, Greenspan then cut interest rates savagely (and even more so after 9/11). Rates were down at1% well into 2004.

As a result, the United States (and the UK and various other deficit countries) were faced by the toxic combination of low interest rates and what Bernanke dubbed a ‘global savings glut’ (e.g. lots of capital competing to find risk).

And my, how the debtors loved it! Bankers went stark raving mad, lending standards collapsed, and a massive asset price bubble was inflated. It ended in a colossal hangover (mostly confined to the West, it should be remembered), once US housing prices finally started to fall in March 2006.

In a seminar I led at Brookings with Bruce Jones earlier this week (discussing our recent paper with Alex on globalization’s woes), I argued that perhaps we should stop pretending the financial crisis started in 2007, but should instead picture it as a truly global crisis that has had (so far) three main waypoints:

• The East Asian crisis (with hits on other countries outside Asia).
• The dot.com crash.
• The ‘subprime’ crisis, (which may itself be triggering another wave of sovereign debt crises).

Admittedly, there was some push back to the notion that we are in the midst not of a shock, but of a slow motion car crash. But the connections seem strong to me. At the very least, it unwarranted to claim that recent events have been ‘unprecedented’ accidents that will only occur every century or so.

It all makes me think of The Way Things Go, a famous and fantastic film by the Swiss artists Peter Fischli and David Weiss – in which you watch unfold a chain reaction of levers, pulleys, slides, seesaws, and lots of whizzes, bangs and explosions. The full film is half an hour long, but the short clip at the top of this post gives you a flavour.

The analogy is not perfect though. Fischli and Weiss understood the causality that tied together their mish mash of junk and chemicals. They could tell you where it was all going to end up. Their whole thing had been intelligently designed.

Our economy, I think, has surpassed human understanding. We can bash, poke and kick it, and hope it will start running smoothly again. But it would be foolish to trust those who confidently pronounce this crisis over, and even less those who claim to know what is coming next.

Update: Alex sends me this 1999 essay on Long-Term Capital Management by Michael Lewis, who has written a much heralded book on the recent crash. Here’s an extract:

It is interesting to see how people respond when the assumptions that get them out of bed in the morning are declared ridiculous by the wider world. There is obviously now a very great social pressure on the young professors [who reinvented bond trading and whose models blew up Long-Term] to abandon the thing they cherish most, their hyperrational view of the world…

Oddly, the question that occupies them is not whether to push on with their models of financial behavior but how to improve the models in light of what has happened to them. ”The solution,” [Nobel Prize winner and Long-Term partner] Robert Merton says, ”is not to go back to the old, simple methods. That never works. You can’t go back. The world has changed. And the solution is greater complexity.”

Everyone on Wall Street knew that the people who ran the models were ripe for exploitation. ‘Guys who can’t get a job on Wall Street get a job at Moody’s,’ as one Goldman Sachs trader-turned-hedge fund manager put it.

Inside the rating agency there was another hierarchy, even less flattering to the subprime mortgage bond raters. ‘At the rating agencies the corporate credit people at the least bad,’ says a quant who engineered mortgage bonds for Morgan Stanley. “Next are the prime mortgage people. Then you have the asset-backed people [dealing with sub-prime mortgages, for the most part], who are basically like brain dead.

Wall Street bond trading desks, staffed by people making seven figures a year, set out to coax from the brain-dead guys making high five figures the highest possible rating for the worst possible loans. They performed the task with Ivy League thoroughness and efficiency.

Despite their pivotal and disastrous role in the financial crisis, business for the ratings agencies is booming. If anything, their influence, meanwhile, has grown, especially over governments, as they threaten countries with a sovereign debt downgrade.

I was especially intrigued by media coverage for a recent report from Moody’s, which claimed that the US, UK, Germany, France and Spain are all at risk of social unrest as governments struggle to get their finances under control. According to Moody’s Chief International Economic and Financial Policy Analyst, Pierre Cailleteau:

Growth alone will not resolve an increasingly complicated debt equation. Preserving debt affordability at levels consistent with AAA ratings will invariably require fiscal adjustments of a magnitude that, in some cases, will test social cohesion.

We are not talking about revolution, but the severity of the crisis will force governments to make painful choices that expose weaknesses in society.

Strong stuff. And interesting too. One of the key questions for the next few years is whether the fallout from the financial crisis will be toxic enough to damage, or even break, some societies.

So I thought I’d read Mr Cailleteau’s report, rather than just relying on the Telegraph’s summary. I wondered how strong his analysis was. Was he a smart guy or one of those dubbed in Lewis’s book as the ‘brain dead’?

But then I hit the buffers. Go to Moody’s website and there’s no content at all available unless you register (which includes pretending to read a 6103 word user agreement – the site knows if you haven’t at least scrolled through it).

Once I’d gone through all this rigmarole and logged in, I was told that access to Cailleteau’s report “is not part of your current service”. (I was allowed to read the report’s press release. Big deal. I struggle to think of another organisation that requires registration for that.) Nor could I find a biography for Cailleteau. Only one of his reports was freely available to subscribers (a research note on methodologies). And even the link to pricing information for his ‘social unrest’ report was not working.

So I am left none the wiser about Cailleteau’s argument or credentials. All I do know is that he dismissed talk of a systemic global banking crisis in August 2007, a year before [corrected] Lehman’s nearly brought down the world’s economy.

Of course, anyone can make a mistake (though that one’s a doozy) – but surely it is no longer acceptable for the ratings agencies to hype their work to the press and lord it over the world’s economies, without letting us see the evidence on which they base their diagnosis and prescriptions.

More transparency please. Either on a voluntary basis. Or enforced through regulation.

- European Geostrategy suggests that EU security and defence policy is like a jazz band and explains why a White Paper providing a “grand strategy” is needed. EUobserver, meanwhile, has news on the emerging shape of the European diplomatic service – its structure and staffing – as member states gear up to secure the important EEAS secretary general post.

- Elsewhere, Constanze Stelzenmüller takes an in-depth look at the travails of German security policy, offering insights into how it might evolve. Highlighting the lack of strategy, she argues that “fundamental decisions regarding German security policy have been repeatedly forced into the Procrustean bed of moral necessity, domestic imperatives, or the demands of external alliances.”

- Finally, over at openDemocracy, Andy Yee explores the “hedgehog’s dilemma” between China and the West, highlighting a gradual acceptance of different core values. TIME magazine, meanwhile, assesses the slow progress toward democracy in Hong Kong and the possible wider implications from Beijing’s perspective.