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Three issues will dominate the final quarter of 2008: the global financial crisis, U.S. self-absorption and the Russian resurgence. The financial crisis has its roots in an American liquidity...

Three issues will dominate the final quarter of 2008: the global financial crisis, U.S. self-absorption and the Russian resurgence.

The financial crisis has its roots in an American liquidity meltdown. But as the days flow by, it will become obvious that the crisis is evolving as it spreads to the rest of the world, and its impact will be harsher and require more time for recovery elsewhere. For in the United States, actions have already been taken to rectify the liquidity imbalances, and although plenty can still go wrong and a recession is probably inevitable, the system is beginning to mend. In Europe, however, the liquidity shortage has unearthed a deep banking debacle.

Remediation is only now being started, and the problem is only now being identified, much less evaluated. The American recession will probably be over by year’s end, but Europe’s will likely stretch through most of 2009. And in East Asia, where the problem is neither liquidity nor banking but loss of export demand, recovery cannot even begin until the West begins demanding Asian goods en masse. The United States might have set the crisis running, but it will be Europe and Asia that really give it its legs.

In the midst of a presidential election, a lame-duck administration, a recession and ongoing efforts to stabilize Iraq, Washington is essentially in lockdown. It has neither the capacity for nor the interest in dealing with anything that is not on a very short list of topics. Mitigating the recession is now at the top of that list, with Iraq second in line. In Iraq, U.S. policy has mutated somewhat. Until now, Washington was forced to deal with Iran, as Iran maintained the ability to scuttle any progress in Iraq. But now Iran, for various reasons, has largely moved away from its policy of stoking militia fires in Iraq. It would be a stretch to say that all concern about Iran’s ability to set Iraq on fire has evaporated, but Washington certainly feels it can shape Iraq into more or less whatever it wishes so long as it does not flagrantly cross any red lines. This does not mean for a second that things are easy; creating a functional state out of the Shiite, Sunni and Kurdish populations is a lengthy and possibly fruitless task. However, Iran’s apparent inability to create chaos in Iraq has drawn some of the desperation out of U.S. policy.

Finally, and to a certain degree integrated into the financial crisis and American preoccupation, comes the issue of Russia’s rise. In the third quarter Russia proved that it remains capable — militarily and politically — of invading a neighbor, the former Soviet state of Georgia. While not immune to global financial chaos, Russia is far better prepared than most states to weather the storm; even after massive investment outflows, Russia still holds more than $700 billion in reserve funds and a fat budget surplus. Moscow has a limited window in which to act before the United States withdraws from Iraq and turns its attention northward, so Russia will be using the time to sow as many problems for the United States as possible. Russian plans are already in the works for Latin America, the Middle East and Africa, in that order. And to keep the pressure on and the momentum going, Russia is expected to make a new thrust — more political and economic than military — in Ukraine. Under the cover of the financial crisis (which is hitting Europe much harder than the United States) and American preoccupation, the chances of Russia successfully expanding its influence definitely qualify as betting odds.

Note to readers: Our fourth-quarter forecast is intended to be a supplement to our annual forecast and third-quarter forecast. Within each section of this quarterly we have extracted the critical trends identified in our previous forecasts and indicated where we have been right or wrong and what is coming in the next three months. We have also examined new trends that have evolved from regional developments, independent of the earlier forecasts.

Global Economy

Ultimately, Stratfor delayed the release of our fourth-quarter forecast due to the winds of change ripping through the U.S. financial industry. With so much uncertainty, it was impossible to peer minutes, much less months, into the future. But now, though the dust is far from settled, the outlines are in place for an American-led financial rescue package that puts the crisis into a context that allows for forecasting.

This section will not serve as an overview on how the crisis came about (we have written a history and tactical forecast on the financial crisis elsewhere), but it will outline the broad picture Stratfor sees in the weeks going forward.

• Regional trend: The United States is in a liquidity crisis, but the fundamentals of the U.S. economy remain strong. Overwhelming state intervention will ensure that the United States recovers quickly from an impending, and probably inevitable, recession.

In the United States, the crisis is ultimately one of liquidity. Underneath all the froth, the American banking system remains stable. Yes, there are some questionable assets that have initiated panic, but on the whole American banks are solid. Before the political process in Washington took over the system and in essence made it impossible for banks to close, only 13 banks had gone under. During the recession of the early 1980s, several hundred went bust per year.

Liquidity crises are relatively — and we emphasize the word “relatively” — easy to fix. They “only” require injections of capital into the system, which the U.S. government has done on a mammoth scale, in order to restart lending and thus normal economic activity. At the time of this writing, banks have already increased their lending rates from the crisis lows, and we see the panic beginning to lift within weeks. For the United States, there will almost certainly be a short recession, but the way out has already been sketched.

• Regional trend: With Europe dealing with a deeply entrenched banking crisis and Asia facing a plunge in exports, the financial contagion will be more deeply felt outside the United States than within.

When the U.S. liquidity crisis slammed into Europe it had identical impacts — at first. But within a few days, it became apparent that Europe has other problems. Unlike the United States, Europe has a banking system with many portions that are not very healthy. Austrian, Swedish and Italian banks are overexposed to Central Europe, which is now in a credit hangover. German banks’ corporatist links have left them with questionable assets far greater in value than anything American subprime practices generated. Irish and Spanish banks face much deeper subprime problems relative to their economic size than American banks. And the list goes on and on. So while the United States has a liquidity crisis that can be addressed “relatively” easily, Europe faces a banking debacle that has been uncovered by the liquidity crisis — and dealing with that banking debacle is likely to take more than a year.

These crises have not really affected Asia directly, for Asian states are built upon massive and artificial flows of liquidity. States routinely funnel more liquidity into their systems than even the U.S. Federal Reserve is doing with its record-breaking operations to combat the American liquidity crisis. So even with the United States and Europe struggling, there are very few liquidity problems in China or Japan.

The Asian problem will be neither liquidity nor banking, but exports. The United States faces a short recession and the Europeans likely a long one. For Asian economies, the problem will be a plunge in Western demand for Asian exports that will hit these economies at their most sensitive point: employment. China and Japan keep their systems flush with liquidity in order to ensure maximum employment regardless of profitability. As Western growth slows, demand for Asian goods will drop, and the Asians will have to either shut factories down or subsidize them to keep operations active. Luckily — and we are not sure that “luckily” is the correct word — this will take some time. We do not expect East Asia to really slide into crisis mode until late in the fourth quarter, but the crisis will strike the region to its very core.

• Regional trend: Inflation is on the rise on a global scale.

High inflation was the primary economic issue for countries across the globe for the first nine months of 2008. Overextension, combined with a deepening economic crunch, will finally turn this trend on its head in the final quarter. Across the developed world, demand is dropping, and that cannot help but put a cap on commodity prices.

• Regional trend: The global financial crisis’ contagion will contribute to a significant decline in the price of oil and defuse much of the “geopolitical heat” in the markets.

Let us close this section with a few words on oil. Stratfor has been saying for some time that the high oil prices of the last three years are not rooted in fundamentals or even in reality in general, so we stopped forecasting any specific prices. In our last quarterly forecast, we said the price of oil would drop (and it did), but we were focused more on causes rooted in geopolitical risk rather than the effects of the financial crisis. At present, much of the speculative froth and fervor that had built up prices has been dying down. In its place is a growing realization that the United States and Europe are in recession, while East Asia is about to slip into recession. With the world’s three largest economies using less energy, prices are certain to slide. This realization is dawning only now, when prices have already dropped from their highs by 50 percent. The hype is mostly gone; all that remain are universally bearish fundamentals. The price drop to date is just the beginning — and several countries, including Venezuela and Russia, stand to lose a lot from a precipitous drop in oil prices.

Former Soviet Union

• Regional trend: Russia is re-emerging and will take advantage of the imbalance in U.S. power that has resulted from the wars in Iraq and Afghanistan.

Russia’s third quarter was dominated by the war with Georgia, which was Moscow’s coming-out party to prove that it could dominate and/or crush its neighbor unless the United States rushed to the smaller country’s aid. The Kremlin had been making technical preparations for such a war for years, but timing was an issue. Moscow was forced to act in the third quarter because of the possibility that the United States might be freed from its entanglements with Iran and in Iraq. Since the war in August, the ripple effects of Russia’s bold move have been felt throughout the world, but they are most defined in Russia’s periphery. As each country re-examines its relations with Russia, Moscow is taking stock of the levers it has carefully placed in its periphery and around the world and considering who it can pressure, or even break.

• Regional trend: Following the Russo-Georgian war, each former Soviet state — and much of the rest of the world — is redefining its relationship with or perception of Russia. Moscow will next turn its focus to Ukraine, which will become the center of the Kremlin’s universe in the fourth quarter.

The center of Russia’s focus for the fourth quarter is Ukraine, which Moscow sees as the cornerstone of its ability to reach into Europe and protect itself from Western encroachment. Since the 2004 Orange Revolution, Ukraine has been unstable and chaotic in its attempts to push away from its former master, Russia, and toward the West. Moscow has encouraged Ukraine’s instability as a means of preventing the former Soviet state from aligning fully with the West, but now is the time to pull Kiev firmly back into the Russian fold.

Russia will use countless levers to influence Ukraine’s inner dynamics, including: the Russian security services’ high degree of infiltration in Ukraine; the country’s complete dependence on Russian energy; Ukraine’s financial and economic turmoil; Russia’s control over most of the Ukrainian oligarchs; the interconnection between the two countries’ organized crime systems; Russian military forces on Ukraine’s soil; and the mere fact that approximately half the Ukrainian population considers itself beholden to Russia.

But the largest opportunity for Moscow will come in the December snap elections, scheduled after the Ukrainian government collapsed (again) in October. Elections in Ukraine are never certain to take place, but the dynamic surrounding possible elections in the country will remain whether or not the polls actually take place. The pro-Western Orange Coalition has already broken up over Kiev’s relationship with Russia, and those coalition partners who are leaning back toward Moscow, along with the pro-Russia parties, are in a healthy lead in public opinion polls. Ukraine has never been predictable, but it also has never seen an election or governmental shift while Russia’s full focus is on ensuring that Ukraine stays as far away from the West as possible.

A few other former Soviet states are on Moscow’s agenda, though they are not as high-priority as Ukraine. Georgia’s government is still seeing the fallout from the war, and Georgian President Mikhail Saakashvili’s future is unclear. Russia has allowed Saakashvili to remain in office because he is a spent force, but the Kremlin has a line of political forces in place to remove him should he gain strength. Russia and Belarus spent much of the third quarter arguing over energy prices, bank credits, missile defense and Minsk’s delay in recognizing the independence of Georgian breakaway regions Abkhazia and South Ossetia. The fourth quarter will be a test for Belarus as it decides whether to bend to Moscow’s will or risk reaching out to the West and being crushed by Russia in the process.

Russia is also active in the Baltic states. An upcoming election is likely to leave Lithuania with a government more amenable to Moscow, but it remains to be seen how this new government will fit in with Lithuania’s historical allies — Poland, Estonia and Latvia, which are all vehemently anti-Russian — and how Moscow can use the new government to divide that allied bloc. Azerbaijan is weighing its future relations with Moscow, since Russia has proven it can cut off the country’s energy flow, which in turn cuts off its cash source. Baku will work to balance its desire to maintain good relations with Moscow and its desire to keep Western cash flowing in.

• Regional trend: The global financial crisis is ripping through Russia, but it is not crippling the country. Rather, the Kremlin is using the situation to assert more control over regulations, banks, businesses and the oligarchs inside Russia while looking for opportunities abroad.

Market economies do not work in general in a country like Russia. Since the Russo-Georgian war, the Russian stock markets have been on a wild roller-coaster ride, and Russian companies have seen massive foreign investment flight. This has left those companies and their oligarchs looking for funding in their own pockets or from the state. But unlike most countries, Russia is not in danger of collapsing financially, because it sits on massive amounts of foreign currency reserves, built up over the past decade from soaring energy prices.

Instead, the Kremlin is using the unstable financial situation to reassert the primacy of the Russian state by weeding out small- and medium-sized institutions that were never really under government control. The Kremlin is also using the situation to force the oligarchs to pour their own cash — which they had stored abroad, far from the Kremlin’s grasp — into the system in order to keep the markets stable and the oligarchs’ companies afloat.

This proves just how much control Russian Prime Minister Vladimir Putin has over this class of billionaires, and it bodes an end to the oligarchic tradition that ruled Russia during most of the 1990s and well into the following decade. The oligarchs are no longer independent power brokers, but simply another tool — and a very wealthy one — for Putin and the Kremlin. The fourth quarter will start revealing who can keep up with the Kremlin’s demands and who will fall. A massive realignment inside Russia’s business sector is under way, though the Kremlin is orchestrating all of it in order to strengthen and prove its power within the country — and over those who thought they could keep their cash outside the motherland.

Russia can now also meddle in, prop up, buy or influence financial systems around the world. It is reaching out with its vast amounts of cash to “help” other countries hit hard by the financial meltdown — though in typical Kremlin style, Moscow is extending aid to states it considers politically valuable. In the past, the Kremlin used oligarchs’ cash to do this covertly, but since that cash is needed at home, the government is openly targeting other countries’ institutions. Russia is getting involved in the financial situations in Iceland, the United Kingdom, Ukraine, Kazakhstan and Georgia, to name a few. But the Kremlin must balance this desire to take advantage of financial tremors around the world with its need to keep the domestic situation stable and plan for the future of Russia’s resurgence, amid concerns that its cash flow could soon dry up as energy prices tumble.

• Regional trend: As Russia reasserts itself against the West, it has many levers with which to counter the United States in regions such as the Middle East and Latin America. However, Russia’s ability to divide the United States’ allies in Europe will give it the most success.

Since the war with Georgia, Russia has shown that it is interested in countering the United States’ status as global hegemon by strengthening its relationships throughout the world. Moscow has also proved to Washington that it has levers in place to erode the United States’ position in the Middle East (which is Washington’s primary focus) and in Latin America (which is in the United States’ backyard). But Russia will not push its ability to meddle with Middle Eastern countries like Iran too far; Moscow does not want a strong Tehran in the long run, and Washington could seriously lash back at the Russians. Moscow also knows that its actions in Latin America are mainly symbolic in that the efforts needed for real military, energy, grassroots or political moves would be enormous and would not benefit Russia much. However, this does not mean Moscow’s friendship is not incredibly important to those in Latin America looking for their own leverage against Washington.

It is in Europe where Russia’s moves against the West will be felt the most. In short, the Europeans are splitting apart and much of it has to do with Russia — a situation Moscow is trying to magnify. Russia is already using Europe’s economic instability to pit the countries against each other. But Moscow is also undermining NATO, a fact that will be highlighted when the alliance meets in December to discuss Russia and the possibility of extending membership action plans to Georgia and Ukraine. Germany has already staunchly come out against this Washington-initiated plan and is also discussing the possibility of a private security agreement with Russia, a major shift toward Berlin’s usual role when Europe is split. But Russia also has its customary levers, like energy, to use in Europe; energy deals with Germany, the Czech Republic, Lithuania and Ukraine will still be up in the air in the next quarter.

Middle East

• Regional trend: The United States has successfully forced the countries that made al Qaeda possible into the American alliance structure. It will now use that structure to clamp down on those still resisting American power. In doing so, it might inadvertently trigger tensions with Israel.
• Regional trend: The Russo-Georgian war interrupted a window of opportunity for the Iranians and the United States to make headway in their negotiations over Iraq. With a U.S. political transition approaching, these negotiations will remain in limbo through the next quarter.