Nationalism Rules

It’s the most powerful political force in the world and ignoring it will come at a price.

What's the most powerful political force in the world? Some of you might say it's the bond market. Others might nominate the resurgence of religion or the advance of democracy or human rights. Or maybe it's digital technology, as symbolized by the Internet and all that comes with it. Or perhaps you think it's nuclear weapons and the manifold effects they have had on how states think about security and the use of force.

Those are all worthy nominees (no doubt readers here will have their own favorites), but my personal choice for the Strongest Force in the World would be nationalism. The belief that humanity is comprised of many different cultures -- i.e., groups that share a common language, symbols, and a narrative about their past (invariably self-serving and full of myths) -- and that those groups ought to have their own state has been an overwhelmingly powerful force in the world over the past two centuries. 

It was nationalism that cemented most of the European powers in the modern era, turning them from dynastic states into nation-states, and it was the spread of nationalist ideology that helped destroy the British, French, Ottoman, Dutch, Portuguese, Austro-Hungarian, and Russian/Soviet empires. Nationalism is the main reason the United Nations had fifty-one members immediately after its founding in 1945 and has nearly 200 members today. It is why the Zionists wanted a state for the Jewish people and why Palestinians want a state of their own today. It is what enabled the Vietnamese to defeat both the French and the American armies during the Cold War. It is also why Kurds and Chechens still aspire to statehood; why Scots have pressed for greater autonomy within the United Kingdom, and it is why we now have a Republic of South Sudan.

Understanding the power of nationalism also tells you a lot about what is happening today in the European Union. During the Cold War, European integration flourished because it took place inside the hot-house bubble provided by American protection. Today, however, the United States is losing interest in European security, the Europeans themselves face few external threats, and the EU project itself has expanded too far and badly overreached by creating an ill-advised monetary union. What we are seeing today, therefore, is a gradual renationalization of European foreign policy, fueled in part by incompatible economic preferences and in part by recurring fears that local (i.e., national) identities are being threatened. When Danes worry about Islam, Catalans demand autonomy, Flemish and Walloons contend in Belgium, Germans refuse to bail out Greeks, and nobody wants to let Turkey into the EU, you are watching nationalism at work.

The power of nationalism is easy for realists to appreciate and understand, as my sometime collaborator John Mearsheimer makes clear in an important new paper. Nations -- because they operate in a competitive and sometimes dangerous world -- seek to preserve their identities and cultural values. In many cases, the best way for them to do that is to have their own state, because ethnic or national groups that lack their own state are usually more vulnerable to conquest, absorption, and assimilation.

Similarly, modern states also have a powerful incentive to promote national unity -- in other words, to foster nationalism -- because having a loyal and united population that is willing to sacrifice (and in extreme cases, to fight and die) for the state increases its power and thus its ability to deal with external threats. In the competitive world of international politics, in short, nations have incentives to obtain their own state and states have incentives to foster a common national identity in their populations. Taken together, these twin dynamics create a long-term trend in the direction of more and more independent nation-states.

Obviously, nations and states don't always reach the goal of a unified "nation-state." Some nations never succeed in gaining independence, and some states never succeed in creating a unified national identity for themselves. And not every cultural or ethnic group thinks of itself as a nation or aspires to independence (though one can never be sure when some group might begin to acquire "national consciousness" and head in that direction). Nonetheless, the past hundred years has seen a steady rise in the number of states and the emergence of strong national movements in many of them, and I see no reason to expect this trend to be reversed.  

Once established, a nation-state is a self-reinforcing phenomenon. Nation-states are hard to conquer and subdue, because the local population will usually resist outside invasion and continue to struggle against a foreign occupier. Successful national movements tend to spawn imitators, leading to further demands for statehood. Despite its occasional shortcomings (and the obvious examples of "failed states" like Somalia, Yemen, or Afghanistan), the national state is likely to remain the most important political entity in world politics for the foreseeable future.

Because American national identity tends to emphasize the civic dimension (based on supposedly universal principles such as individual liberty) and tends to downplay the historic and cultural elements (though they clearly exist) U.S. leaders routinely underestimate the power of local affinities and the strength of cultural, tribal, or territorial loyalties. During the Cold War, we persistently exaggerated the strength of transnational ideologies like Communism, and underestimated the degree to which national identities and interests would eventually generate intense conflicts within the Marxist world. Osama bin Laden made the same mistake when he thought that terrorist attacks and video-taped fulminations would ignite a mass movement to re-establish a transnational Islamic caliphate. And anyone who thinks that a rising China is going to tamely submit to U.S. or Western notions of the proper world order fails to appreciate the degree to which nationalism is also a central part of the Chinese worldview, and far more important than any lingering "communist" ideals.

Unless we fully appreciate the power of nationalism, in short, we are going to get a lot of things wrong about the contemporary political life. It is the most powerful political force in the world, and we ignore it at our peril. 

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Moody's Blues

Everyone hates the credit rating agencies. But will fixing them just make things worse?

In a field that includes Bernie Madoff, AIG, Lehman Brothers, and Bear Stearns, it's pretty tough to take home the prize for most publicly hated financial institution, but credit-rating agencies are now putting up a strong fight. Few institutions have drawn as much political heat in recent weeks as the three main agencies: Standard & Poor's, Moody's, and Fitch.

Much of the criticism is well-deserved. The ratings agencies failed to sound the alarm in time on the risks carried by U.S. subprime mortgages and the securitized and derivatives products based on them. The rating agencies were, according to the U.S. Financial Crisis Inquiry Commission 2011 report, "key enablers of the financial meltdown" and of the economic aftershocks that followed the 2008 financial crisis. The raters only downgraded problematic assets in 2007, despite the fact that they were aware for at least a year of the magnitude of the subprime real estate bubble. An earlier downgrade would have likely gone a long way toward at least mitigating or diffusing the magnitude of the crisis.

Given the rating agencies' mandate is to inform investors of credit risks, it's hard to imagine a more colossal failure. These institutions plainly need serious reform. But the biggest risk facing markets, investors, and governments at the moment is not that ratings agencies are incompetent but that government efforts to "fix" them will be motivated largely by the need to assure near-term economic stability, fatally undermining their independence and integrity. Efficient markets and fair competition depend on access to reliable data and information. Politicizing the ratings game would only make matters worse -- for tomorrow and for the more distant future.

During the financial crisis, raters were too close to the financial institutions whose debt they were supposed to assess. In some cases, they have been accused of advising banks on how to create new financial products to earn better ratings. There is also an unsolved and inherent conflict of interest, as the issuers of debt (governments and corporations) directly pay the agencies who rate them. Ratings agencies also form a powerful oligopoly, one whose ability to move markets is problematic, given the opacity with which they make calls.

Both the United States and the European Union have passed reforms over the past year that go some way toward better regulating the credit raters, for instance by putting in place rules requiring more transparency in the assignment of credit ratings. In the United States, legal requirements for certain corporations to use rating agencies (an important driver of the raters' business) have been removed. This should create more competition and, over time, the development of alternative rating methods and organizations. The EU is pushing to break the credit ratings' oligopoly by creating a more competitive space to allow new private ratings agencies to arise and/or by creating an EU-run "independent" ratings institute. The last option is a particularly bad idea, given the obvious conflicts of interests involved, but fostering more ratings competition is a welcome goal.

That said, it's worth considering that not all current government actions are meant to create accurate ratings. There's an increasing, and more troubling, risk that governments, especially in Europe, will politicize this reform process to pressure the credit raters, as well as other independent assessment providers, to suppress negative analysis. Governments, when faced with the prospects of another crisis, would rather prefer favorable than accurate and fair ratings. 

Consider an alternative scenario. What would have happened to the rating agencies if they had properly done their jobs? What if, say in 2005 or 2006, the three raters had downgraded the credit of all the U.S. mortgage products and institutions and burst the U.S. real estate bubble? Alternative history often raises more questions than it answers, but some logical assumptions can be made. Had raters fulfilled their responsibilities before the financial crisis made landfall, markets would have still registered serious losses. Banks and other financial institutions with significant exposure to real estate would have lost shareholder value. The U.S. economy might well have slowed dramatically. It could even have fallen into recession, though the dip might not have been nearly as deep and wide as the curve we're riding now.

But we can also assume that the ratings agencies would have faced a considerable political backlash. Up to 2008, both the George W. Bush administration and Congress were heavily invested in the idea of increasing homeownership. Downgrades of the derivatives and securitized products based on residential real estate by the credit raters would have created a significant roadblock for that policy. The financial industry would have been incredibly upset. Both Washington and Wall Street would have blamed the credit raters for the dip in financial markets.

Remember: In 2005-2006, fear of a massive, real estate-driven financial crisis was far from a mainstream view. At the time, many economists and politicians thought that housing had bedrock "inherent" value; housing prices had been rising since the late 1940s. In other words, the rating agencies would have been blamed for creating a crisis out of prosperity. Calls for investigations of ratings agencies would have fueled demands for new regulations to prevent their assessments from collapsing the economy. Though they failed to spot the mortgage crisis (which, of course, did nothing for their credibility), averting the disaster might not have won them many new friends either.

This returns us to the current problems in Europe and the United States. In recent weeks, the ratings agencies have downgraded the sovereign debt of Greece, Ireland, and Portugal, and they've warned that the debt of key nations, such as the United States and Italy, could be downgraded in the future. These actions signal that the raters are (conceivably) doing their job. Yet increasingly, they're facing exactly the kind of politicized pressure they would have faced had they correctly predicted the sub-prime crisis in the United States.

On July 7, 2011, Jose Manuel Barroso, the European Commission president, attacked the ratings agencies as "anti-European." And more pressure on the ratings agencies will come this year and next. In spite of regulating the rating agencies at the beginning of the year, the European Commission is now considering further and tougher rules for them. Meanwhile, individual EU states, such as Portugal and Spain, are beginning to investigate the raters. As many of these EU criticisms come in the wake of recent downgrades, it is hard to believe that they are not meant to influence the raters' work and diminish their independence. Similar political pressures are also not inconceivable in the United States, especially if the agencies lower the ratings of the U.S. government: Congress and the regulators would likely increasingly focus on "reining in" the raters.

The EU and the United States are right to worry that sovereign credit downgrades will have a very negative market impact. That impact will carry political costs. But trying to suppress the analysis is not only worrisome; it's part of a broader and troubling pattern. During the financial crisis, as governments have increasingly been concerned with maintaining the stability of financial markets, they have sometimes proven willing to tweak certain market analysis and data to maintain stability. For instance, in 2008-2009, both the EU and the United States modified "mark-to-market" accounting standards to ensure that their banking systems appeared more stable.

Similarly, both undertook "stress tests" in 2009 -2010 to show that their financial systems were safe. The assumptions for these tests, meant to assure markets, were extremely weak, especially in the EU. Months after their publication, which showed that most European banks that were included in the 2010 tests were well-capitalized, the main Irish banks failed, exacerbating the current Eurozone crisis. And on Friday, July 15, another eight European banks failed and 16 more scraped by a new round of stress tests.

Populist pressures also ensure that credit raters will continue to be blamed for the financial crisis, no matter what their exact role. The raters are not alone in this. European politicians in particular have also focused on blaming nebulous "speculators," hedge funds, and market practices for the continent's woes. Much of this was done to obscure the fact that at the heart of the European crisis is an intractable problem: Northern banks have unwisely lent to southern states that simply cannot repay the loans. The ratings agencies are not blameless here, but the problem has as much to do longstanding structural issues in the euro currency zone and with the willingness particular countries such as Greece and Italy to fudge their economic numbers to gain entry into the euro.

Solving the EU fiscal crisis would require either re-capitalizing many of the lending northern banks, bailing out the southern states, or both. Any of these alternatives would inflict real pain on German and French and other EU taxpayers. The political costs of such economic dislocations are enormous, which explains why EU officials have taken such a dim view of the credit raters' downgrades of the southern European states.

The ratings agencies are far from irreproachable. But the complaints coming from Western governments smack of desperation. Political pressure on the agencies raises questions of both principle and precedent: If they're applying pressure to suppress ratings, what data will governments try to tweak next? To what extent is it acceptable for governments and regulators to lean on analysts to gain a favorable economic outcome? And how long would economic stability based on lousy data last?

No one likes the umpire, particularly when instant replay shows he's blowing some important calls. But it's awfully hard to have a real game without him.