by Bill O’Grady and Thomas Wash

[Posted: 9:30 AM EST] Oh my, it was a very busy weekend for news.  Let’s dig in.

Saudi Arabia: The Kingdom of Saudi Arabia (KSA) was a hub of activity.  There were a few items of note.

1. It appears that Crown Prince Muhammad bin Salman (MbS) has engineered a massive purge, arresting at least 17 prominent members of the Saudi security apparatus and important business figures.[1]  Among the most important is Prince Miteb bin Abdullah, the son of the late King Abdullah and, until yesterday, the head of the Saudi National Guard.  There are three major military/security agencies in the KSA.  The regular military, the interior ministry and the National Guard.  King Salman is generally in control of the first two, but the latter was under the authority of Prince Miteb.  The National Guard has been in the Abdullah family for years; arresting Abdullah, along with other military leaders, consolidates MbS’s power in the kingdom.  Prince Waleed bin Ibrahim al-Ibrahim was also detained; a major global investor, he is often referred to as the “Buffett of Saudi Arabia.”  Major media leaders were arrested as were numerous military figures.  This is a major action by MbS to consolidate power.  The unknown here is whether this was a purge or a counter-coup.  MbS has been moving quickly to consolidate power and this action is threatening lots of powerful people in the KSA.  It would not be a surprise if there are plots to overthrow the king.  However, whether there was nothing afoot or something brewing, the outcome is the same—King Salman has eliminated most of his rivals and can now smoothly abdicate for his son and crown prince, MbS.  The official discussion was that the arrests were over “corruption” and were the actions of a newly created anti-corruption body.  However, the fact that they could react this quickly does suggest that it’s a cover for a purge.  That’s not to say there isn’t corruption in the KSA; Transparency International[2] ranks the KSA at 62^nd on its corruption scale out of 176 nations.  That’s in the “neighborhood” of Italy and Montenegro, meaning it’s fairly corrupt but not all that bad for the region.  Still, as we noted above, this appears to be more of a purge and anti-corruption is a tool.
2. A missile reportedly launched from Yemen was aimed at the Saudi Airport but was shot down by an anti-missile defense system, a Patriot.  At first glance, this isn’t a story that would be a huge shock.  After all, the KSA is involved in a conflict in Yemen.  On the other hand, it does appear to be a significant upgrade to the Houthi’s arsenal.  However, in light of the rest of the news, there is some speculation that this may have been a “false flag” operation.  In other words, given that the Houthis are thought to be aligned with Iran, this launch could be casus belli for a conflict with Iran.
3. Lebanon’s PM, Saad al-Hariri, abruptly resigned while visiting the KSA.  Lebanon’s political system is delicately balanced.  There have always been constant tensions between Sunni, Shiites and Christians.  As populations have changed, the country has been forced to adjust.  The long civil war during the 1970s was in part due to the difficulties in adjusting to changes in socio-ethnic-religious allocations of power.  At present, the Shiites are the most dominant group and Hezbollah the most potent military force.  For the past few years, Hezbollah has been focused on the war in Syria.  This has given Hariri political space to pass important legislation, including rules on oil and gas exploration.  The fact that Hariri resigned in Riyadh (apparently after an assassination attempt) suggests the Saudis want a leader in Lebanon who will more strongly oppose Hezbollah.  We note that Hezbollah’s leader, Hassan Nasrallah, indicated that his group did not push for Hariri’s removal and that the decision had been imposed by Riyadh.  Hariri’s departure will likely increase instability in Lebanon; Israel has, for the most part, been able to avoid the regional turmoil as Syria and Iraq deal with devolution.  However, if tensions in Lebanon rise and Hezbollah tries to dominate, Israel may find itself pulled into a widening conflict.
4. There was a helicopter crash that reportedly killed Prince Mansour bin Muqrin, the deputy governor of the Asir province.  He was the son of former Crown Prince Muqrin bin Abdulaziz, the last “king worthy” son of Ibn Saud, the founder of the KSA.  According to reports, Prince Mansour was returning from an inspection tour of his province when his helicopter crashed.  The cause of the crash has not been determined.[3]

So, what do we make of all this?  The context of these events goes back to the end of WWII, when Franklin Roosevelt and Ibn Saud created a friendship agreement between the U.S. and the KSA.  The U.S. didn’t want Saudi oil falling into the hands of the British or the Soviets, and thus established relations with what is essentially a medieval kingdom.  American policymakers knew that the states created by colonial powers in the Middle East were inherently unstable, where minority groups were given power in many cases to force the local leaders to rely on the colonial powers for support.  When the colonialists departed, these nations devolved into authoritarian states often run by despots; although such leaders were antithetical to America’s views on government, the U.S. maintained the borders in the region to prevent instability.  That’s why President George H.W. Bush built a coalition to remove Iraqi forces from Kuwait but didn’t pursue these forces back to Baghdad or attempt to overthrow the Hussein regime.  However, every president after Bush has undermined stability.  President Clinton implemented harsh sanctions on Iraq and steadily weakened its economy.  President George W. Bush invaded Iraq and removed its leader, but was unable to build a working government to replace the tyrant.  President Obama wanted to “pivot to Asia” which implied a “pivot from the Middle East.”  Adding to tensions was his support for the “Arab Spring” which has proven, in almost all cases, to lead to chaos.  Because Obama wanted to reduce U.S. influence in the Middle East, he had to elevate a new regional hegemon.  He chose Iran; the Iranian nuclear deal was, in part, a starting point to Iranian ascendency.[4]  That decision, while defensible, was destined to be politically unpopular and President Obama lacked the political finesse to execute what would have been a difficult political feat.  President Trump has returned to the American position of hostility toward Iran that occurred after the 1979 Iranian Revolution and hostage crisis.  Current U.S. policy appears to support the ascendency of Saudi Arabia as the regional hegemon.  And so, the events of this weekend should be seen in the context of the KSA taking steps to assume the regional hegemonic role.  We doubt the KSA has the ability to execute this role but consolidating power, reforming the economy and modernizing social life in Saudi Arabia are probably necessary if MbS can transform the KSA into the dominant regional power.

The problem is that if the KSA can’t perform the role, Iran, which views itself as the regional dominant power, will aggressively take steps to undermine the KSA in the region.  The U.S. will need to decide if it will commit resources to the region when it faces a rapidly rising China in the Far East and a devolving EU in Europe.  We fear the U.S. doesn’t have the resources or the will to deal with a three-front world.  The most likely outcome is that the U.S. allows the Middle East to devolve and focuses on Europe and the Far East (the Obama pivot).  That means, at some point, a disruption of Middle East oil supplies and higher oil prices.  In the past, fears of this outcome would have determined U.S. policy.  However, shale oil and improving efficiency can allow the U.S. to focus outside the region.

Paradise Papers: We have links to the enormous data dump that exposed governments and individuals who have used offshore accounts to shelter wealth and income from taxes.[5]  But, the key takeaway from the breadth of those revealed (the Queen? Really?! And Bono?) is that the populists have a point.  Leaders across the establishment, whether center-left or center-right, have availed themselves of questionable to illegal means to avoid taxes.  It smacks of Leona Helmsley’s infamous line, “We don’t pay taxes; only the little people pay taxes.”  Populist leaders around the world now have new fodder with which to attack the establishment.

Dudley to retire: NY FRB President Bill Dudley announced he plans to retire about mid-year 2018; he was scheduled to leave at year-end.  The NY FRB president has unique powers on the FOMC.  As true of all regional bank presidents, he is appointed by the board of directors of said bank.  However, unlike other regional FRB presidents, the NY FRB president is a permanent voter on the FOMC.  In other words, he has the voting power of a governor without the Congressional appointment.  This power is given to the NY FRB because of New York’s predominant role in the U.S. financial system.  Although Dudley has historically been a moderate (we rate him a “3” on our hawk/dove scale), he has evolved into a “Minskyist.”  We break the FOMC into three groups—Phillips Curve Disciples, Phillips Curve Heretics, and Minskyists.  The disciples believe in the Phillips Curve and believe that tight labor markets require higher rates.  The heretics believe the curve is no longer functional and believe the FOMC shouldn’t raise rates until inflation exceeds the target.  The Minskyists believe that lower rates trigger financial market distortions and thus call for higher rates to prevent asset bubbles.  Thus, Dudley has become rather hawkish recently.  The odds favor that Dudley will be replaced by a disciple simply because there are more of them around.  That outcome may mean a somewhat less hawkish stance from the NY FRB.

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[1] https://en.wikipedia.org/wiki/2017_Saudi_Arabian_anti-corruption_arrests

[2] https://www.transparency.org/news/feature/corruption_perceptions_index_2016

[3] http://www.geographicguide.com/asia/maps/saudi-arabia.htm

[4] Although Iran remains wildly unpopular in the U.S., there are regional specialists who have argued that Iran is best suited for this role.  The strongest argument is expressed by Robert Baer. Baer, R. (2008). The Devil We Know:  Dealing with the New Iranian Superpower. New York, NY: Crown Publishers.

[5] https://www.bloomberg.com/news/articles/2017-11-05/panama-papers-redux-may-show-how-firms-wealthy-skirt-taxes ; http://www.bbc.com/news/uk-41876942?utm_source=newsletter&utm_medium=email&utm_campaign=newsletter_axiosam&stream=top-stories ; https://www.icij.org/investigations/paradise-papers/explore-politicians-paradise-papers/ ; https://www.nytimes.com/2017/11/05/world/paradise-papers.html?emc=edit_mbe_20171106&nl=morning-briefing-europe&nlid=5677267&te=1