Welcome Back
To the Great Game

By MELIK KAYLAN

Last year, President Mikheil Saakashvili invited me along on a helicopter flight to see Tskhinvali, South Ossetia's capital, from the air. We viewed it at some distance to avoid Russian antiaircraft missiles manned by Russian personnel.

He pointed out a lone hilltop sprinkled with houses some 10 miles inside Georgian territory -- scarcely even a town. Much of the population, namely the Georgians, had long ago been purged by Russian-backed militias, leaving behind a rump population of Ossetian farmers and Russian security forces posing as Ossetians. "We have offered them everything," he said, "language rights, land rights, guaranteed power in parliament, anything they want, and they would take it, if the Kremlin would let them."

AP

Russian armed vehicles en route to Tskhinvali, Aug. 9, 2008.

Moscow's thin pretense of protecting an ethnic group provided just enough cover for Georgia's timorous friends in the West to ignore increasing Russian provocations over the past few years. Moscow, it now seems, intends to "protect" large numbers of Georgians too -- by occupying and killing them if that's what it takes -- and prevent them from building their own history and pursuing their democratic destiny, as it has for almost two centuries.

As we worry about another Russian imperialist adventure in Georgia, we shouldn't lose sight of the bigger picture either: To wit, Moscow has always had a clear strategic use for the Caucasus, one that concerns the U.S. today more than ever.

Having overestimated the power of the Soviet Union in its last years, we have consistently underestimated the ambitions of Russia since. Already, a great deal has been said about the implications of Russia's invasion for Ukraine, the Baltic States and Europe generally. But few have noticed the direct strategic threat of Moscow's action to U.S. efforts in Iraq and Afghanistan. The Kremlin is not about to reignite the Cold War for the love of a few thousand Ossetians or even for its animosity toward five million Georgians. This is calculated strategic maneuvering. And make no mistake, it's about countering U.S. power at its furthest stretch with Moscow's power very close to home.

The pivotal geography of the Caucasus offers the Kremlin just such an opportunity. Look at a map, and the East-meets-West, North-meets-South vector lines of the region illustrate all too clearly how the drama now unfolding in the Caucasus casts Moscow's shadow all across Central Asia and down into the Middle East. In effect, we in the West are being challenged by Russian actions in Georgia to show that we have the nerve and the stamina to secure the gains not just of the wars in Iraq and Afghanistan, but of the entire collapse of Soviet power.

Between Russia and Iran, in the lower Caucasus, sits a small wedge of independent soil -- namely, the soil of Azerbaijan and Georgia combined. Through those two countries runs the immensely important Baku-Tbilisi-Ceyhan pipeline, which delivers precious oil circuitously from Azerbaijan to Turkey and out to the world. This is important not just because of the actual oil being delivered free of interference from Russia and Iran and the Middle East, but also for symbolic reasons. It says to the world that if any former Moscow colonies wish to sell their wares to the West directly, they have a right to do so, and the West will support that right. According to Georgian authorities, Russian warplanes have tried to demolish the Georgian leg of that pipeline several times in the last days. Their message cannot be clearer.

Besides their own pipeline, Georgia and Azerbaijan offer a fragile strategic conduit between the West and the "stans" of Central Asia -- including Afghanistan -- an area that the Soviets once controlled in toto. We should remember that an isolated Central Asia means an isolated Afghanistan. Look at the countries surrounding Afghanistan -- all former Soviet colonies, then Iran, then Pakistan.

The natural resources of Central Asia, from Turkmenistan's natural gas to Kazakhstan's abundant oil, cannot reach the West free of Russia and Iran except through that narrow conduit in the Caucasus. Moscow's former colonies in Central Asia are Afghanistan's most desirable trading partners. They are watching the strife in Georgia closely. It will tell them whether or not they will enter the world's free markets without a Russian chokehold on their future -- or, whether they, and their economies, are doomed for the foreseeable future to remain colonies in all but name. And it won't be long before Moscow dictates to them exactly how to isolate Kabul. Moscow is perfectly aware, even if we are not, that choking off the bottleneck in the Caucasus gives Iran and Russia much say over our efforts in Afghanistan.

In Iraq too, the Kremlin's projection of power down through Georgia will soon be felt. Take another look at the map. If Russia is allowed to extend its reach southwards, as in Soviet times, down the Caucasus to Iran's borders, Moscow can support Iran in any showdown with the West. Iran, thus emboldened, will likely attempt to reassert itself in Iraq, Syria and, via Hezbollah, in Lebanon.

We could walk away from this challenge, hoping for things to cool off, and let the Russians impose sway over the lower Caucasus for now. But no one will fail to notice our weakness. If we don't draw the line here, it doesn't get easier down the road with any other border or country. We would be risking the future of Afghanistan, and the stability of Iraq, on the good will of Moscow and the mullahs in Tehran. This is how the game of grand strategy is played, whether we like it or not.

Mr. Kaylan is a New York-based writer who has reported often from Georgia.

First Yukos, Then Georgia

Holman Jenkins

Now the world is getting an idea of what a "war for oil" really looks like. Few in the West appreciate the degree to which Vladimir Putin and the Soviet, er, Russian, elite subscribe to a prewar view of power relations and national greatness. Their view is not based on self-reproducing institutions and innovation and the power of trade, but on territory and resources -- lebensraum, as one of their intellectual progenitors called it.

Whatever the pretexts and emotional resonances, the Republic of Georgia, transit territory for two important energy pipelines, was also a challenge to Mr. Putin's pursuit of power through control of energy supplies, especially for home heating, to Western Europe.

AP

Vladimir Putin chairs a meeting in Vladikavkaz, the provincial capital of the region of North Ossetia, Aug. 9.

Western governments and Western oil executives have played an unwise role in Mr. Putin's plan. No amount of contract abrogation, outright seizure of property or subsidiary mayhem by Russian authorities seems able to dissuade them from throwing good money after bad in pursuit of Russian resources. Western minority shareholders in Yukos were wiped out with nary a peep when the Russian government seized the oil company on tax charges. There's been virtually no official pushback as environmental offenses were alleged as a reason to squeeze Western partners out of various drilling and pipeline projects after billions of dollars were committed.

Indeed, with what breezy confidence Mr. Putin must have turned Western oil companies into his political punching bags, knowing that back home Western politicians (Nancy Pelosi, Byron Dorgan, Dick Durbin, etc.) were doing exactly the same in pursuit of their own narrow and shortsighted political quests.

Barack Obama thinks the solution to high gasoline prices is punitive taxes on Exxon. All this in the background could not have failed to reassure Mr. Putin that the West would not invest political capital in protecting the interests of its oil companies. He learned that his allies could go so far as to commit nuclear terrorism (so it has been alleged) to murder one of his political critics in London without consequences. Why expect any blowback from merely repeatedly defrauding Western energy investors?

All along, governments and CEOs have reasoned that sooner or later Russia would discover its stake in commercial comity: Russia needs Western capital and technology to develop its oil. To get, you have to give; potential partners must see over time that Russia's word is reliable.

Westerners miscalculated Mr. Putin's ability to miscalculate, a mistake they've made before.

More than once, we've likened Mr. Putin to Saddam Hussein. Both got the upper hand over aging mentors, and forced them into retirement. Both launched wars (Chechnya and Iran). Both gambled that their control of energy made them immune to Western pushback. Never mind that a U.S.-led coalition willingly shut Iraqi and Kuwaiti oil out of world markets after Saddam's invasion in 1990, even at the cost of spiking prices and recession in the West. Saddam to the end believed dangling oil contracts in front of French and Russian companies would be proof against a second President Bush's determination to remove him.

Likely, Mr. Putin miscalculates too. Western powers may not do much immediately about his squeeze on Georgia, but over time he will find he has created conditions for the emergence of a coalition to contain Russian energy power. His immediate neighbors, with fresh memories of Soviet domination, will be even more eager to align themselves with the West and NATO. Possibly even the myopic Germans will discern they've gone too far in putting themselves in energy hock to Moscow. They may even start asking pointed questions about the presence of former Chancellor Gerhard Schroeder on the board of Nord Stream, a Gazprom affiliate devoted to increasing German reliance on Russian gas.

Those of escapist bent will see in all this a reason to put Congress in charge of spending billions aimed at the false utopia of "energy independence." You will hear such blather in the coming months, but it will amount to little. America instead will grapple with the need to administer the reality principle to the Russian regime; we will face up to our responsibility to diversify our energy supplies -- dropping our trade barriers to Brazilian ethanol and opening up our domestic resources to development would be good places to start. The time to really worry will be when America, in pursuit of primitive concepts like energy independence, decides to follow Mr. Putin back to the 1930s.

Bavaria

Old soldiers march into the unknown

Germany’s most traditional and successful state faces political upheaval

IF AUSTRIANS were ever to storm over the Alps into Bavaria, they would have to reckon with the men of the Gebirgsschützen, the “Mountain Guards” descended from the local militias of the late Middle Ages who later fought the Swedes in the Thirty Years War of the 17th century. The old threats may have gone. But the members of the Gebirgsschützen (photographed above) still don traditional garb and weapons to shoot, sing and pray together, sustaining customs that make Bavaria the most distinctive of Germany’s 16 Länder.

The role of the Gebirgsschützen is now to defend Bavarian culture, says Ewald Brückl, the captain of a company of mountain guards in Wolfratshausen, a community of about 17,000 south of Munich. That is no easy task. Munich’s high technology and service companies draw migrants from across Germany; those who cannot afford the city’s high prices settle in outlying towns like Wolfratshausen, the last stop on a commuter train line. One-third of Wolfratshausen’s population turns over every six years, say local officials. That, and the indifference of the young, gnaws at Bavarian roots. Mr Brückl has a hard time recruiting young people, who, he grumbles, “have no interest in duty”.

This is a worry not only for local-history buffs but for the Christian Social Union (CSU), which has governed Bavaria alone for 46 years, establishing what one scholar called “a political dominance unequalled by any other party” in post-war western Europe. Shrewd economic and social policies are part of the CSU’s success. The CSU, moreover, established itself as the embodiment of a regional patriotism—stronger south than north of the Danube—that fuses Bavaria’s thousand-year history with (mainly Catholic) Christianity and a sense that it is to be envied for its Alpine scenery and economic success. Bavaria styles itself a Freistaat, a “Free State”, rather than a mere Land.

It has Germany’s lowest unemployment rate, the lowest debt per head and a budget surplus. Since 1970, GDP per person in Bavaria has grown faster than in other western German states (see chart). Crime rates are well below the German average. In international tests of maths and reading, its schoolchildren outscore their peers from the rest of Germany.

The CSU is exceptional in part because Bavaria is exceptional. But the party’s dominance may be in jeopardy in September’s state elections. In recent opinion polls it has hovered at, and sometimes dropped below, the symbolically important 50% mark. Some slippage is inevitable: the CSU won 61% of the state vote in 2003, when Bavarians registered their anger against an unpopular government in Berlin. But the CSU could be forced for the first time since the 1960s to govern Bavaria with a coalition partner. That would be “catastrophic”, says Alois Glück, the president of Bavaria’s legislature.

The shock would be felt nationwide. The CSU is the electoral partner of the Christian Democratic Union (CDU), the mainstream conservative party for the rest of Germany and the senior member of the national “grand coalition” government. Bavaria, with 15% of Germany’s population, supplied a quarter of conservatives’ overall votes in the last national election. A stumble by the CSU in September would be a bad omen for conservatives in the next parliamentary vote in September 2009. That is why at the CSU’s convention in Nuremberg in July the chancellor, Angela Merkel, reminded Bavarians how lucky they were. “Bavaria is where Germany wants to be,” she told the delegates.

Bavaria was not always so fortunate. Its largely agrarian economy missed the first stage of Germany’s Wirtschaftswunder, the post-war “economic miracle”, and absorbed some 2m ethnic German refugees from Czechoslovakia and Poland. But these burdens turned out in the end to be blessings too; Bavaria was not held back by industries destined to become uncompetitive, except in parts of Franconia, the Protestant north, which now lag behind the south. Refugees became entrepreneurs backed by government-guaranteed loans, the germ of later schemes to promote enterprise through credit.

By the late 1950s full employment elsewhere pushed German industry towards Bavaria’s beckoning arms. It used the federal aid to which it was entitled as a poor state to build roads and other things useful to business. It secured cheap and reliable energy, partly by building an oil pipeline from Italy and Germany’s first nuclear power plant. It was an early promoter of industrial “clusters” and realised that universities would be a draw (it is home to two of the best nine). Nine of the 30 companies whose shares comprise the DAX index have their headquarters in Bavaria, among them BMW, a carmaker.

The late Franz Josef Strauss, the CSU’s pugnacious chairman from 1961, who served as Bavaria’s premier for a decade, championed defence and aerospace (and helped found Airbus). Günther Beckstein, the current premier, says that he wants his state to be “one of the five most innovative regions in the world”.

The CSU did not get where it is by catering only to business. It befriended the common folk, who are more rural and, especially in Catholic “old Bavaria”, the state’s southern and eastern heartland, more conservative than the bulk of Germany’s working class. CSU governments blanketed the countryside with schools and lobbied for federal welfare spending; the party was traditional on family matters and tough on criminal ones. It is “unbelievably well networked” in Bavarian society, says Michael Weigl of the Ludwig Maximilian University in Munich. No town lacks a CSU office (which cannot be said of the opposition Social Democrats). It has links, often more of affinity than formal, to local football clubs, volunteer fire departments and the Gebirgsschützen companies.

Now, though, the CSU is looking vulnerable. Last year it ousted Edmund Stoiber as state premier and party chief, fearing he would lead the party to defeat after nearly 15 years in power. The charismatic strongman yielded to an uninspiring duo: Mr Beckstein, a Franconian who is the first Protestant premier; and Erwin Huber, an old Bavarian, now party chairman.

The state government alienated innkeepers with Germany’s toughest smoking ban. The state-owned Bayerische Landesbank lost €4 billion ($6.23 billion) in subprime punts. A plan to reduce from nine to eight the number of years pupils spend in Gymnasium, which prepares them for university, was poorly executed. Parents now suspect that Bavarian education is not as good as advertised; just a third of pupils make it to university, compared with more than half in North Rhine-Westphalia, the most populous state. In local elections in March the CSU’s vote fell to 40%, its worst result in nearly 40 years.

The CSU has bounced back from scandals and setbacks before and may well do so again. It has already regained some support by demanding tax cuts aimed at the middle class in defiance of the chancellor. The Social Democrats, moreover, are in a state of internal turmoil (see article), and anti-CSU votes may be split among several other parties.

Yet victory would be a reprieve for the CSU, not a resolution. The party is changing, for example by accepting that working mothers need to park young children in crèches, but Bavaria is changing faster. An inspirational video screened at the party’s convention—“Proud of Bavaria”—failed to show a single non-white face.

Partly thanks to Bavaria’s economic success, the CSU’s traditional demographic base of often rural Bavarians is losing importance. The state’s growing ethnic and social diversity means that “it will be ever more difficult to get more than 50% of the vote”, admits Mr Glück. The CSU helped modernise Bavaria; now it is stalked by modernity.

The feisty men of the Gebirgsschützen cannot defend it for ever.

Economics focus

Home truths

A housing slump helped cause the credit crisis. But its effect on spending may have been exaggerated

FALLING house prices have been at the heart of the rich world’s economic troubles in the past year. They led to the surge in defaults on American subprime mortgages that poisoned the market for asset-backed securities and drove up inter-bank rates. Mortgage-related losses have made international banks wary of lending to even creditworthy borrowers. The drying-up of credit has meant fewer buyers for new homes, leading to construction busts in America, Spain and Ireland. Now even countries unaffected by the global housing boom, such as Germany and Japan, are suffering from weaker export demand.

In America the tangible impact of the housing slump is plain to see in the number of empty homes and in rising unemployment. There is greater uncertainty about the indirect effects of falling house prices, including the extent to which consumer spending will be held back by the “wealth effect”. Spending is largely driven by how much people earn in real terms today, but it is also affected by expectations about incomes tomorrow. An important part of future incomes is tied up in the assets—stocks, bonds, property—where household wealth is stored. When asset values fall, those who own them are poorer, hence they spend less and save more. When wealth increases, they spend more.

An OECD study in 2004 put the marginal propensity to spend out of financial wealth at between 0.01 and 0.07 for rich countries: that is, if wealth rises by $1, spending rises by between one and seven cents. The Federal Reserve’s model puts the wealth effect in America at 0.0375.

The Fed’s model assumes the same wealth effect for housing as for financial assets. From the perspective of lifetime income, a dollar of housing wealth is the same as a dollar of stockmarket wealth. But some argue that the negative wealth effect from falling home values may be larger than for other assets. One reason is that housing wealth is spread more evenly than financial wealth, which is concentrated among rich households whose spending is less sensitive to the changing tides. Another is that housing slumps are rarer than stockmarket downturns. Consumers are likely to consider a fall in house values as a durable change in wealth and may cut spending more sharply in response.

Alternatively some, such as Willem Buiter, a former member of the Bank of England’s monetary-policy committee, believe there is no wealth effect from housing at all. In a provocatively titled new paper* Mr Buiter, now at the London School of Economics, argues that “Housing Wealth Isn’t Wealth”. The title, he admits, is a device to capture the attention of readers. It is not strictly true: the housing stock is valuable because of the shelter it provides now and in the future. The more housing we have, the wealthier we are. Mr Buiter’s point is that there is no wealth effect from falling house prices, because while there are winners and losers, the average consumer is no worse off. It is, he says, an idea that was first put to him a decade ago by Mervyn King, now governor of the Bank of England.

A shift in the value of housing does not affect household wealth in the aggregate, he says, because on average everyone is a tenant in his own home. A price fall hurts those who are “long” housing assets, ie, those who own more property than they will need over their lifetime (call them landlords). It benefits those who are “short” housing, ie, those who plan to buy a property or to trade up to a bigger one in the future (call them tenants). The average experience is of an owner-occupier who plans to live in his home until he dies. Unless he worries about how much he will leave to his heirs, he is indifferent to the value of his home.

Changes in house prices shift the distribution of household wealth: they do not alter it, says Mr Buiter. Yet in his schema, there is an exception to the rule: should prices fall because of a bubble bursting, then there is a wealth effect. Landlords are worse off because they lose the bubble value—the part that did not reflect fundamentals. But tenants are no better off, because the present cost of future housing services is unchanged.

A fall in overall housing wealth might still affect spending if the housing-rich and housing-poor respond with different force to their respective fortunes. Homeowners are very likely to register the effect of their loss of wealth and to cut back on spending. The gain to renters and those wishing to trade up in the housing market is less tangible and may not affect consumer spending as much. Mr Buiter is rather sceptical about this argument. Young people saving hard for a first property or to buy a bigger home have more licence to spend freely when house prices fall, he says.

When the cash machine stops working

Falling housing wealth might also crimp spending by restricting access to credit. Banks are happier to lend against collateral. For many households, their homes are the only form of wealth they can offer as security. A fall in house values means there is less scope for running down home equity to prop up consumption.

Mr Buiter agrees that this is an important channel through which falling house prices might hurt spending. His concern is that judgments about the impact of America’s housing bust, including those of a number of senior Fed officials, assume a downward effect from restricted credit over and above what would normally—though erroneously in his view—be the wealth effect. To him, this is double counting the negatives. It means “the Fed may have been convinced to cut rates too fast and too far.”

There is a also a more general point that emerges from Mr Buiter’s paper. Very often there is too much emphasis on the losers from falling house prices and too little on the winners. A fall in house prices is not bad for everybody. In an important sense, a house is much like any other durable good: a fall in prices is a boon for those consumers who have yet to buy one.