RENOVATIO IMPERII

2011-02-02T11:36:00.000-05:00

WikiLeaks: FBI hunts the 9/11 gang that got away

The FBI has launched a manhunt for a previously unknown team of men suspected to be part of the 9/11 attacks, the Daily Telegraph can disclose.

By Steven Swinford, Robert Winnett and Nick Allen in Los Angeles 8:55PM GMT 01 Feb 2011

Secret documents reveal that the three Qatari men conducted surveillance on the targets, provided “support” to the plotters and had tickets for a flight to Washington on the eve of the atrocities.

The suspected terrorists flew from London to New York on a British Airways flight three weeks before the attacks.

They allegedly carried out surveillance at the World Trade Centre, the White House and in Virginia, the US state where the Pentagon and CIA headquarters are located.

Ten days later they flew to Los Angeles, where they stationed themselves in a hotel near the airport which the FBI has now established was paid for by a “convicted terrorist”, who also paid for their airline tickets.

Hotel staff have told investigators they saw pilot uniforms in their room along with computer print outs detailing pilot names, flight numbers and times and packages addressed to Syria, Afghanistan, Jerusalem and Jordan.

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On September 10 they were booked on an American Airlines flight from Los Angeles to Washington, but failed to board. The following day the same Boeing 757 aircraft was hijacked by five terrorists and crashed into the Pentagon.

But, instead of boarding the American flight, the Qatari suspects – named as Meshal Alhajri, Fahad Abdulla and Ali Alfehaid - flew back to London on a British Airways flight before returning to Qatar. Their current location is unknown.

Investigators are also hunting a fourth man, Mohamed Al Mansoori, who they say supported the alleged terrorist cell while they were in the US.

The man, who is from the United Arab Emirates, previously lived in Long Beach, Los Angeles. His current location is also unknown, and US officials recommended that he is put on an international terror watch list because he “may pose a threat to aviation in the US and abroad”.

The details of the secret 9/11 team have emerged in a secret American government document obtained by the Wikileaks website and passed to The Daily Telegraph. It was sent between the American Embassy in Doha and the Department for Homeland Security in Washington.

The document, sent on 11th February 2010, states: “Mr Al Mansoori is currently under investigation by the FBI for his possible involvement in the 11 September 2001 attacks. He is suspected of aiding people who entered the US before the attacks to conduct surveillance of possible targets and providing other support to the hijackers.”

Details of the unknown 9/11 alleged plotters has never previously been disclosed. An official inquiry into the 9/11 attacks, which killed nearly 3,000 people, indicated that the hijackers may have received assistance in Los Angeles but investigators did not publicly provide more details.

The 9/11 Commission report, published in July 2004, states that at least two of the hijackers previously visited Los Angeles but, at the time, investigators appeared to have little information on their movements. The report states they had a "brief stay in Los Angeles about which we know little".

Only one person – Zacarias Moussaoui - has been tried and convicted over involvement in the 9/11 attacks as all the terrorists died in the crashed planes. Moussaoui, accused of being the twentieth hijacker, was sentenced to life in prison.

The secret American document contains detailed information about the movements of the three alleged Qatari plotters.

They took BA flight 185 from London to New York on 15th August, 2001, and the memo alleges that they subsequently conducted “surveillance” on potential targets ahead of the 9/11 attacks. It states: “They visited the World Trade Centre, the Statue of Liberty, the White House and various areas in Virginia.”

They then flew on an American Airlines flight from Washington to Los Angeles, arriving on 24th August and checking into a single room at a hotel near the airport. They paid for the room with cash and during the last few days of their stay requested that their room should not be cleaned.

The cable states: “Hotel cleaning staff grew suspicious of the men because they noticed pilot type uniforms, several laptops and several cardboard boxes addressed to Syria, Jerusalem, Afghanistan and Jordan in the room on previous cleaning visits.

“The men had a smashed cellular phone in the room and a cellular phone attached by wire to a computer. The room also contained pin feed computer paper print outs with headers listing pilot names, airlines, flight numbers, and flight times.”

While in the US, they were aided by Mohamed Ali Mohamed Al Mansoori. The secret document also states that the three Qatari men spent a week travelling with Mr Al Mansoori to “different destinations in California”.

The Qatari men were scheduled to board American Airlines Flight 144 on September 10th from Los Angeles to Washington but did not turn up.

They instead boarded a British Airways flight to London, before flying back to Doha on another BA flight.

The following day the same American Airlines aircraft, flying on route AA77, was hijacked as it returned from Washington and crashed into the Pentagon, killing 184 people.

It is not known whether the FBI believe that the men were simply assisting the hijackers or were a fifth cell who pulled out at the final moment. Alternatively, they may have been planning an attack on the West Coast of America or even London which was abandoned or went wrong.

Mr Al Mansoori has never been publicly named in connection with the 9/11 attacks. The three Qatari men were included on an FBI list of more than 300 people who were wanted for questioning in connection with the 9/11 attacks, which was leaked in 2002.

At the time, the FBI stressed it was not a list of suspects, but merely parties they thought might have information useful to the investigation.

The US embassy cable obtained by the Daily Telegraph was written by Mirembe Nantongo, the deputy chief of mission in Doha. It was marked “priority” and sent to the office of Hillary Clinton, the US Secretary of State, the Department of Homeland Security, the FBI and the CIA.

Mr Al Mansoori’s visa was revoked after the information about him came to light, but “his name was not watchlisted in the class system”, suggesting he may have managed to leave America.

A spokesman for the FBI declined to comment.

2010-11-29T08:33:00.000-05:00

THE SATURDAY ESSAY NOVEMBER 18, 2010

In China's Orbit

After 500 years of Western predominance, Niall Ferguson argues, the world is tilting back to the East.

By NIALL FERGUSON
wsj.com

"We are the masters now." I wonder if President Barack Obama saw those words in the thought bubble over the head of his Chinese counterpart, Hu Jintao, at the G20 summit in Seoul last week. If the president was hoping for change he could believe in—in China's currency policy, that is—all he got was small change. Maybe Treasury Secretary Timothy Geithner also heard "We are the masters now" as the Chinese shot down his proposal for capping imbalances in global current accounts. Federal Reserve Chairman Ben Bernanke got the same treatment when he announced a new round of "quantitative easing" to try to jump start the U.S. economy, a move described by one leading Chinese commentator as "uncontrolled" and "irresponsible."

"We are the masters now." That was certainly the refrain that I kept hearing in my head when I was in China two weeks ago. It wasn't so much the glitzy, Olympic-quality party I attended in the Tai Miao Temple, next to the Forbidden City, that made this impression. The displays of bell ringing, martial arts and all-girl drumming are the kind of thing that Western visitors expect. It was the understated but unmistakable self-confidence of the economists I met that told me something had changed in relations between China and the West.

One of them, Cheng Siwei, explained over dinner China's plan to become a leader in green energy technology. Between swigs of rice wine, Xia Bin, an adviser to the People's Bank of China, outlined the need for a thorough privatization program, "including even the Great Hall of the People." And in faultless English, David Li of Tsinghua University confessed his dissatisfaction with the quality of Chinese Ph.D.s.

You could not ask for smarter people with whom to discuss the two most interesting questions in economic history today: Why did the West come to dominate not only China but the rest of the world in the five centuries after the Forbidden City was built? And is that period of Western dominance now finally coming to an end?

In a brilliant paper that has yet to be published in English, Mr. Li and his co-author Guan Hanhui demolish the fashionable view that China was economically neck-and-neck with the West until as recently as 1800. Per capita gross domestic product, they show, stagnated in the Ming era (1402-1626) and was significantly lower than that of pre-industrial Britain. China still had an overwhelmingly agricultural economy, with low-productivity cultivation accounting for 90% of GDP. And for a century after 1520, the Chinese national savings rate was actually negative. There was no capital accumulation in late Ming China; rather the opposite.

The story of what Kenneth Pomeranz, a history professor at the University of California, Irvine, has called "the Great Divergence" between East and West began much earlier. Even the late economist Angus Maddison may have been over-optimistic when he argued that in 1700 the average inhabitant of China was probably slightly better off than the average inhabitant of the future United States. Mr. Maddison was closer to the mark when he estimated that, in 1600, per capita GDP in Britain was already 60% higher than in China.

For the next several hundred years, China continued to stagnate and, in the 20th century, even to retreat, while the English-speaking world, closely followed by northwestern Europe, surged ahead. By 1820 U.S. per capita GDP was twice that of China; by 1870 it was nearly five times greater; by 1913 the ratio was nearly 10 to one.

Despite the painful interruption of the Great Depression, the U.S. suffered nothing so devastating as China's wretched mid-20th century ordeal of revolution, civil war, Japanese invasion, more revolution, man-made famine and yet more ("cultural") revolution. In 1968 the average American was 33 times richer than the average Chinese, using figures calculated on the basis of purchasing power parity (allowing for the different costs of living in the two countries). Calculated in current dollar terms, the differential at its peak was more like 70 to 1.

This was the ultimate global imbalance, the result of centuries of economic and political divergence. How did it come about? And is it over?

As I've researched my forthcoming book over the past two years, I've concluded that the West developed six "killer applications" that "the Rest" lacked. These were:

• Competition: Europe was politically fragmented, and within each monarchy or republic there were multiple competing corporate entities.

• The Scientific Revolution: All the major 17th-century breakthroughs in mathematics, astronomy, physics, chemistry and biology happened in Western Europe.

• The rule of law and representative government: This optimal system of social and political order emerged in the English-speaking world, based on property rights and the representation of property owners in elected legislatures.

• Modern medicine: All the major 19th- and 20th-century advances in health care, including the control of tropical diseases, were made by Western Europeans and North Americans.

• The consumer society: The Industrial Revolution took place where there was both a supply of productivity-enhancing technologies and a demand for more, better and cheaper goods, beginning with cotton garments.

• The work ethic: Westerners were the first people in the world to combine more extensive and intensive labor with higher savings rates, permitting sustained capital accumulation.

Those six killer apps were the key to Western ascendancy. The story of our time, which can be traced back to the reign of the Meiji Emperor in Japan (1867-1912), is that the Rest finally began to download them. It was far from a smooth process. The Japanese had no idea which elements of Western culture were the crucial ones, so they ended up copying everything, from Western clothes and hairstyles to the practice of colonizing foreign peoples. Unfortunately, they took up empire-building at precisely the moment when the costs of imperialism began to exceed the benefits. Other Asian powers—notably India—wasted decades on the erroneous premise that the socialist institutions pioneered in the Soviet Union were superior to the market-based institutions of the West.

Beginning in the 1950s, however, a growing band of East Asian countries followed Japan in mimicking the West's industrial model, beginning with textiles and steel and moving up the value chain from there. The downloading of Western applications was now more selective. Competition and representative government did not figure much in Asian development, which instead focused on science, medicine, the consumer society and the work ethic (less Protestant than Max Weber had thought). Today Singapore is ranked third in the World Economic Forum's assessment of competitiveness. Hong Kong is 11th, followed by Taiwan (13th), South Korea (22nd) and China (27th). This is roughly the order, historically, in which these countries Westernized their economies.

Today per capita GDP in China is 19% that of the U.S., compared with 4% when economic reform began just over 30 years ago. Hong Kong, Japan and Singapore were already there as early as 1950; Taiwan got there in 1970, and South Korea got there in 1975. According to the Conference Board, Singapore's per capita GDP is now 21% higher than that of the U.S., Hong Kong's is about the same, Japan's and Taiwan's are about 25% lower, and South Korea's 36% lower. Only a foolhardy man would bet against China's following the same trajectory in the decades ahead.

China's has been the biggest and fastest of all the industrialization revolutions. In the space of 26 years, China's GDP grew by a factor of 10. It took the U.K. 70 years after 1830 to grow by a factor of four. According to the International Monetary Fund, China's share of global GDP (measured in current prices) will pass the 10% mark in 2013. Goldman Sachs continues to forecast that China will overtake the U.S. in terms of GDP in 2027, just as it recently overtook Japan.

But in some ways the Asian century has already arrived. China is on the brink of surpassing the American share of global manufacturing, having overtaken Germany and Japan in the past 10 years. China's biggest city, Shanghai, already sits atop the ranks of the world's megacities, with Mumbai right behind; no American city comes close.

Nothing is more certain to accelerate the shift of global economic power from West to East than the looming U.S. fiscal crisis. With a debt-to-revenue ratio of 312%, Greece is in dire straits already. But the debt-to-revenue ratio of the U.S. is 358%, according to Morgan Stanley. The Congressional Budget Office estimates that interest payments on the federal debt will rise from 9% of federal tax revenues to 20% in 2020, 36% in 2030 and 58% in 2040. Only America's "exorbitant privilege" of being able to print the world's premier reserve currency gives it breathing space. Yet this very privilege is under mounting attack from the Chinese government.

For many commentators, the resumption of quantitative easing by the Federal Reserve has appeared to spark a currency war between the U.S. and China. If the "Chinese don't take actions" to end the manipulation of their currency, President Obama declared in New York in September, "we have other means of protecting U.S. interests." The Chinese premier Wen Jiabao was quick to respond: "Do not work to pressure us on the renminbi rate…. Many of our exporting companies would have to close down, migrant workers would have to return to their villages. If China saw social and economic turbulence, then it would be a disaster for the world."

Such exchanges are a form of pi ying xi, China's traditional shadow puppet theater. In reality, today's currency war is between "Chimerica"—as I've called the united economies of China and America—and the rest of the world. If the U.S. prints money while China effectively still pegs its currency to the dollar, both parties benefit. The losers are countries like Indonesia and Brazil, whose real trade-weighted exchange rates have appreciated since January 2008 by 18% and 17%, respectively.

But who now gains more from this partnership? With China's output currently 20% above its pre-crisis level and that of the U.S. still 2% below, the answer seems clear. American policy-makers may utter the mantra that "they need us as much as we need them" and refer ominously to Lawrence Summers's famous phrase about "mutually assured financial destruction." But the Chinese already have a plan to reduce their dependence on dollar reserve accumulation and subsidized exports. It is a strategy not so much for world domination on the model of Western imperialism as for reestablishing China as the Middle Kingdom—the dominant tributary state in the Asia-Pacific region.

If I had to summarize China's new grand strategy, I would do it, Chinese-style, as the Four "Mores": Consume more, import more, invest abroad more and innovate more. In each case, a change of economic strategy pays a handsome geopolitical dividend.

By consuming more, China can reduce its trade surplus and, in the process, endear itself to its major trading partners, especially the other emerging markets. China recently overtook the U.S. as the world's biggest automobile market (14 million sales a year, compared to 11 million), and its demand is projected to rise tenfold in the years ahead.

By 2035, according to the International Energy Agency, China will be using a fifth of all global energy, a 75% increase since 2008. It accounted for about 46% of global coal consumption in 2009, the World Coal Institute estimates, and consumes a similar share of the world's aluminum, copper, nickel and zinc production. Last year China used twice as much crude steel as the European Union, United States and Japan combined.

Such figures translate into major gains for the exporters of these and other commodities. China is already Australia's biggest export market, accounting for 22% of Australian exports in 2009. It buys 12% of Brazil's exports and 10% of South Africa's. It has also become a big purchaser of high-end manufactured goods from Japan and Germany. Once China was mainly an exporter of low-price manufactures. Now that it accounts for fully a fifth of global growth, it has become the most dynamic new market for other people's stuff. And that wins friends.

The Chinese are justifiably nervous, however, about the vagaries of world commodity prices. How could they feel otherwise after the huge price swings of the past few years? So it makes sense for them to invest abroad more. In January 2010 alone, the Chinese made direct investments worth a total of $2.4 billion in 420 overseas enterprises in 75 countries and regions. The overwhelming majority of these were in Asia and Africa. The biggest sectors were mining, transportation and petrochemicals. Across Africa, the Chinese mode of operation is now well established. Typical deals exchange highway and other infrastructure investments for long leases of mines or agricultural land, with no questions asked about human rights abuses or political corruption.

Growing overseas investment in natural resources not only makes sense as a diversification strategy to reduce China's exposure to the risk of dollar depreciation. It also allows China to increase its financial power, not least through its vast and influential sovereign wealth fund. And it justifies ambitious plans for naval expansion. In the words of Rear Admiral Zhang Huachen, deputy commander of the East Sea Fleet: "With the expansion of the country's economic interests, the navy wants to better protect the country's transportation routes and the safety of our major sea-lanes." The South China Sea has already been declared a "core national interest," and deep-water ports are projected in Pakistan, Burma and Sri Lanka.

Finally, and contrary to the view that China is condemned to remain an assembly line for products "designed in California," the country is innovating more, aiming to become, for example, the world's leading manufacturer of wind turbines and photovoltaic panels. In 2007 China overtook Germany in terms of new patent applications. This is part of a wider story of Eastern ascendancy. In 2008, for the first time, the number of patent applications from China, India, Japan and South Korea exceeded those from the West.

The dilemma posed to the "departing" power by the "arriving" power is always agonizing. The cost of resisting Germany's rise was heavy indeed for Britain; it was much easier to slide quietly into the role of junior partner to the U.S. Should America seek to contain China or to accommodate it? Opinion polls suggest that ordinary Americans are no more certain how to respond than the president. In a recent survey by the Pew Research Center, 49% of respondents said they did not expect China to "overtake the U.S. as the world's main superpower," but 46% took the opposite view.

Coming to terms with a new global order was hard enough after the collapse of the Soviet Union, which went to the heads of many Western commentators. (Who now remembers talk of American hyperpuissance without a wince?) But the Cold War lasted little more than four decades, and the Soviet Union never came close to overtaking the U.S. economically. What we are living through now is the end of 500 years of Western predominance. This time the Eastern challenger is for real, both economically and geopolitically.

The gentlemen in Beijing may not be the masters just yet. But one thing is certain: They are no longer the apprentices.

—Niall Ferguson is a professor of history at Harvard University and a professor of business administration at the Harvard Business School. His next book, "Civilization: The West and the Rest," will be published in March.

2010-11-09T15:35:00.002-05:00

If you thought the bank bailout was bad, wait until the mortgage defaults hit home

Mon, Nov 08, 2010

THE BIG PICTURE: Ireland is effectively insolvent – the next crisis will be mass home mortgage default, writes MORGAN KELLY

SAD NEWS just in from Our Lady of the Eurozone Hospital: After a sudden worsening in her condition, the Irish Patient, formerly known as the Irish Republic, has been moved into intensive care and put on artificial ventilation. While a hospital spokesman, Jean-Claude Trichet, tried to sound upbeat, there is no prospect that the Patient will recover.

It will be remembered that, after a lengthy period of poverty following her acrimonious divorce from her English partner, in the 1990s Ireland succeeded in turning her life around, educating herself, and holding down a steady job. Although her increasingly riotous lifestyle over the last decade had raised some concerns, the Irish Patient’s fate was sealed by a botched emergency intervention on September 29th, 2008 followed by repeated misdiagnoses of the ensuing complications.

With the Irish Patient now clinically dead, her grieving European relatives face the melancholy task of deciding when to remove her from life support, and how to deal with the extraordinary debts she ran up in the last months of her life . . .

WHEN I wrote in The Irish Times last May showing how the bank guarantee would lead to national insolvency, I did not expect the financial collapse to be anywhere near as swift or as deep as has now occurred. During September, the Irish Republic quietly ceased to exist as an autonomous fiscal entity, and became a ward of the European Central Bank.

It is a testament to the cool and resolute handling of the crisis over the last six months by the Government and Central Bank that markets now put Irish sovereign debt in the same risk group as Ukraine and Pakistan, two notches above the junk level of Argentina, Greece and Venezuela.

September marked Ireland’s point of no return in the banking crisis. During that month, €55 billion of bank bonds (held mainly by UK, German, and French banks) matured and were repaid, mostly by borrowing from the European Central Bank.

Until September, Ireland had the legal option of terminating the bank guarantee on the grounds that three of the guaranteed banks had withheld material information about their solvency, in direct breach of the 1971 Central Bank Act. The way would then have been open to pass legislation along the lines of the UK’s Bank Resolution Regime, to turn the roughly €75 billion of outstanding bank debt into shares in those banks, and so end the banking crisis at a stroke.

With the €55 billion repaid, the possibility of resolving the bank crisis by sharing costs with the bondholders is now water under the bridge. Instead of the unpleasant showdown with the European Central Bank that a bank resolution would have entailed, everyone is a winner. Or everyone who matters, at least.

The German and French banks whose solvency is the overriding concern of the ECB get their money back. Senior Irish policymakers get to roll over and have their tummies tickled by their European overlords and be told what good sports they have been. And best of all, apart from some token departures of executives too old and rich to care less, the senior management of the banks that caused this crisis continue to enjoy their richly earned rewards. The only difficulty is that the Government’s open-ended commitment to cover the bank losses far exceeds the fiscal capacity of the Irish State.

The Government has admitted that Anglo is going to cost the taxpayer €29 to €34 billion. It has also invested €16 billion in the other banks, but expects to get some or all of that investment back eventually.

So, the taxpayer cost of the bailout is about €30 billion for Anglo and some fraction of €16 billion for the rest. Unfortunately, these numbers are not consistent with each other, and it only takes a second to see why.

Between them, AIB and Bank of Ireland had the same exposure to developers as Anglo and, to the extent that they were scrambling to catch up with Anglo, probably lent to even worse turkeys than it did. AIB and Bank of Ireland did start with more capital to absorb losses than Anglo, but also face substantial mortgage losses, which it does not. It follows that AIB and Bank of Ireland together will cost the taxpayer at least as much as Anglo.

Once we accept, as the Government does, that Anglo will cost the taxpayer about €30 billion, we must accept that AIB and Bank of Ireland will cost at least €30 billion extra.

In my article of last May, when I published my optimistic estimate of a €50 billion bailout bill, I posted a spreadsheet on the irisheconomy.ie website, giving my realistic estimates of taxpayer losses. My realistic estimate for Anglo was €34 billion, the same as the Government’s current estimate.

When you apply the same assumptions about lending losses to the other banks, you end up with a likely taxpayer bill of €16 billion for Bank of Ireland (deducting the €3 billion they have since received from investors) and €26 billion for AIB: nearly as bad as Anglo.

Indeed, the true scandal in Irish banking is not what happened at Anglo and Nationwide (which, as specialised development lenders, would have suffered horrific losses even had they not been run by crooks or morons) but the breakdown of governance at AIB that allowed it to pursue the same suicidal path.

Once again we are having to sit through the same dreary and mendacious charade with AIB that we endured with Anglo: “AIB only needs €3.5 billion, sorry we meant to say €6.5 billion, sorry . . .” and so on until it is fully nationalised next year, and the true extent of its folly revealed.

This €70 billion bill for the banks dwarfs the €15 billion in spending cuts now agonised over, and reduces the necessary cuts in Government spending to an exercise in futility. What is the point of rearranging the spending deckchairs, when the iceberg of bank losses is going to sink us anyway?

What is driving our bond yields to record levels is not the Government deficit, but the bank bailout. Without the banks, our national debt could be stabilised in four years at a level not much worse than where France, with its triple A rating in the bond markets, is now.

As a taxpayer, what does a bailout bill of €70 billion mean? It means that every cent of income tax that you pay for the next two to three years will go to repay Anglo’s losses, every cent for the following two years will go on AIB, and every cent for the next year and a half on the others. In other words, the Irish State is insolvent: its liabilities far exceed any realistic means of repaying them.

For a country or company, insolvency is the equivalent of death for a person, and is usually swiftly followed by the legal process of bankruptcy, the equivalent of a funeral.

Two things have delayed Ireland’s funeral. First, in anticipation of being booted out of bond markets, the Government built up a large pile of cash a few months ago, so that it can keep going until the New Year before it runs out of money. Although insolvent, Ireland is still liquid, for now.

Secondly, not wanting another Greek-style mess, the ECB has intervened to fund the Irish banks. Not only have Irish banks had to repay their maturing bonds, but they have been haemorrhaging funds in the inter-bank market, and the ECB has quietly stepped in with emergency funding to keep them going until it can make up its mind what to do.

Since September, a permanent team of ECB “observers” has taken up residence in the Department of Finance. Although of many nationalities, they are known there, dismayingly but inevitably, as “The Germans”.

So, thanks to the discreet intervention of the ECB, the first stage of the crisis has closed with a whimper rather than a bang. Developer loans sank the banks which, thanks to the bank guarantee, sank the Irish State, leaving it as a ward of the ECB.

The next act of the crisis will rehearse the same themes of bad loans and foreign debt, only this time as tragedy rather than farce. This time the bad loans will be mortgages, and the foreign creditor who cannot be repaid is the ECB. In consequence, the second act promises to be a good deal more traumatic than the first.

Where the first round of the banking crisis centred on a few dozen large developers, the next round will involve hundreds of thousands of families with mortgages. Between negotiated repayment reductions and defaults, at least 100,000 mortgages (one in eight) are already under water, and things have barely started.

Banks have been relying on two dams to block the torrent of defaults – house prices and social stigma – but both have started to crumble alarmingly.

People are going to extraordinary lengths – not paying other bills and borrowing heavily from their parents – to meet mortgage repayments, both out of fear of losing their homes and to avoid the stigma of admitting that they are broke. In a society like ours, where a person’s moral worth is judged – by themselves as much as by others – by the car they drive and the house they own, the idea of admitting that you cannot afford your mortgage is unspeakably shameful.

That will change. The perception growing among borrowers is that while they played by the rules, the banks certainly did not, cynically persuading them into mortgages that they had no hope of affording. Facing a choice between obligations to the banks and to their families – mortgage or food – growing numbers are choosing the latter.

In the last year, America has seen a rising number of “strategic defaults”. People choose to stop repaying their mortgages, realising they can live rent-free in their house for several years before eviction, and then rent a better house for less than the interest on their current mortgage. The prospect of being sued by banks is not credible – the State of Florida allows banks full recourse to the assets of delinquent borrowers just like here, but it has the highest default rate in the US – because there is no point pursuing someone who has no assets.

If one family defaults on its mortgage, they are pariahs: if 200,000 default they are a powerful political constituency. There is no shame in admitting that you too were mauled by the Celtic Tiger after being conned into taking out an unaffordable mortgage, when everyone around you is admitting the same.

The gathering mortgage crisis puts Ireland on the cusp of a social conflict on the scale of the Land War, but with one crucial difference. Whereas the Land War faced tenant farmers against a relative handful of mostly foreign landlords, the looming Mortgage War will pit recent house buyers against the majority of families who feel they worked hard and made sacrifices to pay off their mortgages, or else decided not to buy during the bubble, and who think those with mortgages should be made to pay them off. Any relief to struggling mortgage-holders will come not out of bank profits – there is no longer any such thing – but from the pockets of other taxpayers.

The other crumbling dam against mass mortgage default is house prices. House prices are driven by the size of mortgages that banks give out. That is why, even though Irish banks face long-run funding costs of at least 8 per cent (if they could find anyone to lend to them), they are still giving out mortgages at 5 per cent, to maintain an artificial floor on house prices. Without this trickle of new mortgages, prices would collapse and mass defaults ensue.

However, once Irish banks pass under direct ECB control next year, they will be forced to stop lending in order to shrink their balance sheets back to a level that can be funded from customer deposits. With no new mortgage lending, the housing market will be driven by cash transactions, and prices will collapse accordingly.

While the current priority of Irish banks is to conceal their mortgage losses, which requires them to go easy on borrowers, their new priority will be to get the ECB’s money back by whatever means necessary. The resulting wave of foreclosures will cause prices to collapse further.

Along with mass mortgage defaults, sorting out our bill with the ECB will define the second stage of the banking crisis. For now it is easier for the ECB to drip feed funding to the Irish State and banks rather than admit publicly that we are bankrupt, and trigger a crisis that could engulf other euro-zone states. Our economy is tiny, and it is easiest, for now, to kick the can up the road and see how things work out.

By next year Ireland will have run out of cash, and the terms of a formal bailout will have to be agreed. Our bill will be totted up and presented to us, along with terms for repayment. On these terms hangs our future as a nation. We can only hope that, in return for being such good sports about the whole bondholder business and repaying European banks whose idea of a sound investment was lending billions to Gleeson, Fitzpatrick and Fingleton, the Government can negotiate a low rate of interest.

With a sufficiently low interest rate on what we owe to Europe, a combination of economic growth and inflation will eventually erode away the debt, just as it did in the 1980s: we get to survive.

How low is sufficiently low? Economists have a simple rule to calculate this. If the interest rate on a country’s debt is lower than the sum of its growth rate and inflation rate, the ratio of debt to national income will shrink through time. After a massive credit bubble and with a shaky international economy, our growth prospects for the next decade are poor, and prices are likely to be static or falling. An interest rate beyond 2 per cent is likely to sink us.

This means that if we are forced to repay the ECB at the 5 per cent interest rate imposed on Greece, our debt will rise faster than our means of servicing it, and we will inevitably face a State bankruptcy that will destroy what few shreds of our international reputation still remain.

Why would the ECB impose such a punitive interest rate on us? The answer is that we are too small to matter: the ECB’s real concerns lie with Spain and Italy. Making an example of Ireland is an easy way to show that bailouts are not a soft option, and so frighten them into keeping their deficits under control.

Given the risk of national bankruptcy it entailed, what led the Government into this abject and unconditional surrender to the bank bondholders? I have been told that the Government’s reasoning runs as follows: “Europe will bail us out, just like they bailed out the Greeks. And does anyone expect the Greeks to repay?”

The fallacy of this reasoning is obvious. Despite a decade of Anglo-Fáil rule, with its mantra that there are no such things as duties, only entitlements, few Irish institutions have collapsed to the third-world levels of their Greek counterparts, least of all our tax system.

And unlike the Greeks, we lacked the tact and common sense to keep our grubby dealing to ourselves. Europeans had to endure a decade of Irish politicians strutting around and telling them how they needed to emulate our crony capitalism if they wanted to be as rich as we are. As far as other Europeans are concerned, the Irish Government is aiming to add injury to insult by getting their taxpayers to help the “Richest Nation in Europe” continue to enjoy its lavish lifestyle.

My stating the simple fact that the Government has driven Ireland over the brink of insolvency should not be taken as a tacit endorsement of the Opposition. The stark lesson of the last 30 years is that, while Fianna Fáil’s record of economic management has been decidedly mixed, that of the various Fine Gael coalitions has been uniformly dismal.

As ordinary people start to realise that this thing is not only happening, it is happening to them, we can see anxiety giving way to the first upwellings of an inchoate rage and despair that will transform Irish politics along the lines of the Tea Party in America. Within five years, both Civil War parties are likely to have been brushed aside by a hard right, anti-Europe, anti-Traveller party that, inconceivable as it now seems, will leave us nostalgic for the, usually, harmless buffoonery of Biffo, Inda, and their chums.

You have read enough articles by economists by now to know that it is customary at this stage for me to propose, in 30 words or fewer, a simple policy that will solve all our problems. Unfortunately, this is where I have to hold up my hands and confess that I have no solutions, simple or otherwise.

Ireland faced a painful choice between imposing a resolution on banks that were too big to save or becoming insolvent, and, for whatever reason, chose the latter. Sovereign nations get to make policy choices, and we are no longer a sovereign nation in any meaningful sense of that term.

From here on, for better or worse, we can only rely on the kindness of strangers.

--------------------------------------------------------------------------------

Morgan Kelly is Professor of Economics at University College Dublin

2010-10-19T11:53:00.000-04:00

The Great Game: Geopolitics and Oil (October 19, 2010)

The Great Game is afoot and no matter how we may disapprove of the Global Empire, we would be wise not to discount the cards it alone holds.

Geopolitics is not called The Great Game without reason. The game of dominating the world's resources, nation-states and alliances is like a combination of Go and chess, with the threat of military conquest or defeat always hovering over the statecraft and financial game.

I am going to present a number of statements and speculations here, most of which are at odds with the status quo thinking. I present them not to be contrarian but because they seem self-evident.

As I have noted here before, the value of "hard power" (military dominance) and "soft power" (cultural, financial, diplomatic) cannot be assessed until you don't have any.

That establishes a conundrum: one must maintain these quite different forms of global power without knowing if the cost is justified, until the moment arrives when others would pay ten times over to hold what you have in hand.

If that moment never arrives, it may be because you maintained an overwhelming advantage. Wars are launched when one side perceives a rough balance has been achieved; no nation is so suicidal that it chooses to attack a far superior power.

While I don't approve of the American Global Empire, I respect the intelligence and drive of those tasked with maintaining and expanding it--and they number in the millions.

There is only one nation-state which can project hard power: the U.S. A missile is not power-projection, because it exerts control over nothing; it is deterrence or threat, but not power that can be projected. Only aircraft carrier groups and the ability to transport an army by sea and air to any locale in the world is power projection.

The U.S. has 11 carrier groups, China has zero. The U.S. has the ability to transport a small army by air, China does not. The U.S. has the sealift capability to transport a large army by sea. China does not, and neither does Russia or the E.U.

Power projection is far more costly than defensive Armed Forces, and the U.S. is the only great power with true power projection because it alone has hegemony over the world's reserve currency. The U.S. skims a stupendous arbitrage profit from creating dollars and exporting them in exchange for real goods.

China and other aspiring great powers must actually make real profits. Just to put costs in context: China's huge $1.8 trillion in foreign reserves would cover the costs of global power projection for about two years.

We should also stipulate that an aircraft carrier alone is simply a sitting duck; it projects nothing but vulnerability. It is a carrier group which projects power, and that requires an enormous infrastructure: a small fleet of other vessels, satellite communications, anti-submarine capabilities, global bases to refuel/ reprovision, and so on.

When two carrier groups steam offshore, they are the largest air force in the world save a very few. The U.S. could trim its 11 carrier groups to 8 or 9 and still have the only large-scale, globally decisive 8 or 9 carrier groups in existence.

The same infrastructure is required to airlift or sealift troops: you need AWACS aircraft, global communications, global bases, and so on.

Why is all this important? because when push comes to shove, there is only nation which can project hard power in a meaningful, decisive manner: the U.S. Bankrupt, wounded, in decline, however you wish to characterize the U.S., it holds decisive dominance in hard power. And as long as the world accepts dollar hegemony, then the U.S. can afford its Empire.

As noted above: the true value of hard power cannot assessed until you don't have any.

When Canada and Australia impose restrictions on the export of natural resources to nations such as China--a move I fully expect by 2015--then exactly what is China going to do in retaliation? Virtually all of China's exports can be duplicated elsewhere. There are only three essentials (four counting fertile soil), what I call the FEW essentials: food, energy and water.

China's ability to export any of these is limited. Indeed, it is importing vast quantities of oil and food right now, even before global weather turns truly nasty.

The only leverage China really has on the global stage is its stash of rare-earth metals. As for that leverage: you can rest assured that DARPA (Defense Advanced Research Projects Agency) has long been funding research efforts to replace the rare-earth metals with other materials. In the meantime, mines will be reopened or other potential sources explored.

China is busy buying up Africa, which carries a number of ironies that have yet to unfold. To buy up other nations' assets is the essence of Neoliberal Global Capitalism, and in playing within that system China is now vulnerable to the same nationalist and revolutionary forces as those opposing U.S. domination.

The other irony is the "revolutionary" forces which I fully expect to take power in many African nations by 2015 will expropriate Chinese properties just as they will expropriate any other colonial powers' "property." And the Chinese will be powerless to reverse those expropriations; they possess neither the hard power to conquer and re-install pliant kleptocracies nor the soft power to do so by other means.

I doubt that any nation has that power now.

The only resource of any import (pun intended) is oil. Water, you either have within your borders or you don't, and those sharing a river will find conflicts becoming more likely with each passing year. Ditto soil--if yours has blown away in duststorms, you can't import enough to make a difference. And unless you have the ability to enforce your will via power projection, then buying up other nations' farmland is only a "solution" until they need it themselves.

Those who believe nationalism is no longer a force will be surprised in the coming decade how scarcity can fuel a fiery, unquenchable nationalism.

The supremely nationalist Chinese will come to understand nationalism from the other end: from that point of view, they are just another colonial power jockeying for someone else's wealth.

I am indebted to frequent contributor B.C. of Imperial Economics for this depiction of the coming struggle for the world's remaining oil.

B.C. posits that China's imports cannot be allowed to surpass the U.S. levels, lest the U.S. be deprived of that oil.

There are ironies galore in China's pride in surpassing the U.S. in auto production-- China produced 17 million vehicles last year to America's 13 million. The irony of course is that China's dependence on oil only deepens with every additional car on its roadways.

Both China and the U.S. have plentiful coal, but gasifying coal or even scrubbing the sulfur from it is costly. Having plentiful costly energy is not the same as having plentiful cheap energy, and oil remains the ultimate transportable energy and chemical feedstock.

Here is a map of the last great reserves of oil on the planet: the Mideast. Note that by some peculiar coincidence, the U.S. occupies the very heart of the oil reserves and the nation which lies between China and the oil.

If you want to control or influence the Mideast, then by all means take the center, Iraq; and if you want to extend your influence all the way to China, Pakistan, Russia and India, then take Afghanistan, too.

A cursory glance at the map offers a staggering array of strategic advantages to controlling or influencing Iraq and Afghanistan. Even to an amateur these pop off the map:

you divide troublemakers Syria and Iran, collaborators despite Syria being Sunni and Iran being Shi'ite.

you sit astride two great rivers in a parched landscape.

you can easily project military power into Turkey, Saudi Arabia, Syria, Iran, Jordan and Kuwait, and threaten Russia's southern flank and Egypt.

you can also fill the airwaves of all these surrounding nations with disruptive ideas/propaganda like freedom of the press, individual liberty, economic opportunity, etc.-- dangerous ideas to the surrounding kleptocracies/oligarchies.

you sandwich Iran between Afghanistan and Iraq.

your land forces are within easy range of air support from the US Navy in the Persian Gulf, Arabian Sea and the Mediterranean Sea, not to mention long-range air power from bases in Europe, Diego Garcia and the U.S. mainland.

Afghanistan is central to "the Stans" and shares a small border with China.

even if you do nothing, you unsettle everyone around you because you hold the strategic aces of location, power projection, etc.

We know about the oil, but what else is in play strategically? It's about the oil, of course, but beyond that observation lies a wealth of other factors, such as denying that oil to others who you might want to influence. Just choke off the Straits of Hormuz and a world of leverage suddenly opens up.

The general assumption is that the U.S. is vulnerable to Iran shutting that chokepoint, but what happens if Iranian tankers bound for China get stopped? Who gets hurt then? Certainly not the U.S. The chokepoints work in all kinds of directions.

As I have often noted here, disrupting production and control works both ways, too. The U.S. needn't "control" Iraq; all it need do is disrupt anyone else's grand ambitions or access to the oil. Disruption is cheaper and easier than control, as the Taliban discovered in 2001 when their control of Afghanistan was fatally disrupted by homegrown resistance.

In other words: all the U.S. need do is deny others access to the oil. So China has Sudan, and the U.S. controls access to the Mideast and 80% of the world's remaining oil reserves. Which position would you choose?

Here are my geopolitical predictions. I could ramble on for pages, so let's cut to the chase.

1. As I have described many times, I expect oil to plummet to $25/barrel at some point in 2011-13 as the global economy implodes. Demand will crash and kleptocracies everywhere will pump more in a desperate attempt to keep their welfare states afloat. I call this the "Oil Head-Fake." Apparently a few other analysts are of the same mind.

2. This dramatic decline in oil revenues will trigger regime change in Venezuela, Iran and all other nations which are dependent on oil revenues for the maintenance of their welfare state/Armed Forces/Political Elites.

In effect, all the U.S. needs to do is either wait for this crash in oil prices, or nudge the Saudis into creating the crash with overproduction. The Saudis (Sunni) fear the Iranians (Shi'ite) and would not be sorry to see regime change in Iran.

3. Capital restrictions will become commonplace, as nations awaken to the fact that their sovereignty and control of their own assets will be lost if they allow uncontrolled flows of capital in and out of their economy.

4. That means the clock is ticking on the U.S. dollar hegemony. Capital controls are the first step in controlling foreign exchange. Either an alternative global reserve currency will be established, or nations will institute dual-currency trading: one value for real trade, another value for foreign exchange.

5. Until the U.S. loses its currency hegemony, it can outbid any other great power for any resource. The U.S. funds its Empire by selling its bonds (debt) to those who have traded goods for our dollars. Thus the cost of the Empire is largely borne by other nations as the U.S. exports inflation and its currency in exchange for cheap goods and resources.

Until China gains an equivalent advantage, then it will have to bid for resources with earned income. That means they will lose any competition for resources because their apparently substantial wealth (a few trillion dollars in reserves) is modest compared to what the U.S. can create/print.

6. Capital controls will be followed by resource controls. The export of energy, food and minerals will be controlled. The excuses given won't matter; there will be no alternative. Governments which let their own populaces starve in order to ship food overseas will be overthrown bywhatever means are necessary. As Bob Marley observed, "a hungry mob is an angry mob." That's how Bastilles get torn down, brick by brick, by enraged, hungry mobs.

7. The clock is ticking on China's moment in the sun. As its costs of commodities and food skyrockets, its citizens' restive ambitions are thwarted by the limits facing all consuming nations, and its aging populace catches up with it, then China's resources will be stretched too thin to construct a Grand Empire with decisive hard and soft power.

Perhaps if Mao hadn't struck down an entire generation in the Cultural Revolution and China had started integrating its economy and ambitions 20 years earlier, that hard and soft power might have been assembled. But now it is too late; there are too many demands on China's financial resources, and its stash of $2 trillion foreign reserves looks modest compared to the demands of Empire and a populace of 1.2 billion people with expectations raised to the sky.

China's bellicose worldview that it has been the center of the world for the past 5,000 years and that dominance is its proper role is winning few friends. Its dependence on domestic credit bubbles, corruption, short-cuts and stolen intellectual property will dramatically shorten the time it has to create a sustainable domestic energy supply.

Would it be wiser for the U.S. to invest the trillions spent on controlling Mideast oil on domestic alternatives? Undoubtedly. But the wealth generated by oil far outstrips the wealth of alternatives, and until that profit flow reverses then the status quo in the U.S. will pursue Oil and Empire until the U.S. economy and dollar are no longer able to support an Empire.

Would China be wiser to pour its energies and wealth into sustainable energy? Yes, but its status quo is too wedded to corruption, easy credit, coal and delusions of global grandeur to make the kind of commitment needed to develop clean energy on the scale China needs to continue industrializing.

When competition between the U.S. and China comes up, I always ask this to settle the core issues quickly: Which nation's Power Elites have made sure their children have green cards and homes in Vancouver and/or Los Angeles?

If the U.S. Power Elites had secured Chinese citizenship for their beloved children and purchased properties in Beijing, then that would be proof that the leadership of the Empire had lost faith in the Empire's durability and future.

But it is the other way round: it is China's leadership which has moved its capital and offspring to Canada and the U.S. Indeed, having citizenship or green cards for one's children is proof of membership in the Chinese Elite.

Don't bother asking for verification of this; it is a deep, dark secret because of what it says about China, just like the secret organic farms which feed the Chinese Elites.

As much as I see the U.S. Global Empire as a tragic waste of wealth and resources, I also see very clearly that all the Empire needs to do to continue its dominance is:

1. Stop destroying the dollar with the Fed's idiotic, self-destructive Quantitative Easing.

2. Wait for the global demand for oil to decline, and then push the Saudis to increase supply, driving prices down to the point that the enemies of the U.S. and Saudi Arabia implode for domestic reasons.

3. Wait for China's inherent contradictions to fully bloom.

In other words: don't do anything foolish, just stand aside and let everyone else implode as their own reliance on ever-expanding credit and the U.S. dollar hegemony brings them to their knees.

Special note: Steve over at Two Beers with Steve was kind enough to let me ramble semi-coherently for an hour; we had a great time and I think I should have interviewed him.... Check it out if you have an hour of sitting in traffic to burn: Two Beers with Steve podcast.

If you would like to post a comment where others can read it, please go to DailyJava.net, (registering only takes a moment), select Of Two Minds-Charles Smith, and then go to The daily topic. To see other readers recent comments, go to New Posts.

2010-10-13T12:08:00.000-04:00

Annals of Innovation

Small Change

Why the revolution will not be tweeted.

by Malcolm Gladwell

October 4, 2010 Text Size:

Social media can’t provide what social change has always required.

At four-thirty in the afternoon on Monday, February 1, 1960, four college students sat down at the lunch counter at the Woolworth’s in downtown Greensboro, North Carolina. They were freshmen at North Carolina A. & T., a black college a mile or so away.

“I’d like a cup of coffee, please,” one of the four, Ezell Blair, said to the waitress.

“We don’t serve Negroes here,” she replied.

The Woolworth’s lunch counter was a long L-shaped bar that could seat sixty-six people, with a standup snack bar at one end. The seats were for whites. The snack bar was for blacks. Another employee, a black woman who worked at the steam table, approached the students and tried to warn them away. “You’re acting stupid, ignorant!” she said. They didn’t move. Around five-thirty, the front doors to the store were locked. The four still didn’t move. Finally, they left by a side door. Outside, a small crowd had gathered, including a photographer from the Greensboro Record. “I’ll be back tomorrow with A. & T. College,” one of the students said.

By next morning, the protest had grown to twenty-seven men and four women, most from the same dormitory as the original four. The men were dressed in suits and ties. The students had brought their schoolwork, and studied as they sat at the counter. On Wednesday, students from Greensboro’s “Negro” secondary school, Dudley High, joined in, and the number of protesters swelled to eighty. By Thursday, the protesters numbered three hundred, including three white women, from the Greensboro campus of the University of North Carolina. By Saturday, the sit-in had reached six hundred. People spilled out onto the street. White teen-agers waved Confederate flags. Someone threw a firecracker. At noon, the A. & T. football team arrived. “Here comes the wrecking crew,” one of the white students shouted.

By the following Monday, sit-ins had spread to Winston-Salem, twenty-five miles away, and Durham, fifty miles away. The day after that, students at Fayetteville State Teachers College and at Johnson C. Smith College, in Charlotte, joined in, followed on Wednesday by students at St. Augustine’s College and Shaw University, in Raleigh. On Thursday and Friday, the protest crossed state lines, surfacing in Hampton and Portsmouth, Virginia, in Rock Hill, South Carolina, and in Chattanooga, Tennessee. By the end of the month, there were sit-ins throughout the South, as far west as Texas. “I asked every student I met what the first day of the sitdowns had been like on his campus,” the political theorist Michael Walzer wrote in Dissent. “The answer was always the same: ‘It was like a fever. Everyone wanted to go.’ ” Some seventy thousand students eventually took part. Thousands were arrested and untold thousands more radicalized. These events in the early sixties became a civil-rights war that engulfed the South for the rest of the decade—and it happened without e-mail, texting, Facebook, or Twitter.

The world, we are told, is in the midst of a revolution. The new tools of social media have reinvented social activism. With Facebook and Twitter and the like, the traditional relationship between political authority and popular will has been upended, making it easier for the powerless to collaborate, coördinate, and give voice to their concerns. When ten thousand protesters took to the streets in Moldova in the spring of 2009 to protest against their country’s Communist government, the action was dubbed the Twitter Revolution, because of the means by which the demonstrators had been brought together. A few months after that, when student protests rocked Tehran, the State Department took the unusual step of asking Twitter to suspend scheduled maintenance of its Web site, because the Administration didn’t want such a critical organizing tool out of service at the height of the demonstrations. “Without Twitter the people of Iran would not have felt empowered and confident to stand up for freedom and democracy,” Mark Pfeifle, a former national-security adviser, later wrote, calling for Twitter to be nominated for the Nobel Peace Prize. Where activists were once defined by their causes, they are now defined by their tools. Facebook warriors go online to push for change. “You are the best hope for us all,” James K. Glassman, a former senior State Department official, told a crowd of cyber activists at a recent conference sponsored by Facebook, A. T. & T., Howcast, MTV, and Google. Sites like Facebook, Glassman said, “give the U.S. a significant competitive advantage over terrorists. Some time ago, I said that Al Qaeda was ‘eating our lunch on the Internet.’ That is no longer the case. Al Qaeda is stuck in Web 1.0. The Internet is now about interactivity and conversation.”

These are strong, and puzzling, claims. Why does it matter who is eating whose lunch on the Internet? Are people who log on to their Facebook page really the best hope for us all? As for Moldova’s so-called Twitter Revolution, Evgeny Morozov, a scholar at Stanford who has been the most persistent of digital evangelism’s critics, points out that Twitter had scant internal significance in Moldova, a country where very few Twitter accounts exist. Nor does it seem to have been a revolution, not least because the protests—as Anne Applebaum suggested in the Washington Post—may well have been a bit of stagecraft cooked up by the government. (In a country paranoid about Romanian revanchism, the protesters flew a Romanian flag over the Parliament building.) In the Iranian case, meanwhile, the people tweeting about the demonstrations were almost all in the West. “It is time to get Twitter’s role in the events in Iran right,” Golnaz Esfandiari wrote, this past summer, in Foreign Policy. “Simply put: There was no Twitter Revolution inside Iran.” The cadre of prominent bloggers, like Andrew Sullivan, who championed the role of social media in Iran, Esfandiari continued, misunderstood the situation. “Western journalists who couldn’t reach—or didn’t bother reaching?—people on the ground in Iran simply scrolled through the English-language tweets post with tag #iranelection,” she wrote. “Through it all, no one seemed to wonder why people trying to coordinate protests in Iran would be writing in any language other than Farsi.”

Some of this grandiosity is to be expected. Innovators tend to be solipsists. They often want to cram every stray fact and experience into their new model. As the historian Robert Darnton has written, “The marvels of communication technology in the present have produced a false consciousness about the past—even a sense that communication has no history, or had nothing of importance to consider before the days of television and the Internet.” But there is something else at work here, in the outsized enthusiasm for social media. Fifty years after one of the most extraordinary episodes of social upheaval in American history, we seem to have forgotten what activism is.

Greensboro in the early nineteen-sixties was the kind of place where racial insubordination was routinely met with violence. The four students who first sat down at the lunch counter were terrified. “I suppose if anyone had come up behind me and yelled ‘Boo,’ I think I would have fallen off my seat,” one of them said later. On the first day, the store manager notified the police chief, who immediately sent two officers to the store. On the third day, a gang of white toughs showed up at the lunch counter and stood ostentatiously behind the protesters, ominously muttering epithets such as “burr-head nigger.” A local Ku Klux Klan leader made an appearance. On Saturday, as tensions grew, someone called in a bomb threat, and the entire store had to be evacuated.

The dangers were even clearer in the Mississippi Freedom Summer Project of 1964, another of the sentinel campaigns of the civil-rights movement. The Student Nonviolent Coordinating Committee recruited hundreds of Northern, largely white unpaid volunteers to run Freedom Schools, register black voters, and raise civil-rights awareness in the Deep South. “No one should go anywhere alone, but certainly not in an automobile and certainly not at night,” they were instructed. Within days of arriving in Mississippi, three volunteers—Michael Schwerner, James Chaney, and Andrew Goodman—were kidnapped and killed, and, during the rest of the summer, thirty-seven black churches were set on fire and dozens of safe houses were bombed; volunteers were beaten, shot at, arrested, and trailed by pickup trucks full of armed men. A quarter of those in the program dropped out. Activism that challenges the status quo—that attacks deeply rooted problems—is not for the faint of heart.

What makes people capable of this kind of activism? The Stanford sociologist Doug McAdam compared the Freedom Summer dropouts with the participants who stayed, and discovered that the key difference wasn’t, as might be expected, ideological fervor. “All of the applicants—participants and withdrawals alike—emerge as highly committed, articulate supporters of the goals and values of the summer program,” he concluded. What mattered more was an applicant’s degree of personal connection to the civil-rights movement. All the volunteers were required to provide a list of personal contacts—the people they wanted kept apprised of their activities—and participants were far more likely than dropouts to have close friends who were also going to Mississippi. High-risk activism, McAdam concluded, is a “strong-tie” phenomenon.

This pattern shows up again and again. One study of the Red Brigades, the Italian terrorist group of the nineteen-seventies, found that seventy per cent of recruits had at least one good friend already in the organization. The same is true of the men who joined the mujahideen in Afghanistan. Even revolutionary actions that look spontaneous, like the demonstrations in East Germany that led to the fall of the Berlin Wall, are, at core, strong-tie phenomena. The opposition movement in East Germany consisted of several hundred groups, each with roughly a dozen members. Each group was in limited contact with the others: at the time, only thirteen per cent of East Germans even had a phone. All they knew was that on Monday nights, outside St. Nicholas Church in downtown Leipzig, people gathered to voice their anger at the state. And the primary determinant of who showed up was “critical friends”—the more friends you had who were critical of the regime the more likely you were to join the protest.

So one crucial fact about the four freshmen at the Greensboro lunch counter—David Richmond, Franklin McCain, Ezell Blair, and Joseph McNeil—was their relationship with one another. McNeil was a roommate of Blair’s in A. & T.’s Scott Hall dormitory. Richmond roomed with McCain one floor up, and Blair, Richmond, and McCain had all gone to Dudley High School. The four would smuggle beer into the dorm and talk late into the night in Blair and McNeil’s room. They would all have remembered the murder of Emmett Till in 1955, the Montgomery bus boycott that same year, and the showdown in Little Rock in 1957. It was McNeil who brought up the idea of a sit-in at Woolworth’s. They’d discussed it for nearly a month. Then McNeil came into the dorm room and asked the others if they were ready. There was a pause, and McCain said, in a way that works only with people who talk late into the night with one another, “Are you guys chicken or not?” Ezell Blair worked up the courage the next day to ask for a cup of coffee because he was flanked by his roommate and two good friends from high school.

The kind of activism associated with social media isn’t like this at all. The platforms of social media are built around weak ties. Twitter is a way of following (or being followed by) people you may never have met. Facebook is a tool for efficiently managing your acquaintances, for keeping up with the people you would not otherwise be able to stay in touch with. That’s why you can have a thousand “friends” on Facebook, as you never could in real life.

This is in many ways a wonderful thing. There is strength in weak ties, as the sociologist Mark Granovetter has observed. Our acquaintances—not our friends—are our greatest source of new ideas and information. The Internet lets us exploit the power of these kinds of distant connections with marvellous efficiency. It’s terrific at the diffusion of innovation, interdisciplinary collaboration, seamlessly matching up buyers and sellers, and the logistical functions of the dating world. But weak ties seldom lead to high-risk activism.

In a new book called “The Dragonfly Effect: Quick, Effective, and Powerful Ways to Use Social Media to Drive Social Change,” the business consultant Andy Smith and the Stanford Business School professor Jennifer Aaker tell the story of Sameer Bhatia, a young Silicon Valley entrepreneur who came down with acute myelogenous leukemia. It’s a perfect illustration of social media’s strengths. Bhatia needed a bone-marrow transplant, but he could not find a match among his relatives and friends. The odds were best with a donor of his ethnicity, and there were few South Asians in the national bone-marrow database. So Bhatia’s business partner sent out an e-mail explaining Bhatia’s plight to more than four hundred of their acquaintances, who forwarded the e-mail to their personal contacts; Facebook pages and YouTube videos were devoted to the Help Sameer campaign. Eventually, nearly twenty-five thousand new people were registered in the bone-marrow database, and Bhatia found a match.

But how did the campaign get so many people to sign up? By not asking too much of them. That’s the only way you can get someone you don’t really know to do something on your behalf. You can get thousands of people to sign up for a donor registry, because doing so is pretty easy. You have to send in a cheek swab and—in the highly unlikely event that your bone marrow is a good match for someone in need—spend a few hours at the hospital. Donating bone marrow isn’t a trivial matter. But it doesn’t involve financial or personal risk; it doesn’t mean spending a summer being chased by armed men in pickup trucks. It doesn’t require that you confront socially entrenched norms and practices. In fact, it’s the kind of commitment that will bring only social acknowledgment and praise.

The evangelists of social media don’t understand this distinction; they seem to believe that a Facebook friend is the same as a real friend and that signing up for a donor registry in Silicon Valley today is activism in the same sense as sitting at a segregated lunch counter in Greensboro in 1960. “Social networks are particularly effective at increasing motivation,” Aaker and Smith write. But that’s not true. Social networks are effective at increasing participation—by lessening the level of motivation that participation requires. The Facebook page of the Save Darfur Coalition has 1,282,339 members, who have donated an average of nine cents apiece. The next biggest Darfur charity on Facebook has 22,073 members, who have donated an average of thirty-five cents. Help Save Darfur has 2,797 members, who have given, on average, fifteen cents. A spokesperson for the Save Darfur Coalition told Newsweek, “We wouldn’t necessarily gauge someone’s value to the advocacy movement based on what they’ve given. This is a powerful mechanism to engage this critical population. They inform their community, attend events, volunteer. It’s not something you can measure by looking at a ledger.” In other words, Facebook activism succeeds not by motivating people to make a real sacrifice but by motivating them to do the things that people do when they are not motivated enough to make a real sacrifice. We are a long way from the lunch counters of Greensboro.

The students who joined the sit-ins across the South during the winter of 1960 described the movement as a “fever.” But the civil-rights movement was more like a military campaign than like a contagion. In the late nineteen-fifties, there had been sixteen sit-ins in various cities throughout the South, fifteen of which were formally organized by civil-rights organizations like the N.A.A.C.P. and CORE. Possible locations for activism were scouted. Plans were drawn up. Movement activists held training sessions and retreats for would-be protesters. The Greensboro Four were a product of this groundwork: all were members of the N.A.A.C.P. Youth Council. They had close ties with the head of the local N.A.A.C.P. chapter. They had been briefed on the earlier wave of sit-ins in Durham, and had been part of a series of movement meetings in activist churches. When the sit-in movement spread from Greensboro throughout the South, it did not spread indiscriminately. It spread to those cities which had preëxisting “movement centers”—a core of dedicated and trained activists ready to turn the “fever” into action.

The civil-rights movement was high-risk activism. It was also, crucially, strategic activism: a challenge to the establishment mounted with precision and discipline. The N.A.A.C.P. was a centralized organization, run from New York according to highly formalized operating procedures. At the Southern Christian Leadership Conference, Martin Luther King, Jr., was the unquestioned authority. At the center of the movement was the black church, which had, as Aldon D. Morris points out in his superb 1984 study, “The Origins of the Civil Rights Movement,” a carefully demarcated division of labor, with various standing committees and disciplined groups. “Each group was task-oriented and coordinated its activities through authority structures,” Morris writes. “Individuals were held accountable for their assigned duties, and important conflicts were resolved by the minister, who usually exercised ultimate authority over the congregation.”

This is the second crucial distinction between traditional activism and its online variant: social media are not about this kind of hierarchical organization. Facebook and the like are tools for building networks, which are the opposite, in structure and character, of hierarchies. Unlike hierarchies, with their rules and procedures, networks aren’t controlled by a single central authority. Decisions are made through consensus, and the ties that bind people to the group are loose.

This structure makes networks enormously resilient and adaptable in low-risk situations. Wikipedia is a perfect example. It doesn’t have an editor, sitting in New York, who directs and corrects each entry. The effort of putting together each entry is self-organized. If every entry in Wikipedia were to be erased tomorrow, the content would swiftly be restored, because that’s what happens when a network of thousands spontaneously devote their time to a task.

There are many things, though, that networks don’t do well. Car companies sensibly use a network to organize their hundreds of suppliers, but not to design their cars. No one believes that the articulation of a coherent design philosophy is best handled by a sprawling, leaderless organizational system. Because networks don’t have a centralized leadership structure and clear lines of authority, they have real difficulty reaching consensus and setting goals. They can’t think strategically; they are chronically prone to conflict and error. How do you make difficult choices about tactics or strategy or philosophical direction when everyone has an equal say?

The Palestine Liberation Organization originated as a network, and the international-relations scholars Mette Eilstrup-Sangiovanni and Calvert Jones argue in a recent essay in International Security that this is why it ran into such trouble as it grew: “Structural features typical of networks—the absence of central authority, the unchecked autonomy of rival groups, and the inability to arbitrate quarrels through formal mechanisms—made the P.L.O. excessively vulnerable to outside manipulation and internal strife.”

In Germany in the nineteen-seventies, they go on, “the far more unified and successful left-wing terrorists tended to organize hierarchically, with professional management and clear divisions of labor. They were concentrated geographically in universities, where they could establish central leadership, trust, and camaraderie through regular, face-to-face meetings.” They seldom betrayed their comrades in arms during police interrogations. Their counterparts on the right were organized as decentralized networks, and had no such discipline. These groups were regularly infiltrated, and members, once arrested, easily gave up their comrades. Similarly, Al Qaeda was most dangerous when it was a unified hierarchy. Now that it has dissipated into a network, it has proved far less effective.

The drawbacks of networks scarcely matter if the network isn’t interested in systemic change—if it just wants to frighten or humiliate or make a splash—or if it doesn’t need to think strategically. But if you’re taking on a powerful and organized establishment you have to be a hierarchy. The Montgomery bus boycott required the participation of tens of thousands of people who depended on public transit to get to and from work each day. It lasted a year. In order to persuade those people to stay true to the cause, the boycott’s organizers tasked each local black church with maintaining morale, and put together a free alternative private carpool service, with forty-eight dispatchers and forty-two pickup stations. Even the White Citizens Council, King later said, conceded that the carpool system moved with “military precision.” By the time King came to Birmingham, for the climactic showdown with Police Commissioner Eugene (Bull) Connor, he had a budget of a million dollars, and a hundred full-time staff members on the ground, divided into operational units. The operation itself was divided into steadily escalating phases, mapped out in advance. Support was maintained through consecutive mass meetings rotating from church to church around the city.

Boycotts and sit-ins and nonviolent confrontations—which were the weapons of choice for the civil-rights movement—are high-risk strategies. They leave little room for conflict and error. The moment even one protester deviates from the script and responds to provocation, the moral legitimacy of the entire protest is compromised. Enthusiasts for social media would no doubt have us believe that King’s task in Birmingham would have been made infinitely easier had he been able to communicate with his followers through Facebook, and contented himself with tweets from a Birmingham jail. But networks are messy: think of the ceaseless pattern of correction and revision, amendment and debate, that characterizes Wikipedia. If Martin Luther King, Jr., had tried to do a wiki-boycott in Montgomery, he would have been steamrollered by the white power structure. And of what use would a digital communication tool be in a town where ninety-eight per cent of the black community could be reached every Sunday morning at church? The things that King needed in Birmingham—discipline and strategy—were things that online social media cannot provide.

The bible of the social-media movement is Clay Shirky’s “Here Comes Everybody.” Shirky, who teaches at New York University, sets out to demonstrate the organizing power of the Internet, and he begins with the story of Evan, who worked on Wall Street, and his friend Ivanna, after she left her smart phone, an expensive Sidekick, on the back seat of a New York City taxicab. The telephone company transferred the data on Ivanna’s lost phone to a new phone, whereupon she and Evan discovered that the Sidekick was now in the hands of a teen-ager from Queens, who was using it to take photographs of herself and her friends.

When Evan e-mailed the teen-ager, Sasha, asking for the phone back, she replied that his “white ass” didn’t deserve to have it back. Miffed, he set up a Web page with her picture and a description of what had happened. He forwarded the link to his friends, and they forwarded it to their friends. Someone found the MySpace page of Sasha’s boyfriend, and a link to it found its way onto the site. Someone found her address online and took a video of her home while driving by; Evan posted the video on the site. The story was picked up by the news filter Digg. Evan was now up to ten e-mails a minute. He created a bulletin board for his readers to share their stories, but it crashed under the weight of responses. Evan and Ivanna went to the police, but the police filed the report under “lost,” rather than “stolen,” which essentially closed the case. “By this point millions of readers were watching,” Shirky writes, “and dozens of mainstream news outlets had covered the story.” Bowing to the pressure, the N.Y.P.D. reclassified the item as “stolen.” Sasha was arrested, and Evan got his friend’s Sidekick back.

Shirky’s argument is that this is the kind of thing that could never have happened in the pre-Internet age—and he’s right. Evan could never have tracked down Sasha. The story of the Sidekick would never have been publicized. An army of people could never have been assembled to wage this fight. The police wouldn’t have bowed to the pressure of a lone person who had misplaced something as trivial as a cell phone. The story, to Shirky, illustrates “the ease and speed with which a group can be mobilized for the right kind of cause” in the Internet age.

Shirky considers this model of activism an upgrade. But it is simply a form of organizing which favors the weak-tie connections that give us access to information over the strong-tie connections that help us persevere in the face of danger. It shifts our energies from organizations that promote strategic and disciplined activity and toward those which promote resilience and adaptability. It makes it easier for activists to express themselves, and harder for that expression to have any impact. The instruments of social media are well suited to making the existing social order more efficient. They are not a natural enemy of the status quo. If you are of the opinion that all the world needs is a little buffing around the edges, this should not trouble you. But if you think that there are still lunch counters out there that need integrating it ought to give you pause.

Shirky ends the story of the lost Sidekick by asking, portentously, “What happens next?”—no doubt imagining future waves of digital protesters. But he has already answered the question. What happens next is more of the same. A networked, weak-tie world is good at things like helping Wall Streeters get phones back from teen-age girls. Viva la revolución. ♦

Read more http://www.newyorker.com/reporting/2010/10/04/101004fa_fact_gladwell?printable=true#ixzz12Fuc6tzJ

2010-10-11T13:27:00.003-04:00

The End of Big Oil

Houston, we have a problem.

Steve LeVine February 27, 2008
12:00 am

When historians one day dissect the long arc of humankind's use of fossil fuels, they may very well zero in on October 9, 2006, as a turning point for Big Oil. That's when it became clear that the major oil companies--the giants that had survived numerous predicted extinctions and gone on to ever-greater profit and influence--were undergoing a tectonic shift and would either reinvent themselves or die. It's the day Moscow dashed the hopes of five major oil companies from three countries and announced that Russia itself, and not they, would develop the biggest new natural gas field on the planet, an undersea Arctic reservoir called Shtokman.

Shtokman is the oilman's Angelina Jolie: much-coveted but out of reach. Experts believe it contains the carbon fuel equivalent of 23 billion barrels of oil--that in an industry that considers a field of one billion barrels gigantic. Shtokman alone contains sufficient energy to power all of Europe for several years, and the world's big oil companies had sought rights to it for years.

In another time, Russia's declaration that its natural gas behemoth, Gazprom, would develop such a field would have set off peals of laughter among Western oilmen. Gazprom lacked the know-how to keep production at its current fields from declining; how would it manage a technological feat under the deep, icy waters of the Barents Sea? But there was nothing humorous about Russia's plans. Gazprom knew it wasn't capable of drilling the field; instead, it planned to hire Big Oil to do so. Big Oil would be its employee.

That notion flew in the face of oil-industry orthodoxy, which says that big potential profits accrue to those who assume big risks. If a company developed an oilfield, it was rewarded with the gold star used by Wall Street to measure oil company value--the rights to "booked reserves," in industry parlance. Booked reserves consist of how much oil and natural gas a company controls, and thus can sell at some point at, say, $95 per barrel or $260 per 1,000 cubic meters. The Securities and Exchange Commission measures booked reserves, and investors regard them as the main determinant of a company's fundamental worth. Yet now Gazprom was suggesting stripping the Western oil giants of that incentive--they would be unable to book Shtokman's natural gas. The industry's mood has become even more somber over the last half-year as two European companies--France's Total and Norway's StatoilHydro--actually agreed to Russia's terms.

The truth is that any of the oil majors--with the possible exception of Exxon Mobil--eventually would have. Why? Because oilmen know that, despite recent unprecedented profits-- Exxon alone reported a record $11.7 billion in net income for the fourth quarter of 2007--they are on the decline. The combined booked reserves of the world's biggest five companies have shrunk by almost 20 percent per year on average since 1999, according to a paper by Rice University's James A. Baker Institute for Public Policy. Shtokman is a blueprint for how the major oil companies are increasingly being treated around the world. Today, state oil companies and ministries from countries like Venezuela, Saudi Arabia, and Russia control somewhere between 80 percent and 90 percent of the world's known oil and natural gas reserves. And, over the next two decades and beyond, those countries are going to ask foreign oil companies to serve as their contract employees in the same way that Gazprom brought on Total and Statoil.

Big Oil, then--the indomitable giant symbolized by the pitiless John D. Rockefeller--is dying. At the very least, it will soon have to fundamentally change the way it does business. But the shock of Shtokman is merely a tremor compared with the coming transition to a non-carbon energy economy. Big Oil could transcend its current woes and weather that revolution-- perhaps even lead it--if it reinvented itself as Big Energy, striving to develop renewable power sources like wind and solar, or even to deliver the industry's holy grail: a clean energy mechanism that renders fossil fuels obsolete. True, no one yet knows what the revolution will look like; but the odd thing is that, for the most part, the oil companies don't seem to care.

The irony of the events at Shtokman, and the lesson to be learned from them, is that the former Soviet Union represents Big Oil's last hurrah. It's there that the major oil companies have rushed over the last two decades and been permitted access to several of the world's biggest oil and natural gas fields. When the companies arrived in the late '80s, it was amid their last industry-threatening crisis.

Back then, a Houston man named Tom Hamilton was BP's new chief for international exploration. Hamilton is a paunchy, slow-talking, professorial Ohio native with a PhD in geology. When he inspected the company's books, he saw that it was in deep trouble. Its bank of oil reserves had fallen from 70 billion barrels to 4 billion barrels, partly as a result of a wave of nationalization that had swept away some or all of BP's oil supply from six different countries, including Libya, Iraq, and Kuwait. Hamilton foresaw a similar future in the British company's actual sales--the prospect that current production of 1.5 million barrels per day would decline below 900,000 barrels a day within just a few years, a 60 percent drop in its key marketable commodity. In Hamilton's view, that wasn't just the fault of OPEC politics. BP itself had become complacent in the fat years, the 1960s and '70s, and excessively fearful of drilling a dry hole, he thought.

Worse, at the same time that the company recognized its supply problem, it also realized that it lacked the in-house skill to rectify it. Over the years, BP had retired too many of its expert oil trackers, the seasoned hands who seemed able to divine where to drill on little more than intuition. Now the company mostly had younger geologists, who relied too heavily on often-imperfect technology.

The problem plagued BP's rivals as well. The era's petronationalism confused the industry, and, to stabilize profits, many companies tried to diversify and expand the kinds of business they did. In those years, BP went into animal feeding and breeding; Mobil bought the Container Corporation of America and the Montgomery Ward department store chain; Exxon made office machines; and, though it eventually dropped the idea, Gulf Oil actually agreed to buy the Ringling Brothers/ Barnum & Bailey Circus. A raft of mergers broke out, as well: Chevron paid a then-record $13.2 billion in cash for Gulf, and Texaco acquired Getty Oil for $10.2 billion. Then, in 1985 and 1986, oil prices plummeted from more than $31.50 a barrel to less than $10, and the mass firings began.

At BP, Hamilton was appointed to head a study of the most important oil-field discoveries in the industry's entire 140-year history, the aim being to track how the company had reached its current crisis. With a team of some 30 men, Hamilton inspected a Los Angeles field struck in 1887; Texas's famous Spindletop, which hit in 1901; Venezuela's Maracaibo Basin, which delivered a giant in 1914; the massively prolific Arabian Basin, which yielded its first reservoir in 1932; and West Siberia, which produced a gusher in 1961. In all, they examined more than 1,000 fields. The result was a report titled, "The Way Ahead," whose chief finding was that BP, like its rivals, had a habit of spending large sums for ever-smaller pieces of proven oil regions. Such methods were safe--there was little danger of drilling a dry hole--but they would never produce sufficient volumes to turn around the company. The group stressed an odd fact regarding discovered oil basins: Many held far less than one billion barrels, and some possessed far more than three billion barrels, but few were in between. In other words, oil fields were either monstrously large or relatively small. Hamilton's group proposed that BP aim only for super-giant fields in previously unexplored parts of the world.

BP's competitors reached similar conclusions. The firm now called Amoco resolved to penetrate what it labeled "breakthrough countries." A company report from that time discussed the virtue of trying to secure deals in oil-rich countries by overcoming existing political, economic, or legal obstacles. Chevron, concluding its own "Global Basin Study," watched to see if any such territory opened up. Under the microscope were Latin American countries, Arab nations that had previously nationalized Western holdings, and so-called "rogue states," such as Libya and Iran, which were off-limits to American companies because of U.S. law.

But the Soviet Union, with enormous known reserves trapped behind the Iron Curtain, led everyone's list. So, when Soviet leader Mikhail Gorbachev invited the Western oil companies to take a look around in the hopes of reviving the country's economy, the companies poured in. In 1990, Hamilton flew into Kazakhstan to inspect its super-giant Tengiz oilfield, which could build up BP's reserves by some 9 billion barrels of oil. After a sumptuous 2 a.m. meal of jellied camel tendons and fermented camel's milk, he and his colleagues got a few hours' rest before being invited to gather in front of a snooker table. As the BP men watched, their hosts unfurled enormous rolls of paper containing the geological outlines of the northeast Caspian Sea. Scrutinizing the data, Hamilton suddenly saw the lines of a huge, previously undiscovered offshore reservoir. He and his companions thanked the Kazakhs and suggested they take a break. "Holy shit," Hamilton blurted out when they were alone. "These were Ray Charles kind of structures--a blind man could see what they were."

Hamilton didn't end up securing rights to those fields for BP; instead, he moved on to Azerbaijan, on the west side of the Caspian. There, BP eventually booked a 34 percent share of a 5.6-billion-barrel oil region offshore from the capital of Baku.

Hamilton, who left BP and is currently a private wildcatter, sees parallels between then and now. But he doesn't expect the industry to explore its way out of its current crisis. Big Oil has been so talented and lucky, he says, that it's already found almost all the world's easy crude. What's left is a slew of much smaller fields--those reservoirs of fewer than 1 billion barrels of oil--and therefore far more expense and difficulty in amassing the volume of energy needed to supply the world economy. At the same time, he thinks it will take two or three decades before any alternative fuel can substitute for oil. So the question for Big Oil, he says, is, "How do you build a bridge to something else? How do you transition? What might that bridge look like?"

There are several ways in which Big Oil could reinvent itself-- or at least pretend to reinvent itself. One of the most probable is, in essence, a ruse: To hide the fact that they are shrinking, the major companies could attempt to persuade Wall Street to stop evaluating them by barrels of oil and cubic meters of natural gas and instead look at the pure profit they can muster by managing and financing projects. Big Oil could argue that its ability to take on the most difficult jobs, such as drilling in deep, offshore fields, is worth the same multiple on earnings that Wall Street is currently paying. But there is little appetite on Wall Street for such brazenly self-interested changes. And, indeed, one might ask whether one can plausibly argue that "Exxon, project-completion company" is worth the same as "Exxon, company with 23 billion barrels of oil and natural gas." It's hard to imagine the stock market according the companies the same value, since it's hard to imagine profits being the same.

That is why it seems more likely that Big Oil will pursue a different tack: merging with national oil companies--such as Brazil's Petrobras, Russia's Gazprom, or Qatar Petroleum--and thereby sliding right back into the slipstream of high profit. At least one member of Big Oil has already explored this idea. In 2003, Chevron and Russia's Yukos completed an agreement that would have resulted in Chevron being heavily influenced by two Russian oligarchs: Mikhail Khodorkovsky and Roman Abramovich. According to a senior Russian official, the plan was for the two Russian energy giants they controlled, Yukos and Sibneft, to first merge. Then that company would have joined with Chevron. The resulting behemoth would have been American, but the two oligarchs would have owned 20 percent of Chevron's shares. (Chevron declined to comment.)

The courtship between Chevron and Yukos has been public knowledge for some time, but not how transformational the plan was, nor that it was basically a done deal, one actually approved by Russian President Vladimir Putin. In the end, it collapsed when Putin and Khodorkovsky fell out and the former threw the latter in prison. The Yukos-Sibneft agreement, too, unwound, and, in an ugly aftermath, the companies were largely subsumed by Gazprom and Rosneft, another state-owned Russian oil firm.

Nevertheless, in some ways the deal could serve as a model for future mergers: Yukos and Sibneft were interested in Chevron because of its cash, its established reputation, and its far-flung refinery-and-retail network. But Big Oil will need to accept that it is in a real bind--reserves and stock prices may need to crater--before it cedes substantial control to a national oil company.

Ultimately, the only Big Oil company left standing in 20 years may be the one that wholly reinvents itself. The future of energy, after all, lies not in hydrocarbons like oil and gas, but in cleaner fuels that emit fewer greenhouse gases or in some other transformational technology. Unfortunately, that is about all we know about the future of energy right now. Hydrogen fuel cells and cellulosic ethanol could someday replace oil, but neither has proved workable yet. Indeed, there is a considerable chance that we will be surprised by both the timing and the substance of the post-carbon revolution.

One would expect that Big Oil would be trying to unmask the nature of that revolution so that it could be the one driving and, more importantly, profiting from it. But neither the oil companies nor the world's energy experts seem to think this leap forward is on the horizon. Recently, Fatih Birol, the much-respected chief economist at the Paris-based International Energy Agency, suggested that it "may be too optimistic" to expect a discovery any time soon of a clean-energy mechanism that replaces fossil fuels. In a November appearance at the Council on Foreign Relations in New York, Birol said he expects improvements in energy efficiency "but no major surprises in the next twenty years."

That's a remarkable statement, given the technological breakthroughs of the last two decades--and given the hundreds of billions of dollars that would accrue to the inventor of an energy breakthrough. Silicon Valley certainly doesn't agree with Birol: Venture capitalists are pouring money into the competition to invent a technology that would be as significant as the transistor. It would be insane to presume to predict a winner. But the revolution is likely to come from one of the high-tech corridors in India, China, Europe, or the United States; the research arms of associated industries, like auto manufacturing; or the laboratories of Big Oil.

I myself have put much store in the latter-- because the oil companies have the most to lose. In particular, I've focused on Exxon, with its disciplined and ostensibly forward-thinking 25-year plan. Within the bowels of the world's largest publicly traded company, I've imagined, a group of energy nerds surely sits, cooking up some new, new thing. But, if it is, Exxon Chairman Rex Tillerson is doing a mighty head fake. In speeches and remarks to shareholders in recent months, the Exxon chief has aggressively argued that the carbon world is not changing--that oil will rule the planet until at least 2030. And it's true that the world is so dependent on oil that, even if a technological breakthrough happened today, we would require decades to adapt to its use. Until then, oil would remain king.

Where Tillerson's confidence begins to assume the worrying character of ancient Rome is on Exxon's role in that future. While some of the oil majors may die in the new world of national oil companies, he argues, Exxon won't be among the victims. Why? Because it's more financially disciplined and technologically equipped than anyone else. "If everyone were equal, if all of us had the same technology capabilities and the same know-how, then it would just be a straight up bidding war. You know, I'll give you ten, and the next chap says, 'I'll give you eleven,'" Tillerson told the Financial Times last summer on Exxon and its rivals' efforts to book new oil reserves against competition from majority state-owned companies. "But we're not all equal, and most of the host governments recognize that we're not all equal."

This argument misses the point. The national oil companies know that the West has technology they need. But, in most cases, they can bring in oil service companies like FMC, Schlumberger, and Parker Drilling to develop their fields for them. And, in the minority of cases where they need to bring in the majors and confer reserves upon them, they will grant Big Oil a miniscule position, not the large share to which it is accustomed. There simply will not be sufficient reserves for Big Oil--including Exxon--to maintain its size.

Exxon's final line of defense is its toughness--it simply won't be pushed around. Russia is an example: In addition to the European concession at Shtokman, Big Oil rivals Shell, BP, and Total have been forced over the last year to surrender their majority positions in other key oil and natural fields to Russian companies. Yet, so far, an Exxon project called Sakhalin-I has been exempt from contract revisions. Tillerson maintains that Sakhalin-I's contract will continue to be honored because Exxon won't contribute its technological know-how unless it is. But, eventually, Russia will treat Exxon as it has everyone else and demand revisions, and, eventually, Exxon is likely to accept those demands--as it recently did in Kazakhstan, where it agreed to make the state an equal partner in the super-giant offshore Kashagan oilfield.

Will Exxon be a major player in the energy world beyond 2030? On the record, at least, Exxon isn't hedging its bets. Its publicly released research focuses on carbon fuels. Last February, at the industry's leading annual event, the Cambridge Energy Research Associates conference, Tillerson maintained the standard line: Two trillion barrels of conventional oil sources are left on the planet, and Exxon will find and produce those, not make "moonshine," as he calls biofuels. Nor is he interested in developing a successful formulation of cellulosic ethanol: "There is really nothing I see Exxon can bring to this."

What about the other members of the Big Oil fraternity? On paper, Shell is aggressively pursuing company reinvention. It is taking dual stabs at cellulosic ethanol and hydrogen fuel cells--and speaks enthusiastically about both becoming commercial in the next couple of decades. Still, Shell maintains that fossil fuels will be the world's main fuel source 50 years from now. By then, Shell as we know it today will not exist. BP and Chevron are behaving little differently.

From an outsider's perspective, it is difficult to fathom such obstinacy. A whole raft of factors--including the natural instinct to self-preservation and the possibility of enormous profit--is pushing Big Oil to become something else. But the culture of the industry--a macho tradition that is resistant to change--seems to refuse to countenance evolution, even when the alternative is extinction. Such an attitude may seem absurd, but, of course, this phenomenon has a long history in American capitalism: A friend reminds me that U.S. steel and automobile companies also had much advance notice of impending doom but opted to ignore the barbarians just over the hill. In that case, perhaps Houston will soon look like Detroit.

Steve LeVine is the author of The Oil and the Glory: The Pursuit of Empire and Fortune on the Caspian Sea. He blogs at www.oilandglory.com.

2010-05-23T19:59:00.000-04:00

Senate's Goldman Probe Shows Toxic Magnification
Wall Street Banks Repackaged Same Risky Bonds into Numerous Securities, Spreading the Pain Across Multiple CDOs
LAW - MAY 2, 2010
wsj.com

By CARRICK MOLLENKAMP And SERENA NG

Even at its peak, subprime lending accounted for a relatively small portion of overall mortgage lending. Yet losses from these mortgages caused deep damage to the financial system.

Now, documents released by Senate investigators last week provide clues in understanding why the losses were so severe. The documents show how Wall Street banks packaged and repackaged the same risky bonds into securities that ultimately helped magnify the impact of defaulting subprime mortgages on the financial system.

In one case, a $38 million subprime-mortgage bond created in June 2006 ended up in more than 30 debt pools and ultimately caused roughly $280 million in losses to investors by the time the bond's principal was wiped out in 2008, according to data reviewed by The Wall Street Journal.

This was a central finding of the Senate investigative panel probing Goldman Sachs Group Inc.'s actions in the mortgage market. In a memo last week, panel Chairman Sen. Carl Levin (D., Mich.) said Goldman's work "magnified the impact of toxic mortgages" by replicating mortgage securities in debt pools known as collateralized debt obligations as well as CDO derivatives, and also in an index that tracks subprime bonds.

The subprime mortgages that caused big losses generally were packaged into CDOs, in which dozens of mortgage-backed bonds were pooled together and slices of the CDOs were sold to investors. Another version of these CDOs didn't contain actual mortgage bonds but were linked to them via derivatives called credit-default swaps. Through the use of derivatives, banks created many of these synthetic CDOs using the same mortgage securities, all of which would rise or fall in value depending on how the mortgages were performing. With synthetic CDOs, those who had bet that the loans would perform well were on the hook if their performance deteriorated.

In effect, the documents said, Wall Street was "copying and pasting" what turned out to be the worst-performing securities of the mortgage boom. Such activity helped multiply opportunities for hedge funds and traders who wanted to short the housing market, but magnified the losses of those on the other side of the trades. To short a trade, in this instance, is to bet the housing market will turn down.

"There was a limited number of similar bonds," said Darrell Duffie, a finance professor and derivatives authority at Stanford University. "So they are likely to show up in multiple deals."

Goldman Sachs executive Fabrice Tourre, at last week's Senate hearing

A Goldman spokesman declined to comment.

An important moment in the housing cycle came in January 2006, a year before the downturn of the housing market had crystallized. That month, a consortium of banks, including Goldman and Deutsche Bank AG, with the help of a London data firm, launched an index, known as the ABX, which served as a proxy for subprime loans.

For the first time, banks and hedge funds had an indicator of the prices of subprime-mortgage securities, and a somewhat active market to buy and sell credit protection against housing-market losses. There were four ABX indexes, each tied to 20 subprime bonds, some of which reappeared in numerous CDOs.

By late 2006, Goldman had a large bullish position on the ABX, because it had taken the other side of bearish bets by hedge-fund clients, according to the Senate documents. Subsequent deals would help reverse that position.

One mortgage bond, Soundview Home Loan Trust 2006-OPT5 M8, was a component of the ABX and showed up in more than 30 CDOs.

The Soundview deal in June 2006 bundled together roughly $3.1 billion in subprime home loans made by Option One Mortgage Corp. to 15,746 individuals across the country, with a high concentration in California and Florida, two states that were among the worst hit by the housing downturn. The securities from the deal were sold in slices with different credit ratings, interest rates and risk levels.

One slice of the Soundview bonds, called "M8," began making its way through Wall Street. About $38 million of the "M8" bond was issued, and it stood to lose money if roughly 5% of the loans in the pool were wiped out by losses.

In July 2006, the Soundview deal was picked by Wall Street banks to be one component of the ABX, and the Soundview M8 bond also was replicated in multiple CDOs. They included Hudson Mezzanine Funding 2006-1, a Goldman-arranged CDO, which took on a $15 million exposure to the Soundview M8 bond in late 2006, according to documents released last week by the Senate panel.

Hudson represented Goldman's bearish view on housing. According to the Senate inquiry, Goldman used the CDO to protect itself against losses by the $2 billion of assets referenced in the pool. Among the assets was $1.2 billion in bullish bets on bonds underpinning the ABX indexes. Goldman was the buyer of protection from Hudson, meaning that the bank had a bearish position on the same bonds.

The Soundview M8 bond appeared again in a CDO called Abacus 2007-AC1, the mortgage deal at the center of the Securities and Exchange Commission's civil-fraud lawsuit against Goldman. That CDO, which closed in April 2007, had a $22.2 million bullish position on the Soundview bond. Goldman has denied any wrongdoing in the case.

Some Goldman employees appeared to be aware that the Soundview M8 bond was shaky by early 2007. In an April 2007 email, a Goldman employee included it in a list of what he called "dirty '06 originations," referring to the period in which lending standards loosened. By that time, about 8% of the loans in the Soundview pool already were at least 60 days past due.

In July 2007, Mizuho International PLC, a unit of Japan's Mizuho Financial Group Inc. and seeking to break into the CDO business, included the Soundview bond in a CDO called Delphinus CDO 2007-1. That CDO had a $13 million exposure to the Soundview M8 bond, according to documents reviewed by The Wall Street Journal.

In all, more than $280 million of bullish positions on the Soundview M8 bond were in at least 30 CDOs underwritten by various banks, according to data reviewed by the Journal. As defaults among the subprime loans backing the deal mounted in 2007, the M8 bond's value fell. Its entire $38 million face amount eventually was wiped out.

Anthony Sanders, a real-estate finance professor and authority in securitization at George Mason University in Fairfax, Va., said the problem was that the same mortgage bonds ended up in many deals, potentially multiplying the losses.

"Serious problems with common [asset-backed securities] deals can decimate all CDO deals," Mr. Sanders said.

Write to Carrick Mollenkamp at carrick.mollenkamp@wsj.com and Serena Ng at serena.ng@wsj.com

2010-04-01T13:34:00.003-04:00

How Lou Lucido Let AIG Lose $35 Billion With Goldman Sachs CDOs
bloomberg.com
By Bob Ivry and Jody Shenn

March 31 (Bloomberg) -- Joseph Cassano insisted American International Group Inc. would be fine.

The insurer had quit guaranteeing securities tied to U.S. subprime loans in 2005, before lenders got reckless, the head of AIG’s derivatives unit told investors on Dec. 5, 2007, as home prices plummeted and mortgage losses mounted.

Cassano didn’t mention Lou Lucido, 61, a guitar-playing bond buyer at TCW Group Inc. in Los Angeles with a taste for the Rolling Stones. Throughout 2006 and 2007, Lucido had been buying bundles of subprime loans for an investment pool that AIG was bound by contract to insure against failure.

In one such purchase, 11 months before Cassano, 55, reassured shareholders, Lucido’s team bought $7 million of a mostly subprime bond. They put it in a $1.5 billion fund managed by TCW called Davis Square Funding III Ltd., which was created by Goldman Sachs Group Inc. and registered in the Cayman Islands. A few months later, Lucido bought $3 million more.

By May 2008, the bond was worthless.

Without having to ask AIG’s permission, firms such as TCW, hired to oversee funds called collateralized debt obligations, replaced maturing assets with junk that quickly went bad. Managers including Lucido said they didn’t realize how severe the mortgage crash would be and were called upon by CDO contracts to reinvest. At the same time, buying riskier assets could mean bigger paydays.

‘Perverse’ Incentives

“The incentive was perverse,” said Michael Lea, a finance professor at San Diego State University and former chief economist at mortgage giant Freddie Mac. “The fee structure encouraged TCW to put lower-rated bonds into CDOs over time.”

A look at the month-by-month transactions in one CDO -- Davis Square III, named for a difficult-to-navigate section of Somerville, Massachusetts, near Harvard University -- shows how collateral replacements helped drive New York-based AIG to the brink of disaster. The insurer ended up paying $616 million to make up for Davis Square III’s loss in value and more than $35 billion overall, liabilities that helped push it into insolvency in September 2008.

Lucido’s team, following criteria set by Goldman Sachs, changed almost one-third of the collateral in Davis Square III after the CDO’s creation in 2004, according to data compiled by Bloomberg from Moody’s Investors Service reports. The securities were mostly backed by the types of newer loans that are going bad at more than twice the rate of older ones. By November 2008, after U.S. taxpayers rescued AIG with a bailout that later swelled to $182.3 billion, even the highest-rated parts of Davis Square III had lost almost half their value.

‘Standards Fell’

“Mortgage underwriting standards fell so much that replacing a bunch of 2004 bonds with 2006 and 2007 bonds definitely screwed AIG,” said Thomas Adams, a former managing director at bond insurer Ambac Financial Group Inc. and now a partner at New York law firm Paykin Krieg & Adams LLP.

CDOs were at the heart of the financial crisis that sparked the highest U.S. jobless rate in a generation. They were among the largest contributors to the $1.8 trillion of losses at the world’s largest financial firms since the start of 2007, according to data compiled by Bloomberg.

The U.S. Securities and Exchange Commission is investigating how Wall Street banks bet against mortgage-linked securities to profit as their clients took losses, according to people familiar with the matter. As part of its examination of the market, the agency is looking at collateral replacement, said an SEC official with knowledge of the probe who asked not to be identified because he wasn’t authorized to comment.

Collateral Triggers

Replacing good collateral with bad helped erode Davis Square III’s value. Declines in quality added to the cash AIG had to pay to holders of its insurance because its Financial Products division, headed by Cassano, made agreements with banks that included what are called collateral triggers. That was a feature other bond insurers didn’t offer, Adams said.

The triggers kicked in when the value of the CDOs declined or if a rating company downgraded AIG’s creditworthiness. By December 2008, the insurer had paid out more than $35 billion, according to a list of collateral provided by AIG to Congress.

When the Financial Products unit agreed to guarantee certain top-rated CDO pieces, it didn’t envision that assets added later could cause losses, according to a person with knowledge of AIG’s thinking who spoke on condition of anonymity because he wasn’t authorized to comment.

As long as managers adhered to investment criteria outlined in the prospectus, there was little AIG could do, according to Mark Herr, a spokesman for the insurer.

Joseph Warin, Cassano’s lawyer, declined to comment.

‘Informed Decisions’

Davis Square III’s 209-page prospectus spelled out the risks for potential investors. “Characteristics” of replacement collateral wouldn’t necessarily be the same as those of existing assets, it said.

It also spelled out Goldman Sachs’s investment guidelines, which allowed as much as half of Davis Square III to be bonds backed by subprime mortgages, given to people with bad or limited credit histories. Among other constraints, TCW needed to meet collateral ratings requirements and maintain a mix of lenders and types of debt.

Lucido and his team followed the guidelines and avoided certain types of mortgages and particular issuers as the home- loan market got dicier, he said in an interview.

“We made informed decisions based on the underwriting criteria at the time and felt we were working toward our investors’ best interests,” he said.

Lucido left TCW in December to become executive vice president of DoubleLine Capital LP, a Los Angeles investment firm founded by his former boss, Jeffrey Gundlach.

Maiden Lane III

Erin Freeman, a spokeswoman for TCW, said her firm bought only collateral for Davis Square III that met the guidelines and didn’t allow Goldman Sachs to dictate what to buy.

“TCW has managed these assets prudently and in the best interests of investors,” Freeman said.

By December 2008, more than 170 AIG-insured pieces of CDOs, including parts of Davis Square III, had been taken over by a U.S. taxpayer-funded asset pool called Maiden Lane III after the street where the Federal Reserve Bank of New York is located.

Goldman Sachs and TCW’s parent, Paris-based Societe Generale SA, were paid the most before and after the New York Fed reimbursed AIG’s customers in full. Societe Generale got $16.5 billion, more than any other firm. Goldman Sachs was second with $14 billion. Together they accounted for almost half of the payouts.

New York-based Goldman Sachs was the biggest underwriter of CDOs taken over by Maiden Lane III. TCW managed about twice as many CDO assets that ended up in Maiden Lane III as anyone else, according to the AIG list and data compiled by Bloomberg.

Teen Bodybuilder

Among other overseers of AIG-guaranteed CDOs were Ellington Management Group LLC’s Michael Vranos, a former teen Mr. Connecticut bodybuilder who ran the top-ranked mortgage-bond underwriter in the early 1990s, and Michael Barnes, whose Tricadia Capital Management LLC is so secretive that, when asked to discuss CDO reinvestment, said, “We as a policy do not comment on anything.”

That was the thing about CDOs, too. They were secretive. Prospectuses ran hundreds of pages yet often failed to detail a single purchase. What assets they held couldn’t be seen publicly. And they gave banks the chance to repackage risky securities and market them as safe investments, at the same time allowing firms to bet that mortgages would fail.

CDO Tranches

CDOs are investment pools made up of anything that provides a flow of cash. They can contain loans to companies used in leveraged buyouts or securities backed by commercial and residential mortgages, auto loans, credit-card receivables, even pieces of other CDOs.

Underwriters such as Goldman Sachs split CDOs into classes, or tranches, categorizing them by how likely they were to continue paying. The biggest group, called the senior classes, accounted for 93 percent of Davis Square III and got top ratings from Moody’s, according to a September 2004 Fitch Ratings analysis. In exchange for being first under the waterfall of payments, senior-class investors received less interest.

Calyon, a unit of Paris-based Credit Agricole SA, bought most of the senior portion of the CDO, which was insured by AIG.

Investors in a smaller tier, known as the mezzanine, were paid a higher rate because they got money only after the senior investors did. The “mezz” pieces made up a little more than 6 percent of Davis Square III and received lower credit ratings.

Equity Stakes

The tiniest slice, less than 1 percent in the case of Davis Square III, was made up of what’s called equity, which wasn’t rated by credit companies. Equity investors were paid only after everyone else. They received a higher return while the going was good because they took the most risk and were the first ones wiped out if borrowers quit paying their mortgages.

While Lucido said he didn’t own a stake in Davis Square III, he said he did have his own money riding on the equity pieces of some CDOs.

Goldman Sachs did own an equity stake in Davis Square III, according to Michael DuVally, a spokesman for the firm, who declined to say how much it was. Even so, the bank didn’t try to influence TCW’s investment decisions, DuVally said.

It didn’t have to. TCW was promised 20 percent of what was left over after equity investors got 10 percent returns, according to a Goldman Sachs sales pitch to potential equity investors dated September 2004. That was on top of its fee of 0.10 percent of the CDO’s assets, according to the prospectus.

Trickle Down

Such fees gave managers incentive to move riskier assets into CDOs because the higher returns they produced were likelier to trickle down to equity investors. That was especially true in 2006 and early 2007 when projected earnings on safer securities were dwindling, said Andrey Krakovsky, chief investment officer at New York-based asset manager Tacticus Capital LLC.

As existing collateral shrank because of mortgage prepayments, bond maturities and pay-downs, buying safer securities meant “equity investors would have gotten hammered because there wouldn’t have been enough cash flow for them,” Krakovsky said.

He said managers often owned equity pieces of CDOs and earned fees linked to their returns.

Howard Hill, a former Babson Capital Management LLC executive who helped start securitization-related departments at four banks, said CDO managers had little choice but to reinvest in what he called “crappier ‘06, ‘07 production’’ because older, better-quality securities weren’t available.

Abacus Slice

Underwriting standards deteriorated in those years. Cumulative loan losses as a percentage of original balances are expected to be 18.7 percent for subprime mortgages underlying 2005 bonds, 38.4 percent for 2006 bonds and 48.1 percent for 2007 securitizations, according to Moody’s.

‘‘The managers tried their best to be able to keep the thing alive and make money,” Hill said. “The rules were written by the underwriters, weren’t they?”

One of Lucido’s earliest purchases for Davis Square III was a $12 million slice of Abacus 2004-1, a CDO created by Goldman Sachs in July 2004 and filled with credit-default swaps, according to the prospectus.

The swaps were side bets that paid off if an investment failed. Goldman Sachs or its customers were essentially using Abacus as a way to short, or bet against, certain mortgage bonds. They would sell the swaps as an investment to customers who took the other side of the bet, believing the mortgage bonds would keep paying. CDOs made up of these side bets and not the actual mortgages were called synthetic CDOs.

Goldman Sachs

By 2007, Goldman Sachs had moved so many securities into Abacus 2004-1 that much of the collateral didn’t exist when the CDO was created, according to data compiled by Moody’s. While AIG insured parts of Abacus deals, Goldman Sachs didn’t change the collateral in the pieces AIG insured, DuVally said.

Other swaps that Goldman Sachs used to bet against subprime mortgages were contained in the $7 million bond that Lucido bought in January 2007, according to the prospectus. The purchase was made a month after Gundlach, TCW’s chief investment officer, told Barron’s it was “silly optimism” to think housing prices had bottomed out.

The bond was known as GSCSF 2006-3GA C after its manager, New York-based GSC Group, whose chief executive officer, Alfred C. Eckert III, was a former Goldman Sachs executive. It paid 0.90 percentage point more than another subprime-backed bond issued the same month with the same rating, according to data compiled by Bloomberg.

‘Toxic’ Resecuritizations

It offered a higher return because it was a resecuritization, a repackaging of securities that bankers used to “shuffle the deck to hide the bad ace,” according to Ann Rutledge, founding principal of R&R Consulting, a structured- finance adviser in New York. The bond was rated A2 by Moody’s, the firm’s sixth-highest rating.

Asset managers typically bought resecuritizations because of their credit ratings and didn’t bother to examine the thousands of mortgages that made up each of the hundreds of bonds in the CDO, according to Rutledge, co-author of “The Analysis of Structured Securities,” published in 2003 by Oxford University Press.

“Resecuritization has always been toxic,” Rutledge said.

Between May 2005 and May 2007, Davis Square III’s ownership of pieces of other CDOs rose to 11 percent of its total assets from 8.5 percent, according to data compiled by Moody’s. Over the same period its credit ratings on investments drifted about a quarter of a grade lower, the data show.

‘Deals Go Bad’

“A lot of managers and equity investors were looking for ways to make sure these deals cash-flowed,” said James Frischling, president of NewOak Capital LLC, a New York investment and advisory firm, and former head of CDO groups at two European banks.

“That really does explain why seasoned deals go bad,” he said, referring to CDOs that have been around a while.

At the same time TCW bought the GSC bond for Davis Square III, it purchased a $5 million bundle of Alt-A home loans underwritten by Goldman Sachs. Alt-A mortgages were available to borrowers who didn’t show proof of income. That security, GSAA 2007-1 M2, also quit paying, according to Moody’s.

In February and March 2007, after London-based HSBC Holdings Plc, Europe’s biggest bank, announced it was setting aside more money to cover losses on U.S. subprime mortgages, Lucido’s team bought $29.7 million of subprime bonds.

“It’s not that we’re arrogant, or that we’ve got a lot of hubris,” Lucido told the Los Angeles Times in March 2007, “but we think we’ve got the position and the talent in place to be able to analyze and manage through this period.”

Bonded Blues Band

One of TCW’s March 2007 purchases, consisting of loans originated by Option One Mortgage Corp., then a unit of H&R Block Inc., quit paying by the end of October 2008.

Between April and May 2007, TCW bought another $48 million of securities for Davis Square III, including three bundles of Alt-A mortgages underwritten by New York-based Morgan Stanley. Two of those bonds have stopped paying.

The asset manager also bought a subprime-mortgage-backed bond called HASC 2007-HE2 2A4, underwritten by HSBC. It was rated Aaa by Moody’s, its top ranking. As of the end of January, 67 percent of the borrowers of mortgages backing the bond were at least two months late with payments, according to data compiled by Bloomberg.

“Unfortunately, things deteriorated in an industry way that went beyond even our worst range of forecasts,” said Lucido, who’s on the dean’s executive board at New York University’s Stern School of Business and who performed with other mortgage-securities executives in the Bonded Blues Band in the 1990s.

Stockton CDO

In June and July 2007, while two Bear Stearns Cos. hedge funds unraveled as a result of subprime-linked investments, Lucido’s team bought a $10 million piece of another mostly subprime-mortgage CDO, Stockton CDO Ltd., underwritten by Brussels-based Fortis Securities LLC. Moody’s gave it a top rating. It failed within a year.

As central banks around the world made emergency loans to financial firms in August 2007 to thaw a freeze in lending triggered by the failure of subprime mortgages, TCW continued to buy bonds backed by risky loans. From July 30 to Oct. 24, it purchased about $50 million of such bonds, according to Moody’s.

Between May 2005 and November 2008, when the New York Fed agreed to buy pieces of Davis Square III, TCW put in about $400 million of assets originated after 2004 that weren’t guaranteed by government-backed companies such as Freddie Mac.

‘Apples to Oranges’

While TCW was adding bonds made up of risky loans, its biggest mutual fund took a more ambivalent approach. TCW Total Return Bond Fund shrank its mortgage holdings not guaranteed by government-sponsored firms to 15.9 percent in July 2007 from 18.8 percent three months earlier, according to company filings.

As early as August 2006, Gundlach was preparing to act on his prediction that U.S. home prices would continue their slide. He announced that TCW was putting together a $1.5 billion fund to invest in bad mortgages.

Gundlach wouldn’t comment on Davis Square III and referred questions to Lucido, who said he was hindered from talking because he no longer had access to TCW’s files.

Freeman, the TCW spokeswoman, said the bond fund, which beat 99 percent of competitors over the past five years, catered to individual investors and had different investment objectives than Davis Square III. Any comparison is “apples to oranges,” she said.

She praised TCW’s performance in managing Davis Square III.

“Through the worst credit environment in our lifetimes, this CDO is still performing,” she said. “It’s still paying interest to investors, and it hasn’t had any event of default, which is a credit to TCW’s skill in security selection.”

‘High Default Risk’

The CDO’s maturity date is 2039, so any declaration of success is premature, said Rutledge of R&R Consulting.

“A man who jumps off a 100-story building can pass the 98th floor and say, ‘So far, so good,’” she said.

Davis Square III continues to deteriorate as more U.S. mortgage borrowers quit paying their monthly bills. Fitch Ratings in February 2009 downgraded the safest class of Davis Square III to CCC, meaning it’s a “high default risk.”

More than $16 billion of CDOs managed by TCW have defaulted, been liquidated or stopped paying some investors, according to RBS Securities Inc.

TCW now finds itself defending Gundlach’s team at the same time it’s suing him for having “no understanding or respect for the obligations of a fiduciary,” according to a complaint filed Jan. 7 in Los Angeles Superior Court.

Sex Toys

In the suit, TCW accuses Gundlach and three other employees of stealing data on 24,000 clients and prospects, as well as proprietary trading information, to start their own firm. Lucido wasn’t named in the TCW complaint.

TCW also said in its complaint that Gundlach, a former company director, kept marijuana and “12 sexual devices, 34 hardcore pornographic magazines, 17 hardcore sexually explicit DVDs and 19 hardcore sexually explicit videocassettes” in his two offices.

Gundlach, now CEO of DoubleLine, denied the allegations that he stole client data or used proprietary information. He countersued in February, claiming TCW owed him as much as $1.25 billion in compensation.

As for the drugs, porn and sex toys, Gundlach said in an interview with Bloomberg Markets in January that they were relics from a closed chapter in his life being used by TCW to damage his reputation.

“It’s ancient stuff, like a box in an attic,” he said.

Ellington, Duke

A dispute over replacement collateral landed in New York Supreme Court in 2008. Hamburg-based HSH Nordbank AG, the world’s biggest shipping financier, said in a complaint that UBS AG had been “deliberately selecting inferior quality” assets for a synthetic CDO called North Street 2002-4.

Doug Morris, a spokesman for Zurich-based UBS, declined to comment.

Ellington Management, the asset-management firm founded by Vranos in Old Greenwich, Connecticut, was another manager that replaced collateral in CDOs insured by AIG. The firm bought $11.5 million of bonds backed by mortgages originated by Irvine, California-based New Century Financial Corp. at least two months after the subprime lender declared bankruptcy in April 2007, placing them in a CDO called Duke Funding VII.

About $3.4 billion of the CDOs that ended up in Maiden Lane III were managed by Ellington. Their value had fallen by $1.9 billion.

Steve Bruce, a spokesman for the firm, declined to comment.

Tricadia Capital

Tricadia Capital, the asset-management affiliate of New York-based Mariner Investment Group, also managed CDOs containing collateral that didn’t exist when they were created. One was TABS 2005-4, which bundled mostly subprime mortgages and was underwritten by Morgan Stanley in January 2006. AIG guaranteed $248.8 million of the CDO, which lost almost three- quarters of its value by the time it was bought by the New York Fed for Maiden Lane III.

Tricadia told investors it might bet against bonds it put into CDOs -- even ones in which it owned equity stakes.

In AIG’s Dec. 5, 2007, presentation, Cassano said the Financial Products unit had conducted “a highly selective review” of investment managers and their incentives and didn’t expect to make any payments on the insurance it wrote on the senior classes of subprime CDOs.

“We are highly confident that we will have no realized losses on these portfolios during the life of these portfolios,” Cassano said. “Vintages within the subprime sector are key, and we do not have a lot of exposure in our portfolio to the ‘06 and ‘07 subprime issuance.’’

AIG underestimated the repercussions caused by asset managers trading collateral after CDOs were issued, said Gene Phillips, director of PF2 Securities Evaluations, an advisory firm in New York.

‘‘As it turns out, the ramifications were quite drastic,’’ Phillips said.

To contact the reporters on this story: Bob Ivry in New York at bivry@bloomberg.net; Jody Shenn in New York at jshenn@bloomberg.net.

Last Updated: March 31, 2010 00:01 EDT

2010-03-28T10:04:00.000-04:00

18 Mar 2010
Hidden Money, Covert Operations
www.isn.ethz.ch

Legal European trust practices allow multinationals to hide finances and operate covertly, Jody Ray Bennett writes for ISN Security Watch.

By Jody Ray Bennett for ISN Security Watch

In 1995, then-US President Bill Clinton signed an executive order prohibiting American companies from doing business in Iran. When the decision was made to extend Washington’s unilateral economic sanctions against Tehran, multinational companies bemoaned the move and criticized the policy, claiming that American businesses would be punished for Iran’s actions.

Speaking before the CATO Institute in 1998 as the CEO of Halliburton, Dick Cheney complained about the company’s inability to penetrate the Iranian market: “[This] has to do with efforts to develop the resources of the former Soviet Union in the Caspian Sea area. It is a region rich in oil and gas. Unfortunately, Iran is sitting right in the middle of the area and the [US] has declared […] sanctions against that country. […] Iran is not punished by this decision. There are numerous oil and gas development companies from other countries that are now aggressively pursuing opportunities to develop those resources. That development will proceed, but it will happen without American participation.”

Just a few years after Cheney’s statement, Halliburton was under investigation for doing business in Iran through one of its subsidiaries registered in the Cayman Islands, a well known tax haven utilized by businesses to hide and protect profits offshore. More recently, Halliburton’s ties to Iran were shown to involve more than just an offshore letterbox business with no employees that exploits a loophole in the US sanction policy that “allow[s] foreign subsidiaries of foreign companies to work in Iran as long as they [are] completely independent of their parent in America.”

How was Halliburton able to do business in Iran through a completely independent company with no ties to its headquarters in the US?

The process occurs through a little known practice in European trust law called Hidden Treuhand, which “submits to legal local customs in Austria, Germany, Liechtenstein, Luxemburg and Switzerland, but due to globalization, has moved beyond European borders via corporations and individuals, who put it to personal use.”

In a new book titled Hidden Treuhand: How Corporations and Individuals Hide Assets and Money, author Shelley Stark details the history of the Hidden Treuhand, how it operates, who it benefits and its implications for the global economy.

How Treuhand works

In Austria, the legal code §1002 defines a Treuhand contract as a contract coupled with a power of attorney, where someone - usually a lawyer referred to as a Treuhänder - conducts business duties in his name. According to Stark, the relationship begins with a non-public agreement between one party (referred to as a ‘Giver’) who transfers profits or assets to another (‘Taker’).

“The Giver appoints the Taker to be his direct representative in the inner relationship and controls the Taker’s actions as regards the asset with the ‘secret power of attorney.’ This inner relationship is only described in the documentation between the Taker and Giver and is created separately so that no legal relationship between the Taker and Giver can be proven. Thus, a Taker’s function as a trustee morphs into the property owner and his function as the Giver’s lawyer is hidden by virtue of the ‘secret power or attorney’,” Stark told ISN Security Watch.

“The Hidden Treuhand can exist without any public record and concluded by any two people capable of being party to a contract. It is a civil contract not regulated by law, but is based on the general principal that one has the right to make contracts as one pleases. It gives the appearance that an asset belongs to another. The true beneficiary’s identity is not publicly apparent, nor is it outwardly recognizable an asset is in a Treuhand. Thus, any kind of asset: corporate shares, financial instruments such as derivatives, stock, and bonds, bank accounts, hedge funds, real estate, even an offshore subsidiary of a publically traded company can be owned completely in secret,” said Stark.

According to Stark’s research, it is virtually impossible to apply law to a contract or business situation that is not transparent.

“Lawyers are often called upon to act as a ‘trustee’ in a hidden ‘Treuhand’. But there is no law regulating hidden Treuhand, only laws specifying that the lawyer cannot divulge any secrets pertaining to the client,” Stark said.

Stark explained how it all works: A notary public notarizes the names of all shareholders and registers them in the public corporate register. Anybody wishing not to be evident in this public registry engages a lawyer to represent his shares or ownership. Anonymity is insured because only the lawyer’s name will be notarized and visible in the corporate registry. The true beneficiary’s name is not notarized or publically evidenced in any form. The private contract, known as a hidden Treuhand, documents the arrangement between the lawyer and client, and only they are privy to its contents.

“Despite the secretiveness, there are nonetheless quite a few examples of hidden Treuhands causing severe concern,” Stark said, noting the case of the Bawag bank in Austria and hidden losses of €1.4 billion through Treuhands established in Liechtenstein, the Refco case, which became the 14th largest bankruptcy in America, and the UBS bank vs US attorney generals. “Germany is deeply embattled with regards to Treuhand banks accounts in Liechtenstein siphoning off millions in taxable income from Germany,” Stark added.

Security implications

As the practice is completely legal, Halliburton was able to establish a shell company in Austria called Halliburton International GmbH that contains no employees and generates no income. Because 51 percent or more is controlled by a Taker (secretly controlled by a Giver), Halliburton was able to circumvent international sanctions and conduct business in Iran legally.

“All that is needed for a US company to be completely independent of the parent company in America is to have 51 percent of the company owned by a foreigner, or someone without American citizenship. With a Hidden Treuhand embedded in the corporate structure, a Taker, who is a foreigner, can hold the 51 percent on behalf of the company. With little effort, any company could slip under that radar,” Stark said.

Thus, profits generated from these ventures cannot publicly be traced back to Halliburton’s American headquarters.

“Halliburton uses it subsidiaries in Europe, especially Austria, to move funds without transparency and also profits from the few regulations in the accounting standards. Its Austrian subsidiary receives all income from other subsidiaries (in Russia and Kazakhstan, for example), zeros out the book value, loses the paper work, and the these firms disappear from records, ostensibly hidden in other Treuhands,” Stark explained.

A recent New York Times investigative story discovered that more than $100 billion was awarded to multinational corporations for contracts while conducting business in Iran - $15 billion of which went to companies that “defied American sanctions law by making large investments that helped Iran develop its vast oil and gas reserves.”

The issue of the hidden Treuhand raises concerns about companies that are financially powerful enough to penetrate a global market and supply sensitive infrastructure, private security and intelligence for international clientele. That large financial institutions can affect or alter state-to-state relations speaks volumes about the cult of deregulation, a core feature of present day globalization.

While Stark maintains that Halliburton is just one of many large multinationals that makes use of Treuhand practices, the use of Treuhands - not only by mammoth defense contractors - raises serious questions over corporate accountability for both taxpayers and shareholders. But the implications for national security becomes even more dire, as Hidden Treuhand contracts can enable large, private companies to directly interfere and affect interstate relations. Stark recently wrote about how hidden Treuhands have the ability to fund organized crime, money laundering operations or covertly finance terrorist groups.

“The impact of hidden Treuhands for International Relations and Security is enormous. Foreign policy decisions can be rendered moot when a foreigner owns 51 percent of the subsidiary. This fortuitous loophole allows a US subsidiary to effectually not be subject to US foreign policy decisions and speaks volumes for how ineffectual sanctions really are,” Stark said.

Jody Ray Bennett is a freelance writer and academic researcher. His areas of analysis include the private military and security industry, the materialization of non-state forces and the transformation of modern warfare

2010-03-13T09:17:00.000-05:00

Complexity and Collapse

Empires on the Edge of Chaos
March/April 2010
Niall Ferguson

foreignaffairs.com

NIALL FERGUSON is Laurence A. Tisch Professor of History at Harvard University, a Fellow at Jesus College, Oxford, and a Senior Fellow at the Hoover Institution at Stanford University. His most recent book is The Ascent of Money: A Financial History of the World.

There is no better illustration of the life cycle of a great power than The Course of Empire, a series of five paintings by Thomas Cole that hang in the New-York Historical Society. Cole was a founder of the Hudson River School and one of the pioneers of nineteenth-century American landscape painting; in The Course of Empire, he beautifully captured a theory of imperial rise and fall to which most people remain in thrall to this day.

Each of the five imagined scenes depicts the mouth of a great river beneath a rocky outcrop. In the first, The Savage State, a lush wilderness is populated by a handful of hunter-gatherers eking out a primitive existence at the break of a stormy dawn. The second picture, The Arcadian or Pastoral State, is of an agrarian idyll: the inhabitants have cleared the trees, planted fields, and built an elegant Greek temple. The third and largest of the paintings is The Consummation of Empire. Now, the landscape is covered by a magnificent marble entrepôt, and the contented farmer-philosophers of the previous tableau have been replaced by a throng of opulently clad merchants, proconsuls, and citizen-consumers. It is midday in the life cycle. Then comes Destruction. The city is ablaze, its citizens fleeing an invading horde that rapes and pillages beneath a brooding evening sky. Finally, the moon rises over the fifth painting, Desolation. There is not a living soul to be seen, only a few decaying columns and colonnades overgrown by briars and ivy.

Conceived in the mid-1830s, Cole's great pentaptych has a clear message: all empires, no matter how magnificent, are condemned to decline and fall. The implicit suggestion was that the young American republic of Cole's age would be better served by sticking to its bucolic first principles and resisting the imperial temptations of commerce, conquest, and colonization.

For centuries, historians, political theorists, anthropologists, and the public at large have tended to think about empires in such cyclical and gradual terms. "The best instituted governments," the British political philosopher Henry St. John, First Viscount Bolingbroke, wrote in 1738, "carry in them the seeds of their destruction: and, though they grow and improve for a time, they will soon tend visibly to their dissolution. Every hour they live is an hour the less that they have to live."

Idealists and materialists alike have shared that assumption. In his book Scienza nuova, the Italian philosopher Giambattista Vico describes all civilizations as passing through three phases: the divine, the heroic, and the human, finally dissolving into what Vico called "the barbarism of reflection." For Hegel and Marx, it was the dialectic that gave history its unmistakable beat. History was seasonal for Oswald Spengler, the German historian, who wrote in his 1918-22 book, The Decline of the West, that the nineteenth century had been "the winter of the West, the victory of materialism and skepticism, of socialism, parliamentarianism, and money." The British historian Arnold Toynbee's universal theory of civilization proposed a cycle of challenge, response, and suicide. Each of these models is different, but all share the idea that history has rhythm.

Although hardly anyone reads Spengler or Toynbee today, similar strains of thought are visible in contemporary bestsellers. Paul Kennedy's The Rise and Fall of the Great Powers is another work of cyclical history -- despite its profusion of statistical tables, which at first sight make it seem the very antithesis of Spenglerian grand theory. In Kennedy's model, great powers rise and fall according to the growth rates of their industrial bases and the costs of their imperial commitments relative to their GDPs. Just as in Cole's The Course of Empire, imperial expansion carries the seeds of future decline. As Kennedy writes, "If a state overextends itself strategically . . . it runs the risk that the potential benefits from external expansion may be outweighed by the great expense of it all." This phenomenon of "imperial overstretch," Kennedy argues, is common to all great powers. In 1987, when Kennedy's book was published, the United States worried that it might be succumbing to this disease. Just because the Soviet Union fell first did not necessarily invalidate the hypothesis.

More recently, it is Jared Diamond, an anthropologist, who has captured the public imagination with a grand theory of rise and fall. His 2005 book, Collapse: How Societies Choose to Fail or Succeed, is cyclical history for the so-called Green Age: tales of past societies, from seventeenth-century Easter Island to twenty-first-century China, that risked, or now risk, destroying themselves by abusing their natural environments. Diamond quotes John Lloyd Stevens, the American explorer and amateur archaeologist who discovered the eerily dead Mayan cities of Mexico: "Here were the remains of a cultivated, polished, and peculiar people, who had passed through all the stages incident to the rise and fall of nations, reached their golden age, and perished." According to Diamond, the Maya fell into a classic Malthusian trap as their population grew larger than their fragile and inefficient agricultural system could support. More people meant more cultivation, but more cultivation meant deforestation, erosion, drought, and soil exhaustion. The result was civil war over dwindling resources and, finally, collapse.

Diamond's warning is that today's world could go the way of the Maya. This is an important message, no doubt. But in reviving the cyclical theory of history, Collapse reproduces an old conceptual defect. Diamond makes the mistake of focusing on what historians of the French Annales school called la longue durée, the long term. No matter whether civilizations commit suicide culturally, economically, or ecologically, the downfall is very protracted. Just as it takes centuries for imperial overstretch to undermine a great power, so, too, does it take centuries to wreck an ecosystem. As Diamond points out, political leaders in almost any society -- primitive or sophisticated -- have little incentive to address problems that are unlikely to manifest themselves for a hundred years or more.

Did the proconsuls in Cole's The Consummation of Empire really care if the fate of their great-great-grandchildren was destruction? No. Would they have accepted a tax increase that would have financed a preemptive strike against the next millennium's barbarian horde? Again, no. As the UN Climate Change Conference in Copenhagen last December made clear, rhetorical pleas to save the planet for future generations are insufficient to overcome the conflicts over economic distribution between rich and poor countries that exist in the here and now.

The current economic challenges facing the United States are also often represented as long-term threats. It is the slow march of demographics -- which is driving up the ratio of retirees to workers -- and not current policy, that condemns the public finances of the United States to sink deeper into the red. According to the Congressional Budget Office's "alternative fiscal scenario," which takes into account likely changes in government policy, public debt could rise from 44 percent before the financial crisis to a staggering 716 percent by 2080. In its "extended-baseline scenario," which assumes current policies will remain the same, the figure is closer to 280 percent. It hardly seems to matter which number is correct. Is there a single member of Congress who is willing to cut entitlements or increase taxes in order to avert a crisis that will culminate only when today's babies are retirees?

Similarly, when it comes to the global economy, the wheel of history seems to revolve slowly, like an old water mill in high summer. Some projections suggest that China's GDP will overtake the United States' GDP in 2027; others say that this will not happen until 2040. By 2050, India's economy will supposedly catch up with that of the United States, too. But to many, these great changes in the balance of economic power seem very remote compared with the timeframe for the deployment of U.S. soldiers to Afghanistan and then their withdrawal, for which the unit of account is months, not years, much less decades.

Yet it is possible that this whole conceptual framework is, in fact, flawed. Perhaps Cole's artistic representation of imperial birth, growth, and eventual death is a misrepresentation of the historical process. What if history is not cyclical and slow moving but arrhythmic -- at times almost stationary, but also capable of accelerating suddenly, like a sports car? What if collapse does not arrive over a number of centuries but comes suddenly, like a thief in the night?

WHEN GOOD SYSTEMS GO BAD

Great powers and empires are, I would suggest, complex systems, made up of a very large number of interacting components that are asymmetrically organized, which means their construction more resembles a termite hill than an Egyptian pyramid. They operate somewhere between order and disorder -- on "the edge of chaos," in the phrase of the computer scientist Christopher Langton. Such systems can appear to operate quite stably for some time; they seem to be in equilibrium but are, in fact, constantly adapting. But there comes a moment when complex systems "go critical." A very small trigger can set off a "phase transition" from a benign equilibrium to a crisis -- a single grain of sand causes a whole pile to collapse, or a butterfly flaps its wings in the Amazon and brings about a hurricane in southeastern England.

Not long after such crises happen, historians arrive on the scene. They are the scholars who specialize in the study of "fat tail" events -- the low-frequency, high-impact moments that inhabit the tails of probability distributions, such as wars, revolutions, financial crashes, and imperial collapses. But historians often misunderstand complexity in decoding these events. They are trained to explain calamity in terms of long-term causes, often dating back decades. This is what Nassim Taleb rightly condemned in The Black Swan as "the narrative fallacy": the construction of psychologically satisfying stories on the principle of post hoc, ergo propter hoc.

Drawing casual inferences about causation is an age-old habit. Take World War I. A huge war breaks out in the summer of 1914, to the great surprise of nearly everyone. Before long, historians have devised a story line commensurate with the disaster: a treaty governing the neutrality of Belgium that was signed in 1839, the waning of Ottoman power in the Balkans dating back to the 1870s, and malevolent Germans and the navy they began building in 1897. A contemporary version of this fallacy traces the 9/11 attacks back to the Egyptian government's 1966 execution of Sayyid Qutb, the Islamist writer who inspired the Muslim Brotherhood. Most recently, the financial crisis that began in 2007 has been attributed to measures of financial deregulation taken in the United States in the 1980s.

In reality, the proximate triggers of a crisis are often sufficient to explain the sudden shift from a good equilibrium to a bad mess. Thus, World War I was actually caused by a series of diplomatic miscalculations in the summer of 1914, the real origins of 9/11 lie in the politics of Saudi Arabia in the 1990s, and the financial crisis was principally due to errors in monetary policy by the U.S. Federal Reserve and to China's rapid accumulation of dollar reserves after 2001. Most of the fat-tail phenomena that historians study are not the climaxes of prolonged and deterministic story lines; instead, they represent perturbations, and sometimes the complete breakdowns, of complex systems.

To understand complexity, it is helpful to examine how natural scientists use the concept. Think of the spontaneous organization of half a million ants or termites, which allows them to construct complex hills and nests, or the fractal geometry of water molecules as they form intricate snowflakes. Human intelligence itself is a complex system, a product of the interaction of billions of neurons in the central nervous system, or what Charles Sherrington, the pioneering neuroscientist, called "an enchanted loom."

The political and economic structures made by humans share many of the features of complex adaptive systems. Heterodox economists such as W. Brian Arthur have been arguing along these lines for decades. To Arthur, a complex economy is characterized by the interaction of dispersed agents, a lack of central control, multiple levels of organization, continual adaptation, incessant creation of new market niches, and the absence of general equilibrium. This conception of economics goes beyond both Adam Smith's hallowed idea that an "invisible hand" causes markets to work through the interactions of profit-maximizing individuals and Friedrich von Hayek's critique of economic planning and demand management. In contradiction to the classic economic prediction that competition causes diminishing returns, a complex economy makes increasing returns possible. In this version of economics, Silicon Valley is a complex adaptive system; so is the Internet itself.

Researchers at the Santa Fe Institute, a nonprofit center devoted to the study of complex systems, are currently looking at how such insights can be applied to other aspects of collective human activity, including international relations. This effort may recall the futile struggle of Edward Casaubon to find "the key to all mythologies" in George Eliot's novel Middlemarch. But the attempt is worthwhile, because an understanding of how complex systems function is an essential part of any strategy to anticipate and delay their failure.

Whether the canopy of a rain forest or the trading floor of Wall Street, complex systems share certain characteristics. A small input to such a system can produce huge, often unanticipated changes -- what scientists call "the amplifier effect." A vaccine, for example, stimulates the immune system to become resistant to, say, measles or mumps. But administer too large a dose, and the patient dies. Meanwhile, causal relationships are often nonlinear, which means that traditional methods of generalizing through observation (such as trend analysis and sampling) are of little use. Some theorists of complexity would go so far as to say that complex systems are wholly nondeterministic, meaning that it is impossible to make predictions about their future behavior based on existing data.

When things go wrong in a complex system, the scale of disruption is nearly impossible to anticipate. There is no such thing as a typical or average forest fire, for example. To use the jargon of modern physics, a forest before a fire is in a state of "self-organized criticality": it is teetering on the verge of a breakdown, but the size of the breakdown is unknown. Will there be a small fire or a huge one? It is very hard to say: a forest fire twice as large as last year's is roughly four or six or eight times less likely to happen this year. This kind of pattern -- known as a "power-law distribution" -- is remarkably common in the natural world. It can be seen not just in forest fires but also in earthquakes and epidemics. Some researchers claim that conflicts follow a similar pattern, ranging from local skirmishes to full-scale world wars.

What matters most is that in such systems a relatively minor shock can cause a disproportionate -- and sometimes fatal -- disruption. As Taleb has argued, by 2007, the global economy had grown to resemble an over-optimized electrical grid. Defaults on subprime mortgages produced a relatively small surge in the United States that tipped the entire world economy into a financial blackout, which, for a moment, threatened to bring about a complete collapse of international trade. But blaming such a crash on a policy of deregulation under U.S. President Ronald Reagan is about as plausible as blaming World War I on the buildup of the German navy under Admiral Alfred von Tirpitz.

EMPIRE STATE OF MIND

Regardless of whether it is a dictatorship or a democracy, any large-scale political unit is a complex system. Most great empires have a nominal central authority -- either a hereditary emperor or an elected president -- but in practice the power of any individual ruler is a function of the network of economic, social, and political relations over which he or she presides. As such, empires exhibit many of the characteristics of other complex adaptive systems -- including the tendency to move from stability to instability quite suddenly. But this fact is rarely recognized because of the collective addiction to cyclical theories of history.

Perhaps the most famous story of imperial decline is that of ancient Rome. In The History of the Decline and Fall of the Roman Empire, published in six volumes between 1776 and 1788, Edward Gibbon covered more than 1,400 years of history, from 180 to 1590. This was history over the very long run, in which the causes of decline ranged from the personality disorders of individual emperors to the power of the Praetorian Guard and the rise of monotheism. After the death of Marcus Aurelius in 180, civil war became a recurring problem, as aspiring emperors competed for the spoils of supreme power. By the fourth century, barbarian invasions or migrations were well under way and only intensified as the Huns moved west. Meanwhile, the challenge posed by Sassanid Persia to the Eastern Roman Empire was steadily growing.

But what if fourth-century Rome was simply functioning normally as a complex adaptive system, with political strife, barbarian migration, and imperial rivalry all just integral features of late antiquity? Through this lens, Rome's fall was sudden and dramatic -- just as one would expect when such a system goes critical. As the Oxford historians Peter Heather and Bryan Ward-Perkins have argued, the final breakdown in the Western Roman Empire began in 406, when Germanic invaders poured across the Rhine into Gaul and then Italy. Rome itself was sacked by the Goths in 410. Co-opted by an enfeebled emperor, the Goths then fought the Vandals for control of Spain, but this merely shifted the problem south. Between 429 and 439, Genseric led the Vandals to victory after victory in North Africa, culminating in the fall of Carthage. Rome lost its southern Mediterranean breadbasket and, along with it, a huge source of tax revenue. Roman soldiers were just barely able to defeat Attila's Huns as they swept west from the Balkans. By 452, the Western Roman Empire had lost all of Britain, most of Spain, the richest provinces of North Africa, and southwestern and southeastern Gaul. Not much was left besides Italy. Basiliscus, brother-in-law of Emperor Leo I, tried and failed to recapture Carthage in 468. Byzantium lived on, but the Western Roman Empire was dead. By 476, Rome was the fiefdom of Odoacer, king of the Goths.

What is most striking about this history is the speed of the Roman Empire's collapse. In just five decades, the population of Rome itself fell by three-quarters. Archaeological evidence from the late fifth century -- inferior housing, more primitive pottery, fewer coins, smaller cattle -- shows that the benign influence of Rome diminished rapidly in the rest of western Europe. What Ward-Perkins calls "the end of civilization" came within the span of a single generation.

Other great empires have suffered comparably swift collapses. The Ming dynasty in China began in 1368, when the warlord Zhu Yuanzhang renamed himself Emperor Hongwu, the word hongwu meaning "vast military power." For most of the next three centuries, Ming China was the world's most sophisticated civilization by almost any measure. Then, in the mid-seventeenth century, political factionalism, fiscal crisis, famine, and epidemic disease opened the door to rebellion within and incursions from without. In 1636, the Manchu leader Huang Taiji proclaimed the advent of the Qing dynasty. Just eight years later, Beijing, the magnificent Ming capital, fell to the rebel leader Li Zicheng, and the last Ming emperor hanged himself out of shame. The transition from Confucian equipoise to anarchy took little more than a decade.

In much the same way, the Bourbon monarchy in France passed from triumph to terror with astonishing rapidity. French intervention on the side of the colonial rebels against British rule in North America in the 1770s seemed like a good idea at the time -- a chance for revenge after Great Britain's victory in the Seven Years' War a decade earlier -- but it served to tip French finances into a critical state. In May 1789, the summoning of the Estates-General, France's long-dormant representative assembly, unleashed a political chain reaction that led to a swift collapse of royal legitimacy in France. Only four years later, in January 1793, Louis XVI was decapitated by guillotine.

Although several narrative fallacies suggest that the Hapsburg, Ottoman, and Romanov empires were doomed for decades before World War I, the disintegration of the dynastic land empires of eastern Europe came with equal swiftness. What was impressive, in fact, was how well these ancient empires were able to withstand the test of total war. Their collapse only began with the Bolshevik Revolution of October 1917. A mere five years later, Mehmed VI, the last sultan of the Ottoman Empire, departed Constantinople aboard a British warship. With that, all three dynasties were defunct.

The sun set on the British Empire almost as suddenly. In February 1945, Prime Minister Winston Churchill was at Yalta, dividing up the world with U.S. President Franklin Roosevelt and Soviet Premier Joseph Stalin. As World War II was ending, he was swept from office in the July 1945 general election. Within a decade, the United Kingdom had conceded independence to Bangladesh, Bhutan, Burma, Egypt, Eritrea, India, Iran, Israel, Jordan, Libya, Madagascar, Pakistan, and Sri Lanka. The Suez crisis in 1956 proved that the United Kingdom could not act in defiance of the United States in the Middle East, setting the seal on the end of empire. Although it took until the 1960s for independence to reach sub-Saharan Africa and the remnants of colonial rule east of the Suez, the United Kingdom's age of hegemony was effectively over less than a dozen years after its victories over Germany and Japan.

The most recent and familiar example of precipitous decline is, of course, the collapse of the Soviet Union. With the benefit of hindsight, historians have traced all kinds of rot within the Soviet system back to the Brezhnev era and beyond. Perhaps, as the historian and political scientist Stephen Kotkin has argued, it was only the high oil prices of the 1970s that "averted Armageddon." But this did not seem to be the case at the time. In March 1985, when Mikhail Gorbachev became general secretary of the Soviet Communist Party, the CIA estimated the Soviet economy to be approximately 60 percent the size of the U.S. economy. This estimate is now known to have been wrong, but the Soviet nuclear arsenal was genuinely larger than the U.S. stockpile. And governments in what was then called the Third World, from Vietnam to Nicaragua, had been tilting in the Soviets' favor for most of the previous 20 years. Yet less than five years after Gorbachev took power, the Soviet imperium in central and Eastern Europe had fallen apart, followed by the Soviet Union itself in 1991. If ever an empire fell off a cliff -- rather than gently declining -- it was the one founded by Lenin.

OVER THE EDGE

If empires are complex systems that sooner or later succumb to sudden and catastrophic malfunctions, rather than cycling sedately from Arcadia to Apogee to Armageddon, what are the implications for the United States today? First, debating the stages of decline may be a waste of time -- it is a precipitous and unexpected fall that should most concern policymakers and citizens. Second, most imperial falls are associated with fiscal crises. All the above cases were marked by sharp imbalances between revenues and expenditures, as well as difficulties with financing public debt. Alarm bells should therefore be ringing very loudly, indeed, as the United States contemplates a deficit for 2009 of more than $1.4 trillion -- about 11.2 percent of GDP, the biggest deficit in 60 years -- and another for 2010 that will not be much smaller. Public debt, meanwhile, is set to more than double in the coming decade, from $5.8 trillion in 2008 to $14.3 trillion in 2019. Within the same timeframe, interest payments on that debt are forecast to leap from eight percent of federal revenues to 17 percent.

These numbers are bad, but in the realm of political entities, the role of perception is just as crucial, if not more so. In imperial crises, it is not the material underpinnings of power that really matter but expectations about future power. The fiscal numbers cited above cannot erode U.S. strength on their own, but they can work to weaken a long-assumed faith in the United States' ability to weather any crisis. For now, the world still expects the United States to muddle through, eventually confronting its problems when, as Churchill famously said, all the alternatives have been exhausted. Through this lens, past alarms about the deficit seem overblown, and 2080 -- when the U.S. debt may reach staggering proportions -- seems a long way off, leaving plenty of time to plug the fiscal hole. But one day, a seemingly random piece of bad news -- perhaps a negative report by a rating agency -- will make the headlines during an otherwise quiet news cycle. Suddenly, it will be not just a few policy wonks who worry about the sustainability of U.S. fiscal policy but also the public at large, not to mention investors abroad. It is this shift that is crucial: a complex adaptive system is in big trouble when its component parts lose faith in its viability.

Over the last three years, the complex system of the global economy flipped from boom to bust -- all because a bunch of Americans started to default on their subprime mortgages, thereby blowing huge holes in the business models of thousands of highly leveraged financial institutions. The next phase of the current crisis may begin when the public begins to reassess the credibility of the monetary and fiscal measures that the Obama administration has taken in response. Neither interest rates at zero nor fiscal stimulus can achieve a sustainable recovery if people in the United States and abroad collectively decide, overnight, that such measures will lead to much higher inflation rates or outright default. As Thomas Sargent, an economist who pioneered the idea of rational expectations, demonstrated more than 20 years ago, such decisions are self-fulfilling: it is not the base supply of money that determines inflation but the velocity of its circulation, which in turn is a function of expectations. In the same way, it is not the debt-to-GDP ratio that determines government solvency but the interest rate that investors demand. Bond yields can shoot up if expectations change about future government solvency, intensifying an already bad fiscal crisis by driving up the cost of interest payments on new debt. Just ask Greece -- it happened there at the end of last year, plunging the country into fiscal and political crisis.

Finally, a shift in expectations about monetary and fiscal policy could force a reassessment of future U.S. foreign policy. There is a zero-sum game at the heart of the budgetary process: if interest payments consume a rising proportion of tax revenue, military expenditure is the item most likely to be cut because, unlike mandatory entitlements, it is discretionary. A U.S. president who says he will deploy 30,000 additional troops to Afghanistan and then, in 18 months' time, start withdrawing them again already has something of a credibility problem. And what about the United States' other strategic challenges? For the United States' enemies in Iran and Iraq, it must be consoling to know that U.S. fiscal policy today is preprogrammed to reduce the resources available for all overseas military operations in the years ahead.

Defeat in the mountains of the Hindu Kush or on the plains of Mesopotamia has long been a harbinger of imperial fall. It is no coincidence that the Soviet Union withdrew from Afghanistan in the annus mirabilis of 1989. What happened 20 years ago, like the events of the distant fifth century, is a reminder that empires do not in fact appear, rise, reign, decline, and fall according to some recurrent and predictable life cycle. It is historians who retrospectively portray the process of imperial dissolution as slow-acting, with multiple overdetermining causes. Rather, empires behave like all complex adaptive systems. They function in apparent equilibrium for some unknowable period. And then, quite abruptly, they collapse. To return to the terminology of Thomas Cole, the painter of The Course of Empire, the shift from consummation to destruction and then to desolation is not cyclical. It is sudden.

A more appropriate visual representation of the way complex systems collapse may be the old poster, once so popular in thousands of college dorm rooms, of a runaway steam train that has crashed through the wall of a Victorian railway terminus and hit the street below nose first. A defective brake or a sleeping driver can be all it takes to go over the edge of chaos.

2010-03-13T09:14:00.002-05:00

America, the fragile empire
Here today, gone tomorrow -- could the United States fall that fast?

By Niall Ferguson

February 28, 2010

latimes.com

For centuries, historians, political theorists, anthropologists and the public have tended to think about the political process in seasonal, cyclical terms. From Polybius to Paul Kennedy, from ancient Rome to imperial Britain, we discern a rhythm to history. Great powers, like great men, are born, rise, reign and then gradually wane. No matter whether civilizations decline culturally, economically or ecologically, their downfalls are protracted.

In the same way, the challenges that face the United States are often represented as slow-burning. It is the steady march of demographics -- which is driving up the ratio of retirees to workers -- not bad policy that condemns the public finances of the United States to sink deeper into the red. It is the inexorable growth of China's economy, not American stagnation, that will make the gross domestic product of the People's Republic larger than that of the United States by 2027.

As for climate change, the day of reckoning could be as much as a century away. These threats seem very remote compared with the time frame for the deployment of U.S. soldiers to Afghanistan, in which the unit of account is months, not years, much less decades.

But what if history is not cyclical and slow-moving but arrhythmic -- at times almost stationary but also capable of accelerating suddenly, like a sports car? What if collapse does not arrive over a number of centuries but comes suddenly, like a thief in the night?

Great powers are complex systems, made up of a very large number of interacting components that are asymmetrically organized, which means their construction more resembles a termite hill than an Egyptian pyramid. They operate somewhere between order and disorder. Such systems can appear to operate quite stably for some time; they seem to be in equilibrium but are, in fact, constantly adapting. But there comes a moment when complex systems "go critical." A very small trigger can set off a "phase transition" from a benign equilibrium to a crisis -- a single grain of sand causes a whole pile to collapse.

Not long after such crises happen, historians arrive on the scene. They are the scholars who specialize in the study of "fat tail" events -- the low-frequency, high-impact historical moments, the ones that are by definition outside the norm and that therefore inhabit the "tails" of probability distributions -- such as wars, revolutions, financial crashes and imperial collapses. But historians often misunderstand complexity in decoding these events. They are trained to explain calamity in terms of long-term causes, often dating back decades. This is what Nassim Taleb rightly condemned in "The Black Swan" as "the narrative fallacy."

In reality, most of the fat-tail phenomena that historians study are not the climaxes of prolonged and deterministic story lines; instead, they represent perturbations, and sometimes the complete breakdowns, of complex systems.

To understand complexity, it is helpful to examine how natural scientists use the concept. Think of the spontaneous organization of termites, which allows them to construct complex hills and nests, or the fractal geometry of water molecules as they form intricate snowflakes. Human intelligence itself is a complex system, a product of the interaction of billions of neurons in the central nervous system.

All these complex systems share certain characteristics. A small input to such a system can produce huge, often unanticipated changes -- what scientists call "the amplifier effect." Causal relationships are often nonlinear, which means that traditional methods of generalizing through observation are of little use. Thus, when things go wrong in a complex system, the scale of disruption is nearly impossible to anticipate.

There is no such thing as a typical or average forest fire, for example. To use the jargon of modern physics, a forest before a fire is in a state of "self-organized criticality": It is teetering on the verge of a breakdown, but the size of the breakdown is unknown. Will there be a small fire or a huge one? It is nearly impossible to predict. The key point is that in such systems, a relatively minor shock can cause a disproportionate disruption.

Any large-scale political unit is a complex system. Most great empires have a nominal central authority -- either a hereditary emperor or an elected president -- but in practice the power of any individual ruler is a function of the network of economic, social and political relations over which he or she presides. As such, empires exhibit many of the characteristics of other complex adaptive systems -- including the tendency to move from stability to instability quite suddenly.

The most recent and familiar example of precipitous decline is the collapse of the Soviet Union. With the benefit of hindsight, historians have traced all kinds of rot within the Soviet system back to the Brezhnev era and beyond. Perhaps, as the historian and political scientist Stephen Kotkin has argued, it was only the high oil prices of the 1970s that "averted Armageddon." But this did not seem to be the case at the time. The Soviet nuclear arsenal was larger than the U.S. stockpile. And governments in what was then called the Third World, from Vietnam to Nicaragua, had been tilting in the Soviets' favor for most of the previous 20 years.

Yet, less than five years after Mikhail Gorbachev took power, the Soviet imperium in central and Eastern Europe had fallen apart, followed by the Soviet Union itself in 1991. If ever an empire fell off a cliff, rather than gently declining, it was the one founded by Lenin.

If empires are complex systems that sooner or later succumb to sudden and catastrophic malfunctions, what are the implications for the United States today? First, debating the stages of decline may be a waste of time -- it is a precipitous and unexpected fall that should most concern policymakers and citizens. Second, most imperial falls are associated with fiscal crises. Alarm bells should therefore be ringing very loudly indeed as the United States contemplates a deficit for 2010 of more than $1.5 trillion -- about 11% of GDP, the biggest since World War II.

These numbers are bad, but in the realm of political entities, the role of perception is just as crucial. In imperial crises, it is not the material underpinnings of power that really matter but expectations about future power. The fiscal numbers cited above cannot erode U.S. strength on their own, but they can work to weaken a long-assumed faith in the United States' ability to weather any crisis.

One day, a seemingly random piece of bad news -- perhaps a negative report by a rating agency -- will make the headlines during an otherwise quiet news cycle. Suddenly, it will be not just a few policy wonks who worry about the sustainability of U.S. fiscal policy but the public at large, not to mention investors abroad. It is this shift that is crucial: A complex adaptive system is in big trouble when its component parts lose faith in its viability.

Over the last three years, the complex system of the global economy flipped from boom to bust -- all because a bunch of Americans started to default on their subprime mortgages, thereby blowing huge holes in the business models of thousands of highly leveraged financial institutions. The next phase of the current crisis may begin when the public begins to reassess the credibility of the radical monetary and fiscal steps that were taken in response.

Neither interest rates at zero nor fiscal stimulus can achieve a sustainable recovery if people in the United States and abroad collectively decide, overnight, that such measures will ultimately lead to much higher inflation rates or outright default. Bond yields can shoot up if expectations change about future government solvency, intensifying an already bad fiscal crisis by driving up the cost of interest payments on new debt. Just ask Greece.

Ask Russia too. Fighting a losing battle in the mountains of the Hindu Kush has long been a harbinger of imperial fall. What happened 20 years ago is a reminder that empires do not in fact appear, rise, reign, decline and fall according to some recurrent and predictable life cycle. It is historians who retrospectively portray the process of imperial dissolution as slow-acting. Rather, empires behave like all complex adaptive systems. They function in apparent equilibrium for some unknowable period. And then, quite abruptly, they collapse.

Washington, you have been warned.

Niall Ferguson is a professor at Harvard University and Harvard Business School, and a fellow of Jesus College, Oxford. His latest book is "The Ascent of Money: A Financial History of the World." A longer version of this essay appears in the March/April issue of Foreign Affairs.

2010-02-09T12:41:00.000-05:00

China's 8,000 Credit Risks
Beijing's stimulus has spawned thousands of special government investment funds holding billions of dollars in off-balance-sheet debt.

By VICTOR SHIH

OPINION ASIA FEBRUARY 8, 2010, 10:47 A.M. ET
wsj.com

As the world struggles to recover from the most severe economic slowdown in a generation, China seemingly has accomplished a miracle. Growth registered at almost 9% last year, yet the government debt-to-GDP ratio still stood around a modest 20% as of December 31. Has China enjoyed the proverbial free lunch?

Far from it: The Chinese government has financed much of an enormous stimulus package through thousands of investment entities created by local governments. If Beijing doesn't soon recognize this problem and put a stop to it, banks in China, which have provided the bulk of the funding, may soon face delinquent loans that rival even China's enormous fiscal and foreign-exchange capacity.

After Beijing announced a $588 billion stimulus package in late 2008, local governments enthusiastically rolled out plans to invest more than $4 trillion over the following few years. These were far from idle pipe dreams. The central authorities permitted and even encouraged local governments to borrow heavily from banks to finance infrastructure projects. Because Chinese law forbids banks from lending directly to government institutions, these governments set up some 8,000 investment companies, according to official figures. Banks lending to these entities class the outlays as "enterprise loans."

Beijing is no longer sure how much money local investment entities have borrowed from banks and raised from bond and equity investors. The amount, however, must be large. In September, the Chinese press, citing government sources, suggested that these entities have borrowed $880 billion. In a January interview with the Twentieth Century Business Herald, a Chinese newspaper, the vice chairman of the Finance and Economic Committee of the National People's Congress, Yi Zhongliu, revealed that local investment entities borrowed some $735 billion in 2009 alone.

These are mere guesses, however. A National Audit Agency audit conducted late last year uncovered so many problems with the data that Premier Wen Jiabao ordered another large-scale audit of local investment entities. Until a thorough audit is completed and the results announced to the public, no one really knows the total scale of local borrowing.

To obtain an independent estimate, I collected data from thousands of sources, including regulatory filings, bond-rating reports and press releases of government-bank cooperative agreements. I estimate local investment entities' borrowing between 2004 and the end of 2009 totals some $1.6 trillion. The data are far from perfect because borrowing by low-level government entities and lending by small banks are difficult to track. Nonetheless, my evidence suggests that the scale of the problem is much larger than previous government estimates. At $1.6 trillion, the local debt is roughly one-third of China's 2009 GDP and 70% of its foreign-exchange reserves.

Although local budgets are limited, regional governments can sell land to raise money to pay interest and ultimately principal. Indeed, local authorities across the country sold land worth $233 billion in 2009, benefiting from the real-estate upsurge in the second half of the year. For local investment vehicles to fully repay interest and debt through the sale of land, however, the real-estate boom must continue for years to come, sustaining high demand for land. Worse, banks have already pledged more than a trillion dollars in additional credit lines to local investment entities. If the central government does not restrict bank lending to them, these entities will go deeper into debt, thus either requiring the sale of much more land or the creation of a pile of nonperforming loans.

The central government is already ordering banks to slow lending to local investment vehicles. However, stronger actions are needed to forestall disaster. First, the government needs to order banks to stop lending to all new or newly started investment projects undertaken by local entities. This also would slow the overall amount of lending and constrain rising inflation. Second, since county governments are in the poorest fiscal shape and have the least ability to repay banks, the central government should take over the debt of almost all of the county-level investment vehicles. Although this will increase China's debt-to-GDP ratio significantly, the total would still be low by international standards.

A sudden contraction of lending to local investment vehicles will generate a wave of nonperforming loans, but a greater reliance on market mechanisms can easily solve this problem over the next few years. First, banks will fully recover the debt of the healthiest local entities, which may account for half of total local debt. For the remainder, the government needs to allow banks to directly sell subprime or distressed loans to both foreign and domestic investors. Beijing need not fear that China's listed banks will sell their nonperforming loans at below-market prices, as these banks report to shareholders. Banks, in conjunction with investment banks and distressed-asset investors, should also explore ways to securitize local debt for sale to both domestic and international investors. The latter in particular would have a healthy appetite for yuan-denominated security, anticipating a currency revaluation soon.

Beijing's mantra of "reform and opening" rings increasingly hollow in recent years as a larger share of financial resources is poured into the state sector. However, a timely, bold and market-oriented intervention to resolve the local-debt problem would once again put China on a path of reform.

Mr. Shih is assistant professor of political science at Northwestern University and the author of "Factions and Finance in China: Elite Conflict and Inflation" (Cambridge University Press, 2008).

2010-02-02T12:40:00.000-05:00

CIA moonlights in corporate world
By: Eamon Javers
February 1, 2010 12:57 AM EST
politico.com

In the midst of two wars and the fight against Al Qaeda, the CIA is offering operatives a chance to peddle their expertise to private companies on the side — a policy that gives financial firms and hedge funds access to the nation’s top-level intelligence talent, POLITICO has learned.

In one case, these active-duty officers moonlighted at a hedge-fund consulting firm that wanted to tap their expertise in “deception detection,” the highly specialized art of telling when executives may be lying based on clues in a conversation.

The never-before-revealed policy comes to light as the CIA and other intelligence agencies are once again under fire for failing to “connect the dots,” this time in the Christmas Day bombing plot on Northwest Flight 253.

But sources familiar with the CIA’s moonlighting policy defend it as a vital tool to prevent brain-drain at Langley, which has seen an exodus of highly trained, badly needed intelligence officers to the private sector, where they can easily double or even triple their government salaries. The policy gives agents a chance to earn more while still staying on the government payroll.

A government official familiar with the policy insists it doesn’t impede the CIA’s work on critical national security investigations. This official said CIA officers who want to participate in it must first submit a detailed explanation of the type of work involved and get permission from higher-ups within the agency.

“If any officer requests permission for outside employment, those requests are reviewed not just for legality, but for propriety,” CIA spokesman George Little told POLITICO.

There is much about the policy that is unclear, including how many officers have availed themselves of it, how long it has been in place and what types of outside employment have been allowed. The CIA declined to provide additional details.

Generally, federal employees across the vast government work force are allowed to moonlight in the private sector, but under tight guidelines, that can vary from agency to agency, according to the federal Office of Government Ethics.

“In general, for most nonpolitical employees, they may engage in outside employment, but there are some restrictions,” said Elaine Newton, an attorney at the Office of Government Ethics. She explained that agencies throughout the federal government set their own policies on outside employment, and that they all typically require that the employment not represent a conflict of interest with the employee’s federal job and that the employee have written approval before taking on the work.

But the close ties between active-duty and retired CIA officers at one consulting company show the degree to which CIA-style intelligence gathering techniques have been employed by hedge funds and financial institutions in the global economy.

The firm is called Business Intelligence Advisors, and it is based in Boston. BIA was founded and is staffed by a number of retired CIA officers, and it specializes in the arcane field of “deception detection.” BIA’s clients have included Goldman Sachs and the enormous hedge fund SAC Capital Advisors, according to spokesmen for both firms.

BIA has employed active-duty CIA officers in the past, although BIA president Cheryl Cook said that has “not been the case with BIA for some time.”

But the ties between BIA and the intelligence world run deep. The name itself was chosen as a play off CIA. And the presence of so many former CIA personnel on the payroll at BIA causes confusion as to whether the intelligence firm is actually an extension of the agency itself. As a result, BIA places a disclaimer in some of its corporate materials to clarify that it is not, in fact, controlled by Langley.

BIA’s clients can put the company on a retainer for as much as $400,000 to $800,000 a year. And in return, they receive access to a variety of services, from deception detection to other programs that feature the CIA intelligence techniques.

In one presentation in 2006, BIA personnel promised to teach managers at a leading hedge fund some of the CIA’s own foolproof techniques.

The presenters that day at SAC Capital Advisors in Stamford, Conn., included two women with backgrounds in intelligence. One spent 20 years with the CIA, specializing in polygraph, interviewing, and deception detection. The other had more than 25 years of interrogation experience.

In their intensity, they reminded one person in the room of Clarice Starling, the no-nonsense FBI agent played by Jodie Foster in the movie “The Silence of the Lambs”: “You could tell they knew exactly what they were doing.”

The tactics that BIA officials such as these teach hedge fund clients are based in a program it calls “Tactical Behavior Assessment.”.

Unlike polygraph machines, the TBA technique allows examiners to work without hooking up their subject to a series of wires. The subject never knows he’s being scrutinized.

Polygraph machines work by measuring a person’s physical responses, such as heart rate, that indicate stress. Analysts using the machine need to sit with their subject for a long time. They have to establish a person’s physiological baseline, so they begin with a “control” conversation about neutral topics, before they can begin grilling the subject. Conducting an interview and doing a thorough analysis of polygraph results can take hours.

TBA focuses on the verbal and nonverbal cues that people convey when they aren’t telling the truth. Psychologists familiar with the method say it works because human beings just aren’t hard-wired to lie well. Holding two opposing ideas in your brain at the same time — as you have to do in order to tell a lie — causes a phenomenon they term “cognitive dissonance,” which creates actual physical discomfort. And when people are uncomfortable, they squirm. They fidget ever so slightly, they pick lint off their clothes, they shift their bodily positions.

Agents look for the physical indicators of lying. They watch for a person shifting anchor points. If the person is leaning forward on one elbow, does he switch to the other one? Interrogators watch for grooming gestures such as adjusting clothes, hair or eyeglasses. They look to see if the person picks at his fingernails or scratches himself. They watch for the person to clean his surroundings — does he straighten the paper clips on the table or line up the pens? If he does, he could be lying.

To obtain verbal clues, agents listen for several kinds of statements. They’ll listen for qualifying answers, phrases that begin with words like “honestly,” “frankly” or “basically.” The agents will be listening for detour phrases like “as I said before ...” They’ll want to hear if the person invokes religion — “I swear to God” — or attacks the questioner: “How dare you ask me something like that?”

Other red flags: Complaints —“How long is this going to take?” Selective memory —“To the best of my knowledge.” Overly courteous responses —“Yes, sir.”

BIA doesn’t just offer training, though. For a fee, its officers do the analysis themselves.

Often, BIA deploys its CIA-trained operatives to analyze quarterly corporate-earnings calls. Those conference calls are an important Wall Street ritual that serves as a direct line from the corporate boardroom to the trading floor.

Companies use the calls to put the best spin on the events of the quarter and give investors a sense of the way ahead. Analysts for top-of-the-line investment houses use them to ask probing questions of senior management.

And BIA uses them to figure out if the company may not be disclosing the truth — all with the help of the CIA-trained analysts.

In one particular instance in August 2005, Hong Liang Lu, the chairman and CEO of a company called UTStarcom, walked through the numbers with a telephone audience of Wall Street investment bankers. With his slicked-back hair, rimless glasses and wide smile, Lu projected an image of intelligence and competence.

And as he began the call, Lu couldn’t know that it also was being patched into a room thousands of miles away where interrogators trained in CIA-style techniques would analyze each inflection in Lu’s voice. The analysts were human lie detectors, working for BIA. They were trying to find out whether Lu was telling the whole truth about UTStarcom’s financial health.

When they came to their conclusion, they’d report it to BIA’s client, an enormous hedge fund. The secret intelligence they produced would help the hedge fund decide whether to buy or sell UTStarcom stock. If the intelligence analysts did their jobs, the hedge fund would be far ahead of the rest of the market.

The information they gleaned from this phone call could be worth millions of dollars.

The company Hong Liang Lu ran sells broadband, wireless and hand-held Internet equipment and technology around the world. It had generated more than $700 million in revenue that quarter, and although it was still losing money, that performance was good enough to bring it close to profitability. The company thought the results were positive, and the CEO seemed optimistic.

Investment analysts from Bank of America, Smith Barney, Deutsche Bank and other Wall Street powerhouses were the official participants in UTStarcom’s call. The analysts prepared their best questions to help them figure out the answer to one big question: Would UTStarcom emerge as a hot stock in the third quarter?

After some opening remarks, Lu threw open the session to questions from the Wall Streeters. One of them, Mike Ounjian, a keen-eyed analyst with Credit Suisse First Boston, asked about potential problems he’d spotted with how the company’s income was being counted in the books, a process known as revenue recognition.

There seemed to be a backlog in the recording, and Ounjian wanted to know why. If the problems were serious, they could affect the company’s financial results in the next quarter and might cause the stock price to dip.

“Are there any issues related to recognizing revenues on these?” Ounjian asked.

The voice of Michael Sophie, then the company’s interim chief financial officer, came over the phone line: “Yes, with the backlog, the vast majority of the wireless backlog is clearly PAS [an acronym for one of the company’s products, Personal Access System]. I think you saw the announcement at the end of June where we announced on the PAS infrastructure orders in China. And again, it’s just the timing of deployment and achieving final acceptance, we’ve also got some CDMA [an acronym for a type of mobile phone standard] to a lesser extent in the backlog. ... But Q3 is clearly a little more handset-oriented than we would typically run.”

After analyzing the call, BIA’s employees supplied a 27-page confidential report to their client, and they singled out Sophie’s response to the question about revenue recognition for particular attention. They noted that Sophie qualified his response and referred back to another announcement from the end of June.

BIA called that kind of conversational reference a “detour statement,” and its analysts were convinced that Sophie was trying to minimize the delays. “Mr. Sophie avoids commenting on any issues related to revenue recognition, and his overall behavior indicates that revenue recognition problems cannot be ruled out.”

Overall, BIA’s team rated the second-quarter conference call as a “medium high level of concern”— the same rating they’d given UTStarcom’s call the quarter before. This time, though, the BIA team found more problems, which they listed in a box on the first page of their report: “Lacks Confidence,” “Underlying Concern,” “Avoids Providing Information.”

In their conclusion, the BIA team said they’d found that the executives were worried about the timing of the company’s profitability date and the issue of revenue recognition. The report says: “Management’s behavior indicates that they will post poor third-quarter results, and it is also highly unlikely they will achieve profitability in the fourth quarter.”

It might not seem like much, one take on whether the company will do well in the next six months. But to hedge-fund investors — who are looking for ways to make money off of falling stocks by selling short — that is valuable information indeed.

BIA’s client had no way of telling whether the deception analysis report was accurate or not. It was the client’s job to take the report, combine it with other information known about UTStarcom and make a bet for or against the company. And there’s no evidence that UTStarcom officials weren’t being truthful during the call.

With the benefit of hindsight, though, it’s possible to go back and check the record to find out what did happen to UTStarcom stock in the weeks after the call.

It turns out that any investor who shorted UTStarcom at the time BIA submitted its report would have been in a position to reap substantial gains.

Over the next month or so after the call of Aug. 2, UTStarcom’s stock price lost about $1 per share, a nice win for any short seller. But on Oct. 6, 2005, the company released its third-quarter results, shocking Nasdaq traders with numbers that were below the guidance executives had offered during the conference call. In October, UTStarcom said it expected total revenues of between $620 million and $640 million, compared with its previous target of $660 million to $680 million. The next morning, investors frantically sold their shares: more than 23 million transactions took place on Oct. 7, 2005.

A day after the third-quarter results were released, the stock was down roughly an additional $2, closing at $5.64. It had been at $8.54 when the BIA team listened in on the conference call in August and flagged the potential problems with revenue recognition.

And what reason did UTStarcom give for its poor third-quarter performance? It disclosed difficulties with revenue recognition.

2010-02-01T18:36:00.001-05:00

Lunch with the FT: Madam Fu Ying
By Lionel Barber
ft.com

Published: January 29 2010 16:52 | Last updated: January 29 2010 16:52

The elegant 57-year-old gliding towards our table does not fit the stern face of Chinese officialdom. She is wearing a pink checked jacket and skirt; pink and white pearls; and a sunny smile. As other luncheon guests at the Goring Hotel, one of the last family-owned hotels in London, look on, we pose for a photograph. With one enthusiastic eye on posterity, the other on future career prospects, an ambassadorial aide takes two pictures before China’s outgoing ambassador to the UK dismisses him with a mildly embarrassed wave.

Madam Fu Ying is a rare specimen in the ranks of Chinese diplomacy. She is female, she comes from an ethnic minority – she was born in Inner Mongolia – and this week, she takes up a new post in Beijing as only the second female vice-foreign minister since the founding of the People’s Republic in 1949. (The first was Wang Hairong, Chairman Mao’s niece, who was appointed during the Cultural Revolution.)

We settled on the Goring Hotel, near Victoria, as the location for our lunch after delicate negotiations. The biscuit-brown and cream decor is classic and understated; the menu unequivocally English. The ambassador is delighted. Though she describes the past three years in London as her toughest diplomatic assignment, far more demanding than earlier stints in Australia, Indonesia and the Philippines, she will, she says, miss much: the jogs in the park, the walks down Oxford Street, the West End theatre, the football ...

The football? “Yes, very much,” says the ambassador. “A friend of mine introduced me to Arsenal. He was so keen that I started to support Arsenal. I even have an Arsenal T-shirt, with a number 08.”

As a Spurs supporter, I am underwhelmed but the soft-spoken ambassador presses on regardless. “Last November, Arsenal were playing Chelsea and it was a Sunday. Very cold. I have a blue down coat and I matched it with light blue jeans and a royal blue scarf. Very beautiful. But when I arrived in the stadium I already knew I had made a mistake. It was very awkward cheering for Arsenal [whose shirts are bright red] in bright blue.”

Madam Fu is charming but she also knows that charm can serve as a weapon. As when she was questioned at a 2008 trade conference about the possibility of a British trade boycott because of China’s crackdown in Tibet. Such threats, she replied, could have embarrassing consequences since most of the attendees were wearing clothes made in China: “You’ll all be naked.”

The ambassador claims to have forgotten the incident, and turns to the menu. She selects soused herrings, admitting she has no idea what “soused” means but she is determined to order something authentically British. The waiter recites a word-perfect explanation. Satisfied, she moves on to steamed Cornish sea bass as a main course. I, too, choose sea bass, with a pear and beetroot salad as a starter. The ambassador declines a glass of wine. “Need to stay alert,” she says, conscious perhaps that her superiors in Beijing will study this interview as keenly as any diplomatic dispatch.

Highlights of her three years in London include, says the ambassador, lots of visits to advanced manufacturing sites; trips to the homes of Jane Austen, the Brontë sisters and William Shakespeare; and, less predictably, the British TV talent show The X Factor.

The trickiest point in her tenure came in 2008 with the unrest in Tibet ahead of the Beijing Olympics. A flash of irritation appears on her face as she recalls international pressure for an official boycott of the opening ceremony in Beijing. The very idea of China being “humiliated” – “the last word you would use on China now” – was insulting, not least because it impugns China’s status. She prefers to draw attention to the wave of sympathy for the Chinese people expressed by the British after the devastating earthquake in Sichuan in May 2008. In one month, she notes, the embassy received £2m, including donations from a delegation of 13 policemen who bicycled from Birmingham to London to drop off the cash.

Madam Fu’s command of English is excellent, thanks not only to her background as an interpreter but also to her postgraduate studies at the University of Kent in 1985-86, when she shared a scholarship with another Chinese student. She remembers having to live on £1 a day, after payment of the rent. But however hard life may have been in Canterbury during the Thatcher years, it was nowhere near as tough as her childhood.

Fu Ying was born in 1953 in Hohhot, the capital of Inner Mongolia, an “autonomous region” of China. Her parents were bilingual, speaking Mandarin and Mongolian. Her father wrote poetry. She can, she tells me, still remember the day that a tall, ethnically Chinese man arrived at the family home to take her father away. It was 1967 and the height of the Cultural Revolution, the bloody chaos unleashed by Mao to purge the party and consolidate power.

“The [tall] man looked into my eyes and said, ‘Democracy is great. Do you know what is democracy?’ I shook my head; I didn’t know. And he said, ‘That’s the change of history. You will be swept away by the change of history.’” (Democracy, during the Cultural Revolution, was equivalent to anarchy. No wonder, I muse to myself, it does not carry the same positive connotations in China as in the west.)

A tear appears in Madam Fu’s eye. She recounts how school was shut down and she was taken away, aged 17, to a remote town in the mountains, Wulashan, five hours distant by train. There she worked in the fields – “very, very physical, really stressful and extreme for a young girl” – before helping to build a new factory where she was employed as an announcer, broadcasting information to her co-workers about the weather and the like through a loudspeaker.

But then, in 1973, she had her first break. The Cultural Revolution was in its last throes and previously frowned-upon practices such as examinations to test pupil ability were revived. Fu Ying excelled, having squirrelled away first Russian and then French classics from a library in Wulashan. She also excelled in English, having picked up the basics on Chinese radio. She gained a place to study for four years at Beijing Foreign Studies University.

After the death of Chairman Mao in 1976, China started to open to the rest of the world. Suddenly, interpreters were in heavy demand. Madam Fu joined the elite translation department of the diplomatic service. When I ask her if it is correct that she was a protégée of Mao’s favourite interpreter, she will not confirm it – though she certainly made enough of a mark to be elevated to be interpreter to Deng Xiaoping, Mao’s successor and the man widely credited for introducing market reforms in China.

While the ambassador declines to reveal much about life with Deng, she does confirm a memorable public mistranslation. In January 1988, when the 84-year-old Chinese leader greeted Gro Harlem Brundtland, the then 48-year-old Norwegian premier, on an official visit to China, he observed that she was not so old. Brundtland said that Deng did not look so old either. Deng laughed and said he was only 84 but, explains Fu Ying, “I was in a hurry and said he was 48 ... Deng laughed. But Deng was great. Interpreting for him was really a very exciting experience.”

I ask the ambassador if she was the translator when Deng reportedly declared that he was very pleased with the one-child policy in China because he no longer needed to invade Siberia. “He never said that,” says Madam Fu, showing a momentary sense of humour failure. “He was a very kind man, very alert about the world. I liked Deng; he was very simple, very quick.”

The waiter arrives with our steamed sea bass wrapped in baby spinach. We agree that the fish tastes as good as it looks before I turn to the vexing question of China’s relationship with the rest of the world. How should the west accommodate Chinese power, and why does the scope for mutual misunderstanding seem greater than ever? Madam Fu weighs her answers carefully. “You have your standard [in the west] and you use that standard to measure China, and every time you find China does not fit that standard. But China is never going to, is it? China has such a long history of its own, the only continuous culture in 5,000 years. But it also has about 200 years of a very sad history, with foreign occupations. That hurt China. That’s why the Chinese remember the suffering more than the victories. China has a strong sense of crisis.”

Beyond what I take to be the implied reference to the brutal Japanese invasion of Manchuria in 1931 lies a gut Chinese hostility to being lectured by anyone, whether on human rights, an artificially undervalued currency, the environment or the scramble for raw materials in Africa needed to power the Chinese economy. “There is this frustration about not being understood, not being accepted,” says Madam Fu, who compares different political systems to different types of roof which cannot be imposed willy-nilly on different types of buildings.

The metaphor is seductive but what about universal values, such as freedom of expression, or, more concretely, the controversy over Google, which has just threatened to pull out of China on the grounds that the giant internet group was being both censored and targeted by cyber-hackers? The ambassador seems slightly flustered. “I don’t know the inside story. I don’t know exactly what happened ... I don’t think it’s a clear picture.”

But she soon recovers her poise, noting pointedly that Google apologised last year to Beijing for allowing offensive material on its site (even though the pressure from Beijing that elicited this apology was widely seen in the west as a pretext for renewing state censorship).

As for cyber-attacks, “That is a problem in China and all over the world, so you probably know which country has the best hackers.” The real answer to my Google question comes a few minutes later, and it centres on the Communist party’s determination to maintain its monopoly on information flows and propaganda. As so often with even the most sophisticated Chinese officials, the essence of the argument lies in two words: “political stability”.

“China is in the middle of reform. On the one hand [there is] the importance of maintaining political stability, which is the essential condition for China to grow – and on the other hand, the changing horizon for the government ... I think China is gradually finding the right path and finding the right balance between maintaining political stability while making change, which is one of the most difficult challenges for a government in a developing country. And China is”, she adds, “still a developing country.”

But China is also the coming global power. Does China wish to replace the US as the world’s hegemon? “Deng Xiaoping said China will never be a hegemon. If one day, China becomes one, the world will stand up against China. That is very deep in our hearts. Every diplomat knows that.

“The west should calm down and learn to see China for what it is, not keep speculating and putting their own colour into this painting,” explains Madam Fu, who has a collection of modern Chinese and Mongolian art. “A Chinese painting is watercolour: fresh, very light. If you pour oil on it, you don’t see the painting any more.”

The waiter arrives with Madam Fu’s roly-poly pudding. To show solidarity, I break my informal rule and order a dessert (a poached pear with stem-ginger ice-cream). We have a coffee and tea respectively, and I ask about her next post in Beijing. She treads carefully, noting only that her husband, an anthropologist at the Academy of Social Sciences in Beijing, is, as we speak, en route to London to help with the packing. As I prepare to pay the bill, Fu Ying opens her bag and presents me with a small gift: three tiny, out-of-circulation food coupons from Inner Mongolia, once preserved by her mother. The gift at the end of a meal conforms to Chinese etiquette but it also displays a personal and diplomatic touch (she donated a similar gift last October to the British Museum to mark the 60th anniversary of the People’s Republic).

Earlier Fu Ying had referred to Britain’s strong sense of justice. Now she says she feels a sense of personal accomplishment as well as a sense of history and her own modest place in it. “I think I will be leaving with a few full-stops, but lots of commas. I opened things, but I haven’t accomplished much, but the passage is open. And there are still a few question-marks which will be answered in future.”

Madam Fu’s language is deliberately opaque. For two-and-a-half hours I have listened to a consummate professional; charming, steely, wary. We started to scratch the surface but there is more to come: how about a rematch in Beijing?

Lionel Barber is editor of the FT

2010-01-31T16:16:00.000-05:00

Dead Men Walking
Why 2009's truly top thinkers are yesterday's news.
BY NIALL FERGUSON | DECEMBER 2009
foreignpolicy.com

There is nothing like a really big economic crisis to separate the Cassandras from the Panglosses, the horsemen of the apocalypse from the Kool-Aid-swigging optimists. No, the last year has shown that all is not for the best in the best of all possible worlds. On the contrary, we might be doomed.

At such times, we do well to remember that most of today’s public intellectuals are mere dwarves, standing on the shoulders of giants. So, if they had e-mail in the hereafter, which of the great thinkers of the past would be entitled to send us a message with the subject line: "I told you so"? And which would prefer to remain offline?

It has, for example, been a bad year for Adam Smith (1723-1790) and his "invisible hand," which was supposed to steer the global economy onward and upward to new heights of opulence through the action of individual choice in unfettered markets. By contrast, it has been a good year for Karl Marx (1818-1883), who always maintained that the internal contradictions of capitalism, and particularly its tendency to increase the inequality of the distribution of wealth, would lead to crisis and finally collapse. A special mention is also due to early 20th-century Marxist theorist Rudolf Hilferding (1877-1941), whose Das Finanzkapital foresaw the rise of giant "too big to fail" financial institutions.

Joining Smith in embarrassed silence, you might think, is Friedrich von Hayek (1899-1992), who warned back in 1944 that the welfare state would lead the West down the "road to serfdom." With a government-mandated expansion of health insurance likely to be enacted in the United States, Hayek's libertarian fears appear to have receded, at least in the Democratic Party. It has been a bumper year, on the other hand, for Hayek's old enemy, John Maynard Keynes (1883-1946), whose 1936 work The General Theory of Employment, Interest and Money has become the new bible for finance ministers seeking to reduce unemployment by means of fiscal stimuli. His biographer, Robert Skidelsky, has hailed the "return of the master." Keynes's self-appointed representative on Earth, New York Times columnist Paul Krugman, insists that the application of Keynesian theory, in the form of giant government deficits, has saved the world from a second Great Depression.

The marketplace of ideas has not been nearly so kind this year to the late Milton Friedman (1912-2006), the diminutive doyen of free-market economics. "Inflation," wrote Friedman in a famous definition, "is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output." Well, since September of 2008, Ben Bernanke has been printing dollars like mad at the U.S. Federal Reserve, more than doubling the monetary base. And inflation? As I write, the headline consumer price inflation rate is negative 2 percent. Better throw away that old copy of Friedman's Monetary History of the United States, 1867-1960 (co-authored with Anna J. Schwartz, who is happily still with us).

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The FP Top 100 Global Thinkers
They had the big ideas that shaped our world in 2009.
Invest, instead, in a spanking new edition of The Great Transformation by Karl Polanyi (1886-1964). We surely need Polanyi's more anthropological approach to economics to explain the excesses of the boom and the hysteria of the bust. For what in classical economics could possibly account for the credulity of investors in Bernard Madoff's long-running Ponzi scheme? Or the folly of Richard Fuld, who gambled his personal fortune and reputation on the very slim chance that Lehman Brothers, unlike Bear Stearns and Merrill Lynch, could survive the crisis without being sold to a competitor?

The biggest intellectual losers of all, however, must be the pioneers of the theory of efficient markets -- economists still with us, such as Harry M. Markowitz, the University of Chicago-trained economist who developed the theory of portfolio diversification as the best protection against economic volatility, and William Sharpe, inventor of the capital asset pricing model. In two marvelously lucid books, the late Peter Bernstein extolled their "capital ideas." Now, with so many quantitative hedge funds on the scrap heap, their ideas don't seem quite so capital.

And the biggest winners, among economists at least? Step forward the "Austrians" -- economists like Ludwig von Mises (1881-1973), who always saw credit-propelled asset bubbles as the biggest threat to the stability of capitalism. Not many American economists carried forward their work into the later 20th century, but one heterodox figure has emerged as a posthumous beneficiary of this crisis: Hyman Minsky (1919-1996). At a time when other University of Chicago-trained economists were forging the neoclassical synthesis -- Adam Smith plus applied math -- Minsky developed his own math-free "financial instability hypothesis."

Yet it would surely be wrong to make the Top Dead Thinker of 2009 an economic theorist. The entire discipline of economics has flopped too embarrassingly for that to be appropriate. Instead, we should consider the claims of a historian, because history has served as a far better guide to the current crisis than any economic model. My nominee is the financial historian Charles Kindleberger (1910-2003), who drew on Minsky's work to popularize the idea of financial crisis as a five-stage process, from displacement and euphoric overtrading to full-fledged mania, followed by growing concern and ending up with panic. (If those five steps to financial hell sound familiar, they should. We just went down them, twice in the space of 10 years.)

Of course, history offers more than just the lesson that financial accidents will happen. One of the most important historical truths is that the first draft of history -- the version that gets written on the spot by journalists and other contemporaries -- is nearly always wrong. So though superficially this crisis seems like a defeat for Smith, Hayek, and Friedman, and a victory for Marx, Keynes, and Polanyi, that might well turn out to be wrong. Far from having been caused by unregulated free markets, this crisis may have been caused by distortions of the market from ill-advised government actions: explicit and implicit guarantees to supersize banks, inappropriate empowerment of rating agencies, disastrously loose monetary policy, bad regulation of big insurers, systematic encouragement of reckless mortgage lending -- not to mention distortions of currency markets by central bank intervention.

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Market Riot
How the crisis inspired an entirely new set of big ideas on big money.
By Noam Scheiber
Consider this: The argument for avoiding mass bank failures was made by Friedman, not Keynes. It was Friedman who argued that the principal reason for the depth of the Depression was the Fed's failure to avoid an epidemic of bank failures. It has been Friedman, more than Keynes, who has been Bernanke's inspiration over the past two years, as the Fed chairman has honored a pledge he made shortly before Friedman's death not to preside over another "great contraction." Nor would Friedman have been in the least worried about inflation at a time like this. The Fed's balance sheet may have expanded rapidly, but broader measures of money are growing slowly and credit is contracting. Deflation, not inflation, remains the monetarist fear.

From a free market perspective, the vital thing is that legitimate emergency measures do not become established practices. For it cannot possibly be a healthy state of affairs for the core institutions of the Western financial system to be effectively guaranteed, if not actually owned, by the government. The thinker who most clearly discerned the problems associated with that kind of state intervention was Joseph Schumpeter (1883-1950), whose "creative destruction" has been one of this year's most commonly cited phrases.

"[T]his evolutionary ... impulse that sets and keeps the capitalist engine in motion," wrote Schumpeter in Capitalism, Socialism and Democracy, "comes from ... the new forms of industrial organization that capitalist enterprise creates.... This process of creative destruction is the essential fact about capitalism." This crisis has certainly unleashed enough economic destruction in the world (though its creativity at this stage is still hard to discern). But in the world of the big banks, there has been far too little destruction, and about the only creative thing happening on Wall Street these days is the accounting.

"This economic system," Schumpeter wrote in his earlier The Theory of Economic Development, "cannot do without the ultima ratio [final argument] of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted." Indeed, he saw that the economy remained saddled with too many of "those firms that are unfit to live." That could serve as a painfully accurate description of the Western financial system today.

Yet all those allusions to evolution and fitness to live serve as a reminder of the dead thinker we should all have spent at least part of 2009 venerating: Charles Darwin (1809-1882). This year was not only his bicentennial but the 150th birthday of his paradigm-shifting On the Origin of Species. Just reflect on these sentences from Darwin's seminal work:

"All organic beings are exposed to severe competition."

"As more individuals are produced than can possibly survive, there must in every case be a struggle for existence."

"Each organic being ... has to struggle for life and to suffer great destruction.... The vigorous, the healthy, and the happy survive and multiply."

Thanks in no small measure to the efforts of his modern heirs, notably Richard Dawkins, we are all Darwinians now -- except in the strange parallel worlds of fundamentalist Christianity and state-guaranteed finance.

Neither Cassandra nor Pangloss, Darwin surely deserves to top any list of modern thinkers, dead or alive.

2010-01-29T18:11:00.002-05:00

A global fiasco is brewing in Japan

By Ambrose Evans-Pritchard Economics Last updated: January 12th, 2010

telegraph.co.uk

I have felt rather lonely after suggesting in my New Year Predictions that Japan is dangerously close to blowing up on its sovereign debts, with consequences that will be felt across the world.

My intended point — overly condensed — was that 2010 will prove to be the year that Japan flips from deflation to something very different: the beginnings of debt monetization by a terrified central bank that will ultimately spin out of control, perhaps crossing into hyperinflation by the middle of the decade.

So it is nice to have some company: first from PIMCO’s Paul McCulley, who said that the Bank of Japan should buy “unlimited amounts” of long-term government debt (JGBs) to lift the country out of a “deflationary liquidity trap” and raise the souffle again.

His point is different from mine, in that he discerns deflation “as far as the eye can see”. But in a sense it is the same point. Once a country embarks on such policies, the game is nearly up. The IMF says Japan’s gross public debt will reach 227pc of GDP this year. This is compounding at ever faster speeds towards 250pc by mid-decade.

The only reason why this has not yet blown up is because investors (mostly Japanese) have not yet had the leap in imagination required to understand their predicament, and act on it. That roughly is the argument of Dylan Grice from Societe Generale in his latest Popular Delusions note released today. “A global fiasco is brewing in Japan.”

Japan’s deficits are already within the hyperinflation “red flag” zone identified by historian Peter Bernholz (”Monetary Regimes and Inflation” .. the Bible on this subject). As you can see from the charts below, prices start to spiral into the stratosphere once the deficits as a share of government expenditure rises above a third and stays there for several years.

The Bernholz range for the five hyperinflations of France, Germany, Poland, Brazil, and Bolivia over the centuries is surprisingly wide, from 33pc to 91pc. Japan has been in the that range almost continuously for the last eight years. The US joined the party in 2009. Japan’s Bernholz index will rise above 50pc this year for the first time, meaning that it will have to borrow more from the bond markets than raises in tax revenue. You see the problem.

We all know that Japan has been racking up debt for Two Lost Decades, yet the sky has refused to fall. Borrowing costs have slithered down to 1.36pc on 10-year JGBs and under 1pc on shorter debt, though they are not as low as they were .. nota bene. This seeming defiance of gravity has emboldened the Krugmanites and Keynesian prime-pumpers to call for a repeat in the US, UK, and Europe. There lies a great danger.

Mr Grice said Japan was able to pull off this feat only because its captive saving pool was large enough to cover the short-fall, and because the Japanese people continued to be reassured by the conjurer’s illusion that all was well. This cannot continue.

The country tipped into outright demographic decline in 2005. Households have already stopped adding to their stock of JGBs. As the aging crisis accelerates, the elderly are running down their assets. The savings rate will soon crash below zero.

Japan can turn to foreign investors to plug the gap, or course, but at what price? If yields reached UK or US levels of 4pc, debt costs would soak up nearly all the budget, leaving nothing for schools, roads, the police, or salaries for the Ministry of Finance. “I doubt there is any yield that international capital markets can find acceptable that will not bankrupt the Japanese state,” he said.

Note too that the Japanese will also have to run down their holdings of US Treasuries, currently $750bn or 10pc of the entire stock of US Treasury debt, as well as selling a lot of Gilts and Belgian bonds.

“This might very well precipitate other government funding crises. At the very least I’d expect it to trigger an international bond market rout scary enough to spook all other asset classes. So maybe we should all be concerned that Japan is in the hyperinflationary range. And if so, maybe we should think a little more carefully about how Western governments consider their debt burdens. Maybe Japan’s will be the crisis that wakes up the rest of the world,” he said.

Will it happen, this week, this month, this year, or will Tokyo keep the illusion of solvency going for years longer? Who knows. Japan is an endlessly mystifying society. But as Mr Grice puts it, if you are sitting on a tectonic fault line, expect an earthquake.

2010-01-18T18:57:00.000-05:00

The parable of the sower

Nov 19th 2009 | ST LOUIS
From The Economist print edition

The debate over whether Monsanto is a corporate sinner or saint

FEW companies excite such extreme emotions as Monsanto. To its critics, the agricultural giant is a corporate hybrid of Victor Frankenstein and Ebenezer Scrooge, using science to create foods that threaten the health of both people and the planet, and intellectual-property laws to squeeze every last penny out of the world’s poor. The list of Monsanto’s sins dates back to when (with other firms) it produced Agent Orange, a herbicide notorious for its use by American forces in Vietnam. Recently “Food Inc”, a documentary film, lambasted the company.

To its admirers, the innovations in seeds pioneered by Monsanto are the world’s best hope of tackling a looming global food crisis. Hugh Grant, the firm’s boss since 2003, says that without the sort of technological breakthroughs Monsanto has achieved the world has no chance of doubling agricultural output by 2050 while using less land and water, as many believe it must. Mr Grant, of course, would say that. But he is not alone. Bill Gates sees Monsanto’s innovations as essential to the agricultural revolution in Africa to which his charitable foundation is committed. Josette Sheeran, the head of the United Nations World Food Programme, is also a fan.

Monsanto has come a long way from its roots in pharmaceuticals and chemicals (in which capacity it made Agent Orange). The original company was formed in 1901 to make saccharine. In 2000 it merged with Pharmacia & Upjohn, a drugmaker. Two years later the group’s agricultural activities were spun off into a new Monsanto. At that time the company was best known for Roundup, a herbicide popular with farmers. Roundup is still a leading brand, but margins have been eroded by competition from Chinese producers of other forms of glyphosate weedkiller. Roundup’s share of Monsanto’s revenue is shrinking towards 10%. There is talk that it might be sold. “It is no sacred cow. We look at it every year,” says Mr Grant.

Today most of Monsanto’s $11.7 billion of annual sales come from seeds, increasingly of genetically modified (GM), or transgenic, varieties (see chart), and from licensing genetic traits. Indeed, it is now best known, for better or worse, for applying biotechnology to seed production, winning a string of the sort of patents on living organisms that became legal in America only after a Supreme Court decision in 1980. In July it gave its GM seed a new master brand: Genuity, a name that evokes “being genuine, authentic and original”, according to a company spokesman. It will denote a “family of innovative products that will enable farmers to do what they do best, even better.”

In the 13 years since GM seed was first farmed commercially, agriculture—and Monsanto with it—has become increasingly central to several of the world’s most pressing policy debates, says Mr Grant, a Scot who joined the company in 1981. Nowadays he spends a good deal of his time taking part in those debates, which range from concerns about higher prices and shortages of supply to the use of land for growing biofuels rather than food, climate change and water. Arguments over water, thinks Mr Grant, “will dwarf the discussion that has taken place so far over food.” Monsanto is also getting caught up in the debate over intellectual-property rights in food and their implications for antitrust policy, on which Barack Obama’s administration sounds less friendly than that of George Bush. It has already marked agriculture for attention.

How successful Monsanto and rival makers of GM seed, such as DuPont and Syngenta, are in winning round a sceptical public and policymakers will play a big part in determining how lucrative their innovations prove to be. In public attitudes to GM food, Mr Grant believes “there’s been progress everywhere compared with 15 years ago.” Still, Europe remains “slow, a real slouch. European farmers have been denied the right to choose.” Although the European Union is slowly becoming open to imports of GM food, it is still largely opposed to growing the stuff. Monsanto has still to complete a test of any GM seed in Britain because protesters have destroyed its experiments. In Latin America, by contrast, Argentina and Brazil are both growing GM corn (maize) and soyabeans. In some ways, rising awareness of the food crisis has helped people to see “GM as something with potential benefits other than just boosting the profits of Big Food,” says Mr Grant—to Monsanto’s benefit. Well, maybe.

Turbo-charging Mendel
Monsanto’s innovations fall into two categories. The first is breeding, which seedmakers have been doing with increasing sophistication for decades. Monsanto is able to accelerate the process of selective breeding through better mapping of a seed’s genetic qualities and its suitability to grow in a particular place.

At Monsanto’s research laboratory in St Louis, the company’s home city, farmers on one of the many tours that are part of its marketing efforts are clearly fascinated by a piece of technology known as the corn chipper. A machine picks up an individual seed, rotates it to the right position, then chips off a sample, which has its genetic material analysed. (Getting the seed in the right position is the hardest step, because each one has a different shape and it is crucial that the chipper does not damage the embryo and thus stop the seed from growing properly.) The likely attributes of the plant that would grow from each seed are predicted from its DNA, the most promising seeds are planted, and the process is repeated with the seeds that those plants go on to produce.

The tour guide refers to the operation as “CSI: St Louis”, although testing now goes on all year, at centres around the world. In the past three years this technology has helped speed up dramatically Monsanto’s ability to identify and grow the most productive seed for any given location. “It is the mother and father of all dating agencies: we can analyse every single seed we harvest, do a health check, guess what its grandchildren will be like, send it anywhere in the world,” says Mr Grant.

The second category of innovation, in which Monsanto is becoming increasingly adventurous, is genetic modification: identifying genetic traits with particular qualities and transplanting those traits into seeds to improve their performance. In essence, the goal is to pack as much technology into a seed as possible.

The biggest breakthroughs so far have been in weed and bug control. Perhaps the most common feature of Monsanto’s range of seeds is that they are Roundup Ready, meaning that they are guaranteed to survive spraying with Roundup that will take out any surrounding weeds. Some plants have been bioengineered to deter pests from eating their leaves and roots, which reduces or even eliminates the need for insecticides. Farmers on their tours cannot fail to miss the display cases in which a healthy Monsanto plant grows next to a seriously ailing traditional specimen of the same variety.

Monsanto has just launched two new varieties of seed that have been engineered to be far more productive: Genuity SmartStax corn, which company trials suggest can increase yields by 5-10%; and Genuity Roundup Ready 2 Yield soyabeans, which in trials have shown yields 7-11% higher than the first generation of Roundup Ready soyabeans. Over the past couple of decades, soyabean yields have risen at an annual rate of barely 1%.

In around 2012 or 2013 Monsanto expects to launch a soyabean whose processing will result in fewer transfats. It will also offer an “omega-3 soyabean”, genetically enhanced to give consumers the many proven health benefits of omega-3 fatty acids. Until now, omega-3 has been harvested from fish and so, in Mr Grant’s words, “products with omega-3 in them taste a bit fishy.” Fish derive omega-3 from algae, so Monsanto has done likewise, extracting the relevant genetic material from the algae and putting it into soyabeans. Now, he says, without the fishy taste, omega-3 will go well in yogurts, health bars and so forth.

The company is also aiming to engineer seed to use nitrogen more efficiently—and hence to require less fertiliser. This would reduce farmers’ exposure to the price of oil, from which fertilisers are made, and the damage done when nitrogen leaches into the water supply.

In about three years’ time Monsanto expects to launch its first “drought tolerant” products. It is examining several ways of making plants more tolerant of drought. One is to improve the roots’ take-up of water. Another is to reduce water loss through the leaves. A third is to alter plants’ reaction to lack of water. When stressed, a plant shuts down growth in order to conserve what it has. They often over-react, and use a lot of energy when they restart. Genetic modification can help it interpret water conditions more accurately and avoid unnecessary stops and starts.

Because water shortages are predicted for many parts of the world, Monsanto expects these drought-tolerant plants to be a huge commercial success. The first of them will be corn, intended for a dry strip of America running from northern Texas to the Dakotas. Drought-tolerant technology has also prompted Monsanto to start focusing on dry-land wheat. Wheat acres have declined in recent years, contributing to shortages. In July the company paid $45m for WestBred, a wheat-seed firm.

Trust and antitrust
Acquisitions have been a key part of Monsanto’s strategy, giving it access to new seed markets. In 2005, it began to apply biotech to vegetables after buying Seminis, the world’s largest vegetable-seed company, for $1.4 billion. Since it was spun off, Monsanto has made more than 20 acquisitions (as well as several disposals). Those purchases are one reason why it was singled out as an appropriate target for the antitrust authorities in a paper published in October by the American Antitrust Institute, an independent competition watchdog. The paper laments the “impaired state of competition in transgenic seed”—which it blames on Monsanto above all.

The company’s acquisitions have been crucial in creating the horizontal and vertical integration that support its platforms in cotton, corn and soyabeans. Last year its share of the markets for GM corn and soyabeans was about 65% and that for GM cotton about 45%. The institute’s paper argues that, thanks to its dominance, Monsanto is actually harming innovation in seed. Monsanto had to make concessions to win the antitrust authorities’ approval for two of its biggest purchases, of DeKalb in 1998 and of Delta and Pine Land in 2007.

True, for the past 13 years Monsanto has been licensing its technology broadly, to hundreds of firms, including some of its main competitors. This, the paper concedes, has ensured that Monsanto has not ended up in “control of large, totally closed platforms in transgenic seed that could be challenged only by the unlikely emergence of rival platforms.” However, it cites Monsanto’s reputation for defending its intellectual property fiercely through the courts as another reason why the antitrust authorities should take a look at the firm.

Monsanto’s terms of business require farmers to buy fresh seed every year. Its new Violator Exclusion Policy denies farmers who break the terms of its licences access to all its technology for ever. This summer it achieved its latest success in enforcing its stern line when it won a case against some Canadian farmers who had held on to seed.

Agricultural markets have been mentioned as an area under review by officials in the antitrust division of the Department of Justice. The DoJ is expected to make Google its main target, but it will be no surprise if Monsanto comes a close second. Already, the DoJ is looking into complaints by DuPont, perhaps Monsanto’s fiercest rival. In May Monsanto sued DuPont, alleging that Pioneer, DuPont’s seed arm, had broken licensing terms for herbicide-resistant technology in corn and soyabeans. After an ugly war of words, DuPont countersued and complained to the DoJ.

“We are in a hyper-competitive business. Farmers have no shortage of choice,” insists the unapologetic Mr Grant. “Our goal is to be competitive every spring at the farmer’s table. A farmer may be willing to abdicate the decision on what chemicals to use, but not on what seed to plant. We aim to win one field at a time, one spring at a time.” Enforcing licences is crucial to that strategy. Just as in the drug industry, innovation is expensive: Monsanto has a research and development budget of nearly $1 billion a year, and reckons it costs $100m to bring a new GM seed to market. If there is to be innovation, the firm insists, intellectual property must be protected.

However, Monsanto is using different language—and a different approach from that of big drugmakers—when it comes to dealing with the millions of poor people in Africa. Mr Grant says that he is determined not to repeat the mistakes of the pharmaceutical industry in holding back on making valuable innovations available to the developing world. He believes that “in a perfect world, on the same day you launch [a drought-resistant seed] in Kansas, you would launch it similarly in Nairobi”—although in practice Africa and other poor places that are short of water will have to wait a while longer.

Over the past three years, the firm has started to play a leading role in efforts collectively described as an attempt to create a “green revolution in Africa”. Mr Grant talks enthusiastically about his friendship with Norman Borlaug, the driving force behind the Green Revolution, first in Mexico, then in Asia, in the second half of the past century, which is generally reckoned to have saved at least 1 billion lives. Shortly before his death this year, aged 95, Borlaug reportedly expressed regret that he would not live to see the “gene revolution”.

In white corn, a staple in Africa and Mexico, Monsanto has donated all its intellectual property, seed and know-how for developing drought-tolerant genes to Water Efficient Maize for Africa (WEMA), a public-private partnership that has received grants from the Bill & Melinda Gates Foundation and the foundation of Howard Buffett, an Illinois farmer (and son of Warren Buffett). The five countries to benefit are Kenya, Mozambique, South Africa, Tanzania and Uganda. Mr Grant expects to launch drought-tolerant corn in Africa within two or three years of the launch in America. The company is also working with Millennium Villages, an anti-poverty project led by Jeffrey Sachs, an economist at Columbia University.

Big Pharma versus Big Farma
In contrast to the anti-retroviral drugs that pharmaceutical companies sell in Africa, this product will generate no royalties for Monsanto, says Mr Grant. “The buzzword is the ‘democratisation of technology’ and we have learnt from Big Pharma the dangers of being too slow,” says Mr Grant. The fact that seeds suited to one place do not necessarily grow well elsewhere greatly reduces the risk of parallel imports that affected the drugmakers. They feared that drugs given away in Africa would be shipped back to rich countries, undermining their business there.

That said, he does not believe that Monsanto could or should be expected to solve this problem on its own. “We studied what Borlaug did, which was work with local NGOs, tapped research institutes, brought disparate groups together. The new piece today is getting big companies involved, which hopefully means we can get this done much faster than Borlaug did.”

Mr Grant nonetheless regards this approach as “good business”, not least because the developing world will be a huge source of future growth for the firm. Monsanto sells more GM cotton in India than in America. Already, most of the countries where GM seed is sown are emerging ones. Around 90% of the world’s 12m farmers with at least a hectare planted with GM seed are smallholders in developing countries. America has 250,000-300,000 active farmers; India has 15m cotton farmers alone, several million of whom Monsanto says it has reached already.

This reinforces the firm’s fundamental message, that it is a driving force for higher farm productivity—and that higher productivity, not a return to the methods of the past, is likely to be the true source of agricultural sustainability. In America, GM seed has already brought about huge increases in productivity, says Mr Grant. He has no time for the “Malthusian thing about running out of food. This is eminently solvable.” He sees huge potential in merely raising yields in the rest of the world to levels already achieved in America thanks to better farming practices, Roundup and improved seed productivity. American farmers average about 160 bushels (of 56lb, or 25.5kg) of corn per acre per year, against 60 in Brazil and 27 in sub-Saharan Africa (22 excluding South Africa).

Moreover, even in America there is the potential to double yields again. Already, farmers in Iowa are producing as many as 200 bushels an acre. Mr Grant believes that 300 bushels are achievable by 2030. “We have just scratched the surface,” he says, pointing out that after the first GM crops came on the market in 1996, it took ten years for 1 billion acres to be planted. But the second billion took only another three years. “We are where transistors were in the 1970s.”

2010-01-17T20:06:00.003-05:00

Finance
Wall Street Lays Another Egg
Not so long ago, the dollar stood for a sum of gold, and bankers knew the people they lent to. The author charts the emergence of an abstract, even absurd world—call it Planet Finance—where mathematical models ignored both history and human nature, and value had no meaning.

by Niall Ferguson
vanityfair.com
December 2008

The bigger they come: Uncle Sam and Wall Street take the hardest fall since the Depression.

This year we have lived through something more than a financial crisis. We have witnessed the death of a planet. Call it Planet Finance. Two years ago, in 2006, the measured economic output of the entire world was worth around $48.6 trillion. The total market capitalization of the world’s stock markets was $50.6 trillion, 4 percent larger. The total value of domestic and international bonds was $67.9 trillion, 40 percent larger. Planet Finance was beginning to dwarf Planet Earth.

Planet Finance seemed to spin faster, too. Every day $3.1 trillion changed hands on foreign-exchange markets. Every month $5.8 trillion changed hands on global stock markets. And all the time new financial life-forms were evolving. The total annual issuance of mortgage-backed securities, including fancy new “collateralized debt obligations” (C.D.O.’s), rose to more than $1 trillion. The volume of “derivatives”—contracts such as options and swaps—grew even faster, so that by the end of 2006 their notional value was just over $400 trillion. Before the 1980s, such things were virtually unknown. In the space of a few years their populations exploded. On Planet Finance, the securities outnumbered the people; the transactions outnumbered the relationships.

New institutions also proliferated. In 1990 there were just 610 hedge funds, with $38.9 billion under management. At the end of 2006 there were 9,462, with $1.5 trillion under management. Private-equity partnerships also went forth and multiplied. Banks, meanwhile, set up a host of “conduits” and “structured investment vehicles” (sivs—surely the most apt acronym in financial history) to keep potentially risky assets off their balance sheets. It was as if an entire shadow banking system had come into being.

Then, beginning in the summer of 2007, Planet Finance began to self-destruct in what the International Monetary Fund soon acknowledged to be “the largest financial shock since the Great Depression.” Did the crisis of 2007–8 happen because American companies had gotten worse at designing new products? Had the pace of technological innovation or productivity growth suddenly slackened? No. The proximate cause of the economic uncertainty of 2008 was financial: to be precise, a crunch in the credit markets triggered by mounting defaults on a hitherto obscure species of housing loan known euphemistically as “subprime mortgages.”

Central banks in the United States and Europe sought to alleviate the pressure on the banks with interest-rate cuts and offers of funds through special “term auction facilities.” Yet the market rates at which banks could borrow money, whether by issuing commercial paper, selling bonds, or borrowing from one another, failed to follow the lead of the official federal-funds rate. The banks had to turn not only to Western central banks for short-term assistance to rebuild their reserves but also to Asian and Middle Eastern sovereign-wealth funds for equity injections. When these sources proved insufficient, investors—and speculative short-sellers—began to lose faith.

Beginning with Bear Stearns, Wall Street’s investment banks entered a death spiral that ended with their being either taken over by a commercial bank (as Bear was, followed by Merrill Lynch) or driven into bankruptcy (as Lehman Brothers was). In September the two survivors—Goldman Sachs and Morgan Stanley—formally ceased to be investment banks, signaling the death of a business model that dated back to the Depression. Other institutions deemed “too big to fail” by the U.S. Treasury were effectively taken over by the government, including the mortgage lenders and guarantors Fannie Mae and Freddie Mac and the insurance giant American International Group (A.I.G.).

By September 18 the U.S. financial system was gripped by such panic that the Treasury had to abandon this ad hoc policy. Treasury Secretary Henry Paulson hastily devised a plan whereby the government would be authorized to buy “troubled” securities with up to $700 billion of taxpayers’ money—a figure apparently plucked from the air. When a modified version of the measure was rejected by Congress 11 days later, there was panic. When it was passed four days after that, there was more panic. Now it wasn’t just bank stocks that were tanking. The entire stock market seemed to be in free fall as fears mounted that the credit crunch was going to trigger a recession. Moreover, the crisis was now clearly global in scale. European banks were in much the same trouble as their American counterparts, while emerging-market stock markets were crashing. A week of frenetic improvisation by national governments culminated on the weekend of October 11–12, when the United States reluctantly followed the British government’s lead, buying equity stakes in banks rather than just their dodgy assets and offering unprecedented guarantees of banks’ debt and deposits.

Since these events coincided with the final phase of a U.S. presidential-election campaign, it was not surprising that some rather simplistic lessons were soon being touted by candidates and commentators. The crisis, some said, was the result of excessive deregulation of financial markets. Others sought to lay the blame on unscrupulous speculators: short-sellers, who borrowed the stocks of vulnerable banks and sold them in the expectation of further price declines. Still other suspects in the frame were negligent regulators and corrupt congressmen.

This hunt for scapegoats is futile. To understand the downfall of Planet Finance, you need to take several steps back and locate this crisis in the long run of financial history. Only then will you see that we have all played a part in this latest sorry example of what the Victorian journalist Charles Mackay described in his 1841 book, Extraordinary Popular Delusions and the Madness of Crowds.

Nothing New
As long as there have been banks, bond markets, and stock markets, there have been financial crises. Banks went bust in the days of the Medici. There were bond-market panics in the Venice of Shylock’s day. And the world’s first stock-market crash happened in 1720, when the Mississippi Company—the Enron of its day—blew up. According to economists Carmen Reinhart and Kenneth Rogoff, the financial history of the past 800 years is a litany of debt defaults, banking crises, currency crises, and inflationary spikes. Moreover, financial crises seldom happen without inflicting pain on the wider economy. Another recent paper, co-authored by Rogoff’s Harvard colleague Robert Barro, has identified 148 crises since 1870 in which a country experienced a cumulative decline in gross domestic product (G.D.P.) of at least 10 percent, implying a probability of financial disaster of around 3.6 percent per year.

If stock-market movements followed the normal-distribution, or bell, curve, like human heights, an annual drop of 10 percent or more would happen only once every 500 years, whereas in the case of the Dow Jones Industrial Average it has happened in 20 of the last 100 years. And stock-market plunges of 20 percent or more would be unheard of—rather like people a foot and a half tall—whereas in fact there have been eight such crashes in the past century.

The most famous financial crisis—the Wall Street Crash—is conventionally said to have begun on “Black Thursday,” October 24, 1929, when the Dow declined by 2 percent, though in fact the market had been slipping since early September and had suffered a sharp, 6 percent drop on October 23. On “Black Monday,” October 28, it plunged by 13 percent, and the next day by a further 12 percent. In the course of the next three years the U.S. stock market declined by a staggering 89 percent, reaching its nadir in July 1932. The index did not regain its 1929 peak until November 1954.

That helps put our current troubles into perspective. From its peak of 14,164, on October 9, 2007, to a dismal level of 8,579, exactly a year later, the Dow declined by 39 percent. By contrast, on a single day just over two decades ago—October 19, 1987—the index fell by 23 percent, one of only four days in history when the index has fallen by more than 10 percent in a single trading session.

This crisis, however, is about much more than just the stock market. It needs to be understood as a fundamental breakdown of the entire financial system, extending from the monetary-and-banking system through the bond market, the stock market, the insurance market, and the real-estate market. It affects not only established financial institutions such as investment banks but also relatively novel ones such as hedge funds. It is global in scope and unfathomable in scale.

Had it not been for the frantic efforts of the Federal Reserve and the Treasury, to say nothing of their counterparts in almost equally afflicted Europe, there would by now have been a repeat of that “great contraction” of credit and economic activity that was the prime mover of the Depression. Back then, the Fed and the Treasury did next to nothing to prevent bank failures from translating into a drastic contraction of credit and hence of business activity and employment. If the more openhanded monetary and fiscal authorities of today are ultimately successful in preventing a comparable slump of output, future historians may end up calling this “the Great Repression.” This is the Depression they are hoping to bottle up—a Depression in denial.

To understand why we have come so close to a rerun of the 1930s, we need to begin at the beginning, with banks and the money they make. From the Middle Ages until the mid-20th century, most banks made their money by maximizing the difference between the costs of their liabilities (payments to depositors) and the earnings on their assets (interest and commissions on loans). Some banks also made money by financing trade, discounting the commercial bills issued by merchants. Others issued and traded bonds and stocks, or dealt in commodities (especially precious metals). But the core business of banking was simple. It consisted, as the third Lord Rothschild pithily put it, “essentially of facilitating the movement of money from Point A, where it is, to Point B, where it is needed.”

The system evolved gradually. First came the invention of cashless intra-bank and inter-bank transactions, which allowed debts to be settled between account holders without having money physically change hands. Then came the idea of fractional-reserve banking, whereby banks kept only a small proportion of their existing deposits on hand to satisfy the needs of depositors (who seldom wanted all their money simultaneously), allowing the rest to be lent out profitably. That was followed by the rise of special public banks with monopolies on the issuing of banknotes and other powers and privileges: the first central banks.

With these innovations, money ceased to be understood as precious metal minted into coins. Now it was the sum total of specific liabilities (deposits and reserves) incurred by banks. Credit was the other side of banks’ balance sheets: the total of their assets; in other words, the loans they made. Some of this money might still consist of precious metal, though a rising proportion of that would be held in the central bank’s vault. Most would be made up of banknotes and coins recognized as “legal tender,” along with money that was visible only in current- and deposit-account statements.

Until the late 20th century, the system of bank money retained an anchor in the pre-modern conception of money in the form of the gold standard: fixed ratios between units of account and quantities of precious metal. As early as 1924, the English economist John Maynard Keynes dismissed the gold standard as a “barbarous relic,” but the last vestige of the system did not disappear until August 15, 1971—the day President Richard Nixon closed the so-called gold window, through which foreign central banks could still exchange dollars for gold. With that, the centuries-old link between money and precious metal was broken.

Though we tend to think of money today as being made of paper, in reality most of it now consists of bank deposits. If we measure the ratio of actual money to output in developed economies, it becomes clear that the trend since the 1970s has been for that ratio to rise from around 70 percent, before the closing of the gold window, to more than 100 percent by 2005. The corollary has been a parallel growth of credit on the other side of bank balance sheets. A significant component of that credit growth has been a surge of lending to consumers. Back in 1952, the ratio of household debt to disposable income was less than 40 percent in the United States. At its peak in 2007, it reached 133 percent, up from 90 percent a decade before. Today Americans carry a total of $2.56 trillion in consumer debt, up by more than a fifth since 2000.

Even more spectacular, however, has been the rising indebtedness of banks themselves. In 1980, bank indebtedness was equivalent to 21 percent of U.S. gross domestic product. In 2007 the figure was 116 percent. Another measure of this was the declining capital adequacy of banks. On the eve of “the Great Repression,” average bank capital in Europe was equivalent to less than 10 percent of assets; at the beginning of the 20th century, it was around 25 percent. It was not unusual for investment banks’ balance sheets to be as much as 20 or 30 times larger than their capital, thanks in large part to a 2004 rule change by the Securities and Exchange Commission that exempted the five largest of those banks from the regulation that had capped their debt-to-capital ratio at 12 to 1. The Age of Leverage had truly arrived for Planet Finance.

Credit and money, in other words, have for decades been growing more rapidly than underlying economic activity. Is it any wonder, then, that money has ceased to hold its value the way it did in the era of the gold standard? The motto “In God we trust” was added to the dollar bill in 1957. Since then its purchasing power, relative to the consumer price index, has declined by a staggering 87 percent. Average annual inflation during that period has been more than 4 percent. A man who decided to put his savings into gold in 1970 could have bought just over 27.8 ounces of the precious metal for $1,000. At the time of writing, with gold trading at $900 an ounce, he could have sold it for around $25,000.

Those few goldbugs who always doubted the soundness of fiat money—paper currency without a metal anchor—have in large measure been vindicated. But why were the rest of us so blinded by money illusion?

Blowing Bubbles
In the immediate aftermath of the death of gold as the anchor of the monetary system, the problem of inflation affected mainly retail prices and wages. Today, only around one out of seven countries has an inflation rate above 10 percent, and only one, Zimbabwe, is afflicted with hyperinflation. But back in 1979 at least 7 countries had an annual inflation rate above 50 percent, and more than 60 countries—including Britain and the United States—had inflation in double digits.

Inflation has come down since then, partly because many of the items we buy—from clothes to computers—have gotten cheaper as a result of technological innovation and the relocation of production to low-wage economies in Asia. It has also been reduced because of a worldwide transformation in monetary policy, which began with the monetarist-inspired increases in short-term rates implemented by the Federal Reserve in 1979. Just as important, some of the structural drivers of inflation, such as powerful trade unions, have also been weakened.

By the 1980s, in any case, more and more people had grasped how to protect their wealth from inflation: by investing it in assets they expected to appreciate in line with, or ahead of, the cost of living. These assets could take multiple forms, from modern art to vintage wine, but the most popular proved to be stocks and real estate. Once it became clear that this formula worked, the Age of Leverage could begin. For it clearly made sense to borrow to the hilt to maximize your holdings of stocks and real estate if these promised to generate higher rates of return than the interest payments on your borrowings. Between 1990 and 2004, most American households did not see an appreciable improvement in their incomes. Adjusted for inflation, the median household income rose by about 6 percent. But people could raise their living standards by borrowing and investing in stocks and housing.

Nearly all of us did it. And the bankers were there to help. Not only could they borrow more cheaply from one another than we could borrow from them; increasingly they devised all kinds of new mortgages that looked more attractive to us (and promised to be more lucrative to them) than boring old 30-year fixed-rate deals. Moreover, the banks were just as ready to play the asset markets as we were. Proprietary trading soon became the most profitable arm of investment banking: buying and selling assets on the bank’s own account.

There was, however, a catch. The Age of Leverage was also an age of bubbles, beginning with the dot-com bubble of the irrationally exuberant 1990s and ending with the real-estate mania of the exuberantly irrational 2000s. Why was this?

The future is in large measure uncertain, so our assessments of future asset prices are bound to vary. If we were all calculating machines, we would simultaneously process all the available information and come to the same conclusion. But we are human beings, and as such are prone to myopia and mood swings. When asset prices surge upward in sync, it is as if investors are gripped by a kind of collective euphoria. Conversely, when their “animal spirits” flip from greed to fear, the bubble that their earlier euphoria inflated can burst with amazing suddenness. Zoological imagery is an integral part of the culture of Planet Finance. Optimistic buyers are “bulls,” pessimistic sellers are “bears.” The real point, however, is that stock markets are mirrors of the human psyche. Like Homo sapiens, they can become depressed. They can even suffer complete breakdowns.

This is no new insight. In the 400 years since the first shares were bought and sold on the Amsterdam Beurs, there has been a long succession of financial bubbles. Time and again, asset prices have soared to unsustainable heights only to crash downward again. So familiar is this pattern—described by the economic historian Charles Kindleberger—that it is possible to distill it into five stages:

(1) Displacement: Some change in economic circumstances creates new and profitable opportunities. (2) Euphoria, or overtrading: A feedback process sets in whereby expectation of rising profits leads to rapid growth in asset prices. (3) Mania, or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money. (4) Distress: The insiders discern that profits cannot possibly justify the now exorbitant price of the assets and begin to take profits by selling. (5) Revulsion, or discredit: As asset prices fall, the outsiders stampede for the exits, causing the bubble to burst.

The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks.

The bubbles of our time had their origins in the aftermath of the 1987 stock-market crash, when then novice Federal Reserve chairman Alan Greenspan boldly affirmed the Fed’s “readiness to serve as a source of liquidity to support the economic and financial system.” This sent a signal to the markets, particularly the New York banks: if things got really bad, he stood ready to bail them out. Thus was born the “Greenspan put”—the implicit option the Fed gave traders to be able to sell their stocks at today’s prices even in the event of a meltdown tomorrow.

Having contained a panic once, Greenspan thereafter had a dilemma lurking in the back of his mind: whether or not to act pre-emptively the next time—to prevent a panic altogether. This dilemma came to the fore as a classic stock-market bubble took shape in the mid-90s. The displacement in this case was the explosion of innovation by the technology and software industry as personal computers met the Internet. But, as in all of history’s bubbles, an accommodative monetary policy also played a role. From a peak of 6 percent in February 1995, the federal-funds target rate had been reduced to 5.25 percent by January 1996. It was then cut in steps, in the fall of 1998, down to 4.75 percent, and it remained at that level until June 1999, by which time the Dow had passed the 10,000 mark.

Why did the Fed allow euphoria to run loose in the 1990s? Partly because Greenspan and his colleagues underestimated the momentum of the technology bubble; as early as December 1995, with the Dow just past the 5,000 mark, members of the Fed’s Open Market Committee speculated that the market might be approaching its peak. Partly, also, because Greenspan came to the conclusion that it was not the Fed’s responsibility to worry about asset-price inflation, only consumer-price inflation, and this, he believed, was being reduced by a major improvement in productivity due precisely to the tech boom.

Greenspan could not postpone a stock-exchange crash indefinitely. After Silicon Valley’s dot-com bubble peaked, in March 2000, the U.S. stock market fell by almost half over the next two and a half years. It was not until May 2007 that investors in the Standard & Poor’s 500 had recouped their losses. But the Fed’s response to the sell-off—and the massive shot of liquidity it injected into the financial markets after the 9/11 terrorist attacks—prevented the “correction” from precipitating a depression. Not only were the 1930s averted; so too, it seemed, was a repeat of the Japanese experience after 1989, when a conscious effort by the central bank to prick an asset bubble had ended up triggering an 80 percent stock-market sell-off, a real-estate collapse, and a decade of economic stagnation.

What was not immediately obvious was that Greenspan’s easy-money policy was already generating another bubble—this time in the financial market that a majority of Americans have been encouraged for generations to play: the real-estate market.

The American Dream
Real estate is the English-speaking world’s favorite economic game. No other facet of financial life has such a hold on the popular imagination. The real-estate market is unique. Every adult, no matter how economically illiterate, has a view on its future prospects. Through the evergreen board game Monopoly, even children are taught how to climb the property ladder.

Once upon a time, people saved a portion of their earnings for the proverbial rainy day, stowing the cash in a mattress or a bank safe. The Age of Leverage, as we have seen, brought a growing reliance on borrowing to buy assets in the expectation of their future appreciation in value. For a majority of families, this meant a leveraged investment in a house. That strategy had one very obvious flaw. It represented a one-way, totally unhedged bet on a single asset.

To be sure, investing in housing paid off handsomely for more than half a century, up until 2006. Suppose you had put $100,000 into the U.S. property market back in the first quarter of 1987. According to the Case-Shiller national home-price index, you would have nearly tripled your money by the first quarter of 2007, to $299,000. On the other hand, if you had put the same money into the S&P 500, and had continued to re-invest the dividend income in that index, you would have ended up with $772,000 to play with—more than double what you would have made on bricks and mortar.

There is, obviously, an important difference between a house and a stock-market index. You cannot live in a stock-market index. For the sake of a fair comparison, allowance must therefore be made for the rent you save by owning your house (or the rent you can collect if you own a second property). A simple way to proceed is just to leave out both dividends and rents. In that case the difference is somewhat reduced. In the two decades after 1987, the S&P 500, excluding dividends, rose by a factor of just over six, meaning that an investment of $100,000 would be worth some $600,000. But that still comfortably beat housing.

There are three other considerations to bear in mind when trying to compare housing with other forms of assets. The first is depreciation. Stocks do not wear out and require new roofs; houses do. The second is liquidity. As assets, houses are a great deal more expensive to convert into cash than stocks. The third is volatility. Housing markets since World War II have been far less volatile than stock markets. Yet that is not to say that house prices have never deviated from a steady upward path. In Britain between 1989 and 1995, for example, the average house price fell by 18 percent, or, in inflation-adjusted terms, by more than a third—37 percent. In London, the real decline was closer to 47 percent. In Japan between 1990 and 2000, property prices fell by more than 60 percent.

The recent decline of property prices in the United States should therefore have come as less of a shock than it did. Between July 2006 and June 2008, the Case-Shiller index of home prices in 20 big American cities declined on average by 19 percent. In some of these cities—Phoenix, San Diego, Los Angeles, and Miami—the total decline was as much as a third. Seen in international perspective, those are not unprecedented figures. Seen in the context of the post-2000 bubble, prices have yet to return to their starting point. On average, house prices are still 50 percent higher than they were at the beginning of this process.

So why were we oblivious to the likely bursting of the real-estate bubble? The answer is that for generations we have been brainwashed into thinking that borrowing to buy a house is the only rational financial strategy to pursue. Think of Frank Capra’s classic 1946 movie, It’s a Wonderful Life, which tells the story of the family-owned Bailey Building & Loan, a small-town mortgage firm that George Bailey (played by James Stewart) struggles to keep afloat in the teeth of the Depression. “You know, George,” his father tells him, “I feel that in a small way we are doing something important. It’s satisfying a fundamental urge. It’s deep in the race for a man to want his own roof and walls and fireplace, and we’re helping him get those things in our shabby little office.” George gets the message, as he passionately explains to the villainous slumlord Potter after Bailey Sr.’s death: “[My father] never once thought of himself.… But he did help a few people get out of your slums, Mr. Potter. And what’s wrong with that? … Doesn’t it make them better citizens? Doesn’t it make them better customers?”

There, in a nutshell, is one of the key concepts of the 20th century: the notion that property ownership enhances citizenship, and that therefore a property-owning democracy is more socially and politically stable than a democracy divided into an elite of landlords and a majority of property-less tenants. So deeply rooted is this idea in our political culture that it comes as a surprise to learn that it was invented just 70 years ago.

Fannie, Ginnie, and Freddie
Prior to the 1930s, only a minority of Americans owned their homes. During the Depression, however, the Roosevelt administration created a whole complex of institutions to change that. A Federal Home Loan Bank Board was set up in 1932 to encourage and oversee local mortgage lenders known as savings-and-loans (S&Ls)—mutual associations that took in deposits and lent to homebuyers. Under the New Deal, the Home Owners’ Loan Corporation stepped in to refinance mortgages on longer terms, up to 15 years. To reassure depositors, who had been traumatized by the thousands of bank failures of the previous three years, Roosevelt introduced federal deposit insurance. And by providing federally backed insurance for mortgage lenders, the Federal Housing Administration (F.H.A.) sought to encourage large (up to 80 percent of the purchase price), long (20- to 25-year), fully amortized, low-interest loans.

By standardizing the long-term mortgage and creating a national system of official inspection and valuation, the F.H.A. laid the foundation for a secondary market in mortgages. This market came to life in 1938, when a new Federal National Mortgage Association—nicknamed Fannie Mae—was authorized to issue bonds and use the proceeds to buy mortgages from the local S&Ls, which were restricted by regulation both in terms of geography (they could not lend to borrowers more than 50 miles from their offices) and in terms of the rates they could offer (the so-called Regulation Q, which imposed a low ceiling on interest paid on deposits). Because these changes tended to reduce the average monthly payment on a mortgage, the F.H.A. made home ownership viable for many more Americans than ever before. Indeed, it is not too much to say that the modern United States, with its seductively samey suburbs, was born with Fannie Mae. Between 1940 and 1960, the home-ownership rate soared from 43 to 62 percent.

These were not the only ways in which the federal government sought to encourage Americans to own their own homes. Mortgage-interest payments were always tax-deductible, from the inception of the federal income tax in 1913. As Ronald Reagan said when the rationality of this tax break was challenged, mortgage-interest relief was “part of the American dream.”

In 1968, to broaden the secondary-mortgage market still further, Fannie Mae was split in two—the Government National Mortgage Association (Ginnie Mae), which was to cater to poor borrowers, and a rechartered Fannie Mae, now a privately owned government-sponsored enterprise (G.S.E.). Two years later, to provide competition for Fannie Mae, the Federal Home Loan Mortgage Corporation (Freddie Mac) was set up. In addition, Fannie Mae was permitted to buy conventional as well as government-guaranteed mortgages. Later, with the Community Reinvestment Act of 1977, American banks found themselves under pressure for the first time to lend to poor, minority communities.

These changes presaged a more radical modification to the New Deal system. In the late 1970s, the savings-and-loan industry was hit first by double-digit inflation and then by sharply rising interest rates. This double punch was potentially lethal. The S&Ls were simultaneously losing money on long-term, fixed-rate mortgages, due to inflation, and hemorrhaging deposits to higher-interest money-market funds. The response in Washington from both the Carter and Reagan administrations was to try to salvage the S&Ls with tax breaks and deregulation. When the new legislation was passed, President Reagan declared, “All in all, I think we hit the jackpot.” Some people certainly did.

On the one hand, S&Ls could now invest in whatever they liked, not just local long-term mortgages. Commercial property, stocks, junk bonds—anything was allowed. They could even issue credit cards. On the other, they could now pay whatever interest rate they liked to depositors. Yet all their deposits were still effectively insured, with the maximum covered amount raised from $40,000 to $100,000, thanks to a government regulation two years earlier. And if ordinary deposits did not suffice, the S&Ls could raise money in the form of brokered deposits from middlemen. What happened next perfectly illustrated the great financial precept first enunciated by William Crawford, the commissioner of the California Department of Savings and Loan: “The best way to rob a bank is to own one.” Some S&Ls bet their depositors’ money on highly dubious real-estate developments. Many simply stole the money, as if deregulation meant that the law no longer applied to them at all.

When the ensuing bubble burst, nearly 300 S&Ls collapsed, while another 747 were closed or reorganized under the auspices of the Resolution Trust Corporation, established by Congress in 1989 to clear up the mess. The final cost of the crisis was $153 billion (around 3 percent of the 1989 G.D.P.), of which taxpayers had to pay $124 billion.

But even as the S&Ls were going belly-up, they offered another, very different group of American financial institutions a fast track to megabucks. To the bond traders at Salomon Brothers, the New York investment bank, the breakdown of the New Deal mortgage system was not a crisis but a wonderful opportunity. As profit-hungry as their language was profane, the self-styled “Big Swinging Dicks” at Salomon saw a way of exploiting the gyrating interest rates of the early 1980s.

The idea was to re-invent mortgages by bundling thousands of them together as the backing for new and alluring securities that could be sold as alternatives to traditional government and corporate bonds—in short, to convert mortgages into bonds. Once lumped together, the interest payments due on the mortgages could be subdivided into strips with different maturities and credit risks. The first issue of this new kind of mortgage-backed security (known as a “collateralized mortgage obligation”) occurred in June 1983. The dawn of securitization was a necessary prelude to the Age of Leverage.

Once again, however, it was the federal government that stood ready to pick up the tab in a crisis. For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie, and Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtual government bonds and considered “investment grade.” Between 1980 and 2007, the volume of such G.S.E.-backed mortgage-backed securities grew from less than $200 billion to more than $4 trillion. In 1980 only 10 percent of the home-mortgage market was securitized; by 2007, 56 percent of it was.

These changes swept away the last vestiges of the business model depicted in It’s a Wonderful Life. Once there had been meaningful social ties between mortgage lenders and borrowers. James Stewart’s character knew both the depositors and the debtors. By contrast, in a securitized market the interest you paid on your mortgage ultimately went to someone who had no idea you existed. The full implications of this transition for ordinary homeowners would become apparent only 25 years later.

The Lessons of Detroit
In July 2007, I paid a visit to Detroit, because I had the feeling that what was happening there was the shape of things to come in the United States as a whole. In the space of 10 years, house prices in Detroit, which probably possesses the worst housing stock of any American city other than New Orleans, had risen by more than a third—not much compared with the nationwide bubble, but still hard to explain, given the city’s chronically depressed economic state. As I discovered, the explanation lay in fundamental changes in the rules of the housing game.

I arrived at the end of a borrowing spree. For several years agents and brokers selling subprime mortgages had been flooding Detroit with radio, television, and direct-mail advertisements, offering what sounded like attractive deals. In 2006, for example, subprime lenders pumped more than a billion dollars into 22 Detroit Zip Codes.

These were not the old 30-year fixed-rate mortgages invented in the New Deal. On the contrary, a high proportion were adjustable-rate mortgages—in other words, the interest rate could vary according to changes in short-term lending rates. Many were also interest-only mortgages, without amortization (repayment of principal), even when the principal represented 100 percent of the assessed value of the mortgaged property. And most had introductory “teaser” periods, whereby the initial interest payments—usually for the first two years—were kept artificially low, with the cost of the loan backloaded. All of these devices were intended to allow an immediate reduction in the debt-servicing costs of the borrower.

In Detroit only a minority of these loans were going to first-time buyers. They were nearly all refinancing deals, which allowed borrowers to treat their homes as cash machines, converting their existing equity into cash and using the proceeds to pay off credit-card debts, carry out renovations, or buy new consumer durables. However, the combination of declining long-term interest rates and ever more alluring mortgage deals did attract new buyers into the housing market. By 2005, 69 percent of all U.S. householders were homeowners; 10 years earlier it had been 64 percent. About half of that increase could be attributed to the subprime-lending boom.

Significantly, a disproportionate number of subprime borrowers belonged to ethnic minorities. Indeed, I found myself wondering, as I drove around Detroit, if “subprime” was in fact a new financial euphemism for “black.” This was no idle supposition. According to a joint study by, among others, the Massachusetts Affordable Housing Alliance, 55 percent of black and Latino borrowers in Boston who had obtained loans for single-family homes in 2005 had been given subprime mortgages; the figure for white borrowers was just 13 percent. More than three-quarters of black and Latino borrowers from Washington Mutual were classed as subprime, whereas only 17 percent of white borrowers were. According to a report in The Wall Street Journal, minority ownership increased by 3.1 million between 2002 and 2007.

Here, surely, was the zenith of the property-owning democracy. It was an achievement that the Bush administration was proud of. “We want everybody in America to own their own home,” President George W. Bush had said in October 2002. Having challenged lenders to create 5.5 million new minority homeowners by the end of the decade, Bush signed the American Dream Downpayment Act in 2003, a measure designed to subsidize first-time house purchases in low-income groups. Between 2000 and 2006, the share of undocumented subprime contracts rose from 17 to 44 percent. Fannie Mae and Freddie Mac also came under pressure from the Department of Housing and Urban Development to support the subprime market. As Bush put it in December 2003, “It is in our national interest that more people own their own home.” Few people dissented.

As a business model, subprime lending worked beautifully—as long, that is, as interest rates stayed low, people kept their jobs, and real-estate prices continued to rise. Such conditions could not be relied upon to last, however, least of all in a city like Detroit. But that did not worry the subprime lenders. They simply followed the trail blazed by mainstream mortgage lenders in the 1980s. Having pocketed fat commissions on the signing of the original loan contracts, they hastily resold their loans in bulk to Wall Street banks. The banks, in turn, bundled the loans into high-yielding mortgage-backed securities and sold them to investors around the world, all eager for a few hundredths of a percentage point more of return on their capital. Repackaged as C.D.O.’s, these subprime securities could be transformed from risky loans to flaky borrowers into triple-A-rated investment-grade securities. All that was required was certification from one of the rating agencies that at least the top tier of these securities was unlikely to go into default.

The risk was spread across the globe, from American state pension funds to public-hospital networks in Australia, to town councils near the Arctic Circle. In Norway, for example, eight municipalities, including Rana and Hemnes, invested some $120 million of their taxpayers’ money in C.D.O.’s secured on American subprime mortgages.

In Detroit the rise of subprime mortgages had in fact coincided with a new slump in the inexorably declining automobile industry. That anticipated a wider American slowdown, an almost inevitable consequence of a tightening of monetary policy as the Federal Reserve belatedly raised short-term interest rates from 1 percent to 5.25 percent. As soon as the teaser rates expired and mortgages were reset at new and much higher interest rates, hundreds of Detroit households swiftly fell behind in their mortgage payments. The effect was to burst the real-estate bubble, causing house prices to start falling significantly for the first time since the early 1990s. And the further house prices fell, the more homeowners found themselves with “negative equity”—in other words, owing more money than their homes were worth.

The rest—the chain reaction as defaults in Detroit and elsewhere unleashed huge losses on C.D.O.’s in financial institutions all around the world—you know.

Drunk on Derivatives
Do you, however, know about the second-order effects of this crisis in the markets for derivatives? Do you in fact know what a derivative is? Once excoriated by Warren Buffett as “financial weapons of mass destruction,” derivatives are what make this crisis both unique and unfathomable in its ramifications. To understand what they are, you need, literally, to go back to the future.

For a farmer planting a crop, nothing is more crucial than the future price it will fetch after it has been harvested and taken to market. A futures contract allows him to protect himself by committing a merchant to buy his crop when it comes to market at a price agreed upon when the seeds are being planted. If the market price on the day of delivery is lower than expected, the farmer is protected.

The earliest forms of protection for farmers were known as forward contracts, which were simply bilateral agreements between seller and buyer. A true futures contract, however, is a standardized instrument issued by a futures exchange and hence tradable. With the development of a standard “to arrive” futures contract, along with a set of rules to enforce settlement and, finally, an effective clearinghouse, the first true futures market was born.

Because they are derived from the value of underlying assets, all futures contracts are forms of derivatives. Closely related, though distinct from futures, are the contracts known as options. In essence, the buyer of a “call” option has the right, but not the obligation, to buy an agreed-upon quantity of a particular commodity or financial asset from the seller (“writer”) of the option at a certain time (the expiration date) for a certain price (known as the “strike price”). Clearly, the buyer of a call option expects the price of the underlying instrument to rise in the future. When the price passes the agreed-upon strike price, the option is “in the money”—and so is the smart guy who bought it. A “put” option is just the opposite: the buyer has the right but not the obligation to sell an agreed-upon quantity of something to the seller of the option at an agreed-upon price.

A third kind of derivative is the interest-rate “swap,” which is effectively a bet between two parties on the future path of interest rates. A pure interest-rate swap allows two parties already receiving interest payments literally to swap them, allowing someone receiving a variable rate of interest to exchange it for a fixed rate, in case interest rates decline. A credit-default swap (C.D.S.), meanwhile, offers protection against a company’s defaulting on its bonds.

There was a time when derivatives were standardized instruments traded on exchanges such as the Chicago Board of Trade. Now, however, the vast proportion are custom-made and sold “over the counter” (O.T.C.), often by banks, which charge attractive commissions for their services, but also by insurance companies (notably A.I.G.). According to the Bank for International Settlements, the total notional amounts outstanding of O.T.C. derivative contracts—arranged on an ad hoc basis between two parties—reached a staggering $596 trillion in December 2007, with a gross market value of just over $14.5 trillion.

But how exactly do you price a derivative? What precisely is an option worth? The answers to those questions required a revolution in financial theory. From an academic point of view, what this revolution achieved was highly impressive. But the events of the 1990s, as the rise of quantitative finance replaced preppies with quants (quantitative analysts) all along Wall Street, revealed a new truth: those whom the gods want to destroy they first teach math.

Working closely with Fischer Black, of the consulting firm Arthur D. Little, M.I.T.’s Myron Scholes invented a groundbreaking new theory of pricing options, to which his colleague Robert Merton also contributed. (Scholes and Merton would share the 1997 Nobel Prize in economics.) They reasoned that a call option’s value depended on six variables: the current market price of the stock (S), the agreed future price at which the stock could be bought (L), the time until the expiration date of the option (t), the risk-free rate of return in the economy as a whole (r), the probability that the option will be exercised (N), and—the crucial variable—the expected volatility of the stock, i.e., the likely fluctuations of its price between the time of purchase and the expiration date (s). With wonderful mathematical wizardry, the quants reduced the price of a call option to this formula (the Black-Scholes formula):

in which:

Feeling a bit baffled? Can’t follow the algebra? That was just fine by the quants. To make money from this magic formula, they needed markets to be full of people who didn’t have a clue about how to price options but relied instead on their (seldom accurate) gut instincts. They also needed a great deal of computing power, a force which had been transforming the financial markets since the early 1980s. Their final requirement was a partner with some market savvy in order to make the leap from the faculty club to the trading floor. Black, who would soon be struck down by cancer, could not be that partner. But John Meriwether could. The former head of the bond-arbitrage group at Salomon Brothers, Meriwether had made his first fortune in the wake of the S&L meltdown of the late 1980s. The hedge fund he created with Scholes and Merton in 1994 was called Long-Term Capital Management.

In its brief, four-year life, Long-Term was the brightest star in the hedge-fund firmament, generating mind-blowing returns for its elite club of investors and even more money for its founders. Needless to say, the firm did more than just trade options, though selling puts on the stock market became such a big part of its business that it was nicknamed “the central bank of volatility” by banks buying insurance against a big stock-market sell-off. In fact, the partners were simultaneously pursuing multiple trading strategies, about 100 of them, with a total of 7,600 positions. This conformed to a second key rule of the new mathematical finance: the virtue of diversification, a principle that had been formalized by Harry M. Markowitz, of the Rand Corporation. Diversification was all about having a multitude of uncorrelated positions. One might go wrong, or even two. But thousands just could not go wrong simultaneously.

The mathematics were reassuring. According to the firm’s “Value at Risk” models, it would take a 10-s (in other words, 10-standard-deviation) event to cause the firm to lose all its capital in a single year. But the probability of such an event, according to the quants, was 1 in 10,24—or effectively zero. Indeed, the models said the most Long-Term was likely to lose in a single day was $45 million. For that reason, the partners felt no compunction about leveraging their trades. At the end of August 1997, the fund’s capital was $6.7 billion, but the debt-financed assets on its balance sheet amounted to $126 billion, a ratio of assets to capital of 19 to 1.

There is no need to rehearse here the story of Long-Term’s downfall, which was precipitated by a Russian debt default. Suffice it to say that on Friday, August 21, 1998, the firm lost $550 million—15 percent of its entire capital, and vastly more than its mathematical models had said was possible. The key point is to appreciate why the quants were so wrong.

The problem lay with the assumptions that underlie so much of mathematical finance. In order to construct their models, the quants had to postulate a planet where the inhabitants were omniscient and perfectly rational; where they instantly absorbed all new information and used it to maximize profits; where they never stopped trading; where markets were continuous, frictionless, and completely liquid. Financial markets on this planet followed a “random walk,” meaning that each day’s prices were quite unrelated to the previous day’s, but reflected no more and no less than all the relevant information currently available. The returns on this planet’s stock market were normally distributed along the bell curve, with most years clustered closely around the mean, and two-thirds of them within one standard deviation of the mean. On such a planet, a “six standard deviation” sell-off would be about as common as a person shorter than one foot in our world. It would happen only once in four million years of trading.

But Long-Term was not located on Planet Finance. It was based in Greenwich, Connecticut, on Planet Earth, a place inhabited by emotional human beings, always capable of flipping suddenly and en masse from greed to fear. In the case of Long-Term, the herding problem was acute, because many other firms had begun trying to copy Long-Term’s strategies in the hope of replicating its stellar performance. When things began to go wrong, there was a truly bovine stampede for the exits. The result was a massive, synchronized downturn in virtually all asset markets. Diversification was no defense in such a crisis. As one leading London hedge-fund manager later put it to Meriwether, “John, you were the correlation.”

There was, however, another reason why Long-Term failed. The quants’ Value at Risk models had implied that the loss the firm suffered in August 1998 was so unlikely that it ought never to have happened in the entire life of the universe. But that was because the models were working with just five years of data. If they had gone back even 11 years, they would have captured the 1987 stock-market crash. If they had gone back 80 years they would have captured the last great Russian default, after the 1917 revolution. Meriwether himself, born in 1947, ruefully observed, “If I had lived through the Depression, I would have been in a better position to understand events.” To put it bluntly, the Nobel Prize winners knew plenty of mathematics but not enough history.

One might assume that, after the catastrophic failure of L.T.C.M., quantitative hedge funds would have vanished from the financial scene, and derivatives such as options would be sold a good deal more circumspectly. Yet the very reverse happened. Far from declining, in the past 10 years hedge funds of every type have exploded in number and in the volume of assets they manage, with quantitative hedge funds such as Renaissance, Citadel, and D. E. Shaw emerging as leading players. The growth of derivatives has also been spectacular—and it has continued despite the onset of the credit crunch. Between December 2005 and December 2007, the notional amounts outstanding for all derivatives increased from $298 trillion to $596 trillion. Credit-default swaps quadrupled, from $14 trillion to $58 trillion.

An intimation of the problems likely to arise came in September, when the government takeover of Fannie and Freddie cast doubt on the status of derivative contracts protecting the holders of more than $1.4 trillion of their bonds against default. The consequences of the failure of Lehman Brothers were substantially greater, because the firm was the counter-party in so many derivative contracts.

The big question is whether those active in the market waited too long to set up some kind of clearing mechanism. If, as seems inevitable, there is an upsurge in corporate defaults as the U.S. slides into recession, the whole system could completely seize up.

The China Syndrome
Just 10 years ago, during the Asian crisis of 1997–98, it was conventional wisdom that financial crises were more likely to happen on the periphery of the world economy—in the so-called emerging markets of East Asia and Latin America. Yet the biggest threats to the global financial system in this new century have come not from the periphery but from the core. The explanation for this strange role reversal may in fact lie in the way emerging markets changed their behavior after 1998.

For many decades it was assumed that poor countries could become rich only by borrowing capital from wealthy countries. Recurrent debt crises and currency crises associated with sudden withdrawals of Western money led to a rethinking, inspired largely by the Chinese example.

When the Chinese wanted to attract foreign capital, they insisted that it take the form of direct investment. That meant that instead of borrowing from Western banks to finance its industrial development, as many emerging markets did, China got foreigners to build factories in Chinese enterprise zones—large, lumpy assets that could not easily be withdrawn in a crisis.

The crucial point, though, is that the bulk of Chinese investment has been financed from China’s own savings. Cautious after years of instability and unused to the panoply of credit facilities we have in the West, Chinese households save a high proportion of their rising incomes, in marked contrast to Americans, who in recent years have saved almost none at all. Chinese corporations save an even larger proportion of their soaring profits. The remarkable thing is that a growing share of that savings surplus has ended up being lent to the United States. In effect, the People’s Republic of China has become banker to the United States of America.

The Chinese have not been acting out of altruism. Until very recently, the best way for China to employ its vast population was by exporting manufactured goods to the spendthrift U.S. consumer. To ensure that those exports were irresistibly cheap, China had to fight the tendency for its currency to strengthen against the dollar by buying literally billions of dollars on world markets. In 2006, Chinese holdings of dollars reached 700 billion. Other Asian and Middle Eastern economies adopted much the same strategy.

The benefits for the United States were manifold. Asian imports kept down U.S. inflation. Asian labor kept down U.S. wage costs. Above all, Asian savings kept down U.S. interest rates. But there was a catch. The more Asia was willing to lend to the United States, the more Americans were willing to borrow. The Asian savings glut was thus the underlying cause of the surge in bank lending, bond issuance, and new derivative contracts that Planet Finance witnessed after 2000. It was the underlying cause of the hedge-fund population explosion. It was the underlying reason why private-equity partnerships were able to borrow money left, right, and center to finance leveraged buyouts. And it was the underlying reason why the U.S. mortgage market was so awash with cash by 2006 that you could get a 100 percent mortgage with no income, no job, and no assets.

Whether or not China is now sufficiently “decoupled” from the United States that it can insulate itself from our credit crunch remains to be seen. At the time of writing, however, it looks very doubtful.

Back to Reality
The modern financial system is the product of centuries of economic evolution. Banks transformed money from metal coins into accounts, allowing ever larger aggregations of borrowing and lending. From the Renaissance on, government bonds introduced the securitization of streams of interest payments. From the 17th century on, equity in corporations could be bought and sold in public stock markets. From the 18th century on, central banks slowly learned how to moderate or exacerbate the business cycle. From the 19th century on, insurance was supplemented by futures, the first derivatives. And from the 20th century on, households were encouraged by government to skew their portfolios in favor of real estate.

Economies that combined all these institutional innovations performed better over the long run than those that did not, because financial intermediation generally permits a more efficient allocation of resources than, say, feudalism or central planning. For this reason, it is not wholly surprising that the Western financial model tended to spread around the world, first in the guise of imperialism, then in the guise of globalization.

Yet money’s ascent has not been, and can never be, a smooth one. On the contrary, financial history is a roller-coaster ride of ups and downs, bubbles and busts, manias and panics, shocks and crashes. The excesses of the Age of Leverage—the deluge of paper money, the asset-price inflation, the explosion of consumer and bank debt, and the hypertrophic growth of derivatives—were bound sooner or later to produce a really big crisis.

It remains unclear whether this crisis will have economic and social effects as disastrous as those of the Great Depression, or whether the monetary and fiscal authorities will succeed in achieving a Great Repression, averting a 1930s-style “great contraction” of credit and output by transferring the as yet unquantifiable losses from banks to taxpayers.

Either way, Planet Finance has now returned to Planet Earth with a bang. The key figures of the Age of Leverage—the lax central bankers, the reckless investment bankers, the hubristic quants—are now feeling the full force of this planet’s gravity.

But what about the rest of us, the rank-and-file members of the deluded crowd? Well, we shall now have to question some of our most deeply rooted assumptions—not only about the benefits of paper money but also about the rationale of the property-owning democracy itself.

On Planet Finance it may have made sense to borrow billions of dollars to finance a massive speculation on the future prices of American houses, and then to erect on the back of this trade a vast inverted pyramid of incomprehensible securities and derivatives.

But back here on Planet Earth it suddenly seems like an extraordinary popular delusion.

Niall Ferguson is Laurence A. Tisch Professor of History at Harvard University and a Senior Fellow of the Hoover Institution at Stanford, and the author of The War of the World: Twentieth-Century Conflict and the Descent of the West.

2010-01-17T16:07:00.000-05:00

Lessons Unlearned
Empire Falls
They called it “the American Century,” but the past hundred years actually saw a shift away from Western dominance. Through the long lens of Edward Gibbon’s history, The Decline and Fall of the Roman Empire, Rome 331 and America and Europe 2006 appear to have more than a few problems in common.

by Niall Ferguson
vanityfair.com
October 2006

The decline of Rome was the natural and inevitable effect of immoderate greatness. Prosperity ripened the principle of decay; the causes of destruction multiplied with the extent of conquest. —Edward Gibbon, The Decline and Fall of the Roman Empire, “General Observations on the Fall of the Roman Empire in the West.”

I. It was 230 years ago that Edward Gibbon published the first volume of The Decline and Fall of the Roman Empire, a work conceived, as he put it, “amidst the ruins of the Capitol” in Rome. It was among the shining and still-intact buildings of another capital that I began (presumptuously, no doubt) to imagine a sequel that might be written: the history of the decline of the West, meaning that distinctive complex of beliefs and institutions which originated with the Greeks, was planted across Europe by the Romans, embraced Christianity under the Emperor Constantine, and crossed to the New World with Columbus.

The idea of Western decline is hardly a new one. In the aftermath of the First World War, a prematurely retired German schoolteacher named Oswald Spengler published the first volume of one of the most influential books of the 20th century, Der Untergang des Abendlandes, usually translated as The Decline of the West. These days, however, few people bother with Spengler; his prose is too turgid, his debt to the philosopher Friedrich Nietzsche too large, his influence on the Nazis (for whom he voted but against whom he later turned) too obvious. And no one takes seriously his idiosyncratic theory that civilizations, like the weather, pass through seasons. In any case, events since 1945 have tended to discredit Spengler’s central idea of a Western downfall. It has seemed much more convincing—and perhaps also more gratifying—to portray the history of the 20th century as part of a protracted Occidental ascendancy. “Much of the last three centuries,” wrote the late British historian J. M. Roberts in his book Triumph of the West, published in 1985, “is the story of a triumph of the outright power of the West.” But not only a triumph of Western power, he argued—above all, the triumph of Western civilization.

Just four years later, the 20th century appeared to culminate in a comprehensive Western victory, with the breakup of the Soviet empire in Eastern Europe and the collapse of the Soviet Union itself. Famously, on the very eve of those events, Francis Fukuyama, professor at Johns Hopkins University, was moved to proclaim “the end of history” and the victory of the Western model of liberal and democratic capitalism. Far from suffering its downfall in the 20th century, as Spengler had anticipated, the West appeared to attain its historic zenith. Neoconservatives in the United States, intoxicated by their country’s unrivaled status as a “hyperpower” and its achievement of “full-spectrum dominance” in warfare, wondered only how American primacy could be perpetuated for another “American century.”

Yet in many ways this inversion of Spengler is a fundamental misreading of the trajectory of the last hundred years. Far from being a time of Western ascendancy, the past century has in reality witnessed something more like a re-orientation of the world—albeit only a partial re-orientation—and the relative decline of the West.

In 1900 the West really did rule the world. From the Bosporus to the Bering Strait, from Siberia to Ceylon, nearly all of what was then known as the Orient was under some form of Western imperial rule. The British had long ruled India, the Dutch the East Indies, and the French Indochina; the Americans had just seized the Philippines; the Russians aspired to control Manchuria. All the imperial powers had established parasitical outposts in China. The East, in short, had been subjugated, even if that process involved far more complex negotiations and compromises between rulers and ruled than used to be acknowledged.

Western hegemony was one of the great asymmetries of world history. Taken together, the metropoles of all the Western empires—the American, Belgian, British, Dutch, French, German, Italian, Portuguese, and Spanish—accounted for 7 percent of the world’s land surface and just 18 percent of its population. Their possessions, however, amounted to 37 percent of global territory and 28 percent of mankind. And if we regard the Russian empire as effectively another European empire extending into Asia, the total share of these Western empires rises to more than half the world’s area and population. This was a political globalization unseen before or since.

What enabled the minority in the West to rule the majority in the East in 1900 was not so much scientific knowledge in its own right as its systematic application to both production and destruction. By contrast, the empires of the East, from the Ottoman to the Qing, failed disastrously to modernize themselves. Their economies remained trapped in subsistence agriculture while the West forged ahead, colonizing and industrializing, devouring sugar and burning coal. Their tax systems were inefficient, forcing Oriental rulers to borrow from Western capital bankers. Eastern armies remained long on pageantry and short on firepower, while the West could deploy well-drilled troops equipped with machine guns and heavy artillery. Eastern navies stood no chance against the Western combination of steam and steel.

Nothing symbolized better the humiliation of the East than the Western military intervention to suppress the Boxer Rebellion, in China, in 1900. The rebels, who had menaced Western diplomats and missionaries, relied on martial arts and magic. Having wiped them out, the Western expeditionary force staged a “grand march” through Beijing’s Forbidden City and then undertook punitive raids deep into Shanxi Province, Inner Mongolia, and Manchuria.

Just a few years later, however, the East began to re-assert itself. Japan’s defeat of Russia on land and at sea in 1904–5 marked a turning point in world history. From that point on, the balance of geopolitical power began to turn, slowly and painfully, back toward the more populous part of the world. It is only when the extent of Western dominance in 1900 is appreciated that the true narrative arc of the 20th century reveals itself. This was not “the triumph of the West,” but rather the crisis of the European empires, the ultimate result of which was the revival of the East—beginning in Japan—and the relative decline of the West.

This has not been a decline in the sense that Spengler envisaged: a kind of corrosive metropolitan ennui. Rather, it has been an unexpected but inexorable military decline. It has been a scarcely perceptible economic decline. It has been a subtle but unmistakable cultural decline. Above all, it has been a creeping demographic decline. In short, it has been a decline in precisely the sense that Gibbon understood the decline of Rome’s empire.

According to Gibbon, Rome fell through a combination of external overreach, internal corruption, religious transformation, and barbarian invasion. That the United States—and, perhaps even more, the European Union—might have something to learn from his account is too seldom acknowledged, perhaps because Americans and Europeans like to pretend that their polities today are something more exalted than empires. But suppose for a moment (as the Georgetown University historian Charles Kupchan has suggested in The End of the American Era) that Washington really is the Rome of our time, while Brussels, the headquarters of the European Union, is Byzantium, the city transformed in the fourth century into the second imperial capital, Constantinople. Like the later Roman Empire, the West today has its Western and Eastern halves, though they are separated by the Atlantic rather than the Adriatic. And that is not the only thing we have in common with our Roman predecessors of a millennium and a half ago.

II. The Romans … had acquired the virtues of war and government; by the vigorous exertion of those virtues … they had obtained, in the course of the three succeeding centuries, an absolute empire over many countries.… The limits of the Roman empire still extended from the Western Ocean to the Tigris … but the animating health and vigour were fled.… The barbarians … soon discovered the decline of the Roman empire. —Gibbon, Chapter VII.

There is a well-established American tradition, perhaps best expressed by Gore Vidal in The Decline and Fall of the American Empire, of worrying that the United States might go the way of Rome. But the perennial liberal fear is of the early Roman predicament more than the late one. It is the fear that the republican institutions of the United States—above all, its hallowed Constitution, based on the careful separation of powers—could be corrupted by the ambitions of an imperial presidency. Every time a commander in chief attempts to increase the power of the executive branch, pleading wartime exigency, there is a predictable chorus of “The Republic is in danger.” We have heard that chorus most recently with respect to the status of prisoners detained without trial at Guantánamo Bay and the use of torture in the interrogation of suspected insurgents in Iraq.

Gibbon could scarcely ignore the question of the Roman republic’s decay. Indeed, there is an important passage in The Decline and Fall that specifically deals with the revival of torture as a tool of tyranny. Few generations of Englishmen were more sensitive than Gibbon’s to the charge that their own ideals of liberty were being subverted by the temptations of empire. The year when his first volume appeared was also the year the American colonies used precisely that charge to justify their own bid for independence.

Yet Gibbon’s real interest lay elsewhere, with the period of Roman decline long after republican virtue had yielded to imperial vice. The Decline and Fall is not concerned with the fall of the republic. It is a story that properly begins with the first signs of imperial overstretch. Until the time of the Emperor Julian (A.D. 331–63), Rome could still confidently send its legions as far as the river Tigris. Yet Julian’s invasion of Mesopotamia (present-day Iraq, but then under Persian rule) proved to be his undoing. According to Gibbon, he had resolved, “by the final conquest of Persia, to chastise the haughty nation which had so long resisted and insulted the majesty of Rome.” Although initially victorious at Ctesiphon (approximately 20 miles southeast of modern Baghdad), Julian was forced by his enemy’s scorched-earth policy to retreat back to Roman territory. “As soon as the flames had subsided which interrupted [his] march,” Gibbon relates, “he beheld the melancholy face of a smoking and naked desert.” The Persians harried his famished legions as they withdrew. In one skirmish, Julian himself was fatally wounded.

What had gone wrong? The answer sheds revealing light on some of the problems the United States currently faces in the same troubled region. A recurrent theme of Gibbon’s work is that the Romans gradually lost “the animating health and vigour” which had made them militarily invincible in the glory days of Julian’s predecessor Trajan. They had lost their discipline. They started complaining about the weight of their armor. In a word, they had gone soft. At the same time, like most armies, their fighting effectiveness diminished the farther they were from home.

Most of us take it for granted that the United States Army is the best in the world. It might be more accurate to say that it is the best equipped and the best fed. More doubtful is how well it is configured to win a protracted low-intensity conflict in a country such as Iraq. One sign of the times that might have amused Gibbon has been the recent relaxation of conditions for recruits undergoing basic training. (A friend of mine who was in the army snorted with derision on hearing that trainees are now allowed eight and a half hours of sleep a night.) Another symptom of military malaise has been the heavy reliance of the Defense Department on National Guard and reserve troops, who have at times accounted for about half of the U.S. contingent deployed in Iraq.

The real problem, however, is a simple matter of numbers. To put it bluntly, the United States has a chronic manpower deficit, which means it cannot put enough boots on the ground to maintain law and order in conquered territory. This is not because it lacks young men; it has at least seven times as many as Iraq. It is that it chooses, for a variety of reasons, to employ only a tiny proportion of its population (half of 1 percent) in its armed forces, and to deploy only a fraction of these in overseas conflict zones.

In 1920, to illustrate the difficulty, when British forces quelled a major insurgency in Iraq, they numbered around 135,000. Coincidentally, that is very close to the number of American military personnel currently in that country. The trouble is that the population of Iraq was just over 3 million in 1920, whereas today it is around 26 million. Thus the ratio of Iraqis to foreign forces in 1920 was, at most, 23 to 1. Today it is around 210 to 1. To arrive at a ratio of 23 to 1, roughly one million American troops would be needed. Reinforcements on that scale are, needless to say, inconceivable.

This is the reality of what Michael Ignatieff, the Canadian Liberal politician and scholar, has called “empire lite” in his book of that name. In theory, the American military is a lean and mean fighting machine. In practice, however, downsizing has left it with too few combat soldiers to make a success of imperial policing—a labor-intensive task that renders redundant much of its high-tech hardware.

III. The tranquil and prosperous state of the empire was warmly felt, and honestly confessed, by the provincials as well as Romans.… It was scarcely possible that the eyes of contemporaries should discover in the public felicity the latent causes of decay and corruption. —Gibbon, Chapter II.

You are still not convinced. So, you say, the war in Iraq is not going well. But what about the bigger picture? How can the West possibly be regarded as being in decline when it is so economically dominant in the world? Today the combined output of the six biggest Western economies—Canada, France, Germany, Italy, the United Kingdom, and the United States—exceeds half of total global output. Gross domestic product (G.D.P.) per capita in the United States is more than 30 times higher than it is in the economies of East Asia and the Pacific.

Yet the difference between the West and the Rest is much narrower than it once was. As recently as 1968, American G.D.P. per capita was 127 times higher than that of East Asia. By this measure alone, the gap between West and East has narrowed dramatically in our time. And it will continue to narrow. The International Monetary Fund estimates that the Chinese economy is growing at a rate roughly three times that of the United States. According to Goldman Sachs, China’s G.D.P. will overtake Britain’s this year. By 2041 it is likely to be the biggest economy in the world.

At the same time, the Western economies have vulnerabilities that have been largely obscured by the debt-financed boom of the past five years. America’s gross federal debt now exceeds $8.5 trillion, and if the Congressional Budget Office’s outlook turns out to be correct, we are just a decade away from a $12.8 trillion debt—more than double what President Bush inherited from his predecessor. Moreover, the officially stated borrowings of the federal government are only a small part of the U.S. debt problem. Ordinary American households, too, have gone on a borrowing spree of unprecedented magnitude. U.S. household credit-market debt has risen from just above 45 percent of G.D.P. in the early 1980s to more than 70 percent in recent years. The remarkable resilience of American consumer spending in the past 15 years has been based partly on a collapse in the personal savings rate from around 7.5 percent of income to below zero.

For demographic reasons, Americans need to be saving much more than this. According to the United Nations’ intermediate projections, male life expectancy in the United States will rise from 75 to 80 between now and 2050. The share of the American population that is aged 65 or over will rise from 12 percent to nearly 21 percent. By 2050 the elderly-dependency ratio (the ratio of the population aged 65 years or over to the population aged 15–64) could double. Only a minority of Americans have made adequate private provision for their retirement. That implies that most new retirees in the years ahead will depend to some extent on Social Security, Medicare, and Medicaid. Today, the average retiree receives benefits totaling $21,000 a year from these programs. Multiply that by 37 million (the current number of elderly Americans) and you can see why these programs already consume 42 percent of federal outlays.

All this implies that the federal government has much larger unfunded liabilities than official data imply. If you compare the current value of all projected future government expenditures—including debt-service payments—with the current value of all projected future government receipts, the gap is about $66 trillion, according to calculations by economists Jagadeesh Gokhale, of the Cato Institute, and Kent Smetters, professor at the Wharton School.

Americans, however, are not just borrowing from one another and, in effect, from the next generation. They are also, to a vast extent, borrowing from foreigners. In all but two years since 1992, the gap between the amount of goods and services the United States exports and the amount it imports has grown wider. This year, the current account deficit—which is largely a trade deficit—could rise as high as 7 percent of G.D.P., or nearly double its peak in the mid-1980s. The result is a remarkable accumulation of foreign debt. Estimates of the net international investment position of the United States—the difference between the overseas assets owned by Americans and the American assets owned by foreigners—have declined from a modest positive balance of 8 percent of G.D.P. in the mid-1980s to a huge net liability of minus 22 percent today. In other words, foreigners are accumulating large claims on the future output of the United States. Around 20 percent of corporate bonds are now in foreign hands, and nearly 10 percent of the U.S. stock market.

These are largely hidden weaknesses at present. Yet it cannot be a sign of Western strength that the annual bill for Social Security in the United States ($554 billion) is now larger than the bill for national security ($512 billion). And it cannot be a sign of imperial vigor that the United States needs to rely so heavily on foreign investors—including Asian central banks and Middle Eastern treasuries—to help finance a foreign policy that currently has minimal international support.

IV. The minds of men were gradually reduced to the same level, the fire of genius was extinguished.… The name of Poet was almost forgotten; that of Orator was usurped by the sophists. A cloud of critics, of compilers, of commentators, darkened the face of learning, and the decline of genius was soon followed by the corruption of taste.… This diminutive stature of mankind … was daily sinking below the old standard. —Gibbon, Chapter II.

Perhaps our most perplexing vulnerability, however, is cultural. Gibbon was acute in identifying literary decline as one symptom of a more profound Roman malaise. And if his barbed allusion to the “darkened … face of learning” does not immediately strike a chord, then some of the other symptoms may. While “the corrupt and opulent nobles of Rome gratified every vice that could be collected from the mighty conflux of nations and manners,” Gibbon wrote, “the most lively and splendid amusement of the idle multitude depended on the frequent exhibition of public games and spectacles.” Orgies and circuses are not precisely the favorite pastimes of Western society today. But if you substitute pornography and NASCAR, the parallel is not so far-fetched.

Outwardly, it is true, the institutions that exist to preserve and propagate our culture are in good shape. Never has the percentage of young people attending college been higher. Never have American universities dominated higher education and academic research as they do today. Our museums and concert halls offer more exhibitions and recitals than the enthusiast can possibly hope to attend. And to enter any branch of Barnes & Noble is to be overwhelmed by the sheer number of books being published.

Yet beneath this upper crust of high culture there simmers a less appetizing stew. Few children read for pleasure. Most boys would rather fritter away their time on brutalizing video games such as Grand Theft Auto. Girls no longer play with dolls; they are themselves the dolls, dressed according to the dictates of the fashion industry. Endlessly gaming, chatting, and chilling with their iPods, the next generation already has a more tenuous connection to “Western civilization” than most parents appreciate.

Gibbon’s argument against Roman “luxury” was in part that it sapped the empire’s martial strength. Here, too, there is a striking analogy. For our culture’s sedentary character—our strong preference for watching over doing, for virtual over real action—seems closely correlated to our changing physical shape. Gibbon’s Romans became metaphorical pygmies. We, by contrast, are being transformed into actual giants. We are certainly taller on average than past generations, a consequence of improvements in nutrition. But we are also wider, since we now consume significantly more fats and carbohydrates than we actually need. According to the standard measure of obesity, the body-mass index, the percentage of Americans classified as obese nearly doubled, from 12 percent to 21 percent, between 1991 and 2001. Nearly two-thirds of all American men are officially considered overweight, and nearly three-quarters of those between 45 and 64. Only Western Samoans and Kuwaitis are fatter.

V. The natives of Europe … no longer possessed that public courage which is nourished by the love of independence, the sense of national honor, the presence of danger, and the habit of command.… They … trusted for their defence to a mercenary army. The posterity of their boldest leaders was contented with the rank of citizens. —Gibbon, Chapter II.

Often fat and sometimes fatheaded, the new Romans of the United States are nevertheless less decadent than their counterparts in that part of the new West across the Atlantic, governed from the new Constantinople, Brussels. The United States remains a vigorously Christian country, thanks in part to the invigorating competition there has always been among its multiple denominations and sects. Americans also remain capable of a robust patriotism (though this seems to require regular foreign attacks on U.S. soil to be sustained). And—unlike the Romans—they still have a resilient work ethic.

Things are different in Europe. The Europeans have all but renounced warfare as a tool of policy. Their armies are puny, their weapons inferior. In some areas, standards of physical fitness are even lower than in Middle America. Take Scotland, the land of my birth. Male life expectancy in some parts of Glasgow is now as low as 54. There has been a 350 percent rise in alcohol-related deaths in the last two decades. About 13,000 people die from smoking-related diseases every year. More than a third of Scotland’s 12-year-olds are overweight or clinically obese.

While Americans work, young Europeans are to a remarkable extent idle. In Britain as a whole, more than 5 million adults of working age—nearly 15 percent of the workforce—are now dependent on benefits. Nearly half of those have been living on welfare for more than five years. The reason these people do not show up in the official unemployment statistics is that many of them are counted as unfit for work rather than jobless. Every day, 23 more teenagers in Britain sign up for “incapacity benefit.” This reflects a crisis of public education as much as of public health. As the Organization for Economic Cooperation and Development recently pointed out, an exceptionally large share of British pupils leave school without any qualifications at all. One in six British adults lacks the literacy skills of an 11-year-old. It may be technically correct that the incapacitated are not unemployed. The reality is that they are unemployable.

Most striking of all, Europe has become the world’s first post-Christian society. There was a time when Europe could justly refer to itself as “Christendom”; indeed, this was the most enduring legacy of both Rome and Byzantium. Europeans built the continent’s great cathedrals to accommodate their acts of worship. As pilgrims, missionaries, and conquistadores, they sailed to the four corners of the earth, intent on converting the heathens to the true faith. Now, however, it is they who are the heathens. According to the Gallup International Millennium Survey of religious attitudes, barely 20 percent of Western Europeans attend church services at least once a week, while 47 percent of North Americans and 82 percent of West Africans do. And fully 15 percent of Western Europeans deny that there is any kind of “spirit, God, or life force”—more than 7 times the American figure and 15 times the West African.

The exceptionally low level of British religiousness was perhaps the most striking revelation of a recent ICM Research poll. One in five Britons claims to “attend an organized religious service regularly,” less than half the American figure. And only 19 percent would be willing to die for his or her beliefs, while 71 percent of Americans say they would.

The de-Christianization of Britain is a relatively recent phenomenon, as British religious and cultural historian Callum Brown has shown. For most of the first half of the 20th century, Anglican Easter Day communicants accounted for between 5 and 6 percent of the population of England; it was only after 1960 that the proportion slumped to 2 percent. Figures for the Church of Scotland show a similar trend: steady until 1960, then falling by roughly half. As those figures suggest, British Protestants were not especially observant (compared, for example, with Irish Catholics), but until the late 1950s established-church membership, if not attendance, was relatively high and steady.

Prior to 1960, most marriages in England and Wales were solemnized in a church; then the slide began, down to around 40 percent in the late 1990s. Especially striking is the decline in confirmations of baptized children. Fewer than a fifth of those baptized are now confirmed, roughly half the figure for the period from 1900 to 1960.

Contrary to popular belief, it was not the British Catholic writer G. K. Chesterton who said, “When men stop believing in God, they don’t believe in nothing. They believe in anything.” But he could have said it. Chesterton viewed atheism with the utmost suspicion. Those who disbelieve in God on supposedly rational grounds, he argued, merely become prey to pseudo-religions and superstitions. His neatest formulation was in The Miracle of Moon Crescent, where he wrote, “You all swore you were hard-shelled materialists; and as a matter of fact you were all balanced on the very edge of belief—of belief in almost anything.” Evidence to support his point is now abundantly available in post-Christian Europe, where all kinds of New Age cults and irrational beliefs flourish. Otherwise intelligent people choose apartments on the basis of feng shui. They delude themselves into thinking that attendance at a concert will reduce poverty in Africa. They are simultaneously against poverty and against global warming, when it is precisely the reduction of poverty in Asia that is increasing emissions of carbon dioxide. Drawn to conspiracy theories as the ancients were to superstitions, some Europeans blame the U.S. government for rising sea levels (not to mention the 9/11 terrorist attacks).

With the decline of Christianity, Europe is also experiencing a rise in what politicians euphemistically call “antisocial behavior.” The restrained civility that was once a hallmark of English life has all but vanished, to be replaced by a startling rudeness. Profanity in the street and on television has become the norm. Once, a lifetime ago, an English writer warned of a future in which the state would keep the population under permanent surveillance. Today, George Orwell’s imaginary Big Brother is the name of a television series in which individuals volunteer for surveillance by the rest of the population. Far from being inhibited by their loss of privacy, they glory in mutual degradation. Shame has gone; so has civility. On Friday and Saturday nights, most English city centers become no-go zones where drunken, knife-wielding youths brawl with one another and the police. Another striking symptom of this new primitivism is the extraordinary surge in the popularity of tattoos, once associated with the unruly Picts of the Far North. In this modern decline and fall, it seems, at least some of the barbarians come from within the empire.

VI. A perpetual stream of strangers and provincials flowed into the capacious bosom of Rome. Whatever was strange or odious, whoever was guilty or suspected, might hope, in the obscurity of that immense capital, to elude the vigilance of the law.… It was the just complaint of the ingenuous natives that the capital had attracted the vices of the universe and the manners of the most opposite nations. —Gibbon, Chapters XV and XXXI.

Nothing changed Rome more than immigration. The same is true of the West today. But whereas a large proportion of immigrants to the United States come from countries that were colonized by Roman Catholics and quickly find jobs in America’s dynamic labor market, the situation in Europe is altogether different.

The demographic transformation of the West has its roots in feminism. Legislation against sex discrimination opened all kinds of careers to women that had previously been dominated by men. At the same time, the ready availability of contraception and abortion gave women an unprecedented control over their own fertility. Beginning in the late 1970s, the average Western European couple had fewer than two children. Today the figure is around 1.4, whereas it needs to be slightly higher than 2 for a population to remain constant. Europeans, quite simply, have ceased to reproduce themselves. The United Nations Population Division forecasts that, if Spanish fertility persists at such low levels, within 50 years the country’s population will decline by more than 4 million. The population of Italy will fall by a fifth. The overall reduction in native-born European numbers could be as much as 14 million. Not even two World Wars inflicted such an absolute decline in population.

Meanwhile, however, the combination of relative poverty and religious revival had a very different effect on Europe’s southern and eastern neighbors. Since the 1950s, according to U.N. figures, the crude birthrate in seven of the Muslim countries to the south and east of the Mediterranean—Morocco, Algeria, Tunisia, Libya, Egypt, Jordan, and Syria—has been two or three times the European average. The gap between Pakistan and Britain has been even wider. The total number of children per woman in Britain today is around 1.7. The latest figure for Pakistan, one of the principal sources of immigrants to Britain, is 4.3.

The first wave of immigration to Europe after World War II was a post-imperial phenomenon; people from former colonies migrated in response to apparent labor shortages. Many family members later followed. Now, as European societies age, they are attracting immigrants from rather closer to home—from Eastern Europe especially—but the flow from the Muslim periphery continues, much of it illegal. The trouble is that many of the newcomers are moving to residential ghettos with miserable economic prospects. In France, the Western European country with the largest Muslim population, the unemployment rate among foreign-born residents is more than twice the national average, which, at 9 percent, is already high enough.

Today, around 20 million Muslims make their home in the European Union, and that number is certain to rise, even if Middle East expert Bernard Lewis’s recent prophecy—that Muslims would be a majority in Europe by the end of the 21st century—surely goes too far. Fouad Ajami, director of the Middle East Studies Program at Johns Hopkins University, is more realistic when he anticipates that Muslim “colonization” will continue to be concentrated in certain regions of Europe, just as it was when the Moors ruled southern Spain (which they did from the 8th to the 15th century), or when the Ottomans ruled the Balkans (from the 14th to the 19th).

Those historic parallels are a reminder that Islam played a crucial role in Gibbon’s explanation of the decline and fall of the Roman Empire. For it was Islam that struck a heavy blow to what remained of the Roman Empire in the West when the Moors advanced into France as far as Poitiers, where they were finally halted, in 732. And it was again Islam which finally decapitated what remained of the empire in the East when the Turks sacked Constantinople in 1453.

Gibbon’s account of monotheism is certainly the most controversial part of his great work. It was the spread of Christianity within the Roman world, he argues in the notorious 15th chapter of The Decline and Fall, that tended to dilute the martial values of the Romans. Venerating the Virgin Mary was very different from venerating Mars, the god of war. Yet the monotheism of Muhammad had a very different character from that of Christianity. Islam, in Gibbon’s account, was always a belligerent religion. “The intrepid souls of the Arabs were fired with enthusiasm” by it, he notes. “The death which they had always despised became an object of hope and desire.”

That passage resonates in our own time, when suicide bombers stalk our transport systems, dreaming of heavenly trysts with multiple virgins. The problem, as Europeans have come to understand, is that it takes only a few would-be martyrs within a single Muslim community to produce a calamity.

VII. Gibbon called the decline and fall of the Roman Empire “the greatest, perhaps, and most awful scene in the history of mankind.” Could a still more awful scene be unfolding in the form of the West’s decline and fall? For Gibbon, Rome’s decline was the result of military overstretch, inner decadence, religious conversion, and barbarian invasion. To my mind, all of these are operating today to undermine what remains of Western dominance in the world. If the United States suffers mainly from the first and second, the European Union seems even more afflicted by the third and fourth.

A hundred years ago, as we have seen, the West could justly claim to rule the world. After a century during which one Western empire after another has declined and fallen, that can no longer credibly be claimed. Empires, of course, take time to decline and fall. Gibbon begins his narrative in A.D. 96; he ends it in 1430, more than a millennium later. Yet there can be no question that the pace of imperial descent has quickened in modern times. The longest-lived empire after the Romans was the Ottoman Empire, which endured for 469 years. The East European empires of the Habsburgs and the Romanovs each existed for more than three centuries. The Moguls ruled a substantial part of what is now India for 235 years. Of an almost identical duration was the realm of the Safavids in Persia. The Spanish, Dutch, French, and British empires can all be said to have endured about 300 years. The lifespan of the Portuguese empire was closer to 500.

The empires created in the 20th century, on the other hand, were all of comparatively short duration. The Bolsheviks’ Soviet Union (1922–91) lasted less than 70 years, a meager record indeed, though one not yet equaled by the People’s Republic of China, established in 1949. Japan’s colonial empire, which can be dated from the conquest of Taiwan in 1895, lasted barely 50. Most ephemeral of all modern empires was the so-called Third Reich of Adolf Hitler, which did not extend beyond its predecessor’s borders before 1938 and had retreated within them by the end of 1944. The remaining empires of the West are young by Roman standards. But by the standards of modern times, the United States—at 230 years—is quite long in the tooth. The day when the Capitol in Washington, D.C., will be reduced to a picturesque ruin may seem to us infinitely remote. History—including the greatest historian of them all, Edward Gibbon—suggests that it may come sooner than we think.

Niall Ferguson is Laurence A. Tisch Professor of History at Harvard University and a Senior Fellow of the Hoover Institution at Stanford, and the author of The War of the World: Twentieth-Century Conflict and the Descent of the West.

2010-01-04T10:18:00.001-05:00

The Carter Syndrome
Barack Obama might yet revolutionize America's foreign policy. But if he can't reconcile his inner Thomas Jefferson with his inner Woodrow Wilson, the 44th president could end up like No. 39.
BY WALTER RUSSELL MEAD | JANUARY/FEBRUARY 2010
foreignpolicy.com

Neither a cold-blooded realist nor a bleeding-heart idealist, Barack Obama has a split personality when it comes to foreign policy. So do most U.S. presidents, of course, and the ideas that inspire this one have a long history at the core of the American political tradition. In the past, such ideas have served the country well. But the conflicting impulses influencing how this young leader thinks about the world threaten to tear his presidency apart -- and, in the worst scenario, turn him into a new Jimmy Carter.

Obama's long deliberation over the war in Afghanistan is a case study in presidential schizophrenia: After 94 days of internal discussion and debate, he ended up splitting the difference -- rushing in more troops as his generals wanted, while calling for their departure to begin in July 2011 as his liberal base demanded. It was a sober compromise that suggests a man struggling to reconcile his worldview with the weight of inherited problems. Like many of his predecessors, Obama is not only buffeted by strong political headwinds, but also pulled in opposing directions by two of the major schools of thought that have guided American foreign-policy debates since colonial times.

In general, U.S. presidents see the world through the eyes of four giants: Alexander Hamilton, Woodrow Wilson, Thomas Jefferson, and Andrew Jackson. Hamiltonians share the first Treasury secretary's belief that a strong national government and a strong military should pursue a realist global policy and that the government can and should promote economic development and the interests of American business at home and abroad. Wilsonians agree with Hamiltonians on the need for a global foreign policy, but see the promotion of democracy and human rights as the core elements of American grand strategy. Jeffersonians dissent from this globalist consensus; they want the United States to minimize its commitments and, as much as possible, dismantle the national-security state. Jacksonians are today's Fox News watchers. They are populists suspicious of Hamiltonian business links, Wilsonian do-gooding, and Jeffersonian weakness.

Moderate Republicans tend to be Hamiltonians. Move right toward the Sarah Palin range of the party and the Jacksonian influence grows. Centrist Democrats tend to be interventionist-minded Wilsonians, while on the left and the dovish side they are increasingly Jeffersonian, more interested in improving American democracy at home than exporting it abroad.

Some presidents build coalitions; others stay close to one favorite school. As the Cold War ended, George H.W. Bush's administration steered a largely Hamiltonian course, and many of those Hamiltonians later dissented from his son's war in Iraq. Bill Clinton's administration in the 1990s mixed Hamiltonian and Wilsonian tendencies. This dichotomy resulted in bitter administration infighting when those ideologies came into conflict -- over humanitarian interventions in the Balkans and Rwanda, for example, and again over the relative weight to be given to human rights and trade in U.S. relations with China.

More recently, George W. Bush's presidency was defined by an effort to bring Jacksonians and Wilsonians into a coalition; the political failure of Bush's ambitious approach created the context that made the Obama presidency possible.

Sept. 11, 2001, was one of those rare and electrifying moments that waken Jacksonian America and focus its attention on the international arena. The U.S. homeland was not only under attack, it was under attack by an international conspiracy of terrorists who engaged in what Jacksonians consider dishonorable warfare: targeting civilians. Jacksonian attitudes toward war were shaped by generations of conflict with Native American peoples across the United States and before that by centuries of border conflict in England, Scotland, and Ireland. Against "honorable" enemies who observe the laws of war, one is obliged to fight fair; those who disregard the rules must be hunted down and killed, regardless of technical niceties.

When the United States is attacked, Jacksonians demand action; they leave strategy to the national leadership. But Bush's tough-minded Jacksonian response to 9/11 -- invading Afghanistan and toppling the Taliban government that gave safe haven to the plotters -- gave way to what appeared to be Wilsonian meddling in Iraq. Originally, Bush's argument for overthrowing Saddam Hussein rested on two charges that resonated powerfully with Jacksonians: Hussein was building weapons of mass destruction, and he had close links with al Qaeda. But the war dragged on, and as Hussein's fabled hoards of WMD failed to appear and the links between Iraq and al Qaeda failed to emerge, Bush shifted to a Wilsonian rationale. This was no longer a war of defense against a pending threat or a war of retaliation; it was a war to establish democracy, first in Iraq and then throughout the region. Nation-building and democracy-spreading became the cornerstones of the administration's Middle East policy.

Bush could not have developed a strategy better calculated to dissolve his political support at home. Jacksonians historically have little sympathy for expensive and risky democracy-promoting ventures abroad. They generally opposed the humanitarian interventions in Somalia, Bosnia, and Haiti during the Clinton years; they did not and do not think American young people should die and American treasure should be scattered to spread democracy or protect human rights overseas. Paradoxically, Jacksonians also opposed "cut and run" options to end the war in Iraq even as they lost faith in both Bush and the Republican Party; they don't like wars for democracy, but they also don't want to see the United States lose once troops and the national honor have been committed. In Bush's last year in office, a standoff ensued: The Democratic congressional majorities were powerless to force change in his Iraq strategy and Bush remained free to increase U.S. troop levels, yet the war itself and Bush's rationale for it remained deeply unpopular.

Enter Obama. An early and consistent opponent of the Iraq war, Obama was able to bring together the elements of the Democratic Party's foreign-policy base who were most profoundly opposed to (and horrified by) Bush's policy. Obama made opposition to the Iraq war a centerpiece of his eloquent campaign, drawing on arguments that echoed U.S. anti-war movements all the way back to Henry David Thoreau's opposition to the Mexican-American War.
Like Carter in the 1970s, Obama comes from the old-fashioned Jeffersonian wing of the Democratic Party, and the strategic goal of his foreign policy is to reduce America's costs and risks overseas by limiting U.S. commitments wherever possible. He's a believer in the notion that the United States can best spread democracy and support peace by becoming an example of democracy at home and moderation abroad. More than this, Jeffersonians such as Obama think oversize commitments abroad undermine American democracy at home. Large military budgets divert resources from pressing domestic needs; close association with corrupt and tyrannical foreign regimes involves the United States in dirty and cynical alliances; the swelling national-security state threatens civil liberties and leads to powerful pro-war, pro-engagement lobbies among corporations nourished on grossly swollen federal defense budgets.

While Bush argued that the only possible response to the 9/11 attacks was to deepen America's military and political commitments in the Middle East, Obama initially sought to enhance America's security by reducing those commitments and toning down aspects of U.S. Middle East policy, such as support for Israel, that foment hostility and suspicion in the region. He seeks to pull U.S. power back from the borderlands of Russia, reducing the risk of conflict with Moscow. In Latin America, he has so far behaved with scrupulous caution and, clearly, is hoping to normalize relations with Cuba while avoiding collisions with the "Bolivarian" states of Venezuela, Ecuador, and Bolivia.

Obama seeks a quiet world in order to focus his efforts on domestic reform -- and to create conditions that would allow him to dismantle some of the national-security state inherited from the Cold War and given new life and vigor after 9/11. Preferring disarmament agreements to military buildups and hoping to substitute regional balance-of-power arrangements for massive unilateral U.S. force commitments all over the globe, the president wishes ultimately for an orderly world in which burdens are shared and the military power of the United States is a less prominent feature on the international scene.

While Wilsonians believe that no lasting stability is possible in a world filled with dictatorships, Jeffersonians like Obama argue that even bad regimes can be orderly international citizens if the incentives are properly aligned. Syria and Iran don't need to become democratic states for the United States to reach long-term, mutually beneficial arrangements with them. And it is North Korea's policies, not the character of its regime, that pose a threat to the Pacific region.

At this strategic level, Obama's foreign policy looks a little bit like that of Richard Nixon and Henry Kissinger. In Afghanistan and Iraq, he hopes to extract U.S. forces from costly wars by the contemporary equivalent of the "Vietnamization" policy of the Nixon years. He looks to achieve an opening with Iran comparable to Nixon's rapprochement with communist China. Just as Nixon established a constructive relationship with China despite the radical "Red Guard" domestic policies Chinese leader Mao Zedong was pursuing at the time, Obama does not see ideological conflict as necessarily leading to poor strategic relations between the United States and the Islamic Republic. Just as Nixon and Kissinger sought to divert international attention from their retreat in Indochina by razzle-dazzle global diplomacy that placed Washington at the center of world politics even as it reduced its force posture, so too the Obama administration hopes to use the president's global popularity to cover a strategic withdrawal from the exposed position in the Middle East that it inherited from the Bush administration.

This is both an ambitious and an attractive vision. Success would reduce the level of international tension even as the United States scales back its commitments. The United States would remain, by far, the dominant military power in the world, but it would sustain this role with significantly fewer demands on its resources and less danger of war.

Yet as Obama is already discovering, any president attempting such a Jeffersonian grand strategy in the 21st century faces many challenges. In the 19th-century heyday of Jeffersonian foreign policy in American politics, it was easier for U.S. presidents to limit the country's commitments. Britain played a global role similar to that of the United States today, providing a stable security environment and promoting international trade and investment. Cruising as a free rider in the British world system allowed Americans to reap the benefits of Britain's world order without paying its costs.

As British power waned in the 20th century, Americans faced starker choices. With the British Empire no longer able to provide political and economic security worldwide, the United States had to choose between replacing Britain as the linchpin of world order with all the headaches that entailed or going about its business in a disorderly world. In the 1920s and 1930s, Americans gave this latter course a try; the rapid-fire series of catastrophes -- the Great Depression, World War II, Stalin's bid for Eurasian hegemony -- convinced virtually all policymakers that the first course, risky and expensive as it proved, was the lesser of the two evils.

Indeed, during Franklin D. Roosevelt's first two terms, the United States pursued essentially Jeffersonian policies in Europe and Asia, avoiding confrontations with Germany and Japan. The result was the bloodiest war in world history, not a stable condominium of satisfied powers. Since that time, Jeffersonians have had to come to terms with the vast set of interlocking political, economic, and military commitments that bind the United States to its role in the postwar era. Jeffersonian instincts call for pruning these commitments back, but it is not always easy to know where to cut.

The other schools are generally skeptical about reducing American commitments. Wilsonians interpret Jeffersonian restraint as moral cowardice. Why, they ask, did Obama refuse to meet the sainted Dalai Lama on his way to kowtow to the dictators in Beijing? Jacksonians think it is cowardice pure and simple. And why not stand up to Iran? Hamiltonians may agree with Jeffersonian restraint in particular cases -- they don't want to occupy Darfur either -- but sooner or later they attack Jeffersonians for failing to develop and project sufficient American power in a dangerous world. Moreover, Hamiltonians generally favor free trade and a strong dollar policy; in current circumstances Hamiltonians are also pushing fiscal restraint. Obama will not willingly move far or fast enough to keep them happy.

The widespread criticism of Obama's extended Afghanistan deliberations is a case in point. To a Jeffersonian president, war is a grave matter and such an undesirable course that it should only be entered into with the greatest deliberation and caution; war is truly a last resort, and the costs of rash commitments are more troubling than the costs of debate and delay. Hamiltonians would be more concerned with executing the decision swiftly and with hiding from other powers any impression of division among American counsels. But Obama found harsh critics on all sides: Wilsonians recoiled from the evident willingness of the president to abandon human rights or political objectives to settle the war. Jacksonians did not understand what, other than cowardice or "dithering," could account for his reluctance to support the professional military recommendation. And the most purist of the Jeffersonians -- neoisolationists on both left and right -- turned on Obama as a sellout. Jeffersonian foreign policy is no bed of roses.

In recent history, Jeffersonian foreign policy has often faced attacks from all the other schools of thought. Kissinger's policy of détente was blasted on the right by conservative Republicans who wanted a stronger stand against communism and on the left by human rights Democrats who hated the cynical regional alliances the Nixon Doctrine involved (with the shah of Iran, for example). Carter faced many of the same problems, and the image of weakness and indecision that helped doom his 1980 run for re-election is a perennial problem for Jeffersonian presidents. Obama will have to leap over these hurdles now, too.

It is not only Americans who will challenge the new American foreign policy. Will Russia and Iran respond to Obama's conciliatory approach with reciprocal concessions -- or, emboldened by what they interpret as American weakness and faltering willpower, will they keep pushing forward? Will the president's outreach to the moderate majority of Muslims around the world open an era of better understanding, or will the violent minority launch new attacks that undercut the president's standing at home? Will the president's inability to deliver all the Israeli concessions Arabs would like erode his credibility and contribute to even deeper levels of cynicism and alienation across the Middle East? Can the president execute an orderly reduction in the U.S. military stake in Iraq and Afghanistan without having hostile forces fill the power vacuum? Will Venezuelan leader Hugo Chávez be so impressed with American restraint under Obama that he moderates his own course and ceases to make anti Yanquismo a pillar of his domestic and international policy? Will other countries heed the president's call to assume more international responsibility as the United States reduces its commitments -- or will they fail to fulfill their obligations as stakeholders in the international system?

A Jeffersonian policy of restraint and withdrawal requires cooperation from many other countries, but the prospect of a lower American profile may make others less, rather than more, willing to help the United States.

There is an additional political problem for this president, one that he shares with Carter. In both cases, their basic Jeffersonian approach was balanced in part by a strong attraction to idealistic Wilsonian values and their position at the head of a Democratic Party with a distinct Wilsonian streak. A pure Jeffersonian wants to conserve the shining exceptionalism of the American democratic experience and believes that American values are rooted in U.S. history and culture and are therefore not easily exportable.

For this president, that is too narrow a view. Like Abraham Lincoln, Woodrow Wilson, and Martin Luther King Jr., Barack Obama doesn't just love the United States for what it is. He loves what it should -- and can -- be. Leadership is not the art of preserving a largely achieved democratic project; governing is the art of pushing the United States farther down the road toward the still-distant goal of fulfilling its mission and destiny.

Obama may well believe what he said in his inaugural speech -- "we reject as false the choice between our safety and our ideals" -- but as any president must he is already making exactly those tradeoffs. Why else refuse to meet the Dalai Lama? Why else pledge support to the corrupt regime of President Hamid Karzai in Afghanistan or aid Pakistan despite the dismal track record of both the civil and military arms of the Pakistani government when it comes to transparent use of U.S. resources? Did the administration not renew its efforts to build a relationship with the regime in Tehran even as peaceful democratic protesters were being tortured and raped in its jails? Is Obama not taking "incentives" to Khartoum, a regime that has for more than a decade pursued a policy in Darfur that the U.S. government has labeled genocidal?

It is hard to reconcile the transcendent Wilsonian vision of America's future with a foreign policy based on dirty compromises with nasty regimes. If the government should use its power and resources to help the poor and the victims of injustice at home, shouldn't it do something when people overseas face extreme injustice and extreme peril? The Obama administration cannot easily abandon a human rights agenda abroad. The contradiction between the sober and limited realism of the Jeffersonian worldview and the expansive, transformative Wilsonian agenda is likely to haunt this administration as it haunted Carter's, most fatefully when he rejected calls to let the shah of Iran launch a brutal crackdown to remain in power. Already the Wilsonians in Obama's camp are muttering darkly about his failure to swiftly close the Guantánamo prison camp, his fondness for government secrecy, his halfhearted support for investigating abuses of the past administration, and his failure to push harder for a cap-and-trade bill before the Copenhagen summit.

Over time, these rumblings of discontent will grow, and history will continue to throw curveballs at him. Can this president live with himself if he fails to prevent a new round of genocide in the Great Lakes region of Africa? Can he wage humanitarian war if all else fails? Can he make these tough decisions quickly and confidently when his closest advisors and his political base are deeply and hopelessly at odds?

The Jeffersonian concern with managing America's foreign policy at the lowest possible level of risk has in the past helped presidents develop effective grand strategies, such as George Kennan's early Cold War idea of containment and the early 19th-century Monroe Doctrine. If successful, Obama's restructuring of American foreign policy would be as influential as these classic strategic designs.

Recent decades, however, have seen diminishing Jeffersonian influence in U.S. foreign policy. Americans today perceive problems all over the world; the Jeffersonian response often strikes people as too passive. Kennan's modest form of containment quickly lost ground to Dean Acheson's more muscular and militarized approach of responding to Soviet pressure by building up U.S. and allied forces in Europe and Asia. The Nixon-Kissinger policy of détente was repudiated by both the Republican and Democratic parties. Carter came into the White House hoping to end the Cold War, but by the end of his tenure he was supporting the resistance to the Soviet occupation of Afghanistan, increasing the defense budget, and laying the groundwork for an expanded U.S. presence in the Middle East.

In the 21st century, American presidents have a new set of questions to consider. The nature of the international system and the place of the United States in it will have to be rethought as new powers rise, old ones continue to fade, and attention shifts from the Atlantic to the Pacific. The rapid technological development that is the hallmark of our era will reshape global society at a pace that challenges the ability of every country in the world to manage cascading, accelerating change.

With great dignity and courage, Obama has embarked on a difficult and uncertain journey. The odds, I fear, are not in his favor, and it is not yet clear that his intuitions and instincts amount to the kind of grand design that statesmen like John Quincy Adams and Henry Kissinger produced in the past. But there can be no doubt that American foreign policy requires major rethinking.

At their best, Jeffersonians provide a necessary element of caution and restraint in U.S. foreign policy, preventing what historian Paul Kennedy calls "imperial overstretch" by ensuring that America's ends are proportionate to its means. We need this vision today more than ever: If Obama's foreign policy collapses -- whether sunk by Afghanistan or conflicts not yet foreseen -- into the incoherence and reversals that ultimately marked Carter's well-meaning but flawed approach, it will be even more difficult for future presidents to chart a prudent and cautious course through the rough seas ahead.

2009-11-29T09:32:00.001-05:00

An Empire at Risk
We won the cold war and weathered 9/11. But now economic weakness is endangering our global power.
By Niall Ferguson | NEWSWEEK

Published Nov 28, 2009

From the magazine issue dated Dec 7, 2009

Call it the fractal geometry of fiscal crisis. If you fly across the Atlantic on a clear day, you can look down and see the same phenomenon but on four entirely different scales. At one extreme there is tiny Iceland. Then there is little Ireland, followed by medium-size Britain. They're all a good deal smaller than the mighty United States. But in each case the economic crisis has taken the same form: a massive banking crisis, followed by an equally massive fiscal crisis as the government stepped in to bail out the private financial system.

Size matters, of course. For the smaller countries, the financial losses arising from this crisis are a great deal larger in relation to their gross domestic product than they are for the United States. Yet the stakes are higher in the American case. In the great scheme of things—let's be frank—it does not matter much if Iceland teeters on the brink of fiscal collapse, or Ireland, for that matter. The locals suffer, but the world goes on much as usual.

But if the United States succumbs to a fiscal crisis, as an increasing number of economic experts fear it may, then the entire balance of global economic power could shift. Military experts talk as if the president's decision about whether to send an additional 40,000 troops to Afghanistan is a make-or-break moment. In reality, his indecision about the deficit could matter much more for the country's long-term national security. Call the United States what you like—superpower, hegemon, or empire—but its ability to manage its finances is closely tied to its ability to remain the predominant global military power. Here's why.

The disciples of John Maynard Keynes argue that increasing the federal debt by roughly a third was necessary to avoid Depression 2.0. Well, maybe, though some would say the benefits of fiscal stimulus have been oversold and that the magic multiplier (which is supposed to transform $1 of government spending into a lot more than $1 of aggregate demand) is trivially small.

Credit where it's due. The positive number for third-quarter growth in the United States would have been a lot lower without government spending. Between half and two thirds of the real increase in gross domestic product was attributable to government programs, especially the Cash for Clunkers scheme and the subsidy to first-time home buyers. But we are still a very long way from a self--sustaining recovery. The third-quarter growth number has just been revised downward from 3.5 percent to 2.8 percent. And that's not wholly surprising. Remember, what makes a stimulus actually work is the change in borrowing by the whole public sector. Since the federal government was already running deficits, and since the states are actually raising taxes and cutting spending, the actual size of the stimulus is closer to 4 percent of GDP spread over the years 2007 to 2010—a lot less than that headline 11.2 percent deficit.

Meanwhile, let's consider the cost of this muted stimulus. The deficit for the fiscal year 2009 came in at more than $1.4 trillion—about 11.2 percent of GDP, according to the Congressional Budget Office (CBO). That's a bigger deficit than any seen in the past 60 years—only slightly larger in relative terms than the deficit in 1942. We are, it seems, having the fiscal policy of a world war, without the war. Yes, I know, the United States is at war in Afghanistan and still has a significant contingent of troops in Iraq. But these are trivial conflicts compared with the world wars, and their contribution to the gathering fiscal storm has in fact been quite modest (little more than 1.8 percent of GDP, even if you accept the estimated cumulative cost of $3.2 trillion published by Columbia economist Joseph Stiglitz in February 2008).

And that $1.4 trillion is just for starters. According to the CBO's most recent projections, the federal deficit will decline from 11.2 percent of GDP this year to 9.6 percent in 2010, 6.1 percent in 2011, and 3.7 percent in 2012. After that it will stay above 3 percent for the foreseeable future. Meanwhile, in dollar terms, the total debt held by the public (excluding government agencies, but including foreigners) rises from $5.8 trillion in 2008 to $14.3 trillion in 2019—from 41 percent of GDP to 68 percent.

In other words, there is no end in sight to the borrowing binge. Unless entitlements are cut or taxes are raised, there will never be another balanced budget. Let's assume I live another 30 years and follow my grandfathers to the grave at about 75. By 2039, when I shuffle off this mortal coil, the federal debt held by the public will have reached 91 percent of GDP, according to the CBO's extended baseline projections. Nothing to worry about, retort -deficit-loving economists like Paul Krugman. In 1945, the figure was 113 percent.

Well, let's leave aside the likely huge differences between the United States in 1945 and in 2039. Consider the simple fact that under the CBO's alternative (i.e., more pessimistic) fiscal scenario, the debt could hit 215 percent by 2039. That's right: more than double the annual output of the entire U.S. economy.

Forecasting anything that far ahead is not about predicting the future. Everything hinges on the assumptions you make about demographics, Medicare costs, and a bunch of other variables. For example, the CBO assumes an average annual real GDP growth rate of 2.3 percent over the next 30 years. The point is to show the implications of the current chronic imbalance between federal spending and federal revenue. And the implication is clear. Under no plausible scenario does the debt burden decline. Under one of two plausible scenarios it explodes by a factor of nearly five in relation to economic output.

Another way of doing this kind of exercise is to calculate the net present value of the unfunded liabilities of the Social Security and Medicare systems. One recent estimate puts them at about $104 trillion, 10 times the stated federal debt.

No sweat, reply the Keynesians. We can easily finance $1 trillion a year of new government debt. Just look at the way Japan's households and financial institutions funded the explosion of Japanese public debt (up to 200 percent of GDP) during the two "lost decades" of near-zero growth that began in 1990.

Unfortunately for this argument, the evidence to support it is lacking. American households were, in fact, net sellers of Treasuries in the second quarter of 2009, and on a massive scale. Purchases by mutual funds were modest ($142 billion), while purchases by pension funds and insurance companies were trivial ($12 billion and $10 billion, respectively). The key, therefore, becomes the banks. Currently, according to the Bridgewater hedge fund, U.S. banks' asset allocation to government bonds is about 13 percent, which is relatively low by historical standards. If they raised that proportion back to where it was in the early 1990s, it's conceivable they could absorb "about $250 billion a year of government bond purchases." But that's a big "if." Data for October showed commercial banks selling Treasuries.

That just leaves two potential buyers: the Federal Reserve, which bought the bulk of Treasuries issued in the second quarter; and foreigners, who bought $380 billion. Morgan Stanley's analysts have crunched the numbers and concluded that, in the year ending June 2010, there could be a shortfall in demand on the order of $598 billion—about a third of projected new issuance.

Of course, our friends in Beijing could ride to the rescue by increasing their already vast holdings of U.S. government debt. For the past five years or so, they have been amassing dollar--denominated international reserves in a wholly unprecedented way, mainly as a result of their interventions to prevent the Chinese currency from appreciating against the dollar.

Right now, the People's Republic of China holds about 13 percent of U.S. government bonds and notes in public hands. At the peak of this process of reserve accumulation, back in 2007, it was absorbing as much as 75 percent of monthly Treasury issuance.

But there's no such thing as a free lunch in the realm of international finance. According to Fred Bergsten of the Peterson Institute for International Economics, if this trend were to continue, the U.S. -current-account deficit could rise to 15 percent of GDP by 2030, and its net debt to the rest of the world could hit 140 percent of GDP. In such a scenario, the U.S. would have to pay as much as 7 percent of GDP every year to foreigners to service its external borrowings.

Could that happen? I doubt it. For one thing, the Chinese keep grumbling that they have far too many Treasuries already. For another, a significant dollar depreciation seems more probable, since the United States is in the lucky position of being able to borrow in its own currency, which it reserves the right to print in any quantity the Federal Reserve chooses.

Now, who said the following? "My prediction is that politicians will eventually be tempted to resolve the [fiscal] crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar."

Seems pretty reasonable to me. The surprising thing is that this was none other than Paul Krugman, the high priest of Keynesianism, writing back in March 2003. A year and a half later he was comparing the U.S. deficit with Argentina's (at a time when it was 4.5 percent of GDP). Has the economic situation really changed so drastically that now the same Krugman believes it was "deficits that saved us," and wants to see an even larger deficit next year? Perhaps. But it might just be that the party in power has changed.

History strongly supports the proposition that major financial crises are followed by major fiscal crises. "On average," write Carmen Reinhart and Kenneth Rogoff in their new book, This Time Is Different, "government debt rises by 86 percent during the three years following a banking crisis." In the wake of these debt explosions, one of two things can happen: either a default, usually when the debt is in a foreign currency, or a bout of high inflation that catches the creditors out. The history of all the great European empires is replete with such episodes. Indeed, serial default and high inflation have tended to be the surest symptoms of imperial decline.

As the U.S. is unlikely to default on its debt, since it's all in dollars, the key question, therefore, is whether we are going to see the Fed "printing money"—buying newly minted Treasuries in exchange for even more newly minted greenbacks—followed by the familiar story of rising prices and declining real-debt burdens. It's a scenario many investors around the world fear. That is why they are selling dollars. That is why they are buying gold.

Yet from where I am sitting, inflation is a pretty remote prospect. With U.S. unemployment above 10 percent, labor unions relatively weak, and huge quantities of unused capacity in global manufacturing, there are none of the pressures that made for stagflation (low growth plus high prices) in the 1970s. Public expectations of inflation are also very stable, as far as can be judged from poll data and the difference between the yields on regular and inflation-protected bonds.

So here's another scenario—which in many ways is worse than the inflation scenario. What happens is that we get a rise in the real interest rate, which is the actual interest rate minus inflation. According to a substantial amount of empirical research by economists, including Peter Orszag (now at the Office of Management and Budget), significant increases in the debt-to-GDP ratio tend to increase the real interest rate. One recent study concluded that "a 20 percentage point increase in the U.S. government-debt-to-GDP ratio should lead to a 20–120 basis points [0.2–1.2 percent] increase in real interest rates." This can happen in one of three ways: the nominal interest rate rises and inflation stays the same; the nominal rate stays the same and inflation falls; or—the nightmare case—the nominal interest rate rises and inflation falls.

Today's Keynesians deny that this can happen. But the historical evidence is against them. There are a number of past cases (e.g., France in the 1930s) when nominal rates have risen even at a time of deflation. What's more, it seems to be happening in Japan right now. Just last week Hirohisa Fujii, Japan's new finance minister, admitted that he was "highly concerned" about the recent rise in Japanese government bond yields. In the very same week, the government admitted that Japan was back in deflation after three years of modest price increases.

It's not inconceivable that something similar could happen to the United States. Foreign investors might ask for a higher nominal return on U.S. Treasuries to compensate them for the weakening dollar. And inflation might continue to surprise us on the downside. After all, consumer price inflation is in negative territory right now.

Why should we fear rising real interest rates ahead of inflation? The answer is that for a heavily indebted government and an even more heavily indebted public, they mean an increasingly heavy debt-service burden. The relatively short duration (maturity) of most of these debts means that a large share has to be rolled over each year. That means any rise in rates would feed through the system scarily fast.

Already, the federal government's interest payments are forecast by the CBO to rise from 8 percent of revenues in 2009 to 17 percent by 2019, even if rates stay low and growth resumes. If rates rise even slightly and the economy flatlines, we'll get to 20 percent much sooner. And history suggests that once you are spending as much as a fifth of your revenues on debt service, you have a problem. It's all too easy to find yourself in a vicious circle of diminishing credibility. The investors don't believe you can afford your debts, so they charge higher interest, which makes your position even worse.

This matters more for a superpower than for a small Atlantic island for one very simple reason. As interest payments eat into the budget, something has to give—and that something is nearly always defense expenditure. According to the CBO, a significant decline in the relative share of national security in the federal budget is already baked into the cake. On the Pentagon's present plan, defense spending is set to fall from above 4 percent now to 3.2 percent of GDP in 2015 and to 2.6 percent of GDP by 2028.

Over the longer run, to my own estimated departure date of 2039, spending on health care rises from 16 percent to 33 percent of GDP (some of the money presumably is going to keep me from expiring even sooner). But spending on everything other than health, Social Security, and interest payments drops from 12 percent to 8.4 percent.

This is how empires decline. It begins with a debt explosion. It ends with an inexorable reduction in the resources available for the Army, Navy, and Air Force. Which is why voters are right to worry about America's debt crisis. According to a recent Rasmussen report, 42 percent of Americans now say that cutting the deficit in half by the end of the president's first term should be the administration's most important task—significantly more than the 24 percent who see health-care reform as the No. 1 priority. But cutting the deficit in half is simply not enough. If the United States doesn't come up soon with a credible plan to restore the federal budget to balance over the next five to 10 years, the danger is very real that a debt crisis could lead to a major weakening of American power.

The precedents are certainly there. Habsburg Spain defaulted on all or part of its debt 14 times between 1557 and 1696 and also succumbed to inflation due to a surfeit of New World silver. Prerevolutionary France was spending 62 percent of royal revenue on debt service by 1788. The Ottoman Empire went the same way: interest payments and amortization rose from 15 percent of the budget in 1860 to 50 percent in 1875. And don't forget the last great English-speaking empire. By the interwar years, interest payments were consuming 44 percent of the British budget, making it intensely difficult to rearm in the face of a new German threat.

Call it the fatal arithmetic of imperial decline. Without radical fiscal reform, it could apply to America next.

Ferguson is Laurence A. Tisch professor of history at Harvard and the author of The Ascent of Money.

2009-11-03T12:19:00.000-05:00

Op-Ed Contributor Beijing's 'Marshall Plan'
By BEN SIMPFENDORFER
NYT
November 4, 2009

China’s foreign policy is about to change, and not entirely by choice.

The country’s engagement with the developing world has accelerated markedly in the wake of the economic crisis. And for all the focus on Beijing’s relationship with Washington, it is Beijing’s relationship with the emerging world’s capitals, from Cairo to New Delhi, that may contain the greater surprise.

In the past months, a series of Chinese academics have proposed using the country’s foreign-exchange reserves to finance infrastructure projects in the developing world. The economist Xu Shanda has called for a Chinese “Marshall Plan” to boost demand for Chinese goods. A governor of the People’s Bank of China, Zhou Xiaochuan, has argued for establishing a supra-sovereign wealth fund to invest in the developing world.

It is an idea born of opportunism and necessity. The opportunism arises from the difficulties the emerging world has in financing infrastructure projects, especially as foreign banks retreat to their home markets. China benefits from such infrastructure, whether it is railways to ship copper from Afghanistan, or industrial parks to produce goods in Egypt.

Necessity stems from the challenges China faces in investing nearly $2.3 billion worth of foreign reserves. Over 65 percent are invested in U.S. assets, and thus exposed to the risks of a weak dollar or rising yields. Diversification is necessary. Investment in foreign infrastructure offers a useful alternative.

China may not have a choice in the matter. Its relations with the emerging world are about to face serious challenges, and development aid would be a positive response. How so?

China’s exports to the emerging world have surged from $190 billion to $670 billion in the past five years. China has captured market share in almost all emerging market countries to produce factory closures and job losses from India to Syria. Export subsidies and a currency effectively pegged to the dollar have only aided Chinese exporters in the past year.

For the past decade, China was seen as a natural leader of the emerging world, as it challenged the West’s economic hegemony. But China is now of a sufficient size to challenge the emerging world itself. And China’s image will deteriorate markedly unless the emerging world starts to share in the benefits of the country’s spectacular economic rise.

Indeed, in a recent debate on the “Marshall Plan,” a number of Chinese academics argued that the draft plan focuses overly on selling more goods to emerging markets as a way to reduce China’s overcapacity problems. The same academics warned that unless more attention was paid to creating jobs for locals and raising living standards, the plan might yet fail.

The challenge for China is its policy of nonintervention. This prevents Beijing from taking positions on issues like the Israel-Palestine conflict. It is a strategy that has enabled China to avoid entanglement in complex political issues. But it also limits the country’s policy options in trying to exert its weight in the emerging world.

A case in point: Saudi Arabia provided $60 million in aid for reconstruction in Sichuan following the earthquake in 2008. But when China provided only $2 million in aid for reconstruction programs after the war in Gaza, Arab sentiment toward China reportedly weakened.

It thus makes sense that China follows the Japan model. Japan rarely intervenes in another country’s internal politics. But it is one of the world’s largest providers of development aid. For example, Tokyo provides over $1 billion in aid to the Middle East annually, a large share of it to the Palestinians. This helps to bolster Japan’s image in the region.

It is this convergence of opportunism and necessity that will shortly produce a change in China’s foreign policy and spur its development aid.

For all the talk of a supra-sovereign wealth fund, it is more likely that China will offer aid bilaterally, thus more directly benefiting Chinese companies and providing much-needed burnishing of China’s reputation abroad. This development aid likely will go to countries with large domestic markets or commodity resources. Africa, the Middle East and Latin America will rank high.

Take the acquisition of Afghanistan’s Aynak copper mine by the Mettallurgical Corporation of China. The company’s bid was successful largely because it was linked to development aid, specifically the construction of electricity generation, road and rail projects, as James Yeager, a former adviser to the Afghanistan Ministry of Mines, noted in a report published this month.

China’s rapid accumulation of foreign reserves is unsustainable. Its commercial push into the emerging world is untenable. The economic crisis has brought about big shifts in the global economy. But bigger shifts are yet to come. And it is within the emerging world itself that the bigger surprises from China will lie.

Ben Simpfendorfer is the chief China economist for the Royal Bank of Scotland and the author of “The New Silk Road.”

2009-11-02T08:42:00.000-05:00

Mother of all carry trades faces an inevitable bust
By Nouriel Roubini

Published: November 1 2009 18:44 | Last updated: November 1 2009 18:44
ft.com

Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply , while government bond yields have gently increased but stayed low and stable.

This recovery in risky assets is in part driven by better economic fundamentals. We avoided a near depression and financial sector meltdown with a massive monetary, fiscal stimulus and bank bail-outs. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.

But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage-backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

While this policy feeds the global asset bubble it is also feeding a new US asset bubble. Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble. Finally, a weak dollar is good for US equities as it may lead to higher growth and makes the foreign currency profits of US corporations abroad greater in dollar terms.

The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy. Near-zero policy rates and quantitative easing were already in place in the UK, eurozone, Japan, Sweden and other advanced economies, but the dollar weakness is making this global monetary easing worse. Central banks in Asia and Latin America are worried about dollar weakness and are aggressively intervening to stop excessive currency appreciation. This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day.

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

The writer is a professor at New York University’s Stern School of Business and chairman of Roubini Global Economics

2009-11-01T17:40:00.002-05:00

Oil, Ideology Keep China From Joining Push Against Iran

By John Pomfret
Washington Post Staff Writer
Wednesday, September 30, 2009

In its effort to muster support for sterner action against Iran, the Obama administration will have to overcome China's reluctance to punish a country that is one of its top oil suppliers and a major beneficiary of its energy-related investments.

The administration's frustration with Beijing is growing. U.S. officials have noted that China has appeared even more reluctant than Russia to take action against Iran after disclosures about its nuclear program. U.S. officials said they are particularly concerned that China has blocked their efforts to target freight-forwarding companies based in Hong Kong that reship goods, including prohibited weaponry, to Iran.

The Chinese "have not displayed a sense of urgency" on Iran, said a senior administration official. Instead, the official said, China has attempted to "have it both ways," preserving its relationship with Iran while also working with the United States and other countries involved in the effort to prevent Iran from developing a nuclear weapon.

Why is China protecting Iran? Two reasons, analysts say: oil and ideology.

Iran is China's second-biggest supplier of oil, and imports are rising. In a country where more people are expected to buy cars this year than in the United States, China's appetite for oil is unquenchable.

Furthermore, China's rapid economic growth is the ruling Communist Party's single most important claim to legitimacy. Tougher economic sanctions against Iran would probably cause the price of oil to spike in China, threatening its economic juggernaut.

China's investments in Iran also lessen the likelihood that Beijing will support enhanced sanctions. China's state-run oil behemoths have committed so much money to Iran -- an estimated $120 billion over the past five years -- that analysts estimate that its engineering firms will not be able to handle all the work.

Over the past five years, Chinese firms have moved in on projects that Western and Japanese firms have left dangling. In 2004, Sinopec, also known as China Petroleum and Chemical Corp., signed a $70 billion deal to develop the Yadavaran oil field and buy 10 million metric tons of liquefied natural gas from Iran every year for 25 years.

In June, China National Petroleum Corp. signed a $5 billion contract with National Iranian Oil Co. to develop the massive South Pars gas field, after the Iranians accused French oil producer Total SA -- which had signed an initial agreement to develop the fields -- of delaying the project.

"While we in the West are going through economic hari-kiri, the Chinese are out there taking all of the oil and gas deals," said Michael Economides, professor of chemical engineering at the University of Houston and author of the forthcoming "Energy: China's Choke Point." "The Chinese don't look at Iran as the country of the mullahs that everybody is afraid of; they look at it as a country with lots of oil and gas. Every time I go to China, they ask me, 'Why are you in the West letting us have it so easy?' "

China's investments are also helping shield Iran against the prospect of what Secretary of State Hillary Rodham Clinton contended last week would be "crippling" sanctions. Specifically, Sinopec Engineering has signed contracts worth more than $5 billion to either expand or build four refineries there.

Gal Luft, executive director of the Institute for the Analysis of Global Security, said Iran has dropped its reliance on gasoline imports from 40 percent to 25 percent. That explains, in part, why Western powers appear less interested than they once were in targeting such imports with sanctions.

"There is a lot of hype about gasoline sanctions, but they are not going to be very effective," Luft said. "We've missed the boat on this one."

At the Group of 20 meeting last week, China's statement on Iran was significantly weaker than that of Russia. China called on Iran to cooperate with the International Atomic Energy Agency (IAEA), but it subsequently said sanctions were not the way to go.

In addition, China has declined to cooperate with a U.S. Treasury Department program to crack down on freight-forwarding companies based in Hong Kong, according to government officials and analysts.

"The Chinese government has also been stepping in to protect Iranians targeted by U.S. enforcement efforts," Michael Jacobson, a senior fellow at the Washington Institute for Near East Policy, wrote in a paper in August. In the most prominent case so far, China blocked the extradition to the United States from Hong Kong of an Iranian procurement agent who had been indicted in New York on charges of attempting to acquire F-14 fighter plane parts. He was subsequently released from custody.

China also opposes sanctions for ideological reasons. The concept of "noninterference in internal affairs" has animated China's foreign policy since the 1950s. Michael Green, a former senior director for Asian affairs at the National Security Council, said China opposes a military solution to the crisis and is concerned that the United States might seek the authority from the U.N. Security Council to attack Iran.

"They are anticipating that the more they put the brakes on sanctions now, the more they are delaying really troubling decisions to authorize force down the line," he said.

Zhu Feng, deputy director of the Center for International and Strategic Studies at Peking University, said a key issue in determining how China approached the crisis would probably be Tehran's attitude -- specifically how it responds to demands that the IAEA be allowed to inspect Iran's recently disclosed second uranium-enrichment plant.

"If Iran refuses IAEA engagement and shows no sincerity of reaching deal with the West," Zhu said in an e-mail, "I don't think that Beijing will keep opposing sanctions." A U.S. official said he hopes Zhu is right.

2009-11-01T17:05:00.000-05:00

Disrupting the Foreign Fighter Flow

On the battlefields of Iraq and Afghanistan, US soldiers, sailors, airmen and Marines have confronted third-party national combatants. Widely known as 'foreign fighters,' these individuals have gained deadly skills, combat experience and global connections that can be exported and exploited to devastating effect, Michael P Noonan writes for FPRI.

By Michael P Noonan for FPRI
20 Oct 2009
www.isn.ethz.ch

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Whether one believes that the extremism of Al Qaeda and affiliated movements is an existential threat to the United States or that such threats pose more of a nuisance to international security, the fact is that foreign fighters motivated by such causes do pose risks not only to U.S. service members deployed to combat zones, but also to geostrategically important governments in North Africa, the Middle East, and South and Southeast Asia, not to mention potential targets in the United States, Europe, and other locations. Therefore, disrupting the flow of foreign fighters is an important undertaking. But how does one do so?

The foreign fighter phenomenon at a glance

The foreign fighter phenomenon has grown since the call to jihad against the Soviet invasion of Afghanistan in 1979. Following that conflict foreign fighters migrated to such places as the Balkans and Chechnya, Dagestan, and Tajikistan in the former Soviet Union. But this is not a new problem. Foreign fighter belligerents on both “sides of the hill” were a marked feature of the 1930’s Spanish Civil War. Furthermore, the incidence of such fighters has been fairly widespread throughout history. As David Malet, a recognized expert on the phenomenon, has noted, “Among the 331 civil conflicts [occurring between] 1815 [and] 2005, at least 67 of them featured the presence of foreign fighters.”

Still, the emergence of Al Qaeda directly from the experience of 1980s Afghanistan, portends ominous possibilities from this latest cohort of global foreign fighters. According to Clint Watts, a former Army officer and FBI special agent with expertise on foreign fighters, “[l]eft unchecked, the Second Foreign Fighter Glut will produce the next generation of terrorist organizations and attacks much as the First Foreign Fighter Glut fueled [Al Qaeda].” While they might not be as numerous as those that participated in the 1980s jihad, which was in many cases sanctioned by regional governments, “they have learned skills that far outweigh those of the original Jihadis. Their understanding and employment of urban tactics, weaponry and advanced technology make them far more lethal than their predecessors.” In Iraq, for instance, while such fighters have accounted for less than 5 percent of insurgents they were estimated at producing over 90 percent of high lethality attacks.

But what — if anything — is new about this latest wave of foreign fighter activity? Malet suggests that, “[i]n modern history, transnational insurgencies have been based on various ties of ethno-nationalism and ideology, but contemporary foreign fighters in conflicts around the globe now all share the same religious identity.” This does not mean that Islam itself is the cause of this phenomenon, rather “the cause appears to be partly the result of a period effect, the coincidence of increasingly globalized communications and transportation technology with a particular identity community whose members have transnational identities that are currently particularly salient.” Perceived threats to such identity communities, thus, foster and propel defensive mobilization by motivated individuals. To Malet, such defensive mobilization is the key to recruitment across cases, ideologies, and religious networks.

Disrupting the foreign fighter flow

Clint Watts asserts that the foreign fighter pipeline has three phases: (1) source country/flashpoint, (2) safe havens and the transit network, and (3) target locations. Others suggest that a fourth phase, outflow destinations, is important as well. Each of these phases is examined below. It is important to remember that at least since the original anti-Soviet jihad in Afghanistan there has been a large chicken-and-egg effect and overlap between and amongst these phases. The complexity of the issue, however, suggests that one cannot deal singly with any particular phase. A combined approach working within and across phases appears to be the only realistic way to minimize the problem in the short- to mid-term. Full eradication of the phenomenon seems unrealistic.

Source Country/Flashpoint. Foreign fighters like most other combatants must be recruited. While self-selection and varying degrees of intrinsic motivation are important, extrinsic factors also appear to be crucial. Watts argues that “social-familial-religious” networks fuel such recruitment with the assistance and influence of former foreign fighters. Defensive mobilization recruitment themes similar to former President George W. Bush’s statement to “fight them over there so we don’t have to fight them here” are employed. Autocatalytic recruitment from, say, the internet appears to be rare. Cities and neighborhood kinship and cultural nodes are important. For instance, according to the “Sinjar files” — the most complete personnel files on the foreign fighter inflow into Iraq captured near that northwestern Iraqi city — the top five foreign fighter producing cities for that cohort of individuals per capita were: Darnah, Libya; Mecca, Saudi Arabia; Jawf, Saudi Arabia; Dayr al zur, Syria; and Sanaa, Yemen, respectively.

In the long run this phase is probably the most important one but suppressing the flashpoints is also fraught with difficulties. As the terrorism scholar Jarrett Brachman has noted,

…over the last eight years al Qaeda has undergone a metamorphosis. It has transformed from a global terrorist group into a global terrorist movement, one with its own founding fathers, well-codified doctrine, substantial and accessible corpus of literature, and deep bench of young, bright, and ambitious commanders. Attacks still matter to them, but in an era of increased counter-terrorism pressure, al Qaeda is beginning to realize that it is a lot more effective at being a movement, an ideology, even a worldview. It is starting to see that terrorism is only one of many tools in its arsenal and that changing minds matters more than changing policies.

Pivoting popular narratives away from Al Qaeda and other extremists, as the past decade-plus has shown, however, is difficult. As the late French counterinsurgency practitioner and theorist David Galula said, “[t]he insurgent, having no responsibility, is free to use every trick; if necessary, he can lie, cheat, exaggerate. He is not obliged to prove; he is judged by what he promises, not by what he does. Consequently, propaganda is a powerful weapon for him.”

Within the U.S. government bureaucratic layers and seams inhibit the effective coordination to counter such narratives even before getting to work by, with, and through the numerous governments whose populations are subject to the messages of the global movement. And even when working with these governments, the embassy teams tend to focus more on bilateral relations rather than on stemming the outflow of extremist foreign fighters who operate sometimes thousands of miles away from their day-to-day realities. It is important to increase the flow of counter-narratives to messages of Muslim oppression or victimization, but this is often difficult given the reasons stated above. Additionally, while host nation governments today do a much better job of tracking individuals who have left to become foreign fighters, those fighters who do not achieve martyrdom pose risks to their home countries and to others abroad.

Safe Havens and the Transit Network. Unless such fighters go to fight in a neighboring country, much depends on getting foreign fighters to training sites and to target destinations intact and undetected. (Unfortunately, thanks to the internet, training sanctuaries for some skills may not be as critical as they once were.) In addition, it is necessary to establish logistical hubs not only for the transit and training of fighters, but also locations to conduct a wide array of financial activities — ranging from the illicit (such as product piracy, smuggling, money laundering, etc.) to the more commonplace (access to banking, legitimate businesses, etc.) — which are necessary to fund current and future operations.

Prior to September 11, 2001 national governments (e.g., the Sudan and Afghanistan) were more willing to offer sanctuary to groups such as Al Qaeda, but the U.S. reaction to the attacks on New York and Washington, DC, in Afghanistan and other locations has diminished such flagrant support. Today, such groups seek out the freedom of action offered by geopolitical “dead spaces,” like areas of the Sahel, Somalia, and Yemen. Punitive strikes may be taken against targets using such dead space — see for example the alleged U.S. raid near Deir Ezzor, Syria in 2008, [18] the Israeli Air Force attack on a supply convoy in Sudan in spring 2009, and the recent U.S. strike to kill Saleh ali Saleh Nabhan in Somalia — but political sensitivities and the resources required to undertake these special missions can impose costs. In addition, some experts claim that international cooperation in the fight on terrorists is enhanced when the United States respects sovereignty.

Such cooperation may be necessary in order to restrict the free movement of foreign fighters. For instance, law enforcement and intelligence organizations need to collaborate more in sharing information. They should also keep tabs on those with whom such individuals are interacting. In addition, such cooperation might assist in making it more expensive or more difficult for obvious foreign fighter candidates to travel to known transshipment points. But such cooperation will not always be possible. A local government, if one exists, may be unable or unwilling to cooperate. Under such circumstances, punitive or information gathering raids, as described earlier, may be undertaken or more creative approaches such as “false flag” operations to complicate the smuggling of fighters into and out of target areas. These operations might also demoralize and dissuade such fighters from following through with going to, or recruiting others to, fight.

Target Locations. By the time foreign fighters arrive at target locations they are mainly the problem of the host nation security forces or are, like in Afghanistan and Iraq, also the problem of external armed forces. As stated earlier, such fighters, particularly in Iraq and Afghanistan, have deployed tactics, techniques, and procedures of great skill and oftentimes of greater lethality than those previously used on scene — e.g., the diffusion of innovative uses of person-borne, vehicle-borne, or static emplaced improvised explosive devices (IEDs). Furthermore, as the “McChrystal Assessment” on Afghanistan states, “[f]oreign fighters provide materiel, expertise, and ideological commitment." Abu Musab al-Zarqawi, among others, showed what such materiel assistance, expertise, and ideological commitment could accomplish by bringing Iraq to the precipice of civil war in 2006 by employing a strategy pitting Sunni Arabs vs. Shi`i Arabs vs. Kurds.

Vast amounts of information and specialized capabilities are necessary to counteract such networks. You need human networks to go after foreign fighter and insurgent networks, but all insurgencies are sui generis. Population-centric counterinsurgency or foreign internal defense approaches may work in certain environments, but not in other locations where the physical or human terrain may favor other methods of force and resource employment. Foreign fighters themselves must also operate in these varied terrains. Not all environs will be hospitable. As the Anbar Awakening showed, such foreign fighters may operate more effectively when divorced from the local populace who, in any event, may tire of such visitors and their behavior.

Aside from those who stay on the battlefield or move to other destinations, some foreign fighters in the target locations will be killed — and many request to be suicide bombers — while others are captured. Of those captured, some are returned to their source countries for imprisonment or for attempts at reintegration into society. Such reintegration seems to work in certain cases, but not in others. As of the spring of 2009, for instance, a Pentagon report found that there was roughly a 14 percent recidivism rate among those prisoners transferred from Guantanamo Bay, Cuba to other locations.

If — and it may be a big if — this other 86 percent of individuals holds across other samples and such individuals become solid citizens and do not incite others to go off and fight then that would be a great success. But as was stated earlier, former foreign fighters, even if not actively engaged in fighting themselves, appear to be important cogs in recruiting others to fight — either by word or by past example. Of course, those who had unpleasant experiences while off fighting might be useful in dissuading others from following their paths, too.

Outflow Destinations. Those foreign fighter veterans who are not killed or captured at target locations generally may either: (1) return to their source country, (2) go to a safe haven, or (3) go to a current or future conflict zone. Since the first foreign fighter glut of the 1980s and 1990s, this situation has spawned something akin to a deadly version of the “show that never ends.”

Examining the so-called “Arab Afghans,” who fought the Soviets in the 1980s, the terrorism scholar Mohammed Hafez suggests that that conflict produced six types of veterans: reintegrationists (those who went home again and reintegrated into their original societies), government assets (e.g., Arab Afghan Yemenis who fought against southern Yemenis during the civil war following Yemen’s reunification), facilitators, social revolutionaries (e.g., Egyptians and Algerians who fought against their governments upon return from Afghanistan in the 1990s), global jihadists, and unaffiliated terrorists (e.g., Ramzi Yusef).[28] Some will continue due to their religious or ideological beliefs while others are attracted to the lifestyle — a powerful argument. As the military historian, and retired U.S. Army Lieutenant Colonel, Robert Mackey has stated about a different historical context, “the guerrilla fighters of Arkansas and Missouri during the [American] Civil War formed the cadres of the Old West criminal gangs — Cole Younger, Jesse James. They were people who did not fit back into their societies; they couldn’t go home again.”

Whether individuals are motivated by religion, ideology, or lifestyle, the Islamist strategic studies scholar Barak Mendelsohn has offered a simple, yet important distinction between different groups of foreign fighters: those that are experienced and those that are not. According to Mendelsohn, the experienced cadres deserve more attention because of their leadership abilities, their technical, tactical, and strategic knowledge that they can transmit through training and advising, and their connections. While the less experienced might be capable of causing large-scale carnage, particularly in spectacular suicide attacks, the experienced cadres are the planners and instigators.

To counter such individuals it is, therefore, important to plan for and deal with foreign fighter outflows, especially the cadres leaving from Iraq and Afghanistan. To Mackey the key to such planning is to consider what happens 5, 10, or 15 years from now and develop a series of “indications and warnings.” In particular, the United States should: (1) stringently look at where money goes and where it moves (“funding, financing, travel and movement”), (2) focus on the law enforcement angle and on coalition partner capacity-building, (3) acknowledge that once fighters start leaving a country such as Iraq it is critical to know where they are going, and (4) focus on conflict abatement. Wars allow foreign fighters the opportunity to fight, provide them with expertise and the repetition of practice, and serve as the training ground for the next fight. Lastly, as Mendelsohn has suggested, we need to identify the connections to local groups from source or future target countries where outflow may become a lot more relevant.

Beyond these steps, Mackey suggests that we need to establish an international fusion center overseas that would aggregate intelligence and share it cross-nationally. This would allow us to track outflow and leverage comparative advantages in human intelligence capabilities. And while he noted that the Foreign Fighter Task Force is doing a great job, it is focused on U.S. Central Command area of responsibility. That task force model needs to be copied and applied elsewhere and given an international role. In other words, “[w]e need to modify our organization bureaucratically to meet the threat and not necessarily try to force the threat into our bureaucratic model,” argued Mackey.

From a different — but largely complementary — angle, Dan Green, a former Provincial Reconstruction Team member in Afghanistan and Naval Reservist tribal engagement officer in Iraq, has suggested the need to build U.S. personnel capacity. Michael Doran, a Middle East scholar and former National Security Council, Department of Defense, and Department of State official, has argued that the United States must build a political warfare capability. To Green, building personnel capacity is essential in developing bases of knowledge, expertise, familiarity, and the relationships needed to operate in the locales where foreign fighters originate, transit, and fight. Unfortunately, bureaucratic structures impede such deep specialization and inhibit precisely the development of the skills required for the political warfare capabilities suggested by Doran. According to Doran, we have some great programs in place, but that they are all ad hoc.

What is needed is: (1) greater flexibility in moving between war zones and non-war zones, (2) better local intelligence and the ability to put the right answer (often non-military) on target, (3) better understanding of cultural contexts, (4) legislative relief to create constructive linkages between things like intelligence collection and development assistance under a new organization, and (5) increasing relationship linkages by developing educational institutions such as the George C. Marshall European Center for Security Studies — but from a “whole of government” perspective — for Africa and Central Commands. Such capabilities — when combined with those offered by Mackey and Mendelsohn — would offer robust, yet scalable measures for dealing with issues across and within the four foreign fighter phases.

Conclusion

Today the United States focuses largely on what to do in Afghanistan and in neighboring Pakistan. Still, some reports suggest that the drone strikes against Al Qaeda in Pakistan have produced an outflow of foreign fighters to Yemen and Somalia. Meanwhile the situation in Iraq remains improved from the dark days of 2004-2007, yet still tenuous. But there are other reports claiming that Al Qaeda has reinforced their leadership to refocus and direct the fight in Iraq by sending Sheikh Issa al-Masri to Syria. Strategically, these developments lumped together suggest three things: (1) the foreign fighter problem and the “Al Qaeda movement,” however defined, are not going away, (2) such fighters are intent on keeping the United States widely engaged across theaters of operations, and (3) the movement to Yemen and Somalia, aside from their geopolitical dead space benefits, are in close striking distance of the heart of the Arabian peninsula and Egypt.

Financial reality and limited diplomatic, development, and defense capabilities already stretched thin by eight years of war suggest further difficulties in dealing with foreign fighters. Realistically this means that the United States must leverage its friendships and acquaintances to work by, with, and through others and employ indirect strategy. As the late French Army General Andre Beaufre stated in his magisterial An Introduction to Strategy

Though its outward manifestations are of a specialized and frequently disconcerting nature, indirect strategy is no specialized form of strategy divorced from direct strategy. The key to it, as with all strategy, is freedom of action; it is only the method by which this freedom is obtained which is different. It must be obtained by initiative combined with security and it is different because the area of freedom of action (and therefore the limits of security) depends upon what is done outside, not inside, the area at issue. This is its special feature and it is this which gives it its indirect character.

In other words, while foreign fighters are by no means chiefly responsible for all of the problems in places such as Iraq, Afghanistan, or Pakistan, working against them successfully will help to reduce violence in the war zones. Combined with effective actions on the ground, an indirect strategy that husbands and appropriately distributes resources across borders to limit recruitment, transit, and logistics for these international killers is essential to success.

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Michael P. Noonan is the managing director of the Program on National Security at the Foreign Policy Research Institute and a veteran of Operation Iraqi Freedom.

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