Careful What You Wish For

Today’s Wall Street Journal editorial urges the Obama Administration to catch up with events in Iran and make it American policy to support and encourage the so-called “Green Movement” (democracy movement) rather than continue to give legitimacy to the Ahmedinejad government.

The Obama Administration has deeply committed itself to a strategy of “engagement” with the Ahmedinejad regime, and has specifically and pointedly rejected the approach of the Bush Administration, which was to seek regime change, in part through encouragement of democratic and dissident elements in Iran. To make such a change of policy, the Administration would either have to (i) develop courage and a moral clarity which is fundamentally inconsistent with its previous appeasement policy (and the cowardice and moral relativism on which it is based) or (ii) conclude, through a political calculation, that the odds of the Green Movement’s success are so great that it is time to get on the bandwagon and try to claim credit for the result.

I leave to you, dear reader, to judge the likelihood of the former. That latter is a practical impossibility because, in the swirling fog of “intelligence” concerning fast moving events (which are inconsistent with previous “intelligence” assessments), it will never be possible to reach the level of confidence necessary for such political calculus, about the inevitability of the fall of the Iranian regime, until it is virtually a fact.

Of course, I can easily imagine the Administration “hedging its bets” by saying something vague about human rights or the importance of democracy, in order to be able to later claim that it was supportive, in the event the Green Movement prevails. But don’t look for the Administration to take any step that would jeopardize (God forbid halt) its “engagement” track.

If the Ahmedinejad government truly feels threatened, it may seek further legitimacy by offering the possibility of concessions in the nuclear talks. Supporting the Green Movement would mean choosing not to be lured by such offers into an unclear, unenforceable nuclear compromise with this Iranian government, but rather choosing this moment to stiffen our negotiating stance; becoming progressively more insistent that the only thing that would be acceptable would be a complete and verifiable end to all nuclear activity, a destruction of all existing nuclear facilities and a complete accounting of all past activities and uranium inventories and international control of all uranium stockpiles. Does that sound like something of which this Administration is capable? Don’t forget, with the widespread criticism of the Administration’s failure at Copenhagen, the Administration will be desperate for any foreign policy success. In this circumstance, it takes courage to refuse to eat the proffered fruit of an unholy bargain with the devil.

If the Administration did decide to “help” the Green Movement, the Movement would enter an even greater zone of peril (if that is possible). This is because such a policy move could never be kept covert, and the downside to the Movement (giving credence to the Iranian Government’s attempt to tar the opposition as traitors and unpatriotic) would outweigh the feeble, halting, on-again off-again, just-enough-rope-to hang-oneself, style of support that comes from policies created by “nuanced” political calculation.

The Iranians should remember the fate of the Iraqi Shiites who rose up, at the urging of the Bush 1 Administration, after the first Gulf War. That Administration “calculated” that the possible resulting break-up of Iraq was too problematic for our interests and concluded that Saddam was fatally weakened by the war anyway, and therefore doomed to fall very soon to a more pliable Sunni Iraqi leader (who could maintain Iraqi unity).

No administration can be expected to develop the focus and single-mindedness of purpose that is necessary for a reasonable chance of success of a foreign policy initiative which is predicated on fundamental principles that that administration does not embrace. This Administration does not cherish the idea that individual political and economic freedom from an intrusive and paternalistic state power is a transcendent good, without regard to whether that power is, for the time being, benevolent or malevolent. Accordingly, I believe that any Obama Administration initiatives in the direction urged by the WSJ will be incompetent flops and, almost certainly, more harmful than helpful to the Green Movement.

In short, anyone who truly cares for the interests of the democratic dissidents in Iran should not urge the Administration to “help” them. They should pray to God that the Obama Administration dithers.

The Paulson Dilemma - Part 2

In my piece entitled “The Paulson Dilemma”, posted, I am ashamed to say, on June 8, I promised a follow-up “in my next posting”. Since then, what I intended to say has become more obvious as the anti-Wall Street populist demagoguery has ratcheted up, and the banks who received (or were forced to take) TARP money and other Government help have been trying to move heaven and earth to pay back the TARP money and get out of the Government bear-hug.

In “The Paulson Dilemma” I suggested (and tried to show) that 1) free-market financial systems naturally create increasing “systemic risk” during long periods of “good times” and 2) politically, no government which has the executive authority to intervene in the financial markets, regardless of its political philosophy concerning economics (i.e.” laissez faire” or statist or anywhere in between), will stand by and do nothing in the face a financial crisis which seems to pose a “system risk”.

From these two propositions, (and the unstated but known tendency of all government bureaucracies, once in control of anything, to tend to continue in that control) I erected the straw-man question: are all free-market financial systems destined to be transformed into non-free market extensions of the central government (including, for this purpose, the central bank)? I suggested that I would take the contrary view in my next posting. Here goes.

With any government bail-out comes increased government control over the entity that received the benefit. This is natural and appropriate. A democratically installed government that does not gain or exercise this control will not long be in office when the natural populist storm of indignation (toward Wall Street plutocrats feeding at the public trough) comes whistling down main street toward the beltway. And, of course, democratic government is, and is intended to be, a mechanism for converting political influence into policy.

This control over formerly private enterprises will be wielded in favor of those political factions who form the coalition that elected the government. Again, this is meant to be a statement of the obvious, and not necessarily pejorative. This is true whether the “favor” is direct and remunerative, or is merely the adoption of policy that is consistent with the economic philosophy at the center of gravity of the coalition.

Because government is about politics, and politics can channel absolutely any initiative (for example wealth redistribution or the modern economic equivalent of a Bill of Attainder for specific companies or even whole industries), the control gained over financial institutions, inevitably, will be exercised in a manner which is partly or completely at odds with the interests of the non-governmental owners of those companies. For example, (i) limiting executive pay when the national and global marketplace for executive talent is not subject to uniform rules consistent with those limitations, or (ii) insisting, on the one hand, that banks shore up their balance sheets (which means building reserve capital at the expense of deploying that capital in loans) and, on the other hand, threatening political vengeance if banks don’t lend more and, on the third hand, implying that bankers will be severely punished for taking risks that turn out badly. These are not coherent guidelines under which a business can be run rationally, and certainly not in the best interest of the shareholders (in their capacity as profit-seeking owners). Instead, the business becomes a vehicle for achieving political objectives without regard to the impact on the commercial health of the business or the effect on its long-term viability. Businesses that are subject to this control are at a competitive disadvantage. The longer and more intrusively this control is exercised, the more significant will be the impact. Its competitors will “eat its lunch”.

In other words, absent going all the way to a state owned and controlled economy with rigid barriers to the flow of human and monetary capital out of the country (i.e. a state enforced monopoly in favor of the government controlled businesses), the application of government control to businesses will cause those businesses, over time, to become a smaller and smaller percentage of their particular market.

This phenomenon was demonstrated in reverse, so to speak, with the liberalizations in China starting with Deng. At Mao’s death, virtually every enterprise of every industry was a state owned and controlled entity. The liberalizations were implemented by allowing private enterprises to start up and operate in certain economic sectors. Gradually, the permitted range of activities of private enterprise was widened. With certain exceptions (usually involving favored officials or favored government sectors, such as the People’s Liberation Army), the state-owned enterprises were not converted to private businesses. However, in industries where private enterprise was permitted, the percentage of the market represented by the state enterprises declined from 100% to, often, very low percentages, by virtue of the explosive growth of the private businesses and the relatively static activity of the state businesses. The state businesses were at a competitive disadvantage because they continued to be required to satisfy all the non-business (i.e. political) objectives mandated to them under the strict communist period. These objectives included everything from revenue generation for the state (hampering the ability to retain and reinvest profits), employment without regard to business need or productivity, production quotas without regard to whether the enterprise was creating wealth (profitable) or destroying wealth (operating at a loss) and the requirement to use specified sources of material without regard to quality or suitability (in order to create a market for upstream enterprises), to provision of all manner of social services such as housing, food, schools and clinics. Against such competition, any private enterprise with even a little room (freedom) to be nimble and creative will prosper.

As applied to the big US banks, this means that the longer and more intrusive is the Government control, the less competitive the controlled businesses will become. Their relatively less fettered competition will prosper at their expense. This competition could be from the banking sector inside this country, unless the controls are made uniform (i.e. without regard to whether the financial institution was a recipient of bail-out help or not) through national regulation, or from other less regulated forms of financial activity "disintermediating" the banking business (as the securities business did in the last 30 years) or from outside the country.

Over time, banks that were “too big to fail” in the last crisis will become smaller and smaller percentages of the market. Capital will flow to less regulated institutions and, over time, the massive government presence in the industry will diminish as a result of the persistent differential growth rates of the less regulated versus the more regulated.

What I have written above is well understood by the banks themselves, which is why, as of this writing, the last of the TARP banks are struggling to get free of the Government and repay their TARP money and give up their Government loss protection, even though their existing non-governmental shareholders will be massively diluted by the capital-raising required.

The fact that there may be processes at work which may cause it all to come out all right in the end is, however, no reason to be passive in the political debate concerning the role of government and the private sector. Massive wealth destruction, with concomitant lowering of living standards, can result from wrong-head government intervention in the private sector, even if there is a feedback mechanism which mitigates the effect over time. Hundreds of millions of Chinese lived hard, short and unhappy lives between 1949 and the unset of Deng’s reforms who would have lived longer and happier lives had those reformed been introduced earlier.

Lets Hope God Works in Mysterious Ways

First, let me apologize to my 6 readers for being so lazy and inattentive to this blog. I also realize that my last two postings promised follow-ups which I have not provided. I will try to honor that promise soon. However, allow me to move to a new subject today.

I read this morning the thought-provoking Wall Street Journal Op-Ed piece by Amir Taheri about the Democratic Movement in Iran (p. A25). Mr. Taheri describes a process of increasing pressure on the government by an ever bolder opposition. The article implies that the overthrow of the regime is inevitable and imminent. I hope it is true. I am a little concerned that Taheri may be allowing his hopes to run ahead of the reality, but I certainly have no knowledge that enables me to gainsay his views. Clearly, Mr. Taheri loves his country, and as we know, love "hopes all things."

Let’s assume, for the moment, that he is correct that the regime is in its terminal phase and that the opposition, when it comes to power, will: 1) stop Iran's nuclear weapons program; 2) defund Hamas and Hezbollah; 3) establish a constitutional separation of church and state; and 4) establish a true democractic republic, among other things.

In some respects, this may be attributable to the Obama administration's foreign policy, which is no credit to the administration, but may be credit to God.

One of the common placards carried in the opposition rallies poses a question to Obama: "Are you with us, or with them?" To our shame, the administration has repeatedly and emphatically answered "We are with them" by virtue of the choices its makes. The American Government no longer makes encouraging or supportive statements about Iranians yearning for true democracy and an end to totalitarian government (as we used to do, and as we did for Eastern Europeans before the wall fell). We legitimize Ahmadinejad's government by, for example, 1) not making an issue of the Iranian election fraud and 2) negotiating with them about the nuclear issue as if everyone involved is dealing in good faith.

America's current foreign policy, of futilely attempting to make friends of those whose core political identity is built upon virulent Anti-Americanism (e.g. Chavez in Venezuela) while making life difficult for our friends (e.g. Colombia), is so catastrophically inimical to American interests and inept, that national leaders who seek to attribute all their internal problems to the workings of a vast and insidious American conspiracy, implemented by the CIA, are beginning to flunk the laugh test.

America obviously no longer supports its friends or resists its foes. It neither acts in its own national interest, in a "realpolitik" sense, nor does it support those abroad who espouse its core principles and resist those who seek to destroy those principles. (Indeed the domestic activities of this administration suggest that it does not consider broad economic and political freedom of the individual citizen to be a core principle for which we stand - it seems to be motivated by the idea that the best and most efficient generator of societal good is a central government run by an elite who know better than you what is good for you.)

Ahmedinajad has been successful in the past characterizing opposition to his government as treason, giving aid and comfort to the enemy, the Great Satan. This is no longer credible. Iranian's progress toward nuclear power status, for example, is now almost entirely a function of its resources and commitment, (and the decision that Isreal will make) and not a function of the strength of American (or western) resistance.

If the improbable does happen (and the Iranian regime falls), no doubt the Administration will claim credit. But one is not entitled to take credit for an unintended consequence of one’s actions. The Administration's approach to the current Iranian government is based on the premise that they are the legitimate government of that country and they are permanant so we have to deal with them.

I say improbable because I do not believe that history shows us an example of a totalitarian regime falling merely from the effects of internal opposition, even when it expresses the will of the majority, unless that opposition has 1) very strong material support from outside or 2) the regime itself, in the face of opposition, loses its nerve to be as brutal as necessary to stay in power (e.g. the Shah's government). So, if the opposition has the nerve to stay in the streets despite killings, beatings, jailings and torture, the final question will be decided in the hearts of the "guardians" of the republic, who say their primary loyalty is to the will of God.

Let’s hope (pray) that God does work in mysterious ways and speaks authoritatively to these men.

The Paulson Delimma

I recently viewed an excellent "Frontline" program which detailed the events of late '07, '08 and early '09 related to the financial crisis and the onset of recession. In that show, they highlighted the irony of Secretary Paulson, whose career at Goldman was a testament to the free market system, announcing one Government intervention after another. In the press conferences at which he announced the steps, he always expressed his discomfort with the steps and a concern about creating moral hazard, and yet he took the steps (so contrary to his economic philosophy) because he felt forced by events to protect the financial system from even greater collapse, i.e. he perceived "systemic risk".

This started me thinking. Are free market financial systems doomed to bring about their own destruction (i.e. Government takeover)? If a free marketeer like Paulson feels compelled to take drastic action, amounting to a partial nationalization of the entire banking (and investment banking) system, how will a free market system ever survive or re-emerge?

Let's start at the beginning. What created the circumstances which gave rise to the systemic risk? Was it Government action, regulation, or the free market system? I think the answer is all of the above. Certainly Government action, for example in the creation of Fannie and Freddie, and the subsequent political and legislative pressure to accept mortgages from people with lower incomes and weaker credit ratings, contributed enormously. But even without the contributing role of Government, the free market is capable of producing the circumstances that render the system vulnerable to a "systemic risk" cascade of failures triggered by a single negative event. This is proven by the history of numerous prior financial collapses (or, as they are more charmingly referred to in history, panics).

Why and how does the free market produce such events? I think there are two basic reasons.

Firstly, in the financial markets, in normal times, the taking of risk is rewarded, and the taking of greater risk is rewarded more. In a competitive system, the institutions that make a higher return on their capital tend to attract more capital, more talented staff and more of the market. Firms that have internal policies which, for reasons of risk management, prevent the firm from fully participating in the more risky business tend to lose out, over time. For this reason, the longer the good times roll, the riskier the aggregate portfolio of the market. In other words, the longer the good times roll, the more vulnerable each institution is to unusual negative conditions.

Let me digress on the subject of "risk management" for a moment. The most basic form of risk management is the retention of excess capital. However, idle capital is very expensive. Accordingly, managers are always seeking ways of managing their risk through less expensive means. Other means include:
1. internal standards for competence and honesty of employees,
2. diversification and
3. limits on the total exposure in various areas of activity, or to various types of risk, or to particular geographic areas or particular individual credits.

Number 1 is hard to execute and impossible to measure and constrains expansion (since the pool of available prospective employees is more elite and therefor smaller). Numbers 2 and 3 are based on the reasonable, but not infallible, assumption that when things go bad, they don't go bad everywhere all at once.

Secondly, free markets, like free trade, tends to reward specialization, which increases interdependence. In a competitive, profit-oriented system, individual members will concentrate on what they know produces the highest return, and to contract with others for their other needs. For example, most firms need insurance. They can satisfy that need through self-insurance (resulting in increased reserve capital). However, most firms reach the conclusion that it is more efficient to buy insurance from those who specialize in it and who offer the most competitive rates.

A fourth way to manage risk, which has emerged in the last business cycle, is to insure against the various risks sitting on the balance sheet. These insurance policies are called "credit default swaps". If those who measure your financial condition (regulators, credit rating agencies and the market place for your debt) accept that the insurance effectively eliminates the risk insured, they will accept that you can re-use the capital otherwise tied up in those risks and you can treat those risks as nonexistent, for purposes of your various risk limits. In reality, all the firm has done is exchange the risk of default of the underlying counterparty for the risk of default of the insurer.

Credit default swaps allow firms to become massively overexposed to certain risks (looking at their gross actual portfolio) by notionally removing risks from their balance sheet. These massive over exposures (vulnerabilities) suddenly pop back on to the the balance sheet if the insurance evaporates. The insurance evaporates if the insurer defaults (Lehman), and effectively evaporates if the market perceives the insurer as vulnerable to collapse (AIG).

So, to recap, it is the natural consequence of free financial marketns to create massive interdependence and to increase in vulnerability the longer the good times roll. Interdependence and vulnerability produce systemic risk.

From this it would seem inevitable that free financial markets will produce systemic collapse. If we further assume that no administration, whether it be conservative (the Paulson delimma) or liberal, can stand by and watch such a series of events unfold without intervening, we would seem to have demonstrated that free financial markets inevitably tend, over time, to be subjected to ever increasing government intervention.

Does this mean that free financial markets are doomed to disappear? I don't think so. I will attempt to demonstrate this in the next posting.

"Never Waste a Good Crisis"

So say Rahm Emanuel and Hilary Clinton. Very Chinese of them (the Chinese characters for "crisis" are said to be the characters for "danger" and "opportunity").

Something similar could have been said by a spokesperson for the Bush administration concerning 9/11. It was certainly used to achieve policies that would have been next to impossible to achieve (such as the launch of the Iraq war) without it.

Lincoln certainly did the same. Is there any doubt that the 13th, 14th and 15th amendments would not have been added to the constitution without the crisis of the civil war and the absence of southern representation in Congress?

FDR certainly did. Consider the various New Deal programs and the great depression.

Occasionally, someone attempts to steal not only second but third. Consider FDR's court-packing scheme.

Taking advantage of opportunity (whether borne of crisis or not) is very natural for politicians. Occasionally, opportunity is not taken because the politician does not see the opportunity, or is not truly committed to the goal. He is truly worthy of ridicule. Eben's comment about Arafat comes to mind, "he never missed an opportunity to miss an opportunity" [...to make peace.]

Indeed, the rare thing (and the thing that helps to define true character, often) is when the opportunity is perceived but the advantage is not taken, because the politician understands that the long term damage is not worth the short term gain.) Consider, for example, Lincoln's refusal to heed the advice of his Republican advisers who urged him, in the dark days of 1863 and early 1864 (when it seemed almost certain that he would not be re-elected in November 1864), to postpone the election until the war was over.

In other words, the rare and laudable thing is self-restraint. A commodity in short supply right about now.

But the phrase "never waste a good crisis" also has deeper and more sinister implications. I will explore these in my next post.

The Return of "Know-Nothing" Politics

AIG was bailed out for one reason, and one reason only. It was not bailed out because it was a flagship insurance company. It was not bailed out because it employed many people. It was not even bailed out because of its long-standing cozy relationship with the American intelligence community. It was bailed out because, in the judgment of the Fed and the Treasury, its failure would have posed a “systemic risk”.

What is meant by “systemic risk”? Simply that AIG was so interconnected with other financial institutions, through various and myriad counter-party relationships, that its failure would trigger a cascade of losses which might cause other institutions to fail, which, in turn, would bring down more institutions, and so on.

The mechanism of transmission here is breach of contract. If AIG had gone bankrupt, institutions that had open contracts with AIG would have found those contracts dishonored. What kind of contracts were these? They were insurance contracts against the risk of default of other institutions, for example, Lehman.

So what is the difference between a bankrupt and a bailed-out AIG? The bailed-out AIG honors the contracts and therefore pays out to its counter-parties on the default swaps.

So the sleeping giant of American politics, “know-nothing protectionism”, having awoken, finds it shocking that a majority of the funds injected into AIG have been “funneled” to various financial institutions and municipalities throughout the world. In order to turbo-charge the outrage factor, the reporting of this fact is conflated with the news that lots of money was also paid out by AIG as bonuses.

The only thing these two facts may have in common is that they may both involve honoring the terms of pre-existing contracts.

If a financial institution, which was bailed out on the theory of preventing systemic risk, did not pay out a majority of the Government funds to other institutions pursuant to the terms of pre-existing contracts, then the bailed out institution did not represent a systemic risk and was bailed out in error.

One can argue about whether the bail out of AIG was wise, necessary or fiscally prudent. One can ask whether it enhanced "moral hazard" to an unacceptable degree. One can even take issue with the notion that its failure would pose a systemic risk. And finally, one can ask whether it was wise for a regulated industry to be allowed (by the regulation and the implimenting regulators) to make risk bets that were of "bet the ranch" magnitude. All of these questions could be discussed intelligently.

What can not be intelligently discussed is the notion that "AIG paying billions to other financial institutions" is evidence of wrong doing.

Russia - A follow-Up

How much effort was invested by Clinton and her team on the "re-set" button gag? Clearly, not enough to avoid displaying complete incompetence. But, in fact, no energy should have be invested on such frivolous stunts. The only thing more dismaying than the embrassment of having a State Department that lacks a fluent Russian speaker and a culture of quality control is the thought that this is what these folks think will impress their opposite numbers and advance American interests.

Europeans and Asians generally think of America, on the diplomatic stage, as an overweight muscle-bound blind giant staggering around. Very dangerous, but not effective and easily outsmarted.

Part of what Obama was trying to sell was a return to "adult" behavior, a return to highly educated competence at the helm. (Shades of the "best and the brightest.")

Oops.

Russia - Movement in our Peripheral Field of View

It is an unfortunate reality of the "complex" composed of (i) the mainstream press and (ii) those with their hands on the levels of power in Washington, that only one thing can be the focus of attention at any one time. With talk of nationalizing the major banks, the Dow testing new lows and GM and Chrysler accompanying their business plans (which were required in connection with their previous bailout) with a new request for billions, there is no doubt that the focus is on the economy.

Unfortunately for America, independent actors around the world are constantly assessing, and reassessing, their chances of advancing their own agendas. Often, their best chance is when the US is distracted by other things.

The current US economic situation has no obvious solution (other than time) and pretty much everything that anyone has suggested that the federal government do, has been tried. But we are incapable of turning our attention to other things while the remedies which have just been approved are given a reasonable period of time to suceed or fail. We must continue to stare at the problem to the exclusion of our other myriad interests. The economy is the "mother" of all distractions.

Nevertheless, if we try to attend to the information streaming in from peripheral fields of view, and try to make sense of the information, some pretty troubling things come to mind.

Let me briefly discuss one: Russia. In the recent past, Russia has:

• Fought a war with one of its small neighbors (that used to be part of the empire) and occupied a portion of its territory and "recognized" the sovereign independence of two regions thereof (while at the same time issuing Russian passports to persons resident in those areas, which suggests incorporation into the new Russian Empire, not independence). This country has a vital oil pipeline crossing its territory which is owned by western (i.e. non-Russian) interests carrying Azeri oil to western markets. This pipeline was built at great expense, and with massive American diplomatic support, precisely because it would afford a transportation route for the oil that did not run through Russian territory.

• Induced another former part of its empire, through a combination of threats and the promise of remuneration, to close down a NATO airbase that is vital for operations in Afghanistan.

• Demonstrated to Europe, for the second time, its total dependence on Russia for energy supplies by turning off the taps, while bringing to its economic knees a former Soviet Republic that dared to seek incorporation within western organizations (EU and NATO).

• Threatened two eastern European countries who had agreed to base US anti-ballistic missiles (designed to protect the US and Europe from Iranian nuclear attack) that it would install nuclear missiles in Kaliningrad (on the Baltic) and aim those missiles at those two countries.

• Proceeded full bore with its plan to supply Iran with nuclear material for a nuclear reactor which will produce waste that can be made into weapons grade material.

• Sold weapons and provided other forms of encouragement to the South American country which is doing the most to promote anti-Americanism in the region and which is seeking to undermine democratic governments in the region by massive infusions of money to leftist politicians running for high office.

• Triggered a global struggle for resources in the Arctic oceans with provocative acts such as planting Russian flags on remote islands and even the seabed.

And that is just the stuff we know about. We are not attuned to the myriad things passing under the radar: pressure on oil-producing Kazakhstan, energy deals with China in return for China remaining ineffective with respect to reigning in North Korea, massive interference in the internal politics of Ukraine and Moldova, theft and confiscation of western economic interests in Russian industry and energy production, and heavy-handed pressure on western majority owners of the CPC Pipeline to cede effective management control of the only oil pipeline to transit Russian territory not within state control.

A few years ago people were wringing their hands about identifying a new mission for NATO. We need to remember the original mission; the job is not done.

What I have outlined above would be sufficient to establish Russia as the number one threat to American interests around the globe without even considering the harm wrought to American interests by the American response to such provocations. That response is less than anemic. Our policy toward Russia (started by Bush and heightened by Obama/Biden/Clinton) is to treat Russia as a slightly wayward friend who is not smart enough to perceive that its own best interest lies with alignment with the US. A wayward friend whose help needs to be solicited (and purchased) with respect to a major problem: Iran. The Russians are happy to continue playing the Iran card and collecting concessions about as long as The Great Leader is prepared to play the nuclear card and collect round after round of economic bribes from the US and South Korea.

The world is a tough neighborhood. You have to pay attention and have your wits about you. If your mental construct of the world is fundamentally flawed, you are not equipped to make sense out of the actions of others, let alone anticipate their next move. If you can not think three or four or five moves ahead, you are destined to lose; it’s just a matter of time.

Maybe we should make a concerted effort to enlist our best and brightest (and most experienced) to focus on our international interests, not just our most politically ambitious.

Schizophrenic Advice

Imagine that your brother has come to you for advice. He says that he is in debt up to his ears and is having trouble making ends meet.

You advise him as follows:

• Arrange a debt consolidation to reduce the interest cost.
• Stop using all credit cards - spend only cash based upon a strict family budget
  
• Set out a schedule of debt repayment and stick to it
• Reduce your discretionary spending by 80% (teach your wife and children that it is a time of austerity and that everyone has to pull together)
• Urge your children to get after-school jobs to fund their discretionary spending wishes (and ask them to set aside 20% of their earnings to help contribute to family debt reduction)
• If you get any raise at work, use 100% of the after-tax increase to accelerate debt reduction
• When all non-first mortgage debt is paid, start using the money stream previously dedicated to debt reduction for savings growth.
• Try to maintain a savings rate of 15% of gross income.
• If and when family income increases, as long as the savings goals are met first, family spending may increase accordingly.
  

Sound about right?

The fundamental economic problem that our economy is facing is that too high a proportion of our families and business corporations are in the same position as the imaginary brother. The advice given to one is sound for all. In other words, the sound course of action is what is referred to in Wall Street as "straightening up the balance sheet" - that is, reducing liabilities and increasing assets.

And the result is a depression, as demand for goods and services and credit collapse.

If he follows the advice, the brother's family spending will not recover for quite a while; not until the debt is paid off and a steady family savings program is established, and then only as family income rises. This process takes time.

During that time the "economy" of the brother is "depressed", in the sense that aggregate spending per year is reduced. But note that it is "depressed" from an artificial and unsustainable high level.

So too our national economy.

Our national politicians only gauge the health of the national economy based on the level of economic activity, not by looking at the economy's balance sheet. Thus, a healthy correction for the balance sheet is treated as a disease which must be stopped.

The politicians are using Keynesian justification to substitute federal government spending for the missing private spending, to try and maintain overall spending at a level which was clearly artificial and beyond the sustainable means of the economy as a whole. Even if this policy worked (it won't) it is inappropriate, because it is neutralizing the effort of the private economy to "straighten-up" the national balance sheet.

As if this were not bad enough, much of the federal spending is structured to induce the private sector to resume spending at the old level before the balance sheets are repaired. That would be like telling the brother that the decline in family spending is a disease that must be stopped, that he must resume his spending and borrowing immediately, and then offering him financial inducements to do just that.

In light of all this, if I had the foresight, I would have added two additional points to the advice to the brother:

• Resist financial blandishments of credit card companies and retail discount sales
  
• If the government gives you a stimulus check or reduces your taxes, use the money to reduce debt.

The proper role of Government in this crisis is to allow the balance sheet correction to work its way through the system, in other words, patience.

During this period the Government should ensure that individuals are not pushed to an economic level where starvation or homelessness result. That does not mean keeping people in homes that they can't afford; it means keeping them off the streets.

On the business side, the Government should save basically sound businesses, particularly those who are imperiled by an absence of customary credit. Government should do this because the bankruptcy of a business involves not only the rearrangement of asset ownership but the destruction of the the engine of wealth represented by the intangible assets of the accumulation of knowledge and skills of the employees and the organization of that knowledge and skill in a wealth-producing cooperative. However, it is not a proper government role to bail out fundamentally unsound businesses.

And Government should reduce taxes, to reduce the burden it places on the backs of individuals and businesses.

I said the Keynesian stimulus will not work. Why? Because, unless the stimulus money is nothing more than the result of running the government printing press flat out (which will eventually cause a massive wave of inflation resulting from the debasement of the currency), this spending must be funded by borrowing or taxes. Borrowing is funding deferred. So it must be paid for either with higher taxes now or higher taxes later. Taxes reduce the ability of the taxed to spend or invest - dollar for dollar.

Failing "Founding Fathers" 101

In his inaugural speech, President Obama said, amongst other things, "the question is not whether Government is too big or too small, the question is -- does it work?"

From the perspective of the founding fathers, the equivalent rhetoric would be: "The question is not whether we should repose all governmental power in a monarch or design a system of elected representatives and checks and balances, the question is -- will the monarch be wise and benevolent?"

Administrators of government power come and go. Some are wise and benevolent, some are malicious and stupid (and some appear to be both to different segments of the population at the same time). Some are efficient (for example, the Third Reich) and some are inefficient (for example, the US government in the enforcement of prohibition).

The founding fathers would likely see Obama as either naive or maliciously cunning. From their point of view, the most important question was: "Do you want mechanisms in place designed to limit the power and scope of the national government, in order to keep it out of many areas of activity and keep it more responsive to the will of the people in those areas in which it does function, or not?"

Of course, the founding fathers, like everyone else, would like the government to be efficient and effective in those areas in which it legitimately functions, but many of the founding fathers (including Jefferson) would prefer an inefficient government if the scope of that government's activities are not properly bounded.

However, President Obama's question is the only question, if you believe that the scope of government can never be reduced and will always expand until it has crowded out every other competitor for power and economic influence. History suggests that this may be true.

If you examine the effect of the "deregulation" initiative starting with Reagan, you might conclude that the best that can be accomplished in this vein, even with a large public consensus and control of the Presidency and both houses of Congress, is to temporarily stop the further expansion of government. And that is if you are an optimist. Reagan and his heirs, down to Bush 2, presided over a significant expansion of central government power vis-a-vis the States, activities of private religious and charitable institutions, health care, and the mortgage industry, to name a few. During this period, the Government exited no area of activity.

I believe that the combination of:

(i) the elimination of the right of a State to secede,
(ii) the creation of a national central bank,
(iii) the direct election of Senators,
(iv) the creation of the power of the central government to tax income,
(v) the uniform acceptance of the proposition that the constitutional view of the branch of government which is least responsive to the will of the people (Supreme Court) trumps the view of the other two,
(vi) the adoption, by that branch (Supreme Court), of the notion that the Constitution says whatever the Supreme Court says it says, not just what is written and
(vii) the use of that notion to interpret certain clauses in the constitutional list of limited powers of the federal government as being unlimited in potential scope, such as the commerce clause,

have conspired to render the carefully bounded government of the founding fathers effectively unbounded in its scope.

Therefore, in that circumstance, I side with Jefferson and root for a government that tends toward inefficiency and incompetence in the exercise of expanded powers which Constitution, as written, did not grant to it. Given that even a political majority in favor of more limited government has been ineffective in reducing the size of government, government inefficiency may be the only bulwark against perpetual expansion of the central government.