"...and the vegetable?"

The Wall Street Journal carried a front page article on April 21, 2014 entitled "US-Russia Relations Come Full Circle After Ukraine". The article attempts to review the changes in bilateral relations since June 2001 when President Bush gazed into Putin's eyes and was mesmerized. The whole "reset" (or "overload") debacle of Obama-Clinton is, of course, also described.  But, on the whole, it is a strange article for this prominent, politically conservative, US media organ.

The article is noteworthy for what it chooses to include, and for what it leaves out.

Bush is rightly portrayed as having been hypnotized by Putin in 2001, but the fact that his administration finally woke up is air-brushed out. And yet, it was precisely the hardening of the Bush Administration's policy toward Russia in 2008 that Obama ran against.

In the 2008 election season, the liberal intelligentsia was in full cry about how the "cold-warriors" in the Bush Administration didn't understand that the government in Russia was changing for the better and that the Administration's toughened stance toward Russia was interfering with this favorable evolution. The narrative was that the tide of history was working in Russia, slowly but surely, and this change was exemplified, and would be further propelled, by Medvedev who became President in May 2008.

The Democrats saw in Medvedev what they wanted to see. But Russians (of all stripes) saw Medvedev for what he was. In 2008 there was a famous joke that circulated in Russia. Putin and Medvedev go out to dinner at a well-known restaurant in the forest outskirts of Moscow that is renowned for its grilled meats. The waiter asks Putin what he will have. Putin answers "steak". The waiter follows up with Putin: "....and for the vegetable?" Putin responds: "He will have the steak also."

The facts concerning Russia's provocative long-term interference in Georgia's various break-away regions, and their direct military intervention in 2008 (shortly after Medvedev assumed office), when Georgia tried to reestablish control in part of its sovereign territory, were not consistent with the Medvedev-as-reformer narrative. Therefore, these facts were ignored, or explained away as some one-off aberration or special case.

However, instead of pointing out the complete bankruptcy of the the Obama Administration's Russia narrative of the last six years (in which Mrs. Clinton is inextricably involved), the WSJ seems to be allowing the paper to be used to float the new Russia narrative of some Democrats, particularly Mrs. Clinton. This narrative goes something like this: Medvedev was a reformer, so we were right to be nice to him and hope on him. Unfortunately, he couldn't really do as much as he wanted to, and, when Putin came back, things started to go bad. Nevertheless, "Mr. Obama and Mrs. Clinton felt they had to make what progress they could with the counterparts they had at the time in Russia."

The fact that this "progress" was really a series of cave-ins to Russian demands that fundamentally weakened the confidence that eastern European countries (such as Poland) had in the reliability of the US as a strategic partner, is also ignored in this article.

Anyone who has spent substantial time negotiating with Russians (such as yours truly) recognizes the "good cop/bad cop" gambit of Mr.Putin and Mr. Medvedev.

The WSJ may believe that helping some Democrats to scrabble towards the center is a worthy use of the paper's franchise, but an incorrect understanding of past events inevitably leads to bad policy decisions. This was true in 2008-2014 and will be true for this new flawed narrative concerning Russia.

Russia's Foreign Ministry called on Ukraine's parliament to set up a constitutional assembly to draft a new constitution to make the country more federal, Voice of Russia and RIA Novosti reported March 17. See Stratfor.
Crimea was an "autonomous" region in the Ukraine, which meant it had a regional parliament (Duma). The eastern Ukrainian regions are merely administrative provinces (Oblasts) which have a chief executive appointed by the President of the Ukraine and a Rada (Polish for "council").
It was possible to arrange for a reasonable amount of legal window-dressing for the Russian annexation of Crimea because there was a Crimean Duma which could purport to speak for the Crimean people, call a for referendum etc. (The fact that (i) members of the Crimean Duma who did not favor joining Russia were intimidated and (ii) an autonomous Oblast cannot lawfully secede under the Ukrainian constitution and (iii) the referendum was held under military occupation by an interested party will, of course, be put to one side for the moment).
If the Ukraine adopts a federal structure, each region will become an autonomous Oblast with a local Duma. That, of course, leads to a repeat of the opportunity to arrange for the same type of legal window-dressing for the Russian annexation of the eastern Ukraine: various autonomous eastern Ukrainian Oblasts elect their new Dumas, the new Dumas call for a referendum on independence, the Oblast declares itself independent and then asks to be annexed by Russia, which Russia graciously grants.
However, it should be noted that Putin did not trust to the outcome of a free and fair referendum even in the Crimea, the region of the Ukraine with the largest percentage of Russian “compatriots” (to use Putin’s fuzzy word), hence – occupation first – referendum second. Unless Putin strikes a deal with the Ukrainian Oligarchs who control the eastern Ukraine, expect Russian troops (without insignias) and various “militias” to show up in the eastern Ukraine before any voting.
If the Europeans and the Administration want to find a way to let Putin's plans unfold while the west has a legal excuse to do nothing (a policy of appeasement), they will fail to support the Ukrainian central authority when it resists adopting a federal structure.
The annexation of the Crimea is an almost exact historical parallel with the Anschluss, the Third Reich's annexation of Austria in 1938, including a referendum under occupation (97% for Crimea, only 95% for Austria -- Putin is two up on Hitler.)
The dismemberment of the eastern Ukraine will be an almost exact historical parallel with the Sudetenland: -- allegations of oppression of an ethnic minority in an adjacent sovereign country -- saber rattling by the aggressor -- western powers engaging in frantic diplomacy to "calm the crisis" rather than deter the aggressor, leading to western pressure on the borderland country to give in to the aggressor’s demands).
The Russian takeover of the western Ukraine will be an almost exact parallel with the takeover by the Third Reich of the rump of Czechoslovakia.
The Anschluss was accomplished in March 1938, the Crimean annexation in March 2014.
In April 1938 the Sudeten Nazis started to agitate for "autonomy", which would have required a federal structure for Czechoslovakia. Russia has been proposing a federal structure for the Ukraine for a while.
In 1938 France had a treaty of mutual defense with Czechoslovakia and the UK had one with France. In 1994 the US, France, and the UK (not to mention Russia and China) provided the Ukraine with security “assurances” in the Budapest Memorandum committing all of them to defend the Ukraine’s sovereign territory (in return for the Ukraine giving up its nuclear weapons).
In August 1938 a diplomatic effort involving a representative of the UK government failed to "ease the crisis" manufactured by Hitler, and the Czechoslovak government said it would fight rather than cede the Sudetenland. On September 15, 1938 UK Prime Minister Neville Chamberlain met privately with Hitler at Berchtesgaden, without representatives of the Czechoslovak government present, and agreed to cede the Sudetenland to the Third Reich. Deladier did the same on September 18, 1938. These deals were then rolled out in more public diplomatic events in Bad Godesberg on September 22, 1938 and in Munich on September 29, 1938. Germany occupied the Sudetenland in early October 1938. Look for the moment, this summer when Obama decides to get involved personally and goes to a summit with Putin. Perhaps Merkel will come along. (Of course the new Ukrainian government in Kiev cannot attend because Russia does not recognize that government as legitimate.)
The Third Reich invaded the rump of Czechoslovakia in March 1939.
Any bets on whether Putin can beat Hitler's timetable? Any bets on whether Obama and Merkel and Hollande and Cameron can be more craven and feckless than Chamberlain and Deladier were?
As a result of the events of September 1938, the Chamberlain government dramatically sped up its rearming (including particularly with respect to fighter aircraft and the Chain-Home radar stations, which ultimately saved the UK). Any bets on whether the west European countries in NATO will dramatically increase their military strength or preparedness? Any bets on whether NATO will forward deploy crack troops in the eastern-most members of NATO? Any bets on whether Obama reverses his decision to further downsize the US military or even, God forbid, build it back up?
Where will our Churchill come from?

Why Nations Fail-The Unanswered Question

In my previous posting, I described the book "Why Nations Fail" and some of my reactions to it. I ended with the promise of a discussion of the curious point that the book does not address, or appear to provide much in the way of analytical tools to explain, namely the current crisis in Europe or the probable coming one in the U.S.

I refer, of course, to the structural problem in much of Europe of chronic low growth of the private sector, high unemployment, high tax rates, widespread tax evasion, a very large public sector (as a percentage of GDP), large sovereign debt loads (again as a percentage of GDP) and a large portion of the societies who are beneficiaries of significant government entitlement programs.

Obviously, these conditions are closely inter-related.

In order to bring such a fact-pattern within the paradigm if the book, its central theory needs to be expanded.

The authors note that certain South American countries that had the appearance of democracies (i.e. appeared to be inclusive political structures) were, in fact, extractive political structures, where the elite continued to hold power through an informal scheme by which nominally opposing political parties "took turns" holding executive office. They cite Colombia and Venezuela as examples. I can certainly confirm this from personal knowledge as it applies to Venezuela up to Chavez. (With the coming of Chavez, the pluralistic formal institutions of society have been systematically dismantled, so that the clothing of democracy has become thinner than a belly dancers veil.)

However, the authors fail to generate a theoretical framework for this type of situation. I think it exemplifies the possibility of a formally inclusive political institution (i.e a real democracy) being subverted by a self-appointed elite, even without the elections themselves being rigged.

In the U.S. this group is sometimes referred to as the "political class". In truth, the members of the political class, regardless of differing political affiliation, share common interests in maintaining and expanding the proportion of national wealth under government control (and therefore their control) to a greater extent then they share common interests with their constituencies (except, of course, to the extent that their constituency are groups who significantly benefit from government funding). Even politicians who initially get elected by appealing to the interests of taxpayers, on whose backs the whole structure is supported, often switch, over time, as they become seduced by the power (and wealth) that comes to those who control the taking and redistribution of other people's money.

Anyone who is familiar with French society (to take an example in Europe), understands that there is a small political elite at the top of the major parties which is closely interconnected with the economic elite which run most of the economy (both public and privately controlled). In France, this group is self-perpetuating and extremely stable regardless of political winds, the collapse of Republics, wars won and wars lost etc. Since public office is determined by election, with broad universal suffrage, this elite must achieve its balancing act by buying large numbers of votes through the distribution of money in the form of government programmatic handouts. This is not dissimilar to the political elite in the Roman Empire buying peace and political loyalty from the Roman citizenry by means of daily provision of food and entertainment at government expense (bread and circus). In the Roman case, there was not universal suffrage, but the mob still held collective political power in its capacity to riot. French society is dirigiste. As a result, the history of French politics is like plate-tectonics, pressures building inexorable over time, and then a sudden catastrophic release of political energy which often results in barricades in the Paris streets and the collapse of the Republic.

So, I submit that the authors need to realize that an extractive political structure can be created in a real democracy, and one of its hallmarks will be a very significant proportion (ideally a majority) of the population receiving government handouts.

De Tocqueville warned of this possibility and its corrosive effects on what he identified as the societal strengths of America.

The authors note that extractive structures do not cavil at wasting national resources, or accepting sub-par growth, provided they get their skim. I submit, to the authors of "Why Nations Fail", that the European welfare state is (counter-intuitively) an extractive structure for the benefit of a small self-perpetuating elite even though a broad swath of society receives money (taken from a partially overlapping group known as tax-payers), thereby giving the structure the superficial appearance of an inclusive structure.

The problem with these structures is the risk that the perpetual need to buy voter loyalty leads to ever-increasing government largesse (as a percentage of GDP), and extraction to pay for it, which creates a disincentive to entrepreneurial wealth creation, which undermines the tax base, which requires borrowing to square the circle, which eventually leads to a debt crisis.

Why Nations Fail

I recently read "Why Nations Fail" by Daron Acemoglu and James A. Robinson. Through the first half of the book I kept trying to decide whether it was one of the most intelligent books I have read in the last thirty years or another example of the common academic conceit of claiming great insight when all that has been done is to invent new nomenclature. I finally decided it was the former, despite the latter.

The nomenclature in the book is "extractive" political and economic structures and institutions versus "inclusive" ones.

Extractive economy institutions are designed to reinforce the ability of a small self-perpetuating proportion of a society to benefit at the expense of the rest, and extractive political institutions concentrate political power in a small group and exclude from power the others. Some extreme examples of societies with extractive economic and political institutions are present-day North Korea, pre-revolutionary France and the US South during both the antebellum and "jim crow" periods.

Inclusive institutions create opportunity for economic and political participation of the great majority.

The book is a slog because it follows the standard advice to speakers, namely "tell them what you are going to tell them, then tell them what you are telling them and finally tell them what you have told them" nested in a fractal like structure of repetition.

None the less, it is an extremely important book. Aside from the central ideas, the great strength of the book is the authors' broad grasp of economic and political history, which allows them to mine it for numerous examples to illustrate their ideas.

Although never stated this way in the book, its essential syllogism is as follows:

1. National prosperity is a function of continuous wealth creation activity (the longer the better).

2. Wealth-creation activity is a function of risk-taking entrepreneurial activity and technological innovation.

3. A society's level of entrepreneurial activity and technological innovation is a function of:

a) the proportion of the population permitted to engage in such activity (e.g. slaves and serfs (and jews in many parts of Europe during different periods) were not),

b) the existence (and reliability of) essential supporting structures (e.g. private property and contract rights, a just rule of law, and a functioning capital market) and

c) the absence (or minimization of) impediments such as corrupt public officials, prohibitive regulations, confiscatory taxing policies and politically protected (or created) cartels or monopolies.

4. Entrepreneurial and innovative activity results in "creative destruction" which as economically and politically adverse to those who are currently at the top of the political and economic heap (elites).

5. Therefore, political and economic elites will tend to seek to shape political and economic institutions (if permitted) so as to discourage entrepreneurial activity and the introduction of technological innovations in order to avoid creative destruction.

6. Inclusive political and economic institutions are mutually and self- reinforcing (virtuous circle) as are extractive institutions (vicious circle).

7. Other than as a result of 6 above, there is no historical, cultural or geographic destiny or imperative or immutable law governing the economic trajectories of nations. (The book is a very effective refutation of Jared Diamond's theories).

8. Counter-intuitively (to the central idea), nations with extractive institutions can engineer bursts of strong economic activity by importing technology but they cannot sustain the high rates of growth when further advances require risking creative destruction of the economic base that sustains the extractive institutions.

Oddly enough, the book utterly fails to address the current crisis in Europe or the coming one in the US. More on that in the next posting.

European Debt Crisis – Moral Hazard and the Sovereignty Issue

The bail-out plans for Greece, Ireland and, via the new enlarged EU bailout fund, for the next countries to go to the brink, are all deeply flawed because they encourage behavior that will tend toward ensuring that future crises and bail-outs occur.

First and foremost, it makes explicit what some in the financial markets were betting would happen, but didn’t know for sure would happen, namely a bailout. Up until now, those who bought the debt of financially weak European countries, or sold default insurance on such debt (pre-bailout), were at least taking a risk that they were guessing wrong as to what the EU would do when the music stopped. (Not much of a risk, I admit, after the Greek bail-out.) Now there is virtually no risk, at least in the near and medium term. Germany sought to require that, for future bail-outs, private holders of bailed-out government debt, or the private issuers of default insurance on such debt, should suffer some automatic loss of value (compared to face value) as a pre-requisite to a bailout. In other words, these countries would have to go through some form of debt default and work-out which would impose at least some pain on those who had lent to a risky credit, or who wrote default insurance on such debt. However, in order to get a deal done, Germany eventually dropped that demand. So now buyers of the debt of Portugal, Spain and Italy, and sellers of default insurance on such debt, know that any debt of these counties with a maturity of, say, five years or less, will be paid off in full, either because the country will, at maturity, be able to borrow the money it needs to pay the debt from the private market or from the EU bail-out fund. As a result, buyers of debt of potentially insolvent European countries, and sellers of default insurance on such debt, are only taking the much lower risk that the EU as a whole defaults or reneges or breaks-up prior to maturity. The consequence, of course, is that many more investors will be willing to buy and hold such debt at substantially lower yields than otherwise, which means that the private market will remain open to these countries, and at lower borrowing costs, without regard to whether they are taking the politically difficult steps to straighten out their national finances. This leads us to the second perverse result.

Straightening out the finances of a financially weak country, without a debt default and workout, or currency devaluation (not available to Euro-zone countries), requires enormous political will and, in democracies, involves taking enormous political risks, because the measures necessary to straighten out a country’s finances involve massive spending cuts and/or tax increases. Politicians in the governments of Spain and Portugal and Ireland (pre-bailout) were taking those political risks and were adopting those painful measures (to varying degrees) to avoid the risk of default. Now, the political calculus is different. They will continue to take those risks and adopt those measures only if they believe that the political risk of taking responsibility for austerity measures is less than the political risk of sailing into 1) the stigma of being a bail-out recipient and 2) losing most of the remainder of its national sovereignty (namely sovereign control of its spending and taxing policy) not already given up under the Maastricht and other EU treaties. (Point 2 was why Ireland was resisting for so long the proffered EU bail-out.) These risks may not be sufficient political motivation. It may be more politically attractive to defer taking responsibility for the tough measures (thereby ensuring a bail-out) and letting the measures be imposed on the country by a force not answerable to the people of that country at the polls. This leads us to the third perverse result.

Greece and Ireland, and in the future perhaps Spain, Portugal and maybe Italy, will become colonies of the creditor-countries of Europe: they will have taxation without effective representation like the American colonies prior to 1776. Yes, they will be represented in Strasbourg, but not were the decisions will be taken (the capitals of the European creditor-countries). This is an intolerable situation for a country with a tradition of democracy. If democracy means anything, it means that those who make the laws and determine taxes and spending policy should periodically run the risk of being thrown out of office. The Irish citizen (for example) has no option to throw out of office European creditor-country politicians who impose, as a condition of a bail-out, a particular cocktail of spending cuts and tax increases on Ireland which that citizen believes is wrong-headed or ruinous or simply unfair (imposing too much pain on one sector of Irish society and not enough on another sector of Irish society or imposing to much pain on Irish citizens and businesses as a whole and not enough pain on citizens and businesses of creditor countries of the EU, for example). He can, however, vote for Irish politicians who stand for revolution, namely, Ireland dropping out of the Euro-Zone and the EU. Unfortunately, the Irish citizen has no democratic option between suffering in silence (maybe for a generation) and voting for revolution. This is a very dangerous situation.

This erosion of democracy could, of course, be solved by completing the unification of Europe: by giving the EU parliament (in which the Irish citizen has a voice) the power to require any member country (say Germany) to contribute to a bail-out of another member country which is approved by majority (or some super-majority) vote of that parliament (and despite the objections of the German Government). Of course, that means equalizing the losses of sovereignty of member countries. Under this change, not just the debtor-country governments lose sovereignty, the creditor-country governments do also. Of course, this would effectively entail giving the EU Government the power to directly tax the citizens of each member country, in the same way that the US Federal government has direct power to tax the citizens of the various states of the union (without regard to the protestations of the state government).

Will the citizens of the creditor-countries of Europe agree to this? The last round of transfer of sovereignty from EU member countries to the center was a near run thing, with various national “no” votes, and that was when it was still possible for elites who were pushing the plan to say, with a straight face (although fraudulently), that concerns about loss of sovereignty were over-blown and inspired by ignorant, xenophobic politicians. There will be no disguising this loss of sovereignty.

Absent the completion of EU unification, the pressure for revolt will continue to build. It may be relieved to some extent by creditor-country governments sweetening the pot: either by easing the terms of the EU bail-out debt or by easing the required austerity measures. But such steps entail increased political risk in the creditor-countries. Too much of that and one or more creditor-country governments fall, in favor or a political group that gets elected on a "get tough" policy platform.

Bear in mind that each European creditor-country also has huge domestic fiscal time-bombs ticking. Even though they have been less profligate then the PIGS (Portugal, Ireland or Italy, Greece, Spain), the difference is only one of degree. Each are locked into expensive welfare state policies with declining and aging populations and high taxes and national debt levels. These situations will eventually force tough political decisions concerning tax increases and spending cuts, even without the added cost burden of bail-outs of the European debtor countries.

So, in the near or medium future, Europe will be forced to address the sovereignty issues swept under the carpet at Masstricht, one way or the other.

Damned if You Do and Damned if You Don't

In the recent past, we were shown the spectacle of CEO's of failed and almost failed financial institutions (i.e. Fuld (Lehman) and Prince (Citibank)) raked over the coals in the Senate. Their crime was to buy, and promote to their customers, what the Government (Fannie and Freddie) was selling and not being smart enough or insightful enough to foresee the coming housing collapse and therefore not able to position their institution to weather the financial storm. They were forced to act contrite (even as they assert that "everyone was doing it" and "nobody was smart enough to foresee the collapse"). It was not pretty, but understandable; big losers often get pilloried.

Now, however, we have the spectacle of a CEO of a successful financial institution (Goldman) that did foresee the collapse (or at least recognized the significant risk and took steps to manage that risk) being raked over the same coals in the Senate. Their crime was in participating in the marketplace, buying and selling instruments that regulators permitted to circulate there, and to do so in such a way as to avoid losing (and even worse, perhaps making) money during the financial meltdown.

So, there we have it. The crime is not being stupid (failing the trust put in them by others), the crime is just being a financial institution in bad times.

The Government (including the Fed) serves up a dangerous cocktail of easy credit and legislatively mandated reduction of credit standards, and a major increase in the availability of Government guarantees for dubious credits. Private institution take these components and play a furious game of musical chairs for profit. The music stops. Some are winners and some are losers. And the guys who created the environment sit in judgment of the players and declare that winners and losers are both at fault.

Judge not lest ye be judged. Election time is coming. The public is not as gullible as populist demagogues think.

Abacus 2007 AC-1

A sophisticated gambler ("A") walks into a casino and joins a private game of poker. He knows some but not all of the other gamblers at the table, but they all appear to be pros like him. The house has set the rules (maximum bet, maximum number of raises, permissible poker games which may be called by the dealer, and so forth). Unbeknownst to A, one of the anonymous faces at the table is a gambler ("B") who is as experienced as he is, and was consulted by the casino concerning the setting of the house rules. The casino itself is represented at the table by one of the players. A loses heavily, as does every other player (including the house), except B, who wins everything. Later, the Government sues the casino for fraud: it failed to tell A the identity of B and that B was on the other side of each bet A made. Further, the complaint alleges that the casino committed fraud by failing to tell A that B had been consulted on the setting of the house rules. The case was launched by the Government just as it ramped up its efforts to pass legislation to further regulate casinos.

I submit that this is an accurate analogy to the fraud case launched by the Government against Goldman Sachs (with the exception that there is no law requiring material disclosure in the casino world). I also suggest that, just as in the analogy, there is no fraud in the case. Any sophisticated gambler knows that in order to have a chance to win money, some other gambler must be willing to take the opposite side of each bet he makes. Who was involved in setting the house rules is not material, the house rules themselves were fully disclosed at the start of the game, and each player could analyze the impact of those rules on his style of play and his chances of winning.

The bigger issue posed by the facts of the Abacus 2007 AC-1 deal is whether such deals should be permitted at all (other than in a casino).

Healthy capital markets are necessary for the smooth and efficient movement of capital from those who have it and want to invest, to those who do not, and need investment capital. The entire structure of our (small "l") liberal western economy since the Renaissance is built on such a financial foundation. However, that does not mean that any transaction that can be imagined, that has the potential to create winners and losers, should be allowed to occur within the precincts of the capital market. We do not allow investment banks to create synthetic securities, the purchase and sale of which is the functional equivalent of betting on the outcomes of the following week's sports events. Such a side bet does not facilitate the larger purpose of a capital market.

I suggest that before any product is allowed in the capital marketplace its proponents must give satisfactory answers to two questions (1) “What legitimate purpose does it serve?” and (2) who has a legitimate need to buy or sell the product?” Credit default swaps pass the first question—they allow those with credit default risk to insure against it. However, that does not mean that those who do not have a credit default risk should be allowed to buy a swap. If the proper analogy for a credit default swaps is insurance, than the prohibition against a person without an insurable risk buying an insurance policy should apply.

Allegedly, Abacus 2007 AC-1 was fashioned for the sole purpose of permitting one party to place a massive bet that a certain group of securities collateralized by a pool of mortgages would be downgraded and ultimately default (and, of course, to generate fees for Goldman). There is nothing wrong with wanting to profit from a market insight you have that others don’t share. But that does not justify building a security for that specific purpose. There were ample other means of placing negative bets on the mortgage market (although those means would, undoubtedly, be more expense and more transparent). In addition, it masks price information. If all those who think x will go up or down must place their bets by buying or shorting x, this activity affects the price of x. A side bet does not. Furthermore, creating such a security also has a money supply inflationary effect, it creates an “asset” out of thin air, out of the fact that there is a person who thinks x will go up and another who thinks x will go down.