"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.

Meta Level

I was introduced to the idea of looking at things from a meta level a long time ago by Douglas R. Hofstadter in his brilliant book "Gödel, Escher, Bach". He was referring to the ability to rise, mentally, to a sufficiently high level of both perspective and insight that one can begin to discern similarities in seemingly disparate things (such as the work of Escher and Bach) and even in apparently different systems (for example, different self-contained systems of higher mathematics).

Meta level thinking is critically important when designing systems. Meta level thinking is hard, even for very smart people.

The Founding Fathers, the Soviet System and Alan Greenspan.

Good examples of meta level thinkers engaged in system design are the Founding Fathers.

Contrary examples are legion. Two from recent history come to mind: the designers of the Soviet political and economic system and Alan Greenspan at the Federal Reserve. (What meta level thoughts, you ask, could possibly connect these two examples from the extreme ends of the spectrum on economic system design: top down vs. bottom up; collective vs. individual; capitalism vs. communism, etc.? Well, both failed to take into account something that the Founding Fathers did take into account, namely, human nature.)

The designers of the Soviet system were not just involved in a power grab (although they were certainly doing that), they were implementing a new system which was intended to eliminate the obvious problems of 19th century capitalism, in terms of exploitation of workers etc. And those societal problems were significant.

However, their system failed to take into account that the same human nature that produced the vilified behavior of the captains of industry was embedded in the down-trodden masses: a tendency to act in one's own self interest to the extent that one has an opportunity to do so. (This point is rather nicely made in a fairly obscure Peter Sellers movie "Heavens Above".) The Soviet system would only function well if a great majority of people in the system chose to subordinate their own self interest to the interests of the collective, as identified by the leaders. (I am not suggesting that the Soviet system did not also have other significant defects; those other defects are another topic.)

Speaking about the current financial meltdown, Greenspan said, in effect, that he was surprised that bankers allowed their greed for higher profits to overwhelm their prudence (i.e. sound risk management). That's like Capt. Renault saying, in Rick's Cafe Americain, "I am shocked, shocked to find that there is gambling going on here!"