Pakistan: The World's Most Dangerous State

Lost amidst the graphic images of this week's stunning terrorist display in Mumbai was a discussion of its origins. If American intelligence is to be believed, the group claiming responsibility is connected to a radical Islamist organization at the forefront of efforts to "liberate" the province of Kashmir from Indian rule. This group has received financing and logistical backing from the notorious Directorate for Inter-Services Intelligence, Pakistan's equivalent of the CIA.

A closer look at Pakistan reveals a deadly mix of corruption, violence, and lawlessness, the consequences of which extend far beyond the Indian subcontinent. It is, put simply, the world's most dangerous state.


Opportunistic origins
The founding of modern Pakistan can be credited to a whiskey-drinking politician whose late discovery of Islam had more to do with opportunism than conviction. In 1939, the British, who had long been India's colonial masters, were mobilizing international support for their war against the Nazis. Ali Jinnah, head of the local Muslim League, saw an opportunity and threw his weight behind Great Britain while the Indian Congress Party, India's main independence movement, vacillated. In return, he secured British support for an independent Pakistan to be carved out of the Muslim sections of India.

His ambitions were finally realized in 1947, when a war-weary Britain was seeking a quick exit from its overseas imperial burdens. The British convinced Jinnah along with the Congress Party to let the leaders of India's princely states decide for themselves which country to join: India, or the newly-established Pakistan. In most cases, the decision was a foregone conclusion; the Muslim-majority regions to the north joined Pakistan, while the Hindu-majority provinces in the south opted for India.

In one region, however, the decision would prove more complicated. The state of Kashmir had a majority-Muslim population but was ruled by a Hindu prince. His decision to unite the territory with India provoked an invasion by Muslim tribesmen intent on absorbing the province into Pakistan. But the new Indian government mobilized its forces and was able to defend most of Kashmir against the attack, heading off the invading army at what would soon become known as the "Line of Control."

To this day, the Line of Control remains the most dangerous nuclear flash point in the world.


Violence and its advantages
Kashmir is a region of legendary scenic beauty set in the Himalayas. The same mountains that create its picturesque landscape also give it a critical strategic importance. Four times in the past fifty years the conflict over Kashmir has led to war between India and Pakistan - in 1947, 1965, 1971, and 1999.

Since 1947, however, the bulk of Kashmir's territory and population have remained under India's writ. This is despite the wishes of most of its Muslim inhabitants for independence. India maintains control through the heavy-handed presence of its troops, who have often been accused of mistreating Kashmir's populace. Pakistan, for its part, demands that India allow a plebiscite that would give the people of Kashmir the choice to remain part of India or become independent. India insists that Pakistan withdraw its troops from the Pakistani-controlled parts of Kashmir before any independence vote is held. With neither side willing to budge, a stalemate has prevailed, albeit one that is perfectly acceptable to India.

Despite the frequent maneuverings of the Pakistani and Indian governments, Kashmir's own population remained relatively docile until 1987. During that year the first independence movement arose in protest against a provincial election that India had blatantly rigged. Within a few years, however, the initiative for an independent Kashmir was hijacked by radical Islamist militants imported from Pakistan, Afghanistan, Chechnya, and Saudi Arabia. The jihadists received training and support from the Pakistani government, who sought to use them to undermine India's hold on the province.

One of these groups, Lashkar-e-Taiba ("The Army of the Pure"), is believed to be behind this week's attacks in Mumbai. Its main stated goal is independence for Kashmir. Recently, however, it, along with its backers in Pakistan's Directorate for Inter-Services Intelligence (ISI) , has faced a new obstacle in the form of Pakistan's newly-elected president, Asif Zardari. Zardari, who in September replaced the country's long-serving military ruler, Pervez Musharraf, has gone to great lengths to pursue peace with India, referring to Kashmir's militant jihadists as "terrorists" and taking steps to weaken the ISI.

The worst possible outcome for Lashkar-e-Taiba and the ISI would be a resolution of the Kashmir dispute and a final peace settlement with India. The Indian threat is the primary justification for these organizations' activities, and a lasting peace with India would eliminate the very rationale for their existence. What better way to derail Zardari's peace initiative than to launch a colossal terrorist attack that stokes India's rage against the Kashmiri mlitants and their Pakistani backers?


Lawlessness, corruption and nukes
To account for why Pakistan serves as a launching pad for terrorism and militancy requires one to look well beyond Kashmir. Since its founding as an independent state, Pakistan has endured decades of instability and mismanagement. Periods of thieving civilian rule (1947-58, 1971-77, and 1988-99) have been interspersed with equally long stints of military dictatorship (1958-71, 1977-1988, and 1999-2008). Uniting all these governments has been an enduring proclivity for incompetence and corruption.

What's more, the Pakistani state has historically proved unable to control large parts of its territory. Vast sections of the country continue to exist under the rule of autonomous tribal strongmen. Some of these tribes have provided a haven for Taliban fighters from Afghanistan, al-Qaeda, and other militant groups. So long as these organizations have a base of operations inside Pakistan, they will continue to threaten India, America, and the world.

The dangers posed by Pakistan's feeble and corrupt state would not be nearly as ominous were it not for the country's sizable nuclear weapons arsenal. India first tested a nuclear device in 1974 and Pakistan followed with a successful test of its own in 1998. While India has vowed not to be the first to launch a nuclear attack in a dispute with a foreign state, Pakistan has decidedly refrained from such a promise. Maintaining a first-strike nuclear stance is one of the only ways that Pakistan can offset its clear military disadvantage vis-a-vis its larger and more powerful neighbor.

To make matters worse, Pakistan lacks the robust system of checks and safeguards that most other nuclear powers have in place to prevent an accidental nuclear launch. Combine this with a paranoid, trigger-happy military elite that has a habit of seizing the reins of power and the prospect of a devastating nuclear conflict becomes all the more conceivable.

But a state-to-state nuclear conflagration is not the only scenario the world has to fear from a nuclear-armed Pakistan. A state bureaucracy as corrupt as Pakistan's opens up the real possibility that officials with direct access to the country's nuclear technology might sell it to the highest bidder. In fact, this has already happened. A.Q. Khan, the father of Pakistan's nuclear program, admitted in 2004 to selling vital nuclear technology to Libya, Iran, and North Korea. The notion that well-placed personnel might move actual nuclear weapons onto international black markets is not so far-fetched.

Who else might Pakistan's crooked bureaucrats be selling to?

*For a fascinating introduction to contemporary India, I highly recommend Edward Luce's In Spite of the Gods: The Rise of Modern India. Several chapters detail the history of the conflict with Pakistan.

The Crisis in Congo - A Primer

The worst humanitarian disaster since WWII remains overshadowed in the media by ones far less severe. Here is everything you need to know.

It was Africa's First World War and it is on the verge of erupting again. Already, an estimated five million people are dead. Another sixty million remain trapped under a corrupt and impotent government that provides no social services to its long-suffering population. All this in a country that possesses one of the world's most fantastic endowments of natural riches - gold, diamonds, copper, and tin, among others.

The conflict, which lasted from 1997 to 2003 and simmers on today, drew the involvement of eight countries. It birthed a dozen armed organizations with such misleading names as the "Congolese Rally for Democracy" and the "Movement for the Liberation of Congo." Congo, formerly called Zaire, today looks much as Europe did 500 years ago. Among the few modern trappings is the rather advanced technology of killing, readily supplied to the combatants by shady arms dealers from Russia and Ukraine.

In the developed West, the individuals who rise to the upper echelons of politics and commerce may not be the best that society has to offer. But they are hardly the worst either. Selfish, manipulative, and narcissistic, perhaps, but most are law-abiding citizens. Society's criminal elements - those who thrive by theft and strong-arming - generally remain on the margins or in prison.

In the countries I've lived in over the past couple of years, the situation is often reversed. Most of those at the top would be in jail if they lived in America, prosecuted for crimes like fraud, bribery, and racketeering. Those who are honest find themselves deliberately sidelined and often imprisoned. Elsewhere in the world too, the kinds of people who hold top positions in politics and business would in the West be incarcerated, though for far more heinous and violent offenses

In Congo, however, it is as if Sing Sing emptied its murderers, armed robbers, and rapists into the gleaming halls of Washington. How could a country come to this point?

The Rwandan genocide

The seeds of the Congolese civil war were set in 1994 in neighboring Rwanda during the genocide of 800,000 ethnic Tutsis and moderate Hutus by the "Interahamwe," radical bands of militant Hutus. In the precolonial era, the terms "Tutsi" and "Hutu" denoted class distinctions, not ethnic ones; to be a "Tutsi" merely signified having greater wealth than a "Hutu." This changed in the late 19th century with the arrival of the Belgians, who decided the two groups were different races, one superior and the other inferior. The colonial state bestowed power and privilege on the minority Tutsis, who now ruled as an ethnic aristocracy over the Hutu majority.

The end of colonial rule coincided with periodic ethnic violence as members of the two groups jostled for power, culminating in the 1972 genocide of Hutus by Tutsis. In 1994, the Hutu president of Rwanda was assassinated in mysterious circumstances, prompting Hutu leaders to attempt their own final solution against the Tutsis. The Interahamwe embarked on a massacre. Using the medium of radio, extremist demagogues, later prosecuted for war crimes, called on their Hutu brethren to rape, machete, and burn their Tutsi neighbors to death.

The carnage ended later that year with the seizure of power by a Tutsi rebel group, the Rwandan Patriotic Front (RPF) led by Paul Kagame. The Interahamwe were forced to flee into neighboring Zaire along with thousands of Hutu refugees. Yet Kagame and the RPF would not rest until the organizers of the genocide were killed. Zaire's fate had thus been sealed.

Congo/Zaire under Mobutu

Even before the Europeans arrived, the region that would later become Congo had a rich history of exploitation by the powerful. However, King Leopold II of Belgium raised the bar. Author Michela Wrong, a former Financial Times correspondent, aptly describes him as "the only European king to ever personally own an African colony."

Among the tasks he neglected while extracting Congo's riches and repressing its inhabitants was building a functioning state bureaucracy. The feeble government that Belgium bequeathed the country's post-independence rulers in 1960 was wholly unable to fulfill the administrative functions that we in the West take for granted - the collection of taxes, the provision of basic public services, and monopolizing control over the use of force within its borders.

The Belgians left Congo during the height of the Cold War at a time when dozens of countries throughout Africa and Asia were gaining independence from their colonial masters. America, looking to prevent the Soviet Union from winning influence with the new states, was searching out regional allies. Congo, a mineral-rich country the size of Western Europe, was seen as a key pawn in this struggle.

Standing in the way of the US was the democratically elected, left-wing prime minister, Patrice Lumumba, who looked to the Soviets for support. To resolve this problem, the CIA in 1961 backed a coup by the military chief, a man named Joseph-Désiré Mobutu. Lumumba, with America's blessing, was jailed and executed.

Mobutu went on to become one of the most infamous dictators the world has known, notorious less for his brutality, which he dished out generously, than for his sheer venality and astonishing corruption. As part of his "authenticity" campaign designed to bring the country back to its African roots, in 1971 he renamed the country Zaire. He himself adopted the name Mobutu Sese Seko Nkuku Ngbendu wa Za Banga - more commonly shortened to Mobutu Sese Seko.

While his underlings plundered and decimated Zaire's state institutions, Mobutu was known for packing his family on the Concorde and taking off to Paris for weekend shopping trips. In place of traditional religion, he promoted a doctrine called "Mobutuism," which glorified the visionary thinking of the man himself. The nightly news opened with a depiction of Mobutu's image descending from the heavens.

In an environment where resources were scarce and potential rivals constantly knocking on his door, it was far too dangerous for Mobutu to attempt to rule by relying on Zaire's weak state institutions - the executive, legislature, and bureaucracy. Instead, he put trusted allies and family members in key positions in the army and police. He constantly shuffled ministerial appointments to prevent any one official from building a base of power that could rival his own.

William Reno, one of the most astute Western observers of sub-Saharan Africa, shows how Mobutu systematically maintained personal control over Zaire's economic resources while preventing them from falling into the hands of his opponents. He concluded agreements with multinational mining firms, giving them access to Zaire's immense natural resource deposits in return for billions of dollars in revenue. The vast preponderance of this money was deposited not in the state coffers but rather the foreign bank accounts of Mobutu, his family, and key supporters. By the 1980s Mobutu was personally worth an estimated five billion dollars.

While amassing this wealth, he not only avoided funding Zaire's state agencies but actively undermined them. For the doctors, teachers, and civil servants who staffed these bodies, Reno notes, "could become the nuclei for demands to spend state resources on development...or even mobilize people directly against him." Left to their own devices, the bureaucrats, police officers, and soldiers of Zaire tyrannized the population, extracting any meager tribute that they could from the country's hapless citizens.

Aside from natural resources, Mobutu's other source of funding was the United States government, which during the Cold War granted, either directly or through international institutions like the IMF and World Bank, a total of $8.5 billion to Zaire - or rather, to Mobutu himself.

Had the conflict with the Soviet Union endured, so might have Mobutu. Alas, it did not. With the collapse of the Soviet Union went any incentive America had to continue propping up its African ally. By 1990, US aid to Zaire had dried up entirely. The game was over, though Mobutu managed to stay in power for another seven years. But his sway over Zaire steadily deteriorated, as he could no longer pay off the strongmen he needed to support him.

The civil war
What's more, Mobutu provoked the enmity of his neighbors. He provided money and a territorial base within Zaire to rebel movements from Angola and Uganda, thereby alienating the governments of these countries. Yet his most fateful error was to ally with the Hutu Interahamwe who had organized the Rwandan genocide. Eastern Zaire had a large Tutsi population of its own. When the Interahamwe arrived, local elites saw an opportunity to seize for themselves the landholdings of the local Tutsis and enlisted the Interahamwe's help to do it. Mobutu backed this effort and even stripped the Tutsis of their Zairian citizenship.

For the Tutsi-led government of Rwanda, this was the final straw. President Kagame, in alliance with the Ugandan and Angolan militaries, launched an invasion of eastern Zaire. They chose as their local proxy a washed-out Maoist rebel named Laurent Kabila. Kabila, riding towards the capital, Kinshasa, on the back of the foreign armies, swiftly advanced across Zaire's enormous landscape. The dilapidated Zairian army collapsed; it turned out that thieving generals had sold the bulk of the army's military hardware to the rebels prior to the invasion. "To misquote Churchill," writes Wrong, "never in the field of military history had so much territory been captured by so few with such little effort." An ailing Mobutu was forced to flee to Morocco, where he died four months later.

In addition to the foreign powers, notes Reno, Kabila also enjoyed backing from a slew of multinational mining companies who in early 1997 made substantial payments to him, promising more if he managed to take Kinshasa. Once in control of the capital, Kabila renamed the country The Democratic Republic of Congo.

However, he quickly fell out with his foreign allies, and in 1998 issued an order for all foreign armies to leave the territory of Congo. Rwanda and Uganda had little intention of complying and began advancing once again on Kinshasa, this time to oust Kabila. Their bid would have succeeded were it not for the quick intervention on Kabila's behalf of three other regional powers, Zimbabwe, Namibia, and Angola. Three more countries, Chad, Libya and Sudan, followed later. The stage was now set for the much longer and brutal second phase of Congo's civil war.

The foreign states were mostly interested in exploiting Congo's mineral resources. Kabila secured Zimbabwe's support by offering exclusive mining concessions to family members and allies of president Robert Mugabe. Namibia received similar benefits. Angola, meanwhile, wanted to prevent its own rebels from gaining control over Congolese diamonds. It also received lucrative contracts to sell its petroleum products in Congo.

Material motivations figured in even for Rwanda and Uganda. They initially intervened to eliminate existential threats to their own statehood (the Hutu Interahamwe for Rwanda, and the Lord's Resistance Army fighting against the Ugandan government). Yet the two allies soon found themselves battling for control of diamond mines around the town of Kisangani. More recently, in 2007, they came to blows around Lake Albert, which is believed to contain significant oil deposits. That said, Rwanda's primary motivation remains the elimination of the Hutu elements in Congo who were responsible for the 1994 genocide.

The peace accords
In 2001, Laurent Kabila was assassinated and succeeded by his son, Joseph, who immediately set about negotiating a peace agreement with the warring parties. A deal was finally concluded in 2002. It had two main components - for Rwanda, a promise to clamp down on the Hutu genocidaires in eastern Congo and, for the others, lucrative positions in a unified transitional government in Kinshasa. Four vice presidencies were created for the leaders of the main rebel factions, each of whom received $250,000 per month in compensation for what would surely be a job well-done. Others, according to observer Jason Stearns, were granted posts in state companies earning monthly salaries of $20,000. During the next two years, Stearns notes, military officers were found to have embezzled half the payroll of the army and police each month.

The foreign armies that had backed the rebel groups agreed to withdraw their troops from the country. To enforce the peace accords, the United Nations sent in an 18,000-strong peacekeeping contingent. Elections were held in 2006 that saw Joseph Kabila and his party solidify their control.

While peace has returned to most of Congo, large parts remain tense and have occasionally erupted in renewed violence. The main unresolved issue is the continued presence in eastern Congo of organizers of the Rwandan genocide. The Tutsi-led Rwandan government is not likely to cease its interventions until these elements have been liquidated entirely. Yet the Kabila government in Kinshasa has little capacity to comply with Rwanda's demand, whether it wants to or not; its writ in this part of the country is far too feeble.

For this reason, Rwanda continues to support a renegade Tutsi general in eastern Congo named Laurent Nkunda. His Congolese Rally for Democracy has repeatedly sparred with Hutu remnants of the 1994 genocide, who fear annihilation at the hands of their Tutsi rivals. Nkunda's troops have terrorized the local population as well and are responsible for the latest displacement of up to one million people from around the town of Goma. Most of these refugees have been reduced to living in makeshift camps and are on the verge of starvation.

The UN peacekeepers who are supposed to prevent such episodes have proved adept at avoiding confrontations with the rebels. Incompetent, anxious, and wary of suffering any casualties, their conduct resembles that of 18,000 Woody Allens in the heat of battle.

Even in those parts of the country that are mostly peaceful, the primary instruments of Congolese politics remain personal control over economic resources and the use of force. This was illustrated in 2006 when Kabila's presidential guard clashed in the capital with armed contingents loyal to his vice-president, who was forced to flee abroad as a result. Until this fundamental dynamic changes, Congo will continue to be ruled by criminals and thugs instead of that less unsavory type of politician to which we in the West are accustomed. And the suffering of Congo's people will endure.

A Portrait of the World in 2018

America's Great Retreat

Will there be war? There is much disagreement on the prospect. What everyone does agree on is that, if war comes, America will not participate. A destabilizing conflict between China and Japan can only heap more misfortune on the US economy, having already shriveled to sixty percent of its previous size.

The great Panic of 2008-2009 spared few countries. Among the hardest hit was the United States. The near-absolute drying up of bank lending unleashed a wave of insolvencies that penetrated every sector of the economy. America experienced the worst economic slump in its history, exceeding even that of the Great Depression.

The US financial system now exists entirely under the ownership of the Treasury and Federal Reserve. This places finance in the same league as national security as a government-provided public good. The third and final bank bailout, this time to the tune of $1.2 trillion, left the federal government stuck with loads of assets that nobody else had the stomach to buy.

It was at this point that President Obama proposed a comprehensive solution. Inspired by Roosevelt's New Deal, it was to involve massive, government-sponsored public works projects to stimulate investment and growth. The program would be called "The Audacity of Hope," after the title of Obama's autobiography. It soon emerged that the government was to pay him royalties for the rights to the phrase.

Before Congress even had a chance to consider it, however, the capital markets staged a revolt. The mere announcement of the gargantuan initiative sent yields on US Treasuries into the stratosphere. Overnight, the government's cost of borrowing skyrocketed from 14 to 35 percent, forcing the program's complete abandonment. It turned out that all the money the Treasury had spent bailing out the financial institutions had left it unable to finance a viable recovery plan for the broader economy.

Obama was duly ousted in 2012. His replacement was Cleetus Jenks, a plain-talking country singer and town mayor from Tennessee. His first move in office was to extend the ban on short-selling and long-buying to cover "sideways glancin'." This brought trading on the New York Stock Exchange to a complete halt, as nobody could figure out what the new policy actually entailed. He went on to abolish the Fed, loot the Treasury, and fire up the printing presses to finance his bizarre initiatives. Most of these involved NASCAR in some form or another. With inflation at 40 percent and gold pushing $22,000 an ounce, voters returned Obama to power in 2016 under the slogan of "boundaries." Jenks now sits in a federal prison.

Obama's second presidency was to bring more misery upon Americans. Fiscal necessity, heightened severely by the economic crisis, dictated a drastic reduction in Social Security and Medicare provisions. For many seniors, the added financial burden proved too difficult to bear, pushing masses of retirees to move in with their children.

One unanticipated consequence was the return of the credit-default swap (CDS), an esoteric financial derivative whose blowup in 2009 cemented America's final descent into the economic abyss. As more and more seniors shacked up with their kids, financial entrepreneurs began selling CDS to help people offload this risk onto those more willing to shoulder it. In return for a premium, the CDS seller would offer to take the buyer's parents into his or her own home in the case of a "move-in event."

Former Fed Chairman Alan Greenspan praised the new derivatives for "effectively spreading risk from those with large short-term obligations to those with diffuse long-term liabilities, or no liabilities at all."

The drastic curtailment of entitlements followed a long series of similarly momentous spending cuts initiated under the first Obama administration. Of these measures, the most far-reaching was the withdrawal of US troops from all military outposts around the globe. The consequences were disastrous, not least in Asia, where Japan was now left on its own to fend off a rapidly rising China.

Few in America expected the resulting wave of paranoia that was to spread across Japan. The Liberal Democratic Party, having governed the country for the previous seven decades, was unable to present a viable solution. Swept away on the back of mass anti-government protests, the Liberal Democratic era gave way to that of the fascist Forward Japan Party. The FJP summarily dispensed with the constitution and jailed the political establishment. It then deployed the country's immense foreign currency reserves toward a massive military build-up, propelling Japan out of its 23-year economic slumber and forever shaking the world's geopolitical map.

It was not long before Forward Japan abandoned the pacifist foreign policy of the preceding decades. Its first act was to create and finance a rebel group that ousted the rapidly decaying North Korean regime following the third and final death of Kim Jong-il. This prompted China to step in and back remnants of the Korean People's Army in an attempt to undermine the new government, spiraling the country into a calamitous civil war.

North Korea's collapse has prompted many to ponder the whereabouts of its nuclear, chemical and biological weapons arsenal.

The Korean civil conflict was only the first in a series of proxy wars between Japan and China. Their rapid economic growth has placed renewed pressure on the world's natural resources, leading the two Asian powers to finance rival warlord factions in several oil-producing states. The "energy wars" have brought devastation to Venezuela, Angola, and Saudi Arabia, where intense fighting over oil wells has created frightening refugee flows into neighboring countries.

The new geopolitical environment has thrust Russia, with its vast oil and gas reserves, into the role of kingmaker. To the surprise of many, the Putin-Medvedev partnership has endured. Putin, known derisively to the public by his new nickname, "Sani Abacha," spreads the Kremlin's plentiful oil revenues around the country's corrupt and venal elite. He has secured his alliance with president Medvedev by engineering the government takeover of Lukoil, Russia's last privately-owned energy conglomerate, and selling it to the president's brother-in-law in exchange for a half-eaten Chicken McNugget.

If the shocking effects of America's Great Retreat in Asia came as a surprise to many, no less dramatic were its consequences for the Middle East. The Obama administration's first foreign policy move, of course, was to hastily withdraw all US forces from the region. To be sure, the intensifying economic crisis left Obama with few other options. The aftermath in Iraq, however, was horrifying. The halting progress it had made since the "surge" now disintegrated into a vicious three-way civil war. Opposing factions backed by Syria, Iran, and Turkey clashed violently, plundering, raping, maiming, and killing in their pursuit of Iraq's oil wealth.

The unspeakable atrocities committed by all sides eventually triggered a popular backlash against the three foreign powers and their domestic clients. Having transparently cloaked their naked quest for riches in extreme religious ideologies, the warlords unwittingly laid the foundation for a new movement espousing a secular, pan-Iraqi nationalism. Formed mostly by Shias, it brought under its universal umbrella many Sunnis and Kurds as well. Its ability to inspire mass support and recruit committed volunteers enabled it to gradually expel the warlords and their foreign backers. As it did so, the new ruling party consolidated its authority across ever-larger swathes of the country, bringing with it stability and economic modernization. Iraq had finally gotten its Ataturk.

Inspired by the Iraqi example, a similar movement sprung up in neighboring Iran. The pampered and privileged Islamist elite under the Ayatollah Brezhnev soon found itself under siege, its authority limited to a rapidly diminishing island around Tehran. Accelerating its demise was a series of newspaper exposés detailing the full extent of top officials' involvement in the trafficking of Afghan opium.

Afghanistan, for its part, witnessed the rapid advance on Kabul of the Taliban following America's withdrawal. From Kabul the Islamists descended on Pakistan, where years of economic collapse had left its previously imposing army decimated by mutinies. The Afghan Taliban was able to rely on the help of its Pakistani counterpart to briefly take control of the capital, Islamabad, before being ousted by a China-backed coalition of army officers. The country's substantial nuclear arsenal is assumed to have disappeared onto the international black market.

Halfway across the world in Europe, things are looking better, but gloomy still. Europeans' widespread gloating at America's misfortunes ended with a severe depression of their own, prompting a backlash against dark-skinned immigrants from North Africa and Turkey. Frightening pogrom-style attacks ensued in Austria and Denmark. Across the continent, radical nationalist parties were swept to power. One by one, they pulled their countries out of the Euro mechanism and re-adopted their own national currencies. This prompted a wave of competitive currency devaluations from country to country, bringing Europe back to the brink of 1920s-style hyperinflation.

On paper, the single European market still exists. In substance, it is all but dead. Governments responded to the financial crisis with massive bailouts of loss-making national "champions" and, later, of smaller firms. The European Union is now little more than a collection of protectionist fiefdoms. This time, however, there will be no Great War; Europeans, fortunately, have become too lazy to fight each other.

Like Europe, Latin America did not manage to avoid the financial contagion. New debt and currency crises befell Argentina, Mexico, and Brazil, wiping out the middle classes that had emerged there over the preceding two decades. With them went the democratic regimes that depended on these middle classes for support.

In Zimbabwe, the good news is that Mugabe is finally dead. The bad news is that his defiant corpse has vigorously rebuffed all attempts to remove him from his chair in the National Security Council meeting room.

Israel has extended to its logical conclusion its policy of walling itself in from the Palestinian territories by erecting a roof over top of itself connecting the walls. It has been nicknamed "the Jafrodome."

Al-Qaeda broke up following bin-Laden's insistence that the group change its name to "Osama and the al-Qaedans." He went on to launch a solo career releasing more threatening videos.

But something, alas, is stirring in America. A group of PhD dropouts from Berkeley trying to engineer an ever-more potent strain of marijuana stumbled upon a cheap source of renewable energy. They have already secured a patent along with backing from venture capitalists, and the project is set to go into mass production. If the new technology succeeds, it will require scores of industrial-made products to be redesigned and manufactured anew to utilize the new energy source. Demand from Asia is set to explode. America may be back yet.

Some Hard Truths About You and Your Money

Edges and anti-edges in the markets

The reader must forgive me for devoting three entries in a row to the financial markets. It was my intention when creating this blog to present essays on a wider range of topics, from Pakistan and Iran to the future of American power. But these are extraordinary times. And they call for an extraordinary response, not least from irrelevant bloggers.

As I write this, the markets have just closed in New York. Last week's breathtaking decline puts the S&P 500 43 percent off its peak a year ago. This places the current slump within striking distance of the second and third worst bear markets of all time, set respectively from 2000 to 2002 and 1973 to 1974.

Now is thus as good a time as ever to draw your attention to some basic market realities. Of course, they constitute the truth "as I see it." You are free to disagree. But most of these ideas are regarded as self-evident among successful traders. And they are principles you must be aware of if you are to avoid severe damage to your savings and an impoverished retirement.

Brace yourself; for most of you, what follows is not going to be pleasant to read.

Truth #1: Only a small minority of market participants can consistently make money over the long run. This is the essence of market speculation; ultimately, it rewards the few and punishes the many. If it were really that easy, you would see a lot more multi-millionaires walking around.

Truth #2: As soon as you buy a stock, commodity, or any other financial instrument, you are entering into competition against thousands of professionals. What is your edge? "Incidentally," notes famed market chronicler Jack Schwager, "if you don't know what your edge is, you don't have one."

In most markets, you can only make money by taking it away from other participants. These other participants are trying equally hard to take your money away from you. You must ask yourself what, exactly, your advantage is over the legions of large trading firms that staff hundreds of specialists equipped with proprietary software.

Truth #3: Buy-and-hold is not an edge. Let me repeat that: buy-and-hold is not an edge. This, of course, is contrary to what the financial industry tells you. If they are to be believed, you can profit over the long run by purchasing a "diversified" basket of stocks and bonds and holding them until retirement. Alternatively, you can follow the same strategy by buying into a mutual fund, which itself buys and holds any number of stocks, and "letting the magic of compounding turbo-charge your wealth."

The buy-and-hold concept is problematic for a number of reasons. First, as has become all too evident in the current crisis, plenty of the stocks you own may fall to zero while you're holding them. Second, there is no such thing as a diversified basket of stocks. In a bear market, they all tank together.

An even more serious problem is that the buy-and-hold philosophy is based on a myth. It is simply not true that stocks always go up over the long-run. Victor Sperandeo, a well-known stock trader, notes that if you bought stocks at any time between 1896 and 1932, you would have lost money by 1932. This is a 36-year period in which a buy-and-hold strategy failed.

However, you might object, that was a different era. The stock market has surely matured since then. No, it hasn't. If you bought at any time between 1962 and 1974, you would have lost money. By August 1982 the Dow Jones average was at the exact same level as it was in 1967. But the ravages of inflation over that period meant that a dollar invested in 1967 would have been worth a lot less fifteen years later. Currently, the S&P 500 is at approximately the same level as it was ten years ago.

Even in periods where buy-and-hold does work, such as 1982-1999, most people have a hard time sticking to the approach. Our natural inclinations lead us to buy at the highs, when hysteria is at its peak, and get out at the dead lows, as panic envelops the markets. As a result, people's actual performance in such periods tends to fall well below the opportunities the markets present.

This past week, the stock market plummeted to levels not seen since 2003. And it may still have a ways to go. Will the next 20 years be more like the 80s and 90s, or more like the 60s and 70s? Who knows? If you're buying and holding, however, you are leaving it to chance.

If you want to learn more about the often disappointing returns the stock market has offered buy-and-hold investors over the last 100-odd years, read Ed Easterling's sobering empirical study, Unexpected Returns.


Your anti-edge
If you are like most investors, you do not have any kind of edge that would allow you to grow your funds over time. What, then, does constitute an edge? There are many, and few of them are rocket science. An example would be systematically buying stocks that are going up and selling stocks that are going down. This is called trend-following, and it is a well-known strategy employed by many of the world's most successful traders. Another edge is to sell strength and buy weakness. This is counter-trend trading, the opposite of trend-following. Used wisely, it can produce plenty of profits.

To put these strategies into practice, you must surely render them more specific than the way they are outlined here. The point, however, is that they are actual strategies, made up of rules applied consistently across similar opportunities. This stands in contrast to trading on your whim, the method preferred by the masses.

Truth #4: Most people do not simply lack an edge. They possess any number of what might be termed anti-edges. That is, you are wired, by virtue of experience, beliefs, and genetics, to lose money in the markets. Here are some of the most common anti-edges.

Being human. Four decades of experimental research in behavioral finance has demonstrated, time and again, that we as humans are built to hemorrhage money in the markets. The golden rule of trading, as you may have heard before, is to cut your losses short and let your profits run. That is, if you are in a losing investment, sell it, and if your investment is making money, keep holding it. Our brains, unfortunately, are wired to do the opposite. As popularly disseminated as this finding is, it does not seem to be heeded; most people who encounter it believe it applies to everyone but themselves.

The reason that cutting losses and riding profits works is precisely the fact that it is psychologically difficult to do. As a result, most people cannot follow this maxim. If most people are not doing it, then the few who are will profit from it. This follows logically from Truth #1: it is the essence of markets to reward the few and punish the many.

Perhaps this is why studies have found that brain-damaged patients outperform individuals with normally functioning brains in financial investments. If you have brain damage, you are probably acting contrary to the majority of market participants. This is likely to help you profit.

If everybody suddenly started cutting their losses short and letting profits run, the optimal strategy would be to let your losses run and cut your profits short. But I don't expect that to happen anytime soon.

Investing on the basis of your common sense. If human nature leads you to make the wrong financial decisions, it does so by acting on your common sense. "Hey, everybody's wearing white headphones. I think I'll buy Apple." By the time you figure this out, chances are that others have too, and the opportunity is gone.

A better strategy might be the following. Post the Wall Street Journal stock listings to the wall, throw 50 darts at it, and buy the stocks the darts land on. Sell a stock if it drops 20% below your purchase price or, if the trade is profitable, exit it after three months. Why might this be an edge? Precisely because you are not making decisions in line with what human nature - and your resulting common sense - is telling you to do.

Possessing a graduate degree. In the financial markets, having a PhD can put you at a disadvantage. The same is true for a degree in law, medicine, or dentistry. People with advanced degrees are fodder for predatory brokers and financial advisers who flatter your intelligence in pursuit of commissions and fees ("you're a sophisticated investor; you deserve a solution that meets your demanding needs").

If you have one of these degrees, you are prone to believe you are more intelligent than most people. Even if you are, this has nothing to do with making money in the markets. The problem with intelligent people is that they have trouble admitting when they're wrong. As such, they are likely to hold onto plummeting investments until, finally, in a state of panic and dejection, they are forced to sell.

Having an MBA is even worse. For it spawns people who are not only intelligent but who consider themselves particularly shrewd when it comes to trading and investing. Most all executives of the Wall Street institutions that recently collapsed had MBAs.

I do not mean to say that everybody with an MBA is unsuited to market speculation. Many MBAs are smart, prudent risk managers and successful investors. I am instead referring to those people who believe they are better investors because they have an MBA. These are the ones who may one day find themselves on the wrong end of a bankruptcy receiver.

Being an avid reader of The Wall Street Journal. The WSJ is a tremendous newspaper. That does not mean you should use it to make investment decisions. Like a graduate degree, reading a financial newspaper on a regular basis can lead people to the erroneous conclusion that they are savvy investors. By the time it is in the newspaper, the opportunity is gone.

Watching a 24-hour news network, especially CNBC. These networks are toxic waste for your financial decision-making. The people who appear on CNBC are there because of their velvety voices and sound-bite sensibilities, not because of any higher power to offer profitable advice. Turn it off!

Investing on the basis of tips. A tip refers not only to a "hot" stock idea from a friend but also any advice from a broker or financial adviser about what to buy. If your financial adviser actually had good investment ideas, why would he give them to you? Why would he be working as a financial adviser in the first place? Good traders trade. They do not seek employment as financial advisers.

Investing on the basis of market history. This method is a little more sophisticated than tip-taking. It involves looking at past history, assuming the future will be like the past, and making trading decisions accordingly. An example: "National real estate prices have never gone down. Therefore, they will never go down." This was the belief of traders and executives in many Wall Street institutions that are no longer with us. In the markets, things that have never happened before happen all the time. (For more on this, see my previous post, "Financial Market Chaos Explained.")

Handing your funds to a "money-manager" such as a mutual fund. The problem with mutual funds is that they follow a buy-and-hold strategy. If the stock market doesn't go anywhere for the next 15 years, chances are any money you place with a money manager won't either.

Investing without any background in statistics and probability. If you intend to speculate, you need to have a basic grasp of such concepts as standard deviation, expectancy, and probability distribution. If you don't understand them, you are putting yourself at a disadvantage to those who do.

Investing with too much background in statistics and probability. Be careful. Many conventional statistical methods are downright dangerous when applied to the markets (again, see "Financial Market Chaos Explained"). If, in your studies, you ever come across the word "normal distribution," run.

Not having a preconceived exit point. This is perhaps the most hazardous anti-edge. When you buy a stock, or any other investment, and you have not already specified the conditions under which you will sell it, you are setting yourself up for disaster. Note that the decision about when to exit must be made before the trade is entered. Otherwise, you end up having to make on-the-fly judgments in the midst of battle, when your irrational human emotions are at their peak. You must actually have two exits - one in the event that your investment loses money, and another for taking profits.

Most people do indeed use exits. Two of them are particularly popular. The first is to sell when you need the money. Of course, you must hope the investment is still profitable by the time you reach that point. The other method is to wait until the value of the investment goes to zero. This is the exit type that comes most naturally to the majority of people; at least you don't have to pay any capital-gains taxes afterward.


Is there an easy answer?
The good news is that most all of the anti-edges boil down to your beliefs. Do you believe you can invest successfully using your own common sense? Do you believe you are more intelligent than most people, and that this gives you an edge in the marketplace? Do you believe you can consistently find profitable investment opportunities by reading a financial newspaper every day? All you really have to do is change your beliefs. If you manage to do that, you just may have a chance.

The bad news is that finding a real edge that is right for you can take a lot of work. And applying this edge successfully over a long period of time often requires a degree of psychological introspection with which many people are uncomfortable.

Just remember this: if you do choose to put your money anywhere besides US Treasuries, you have now joined the ranks of the speculators. And you had better learn what you are doing. A great place to start would be Market Wizards and The New Market Wizards by Jack Schwager. They are a fascinating series of extended interviews with top traders. If nothing in these two books really grabs you, then you probably have no business in this business.

There are many other good books out there that touch on important aspects of trading strategy development, trading psychology, and building a trading business. Among the best I've encountered are The Psychology of Trading and Enhancing Trader Performance by Brett Steenbarger; Mastering the Trade by John Carter; Trade Your Way to Financial Freedom and The Definitive Guide to Position-Sizing by Van Tharp; Way of the Turtle by Curtis Faith; The Evaluation and Optimization of Trading Strategies by Robert Pardo; The Complete Guide to Building a Trading Business by Paul King; Technical Traders Guide to Computer Analysis of the Futures Markets by LeBeau and Lucas; Winner Take All by William Gallacher; Smarter Trading by Perry Kaufman; Trading for a Living by Alexander Elder; Street Smarts by Connors and Raschke; and Evidence-Based Technical Analysis by David Aronson. I also highly recommend the numerous home trading courses offered by Van Tharp's International Institute of Trading Mastery.

I am personally skeptical that you can make money consistently by adopting someone else's strategy and putting little work into the process yourself. If it is possible, then the only reliable place I know of where you might find an answer is Tharp's book, Safe Strategies for Financial Freedom, along with his weekly newsletter. His focus, like that of all the authors listed above, is not on giving tips but rather following an established set of rules for when to buy and sell. Check it out for yourself.

If you do not take the time to learn what you are doing, you are setting yourself up for frustration and failure. You are better off sticking your cash under a mattress.

The Unheard Case Against the Bailout Plan

The bailout package is worse than wrong; it is unnecessary

As you well know, our government is about to spend a whopping $700 billion of taxpayer money to bail out the major financial institutions. The obvious objections you have surely encountered already. Why should we have to spend anything, much less a gigantic sum like this, to save a bunch of failed financiers who lost a ton of money making risky bets? More importantly, do we really want to create a state-sponsored financial system where private banks reap the rewards from their risk-taking while all losses are shoved onto the taxpayer?

Our Treasury Secretary and Fed Chairman feel our pain. Yes, it is a shame we have come to this. However, they exhort, without it we will descend into the abyss. The financial system will collapse and take the rest of the economy with it. The bailout plan, they claim, is like having your hemorrhoids removed - painful but necessary. (And the parallels between the financial crisis and proctology do not end there; see my previous post, "Financial Market Chaos Explained.")

I am currently overseas in Estonia, a real market economy as opposed to the one in which you apparently reside. But I would imagine that in the last few days you have heard this line about painful-yet-necessary medicine plenty of times.

What you have not heard is that there is a far cheaper and less damaging solution than the one currently under discussion. Its author is Luigi Zingales, the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago. Writing in the new issue of The Economists’ Voice, he sets forth in simple terms a plan which would resolve the banks’ problems while punishing those responsible for them. Best of all, it would not cost the taxpayers a single dime.

To understand it, however, requires some background in corporate finance. So here is a primer. You can thank me later by wiring to my bank account a portion of the tax dollars you will save in the happy circumstance that the bailout package fails to pass. Those already familiar with these basics can feel free to skip down to the meat of Zingales’ plan.

A corporation receives financing from two sources: debt and equity. Debt refers to any loans from a bank. It can also consist of bonds the business issues to investors in return for cash. Similarly to a loan, the bonds have to be redeemed at a later date – that is, the money must be repaid. Until that point, the bondholders receive a stream of interest payments as their reward for helping finance the business.

The other source of financing is the “equity holders,” meaning the shareholders. No bank or bondholder will offer you all the money you need to start your business. They rather demand that you put up a portion of the money yourself. The money you and your partners personally invest represents the equity, and it is divided into shares you now own. By paying for these shares, you are offering the company money it can use to finance its operations. In return, you are entitled to the profits.

If the business flourishes, the equity holders reap the rewards. But they also take a big risk. If the business fails, they get nothing. Any assets that are left over go instead to the bondholders and the banks that provided the loans. In bankruptcy law, this is called a Chapter 7 liquidation. In a Chapter 7, the business is dissolved entirely and its assets sold. The cash raised from the sale of the assets is then distributed to the bondholders and the banks.

But there is another type of bankruptcy called a Chapter 11. It is reserved for situations where the core business remains solid yet the company does not have the cash to pay all its debts. A bankruptcy judge oversees a reorganization in which some of the debts are forgiven and the company gets a fresh start.

In some Chapter 11 bankruptcies, however, the business is not merely short of cash. The value of all its “assets” – plant equipment, intellectual property and, of course, mortgage-backed securities – falls below the value of its “liabilities,” or the total value of everything it owes to creditors. In these bankruptcies, the shareholders lose everything while the debtholders are given new shares in the business in return for forgiving the debts they are owed. The debtholders are thereby exchanging debt for equity, or the right to share in the company’s future profits.

This is the situation many Wall Street financial institutions currently find themselves in; at least part of their underlying business remains profitable, but the value of their liabilities exceeds that of their assets. So why not put them into Chapter 11? The obvious answer is that conventional Chapter 11 proceedings take a long time to sort out – creditors have to negotiate with one another over the remaining spoils, and this can take months. Currently, our financial system is teetering on the brink. It has not months, but days.

That is where Professor Zingales comes in. These are extraordinary times and, as the absurd “rescue package” attests, our Fed and Treasury officials are already in the mood for extraordinary solutions. So, he asks, why not set up a special committee of bankruptcy judges that will force a quick solution down the creditors’ throats? This is typically what a bankruptcy judge does when negotiations among the creditors have become too drawn out. There is no apparent reason why it cannot be done now as well.

Under his proposal, existing shareholders in the failed financial institutions will get nothing, and the debtholders will become the new shareholders. That is, in exchange for relinquishing their rights to most of the debt, they will now be entitled to the future profits of the business instead. The debtholders should be happy with this outcome, since the bank’s core business remains sound and its future profitability is relatively assured.

American history offers up a precedent for a massive Chapter 11. In the Great Depression, Roosevelt forced through a similar arrangement after the end of dollar convertibility into gold put extreme burdens on companies’ abilities to service their debts. The Supreme Court later upheld it, and so it should have no problem with a similar solution now.

If it is that easy, then why have we not heard it proposed? “The major players in the financial sector do not like it,” replies Zingales. For they have large shareholdings in these companies, and such an arrangement would wipe out the value of their equity. They would rather the taxpayers be wiped out instead.

The solution we adopt right now will shape our financial system for decades to come. Zingales states the dilemma most articulately: “Do we want to live in a system where profits are private, but losses socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded?”

We cannot stand by and let a few Wall Street executives undermine the basic underpinnings of our capitalist system. “The time has come,” Zingales writes, “to save capitalism from the capitalists.”

Financial Market Chaos Explained

"It was a million-to-one shot, Doc. Million-to-one!"

The current financial crisis, like most that have come before it, has resulted largely from the excessive use by banks of something called “leverage.” If you have an MBA, you know what this word means. Evidently, however, an MBA does not qualify you to use it with any degree of prudence, as the near-collapse of our financial system has just shown.

Most people who buy stocks are accustomed to putting up all of the cash that is necessary to purchase it. The stock costs $5 a share, and you want to buy 100 shares, so you yourself fork over the $500 in cash to pay for it. But it does not have to be done this way. If you open a margin account with your broker, you only have to put up half the cash necessary to buy the stock. The portion that you deposit yourself is called “margin.” Your broker can put up the rest of the money for the stock purchase in the form of a loan to you.

Why do this? It enhances the potential return on your investment. Instead of buying 100 shares with my $500, I can now buy 200 shares. If I only bought 100 shares and the stock went up by $1 per share, I’d make a profit of 100 * $1, or $100. But if I were using leverage, and I bought 200 shares instead, I’d make a profit of 200 * $1, or $200. My potential return has now doubled; instead of 20 percent ($100/$500), it is now 40 percent ($200/$500). Or, perhaps I’ll use $250 to purchase 100 shares and the remaining $250 of my money to buy something else. Either way, the potential profit on my investment doubles, to 40 percent.

However, so does my risk. If the stock drops by $1, I lose 40 percent using leverage and only 20 percent using all cash. And if it goes down by more than $2.50, I’m broke and could even owe money to my broker. An SEC regulation, imposed after the 1929 stock market crash, prevents stock market participants from using more than 2:1 leverage; in other words, I am restricted to borrowing only double the amount that I put up myself, as in the above example. For other assets, these restrictions do not apply.

Losing your shirt, and then some

In a world where markets hardly ever exhibit extreme movements, using lots of leverage would not be particularly hazardous. Alas, we do not inhabit such a world. Most days, markets move up and down by small amounts. But quite frequently, markets can go wild, moving multiples of their normal volatility in a day, or even several days in a row. What’s worse, sometimes all markets go haywire in unison.

This is a statistical property that quant-types refer to as an “infinite variance.” What it means is that, in the financial markets, things that have never happened before happen all the time. Out there lurking somewhere is a much larger price movement than we have ever seen previously. The French mathematician Benoit Mandelbrot was the first to point this out. Nassim Nicholas Taleb has brilliantly expounded on it, as have others. Apparently, the last people to realize this were the legions of PhDs employed to "measure risk" in the trading departments of the major Wall Street banks.

How can a bunch of quants with advanced graduate degrees commit such an error of judgment, especially when so many others have long recognized the wild nature of markets? To use the fancy statistical methods they so enjoy requires the analyst to assume that market volatility never strays very far beyond the norm. Otherwise, the results these models produce are meaningless. And what the hell did I go to graduate school for if I can't even use these complicated statistical techniques? So they make the assumption that markets are generally placid and hope everything turns out alright.

A couple of years pass and a market crisis hits. In a few days, the investment bank manages to lose several multiples of all the trading profits it has accumulated over the last five years. A risk manager with a PhD from Berkeley is quoted in the press expressing his surprise that such an event has come to pass. For, according to his models, a market occurrence of this magnitude should happen only once every 10,000 years. He is summarily fired, along with the managers who hired him in the first place.

Financial markets eventually return to normal, and a new batch of PhDs are brought in. Employing the same fancy risk models, they once again place huge market bets using absurd leverage. After a few years, the next market blowup arrives. Once again, all the bank's hard-won trading profits since the last crisis are gone. Another risk manager with a Harvard PhD is quoted in the press expressing astonishment at this turn of events; his models predict such an extreme abberation to take place once every 25,000 years. He and his bosses are swiftly removed, and the proces begins anew.

One is reminded of Frank Costanza's explanation to the proctologist as to how a fusilli stauette of Jerry Seinfeld came to be lodged in his rectum: "Million-to-one shot doc, million to one!" If you need some evidence of this phenomenon from the credit crisis, see the following Financial Times article from August 2007. In it, Goldman Sachs utters bewilderment at a market event its models predict to occur once in 100,000 years.

In an environment where extreme price changes are frequent, excessive leverage is dangerous. Most people should never use more than 3:1 or 4:1 leverage trading anything. The financial institutions that just collapsed, or came near to collapse, were sometimes using leverage of 30:1. That’s ridiculous. With that kind of risk, a few positions that move against you at the same time can lead to huge losses. And that’s exactly what happened. Since real estate prices have started falling, big leverage has led to outsized losses on the mortgage-backed assets held by major financial institutions.

It remains to be seen what kind of long-term regulatory response the US government will come up with in response to this crisis. Whatever it is, it may very well include limits on the amount of leverage that any financial institution can take on. History shows this may not be as simple as it seems.

(Thus ends the short version of the crisis. Readers seeking a little more detail are invited to read on.)

Money and credit: More slippery than we think

Every asset price bubble is fueled by the expansion of credit, often beyond the limits central banks would like to impose. This was the thesis of Hyman Minsky, reproduced by late MIT economist Charles Kindleberger in his book, Manias, Panics, and Crashes, regarded as the classic text on the subject. Financial history, Kindleberger shows, is in large part a struggle between monetary authorities, who seek to limit the supply of money and credit, and private financial actors, who are continuously devising new and innovative ways of creating substitutes for cash. These cash substitutes are used to buy more assets and can occasionally bid their prices up to unseen heights, only to be followed by a crash once the dentists have finally decided to get in on the riches.

In the early 19th century, for example, financial institutions around the world began exchanging sterling bills of exchange instead of shipping the actual silver to one another. So when America started sending these bills to China as payment for goods, the silver itself could remain in the US. More silver enabled greater lending by banks, which led to an effective expansion in the money supply. This extra money had to go somewhere, so it contributed to a boom in asset prices.

In the mid-19th century, banks collectively established clearing houses to guarantee payments to each another. The clearing houses would issue clearing house certificates, which the banks could use in lieu of cash to settle payments to one another. The actual cash could then be diverted elsewhere, and in the 1850s it fueled a global boom in economic activity and asset prices. The excesses culminated in the Panic of 1857.

In the early 20th century, financial entrepreneurs established "trust companies," which were banks in all but name - except that they were not subject to traditional banking regulations and could engage in riskier forms of speculation. The trusts represented new ways of extending more credit, which spawned excessive commercial lending and stock market speculation. The failure of these trust companies precipitated the great Panic of 1907.

In the 1920s, the big innovation was "call money,” or funds that could be borrowed on margin to buy stocks. Under this system, you would only have to put up 10% of the value of your stock purchase. Your broker, borrowing call money from a bank, would put up the rest. As stock prices rose, brokerages had to attract more and more funds to support the continuing use of call money to buy stocks. To do so, the banks lending the call money to the brokerages raised the interest rates offered to depositors. By 1928-29, these interest rates had become so attractive that they began diverting massive amounts of funds away from normal consumption and investment. This, argues Kindleberger, was likely a major cause of the Great Depression.

The upshot of all this is that it may be a lot harder than we think for the US government to regulate future crises out of existence. People will always find new ways of engaging in excessive risk-taking. The cycle of booms followed by meltdowns will thus continue.

Derivatives

In recent times we've seen yet another innovative substitute for money and credit: derivatives. Derivatives allow you to place bets on the movement of asset prices without actually buying and selling the assets. Some derivatives are traded on established exchanges. An example is commodity futures. It would be somewhat impractical to bring live cattle onto the floor of the Chicago Board of Trade. To resolve this problem, a derivative of live cattle is traded instead. That is what a futures contract is; instead of trading the actual cow, you’re only buying or selling the right to take possession of a certain quantity of live cattle at a set price on some future date. Other commodities, like oil, gold, and soybeans, are traded in the same manner.

More recently we've seen the massive expansion of the market for over-the-counter (OTC) derivatives, which are traded not on exchanges but rather directly among major financial institutions and their clients. This market is worth many trillions of dollars and dwarfs the market for traditional exchange-traded derivatives. There are a number of good books out there that explain OTC derivatives in relatively clear language. The best I’ve seen is Traders, Guns, and Money by Satyajit Das. It has done much for my understanding of these arcane financial time-bombs.

CDOs

One example of an OTC derivative featuring prominently in the current crisis is the Collateralized Debt Obligation (CDO). The CDO enables lenders to offload onto somebody else the risk that borrowers may not pay their money back. Let's say a local mortgage lender extends a home loan to a "subprime" borrower whom the lender expects to default on his mortgage. The lender doesn't care, because upon finalizing the loan he sells the right to collect interest and principal payments to, say, Lehman Brothers. Lehman Brothers then takes a bunch of these mortgages, or corporate loans, or any other kind of asset, and packages them together into a CDO, which it then sells to customers.

Officially, however, Lehman Brothers itself does not perform this task. Rather, it sets up a Special Purpose Vehicle (SPV) to manage the restructuring process and subsequent sale to clients. What's the point of the SPV? First, the SPV is registered in an offshore tax haven. Second, much like the trust companies in 1907, it is a bank in everything but name and is completely unregulated. Third, by selling the rights to collect payments on these mortgages to the SPV, Lehman Brothers generates immediate cash flow. This is considered preferable to the long-term trickle of cash it would otherwise receive if it waited for the various mortgages to be paid off over time.

It hardly needs mentioning that this immediate cash flow translates directly into current profits for Lehman Brothers and, thus, bigger bonuses for its traders and executives. This commentator is not expecting them to give their bonuses back to shareholders now that the company has gone belly-up.

The SPV is basically structured as a bank, with assets on one side and liabilities on the other. The assets consist of the right to collect interest and principal payments on the mortgages. Let's say the CDO is worth $1bn and is composed of 100 loans of $10m each. (Recall that the SPV doesn't actually "own" the loans; it just owns the right to collect on these loans. This is what makes the CDO a "derivative.") Each of these loans has been granted to a different borrower, and the borrowers vary widely in their (perceived) ability to pay interest and principal on the loans.

The SPV raises the cash to "buy" this debt by selling the right to collect on these loans to customers - usually big financial institutions and wealthy individuals. This debt is divided into three categories. $920m of the $1bn total might consist of “super-senior” AAA-rated debt, considered very safe from the threat of default. Another $50m consists of "mezzanine" debt, which is subordinated debt, the principal on which can be collected only once the holders of the AAA-rated debt have been paid. The last $30m is equity. If any three of the 100 borrowers at the end of the debt chain default on their payments, the owners of the equity in the CDO do not get paid.

One might think that the holders of the equity and mezzanine debt are taking on all of the risk here. One would be mistaken. The current crisis has seen declines in the value of the “super-senior,” AAA-rated debt tranches as well. Remember: in the markets, things that have never happened before happen all the time. And because the financial institutions that trade these assets have taken on so much leverage, on the order of 30:1, the price of the assets has only to decline by a relatively small amount to produce massive losses for these firms. Goodbye, Lehman Brothers.

Conduits

In many cases, the large Wall Street banks do not even bother sell the assets on to long-term investors. They rather stash them in vehicles they have established called “conduits.” Conduits are similar to SPVs, in that they are located in offshore tax havens and buy the mortgages or other assets from the banks. But instead of selling these assets to long-term investors, the conduits raise the money to buy the assets by selling short-term “commercial paper." Commercial paper represents a promise by the conduit to pay the holder of the paper a stream of interest payments until the term, typically lasting a few weeks, expires. At this point the conduit gives the commercial paper holder, usually another big bank or money market fund, its money back. If the conduit is to keep holding onto the mortgage assets it owns, it has to issue more short-term commercial paper, and the process begins anew.

The sole point of conduits, so far as I can tell, is to generate immediate income for the bank and bonuses for its executives while hiding from investors the true extent of the risk the bank has taken on. For if the conduit fails to keep finding new short-term financing every few weeks, the bank must take the loss back onto its own books.

For years, the scam worked. Then came August 2007, when the market for short-term commercial paper seized up. Increasing defaults on subprime mortgage loans had spooked the holders of the commercial paper. So when the terms on the paper expired, as they routinely do, the banks could not find any more buyers. The same thing has happened several other times since then, including in the last week, causing very severe and very immediate problems for the major Wall Street banks. You see, the amount of money controlled by conduits amounts to $3 trillion. That’s trillion. A failure to find more financing for these assets could spell catastrophe. This has forced central banks to inject hundreds of billions of dollars into the financial system to help maintain an orderly market. They did the same thing back in March. But even this wasn’t enough to save Bear Stearns.

Credit-default swaps

Another important derivative involved in the current crisis is the credit-default swap. Let's say a bank makes a loan to a business but for some reason becomes concerned about the customer's ability to pay it back. Traditionally, the bank would have to call in the loan or sell it to another bank. This might antagonize the customer and jeopardize the bank's future relationship with him. Eventually, someone had the insight to offer to pay the bank a sum equal to the amount of the loan in the event that the customer defaulted. In return the bank would pay this person a premium. That way, the bank can dump the risk of default onto somebody else without actually selling the loan - or letting the customer know what it is doing.

This basically amounts to an insurance policy, but the person selling the insurance isn't licensed by the government to do so. So they call it a "credit-default swap" instead of insurance. When you read in the newspaper back in March that "the cost of insuring against a default by Bear Stearns has risen to $2.7m for each $10m of debt," the reference here is to the premium demanded by the issuers of credit-default swaps in return for insuring against a default by Bear Stearns.

“Too big to fail:” Avoiding financial Armageddon

Incidentally, Bear Stearns was the issuer of many credit default swaps. Its downfall threw into question the ability of banks to get the money they had been promised by Bear in the event that their customers default. If this were allowed to happen, then everybody who bought credit-default swaps from Bear Sterns would have panicked and sold the assets Bear was insuring, since they no longer had protection against default. With everyone a seller and nobody a buyer, this would have caused the prices of assets to spiral downward to zero.

If you’re a company and the prices of the assets you own start to plummet, this makes banks less willing to lend you the money you need to operate on a daily basis. You are put in a difficult position; you either raise enough cash to continue on, or you go bankrupt, and your assets are put on the market in a fire-sale. But when lots of companies start selling the same assets at the same time, the prices of these assets decline even further, causing more bankruptcies, more asset fire-sales, and yet more bankruptcies.

We have not seen this happen in the current crisis…yet. But history does offer up an example of what happens when this process is allowed to unfold. It was called the Great Depression, and it is precisely the scenario the Fed has been trying to avoid. When everybody wants to sell and nobody wants to buy, and the prices of assets are plummeting as a result, it is the Fed’s job to step in and lend money to solvent companies who are short of cash. That is what it means to be a “lender of last resort,” which is the Fed’s formal job description. However, insolvent companies – those whose debt obligations outstrip the value of their assets – should be allowed to fail.

In theory, at least. Some institutions have managed to make themselves “too big to fail.” That is, regardless of their solvency, they have to be bailed out, or the whole financial system goes to hell. Bear Stearns was considered too big to fail, and so the Fed bailed it out (actually, Bernanke prodded JP Morgan to buy Bear Stearns and and then guaranteed the investment. That’s basically a bail-out).

This was also the case with AIG, the world’s largest insurance company, which the Fed just saved from chaotic extinction with an $80 billion loan. The sheer size of this loan suggests that AIG’s problems may have gone beyond a mere need for short-term financing and extended to its very solvency. But AIG was too big to fail. It had become one of the market's biggest issuers of credit-default swaps, explained above. Since CDS are similar to insurance policies, AIG thought it wise to expand into these derivatives. Evidently, it got in over its head. Merrill Lynch was also too big to fail, which is why the Fed pushed Bank of America to absorb it. Lehman Brothers, on the other hand, had not quite managed to make itself too big to fail. So the Fed allowed it to collapse entirely.

A global solution?

After a few days, Fed and Treasury officials decided to stop bailing out institutions on a case-by-case basis and create a system-wide solution. The goal is to stop the prices of assets – mortgages and stocks – from falling way below the value they would obtain in an orderly market. So, under the new plan, the government will buy these assets, thereby putting a “floor” under their price. It will then invite private partners who specialize in distressed debt to restructure the assets and sell them. If all goes according to plan, the assets the government would now own will be sold at a profit, which will make up for the $700 billion the government has to shell out to buy the assets in the first place. $700 billion is a lot of money. Let’s hope it works.

The problem is, there are many other asset classes besides mortgages that have not yet entered the crisis. The major financial institutions continue to deal in CDOs and credit default swaps backed by corporate debt, auto-loans, credit card debt, and so on. There are untold billions of dollars in assets remaining that may yet go bad. If that happens, well, we're screwed.

Putin to world: I promise baby, I'll pull out

Georgia's president lets himself be drawn into Russia's trap.

A few friends have asked me to explain what's been happening in Georgia. What follows is a brief summary.

Georgia declared independence from the Soviet Union in late 1991. Soon afterward the United Nations recognized Georgia, along with the other 14 Soviet Republics, as an independent state. Aside from ethnic Georgians, the country contains a number of ethnic minorities, most prominent among whom are the Ossetians and the Abkhazis. Under Soviet rule, each of these two minorities were granted their own "autonomous republics" - the region where most Ossetians lived was now made into an administrative unit called "South Ossetia," while Abkhazis received "Abkhazia."

The autonomous republics were one step down in status from a "union republic" like Georgia, Ukraine, Lithuania, Kazakhstan, etc., each of which, like the autonomous republics, were named after an ethnic group residing there. Stalin, ever the master of divide-and-rule, created these smaller autonomous republics inside some of the union republics so that he would have some future way of sowing discord among the different ethnic groups inhabiting the Soviet Union.

While all the autonomous republics and union republics had their own formal government trappings - a legislature, an executive, a flag, etc., during most of the Soviet period they had no real autonomy; everything was controlled from Moscow. That all changed under Gorbachev, when power began devolving from the center to the regions. The republics began asserting themselves - the Soviet republics against Moscow, and the autonomous republics against the union republics.

This process of devolution was mostly peaceful, with a few exceptions. One of these exceptions was Georgia, where civil war erupted. After Georgia declared independence from the Soviet Union, the rulers of South Ossetia and Abkhazia declared independence from Georgia. This prompted the Georgian government to forcefully intervene in an attempt to prevent the two regions from seceding. It would have succeeded were it not for Russia, who sent "peacekeeping" troops into the two regions and drove out the Georgian forces. Local Russian-backed militias additionally expelled the ethnic Georgians living in these regions in a campaign of ethnic cleansing.

This all happened mostly in 1992 and 1993. Ever since then, a peaceful stalemate has prevailed. South Ossetia and Abkhazia, while not recognized as independent states by the United Nations, are independent in all but name. Backed by the Russian military, the two regions conduct their own affairs completely independently of the Georgian state.

While Abkhazia has at least proved functional as a state, South Ossetia has been described by one astute observer as a "joint venture between the KGB and a local gangster." The business this joint venture is engaged in is smuggling - drugs, people, and arms, which are free to pass through the territory under the protection of its political masters. Over the past 15 years there has been a seemingly endless series of initiatives led by the UN to form a conclusive peace settlement, but none of them has ever gotten off the ground; a few powerful people were making too much money from the status quo for that to happen.

Eduard Shevardnadze, when he was president of Georgia from 1995 to 2003, tended not to interfere in the situation. But his successor, Mikhail Saakashvili, is a Georgian nationalist who in 2003 was swept to power in part on a promise to bring South Ossetia and Abkhazia back under Georgian rule. Ever since then, tensions have remained high. Meanwhile, the Bush administration and many European states have offered strong rhetorical backing to Saakashvili, the Columbia University-educated democrat. The Bush administration has even mused about letting Georgia into NATO. That would give Georgia an explicit security guarantee from the alliance, whose member states would be obligated to intervene militarily on Georgia's behalf if any external state (i.e. Russia) attacked it. So admitting Georgia into NATO is obviously regarded as an intolerable prospect by Moscow.

The Kremlin, for its part, has repeatedly tried to provoke Saakashvili into sending Georgian troops to try and reoccupy the two regions. In August, these provocations finally succeeded. The Georgian military started shelling civilian targets in South Ossetia, prompting Russia to launch an excessive "peacekeeping" campaign to defend the region against Georgian "aggression." So, once again, the Russian military has driven Georgian troops out of South Ossetia.

But it didn't stop there. They've also occupied key cities, towns, and ports in the rest of Georgia, blown up transport links connecting one part of the country to another, and embarked on a mass campaign of looting. All the while the Russian government has been signing EU-brokered "cease-fire" agreements which they promptly proceed to violate before the ink has had a chance to dry.

The question is, why did Russia try to provoke Georgia into launching attacks in South Ossetia? For a number of reasons, but mostly because it would give Moscow an excuse to mobilize a brutal display of military force against the Georgian government. This would show the world just who the real boss is in this strategically sensitive part of the former USSR. For all its rhetorical support, the Bush administration was never prepared to intervene militarily on Georgia's behalf in a Russian-Georgian conflict. The Kremlin knew that, and called America's bluff.

Moreover, now that the West sees that Russia is really willing to launch a war against Georgia at the drop of a hat, do they really want to take on the formal obligation of defending Georgia by letting it into NATO? This fiasco the Georgian president let himself be drawn into will only serve to make American and European politicians think twice before admitting Georgia into the alliance. And that was the whole idea. Putin, meanwhile, is relishing his glorious little war against his renegade southern neighbor.