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The Light-Handed State and the Heavy-Handed State

Does the blame for our economic woes reside with a government that shirked its regulatory duties or rather one that proved too intrusive in the markets? The answer is “yes.”

My last piece, written an unforgivably long time ago, showed in detail how the downfall of a major financial institution can spark a broader unraveling of the financial system. A similar scenario occurred last fall after the failure of Lehman Brothers. And we would be deceiving ourselves to deny that a collapse of far greater magnitude remains possible, if not probable.

How did we get to this point? The question of what causes financial booms and busts splits analysts along the conventional left-right political divide. Those on the left hold that they result from too little state regulation; markets, when left to their own devices, have a tendency to run out of control and must be reined in if perennial instability is to be avoided. Those on the right make the opposite claim that it is excessive regulation that distorts markets and produces the boom-bust cycle. Who is correct?

The Light-Handed State

The factors at work in the current crisis certainly lend credence to the leftist view; the government, in a number of ways, abrogated its regulatory responsibilities through feeble oversight of financial markets. In a celebrated article published recently in The Atlantic, economist Simon Johnson details the erosion of financial regulation over the past 20-odd years. During that time, he argues, a group of powerful Wall Street firms managed to persuade lawmakers to relax a series of regulations that previously limited their growth and freedom to speculate.

Referring to the heads of these institutions as “oligarchs,” the author quite consciously evokes the image of similar crises that befell less developed countries in the 1990s such as Russia, Thailand, and Indonesia. If he does so it is because the momentous regulatory shriveling that took place in America, often at the behest of financiers, mirrored the light hand these other governments took in managing their own financial sectors. Johnson details a host of regulatory rollbacks that spanned both Democratic and Republican administrations and which now appear shocking in light of what has happened. They include:

*The promotion of free capital flows across borders;
*The repeal of regulations dating back to the Great Depression which mandated the separation of investment and commercial banking;
*A Congressional law banning the regulation of credit default swaps (for an explanation of these, see “Financial Market Chaos Explained”);
*A loosening of controls on the amount of leverage investment banks are permitted to take on (for more on leverage see, again, “Financial Market Chaos Explained” and “Anatomy of a Bank Run”);
*Lax regulatory enforcement by the Securities and Exchange Commission;
*International conventions that allow banks themselves to measure the amount of risk they are carrying; and
*An “intentional failure” by regulators to bring regulations into line with the enormous innovation in financial markets.

If Johnson’s talk of an “oligarchy” strikes some as extreme, recall that it is coming not from a foul-smelling schizophrenic on Berkeley’s Telegraph Avenue but rather from the former chief economist of the International Monetary Fund and an esteemed professor of economics at M.I.T. It is penned, in other words, by a beacon of the establishment.

And, clearly, he is correct; deliberately lax enforcement by regulators played a major part in the buildup of financial risk and its subsequent unraveling.

The Heavy-Handed State

Yet this is where most left-leaning analyses end and the rest of the story begins. For if government regulation proved too permissive in some respects, in other ways it served to distort markets and cushion risk-takers.

To begin with, the mountain of mortgage debt managed to reach the extremes it did partly because it received backing from Fannie Mae and Freddie Mac, two quasi-governmental agencies. These institutions are charged with guaranteeing the mortgages issued by banks and other lenders; if the bank that lent you the money to buy your home wants to sell your mortgage but nobody wants to buy it, Fannie Mae will. By serving in this role, Fannie and Freddie allow banks to issue more mortgages at lower interest rates and thus increase the level and affordability of home ownership.

Over time, however, they have come to serve as state-sponsored rackets. On the one hand the government will not allow them to fail, and everybody knows this. This gives them access to cheap financing which they can then lend out at a higher rate of interest and log an easy profit. On the other hand they technically are privately-owned companies. So the profits they create by borrowing cheaply and lending dear go not to the taxpayer but to their private shareholders and executives. It is a license to print money, and print they did. In the process they facilitated the buildup of a huge amount of mortgage debt, the consequences of which have now become clear.

Yet the excesses promoted by these state-sponsored entities are dwarfed by that enabled by our own central bank, the Federal Reserve. Of the scores of books to have emerged on the current financial turmoil, The Origins of Financial Crises by George Cooper, a former fund manager and strategist on Wall Street, stands out as perhaps the best. Cooper, in elegantly lucid prose, lays down a devastating critique of the major intellectual edifice adopted in recent decades by central banks and financial economists. Termed the “efficient markets hypothesis,” it makes two claims – first that financial markets, if left alone, allocate money efficiently to where it is needed most and, second, that the markets are essentially tame and not prone to manias and panics.

If events have shown this view to be wrong enough, Cooper argues that central banks, and particularly the Federal Reserve, have made things worse by perverting it. And this is where we see the distorting effects of government intervention. The space available here is far from adequate to do justice to the nuances of Cooper’s analysis, much less his smart and original policy prescriptions. But the thrust of his argument is as follows. While asset prices are rising and a bubble is forming, monetary authorities enthusiastically follow the tenets of the efficient markets hypothesis by leaving markets alone. However, as soon as the bubble bursts, causing distress among those who borrowed too much, central banks suddenly rediscover that the markets are not efficient after all. They accordingly respond by flooding the markets with money and credit. This serves to bail out irresponsible borrowers by giving them access to cheap financing when they would otherwise be forced to pay the consequences of their frivolous risk-taking.

This pattern has been repeated numerous times over the past two decades and was manifest in a series of aggressive monetary interventions by the Federal Reserve – first following the 1987 stock market crash; again from 1990 to 1992 to mitigate a recession; again in 1998 in the wake of the Russian financial crisis and the collapse of Long-Term Capital Management; and finally from 2001 to 2003 to weaken the effects of another recession.

The Light-Handed State and the Heavy-Handed State: A Combustible Combo

In each of these instances, the Wall Street banks, enjoying the benefits of scaled-back regulation, enthusiastically took the money the Fed had pumped into the markets and used it to finance more speculative activity. New mortgages, guaranteed by state-sponsored institutions Fannie Mae and Freddie Mac, along with other forms of debt such as corporate loans, ballooned. And whenever an economic downturn seemed possible, the Fed would come to the rescue and flood the markets with still more cheap money. This enabled irresponsible borrowers to get their hands on easy credit to repay their debts. Once relieved of their old financial obligations, they used more of the cheap Fed-provided money to take on even more debt to finance still more speculation. Over time and through repeated interventions, the mountain of debt grew bigger and bigger.

The consequence of all these bailouts was not just to delay the final reckoning but to make it worse once it arrived, as it now has. And yet the Federal Reserve under Bernanke is attempting exactly the same response it took in previous crises. Only this time the level of debt that has built up through the years has become so massive that no amount of central bank intervention can do much about it.

The unfortunate state of affairs we now face was the result neither of government policies that proved too weak nor a state that was too interventionist – but rather of both. Our political, social, and economic reality is a complex organism. It is rarely reducible to simplistic explanations from either the right or the left. The current crisis is no exception.

In future installments I will examine the potential solutions to our troubles – both short-term, for solving the immediate crisis, and long-term, for preventing future ones. As we will see, the measures that would clean things up quickly and equitably are quite the opposite of what the government is doing.

Anatomy of a Bank Run

One may be forgiven for asking what I can possibly hope to add to the voluminous commentary others have already put forth on the economic crisis. The answer, in short, is that our media – in particular the relatively few outlets whose reporters actually understand what is going on – has mostly proven inept at explaining the problem clearly to those of us who lack a background in corporate finance. Terms like “capital injection,” “credit derivatives,” “secured creditor,” and “repo market” are bandied about with little elaboration, as if the average person with a college degree has any clue of their meaning.

The sheer complexity of the problem is such that the vast majority of the educated public has an inadequate understanding of what is happening along with the costs and benefits of the alternative solutions. This, in turn, is allowing our financial and political elite to get away with highway robbery, all the while duping us into believing that the courses of action which happen to be most advantageous to themselves have no feasible alternatives.

What follows is a two-part series that gets to the heart of the matter – the paralysis of the global financial system. The first part examines in detail how a crisis of confidence around a particular financial institution can precipitate its rapid demise and take the rest of the financial system down with it. The next segment will address how we got to this point along with the possible remedies.

Other People’s Money
Let us begin with the crux of the problem: financial speculation using other people’s money. When one speculates with borrowed money, it does not necessarily have to create an existential threat to Western civilization – so long as the amounts borrowed are not excessive. Alas, our financial institutions – banks, brokerages, insurance companies, and hedge funds – have over the past twenty-odd years failed to heed this maxim.

Using borrowed money to supplement your own can be lucrative insofar as it can increase your profits over and above what they would be without the borrowed funds. Let’s say I have $500 and want to use this money to buy XYZ Corp’s stock. The stock is priced at $10 per share. Using my own money, I can buy $500 / $10 = 50 shares of XYZ stock. If the price subsequently increases by $2 per share, I stand to gain $2 * 50 shares, or $100 in profits. That’s a 20 percent return on my $500.

That may be fine for you, but I’ve got to keep my wife happy, and my son, for Christmas, is demanding the G.I. Joe with the kung-fu grip. Surely I can do better than 20 percent. Indeed, if I borrow another $500 and add that to my own funds, I now have $1000 to bet with. And I can buy twice the number of XYZ shares – that is, 100 shares instead of 50.

The portion of the $1000 that belongs to me is called my equity. The other, borrowed portion is called leverage. Using leverage, the same $2 rise in the stock’s price will give me double the profits than if I were only using my own $500; my profit now equals $2 * 100 shares, or $200. This represents a far more amenable 40 percent return on my $500, as compared to the meager 20 percent return I would obtain without any leverage. Sure, I still have to repay the $500 I borrowed. But I get to keep the extra profits for myself.

In this example, I am using 2 to 1 leverage; that is, the amount I borrow is twice that of my equity. The more I borrow in relation to my own personal funds, the bigger the potential return on my investment.

Like all good things, however, leverage has its downsides. If I’m using 2 to 1 leverage and the price falls, I lose twice the amount than if I were only using my own funds; a $2 fall in the stock price amounts to a 20 percent loss using no leverage and a 40 percent loss borrowing that extra $500. Using still more leverage can multiply my losses even further; not only can I lose everything I have, I can end up in the unfortunate position of owing money to my creditors.

Most traders and investors should never use more than 4 to 1 or 5 to 1 leverage. The Wall Street banks that have collapsed or been bailed out were frequently using leverage of 30 to 1 and, in some cases, 50 to 1. Employing leverage at such insane levels means the prices of the assets in which you are speculating have only to fall by a small amount before you are wiped out entirely.

One might reasonably believe that our financial institutions focus on their primary jobs and don’t get distracted by other ventures – insurance companies sell insurance, banks concentrate on lending to businesses, while investment banks stick to mergers, acquisitions, and underwriting. Yet this is not the case. Over the past several decades these financial institutions have come to believe that they can speculate as well.

The assets they speculate in are described in detail in my previous post, “Financial Market Chaos Explained.” In essence, the financial institutions make bets on various assets, such as mortgages. They don’t actually own your mortgage; they are just betting amongst themselves whether you will continue to make your mortgage payments. It is like you and I betting on the Giants vs. the Packers. Neither of us have any connection to the actual teams, but we can still place bets on the outcome of the game. The major financial institutions do the same thing with mortgages, corporate loans, credit card debts, auto-loans, and other assets.

When used prudently, these bets allow them to reduce their risk, which in turn enables them to lend more money to businesses and consumers and in doing so increase the amount of investment and jobs in the broader economy. When used excessively, however, they can be quite dangerous, as we will see.

Introducing P.J. Nagrom
Let us examine how the abuse of leverage can spark the unraveling of a fictitious bank. We will call it P.J. Nagrom. Similarly to the example of the leveraged speculator above, P.J. Nagrom obtains its operating funds through two sources. First, its owners put up their own money in the form of equity. The equity is divided into shares that represent the owners’ claim to any profits the bank makes. In the case of P.J. Nagrom, these shares are publicly traded on the stock exchange, where any owner can sell her shares at any time to a willing buyer. Secondly, the bank borrows money from others. The borrowed money represents leverage and, as in the above example, is designed to enhance the returns available to the bank’s owners, the shareholders.

Everyone – shareholders and creditors – knows at the outset that, if the bank fails, any money that is left over gets distributed among themselves. However, in the event that there does not remain enough money to satisfy everybody’s claims, the law gives some claimants priority over others.

At the top of this hierarchy are the senior bondholders; their claims are considered sacrosanct and must be made whole before those of anyone else. Below them sit the subordinated debt holders. The term “subordinated” denotes the fact that the debts the claimants are owed can be repaid only after the senior bondholders have received all of their money. The subordinated debt holders are in turn divided into senior and junior segments, with the former’s claims given priority over the latter’s.

Finally there are the shareholders. If the bank fails, the shareholders are the last to recover their money – if enough is even left over at all, which is rarely the case. But this is the price they pay in exchange for their right to the bank’s profits. The shareholders come in two forms – preferred and common. Preferred shareholders, as the name suggests, get priority over the common shareholders in the distribution of any funds that remain once the bank is wound up.

Like many other financial institutions, P.J. Nagrom made some bad bets on mortgages and now faces serious losses. It is the shareholders, who sit at the very bottom of the financing hierarchy, who are the first to take a hit whenever the bank loses money. After all, they are the last to receive any leftover funds if the bank goes belly up. Thus, by sheer logic, they are necessarily the first to absorb any losses the bank suffers. Accordingly, whenever P.J. Nagrom reports a loss for the quarter, it will announce a “writedown” in the value of the shareholders’ equity. As soon as the writedown is announced (and frequently beforehand), the stock price will drop to reflect the new, lower value of this equity.

Our bank, whose stock price reached an all-time high of $150 per share in July of 2007, suddenly reported its first ever quarterly loss from subprime mortgages in September of that year. This was followed by an unending string of further losses in every quarter since then, resulting in more writedowns and, consequently, a continuous decline in the price of the stock. In early September 2009, the stock plunged from $34 per share to $17 in the span of a week, as investors anticipated a major loss for the third quarter.

Until this one-week drop of 50 percent, debtholders had been rather complacent, assuming they would continue enjoying regular interest payments on their loans and get their money back in the end; the shareholders, after all, were there to soak up any losses the bank made. However, while the shareholders absorb the first losses, once the stock price falls to zero the debtholders begin to suffer. At that point, any further losses begain eating into the bank’s remaining assets, and there are no longer enough assets left over to satisfy all the debtholders’ claims.

Recall that the massive leverage P.J. Nagrom has taken on means that even a mild decline in the prices of the assets the bank owns takes a hefty chunk out of its equity. At these levels of leverage, the equity can disappear rather quickly, and it did, placing into jeopardy the claims of the debtholders.

P.J. Nagrom is sufficiently large that its debt is traded frequently among willing buyers and sellers, who daily agree to a price on the right to collect a given dollar of P.J. Nagrom debt. During the heady days of 2006, most market participants subscribed to the belief that P.J. Nagrom was immortal. As such the buyers were willing to pay $1.15 for the near certain prospect of collecting one dollar of P.J. Nagrom debt.

Now that the bank is looking rather like a mortal, and a frail, sickly one at that, the price of its debt has dropped to well below one dollar. The junior subordinated debt holders, who occupy the next lowest rung on the funding hierarchy after the shareholders, have taken the biggest loss; their debt is now trading at a mere 30 cents on the dollar. This reflects the market’s belief that they are not likely to receive much of the money they are due if P.J. Nagrom goes under.

The senior subordinated debt holders, who are next in line, have seen the value of their debt fall to 60 cents. Even the illustrious senior bondholders are aghast as they’ve watched the price of their bonds creep down to 95 cents on the dollar. Might the bank’s future losses be so severe as to extinguish the shareholders’ equity and burn through the debt of the subordinated holders to threaten the claims of the senior bondholders as well? Evidently, the markets believe they might.

As the losses mount, the prudent response for P.J. Nagrom’s managers would be to sell the bad assets and eliminate the problem once and for all. Alas, our esteemed chiefs, despite their Harvard degrees and untold fortunes, are human after all. And part of being human is to stick to one’s laurels when the going gets tough and hope luck intervenes in one’s favor. Did Joshua surrender to the enemy at the Battle of Jericho? Did Daniel cower before the ferocious beasts in the lions’ den? Did Gilligan ever give up hope of getting off that island?

Perhaps drawing inspiration from these heroic predecessors, the P.J. Nagrom executives resolved to hold onto the poisonous assets soon after their prices began dropping. Unfortunately, instead of giving way to a quick turnaround, the carnage only got worse; month after month, the prices kept falling.

Along with the mounting losses came the need for the bank’s leaders to justify their actions, or lack thereof. To do so they turned to the fallacious argument that the problem assets are “illiquid” – in other words, there are simply no buyers to be found. This, of course, was a myth. The truth is that there were plenty of willing buyers before, and there are plenty now. It is only that the prices the buyers are offering to pay are, in the opinion of management, unacceptably low.

At each step along the way the heads of P.J. Nagrom were holding out hope that the bloodletting's end was near. And so they chose not to recognize reality and sell the assets at their true prevailing prices. And now, it seems, the prices have sunk to such depths as to render our bank insolvent – that is, the value of P.J. Nagrom’s assets, at the new, low prices, would fall far short of the amount the bank owes to its creditors.

From Venerable to Vulnerable
If the sheer amount of leverage P.J. Nagrom employs has not endangered it enough, the structure of all this borrowed money leaves the bank even more exposed to jittery creditors. The problem is this: while the assets P.J. Nagrom owns are meant to be held over the long-term, the bank must repay its liabilities over much shorter time frames. Whenever this money comes due, the bank must renegotiate with creditors for new loans. If a creditor does not agree to roll over the old debt into a new loan, the bank must either find a new creditor to replace the old one or sell the assets the old loan had been financing.

The senior bondholders generally do not present a problem in this regard, as most of their bonds must be refinanced only every few years. But another big chunk of P.J. Nagrom’s debt consists of “commercial paper.” Purchased mostly by money market funds (which are similar to deposit-taking banks, only riskier), commercial paper is short-term debt that must be repaid in a matter of weeks, not years. As a result, every few weeks the bank must renegotiate with the commercial paper holders to roll over the old commercial paper into new paper. If this proves impossible, the bank must sell the assets the commercial paper was financing at whatever price the market can accept. As mentioned above, these prices would now be so low as to make the bank insolvent.

To make matters worse, another, very large portion of P.J. Nagrom’s assets are financed by “repo loans.” Whereas commercial paper must be repaid and renewed every few weeks, repo loans have to be renewed each day. Every morning P.J. Nagrom’s staff calls up the repo lenders and asks if they will agree to continue providing financing for one more day. Never has the answer to this question been anything but “yes.” But if the repo lenders ever responded in the negative, it would cut off the bank’s oxygen supply, and P.J. Nagrom would immediately be in danger of going under.

Another large segment of the funds P.J. Nagrom uses comes from other big financial institutions, like hedge funds, who rely on the bank as their “prime broker.” What this means is that these other institutions, speculators in their own right, use P.J. Nagrom to execute their trades for them. To do so they open accounts at the bank. Naturally, any hedge fund can close its P.J. Nagrom account at any time and demand its money back. Normally, however, new accounts are opened about as often as old accounts are closed. This leaves P.J. Nagrom sitting on a substantial, unused pool of cash. Like any bank, it puts this cash to use for profit. In P.J. Nagrom’s case, the money is used to fund the bank’s own speculative activities.

It is rather unlikely that many prime brokerage clients would demand their money back at the same time. Unlikely, but not impossible. If this ever did happen, P.J. Nagrom would have a problem; it would be forced to dump lots of assets on the market simultaneously, probably at very unfavorable prices, in order to raise enough cash to satisfy the demands of the fleeing prime brokerage customers. While this might have happened to failed rivals such as Bear Stearns and Lehman Brothers, P.J. Nagrom’s chiefs do not believe this to be a realistic possibility.

Endgame
Following its 50 percent plunge in a single week, P.J. Nagrom’s stock price appeared to be stabilizing. The respite proved short-lived. Several weeks later, it began falling again as fears about the bank’s solvency started to gain momentum. It was at this point that several large hedge funds, all prime brokerage customers, closed their accounts and withdrew their money.

News of this event, combined with the plummeting stock price, prompted a number of commercial paper holders to decide it unwise to buy new P.J. Nagrom paper once the old paper was redeemed. Instead they took the prudent decision to hold onto their money until the market uncertainty abated.

With the stock price now at $5, and rumors circulating that the bank was running out of cash, the other debt holders and prime brokerage customers took fright. During a single week in December 2009, the stock plumbed new depths, closing the week at a mere $1.25 per share. Overnight repo lenders now feared that the evaporation of P.J. Nagrom’s equity and rapidly deteriorating cash reserves might threaten their ability to get their money back the next day. They too began stampeding for the exits.

The revolt of the repo lenders starved P.J. Nagrom of its very life source, leaving the bank with three options, all rather unpalatable. The first and least disagreeable option was to find a new investor who would purchase a substantial portion – if not a majority – of the bank’s stock at a price significantly above the market price of $1.25. Not only would this provide the bank with extra cash to satisfy the demands of the panicking debt holders and prime brokerage customers. It would also re-inflate the equity cushion that protects the debt holders from any losses (recall that the debt holders begin absorbing the losses once the value of the bank’s equity disappears). This might persuade the remaining debt holders to stay put and even convince those who had already fled to return. However, despite frantic negotiations over the weekend with a few potential suitors, none was willing to take on the risk.

This prompted the bank’s management to push for the second option – a government bailout. Under this plan, the government would guarantee most of the losses incurred by a private institution that acquired P.J Nagrom. That is to say, any institution that agreed to purchase the bank would have its potential losses capped at, say, $1 billion. The government would pick up the tab for any additional losses. At this late stage, though, the public and its elected representatives were suffering from a severe case of bailout fatigue. On the afternoon of Sunday, December 6, 2009, the president of the New York Fed notified P.J. Nagrom’s CEO that no government assistance would be forthcoming.

This left the bank with the much-loathed third option – bankruptcy receivership and liquidation. That Sunday night, P.J. Nagrom’s chiefs filed for bankruptcy. Tens of thousands of employees, having already witnessed the value of their stock options disintegrate, would be cast onto the street. Control of the bank was handed to a government-appointed bankruptcy receiver charged with overseeing the winding up of the hundred-year-old institution. The receiver would sell all of P.J. Nagrom’s assets and distribute to the debt holders any resulting cash that was raised.

Needless to say, the sudden appearance of such a vast supply of assets for sale on the market, umatched by any corresponding increase in demand from willing buyers, precipitated a severe drop in their prices. The prices of everything from mortgages to corporate loans, credit card debts, and auto-loans began tanking.

This development pushed a number of other large financial institutions into insolvency, as the prices of the assets they owned had now fallen to levels well below the amount they owed to their own creditors. The bank run, previously restricted to P.J. Nagrom, had now become systemic; fleeing creditors and frightened prime brokerage customers withdrew their money in hordes. The country was now on the brink of its first nationwide banking panic since the 1930s.

The placing of these institutions into bankruptcy receivership presented the horrific prospect of further asset firesales on an even larger scale; the new receivers, having taken control of the other bankrupt institutions, would now have to sell off the banks’ speculative assets in order to raise money to pay back the claims of creditors. This would further spur the downward spiral of asset prices and threaten still more banks, hedge funds, and other institutions.

To stem the panic, president Obama announced, for the first time since the Great Depression, the imposition of a national bank holiday. Nobody would be able to withdraw their funds from any bank for an indefinite period.

The bank holiday, however, was not sufficient to soothe the fears enveloping the remaining financial institutions. Amidst such unprecedented uncertainty, the country’s largest banks, money market funds, and other institutions had all but stopped lending to businesses and began calling in their loans. This offered up the possibility of a new wave of insolvencies throughout the broader economy, much bigger than any seen in decades; those businesses that did not have the cash to pay back their loans would be forced into bankruptcy and their assets sold to pay off their creditors. While the effect on unemployment would be difficult to estimate, it was clear that millions would lose their jobs.

The United States stood on the edge of the abyss.


Conclusion
While the above scenario may sound depressing, it is merely a possibility, not an inevitability. And, despite the short-term harm it could inflict, it will ultimately pave the way for a recovery. But it is a real danger.

The next and final part of the series will examine how we got to this point, what should be done, and what is likely be done (which is quite different from what should be done). I will also present a few simple steps you can take to protect yourself.

*For further reading, I recommend House of Cards by William D. Cohan, which provided the inspiration for this piece. It is the story of the rise and demise of Bear Stearns and includes a particularly gripping account of its final days.

Israel-Palestine: Get a Grip

Few subjects bring out the idiocy in otherwise smart and reasonable people quite like the Israeli-Palestinian conflict. Enter any gathering here on Berkeley's campus, mention the word "Palestine," and watch as brilliant academics transform at once into blathering lunatics. The principle applies regardless of whether the individual in question supports the Palestinians or the Israelis.

I normally approach this strange phenomenon by studiously avoiding discussions of the topic with anyone in my life. Whenever the conflict flares up, I go into hibernation until it dies down again.

This time I've decided - unwisely, probably - to lay my position on the line. In doing so I will likely attract a barrage of condemnation from most everybody I know. The upside is that whenever someone tries to draw me into this argument in the future, I can wash my hands of it simply by pointing them to this blog post and running away.

Most people who have a strong opinion on the conflict tend to regard one side as "good" and the other as "bad." The Palestinian (Israeli) cause is fundamentally just, while the Israelis (Palestinians) are a bunch of conniving brutes who flat-out refuse a reasonable compromise. As always in international politics, reality is far too complex to warrant such one-sided judgments.


Extremists and the perpetuation of hostilities

To me, it is short-sighted to regard one community as innocent and the other as malevolent. When I look at the Israeli-Palestinian dispute, I rather see the same thing I observe in almost every other civil conflict around the world. On each side you have a faction of relatively moderate leaders pitted against a group of extremists. The moderates tend to be receptive to compromising with the other side. They seek support among their constituents by posing as the party of reason.

The extremists, by contrast, cast themselves as the defenders of the nation from enemy aggressors. Paradoxically, however, they must continue stoking this external threat in order to justify their political existence. Without it, there is no rationale behind their quest to hold positions of power. In this way, extremists thrive on discord and violence. They gain political advantage by undermining any and all peace efforts initiated by the moderates.

Remarkably, this dynamic holds in practically every civil conflict around the globe, from Yugoslavia, Iraq, and Congo to Chechnya, Georgia, Sri Lanka, Kashmir, Turkey/Kurdistan, and Colombia. In the case of Israel-Palestine, the moderates take the form of the Labor Party and Kadima on the Israeli side and the PLO and parts of Fatah among the Palestinians. The extremists on the Palestinian side consist of Hamas; Fatah's military wing, the al-Aqsa Martyrs Brigades; and Hezbollah, a militant group operating in southern Lebanon. Among the Israelis, the extremists are to be found in the Likud Party, segments of the religious right wing, and the Jewish settlers in the West Bank (and, previously, Gaza).

Palestinian and Israeli extremists engage in a symbiotic dance, each undertaking provocative and often violent actions that unwittingly promote the interests of the other. The pattern is eminently predictable; each time moderates among the two sides seem close to an agreement, the extremists step in to scupper it.

In the early 1990s the Oslo peace process, which ended the first Palestinian uprising, terminated abruptly when a radical Jewish settler assassinated Prime Minister Yitzhak Rabin, the only Israeli politician with enough authority to oversee the full implementation of the accords. His successor, Shimon Peres, restarted peace negotiations but failed to win re-election in 1996. Why? Just before the elections were held, Hamas carried out a string of suicide bombings, sparking outrage among Israelis and springing Binyamin Netanyahu, his hawkish opponent, to power. This was precisely the outcome desired by Hamas, who wanted to ensure that Peres' peace initiative never got off the ground.

In 2000, the two sides were arguably as close to a settlement as they had ever been. It was at this time that Ariel Sharon, then the leader of the opposition Likud Party, staged his famous visit to the Temple Mount, one of the holiest sites in both Judaism and Islam. While Sharon could not have predicted the scale of the response, he surely knew his action would prove incendiary. Fatah responded by sending trained Palestinian youths into full-fledged rebellion against Israel. The second Palestinian uprising thus began. The resulting violence hardened Israeli public opinion and, in elections held a few weeks later, propelled Sharon and Likud to power.

Further examples abound. In 2002, on the eve of a major peace summit in Beirut, a Hamas youth blew himself up in the "Passover Massacre." Later, in 2006, Hezbollah crossed the Lebanese border to attack and kidnap a contingent of Israeli soldiers. The results must have exceeded their wildest expectations; the incursion brought on a massive retaliatory response by the Israeli army, killing scores of civilians and solidifying Hezbollah's standing as the exalted defenders of Lebanese Muslims and Palestinians. Israel's current offensive in Gaza began in similar fashion; this time, Hamas escalated its rocket attacks in the weeks preceding the assault, prompting the heavy-handed Israeli reaction you are now witnessing.

On both sides of the conflict, then, one can observe a small group of elites who cynically bolster their own power by keeping ordinary people locked in a semi-perpetual state of violence. Granted, it is only the Palestinian extremists that deliberately target civilians. Does this mean their Israeli counterparts are to be regarded as more virtuous? Hardly. The extremists on both sides will do anything they can get away with. It is simply that the Israeli ones can get away with less. Israel, an internationally-recognized state that seeks normal relations with most of the world, cannot afford to be seen intentionally and indiscriminately blowing up Palestinian civilians. Therefore, Israel's leaders - even the extremists among them - go to considerable lengths to avoid such displays.

Hamas, by contrast, is not bound by the niceties of diplomatic relations and international treaties. Since they have far less at stake, they can send their suicide bombers into Israeli cafes without fearing serious consequences. They are also free to use as weapons of war the very Palestinian civilians they claim to be defending, firing rockets into Israel from launchers stationed in heavily-populated areas. That way, any retaliation by Israel has a high probability of killing these civilians and stoking more rage of the kind on which Hamas thrives.

If you insist upon taking a strong moral stand on the Israel-Palestine issue, then at least direct your hostility where it is due. Refrain from silly and simplistic condemnations of one side in favor of the other and dispense your venom towards the extremists who reign over both.


Stifle yourself, please

Even then, however, you must explain why you are so concerned with this particular conflict over the many other worthy candidates the world has to offer. Most of these other disputes are equally, if not more, deserving of your outrage. If you are Jewish or Palestinian, or even simply Muslim, your preoccupation with Israel may be justified. If you do not belong to any of these communities and still find yourself furiously pounding your fist over what is happening in Palestine, then a bit of self-reflection may be in order.

Why, for example, do you support the Palestinian cause while ignoring the plight of the Sahrawis, oppressed under Moroccan domination since 1976? Or the Kurds' struggle against Turkey, whose military regimes have brutally crushed their quest for independence? Why are you not similarly enraged at India's occupation of Kashmir? Or Sri Lanka's ham-fisted repression of its ethnic Tamil population? The list of embattled minority groups goes on and on. If you are to persist in your cheerleading for the Palestinians, then you must promote all of these other causes as well - unless, that is, you are unburdened by a desire for logical consistency.

Palestine's armchair activists, when pressed on this point, give a common reply. There is, they admit, nothing special about the injustices endured by the Palestinians. Their anger, they claim, stems instead from the fact that their tax dollars are supporting these injustices by way of the billions America provides each year to Israel in the form of aid.

This argument fails to stand up to scrutiny, however. The US extends similar aid, directly or indirectly, to Turkey, which represses its Kurdish minority; to Colombia, whose military and paramilitaries terrorize rural peasants suspected of sympathizing with the FARC rebels; and to Egypt, which brutalizes, jails, and tortures its own population. Yet when it comes to these other instances, Palestine's Upper West Side crusaders fall strangely silent.

There is, I believe, another explanation for their arbitrary rage. Israel's occupation of the Palestinian territories offers up the stark image of rich white people oppressing poor brown people. This pattern harks back to European imperialism in the Third World along with America's own mistreatment of its African-American population. The concept is an easy one for Westerners to digest.

Yet most of the oppression in the world today is perpetrated by poor brown people against other poor brown people - think of sub-Saharan Africa, South Asia, and the rest of the Middle East. Unlike white-on-brown injustice, the notion of brown-on-brown repression is too complex for many people in the West to fit into their simplistic moral frames. Aren't the dark-skinned people of the world supposed to live together in harmony and unite against the White Man?

Thus, when it comes to mass rape, mutilation, and murder in Congo, most people in the West just turn away befuddled. But when the Israeli army bulldozes homes in the West Bank, the legions of "progressives" start plastering their Volkswagen Jettas with bold-lettered bumper stickers.

At best, we can chalk up this tendency to ignorance; most people are simply unaware of what's happening in these other places because the media devotes less coverage to them. At worst, however, it is a subtle form of racism. Many of us in the West expect a higher standard of conduct from prosperous white people than we do of impoverished brown people. How else to explain why the Israelis' comparatively light treatment of the Palestinians monopolizes everybody's attention while the bloodletting in Congo barely merits a headline? The total body count in Palestine since the second uprising began in 2000 numbers several thousand. In Congo, five million people have been killed since 1997. Yet when was the last time you heard your aunt, the professor of comparative literature who routinely rants about the Israeli occupation, say anything at all about Congo? Or Zimbabwe? Or Colombia?

If you feel compelled to render judgment, then at least apply some logic in how you apportion it.