Essential Financial Reforms

Congress asked the Government Accountability Office (GAO) to assess the cost of the 2007 financial crisis and if the 2010 Dodd-Frank legislation will prevent future crises. GAO just released their findings: “the present value of cumulative output losses could exceed $13 trillion” and “[there is] no clear consensus on the extent to which, if at all, the Dodd-Frank Act will help reduce the probability or severity of a future crisis”. $13 trillion? If at all? That’s alarming.

GAO studied not just the bailout cost, which looks to be $1.5T to $3T, but the overall cost. “While the structural imbalance between spending and revenue paths in the federal budget predated the financial crisis … From the end of 2007 to the end of 2010, federal debt held by the public increased from roughly 36 percent of GDP to roughly 62 percent. Key factors … included (1) reduced tax revenues … (2) increased spending on unemployment insurance … (3) fiscal stimulus programs … (4) increased government assistance to stabilize financial institutions and markets.” 36% to 62% is one big jump.

Consumer spending (70% of our economy) fell, GAO notes, because: “median household net worth fell by $49,100 per family, or by nearly 39 percent, between 2007 and 2010”. They also show the high human cost of long-term unemployment from the financial sector’s collapse.

Maybe later I’ll explore why Congress passed legislation GAO found may or may not “reduce the probability or severity of a future crisis“, legislation that is both enormously too complex and not what we normally think of as regulation. The Glass-Steagall Act that transformed finance after the 1929 Wall Street Crash has 37 pages. Dodd-Frank has 848 and does not specify rules people must follow but new regulations bureaucrats must create along with enforcement agencies. That’s not how we do things where I’d like to come from.

The immediate, urgent question is, what must we make Congress do instead? Now I understand the problem (see previous pasts), the solution looks pretty straightforward:

Eliminate too-big-to-fail. The collapse of the big banks and AIG threatened to paralyze our entire economy. They were bailed out because they were considered too big to be allowed to fail. Businesses that go wrong should fail. And they should fail without damaging the economy. This means banks must be limited to a maximum of, say, 5% of total US deposits and any that become insolvent must be forced into receivership under the FDIC.
Regulate derivatives. The collapse of any one financial institution could trigger the collapse of the whole system because inter-dependencies via derivatives were gigantic and invisible to regulators. To make them visible, derivatives must be traded on exchanges like stocks and futures, and ones that could require a future payout must be treated like insurance with their underwriters required to carry reserves.
Restore 12:1 leverage. The big banks failed so fast because their capital reserves were too low. Our economy depends on lending and they had to stop when they became insolvent. The SEC waiver of the 1975 net capitalization rule must be reversed and SEC discretion over the rule must be eliminated.
Restore Glass-Steagall. Tax-payers have to foot the cost of the mega-banks’ mismanagement because speculation and underwriting is no longer separate from taxpayer-backed depository banks. The separation must be restored.
Regulate non-bank lenders. Many of the loans most likely to default were originated by non-banks who securitized and sold them. Any institution that originates a loan must be required to keep, say, 10% of its securitized loans and absorb the first 10% of default losses incurred by investors in the securitized loans.

Among other things, the Dodd-Frank Act mandates the SEC to require US public companies to repossess executives’ short-term profits that result in long-term liabilities that require an accounting restatement. There is also discussion of ways to make senior management personally liable in the event of a taxpayer bailout. I have little confidence in either approach. Compensation committees will indemnify executives from such provisions. Shareholders and taxpayers will continue to pay.

The Justice Department recently sued S&P for up to $5B for defrauding investors with inflated credit ratings. I assume Moody’s will also be sued because they, too,were paid for ratings by investment banks that issued mortgage securities. We might hope S&P and Moody’s will change the way they do business to eliminate the conflict of interest. More proactive would be to open the ratings business to competition.

Hmm, my Buddhist practice must be helping – I got through exploring all this Washington/Wall Street malarkey without feeling angry. I feel wrathful determination to do whatever I can to get it fixed, but wrath can be positive.

Fixing the negatives will discourage allocation of capital where it will have little or no value. Next I’ll turn to the positive and explore what could guide good allocation.

Feb 17 2013

It Takes a Pillage

Our finance system stopped allocating capital where it will have most value and efficiently reallocating risk. Previous posts showed how deregulation and bailouts introduced moral hazard, how leaders of big financial institutions responded, and how in 2007 it all blew up. But why did Washington allow the moral hazard to develop and respond as they did to the result? Was there a cabal of corrupt Mr. Moolas?

Probably not. The protagonists seem genuinely to have believed markets would regulate the behavior of their participants. When it went wrong, they did not consider it self-interested to preserve the big financial institutions they understood to be the financial system.

How we conceptualize the world is shaped by our experience. It’s instructive to explore the experience of those whose beliefs got us so far off course but future Fed Chairpersons and Treasury Secretaries will also have conceptual blinders. To avert repeating the catastrophe we must make structural changes.

In this post we considered Alan Greenspan’s expansion of the Fed’s mission to include managing asset prices. His successor, Ben Bernanke, holds the same belief. Central banks do influence asset prices while raising and lowering interest rates to help manage inflation and unemployment but they overestimate monetary policy hoping it can compensate for poorly managed fiscal policy, i.e., government revenue and spending.

What set the beliefs of Treasury Secretaries? Robert Rubin, 1995-1999, had worked at Goldman Sachs for 26 years and was co-chairman from 1990 to 1992. He later became a director of Citigroup and was its chairman at the height of the 2007 crisis. Larry Summers, 1999-2001, formerly Rubin’s deputy, followed his lead against regulating derivatives and for deregulating big banks. Paul O’Neill, 2001-2002, formerly CEO of Alcoa, deplored Bush’s tax cuts, investigated al-Qaeda funding by American allies, objected to the invasion of Iraq, and was fired. John Snow, 2003-2006, formerly CEO of CSX, had to resign when it was revealed he failed to pay income taxes on $24M at CSX . Henry Paulson, 2006-2009, was formerly chairman and CEO of Goldman Sachs. Tim Geithner, 2009-2013, was at Treasury from 1998–2001 under Rubin and Summers, then President of the NY Fed.

With the exception of O’Neill and Snow who had little impact, the beliefs of all these men were shaped by Goldman Sachs. Did they act always in what they believed to be the best interests of all the people? Let’s assume they did. What they believed would have led them to the actions they took. Of course they believed big financial institutions must be saved, and of course they believed it essential to bail them out.

They may well have been right. Deregulation probably had made the big financial institutions too big to fail and bailouts had become Washington’s Pavlovian response to confidence-threatening failure of big enterprises.

But what about after the bailouts? We already considered moral hazard created by bailouts that protect fools from the disasters they create. What about moral hazard created after the bailouts by weak punishment of those who committed fraud? This is where more folks think they see Mr. Moola.

Financial institutions have agreed to settlements that sound large. Global banks agreed to pay almost $11B in the US last year. This January, Bank of America reached a $10.3B settlement with Fannie Mae. The Fed and Treasury reached a separate $8.5B settlement with 10 banks, including BofA. But no institution or executives have been brought to trial. And while $11 + 10.3 + 8.5 = $30B of settlements is a big number, financial sector stocks in the S&P 500 earned $168B in profits last year, up 21% from 2011. The cost of the settlements was inconsequential, $30B of what would have been $200B.

The settlements make even less difference to those responsible. Angelo Mozilo, for example, was paid almost $470M as CEO of Countrywide Financial but paid none of BoA’s settlement for what Countrywide did under his leadership. He did settle with the SEC on unrelated insider trading charges but even there he paid only $47M of the $67M settlement because he had a $20 million indemnification in his employment contract. Criminal convictions have discouraged insider trading. Mortgage and other financial frauds should also have been vigorously prosecuted.

But far more important than punishment for crimes past are major changes we must make (1) to minimize moral hazard and the likelihood of another financial crisis, and (2) so the financial system will allocate capital where it has the highest value. The first, which I will itemize in the next post, are easy to see now that I understand the problem. The second requires more exploration.

Feb 15 2013

The Dukes of Moral Hazzard

In the world of finance, moral hazard exists when someone can profit from successful bets and suffer little or nothing from bad ones. In the 1980s Dukes of Hazzard show the Duke boys, their beefed-up Dodge Charger and their short-shorted cousin Daisy keep foiling corrupt county commissioner “Boss” Hogg’s scams but because the well-meaning boys often bail him out, he’s always coming up with new scams. So it has been in the world of finance for the last three decades.

Moral hazard inflated the bubble whose collapse in 2007 left us wallowing in the Great Recession. Wall Street executives made bets that profited them immensely expecting, correctly, they would not suffer when the bubble blew. Their firm might suffer, perhaps even cease to exist, but they would keep their profits. Their firm might pay penalties for law-breaking, but they would not. Moral hazard defeats what finance should do, allocate capital where it will have most value and efficiently reallocate risk. This post examined finance’s mechanisms – securities, credit and insurance – and the following one highlighted regulatory changes enabling the mechanisms to be used in ways that led to the 2007 financial crisis. This post explores how Washington became Wall Street’s savior.

Bailouts of individual enterprises started in 1971 when defense contractor Lockheed was rescued from financial mismanagement with $250M of loan guarantees. Then in 1973, the Penn Central Railroad, which declared bankruptcy in 1970 but was considered “too big to fail”, was merged by Congress into Conrail, whose operating costs Congress spent $7B subsidizing. Next, in 1980, Chrysler was bailed out with $1.5B in loan guarantees. So, with these bailouts starting in 1971, Washington began thwarting capitalism’s creative destruction.

Lockheed was mismanaged financially, its defense and civilian mega-projects had big cost overruns and were late, and it was bribing foreign government officials. Penn Central’s executives utterly failed to gain operational control after it was formed in a 1968 merger. Chrysler’s executives produced its uncompetitive cost structure and low quality products. If, to take just one example, Chrysler had declared bankruptcy, its management would have been replaced and its contracts renegotiated. Because it was not restructured, it inevitably failed again and leaders of GM, Ford and the unions learned they, too, might expect to be bailed out.

The Chrysler bailout, the first whose rationale was to save jobs and the economy, set an especially bad precedent. In 1987, the Fed took the next step along that path of unintended consequences which led to the 2007 financial collapse. The Fed’s traditional mission had been to manage inflation and promote sustained output growth by supervising credit. Now it began trying to manage asset prices.

When the Dow plunged 23% on October 19, 1987 following drops of 4% and 5% the previous week, the Fed promised before the market opened the next day to “serve as a source of liquidity to support the financial and economic system”. No economic event had triggered the crash. Stock prices had simply risen too far too fast, 40% in the first eight months of the year, and there was panic at the first sign of the bubble deflating.

Why, then, did the Fed do anything? Because Fed Chairman Greenspan saw market prices not as an indicator of the economy’s health but as something he should manage.

Market prices kept heading up through the 1990s following each downward blip, e.g., the LTCM hedge fund collapse and bailout in 1998, until in 2000 the dotcom bubble collapsed. Greenspan then began cutting interest rates almost month to month from 6% in January 2001 to 1.75% by year-end, and he kept on down to 1% in 2003. Consumer spending, around 70% of the entire US economy, had barely dropped; only the stock market had plunged. Greenspan’s unprecedented rate-cutting was not required to stimulate economic growth but stock prices, which it did until the next collapse.

Interest from investment was now so low that it became essential to speculate for income – trust funds and foundations must disperse 5% of assets each year. And speculation seemed safe because a new pattern had emerged; when bubbles collapsed, the Fed would save the day. So houses, traditionally a safe investment, became a vehicle for speculation. Until that bubble collapsed in 2007.

The Fed was not the only creator of moral hazard. Congress, in the 1995 Securities Litigation Reform Act to control nuisance class action lawsuits, exempted accountants from liability for fraud by their clients. Accounting scandals soon followed. Enron was the most dramatic and its 2001 fall also took down its auditor, Arthur Andersen, one of the “Big Five” accounting firms.

The SEC’s contribution to the 2007 crisis was facilitation of stupidity. From 1975, the SEC limited investment bank borrowing to no more than $12 on each $1 of their capital. In 2004 they gave the five biggest ones a special exemption that allowed them to lever as much as 40:1. Three years later, all five of them were insolvent. First, Bear Stearns went belly-up in a bank run when clients fearing it was over-leveraged pulled out 90% of its liquidity in two days. Almost immediately after that Lehman Brothers became the largest bankruptcy ever in the USA.

Bear was eased into the arms of JP Morgan with $29B of guarantees from Washington. Lehman was allowed to fail. Its clean assets were bought by Barclays and others. But then Washington stepped in full force. Merrill Lynch was helped to sell itself to Bank of America. Morgan Stanley and Goldman Sachs borrowed massively from Washington and changed their status to commercial banks so Washington would lend them more. The Fed bailed out AIG whose massive exposure to derivatives made it “too big to fail” and Secretary of the Treasury Paulson, ex-CEO of Goldman Sachs, nationalized Fannie Mae and Freddie Mac for the same reason.

Why were these economy-threatening institutions allowed to grow so big? Deregulation of the barriers was strongly advocated throughout the 1990s by Treasury Secretary Rubin, formerly co-chairman of Goldman Sachs.

And why were economy-threatening derivatives not regulated? Rubin’s advice was instrumental in that decision, too. He later became a director and temporary chairman of Citigroup.

When asset prices tumbled as the real estate bubble collapsed, banks had to stop lending, not that there was much demand for new borrowing. It was said to be a liquidity crisis because the big banks were, or were close to being, insolvent. The confusion led to a Wall Street crash. In that panic, Treasury Secretary Paulson proposed a $700B program to inject capital into the big banks and buy the junk off their books while the Fed began far more massive capital injections via all the big banks.

Pretty soon Washington (the Fed, FDIC, Treasury and FHA) had a $15T commitment of monies spent, lent, and guaranteed, around the size of the entire US economy. Much of what was lent has since been repaid because the big banks were saved and many of the guaranteed loans were sound. Nonetheless, the cost looks likely to end up in the range of $1.5T to $3T. Those numbers are too large to imagine. For comparison purposes, the inflation adjusted cost of WW2 was around $3.5T.

And saving the banks but did not avert global economic recession. Furthermore, the saved big banks are still too large to fail and their executives are still profiting as they did before when, for example, the CEO of Citibank was paid $130M from 2003 until late 2007 when Citi’s stock collapsed from 55 to 2.

I’ll explore in the next post why the people who wreaked such destruction on their employers got to keep their enormous rewards and why although their employers later had to pay big penalties for fraudulent actions on their watch, none of the executives has been indicted.

Feb 10 2013

Mr Economy’s Paralyzing Stroke

Finance is like the circulatory system distributing oxygen and nutrients through the human body, stabilizing its temperature, and so on. It’s prone to strokes. What led to Mr Economy’s massive one in 2007? Will he have more? How severe will they be? And will he ever recover from the paralysis that one caused?

Our economy depends on finance to flow. Unfortunately, Washington has the wrong model. When the flow stopped in 2007 they applied giant plungers, TARP and Quantitative Easing, to what they imagine is a blocked financial toilet. Not surprisingly, the flow has not been restored.

To understand what led to the cerebrovascular accident and what risk factors to change, we must first know the purpose of finance, what it should do, and its basic mechanisms. Its purpose is to help people save, manage, and raise money. What it should do is allocate capital where it will have most value and efficiently reallocate risk. Its mechanisms are securities, credit and insurance.

We need to know how those mechanisms work to understand how and why the circulation of finance got interrupted.

Securities can be bought and sold. Their traditional function is for commercial enterprises to raise new capital from investors who seek income and/or capital gain. Their traditional categories are equity and debt. Equity securities represent fractional ownership of the issuer, debt securities a loan. Debt securities typically require regular interest payments and the issuer must repay the loan. Equity securities are not entitled to payment but may receive a periodic share of the issuer’s profits. Equity owners hope the value of the issuer, and therefore their securities, will increase.

Credit has traditionally been supplied by bank loans governed by an agreement between issuer and borrower. Those loans could not be traded. The issuer received interest payments for the use of their capital and protected against failure to repay with a claim on the borrower’s assets, i.e., collateral.

Insurance transfers the risk of a loss from one entity to another in exchange for a payment. The insured accepts a definite small loss in the form of their payment to the insurer in return for compensation in the uncertain event of a larger financial loss.

Several things changed in the past three decades. There was a great increase in securitization of what was originally credit. Security, credit and insurance transactions got combined in new and ever more complex ways. Financial regulation was relaxed and funding of regulatory oversight was cut.

Mortgages (i.e., credit) were bought in bulk, repackaged and resold as new types of securities, CDOs, Collateralized Debt Obligations, Re-REMICs, Re-securitizations of Real Estate Mortgages, ABS, Asset-Backed Securities, MBS, Mortgage-backed Securities and etc. Banks could now originate more mortgages because the ones they sold were no longer on their balance sheet. Buyers of mortgage-backed securities could pay for them with money borrowed against other securities as collateral and hope to resell them for a quick profit. They could insure against their collateral’s possible loss of value. And so on and so on.

That increased complexity accelerated the financial system’s growth but also made it more fragile, which increased risk for the overall economy. Issuance of these new kinds of derivative securities (chains of transactions derived from an asset) exploded from less than $100B in 2000 to more than $500B in 2007. That’s when the uber-stimulated financial system cratered and Mr Economy had his paralyzing stroke.

Financing , refinancing and securitizing doubled household debt from 48% of GDP in 1980 to 99% in 2007. Most of that increase was in residential mortgages, up from 34% to 79% of GDP.

Financial services grew not just from credit intermediation. Management fees grew as people switched from owning individual securities to managed funds, transferred their assets to professional managements, traded more, and as asset values increased. Only 25% of household equity holdings were professionally managed in 1980. That more than doubled to 53% by 2007.

The growth in insurance was mainly in new kinds of insurance associated with securitization.

Earnings of financial services employees grew rapidly along with the financial sector’s growth. In 1980, they typically earned about the same as their counterparts in other industries. By 2006, they earned an average of 70% more.

The increase in household debt and associated derivative securities drove the value of total financial assets, stocks, bonds, derivatives, and etc from about five times GDP in 1980 to double by 2007. The ratio of financial assets to tangible assets, e.g. plant and equipment, land, residential structures and etc. grew in the same rapid way. Debt creates money because if you lend me $100 there is now $200, my $100 plus your $100 asset, i.e., my promise to repay. Assuming I do repay.

Much of the asset growth came from securitization of loans on bank balance sheets, i.e., transforming credit into securities. The total value of debt securities was 57% of GDP in 1980. Securitization of loans added 58% by 2007. The total value of debt securities more than tripled to 182% of GDP.

Much of the growth in equity securities came just from higher equity valuations, i.e., the exuberant willingness of buyers to pay more for potential future gain. The total value of equity securities nearly tripled as a share of GDP between 1980 and 2007, from 50% to 141% of GDP.

Financial institutions traditionally earned spreads on loans on their balance sheets, i.e., they got higher rates of interest on capital they lent than they paid to depositors. That changed with securitization. Now they profited mainly from fee income. By 2007, 61% of home mortgages were in loan pools of mortgage-backed securities, 72% of which were guaranteed by the Federal Housing Administration (FHA) or one of two Government Sponsored Enterprises (GSEs), Fannie Mae or Freddie Mac.

Securitization of credit was a major part of the development of the “shadow banking” system. Many types of non-bank financial entities now perform some essential functions of traditional banking. Like banks, they use short-term borrowing to issue or buy longer-term securities. Their short term lenders can demand repayment at any time, and they are vulnerable to a drop in the value of longer-term securities, either of which can result in the equivalent of a bank run because deposits at shadow banks are not federally insured.

When financial transactions were primarily between a security issuer and a purchaser, or a bank and a borrower, each party’s risk could be known. When a package of mortgages is securitized, however, third parties buy the securities, insure themselves against severe loss with a fourth party which perhaps insures itself with a fifth party, and so on and so on. It becomes impossible to assess risk for any party. Prudently managed entities can be brought down by others in the chain and if large enough ones fail, the economy of which they are part can collapse. That’s what happened in 2007.

In future posts I will explore, not necessarily in this order:

What Washington and Wall Street did that made the collapse inevitable
Why Washington bailed out Wall Street’s largest enterprises instead of allowing them to fail
Why some Wall Street enterprises were fined for criminal behavior but no executives were jailed
What must be done so the financial system will fulfill its purpose

We will, I’m sorry to say, come to see that our financial system that should function as a circulatory system is instead being operated as a Washington/Wall Street mine and we are being poisoned by its toxic waste. By exploring how that happened we’ll identify essential changes so the system will instead do what it should. Now, where did I put my hard-hat, flashlight and canary?

Feb 7 2013

Why I Feel Like an Extraterrestrial

Maybe it’s because I don’t watch TV. But I’m getting ahead of myself.

I’m lying in the dentist chair. The TV on the ceiling is tuned to CNBC. The technician asks, “Would you like me to turn the TV off or shall I leave it on?” I tell her it’s OK either way. I think I don’t care and most of the time I am indifferent but every so often the moving images and voices attract my attention. “Look,” says an intelligent looking young man, “if we eliminated the entire defense budget it still wouldn’t fix the deficit.”

The voices were being processed by my brain all the time. Recognizing “defense budget”, something said, “heh, pay attention” and presented the entire sentence the man had spoken. The interviewer thanked the young Congressman. Nobody broke out howling with laughter.

We can’t know everything so maybe the Congressman didn’t know how much we spend on defense. Maybe he didn’t know what he said was factually incorrect. Perhaps he’s too busy to investigate what took me only a short time to learn (see this ) but can he really be a stranger to logic?

Let’s say it was true we would still have a deficit if we entirely eliminated defense spending. Does that mean we have no choice but to continue defense spending at the same rate? If those we elect can say such things and be treated as wise and suitable leaders, I must be an extraterrestrial. Why isn’t anyone laughing?

The technician continues to chip away. I try to relax, telling myself, “you’re over-reacting. He probably knows what he said is nonsense and that many people like to hear such things.” It doesn’t make me feel better but you can’t expect to feel all that great in a dentist chair, anyway.

The pattern recognizer alerts me again: “If we make enough laws, we can all be criminals”. It remembers I was interested when I heard that before. The speaker is another thoughtful looking man who also seems to be an elected representative. He’s being asked about the President’s push for stronger gun control legislation. He says new legislation will only make things worse. Again, my hopes for a raucous laugh track are disappointed.

In the decade since 9/11 when 3,000 were killed, there were no additional terrorist killings on the USA mainland. In that same ten years, 340,000 of us killed ourselves and others with firearms (40% homicides, 60% suicides).

We took action to avert more terrorist attacks. We took too much of the wrong kind but we also took some that was both appropriate and effective. Pretty much all of us are pleased by the results of the effective action. Why, then, would it be impossible to take effective action to avert more firearm deaths? Isn’t that why we elect representatives – so they will establish effective legislation?

Maybe I’ve forgotten my extraterrestrial childhood but I remember and never regretted choosing to become an American. So what if I feel like an extraterrestrial when I watch TV or read things like this ?. I’m committed to this society and I will keep doing everything I can to help it grow ever better.

Feb 5 2013

Evaluation of War on Terror Strategy

Our War on Terror strategy (see this) implies readiness for large and small scale action in multiple theaters throughout Africa, the Middle East and Central Asia, Southeast Asia, and Northern and Western South America. How likely is its success, how long will it take, can we afford the cost, and is there a better approach?

The goal of the strategy is to eliminate Islamic “holy war” terrorists who might attack us from anywhere in the world. It is unachievable. That kind of threat can not be ended, only mitigated and endured. Military action is in fact counter-productive because the collateral destruction creates more terrorists and strengthens their support. Even if we could utterly destroy al Qaeda, we could not declare victory because we declared war on all Muslim terrorists. Since there are over a billion Muslims, there will always be a few Muslim extremists just as there will always be some who are Christian.

Response to aggression should always be proportional to the threat, and it must be able to succeed. Our response is massively disproportional and it can never succeed.

A strategy of unending military engagement everywhere would exhaust any nation. That strategy for the USA predates the War on Terror. We spend more on military activities than the next 20 nations combined, which is half our total expected Federal tax revenue. The cost of our already high Federal debt must become unaffordable when our spending is persistently so much higher than revenue. No nation can afford war that is permanent. We cannot afford this strategy’s cost.

And the strategy will make us permanently less free. When we go to war to preserve our liberty, we willingly forgo some of the freedoms we enjoy in everyday life, expecting them to be restored when victory is achieved. If victory never can be won, those freedoms never will be regained.

Finally, the strategy creates unwarranted suffering for our own people. Enormously more of our troops are killed than the number of US citizens threatened by terrorists and enormously more of them suffer physical and/or psychological damage from which they will never recover. Caring for them has a high dollar cost. Far more important, we are wrong to demand their sacrifice.

So, we are forcing future generations to pay for a war that cannot succeed and which limits the very freedoms we claim it will preserve. How did this happen?

For the first half century after we emerged as a great power early in the 20th century, we acted overseas only after deliberation and then with decisive power. The great good fortune of our geography gave us time to prepare and sufficient resources to do so. We entered WW1 and WW2 when we were ready and we brought about rapid victory.

We radically changed strategy following WW2. We began managing the world whether or not our immediate interests were threatened in any particular situation. We took the lead in Korea, which the Allies had split into two nations at the end of WW2. Then we initiated a long, bloody and fruitless war in Vietnam that spilled over into Laos and Cambodia. And we established a nuclear strategy of “mutually assured destruction” which we did not change after Soviet Russia, our only military rival, collapsed and we no longer faced any existential threat.

In response to the 9/11 attack on two mainland USA targets by al Queda terrorists, we initiated not just detective work but war, as if we had been attacked by a nation. We invaded Iraq even though we knew there was no Iraqi involvement in the attacks. We heavily bombed Afghanistan where al Queda’s leaders were based and inserted ground forces there. After Al Queda’s command cell relocated to Pakistan, we greatly increased our activities in Afghanistan. By about 2004 we had lost focus on what our War on Terror was intended to achieve.

No satisfactory reason for our invasion of Iraq emerged, civil war broke out, and opposition to us was so strong by 2004 that we could only maintain our presence by allying with our enemies. Furthermore, by destroying Iraq’s power we had eliminated the only regional balance against Iran, which we now view as our enemy. After entering Afghanistan to disrupt al Qaeda’s leadership, we drifted into fighting the Taliban, a different and far more costly objective that required massive force. We then, as in Iraq, set a far longer term objective, building a democratic society. When we installed the Karzai government, the Taliban retreated to the mountains to wait us out. We are now downsizing our presence but the end of our war in Afghanistan is indefinitely far distant.

Meanwhile, we began to capture and monitor all electronic communications to identify terrorists. Believing we were threatened by potentially massive new attacks, we could only hope to avert them by monitoring all communications between everyone, and storing everything so we could monitor earlier communications of new suspects. We partially suspended habeas corpus so suspects could be jailed indefinitely without trial. We began torturing them, illegal in the USA even in wartime, in camps overseas. We began killing suspects without due process. The President can now direct even US citizens to be killed.

In the past 10 years we have killed around 3,000 terrorists and civilians with drones in Pakistan, Somalia, Yemen and elsewhere, i.e., inside nations on which we have not declared war, and the Joint Special Operations Command (JSOC), which killed bin Laden, has established commando teams in Africa for operations throughout NE Africa and the Middle East. Attorney General Holder asserts: “Our legal authority is not limited to the battlefield in Afghanistan… We are at war with a stateless enemy, prone to shifting operations from country to country.” That authority extends, he says, to killing US citizens without regard to geography or due process.

War changes society by limiting citizens’ rights. Inspecting the private communications of citizens is routine during war, habeas corpus and due process are routinely suspended, and what would be assassination in time of peace becomes legal. But if our war on terror never ends, our civil liberties and peacetime rules of law will never be restored. They will be further eroded.

We are now, 12 years into this war, committing massive resources to missions that are not even clearly connected with preventing Islamist terrorism and we are making permanent what were introduced as emergency overrides on the Bill of Rights, e.g., the need to obtain a warrant for certain actions.

No nation can afford the dollar cost of permanent war or the spiritual cost of war that can never be won. When we do take military action it should be with clear goals and sufficient force applied in a way that will achieve the goals. Our present strategy has none of these attributes.

Jan 27 2013

The 2nd and 3rd Amendments

We should periodically review assumptions that direct our beliefs. The world may have changed so they are no longer accurate. We may need to make structural changes to direct new behavior.

Businesses that don’t update their assumptions fail. My 1980s minicomputer consulting clients no longer exist. They were ex-pioneers who imagined their competition was still each other. They were aware of networked microprocessor-based systems but not the implications of a competing technology with a cost advantage that was already tenfold. Their customers were little harmed because they could simply switch to new suppliers.

A nation’s customers, its citizens, can be greatly harmed, however, because it’s not easy to switch to a new one. Nations keep going where they’re headed like giant cruise ships whose passengers were happy enough for long enough so the captain assumes they always will be happy. He’s still happy. He doesn’t notice the passengers’ distress now they’re in Antarctic waters in summer clothes.

Just as businesses degenerate slowly then collapse when their structure is not kept up to date, so it is with nations and empires. The structure of GM, for example, where each brand (Chevy, Buick, Cadillac, etc) was targeted to a distinct market segment within which it battled competitors later ossified into baronies whose leaders fought each other. Our Congress in the USA has similarly degenerated into warring factions whose eyes are closed to new realities.

The problem is in part institutional. Our direction is governed by a Constitution established two and a half centuries ago with no requirement for periodic update. Let’s consider two Constitutional Amendments to illustrate this issue.

The 3rd Amendment decrees that: “No Soldier shall, in time of peace be quartered in any house, without the consent of the Owner, nor in time of war, but in a manner to be prescribed by law.” That is just about as useful today as prohibiting an elephant from being quartered in our house without our consent. Citizens once needed such protection. We no longer do. This Amendment is now so completely irrelevant that must people are unaware it even exists.

The USA 3rd Amendment echoed the English Bill of Rights 1689 that prohibited the monarch from “raising and keeping a standing army within this kingdom in time of peace without consent of Parliament, and quartering soldiers contrary to law” and was in response to 1760s and ’70s British Quartering Acts that required American colonies to pay the costs of British soldiers here and colonists to provide space for them to live.

The English Bill of Rights was passed when Protestant William and Mary were invited by parliament to replace Roman Catholic King James II and become joint sovereigns of England. It set limits on the powers of the crown and among other things reestablished the right of Protestants to own firearms. James II had tried to disarm Protestants and maintain a standing army. Civilians were at that time required to help suppress riots.

So the English Bill of Rights was also the basis for the 2nd Amendment to the US Constitution as one of our Bill of Rights which decrees that: “A well regulated militia being necessary to the security of a free state, the right of the people to keep and bear arms shall not be infringed.” It was adopted on December 15, 1791, along with the rest of the Bill of Rights and, interestingly, is the only amendment to the Constitution that states a purpose.

There was at that time substantial public opposition to a standing army from both Anti-Federalists and Federalists. On May 8, 1792, Congress passed an Act decreeing that: “every free able-bodied white male citizen of the respective States, resident therein, who is or shall be of age of eighteen years, and under the age of forty-five years […] shall severally and respectively be enrolled in the militia…[and] every citizen so enrolled and notified, shall, within six months thereafter, provide himself with a good musket or firelock, a sufficient bayonet and belt, two spare flints, and a knapsack, a pouch with a box therein to contain not less than twenty-four cartridges [and etc] and shall appear, so armed, accoutred and provided, when called out to exercise, or into service”.

The purpose of the 2nd Amendment, to provide for “the security of a free state“, has for many years been met in a different way. We now have a standing militia armed with weapons whose power could never have been imagined in the days of muskets and firelocks. Unlike the 3rd Amendment, however, its provisions are still relevant but are applied to a different purpose.

It would be better to retire both the 2nd and 3rd Amendments and draft new legislation suited to the purpose today.

People still want successors to muskets and firelocks for some of the same reasons left unstated in the 2nd Amendment, to hunt animals for food, defend themselves if police are unavailable, or just recreation. It would be far easier to establish broadly acceptable legislation specifying who could own what firearms if we were now drafting legislation specifically for that purpose.

Jan 25 2013

“If You Really Want to End Suffering,

it’s very simple,” Shugen Sensei told us at the start of our week of Zen Buddhist meditation: “Stop creating it.” I’ll come back to that in a moment. Just notice he did not say it’s easy.

Thinking why I blog reminded me of what Steve Jobs said is the secret to product development “Start somewhere”. Just starting has always been my path. Only later, sometimes much later, if what I started still feels worth doing, do I try to understand why. The urge to figure out the why of Himalayan exploration, Buddhist practice, economic and governance research and blogging has now arrived. To my surprise, it centers on ending suffering.

It all started ten years ago in the Himalayan mountains. It wasn’t my idea to go there and I had no specific objective. What happened was I found myself among people who appeared to be living with dignity, not aggressively, not hurriedly, and happily without the nice things we take for granted. Could it be true? Did they have a recipe my society might learn from? So I kept going back.

I began to wonder if Buddhism was part of the recipe. When we visited Buddhist temples our crew always lit lamps and prostrated. But later, when we visited Hindu temples and the dwelling places of animist spirits, they showed reverence there, too. I’d done some Buddhist reading by that time and was trying to meditate. That’s why I went to the Zen monastery.

By the end of the first day I was pretty sure I’d made a mistake. It was so hard to do nothing, sit completely still, just notice my thoughts, make no judgments, not reject or follow them. By the end of the day I was exhausted although I’d “done” nothing. I fell instantly asleep. In the morning I thought, “I’ll see how it goes until breakfast”. After breakfast I thought, “I’ll see if I can hang on ’til lunch”. At day’s end I thought, “Maybe day three will be better“. It was worse. Day four was a little better, though, and so it went. I’d suffered a lot by the end of the week but I’d also had glimpses of the truth of what Shugen Sensei told us at the start. I was bringing my suffering onto myself. That felt worth knowing.

Before I could go to the Himalayas I’d forced myself to retire. It was hard because from then on, investments would have to support us. With more time to worry, I realized my ignorance of how the economy works meant I had little confidence we’d made good investments. So, when I wasn’t in the Himalayas I studied investment and economic theory. The Great Recession arrived just as I was starting to feel I had the theories sufficiently clear.

Now I had to understand why our economy collapsed. I studied governance and saw some parallels with the paralysis of government in Nepal. That’s when I started blogging. The US economy is embedded in the global economy. There are so many moving parts in the system. I had to start recording facts and analyses to get a holistic picture. Charts and writing are my best tools for thinking and I hoped for critical feedback.

It’s only recently that I began to sense all these activities are related and they all start where Shugen Sensei was pointing. They’re all aimed at happiness and stopping the creation of suffering.

The historical Buddha taught that we will only become truly happy when we work to end the suffering of others. It must be so because we are not separate from others. If they are unhappy we will also be made unhappy. Communities were small two and a half thousand years ago. People made each other happier or not with face to face interactions. Today we also interact via nation-state and global systems that impact both us and future generations. That’s why I care about governance.

Jan 23 2013

Rejection or Ignorance of Science?

In summary, Gallup writes: “almost half of Americans today hold a belief, at least as measured by this question wording, that is at odds with the preponderance of the scientific literature.” What are they talking about? “The 46% of Americans who today believe that God created humans in their present form within the last 10,000 years is little changed from the 44% who believed this 30 years ago”.

Gallup poll Origin of Humans.jpb

The existence or not of the creative entity we call God is unprovable. Many folks are encouraged by their belief in God to do good. Some throughout history have felt justified to torture others who do not share their belief. Fervent belief is the problem. That can lead to believing others should be forced to the same belief.

It is not necessarily a problem that: “78% of Americans today believe that God had a hand in the development of humans in some way“. It is a serious problem that so many Americans reject “the preponderance of the scientific literature”. This is not the only science being rejected.

How can it be that almost half of all Americans reject tools for understanding the world?

Our educational system is failing disastrously and I do not at all understand why. I’ve joked about its pretensions but there was after all some merit in my alma mater, “Richard Hale’s Free Grammar School for the Deserving Sons of Impecunious Gentlefolk, Founded in 1608” and there must be something different about the schooling of my fellow citizens who do accept facts and believe in reasoning.

I’ll try to say what was good about my school experience. The British school system drove students at an early age to study either science, popularly considered to depend on reasoning, or arts, defined as nonscientific knowledge. I was fortunate because I resisted being driven in that way; I studied both physics and literature. I was also fortunate not to resist my English teacher’s insistence that I understand both what I read and how the language worked.

And, although physics did not yet cover quantum theory (matter and energy have properties of both particles and waves and physical systems can only have properties like energy in discrete amounts or quanta) I did get enough of an overview to see how science progresses. Imaginative leaps verified by experiment enable theories that don’t explain all the facts to be replaced by ones that explain more.

I was taught how to use all humankind’s thinking tools. I learned to value reason, inference and intuition. I learned not to imagine any theory to be a final explanation. I was encouraged to question all theories and evidence. I was taught, in other words, how to investigate, how to learn.

Also, my parents taught me to work hard, practice and be persistent. No question, it would have been better to try harder but that’s a different issue.

Jan 20 2013

The Federal Budget and GDP

I’ve come to think of charts like the ones in this post as cave paintings. We must study them carefully to see what they reveal and also what their structural assumptions obscure.

The bar chart shows we are financing an enormous amount of Federal spending with borrowing – almost one third. The line chart shows we spent more than revenue for most of the last half century and why the current imbalance is so enormous – the Great Recession. As in previous recessions (indicated by darker bars), revenue fell starting in 2007/8 because incomes fell, and spending increased because unemployment increased.

federal-budget-2012

The line chart also shows revenue now heading up and spending down as in most post-recessionary times. But here we start to wonder what we’re measuring. It doesn’t feel like we’re out of recession. Corporate profits are at an all-time high, the unemployment rate is a bit lower, it’s good news federal revenue and spending are heading in the right direction, but we don’t feel good.

The line chart also raises a question. Spending fell after the early ’80s and early ’90s recessions. Why did it increase before the most recent recession? Largely because of a very costly unfunded new program initiated at that time, the War on Terror.

The bar chart shows only a little of what we need to understand. A commercial enterprise with multiple lines of business (LOB) reviews each LOB’s revenue and spending individually. This chart shows, or seems to show that for only a single Federal program, Social Security. Since Social Insurance revenue at $841B is greater than Social Security spending at $768B, it looks to be in good shape. But does what’s labelled “Social Insurance” revenue include Medicare as well as Social Security payroll tax?

Additional research would show that Social Security revenue is in fact greater than spending. Digging deeper would show when that will reverse as well as the past and potential effects of adjusting the formulas that govern its revenue and spending. As I noted in a previous post, it would, for example, show that raising the maximum wage on which S/Sec tax is withheld to its traditional real level would eliminate half the future imbalance.

The bar chart shows that the Federal Government’s borrowing costs at 6% of the total are relatively affordable at this time. It also shows they will not be so if total spending continues to exceed revenue by such a wide margin, currently 32%. We added $1,158B to our total debt in 2012 on which we paid $220B interest.

Questions the charts provokes but does not illuminate include:

Why is Medicare/Medicaid spending so high at $804B and 23% of total spending, how much is its revenue, how can they be balanced?
Why is Defense spending so high at $669B and 19% of total spending, how and by how much should it be cut?
What makes up Non-Defense Discretionary Spending, are we over- or under-spending there?
What makes up “Other” spending, are we over- or under-spending on elements of that?
How can we best increase revenue to pay for spending we choose not to eliminate?
Can we fix the federal spending/revenue imbalance with economic growth?

The next chart suggests the possibility of a positive answer to question 6. Since our real economic growth in the most recent decade was at by far its lowest rate since the decade of the Great Depression, after which it grew rapidly, we could hope that experience will be repeated.

GDP Growth by Decade 1790 - 2009

The primary drivers of post-Great Depression GDP growth were spending on WW2 and on post-WW2 recovery programs including the GI Bill and mortgage subsidies. Fortunately, WW3 seems unlikely in the near future so we need other ways to increase economic activity. We must also answer at least the first two questions above, healthcare and defense costs. The data is visible in cave paintings down those mine-shafts so we’ll take a flashlight and calculator as well as a canary to investigate.

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