Envy as the Foundation of Capitalism

In the 18^th century, the political philosopher and novelist Jean-Jacques Rousseau made a distinction between amour de soi and amour propre. The former involved striking a balance between regard for one’s own welfare and well-being and the empathy that one owed and felt towards others. It was another phrase for self-love, self-regard, and self-awareness. The latter – amour proper – was all about grandiose and malignant narcissism, an unseemly conflation of self-gratification and conceited haughtiness, and the insatiable need to be reflected in the gaze of others as the only path to self-knowledge. Amour de soi was transformed into amour propre by the acquisition of property and the greed and envy that it, inevitably, provoked.

Conservative sociologists self-servingly marvel at the peaceful proximity of abject poverty and ostentatious affluence in American – or, for that matter, Western – cities. Devastating riots do erupt, but these are reactions either to perceived social injustice (Los Angeles 1965) or to political oppression (Paris 1968). The French Revolution may have been the last time the urban sans-culotte raised a fuss against the economically enfranchised.

This pacific co-existence conceals a maelstrom of envy. Behold the rampant Schadenfreude which accompanied the antitrust case against the predatory but loaded Microsoft. Observe the glee which engulfed many destitute countries in the wake of the September 11 atrocities against America, the epitome of triumphant prosperity. Witness the post-World.com orgiastic castigation of avaricious CEO’s.

Envy – a pathological manifestation of destructive aggressiveness – is distinct from jealousy.

The New Oxford Dictionary of English defines envy as:

“A feeling of discontented or resentful longing aroused by someone else’s possessions, qualities, or luck … Mortification and ill-will occasioned by the contemplation of another’s superior advantages.”

Pathological envy – the fourth deadly sin – is engendered by the realization of some lack, deficiency, or inadequacy in oneself. The envious begrudge others their success, brilliance, happiness, beauty, good fortune, or wealth. Envy provokes misery, humiliation, and impotent rage.

The envious copes with his pernicious emotions in five ways:

1. They attack the perceived source of frustration in an attempt to destroy it, or “reduce it” to their “size”. Such destructive impulses often assume the disguise of championing social causes, fighting injustice, touting reform, or promoting an ideology.
2. They seek to subsume the object of envy by imitating it. In extreme cases, they strive to get rich quick through criminal scams, or corruption. They endeavor to out-smart the system and shortcut their way to fortune and celebrity.
3. They resort to self-deprecation. They idealize the successful, the rich, the mighty, and the lucky and attribute to them super-human, almost divine, qualities. At the same time, they humble themselves. Indeed, most of this strain of the envious end up disenchanted and bitter, driving the objects of their own erstwhile devotion and adulation to destruction and decrepitude.
4. They experience cognitive dissonance. These people devalue the source of their frustration and envy by finding faults in everything they most desire and in everyone they envy.
5. They avoid the envied person and thus the agonizing pangs of envy.

Envy is not a new phenomenon. Belisarius, the general who conquered the world for Emperor Justinian, was blinded and stripped of his assets by his envious peers. I – and many others – have written extensively about envy in command economies. Nor is envy likely to diminish.

In his book, “Facial Justice”, Hartley describes a post-apocalyptic dystopia, New State, in which envy is forbidden and equality extolled and everything enviable is obliterated. Women are modified to look like men and given identical “beta faces”. Tall buildings are razed.

Joseph Schumpeter, the prophetic Austrian-American economist, believed that socialism will disinherit capitalism. In “Capitalism, Socialism, and Democracy” he foresaw a conflict between a class of refined but dirt-poor intellectuals and the vulgar but filthy rich businessmen and managers they virulently envy and resent. Samuel Johnson wrote: “He was dull in a new way, and that made many people think him great.” The literati seek to tear down the market economy which they feel has so disenfranchised and undervalued them.

Hitler, who fancied himself an artist, labeled the British a “nation of shopkeepers” in one of his bouts of raging envy. Ralph Reiland, the Kenneth Simon professor of free enterprise at Robert Morris University, quotes David Brooks of the “weekly Standard”, who christened this phenomenon “bourgeoisophobia”:

“The hatred of the bourgeoisie is the beginning of all virtue’ – wrote Gustav Flaubert. He signed his letters ‘Bourgeoisophobus’ to show how much he despised ‘stupid grocers and their ilk … Through some screw-up in the great scheme of the universe, their narrow-minded greed had brought them vast wealth, unstoppable power and growing social prestige.”

Reiland also quotes from Ludwig van Mises’s “The Anti-Capitalist Mentality”:

“Many people, and especially intellectuals, passionately loathe capitalism. In a society based on caste and status, the individual can ascribe adverse fate to conditions beyond his control. In … capitalism … everybody’s station in life depends on his doing … (what makes a man rich is) not the evaluation of his contribution from any ‘absolute’ principle of justice but the evaluation on the part of his fellow men who exclusively apply the yardstick of their personal wants, desires and ends … Everybody knows very well that there are people like himself who succeeded where he himself failed. Everybody knows that many of those he envies are self-made men who started from the same point from which he himself started. Everybody is aware of his own defeat. In order to console himself and to restore his self- assertion, such a man is in search of a scapegoat. He tries to persuade himself that he failed through no fault of his own. He was too decent to resort to the base tricks to which his successful rivals owe their ascendancy. The nefarious social order does not accord the prizes to the most meritorious men; it crowns the dishonest, unscrupulous scoundrel, the swindler, the exploiter, the ‘rugged individualist’.”

In “The Virtue of Prosperity”, Dinesh D’Souza accuses prosperity and capitalism of inspiring vice and temptation. Inevitably, it provokes envy in the poor and depravity in the rich.

With only a modicum of overstatement, capitalism can be depicted as the sublimation of jealousy. As opposed to destructive envy – jealousy induces emulation. Consumers – responsible for two thirds of America’s GDP – ape role models and vie with neighbors, colleagues, and family members for possessions and the social status they endow. Productive and constructive competition – among scientists, innovators, managers, actors, lawyers, politicians, and the members of just about every other profession – is driven by jealousy.

The eminent Nobel prize winning British economist and philosopher of Austrian descent, Friedrich Hayek, suggested in “The Constitution of Liberty” that innovation and progress in living standards are the outcomes of class envy. The wealthy are early adopters of expensive and unproven technologies. The rich finance with their conspicuous consumption the research and development phase of new products. The poor, driven by jealousy, imitate them and thus create a mass market which allows manufacturers to lower prices.

But jealousy is premised on the twin beliefs of equality and a level playing field. “I am as good, as skilled, and as talented as the object of my jealousy.” – goes the subtext – “Given equal opportunities, equitable treatment, and a bit of luck, I can accomplish the same or more.”

Jealousy is easily transformed to outrage when its presumptions – equality, honesty, and fairness – prove wrong. In a paper recently published by Harvard University’s John M. Olin Center for Law and titled “Executive Compensation in America: Optimal Contracting or Extraction of Rents?” the authors argue that executive malfeasance is most effectively regulated by this “outrage constraint”:

“Directors (and non-executive directors) would be reluctant to approve, and executives would be hesitant to seek, compensation arrangements that might be viewed by observers as outrageous.”

Deflation in the USA and its Effects on Consumption and Investment

Interview granted to Bankrate.com, August 2010

Q. Why would deflation happen in the United States?

A. For deflation to happen in the USA, an unlikely confluence of economic developments and policy errors must occur. Unemployment must resurge and reach levels of well above 15% on a prolonged and sustained basis; consumption and, consequently, capital investment must collapse; asset prices – especially equity and residential real-estate – must crumble; the banking system must suffer a substantial contraction; the government must cut its budget deficit considerably and abruptly; and the Federal Reserve must turn strict and demonetize the economy (bleed it dry by siphoning off liquidity). None of these six doomsday scenarios is likely to materialize.

The USA is probably facing years of low inflation, which has pernicious effects of its own, but is not the same as deflation.

Q. How would deflation affect investment and consumption? I have trouble wrapping my head around the concept that inflated dollars are worth more and deflated dollars are worth less, for some reason.

A. It is the other way around, according to orthodox monetary economics: inflated dollars are worth less and deflated dollars are worth more. Deflation means that the prices of goods and services are going down and so the purchasing power of your dollars is going up. Traditional economics claims that deflation actually increases the value of cash to its holder by enhancing its purchasing power in an environment of declining prices (negative growth in the average price level). Consumers are thus incentivized to delay their consumption. If prices are going down, why not wait and purchase the same for less later on?

In my view, though, this is only true in the short-term. It is true that in a deflationary cycle, consumers are likely to delay consumption in order to enjoy lower prices later. But this paralysis in consumption is precisely what renders most asset classes – including cash – precarious and unprofitable in the long-term.

On the policy level, deflationary expectations (let alone actual deflation) lead to “liquidity traps”: zero interest-rates fail to stimulate the economy and the monetary authorities – unable to reduce interest rates further – remain powerless with their ammunition depleted. This means that cash balances and fixed-term deposits in banks yield no interest. But, even zero interest translates into a positive yield in conditions of deflation. Theoretically, this fact should be enough to drive most people to hold cash.

Yet, what economists tend to overlook is transaction costs: banks charge account fees that outweigh the benefits of possessing cash even when prices are decreasing. Only in extreme deflation is cash with zero interest a profitable proposition when we take transaction costs (bank fees and charges) into account. But extreme deflation usually results in the collapse of the banking system as deleveraging and defaults set in. Cash balances and deposits evaporate together with the financial institutions that offer them.

Moreover: deflation results in gross imbalances in the economy: delayed consumption and capital investment and an increasing debt burden (in real, deflation-adjusted terms) adversely affect manufacturing, services, and employment. Government finances worsen as unemployment rises and business bankruptcies soar. Sovereign debt (government bonds) – another form of highly-liquid, “safe” investment – is thus rendered more default-prone in times of deflation.

Like inflation, deflation is a breakdown in the consensus over prices and their signals. As these are embodied in the currency and in other forms of debt, a prudent investor would stay away from them during periods of economic uncertainty. At the end, and contrary to the dicta of current economic orthodoxy, both deflation and inflation erode purchasing power. Thus, all asset classes suffer: equity, bonds, metals, currencies, even real-estate. The sole exception is agricultural land. Food is the preferred means of exchange in barter economies which are the tragic outcomes of the breakdown in the invisible hand of the market.

Q. What can consumers do to protect themselves from deflation and inflation, on an investment level as well as in the broader economy?

A. Inflation increases the state’s revenues while eroding the real value of its debts, obligations, and expenditures denominated in local currency. Inflation acts as a tax and is fiscally corrective, but without the recessionary and deflationary effects of a “real” tax. Thus, inflation is bad for government bonds and deflation increases their value (lowers their yields). Inflation-linked bonds, though, are a great investment at all times, even with minimal deflation.

Inflation also improves the lot of corporate – and individual – borrowers by increasing their earnings and marginally eroding the value of their debts (and savings). It constitutes a disincentive to save and an incentive to borrow, to consume, and, alas, to speculate. “The Economist” called it “a splendid way to transfer wealth from savers to borrowers.” So, inflation is good for equity markets in the short to medium term, while deflation has exactly the opposite effect.

The connection between inflation and asset bubbles is unclear. On the one hand, some of the greatest fizz in history occurred during periods of disinflation. One is reminded of the global boom in technology shares and real estate in the 1990’s. On the other hand, soaring inflation forces people to resort to hedges such as gold and realty, inflating their prices in the process. Inflation – coupled with low or negative interest rates – also tends to exacerbate perilous imbalances by encouraging excess borrowing, for instance.

Deflation is kind to cash and cash-equivalents (e.g., fixed-term deposits and CDs), but only in the short-term. In the long-term it has an adverse effect on all asset classes (see what happened in Japan in the 1990s) with the exception of agricultural land.

Swine Flu as a Conspiracy

The Internet has rendered global gossip that in previous epochs would have remained local. It also allowed rumour-mongers to leverage traditional and trusted means of communication – texts and images – to lend credence to the most outlandish claims. Some bloggers and posters have not flinched from doctoring photos and video clips. Still, the most efficient method of disseminating disinformation and tall tales in the wild is via text.

In May 2009, as swine flu was surging through the dilapidated shanties of Mexico, I received a mass-distribution letter from someone claiming to have worked at the National Institutes of Health in Virology: “I worked in the Laboratory of Structural Biology Research under the NIAMS division of NIH from 2002 – 2004.” Atypically, the source provided a name, an e-mail address, and a phone number. He stated that the newly-minted pandemic was the outcome of a “recombinant virus has been unleashed upon mankind” by a surrealistic coalition: “the Executive Branch of our (USA) government, the World Health Organization (WHO), as well as Baxter Pharmaceutical”, the latter being “involved in international biological weapons programs.” The media was lying blatantly about the number of casualties.

The e-mail letter cautioned against “a martial law type scenario” in which the government will “ban public gatherings, enforce travel restrictions … forced vaccination or forced quarantine.” He advised people to hoard food, obtain N95 or P100 masks, and “Have a means of self-defense”. Tamiflu and, more generally, neuraminidase inhibitors are not effective, he warned. Instead, he recommended organic food (including garlic), drops of Colloidal Silver Hydrosol, Atomic (nascent) iodine, Allicin, Medical Grade, and NAC (N-acetyl-cysteine).

Blaming government and the pharmaceutical industry for instigating the very diseases they are trying to contain and counter is old hat. It is founded on the dubious assertion of cui bono: pandemics are worth anywhere from 8 to 18 billion USD is extra annual income from the enhanced sales of vaccines, anti-virals, antibiotics, wipes, masks, sanitizers, and the like. That’s a drop in the industry’s bucket (close to 1 trillion USD in sales last year), yet it comes handy in times of economic slowdown. Luckily for the drug-makers, most major epidemics and pandemics have occurred during recessions, perfectly timed to shore their balance sheets.

The sales or profits of drug-makers not involved in the swine flu panic (such as Pfizer) actually went down in the third quarter of 2009 as opposed to the revenues and net income of those who were. Novartis expects to make an extra 400-700 million USD in the last quarter of 2009 and first quarter of 2010. Sanofi-Aventis has sold a mere 120 million worth of swine flu related goods, but this will shoot up to 1 billion in the six months to March 2010. Similarly, While Astra-Zeneca’s tally is a meagre 152 million USD, yet it constitutes 2% of its growth and one third of its sales in the USA. It foresees another 300 million USD in revenues. Finally, GlaxoSmithKline has pushed whopping 1.6 billion USD worth of swine flu vaccine out the door plus an extra 250 million USD in related products till end-September 2009. Pandemics are good for business, no two ways about it.

The aura of the pharmaceutical industry is such that people seamlessly lump it together with weapons manufacturers, the CIA, Big Tobacco, and other usual culprits and suspects. Drug manufacturers’ advertising budgets are huge and may exert disproportionate influence on editorial decisions in the print media. Pharma companies are big contributors to campaign coffers and can and do bend politicians’ ears in times of need. There is a thinly-veiled revolving door between underpaid and over-worked bureaucrats in regulatory agencies and the plush offices of the ostensibly regulated. Academic studies are often funded by the industry. People naturally are suspicious and apprehensive of this confluence of power, money, and access. Recent scandals at the FDA (America’s much-vaunted and hitherto-venerated Food and Drug Administration) did not help matters.

The truth is that pharmaceutical companies are very reluctant to develop vaccines, or to cope with pandemics, whose sufferers are often the indigent inhabitants of developing and poor countries. To amortize their huge sunk costs (mainly in research and development) they resort to supply-side and demand-side measures.

On the demand side, they often insist on advance market commitments: guaranteed purchases by governments, universities, and NGOs. They also enjoy tax credits and breaks, grants, and awards. Differential pricing is used to skew decision-making and re-allocate the economic resources of the governments of impoverished countries in favour of purchasing larger quantities of products such as vaccines. On the supply side, they create artificial scarcity by patenting the processes that are involved in the production of vaccines and drugs; by licencing technologies only to a handful of carefully-placed factories; and by producing under the maximum capacity so as to induce rationing within tight release and delivery schedules (which, in itself, induces panic).

Still, collude as they may in profiteering, governments and the pharma industry do not create new diseases, spread them, or sustain them. This job is best left to the poor and the ignorant whose living conditions encourage cross-species infections and whose superstitions foment hysteria every time a new strain of virus is discovered. You can count on them to render the rich drug-manufacturer even richer every single time.

The Economics of Conspiracy Theories

Barry Chamish is convinced that Shimon Peres, Israel’s wily old statesman, ordered the assassination of Yitzhak Rabin, back in 1995, in collaboration with the French. He points to apparent tampering with evidence. The blood-stained song sheet in Mr. Rabin’s pocket lost its bullet hole between the night of the murder and the present.

The murderer, Yigal Amir, should have been immediately recognized by Rabin’s bodyguards. He has publicly attacked his query before. Israel’s fierce and fearsome internal security service, the Shabak, had moles and agents provocateurs among the plotters. Chamish published a book about the affair. He travels and lectures widely, presumably for a fee.

Chamish’s paranoia-larded prose is not unique. The transcripts of Senator Joseph McCarthy’s inquisitions are no less outlandish. But it was the murder of John F. Kennedy, America’s youthful president, that ushered in a golden age of conspiracy theories.

The distrust of appearances and official versions was further enhanced by the Watergate scandal in 1973-4. Conspiracies and urban legends offer meaning and purposefulness in a capricious, kaleidoscopic, maddeningly ambiguous, and cruel world. They empower their otherwise helpless and terrified believers.

New Order one world government, Zionist and Jewish cabals, Catholic, black, yellow, or red subversion, the machinations attributed to the freemasons and the illuminati – all flourished yet again from the 1970’s onwards. Paranoid speculations reached frenzied nadirs following the deaths of celebrities, such as “Princess Di”. Books like “The Da Vinci Code” (which deals with an improbable Catholic conspiracy to erase from history the true facts about the fate of Jesus) sell millions of copies worldwide.

Tony Blair, Britain’s ever righteous prime minister denounced the “Diana Death Industry”. He was referring to the tomes and films which exploited the wild rumors surrounding the fatal car crash in Paris in 1997. The Princess, her boyfriend Dodi al-Fayed, heir to a fortune, as well as their allegedly inebriated driver were killed in the accident.

Among the exploiters were “The Times” of London which promptly published a serialized book by Time magazine reports. Britain’s TV networks, led by Live TV, capitalized on comments made by al-Fayed’s father to the “Mirror” alleging foul play.

But there is more to conspiracy theories than mass psychology. It is also big business. Voluntary associations such as the Ku Klux Klan and the John Birch Society are past their heyday. But they still gross many millions of dollars a year.

The monthly “Fortean Times” is the leading brand in “strange phenomena and experiences, curiosities, prodigies and portents”. It is widely available on both sides of the Atlantic. In its 29 years of existence it has covered the bizarre, the macabre, and the ominous with panache and open-mindedness.

It is named after Charles Fort who compiled unexplained mysteries from the scientific literature of his age (he died in 1932). He published four bestsellers in his lifetime and lived to see “Fortean societies” established in many countries.

A 12 months subscription to “Fortean Times” costs c. $45. With a circulation of  60,000, the magazine was able to spin off “Fortean Television” – a TV show on Britain’s Channel Four. Its reputation was further enhanced when it was credited with inspiring the TV hit series X-Files and The Sixth Sense.

“Lobster Magazine” – a bi-annual publication – is more modest at $15 a year. It is far more “academic” looking and it sells CD ROM compilations of its articles at between $80 (for individuals) and $160 (for institutions and organizations) a piece. It also makes back copies of its issues available.

Its editor, Robin Ramsay, said in a lecture delivered to the “Unconvention 96”, organized by the “Fortean Times”:

“Conspiracy theories certainly are sexy at the moment … I’ve been contacted by five or six TV companies in the past six months – two last week – all interested in making programmes about conspiracy theories. I even got a call from the Big Breakfast Show, from a researcher who had no idea who I was, asking me if I’d like to appear on it … These days we’ve got conspiracy theories everywhere; and about almost everything.”

But these two publications are the tip of a gigantic and ever-growing iceberg. “Fortean Times” reviews, month in and month out, books, PC games, movies, and software concerned with its subject matter. There is an average of 8 items per issue with a median price of $20 per item.

There are more than 186,600 Web sites dedicated to conspiracy theories in Google’s database of 3 billion pages. The “conspiracy theories” category in the Open Directory Project, a Web directory edited by volunteers, contains hundreds of entries.

There are 1077 titles about conspiracies listed in Amazon and another 12078 in its individually-operated ZShops. A new (1996) edition of the century-old anti-Semitic propaganda pamphlet faked by the Czarist secret service, “Protocols of the Learned Elders of Zion”, is available through Amazon. Its sales rank is a respectable 64,000 – out of more than 2 million titles stocked by the online bookseller.

In a disclaimer, Amazon states:

“The Protocols of the Learned Elders of Zion is classified under “controversial knowledge” in our store, along with books about UFOs, demonic possession, and all manner of conspiracy theories.”

Yet, cinema and TV did more to propagate modern nightmares than all the books combined. The Internet is starting to have a similar impact compounded by its networking capabilities and by its environment of simulated reality – “cyberspace”. In his tome, “Enemies Within: The Culture of Conspiracy in Modern America”, Robert Alan Goldberg comes close to regarding the paranoid mode of thinking as a manifestation of mainstream American culture.

According to the Internet Movie Database, the first 50 all time hits include at least one “straight” conspiracy theory movie (in the 13th place) – “Men in Black” with $587 million in box office receipts. JFK (in the 193rd place) grossed another $205 million. At least ten other films among the first 50 revolve around a conspiracy theory disguised as science fiction or fantasy. “The Matrix” – in the 28th place – took in $456 million. “The Fugitive” closes the list with $357 million. This is not counting “serial” movies such as James Bond, the reification of paranoia shaken and stirred.

X-files is to television what “Men in Black” is to cinema. According to “Advertising Age”, at its peak, in 1998, a 30 seconds spot on the show cost $330,000 and each chapter raked in $5 million in ad revenues. Ad prices declined to $225,000 per spot two years later, according to CMR Business to Business.

Still, in its January 1998 issue, “Fortune” claimed that “X-Files” (by then a five year old phenomenon) garnered Fox TV well over half a billion dollars in revenues. This was before the eponymous feature film was released. Even at the end of 2000, the show was regularly being watched by 12.4 million households – compared to 22.7 million viewers in 1998. But X-files was only the latest, and the most successful, of a line of similar TV shows, notably “The Prisoner” in the 1960’s.

It is impossible to tell how many people feed off the paranoid frenzy of the lunatic fringe. I found more than 3000 lecturers on these subjects listed by the Google search engine alone. Even assuming a conservative schedule of one lecture a month with a modest fee of $250 per appearance – we are talking about an industry of c. $10 million.

Collective paranoia has been boosted by the Internet. Consider the computer game “Majestic” by Electronic Arts. It is an interactive and immersive game, suffused with the penumbral  and the surreal. It is a Web reincarnation of the borderlands and the twilight zone – centered around a nefarious and lethal government conspiracy. It invades the players’ reality – the game leaves them mysterious messages and “tips” by phone, fax, instant messaging, and e-mail. A typical round lasts 6 months and costs $10 a month.

Neil Young, the game’s 31-years old, British-born, producer told Salon.com recently:

“… The concept of blurring the lines between fact and fiction, specifically around conspiracies. I found myself on a Web site for the conspiracy theory radio show by Art Bell … the Internet is such a fabulous medium to blur those lines between fact and fiction and conspiracy, because you begin to make connections between things. It’s a natural human reaction – we connect these dots around our fears. Especially on the Internet, which is so conspiracy-friendly. That was what was so interesting about the game; you couldn’t tell whether the sites you were visiting were Majestic-created or normal Web sites…”

Majestic creates almost 30 primary Web sites per episode. It has dozens of “bio” sites and hundreds of Web sites created by fans and linked to the main conspiracy threads. The imaginary gaming firm at the core of its plots, “Amin-X”, has often been confused with the real thing. It even won the E3 Critics Award for best original product…

Conspiracy theories have pervaded every facet of our modern life. A.H. Barbee describes in “Making Money the Telefunding Way” (published on the Web site of the Institute for First Amendment Studies) how conspiracy theorists make use of non-profit “para-churches”.

They deploy television, radio, and direct mail to raise billions of dollars from their followers through “telefunding”. Under section 170 of the IRS code, they are tax-exempt and not obliged even to report their income. The Federal Trade commission estimates that 10% of the $143 billion donated to charity each year may be solicited fraudulently.

Lawyers represent victims of the Gulf Syndrome for hefty sums. Agencies in the USA debug bodies – they “remove” brain  “implants” clandestinely placed by the CIA during the Cold War. They charge thousands of dollars a pop. Cranks and whackos – many of them religious fundamentalists – use inexpensive desktop publishing technology to issue scaremongering newsletters (remember Mel Gibson in the movie “Conspiracy Theory”?).

Tabloids and talk shows – the only source of information for nine tenths of the American population – propagate these “news”. Museums – the UFO museum in New Mexico or the Kennedy Assassination museum in Dallas, for instance – immortalize them. Memorabilia are sold through auction sites and auction houses for thousands of dollars an item.

Numerous products were adversely affected by conspiratorial smear campaigns. In his book “How the Paranoid Style Flourishes and Where it Comes From”, Daniel Pipes describes how the sales of Tropical Fantasy plummeted by 70% following widely circulated rumors about the sterilizing substances it allegedly contained –  put there by the KKK. Other brands suffered a similar fate: Kool and Uptown cigarettes, Troop Sport clothing, Church’s Fried Chicken, and Snapple soft drinks.

It all looks like one giant conspiracy to me. Now, here’s one theory worth pondering…

Seven Concepts in Derivatives

The implosion of the markets in some complex derivatives in 2007-9 drew attention to this obscure corner of the financial realm. Derivatives are nothing new. They consist of the transfer of risk to third parties and the creation of a strong correlation or linkage between the prices of one or more underlying assets and the derivative contract or instrument itself. Thus, whenever guarantors sign on a loan or credit agreement, they, in effect, are creating a derivative contract. Similarly, insurance policies can be construed as derivatives as well as options, futures, and forward contracts.

There are two types of risk: specific to the firm or sector and systemic, usually the outcome of an external shock to the entire economy. Derivatives aim to mitigate risks, but what they actually do is concentrate them in the hands of a few major players. Risk markets encourage the transmission of financial contagion across borders and continents, exactly as do international trade and foreign investment (both direct and portfolio, or “hot money”). Indeed, liquidity: the uninterrupted availability of buyers and sellers in relevant marketplaces factors in the valuation of derivatives. In a way liquidity is another name for the solvency of markets.

The value of derivatives reflects mainly the specific risk with a touch of systemic risk added (measured via value-at-risk, or VAR models). It takes into account the solvency of issuers and traders of both the derivatives and of the the underlying securities or assets (known as “counterparty risk”). The simplest measure of solvency is the capital to debt ratio (“capital adequacy” and debt service measures). Earnings are also important: both historical and projected. High or rising earnings guarantee the wherewithal to pay at a future date. Debt to capital (or to earnings, or to net income, or to assets) ratios are basic gauges of leverage or gearing. A high leverage translates to an increased risk of default on financial obligations, such as the ones represented by derivative contracts. Worse

Still, it is not easy to evaluate a firm (especially in the financial services sector). There is no agreement on how to put a number to intangibles such as brand names, networks of clients and suppliers (loyalty), and intellectual property and, on the other side of the ledger, how to estimate contingent and off-balance-sheet liabilities (such as derivatives). Whether one is an issuer or a buyer, accounting standards (such as the IAS or FASB) are fuzzy on how to incorporate derivatives in financial statements. Primitive, automatic, supposedly pre-emptive mechanisms for the management of the risk of default, such as margin calls (a requirement to add fresh capital as losses mount on a position) often run into difficulties as gearing skyrockets and with it a commensurate counterparty risk. Put simply: margin calls are useless post-facto, when the issuer of a derivative, or its buyer (speculator or hedger) have gone insolvent owing to a high leverage or to losses incurred elsewhere.

There is also the question of recourse, or who owns what and who owes what to whom and when. Securitization has led to the emergence of spliced, diced, and sliced derivative instruments whose origin is obscured in pools of primary and secondary and even tertiary securities. Often, the same asset gives rise to conflicting claims by the holders of a bewildering zoo of derivative contracts which were supposed to function as clear conduits, but whose passthrough mechanisms were far from unambiguous or unequivocal. This intentional fuzziness prevented the formation of clearing and settlement houses or systems, exchanges, or even registries, akin to the ones used in the stock markets. The lack of transparency in the derivatives markets was deliberate, aimed at fostering insider advantages in a “shadow system” with “dark pools”.

Conflicts of interest were thus swept under a carpet of complexity and obscurity. Financial firms traded nostro (for their own accounts) and against their clients. Preferential customers received benefits that were denied their less privileged brethren. Accounting rules were abused to engender the appearance of health where rot and decay have long set in (for instance, high default swap rates – indicating imminent collapse – allowed firms to book lower loan loss provisions and show higher profitability!) Agents (executives and traders) ran amok, blindly robbing shareholders in a perfect illustration of the Agency Problem (or agent-principal conundrum).

A pervasive lack of disclosure allowed a culture of insider trading to flourish. Auditors were compromised by huge fees. They could not afford to lose the bigger clients, which often constituted the bulk of their practice. Rating agencies – whose fees were doled out by the very firms and issuers they were supposed to evaluate professionally and without prejudice – proved to be venal and their work disastrously misleading. The name of the game was asymmetric information: a rapacious elite amplified the inefficiencies of the market to indulge in arbitrage and rake in baroque personal profits.

Regulatory and supervision authorities were helpless to prevent the slide along the slippery slope into mayhem: they suffer from inefficiencies, the inevitable outcomes of overlapping jurisdictions; inherent conflicts of remit (for instance, central banks clashed with bank supervisors over whether asset bubbles should be deflated and the stability of the financial system thus threatened); a revolving door syndrome (regulators became banking and Wall Street executives and vice versa); deficient training; and a lack of supra-national coordination and exchange of information.

None of these pernicious facts was a secret. Everyone treated the derivatives markets as glorified gambling dens. Losses were expected and a Ponzi scheme fatalism prevailed long before the cash dried out in 2007. The lack of trust that manifested later and the resultant lack of liquidity were no surprise (though the financial community feigned a collective shock).

---

Also Read

Models of Stock Valuation

The Due Diligence Process

Financial Investor, Strategic Investor

The Myth of the Earnings Yield

The Friendly Trend – Technical vs. Fundamental Analysis

The Roller Coaster Market – On Volatility and Risk

The Bursting Asset Bubbles

The Future of the SEC – Interview with Gary Goodenow

Portfolio Management Theory and Technical Analysis Lecture Notes

Europe’s Torture Exports

A report published in March 2010 by Amnesty International and the Omega Research Foundation and titled “From Words to Deeds” accused European companies of manufacturing and selling “tools of torture”. Among these were fixed wall restraints, metal “thumb-cuffs”, and electroshock “sleeves” and “cuffs” that deliver 50,000V shocks.

These commercial activities run contra to a 2006 EU-wide legislation which bans (and, for some types of equipment, merely regulates) the sale of policing and security implements and devices that can be used to torture and maim. But the law remains a dead letter in many countries in the Union.

Brian Wood, Amnesty International’s Military Security and Police manager told the media:

“Our research shows that despite the new controls, several Member States, including Germany and the Czech Republic, have since 2006 authorized exports of policing weapons and restraints to at least nine countries where Amnesty International has documented the use of such equipment in torture … Moreover, only seven states have fulfilled their legal obligations to publicly report their exports under the Regulation. We fear that some states are not taking their legal obligations seriously.”

Among the findings of the report:

The Czech Republic has issued licenses to export shackles, electric shock weapons and chemical sprays to six countries whose police and security forces are known offenders against human rights and have made use of precisely such items to torture detainees; Germany allowed the export of foot-chains and chemical sprays to three such countries; Equipment manufacturers in Italy and Spain sold “law enforcement” 50,000V electric shock restraints (“cuffs” or “sleeves”). The EU bans the trading of virtually identical electric “stun belts” but this prohibition did not deter another EU Member State – Hungary – from introducing them in its prisons and police stations.

Five Member States stated that there are no producers (Belgium, Cyprus, Italy, Finland, Malta) or exporters (Belgium, Cyprus, Italy) of such equipment in their territories. At least three of them – Finland, Italy and Belgium – lied: companies in these countries deal with such materiel openly and even maintain online sales catalogues of their own products or torture instruments manufactured in other – mostly developing – countries.

On January 16, 2003, the European Court of Human Rights agreed – more than two years after the applications have been filed – to hear six cases filed by Chechens against Russia. The claimants accuse the Russian military of torture and indiscriminate killings. The Court has ruled in the past against the Russian Federation and awarded assorted plaintiffs thousands of euros per case in compensation.

As awareness of human rights increased, as their definition expanded and as new, often authoritarian polities, resorted to torture and repression – human rights advocates and non-governmental organizations proliferated. It has become a business in its own right: lawyers, consultants, psychologists, therapists, law enforcement agencies, scholars and pundits tirelessly peddle books, seminars, conferences, therapy sessions for victims, court appearances and other services.

Human rights activists target mainly countries and multinationals.

In June 2001, the International Labour Rights Fund filed a lawsuit on behalf of 11 villagers against the American oil behemoth, ExxonMobil, for “abetting” abuses in Aceh, Indonesia. They alleged that the company provided the army with equipment for digging mass graves and helped in the construction of interrogation and torture centres.

In November 2002, the law firm of Cohen, Milstein, Hausfeld & Toll joined other American and South African law firms in filing a complaint that “seeks to hold businesses responsible for aiding and abetting the apartheid regime in South Africa … forced labour, genocide, extrajudicial killing, torture, sexual assault, and unlawful detention”.

Among the accused: “IBM and ICL which provided the computers that enabled South Africa to … control the black South African population. Car manufacturers provided the armoured vehicles that were used to patrol the townships. Arms manufacturers violated the embargoes on sales to South Africa, as did the oil companies. The banks provided the funding that enabled South Africa to expand its police and security apparatus.”

Charges were levelled against Unocal in Myanmar and dozens of other multinationals. In September 2002, Berger & Montague filed a class action complaint against Royal Dutch Petroleum and Shell Transport. The oil giants are charged with “purchasing ammunition and using … helicopters and boats and providing logistical support for ‘Operation Restore Order in Ogoniland'” which was designed, according to the law firm, to “terrorize the civilian population into ending peaceful protests against Shell’s environmentally unsound oil exploration and extraction activities”.

The defendants in all these court cases strongly deny any wrongdoing.

But this is merely one facet of the torture business.

Torture implements are produced – mostly in the West – and sold openly, frequently to nasty regimes in developing countries and even through the Internet. Hi-tech devices abound: sophisticated electroconvulsive stun guns, painful restraints, truth serums, chemicals such as pepper gas. Export licensing is universally minimal and non-intrusive and completely ignores the technical specifications of the goods (for instance, whether they could be lethal, or merely inflict pain).

Amnesty International and the UK-based Omega Foundation, found more than 150 manufacturers of stun guns in the USA alone. They face tough competition from Germany (30 companies), Taiwan (19), France (14), South Korea (13), China (12), South Africa (nine), Israel (eight), Mexico (six), Poland (four), Russia (four), Brazil (three), Spain (three) and the Czech Republic (two).

Many torture implements pass through “off-shore” supply networks in Austria, Canada, Indonesia, Kuwait, Lebanon, Lithuania, Macedonia, Albania, Russia, Israel, the Philippines, Romania and Turkey. This helps European Union based companies circumvent legal bans at home. The US government has traditionally turned a blind eye to the international trading of such gadgets.

American high-voltage electro-shock stun shields turned up in Turkey, stun guns in Indonesia, and electro-shock batons and shields, and dart-firing taser guns in torture-prone Saudi Arabia. American firms are the dominant manufacturers of stun belts. Explains Dennis Kaufman, President of Stun Tech Inc, a US manufacturer of this innovation: ”Electricity speaks every language known to man. No translation necessary. Everybody is afraid of electricity, and rightfully so.” (Quoted by Amnesty International).

The Omega Foundation and Amnesty claim that 49 US companies are also major suppliers of mechanical restraints, including leg-irons and thumbcuffs. But they are not alone. Other suppliers are found in Germany (8), France (5), China (3), Taiwan (3), South Africa (2), Spain (2), the UK (2) and South Korea (1).

Not surprisingly, the Commerce Department doesn’t keep tab on this category of exports.

Nor is the money sloshing around negligible. Records kept under the export control commodity number A985 show that Saudi Arabia alone spent in the United States more than $1 million a year between 1997-2000 merely on stun guns. Venezuela’s bill for shock batons and such reached $3.7 million in the same period. Other clients included Hong Kong, Taiwan, Mexico and – surprisingly – Bulgaria. Egypt’s notoriously brutal services – already well-equipped – spent a mere $40,000.

The United States is not the only culprit. The European Commission, according to an Amnesty International report titled “Stopping the Torture Trade” and published in 2001:

“Gave a quality award to a Taiwanese electro-shock baton, but when challenged could not cite evidence as to independent safety tests for such a baton or whether member states of the European Union (EU) had been consulted. Most EU states have banned the use of such weapons at home, but French and German companies are still allowed to supply them to other countries.”

Torture expertise is widely proffered by former soldiers, agents of the security services made redundant, retired policemen and even rogue medical doctors. China, Israel, South Africa, France, Russia, the United Kingdom and the United States are founts of such useful knowledge and its propagators.

How rooted torture is was revealed in September 1996 when the US Department of Defence admitted that ”intelligence training manuals” were used in the Federally sponsored School of the Americas – one of 150 such facilities – between 1982 and 1991.The manuals, written in Spanish and used to train thousands of Latin American security agents, “advocated execution, torture, beatings and blackmail”, says Amnesty International.

Where there is demand there is supply. Rather than ignore the discomfiting subject, governments would do well to legalize and supervise it. Alan Dershowitz, a prominent American criminal defence attorney, proposed, in an op-ed article in the Los Angeles Times, published November 8, 2001, to legalize torture in extreme cases and to have judges issue “torture warrants”. This may be a radical departure from the human rights tradition of the civilized world. But dispensing export carefully reviewed licenses for dual-use implements is a different matter altogether – and long overdue.

---

Also Read:

The Argument for Torture

The Psychology of Torture

European Banks Threatened by Identity Theft

European banks, from Sweden to Austria, are likely to face, in the near future, an unprecedented wave of attempts at identity theft. Hackers from Latvia to Ukraine and from Serbia to Bulgaria are now targeting financial institutions. The global crisis has added to the rows of unemployed former spies, laid-off bankers, and computer programmers. Networks of secret agents, knowledgeable financiers, and computer-savvy criminals have sprung all over Eastern and Central Europe and the Balkans.

 

How can Europe’s banks defend themselves?

 

1. By assigning account or relationship managers to all business accounts and individual accounts above a certain size. This is the practice in private banking and investment banking, but it has yet to spread to retail. A one-on-one line of communication between client and specific bank officer places an insurmountable obstacle in front of hackers and criminals.

 

2. Banks should allow their clients to “block” their accounts at no charge to the client. Account blockage means that all transfers from the account require the confirmation and approval of one or two specific bank officers who know the client personally. Thus, even if a hacker or a criminal were to succeed to effect a transfer of funds, such illicit and damaging activity could be blocked by the bank.

 

3. Banks should ignore and disallow instructions in the account received by e-mail. E-mail communication is amenable to spoofing, hijacking, hacking, and other forms of impersonation. Even Web-based e-mail services such as Gmail are highly insecure, especially over wireless networks.

 

4. Instructions by fax should be accepted only after the client provided, verbally, a one time code (see below).

 

5. Verbal communication should be conducted via mobile phones, not fixed or land lines. The mobile phone’s SIM card guarantees the identity of the specific device used and allows for tracing in case a crime has been committed. On many networks the communication flow is encrypted. Man-in-the-middle attacks and interception are more difficult with cell phones.

 

Online Banking Safeguards

All of Europe’s major banks offer to their customers financial services and products through the Internet. But there’s a problem: computer security. To withstand the coordinated onslaught of hackers and cyber-criminals, who are constantly trying to empty the bank accounts of their victims, online banking Websites must incorporate many defensive safety features. These render the entire experience cumbersome and complicated and deter the vast majority of clients.

Generally speaking, European banks are far safer than American ones as far as online banking and their online presence go. The list below is short and by no means exhaustive and is based on a study conducted at the University of Michigan by Atul Prakash, a professor in the department of electrical engineering and computer science, and two doctoral students, Laura Falk and Kevin Borders:

1. All the pages of the bank’s Website must use SSL (Secure Sockets Layer) and TLS encryption technologies. In the Internet Explorer Web browser, a small, yellow padlock icon appears at the bottom or the top of the page when such encryption is available. It prevents hackers from tapping into the exchange of information between the user’s computer and the bank’s servers and routers. Most browsers now offer also a wide variety of anti-phishing protections.

2. Users should not use their computer keyboard to type in passwords. Many computers are infected with keyloggers: small software applications that monitor the user’s typing and pass on the information to networks of criminals. Instead, the bank should provide a “virtual keyboard” (a tiny on-screen graphic that looks like a keyboard). Users can then click their mouse and press the various “keys” of the virtual keyboard to form the password. Some banks use Java “sandboxing” and virtualization technologies in order to isolate the online banking session from the user’s potentially-infected browser or computer.

3. The banking Website should not re-direct the user to other domains or sites (which potentially are not as secure).

4. The bank should insist on strong passwords: minimum five characters, allowing combinations of numerals and letters, including capitalized ones. Few banks adhere to this rule, though. Many of them allow passwords with only 4-5 numerals.

5. The bank should never send any information pertaining to the account – especially not passwords – via e-mail. Many European banks violate this cardinal rule by sending a staggering amount of information about the account via email, including account numbers, balances, movements, and ownership.

6. The bank should insist on “two-factor authentication”. The user would need a username and password to access the Website. But, to transact in the account, he would make use of one time “tokens” (codes). Each user should be equipped with printed lists of such codes or with a special device that generates them. They can also receive the codes via SMS. The codes are used to transfer money, change the password, change the limit of withdrawal, give instructions regarding securities and deposits, etc.

The Pros and Cons of Corruption

Corruption runs against the grain of meritocratic capitalism. It skews the level playing-field; it guarantees extra returns where none should have been had; it encourages the misallocation of economic resources; and it subverts the proper functioning of institutions. It is, in other words, without a single redeeming feature, a scourge.

Strangely, this is not how it is perceived by its perpetrators: both the givers and the recipients. They believe that corruption helps facilitate the flow and exchange of goods and services in hopelessly clogged and dysfunctional systems and markets (corruption and the informal economy “get things done” and “keep people employed”); that it serves as an organizing principle where chaos reins and institutions are in their early formative stages; that it supplements income and thus helps the state employ qualified and skilled personnel; and that it preserves peace and harmony by financing networks of cronyism, nepotism, and patronage.

I. The Facts

In 2002, just days before a much-awaited donor conference, the influential International Crisis Group (ICG) recommended to place all funds pledged to Macedonia under the oversight of a “corruption advisor” appointed by the European Commission. The donors ignored this and other recommendations. To appease the critics, the affable Attorney General of Macedonia charged a former Minister of Defense with abuse of duty for allegedly having channeled millions of DM to his relatives during the recent civil war. Macedonia has belatedly passed an anti-money laundering law recently, but failed, yet again, to adopt strict anti-corruption legislation.

In Albania, the Chairman of the Albanian Socialist Party, Fatos Nano, was accused by Albanian media of laundering $1 billion through the Albanian government. Pavel Borodin, the former chief of Kremlin Property, decided not appeal his money laundering conviction in a Swiss court. The Slovak daily “Sme” described in scathing detail the newly acquired wealth and lavish lifestyles of formerly impoverished HZDS politicians. Some of them now reside in refurbished castles. Others have swimming pools replete with wine bars.

Pavlo Lazarenko, a former Ukrainian prime minister, is detained in San Francisco on money laundering charges. His defense team accuses the US authorities of “selective prosecution”.

They are quoted by Radio Free Europe as saying:

“The impetus for this prosecution comes from allegations made by the Kuchma regime, which itself is corrupt and dedicated to using undemocratic and repressive methods to stifle political opposition … (other Ukrainian officials) including Kuchma himself and his closest associates, have committed conduct similar to that with which Lazarenko is charged but have not been prosecuted by the U.S. government”.

The UNDP estimated, in 1997, that, even in rich, industrialized, countries, 15% of all firms had to pay bribes. The figure rises to 40% in Asia and 60% in Russia.

Corruption is rife and all pervasive, though many allegations are nothing but political mud-slinging. Luckily, in countries like Macedonia, it is confined to its rapacious elites: its politicians, managers, university professors, medical doctors, judges, journalists, and top bureaucrats. The police and customs are hopelessly compromised. Yet, one rarely comes across graft and venality in daily life. There are no false detentions (as in Russia), spurious traffic tickets (as in Latin America), or widespread stealthy payments for public goods and services (as in Africa).

It is widely accepted that corruption retards growth by deterring foreign investment and encouraging brain drain. It leads to the misallocation of economic resources and distorts competition. It depletes the affected country’s endowments – both natural and acquired. It demolishes the tenuous trust between citizen and state. It casts civil and government institutions in doubt, tarnishes the entire political class, and, thus, endangers the democratic system and the rule of law, property rights included.

This is why both governments and business show a growing commitment to tackling it. According to Transparency International’s “Global Corruption Report 2001”, corruption has been successfully contained in private banking and the diamond trade, for instance.

Hence also the involvement of the World Bank and the IMF in fighting corruption. Both institutions are increasingly concerned with poverty reduction through economic growth and development. The World Bank estimates that corruption reduces the growth rate of an affected country by 0.5 to 1 percent annually. Graft amounts to an increase in the marginal tax rate and has pernicious effects on inward investment as well.

The World Bank has appointed in 2001 a Director of Institutional Integrity – a new department that combines the Anti-Corruption and Fraud Investigations Unit and the Office of Business Ethics and Integrity. The Bank helps countries to fight corruption by providing them with technical assistance, educational programs, and lending.

Anti-corruption projects are an integral part of every Country Assistance Strategy (CAS). The Bank also supports international efforts to reduce corruption by sponsoring conferences and the exchange of information. It collaborates closely with Transparency International, for instance.

At the request of member-governments (such as Bosnia-Herzegovina and Romania) it has prepared detailed country corruption surveys covering both the public and the private sectors. Together with the EBRD, it publishes a corruption survey of 3000 firms in 22 transition countries (BEEPS – Business Environment and Enterprise Performance Survey). It has even set up a multilingual hotline for whistleblowers.

The IMF made corruption an integral part of its country evaluation process. It suspended arrangements with endemically corrupt recipients of IMF financing. Since 1997, it has introduced policies regarding misreporting, abuse of IMF funds, monitoring the use of debt relief for poverty reduction, data dissemination, legal and judicial reform, fiscal and monetary transparency, and even internal governance (e.g., financial disclosure by staff members).

Yet, no one seems to agree on a universal definition of corruption. What amounts to venality in one culture (Sweden) is considered no more than hospitality, or an expression of gratitude, in another (France, or Italy). Corruption is discussed freely and forgivingly in one place – but concealed shamefully in another. Corruption, like other crimes, is probably seriously under-reported and under-penalized.

Moreover, bribing officials is often the unstated policy of multinationals, foreign investors, and expatriates. Many of them believe that it is inevitable if one is to expedite matters or secure a beneficial outcome. Rich world governments turn a blind eye, even where laws against such practices are extant and strict.

In his address to the Inter-American Development Bank on March 14, 2002 President Bush promised to “reward nations that root out corruption” within the framework of the Millennium Challenge Account initiative. The USA has pioneered global anti-corruption campaigns and is a signatory to the 1996 IAS Inter-American Convention against Corruption, the Council of Europe’s Criminal Law Convention on Corruption, and the OECD’s 1997 anti-bribery convention. The USA has had a comprehensive “Foreign Corrupt Practices Act” since 1977.

The Act applies to all American firms, to all firms – including foreign ones – traded in an American stock exchange, and to bribery on American territory by foreign and American firms alike. It outlaws the payment of bribes to foreign officials, political parties, party officials, and political candidates in foreign countries. A similar law has now been adopted by Britain.

Yet, “The Economist” reports that the American SEC has brought only three cases against listed companies until 1997. The US Department of Justice brought another 30 cases. Britain has persecuted successfully only one of its officials for overseas bribery since 1889. In the Netherlands bribery is tax deductible. Transparency International now publishes a name and shame Bribery Payers Index to complement its 91-country strong Corruption Perceptions Index.

Many rich world corporations and wealthy individuals make use of off-shore havens or “special purpose entities” to launder money, make illicit payments, avoid or evade taxes, and conceal assets or liabilities. According to Swiss authorities, more than $40 billion are held by Russians in its banking system alone. The figure may be 5 to 10 times higher in the tax havens of the United Kingdom.

In a survey it conducted in February 2002 of 82 companies in which it invests, “Friends, Ivory, and Sime” found that only a quarter had clear anti-corruption management and accountability systems in place.

Tellingly only 35 countries signed the 1997 OECD “Convention on Combating Bribery of Foreign Public Officials in International Business Transactions” – including four non-OECD members: Chile, Argentina, Bulgaria, and Brazil. The convention has been in force since February 1999 and is only one of many OECD anti-corruption drives, among which are SIGMA (Support for Improvement in Governance and Management in Central and Eastern European countries), ACN (Anti-Corruption Network for Transition Economies in Europe), and FATF (the Financial Action Task Force on Money Laundering).

Moreover, The moral authority of those who preach against corruption in poor countries – the officials of the IMF, the World Bank, the EU, the OECD – is strained by their ostentatious lifestyle, conspicuous consumption, and “pragmatic” morality.

II. What to Do? What is Being Done?

A few years ago, I proposed a taxonomy of corruption, venality, and graft. I suggested this cumulative definition:

1. The withholding of a service, information, or goods that, by law, and by right, should have been provided or divulged.

1. The provision of a service, information, or goods that, by law, and by right, should not have been provided or divulged.

1. That the withholding or the provision of said service, information, or goods are in the power of the withholder or the provider to withhold or to provide AND That the withholding or the provision of said service, information, or goods constitute an integral and substantial part of the authority or the function of the withholder or the provider.

1. That the service, information, or goods that are provided or divulged are provided or divulged against a benefit or the promise of a benefit from the recipient and as a result of the receipt of this specific benefit or the promise to receive such benefit.

1. That the service, information, or goods that are withheld are withheld because no benefit was provided or promised by the recipient.

There is also what the World Bank calls “State Capture” defined thus:

“The actions of individuals, groups, or firms, both in the public and private sectors, to influence the formation of laws, regulations, decrees, and other government policies to their own advantage as a result of the illicit and non-transparent provision of private benefits to public officials.”

We can classify corrupt and venal behaviors according to their outcomes:

1. Income Supplement – Corrupt actions whose sole outcome is the supplementing of the income of the provider without affecting the “real world” in any manner.

1. Acceleration or Facilitation Fees – Corrupt practices whose sole outcome is to accelerate or facilitate decision making, the provision of goods and services or the divulging of information.

1. Decision Altering (State Capture) Fees – Bribes and promises of bribes which alter decisions or affect them, or which affect the formation of policies, laws, regulations, or decrees beneficial to the bribing entity or person.

1. Information Altering Fees – Backhanders and bribes that subvert the flow of true and complete information within a society or an economic unit (for instance, by selling professional diplomas, certificates, or permits).

1. Reallocation Fees – Benefits paid (mainly to politicians and political decision makers) in order to affect the allocation of economic resources and material wealth or the rights thereto. Concessions, licenses, permits, assets privatized, tenders awarded are all subject to reallocation fees.

To eradicate corruption, one must tackle both giver and taker.

History shows that all effective programs shared these common elements:

1. The persecution of corrupt, high-profile, public figures, multinationals, and institutions (domestic and foreign). This demonstrates that no one is above the law and that crime does not pay.

1. The conditioning of international aid, credits, and investments on a monitored reduction in corruption levels. The structural roots of corruption should be tackled rather than merely its symptoms.

1. The institution of incentives to avoid corruption, such as a higher pay, the fostering of civic pride, “good behavior” bonuses, alternative income and pension plans, and so on.

1. In many new countries (in Asia, Africa, and Eastern Europe) the very concepts of “private” versus “public” property are fuzzy and impermissible behaviors are not clearly demarcated. Massive investments in education of the public and of state officials are required.

1. Liberalization and deregulation of the economy. Abolition of red tape, licensing, protectionism, capital controls, monopolies, discretionary, non-public, procurement. Greater access to information and a public debate intended to foster a “stakeholder society”.

1. Strengthening of institutions: the police, the customs, the courts, the government, its agencies, the tax authorities – under time limited foreign management and supervision.

Awareness to corruption and graft is growing – though it mostly results in lip service. The Global Coalition for Africa adopted anti-corruption guidelines in 1999. The otherwise opaque Asia Pacific Economic Cooperation (APEC) forum is now championing transparency and good governance. The UN is promoting its pet convention against corruption.

The G-8 asked its Lyon Group of senior experts on transnational crime to recommend ways to fight corruption related to large money flows and money laundering. The USA and the Netherlands hosted global forums on corruption – as did South Korea in 2003. The OSCE has responded with its own initiative, in collaboration with the US Congressional Helsinki Commission.

The south-eastern Europe Stability Pact sports its own Stability Pact Anti-corruption Initiative (SPAI). It held its first conference in September 2001 in Croatia. More than 1200 delegates participated in the 10th International Anti-Corruption Conference in Prague last year. The conference was attended by the Czech prime minister, the Mexican president, and the head of the Interpol.

The most potent remedy against corruption is sunshine – free, accessible, and available information disseminated and probed by an active opposition, uncompromised press, and assertive civic organizations and NGO’s. In the absence of these, the fight against official avarice and criminality is doomed to failure. With them, it stands a chance.

Corruption can never be entirely eliminated – but it can be restrained and its effects confined. The cooperation of good people with trustworthy institutions is indispensable. Corruption can be defeated only from the inside, though with plenty of outside help. It is a process of self-redemption and self-transformation. It is the real transition.

III. Asset Confiscation and Asset Forfeiture

The abuse of asset confiscation and forfeiture statutes by governments, law enforcement agencies, and political appointees and cronies throughout the world is well-documented. In many developing countries and countries in transition, assets confiscated from real and alleged criminals and tax evaders are sold in fake auctions to party hacks, cronies, police officers, tax inspectors, and relatives of prominent politicians at bargain basement prices.

That the assets of suspects in grave crimes and corruption should be frozen or “disrupted” until they are convicted or exonerated by the courts – having exhausted their appeals – is understandable and in accordance with the Vienna Convention. But there is no justification for the seizure and sale of property otherwise.

In Switzerland, financial institutions are obliged to automatically freeze suspect transactions for a period of five days, subject to the review of an investigative judge. In France, the Financial Intelligence Unit can freeze funds involved in a reported suspicious transaction by administrative fiat. In both jurisdictions, the fast track freezing of assets has proven to be a more than adequate measure to cope with organized crime and venality.

The presumption of innocence must fully apply and due process upheld to prevent self-enrichment and corrupt dealings with confiscated property, including the unethical and unseemly use of the proceeds from the sale of forfeited assets to close gaping holes in strained state and municipal budgets.

In the United States, according to The Civil Asset Forfeiture Reform Act of 2000 (HR 1658), the assets of suspects under investigation and of criminals convicted of a variety of more than 400 minor and major offenses (from soliciting a prostitute to gambling and from narcotics charges to corruption and tax evasion) are often confiscated and forfeited (“in personam, or value-based confiscation”).

Technically and theoretically, assets can be impounded or forfeited and disposed of even in hitherto minor Federal civil offenses (mistakes in fulfilling Medicare or tax return forms)

The UK’s Assets Recovery Agency (ARA) that is in charge of enforcing the Proceeds of Crime Act 2002, had this chilling statement to make on May 24, 2007:

“We are pursuing the assets of those involved in a wide range of crime including drug dealing, people trafficking, fraud, extortion, smuggling, control of prostitution, counterfeiting, benefit fraud, tax evasion and environmental crimes such as illegal dumping of waste and illegal fishing.” (!)

Drug dealing and illegal fishing in the same sentence.

The British firm Bentley-Jennison, who provide Forensic Accounting Services, add:

“In some cases the defendants will even have their assets seized at the start of an investigation, before any charges have been considered. In many cases the authorities will assume that all of the assets held by the defendant are illegally obtained as he has a “criminal lifestyle”. It is then down to the defendant to prove otherwise. If the defendant is judged to have a criminal lifestyle then it will be assumed that physical assets, such as properties and motor vehicles, have been acquired through the use of criminal funds and it will be necessary to present evidence to contradict this.

The defendant’s bank accounts will also be scanned for evidence of spending and any expenditure on unidentified assets (and in some cases identified assets) is also likely to be included as alleged criminal benefit. This often leads to the inclusion of sums from legitimate sources and double counting both of which need to be eliminated.”

Under the influence of the post-September 11 United States and the FATF (Financial Action Task Force on Money Laundering), Canada, Australia, the United Kingdom, Greece, South Korea, and Russia have similar asset recovery and money laundering laws in place.

International treaties (for instance, the 1959 European Convention on Mutual Legal Assistance in Criminal Matters, the 1990 Convention of the Council of Europe on Laundering, Search, Seizure and Confiscation of the Proceeds from Crime (ETS 141), and The U.N. Convention against Corruption 2003- UNCAC) and European Union Directives (e.g., 2001/97/EC) allow the seizure and confiscation of the assets and “unexplained wealth” of criminals and suspects globally, even if their alleged or proven crime does not constitute an offense where they own property or have bank accounts.

This abrogation of the principle of dual criminality sometimes leads to serious violations of human and civil rights. Hitler could have used it to ask the United Kingdom’s Assets Recovery Agency (ARA) to confiscate the property of refugee Jews who committed “crimes” by infringing on the infamous Nuremberg race laws.

Only offshore tax havens, such as Andorra, Antigua, Aruba, the British Virgin Islands, Guernsey, Monaco, the Netherlands Antilles, Samoa, St. Vincent, the US Virgin Islands, and Vanuatu still resist the pressure to join in the efforts to trace and seize suspects’ assets and bank accounts in the absence of a conviction or even charges.

Even worse, unlike in other criminal proceedings, the burden of proof is on the defendant who has to demonstrate that the source of the funds used to purchase the confiscated or forfeited assets is legal. When the defendant fails to furnish such evidence conclusively and convincingly, or if he has left the United States or had died, the assets are sold at an auction and the proceeds usually revert to various law enforcement agencies, to the government’s budget, or to good social causes and programs. This is the case in many countries, including United Kingdom, United States, Germany, France, Hong Kong, Italy, Denmark, Belgium, Austria, Greece, Ireland, New Zealand, Singapore and Switzerland.

According to a brief written by Jack Smith, Mark Pieth, and Guillermo Jorge at the Basel Institute on Governance, International Centre for Asset Recovery:

“Article 54(1)(c) of the UNCAC recommends that states parties establish non-criminal systems of confiscation, which have several advantages for recovery actions: the standard of evidence is lower (“preponderance of the evidence” rather than “beyond a reasonable doubt”); they are not subject to some of the more restrictive traditional safeguards of international cooperation such as the offense for which the defendant is accused has to be a crime in the receiving state (dual criminality); and it opens more formal avenues for negotiation and settlements. This is already the practice in some jurisdictions such as the US, Ireland, the UK, Italy, Colombia, Slovenia, and South Africa, as well as some Australian and Canadian States.”

In most countries, including the United Kingdom, the United States, Austria, Germany, Indonesia, Macedonia, and Ireland, assets can be impounded, confiscated, frozen, forfeited, and even sold prior to and without any criminal conviction.

In Australia, Austria, Ireland, Hong-Kong, New Zealand, Singapore, United Kingdom, South Africa, United States and the Netherlands alleged and suspected criminals, their family members, friends, employees, and partners can be stripped of their assets even for crimes they have committed in other countries and even if they have merely made use of revenues obtained from illicit activities (this is called “in rem, or property-based confiscation”). This often gives rise to cases of double jeopardy.

Typically, the defendant is notified of the impending forfeiture or confiscation of his or her assets and has recourse to a hearing within the relevant law enforcement agency and also to the courts. If he or she can prove “substantial harm” to life and business, the property may be released to be used, though ownership is rarely restored.

When the process of asset confiscation or asset forfeiture is initiated, banking secrecy is automatically lifted and the government indemnifies the banks for any damage they may suffer for disclosing confidential information about their clients’ accounts.

In many countries from South Korea to Greece, lawyer-client privilege is largely waived. The same requirements of monitoring of clients’ activities and reporting to the authorities apply to credit and financial institutions, venture capital firms, tax advisers, accountants, and notaries.

Elsewhere, there are some other worrying developments:

In Bulgaria, the assets of tax evaders have recently begun to be confiscated and turned over to the National Revenue Agency and the State Receivables Collection Agency. Property is confiscated even when the tax assessment is disputed in the courts. The Agency cannot, however, confiscate single-dwelling houses, bank accounts up to 250 leva of one member of the family, salary or pension up to 250 leva a month, social care, and alimony, support money or allowances.

Venezuela has recently reformed its Organic Tax Code to allow for:

” (P)re-judgment enforcement measures (to) include closure of premises for up to ten days and confiscation of merchandise. These measures will be applied in addition to the attachment or sequestration of personal property and the prohibition against alienation or encumbrance of realty. During closure of premises, the employer must continue to pay workers, thereby avoiding an appeal for constitutional protection.”

Finally, in many states in the United States, “community responsibility” statutes require of owners of legal businesses to “abate crime” by openly fighting it themselves. If they fail to tackle the criminals in their neighborhood, the police can seize and sell their property, including their apartments and cars. The proceeds from such sales accrue to the local municipality.

In New-York City, the police confiscated a restaurant because one of its regular patrons was an alleged drug dealer. In Alabama, police seized the home of a senior citizen because her yard was used, without her consent, for drug dealing. In Maryland, the police confiscated a family’s home and converted it into a retreat for its officers, having mailed one of the occupants a package of marijuana.

Note – The Psychology of Corruption

Most politicians bend the laws of the land and steal money or solicit bribes because they need the funds to support networks of patronage. Others do it in order to reward their nearest and dearest or to maintain a lavish lifestyle when their political lives are over.

But these mundane reasons fail to explain why some officeholders go on a rampage and binge on endless quantities of lucre. All rationales crumble in the face of a Mobutu Sese Seko or a Saddam Hussein or a Ferdinand Marcos who absconded with billions of US dollars from the coffers of Zaire, Iraq, and the Philippines, respectively.

These inconceivable dollops of hard cash and valuables often remain stashed and untouched, moldering in bank accounts and safes in Western banks. They serve no purpose, either political or economic. But they do fulfill a psychological need. These hoards are not the megalomaniacal equivalents of savings accounts. Rather they are of the nature of compulsive collections.

Erstwhile president of Sierra Leone, Momoh, amassed hundreds of video players and other consumer goods in vast rooms in his mansion. As electricity supply was intermittent at best, his was a curious choice. He used to sit among these relics of his cupidity, fondling and counting them insatiably.

While Momoh relished things with shiny buttons, people like Sese Seko, Hussein, and Marcos drooled over money. The ever-heightening mountains of greenbacks in their vaults soothed them, filled them with confidence, regulated their sense of self-worth, and served as a love substitute. The balances in their bulging bank accounts were of no practical import or intent. They merely catered to their psychopathology.

These politicos were not only crooks but also kleptomaniacs. They could no more stop thieving than Hitler could stop murdering. Venality was an integral part of their psychological makeup.

Kleptomania is about acting out. It is a compensatory act. Politics is a drab, uninspiring, unintelligent, and, often humiliating business. It is also risky and rather arbitrary. It involves enormous stress and unceasing conflict. Politicians with mental health disorders (for instance, narcissists or psychopaths) react by decompensation. They rob the state and coerce businessmen to grease their palms because it makes them feel better, it helps them to repress their mounting fears and frustrations, and to restore their psychodynamic equilibrium. These politicians and bureaucrats “let off steam” by looting.

Kleptomaniacs fail to resist or control the impulse to steal, even if they have no use for the booty. According to the Diagnostic and Statistical Manual IV-TR (2000), the bible of psychiatry, kleptomaniacs feel “pleasure, gratification, or relief when committing the theft.” The good book proceeds to say that ” … (T)he individual may hoard the stolen objects …”.

As most kleptomaniac politicians are also psychopaths, they rarely feel remorse or fear the consequences of their misdeeds. But this only makes them more culpable and dangerous.

---

Also Read:

Legalizing Crime

The Greatest Savings Crisis in History

The Typology of Financial Scandals

The Bursting Asset Bubbles

(Case Studies: The Savings and Loans Crisis, Crash of 1929, British Real Estate)

The Shadowy World of International Finance

Hawala, or the Bank that Never Was

Money Laundering in a Changed World

The Varieties of Corruption

Straf – Corruption in CEE

The Criminality of Transition

The Kleptocracies of the East

The Enrons of the East

Bully at Work – Interview with Tim Field

The Economics of Conspiracy Theories

The Industrious Spies

The Business of Torture

Fimaco Wouldn’t Die – Russia’s Missing Billions

Treasure Island Revisited – Maritime Piracy

Organ Trafficking in Eastern Europe

Begging Your Trust in Africa

Slush Funds

Is Energy Security Desirable?

The pursuit of “energy security” has brought us to the brink. It is directly responsible for numerous wars, big and small; for unprecedented environmental degradation; for global financial imbalances and meltdowns; for growing income disparities; and for ubiquitous unsustainable development.

It is energy insecurity that we should seek.

The uncertainty incumbent in phenomena such “peak oil”, or in the preponderance of hydrocarbon fuels in failed states fosters innovation. The more insecure we get, the more we invest in the recycling of energy-rich products; the more substitutes we find for energy-intensive foods; the more we conserve energy; the more we switch to alternatives energy; the more we encourage international collaboration; and the more we optimize energy outputs per unit of fuel input.

A world in which energy (of whatever source) will be abundant and predictably available would suffer from entropy, both physical and mental. The vast majority of human efforts revolve around the need to deploy our meager resources wisely. Energy also serves as a geopolitical “organizing principle” and disciplinary rod. Countries which waste energy (and the money it takes to buy it), pollute, and conflict with energy suppliers end up facing diverse crises, both domestic and foreign. Profligacy is punished precisely because energy in insecure. Energy scarcity and precariousness thus serves a global regulatory mechanism.

But the obsession with “energy security” is only one example of the almost religious belief in “scarcity”.

It is only a mild overstatement to say that the science of economics, such as it is, revolves around the Malthusian concept of scarcity. Our infinite wants, the finiteness of our resources and the bad job we too often make of allocating them efficiently and optimally – lead to mismatches between supply and demand. We are forever forced to choose between opportunities, between alternative uses of resources, painfully mindful of their costs.

This is how the perennial textbook “Economics” (seventeenth edition), authored by Nobel prizewinner Paul Samuelson and William Nordhaus, defines the dismal science:

“Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people.”

The classical concept of scarcity – unlimited wants vs. limited resources – is lacking. Anticipating much-feared scarcity encourages hoarding which engenders the very evil it was meant to fend off. Ideas and knowledge – inputs as important as land and water – are not subject to scarcity, as work done by Nobel laureate Robert Solow and, more importantly, by Paul Romer, an economist from the University of California at Berkeley, clearly demonstrates. Additionally, it is useful to distinguish natural from synthetic resources.

The scarcity of most natural resources (a type of “external scarcity”) is only theoretical at present. Granted, many resources are unevenly distributed and badly managed. But this is man-made (“internal”) scarcity and can be undone by Man. It is truer to assume, for practical purposes, that most natural resources – when not egregiously abused and when freely priced – are infinite rather than scarce. The anthropologist Marshall Sahlins discovered that primitive peoples he has studied had no concept of “scarcity” – only of “satiety”. He called them the first “affluent societies”.

This is because, fortunately, the number of people on Earth is finite – and manageable – while most resources can either be replenished or substituted. Alarmist claims to the contrary by environmentalists have been convincingly debunked by the likes of Bjorn Lomborg, author of “The Skeptical Environmentalist”.

Equally, it is true that manufactured goods, agricultural produce, money, and services are scarce. The number of industrialists, service providers, or farmers is limited – as is their life span. The quantities of raw materials, machinery and plant are constrained. Contrary to classic economic teaching, human wants are limited – only so many people exist at any given time and not all them desire everything all the time. But, even so, the demand for man-made goods and services far exceeds the supply.

Scarcity is the attribute of a “closed” economic universe. But it can be alleviated either by increasing the supply of goods and services (and human beings) – or by improving the efficiency of the allocation of economic resources. Technology and innovation are supposed to achieve the former – rational governance, free trade, and free markets the latter.

The telegraph, the telephone, electricity, the train, the car, the agricultural revolution, information technology and, now, biotechnology have all increased our resources, seemingly ex nihilo. This multiplication of wherewithal falsified all apocalyptic Malthusian scenarios hitherto. Operations research, mathematical modeling, transparent decision making, free trade, and professional management – help better allocate these increased resources to yield optimal results.

Markets are supposed to regulate scarcity by storing information about our wants and needs. Markets harmonize supply and demand. They do so through the price mechanism. Money is, thus, a unit of information and a conveyor or conduit of the price signal – as well as a store of value and a means of exchange.

Markets and scarcity are intimately related. The former would be rendered irrelevant and unnecessary in the absence of the latter. Assets increase in value in line with their scarcity – i.e., in line with either increasing demand or decreasing supply. When scarcity decreases – i.e., when demand drops or supply surges – asset prices collapse. When a resource is thought to be infinitely abundant (e.g., air) – its price is zero.

Armed with these simple and intuitive observations, we can now survey the dismal economic landscape.

The abolition of scarcity was a pillar of the paradigm shift to the “new economy”. The marginal costs of producing and distributing intangible goods, such as intellectual property, are negligible. Returns increase – rather than decrease – with each additional copy. An original software retains its quality even if copied numerous times. The very distinction between “original” and “copy” becomes obsolete and meaningless. Knowledge products are “non-rival goods” (i.e., can be used by everyone simultaneously).

Such ease of replication gives rise to network effects and awards first movers with a monopolistic or oligopolistic position. Oligopolies are better placed to invest excess profits in expensive research and development in order to achieve product differentiation. Indeed, such firms justify charging money for their “new economy” products with the huge sunken costs they incur – the initial expenditures and investments in research and development, machine tools, plant, and branding.

To sum, though financial and human resources as well as content may have remained scarce – the quantity of intellectual property goods is potentially infinite because they are essentially cost-free to reproduce. Plummeting production costs also translate to enhanced productivity and wealth formation. It looked like a virtuous cycle.

But the abolition of scarcity implied the abolition of value. Value and scarcity are two sides of the same coin. Prices reflect scarcity. Abundant products are cheap. Infinitely abundant products – however useful – are complimentary. Consider money. Abundant money – an intangible commodity – leads to depreciation against other currencies and inflation at home. This is why central banks intentionally foster money scarcity.

But if intellectual property goods are so abundant and cost-free – why were distributors of intellectual property so valued, not least by investors in the stock exchange? Was it gullibility or ignorance of basic economic rules?

Not so. Even “new economists” admitted to temporary shortages and “bottlenecks” on the way to their utopian paradise of cost-free abundance. Demand always initially exceeds supply. Internet backbone capacity, software programmers, servers are all scarce to start with – in the old economy sense.

This scarcity accounts for the stratospheric erstwhile valuations of dotcoms and telecoms. Stock prices were driven by projected ever-growing demand and not by projected ever-growing supply of asymptotically-free goods and services. “The Economist” describes how WorldCom executives flaunted the cornucopian doubling of Internet traffic every 100 days. Telecoms predicted a tsunami of clients clamoring for G3 wireless Internet services. Electronic publishers gleefully foresaw the replacement of the print book with the much heralded e-book.

The irony is that the new economy self-destructed because most of its assumptions were spot on. The bottlenecks were, indeed, temporary. Technology, indeed, delivered near-cost-free products in endless quantities. Scarcity was, indeed, vanquished.

Per the same cost, the amount of information one can transfer through a single fiber optic swelled 100 times. Computer storage catapulted 80,000 times. Broadband and cable modems let computers communicate at 300 times their speed only 5 years ago. Scarcity turned to glut. Demand failed to catch up with supply. In the absence of clear price signals – the outcomes of scarcity – the match between the two went awry.

One innovation the “new economy” has wrought is “inverse scarcity” – unlimited resources (or products) vs. limited wants. Asset exchanges the world over are now adjusting to this harrowing realization – that cost free goods are worth little in terms of revenues and that people are badly disposed to react to zero marginal costs.

The new economy caused a massive disorientation and dislocation of the market and the price mechanism. Hence the asset bubble. Reverting to an economy of scarcity is our only hope. If we don’t do so deliberately – the markets will do it for us, mercilessly.

A Comment on “Manufactured Scarcity”

Conspiracy theorists have long alleged that manufacturers foster scarcity by building into their products mechanisms of programmed obsolescence and apoptosis (self-destruction). But scarcity is artificially manufactured in less obvious (and far less criminal) ways.

Technological advances, product revisions, new features, and novel editions render successive generations of products obsolete. Consumerism encourages owners to rid themselves of their possessions and replace them with newer, more gleaming, status-enhancing substitutes offered by design departments and engineering workshops worldwide. Cherished values of narcissistic competitiveness and malignant individualism play an important socio-cultural role in this semipternal game of musical chairs.

Many products have a limited shelf life or an expiry date (rarely supported by solid and rigorous research). They are to be promptly disposed of and, presumably, instantaneously replaced with new ones.

Finally, manufacturers often knowingly produce scarcity by limiting their output or by restricting access to their goods. “Limited editions” of works of art and books are prime examples of this stratagem.

Facts and Fictions in the Securities Industry

The securities industry worldwide is constructed upon the quicksand of self-delusion and socially-acceptable confabulations. These serve to hold together players and agents whose interests are both disparate and diametrically opposed. In the long run, the securities markets are zero-sum games and the only possible outcome is win-lose.

The first “dirty secret” is that a firm’s market capitalization often stands in inverse proportion to its value and valuation (as measured by an objective, neutral, disinterested party). This is true especially when agents (management) are not also principals (owners).

Owing to its compensation structure, invariably tied to the firms’ market capitalization, management strives to maximize the former by manipulating the latter. Very often, the only way to affect the firm’s market capitalization in the short-term is to sacrifice the firm’s interests and, therefore, its value in the medium to long-term (for instance, by doling out bonuses even as the firm is dying; by speculating on leverage; and by cooking the books).

The second open secret is that all modern financial markets are Ponzi (pyramid) schemes. The only viable exit strategy is by dumping one’s holdings on future entrants. Fresh cash flows are crucial to sustaining ever increasing prices. Once these dry up, markets collapse in a heap.

Thus, the market prices of shares and, to a lesser extent debt instruments (especially corporate ones) are determined by three cash flows:

(i) The firm’s future cash flows (incorporated into valuation models, such as the CAPM or FAR)

(ii) Future cash flows in securities markets (i.e., the ebb and flow of new entrants)

(iii) The present cash flows of current market participants

The confluence of these three cash streams translates into what we call “volatility” and reflects the risks inherent in the security itself (the firm’s idiosyncratic risk) and the hazards of the market (known as alpha and beta coefficients).

In sum, stocks and share certificates do not represent ownership of the issuing enterprise at all. This is a myth, a convenient piece of fiction intended to pacify losers and lure “new blood” into the arena. Shareholders’ claims on the firm’s assets in cases of insolvency, bankruptcy, or liquidation are of inferior, or subordinate nature.

Stocks are shares are merely options (gambles) on the three cash flows enumerated above. Their prices wax and wane in accordance with expectations regarding the future net present values of these flows. Once the music stops, they are worth little.

---

Also Read:

The Friendly Trend

Models of Stock Valuation

Portfolio Management Theory and Technical Analysis Lecture Notes

The Economics of Expectations

Economies revolve around and are determined by “anchors”: stores of value that assume pivotal roles and lend character to transactions and economic players alike. Well into the 19 century, tangible assets such as real estate and commodities constituted the bulk of the exchanges that occurred in marketplaces, both national and global. People bought and sold land, buildings, minerals, edibles, and capital goods. These were regarded not merely as means of production but also as forms of wealth.

Inevitably, human society organized itself to facilitate such exchanges. The legal and political systems sought to support, encourage, and catalyze transactions by enhancing and enforcing property rights, by providing public goods, and by rectifying market failures.

Later on and well into the 1980s, symbolic representations of ownership of real goods and property (e.g, shares, commercial paper, collateralized bonds, forward contracts) were all the rage. By the end of this period, these surpassed the size of markets in underlying assets. Thus, the daily turnover in stocks, bonds, and currencies dwarfed the annual value added in all industries combined.

Again, Mankind adapted to this new environment. Technology catered to the needs of traders and speculators, businessmen and middlemen. Advances in telecommunications and transportation followed inexorably. The concept of intellectual property rights was introduced. A financial infrastructure emerged, replete with highly specialized institutions (e.g., central banks) and businesses (for instance, investment banks, jobbers, and private equity funds).

We are in the throes of a third wave. Instead of buying and selling assets one way (as tangibles) or the other (as symbols) – we increasingly trade in expectations (in other words, we transfer risks). The markets in derivatives (options, futures, indices, swaps, collateralized instruments, and so on) are flourishing.

Society is never far behind. Even the most conservative economic structures and institutions now strive to manage expectations. Thus, for example, rather than tackle inflation directly, central banks currently seek to subdue it by issuing inflation targets (in other words, they aim to influence public expectations regarding future inflation).

The more abstract the item traded, the less cumbersome it is and the more frictionless the exchanges in which it is swapped. The smooth transmission of information gives rise to both positive and negative outcomes: more efficient markets, on the one hand – and contagion on the other hand; less volatility on the one hand – and swifter reactions to bad news on the other hand (hence the need for market breakers); the immediate incorporation of new data in prices on the one hand – and asset bubbles on the other hand.

Hitherto, even the most arcane and abstract contract traded was somehow attached to and derived from an underlying tangible asset, no matter how remotely. But this linkage may soon be dispensed with. The future may witness the bartering of agreements that have nothing to do with real world objects or values.

In days to come, traders and speculators will be able to generate on the fly their own, custom-made, one-time, investment vehicles for each and every specific transaction. They will do so by combining “off-the-shelf”, publicly traded components. Gains and losses will be determined by arbitrary rules or by reference to extraneous events. Real estate, commodities, and capital goods will revert to their original forms and functions: bare necessities to be utilized and consumed, not speculated on.

---

Also Read

The Dismal Mind – Economics as a Pretension to Science

Economics – The Neglected Branch of Psychology

The Fabric of Economic Trust

The Distributive Justice of the Market

Scavenger Economies and Predator Economies

Notes on the Economics of Game Theory

Knowledge and Power

The Disruptive Engine – Innovation and the Capitalist Dream

The Spectrum of Auctions

Market Impeders and Market Inefficiencies

Moral Hazard the Survival Value of Risk

The Principal-Agent Conundrum

The Myth of the Earnings Yield

The Principal-Agent Conundrum

Trading in Sovereign Promises