A movie called "World War Z" is opening soon. The title is a play on "World War III" where the "Z" stands in for the "III" part and refers to zombies. The movie is no doubt designed to be escapist entertainment. In my case I am also doing a play on "World War III". But here the "S" stands for Syria and the subject is deadly serious. I am extremely concerned about the Syrian situation. What most concerns me is that I am seeing a pattern of spiraling escalation and I don't see any forces arrayed effectively to break the spiral. What's to stop Syria from growing bigger and bigger to the point where it actually does resemble a World War? As the hero opines in numerous action movies, "I've got a bad feeling about this".
Let me take a look at a classic "runaway" situation, one that resulted in an actual "World War", specifically World War I. The definitive work on the subject is the great book "The Guns of August" by Barbara Tuchman. Stated most simply, World War I started because no one had the simultaneous will and ability to stop the war from starting. This was in spite of the fact that no one was specifically trying to start a war. Events just got out of control.
A large contributing factor was the general attitude of the eventual participants. Each participant believed that a "nice little war" would be a good thing. They all believed that a war could be fought for a reasonable cost and each country believed that the war would be beneficial for them. Finally, they all believed that the war could be controlled, its size could be kept manageable resulting in the cost being kept manageable. All these assumptions turned out to be catastrophically wrong.
Europe had hundreds of years of experience with war in the run up to WWI. I visited Poland in the early '70s. It was fascinating to get their perspective. It turns out that one of the tried and true strategies was to have the war in someone else's country. As the Poles saw it various European powers had been coming to Poland for centuries so that their nice little war would wreck Poland and not any place important. This was hard on Poland. But who cares? After all, it was only Poland.
Another recipient to a lesser extent of this strategy was what is now Germany. Other countries, especially France, had been going to Germany to fight wars, again for centuries. But in the 1800's something changed. Germany got united and militarily powerful. Once they were in a position to do so, the first thing they did was to put a stop to other countries going to Germany to have their war. But by the time this happened (late 1800's) the Germans had built up a great deal of resentment, particularly against France, for all the earlier wars. So Germany had a mad on for France and wanted payback.
By the early 1900's the Germans had the finest military machine in Europe. They were just looking for an excuse to have a nice little war so they beat the crap out of France. Meanwhile France had a glorious history (or so they told themselves) of beating the crap out of Germany. And they had a magic "secret weapon" over the Germans called "élan". They were just damn superior to the Germans so they would no doubt beat the crap out of them every time they got the chance. "The Germans were vastly overrated", they said to themselves. Other countries had other reasons. Let me mention two more.
Again for centuries, the British had been playing "power politics" on the continent of Europe. The idea was to come in on the right side of the many little "continental" wars so that the sides were pretty much evenly matched. This would result in both sides exhausting themselves leaving the British as the last major power standing. The British believed that another continental war would work out the same. France and Germany would beat the crap out of each other. The British would control the rest of the world via the British Empire and the Royal Navy. This would leave the British in a better position after the war.
Finally, there was Russia, "the sick man of Europe". Russia should theoretically been powerful. They had a giant land mass, far more territory than every one else. They had a large population and lots of resources like timber, coal, and steel. On paper they looked great. But they weren't and everyone knew it. They just never could get their act together. But hey, there's always next time. Maybe in the next war the Russians could finally leverage their advantages of large population and vast resources and show everyone else up. But to get a chance to show everyone else up they needed a nice convenient war.
It turns out everyone was delusional. The Germans did in fact have the finest military machine on the continent. But it wasn't superior enough to triumph over the combination of France, Britain, and Russia. France's vaunted "élan" advantage turned out to be so much smoke. The war ended up being so expensive that it effectively bankrupted Britain. And Russia still did not have their act together. In fact, the fact that the Russians did not have their act together turned out to be the single item most responsible for the war starting.
These forces I have outlined above had been in place and building up steam for a long time. In fact, there is a lot of scholarly research that supports the theory that the war should have started in 1912, two years before it actually started. The reasons why it did not start in 1912 and why it did start in 1914 are obscure and not worth going in to. So everyone ended up miscalculating going into the war. And that was not the greatest miscalculation.
As Tuchman so brilliantly documents the war was a war of movement, exactly as everyone had predicted and planned for, when it started. But by the end of six weeks, the point where Tuchman's book ends, the war had stalemated and turned into the beyond horrific "trench" war. This phase of the war gobbled up men by the hundreds of thousands and money and material by the millions and eventually billions of dollars. And for years neither side was able to gain a lasting advantage. By the end, WWI was a war of exhaustion. It simply became a matter of finding out which side would run out of the necessary amount of men and material to continue the war first. It turned out that although small, the U.S. contribution was critical because the U.S. provided the men and material that allowed the winning side to continue on to the end and outlast the losing side.
World War I is the classic example of war going horribly wrong. I see the seeds of the same thing happening in Syria. Many of the same forces are in play that were in play during the run up to and in the early phases of World War I. The last really big war was World War II. It was roughly 70 years ago. Since then we have had any number of wars but they have been limited wars. The poster child for limited war was the Korean War.
It represented a clash of the superpowers with the U.S. and its allies on one side and the U.S.S.R. (as Russia was known at the time) and its allies on the other side. But Truman, the U.S. President, was concerned from the beginning that the war not spiral out of control into a cycle of escalation that would eventually lead to a nuclear war. He formulated and implemented the doctrine of "limited war". That governed the U.S. strategy even when the Chinese, then seen as a puppet of the U.S.S.R., committed a large number of Chinese troops on the other side. Korea turned out to be another classic war of exhaustion. The "armistice" that ended active combat is still in place many decades later. There is no formal end to the conflict in sight and the battle lines ended up very close to where they were the day before the war started.
This "limited war" doctrine was applied to Vietnam a decade later. Gradually it came to be seen as the norm. It is now so much baked into everyone's thinking that almost no one spends any time worrying about nuclear war any more. Everyone assumes that all wars are automatically limited wars and that it is impossible (always a dangerous word when applied to human behavior) for one of these limited wars to escalate to become a "World War" and it is beyond impossible for it to "go nuclear". But just as in the case of World War I, where hundreds of years of European experience demonstrated that wars would always be limited wars for limited objectives, our current experience now tells us the same thing.
No two wars ever play out exactly the same. So Syria will not play out the same way that World War I did. But there are many other similarities. Another similarity is the attitude of the players. Take the Arab world in general, for instance. They now have almost a hundred years of experience with what they call "Crusader" wars. These are wars where one side is a western power (Iraq and Afghanistan are contemporary examples) or wars where western powers are supporting on one side of a nominally Arabs versus Arab war (the first Iraq war, for instance). Pretty much all the wars in the eastern and southern Mediterranean follow this pattern. I can think of no purely Arab versus Arab wars in the modern era since World War II. Generally the side backed by the west has triumphed. This has given Arabs an inferiority complex, like the one Russia had going into World War I. And generally the west has played the "British" role. The west comes in on one side or the other and in most cases the result is to keep all the Arab states weak and effectively leave the west in control.
And there are "élan" factions. The Arabs tell themselves that they have driven the U.S. out or Iraq and will soon drive them out of Afghanistan. They also drove the west out of Iran and the Israelis (a western proxy) out of the Gaza. There may be some wishful thinking going on here but it allows some segments of the Arab population to believe that "we have defeated the west so we have the élan to defeat our enemies, whoever they may be, because we are superior". The argument can be made that these characterizations are delusional but they do not have to be true to have the same effect delusions had on the actions of the various players in the run up to World War I.
And there is another great delusion that is affecting the actions of a major player in the Syrian conflict. Many in the U.S., both government officials and "opinion makers", believe that the U.S. can have an effective positive influence on events in Syria. There opinion of what constitutes the proper "positive influence" might differ but they all agree that "if the U.S. just does the right thing then a good outcome will be the result". This is in spite of a vast amount of evidence to the contrary that has come out of Iran, Iraq, Afghanistan, Egypt, Libya, and other locations. Lots of events turn out the way they do not because of but in spite of U.S. efforts.
The events that touched off World War I happened quickly. Syria is playing out at a much slower pace. We are about two years into the war. It started out as yet another manifestation of the Arab Spring. People demonstrated their unhappiness with their government. The government cracked down. So far we are following the standard "Arab Spring" scenario. But in Syria things then started going their own way. And by that I mean that we has seen a gradual but steady set of escalations by both sides.
The government cracked down hard. The demonstrators went violent. The government started using the military. The opposition (no longer just "demonstrators") was able to secure permission to import weapons from outside. The government started importing bigger and better weapons itself. The opposition scored some impressive military successes. The government started importing fighters from Hezbollah in Lebanon and "freedom fighters" from Iraq. It also seems to have started using poison gas, of which the Syrian government has vast stockpiles and its the "good stuff" like Sarin. This has caused President Obama to signal that the U.S. will now start supplying arms to the Rebels. And. in response to something or other, the Russians recently announced that they will be providing top of the line air defense systems to the Syrian government.
And the Syrian conflict is showing signs of escalating to a regional conflict. It is spilling into Turkey, Lebanon, Jordon, and Iraq to some extent. It has also pulled in "second ring" countries, countries that do not directly border on Syria. These include Iran and Israel so far. And it has pulled in both former superpowers, the U.S. and Russia. Some amount of spill over is common. China got involved in Korea. Vietnam spilled over into Cambodia and Laos. Afghanistan can be seen more accurately as the "Afghanistan/Pakistan" war. But in these other cases there seemed to be an informal fire wall. In Korea the Chinese involvement was limited. The same was true with Cambodia and Laos in Vietnam. Pakistan is deeply involved in Afghanistan but no one else is likely to be pulled in.
There doesn't seem to be the same kind of fire wall operating in Syria. Hezbollah (nominally based in Lebanon) has recently become involved in fighting in Syria in a big way. Iraq started out only involved to the extent that it was looking the other way as Iran sent arms to the Syrian government. That is currently the limit of official government involvement. But unofficially a lot of fighters left over from the Iraq war have moved to Syria. Iran seem to be ratcheting up their involvement and it is hard to see how much support will turn out to be too much. The U.S. and Russia have been increasing their commitment and involvement too. As noted above, the most recent move on the Russian side has been to promise a top tier antiaircraft system. On the U.S. side, we have seen in the past few days that the U.S. is now committed to directly supplying arms. And people like Senator McCain want the U.S. to go much further.
From the U.S. side there has been a significant push for escalation based on the humanitarian problem. The best estimate is that just under a hundred thousand have been killed so far. The humanitarian faction believe that the U.S. can wave some kind of magic wand and cause the slaughter to stop. So Obama is being pushed from the left (oh the humanity) and the right (I never saw a war I couldn't support) to do more. Both sides want contradictory things. Both sides greatly exaggerate the ability of the U.S. to have a positive influence on the outcome. The only thing they agree on is that "the U.S. should do more" but that is enough to move events along. The Russians have their own reasons for escalating their support. But those reasons have been equally effective at greasing the skids for escalation. And its not just within the U.S and Russia that pressure has been building.
There is tremendous pressure in the Arab world. In concert with the pre-World War I European experience, the Arab world has experience dating back to the 1920's with limited wars for limited objectives. And they have lots of experience with "Crusader" wars where the west is heavily involved. Rightly or wrongly this has led to the broadly held belief in the Arab world that "its always the west's fault". This is frequently true. But it is NOT true in the case of Syria. Syria is not a Crusader war. It is a purely Arab on Arab war. The Arab world has no experience with pure Arab on Arab wars. And given this, both sides in Syria will justify anything that goes wrong as "the west's fault". This will allow them to justify almost anything, which in turn will allow them to do almost anything. There will continue to be pressures from multiple directions to continue escalating and no pressure from anyone to wind things down.
Then there is the population boom. There are large numbers of young Arab men all over the Arab world. And these young men live in countries with poorly run economies. So the unemployment rate is high. So there are literally millions of military age Arab men with poor prospects where they are and nothing better to do than go off to participate in a "lovely war" in Syria. And sending large numbers of military age young men off to Syria takes pressure off local governments all over the Arab world. A young man who is off fighting in Syria is not a young man standing around on a local street corner making trouble.
And then there is the fundamental rift of the Arab world, the conflict between Sunnis and Shiites. They have been itching to get at each other for decades. If this sounds like the Germans and the French before World War I, it should. And theoretically they have butted heads before. The Iraq war is one of those times. The minority Sunnis were lording it over the majority Shiites. The U.S. invasion overturned that dynamic. But this example is polluted by the presence of the "Crusader" Americans. And, while Shiites are more populous in Iraq they are less populous in the Arab world as a whole. There have been other examples of Shiite/Sunni conflict before but they have always been polluted by the Crusader influence. So the two groups have not had any recent chance to go at it head to head.
And there has been a small development in Syria that I find very troubling. Historically the Assad family that has led the country has been referred to as being part of the Alawite minority. This made them appear to be neither part of the Sunni nor part of the Shiite factions. But the Alawites long ago split off from the Shiites. Recently Assad's association is being referred to as "Shiite" rather than "Alawite". This puts Assad firmly in the Shiite camp, the camp dominated by Iran. There is a general dislike of Iran in the Arab world because Iran is seen as Persian rather than Arab. But Shiite Arabs are definitely closer to Iran than Sunni Arabs. And Iran is seen as the protector of the minority Shiites against the majority Sunnis. And the Iranians have been strongly supportive of the Assad regime right along.
All this leads me to "be afraid - be very afraid". I think the Syrian war is a long way from being over. And I think it is going to get much bigger and much more ugly as time passes. The roughly hundred thousand fatalities we have seen so far are going to start looking like pocket change. And I would want to do something about this if I was convinced that there was something to do that would be effective. But, unfortunately, I think it's going to get a lot worse before there is a chance of it starting to get better. I think the U.S. is destined to be a peripheral player in all this. We have had too much involvement for too long in various "Crusader" activities to be able to do much good now or for some time in the future. So what should we do?
The good news, and this is definitely very small good news, is that Syria is going to overshadow a lot of other things like Afghanistan. I think Pakistan and the Taliban have booth been looking forward to making a lot of mischief directed at the U.S. as our intervention there winds down. If Syria is blowing as hot as I am concerned that it will be then a lot of energy that would have gone into Afghanistan will be redirected to Syria. This means that Afghanistan has a better chance of sorting itself out and ending up in a positive place than I had previously thought. So my first recommendation is that the U.S. continue to extract itself from Afghanistan.
The second thing I recommend is that we work through proxies with respect to Syria. Lots of people in the Arab world are going to want to point to the U.S. and say the "American Crusaders" are responsible for whatever goes wrong in Syria, and a lot is going to go wrong. The more distance we can put between ourselves and Syria the less effective will be these claims that "America did it". If we are going to arm the insurgents, and I presume we will, we should do it through Turkey or Saudi Arabia or Jordan or whoever. Let them be seen as being the ones providing the arms even if they are U.S. arms.
The third thing we should do is ramp up aid, especially humanitarian aid, to the peripheral countries, particularly Turkey and Jordan. Both counties are currently sheltering large numbers of refugees and neither country can afford it. Jordan has been particularly hard hit. They keep getting hit with large numbers of refugees going all the way back to the 1948 Israeli war of independence. They also got hit with a lot of refugees fleeing the recent Iraq war. They have a small economy and they have been one of our best allies in the Arab world. It is problematic trying to do something for refugees in Iraq or Lebanon so we shouldn't try very hard to help in those countries. Sometimes you really can't help. And the U.S., particularly the media and the public, is very bad at figuring out when we really can't help.
The fourth thing will be very hard to do. If I am right then the violence is going to go much higher than the current horrific level. Other than assisting refugees once they have made it out of the country we should not put much effort into trying to tamp down the war. To the extent we can, and our abilities will most likely be modest, we should try to tilt the outcome in a favorable direction but mostly we need to just let things play out.
Wars end in one of three ways: There can be a complete clean victory for one side. That's what happened in World War II. Second, the war can stumble to an end due to exhaustion. This is what happened in Korea, as I noted above. Finally, outside forces can intervene. This only works for relatively small wars. The classic example is the war between Israel and Egypt for control of the Suez canal in 1956. This was stopped almost single handedly by President Eisenhower.
This third way where someone (and usually people mean the U.S. when they say "someone") steps in, waves a magic wand, and stops a war is what people have wanted the U.S. to do in Syria over the last couple of years and on numerous occasions in the past. It is rarely possible. The U.S. has been trying to broker a peace between the Israelis and the Palestinians for decades and under the direction of numerous Presidents. We haven't succeeded in the Israeli/Palestinian war and we have rarely succeeded elsewhere. If you don't have the overwhelming leverage that Eisenhower did in 1956, it's not going to work. And the Israelis and Egyptians found a way to go to war anyhow in 1967, only 11 years later. So even when it works it often doesn't work very well. But this sorry history doesn't stop the media and "wise heads" agitating over and over for one Administration or another to wave their magic wand and make it stop. If the parties involved actually want to stop and are just looking for a mechanism, an uncommon scenario, then wand waving can work. The rest of the time it is bound to fail.
So the final thing the U.S. should do is prepare for a long and bloody war that is likely to get much bigger and much more ugly than it currently is. We should try as best we can to position ourselves to be in the best position possible when the whole thing eventually burns out. A long time ago (it now seems like a lifetime) there was a list that circulated among IT professionals. Here it is:
The six stages of a project:
- Wild enthusiasm
- Disillusionment as things start going wrong
- Panic and Hysteria about what to do to fix it
- The search for the guilty
- The punishment of the innocent
- The promotion of the uninvolved
I think Syria will follow this model. So our best strategy is to be widely seen as being as uninvolved as we can manage.
Friday, June 14, 2013
Saturday, June 8, 2013
Malicious Phone Calls
I have attacked this general subject before. My first post was http://sigma5.blogspot.com/2012/02/rachel-from-cardholder-services.html dealing with my efforts to do something about the calls from "Rachel from Cardholder Services". Later the FCC announced a contest to solicit ideas for dealing with the problem. So I did a post about that (http://sigma5.blogspot.com/2012/10/fcc-robocall-challenge.html). Since the "FCC" posting I have become quite discouraged. In retrospect my proposal looks quite complicated. Then in the last few days something apparently totally unrelated happened that gives me renewed hope.
It was reported that the secretive NSA, the organization within the Federal Government responsible for collecting and analyzing "Signals Intelligence", was receiving a record of every single phone call made from or to a telephone serviced by the Verizon telephone company for a period of three months. It is since come out that this is a routine procedure. The authorization for the NSA to sweep up this information from Verizon must be renewed every three months. So the specific authorization leaked is one of a series of standard authorizations issued routinely every three months. And it appears that similar requests are made every three months to all the other telephone companies too. So apparently the NSA has a record of every phone call made to or from a U.S. phone number for a period of years.
This revelation is very troubling. Yet it has been coupled with other revelations. It appears that the intelligence community has ways (the details are still being argued about) of getting access to the text of emails, web search histories, pictures, all kinds of web postings (like private blog postings), and other "content" information. It may also be that the actual contents of phone conversations (e.g. if they used Skype or if a leg of the conversation transited an IP phone link) may be available some or all of the time. The official stance of the security services is that spying only takes place if there is a foreigner on one or both ends. But much of the legal opinions, court proceedings, rules and procedures, etc. are top secret. As an example the FBI can issue something called a "National Security Letter". The recipient of one of these is directed to provide all kinds of personal and private information. They are also required to keep the National Security Letter itself a secret. So the target of one of these letters can't even find out that he is the target of the letter, let alone whether the justification for issuing the letter in the first place is valid.
So you can't find out what's going on because it is secret. You can't find out if whoever did it acted legally or properly according to the appropriate laws and regulations because when and how the laws and regulations are applied is secret. In fact, you can't even find out what the laws and regulations say because even that is secret. This situation is correctly described as Kafkaesque (after actions described in a novel called "The Trial" written by Franz Kafka and first published in 1925). The primary legal foundation for these activities lies with a law called the "USA PATRIOT Act" (originally passed in 2001 shortly after 9/11 and reauthorized and updated a couple of times since) and the "FISA Amendments Act" (one of a series of laws relating to "FISA" courts, this specific one was originally passed in 2008 and reauthorized with minor modifications in 2012). The provisions authorized in these laws essentially eviscerate the Fourth Amendment to the U.S. Constitution ("The right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures, shall not be violated, and no Warrants shall issue, but upon probable cause, supported by Oath or affirmation, and particularly describing the place to be searched, and the persons or things to be seized"). I think that major provisions of both acts are completely unconstitutional. But what do I know? As I have remarked elsewhere, (http://sigma5.blogspot.com/2013/01/second-amendment-rights.html), the Constitution means what the Supreme Court says the Constitution means.
And here I am refighting a fight that has been going on at least since the PATRIOT act was first passed. The fact that Congress has chosen by big bipartisan margins to authorize and reauthorize these laws in spite of the many people who agree with me means that it is old news that I am on the wrong side of this argument. In fact, these new revelations have been greeted widely with a reaction of "no big deal" by large segments of the general population, legislators, and the media. So what I want to do instead is move on to an issue that is peripheral to the recent revelations but central to the whole issue of Malicious Phone Calls.
One of the big problems with dealing with "Rachel" and her ilk is the problem of tracing the call. I date back a while. I remember old movies and TV shows where the cops were trying to trace a phone call, say in a kidnapping situation. Back in the old days it would take a couple of minutes to trace a call so if the bad guy hung up quickly enough the cops were foiled. Things progressed to the point where in the movie "Three Days of the Condor" (1975) our hero had to wire together a bunch of pay phones in phone booths (kids: ask your parents if you don't know what I am talking about) to avoid having his calls traced. Theoretically, tracing a call is now a simple and instantaneous process. You just get Caller ID and it tells you what the caller's phone number is. But the "Rachel" people have been able to block (no caller ID shown) or "spoof" (cause a bogus number to be displayed) Caller ID so it doesn't work. I didn't really know how to get around this. So I came up with the complicated plan described in the "FCC" post.
But a detail in the recent NSA revelations indicates that call tracing information is available after the call is completed. Apparently Verizon ships the call data to the NSA about a day after the calls happen. And I am confident that the data the NSA gets includes the real originator of the call. If the bad guys could just block or spoof Caller ID then they would and the data would do the NSA no good. What this means is that in the hunt for "Rachel" nothing has to be done while the call is still in progress. And all the Rachel types have an "instant hangup" device so they can and will cut the call off any time they want. But they can no longer beat the "trace" by just doing an instant hangup. This ability to get usable trace data after the call is over makes everything much simpler.
Having gotten this far, my next thought was to use a telephone "star" code. You know those star-this and star-that codes that do interesting things. For instance, if you dial "*69" it will dial back the person whose call you just missed. Or in the old dial up modem days we would add a "*70" on the front of phone numbers so that your computer session would not be disrupted by a "call waiting" announcement. My thought was to add a new standard star code so that you could report a Rachel call after it ended. But it turns out there is a standard list. You can find it in Wikipedia (where else) in an article titled "Vertical service codes". And we don't have to add a new code. "*57" is defined as "Malicious Caller Identification". "*57" is also sometimes referred to as "MCT - Malicious Call Trace" or, even better, "CAMCT - Caller Activated Malicious Call Trace". This code is perfect for our purposes.
I had never heard of "*57" before so I suspect few people know about it. That leads me to believe its implementation is spotty and inconsistent. But I really don't know. So, on the theory that it is spottily or inconsistently implemented, here's my plan for how it should be implemented:
Basic version
All telephone companies would be required to implement "*57". Whenever a customer received a Malicious call that call would eventually come to an end. After the call ended the customer would, using the same phone line, pick up the handset, get a dial tone, then dial "*57". (On cell phones the user would enter "*57" then hit the "dial" button.) The phone system would recognize the code. This would cause the phone system to locate the call record for the previous call to the same line and instantly forward it to the FCC. The record would be tagged with the phone number of the line that had entered the "*57".
Over time the FCC would accumulate a database of Malicious calls. The call originator would be easily identified. If an originator accumulated a sufficient number of malicious calls then the FCC would investigate and act accordingly. The telephone business is a business. This means that someone "owns" every phone number in the sense that some phone company bills someone for every "in use" phone number. The Malicious call origination data should be aggregated by the person or company that owns the number the call originates from. If I own a thousand numbers then all the Malicious calls that originate from any of those thousand numbers should be bundled together. This would take care of the situation where a Malicious caller distributes the originating numbers over a large group so that no single number stands out. To discourage misbehavior by the phone companies the FCC should allocate Malicious calls from numbers where the owner can't easily be determined to the phone company that controls the number.
This basic version would go a long ways toward a fix to the problem. But more could easily be done.
Advanced version
This would work like the basic version but in addition the caller would be automatically connected to the FCC. We are all familiar with how complex automated answering systems can be so by "FCC" I really mean an automated answering system managed by the FCC. This automated answering system could collect additional data by running the customer down an "answer tree". Here are some ideas for what data could be collected:
With the advanced version it would be possible for a person who received a threatening call from someone under a "no contact" order to "*57" at then end of the call, select the "release the data to law enforcement" option, hang up, then call 911. The 911 operator could then query the FCC database through a "law enforcement" portal and be immediately shown the call information of the released call. I don't know what the current procedure is for these situations but I can't imagine it operates as smoothly, efficiently, or potentially effectively as the scenario I have outlined.
In the case of "Rachel" calls the current procedure is to go to the FCC web site and fill out an online complaint form. But "Rachel" has spoofed or blocked the caller ID, if it is available. And when you get through to a person they do not provide you with the name or contact information of the "Rachel" people. So you don't have the information the FCC needs most to be able to effectively deal with these people. You have to leave key entries in the complaint form blank or enter "don't know".
My "Rachel" calls started years ago. They kind of reached a steady state where I would get a "Rachel" call perhaps once per week. Then the FCC filed suit against 5 "Rachel" companies and things went blissfully quiet for a few months. Then they started back up. Only now besides "Rachel" I get calls from people who want to clean my ducts or drapes or carpets or something else. All these calls are completely illegal. But the people behind these calls know it is extremely unlikely that they will ever be caught. And if they are caught they will receive a slap on the wrist and they can open up again in a few days under a different name. So I now get more of these kinds of calls than ever. And I also get tons of "survey" calls, "political" calls, charitable solicitation calls, and other legal or quasi-legal but quite annoying calls. Its worse than ever.
It was reported that the secretive NSA, the organization within the Federal Government responsible for collecting and analyzing "Signals Intelligence", was receiving a record of every single phone call made from or to a telephone serviced by the Verizon telephone company for a period of three months. It is since come out that this is a routine procedure. The authorization for the NSA to sweep up this information from Verizon must be renewed every three months. So the specific authorization leaked is one of a series of standard authorizations issued routinely every three months. And it appears that similar requests are made every three months to all the other telephone companies too. So apparently the NSA has a record of every phone call made to or from a U.S. phone number for a period of years.
This revelation is very troubling. Yet it has been coupled with other revelations. It appears that the intelligence community has ways (the details are still being argued about) of getting access to the text of emails, web search histories, pictures, all kinds of web postings (like private blog postings), and other "content" information. It may also be that the actual contents of phone conversations (e.g. if they used Skype or if a leg of the conversation transited an IP phone link) may be available some or all of the time. The official stance of the security services is that spying only takes place if there is a foreigner on one or both ends. But much of the legal opinions, court proceedings, rules and procedures, etc. are top secret. As an example the FBI can issue something called a "National Security Letter". The recipient of one of these is directed to provide all kinds of personal and private information. They are also required to keep the National Security Letter itself a secret. So the target of one of these letters can't even find out that he is the target of the letter, let alone whether the justification for issuing the letter in the first place is valid.
So you can't find out what's going on because it is secret. You can't find out if whoever did it acted legally or properly according to the appropriate laws and regulations because when and how the laws and regulations are applied is secret. In fact, you can't even find out what the laws and regulations say because even that is secret. This situation is correctly described as Kafkaesque (after actions described in a novel called "The Trial" written by Franz Kafka and first published in 1925). The primary legal foundation for these activities lies with a law called the "USA PATRIOT Act" (originally passed in 2001 shortly after 9/11 and reauthorized and updated a couple of times since) and the "FISA Amendments Act" (one of a series of laws relating to "FISA" courts, this specific one was originally passed in 2008 and reauthorized with minor modifications in 2012). The provisions authorized in these laws essentially eviscerate the Fourth Amendment to the U.S. Constitution ("The right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures, shall not be violated, and no Warrants shall issue, but upon probable cause, supported by Oath or affirmation, and particularly describing the place to be searched, and the persons or things to be seized"). I think that major provisions of both acts are completely unconstitutional. But what do I know? As I have remarked elsewhere, (http://sigma5.blogspot.com/2013/01/second-amendment-rights.html), the Constitution means what the Supreme Court says the Constitution means.
And here I am refighting a fight that has been going on at least since the PATRIOT act was first passed. The fact that Congress has chosen by big bipartisan margins to authorize and reauthorize these laws in spite of the many people who agree with me means that it is old news that I am on the wrong side of this argument. In fact, these new revelations have been greeted widely with a reaction of "no big deal" by large segments of the general population, legislators, and the media. So what I want to do instead is move on to an issue that is peripheral to the recent revelations but central to the whole issue of Malicious Phone Calls.
One of the big problems with dealing with "Rachel" and her ilk is the problem of tracing the call. I date back a while. I remember old movies and TV shows where the cops were trying to trace a phone call, say in a kidnapping situation. Back in the old days it would take a couple of minutes to trace a call so if the bad guy hung up quickly enough the cops were foiled. Things progressed to the point where in the movie "Three Days of the Condor" (1975) our hero had to wire together a bunch of pay phones in phone booths (kids: ask your parents if you don't know what I am talking about) to avoid having his calls traced. Theoretically, tracing a call is now a simple and instantaneous process. You just get Caller ID and it tells you what the caller's phone number is. But the "Rachel" people have been able to block (no caller ID shown) or "spoof" (cause a bogus number to be displayed) Caller ID so it doesn't work. I didn't really know how to get around this. So I came up with the complicated plan described in the "FCC" post.
But a detail in the recent NSA revelations indicates that call tracing information is available after the call is completed. Apparently Verizon ships the call data to the NSA about a day after the calls happen. And I am confident that the data the NSA gets includes the real originator of the call. If the bad guys could just block or spoof Caller ID then they would and the data would do the NSA no good. What this means is that in the hunt for "Rachel" nothing has to be done while the call is still in progress. And all the Rachel types have an "instant hangup" device so they can and will cut the call off any time they want. But they can no longer beat the "trace" by just doing an instant hangup. This ability to get usable trace data after the call is over makes everything much simpler.
Having gotten this far, my next thought was to use a telephone "star" code. You know those star-this and star-that codes that do interesting things. For instance, if you dial "*69" it will dial back the person whose call you just missed. Or in the old dial up modem days we would add a "*70" on the front of phone numbers so that your computer session would not be disrupted by a "call waiting" announcement. My thought was to add a new standard star code so that you could report a Rachel call after it ended. But it turns out there is a standard list. You can find it in Wikipedia (where else) in an article titled "Vertical service codes". And we don't have to add a new code. "*57" is defined as "Malicious Caller Identification". "*57" is also sometimes referred to as "MCT - Malicious Call Trace" or, even better, "CAMCT - Caller Activated Malicious Call Trace". This code is perfect for our purposes.
I had never heard of "*57" before so I suspect few people know about it. That leads me to believe its implementation is spotty and inconsistent. But I really don't know. So, on the theory that it is spottily or inconsistently implemented, here's my plan for how it should be implemented:
Basic version
All telephone companies would be required to implement "*57". Whenever a customer received a Malicious call that call would eventually come to an end. After the call ended the customer would, using the same phone line, pick up the handset, get a dial tone, then dial "*57". (On cell phones the user would enter "*57" then hit the "dial" button.) The phone system would recognize the code. This would cause the phone system to locate the call record for the previous call to the same line and instantly forward it to the FCC. The record would be tagged with the phone number of the line that had entered the "*57".
Over time the FCC would accumulate a database of Malicious calls. The call originator would be easily identified. If an originator accumulated a sufficient number of malicious calls then the FCC would investigate and act accordingly. The telephone business is a business. This means that someone "owns" every phone number in the sense that some phone company bills someone for every "in use" phone number. The Malicious call origination data should be aggregated by the person or company that owns the number the call originates from. If I own a thousand numbers then all the Malicious calls that originate from any of those thousand numbers should be bundled together. This would take care of the situation where a Malicious caller distributes the originating numbers over a large group so that no single number stands out. To discourage misbehavior by the phone companies the FCC should allocate Malicious calls from numbers where the owner can't easily be determined to the phone company that controls the number.
This basic version would go a long ways toward a fix to the problem. But more could easily be done.
Advanced version
This would work like the basic version but in addition the caller would be automatically connected to the FCC. We are all familiar with how complex automated answering systems can be so by "FCC" I really mean an automated answering system managed by the FCC. This automated answering system could collect additional data by running the customer down an "answer tree". Here are some ideas for what data could be collected:
- Was the caller an individual or a company?
- Was the call associated with a police related matter (e.g. violation of a "no contact" order)?
- Should the information from this call be made available to law enforcement (e.g. authorization to release the information to law enforcement without requiring a search warrant)?
- Was the call associated with a potential scam (e.g. "Rachel")?
- Was it an annoying but probably not illegal call (e.g. survey or charitable solicitation)?
- Did the call appear to be a prank or annoying call rather than a serious threat?
- Does the caller wish to remain anonymous or can the reporter's billing information be forwarded to the FCC?
- Does the caller want to leave a voice message with additional information ("This is a "Rachel" call" or "This is a call from my ex-husband Frank")?
With the advanced version it would be possible for a person who received a threatening call from someone under a "no contact" order to "*57" at then end of the call, select the "release the data to law enforcement" option, hang up, then call 911. The 911 operator could then query the FCC database through a "law enforcement" portal and be immediately shown the call information of the released call. I don't know what the current procedure is for these situations but I can't imagine it operates as smoothly, efficiently, or potentially effectively as the scenario I have outlined.
In the case of "Rachel" calls the current procedure is to go to the FCC web site and fill out an online complaint form. But "Rachel" has spoofed or blocked the caller ID, if it is available. And when you get through to a person they do not provide you with the name or contact information of the "Rachel" people. So you don't have the information the FCC needs most to be able to effectively deal with these people. You have to leave key entries in the complaint form blank or enter "don't know".
My "Rachel" calls started years ago. They kind of reached a steady state where I would get a "Rachel" call perhaps once per week. Then the FCC filed suit against 5 "Rachel" companies and things went blissfully quiet for a few months. Then they started back up. Only now besides "Rachel" I get calls from people who want to clean my ducts or drapes or carpets or something else. All these calls are completely illegal. But the people behind these calls know it is extremely unlikely that they will ever be caught. And if they are caught they will receive a slap on the wrist and they can open up again in a few days under a different name. So I now get more of these kinds of calls than ever. And I also get tons of "survey" calls, "political" calls, charitable solicitation calls, and other legal or quasi-legal but quite annoying calls. Its worse than ever.
Thursday, May 16, 2013
Spies
"You know spies. A bunch of bitchy little girls." - Sam Axe, "Burn Notice"
"Burn Notice" is a pretty typical example of the way spies are depicted in fiction. It is a long running TV show and the quote is from one of the show's first episodes. The quote turned out to be so popular that for years now it has been reprised in the opening credits montage that starts each show. The quote made a small amount of sense in the episode it was included in. Stripped of context it makes no sense at all.
Each episode of "Burn Notice" features the now requisite amount of expended ammunition, car chases, explosions, and other colorful mayhem. Miami is also displayed to advantage. It looks pretty and exotic, a good place to visit on vacation. And have I mentioned the scantily clad "bikini girls" that populate the background of many shots. And, finally, there is the "eye candy" female regular. In this case the assets of Gabrielle Anwar are on display as she expends ammunition, blows things up, etc. What is not on display is the quiet careful acquisition of information.
The details of "Burn Notice" differ from those of say a "James Bond" movie. But they are just that: details. James Bond leaps from location to location around the world. The Burn Notice bunch leap from neighborhood to neighborhood in and around Miami. James Bond drives a sports car model of whatever car company has bought sponsorship for a particular film. The Burn Notice bunch drive the sports car model of whatever car company has bought the "tie in" rights for the season. Lots of bullets are expended. Lots of things are blown up. Lots of time is spent in bars and other locations populated with beautiful people. Lots of alcohol is consumed. In older movies and TV shows, lots of cigarettes would have been consumed.
I like "Burn Notice" and other spy movies and TV shows that hew to this time tested trope. It's fun to watch beautiful people behaving badly. And the script is always contrived so that we have good guys to root for as they take down the bad guys. And the fact that the bad guys are so bad justifies all the bad things (e.g. kill people, blow things up, sleep with women they are not planning to marry) the good guys (and bad guys) do.
And all this bad behavior is consequence free for the most part. The principle characters suffer a lot (it makes for better drama) but their suffering is almost always solely emotional. Nobody, even the bad guys, suffers a debilitating injury. They either come out scot free, or are killed off, never to be seen again. Oh, occasionally someone suffers a telegenic wound, something resulting in a sling or some plaster, but even that is rare. And in almost all cases (the exceptions are inserted to create a plot twist) the authorities never catch wise. Everyone, good guys and bad, can expend prodigious quantities of ammunition, blow up or burn down all kinds of stuff in a very telegenic matter, drive crazily all over the place, etc. and never be caught or even identified by the authorities.
Ok, but what's the point? The point is that it doesn't work that way in the real world. I have also read dozens of books over the years about real spies in the real world. My most recent read is of "The Way of the Knife" by Mark Mazzetti. And here in the real world the rules are quite different.
Mazzetti's book is about drones; how they came into existence, how they are used, and how they are affecting real world organizations like the CIA and the Pentagon. He has something to say about the turf wars between the Pentagon and the CIA. Drones were invented by the CIA (actually a contractor working for the CIA but that's the same thing in the modern world, another issue that Mazzetti gets into) but quickly also adopted by the Pentagon.
Drones are inextricably tied up in the war on terror. They started out as an intelligence tool. You could now get close up surveillance with TV cameras or use them to intercept cell phone signals, or do other kinds of "electronic" surveillance. Here was a new tool to enable intelligence gathering in all kinds of places that had here to for been completely inaccessible. It was the same kind of revolution that the introduction of the spy satellites brought decades ago.
In the '30s, '40s, and '50s spying on the Soviet Union (as an example) had been nearly impossible. Movement of foreigners was strictly controlled so it was nearly impossible to get a spy within visual range of anything that was not located within one small part of Moscow. Various "spy plane" over flights were tried in the late '40s and '50s. But they were infrequent at best and eventually resulted in the famous Gary Powers U-2 shoot down incident. Starting in the '60s it was possible to fly a satellite that could take pictures over the Soviet Union. They were a long ways up (hundreds of miles) but it was now possible to photographically cover the whole country on a regular basis. This was a vast improvement.
But spy satellites fly high and on a regular schedule determined by the laws of celestial mechanics. So if something was small or well camouflaged or could be hidden under cover when the spy satellite was scheduled to fly over, it could be hidden. Many things like factories or military bases or rocket launch pads are too big and too static to hide. But it was definitely limiting to not be able to get "up close and personal". Drones fixed this problem. They could fly as close as a few hundred feet above the ground. They were usually equipped with a TV camera. But they could also be equipped with all manner of electronic gadgets. The original drone designs were purposefully tilted toward slow designs that could "loiter" near the same spot for many hours. In short, their capabilities were the opposite of those inherent to spy satellites. They were a "complementary" technology. What one was bad at, the other was good at. And in these early "intelligence tool" days they were a good fit in the CIA and a poor fit at the Pentagon.
But, as Mazzetti goes into in some detail, it turns out that the Pentagon needs to know what's going on too. Planning for a big military mission like the Iraq invasion requires a lot of detailed information. Theoretically the Pentagon just goes to the CIA. But the Granada invasion, the Iran hostage rescue, and other events made the Pentagon feel that the CIA was unable or unwilling to do the job. This got the Pentagon, especially and particularly Defense Secretary Rumsfeld, to start thinking that it needed to go into the intelligence gathering business. In other words, the Pentagon felt the need to invade the CIA's turf.
Similarly, the CIA felt the need to invade the Pentagon's turf. After 9/11 the CIA was able to get boots on the ground in Afghanistan much more quickly than the Pentagon. And those boots, a relatively small group of CIA agents and Pentagon special forces under the command of the CIA, were able to gin up a military force and militarily rout the Taliban. This made the Pentagon look very bad. Then the CIA was able to weaponize the drone by adding a Hellfire missile to it. They used this combination to kill bad guys. Power politics the way it is played in D.C. rewarded the CIA for these successful incursions into the traditional turf of the Pentagon. So they wanted more, more, more. Mazzetti concludes that this turning the Pentagon into a mirror image of the CIA and the CIA into a mirror image of the Pentagon is a bad thing. I agree with him.
Mazzetti focuses primarily on the last decade. Leaving the Pentagon aside for the rest of this piece, this struggle within the CIA to determine what its mission is has been going on dating all the way back to the World War II predecessor to the CIA, namely the OSS. The OSS was supposedly based on the British model. But the knock on the OSS as an intelligence organization was that it was too much "Burn Notice" and not enough boring intelligence collection. The nickname of the director of the OSS tells us a lot. He was William "Wild Bill" Donovan. The OSS evolved into the CIA in several steps. It's most famous early director was Allan Dulles who had been an OSS officer during the war. It turned out that the early CIA was notoriously incompetent at doing HUMINT (human intelligence).
Efforts to insert spies into the Soviet Union (the "communist" version of Russia) or even Eastern Europe were frequently "blown" (i.e. all the spies were caught). We later found out that Kim Philby was a Soviet mole that had been successfully placed into the British intelligence system in the '30s. He was best friends with James Jesus Angleton, who had an "all access" security pass in order to hunt CIA traitors. Angleton passed along the details of these operations to Philby who passed them to the Russians who rounded everyone up. This pressured the CIA to engage in stunts. They overthrew the government of Iran in 1953. This effort was so successful that many similar efforts were undertaken in Central and South America in the decades to follow. None of the results were as successful as Iran and some of them (e.g. "Bay of Pigs" invasion of Cuba) were spectacularly unsuccessful.
Another area where the CIA was unsuccessful in its early decades was in the area of assassination. Various assassination attempts were undertaken in the '50s and '60s. As the "Church Commission" Senate investigation later documented they were all unsuccessful. Castro, for instance, failed to smoke the exploding cigar. And this was in spite of the fact that the techniques used to such complete lack of success would have fit nicely into a "Burn Notice" episode. If you want these kinds of things to work it really helps to have a script writer pulling strings in the background.
In contrast to this was the success of "national technical" spying. In the '50s the U.S. Air Force, a wholly owned subsidiary of the Pentagon, began mounting spy plane missions to overfly the Soviet Union. These were initially flown in repurposed military planes like B-29s. But eventually custom planes like the U-2 and later SR-71 were developed. The days of U-2 over flights of the Soviet Union ended abruptly when Francis Gary Powers was shot down. But the U-2 was later used successfully over Cuba (see the "Cuban Missile Crisis") and other less well defended targets. The SR-71 missions are still classified but there are no known instances of it being shot down. The Soviet Union did not say anything publicly about the U-2 over flights until they had shot one down. So far no one has complained about SR-71 over flights. The rule seems to be that "it's too embarrassing to admit is happening until you can actually shoot one down".
In the '60s the U.S. began flying spy satellites. Again the mission was run by the Air Force. Electronic spying is done by the NSA. And, while technically not part of the Pentagon, the NSA's budget comes out of the Pentagon's and the director has always been a military officer, usually an Air Force General. So generally the glory for whatever ELINT (ELectronic INTelligence - frequently referred to as "national technical means") successes we have had have redounded to the benefit of the Pentagon.
All this pushed the CIA away from boring intelligence collection. Another influence was the White House. It didn't matter whether the occupant was a Republican or a Democrat. They all felt hemmed in and the "plausible deniability" of mounting some spectacular CIA stunt was mesmerizing. The White House theory always is "if it's a success - claim credit; if it's a failure - claim it was an 'off the books operation run by an agency gone rogue'". In following the CIA for literally decades I have yet to observe a truly rogue operation. Sure, operations blow up on an all to frequent basis. But whenever the CIA is "going rogue" they seem to be doing something that the White House is known to want done. Part of the CIAs mission seems to occasionally step in as whipping boy and all around blame deflector. I don't know why anybody over the age of 5 is fooled any more by this sort of thing.
This tendency for the CIA to go all "Burn Notice" instead of doing the boring job of intelligence collection is too long standing a pattern to be the result of some transient congruence of the crisis of the moment or the personalities of the current set of players. And I'm convinced that the underlying cause is short term thinking. These CIA operations get green lit because someone sees a big short term benefit. Some regime we don't like will get overthrown. Some bad guy we don't like will get killed. And the theory is always "nothing can possibly go wrong" and even if it does, it was worth trying. And part of this is the whole "plausible deniability" thing.
Remember in "Burn Notice" where the cops never seem to catch on. Well the theory is that the rest of the world will not catch on because of "plausible deniability". The problem is that the deniability is not plausible. In one case here or there people may buy it. But, as in the case of the Iranian revolution, if it works once then there is every reason to try it again somewhere else. And after it has happened in a couple of places it becomes a recognizable pattern. So now everyone knows what is going on even if it isn't. So now we have conspiracy theorists who say "the U.S. did it" even when we didn't. And since we actually did it when we said we didn't in case after case, it now becomes implausible when we deny doing it when we didn't.
There is a famous quotation from "On War" the definitive tome on military strategy by Clausewitz. He said "war is the continuation of policy by other means." This usually interpreted cynically to mean "if you can't get what you want by playing fair, go to war". That is not at all what he had in mind. What he really meant was "The decision to go to war must be seen in the context of the national objectives of a country's foreign policy. If war successfully advances those objectives at an acceptable cost then it a good idea. But if it damages those objectives or if the cost is higher than the benefits then it is a bad idea". Seen this way, going to war because you have been attacked is a good idea. You are defending yourself and your interests from unjustified aggression. But most wars of choice are a bad idea. Even if you win the war you have spent a lot of money, gotten a lot of people killed or injured, damaged a lot of property, lost prestige and the moral high ground, etc. In other words the costs are high. And that's if you win. If you lose the costs are even higher. Rarely are the known costs and possible unknown costs going to be less than the calculated benefit. And the calculated benefit may far exceed the actual benefit. See the second Iraq war as a classic example where the actual benefits turned out to be far smaller than the calculated ones.
I contend that this same "continuation of policy" idea applies equally well to the business of spying. The U.S. part of World War II lasted less than 4 years (December 1941 to August 1945). The OSS could afford to have a short term perspective on its actions. Everyone expected the OSS to shut down at the end of the war, and it did. So they could calculate that "if we blow up this bridge it will shorten the war and whatever happens after the war doesn't count". And this would be a reasonable calculation that would turn out to be reasonably correct. People didn't hold a grudge against the U.S. because the OSS blew up a bridge in 1944. Lots of people were blowing a lot of stuff up in 1944.
But the cold war lasted about 50 years. And the "war on terror" was not over after 4 years. We still have no idea when it will be over. So the cost/benefit calculus is far different when the CIA goes all "Burn Notice". The 1953 overthrow of Iran came back to haunt the U.S. in 1978/79 when the Iranians threw out the Shah, the guy we installed in 1953. So the blow back happened 35 years later. The long history of U.S. backed revolutions still haunts U.S. relations in Central and South America today, decades after the last CIA backed revolution. People have long memories for this kind of stuff. And then they put it in their history books and it influences generations.
I am very saddened by the militarization of the CIA for the umpteenth time. It makes it much harder to actually do the job of collecting intelligence. It is already hard enough. First, there is the problem that no one wants to pay for intelligence on "quiet" spots (like Egypt and Tunisia before the Arab Spring) or allies (like Iran under the Shah). Then they don't want to listen to you if you try to tell them things they don't want to hear (I have a bad feeling about what's going to happen in this "quiet" spot). Then "allies" and, for that matter enemies, don't like to be spied upon. (See trying to infiltrate the Soviet Union above as an example.) And the best way to do intelligence collecting involves acting slowly and carefully over a long period of time. But all Washington cares about is the crisis of the minute.
In Mazzetti's book he talks about the CIA parachuting (figuratively, not actually) agents into Pakistan after the Afghan war started up. The problem (among many) was that none of these people knew anything about Pakistan. They didn't understand the language (actually several languages were useful) or the culture. (A key figure in Mazzetti's book was a South American specialist. There were few Catholics who spoke Spanish in Pakistan.) No one should be surprised that these people did not exactly cover themselves in glory. What we needed were people who could blend in (e.g. brown people - not white people) and who understood the language and culture. But we didn't have any of these. (The obvious solution of recruiting people to spy for us from the U.S. population of people of Pakistani descent was impossible for political reasons.) Unfortunately, I see the CIA as having yet again gone down the wrong path. And I don't see any evidence that the intelligence community or the politicians that support them are willing or even able to learn from past mistakes.
So how should it be done? It is possible to get this sort of thing done right. And I would point to the Gates Foundation as an example of how to do things right. They are not in the spy business. But they are in the business of dealing with peoples and cultures around the world through their Global Health Initiative. And specifically I want to talk about their Polio program. The Gates Foundation has been working on Polio for many years. They have had a lot of success. The number of new Polio cases in the world is tiny compared to what it was a decade or so ago. But it is not zero and that's the goal.
The Polio solution looks simple. Just vaccinate everybody. If you have the kind of money the Gates Foundation has it would seem that this is not even particularly expensive. Just buy and administer 7 billion series of Polio shots. That would make everyone immune and the problem would be solved. But, surprise, surprise, it's harder than that. Buying enough Polio medicine is easy. Just write a big enough check to Pharma and they will produce the medicine. It's a big check but not so big that it is a problem for the Foundation. The first problem after that is getting the medicine to the patients. Lots of them live on the back side of nowhere where the roads are crappy and there is no refrigeration. This is a hard but solvable problem. You buy some Land Rovers, coolers, etc. and off you go. It's harder and more complicated than that but you get the idea. It's still not a big enough problem that the Foundation can't solve it.
Those are essentially business/technology problems. But they are not the really hard problems. The really hard problems are people problems. Throwing money or technology at these problem does not even make a small dent. You need to get the vaccine to places that hate westerners. You need to get the vaccine to places where the local medical infrastructure looks to us like a Witch Doctor. You need to get the medicine to places where there is a serious hard core war going on. And when I talk about "war" I mean child soldiers, rape as a military strategy, genocide, etc. These are not "oh what a lovely war" wars. They are not even "trench war with gas attack" wars like World War I. These are really nasty wars. But unfortunately Polio likes places where these kinds of wars are going on. If you want to 100%, "to the last case", wipe out Polio, and that's what the Gates Foundation wants to do, you have to figure out how to operate effectively in even those places.
The Gates Foundation is serious about wiping Polio out. They have already put a lot of money into the business/technology side of things. They have lined up production capability so that they have all the vaccine they need. They have tuned up the vaccine so that it is easier to transport and deliver to the back side of nowhere. They have figured out that you need to make sure that it goes where it is supposed to go. So they GPS track the vaccine to make sure it actually gets to that fly speck village in the back of beyond. They have tricked up the packaging so that if the vaccine is mishandled (i.e. gets too old or overheats) then an obvious "its bad" symbol appears on the package. In short, they have examined the system from end to end and applied all the technical/business fixes they can think of. But that's the easy part and the Gates Foundation knows it.
At the same time they have put a lot of thought, energy, and effort into the people problems. Step one is to develop a very good working relationship with governments and other power players. And a key to success is understanding the culture. They work very hard to understand and work with the culture. This is not a matter of "insert money here" although I am sure that the money helps. The idea is to try to find a "win/win" strategy. If the local power players come to believe that co-operation with the vaccination program will end up benefitting them politically they are much more likely to co-operate. One tactic is prestige enhancement. If you can convince the local powers that putting in the kind of infrastructure that the Foundation needs will benefit the local politicians then the politicians are more likely to go along.
The Gates Foundation does NOT try to rip out whatever medical infrastructure is already there, even if it is literally Witch Doctors. Instead it sells the idea of beefing up what's already there. They pitch "let us do what we want and you will get a better medical system and everyone will like you". The Gates people literally go to Witch Doctors and say "we want to run this program through you. It will make you more successful which will enhance your position". That's a winning proposition to a Witch Doctor who is used to dealing with westerners who want to toss him out on his ear and replace him with a "foreign doctor". Notice that a common thread here is investing the energy in finding out how the local culture works and then figuring out how to work with it rather than trying to tear it down or make it look bad. And it's NOT Americans parachuted in with little training and no understanding of the local culture. In fact, it's mostly not Americans at all. It's locals.
The Gates organization in all these places is almost entirely made up of locals. They come with those built in credentials of local linguistic and cultural knowledge. This immediately translates to local credibility. And the Gates people listen to the locals. They know what they want to achieve. But they are more than willing to trust the locals to get the details right, to get on with the job in the way that will work the best. This is the strategy they applied in India. India has zillions of languages and cultures. The Gates people have wiped out Polio in India and they did it much more quickly than they thought they could. Governments at the national, regional, and local level feel that they know and can trust the Gates people. That means that when they want to the Gates people can move on to the next project and the next. The Indians see the Gates people as trustworthy people who truly do have the interests of Indians at heart.
Right next door to India is Pakistan. The Gates Foundation is working in Pakistan. Any doubt about that was recently removed when we learned that a number of Pakistani women had been killed while working on the Polio project. It is important to note that the victims were Pakistani and that they were women. These attributes alone indicate the degree of trust between the Pakistani government, and more broadly Pakistani society, and the Gates Foundation. Pakistanis are not going to let the typical "foreign devils" employ their women. And in the context of Pakistani society the Gates people decided that Pakistani women would be more effective in getting people vaccinated because they would be perceived as trustworthy and non-threatening.
Contrast that with how the CIA is viewed in Pakistan and the contrast could not be more striking. The long term, culturally sensitive strategy of the Gates Foundation is working a lot better than the "Burn Notice", culturally ignorant strategy of the CIA. The U.S. military will be substantially out of Afghanistan in about 18 months. Based on past experience I would expect that at about the same time the footprint of the CIA in Pakistan will shrink away to almost nothing. I have no doubt that the Gates Foundation will be active in Pakistan many years afterward, even if the Gates Foundation succeeds in eradicating Polio. It would be nice to think that once the fire of war is no longer burning hotly next door in Afghanistan the CIA would have the time, resources, and inclination to install people with the appropriate training and attitude to replace the current "Burn Notice" bunch. But which organization is likely to have a deeper and more thorough understanding of Pakistan five or even twenty-five years from now? I wish I was not so confident I knew the answer to that question.
"Burn Notice" is a pretty typical example of the way spies are depicted in fiction. It is a long running TV show and the quote is from one of the show's first episodes. The quote turned out to be so popular that for years now it has been reprised in the opening credits montage that starts each show. The quote made a small amount of sense in the episode it was included in. Stripped of context it makes no sense at all.
Each episode of "Burn Notice" features the now requisite amount of expended ammunition, car chases, explosions, and other colorful mayhem. Miami is also displayed to advantage. It looks pretty and exotic, a good place to visit on vacation. And have I mentioned the scantily clad "bikini girls" that populate the background of many shots. And, finally, there is the "eye candy" female regular. In this case the assets of Gabrielle Anwar are on display as she expends ammunition, blows things up, etc. What is not on display is the quiet careful acquisition of information.
The details of "Burn Notice" differ from those of say a "James Bond" movie. But they are just that: details. James Bond leaps from location to location around the world. The Burn Notice bunch leap from neighborhood to neighborhood in and around Miami. James Bond drives a sports car model of whatever car company has bought sponsorship for a particular film. The Burn Notice bunch drive the sports car model of whatever car company has bought the "tie in" rights for the season. Lots of bullets are expended. Lots of things are blown up. Lots of time is spent in bars and other locations populated with beautiful people. Lots of alcohol is consumed. In older movies and TV shows, lots of cigarettes would have been consumed.
I like "Burn Notice" and other spy movies and TV shows that hew to this time tested trope. It's fun to watch beautiful people behaving badly. And the script is always contrived so that we have good guys to root for as they take down the bad guys. And the fact that the bad guys are so bad justifies all the bad things (e.g. kill people, blow things up, sleep with women they are not planning to marry) the good guys (and bad guys) do.
And all this bad behavior is consequence free for the most part. The principle characters suffer a lot (it makes for better drama) but their suffering is almost always solely emotional. Nobody, even the bad guys, suffers a debilitating injury. They either come out scot free, or are killed off, never to be seen again. Oh, occasionally someone suffers a telegenic wound, something resulting in a sling or some plaster, but even that is rare. And in almost all cases (the exceptions are inserted to create a plot twist) the authorities never catch wise. Everyone, good guys and bad, can expend prodigious quantities of ammunition, blow up or burn down all kinds of stuff in a very telegenic matter, drive crazily all over the place, etc. and never be caught or even identified by the authorities.
Ok, but what's the point? The point is that it doesn't work that way in the real world. I have also read dozens of books over the years about real spies in the real world. My most recent read is of "The Way of the Knife" by Mark Mazzetti. And here in the real world the rules are quite different.
Mazzetti's book is about drones; how they came into existence, how they are used, and how they are affecting real world organizations like the CIA and the Pentagon. He has something to say about the turf wars between the Pentagon and the CIA. Drones were invented by the CIA (actually a contractor working for the CIA but that's the same thing in the modern world, another issue that Mazzetti gets into) but quickly also adopted by the Pentagon.
Drones are inextricably tied up in the war on terror. They started out as an intelligence tool. You could now get close up surveillance with TV cameras or use them to intercept cell phone signals, or do other kinds of "electronic" surveillance. Here was a new tool to enable intelligence gathering in all kinds of places that had here to for been completely inaccessible. It was the same kind of revolution that the introduction of the spy satellites brought decades ago.
In the '30s, '40s, and '50s spying on the Soviet Union (as an example) had been nearly impossible. Movement of foreigners was strictly controlled so it was nearly impossible to get a spy within visual range of anything that was not located within one small part of Moscow. Various "spy plane" over flights were tried in the late '40s and '50s. But they were infrequent at best and eventually resulted in the famous Gary Powers U-2 shoot down incident. Starting in the '60s it was possible to fly a satellite that could take pictures over the Soviet Union. They were a long ways up (hundreds of miles) but it was now possible to photographically cover the whole country on a regular basis. This was a vast improvement.
But spy satellites fly high and on a regular schedule determined by the laws of celestial mechanics. So if something was small or well camouflaged or could be hidden under cover when the spy satellite was scheduled to fly over, it could be hidden. Many things like factories or military bases or rocket launch pads are too big and too static to hide. But it was definitely limiting to not be able to get "up close and personal". Drones fixed this problem. They could fly as close as a few hundred feet above the ground. They were usually equipped with a TV camera. But they could also be equipped with all manner of electronic gadgets. The original drone designs were purposefully tilted toward slow designs that could "loiter" near the same spot for many hours. In short, their capabilities were the opposite of those inherent to spy satellites. They were a "complementary" technology. What one was bad at, the other was good at. And in these early "intelligence tool" days they were a good fit in the CIA and a poor fit at the Pentagon.
But, as Mazzetti goes into in some detail, it turns out that the Pentagon needs to know what's going on too. Planning for a big military mission like the Iraq invasion requires a lot of detailed information. Theoretically the Pentagon just goes to the CIA. But the Granada invasion, the Iran hostage rescue, and other events made the Pentagon feel that the CIA was unable or unwilling to do the job. This got the Pentagon, especially and particularly Defense Secretary Rumsfeld, to start thinking that it needed to go into the intelligence gathering business. In other words, the Pentagon felt the need to invade the CIA's turf.
Similarly, the CIA felt the need to invade the Pentagon's turf. After 9/11 the CIA was able to get boots on the ground in Afghanistan much more quickly than the Pentagon. And those boots, a relatively small group of CIA agents and Pentagon special forces under the command of the CIA, were able to gin up a military force and militarily rout the Taliban. This made the Pentagon look very bad. Then the CIA was able to weaponize the drone by adding a Hellfire missile to it. They used this combination to kill bad guys. Power politics the way it is played in D.C. rewarded the CIA for these successful incursions into the traditional turf of the Pentagon. So they wanted more, more, more. Mazzetti concludes that this turning the Pentagon into a mirror image of the CIA and the CIA into a mirror image of the Pentagon is a bad thing. I agree with him.
Mazzetti focuses primarily on the last decade. Leaving the Pentagon aside for the rest of this piece, this struggle within the CIA to determine what its mission is has been going on dating all the way back to the World War II predecessor to the CIA, namely the OSS. The OSS was supposedly based on the British model. But the knock on the OSS as an intelligence organization was that it was too much "Burn Notice" and not enough boring intelligence collection. The nickname of the director of the OSS tells us a lot. He was William "Wild Bill" Donovan. The OSS evolved into the CIA in several steps. It's most famous early director was Allan Dulles who had been an OSS officer during the war. It turned out that the early CIA was notoriously incompetent at doing HUMINT (human intelligence).
Efforts to insert spies into the Soviet Union (the "communist" version of Russia) or even Eastern Europe were frequently "blown" (i.e. all the spies were caught). We later found out that Kim Philby was a Soviet mole that had been successfully placed into the British intelligence system in the '30s. He was best friends with James Jesus Angleton, who had an "all access" security pass in order to hunt CIA traitors. Angleton passed along the details of these operations to Philby who passed them to the Russians who rounded everyone up. This pressured the CIA to engage in stunts. They overthrew the government of Iran in 1953. This effort was so successful that many similar efforts were undertaken in Central and South America in the decades to follow. None of the results were as successful as Iran and some of them (e.g. "Bay of Pigs" invasion of Cuba) were spectacularly unsuccessful.
Another area where the CIA was unsuccessful in its early decades was in the area of assassination. Various assassination attempts were undertaken in the '50s and '60s. As the "Church Commission" Senate investigation later documented they were all unsuccessful. Castro, for instance, failed to smoke the exploding cigar. And this was in spite of the fact that the techniques used to such complete lack of success would have fit nicely into a "Burn Notice" episode. If you want these kinds of things to work it really helps to have a script writer pulling strings in the background.
In contrast to this was the success of "national technical" spying. In the '50s the U.S. Air Force, a wholly owned subsidiary of the Pentagon, began mounting spy plane missions to overfly the Soviet Union. These were initially flown in repurposed military planes like B-29s. But eventually custom planes like the U-2 and later SR-71 were developed. The days of U-2 over flights of the Soviet Union ended abruptly when Francis Gary Powers was shot down. But the U-2 was later used successfully over Cuba (see the "Cuban Missile Crisis") and other less well defended targets. The SR-71 missions are still classified but there are no known instances of it being shot down. The Soviet Union did not say anything publicly about the U-2 over flights until they had shot one down. So far no one has complained about SR-71 over flights. The rule seems to be that "it's too embarrassing to admit is happening until you can actually shoot one down".
In the '60s the U.S. began flying spy satellites. Again the mission was run by the Air Force. Electronic spying is done by the NSA. And, while technically not part of the Pentagon, the NSA's budget comes out of the Pentagon's and the director has always been a military officer, usually an Air Force General. So generally the glory for whatever ELINT (ELectronic INTelligence - frequently referred to as "national technical means") successes we have had have redounded to the benefit of the Pentagon.
All this pushed the CIA away from boring intelligence collection. Another influence was the White House. It didn't matter whether the occupant was a Republican or a Democrat. They all felt hemmed in and the "plausible deniability" of mounting some spectacular CIA stunt was mesmerizing. The White House theory always is "if it's a success - claim credit; if it's a failure - claim it was an 'off the books operation run by an agency gone rogue'". In following the CIA for literally decades I have yet to observe a truly rogue operation. Sure, operations blow up on an all to frequent basis. But whenever the CIA is "going rogue" they seem to be doing something that the White House is known to want done. Part of the CIAs mission seems to occasionally step in as whipping boy and all around blame deflector. I don't know why anybody over the age of 5 is fooled any more by this sort of thing.
This tendency for the CIA to go all "Burn Notice" instead of doing the boring job of intelligence collection is too long standing a pattern to be the result of some transient congruence of the crisis of the moment or the personalities of the current set of players. And I'm convinced that the underlying cause is short term thinking. These CIA operations get green lit because someone sees a big short term benefit. Some regime we don't like will get overthrown. Some bad guy we don't like will get killed. And the theory is always "nothing can possibly go wrong" and even if it does, it was worth trying. And part of this is the whole "plausible deniability" thing.
Remember in "Burn Notice" where the cops never seem to catch on. Well the theory is that the rest of the world will not catch on because of "plausible deniability". The problem is that the deniability is not plausible. In one case here or there people may buy it. But, as in the case of the Iranian revolution, if it works once then there is every reason to try it again somewhere else. And after it has happened in a couple of places it becomes a recognizable pattern. So now everyone knows what is going on even if it isn't. So now we have conspiracy theorists who say "the U.S. did it" even when we didn't. And since we actually did it when we said we didn't in case after case, it now becomes implausible when we deny doing it when we didn't.
There is a famous quotation from "On War" the definitive tome on military strategy by Clausewitz. He said "war is the continuation of policy by other means." This usually interpreted cynically to mean "if you can't get what you want by playing fair, go to war". That is not at all what he had in mind. What he really meant was "The decision to go to war must be seen in the context of the national objectives of a country's foreign policy. If war successfully advances those objectives at an acceptable cost then it a good idea. But if it damages those objectives or if the cost is higher than the benefits then it is a bad idea". Seen this way, going to war because you have been attacked is a good idea. You are defending yourself and your interests from unjustified aggression. But most wars of choice are a bad idea. Even if you win the war you have spent a lot of money, gotten a lot of people killed or injured, damaged a lot of property, lost prestige and the moral high ground, etc. In other words the costs are high. And that's if you win. If you lose the costs are even higher. Rarely are the known costs and possible unknown costs going to be less than the calculated benefit. And the calculated benefit may far exceed the actual benefit. See the second Iraq war as a classic example where the actual benefits turned out to be far smaller than the calculated ones.
I contend that this same "continuation of policy" idea applies equally well to the business of spying. The U.S. part of World War II lasted less than 4 years (December 1941 to August 1945). The OSS could afford to have a short term perspective on its actions. Everyone expected the OSS to shut down at the end of the war, and it did. So they could calculate that "if we blow up this bridge it will shorten the war and whatever happens after the war doesn't count". And this would be a reasonable calculation that would turn out to be reasonably correct. People didn't hold a grudge against the U.S. because the OSS blew up a bridge in 1944. Lots of people were blowing a lot of stuff up in 1944.
But the cold war lasted about 50 years. And the "war on terror" was not over after 4 years. We still have no idea when it will be over. So the cost/benefit calculus is far different when the CIA goes all "Burn Notice". The 1953 overthrow of Iran came back to haunt the U.S. in 1978/79 when the Iranians threw out the Shah, the guy we installed in 1953. So the blow back happened 35 years later. The long history of U.S. backed revolutions still haunts U.S. relations in Central and South America today, decades after the last CIA backed revolution. People have long memories for this kind of stuff. And then they put it in their history books and it influences generations.
I am very saddened by the militarization of the CIA for the umpteenth time. It makes it much harder to actually do the job of collecting intelligence. It is already hard enough. First, there is the problem that no one wants to pay for intelligence on "quiet" spots (like Egypt and Tunisia before the Arab Spring) or allies (like Iran under the Shah). Then they don't want to listen to you if you try to tell them things they don't want to hear (I have a bad feeling about what's going to happen in this "quiet" spot). Then "allies" and, for that matter enemies, don't like to be spied upon. (See trying to infiltrate the Soviet Union above as an example.) And the best way to do intelligence collecting involves acting slowly and carefully over a long period of time. But all Washington cares about is the crisis of the minute.
In Mazzetti's book he talks about the CIA parachuting (figuratively, not actually) agents into Pakistan after the Afghan war started up. The problem (among many) was that none of these people knew anything about Pakistan. They didn't understand the language (actually several languages were useful) or the culture. (A key figure in Mazzetti's book was a South American specialist. There were few Catholics who spoke Spanish in Pakistan.) No one should be surprised that these people did not exactly cover themselves in glory. What we needed were people who could blend in (e.g. brown people - not white people) and who understood the language and culture. But we didn't have any of these. (The obvious solution of recruiting people to spy for us from the U.S. population of people of Pakistani descent was impossible for political reasons.) Unfortunately, I see the CIA as having yet again gone down the wrong path. And I don't see any evidence that the intelligence community or the politicians that support them are willing or even able to learn from past mistakes.
So how should it be done? It is possible to get this sort of thing done right. And I would point to the Gates Foundation as an example of how to do things right. They are not in the spy business. But they are in the business of dealing with peoples and cultures around the world through their Global Health Initiative. And specifically I want to talk about their Polio program. The Gates Foundation has been working on Polio for many years. They have had a lot of success. The number of new Polio cases in the world is tiny compared to what it was a decade or so ago. But it is not zero and that's the goal.
The Polio solution looks simple. Just vaccinate everybody. If you have the kind of money the Gates Foundation has it would seem that this is not even particularly expensive. Just buy and administer 7 billion series of Polio shots. That would make everyone immune and the problem would be solved. But, surprise, surprise, it's harder than that. Buying enough Polio medicine is easy. Just write a big enough check to Pharma and they will produce the medicine. It's a big check but not so big that it is a problem for the Foundation. The first problem after that is getting the medicine to the patients. Lots of them live on the back side of nowhere where the roads are crappy and there is no refrigeration. This is a hard but solvable problem. You buy some Land Rovers, coolers, etc. and off you go. It's harder and more complicated than that but you get the idea. It's still not a big enough problem that the Foundation can't solve it.
Those are essentially business/technology problems. But they are not the really hard problems. The really hard problems are people problems. Throwing money or technology at these problem does not even make a small dent. You need to get the vaccine to places that hate westerners. You need to get the vaccine to places where the local medical infrastructure looks to us like a Witch Doctor. You need to get the medicine to places where there is a serious hard core war going on. And when I talk about "war" I mean child soldiers, rape as a military strategy, genocide, etc. These are not "oh what a lovely war" wars. They are not even "trench war with gas attack" wars like World War I. These are really nasty wars. But unfortunately Polio likes places where these kinds of wars are going on. If you want to 100%, "to the last case", wipe out Polio, and that's what the Gates Foundation wants to do, you have to figure out how to operate effectively in even those places.
The Gates Foundation is serious about wiping Polio out. They have already put a lot of money into the business/technology side of things. They have lined up production capability so that they have all the vaccine they need. They have tuned up the vaccine so that it is easier to transport and deliver to the back side of nowhere. They have figured out that you need to make sure that it goes where it is supposed to go. So they GPS track the vaccine to make sure it actually gets to that fly speck village in the back of beyond. They have tricked up the packaging so that if the vaccine is mishandled (i.e. gets too old or overheats) then an obvious "its bad" symbol appears on the package. In short, they have examined the system from end to end and applied all the technical/business fixes they can think of. But that's the easy part and the Gates Foundation knows it.
At the same time they have put a lot of thought, energy, and effort into the people problems. Step one is to develop a very good working relationship with governments and other power players. And a key to success is understanding the culture. They work very hard to understand and work with the culture. This is not a matter of "insert money here" although I am sure that the money helps. The idea is to try to find a "win/win" strategy. If the local power players come to believe that co-operation with the vaccination program will end up benefitting them politically they are much more likely to co-operate. One tactic is prestige enhancement. If you can convince the local powers that putting in the kind of infrastructure that the Foundation needs will benefit the local politicians then the politicians are more likely to go along.
The Gates Foundation does NOT try to rip out whatever medical infrastructure is already there, even if it is literally Witch Doctors. Instead it sells the idea of beefing up what's already there. They pitch "let us do what we want and you will get a better medical system and everyone will like you". The Gates people literally go to Witch Doctors and say "we want to run this program through you. It will make you more successful which will enhance your position". That's a winning proposition to a Witch Doctor who is used to dealing with westerners who want to toss him out on his ear and replace him with a "foreign doctor". Notice that a common thread here is investing the energy in finding out how the local culture works and then figuring out how to work with it rather than trying to tear it down or make it look bad. And it's NOT Americans parachuted in with little training and no understanding of the local culture. In fact, it's mostly not Americans at all. It's locals.
The Gates organization in all these places is almost entirely made up of locals. They come with those built in credentials of local linguistic and cultural knowledge. This immediately translates to local credibility. And the Gates people listen to the locals. They know what they want to achieve. But they are more than willing to trust the locals to get the details right, to get on with the job in the way that will work the best. This is the strategy they applied in India. India has zillions of languages and cultures. The Gates people have wiped out Polio in India and they did it much more quickly than they thought they could. Governments at the national, regional, and local level feel that they know and can trust the Gates people. That means that when they want to the Gates people can move on to the next project and the next. The Indians see the Gates people as trustworthy people who truly do have the interests of Indians at heart.
Right next door to India is Pakistan. The Gates Foundation is working in Pakistan. Any doubt about that was recently removed when we learned that a number of Pakistani women had been killed while working on the Polio project. It is important to note that the victims were Pakistani and that they were women. These attributes alone indicate the degree of trust between the Pakistani government, and more broadly Pakistani society, and the Gates Foundation. Pakistanis are not going to let the typical "foreign devils" employ their women. And in the context of Pakistani society the Gates people decided that Pakistani women would be more effective in getting people vaccinated because they would be perceived as trustworthy and non-threatening.
Contrast that with how the CIA is viewed in Pakistan and the contrast could not be more striking. The long term, culturally sensitive strategy of the Gates Foundation is working a lot better than the "Burn Notice", culturally ignorant strategy of the CIA. The U.S. military will be substantially out of Afghanistan in about 18 months. Based on past experience I would expect that at about the same time the footprint of the CIA in Pakistan will shrink away to almost nothing. I have no doubt that the Gates Foundation will be active in Pakistan many years afterward, even if the Gates Foundation succeeds in eradicating Polio. It would be nice to think that once the fire of war is no longer burning hotly next door in Afghanistan the CIA would have the time, resources, and inclination to install people with the appropriate training and attitude to replace the current "Burn Notice" bunch. But which organization is likely to have a deeper and more thorough understanding of Pakistan five or even twenty-five years from now? I wish I was not so confident I knew the answer to that question.
Sunday, April 21, 2013
Speculative Bubbles (Part 2 of 2)
In Part 1 I talked about one of the "bubbles" David Stockman talks about in interviews about his new book. The whole post can be found at http://sigma5.blogspot.com/2013/04/speculative-bubbles-part-1-of-2.html. In this second post I will talk about the other two items in Stockman's "bubble" list. The first one is the mortgage bubble.
My father was born in 1910. The house he grew up in was built in the same year, 1910. About 25 years later his father died at the height of the Great Depression and my father became responsible for the family finances. The house had originally cost $5,000. In the middle of the Great Depression it was again valued at $5,000. And it turned out that the mortgage on the house was an "interest only" mortgage. There was still $5,000 owing on the mortgage. Fortunately, my father had a good job and no wife and kids. He was able to get the house completely paid off within a couple of years and the family lived in the house for many more years.
But a lot of depression era families did not do so well. They end up having similar mortgage situations but did not have the financial wherewithal to weather the storm. So they ended up losing their houses. This caused the Roosevelt administration to put in rules requiring 20% down for a conventional mortgage. This rule resulted in a stable but boring mortgage market for more than 50 years. It also meant that a lot of people couldn't qualify. Do gooders, who wanted to get more people into home ownership, combined with mortgage industry lobbyists, who wanted to do more business. The result was a loosening of mortgage regulations in several stages. The anti-regulation crowd also chipped in to weaken the powers of the agencies that oversaw the regulated part of the market. They also made sure that efforts to extend regulation and supervision to the (by the '90s) fast growing unregulated segment of the market were thwarted. The result was a "wild west" mortgage market where "anything goes".
I paid 20% down when I bought my house in the early '80s. That later became a thing of the past. The "minimum down" was reduced to 10%, 5%, 3%, and eventually in some cases to "nothing down". And the mortgage market has always been segmented. Besides regular mortgages there are FHA mortgages that have slightly different rules but you had to meet certain criteria to qualify. Then there was the "jumbo" market. The federal agencies that were market makers for mortgages FannieMae (actually the FNMA - you don't want to know what the acronym stands for) and FreddieMac (again an acronym for who cares what) would only take mortgages up to a certain size (I don't know why). Mortgages that exceeded the limit were called Jumbos. This all made some small kind of sense.
Then there were Alt-A mortgages. These were mortgages to people who did not have the financial resources (down payment, income, credit history) to qualify for one of the more standard kinds of mortgages. These mortgages were viewed as substantially more risky than the other kinds. As a result the interest rate charged the borrower was substantially higher than for the other kinds of mortgages. For a long time the Alt-A mortgage market was very small. Most lenders concluded that the reward (higher interest rate) did not justify the additional risk (that the buyer would default on the mortgage) so for a long time very few Alt-A mortgages were made.
There was a slow broad societal change that happened in the second half of the twentieth century. The number of people that lived in the typical house went down. People had smaller families. Older people stayed in their houses after the kids moved out. Single people bought houses. All these trends combined to reduce the average number of people living in a typical house. What this meant was that more houses needed to be built than population growth would indicate. So the housing industry saw prolonged steady growth. This growth tended to keep the price of houses higher than they otherwise would have been. For a long period of time the value of a house ticked up regularly as clockwork year after year. Initially it was a small increase but it was steady.
Then speculators started moving in. It looked like a safe investment to buy a house and then rent it out. The worst thing that could happen is that you would be unsuccessful at finding renters. In this case you just sold the house and perhaps took a small loss. In other words, investing in houses looked like it was low risk. So a lot of people did it and this too propped up housing prices.
Theoretically the risk of default was rising as the size of the down payment dropped. But things did not turn out that way in practice. If someone found that they could not afford their house they could always sell it. The proceeds would cover the mortgage and there would be no default. This even worked if the down payment was pretty small. The increase in the value of the house plus the amount of the small down payment would almost always be enough to cover the remaining balance on the mortgage. As a result perceptions in the mortgage industry changed. "Risky" mortgages were no longer very risky. This meant that Alt-A mortgages were a good deal for the investor. The actual higher return from the high interest rate more than balanced out the now small risk of losing money in case of default. This made Alt-A mortgages actually preferable to a regular mortgage. Both mortgages were low risk but the Alt-A mortgage had a much higher rate of return.
So all of a sudden Alt-A mortgages are a desirable investment. This was coupled with another trend. This trend was internal to Wall Street. For decades Wall Street made a nice living on stock transactions. The fee for a particular transaction was fixed. As computerization took over the cost of executing the transaction plummeted. This nice racket came to an abrupt end when the fixed commission system was scrapped. Now commission rates were negotiated. And the large players got very good deals. Smaller players did not do so well but fees became common knowledge and small investors shopped around. It didn't take long for the profit in handling stock trades to dry up and blow away for all but the most efficient operators.
A second similar blow was struck a few years ago. Most stock prices were quoted in dollars and eighths (12 and 1/2 cents). So prices had to be rounded to the nearest eighth. And there is the "bid" and "asked" prices. They always differ by at least an eighth. This allowed for profit to be made on the eighth point "spread". It wasn't much but it added up. Then the exchanges went to dollars and cents pricing. This dropped the spread to a penny, less than a tenth of what it had been. This took more money out of the "profit" column on Wall Street. All this made Wall Street very greedy for profitable businesses. And Alt-A mortgages seemed made to order. Assuming that the "low risk" assessment was correct, then the high interest rate made for a compelling argument. Wall Street's appetite for Alt-A mortgages became voracious.
The result was a giant unregulated mortgage industry specializing in Alt-A mortgages. And did I mention that this industry was unregulated? Fraud soon became rampant. Many people who could qualify for a standard mortgage were pushed into an Alt-A mortgage. Why? Because Wall Street wanted Alt-A mortgages. And Wall Street wanted the worst Alt-A mortgages that could be created. Why? The worse the mortgage, the higher the interest rate. And they were no risk (well technically low risk but lets not sweat the details). It didn't matter whether the borrower could afford the mortgage because it would not default. The worst that would happen is that it would need to be "rolled over" into a new mortgage.
In this market housing prices started rising very fast, sometimes by as much as 10% per year in some markets. This made the "there's no such thing as a bad Alt-A mortgage" argument just that much stronger. And the best way to insure that a large stream of bad Alt-A mortgages was available was to deal with crooks. Now it's theoretically bad to deal with crooks. But Wall Street's solution to that problem was to erect tall strong barriers to block them from officially hearing anything about crookedness or dirty dealing.
This "tall strong barrier" strategy worked so well that large Wall Street firms bought several of the largest crooked mortgage originators. And they paid top dollar for them. The result has been write downs of many billions of dollars as a result of these investments. And this is after arranging "settlements" in which no wrongdoing is admitted but fines, in some cases amounting to billions of dollars, are paid. But the fines represent pennies on the dollar for the fraudulent activity covered by the "settlement". The level of fraud involved in the mortgage industry, especially in 2000 and later, causes me to put the mortgage bubble into the "artificial" or fraud-based category of bubble. The mortgage bubble and the financial meltdown bubble are closely tied up with each other. So I am arbitrarily cut my discussion of the mortgage bubble off here and move on to the financial crisis bubble now.
I have already covered some of the relevant territory. As noted above, Wall Street has become increasingly desperate to find lines of business that are both high volume and offer big profit margins. As an industry it has become so large that it now needs a lot of business and the business must be very profitable. Otherwise it can't afford to pay bonuses, which in some cases amount to over a billion dollars to one individual for one year's work. Making bonus pools that run to tens of billions of dollars per year for a single company look like just some small overhead cost requires that cash flow amount to literally trillions of dollars. There just aren't that many markets that are big enough to make a difference.
Also, as indicated above, this led Wall Street to the Alt-A mortgage business. A Wall Street firm would buy up a bundle of mortgages (frequently a thousand or more) and bundle them up into a large investment called an MBS (Mortgage Backed Security). They would then split the MBS into shares and sell them to investors. This was a nice little business. Each MBS was like an IPO so various fees and surcharges could be assessed. And they sold themselves because they promised a high interest rate. But it was not enough. There just wasn't enough volume in MBSs, like there wasn't enough volume in IPOs to generate the profit Wall Street firms now felt they needed. And, because it will set things up for later, let me now turn to a small problem Wall Street saw.
Lots of investors are "blue chip" investors. They want (or are required by law) very low risk. The lowest risk investment is one that is rated AAA (usually pronounced triple-A). The AAA comes from a "ratings agency". The big three are Standard & Poor's, Moody's, and Fitch. They use different codes but "AAA" is usually short hand for a top (most safe) rating from one of the "big three". An investment in IBM stock is not an AAA rated investment. Stocks, even the best ones, go up and down. They involve risk. An IBM bond, on the other hand, might be AAA rated. This is because if there is a problem the company is required by law to pay off bond holders before stock holders and many other kinds of creditors. IBM AAA bonds are "senior debt" because the call the bond holder has on the assets of the company is "senior" (comes first) to the call others have on the assets of the same company. Most bonds, even those of big stable companies are not AAA. They are some other lower but "investment grade" rating like AA. Getting an investment rated AAA is a big deal that historically hasn't happened that frequently.
And that's the problem with an MBS. It's not AAA. But wouldn't it be nice if it was AAA? Then the seller of the MBS could market it to all those finicky investors that want or need AAA securities. Wall Street figured out a way to turn an MBS into an AAA security. The vehicle for this is something called a CDO (Collateralized Debt Obligation). What's a CDO? Well it is almost anything. It's an investment you can sell like an IPO or an MBS. But what's in it? In the case of an IPO what's in it is the stock of a specific new company. In the case of an MBS it's a specific list of mortgages. The details are different but the general idea is the same with an IPO and an MBS. The value of your investment rises or falls based on how well the company (IPO) or package of mortgages averaged together (MBS) does. In the case of the CDO what's inside is any kind of "Debt Obligation" that is "Collateralized". It no longer has to be a specific class of thing like a mortgage or a stock.
There has to be something deep down there that can serve as collateral and the something must be some kind of debt. But after that, it can be pretty much anything. It can be an MBS (or part of one), for instance. It can be a bundle of credit card receipts or car loans or other things. You just have to specify what the "debt obligations" are. You can even have a CDO inside a CDO (nickname: CDO squared). So the first step is to decide what to put into a CDO. And here is where something called "tranches" come in. You take one of these investments and slice it up. Each slice is called a tranche. The trick is in the slicing rule. You don't just take the first hundred of the thousand mortgages in a MBS and call it "tranche 1". You use a rule to rate each mortgage. Then you use the rating to determine the tranche. Why do this? We'll see in a minute.
Anyhow Wall Street took a bunch of say MBSs and then tranched them. The put all of the "tranche 1" components from all of the MBSs into the first CDO. Then they put all the "tranche 2" components into the second CDO, and so on. Then they sold each CDO separately. Why? The ratings agencies. Say what? Remember a long time ago we were talking about AAA securities. All this was done to create securities that the ratings agencies would rate AAA. In actuality, as I understand it, things were typically put into only three tranches. And the "tranche rule" for MBS securities is something like "the first 10% of the mortgages that default" goes into the "junk" tranche. The "mezzanine" tranche consists of the next 10% of mortgages that default. The "senior" tranche consists of all the rest of the mortgages.
Now look at what we have. How likely is it that 20% of the mortgages are going to default? If it's before 2006 the answer is "indistinguishable from zero". And that's the definition of a AAA security. So when I hire a ratings agency they will give the senior tranche (actually the CDO containing only senior tranches) a AAA rating. I don't know the details but the interest income from the MBSs was no doubt divided up in such a way that the investors in the "junk" CDO got paid a big premium and the investors in the mezzanine CDO got a smaller premium. The interest rate paid by the senior CDO would be a little smaller but what do you expect for a CDO rated AAA. This trick allowed Wall Street to turn 80% or more of each MBS into AAA securities. And these AAA securities paid a much higher interest rate than a regular AAA security. So they flew off the shelf and Wall Street racked up monstrous profits.
Before moving on, remember I mentioned something called a CDO-squared. What's with that? Well let's build a CDO by consolidating a bunch of junk CDOs together. Now given that the underlying default rate on mortgages is roughly zero, let's play the tranche game again. What is the chance that say 20% of this combination of risky CDOs are going to go under? It's pretty small. (Remember this is before 2006). So using this trick you can turn 80% of the worst 10% into AAA securities. And you can play the same game with the mezzanine CDOs too. So you can turn close to 100% of these CDOs based on MBSs into AAA securities. It's just like magic. And like magic we eventually found out it was not real.
So let me move on to the ratings agencies. It's a cut throat business. And guess who selects the ratings agency. It turns out it is the company that is putting together the security (MBS or CDO). So let's say you put together one of these things and you take it to a ratings agency. And let's say they say "well it's not quite AAA". One option you have is to take the exact same package to another ratings agency and they might give it their AAA stamp of approval. The ratings agencies are beholden to the Wall Street firms for their business. And they know that if they are too hard nosed the business will all go to the other guy. So the ratings agency is under tremendous pressure to rate this stuff AAA. So they did. But they needed a fig leaf. And Wall Street found them one.
Let's say you were the poor soul that was supposed to rate one of these CDOs. They are terribly complicated so going through everything carefully would take a couple of lifetimes. That's one approach. Now what if there existed a computer program that was certified to be wonderful. And it would go through all that detail at warp speed and issue a single magic "risk number". Problem solved. A math whiz came up with just such a computer program. It was thoroughly reviewed by other math whizzes who swear it does a good job. What can possibly go wrong?
Most of the analysis of this issue has said "well all computer programs have shortcomings and this one's shortcomings only became apparent after the market crashed". There is some truth to this but it misses the main problem. The guy that developed the program was on a limited budget. His program needed two kinds of data. The first kind was the specifics of the securities to be analyzed. There was no problem here. But the second kind of data he needed was historical data. He needed a bunch of mortgages and what eventually happened to them (e.g. defaulted or didn't). He pulled the historical data he could easily get his hands on. It covered not that many mortgages and it only covered a short period of time, a period of time when no one was defaulting. He explained all this in the write-up on his program. And it didn't make any difference to the mathematicians who reviewed his work. They had enough information to determine whether the program was doing the right thing with the data it had and that's all they needed.
But things changed (or should have) when this program went to Wall Street. The first thing that happened was the whole "here's the limitations of the program" part got dropped. And Wall Street never went back and added more historical data that covered a longer period, a period when mortgages did actually default. And Wall Street plugged everything into the program without generating historical data that was matched to what was being evaluated. So the program was used to rate credit card debt and car loans and pretty much everything under the sun. And the "historical data" was always the original mortgage data whether that was the proper historical data or not. Whatever inadequacies the program might have had were overwhelmed by the failure to provide appropriate historical data. The result is not surprising. Given that all the historical data showed low risk the program always spit out a "low risk" number no matter what security data you put in. And that suited the sales people responsible for selling the CDOs and the ratings people at the ratings agencies right down to the ground. They had the "magic computer blessing" on what they already wanted to do. If something went wrong they could blame the computer and they eventually did.
So how much of the financial bubble was natural and how much of it was artificial? Most of the damage that resulted in the financial meltdown can be tied to the mortgage meltdown. I have noted above that Wall Street actively encouraged fraud and other illegal behavior in order to have more bad (good in Wall Street's eyes because they had high interest rates) Alt-A mortgages to work with. The ratings agencies also were utterly derelict in their duties to appropriately rate these complex securities. They made no effort to develop appropriate in house expertise with mortgages. Had they it would have been manifestly obvious that many CDOs should have been rated "beneath junk" rather than AAA. They also did not make any attempt to understand either the ratings program itself or the proper use of the ratings program (e.g. verifying that the historical data was appropriate and adequate). Above and beyond all that they should have known that there just isn't that much AAA paper around.
There is ample evidence that Wall Street drank their own cool aid. They were under no pressure to purchase the fraudulent mortgage originators. They should have but obviously didn't know that these businesses were fraudulent. Wall Street firms, some more than others, also ended up purchasing CDOs and other garbage investments for their own portfolios. Some of this was no doubt done "in the course of business" rather than solely as a "good investment". But they held so much of these investments and were so slow to get rid of them that they obviously thought they were sound. The people who made these kinds of decisions were paid obscene amounts of money. Why? Because they were so smart.
Since Wall Street crashed many of these very same "smart" people have frequently said something along the lines of "it was so complicated I really didn't understand what was going on". An executive that is not smart enough to understand the business line that he is overseeing should be preplaced with someone who can understand it. A business activity that is so complicated that no executive can be found that does understand it is a good business activity to exit. Executives overseeing activities they don't understand are violating their fiduciary duty. Executives that employ these under qualified executives are also violating their fiduciary duty. They should all be fired. They certainly are not justifying their obscene compensation packages.
Given this pattern of behavior that extended up and down Wall Street firms and extended across the board to all Wall Street firms, again I go with "artificial". So the final score is one natural bubble (dotcom) and two artificial bubbles (mortgage and financial meltdown). Why does it matter? Well, the "fix" for a natural bubble is different than a fix for an artificial bubble. I don't know that there is much that can be done to prevent natural bubbles. The general fix for artificial bubbles is "law and order". Make sure your laws and regulatory regimes are in good working order. Then throw the crooks in jail and throw away the key.
Stockman is right to the extent that he faults the Fed for doing a poor regulatory job. (I haven't read the book so I don't know if he actually holds this position.) For the rest, congress deserves a great deal of responsibility for not providing the appropriate regulatory environment (the unregulated mortgage industry as an example). Congress also deserves blame for the long term attack on efforts by regulatory agencies to do their jobs. Certainly the ratings agencies utterly failed to do their jobs. But at the center is a Wall Street culture of "anything to make a buck". This resulted in a complete lack of appropriate supervision (as long as the department is making lots of money it's all good) and aiding and abetting efforts through congress to interfere with the ability of regulatory agencies to do their job. "Follow the money" is usually good advice. The people who most benefitted from all the bad behavior that transpired in the mortgage industry and on Wall Street were the senior executives at the various Wall Street firms.
My father was born in 1910. The house he grew up in was built in the same year, 1910. About 25 years later his father died at the height of the Great Depression and my father became responsible for the family finances. The house had originally cost $5,000. In the middle of the Great Depression it was again valued at $5,000. And it turned out that the mortgage on the house was an "interest only" mortgage. There was still $5,000 owing on the mortgage. Fortunately, my father had a good job and no wife and kids. He was able to get the house completely paid off within a couple of years and the family lived in the house for many more years.
But a lot of depression era families did not do so well. They end up having similar mortgage situations but did not have the financial wherewithal to weather the storm. So they ended up losing their houses. This caused the Roosevelt administration to put in rules requiring 20% down for a conventional mortgage. This rule resulted in a stable but boring mortgage market for more than 50 years. It also meant that a lot of people couldn't qualify. Do gooders, who wanted to get more people into home ownership, combined with mortgage industry lobbyists, who wanted to do more business. The result was a loosening of mortgage regulations in several stages. The anti-regulation crowd also chipped in to weaken the powers of the agencies that oversaw the regulated part of the market. They also made sure that efforts to extend regulation and supervision to the (by the '90s) fast growing unregulated segment of the market were thwarted. The result was a "wild west" mortgage market where "anything goes".
I paid 20% down when I bought my house in the early '80s. That later became a thing of the past. The "minimum down" was reduced to 10%, 5%, 3%, and eventually in some cases to "nothing down". And the mortgage market has always been segmented. Besides regular mortgages there are FHA mortgages that have slightly different rules but you had to meet certain criteria to qualify. Then there was the "jumbo" market. The federal agencies that were market makers for mortgages FannieMae (actually the FNMA - you don't want to know what the acronym stands for) and FreddieMac (again an acronym for who cares what) would only take mortgages up to a certain size (I don't know why). Mortgages that exceeded the limit were called Jumbos. This all made some small kind of sense.
Then there were Alt-A mortgages. These were mortgages to people who did not have the financial resources (down payment, income, credit history) to qualify for one of the more standard kinds of mortgages. These mortgages were viewed as substantially more risky than the other kinds. As a result the interest rate charged the borrower was substantially higher than for the other kinds of mortgages. For a long time the Alt-A mortgage market was very small. Most lenders concluded that the reward (higher interest rate) did not justify the additional risk (that the buyer would default on the mortgage) so for a long time very few Alt-A mortgages were made.
There was a slow broad societal change that happened in the second half of the twentieth century. The number of people that lived in the typical house went down. People had smaller families. Older people stayed in their houses after the kids moved out. Single people bought houses. All these trends combined to reduce the average number of people living in a typical house. What this meant was that more houses needed to be built than population growth would indicate. So the housing industry saw prolonged steady growth. This growth tended to keep the price of houses higher than they otherwise would have been. For a long period of time the value of a house ticked up regularly as clockwork year after year. Initially it was a small increase but it was steady.
Then speculators started moving in. It looked like a safe investment to buy a house and then rent it out. The worst thing that could happen is that you would be unsuccessful at finding renters. In this case you just sold the house and perhaps took a small loss. In other words, investing in houses looked like it was low risk. So a lot of people did it and this too propped up housing prices.
Theoretically the risk of default was rising as the size of the down payment dropped. But things did not turn out that way in practice. If someone found that they could not afford their house they could always sell it. The proceeds would cover the mortgage and there would be no default. This even worked if the down payment was pretty small. The increase in the value of the house plus the amount of the small down payment would almost always be enough to cover the remaining balance on the mortgage. As a result perceptions in the mortgage industry changed. "Risky" mortgages were no longer very risky. This meant that Alt-A mortgages were a good deal for the investor. The actual higher return from the high interest rate more than balanced out the now small risk of losing money in case of default. This made Alt-A mortgages actually preferable to a regular mortgage. Both mortgages were low risk but the Alt-A mortgage had a much higher rate of return.
So all of a sudden Alt-A mortgages are a desirable investment. This was coupled with another trend. This trend was internal to Wall Street. For decades Wall Street made a nice living on stock transactions. The fee for a particular transaction was fixed. As computerization took over the cost of executing the transaction plummeted. This nice racket came to an abrupt end when the fixed commission system was scrapped. Now commission rates were negotiated. And the large players got very good deals. Smaller players did not do so well but fees became common knowledge and small investors shopped around. It didn't take long for the profit in handling stock trades to dry up and blow away for all but the most efficient operators.
A second similar blow was struck a few years ago. Most stock prices were quoted in dollars and eighths (12 and 1/2 cents). So prices had to be rounded to the nearest eighth. And there is the "bid" and "asked" prices. They always differ by at least an eighth. This allowed for profit to be made on the eighth point "spread". It wasn't much but it added up. Then the exchanges went to dollars and cents pricing. This dropped the spread to a penny, less than a tenth of what it had been. This took more money out of the "profit" column on Wall Street. All this made Wall Street very greedy for profitable businesses. And Alt-A mortgages seemed made to order. Assuming that the "low risk" assessment was correct, then the high interest rate made for a compelling argument. Wall Street's appetite for Alt-A mortgages became voracious.
The result was a giant unregulated mortgage industry specializing in Alt-A mortgages. And did I mention that this industry was unregulated? Fraud soon became rampant. Many people who could qualify for a standard mortgage were pushed into an Alt-A mortgage. Why? Because Wall Street wanted Alt-A mortgages. And Wall Street wanted the worst Alt-A mortgages that could be created. Why? The worse the mortgage, the higher the interest rate. And they were no risk (well technically low risk but lets not sweat the details). It didn't matter whether the borrower could afford the mortgage because it would not default. The worst that would happen is that it would need to be "rolled over" into a new mortgage.
In this market housing prices started rising very fast, sometimes by as much as 10% per year in some markets. This made the "there's no such thing as a bad Alt-A mortgage" argument just that much stronger. And the best way to insure that a large stream of bad Alt-A mortgages was available was to deal with crooks. Now it's theoretically bad to deal with crooks. But Wall Street's solution to that problem was to erect tall strong barriers to block them from officially hearing anything about crookedness or dirty dealing.
This "tall strong barrier" strategy worked so well that large Wall Street firms bought several of the largest crooked mortgage originators. And they paid top dollar for them. The result has been write downs of many billions of dollars as a result of these investments. And this is after arranging "settlements" in which no wrongdoing is admitted but fines, in some cases amounting to billions of dollars, are paid. But the fines represent pennies on the dollar for the fraudulent activity covered by the "settlement". The level of fraud involved in the mortgage industry, especially in 2000 and later, causes me to put the mortgage bubble into the "artificial" or fraud-based category of bubble. The mortgage bubble and the financial meltdown bubble are closely tied up with each other. So I am arbitrarily cut my discussion of the mortgage bubble off here and move on to the financial crisis bubble now.
I have already covered some of the relevant territory. As noted above, Wall Street has become increasingly desperate to find lines of business that are both high volume and offer big profit margins. As an industry it has become so large that it now needs a lot of business and the business must be very profitable. Otherwise it can't afford to pay bonuses, which in some cases amount to over a billion dollars to one individual for one year's work. Making bonus pools that run to tens of billions of dollars per year for a single company look like just some small overhead cost requires that cash flow amount to literally trillions of dollars. There just aren't that many markets that are big enough to make a difference.
Also, as indicated above, this led Wall Street to the Alt-A mortgage business. A Wall Street firm would buy up a bundle of mortgages (frequently a thousand or more) and bundle them up into a large investment called an MBS (Mortgage Backed Security). They would then split the MBS into shares and sell them to investors. This was a nice little business. Each MBS was like an IPO so various fees and surcharges could be assessed. And they sold themselves because they promised a high interest rate. But it was not enough. There just wasn't enough volume in MBSs, like there wasn't enough volume in IPOs to generate the profit Wall Street firms now felt they needed. And, because it will set things up for later, let me now turn to a small problem Wall Street saw.
Lots of investors are "blue chip" investors. They want (or are required by law) very low risk. The lowest risk investment is one that is rated AAA (usually pronounced triple-A). The AAA comes from a "ratings agency". The big three are Standard & Poor's, Moody's, and Fitch. They use different codes but "AAA" is usually short hand for a top (most safe) rating from one of the "big three". An investment in IBM stock is not an AAA rated investment. Stocks, even the best ones, go up and down. They involve risk. An IBM bond, on the other hand, might be AAA rated. This is because if there is a problem the company is required by law to pay off bond holders before stock holders and many other kinds of creditors. IBM AAA bonds are "senior debt" because the call the bond holder has on the assets of the company is "senior" (comes first) to the call others have on the assets of the same company. Most bonds, even those of big stable companies are not AAA. They are some other lower but "investment grade" rating like AA. Getting an investment rated AAA is a big deal that historically hasn't happened that frequently.
And that's the problem with an MBS. It's not AAA. But wouldn't it be nice if it was AAA? Then the seller of the MBS could market it to all those finicky investors that want or need AAA securities. Wall Street figured out a way to turn an MBS into an AAA security. The vehicle for this is something called a CDO (Collateralized Debt Obligation). What's a CDO? Well it is almost anything. It's an investment you can sell like an IPO or an MBS. But what's in it? In the case of an IPO what's in it is the stock of a specific new company. In the case of an MBS it's a specific list of mortgages. The details are different but the general idea is the same with an IPO and an MBS. The value of your investment rises or falls based on how well the company (IPO) or package of mortgages averaged together (MBS) does. In the case of the CDO what's inside is any kind of "Debt Obligation" that is "Collateralized". It no longer has to be a specific class of thing like a mortgage or a stock.
There has to be something deep down there that can serve as collateral and the something must be some kind of debt. But after that, it can be pretty much anything. It can be an MBS (or part of one), for instance. It can be a bundle of credit card receipts or car loans or other things. You just have to specify what the "debt obligations" are. You can even have a CDO inside a CDO (nickname: CDO squared). So the first step is to decide what to put into a CDO. And here is where something called "tranches" come in. You take one of these investments and slice it up. Each slice is called a tranche. The trick is in the slicing rule. You don't just take the first hundred of the thousand mortgages in a MBS and call it "tranche 1". You use a rule to rate each mortgage. Then you use the rating to determine the tranche. Why do this? We'll see in a minute.
Anyhow Wall Street took a bunch of say MBSs and then tranched them. The put all of the "tranche 1" components from all of the MBSs into the first CDO. Then they put all the "tranche 2" components into the second CDO, and so on. Then they sold each CDO separately. Why? The ratings agencies. Say what? Remember a long time ago we were talking about AAA securities. All this was done to create securities that the ratings agencies would rate AAA. In actuality, as I understand it, things were typically put into only three tranches. And the "tranche rule" for MBS securities is something like "the first 10% of the mortgages that default" goes into the "junk" tranche. The "mezzanine" tranche consists of the next 10% of mortgages that default. The "senior" tranche consists of all the rest of the mortgages.
Now look at what we have. How likely is it that 20% of the mortgages are going to default? If it's before 2006 the answer is "indistinguishable from zero". And that's the definition of a AAA security. So when I hire a ratings agency they will give the senior tranche (actually the CDO containing only senior tranches) a AAA rating. I don't know the details but the interest income from the MBSs was no doubt divided up in such a way that the investors in the "junk" CDO got paid a big premium and the investors in the mezzanine CDO got a smaller premium. The interest rate paid by the senior CDO would be a little smaller but what do you expect for a CDO rated AAA. This trick allowed Wall Street to turn 80% or more of each MBS into AAA securities. And these AAA securities paid a much higher interest rate than a regular AAA security. So they flew off the shelf and Wall Street racked up monstrous profits.
Before moving on, remember I mentioned something called a CDO-squared. What's with that? Well let's build a CDO by consolidating a bunch of junk CDOs together. Now given that the underlying default rate on mortgages is roughly zero, let's play the tranche game again. What is the chance that say 20% of this combination of risky CDOs are going to go under? It's pretty small. (Remember this is before 2006). So using this trick you can turn 80% of the worst 10% into AAA securities. And you can play the same game with the mezzanine CDOs too. So you can turn close to 100% of these CDOs based on MBSs into AAA securities. It's just like magic. And like magic we eventually found out it was not real.
So let me move on to the ratings agencies. It's a cut throat business. And guess who selects the ratings agency. It turns out it is the company that is putting together the security (MBS or CDO). So let's say you put together one of these things and you take it to a ratings agency. And let's say they say "well it's not quite AAA". One option you have is to take the exact same package to another ratings agency and they might give it their AAA stamp of approval. The ratings agencies are beholden to the Wall Street firms for their business. And they know that if they are too hard nosed the business will all go to the other guy. So the ratings agency is under tremendous pressure to rate this stuff AAA. So they did. But they needed a fig leaf. And Wall Street found them one.
Let's say you were the poor soul that was supposed to rate one of these CDOs. They are terribly complicated so going through everything carefully would take a couple of lifetimes. That's one approach. Now what if there existed a computer program that was certified to be wonderful. And it would go through all that detail at warp speed and issue a single magic "risk number". Problem solved. A math whiz came up with just such a computer program. It was thoroughly reviewed by other math whizzes who swear it does a good job. What can possibly go wrong?
Most of the analysis of this issue has said "well all computer programs have shortcomings and this one's shortcomings only became apparent after the market crashed". There is some truth to this but it misses the main problem. The guy that developed the program was on a limited budget. His program needed two kinds of data. The first kind was the specifics of the securities to be analyzed. There was no problem here. But the second kind of data he needed was historical data. He needed a bunch of mortgages and what eventually happened to them (e.g. defaulted or didn't). He pulled the historical data he could easily get his hands on. It covered not that many mortgages and it only covered a short period of time, a period of time when no one was defaulting. He explained all this in the write-up on his program. And it didn't make any difference to the mathematicians who reviewed his work. They had enough information to determine whether the program was doing the right thing with the data it had and that's all they needed.
But things changed (or should have) when this program went to Wall Street. The first thing that happened was the whole "here's the limitations of the program" part got dropped. And Wall Street never went back and added more historical data that covered a longer period, a period when mortgages did actually default. And Wall Street plugged everything into the program without generating historical data that was matched to what was being evaluated. So the program was used to rate credit card debt and car loans and pretty much everything under the sun. And the "historical data" was always the original mortgage data whether that was the proper historical data or not. Whatever inadequacies the program might have had were overwhelmed by the failure to provide appropriate historical data. The result is not surprising. Given that all the historical data showed low risk the program always spit out a "low risk" number no matter what security data you put in. And that suited the sales people responsible for selling the CDOs and the ratings people at the ratings agencies right down to the ground. They had the "magic computer blessing" on what they already wanted to do. If something went wrong they could blame the computer and they eventually did.
So how much of the financial bubble was natural and how much of it was artificial? Most of the damage that resulted in the financial meltdown can be tied to the mortgage meltdown. I have noted above that Wall Street actively encouraged fraud and other illegal behavior in order to have more bad (good in Wall Street's eyes because they had high interest rates) Alt-A mortgages to work with. The ratings agencies also were utterly derelict in their duties to appropriately rate these complex securities. They made no effort to develop appropriate in house expertise with mortgages. Had they it would have been manifestly obvious that many CDOs should have been rated "beneath junk" rather than AAA. They also did not make any attempt to understand either the ratings program itself or the proper use of the ratings program (e.g. verifying that the historical data was appropriate and adequate). Above and beyond all that they should have known that there just isn't that much AAA paper around.
There is ample evidence that Wall Street drank their own cool aid. They were under no pressure to purchase the fraudulent mortgage originators. They should have but obviously didn't know that these businesses were fraudulent. Wall Street firms, some more than others, also ended up purchasing CDOs and other garbage investments for their own portfolios. Some of this was no doubt done "in the course of business" rather than solely as a "good investment". But they held so much of these investments and were so slow to get rid of them that they obviously thought they were sound. The people who made these kinds of decisions were paid obscene amounts of money. Why? Because they were so smart.
Since Wall Street crashed many of these very same "smart" people have frequently said something along the lines of "it was so complicated I really didn't understand what was going on". An executive that is not smart enough to understand the business line that he is overseeing should be preplaced with someone who can understand it. A business activity that is so complicated that no executive can be found that does understand it is a good business activity to exit. Executives overseeing activities they don't understand are violating their fiduciary duty. Executives that employ these under qualified executives are also violating their fiduciary duty. They should all be fired. They certainly are not justifying their obscene compensation packages.
Given this pattern of behavior that extended up and down Wall Street firms and extended across the board to all Wall Street firms, again I go with "artificial". So the final score is one natural bubble (dotcom) and two artificial bubbles (mortgage and financial meltdown). Why does it matter? Well, the "fix" for a natural bubble is different than a fix for an artificial bubble. I don't know that there is much that can be done to prevent natural bubbles. The general fix for artificial bubbles is "law and order". Make sure your laws and regulatory regimes are in good working order. Then throw the crooks in jail and throw away the key.
Stockman is right to the extent that he faults the Fed for doing a poor regulatory job. (I haven't read the book so I don't know if he actually holds this position.) For the rest, congress deserves a great deal of responsibility for not providing the appropriate regulatory environment (the unregulated mortgage industry as an example). Congress also deserves blame for the long term attack on efforts by regulatory agencies to do their jobs. Certainly the ratings agencies utterly failed to do their jobs. But at the center is a Wall Street culture of "anything to make a buck". This resulted in a complete lack of appropriate supervision (as long as the department is making lots of money it's all good) and aiding and abetting efforts through congress to interfere with the ability of regulatory agencies to do their job. "Follow the money" is usually good advice. The people who most benefitted from all the bad behavior that transpired in the mortgage industry and on Wall Street were the senior executives at the various Wall Street firms.
Speculative Bubbles (Part 1 of 2)
The impetus for this post came from David Stockman. He has been making the rounds flogging his new book "The Great Deformation". Stockman has always been good at self promotion. So he has propelled his book, ostensibly a dry economics tome, to number 7 on the New York Times Hardcover nonfiction list as of the day I write this. Unfortunately, I am familiar with Mr. Stockman. He first came to national prominence as director of the Office of Management and Budget under President Ronald Reagan. The OMB is the font of expertise for all things budgetary in the White House.
Stockman was famous as a proponent of what came to be referred to as the "Laffer Curve". The Curve was a shorthand reference to a concept pushed by economist Arthur Laffer. The main idea was that if you reduced tax rates the economy would improve so much that tax revenues would actually go up. Most economists dismissed the idea. But it was politically convenient so it garnered a great deal of support among conservatives. If correct, the concept would result in lower tax rates and a smaller deficit at the same time. Unfortunately, supporters have only been able to find one instance where this actually happened. In the Kennedy administration tax rates were cut and the economy took off. This strong economic growth resulted in enough increased tax revenues to keep the deficit low.
Unfortunately, what happened during the Reagan years was what most people predicted. After a recession in the first couple of years (caused by a change in Fed policy) the economy recovered but not enough to cover for large increase in defense spending (and fairly modest cuts to social programs). Revenues eventually went up a little but spending went up a lot during the same period. So the federal deficit ballooned.
After he left office Stockman claimed that he had become dubious of the whole "Laffer Curve" idea early on. But he did not say anything negative publicly about Reagan fiscal policies until well after he left the administration. Later criminal and civil charges were filed against him in connection with his actions while running Collins & Aikman, a company that went bankrupt. I believe none of these charges led to a conviction. In short, Stockman's record is spotty at best.
I have not read the book. What I want to investigate is a contention he has made in several interviews he has given in the process of promoting the book. He contends that there have been three recent bubbles: the dotcom bubble, the mortgage bubble, and the financial meltdown bubble. He goes on to blame the Fed for all three bubbles (and many other sins). At this point you will be less than surprised to learn that many experts disagree with his analysis. But I am just going to stick with the "three bubbles" part. Are these three events in fact bubbles? To answer that question it is important to understand what a bubble is.
Bubbles have been around for a long time. One of the best works on the subject, "Extraordinary Popular Delusions and the Madness of Crowds" by Charles Mackay was first published in 1841. It has been in print nearly continuously since. Amazon has new copies of several versions of the book (one of which was published in 2012) for sale right now. An early bubble described by Mackay was the market for Tulip bulbs in Holland in the 1630's. Let me use this event to describe the characteristics of a bubble, or more properly a "speculative bubble".
At the time when our story starts, the Dutch has been selling Tulip bulbs for some time. As they became popular an informal market developed. For explanatory purposes I am going to arbitrarily divide market participants into "investors" and "speculators". In my explanation an investor is someone who has a stake in the underlying product. He grows Tulips, or sells Tulips at retail, or whatever. He is primarily in the market because he has a commercial interest in Tulips. A speculator, on the other hand, just wants to make a buck. He has no intrinsic interest in Tulips. They are just a means to an end. Now in the real world the situation is much more complex. There are other types of participants and a particular actor may be part investor and part speculator, even if we just look at a single transaction. But this artificial separation makes it easier to see what is going on.
I will also assume something called the "intrinsic value" of the product, in this case Tulips, exists. Determining intrinsic value is often somewhere between difficult and impossible. And experts can and will differ on what the correct intrinsic value of a specific commodity at a specific time is. But we are going to ignore all these problems and pretend there is an intrinsic value and that it is knowable. Now let's look at markets.
An investor is in a market because in some sense he has to be. There are many forces that push a price up or down. So in a normal market we can expect that the price of a product will sometimes get above its intrinsic value. In this case we can expect prices to eventually go down. Similarly, the price can get below intrinsic value and in this case we can expect the price to eventually rise. The fundamental law of speculation is "buy low - sell high". So, if a speculator can establish the intrinsic value, and if he can identify times where the price is below intrinsic value, he can buy low and expect to sell high later. Similarly, he gets out of the market when the price is above the intrinsic value and waits for the market to "return to the norm".
In this situation a speculator provides an economic benefit to the economy as a whole and specifically to investors by providing "market liquidity". An investor may need to sell when prices are low. The speculator will buy when no one else will. Similarly an investor may need to buy when prices are high. The speculator will sell when no one else will. In these kinds of situations speculators perform the service of smoothing out the market, which is usually beneficial to investors in the long run.
So we have now seen on display two of the components necessary for a speculative bubble. We have a market and we have speculators. And in this benign situation we have described so far, speculators are performing a useful function. But things can go wrong. Let's see how.
Suppose we have a market that has performed well (and in this case by "performed well" I mean gone up) for a significant period of time. For whatever reasons prices have risen steadily and apparently inexorably. This sounds like an opportunity to print money. We buy and hold. The market inexorably goes up. We sell at a profit. Any fool can make money in this market. This is the third component of a bubble. It is usually but not always present.
People may mischaracterize the actual history of a market so that it seems like it always goes up. And probability tells us that if we monitor a lot of markets, and each market has a certain amount of random price fluctuation, then eventually some of these markets will show a pattern where prices seem to always (well, for a "long" time, whatever that is) go up. Now the speculators we talked about before had a level of expertise. They were able to determine the intrinsic value of the product. But in a foolproof market that expertise is no longer necessary. The market always goes up. And we now have the fourth component of our bubble, the "quick buck artists". These are people who have little or no expertise in the particular market.
This set of circumstances moves us into the inflation phase. Prices quickly and inexorably go up. In our Tulip example this happened when French speculators started moving in in 1634. Prices started accelerating and by 1636 they were zooming up. Nothing about the underlying Tulip market had changed. But now trading was dominated by speculators. It is also when investors and the early more experienced speculators started becoming concerned that prices had gotten out of control. Now we move into the "greater fool" phase.
Knowledgeable people conclude that prices are at foolish heights. But it appears that there is always a greater fool who will pay even higher prices so they stay in the market well past when they normally would. Then we finally come to the last phase. At some point the market runs out of greater fools. At this point prices start to weaken and perhaps fall slightly. Knowledgeable people now start to sell aggressively before prices fall even further. The market crashes (i.e. the bubble bursts) and prices drop, frequently to well below intrinsic levels.
To summarize, we need a market and the market needs to be open to speculators. We need (not always but usually) a period where the market goes up apparently inexorably. Then more speculators jump in and prices start rising rapidly. We then have the "greater fool" period, followed by the peak and then the crash. This pattern has been well known for hundreds of years now. When the Tulip bubble happened no one had seen anything like it before. But it certainly wasn't the last bubble. Mackay documents a number of other bubbles like the "South Sea Bubble" that are now known only to historians of the subject. At some point it dawned on some speculators that it was possible to manufacture bubbles.
By the late 1800's "stock operators" were routinely trying to create and profit from bubbles in the price of various individual stocks. The 1923 novel "Reminiscences of a Stock Operator" by Edwin Lefevre documents many of the popular schemes of the time. I bring this up because I want to differentiate between the "natural" speculative bubble, which arises naturally and is then taken advantage of, and the "artificial" bubble, which is created as a scam from the start. With all this out of the way let me now take up the three bubbles that attracted Mr. Stockman's attention.
The dotcom bubble is accurately characterized as a classic natural bubble. Also referred to as the "tech bubble" it started gathering steam in the 1980's. The Apple II (introduced in 1977) and shortly thereafter the IBM PC (introduced in 1981) made home computers practical. Many people who had heretofore not thought of themselves as tech-savvy got computers and fell in love with them. They imputed their feelings to the market as a whole and started looking for stocks they could invest in. An early example was Netscape. Netscape brought the browser to the masses. When Netscape stock went on the market it was immediately snapped up to the surprise of Wall Street experts.
In the beginning Netscape had a reasonable business model. They were going to license their product for $25 a pop. Then Bill Gates came along and gave Internet Explorer away for free. Netscape soon abandoned their licensing model. This destroyed their business model but the public continued to support the stock anyhow. Eventually, Netscape was sold to AOL in a deal initially valued at $4.2 billion (and later at much more). So the faith of the general public in Netscape as an investment was eventually vindicated. It would not be the first time.
Bill Gates was of course famous for creating Microsoft. Microsoft also went off for crazy prices. But, unlike Netscape, Gates turned out to be a savvy businessman. Microsoft turned in spectacular earnings and profit figures year after year. So Microsoft stock zoomed into the stratosphere. Apple had a much bumpier ride, at least at the beginning. The Apple II was a big success. But follow on products (does anyone remember the Apple III) were less so. After a string of duds Apple introduced the Macintosh in 1984. But it too was not a commercial success. It only garnered significant sales after Steve Jobs left the company. Apple then got into so much trouble that Jobs was brought back to rescue the company. The company was rescued and went on to a run of spectacular success. But this mostly happened after the dotcom bubble exploded in 2000.
Microsoft stands out as the great success of the dotcom era. Mostly we have companies with track records like Netscape (never made any real profit but was eventually sold for megabucks) and Apple (up then down and eventually back up but only after the bubble burst). Nevertheless the public was fascinated with these stocks and would buy them at nearly any price. This was in spite of the fact that in most cases no one could figure out how the companies would ever make money.
So in the early days you had a number of these new style tech stocks. And many had a record of inexorably rising in spite of the fact that they never made any money and it didn't look like they would make money any time soon. The most common tool Wall Street uses to calculate the intrinsic value of a stock is PE or the price/earnings ratio. If the price of a stock is $20 and its earnings for the year are $1 per share its PE is 20. Historically, a PE of 15 is considered standard. Anything between 12 and 18 considered within the normal range. There are many reasons why the PE of a stock should be below 12 or above 18 but those are special circumstances. Generally, in the absence of special circumstances, a stock is considered cheap if the PE is below 12 and expensive if the PE is above 18. Many of these tech stocks had no earnings, no "E". So their PE was off the chart on the high side.
This might be ok if there was reason to believe that earnings would skyrocket in a couple of years. If we were certain that three years from now the stock would be earning $5 per share then the "forward" PE would be 10 if the price of the stock is currently $50. This forward PE of 10 might justify buying the stock now. This kind of logic is risky but not insane. The problem with many of these stocks is that no one could figure out how they could earn say $5 per share 3, 5, or even 15 years out. So purchasing these stocks appeared to be completely insane to Wall Street analysts. But the public bought them anyhow. Enter the greater fool.
From start to finish the dotcom bubble took about 15 years. That is an extremely long time period by Wall Street standards. And Wall Street's approach to stocks that eventually became part of the tech bubble went through three stages. Wall Street had been investing in "tech" for a long time. GE dates back to the 1800's. IBM was a Wall Street darling in the '60s and the '70s. But these were big well known companies. They were thought of more as "industrials" than as some weird subspecies. These new companies were an entirely different kettle of fish. By this time Hewlett Packard was a substantial company. But it wasn't a giant. And it had taken decades to grow to its current (as of say 1980) medium size. The idea that a company could go from "startup" to "largest market cap in the world" as Microsoft did was literally unimaginable. So these tech companies started off as a side business. Wall Street could make a couple of bucks off them by managing their IPOs (Initial Public Offering of the sale of the stock) but that was just a nice but small sideline business for a Wall Street firm.
But the public's appetite for the stock of these companies seemed to be insatiable. So Wall Street came to see them as a serious line of business that could generate substantial profits. And the public continued to be happy to shoulder responsibility for being the greater fool. So Wall Street got serious about the business of shearing the sheep.
Wall Street stock brokers like Merrill Lynch maintain a group of people called "stock analysts". They are supposed to provide informed and unbiased research on stocks. By this third stage all the stock analysts had nothing but praise for these companies as sound investments. Why, since the characteristics of the underlying companies had not changed? They still had no earnings and little to no prospects for earnings in many cases. The answer is that the same company has a retail business, servicing individual investors. But it also has a corporate business where they do IPOs, float bond issues, advise corporations on various financial matters, etc. It was easier to get the "corporate side" business of a particular company if the analyst was saying nice things to retail customers. So analysts were given their marching orders to come up with reasons why these companies were good investments. This required a great amount of skill at creative writing. But those analysts that prospered turned out to be very good at it.
Cooking analyst's reports is a bad thing and I believe it is illegal. But I don't think it contributed much to the dotcom bubble. A large segment of the public had started buying these stocks long before this bad behavior became wide spread. Were some people who might have otherwise dodged the bullet enticed into purchases they would not otherwise have made by these reports? No doubt the answer is yes. And I am sure that a number of pension funds and other large investors ended up putting more money into these stocks than they otherwise would have. But the dotcom bubble was of long duration. And it was recognized as a bubble for longer and by more people than any other bubble in history.
The stock market tends to go in one direction for three to five years, or so the experts believe. Then it changes course, at least for a while. The market started up from a bottom in 1982 and climbed more or less continuously until 2000, People started saying "it's time for a correction" by about 1986 or 1987. By the early '90s there was a "when's the correction going to start" cottage industry among investors. But the market continued on its upward course. There were corrections (like Black Monday, October 19, 1987) but they tended to not last more than a few months. Then the upward trend would resume. I was introduced to both of the books mentioned above during this period.
By the late '90s jokes about the bubble were common. I remember a fund manager that I respected saying "I don't understand it but I have to be in these stocks to make money" during this period. But the market kept going up even though "everybody" knew it was too high and that prices couldn't be sustained indefinitely. Over and over in this period the "sensible people" kept being made to look like fools while the "greater fools" made bales of money. What finally happened to derail the gravy train?
The overall economy took a slight dip. This put some people in a modest financial squeeze. So they sold some of the stock they had made so much money on so that they could meet their other financial obligations. This drove the price of some tech stocks down. Much of this stock had been bought on margin (with borrowed money). When the stock price goes down, even a little, margin investors have to either put in more money or sell the stock. A significant number of people, either because they wanted to or because they had to, sold the stock. This drove prices down further. This resulted in more margin calls, etc., a classic example of a vicious cycle. At first only a few stocks went down. But this caused enough investors to decide it was time to sell other tech stocks too, "just to be safe". So the decline in tech stocks spread and soon took the whole category down. The category of speculative tech stocks went down 90% almost over night.
The tech sector has never recovered completely. The NASDAQ is tech heavy. Recently both the Dow Jones Industrial Average and the Standard & Poor "500" have each hit new "all time high" records. The record high for the NASDAQ is 5048.62. It is currently at about the 3000 level.
(to be continued)
Stockman was famous as a proponent of what came to be referred to as the "Laffer Curve". The Curve was a shorthand reference to a concept pushed by economist Arthur Laffer. The main idea was that if you reduced tax rates the economy would improve so much that tax revenues would actually go up. Most economists dismissed the idea. But it was politically convenient so it garnered a great deal of support among conservatives. If correct, the concept would result in lower tax rates and a smaller deficit at the same time. Unfortunately, supporters have only been able to find one instance where this actually happened. In the Kennedy administration tax rates were cut and the economy took off. This strong economic growth resulted in enough increased tax revenues to keep the deficit low.
Unfortunately, what happened during the Reagan years was what most people predicted. After a recession in the first couple of years (caused by a change in Fed policy) the economy recovered but not enough to cover for large increase in defense spending (and fairly modest cuts to social programs). Revenues eventually went up a little but spending went up a lot during the same period. So the federal deficit ballooned.
After he left office Stockman claimed that he had become dubious of the whole "Laffer Curve" idea early on. But he did not say anything negative publicly about Reagan fiscal policies until well after he left the administration. Later criminal and civil charges were filed against him in connection with his actions while running Collins & Aikman, a company that went bankrupt. I believe none of these charges led to a conviction. In short, Stockman's record is spotty at best.
I have not read the book. What I want to investigate is a contention he has made in several interviews he has given in the process of promoting the book. He contends that there have been three recent bubbles: the dotcom bubble, the mortgage bubble, and the financial meltdown bubble. He goes on to blame the Fed for all three bubbles (and many other sins). At this point you will be less than surprised to learn that many experts disagree with his analysis. But I am just going to stick with the "three bubbles" part. Are these three events in fact bubbles? To answer that question it is important to understand what a bubble is.
Bubbles have been around for a long time. One of the best works on the subject, "Extraordinary Popular Delusions and the Madness of Crowds" by Charles Mackay was first published in 1841. It has been in print nearly continuously since. Amazon has new copies of several versions of the book (one of which was published in 2012) for sale right now. An early bubble described by Mackay was the market for Tulip bulbs in Holland in the 1630's. Let me use this event to describe the characteristics of a bubble, or more properly a "speculative bubble".
At the time when our story starts, the Dutch has been selling Tulip bulbs for some time. As they became popular an informal market developed. For explanatory purposes I am going to arbitrarily divide market participants into "investors" and "speculators". In my explanation an investor is someone who has a stake in the underlying product. He grows Tulips, or sells Tulips at retail, or whatever. He is primarily in the market because he has a commercial interest in Tulips. A speculator, on the other hand, just wants to make a buck. He has no intrinsic interest in Tulips. They are just a means to an end. Now in the real world the situation is much more complex. There are other types of participants and a particular actor may be part investor and part speculator, even if we just look at a single transaction. But this artificial separation makes it easier to see what is going on.
I will also assume something called the "intrinsic value" of the product, in this case Tulips, exists. Determining intrinsic value is often somewhere between difficult and impossible. And experts can and will differ on what the correct intrinsic value of a specific commodity at a specific time is. But we are going to ignore all these problems and pretend there is an intrinsic value and that it is knowable. Now let's look at markets.
An investor is in a market because in some sense he has to be. There are many forces that push a price up or down. So in a normal market we can expect that the price of a product will sometimes get above its intrinsic value. In this case we can expect prices to eventually go down. Similarly, the price can get below intrinsic value and in this case we can expect the price to eventually rise. The fundamental law of speculation is "buy low - sell high". So, if a speculator can establish the intrinsic value, and if he can identify times where the price is below intrinsic value, he can buy low and expect to sell high later. Similarly, he gets out of the market when the price is above the intrinsic value and waits for the market to "return to the norm".
In this situation a speculator provides an economic benefit to the economy as a whole and specifically to investors by providing "market liquidity". An investor may need to sell when prices are low. The speculator will buy when no one else will. Similarly an investor may need to buy when prices are high. The speculator will sell when no one else will. In these kinds of situations speculators perform the service of smoothing out the market, which is usually beneficial to investors in the long run.
So we have now seen on display two of the components necessary for a speculative bubble. We have a market and we have speculators. And in this benign situation we have described so far, speculators are performing a useful function. But things can go wrong. Let's see how.
Suppose we have a market that has performed well (and in this case by "performed well" I mean gone up) for a significant period of time. For whatever reasons prices have risen steadily and apparently inexorably. This sounds like an opportunity to print money. We buy and hold. The market inexorably goes up. We sell at a profit. Any fool can make money in this market. This is the third component of a bubble. It is usually but not always present.
People may mischaracterize the actual history of a market so that it seems like it always goes up. And probability tells us that if we monitor a lot of markets, and each market has a certain amount of random price fluctuation, then eventually some of these markets will show a pattern where prices seem to always (well, for a "long" time, whatever that is) go up. Now the speculators we talked about before had a level of expertise. They were able to determine the intrinsic value of the product. But in a foolproof market that expertise is no longer necessary. The market always goes up. And we now have the fourth component of our bubble, the "quick buck artists". These are people who have little or no expertise in the particular market.
This set of circumstances moves us into the inflation phase. Prices quickly and inexorably go up. In our Tulip example this happened when French speculators started moving in in 1634. Prices started accelerating and by 1636 they were zooming up. Nothing about the underlying Tulip market had changed. But now trading was dominated by speculators. It is also when investors and the early more experienced speculators started becoming concerned that prices had gotten out of control. Now we move into the "greater fool" phase.
Knowledgeable people conclude that prices are at foolish heights. But it appears that there is always a greater fool who will pay even higher prices so they stay in the market well past when they normally would. Then we finally come to the last phase. At some point the market runs out of greater fools. At this point prices start to weaken and perhaps fall slightly. Knowledgeable people now start to sell aggressively before prices fall even further. The market crashes (i.e. the bubble bursts) and prices drop, frequently to well below intrinsic levels.
To summarize, we need a market and the market needs to be open to speculators. We need (not always but usually) a period where the market goes up apparently inexorably. Then more speculators jump in and prices start rising rapidly. We then have the "greater fool" period, followed by the peak and then the crash. This pattern has been well known for hundreds of years now. When the Tulip bubble happened no one had seen anything like it before. But it certainly wasn't the last bubble. Mackay documents a number of other bubbles like the "South Sea Bubble" that are now known only to historians of the subject. At some point it dawned on some speculators that it was possible to manufacture bubbles.
By the late 1800's "stock operators" were routinely trying to create and profit from bubbles in the price of various individual stocks. The 1923 novel "Reminiscences of a Stock Operator" by Edwin Lefevre documents many of the popular schemes of the time. I bring this up because I want to differentiate between the "natural" speculative bubble, which arises naturally and is then taken advantage of, and the "artificial" bubble, which is created as a scam from the start. With all this out of the way let me now take up the three bubbles that attracted Mr. Stockman's attention.
The dotcom bubble is accurately characterized as a classic natural bubble. Also referred to as the "tech bubble" it started gathering steam in the 1980's. The Apple II (introduced in 1977) and shortly thereafter the IBM PC (introduced in 1981) made home computers practical. Many people who had heretofore not thought of themselves as tech-savvy got computers and fell in love with them. They imputed their feelings to the market as a whole and started looking for stocks they could invest in. An early example was Netscape. Netscape brought the browser to the masses. When Netscape stock went on the market it was immediately snapped up to the surprise of Wall Street experts.
In the beginning Netscape had a reasonable business model. They were going to license their product for $25 a pop. Then Bill Gates came along and gave Internet Explorer away for free. Netscape soon abandoned their licensing model. This destroyed their business model but the public continued to support the stock anyhow. Eventually, Netscape was sold to AOL in a deal initially valued at $4.2 billion (and later at much more). So the faith of the general public in Netscape as an investment was eventually vindicated. It would not be the first time.
Bill Gates was of course famous for creating Microsoft. Microsoft also went off for crazy prices. But, unlike Netscape, Gates turned out to be a savvy businessman. Microsoft turned in spectacular earnings and profit figures year after year. So Microsoft stock zoomed into the stratosphere. Apple had a much bumpier ride, at least at the beginning. The Apple II was a big success. But follow on products (does anyone remember the Apple III) were less so. After a string of duds Apple introduced the Macintosh in 1984. But it too was not a commercial success. It only garnered significant sales after Steve Jobs left the company. Apple then got into so much trouble that Jobs was brought back to rescue the company. The company was rescued and went on to a run of spectacular success. But this mostly happened after the dotcom bubble exploded in 2000.
Microsoft stands out as the great success of the dotcom era. Mostly we have companies with track records like Netscape (never made any real profit but was eventually sold for megabucks) and Apple (up then down and eventually back up but only after the bubble burst). Nevertheless the public was fascinated with these stocks and would buy them at nearly any price. This was in spite of the fact that in most cases no one could figure out how the companies would ever make money.
So in the early days you had a number of these new style tech stocks. And many had a record of inexorably rising in spite of the fact that they never made any money and it didn't look like they would make money any time soon. The most common tool Wall Street uses to calculate the intrinsic value of a stock is PE or the price/earnings ratio. If the price of a stock is $20 and its earnings for the year are $1 per share its PE is 20. Historically, a PE of 15 is considered standard. Anything between 12 and 18 considered within the normal range. There are many reasons why the PE of a stock should be below 12 or above 18 but those are special circumstances. Generally, in the absence of special circumstances, a stock is considered cheap if the PE is below 12 and expensive if the PE is above 18. Many of these tech stocks had no earnings, no "E". So their PE was off the chart on the high side.
This might be ok if there was reason to believe that earnings would skyrocket in a couple of years. If we were certain that three years from now the stock would be earning $5 per share then the "forward" PE would be 10 if the price of the stock is currently $50. This forward PE of 10 might justify buying the stock now. This kind of logic is risky but not insane. The problem with many of these stocks is that no one could figure out how they could earn say $5 per share 3, 5, or even 15 years out. So purchasing these stocks appeared to be completely insane to Wall Street analysts. But the public bought them anyhow. Enter the greater fool.
From start to finish the dotcom bubble took about 15 years. That is an extremely long time period by Wall Street standards. And Wall Street's approach to stocks that eventually became part of the tech bubble went through three stages. Wall Street had been investing in "tech" for a long time. GE dates back to the 1800's. IBM was a Wall Street darling in the '60s and the '70s. But these were big well known companies. They were thought of more as "industrials" than as some weird subspecies. These new companies were an entirely different kettle of fish. By this time Hewlett Packard was a substantial company. But it wasn't a giant. And it had taken decades to grow to its current (as of say 1980) medium size. The idea that a company could go from "startup" to "largest market cap in the world" as Microsoft did was literally unimaginable. So these tech companies started off as a side business. Wall Street could make a couple of bucks off them by managing their IPOs (Initial Public Offering of the sale of the stock) but that was just a nice but small sideline business for a Wall Street firm.
But the public's appetite for the stock of these companies seemed to be insatiable. So Wall Street came to see them as a serious line of business that could generate substantial profits. And the public continued to be happy to shoulder responsibility for being the greater fool. So Wall Street got serious about the business of shearing the sheep.
Wall Street stock brokers like Merrill Lynch maintain a group of people called "stock analysts". They are supposed to provide informed and unbiased research on stocks. By this third stage all the stock analysts had nothing but praise for these companies as sound investments. Why, since the characteristics of the underlying companies had not changed? They still had no earnings and little to no prospects for earnings in many cases. The answer is that the same company has a retail business, servicing individual investors. But it also has a corporate business where they do IPOs, float bond issues, advise corporations on various financial matters, etc. It was easier to get the "corporate side" business of a particular company if the analyst was saying nice things to retail customers. So analysts were given their marching orders to come up with reasons why these companies were good investments. This required a great amount of skill at creative writing. But those analysts that prospered turned out to be very good at it.
Cooking analyst's reports is a bad thing and I believe it is illegal. But I don't think it contributed much to the dotcom bubble. A large segment of the public had started buying these stocks long before this bad behavior became wide spread. Were some people who might have otherwise dodged the bullet enticed into purchases they would not otherwise have made by these reports? No doubt the answer is yes. And I am sure that a number of pension funds and other large investors ended up putting more money into these stocks than they otherwise would have. But the dotcom bubble was of long duration. And it was recognized as a bubble for longer and by more people than any other bubble in history.
The stock market tends to go in one direction for three to five years, or so the experts believe. Then it changes course, at least for a while. The market started up from a bottom in 1982 and climbed more or less continuously until 2000, People started saying "it's time for a correction" by about 1986 or 1987. By the early '90s there was a "when's the correction going to start" cottage industry among investors. But the market continued on its upward course. There were corrections (like Black Monday, October 19, 1987) but they tended to not last more than a few months. Then the upward trend would resume. I was introduced to both of the books mentioned above during this period.
By the late '90s jokes about the bubble were common. I remember a fund manager that I respected saying "I don't understand it but I have to be in these stocks to make money" during this period. But the market kept going up even though "everybody" knew it was too high and that prices couldn't be sustained indefinitely. Over and over in this period the "sensible people" kept being made to look like fools while the "greater fools" made bales of money. What finally happened to derail the gravy train?
The overall economy took a slight dip. This put some people in a modest financial squeeze. So they sold some of the stock they had made so much money on so that they could meet their other financial obligations. This drove the price of some tech stocks down. Much of this stock had been bought on margin (with borrowed money). When the stock price goes down, even a little, margin investors have to either put in more money or sell the stock. A significant number of people, either because they wanted to or because they had to, sold the stock. This drove prices down further. This resulted in more margin calls, etc., a classic example of a vicious cycle. At first only a few stocks went down. But this caused enough investors to decide it was time to sell other tech stocks too, "just to be safe". So the decline in tech stocks spread and soon took the whole category down. The category of speculative tech stocks went down 90% almost over night.
The tech sector has never recovered completely. The NASDAQ is tech heavy. Recently both the Dow Jones Industrial Average and the Standard & Poor "500" have each hit new "all time high" records. The record high for the NASDAQ is 5048.62. It is currently at about the 3000 level.
(to be continued)
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