Politics, et Cetera

A publication from The Political Forum, LLC

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Tuesday, March 26, 2013

They Said It:

The great source of both the misery and disorders of human life, seems to arise from over-rating the difference between one permanent situation and another. Avarice over-rates the difference between poverty and riches: ambition, that between a private and a public station: vain-glory, that between obscurity and extensive reputation. The person under the influence of any of those extravagant passions, is not only miserable in his actual situation, but is often disposed to disturb the peace of society, in order to arrive at that which he so foolishly admires. The slightest observation, however, might satisfy him, that, in all the ordinary situations of human life, a well-disposed mind may be equally calm, equally cheerful, and equally contented. Some of those situations may, no doubt, deserve to be preferred to others: but none of them can deserve to be pursued with that passionate ardour which drives us to violate the rules either of prudence or of justice; or to corrupt the future tranquillity of our minds, either by shame from the remembrance of our own folly, or by remorse from the horror of our own injustice.

Adam Smith, The Theory of Moral Sentiments, 1759.



We understand that we are breaking no new ground when we say that Paul Krugman is, almost certainly, the most overrated and least rational winner in the history of the Nobel Memorial Prize in Economics.  Conservatives have been picking on and enjoying the hypocrisy and political silliness of Professor Krugman for years.  And for good reason.  Still, we can’t say that we have ever seen a column quite as intellectually vapid as the one he produced last week.

As is his wont, Krugman peppered his piece with disdain for unregulated markets.  Fine.  That’s his thing, so to speak.  But one would think that someone who has spent his entire career grinding just one axe, day in and day out, would, over time, get better at it.  Show some mastery of his trade.  But not our pal Paul.  Consider, if you will, just a taste:

A couple of years ago, the journalist Nicholas Shaxson published a fascinating, chilling book titled “Treasure Islands,” which explained how international tax havens — which are also, as the author pointed out, “secrecy jurisdictions” where many rules don’t apply — undermine economies around the world.  Not only do they bleed revenues from cash-strapped governments and enable corruption; they distort the flow of capital, helping to feed ever-bigger financial crises.

One question Mr. Shaxson didn’t get into much, however, is what happens when a secrecy jurisdiction itself goes bust.  That’s the story of Cyprus right now.  And whatever the outcome for Cyprus itself (hint: it’s not likely to be happy), the Cyprus mess shows just how unreformed the world banking system remains, almost five years after the global financial crisis began . . . .

Basically, Cyprus is a place where people, especially but not only Russians, hide their wealth from both the taxmen and the regulators.  Whatever gloss you put on it, it’s basically about money-laundering.

And the truth is that much of the wealth never moved at all; it just became invisible . . . .

[S]tep back for a minute and consider the incredible fact that tax havens like Cyprus, the Cayman Islands, and many more are still operating pretty much the same way that they did before the global financial crisis.  Everyone has seen the damage that runaway bankers can inflict, yet much of the world’s financial business is still routed through jurisdictions that let bankers sidestep even the mild regulations we’ve put in place.  Everyone is crying about budget deficits, yet corporations and the wealthy are still freely using tax havens to avoid paying taxes like the little people.

So don’t cry for Cyprus; cry for all of us, living in a world whose leaders seem determined not to learn from disaster.

Hmmm.  Tax havens are risky; the banking system remains unreformed; secrecy is troubling; blah, blah, blah.  Of course, as interesting as such critiques might be with respect to most tax havens, they have very little to do with Cyprus.  You see, Cyprus is not your usual tax haven.  It is a tax haven for Russians, which is to say that it is not just a tax haven and not just for people trying to screw over the government.  Indeed, we’d bet dollars to donuts that a good chunk of the money being “hidden” in Cyprus isn’t being hidden from the Russian government, but hidden by the Russian government, or at least by some of its biggest players.

Krugman has his causation all screwed up and therefore misses the proverbial forest for the trees.  Cyprus did not “enable corruption” in Russia.  If anything, corruption in Russia enabled Cyprus.  The Russian state wasn’t starved by the Cypriot bankers.  The Russian people were starved by the Russian state and by its oligarch cronies who just happened to have found willing partners in the Cypriot bankers.  The difference here is significant and largely undeniable.  To everyone except Krugman and his acolytes, we suppose.

In order to understand what happened in Cyprus and what WILL happen as a result of the Cyprus bailout, one need not delve into the links between that island nation and other similar island havens, like the Caymans, ala Krugman.  Rather, one need only understand a little bit about Russia, its history, and its current condition.

As you may or may not recall, fifteen years ago, there was another bailout of another institution that was under-capitalized and whose demise purportedly posed a “systemic risk” to the banking system and to the global economy.  And then, as now, there was a significant Russian connection.

The institution in question, way back when, was, of course, Long Term Capital Management (LTCM), the infamous hedge fund firm that did business with nearly all the big banks on Wall Street in the 1990s and that even served as an investment vehicle for many of the big players in those big banks.  LTCM, as you know, lost its shirt during the Russian financial crisis of 1998, with its master fund shedding some $4.6 billion in value over the span of just a few weeks after the Russian devaluation and default.  The company was bailed out, under supervision of the Fed, when the risk of its collapse became apparent and was deemed a significant risk to be broader financial system.

Now, we have neither the time nor the expertise to get into the finer points of the LTCM bailout here.  Entire books can and indeed have been written about the subject.  Our interest in the topic, then as now, was the trigger for the company’s losses and the subsequent bailout, namely the collapse of the Russian economy.

For starters, we should note that LTCM was not the only Wall Street player hurt by the Russian crisis.  In fact, the firm we worked for at the time – the now defunct Prudential Securities – was stung badly as well.  And that, we suppose, is why the piece we wrote in response didn’t go over so well with our superiors, as was the case with much of what we wrote back then.

You see, we had been writing about Russia for several years at that point and had, in fact, written several pieces about the risks posed by playing around with individuals and governments that were long on cash and short on scruples.  The end result, we argued (time and again!) would be disaster.  After the ’98 financial crisis and the damage done to LTCM and our employer – and our bonuses that year – we reiterated those risks in a piece entitled “The Russian Meltdown:  Who Didn’t Know?”  We put it this way:

What has emerged from 450 years of “leadership” by mass murderers and wackos, none of whom had any regard for such Western concepts as law and order, property rights, or respect for human life, is a highly cynical population that has no inclination to either revere or to trust their government.  And since their leaders no longer engage in systematic mass murder, most citizens no longer fear it either.  The result is a society that is remarkably close to what Hobbes described in his famous book, Leviathan.

“During the time men live without a common power to keep them in awe, they are in that condition which is called war; and such a war as is of every man against every man.”

As Hobbes correctly noted, such conditions will lead to a predatory society in which the strong prey on the weak.

“For the laws of nature, as ‘justice,’ ‘equity,’ ‘modesty,’ ‘mercy,’ and, in sum, ‘doing to others as we would be done to,’ of themselves, without the terror of some power to cause them to be observed, are contrary to our natural passions, that carry us to partiality, pride, revenge, and the like.  And covenants, without the sword, are but words and of no strength to secure a man at all.  Therefore notwithstanding the laws of nature which every one hath then kept, when he has the will to keep them, when he can do it safely, if there be no power erected, or not great enough for our security, every man will and may lawfully rely on his own strength and art, for caution against all other men.”

Now many philosophers have argued, down through the ages, that Hobbes failed to understand that religion, not just “the sword,” could and does act as a check on man’s “natural passions.”  But in Russia, this power too no longer obtains, for the Communists spent all 72 of their years in the Kremlin systematically destroying the once-strong Russian Orthodox church, leaving what has been described by many observers as a profoundly atheistic society.

The result is a nation that is dominated by ruthless gangsters; a nation that can be accurately described, as I have been doing in speeches all over the country for several years now, “the world’s longest lived and largest on-going criminal enterprise.”

Corruption is endemic in Russia.  There is virtually nothing that goes on there that is not tainted by corruption.  Corruption is part of Russia’s marrow.  In fact, I think a case can be made that the one consistent characteristic of Russian economic and political life throughout its tortured history is corruption.  And the inevitable consequence of this corruption – now get this – is severe economic problems, because trust in the law and honest behavior are necessary ingredients in a smoothly functioning capitalist society.

Corruption is inefficient.  It interferes with the flow of capital to its most useful purpose.  Most economists and businessmen are oblivious to this point.  They think that capitalism is capitalism is capitalism.  Many are actually dumb enough to think that corruption is basically good, that it defines the true “free market.”

Long-time readers may well remember that this was not our only piece on corruption, in Russia and elsewhere.  Corruption was one of our two principal long-term themes during the ‘90s.  It just so happens that it is the lesser remembered of the two simply because the other – global and especially Islamist terrorism – became so important, so quickly and has remained so.

Still, we wrote about the dangers of corruption, and of the corruption endemic in the post-Communist world in particular, many times during the mid-to-late 1990s – which explains, in large part, our frustration with our own firm for blatantly disregarding our warnings.

These discussions of corruption were not necessarily lecturing.  We did not then and do not now believe that every single capitalist had to be squeaky-clean in order for the capitalist system to function properly.  We did, however, argue that there were certain rules and structures that enabled capitalism to work and that those rules and structures were derived from Western civilization and from the Judeo-Christian tradition in particular – which is to say that had a foundation in the great religious and ethical traditions of the West.

Among others, we cited Max Weber and Adam Smith, both of whom argued explicitly that capitalism’s rise was fostered by a general, societal belief in the necessity of moral behavior and that its continuance depended on the maintenance of moral structures, even in the face of individual immorality.  Again, this was not to say that every participant had to behave morally.  It was simply to argue that the system itself had to acknowledge the value of probity, which would therefore compensate for the failings of the individual, or of many individuals, as the case may be.  Indeed, as Adam Smith wrote, the individual could not be counted on to behave morally, and thus the structures of the system had to limit the desires of the potentially corrupt businessman, who constituted the greatest risk to markets and their efficient function.  To wit:

Were the officers of the army to oppose with the same zeal and unanimity any reduction in the numbers of forces with which master manufacturers set themselves against every law that is likely to increase the number of their rivals in the home market; were the former to animate their soldiers in the same manner as the latter enflame their workmen to attack with violence and outrage the proposers of any such regulation, to attempt to reduce the army would be as dangerous as it has now become to attempt to diminish in any respect the monopoly which our manufacturers have obtained against us.  This monopoly has so much increased the number of some particular tribes of them that, like an overgrown standing army, they have become formidable to the government, and upon many occasions intimidate the legislature.  The Member of Parliament who supports every proposal for strengthening this monopoly is sure to acquire not only the reputation of understanding trade, but great popularity and influence with an order of men whose numbers and wealth render them of great importance.  If he opposes them, on the contrary, and still more if he has authority enough to be able to thwart them, neither the most acknowledged probity, nor the highest rank, nor the greatest public services can protect him from the most infamous abuse and detraction, from personal insults, nor sometimes from real danger, arising from the insolent outrage of furious and disappointed monopolist.

Given all of this, we argued that the post-Cold-War world threatened capitalist economy because it threatened the moral system that underpinned that served as its foundation.  There were new players in the game, none of whom had any experience with capitalism or, for that matter, with the moral enterprise that made a private economy possible.  The Chinese and especially the Russians were suddenly awash in cash and were looking for ways to make more and more (and more) of it.  They had little concern for the niceties of the Western business model, yet they were, overnight, big time players in the capitalists’ proverbial sandbox.  Among other warnings that we suggested investors heed was the following, which came from the 1998 annual report from the Paris-based “Geopolitical Observatory of Drugs,” which describes itself as the only truly independent organization that monitors the worldwide narcotics trade:

Several major countries, like Russia (and many former Soviet Republics), Turkey, Mexico, etc., are now at the center of an increasingly conspicuous alliance between organized criminal structures and high levels of the state itself.  In Japan, organized crime (yakuza) is behind 30% of the bad debt which has provoked the current financial crisis.  In less developed countries, particularly on the African continent, the privatization of state-owned companies is now the main vehicle for recycling drug money thanks to corruption.  In this way a new and distorted “development” model is emerging which, while enriching the elite classes, also encourages chaos.  This ‘criminalization of politics” is beginning to act as a brake on development as mafia activities produce much larger and especially quicker profits than legitimate activities do.

When legitimate businesses survive, it is often as “fronts” for criminal activities . . . . Legitimate and criminal interests have become so intertwined in some parts of the world that the frontier between the two has become purely theoretical . . . .

The crash of the Mexican economy in 1995 (and again in 1998) and similar problems experienced in Russia and Japan since late summer 1998 probably constitute the first major financial crises in the history of contemporary society, whose principal catalyst is a mafia-like management of the economy.  The problems are no longer of a quantitative nature, such as the percentage of profits stemming from criminal activities (and more specifically from drug trafficking) and redistributed within state institutions or laundered through the economy.  The problems are much more fundamental now . . . .

All of this, we argued, made Russia a particular risk to the global economy.  It had no history of ethical or moral governance.  It had no experience with capitalism as the term is understood in the West.  And yet it had enormous resources, huge supplies of oil and natural gas, an advanced drug-trafficking operation, and a ruling class that was rich, violent, and manifestly corrupt.  “Don’t be surprised by periodic economic meltdowns in Russia,” we wrote in September 1998, “or the emergence of leaders who are extremely nationalistic and antagonistic to Western interests.  That’s the other side of the wonderful ‘globalization of the world’ story that we’ve all heard so much about since the Berlin Wall fell and the financial markets began screaming upward.”

And this brings us back to Cyprus . . . .

As we said above, anyone who thinks that this is the story of just any old tax-haven (cough, Krugman, cough, cough) is nuts.  This is the story of the RUSSIAN tax haven.  Somewhere between 35% and 50% of the 70+ billion euros deposited in Cyprus’s banks is held by foreigners.  And the vast majority of those foreigners are Russians.  And you can bet that the vast majority of those funds are there specifically because Cyprus and its banks promise secrecy.  Contra Krugman, this isn’t about “businessmen” hiding money from their state.  This is about the Russian state and the businesses with which it colludes in mostly illegal operations hiding their money from the rest of the world.

Let’s face the facts about Cyprus.  Yes, it’s an awful thing for a government to confiscate the savings of banks’ depositors.  And yes, it’s an even more awful thing for said government to do so on the orders of an unscrupulous and inhuman bureaucratic apparatus in a far off country and at the direction of the Continent’s wealthiest people.  And yes, even worse still is the precedent that such a move will set.

But then, in the face of all this awfulness, one has to ask why all that money in Cyprus in the first place?  The answer to that question is interesting, to say the least.  The Russians could, after all, have put their money anywhere they wanted to put it.  If they wanted to save in euros, they could have done so in Germany, where both the banking system and the economy are in far better shape than in Cyprus.  But they chose not to.  And they chose not to because the banks in Cyprus paid higher returns, given their riskier investment portfolio.  Of course, most of that investment was in Russia itself, which is to say that the money the Russians put in Cyprus was laundered right back into Russia.  And that brings us to the other reason that the Russians chose Cyprus over, say, Germany:  because they knew the Cypriots would do as they were told and would shut the hell up about it.

Who, exactly, is getting screwed here?  The Russian depositors?  Or the German taxpayers who are footing the bill for the Russian depositors’ insistence on secrecy, obedience, and above all, great returns?

We know how the conventional wisdom answers this question.  But we’re not all that sure that we agree with that answer.  It strikes us that the Russians were playing fast and loose with the rules – as they are wont to do – and are now unhappy that their actions have dictated repercussions.

Of course, the Russians don’t appear to see it this way.  Russian Prime Minister Dmitry Medvedev called the move “stealing.”  He also warned that the confiscation of funds would force Russia to “correct” its relationship with Cyprus.  As far as we can tell, that translates roughly as a warning that Cyprus’s President, Nicos Anastasiades “sleeps with the fishes” or will very soon.  As for Russia’s top thug, President Vladimir Putin, he echoed his Prime Minister, calling the move “unfair, unprofessional, and dangerous.”  It goes without saying that the former KGB agent, whose enemies have a habit of dropping dead, didn’t specify for whom the move would be “dangerous.”

What does this mean, going forward?  Well . . . that’s debatable.   On the one hand, Cyprus will be saved and the EMU will remain intact.  For now.  And markets will, we think, take that as good news.  But there will be other consequences, most of which will be ugly.

Anyone who has read this newsletter more than a couple of times knows that we are fond of reminding you, our dear readers, that we foresaw the euro’s collapse, even as it was in its infancy.  Specifically, we wrote:

It is probable that the adoption of the Euro will be to 21st century Europe, what the killing of the Archduke Ferdinand was to 20th century Europe; i.e., that point in time when history will record that the unraveling began in earnest.

Well, if that is true (and we believe it is), then the appropriate historical analogy for the depositor “haircut” in Cyprus is “Operation Barbarossa,” which was the code name given to the Nazi plan to abandon the Molotov-Ribbentrop non-aggression pact between Germany and the Soviet Union and to invade Mother Russia.

This analogy is not perfect, of course.  In this instance German Chancellor Angela Merkel is the good guy – or at least as close to a good guy as one gets in this case.  But the end result will, we expect, be much the same.  Germany and Russia will go to war.  And this will be only marginally a figurative “war.”  The Russians, at least, will treat it like a real, life or death struggle.

Vladimir Putin may seem like a comic-book heavy, a pretentious goon who is more concerned with displaying power than with actual productive governance.  But in this, he is typically Russian.  More to the point, his buffoonishness does not preclude serious and devastating retaliation, as any Chechen could tell you.  If there were any left alive, that is.

The fact of the matter is that this action on the part of Cyprus/the EU is going to be taken personally in Russia and especially in the Kremlin.  And when the Kremlin takes things personally, conditions have a way of deteriorating quickly.

Nearly 17 years ago, this country’s most renowned Russian scholar, Harvard’s Richard Pipes, penned a piece that still, to this day, serves as the most prescient and insightful analysis of Russia’s history, its psychology, and the likely effect that the two would have on its post-Soviet future.  That article, “Russia’s Past, Russia’s Future,” from the June, 1996 issue of Commentary magazine helped us formulate our expectations for Russia and, to date, has not disappointed us to that end.

According to Dr. Pipes, history teaches that the Russian state has little or no foundation outside of its ability to project to its subjects the image of invincible power.  Both the Russian monarchy and its Communist successor, he notes, legitimized their authority by projecting to their subjects their overwhelming military strength.  “What better way,” Pipes asked, “to inculcate among their own people the sense of futility of resistance than to show that the whole world feared Russia?”

As a consequence, Pipes maintained, there has arisen an intimate link between Russia’s status as a great power and its internal stability.  He put it this way.

One of the principal reasons for the collapse of czarism in 1917, rarely mentioned by scholars captive to the class-war theory of history, is the steady decline of the monarchy’s claim to great-power status as a result of military defeat in the Crimean war of 1854-56, the diplomatic setback following the Balkan war of 1877-78, the debacle in the conflict with Japan in 1904-05, and finally the repeated thrashing at the hands of the Germans in World War I.  As a consequence of these humiliations, the monarchy, in the eyes of its subjects, lost the “mandate of heaven,” and all the more so since it also proved itself unable to cope with radical terrorism on its home territory.

As a result, Pipes argued, Russia has had far greater difficulty adjusting to the post-colonial era than any other European state.  The loss of empire has truly damaged the image of mother Russia in the eyes of her people.  As Dr. Pipes so eloquently wrote:

In Russia . . . the sense of ethnic identity was always indissolubly linked with empire, and its loss has produced bewilderment and anguish.  Indeed nothing so much troubles Russians today, not even the decline in their living standards or the prevalence of crime, and nothing so lowers in their eyes the prestige of their government as the precipitous loss of great-power status.  A superpower under Communism, a peer of the United States, their country is now, they feel, treated like a third-world nation, the humble recipient of Western largesse.  A great deal of the appeal of the red-brown (Communist-Fascist) coalition derives precisely from its promise to restore to Russia the status of a respected – that is, feared – world power.

What this tell us is that Putin, Medvedev, et al. are not particularly likely to see this economic “necessity” as an economic measure at all.  They are, rather, to see it as a personal affront.  More to the point, they are likely to respond accordingly.  And as Dr. Pipes noted lo those many years ago, that means a projection of power.

Is it a coincidence that Boris Berezovsky, an erstwhile Russian “oligarch” who had run afoul of Putin, turned up dead in London under mysterious circumstances this weekend?  Or was it a warning of sorts to anyone else who might cross Vlad the Impaler?  Is it paranoid even to ask that question?  If you were Frau Merkel would you want your security team to be doubled – at least temporarily?   Would Putin, even if capable, possibly resort to such actions?  Would you like to be the guy who finds out?

All of this serves merely as a reminder that both the causes and the effects of the bailout agreement in Cyprus are far more complex than the mainstream press is willing or able to admit.  There is far more going on here than meets the eye.  Likewise, the repercussions of the agreement will be far more numerous and far more severe than most analysts expect.

The Russian regime is ruthless.  It is also deeply corrupt.  And you can bet that it’s up to its eyeballs in money laundering, in Cyprus and elsewhere.

What’s worse, the Russians aren’t alone.  The Saudis, the Chinese, the Latin American drug lords, and countless others all have billions of dollars with which to play, and no compunction whatsoever about messing up the capitalists’ sandbox as they do so.

In February, 1997, Thomas Duesterberg, then a senior fellow at the Hudson Institute, penned a piece for the Wall Street Journal discussing the importance of clean, honest, and open markets in the unprecedented growth and expansion of prosperity that had followed the end of World War II.  He put it this way:

Out of the ashes of World War II, the U.S. and its allies erected a new economic order that has produced the broadest and most sustained period of prosperity in world history.  Its basis is a system of rules to govern, facilitate and promote commerce.  The U.S. and its allies assisted many nations, starting with Japan and Germany, in building domestic commercial and legal codes that assure property rights, promote the free exchange of goods and services and facilitate enforcement of contracts.

Slowly but surely, since the end of the Cold War, that economic order has been under attack, both from within the system and from without.  The euro is an example of the corruption and economic whimsy that has weakened the system from the inside.  The bailout of Cyprus in order to save the euro was made necessary in large part because of the corruption and economic viciousness that has destabilized the system from the outside.

Worse yet, we fear this is only the beginning.

Unless and until the economic powers that be in the West understand and acknowledge that there is a decay and depravity here that goes far beyond merely trying to “avoid paying taxes like the little people,” the attacks from both sides will continue.  And they will only get bigger and more “dangerous” to borrow Comrade Putin’s term.

In the meantime, our advice to Chancellor Merkel?  Sleep with one eye open.  The “haircut” is only the beginning.


Copyright 2013. The Political Forum. 8563 Senedo Road, Mt. Jackson, Virginia 22842, tel. 402-261-3175, fax 402-261-3175. All rights reserved. Information contained herein is based on data obtained from recognized services, issuer reports or communications, or other sources believed to be reliable. However, such information has not been verified by us, and we do not make any representations as to its accuracy or completeness, and we are not responsible for typographical errors. Any statements nonfactual in nature constitute only current opinions which are subject to change without notice.