They're back.

It is not clear how foreign policy strategy is being set in the Obama administration. But the execution has the appearances of a well-considered and orchestrated dance. And when the music stopped this week, standing together on the stage, united in common purpose, were the Big Four of wars gone by—the U.S., Great Britain, France and Russia.

The surprise this week was not the disclosure of a second, secret Iranian uranium enrichment site. Nor the ensuing condemnation and threats of collective action. What was surprising was the distinct voices that were heard. It was French President Sarkozy and British Prime Minister Brown whose declarations were strongest, with Russian President Medvedev joining shortly thereafter. Finally, an American President was able to speak a bit more softly—and by the demonstration of common purpose suggest a bit more stick on behalf of the international community.

For the first time in a while, Iranian President Ahmadinejad seemed caught off guard. His normal swagger was muted, perhaps with the realization that his days of manipulating Russia against the West have ended. More perhaps with cold fear that it was he that was manipulated by Russia, and that his miscalculations may weaken him considerably in his battles to retain power at home.

Perhaps American foreign policy is coalescing around some basic realities of the world. There are real threats out there, and we do not have the capacity to fight them alone. The unilateralism of the past decade was defined less by our determination to go it alone into war than by the belief that we could fight all battles and recast all nations in our own image. Almost without exception—perhaps China, as our lead banker, was the exception—we demanded fealty to our image of democratic progress from all of our antagonists.

But when you are fighting on all fronts, your ability to build enduring coalitions on any one of them is diminished. Russian Foreign Minister Sergey Lavrov has long articulated this view. Yes, as he has suggested for the better part of a decade, Russia and the United States have more issues that unite them than divide them. And yes, when presented with the top five issues of concern facing the U.S. in the international arena—perhaps including among them Afghanistan, Iran, Iraq, Islamic fundamentalism, drug trafficking, nuclear proliferation—Russia was a potentially valuable ally in all of them.

But the problem was that Russia had their own top five list, and Lavrov has long complained that if there was to be a partnership, it could not be one-sided. Russia’s concerns had to matter as well. Yes, Russia was prepared to be an ally in the Global War on Terror, but the Russian list had to be on the table. And they had a different list. Chechnya. Georgia. NATO. Missile defense. Encirclement. Status.

Russia’s list was fundamental to the continued integrity of the Russian nation. Russians may be paranoid, but the simple fact is that people are out to get them. U.S. official policy has been and continues to be one of encirclement, while many prominent voices go well beyond that—most notably Carter-era National Security Advisor Zbigniew Brzezinski—and argue that U.S. policy should be the dismemberment of the Russian state.

The dismemberment of the Russian state is not so far fetched. Before the fall of the Soviet empire, the Soviet Union claimed a population of nearly 300 million people. Today, Russia is a nation of just over 140 million, and it is shrinking rapidly. With low birth rates, high infant mortality, short life expectancy, and minimal immigration, by mid-century Russia’s population is projected to decline by more than 20%, to approximately 110 million.

The prospect of Chechen independence—and the demands for independence that would likely ensue from other minority groups should Chechnya succeed—further threatened the future of Russia. This fear explained in large measure Russia’s vociferous objection to NATO’s declaration of independence for Kosovo, and Russia’s steadfast claim that the international community can only grant nationhood through the legal powers granted to the United Nations.

Russia’s intransigence in dealings with the United States is rooted in its defense of national self-interest. For several years, Putin and Medvedev have been intent in their actions in international affairs—from supporting Iran to instigating the Ukrainian natural gas crisis—to force the United States to deal with them and their issues.

U.S. actions over the past nine months indicate that U.S. policy has evolved, and that we may finally be paying attention. The nuance is the distinction between what we say and what we do. The Bush administration talked about partnership and an alignment of interests, but took every opportunity to dismiss Russian concerns on the ground.

Now, the process seems to have been inverted. Vice President Biden—an early and vociferous backer of the Kosovo action that was so objectionable to Russia—has emerged as the voice of American support for the process of democratization and continued support for Ukraine and Georgia.

But Putin and Medvedev are realists, less moved by words than action. At the same time as Biden was talking the talk, the administration was walking a different path. During the early months of the administration, Russia threatened U.S. resupply routes into Afghanistan, and U.S. access to a key air base in Kyrgyzstan. One can imagine at that moment that the administration looked down the road at the real threats that loomed, and took a hard look at the facts on the ground. One can imagine that at that moment, they weighed the real impact on the ability of the U.S. to pursue its strategic goals and determined that Russia was—as Lavrov long suggested—better to have as an ally than face as an obstacle and an adversary.

It really was never a question. After all, for all the rhetoric—whether from Biden, Bush or Cheney—about U.S. support for Georgia or a common defense of Ukraine—neither we nor our European allies have had or likely would ever have the willingness to go to war with Russia in their Near Abroad. Our actions may have been designed to tweak them and continue the great game wherever possible—but never with the intention of real escalation.

One question this week has been how long ago did the U.S. learn of Iran’s second enrichment facility. Was it many months ago, and were the strategic moves to bring ourselves closer to an effective alliance with Russia—such as shifting our policy on strategic missile defense in Poland—in preparation for this next phase of the confrontation with the Iranian regime? Or was it simply fortuitous that the steps had been taken, and the groundwork had been laid that would allow Russia and the U.S. to stand together against a common threat?

Perhaps it doesn’t matter. But it does matter that our foreign policy may be built less on rhetoric, and more on our capacity to build effective alliances against real, and common, threats.

The grand illusion.

Most of us have lived through, or will live through, the painful years of watching our parents’ health decline. Behind the ugly partisan rancor of the town halls and the healthcare debates is the simple truth of that common experience.

Whether our parents have cancer or Alzheimer’s or dementia, or are simply dying of old age, we watch as their bodies become frail and their minds fade. These are our parents, once our providers and protectors, sapped of the energy and vitality that we for so long took for granted.

The medical bills. The residential communities. The in-home care. The drugs. They drain our parents’ savings and ultimately strain our family resources. We may have thought that Medicare would suffice, until one day a bill arrives from a rehab facility or a hospital, or a new drug is prescribed. From that day, the emotional pain of end of life care is compounded by the financial strains that bleed outward, undermining sibling comity, and threatening the resources set aside for kids' education, for family vacations, or for retirement.

There is no easy solution to this. We are all living longer, and the advances of technology and science now offer us the ability to fend off diseases that years ago barely existed—largely because we used to die younger and never contracted them. As a close friend put it—a Jesuit priest with a way with words—the longer any machine works, the more the maintenance costs go up.

People like to compare Medicare with Social Security, but the challenges facing Social Security are manageable by comparison. When Franklin Roosevelt created Social Security in 1935, it was a stroke of political—if not financial—genius. Social Security offered retirement security at age 65 to American workers whose average mortality at the time was 59. Therefore, it offered an entitlement to people who—on average—would be dead before they were eligible.

But even with longer lifespans, Social Security is a controllable and predictable program. The mortality curve shifts slowly and we can—at the end of the day—choose to change the parameters of the program that affect cost: the retirement age, the cost of living adjustments, the basis of pay, and the basis of taxation.

Healthcare has no such certainties. Unlike information technology, which offers greater and greater power at less and less cost, investments in healthcare technology and pharmacology that increase longevity and cure rare diseases may be moral victories for humanity but only exacerbate the financial strain on society and families. This is the dilemma of healthcare: The better we get at it, the faster the costs will escalate.

Dr. Andrew Weil, and many others, have pointed out that the solution to our healthcare crisis lies in how we choose to live our lives, and ultimately how we choose to die. In a similar vein, Atul Gawande suggests that the solutions to the cost and quality of healthcare lie in large part in the choices and conduct of the providers themselves. If physicians turn the practice of healthcare into an exercise in profit maximization, they will do better as individuals, but their patients and the system itself will suffer.

But as in most areas of life, good choices and ethical practices cannot be compelled or overseen by government. Regulatory regimes can enforce measurable practices—such as the concentration of melamine in dog food, or rat hairs in cola. But the federal government has no capacity to regulate the quality of collaboration among and conduct of individual medical practitioners.

The person who cried out at one town hall meeting to not let the government get its hands on Medicare has been duly castigated for the irony and ignorance of the remark. But at a deeper level, the remark encapsulates the problem we face.

Medicare is a government program. While many proponents of single payer healthcare point to Medicare as a model, it is a program that pays providers far less than the cost of services, and therefore results in substantial cost-shifting that exacerbates the medical insurance costs paid across the rest of society.

But Medicare is the lifeline of the elderly, and of the families of the elderly. That person may want to believe that Medicare exists above and apart from government, but of course it does not. Each Medicare patient—and their families—are relying on Other People's Money for their care, but they feel entitled to have it with few strings attached nonetheless. But the truth is that it is one more tax-funded program. Just like the stimulus money. Just like the wars. Just like everything else.

Medicare is our cushion. It insulates us from painful decisions that otherwise would be ours. But it is an illusion.

The fear and rage evinced by the person at the town hall presages the pain to come as that illusion is laid bare. If Medicare is Other People’s Money, then those other people are surely entitled to set the rules. But even worse is the realization of what would happen if it were not there. Without Medicare, we would have to be paying those costs for our parents’ end of life care ourselves.

Based on Dartmouth research data, per patient Medicare costs for the last two years of life range from approximately $50,000 to $100,000 across the country. And this is just the part paid by Medicare, which as we all learn is only part of the puzzle. These costs stand in stark contrast to the Federal Reserve data on household finances, that indicate that the median family net worth has fallen from $120,000 in 2007 to $99,000 as of October of last year. It is not a stretch, therefore, to suggest that we are spending with other people's money far more than we could spend if it was our own.

The person who cried out at the town meeting may have been voicing a fear we all hold deep inside. What if it is all an illusion? What if Medicare is not an impenetrable wall that protects us from those decisions that are most painful?

For many years we have accepted the illusion and comfort that Medicare offers. Spending Other People's Money has changed the decisions that we make, and our assumptions and expectations about the care our loved ones receive. We now clamor to rest assured that they will receive all of the care a physician might recommend—with little consideration of the cost to the system of which we are a part.

But federal government resources are no more than the pooling of our collective family resources. In the end, we will return to the questions that for many years we have been able to avoid. How would we choose what steps to take—and what procedures to forego—if it was our limited family resources that would be drained away by each of our decisions? And what choices would our parents make if they understood the magnitude of the impact of each decision on their children and grandchildren?

The question of how we are going to spend scarce resources is with us. We confront it around the kitchen table, and it is time that we accept that it is the central question of healthcare challenge. It is the question that will consume our politics in the years ahead, because the years of free money and free choices have come to an end.

The specter.

A specter is haunting America—the specter of debt.

Birthed in the dying years of the Cold War, the American polity lost its way. Public policy, as encapsulated in the Federal budget, was always about making hard choices among competing priorities and constituencies. The notion that resources were limited was a critical discipline, and the ability to navigate the process of allocating resources was the stuff of which Congressional leaders were made. Throwing arrows is easy. Building a budget in a democracy is hard stuff.

Traditionally, Democrats were the party that believed in spending more—and taxing more, while Republicans once were the grownups of the American political system, sternly cautioning against the political urges toward deficit spending and international adventurism.

But the world changed over the last quarter century. Faced with the realities of survival in a competitive world economy—and the exigencies of political fundraising—Democrats brought corporate America inside their tent and muted their hostility to the private sector. For their part, since George H.W. Bush uttered the words Voodoo Economics in his failed efforts to derail the Reagan Revolution, the unholy alliance of tax cutting Republicans and big spending Republicans marked the death knell of that party’s claim to the moral high ground in matters of fiscal propriety, while Neo-conservatives brought to the GOP an evangelical fervor to change the world that was once a Democratic credo.

The numbers are stark. Over the past twenty-five years, Democrats and Republicans alike forswore their allegiance to the central responsibility of elected legislators to make choices, balance priorities and pass budgets with integrity. Perhaps they were not to blame, after all East Asian countries led by China continued to fund our deficits by buying our bonds and offered cheap money as an alternative to the more painful options of cutting spending or raising revenues. These foreign purchases of our debt were not an act of faith in the almighty dollar as much as a simple expedient of the export-driven model of economic development that has become the norm across the world.

Over the past quarter century, China, the Asian Tigers of South Korea, Hong Kong, Taiwan and Singapore, and more recent converts such as Vietnam, pursued a successful economic development strategy built on selling manufactured goods into the U.S. consumer market. As these countries took in massive amounts of dollars, they faced two options: They could recycle those dollars back into the U.S. or watch the value of the dollar decline and their own currencies rise. There really was no choice, as the export-driven development model that was lifting the Asian nations out of poverty required that their currencies not rise in value relative to the dollar, so that their low-cost goods remained attractive in the U.S. market. Accordingly, U.S. Treasury securities became the preferred investment for Asian trade-surplus dollars, and our financial markets become flush with that kept long-term interest rates low.

What was lost in the orgy of low cost debt that ultimately engendered the securitization boom in credit card and home equity lending—and enabled growing deficit spending at the federal level—was that the American economy, like the American household, was living on a chimera of growth that belied the underlying damage that was being done to our economy.

As the table here illustrates, over the past twenty-five years, our economic growth has increasingly been driven by imported capital. In the same way that the average American household saw no real income growth during the past decade, but increased their spending through borrowing, so too the national GDP was flat, but for the growth realized through externally borrowed dollars.

Today, we are faced with stark choices. But if the healthcare debate is any measure, it is evident that our political establishment has lost much of its capacity for honest debate and real decision-making. Twenty-five years of free money and no discipline has made a mockery of the federal budget process, as we now are accustomed to avoiding choices and accepting the false notion that there are obligations that are non-negotiable.


For two decades now, we have become accustomed to justifying any manner of spending, from education to tax cuts, as an investment in our future. This rationale is a direct outgrowth of the availability of low-cost capital that has itself undermined the ability to weigh and make choices. This has undermined as well the notion of a national consensus on foreign policy, as we now go to war with little regard for the financial cost. With no fiscal consequences and no universal service, war has become a sideshow of American political life.


Today, the generation-old paradigm may well be shifting. It is with no small amount of irony that even as our Republican and Democratic representatives have lost anything but a rhetorical commitment to the traditions of responsible budget policy, it is the Chinese Communist Party—the largest holder of our debt and the most at risk for the consequences of a devalued dollar—that is becoming insistent that we pay attention to our cascading fiscal mess.

Surely, as the source of the free capital to which we have become addicted, the Chinese have little more standing to scold us than the crack dealer who declares to the destitute customer that it is time to stop. The true dividend to the Chinese is not the return on their investments, but rather the economic growth that has lifted the livelihood of hundreds of millions of Chinese out of poverty over the past two decades—paid for graciously by the American factory workers whose livelihoods were lost.

But ironies aside, we have to listen. A new economic model could be beneficial to us—over the longer-term. Increased domestic savings and a declining dollar in the short-term could make overseas manufacturing less competitive, and allow America to begin building things again. But the near-term pain will continue for some time, as the process of paying down the debts that we have accumulated will take years. And we have become a very impatient nation.

The problem, however, is not our ability to listen. The problem is that after twenty-five years, the very skills required to build a federal budget that faces up to real facts, weighs priorities and makes real choices, may be gone from our political DNA. The Death Panel debate, while fraudulent on its face, offered the first inkling of the challenges to come when capital becomes scarce once again, and we are confronted with competing priorities for limited budget dollars.

The truth is that there is a Death Panel, that is charged to sit and decide how limited resources should be allocated. To weigh the needs of the elderly against the needs of the young, the costs of healthcare against the costs of war. But it is not the faceless panel of bureaucrats of Sarah Palin's imagination. It is Congress. It is time they get used to it.

The greening of Goldman Sachs.

The US economic turnaround may not be complete. The AIG turnaround may not be complete. The GM turnaround may not be complete. But Goldman Sachs is back.

“A Swift Return to Lofty Profits” proclaimed in the New York Times, as Goldman Sachs reported that it earned $3.44 billion in the second quarter, and is preparing its largest bonus payout in history. And without doubt, those lofty bonuses are well earned.

Consider how effectively Goldman has navigated the roiling waters of the global financial crisis. First, Goldman received a $10 billion injection of TARP funds to help it weather the market turmoil. Next, it swiftly converted itself into a commercial bank and member of the Federal Reserve system, gaining access to low or zero cost capital at the Fed Discount window and access to federally guaranteed borrowing through the FDIC Temporary Liquidity Guaranty Program. Finally, it garnered a $13 billion payout at one hundred cents on the dollar for its outstanding credit default swap contracts with AIG.

Now, we are told, Goldman’s profitability stems from its trading prowess in global markets. Really? A $3.44 billion profit in the second quarter could be accounted for simply by a 25% run-up in the value of the CDS portfolio from its value when AIG stood as a bankrupt counterparty.

No, Goldman may have trading prowess, but that pales against its political prowess.

Thirty years ago, most of the major Wall Street investment banks were partnerships, and those with the greatest prestige and market power—Salomon Brothers, Goldman Sachs, Lehman Brothers and Morgan Stanley—eschewed retail brokerage in favor of institutional relationships and proprietary trading. Only Merrill Lynch prided itself on retail brokerage and being a member of the New York Stock Exchange.

Then, the world changed, as investment banking firms looked far and wide for new ways to strengthen their balance sheets and access new pools of capital. One by one, the old-line partnerships fell by the wayside, casting aside their culture and independence for the lure of other people’s money. Salomon merged first with Phibro, and then was subsumed into the emerging Citibank colossus. Lehman was acquired by American Express. Morgan Stanley suffered the ignominy of merging into the Sears Roebuck/Dean Witter/Discover financial services company.

Only Goldman Sachs retained its culture and identity, even though it too tossed aside its partnership heritage in exchange for the lucre and capital offered through a public stock offering.

As one watches the evolution of Goldman, it is hard not to become a conspiracy theorist. After all, Goldman’s rise from merely the top of the heap into the stratosphere has come after years of growing influence in Washington as one Goldman partner after another were appointed to senior positions in the Cabinet or White House—John Whitehead, Robert Rubin, Josh Bolten, Hank Paulson, to name a few—and tens of millions of dollars of political contributions found their way from Goldman Sachs into the campaign war chests of members of Congress, of Senators and Presidents, Democrats and Republicans alike.

Perhaps the public interest and the private interest just happened to coincide with the passage of the Financial Services Modernization Act in 1999 and the Commodity Futures Modernization Act of 2000. Perhaps the conversion of Goldman Sachs—a non-depositary institution—into a commercial bank, with access to Fed Funds and the Discount window, and eligible for FDIC guarantees on its debt offerings was in the public interest. And perhaps the public interest was somehow served when Goldman and others jumped to the front of the line of AIG creditors and were made whole on their credit default swap contracts with a bankrupt counterparty.

Perhaps. But we must conclude—because we believe in truth, justice and the American way—that Robert Rubin, Josh Bolten and Hank Paulson influenced and guided public policy in ways that was truly in the public interest, and that there was no nefarious connection between all of those campaign dollars and the direction of our national policy in any manner that unduly benefitted Goldman Sachs over the years.

Perhaps. But this year, appearances matter. And this is the year that has seen $10 billion of TARP money and $13 billion of AIG money and who knows what amount of additional Federal Reserve funds or federal guarantee benefits flow into the coffers of Goldman Sachs.

So perhaps, this year, Goldman Sachs employees should be content with the tripling in value of their stock—surely a direct result of all of the financial largesse that has flowed Goldman’s way—and perhaps this is a year when $3.44 billion of Goldman Sachs profits should not turn into bonuses, without due consideration for how all of that was possible, and where that money came from.

From the rest of us.

After the fall.

We have yet to see what the Iranian regime will be prepared to do in the face of real opposition. After all, the leaders of the opposition questioning the election results—Mir Hussein Mousavi, Mehdi Karroubi and Hashemi Rafsanjani, and others who have emerged as fellow travelers, including Ali Larijani and Mohammad Khatami—are each deeply routed in the Islamic revolution, and each served as either the leader of the parliament or the President of the Islamic republic.

More to the point, each rose to the top of Iran’s tightly controlled political apparatus, gaining personal power through a political system that excludes ex ante any candidate deemed to be a threat to the ruling regime. Therefore, one can fairly wonder why the Supreme Leader Ali Khamenei jumped the gun in declaring a winner, since the system was rigged before the vote. But apparently that was not enough.

Here in the realm of the Great Satan, we tend to view things through our own eyes. So before Michael Jackson, Mark Sanford and Sarah Palin drove Iran from our TV screens, we were fixated on the images of street protests in the wake of the Iranian election. For us, in Iran––as in Florida––the question was, “Who really won the vote.”

But as the images of Tehran have faded, debates over who won have given way to a clear understanding that the integrity of the election in Iran is not the measure of democracy there. At the same time, the Iranian regime is coming to realize that the integrity of the election, or lack thereof—whether perceived or real—may be its undoing.

From the moment the polls closed, when Supreme Leader Ayatollah Ali Khamenei declared the victory of President Ahmadinejad a “divine assessment,” Khamenei undercut his own credibility as a dispassionate ruler committed to the integrity of the electoral process. While Iranians may have come to accept limitations on what candidates are allowed on the ballot, fundamental Shia principles of fairness and justice demand that the integrity of the process be respected.

Instead of showing patience and respecting the process, Khamenei undermined his own credibility. But more important, he opened the door for the narrative that soon emerged: Those who questioned the results were guilty of apostasy. And in Islam, apostasy is a mortal sin, and such accusations have justified the most extreme incidents of Islamist violence.

Today, even though the demonstrations in the streets have disappeared from cable news, the debate in Iran has been elevated from vote counting and ballots to treason and apostasy. It doesn’t get much clearer than that.

The issue is no longer about the election results. The issue now is about the core principal of the Islamic Revolution—velayat-e faqih—that Islamic law requires that power over civil society must lie with the clerical order of Islamic jurists.

This debate is deeply rooted in the Islamic Revolution of 1979. At the time of the Revolution, Ayatollah Khomeini was the most vocal proponent among the senior Shia clerics of velayat-e faqih, while he was opposed at the time by his peer and rival Ayatollah Abul-Qassim Khoi, who disagreed with that interpretation of Islamic law, and dissented from the urge to assert clerical dominion over civil society. While Khomeini won the day and dominated the revolution against the Shah of Iran, velayat-e faqih has never been accepted across the senior Shia clerical order as settled law.

The debate over velayat-e faqih has reemerged as the central issue in Iran. Today, even as the Revolutionary Guard—the Praetorian Guard founded by Ayatollah Khomeini in 1979 to defend the clerical regime—is asserting its control over the streets of Tehran, Supreme Leader Ayatollah Ali Khamanei’s impatience in handling the election may ultimately cost the regime its legitimacy.

A central figure in the debate over velayat-e faqih will be the leading protégé of Ayatollah Khoi, Ayatollah Ali Sistani, the Iranian cleric who is demonstrating the principals of his mentor in his patient oversight of civil society and the emerging democracy in Iraq. For Iranians in the streets, as well as clerics in the holy city of Qom, Sistani is among the most revered religious figures, and a cleric of greater authority and stature than Ali Khamenei himself.

The irony is that none of the leading actors the Iranian drama, Mousavi, Karroubi, Rafsanjani, Larijani or Khatami have identified themselves with Sistani or opposition to the existing order of clerical dominion over civil society. They are each products of the existing system. And yet the principle of velayat-e faqih is what is at stake and will emerge as the issue at hand.

The prospect of change—counterrevolution by any reasonable definition—in Iran poses real dangers, as any evolution to a more open democratic process and easing of clerical dominance will yet face many hurdles, and may take many years. As Ali Khamenei loses stature due to his mishandling of the post-election period, the winner over the near term may well be President Mahmoud Ahmadinejad, whose ties to the Revolutionary Guard may allow him to assert greater power in Tehran, even as religious and legal arguments are debated in Qom. How the those debates play out in Qom may determine the long-term direction of the Iranian revolution, but how control over the Revolutionary Guard and the military evolves will likely determine whether the opposing camps in the post-election era reach a near-term accommodation, or Iran devolves instead toward a traditional dictatorship.

All in.

Even as the Obama administration may be consumed by efforts to stem the depth and duration of the recession, we appear to be at a tipping point in foreign affairs that can lead to positive new directions or a new downward spiral in regional conflicts.

The opportunities at hand are complex and interconnected. And unlike the high stakes, three-hand game among Russia, China and the United States of the Nixon era, which subsumed all of the smaller countries into bit roles, the diplomatic world today involves a wide range of actors, each of whom has real interests, has signaled their readiness to play, and can each affect the potential outcomes for the others.

The historical background is important in several regards. First, the global economic collapse has illustrated the interdependence of national economies, while at the same time demonstrated the risks to individual states that flow from that interdependence. Accordingly, many national leaders find themselves at a point where they have to choose—both as a matter of policy and politics—whether they are in or out, whether they accept the rules of globalization, free trade, and interdependence, or whether they will opt for a return to economic protectionism and political self-preservation.

Second, the election of Barack Obama signaled the end of the Neoconservative era in US policy, and portends a renaissance of realism in foreign affairs and diplomacy based on national self-interest. As much as war might be the proven solution to depressions past, Americans have grown weary and cynical over calls to arms and regime change over every looming international confrontation, and the rest of the world seems ready to embrace new directions as well.

Russia, for one, has been pushing for an alignment of interests since Vladimir Putin first called George Bush to pledge Russia’s support after the 9/11 attacks. Putin sought—but ultimately failed—to build a new strategic relationship with the US around a number of specific areas of common interest—stemming the Jihadist threat emerging in Chechnya and Muslim former Soviet republics, defeating the Taliban, controlling Iran’s nuclear ambitions, and controlling drug trafficking—for which Russia could leverage the reinstatement of the Bush ‘41 and Clinton-era US commitments to curtail NATO expansion toward Russia.

Now, after several years of declining relations, and with the ruble in free-fall, Putin is signaling a desire to try again. After years of trying to swing a big stick to get our attention—cutting off natural gas supplies to Ukraine and Europe, sending arms to Iran and Venezuela, and sending tanks into Georgia—Russia is trying a bit of carrot—opening its territory for the US to resupply its troops in Afghanistan and delaying the deployment of missiles in Kaliningrad.

Iran, meanwhile, is looking to get into the carrot and stick game. Like Russia, Iran grates at being disrespected and has sought out strategies that might force the US to bargain on equal terms. Certainly, as President Obama announced his plans for withdrawing from Iraq, it was not lost on many that Iran—almost single-handedly—can determine whether those plans can succeed.

Iran has much to offer—enabling an exit from Iraq, moderating the role and conduct of Hezbollah, and, of course addressing the nuclear issue—and has much to gain—recognition of its role as a regional power, reducing the threat of American troops on both its eastern and western boarders, fears of being frozen out in a US-Russian rapproachment, and an end to American threats of regime change.

Like Russia, Iran’s economy is in shambles, and the June presidential election looms to be a critical moment. The entrance of former president Mohammad Khatami into the presidential race in early February may signal that Iranian Supreme Leader, Ayatollah Khamenei is willing to move toward a moderation of Iran’s hard line direction and rhetoric, embodied in current president Mahmoud Ahmadinejad, and substantively address the concerns of the international community.

Syria, another long-time target of US regime change, also needs to demonstrate its bona fides at this moment of political change. Just as Russia reached out to Syria over the past several years to demonstrate its continuing ability to stir the always-simmering Middle East pot, Syria can on its own significantly influence the next trajectory in the politics of the Middle East.

Like Iran, Syria controls one long border with Iraq, and can influence the outcome of President Obama’s exit strategy. Similarly, as the home of the Hamas political leadership, and as the long-time suzerain of Lebanon, the Syrian intelligence apparatus can directly control the direction and temperature of the Palestinian-Israeli conflict. Like others, Syria has its interests—in territory and regime survival—for which it will play its cards.

Achieving our foreign policy goals requires that each of these key nations change their approach to us and to others. We have tried threats of regime change and war, and we are broke and tired. Ironically, however, this has led to a moment of opportunity where each country may be motivated to move in a new and positive direction.

For Russia, Iran and Syria, this is a moment of opportunity. Their leaders, Putin, Khamenei and Assad, are rational and cunning adversaries. Each has demonstrated the ability to work with us when it served they and their country’s interests, or to resist our threats and recriminations when it did not. Each of them has a hand to play, and yet each knows that they risk being left behind if they fail to seize the moment.

For Barack Obama, as well, this is a moment of opportunity. But as he has suggested when speaking of the economic challenges we face, in the world of foreign policy, our major challenges are interconnected. He cannot put any aside for another day.

Iraq. Afghanistan. Iran. Pakistan. Al Qaeda. Israel-Palestine. Lebanon. Energy. Venezuela. For each of these, Russia, Iran and Syria—in one combination or another—can be the fulcrum for success or failure.

This is the President’s moment.

Reality bites.

This Sunday, the New York Times asked a panel of economists, “When Will the Recession Be Over?” A few panelists offered hopeful words, ‘Perhaps later this year… if there are no more surprises.’ The eternally pessimistic Nuriel Roubini suggested three years… or more. One sage observer offered the wisdom of bubbles past: You don’t reach the bottom until people stop asking.

We are having a hard time accepting that recovery will take time. Leveraging, or getting into debt, is a lot of fun. For twenty years or so, as interest rates declined and lending standards loosened, America went on a debt-funded spending spree. Across the country, as housing prices rose and the home-equity lending came into vogue, Americans used their access to money to live beyond their current incomes, creating an illusion of prosperity and growth.

Deleveraging, on the other hand, is not fun. It ultimately requires reducing debt. Actually getting rid of it. For American households—whose real incomes have been flat for a decade or more—it means returning to the standard of living that they could afford before the borrowing spree started, adjusted further downward to allow them to pay off the debts they accumulated during the boom years.

So far, our public policy responses to the housing collapse and banking crisis have largely amounted to various strategies for shifting the debt burden around. In the name of stability, the TARP program socializes the losses from our financial sector. Now, in a similar vein, we are proposing to tackle the problem of home foreclosures. But unlike the TARP program that puts the bank losses on the broad shoulders of the Federal government, the strategies to boost the housing market will shift the losses experienced by current homeowner onto the next generation of homebuyers.

Consider this. In 1981, the median home price was $62,000, and the annual cost of funding the purchase of that home at the then-current 16.6% mortgage rates, and with a 20% down payment, was $8,900 per year. $8,900 was 47% of the median family income at the time of $19,000, indicating that the median priced home was not affordable for most families.

As interest rates declined through the 1980s and 90s, home prices escalated as affordability increased. By 1998, the cost of carrying an 80% mortgage on a $128,400, median priced home dipped to $8,228, or just 21% of the 1998 median family income.

By 2007, median home prices increased a further 70% to $217,800. 30-year mortgage rates only dip another 1% or so, but home priced increases were aided by the advent of all sorts of “creative” mortgages, that continued to reduce buyer monthly payments.

For more than two decades, the growth in home prices was made possible by the long-term decline in mortgage interest rates, and at the late stage of the bubble by interest only, variable rate, and teaser-rate mortgages. Despite all hopes for a revival of the real estate market, and particularly a new period of growth in home prices, this is not likely to happen.

Current Federal strategies to re-stimulate the housing market to address the foreclosure problem are ill-advised. Over the past several months, the Federal Reserve has initiated efforts to push long-term mortgage rates down toward 4.5% by purchasing mortgage-backed securities. In addition, the newly enacted stimulus package included an $8,000 first-time homebuyers tax credit.

The problem with these efforts is that they will not fix the fundamental problem, but instead will simply push the problem—the loss of home equity—onto the next generation of homebuyers.

Consider this example. Take the median US home that was worth $220,000 during the years 2005 to 2007, but which might be worth $180,000 today, reflecting a loss in value of nearly 20%. This reduced home price, with a market-rate, 6% mortgage and 80% down, would cost the new owner around $10,500 annually. However, with a 4.5% mortgage rate and the $8,000 tax credit, this new owner can afford to pay $215,000, and still owe only $10,500 annually.

This is the same game that we have watched for the better part of two decades. The buyer—who has been taught to focus on the monthly payment as the measure of “affordability”—is willing to pay the higher price for a home because of the availability of low-cost financing. The seller is happy, because they receive close to the 2005-2007 price of their home. For two decades, this logic worked, because interest rates were continuing to drop and home prices were continuing to rise.

But the situation today is different, creating two very real problems. First, these policies constitute deliberate inducements to entice homebuyers to pay over-market prices for homes, as a matter of public policy. It is reasonable to expect that once the Federal actions that induced the purchase are ceased––the artificially low mortgage rates and the tax credit—the market price of the home the buyer purchased for $215,000 in the example above will fall back to its current value of $180,000.

Therefore, the impact of these policies will be to benefit—or “bail out”—the current homeowners who are facing substantial losses, by passing those losses on to the new homebuyers.

Second, and equally important, new homebuyers should be on notice that the “great deals” that they might see in the real estate market today are only great in comparison to prices at the high point of the real estate bubble. The implied suggestion is that once the current mess is behind us, home prices will continue to rise once again. But that is not likely to be the case.

There are two simple reasons for this. First, tightened rules governing mortgage banking will end the lending practices that artificially lowered the carrying costs of purchasing a home and supported the run-up in home prices. Traditional conforming mortgages with real down payments and more conservative underwriting standards will once again tie home affordability to household incomes and long-term mortgage costs.

Second, long-term mortgage rates are more likely to rise than fall, once the Federal Reserve Bank curtails its market intervention to suppress mortgage rates, and particularly if Congressional action allows judicial rewriting of mortgage contracts, which will undermine the security of—and therefore increase the cost of—mortgage loans.

Many will argue that since we have chosen to bail out the banks, it is only fair that we bail out homeowners. That is a fair argument, and one that Hank Paulson and Ben Bernanke and Congress should have considered before we began our long walk down this path.

But Federal actions to artificially boost home values will not socialize the losses in home values, but instead will literally pass one family’s loss on to the next. Like the TARP program, the fundamental problem is that the losses are real, and try as we might to shift them around to avoid the pain, they will not go away.

Learn from Google. Make the federal budget free.

Why tax people?

Really. We now know that no one likes paying taxes. The presumption was that Democrats liked taxes and that Republicans were opposed to them. But clearly that hypothesis was proven wrong. First, when the man who now sits atop the IRS, Tim Geithner, was nominated to be Treasury Secretary, it turned out that he preferred to not pay taxes.

But that failed to prove the point, as for many it was unclear whether Geithner was actually a Democrat. But Tom Daschle turned the trick. It finally was clear that Democrats, like Republicans, do not like to pay taxes.

Back in the day, taxes were not the issue. Spending was the issue. Back then, when everyone presumed that balancing budgets were among the sole tasks that our members of Congress were charged to perform––that and trashing the UN––Republicans liked to spend less and tax less. Democrats liked to spend more… and were somewhat agnostic on taxes. It was not that they liked taxes per se, but they were a necessary step to get to spend more.

Then Ronald Reagan changed everything, and all assumptions were cast to the wind. Since the Reagan Presidency, Republicans learned that spending really was not so bad, as long as taxes didn't have to pay for it. At first they voiced horror at the fiscal consequences of tax cuts, but, in time, they got over it.

And in time it really annoyed the hell out of Democrats. Ronald Reagan had led the Republican Party to the Promised Land. Cut taxes, spend money and let the chips fall where they may.

The premise was simple. It was unarguable. At any level of taxation, there is a lower level that will put more money back in the hands of taxpayers, and that will provide more resources for businesses to hire people and spur the economy onward.

It has become axiomatic. At every level of taxation, there is a lower level that if achieved will spur on the economy.

Therefore, following the logic to its natural conclusion, the optimal tax rate is zero.

Unless you need money. For stuff. Guns. Butter. You know. Stuff.

Or so we thought.

Today, we are approaching political Nirvana. In the final great leap of bipartisanship, the new administration is reaching for a new middle ground. Cut taxes in a nod to Republicans (and, it turns out, to everyone else, who also prefer to not pay taxes.) And increase spending. Because… Well. Because we can. Because we must.

And forget all those arguments about the expiring 2001 and 2003 Bush tax cuts. That is not a tax increase. That is just reality once again coming back to bite us.

Pardon the digression, but those tax cuts marked the beginning of the end of any integrity in tax policy. The scoring rules at the time required that tax legislation be budget neutral over a ten-year horizon. Congress was unable to pay for the tax cuts with other increases or spending cuts, so they paid for them by having them expire in year eight or so. So they complied with the ten-year scoring rules. Kind of. Lots of cuts for eight years. Lots of revenue to pay for them in years nine and ten.

Back in 2001, as they contemplated years of tax cuts that would suddenly expire, people jokingly referred to 2010 as “the year we push momma from the train,” because in 2011 the estate tax would rise dramatically back to its 2001 level. Well, here we are in year eight, and there is no need to worry about the estate tax. The estates were invested with Bernie Madoff.

Everyone gives lip service to debt being the problem that got us into our current mess. Not passing on to our children “a debt they cannot pay” was the great bi-partisan applause line of the President's speech the other night. They applaud fiscal responsibility. They just don’t believe in it. Or know what it is.


Look at the record over the past two decades. Our economic performance has been flat, other than the growth that we have literally purchased with debt. As a nation, we are like households whose real income has been flat for a decade, but who fund an increasing standard of living—new electronics, cruises, home improvements—through more and more borrowing. For years now, as a nation, our GDP growth has increasingly been purchased with imported capital.

Really.

Take a look at the new federal budget. $3.55 trillion of spending. A $1.75 trillion deficit. Maybe we have reached the tipping point. Finally, our revenues may become less than half our budget, and we can begin to migrate our tax rates to their optimal level.

Zero.

That does not mean we will have a 100% deficit. Far from it. We will still have cattle grazing fees.

And we will have the loan guarantee fees that the Federal Reserve charges for guaranteeing private debt. Those should be growing.

Oh. Sorry. Those aren’t in the budget.

My bad.

The return of the business cycle

Twenty years or so ago, when my I was planning a move to California for a new job position, I listened to an interview regarding a study of the psychological affects of recessions on individuals and communities. Specifically, the study compared the incidence of mental illness, depression and suicide in Los Angeles during the recession there in the early 1980s with New Hampshire during the 1970s.

Apparently, mental illness, depression and suicide were more prevalent in southern California at the time than had been the case in New Hampshire during the previous decade. The study attributed much of the different experiences of the affected communities to differences in family and community structure. In New Hampshire, people continued to live in extended families and extended communities. During the economic downturn, older members of the community would tell stories about earlier recessions, and pass on the wisdom of the elders:

Economic cycles are part of life, like the seasons. Families need to cut back and save as the downturn approaches. During the downturn, workers need to be patient and improve their job skills. And, like the seasons, this is normal, and like a hard winter, this too will pass.

Los Angeles was a very different place, where people had moved to the new world of optimism and opportunity. But in the face of an economic downturn, the perspective of life and the economic seasons was lost. Instead, lacking the wisdom of the grandparents and elders in the community, the fear and pessimism that comes with job losses and economic decline was exacerbated and reinforced.

Over the past months, our country has responded to the recession with fear and pessimism that has been largely unchecked by an historical perspective on economic cycles. We have responded as Los Angeles responded, and the politicians and the pundits are exacerbating the fears expressed in conversations around kitchen tables, in beauty salons and at Starbucks.

Looking back, it is apparent that the depth and severity of our current economic downturn is due in large measure to the success of the Federal Reserve in forestalling significant periods of economic downturn for much of the past twenty-five years. We forgot—as individuals, as families and as businesses—that the economy is cyclical.

But even worse, we lost the value of periodic recessions as a cleansing and humbling time. For individuals and families, recessions are a time to take stock, to cut back on our materialist tendencies, to save, to pay down debts, to retool our skills. For businesses, recessions are a time to rethink strategy, to close marginal operations, and improve attention to costs and excess. For bankers, it is time to learn to write off bad debts and tighten up lending standards, and perhaps teach young associates the basic principle that when there are no profits, there are no bonuses.

In 1997, Foreign Affairs magazine published “The End of the Business Cycle,” trumpeting the success of the west in conquering the business cycle.

“Business cycles -- expansions and contractions across most sectors of an economy -- have come to be taken as a fact of life. But modern economies operate differently than nineteenth-century and early twentieth-century industrial economies. Changes in technology, ideology, employment, and finance, along with the globalization of production and consumption, have reduced the volatility of economic activity in the industrialized world. For both empirical and theoretical reasons, in advanced industrial economies the waves of the business cycle may be becoming more like ripples.”

Lost in the triumphalism of the article was recognition of the important role that periodic economic downturns play in stemming the exuberance, the hubris and the bad habits that build up during the expansionary phase of the economic cycle. For the past twenty-five years, the Federal Reserve has managed to forestall the regular economic downturns that previously characterized the post-war years. The dramatic increases in labor productivity that came about through computerization and changes in information technology, and the suppression of wage inflation that resulted from globalization and outsourcing, combined to suppress inflationary pressures.

As a result, the economy ploughed forward through crisis after crisis, through failure and fraud. The collapse of Continental Illinois. The savings and loan crisis. The bankruptcy of Drexel Burnham. The Asian financial crisis. The Russian financial crisis. The Internet bubble. The collapse of Long-Term Capital Management. September 11th. Enron. WorldCom. At each point of crisis or threat to the financial markets and investor confidence, the Fed was able to forestall downturns and spur continued economic growth by flooding liquidity into the system or pushing down interest rates, with little concern to the normal inflationary consequence.

Ten years later, in 2007, Business Week Chief Economist Michael Mandel articulated the new economic paradigm on his Economics Unbound blog.

“We now may be in a world of mini-recessions—sharp falls in one or two sectors which do not pull down the whole economy… A sharp drop in one sector—say, housing—may pull down a couple of adjacent sectors, such as furniture. But the rest of the economy steams on, and maybe even accelerates, as resources are transferred from the weak sectors to the strong sectors.

“This picture of the world actually fits very well with neoclassical economics. We may get a couple of quarters of negative GDP growth, but deep economy-wide recessions may be an anomaly rather than the norm.”

Now, we have learned that there is no new paradigm, and the business cycle is still with us. But this time, without periodic downturns to temper our exuberance and stem our excesses, we are paying a heavy price.

Consider this. Since Paul Volker stepped down as the Chairman of the Federal Reserve twenty years ago, median family income has increased ten percent in real terms. During that same period, household mortgage debt increased almost six-fold and consumer credit more than tripled, and financial institution debt grew more than eight-fold. Together, household and financial institution debt increased by over $24 trillion.

Even now, over a year into this financial crisis, we have yet to fully accept the depth of pain and dislocation that deleveraging may require. As we face the consequences of the boom years, we are going to need old wisdom as much as we need new policies. We are going to need to remain calm in the face of 24-hour cable shows playing on our fears and trumpeting every moment of our economic travails. Last night, President Obama tried to move beyond the position of policy wonk-in-chief, toward the role of the grandfather in New Hampshire. He scolded us for our excesses, while reminding us that the economy is cyclical and will rebound in time.

But what will we have learned when this moment is past? Will students of the Dismal Science no longer see the “end of the business cycle” as the Holy Grail of economic polity? Will we accept that the cycles of economic life are a necessary—and ultimately productive—check on human tendencies toward excess and exuberance? Or will we quickly fall prey to the hubris of policymakers and pundits who will as we ride the next wave, assure us that this time, once again, things will be different.

Take a deep breath, and let go.

This week, the Federal Deposit Insurance Corporation took over Silver Falls Bank in Silverton, Oregon. Silver Falls Bank was the 14th bank taken over by the FDIC this year. This compares with 25 banks that failed in 2008 and 3 in 2007. Bank failure is not unheard of. And up until a week or so ago, the term “nationalization” was not invoked.

Since its creation in 1933, the role of the FDIC has been to prevent runs on banks by insuring bank deposits and to oversee the orderly disposition of failed banks. For the better part of a century, it has done its job quietly and effectively. And today, we would all be well served to let the FDIC and its capable leader, Sheila Bair, do their job.

From the beginning of the current financial crisis, one of the problems has been the failure of the leading agents of the government, embodied by Hank Paulson and Ben Bernanke, to establish clear rules and follow them. Instead, we have plodded along, from crisis point to crisis point. From Bear Stearns to Fannie Mae to Merrill Lynch to Lehman Brothers to AIG to Washington Mutual, each collapse engendered a unique response by the Treasury and the Federal Reserve.

In a similar manner, the focus of the $700 billion Toxic Asset Relief Program—the federal bailout—to address the insolvency of the nation’s largest banks has veered from the purchase of toxic assets to injections of capital to guaranteeing of assets. Now once again, toxic asset purchases are back in vogue as the strategy of choice, this time under the “good bank, bad bank rubric.”

This week, the stock market broke through its technical support levels, and now appears headed toward 6,000 as its next support level. Some observers have suggested that the decline reflected the market response to looming plans for the “nationalization” of the banking system and one more step down the road to socialism, as trumpeted on the cover of Newsweek.

But market decline was not a result of the fear of nationalization, and nationalization would not mark the next milestone on the road to socialism. Quite the contrary. Investors are running away from banks—good banks and bad banks alike—precisely because the federal efforts to date have obscured the true financial condition of the banks. Faced with uncertainty and poor information, investors will always pull back and wait for the fog to clear.

The takeover of insolvent banks by the FDIC is the way the process is supposed to work, and the way it has always been allowed to work—up until now. For all of the debates over the “Swedish Model”—where banks were taken over, balance sheets reconfigured, and then spun back out to private ownership—the way they did it in Sweden is not actually all that different from the way they do it at the FDIC, when the FDIC is allowed to do its job. Insolvent banks are seized. Assets are sold off and the depositors are paid or, if possible, the balance sheet is cleaned up and the bank is sold off to a new owner.

The problem today is that a small number of our insolvent banks, notably Citi, are very big and very visible. But the problems they face are the problems that the FDIC was created to fix. This is not nationalization, it is essentially a debtor-in-possession bankruptcy process whereby the FDIC serves as the receiver.

If left to do its job, the FDIC would do what the banks resolutely refuse to do: sell their bad assets, accept the price of their business decisions, and move on. The banks refuse to do it because it would force them to face up to what the markets, and increasingly outraged taxpayers, have known for a while: They are insolvent.

For years, America has told other countries how to deal with financial crises: Cut your losses. Clean up your balance sheets. Get on with it.

This week, the stock market said the same thing.

On a side note, the Ford Motor Company—the one that is not taking federal money—has seen its market share rise steadily for the past four months. This is the way markets are supposed to work. Saving one company or another—or one bank or another—is not an inherent public good, however politically compelling. And pumping public money into one company serves to dramatically disadvantage their competitors.

One of the biggest mistakes that Hank Paulson made was demanding that banks take TARP money, even if they didn’t want to—or need to—in order to remove the stigma from those who did. Somehow, this was supposed to be a way of maintaining confidence in the system. But instead of protecting the bad banks, by letting them hide among the good, it has achieved the opposite. That is why investors have turned their back and are walking away.

The banking industry and the markets would be better served if the politicians and the pundits quieted their politically loaded hubris about nationalization, and if the Treasury and the Fed let the process work, as it has been designed to work. Forget about creating good banks and bad banks. Let insolvent banks take their medicine. Management, shareholders and bondholders will pay a steep price for business failure. And let the banks that are healthy take market share from those that are not.

It is time to let the process work. Punish failure. Reward success. This is not nationalization, it is the way the system is designed to work. Time to take the banks off the dole, and let Sheila Bair do her job.

Money talks. Or at least it ought to.

It needs to be said: The Congress of the United States has no business setting the terms of executive compensation. That is not how capitalism is supposed to work.

But then again, the US Government has no business giving tens of billions of dollars to corporations, and getting nothing in return but a hope and a prayer. That is not how capitalism is supposed to work, either.

Take Citi. This Thursday, the market value of Citigroup––the icon of the American banking establishment––was $18.3 billion. That is to say, at least according to the old school rules, that for $18.3 billion, you could purchase all of the common stock of the company. For something less than that, you could purchase enough shares to control the Board of Directors.

Yet, over the past few months, the US Government has invested $50 billion in Citi. In the parlance of the venture capital world, we invested $50 billion in a company, and the “post-money” value is $18.3 billion. Suffice it to say that the “pre-money” value––the value of the company before the infusion of new capital––was a big negative number.

By any normal measure, Citi was insolvent. The common equity was worthless, but for the infusion of public money. So, all of the arguments of nationalization are somewhat academic. The federal government did not wipe out the common equity holders, the market did. If there is market value remaining, it exists only at the sufferance of the US taxpayers. The only question is what how the government should be asserting its rights and privileges.

In a normal world, an investor who bails out an insolvent company takes control of the board of directors––by one means or another. And any appropriate controls on executive compensation––on bonuses and the like––are subject to the control of the board, as they are in any corporation. But what seems to be broken in all that has transpired over the past few years, is that the fundamental concept of board control and corporate governance.

The notion is simple. A corporation is a company owned by stockholders. The stockholders elect a board of directors to serve their interests in the governance of the company. The board hires and fires the chief executive and the management team, sets compensation, and establishes corporate policy and the like.

But little has been spoken about the boards of the great American financial institutions that have brought the world economy to its knees. Sure, Robert Rubin has been silenced for his complicity as a member of the board of directors of Citigroup. But little has been said about the more fundamental issues, conflicts and failure of corporate governance that have occurred on our long march toward the abyss.

Richard Fuld, the CEO of Lehman Brothers, who demonstrated an astonishing lack of imagination as he sat before Congress and suggested that, even in the wake of the financial collapse, he could not think of a single thing that he would have done differently if he could do it all over again. Fuld served as both Chairman and CEO of Lehman Brothers, a not uncommon situation in corporate America where a CEO effectively reports to him or her self, evaluates his or her own performance and sets his or her own compensation.

If Lehman had been a partnership––as it was for most of its corporate existence––perhaps this conflict would be acceptable. But for a publicly traded company, this relationship violates one of the central tenets of corporate governance: That the CEO is accountable to the board of directors, and that the directors represent the interests of the stockholders.

AIG further illustrates the problem of the failure of board oversight. The collapse of AIG was directly a result of the company’s failure to understand the risks related to its burgeoning credit default swap business. The profits of the global insurance giant became increasingly tied to its credit derivatives business, run by Joseph Cassano, the head of AIG Financial Products. Yet even as Cassano represented that there was no risk of AIG losing “a single dollar” on any of its credit default swap transactions, no one on the board managed to ask the simple question of why sophisticated financial institutions––the counterparties on the other side of those transactions––would willingly pay AIG billions of dollars annually, if there was no risk of loss. Presuming that all of those sophisticated counterparties were not fools, a board member might have asked, how can that be?

Looking back over years of financial crisis and collapse, and one common thread has been the failure of board governance of public companies. The savings and loan debacle. The collapse of Drexel Burnham Lambert. Enron. Each was characterized by boards who had lost site of their central purpose: To hire and fire the CEO, set corporate policy, and serve the shareholder interests.

Congress should take no action to set the terms of executive compensation. The problem that needs to be fixed is more fundamental: The failure of the fundamental governance structure of public companies. In the investment banking world––in the world of risk––perhaps it is time to return to partnerships and assure that when capital is at risk, people are too. But the days of the cozy, insider boards needs to end. The cost––to the shareholders and the public alike––is too high.

Whether or not the Treasury controls the boards of directors in companies where the common equity has been functionally wiped out is not the salient question, though certainly there is not a true capitalist in the country who would debate whether after a $50 billion investment into a $18.3 billion company, anyone but the US Treasury is entitled to control. The question is how board accountability and responsibility should be reestablished––both for the recipients of TARP funds and across the corporate landscape.

Time to change the rules

Barack Obama has time to consider how his administration will minister to the ailing auto companies, as their demise will be protracted. In the real economy, failure takes time. Sixty days from now GM will still be there.

But the same cannot be said of Citibank.

Today, after investing almost half of the $700 billion appropriated by Congress to buttress the capital reserves of the banking system, the evidence suggests that the Treasury and the Federal Reserve have not achieved their goal of easing the cost or availability of capital. Instead, the major banks are cutting back credit, increasing fees and looking for ways to further solidify their balance sheets. Unless these trends are reversed, the concerted federal action will have been for naught, the recession will deepen and recovery will be forestalled.

More capital alone is not sufficient to fix the commercial banking sector, and a new injection of funds into Citibank will not allay the fear the continues to grip the system. Like Citibank, all of the commercial banks have problem loans and problem business lines, and, traditionally, new injections of capital would provide banks with the resources necessary to work out those issues. But today, the risks are different, and more dire.

The collapse of AIG two months ago highlighted for all market participants the risks presented by derivative contracts on the books of financial institutions. AIG’s demise came in a matter of days––if not hours––once its credit ratings were downgraded from the double-A level to the single-A level. On Friday, September 13th, AIG was in business. On Monday the 15th, AIG was downgraded. On Tuesday the 16th, the global insurance giant was effectively bankrupt.

In the case of AIG, the rating downgrades resulted from write-downs in its holdings of mortgage-backed securities––to comply with mark-to-market accounting rules––which depleted its capital reserves. The downgrades triggered collateralization requirements under the terms of its $450 billion portfolio of credit default swaps. Faced with demands for collateral that exceeded its financial resources, AIG was insolvent.

The lesson for the major commercial banks that face similar risks was simple: Do everything in your power to rebuild your financial strength and stabilize your credit ratings. Cut back lending, reduce outstanding credit facilities, increase fees, conserve capital, and rebuild your balance sheets. In sum, the lesson for the commercial banks is that if you want to survive––if you don't want to be the next AIG––you should not do any of the things--such as increase lending--that the Treasury is trying to get you to do.

Today, Citibank is rated AA-, which by any measure is a strong credit rating. But the markets are anticipating Citibank’s demise. On Friday, Citibank shares fell 20% to $3.77 and its total market value fell to $20.5 billion, a decline of 90% from a year ago, and less than the $25 billion that the US government gave Citibank just last month. In the credit default swap market, the cost of insuring against a Citibank default rose 20% on Friday.

In normal times, a downgrade to A+ would not be a catastrophic event for a commercial bank, but these are not normal times. While there has been no public indication from Citibank of what the financial consequences of a credit rating downgrade to single-A would be, Citibank is currently the guarantor on $1.6 trillion of credit default swap contracts––almost four times the size of AIG’s portfolio––and it is not unreasonable to imagine that those contracts have comparable collateralization terms. If this is AIG all over again, a downgrade of Citibank’s ratings would lead to the swift collapse of what one year ago was the nation’s largest bank.

But this is not just about Citibank. Over the next several days, the Treasury may announce its plans to pour billions more into Citibank. But even if Citibank survives, the Treasury will not have addressed the fear that is gripping the banks. For this, the Treasury and the Fed need to change the rules of the game: They have to tackle head-on the two issues that conspired to lead to AIG's swift collapse.

First, they should change the mark-to-market rules that have made the balance sheets of financial institutions captive of swings in asset market prices. These rules exaggerate the importance of unrealized gains and losses, and exacerbate economic volatility by undermining stability in the banking sector. Instead, consideration should be given to rules that allow for the smoothing of unrealized gains and losses over time, as is the case in pension fund accounting, to mitigate market volatility by recognizing gains and losses over a multi-year period.

Second, immediate regulatory action should be implemented, vitiating the linkage between changes in credit ratings and collateralization requirements under outstanding swap agreements. While changes in bond ratings have always had effect on an entity’s cost of capital over time, the rating agencies never intended for rating actions to trigger cataclysmic events. In fact, until the collapse of AIG, the collective impact of the collateralization triggers in swap contracts was barely recognized as a material risk factor for financial institutions. Any counterparty who objects to this change should be free to void the agreement to which they are a party.

With the implementation of these two steps––changes in the mark-to-market rules and removing the collateralization provisions from existing derivatives contracts––the Treasury can immediately reduce the pressure on Citibank and on other financial institutions. Then they can focus on the real job of recapitalizing the banking system, and perhaps the banks will get back to the business of lending.

Bailouts. All the rage.

The debate over the bailout rages on.

On the one hand, the companies involved have only themselves to blame. No one denies that they brought this on themselves. The nation watches incredulous as the wealthy CEOs fly into the nation’s capital on their private jets and claim that it was not their fault––and begrudge anyone who suggests that their compensation should limited if they receive federal aid.

It is hard not to want to let them face the rigors of bankruptcy. Let others in their industry who did not make bad decisions reap the rewards of their strategic wisdom and take market share from those made bad choices. That is the way it is. That is the way it’s supposed to be.

Those arguing for the bailout question whether the economy can sustain the wreckage and havoc that will ensue if the companies are allowed to fail. They argue that rather than risk the widespread repercussions of a collapse, we should invest in the companies, shore up their financial condition, and hope they make better decisions going forward.

So we held a national debate and in the end, after the cajoling of Wise Men from across the Capitol, Congress and the President approved the $700 billion bailout for the finance industry.

We had a referendum on pain and our willingness to walk the walk of our capitalist principles, and we decided we just weren’t up to it.

Now come the automakers. It is like deja vu all over again. Once again, the companies have brought this on themselves. Once again, the wealthy CEOs fly in on their private jets, and show nothing approaching accountability for their circumstances.

And once again the fundamental question is whether the companies and their stakeholders will suffer for their own bad judgments, and whether their competitors who have demonstrated strategic wisdom will be allowed to take market share from those who made bad choices. The way it is supposed to be.

Those arguing for the Detroit bailout question whether the economy can sustain the wreckage and havoc that will ensue if the companies are allowed to fail. But this time, the resistance is fierce.

The hypocrisy of the moment is profound. This is not an argument for or against aid to Detroit, but against the hubris that now surrounds the debate. Would a debtor-in-possession bankruptcy process be a better choice over the long term to secure a better future for GM and Ford? Perhaps. Are other American automakers that are highly successful in the marketplace—Toyota, Honda, Nissan, BMW et al—disadvantaged by a government bailout? Sure.

And each of these arguments could have been made in the financial bailout. Like the automakers, the best efforts of Hank Paulson may just be delaying the day when Citibank succumbs, and newer, foreign-owned banks with a growing presence—Toronto Dominion, Banco Santander, FirstBank—emerge from the middle market to replace those at the top who fall under the weight of their bureaucratic indifference to the customer and their derivative-laden balance sheets.

As Joseph Schumpeter famously wrote, the process of Creative Destruction is the essential fact about capitalism. It is the driving force of innovation and growth. But as we are now witnessing, there is destruction and collateral damage along the way. Sometimes the damage is small and incidental, and sometimes the damage is cataclysmic.

We already chose not to face head-on the consequences of failure on Wall Street. Now, as the economy is coming undone, one has to question whether this is the moment to let GM and others fall under the weight of their legacy cost structures. The arguments for bankruptcy and the urgency of finally having Detroit make the real changes that are essential to its future are valid. But bailout opponents should not kid themselves into thinking that the process will be smooth or without collateral damage.

All of the obligations that GM will walk away from in bankruptcy—retiree healthcare, support for redundant dealerships, bond and lease payments for redundant facilities—are payments that someone else receives. Our essential challenge as we address the economic recession is to sustain economic activity and demand in the marketplace as consumers and companies reduce their spending. A GM bankruptcy will exacerbate this challenge and increase the costs to government at all levels to sustain economic activity and mitigate the collateral damage.

In many ways, our response to the auto industry is shaped by our response to the financial collapse. We rose to the urgency of that challenge, and now watch incredulous at the apparently arbitrary allocation of those billions of dollars of our money. Why has $150 billion been allocated to secure the interest of counterparties to AIG derivatives rather than simply to secure the policyholders? Why have we given tens of billions to the largest commercial banks only to see them cut back lending and increase banking fees? Why are we giving money to American Express––the lender to the richest Americans––while little is done for homeowners? Why have we rewarded failure and not instead mitigated collateral damage and allowed those who have been successful in the marketplace to win?

We have watched one bailout unfold, and we have not been impressed. We heeded the Wise Men, and now we feel violated.

But how do we now hold failing auto companies to a higher standard? And why now, when money is being tossed around the Street like confetti? Is it because this time the beneficiaries would be autoworkers and retirees rather than well-heeled moneymen, who to this day have yet to apologize to the nation for the destruction they have wrought?

Building US foreign policy in a networked world

Faced with a choice for Secretary of State between Hillary Clinton, Chuck Hagel and Bill Richardson, President-elect Obama’s choice should be clear. While all of them have strengths to serve the new president well, only Governor Richardson brings both a depth of experience and a philosophical commitment to Barack Obama leadership style.

Each of the candidates brings great strengths to the position. Hillary Clinton would bring unrivaled superstar status to the position, and provide unmatched energy and focus to push ahead the Obama foreign policy agenda. Like her husband, she is a pragmatist who will quickly grasp the nuances of every issue, and she will bring––as she does to all things––a tremendous motivation to succeed.

Chuck Hagel is a very different choice. He is a serious student of foreign policy and military affairs, with a deeply grounded understanding of the international world. Unique among the Washington crowd, Hagel understands and has spoken on the most serious foreign policy challenge that we face, which remains our relationship with Russia. Our ability to address all other international issues—Iran, Iraq, the Middle East, nuclear proliferation, drug trafficking, and financial integration and regulation—will be either facilitated or undermined by our relationship with our former adversary. Hagel understood immediately our error in embracing the Kosovar declaration of independence, which undermined the primacy and principles of international law, and the far-reaching consequences of that action, which continue to unfold. Hagel recognizes the importance of American leadership that embraces the world in all its complexity, particularly after years of hubris and empty threats that have eroded our credibility and capacity to lead.

But in Bill Richardson, President-elect Obama can choose a seasoned international diplomat and negotiator who truly embraces the core of Obama’s worldview. Like Obama, Richardson understands and has practiced a style of diplomacy and leadership that begins with listening, and that is grounded in the view that even as disparate parties may have widely differing agendas, the most complex and intractable conflicts can be addressed if differences are acknowledged and respected, as a first step toward identifying and achieving common goals.

In addition, Richardson would bring to the administration a broad network of relationships across the international community and an ability to take on the portfolio of State with no learning curve. From his time as UN Ambassador, to his range of assignments as an international negotiator during both Democrat and Republican administration, Richardson has built an international reputation for diplomatic skill, integrity and credibility.

Much has been made of this being a time of transition from a uni-polar to a multi-polar world. But this is not an accurate reflection of the world that President-elect will inherit. The US will remain the dominant military and financial power for decades to come. However, the significance of that status is what people expected it to be, and the world has not, and will not in the future, march to our tune on account of that power. The emergence of asynchronous warfare and strategy has proven to be an effective counterpoint to US military dominance, and years of US deficits have led to the emergence of China and other countries as powerful financial players, even if the dollar remains dominant in times of crisis. Today, our power gives us the capacity to lead, but will not compel others to follow.

The celebrations around the world that greeted the election of Barack Obama reflect the hope that positive and effective US leadership will reemerge in the world. But that leadership must reflect a new world of struggling and emerging democratic nations that will each need to chart their own politics and path forward. This is a world that will need American support, encouragement and direction, but will not respond well to hubris or dictates from foreign soil.

The world today is defined by overlapping networks. National identity remains elemental, but in almost every conflict across the globe, we are witnessing the influence of transnational linkages and networks that put a claim on community identity. Afghanistan, Georgia, Kenya, Kosovo, Indonesia, Iran, Iraq, Lebanon, Palestine, Russia, Sri Lanka, Syria, Timor, Ukraine, Zimbabwe. All of these nations are facing conflicts where religious, ethnic, tribal and family identities are threatening the primacy national identity as a unifying force. These challenges will be exacerbated rather than solved by democratic reforms––national unity was easier to maintain at the point of a gun––and demand the development of national and transnational institutions to create legal, political and regulatory frameworks for the new century.

In this world, US leadership and policy will need to focus on multiple levels and strategies. At the highest level, the US must define and focus on its core strategic interests. This is and will always be its primary priority. At the same time, the US must implement policies that encourage and support regional networks and leadership to engage regional conflicts and issues. The world of emerging and evolving democratic states must, under American leadership, learn new skills in conflict resolution. And all roads will no longer lead to Rome.

This is a world that is ready for the leadership of Barack Obama, who built a political campaign based on a philosophy of uniting people with vastly differing identities toward common purpose. This is the world in which Bill Richardson has been immersed for decades. A world he understands from extensive personal experience, and one where, like Barack Obama, he is greeted warmly wherever he goes as one who has the knowledge, understanding and philosophical stance that can enable him to bring together even the most entrenched adversaries.

Farther down the rabbit hole

The longer this goes on, the more absurd it is becoming.

Hank Paulson may know what he is doing. He may have insight that is lost on the rest of us. But then again, he might not.

It is not easy to suggest that a man with the pedigree and swagger of a former chairman of Goldman Sachs does not know what he is doing. But there it is.

Over the past few weeks, in the name of recapitalizing the banking system, we have witnessed the largest concentration of financial power and privilege in a century. Three of the new titans of the banking world––JPMorgan, Bank of America and Citibank––have emerged far larger and more powerful than before the financial crisis began. Their assets have ballooned. Regulation W has been waived, and FDIC deposits are now unfettered by restrictions put in place almost a century ago. And they have new infusions of taxpayer capital that some have unabashedly suggested will be used to acquire regional middle market banks and future expand their dominance in the marketplace.

Not to lose out on a good thing, American Express this week sought and received Fed approval to convert itself into a bank, so that they could get in on the action.

This, Hank Paulson suggested, marked the Government’s initiative to unlock the consumer credit market.

The irony, of course, is that these are not the institutions that will pull us out of the recession. These are not the institutions to which small businesses turn to finance the great American engine of job creation and growth. Those would be the community banks and middle market banks, that have largely eschewed the risks of derivatives and securitized obligations that have brought the larger institutions and hedge funds to their knees. And those are the institutions whose plight has been largely overlooked by the bailout strategies that Hank Paulson has pursued. Far from being helped, those institutions have been placed at a competitive disadvantage by the aggressive steps that the Treasury and the Fed have taken to concentrate financial power in a handful of dominant institutions.

We are now in the Alice in Wonderland phase of the financial bailout. The world of public policy has disappeared into the rabbit hole, and we have no idea where we are going to end up. But it is now clear that Hank Paulson has no idea either.

The greatest failure of the bailout has been in not letting institutions that did stupid things fail, and to focus public policy on how to mitigate the public and systemic consequences of that failure. In the case of Lehman Brothers, we failed to anticipate and prepare for the downstream consequences. But instead of learning the lesson that we must look down the road and anticipate systemic consequences, we turned our back on the core principle that failure is essential in competitive markets and exacerbated our problems in our approach to AIG.

The collapse of AIG came as a result of its exposure to the collateralization provisions of its credit default swap (CDS) business. To date, the bulk of the $150 billion federal cost of bailing out AIG has gone to making good on the collateralization obligations under those CDS contracts. Essentially, instead of protecting the AIG policyholders and otherwise letting AIG fail, and reaffirming the principle that stakeholders––from bondholders to CDS counterparties––are at risk in the marketplace, the Treasury chose to protect the rights of CDS counterparties with public dollars.

Halfway through the $700 billion, we are still facing two central problems. First, Paulson, Bernanke and Congress have yet to find a way to unravel the mortgage-backed securities market. The central issue here is that once mortgages are pledged in a pool to multiple investors, the terms of any individual mortgage cannot be renegotiated without impairing the contract rights of some of those investors. As a result, while mortgages held in whole by a single institution can be renegotiated, those that have been securitized may not be able to be fixed. This means that for a subset of mortgages, a foreclosure process may not be avoidable. If this is the case, federal policy should address the affects of foreclosures on families and communities, and let the process of unwinding the CDO market work itself out.

Second, the risk that credit default swap contracts present to the financial system has to be recognized and addressed. CDS contracts are essentially insurance policies against financial loss on bonds, where one party pays a premium to the other party, who agrees to make them whole in the event of a bond default. The issues are twofold. First, there is no regulatory framework that regulates the capital reserves that an institution must hold to write this type of insurance. Second, there is no requirement that the purchaser of the insurance actually own the bond in question, and there is no limit to the amount of insurance that can be written against any given bond. As such, the CDS market has become a purely speculative market that––as Michael Lewis suggested in his magnificent epilogue to Liar’s Poker––allows investors to make side bets in the bond market without actually investing any money. It is, simply state, a market with infinite leverage.

JPMorgan, BofA and Citi have approximately $13.7 trillion of credit derivatives outstanding, in compared to total combined assets of $3.9 trillion, while JPMorgan alone has approximately $7.9 trillion outstanding, in compared to total assets of $1.4 trillion. These banks will argue that their derivatives “book” is evenly balanced between long and short positions. But this ignores the fact that AIG did not collapse because of its exposure to the credit events in its CDS portfolio, but rather because of the collateralization requirements that ensued in the wake if its bonds being downgraded below “AA.”

Today, these three banks are rated "AA," with at least two of them facing downward pressure on their ratings. However, it is likely that even JPMorgan CEO Jamie Dimon––the reigning superstar of the financial firmament––does not know how much collateral JPMorgan would be forced to post to their CDS counterparties in the event they were to be downgraded. But suffice it to say that each of these banks have CDS books that are several times larger than that of AIG, and any such downgrade would likely wipe out their capital reserves.

Even as Congress and the Treasury look for solutions to the mortgage foreclosure problem, they should act immediately on credit derivatives. Three steps are warranted. First, a complete industry database must be created to track contracts, exposure and collateral terms. Second, a regulatory framework must be created to establish capitalization and reserve standards. And third, similar to the insurance industry regulatory framework, the federal government should immediately levy the equivalent of an insurance premium tax on credit derivatives to fund the public costs of financial protections and regulation.

Today, insurance premium taxes are levied in the range of 5% of premium volume. If CDS pricing averages 200 basis points on the outstanding $62 trillion, a similar fee on the annual CDS payments would generate approximately $62 billion, and provide a reasonable start at amortizing the costs of the federal bailout. And perhaps, if the industry complained that the cost was too high, it would serve the higher purpose of providing an incentive to unwind the most highly leveraged sector of our financial system.

The prospect of hanging concentrates the mind

“The prospect of hanging concentrates the mind.” Samuel Johnson.

After decades of fretting over the low American savings rate, Americans are putting away their credit cards and hunkering down for a long, cold winter. And the rest of the world is trembling at the thought.

The anticipation phase of this financial crisis is coming to an end. In a world of six-hour news cycles, people are beginning to realize that nothing is going to be fixed quickly. Last week’s god, Hank Paulson, is this week’s afterthought.

No, he did not fix it. No, he does not know what we should do with the $700 billion. No, he does not know what AIG did with the $100 billion. And no, he does not know what to do next.

Soon, people will turn off the cable news circus. The election will be over, and there will only be the uncertainty of what lies ahead.

For a president Obama—willing to turn the page on the Neoconservative rhetoric that has dominated American foreign policy of late—the financial crisis will offer a dramatic opportunity to reshape international relations, in positive and constructive ways. After all, the denouement of the crisis that is slowly placing a vice grip on nations across the world has brought a new clarity to international relations. And as each nation now looks out over the precipice, the hubris that has characterized the past few years may give way to a new willingness to build bridges.

In the early moments of the financial debacle, our allies in Europe—to say nothing of those across the world resentful of our new militarism—could barely conceal their satisfaction as the dollar fell, the price of oil rose and the end of the era of US dominance loomed. But that moment was fleeting before the interconnectedness of the 21st century economy became the dominant fact of the new world order.

Within a few short weeks, new realities emerged. As stock markets around the world plummeted—from 40% across Europe to 60% across Asia to over 70% in Russia, Ireland and Iceland—the interdependence and integration of national economies, and the ease of migration of capital, undermined newfound notions of prosperity from Ireland to Russia.

In European capitals, the ascendant notion of an economic decoupling from the United States fell by the wayside as nations quickly sought to protect their own interests and the euro crashed. In Russia, the collapse of energy prices demonstrated the fragility of an economy that has failed to build legal institutions and will soon show what little protection Russia’s new financial reserves can provide in the face of an international recession.

At the same time, for the United States, two dominant doctrines of the post-Cold War era have been discredited. First, the consuming conflicts in Iraq and Afghanistan have demonstrated the limits of overwhelming military power to force change and democratization. Second, the financial crisis and final capitulation of Alan Greenspan have demonstrated the limits of unfettered free markets and the power of uncontrolled ambition and greed to foment global chaos.

Today, the reality of economic interdependence can transform political relationships, as evidenced by our relationship with China. Two years ago, as Europe was trumpeting the emerging decoupling, China demurred. China’s communist leaders grasped the implications of the integrated international economy better than her European counterparts, and understood—as good Marxists—that economic imperatives trump traditional political arguments. China tightly linked her currency to the dollar and, after decades of saber rattling, has now tempered her threats to take back Taiwan by force.

Our relations with China are a marked contrast to our relations with Russia. For years, we have dealt with China quietly and respectfully—despite domestic protests regarding Tibet and religious persecution. With Russia, nothing has been quiet or respectful, but rather our policy has been long on hubris and trapped in Cold War rhetoric, if not ideology.

In early October, Chancellor Angela Merkel visited Moscow, where she announced that Germany would oppose efforts to admit Ukraine and Georgia into NATO. Her announcement has offered the US an opportunity to step back and reframe our relations with Russia. A new administration will now have the ability to rebuild our relationships with Russia, as with many other countries, on principles that reflect the new economic realism of international economic integration and our own understanding of the limits of military power. Simply stated, Russia—as China has accepted—can no longer impose her will at the point of the gun, while we must lead with a tempered rhetoric in a world where tanks alone cannot achieve our goals.

The strength of the dollar in a time of global crisis has reaffirmed the critical role of American leadership—to say nothing of the importance to the rest of the world of a vibrant American economy—to others. At the same time, an end to American hubris and a touch of the humility that George W. Bush once embraced, may allow us to provide the leadership that the world now desperately needs.

For a new president who grasps how dramatically the world has changed in the past month, and who appreciates both the complexity of international economic integration and national identity, this will be a time of unprecedented opportunity.