The Markets

As the beloved Peggy Noonan observed today, "the huge and sprawling financial system of Wall Street is maintained essentially on faith, mood, and assumption." That may explain why, over the last two days, the market has (after plummeting in previous days) sky rocketed over 800 points at the mere mention that the federal government may step in and help out.

I say "may explain" because I don't really know. I am by no means a finance expert. I did get a B in my economics class at college, but who remembers that stuff? So, on this topic, I claim "average Joe" status (and, as an average joe, I acknowledge that there are probably all sorts of holes in my logic and conclusions on this topic). Wrapped in my average Joe status, I can't help but to conclude that the people who made their beds need to sleep in them. Not just the heads of these investment banks, and other pin-stripped suit wearing folks sitting in board rooms. I include their willing accomplices, the average consumer who sought to undertake financial responsibilities they could not fulfill (*as noted below, there are purely innocent victims in this).

The underlying problem, of course, is not the housing market. It's the free market itself. The market is not infallible because it not only allows people to succeed, but also to fail. You'll notice some cycles in the market. About every 8-10 years, there's a huge downturn on Wall Street. Right now, it's the housing market that's causing serious problems. But, you all recall 9 years ago or so something called the "tech bubble" popped. And, I bet if I wasn't too lazy to Google the 1992 recession, I'd find that some other trendy market buy led to the '92 recession.

Throughout all of this, Alan Greenspan's use of the term "irrational exuberance" in 1996 to describe the market boom in the tech stocks - those words are echoing through my mind. That now famous term denotes what our dear Peggy Noonan put in more simple terms: the market is largely based on the psychology of people.

So, let's look at the current crisis we're in. It began with the perfect storm of financial troubles from 1999-2001. 1) The market's "irrational exuberance" for tech stocks peaked, and began to crumble, reaching it's apex during the Gore/Bush election race; 2) Enron and a handful of other large companies began to meltdown due to internal corruption; 3) 9/11 terrorist attacks put our economy on its heels.

In order to keep the economy from completely collapsing like it did in the 1920s, President Bush directed 3 actions that were the exact opposite of what took place in the 1920s: 1) he lowered taxes; 2) lowered interest rates; and 3) increased federal spending. This produced the shortest-lived, and shallowest recession in the post-world war II economy.

Step 1 actually increased dollars into the US Treasury. Counter-intuitive as it may seem, the government raked in more dollars by cutting taxes (see Wall Street Journal article below). These increased revenues somewhat offset Step 3, increased government spending; but not entirely. (Conservatives may wonder why President Bush went along with Congress' - a republican Congress, I might add - drunken spending spree. I think his fiscal conservatism is something he had to give up in order to keep Congress focused on his #1 priority, the War on Terror. That's just my theory, though.) Even though the US government raked in record revenues, Congress was outspending that pace on the war and on increased domestic obligations. Hence, increased deficits. I'm not sure, however, how much that has to do with the Housing Market bubble.

Step 2, however, planted the seeds for the Housing Market bubble. With such low interest rates, home loans became deceptively within the reach of those who really were not financially capable of meeting those obligations. I began hearing the term A.R.M. on radio advertisements. I google'd it to find out what it means. "Adjustable Rate Mortgage". My first reaction was, "well, that'd scare the hell out of me."

I understand that undertaking a home loan involves signing ridiculously large amount of documents and contracts that no person could possibly read. They have to trust the lender they are working with. And even though I accept that I'm a financial moron, even I know that signing onto a payment contract when my month to month payments can increase or decrease depending on factors outside of my control - that's just scarey. I kinda like to know how much is coming into my bank account each month, and how much is going out of it.

But, even with the obvious risk of the ARMs (recognizing that ARMs are probably only 1 part of the entire picture; but perhaps a symptomatic part), lending institutions offered them, and consumers ate them up. The irrational exuberance for home buying began. After a while, the market figured out that consumers were offering to pay far more money for tangible assets (homes) of far too little value. The market for homes began to weaken. Like the housing boom began, it fell apart - with a herd mentality. ARMs jumped, home owners defaulted, "for sale" signs popped up in neighborhoods, and property values of "innocent" home owners began to fall (thereby putting these innocent home owners at risk). This also sent shockwaves through every type of housing-related businesses (people in businesses like construction lost their jobs, etc). Congress stepped in and initiated a bailout of many home owners who defaulted on their loans. This action drew howls from all the home owners who met their obligations. But Congress' collective retort was, "if we don't bail them out, then your property values will continue tank with them. This bailout is the lesser of two evils."

In doing this, however, the federal government only addressed the home owners, and did not seek to address the other half of the crisis: the financial institutions who hold propterties that are worth far less than what they have sribbled down in their books. This problem became evident in recent months, the market caught on in recent weeks, and those investment banks who held the loans began to crumble.

Cue bailout from the federal level. Everyone in DC, from the executive branch, and R's and D's in the legislative branch - just about everyone says we gotta bail them out to prevent a major economic melt down. And they may be right.

But, I'm an average Joe. And my (in addition to many others) inclination is to let them sleep in the beds they made. They being, all of them, and all of us. All of them (irresponsible consumers and lenders) will suffer most. All of us (responsible consumers and lenders) will suffer some too. But the market must suffer, because that's what we all get for standing by as our brothers, cousins, neighbors, fellow church members, and co-workers undertake financial obligations we knew they couldn't pay back...and we didn't even seek to lend them friendly advice.

This macro situation (bailout or blood-letting) reminds me of Edward N. Luttwak's article "Give War A Chance" pasted below. Sometimes, it's better just to let the ugliness run its course, than to continue putting band-aids over the problem (with the best of intentions) and hoping it goes away. The tough love response of "that'll learn ya" may actually mitigate the market's cyclical inclination toward irrational exuberance, better than bailing them out. Without this tough love, I don't think the market will learn their lessons about the dangers of "irrational exuberance", and next time, the crash will be much worse.

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REVENUE REVELATION (The Wall Street Journal, New York )

House and Senate GOP conferees finally agreed yesterday on extending the 15% tax rate on dividends and capital gains for two more years through 2010. This means you can expect lots of media and liberal rhetoric about "the deficit" and "the rich," but the real news is how well these lower rates have been soaking the rich to fill government coffers.

The latest evidence is Treasury's monthly budget report for May that tax receipts were up by $137 billion, or a remarkable 11.2%, for the first seven months of Fiscal 2006 through April. That's more than triple the inflation rate. And it comes on top of the $274 billion, or 14.6%, increase in federal revenues for all of Fiscal 2005, which ended last September 30.

The current revenue rush also refutes the prevailing Washington consensus that the federal deficit is the result of the Bush tax cuts. In fact, this revenue tsunami is the direct result of the expansion that took off in earnest at about the time the 2003 tax cuts passed. Lower tax rates have since had precisely the result that supporters predicted, though don't look for that story on page one any time soon.

This explains why tax-cut opponents have tried to change the subject from the sluggish growth they first expected, to the "jobless recovery" that soon became the 4.7% unemployment rate recovery, to lagging wage growth that is also now increasing. The latest liberal themes are allegedly rising "inequality" and allegedly exorbitant executive compensation. These are subjects for other editorials, but their current political and media prominence means the critics are conceding that they can't credibly call the tax cuts an economic failure. So they have to find other election-year talking points.

This revenue wave has also come as a shock to the estimators at the Congressional Budget Office, whose May analysis is full of implicit amazement, not to say chagrin, since they predicted nothing of the sort. As recently as March, CBO was still advertising an expected increase in the baseline for individual income tax receipts of only $76 billion and merely $24 billion in corporate tax receipts for all of Fiscal 2006. Yet in only seven months, individual income tax revenues have already climbed by $56 billion and corporate receipts by $40 billion.

This revenue inflow also means that federal taxes as a share of the economy are now almost back to their post-World War II average of roughly 18%. That share will continue to increase if the economy continues to grow, as more taxpayers get wealthier and are thrown into higher tax brackets. The only reason the federal deficit continues to exist is because Congress continues to spend more than 20% of GDP.

So far in Fiscal 2006, spending is still rising by 7.6% overall. Defense is rising by only about 6%, but Medicare is speeding ahead at nearly 14%, thanks to the new prescription drug benefit. As ever, the real budget problem is spending, especially on entitlements. The solution there is restraint and reform, not higher taxes. At least Republicans can finally point to a policy victory this year, one that should push any big tax increase well past the next election. (May 10)

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Foreign Affairs July/August 1999
Give War a Chance By Edward N. Luttwak

Premature Peacemaking:

An unpleasant truth often overlooked is that although war is a great evil, it does have a great virtue: it can resolve political conflicts and lead to peace. This can happen when all belligerents become exhausted or when one wins decisively. Either way the key is that the fighting must continue until a resolution is reached. War brings peace only after passing a culminating phase of violence. Hopes of military success must fade for accommodation to become more attractive than further combat.

Since the establishment of the United Nations and the enshrinement of great–power politics in its Security Council, however, wars among lesser powers have rarely been allowed to run their natural course. Instead, they have typically been interrupted early on, before they could burn themselves out and establish the preconditions for a lasting settlement. Cease–fires and armistices have frequently been imposed under the aegis of the Security Council in order to halt fighting. NATO’s intervention in the Kosovo crisis follows this pattern.

But a cease–fire tends to arrest war–induced exhaustion and lets belligerents reconstitute and rearm their forces. It intensifies and prolongs the struggle once the cease–fire ends—and it does usually end. This was true of the Arab–Israeli war of 1948–49, which might have come to closure in a matter of weeks if two cease–fires ordained by the Security Council had not let the combatants recuperate.

It has recently been true in the Balkans. Imposed cease–fires frequently interrupted the fighting between Serbs and Croats in Krajina, between the forces of the rump Yugoslav federation and the Croat army, and between the Serbs, Croats, and Muslims in Bosnia. Each time, the opponents used the pause to recruit, train, and equip additional forces for further combat, prolonging the war and widening the scope of its killing and destruction. Imposed armistices, meanwhile—again, unless followed by negotiated peace accords—artificially freezeconflict and perpetuate a state of war indefinitely by shielding the weaker side from the consequences of refusing to make concessions for peace.

The Cold War provided compelling justification for such behavior by the two superpowers, which sometimes collaborated in coercing less–powerful belligerents to avoid being drawn into their conflicts and clashing directly. Although imposed cease–fires ultimately did increase the total quantity of warfare among the lesser powers, and armistices did perpetuate states of war, both outcomes were clearly lesser evils (from a global point of view) than the possibility of nuclear war. But today, neither Americans nor Russians are inclined to intervene competitively in the wars of lesser powers, so the unfortunate consequences of interrupting war persist while no greater danger is averted. It might be best for all parties to let minor wars burn themselves out.

The Problems of Peacekeepers:

Today cease–fires and armistices are imposed on lesser powers by multilateral agreement—not to avoid great–power competition but for essentially disinterested and indeed frivolous motives, such as television audiences’ revulsion at harrowing scenes of war. But this, perversely, can systematically prevent the transformation of war into peace. The Dayton accords are typical of the genre: they have condemned Bosnia to remain divided into three rival armed camps, with combat suspended momentarily but a state of hostility prolonged indefinitely. Since no side is threatened by defeat and loss, none has a sufficient incentive to negotiate a lasting settlement; because no path to peace is even visible, the dominant priority is to prepare for future war rather than to reconstruct devastated economies and ravaged societies.

Uninterrupted war would certainly have caused further suffering and led to an unjust outcome from one perspective or another, but itwould also have led to a more stable situation that would have let the postwar era truly begin. Peace takes hold only when war is truly over.

A variety of multilateral organizations now make it their business to intervene in other peoples’ wars. The defining characteristic of these entities is that they insert themselves in war situations while refusing to engage in combat. In the long run this only adds to the damage. If the United Nations helped the strong defeat the weak faster and more decisively, it would actually enhance the peacemaking potential of war. But the first priority of U.N. peacekeeping contingents is to avoid casualties among their own personnel. Unit commanders therefore habitually appease the locally stronger force, accepting its dictates and tolerating its abuses. This appeasement is not strategically purposeful, as siding with the stronger power overall would be; rather, it merely reflects the determination of each U.N. unit to avoid confrontation. The final result is to prevent the emergence of a coherent outcome, which requires an imbalance of strength sufficient toend the fighting.

Peacekeepers chary of violence are also unable to effectively protect civilians who are caught up in the fighting or deliberately attacked. At best, U.N. peacekeeping forces have been passive spectators to outrages and massacres, as in Bosnia and Rwanda; at worst, they collaborate with it, as Dutch U.N. troops did in the fall of Srebenica by helping the Bosnian Serbs separate the men of military age from the rest of the population.

The very presence of U.N. forces, meanwhile, inhibits the normal remedy of endangered civilians, which is to escape from the combat zone. Deluded into thinking that they will be protected, civilians in danger remain in place until it is too late to flee. During the 1992–94 siege of Sarajevo, appeasement interacted with the pretense of protection in an especially perverse manner: U.N. personnel inspected outgoing flights to prevent the escape of Sarajevo civilians in obedience to a cease–fire agreement negotiated with the locally dominant Bosnian Serbs—who habitually violated that deal. The more sensible, realistic response to a raging war would have been for the Muslims to either flee the city or drive the Serbs out.

Institutions such as the European Union, the Western European Union, and the Organization for Security and Cooperation in Europe lack even the U.N.’s rudimentary command structure and personnel, yet they too now seek to intervene in warlike situations, with predictable consequences. Bereft of forces even theoretically capable of combat, they satisfy the interventionist urges of member states (or their own institutional ambitions) by sending unarmed or lightly armed “observer” missions, which have the same problems as U.N. peacekeeping missions, only more so.

Military organizations such as NATO or the West African Peacekeeping Force (ECOMOG, recently at work in Sierra Leone) are capable of stopping warfare. Their interventions still have the destructive consequence of prolonging the state of war, but they can at least protect civilians from its consequences. Even that often fails to happen, however, because multinational military commands engaged in disinterested interventions tend to avoid any risk of combat, thereby limiting their effectiveness. U.S. troops in Bosnia, for example, repeatedly failed to arrest known war criminals passing through their checkpoints lest this provoke confrontation.

Multinational commands, moreover, find it difficult to control the quality and conduct of member states’ troops, which can reduce the performance of all forces involved to the lowest common denominator. This was true of otherwise fine British troops in Bosnia and of the Nigerian marines in Sierra Leone. The phenomenon of troop degradation can rarely be detected by external observers, although its consequences are abundantly visible in the litter of dead, mutilated, raped, and tortured victims that attends such interventions. The true state of affairs is illuminated by the rare exception, such as the vigorous Danish tank battalion in Bosnia that replied to any attack on it by firing back in full force, quickly stopping the fighting.

The First “Post–Heroic” War:

All prior examples of disinterested warfare and its crippling limitations, however, have been cast into shadow by NATO’s current intervention against Serbia for the sake of Kosovo. The alliance has relied on airpower alone to minimize the risk of NATO casualties, bombing targets in Serbia, Montenegro, and Kosovo for weeks without losing a single pilot. This seemingly miraculous immunity from Yugoslav anti–aircraft guns and missiles was achieved by multiple layers of precautions.

First, for all the noise and imagery suggestive of a massive operation, very few strike sorties were actually flown during the first few weeks. That reduced the risks to pilots and aircraft but of course also limited the scope of the bombing to a mere fraction of NATO’s potential.

Second, the air campaign targeted air–defense systems first and foremost, minimizing present and future allied casualties, though at the price of very limited destruction and the loss of anyshock effect.

Third, NATO avoided most anti–aircraft weapons by releasing munitions not from optimal altitudes but from an ultra–safe 15,000 feet or more.

Fourth, the alliance greatly restricted its operations in less–than–perfect weather conditions. NATO officials complained that dense clouds were impeding the bombing campaign, often limiting nightly operations to a few cruise–missile strikes against fixed targets of known location. In truth, what the cloud ceiling prohibited was not all bombing—low–altitude attacks could easily have taken place—but rather perfectly safe bombing.

On the ground far beneath the high–flying planes, small groups of Serb soldiers and police in armored vehicles were terrorizing hundreds of thousands of Albanian Kosovars. NATO has a panoply of aircraft designed for finding and destroying such vehicles. All its major powers have anti–tank helicopters, some equipped to operate without base support. But no country offered to send them into Kosovo when the ethnic cleansing began—after all, they might have been shot down. When U.S. Apache helicopters based in Germany were finally ordered to Albania, in spite of the vast expenditure devoted to their instantaneous “readiness” over the years, they required more than three weeks of “predeployment preparations” to make the journey. Six weeks into the war, the Apaches had yet to fly their first mission, although two had already crashed during training. More than mere bureaucratic foot–dragging was responsible for this inordinate delay: the U.S. Army insisted that the Apaches could not operate on their own, but would need the support of heavy rocket barrages to suppress Serb anti–aircraft weapons. This created a much larger logistical load than the Apaches alone, and an additional, evidently welcome delay.

Even before the Apache saga began, NATO already had aircraft deployed on Italian bases that could have done the job just as well: U.S. a–10 “Warthogs” built around their powerful 30 mm antitank guns and British Royal Air Force Harriers ideal for low–altitude bombing at close range. Neither was employed, again because it could not be done in perfect safety. In the calculus of the NATO democracies, the immediate possibility of saving thousands of Albanians from massacre and hundreds of thousands from deportation was obviously not worth the lives of a few pilots. That may reflect unavoidable political reality, but it demonstrates how even a large–scale disinterested intervention can fail to achieve its ostensibly humanitarian aim. It is worth wondering whether the Kosovars would have been better off had NATO simply done nothing.

Refugee Nations:

The most disinterested of all interventions in war—and the most destructive—are humanitarian relief activities. The largest and most protracted is the United Nations Relief and Works Agency (UNRWA). It was built on the model of its predecessor, the United Nations Relief and Rehabilitation Agency (UNRRA), which operated displaced–persons’ camps in Europe immediately after World War II. The UNRWA was established immediately after the 1948–49 Arab–Israeli war to feed, shelter, educate, and provide health services for Arab refugees who had fled Israeli zones in the former territory of Palestine.

By keeping refugees alive in spartan conditions that encouraged their rapid emigration or local resettlement, the UNRRA’s camps in Europe had assuaged postwar resentments and helped disperse revanchist concentrations of national groups. But UNRWA camps in Lebanon, Syria, Jordan, the West Bank, and the Gaza Strip provided on the whole a higher standard of living than most Arab villagers had previously enjoyed, with a more varied diet, organized schooling, superior medical care, and no backbreaking labor in stony fields. They had, therefore, the opposite effect, becoming desirable homes rather than eagerly abandoned transit camps. With the encouragement of several Arab countries, the UNRWA turned escaping civilians into lifelong refugees who gave birth to refugee children, who have in turn had refugee children of their own.

During its half–century of operation, the UNRWA has thus perpetuated a Palestinian refugee nation, preserving its resentments in as fresh a condition as they were in 1948 and keeping the first bloom of revanchist emotion intact. By its very existence, the UNRWA dissuades integration into local society and inhibits emigration. The concentration of Palestinians in the camps, moreover, has facilitated the voluntary or forced enlistment of refugee youths by armed organizations that fight both Israel and each other. The UNRWA has contributed to a half–century of Arab–Israeli violence and still retards the advent of peace.

If each European war had been attended by its own postwar unRwa, today’s Europe would be filled with giant camps for millions of descendants of uprooted Gallo–Romans, abandoned Vandals, defeated Burgundians, and misplaced Visigoths—not to speak of more recent refugee nations such as post–1945 Sudeten Germans (three million of whom were expelled from Czechoslovakia in 1945). Such a Europe would have remained a mosaic of warring tribes, undigested and unreconciled in their separate feeding camps. It might have assuaged consciences to help each one at each remove, but it would have led to permanent instability and violence.

The UNRWA has counterparts elsewhere, such as the Cambodian camps along the Thai border, which incidentally provided safe havens for the mass–murdering Khmer Rouge. But because the United Nations is limited by stingy national contributions, these camps’ sabotage of peace is at least localized.

That is not true of the proliferating, feverishly competitive nongovernmental organizations (NGOs) that now aid war refugees. Like any other institution, these NGOs are interested in perpetuating themselves, which means that their first priority is to attract charitable contributions by being seen to be active in high–visibility situations. Only the most dramatic natural disasters attract any significant mass–media attention, and then only briefly; soon after an earthquake or flood, the cameras depart. War refugees, by contrast, can win sustained press coverage if kept concentrated in reasonably accessible camps. Regular warfare among well–developed countries is rare and offers few opportunities for such NGOs, so they focus their efforts on aiding refugees in the poorest parts of the world. This ensures that the food, shelter, and health care offered—although abysmal by Western standards—exceeds what is locally available to non–refugees.

The consequences are entirely predictable. Among many examples, the huge refugee camps along the Democratic Republic of Congo’s border with Rwanda stand out. They sustain a Hutu nation that would otherwise have been dispersed, making the consolidation of Rwanda impossible and providing a base for radicals to launch more Tutsi–killing raids across the border. Humanitarian intervention has worsened the chances of a stable, long–term resolution of the tensions in Rwanda.

To keep refugee nations intact and preserve their resentments forever is bad enough, but inserting material aid into ongoing conflicts is even worse. Many NGOs that operate in an odor of sanctity routinely supply active combatants. Defenseless, they cannot exclude armed warriors from their feeding stations, clinics, and shelters. Since refugees are presumptively on the losing side, the warriors among them are usually in retreat. By intervening to help, NGOs systematically impede the progress of their enemies toward a decisive victory that could end the war. Sometimes NGOs, impartial to a fault, even help both sides, thus preventing mutual exhaustion and a resulting settlement. And in some extreme cases, such as Somalia, NGOs even pay protection money to local war bands, which use those funds to buy arms. Those NGOs are therefore helping prolong the warfare whose consequences they ostensibly seek to mitigate.

Make War to Make Peace:

Too many wars nowadays become endemic conflicts that never end because the transformative effects of both decisive victory and exhaustion are blocked by outside intervention. Unlike the ancient problem of war, however, the compounding of its evils by disinterested interventions is a new malpractice that could be curtailed. Policy elites should actively resist the emotional impulse to intervene in other peoples’ wars—not because they are indifferent to human suffering but precisely because they care about it and want to facilitate the advent of peace. The United States should dissuade multilateral interventions instead of leading them. New rules should be established for U.N. refugee relief activities to ensure that immediate succor is swiftly followed by repatriation, local absorption, or emigration, ruling out the establishment of permanent refugee camps. And although it may not be possible to constrain interventionist NGOs, they should at least beneither officially encouraged nor funded. Underlying these seemingly perverse measures would be a true appreciation of war’s paradoxical logic and a commitment to let it serve its sole useful function: to bring peace.

Edward N. Luttwak is Senior Fellow at the Center for Strategic and International Studies.