Friday, November 30, 2007

Citigroup SIV Debt Ratings

Moody's Says Citigroup SIV Debt Ratings Under Threat
By Shannon D. Harrington
Nov. 30 (Bloomberg)

Moody's Investors Service said $64.9 billion of debt sold by Citigroup Inc.'s structured investment vehicles was cut or placed on review for a downgrade as part of a review of $130 billion of SIV debt.

The ratings company surveyed 20 SIVs since Nov. 7 and expanded its review after noticing ``significant additional deterioration'' in asset values, according to a statement today. Links Finance Corp., a SIV sponsored by Bank of Montreal with $19.1 billion of debt, may have its ratings cut, Moody's said.

SIVs, which sell short-term debt to buy longer-term, higher- yielding assets, were shut out of the short-term market as losses on subprime mortgage securities prompted investors to retreat from all but the safest of securities. Unable to finance themselves, three SIVs have defaulted and others are being bailed out by their sponsors. The world's 30 SIVs have more than $300 billion of assets.

``In recent weeks, Moody's has observed material declines in market value across most asset classes in SIV portfolios,'' the ratings company said in the statement.

Moody's cut at least $10 billion in debt in all, mostly capital notes that rank below commercial paper and medium-term notes and are usually the first to absorb losses, Henry Tabe, managing director in charge of structured finance, said in a telephone interview. The ratings company placed at least $100 billion of debt on review for a downgrade and confirmed the ratings on $11 billion, Tabe said.

`Continued Deterioration'

SIV assets on average are 38 percent financial institution debt, 16 percent asset-backed securities and 12 percent collateralized debt obligations, Moody's said.

The downgrades are ``a reflection of the continued deterioration in market value of SIV portfolios combined with the sector's inability to refinance maturing liabilities,'' Moody's said.

Citigroup, the largest U.S. bank by assets, provided $7.6 billion of emergency financing to the seven SIVs it runs earlier this month after they were unable to repay maturing debt.

Citigroup, based in New York, created the first SIV in 1988 and is the largest manager.

The SIVs' struggle for survival, and the threat of having their assets dumped on the market, prompted Treasury Secretary Henry Paulson to broker talks with Citigroup, JPMorgan Chase & Co. and Bank of America Corp. to form an $80 billion fund to help bail them out.

HSBC Holdings Plc of London this week said it will take on $45 billion of assets from the two SIVs it manages after they were unable to finance themselves. SIVs set up by Dusseldorf- based lender IKB Deutsche Industriebank AG and London-based Cheyne Capital Management Ltd. defaulted last month after investors stopped buying their asset-backed commercial paper.

Centauri, Beta

Centauri Corp., the largest SIV run by Citigroup with $16.9 billion of debt, had its P1 commercial paper rating placed on review for downgrade as well as its AAA medium-term note program, Moody's said. Centauri's net asset value dropped to 60 percent from 85 percent since Sept. 5, Moody's said.

Beta Finance Corp., the second-largest Citigroup SIV with $16 billion of debt, had its senior debt ratings placed on review for downgrade after its net asset value declined to 60 percent from 87 percent, Moody's said.

Sedna, Dorada

Four other Citigroup SIVs, Sedna Finance Corp., with $10.7 billion of debt, Five Finance Corp., with $10.3 billion, Dorada Corp. with $8.5 billion, and Zela Finance Corp., with $2.5 billion, had their P1 commercial paper rating and AAA medium-term note programs placed on review, Moody's said.

Sedna's net asset value dropped to 56 percent, Five's declined to 63 percent, Dorada dropped to 62 percent and Zela's fell to 61 percent. A seventh Citigroup SIV, Vetra Finance Corp., wasn't part of the review.

Dorada's capital note program was reduced to Caa3 from Baa1.

Orion Finance Corp., a SIV managed by Eiger Capital with $835 million of debt, had its P1 commercial paper ratings downgraded to Not Prime, and its AAA medium-term note program to Baa3. Orion's net asset value dropped to 54 percent from 61 percent since Sept. 5, Moody's said.

Links Finance's net asset value declined to 78 percent from 94 percent since a Sept. 5 review, Moody's said. The SIV's AAA ratings may be cut after a review that will be completed within a week, Moody's said. Links' standard capital notes were cut 11 levels to the fourth-lowest ranking.

Toronto-based Bank of Montreal spokesman Ralph Marranca didn't immediately return a call seeking comment.

Monday, November 19, 2007

Mission Accomplished

Mission Accomplished - Prospect October 2007

With most Sunni factions now seeking a deal, the big questions in Iraq have been resolved positively. The country remains one, it has embraced democracy and avoided all-out civil war. What violence remains is largely local and criminal

Bartle Bull

The question of what to do in Iraq today must be separated from the decision to topple Saddam Hussein four and a half years ago. That decision is a matter for historians. By any normal ethical standard, the coalition's current project in Iraq is a just one. Britain, America and Iraq's other allies are there as the guests of an elected government given a huge mandate by Iraqi voters under a legitimate constitution. The UN approved the coalition's role in May 2003, and the mandate has been renewed annually since then, most recently this August. Meanwhile, the other side in this war are among the worst people in global politics: Baathists, the Nazis of the middle east; Sunni fundamentalists, the chief opponents of progress in Islam's struggle with modernity; and the government of Iran. Ethically, causes do not come much clearer than this one.

Some just wars, however, are not worth fighting. There are countries that do not matter very much to the rest of the world. Rwanda is one tragic example; and its case illustrates the immorality of a completely pragmatic foreign policy. But Iraq, the world's axial country since the beginning of history and all the more important in the current era for probably possessing the world's largest reserves of oil, is no Rwanda. Nor do two or three improvised explosive devices a day, for all the personal tragedy involved in each casualty, make a Vietnam.

The great question in deciding whether to keep fighting in Iraq is not about the morality and self-interest of supporting a struggling democracy that is also one of the most important countries in the world. The question is whether the war is winnable and whether we can help the winning of it. The answer is made much easier by the fact that three and a half years after the start of the insurgency, most of the big questions in Iraq have been resolved. Moreover, they have been resolved in ways that are mostly towards the positive end of the range of outcomes imagined at the start of the project. The country is whole. It has embraced the ballot box. It has created a fair and popular constitution. It has avoided all-out civil war. It has not been taken over by Iran. It has put an end to Kurdish and marsh Arab genocide, and anti-Shia apartheid. It has rejected mass revenge against the Sunnis. As shown in the great national votes of 2005 and the noisy celebrations of the Iraq football team's success in July, Iraq survived the Saddam Hussein era with a sense of national unity; even the Kurds—whose reluctant commitment to autonomy rather than full independence is in no danger of changing—celebrated. Iraq's condition has not caused a sectarian apocalypse across the region. The country has ceased to be a threat to the world or its region. The only neighbours threatened by its status today are the leaders in Damascus, Riyadh and Tehran.

The mission in Iraq may be on the way to being accomplished, but it has clearly been imperfect and costly. At least 80,000 and perhaps 200,000 or more Iraqis have been killed since the invasion, almost all of them by Iraqis and other Arabs (although this should be weighed against the 1.5m people killed by war and political violence during the 35-year Baath reign). The Sunni insurgency has degraded the country's utilities infrastructure, with the result that services remain patchy in much of the country and very bad in Baghdad: from April to June 2007, Iraq as a whole averaged 12.8 hours of electricity per day, while Baghdad averaged just 9.2. Oil production is down by 20 per cent since the invasion. Many of the country's professionals—doctors, teachers, academics—have left. There has been much local sectarian cleansing, with around 1m people internally displaced since 2003 and up to another 1m externally displaced. The US-led coalition has lost almost 4,100 lives, with many more wounded. Much money has been stolen, and some of Iraq's priceless historical legacy looted. In parts of the country, local disorder has opened opportunities to criminals and fundamentalists. Much of the police force is militantly Shia, and many units are loyal to militias. Although General Petraeus's military "surge" has had some success in reducing violence, Iraqis are still dying violently at an alarming rate—around 1,500 a month.

Understanding this expensive victory is a matter of understanding the remaining violence. Now that Iraq's big questions have been resolved—break-up? No. Shia victory? Yes. Will violence make the Americans go home? No. Do Iraqis like voting? Yes. Do they like Iraq? Yes—Iraq's violence has largely become local and criminal. The biggest fact about Iraq today is that the violence, while tragic, has ceased being political, and is therefore no longer nearly as important as it was.

Some of the violence—that paid for by foreigners or motivated by Islam's crazed fringes—will not recede in a hurry. Iraq has a lot of Islam and long, soft borders. But the rest of Iraq's violence is local: factionalism, revenge cycles, crime, power plays. It will largely cease once Iraq has had a few more years to build up its security apparatus.

There have been four main sources of political violence in Iraq since the invasion. The "insurgency," which means the Sunni violence, comprised three of these four elements: Baathists, Sunni religious fundamentalists (whom we will call Wahhabis after the most important of their closely related strains), and Sunni tribes. (The fourth source of violence is Shia, about which more later.) Baathism, modelled from its birth in the 1940s on German national socialism, is a secular movement. Wahhabism, fighting for a return to the pure days of Islam in the 7th century, is the opposite. It was clear from the beginning that these two tendencies, which today are fighting each other in much of Sunni Iraq, would not get along forever.

Equally clear was that neither could win in their battle for Iraq. The Baathists wanted a return to the privileges they enjoyed under Saddam. The Wahhabis wanted a return to the days of the prophet. Neither was going to happen; for the 85 per cent of the country that is not Sunni Arab, these forms of Sunni Arab totalitarianism were the ultimate non-starter. Sunni power was broken by the invasion: Iraq, finally recognising a group three times as numerous as the Sunnis, had become a Shia country; Baghdad, the dowager capital of Islam, is today a Shia city for the first time since 1534.

All this was foreseen in the first phase of the violence, from the insurgency's start in spring 2004 until the Samarra mosque bombing in February 2006. The Baathists, thugs but rational actors, would eventually give up and sit down to bargain for as much as they could get from the mess they had made. And the Wahhabis, answering to a higher power and mostly foreigners anyway, would keep blowing themselves up. All sides acknowledge that this is what is happening today: the Wahhabis continue to cross the border in search of their 72 virgins in paradise, and the Baathists are negotiating with the Shias and the Americans to come inside the tent.

A third element of the Sunni violence was tribal. This was particularly prevalent in Anbar province in western Iraq, where Sunni tribes have traditionally prospered from banditry on the Damascus road and where even Saddam was not fully in control. Fighting outsiders is an old habit in Iraq's Sunni bandit country. So is making money. Thus the Sunni tribes, like the Baathists, have done precisely what non-ideological observers predicted at the beginning of the violence. Once the victory of the Shias and the resolve of the US administration became clear, the Sunni tribes decided their interest lay in milking what they could from the new dispensation. Thus it is that Anbar today is one of the safer places in Iraq. (Until the pacification of Anbar, about 80 per cent of Iraq's violence happened in four of its 18 provinces: Anbar, Salah ad Din, Nineveh and Baghdad. In nine of the 18 provinces, there is basically no violence.) The importance of the achievement in Anbar cannot be overemphasised: pacifying the heartland of the Sunni insurgency was considered unachievable as recently as this spring. (The assassination in September of Abu Risha—head of the "Anbar Awakening," an organisation of 25 Sunni tribes fighting al Qaeda in Anbar—while unfortunate, will not be material.)

It was always clear that Iraq's Sunni tribes would eventually take up arms against the Saudis, Jordanians and Syrians in their midst who were banning smoking, killing whisky vendors, executing sheikhs of ancient tribes and forcibly marrying local girls to "emirs" of the soi-disant "Islamic state of Iraq." Of course, Anbar's tribal leaders and Baathists could be bought off either directly or by the indirect promise of owning a chunk of what will be a very rich country now that the basic question of who owns Baghdad has been resolved. At least 14,000 Anbari young men have joined the state security services since the surge began in February and the Iraqi prime minister, Nouri al-Maliki, started reaching out to the chiefs.

The tribes and the Baathists also noticed what happened in Fallujah and Ramadi: when those cities ran out of control, America doubled up. In November 2004, the marines surrounded Fallujah, killed every insurgent (and plenty of civilians), started rebuilding the place and left an effective security cordon around it. Ramadi, on a smaller scale, was next. Now the insurgency has decamped to other provinces, where it does not want to be. Beating them there will be even easier, as is proving to be the case in Diyala.

The Sunni insurgents have recognised that there is little point fighting a strong and increasingly skilled enemy—the US—that is on the right side of Iraq's historical destiny and has a political leadership that—unlike that of the British in Basra—responds to setbacks by trying harder. (That is essentially the Petraeus doctrine: more resources more intelligently applied further forward.) There is even less point doing so when you are a discredited minority, as the Sunnis are after 35 years of Baathism followed by their disastrous insurgency, and the enemy is in fact your main guarantor of a fair place at the national table.

Iraq's Sunnis would not be needing the help of the US today had the Sunni leadership not made a historic miscalculation back in 2004. Saddam, a rational man, made an understandable but fatal misjudgement about the people he was up against, and paid for it with his throne and his neck. His Sunni supporters did not learn from this. Thinking they were dealing with the post-Vietnam America of Carter, Reagan and Clinton, they took up arms to prevent the Americans from delivering on their promise of an Iraq that could freely choose its leaders. The habit of centuries of overlordship also fed the Sunni miscalculation: to them, Shia control was unthinkable and so the insurgency was sure to succeed.

By the second half of 2004, the insurgency had had six months to show what it was capable of, and it became clear that its goal could not be the military defeat of the Americans. The Sunnis were now fighting not for a military victory but a political one, to win in the US congress and the newsrooms of CNN and the New York Times the war they could not win in the alleys and date palm groves of Mesopotamia.

With regard to violence against their fellow Iraqis, the Sunni strategy revealed itself quickly to be an effort to provoke the Shias into full-fledged communal violence and civil war. Such a conflagration would be so hot that even Bush's Americans would run for home. The key moment in this strategy was the bombing of the Shia mosque in Samarra. Until then, the Shias had shown great restraint at the stream of Sunni provocations. Shia cells targeted Wahhabis and Baathists, but mostly left the Sunni populace alone. Under the steadying influence of Grand Ayatollah Ali al-Sistani, their religious leader, the Shias endured mass slaughters in markets, buses and schools throughout 2004, 2005 and early 2006 without large-scale retaliation. As the main beneficiaries from the new Iraq, the Shias could only lose from a prolonged civil war.

The Samarra bombing seemed briefly to be the final straw. The Shia death squads, most associated with the young cleric Muqtada al-Sadr and his Mahdi army, long chafing under Sistani's restraining hand, were let slip. Neighbourhood cleansing began in much of Baghdad and went on for a year until Petraeus's surge began in February. It continues in many places where his troops are not present.

The world held its breath after Samarra: here, we thought, comes the cataclysm, the civil war that many had feared and that others had sought for three years. But it never happened. The Shia backlash in parts of Baghdad was vicious, and the Sunnis were more or less kicked out of much of the city. But over 18 months later, it is clear that the Shias were too sensible to go all the way. It was never a civil war: no battle lines or uniforms, no secession, no attempt to seize power or impose constitutional change, no parallel governments, not even any public leaders or aims. The Sunnis rolled the dice, launched the battle of Baghdad and lost. Now they are begging for an accommodation with Shia Iraq.

What is the evidence for this? This summer, Maliki's office reached out to Baathist ex-soldiers and officers and received 48,600 requests for jobs in uniform; he made room for 5,000 of them, found civil service jobs for another 7,000, and put the rest of them on a full pension. Meanwhile leading Baathists have told Time magazine they want to be in the government; the 1920 Revolution Brigade—a Sunni insurgent group—is reportedly patrolling the streets of Diyala with the 3rd infantry division, and the Sunni Islamic Army in Iraq is telling al Jazeera it may negotiate with the Americans. The anecdotes coming out of Baghdad confirm the trend. The drawing rooms of the capital's dealmakers are full of Baathists, cap in hand. They are terrified of the Shia death squads and want to share in the pie when the oil starts flowing. Both Izzat al-Douri, the more prestigious of the two main Baathist leaders, and Mohamed Younis al Ahmed, the more lethal, have been reaching out from neighbouring countries to negotiate an accommodation. Since the summer, the news coming out on the Sunni front has consistently been in this one, inevitable direction.

The Shia story was different. There have been two broad tendencies in Iraq's Shia politics: the pro-Iranian camp and the nationalist camp. Iraq has two great traditional pro-Iranian Shia parties—Nouri al-Maliki's Dawa party and the Supreme Iraqi Islamic Council (the former SCIRI). They fought Saddam from exile and spent the wilderness years in Iran. Opposed to these two is the al-Sadr movement, which—under Muqtada al-Sadr's father Mohammad Sadeq, killed by Saddam's men in 1999—fought Saddam from inside Iraq and kept its sense of anti-Iranian Iraqi nationalism intact. Of these tendencies, only al-Sadr's rose up to fight the Americans.

Muqtada al-Sadr's announcement of a unilateral six-month ceasefire on 29th August was significant, but not for the reasons most apparent. Al-Sadr actually stopped fighting the Americans three years ago. He rose up against them twice in 2004, but since the end of his second uprising, his Mahdi army has focused its violence on Wahhabis and Baathists, with frequent clashes against other Shia factions. Al-Sadr's movement is splintered and immature. Its less legitimate fringes have been active in sectarian cleansing. Many who do have ties to his movement frequently work beyond his control. Some of these tendencies continue to direct violence against the coalition, but this is negligible compared to the force of a true Sadrist resistance, as anyone who was in Najaf or Sadr City in 2004 will attest. Since this spring, US troops have been comfortably based in Sadr City—the giant Baghdad slum that is the power base of the Sadrists.

In mid-September, the al-Sadr parliamentary bloc withdrew its support for Maliki's government, without providing a public explanation. This repeats a pattern. In April, al-Sadr withdrew his ministers from the cabinet in ostensible protest at the remaining presence of the coalition forces; while in December 2006 he did the same thing in protest at a meeting between Maliki and Bush. Each of these exercises was greeted as Iraq's latest cataclysm, but, in the latter two cases, a month or two later al-Sadr's chiefs were quietly back fronting the ministries that their minions had continued to run in their absence. The point is that having al-Sadr playing political games rather than military ones is the most positive thing that could be happening in Iraq.

Muqtada al-Sadr, Iraq's most successful, popular and important politician, has underwritten Iraq's progress towards legitimate politics since late 2004. His sense of Iraqi nationalism will never allow Iranian dominance; his fraternal stance towards the peaceful Sunni tendencies, and the sheer size and passion of his movement, make his support for the project of reconstruction and pluralism in Iraq the most important political factor in the country. Prospect readers will not be surprised to read that al-Sadr is on the right side of the key issues, and that this is helping Iraq get over its transition from 35 years of Baathism's murderous apartheid (see "Iraq's rebel democrats," Prospect June 2005). Since 2004 I have pointed out that al-Sadr, as leader of the country's largest popular movement, has more to win from a functioning electoral politics than from fighting the Americans who guaranteed the polls that liberated his people, or from fighting the Iraqi government of which he is himself the joint largest part.

As we have noted, the real al-Sadr ceasefire began three years ago. But by saying publicly, again, that his men are putting down their guns, al-Sadr is declaring in the most unequivocal way that the violence in Iraq is not in his name.

Iranian-made rockets will continue to kill British and American soldiers. Saudi Wahhabis will continue to blow up marketplaces, employment queues and Shia mosques when they can. Iraqi criminals will continue to bully their neighbourhoods into homogeneities that will give the strongest more leverage, although even this tide is turning in most places where Petraeus's surge has reached. Bodies will continue to pile up in the ditches of Doura and east Baghdad as the country goes through the final spasm of the reckoning that was always going to attend the end of 35 years of brutal Sunni rule.

But in terms of national politics, there is nothing left to fight for. The only Iraqis still fighting for more than local factional advantage and criminal dominance are the irrational actors: the Sunni fundamentalists, who number but a thousand or two men-at-arms, most of them not Iraqi. Like other Wahhabi attacks on Iraq in 1805 and 1925, the current one will end soon enough. As the maturing Iraqi state gets control of its borders, and as Iraq's Sunni neighbours recognise that a Shia Iraq must be dealt with, the flow of foreign fighters and suicide bombers into Iraq from Syria will start to dry up. Even today, for all the bloodshed it causes, the violence hardly affects the bigger picture: suicide bombs go off, dozens of innocents die, the Shias mostly hold back and Iraq's tough life goes on.

In early September, Nouri al-Maliki said, "We may differ with our American friends about tactics… But my message to them is one of appreciation and gratitude. To them I say, you have liberated a people, brought them into the modern world… We used to be decimated and killed like locusts in Saddam's endless wars, and we have now come into the light." Here is an eloquent answer to the question of when American troops will leave Iraq. They will leave Iraq when the Iraqis, through their elected leadership, tell them to. According to a September poll, 47 per cent of Iraqis would prefer the Americans to leave. The surprise is that it's not 100 per cent. Who, after all, would not want his country rid of foreign troops? But if Iraqis had wanted government by opinion poll, they would have written their constitution that way. Instead, they chose, as do most people when given the choice, representative government.

Now that the outcome of the war in Iraq has been decided, a common argument heard on Capitol Hill and elsewhere is about moral hazard: the longer we stay, the less incentive Iraqis have to get their act together. They will not achieve reconciliation or become capable of keeping order in their own country, because America is doing the work for them.

This presumes that Iraq's elite is not trying on either front. That is nonsense. What is the basis for the presumption that Iraq's government is failing at political reconciliation? Parts of a 15 per cent minority have capped a 35-year reign of terror with four bloody years of a failed effort to drag historic injustices into the new era, and now the other players do not want to treat that failure like a victory. On a partisan basis, Iraq's governing coalition represents about 85 per cent of the country: almost everybody but some of the Sunnis. This means the Shia Dawa, SIIC, Sadrists and others; the Kurdish KDP and PUK; and various secular and moderate Sunnis. At the local level, the government is reaching out to the Sunnis. Federal money is being pumped into Anbar, and in Baghdad 30 Sunni mosques have been reopened, over half of them in the mostly Shia east. For all Iraqis' understandable complaints about corruption, the coalition, public services and safety, Maliki's government would win another big majority tomorrow.

The Sunnis have three specific worries: oil money, federalism and de-Baathification. On oil, revenues are already being shared out among the provinces and, to please the Americans, an oil-sharing law will probably be passed in the next 6 months. On federalism, the principle of regional autonomy is enshrined in the constitution, the Sunnis will benefit from it by being able to run their own affairs, and everyone else will benefit from avoiding a repeat of the Baathist nightmare of a strong central state, when a much looser arrangement worked for 300 years under the Ottomans. On de-Baathification, a new law this autumn should restore pensions and job access to all but the previous top 1,500 Baathists, almost all of whom are in prison, Syria or Jordan.

The other half of the moral hazard argument is about security: if we provide Iraqis' security for them, they will never do it for themselves. This is equally inaccurate. First, Iraqis are increasingly providing their own security. Second, Maliki and his colleagues run an elected government. They are subject to the judgement of their people in two years' time. They have every reason to try as hard as possible to deliver an end to the embarrassing reliance on the foreigner. It would be foolhardy to bet on Iraq, of all places, becoming the first Islamic state in the middle east not to achieve a basic monopoly on domestic violence.

The argument of this article—that with nothing more to resolve from political violence, Iraqis can now settle down to gorge themselves at the oil trough—is based on two premises: Sunni acknowledgement of the failure of their insurgency and the need to reach an accommodation with the new Iraq, and a conjunction of interests between the coalition on one hand and the Kurds and Shias on the other.

We have become very familiar with General Petraeus and the disputed numbers of his surge. Does US strategy reflect the phenomena I have described? The Americans have never argued this way. But reading between the lines, American thinking does seem broadly to accord with the conclusions of this argument, if not its premises. Petraeus has already announced the first marine and army drawdowns for September and December respectively. His boss, defence secretary Robert Gates, is hoping publicly for a net withdrawal of 60,000 troops next year. Bush too is promising cuts. These plans are a recognition that the job in Iraq is moving rapidly towards something closer to Iraqi police work than American war.

Wednesday, October 31, 2007

GDP grows at 3.9 percent in third quarter

U.S. Economy: Growth Unexpectedly Accelerated
By Bob Willis
Oct. 31 (Bloomberg)


Economic growth in the U.S. unexpectedly accelerated in the third quarter as increases in exports, consumer spending and business investment made up for another plunge in home construction.

Gross domestic product grew at an annual rate of 3.9 percent, the most in more than a year, the Commerce Department said today in Washington. The quarter included the period when some mortgage and commercial-borrowing costs jumped to six-year highs, prompting economists to cut their growth forecasts, and some to even warn of recession.

Federal Reserve policy makers today cut the benchmark lending rate by a quarter point to 4.5 percent and signaled they may have already done enough to prevent the economy from stalling. Third-quarter growth was ``solid'' and financial market strains had ``eased somewhat,'' the Fed said. Stocks advanced, and Treasury notes fell.

``It depends on how the economy unfolds as to whether they'll reduce rates again,'' said Brian Bethune, senior financial economist at Global Insight, a research firm in Lexington, Massachusetts.

Market Reaction

The yield on the benchmark 10-year note rose to 4.45 percent at 3.35 p.m. in New York, from 4.38 percent late yesterday. The Dow Jones Industrial Average climbed 0.8 percent to 13,900.75.

The collapse in subprime lending caused the average rate on one-year adjustable mortgages to shoot up to 5.84 percent in late August, the highest since June 2001, according to figures from Freddie Mac. The rate on one-day asset-backed commercial paper rose to the highest since January 2001.

Consequently, home purchases and construction slumped at the end of the quarter. Existing home sales in September fell 8 percent from the prior month, while housing starts declined 10 percent to the lowest since March 1993, reports earlier this month showed.

The National Association of Purchasing Management-Chicago said its business-activity index fell to 49.7 in October, from 54.2 the previous month. Readings below 50 signal a contraction. The median forecast among economists surveyed by Bloomberg News was for a drop to 53.

Job Gain

Companies in the U.S. added 106,000 jobs in October, more than economists had forecast, according to a report today from ADP Employer Services. A report from the Labor Department also showed employment costs rose in the third quarter at a slower pace than in the previous three months, suggesting increases in wages and benefits aren't heating up inflation. Additional figures from the Commerce Department showed construction spending increased last month as the building of factories, hotels and schools compensated for a drop in housing.

The GDP report is the first for the quarter and will be revised in November and December as more information becomes available. The median forecast in a Bloomberg News survey was for an expansion of 3.1 percent.

The Fed's preferred inflation gauge, which is tied to consumer spending and strips out food and energy costs, rose at a 1.8 percent annual pace following a 1.4 percent increase the prior quarter, according to the report.

The gain leaves prices within the 1 percent to 2 percent range policy makers, including Ben S. Bernanke before becoming Fed chairman, have said is their preferred zone.

Price Slowdown

The GDP figures are adjusted for inflation and the acceleration in growth came in part because of the smallest gain in overall prices since 1998. The report's price index rose at a 0.8 percent annual rate after a 2.6 percent second-quarter rise.

Consumer spending grew at a 3 percent pace following a 1.4 percent increase in the prior quarter, contributing the most to the gain in growth. Still, many economists project spending will slow as declining property values turn Americans pessimistic.

``I don't expect we're going to see GDP at all like this in the fourth quarter, but coming from where we've been in mid- 2007, it won't be bad,'' said Richard DeKaser, chief economist at National City Corp. in Cleveland, who forecast growth of 3.8 percent.

The economy will probably expand at a 1.8 percent pace in the current quarter, according to the median forecast of economists surveyed earlier this month.

Investment Increases

Consumers weren't the only ones buying last quarter. Gains in both commercial construction projects and purchases of equipment and software contributed to a 7.9 percent increase in business investment. The 5.9 percent rise in spending on new equipment was the biggest since the first quarter of 2006.

An increase in inventories contributed another 0.4 percentage point to growth.

The economy was also buttressed by a narrowing of the trade deficit that added 0.9 percentage point to the rate of expansion. The gap shrank to $546.2 billion at an annual pace, the smallest since the last three months of 2003.

General Electric Co.'s third-quarter profit rose as large- equipment orders climbed 39 percent amid a surge in demand from countries that are building airports and power grids, the Fairfield, Connecticut-based company said Oct. 12.

``We see orders everywhere around the world,'' GE's Chief Executive Officer Jeffrey Immelt said on a conference call earlier this month. ``That seems to be accelerating, not diminishing.''

Home construction remained the biggest drag on GDP, the report showed. A 20.1 percent plunge in homebuilding, the seventh consecutive decline, subtracted a percentage point from growth.

Thursday, September 20, 2007

The Middle of Nowhere

The middle of nowhere
Edward Luttwak

Western analysts are forever bleating about the strategic importance of the middle east. But despite its oil, this backward region is less relevant than ever, and it would be better for everyone if the rest of the world learned to ignore it

http://www.prospect-magazine.co.uk/article_details.php?id=9302


Why are middle east experts so unfailingly wrong? The lesson of history is that men never learn from history, but middle east experts, like the rest of us, should at least learn from their past mistakes. Instead, they just keep repeating them.

The first mistake is "five minutes to midnight" catastrophism. The late King Hussein of Jordan was the undisputed master of this genre. Wearing his gravest aspect, he would warn us that with patience finally exhausted the Arab-Israeli conflict was about to explode, that all past conflicts would be dwarfed by what was about to happen unless, unless… And then came the remedy—usually something rather tame when compared with the immense catastrophe predicted, such as resuming this or that stalled negotiation, or getting an American envoy to the scene to make the usual promises to the Palestinians and apply the usual pressures on Israel. We read versions of the standard King Hussein speech in countless newspaper columns, hear identical invocations in the grindingly repetitive radio and television appearances of the usual middle east experts, and are now faced with Hussein's son Abdullah periodically repeating his father's speech almost verbatim.

What actually happens at each of these "moments of truth"—and we may be approaching another one—is nothing much; only the same old cyclical conflict which always restarts when peace is about to break out, and always dampens down when the violence becomes intense enough. The ease of filming and reporting out of safe and comfortable Israeli hotels inflates the media coverage of every minor affray. But humanitarians should note that the dead from Jewish-Palestinian fighting since 1921 amount to fewer than 100,000—about as many as are killed in a season of conflict in Darfur.

Strategically, the Arab-Israeli conflict has been almost irrelevant since the end of the cold war. And as for the impact of the conflict on oil prices, it was powerful in 1973 when the Saudis declared embargoes and cut production, but that was the first and last time that the "oil weapon" was wielded. For decades now, the largest Arab oil producers have publicly foresworn any linkage between politics and pricing, and an embargo would be a disaster for their oil-revenue dependent economies. In any case, the relationship between turmoil in the middle east and oil prices is far from straightforward. As Philip Auerswald recently noted in the American Interest, between 1981 and 1999—a period when a fundamentalist regime consolidated power in Iran, Iran and Iraq fought an eight-year war within view of oil and gas installations, the Gulf war came and went and the first Palestinian intifada raged—oil prices, adjusted for inflation, actually fell. And global dependence on middle eastern oil is declining: today the region produces under 30 per cent of the world's crude oil, compared to almost 40 per cent in 1974-75. In 2005 17 per cent of American oil imports came from the Gulf, compared to 28 per cent in 1975, and President Bush used his 2006 state of the union address to announce his intention of cutting US oil imports from the middle east by three quarters by 2025.

Yes, it would be nice if Israelis and Palestinians could settle their differences, but it would do little or nothing to calm the other conflicts in the middle east from Algeria to Iraq, or to stop Muslim-Hindu violence in Kashmir, Muslim-Christian violence in Indonesia and the Philippines, Muslim-Buddhist violence in Thailand, Muslim-animist violence in Sudan, Muslim-Igbo violence in Nigeria, Muslim-Muscovite violence in Chechnya, or the different varieties of inter-Muslim violence between traditionalists and Islamists, and between Sunnis and Shia, nor would it assuage the perfectly understandable hostility of convinced Islamists towards the transgressive west that relentlessly invades their minds, and sometimes their countries.

Arab-Israeli catastrophism is wrong twice over, first because the conflict is contained within rather narrow boundaries, and second because the Levant is just not that important any more.

The second repeated mistake is the Mussolini syndrome. Contemporary documents prove beyond any doubt what is now hard to credit: serious people, including British and French military chiefs, accepted Mussolini's claims to great power status because they believed that he had serious armed forces at his command. His army divisions, battleships and air squadrons were dutifully counted to assess Italian military power, making some allowance for their lack of the most modern weapons but not for their more fundamental refusal to fight in earnest. Having conceded Ethiopia to win over Mussolini, only to lose him to Hitler as soon as the fighting started, the British discovered that the Italian forces quickly crumbled in combat. It could not be otherwise, because most Italian soldiers were unwilling conscripts from the one-mule peasantry of the south or the almost equally miserable sharecropping villages of the north.

Exactly the same mistake keeps being made by the fraternity of middle east experts. They persistently attribute real military strength to backward societies whose populations can sustain excellent insurgencies but not modern military forces.

In the 1960s, it was Nasser's Egypt that was mistaken for a real military power just because it had received many aircraft, tanks and guns from the Soviet Union, and had many army divisions and air squadrons. In May 1967, on the eve of war, many agreed with the prediction of Field Marshal Montgomery, then revisiting the El Alamein battlefield, that the Egyptians would defeat the Israelis forthwith; even the more cautious never anticipated that the former would be utterly defeated by the latter in just a few days. In 1973, with much more drama, it still took only three weeks to reach the same outcome.

In 1990 it was the turn of Iraq to be hugely overestimated as a military power. Saddam Hussein had more equipment than Nasser ever accumulated, and could boast of having defeated much more populous Iran after eight years of war. In the months before the Gulf war, there was much anxious speculation about the size of the Iraqi army—again, the divisions and regiments were dutifully counted as if they were German divisions on the eve of D-day, with a separate count of the "elite" Republican Guards, not to mention the "super-elite" Special Republican Guards—and it was feared that Iraq's bombproof aircraft shelters and deep bunkers would survive any air attack.

That much of this was believed at some level we know from the magnitude of the coalition armies that were laboriously assembled, including 575,000 US troops, 43,000 British, 14,663 French and 4,500 Canadian, and which incidentally constituted the sacrilegious infidel presence on Arabian soil that set off Osama bin Laden on his quest for revenge. In the event, two weeks of precision bombing were enough to paralyse Saddam's entire war machine, which scarcely tried to resist the ponderous ground offensive when it came. At no point did the Iraqi air force try to fight, and all those tanks that were painstakingly counted served mostly for target practice. A real army would have continued to resist for weeks or months in the dug-in positions in Kuwait, even without air cover, but Saddam's army was the usual middle eastern façade without fighting substance.

Now the Mussolini syndrome is at work over Iran. All the symptoms are present, including tabulated lists of Iran's warships, despite the fact that most are over 30 years old; of combat aircraft, many of which (F-4s, Mirages, F-5s, F-14s) have not flown in years for lack of spare parts; and of divisions and brigades that are so only in name. There are awed descriptions of the Pasdaran revolutionary guards, inevitably described as "elite," who do indeed strut around as if they have won many a war, but who have actually fought only one—against Iraq, which they lost. As for Iran's claim to have defeated Israel by Hizbullah proxy in last year's affray, the publicity was excellent but the substance went the other way, with roughly 25 per cent of the best-trained men dead, which explains the tomb-like silence and immobility of the once rumbustious Hizbullah ever since the ceasefire.

Then there is the new light cavalry of Iranian terrorism that is invoked to frighten us if all else fails. The usual middle east experts now explain that if we annoy the ayatollahs, they will unleash terrorists who will devastate our lives, even though 30 years of "death to America" invocations and vast sums spent on maintaining a special international terrorism department have produced only one major bombing in Saudi Arabia, in 1996, and two in the most permissive environment of Buenos Aires, in 1992 and 1994, along with some assassinations of exiles in Europe.

It is true enough that if Iran's nuclear installations are bombed in some overnight raid, there is likely to be some retaliation, but we live in fortunate times in which we have only the irritant of terrorism instead of world wars to worry about—and Iran's added contribution is not likely to leave much of an impression. There may be good reasons for not attacking Iran's nuclear sites—including the very slow and uncertain progress of its uranium enrichment effort—but its ability to strike back is not one of them. Even the seemingly fragile tanker traffic down the Gulf and through the straits of Hormuz is not as vulnerable as it seems—Iran and Iraq have both tried to attack it many times without much success, and this time the US navy stands ready to destroy any airstrip or jetty from which attacks are launched.

As for the claim that the "Iranians" are united in patriotic support for the nuclear programme, no such nationality even exists. Out of Iran's population of 70m or so, 51 per cent are ethnically Persian, 24 per cent are Turks ("Azeris" is the regime's term), with other minorities comprising the remaining quarter. Many of Iran's 16-17m Turks are in revolt against Persian cultural imperialism; its 5-6m Kurds have started a serious insurgency; the Arab minority detonates bombs in Ahvaz; and Baluch tribesmen attack gendarmes and revolutionary guards. If some 40 per cent of the British population were engaged in separatist struggles of varying intensity, nobody would claim that it was firmly united around the London government. On top of this, many of the Persian majority oppose the theocratic regime, either because they have become post-Islamic in reaction to its many prohibitions, or because they are Sufis, whom the regime now persecutes almost as much as the small Baha'i minority. So let us have no more reports from Tehran stressing the country's national unity. Persian nationalism is a minority position in a country where half the population is not even Persian. In our times, multinational states either decentralise or break up more or less violently; Iran is not decentralising, so its future seems highly predictable, while in the present not much cohesion under attack is to be expected.

The third and greatest error repeated by middle east experts of all persuasions, by Arabophiles and Arabophobes alike, by Turcologists and by Iranists, is also the simplest to define. It is the very odd belief that these ancient nations are highly malleable. Hardliners keep suggesting that with a bit of well-aimed violence ("the Arabs only understand force") compliance will be obtained. But what happens every time is an increase in hostility; defeat is followed not by collaboration, but by sullen non-cooperation and active resistance too. It is not hard to defeat Arab countries, but it is mostly useless. Violence can work to destroy dangerous weapons but not to induce desired changes in behaviour.

Softliners make exactly the same mistake in reverse. They keep arguing that if only this or that concession were made, if only their policies were followed through to the end and respect shown, or simulated, hostility would cease and a warm Mediterranean amity would emerge. Yet even the most thinly qualified of middle east experts must know that Islam, as with any other civilisation, comprehends the sum total of human life, and that unlike some others it promises superiority in all things for its believers, so that the scientific and technological and cultural backwardness of the lands of Islam generates a constantly renewed sense of humiliation and of civilisational defeat. That fully explains the ubiquity of Muslim violence, and reveals the futility of the palliatives urged by the softliners.

The operational mistake that middle east experts keep making is the failure to recognise that backward societies must be left alone, as the French now wisely leave Corsica to its own devices, as the Italians quietly learned to do in Sicily, once they recognised that maxi-trials merely handed over control to a newer and smarter mafia of doctors and lawyers. With neither invasions nor friendly engagements, the peoples of the middle east should finally be allowed to have their own history—the one thing that middle east experts of all stripes seem determined to deny them.

That brings us to the mistake that the rest of us make. We devote far too much attention to the middle east, a mostly stagnant region where almost nothing is created in science or the arts—excluding Israel, per capita patent production of countries in the middle east is one fifth that of sub-Saharan Africa. The people of the middle east (only about five per cent of the world's population) are remarkably unproductive, with a high proportion not in the labour force at all. Not many of us would care to work if we were citizens of Abu Dhabi, with lots of oil money for very few citizens. But Saudi Arabia's 27m inhabitants also live largely off the oil revenues that trickle down to them, leaving most of the work to foreign technicians and labourers: even with high oil prices, Saudi Arabia's annual per capita income, at $14,000, is only about half that of oil-free Israel.

Saudi Arabia has a good excuse, for it was a land of oasis hand-farmers and Bedouin pastoralists who cannot be expected to become captains of industry in a mere 50 years. Much more striking is the oil parasitism of once much more accomplished Iran. It exports only 2.5m barrels a day as compared to Saudi Arabia's 8m, yet oil still accounts for 80 per cent of Iran's exports because its agriculture and industry have become so unproductive.

The middle east was once the world's most advanced region, but these days its biggest industries are extravagant consumption and the venting of resentment. According to the UN's 2004 Arab human development report, the region boasts the second lowest adult literacy rate in the world (after sub-Saharan Africa) at just 63 per cent. Its dependence on oil means that manufactured goods account for just 17 per cent of exports, compared to a global average of 78 per cent. Moreover, despite its oil wealth, the entire middle east generated under 4 per cent of global GDP in 2006—less than Germany.

Unless compelled by immediate danger, we should therefore focus on the old and new lands of creation in Europe and America, in India and east Asia—places where hard-working populations are looking ahead instead of dreaming of the past

Monday, September 17, 2007

Breaking The Bank

It is widely understood that the sophistication and capabilities of electronic products have been increasing much faster than their cost. Ever since the first Texas Instruments calculators, consumers have experienced steadily increasing performance from personal computers and a host of other products such as TVs and GPS equipment, while their unit cost has not increased in proportion, and in some cases has fallen.

Buyers know that the true cost of most electronic equipment, and not just computers, has declined more or less in accordance with the so-called Grosch’s Law: The cost of computing systems increases as the square root of their computational power. In other words, a buyer will get exponentially more performance bang for each additional buck spent on a computer or any gadget with a computer in it.

Now, since electronic systems, sub-systems and components account for an increasing proportion of all weapons platforms from armed helicopters to warships, it follows that, other things being equal, their unit cost should be declining rapidly courtesy of Grosch’s Law. Instead the very opposite is the case: Unit costs in each and every category—combat aircraft, warships, armored fighting vehicles, air-defense radars and the rest—continue to increase. Evidently, other things are not equal. But what things?

First, we must set aside a common but erroneous presumption: the belief that the high cost of military equipment is caused mainly by the oligopolistic nature of military industries—or as they prefer to call themselves, the military aerospace and defense industry. Because relatively few governments buy major military platforms from relatively few large manufacturers, the result is that the normal cost-constraining function of the free market is absent from military purchasing. Contractors can thus charge pretty much whatever they want, it is said, a process presumably facilitated by “revolving door” relationships between the services and their major contractors.

This line of reasoning is popular but explains much less than one would think. Oligopoly there certainly is; competition is weak even in the United States and almost absent in Europe, where national, bi-national or tri-national conglomerates simply own their respective home markets. But inefficiency is not extreme because there is so much scrutiny, starting with the military buyers themselves who need their aircraft to fly and their missiles to hit their targets, while monopolistic extortion is resisted by the U.S. Congress and even by European parliaments. That is why all long-term comparisons show that military industries are not especially profitable. They have done well out of the post-2001 build-up, but they did poorly before that and will no doubt do poorly again when the Iraq war winds down. Many investors systematically avoid military aerospace and defense stocks for the same reason they avoid airline stocks: the glamour greatly exceeds the returns on equity.

The Procurement Paradox

The most obvious real cause of increasing unit costs is the decline in the production rates of weapon systems, which generates negative economies of scale. That decline has been drastic, and so have been the industrial consequences.

Weapon systems were once truly industrial products, mass-produced for the most part, except for oddities like giant, rail-mounted guns. As in all forms of manufacturing, the efficiency of production was increased by investing in more dedicated as opposed to generic assembly lines or batch-production infrastructures, in more automated machinery, more specialized tooling, and in other ways of replacing labor with capital equipment. Even in wartime conditions, when monetary savings are of secondary importance, the efficiency of highly capitalized mass production was still valued, because it increased the supply of weapons and the homogeneity of their performance. Millions of identical rifles produced by assembly-line workers are more valuable to a mass force than individual match-grade weapons forged by highly skilled gunsmiths. Even if budgets were not significantly limited, the supply of skilled labor was, which is what the highly capitalized plant replaced most advantageously. Only the limitations of available production technologies set final limits at any one time on the substitution of capital for labor.

These days, advanced production technologies allow labor-saving investments up to the limit of fully robotic plants, which require labor only for maintenance, not operation. But because so few weapon systems of any given type are purchased, very little investment in advanced production-plant technologies can be economical. In contrast to civilian industry, in which IT-controlled plants and equipment can produce customized as well as classic mass-produced items, most weapon systems are almost entirely made by hand, with a profligate use of costly skilled labor. That in turn generates additional costs: Humans are less reliable than machines, so the greater the manual content of production, the greater the potential for manufacturing errors that require repairs or replacement, or that simply cause disruptive delays.

The contrast between a typical military production plant and its typical civilian counterpart is stark—for example, between armored-combat vehicle factories and ordinary automotive plants. The former consist mostly of empty space within which highly skilled workers can get under, over and inside the combat vehicles as they are assembled one by one. The latter consist of a production line densely packed with automated machinery. A production capacity of 100,000 per year is more or less a minimum for an automobile plant, and 10,000 per year would not be much at all for a truck plant. Yet no armored vehicle is produced in such numbers. Indeed, these numbers exceed typical total production runs of armored vehicles over a period of many years.

The example of fighter jets, illustrated in Table 1, shows the changes in production rates and the implied potential for economies of scale. Even these data, however, overstate the economies of scale that have been obtainable as time has passed, because they ignore the effect of modifications and upgrades introduced to overcome anticipated obsolescence. Each upgrade imposed its own learning curve and caused a temporary loss of production efficiency. The differences between the (Block 1) F-16s of 1978 and the (Block 50/52) F-16s of 2006, for example, are so great that they are scarcely the same aircraft. They certainly have much less in common with each other than did the first and last versions of the Spitfire or Messerschmitt Bf 109.

Nor are fighter aircraft the most extreme case from the viewpoint of diminished production rates and resulting inefficiencies. Bombers are worse still; armored vehicles are worse than bombers; and tanks are worse than armored vehicles—not to mention ships for the Navy.

So the explanation seems simple, and a remedy impossible. If the unit cost of weapon systems continues to increase because too few are purchased for economies of scale to be brought to bear, then the only solution is to produce more of them. But not even the U.S. military could pay for 15,586 F-35 Joint Strike Fighters, an infinitely more elaborate aircraft than the P-51 Mustang ever was. Nor could the Air Force begin to absorb them into any rational order of battle. The Army cannot afford nor use 21,231 Abrams tanks, whose armor and systems are far more elaborate than those of the M4 Sherman tank—which brings us to a second, related thing that is not equal.

The unit costs of weapon systems have continued to increase not just because fewer and fewer are acquired, but also because of their increasing complexity. A vicious circle has long been at work, starting with the recognition that weapon systems are so expensive that few can be acquired. It continues with the reasoning that if few weapon systems can be acquired, those that are acquired must deliver superior performance. To do that, however, requires both macro- and micro-innovations that are costly, so costly that those innovations make weapons even more expensive—so that even fewer are acquired, and so on and on we have gone.

That is not all: The circle has really been a downward spiral from the 1950s to the present, because the time needed to bring innovations into production has expanded, as well. Weapons that will not be fielded for many years must promise even higher performance to hedge against the uncertainties of what competitors might devise. That increases innovation costs, further reducing acquisition numbers and further raising per-unit costs.

Taken together, problems of scale and complexity define the procurement paradox: We have ever more sophisticated weapons, but so few in number because of cost that overall capabilities either stay the same, decrease, or become simply incalculable against novel changes in the threat environment.

Prisoners of Tradition

The procurement paradox, thus defined, explains a great deal about the rising per-unit costs of major military platforms. But it does not explain everything. Often overlooked by those close to the procurement process, and almost completely opaque to most policy officials high and low, are the hidden costs inflicted by the astounding persistence of traditional weapon configurations.

There have been many wars and much technological advancement since 1945, but nothing as revolutionary as a prolonged world war has fully engaged the energies and talents of the developed countries to overthrow old paradigms of war-fighting. The result is that the canonical weapons platforms and configurations of World War II have endured, despite all the new possibilities opened by technological advancements in the past six decades.

The old configurations were a good fit for the technology of 1945. Today, they have become obstacles to military advancement, severely compounding the procurement paradox. Instead of shaping new platform and weapon configurations to fit today’s information technology, communications, sensor and guidance equipment, we are shoving, cramming and molding such technology to fit into the nooks and crannies of 1945-era platforms. Moreover, those traditional platforms mostly retain their 1945 character as autonomously operating units, even though in war they would always operate in groups of near-identical platforms and, increasingly likely, in joint configurations with other kinds of platforms.

For example, airborne radars, including the latest Active Electronically Scanned Arrays, are perhaps a hundred times as expensive pound for pound as even the most elaborate high-definition television sets. But what makes them almost a thousand times more expensive is the need to miniaturize and package the new radars so that they will fit into the nose-cone of fighter aircraft designed for aerodynamic optimality rather than to accommodate equipment as elaborate as today’s best radars.

Given the potentially revolutionary combat value of the new radars, which can not only detect, acquire and track multiple targets but also attack electronic circuitry with highly focused beams, combat aircraft should be designed around them, not the other way around. Even greater cost-effectiveness could be achieved if ensembles of dissimilar combat aircraft were designed around the new technology, some with their own full-scale radars, others with a greater weapons load, others still equipped for defense suppression and so on. We are not doing this. Instead, the latest variants of the F-18 and F-15 aircraft have one radar set, old or new, per nose-cone, just as it was with mechanically scanned radars more than thirty years ago, and just as it was with the first radar-equipped fighters of World War II. Things are no different with the new F-22, and the F-35 Joint Strike Fighter, the future combat aircraft of many air forces. In those designs, as well, the new radar must fit wherever there happens to be room for it, in an aircraft designed according to impeccably traditional, and decreasingly consequential, aerodynamic criteria.

Today’s advanced airborne radar sets are not a unique example. The same is true of most other new equipment and of most platforms. Instead of providing suitable and economical new forms into which the new content can best be accommodated, operated and maintained, the new content is expensively miniaturized, fragmented and contorted so that it can fit into the old classic forms. This not only greatly increases costs; it also constrains effectiveness.

For all the heady talk of advancement and breakthrough technologies, the 1945 platforms have proven amazingly persistent, probably for an entirely irrational, albeit compelling, reason: fond memories of their central role in the war that remains emblematic for the few countries that design, develop and produce the world’s major weapon systems. Whatever the ultimate explanation, the facts are undeniable, as three case studies illustrate: fighter aircraft, tanks and aircraft carriers.


Fighter Aircraft: There were no dedicated fighter aircraft in 1914; only a variety of biplanes (and a triplane or two), none armed. Thanks to the crucible of two world wars, a mere thirty years later an all-metal, jet-propelled monoplane fighter (the Messerschmitt 262) was flying in combat service.

More than sixty years later, in 2007, instead of even more drastic changes to accommodate the IT revolution, networked communications, new sensor technology and so forth, the 1944 configuration has not changed at all. All current and upcoming fighters—the F-15, F-16, F-18, F-22, F-35 JSF, Jaguar, Gripen, Eurofighter, Rafale, MiG-29 and Su-27/30—perpetuate the Me 262 configuration. All feature aerodynamically optimized forms, one or two aircrew, one or two engines and full sets of sensors for self-sufficient operation in both air-to-air and air-to-ground missions (despite the fact that a single fighter aircraft would only ever fly on its own in the immediate aftermath of a very unsuccessful combat operation).

Nobody could ever confuse a 1914 biplane with the Me 262 after thirty years of macro innovation, but after more than sixty years of post-1945 conservatism, only experts and enthusiasts would immediately categorize the Me 262 as anything other than a contemporary aircraft.

Even more important than mere appearance, today’s fighters perpetuate a 1945 conception of air power that views the fighter pilot as an airborne knight with all his weapons on his flying horse, ready to battle the enemy on his own (or sometimes with a second crewman to play the loyal squire). From this conception follows the homogeneity principle: Aircraft of any one type are all equipped the same way, without any effort at task-force optimization—again, despite the fact that fighter aircraft are never sent into action on their own.


Main Battle Tanks: There were no armored fighting vehicles in 1914 except for a handful of very lightly armored cars; for the rest, soldiers only had wheeled trucks and some tractors, none armored or armed. Only thirty years later, the heavily armored main battle tank—manned by a four- or five-man crew and armed with a high-velocity, long-barreled gun in a rotating turret (T-34, Sherman, Tiger)—was operating on a large scale.

More than sixty years later, in 2007, instead of drastic platform innovation to respond to the proliferation of light, armor-piercing weapons and of surface-to-surface missiles, today’s main battle tanks—the M1, T-80, Leopard, AMX-50 and the rest—can all still be easily confused with a Panzerkampfwagen VI Sd.Kfz 182 (“King Tiger”) of 1944. And all still rely on a rotating high-velocity turret gun as their main armament, as if guided missiles had never been invented.

In other respects, too, post-1945 improvements to tanks have only been incremental—not revolutionary, as they were in the tanks of 1944 as compared to those of 1918. Yes, today’s composite armor is more resistant to kinetic penetration than the armor of 1944, pound for pound, but the difference is not qualitative. Acceleration on the battlefield can be somewhat higher, too, because of better suspensions, but it is the difference in fire-control sub-systems that really counts: If potential first-round hit probabilities go way up, acceleration becomes less important. But those sub-systems are expensively and poorly accommodated in modern tanks, which still replicate the canonical World War II configuration, no matter what else about the battlefield has changed.

The only way to explain this is to conjecture that each generation of armor officers since 1944 has demanded incremental improvements on the 1944 design while simultaneously refusing to seriously consider any other configuration. That is exactly what happened, and that is why, instead of offering altogether greater striking power, today’s battle tanks are burdened with ever more active and passive defenses against anti-tank missiles that cost less than a hundredth of those defenses.


Aircraft Carriers: There were no aircraft carriers in 1914, only the British seaplane tender HMS Hermes. Thirty years later, the large-deck aircraft carrier with below-deck hangar space, a small island on top, hydraulic catapults for launching and arrestor cables for recovering aircraft had become the capital ship of the age. The aircraft carrier was greatly valued for its unique ability to convey air power beyond the range limits of combat aircraft in the days before aerial refueling.

Now, 63 years later, that same 1944 configuration remains unchanged in its basic forms despite all subsequent incremental improvements, large and small—from steam catapults to angled decks to nuclear propulsion. More important, aircraft carriers remain the capital ships of the navies that have them, and the envy of those that do not. Yet manned aircraft, as well as missiles and unmanned aircraft, can now have global range, so sea-basing has lost its once indispensable function of bringing short-range aircraft within reach of their targets. Instead it provides a hugely expensive and vulnerable (albeit more versatile) base to attack targets also within reach of other aircraft.

Not coincidentally, the fighter aircraft, main battle tank and aircraft carrier are of central importance institutionally for their respective components of U.S. and other armed forces. Hence the renewal of those specific platforms with ever more perfected versions of the same classic forms greatly preoccupies service organizations, service chiefs and their civilian appendages. There is a veritable culture around each of these weapon configurations, which is of course inherently conservative, as is any culture.


Other platforms and weapons are just as resistant to change as fighter aircraft, tanks and aircraft carriers in ways that increase costs and degrade effectiveness. Three are most interesting for our purposes: the very ancient field artillery, last century’s over-the-beach amphibious vessels and vehicles, and the more recent attack helicopter. All three configurations can still be valuable in combat as specialized equipment acquired in small numbers, but not in the way they are designed and deployed today.

In the case of field artillery, more can be done these days by much cheaper mortars with guided bombs and by geographically more flexible air power. In the case of amphibious vehicles, it is because large-scale amphibious landings in D-Day style are wildly unlikely today. And for good reason. In the 1991 Gulf War, for example, the Marines were forced to cancel the largest landing operation since Inchon in 1950 because fewer than fifty reasonably modern, and quite inexpensive, anti-ship were mines in their way.

In the case of attack helicopters it is because air assaults by massed attack helicopters cannot possibly succeed in modern conditions against armed enemies because of their high vulnerability to contemporary weapons. Case in point: In 2003 the U.S. Army’s AH-64s failed against Iraqi armored forces of low quality, suffering much damage while inflicting little. Large, very noisy machines that cannot fly either fast or high cannot prevail against the contemporary proliferation of ground weapons that can shoot them down, including ordinary machine-guns and hand-held missiles that fixed-wing combat aircraft can over- or out-fly with ease.

In contrast to field artillery and amphibious craft, which served important purposes at one time or another, attack helicopters may well be an outright wrong turn in the evolution of weapons. They always seem to fail in combat against enemies who can shoot back, and have therefore been absent, inconsequential or highly problematic in recent wars. Only their unique institutional value to armies that are not allowed their own fixed-wing combat aircraft can explain why attack helicopters continue to be developed and produced in large numbers.

Overcoming the Procurement Paradox

The only way to overcome the procurement paradox is to pursue macro-innovation in major platforms to make best use of new technology. But thanks to hidebound service cultures, we instead spend fortunes on micro-innovations meant to remedy the obsolescence of old configurations and practically nothing on revolutionary new platforms.

Worse, perhaps, we cling still to the old model of maximum homogeneity in platforms and weapons. There was once a time when mass armies, mass air forces and 2,000-ship navies could only be equipped efficiently with mass-produced equipment, but that has not been true for years. Not only do we rely much less on sheer numbers, but today’s flexible-production technology allows for far more economical customization than we ask of it. If we are going to pay the costs of building weapons more or less by hand, it makes no sense to build them all the same. Indeed, the great variety of available sub-systems favors heterogeneity and mixed task forces because all these sub-systems can be useful, but very few platforms, if any, can include them all.

For example, many kinds of sensors now operate across the electromagnetic spectrum and all sensor data can be securely communicated all the way up and down the chain of command in real time. Therefore, not all platforms need their own identical set of sensors, even if they could accommodate them all. By equipping the individual platforms of air squadrons, tank battalions, missile-boat flotillas and so forth with dissimilar but integrable sensor suites, total sensor costs could be greatly reduced with no significant loss of performance.

Here’s one way to describe the essence of the point: Think of individual weapons platforms not as discrete units, but as fractional, networked parts of a whole. If the conceptual unit of operation is the ensemble of platforms linked together with reliable, real-time communications rather than a individual machine, platform design and function begin to look radically different. We are living at a time when the concept of a distributed system is widely understood. Why we are unable to apply this elemental understanding to weapons design is a reason for wonder, particularly when it is so easy to demonstrate how it can work. Consider the following two examples.


Unmanned Aerial Vehicles. Resistance to one recent macro-innovation—the unmanned aerial vehicle, or UAV—has already been partially overcome, proving that we can do this if we try. The simplest function of a UAV is to fly over enemy territory to observe “the other side of the hill.” This is a requirement so elemental that even the most conservative armies have rushed into service anything that could fly, starting with hot air balloons long before Italy used biplanes in the 1911 conquest of Libya to inaugurate heavier-than-air combat aviation.

Unmanned aerial vehicles are not new: Several kinds were operating in the 1950s and remotely controlled drones were flying long before then. Yet it was not until June 1982 that UAVs were deployed operationally as an integral part of a combat force in war: The Israeli Army’s 162nd Division used observation RPVs (remotely piloted vehicles, as they were then called) in their fight against Syrian forces in Lebanon. The dramatic results of that experience were widely shared with the U.S. Department of Defense. The evidence ought to have been immediately convincing: The actual imagery was taped. Yet here we are in 2007, and the integration of UAVs has only just begun, even in the most advanced armed forces, including those of the United States. How does one explain this?

The most prevalent excuse for resisting anything new is cost, but that excuse cannot be used against UAVs as a category. While one or two types of UAVs are very expensive, most are rather cheap. Nor is there evidence to support the widespread belief that the introduction of pilotless aircraft has been impeded by pilot-dominated command structures. It seems instead that the resistance to UAVs is more a case of diffused institutional resistance to any new platform category that must inevitably be funded at the expense of established ones.

Such determined institutional resistance can be documented. For example, the IAI/TRW Hunter UAV program was cancelled in 1996 after the acquisition of an initial batch because U.S. Army evaluators reported many severe defects: inadequate range, unsatisfactory datalink, too big to fit into the designated transport aircraft, unstable software, and unacceptable engines. After considering (one hopes only perfunctorily) an absurdly expensive $2 billion program to remedy this long list of crippling defects, the planned acquisition was simply cancelled. The cancellation inevitably perpetuated the roles of existing U.S. aviation platforms, notably helicopters and fixed-wing light observation aircraft. Alas, this could not be helped, for the cancellation was seemingly a straightforward matter of rejecting defective equipment.

As it happens, however, the initial batch of entirely unimproved Hunters, supposedly crippled by defects, did not go to waste. In the spring of 1999, eight of the surviving Hunters, redesignated RQ-5A, were sent to Albania in support of Operation Allied Force, the NATO air campaign against Serbia. In the course of 281 sorties (281 sorties for only eight aircraft) the Hunters provided real-time video of conditions on the ground both to commanders on the spot and, via satellite links, to NATO headquarters. Hunter operators identified and located targets for the air campaign and often stayed on station during air strikes to provide real-time damage-assessment, greatly reducing the need for follow-up strikes.

In 2002, Hunters were tested experimentally for ground strike operations, dropping Brilliant Antiarmor Munitions (BATs) to achieve direct hits on tank targets. Later a Hunter was armed with the BAT-derived “Viper Strike” fitted with a laser seeker: Nine drops yielded seven hits. In 2003, the Army used Hunters for scouting, fire-observation, damage assessment and overwatch roles during the invasion and subsequent occupation of Iraq. By mid-2004, when leftover Hunters had flown some 30,000 flight hours—a remarkable demonstration of reliability—another 14 unimproved Hunters were purchased and immediately pressed into service.

The 1996 cancellation of the Hunter program was thus clearly not the result of its shortcomings but of exaggerated or simply unnecessary requirements, all in the service of institutional resistance to new platform configurations. UAVs were not rejected outright but were instead disqualified through the imposition of requirements that were inappropriate for the new configuration—namely, reliability and versatility characteristics of manned aircraft. The bureaucratic kill mechanism worked like this: Adding redundancy for more reliability would increase costs, but something so expensive should carry more than just one sensor. Adding sensors would make the UAV more expensive still, so much so that it should be equipped for safe recovery in all circumstances. A few applications of this line of reasoning soon made UAVs as costly as the equivalent manned platforms or more so, without giving it the versatility of manned platforms. The result, though bad for U.S. military capabilities, was certainly good for the attack helicopter business, on which far more has been spent since the advent of UAVs than on UAVs themselves, and by orders of magnitude.

Today, UAVs have overcome most institutional barriers in the world’s more advanced armed forces. They are likely to be fully accepted when the next necessary step is taken: the deployment of UAVs in groups, as squadrons and fleets operating synergistically, as manned platforms now do. This benchmark will lead to a new requirement: automatic or nearly automatic operation from pre-flight check-out to debriefing downloads. This will happen because once UAVs are deployed as broadly as they should be, they will require so many pilot-rated personnel that it will eventually be necessary to automate them.


Versatile Combat Aircraft. Multi-role fighters gradually became the standard configuration in the 1960s as distinctions between fighter-bomber, interdiction and attack roles grew blurry, thanks to technological change. The technical constraints that had forced sharp choices between these sub-configurations began to erode long before then, but institutional urges prolonged role distinctions. For example, the survival into the 1960s of the pure interceptor aircraft—such as the American F-102 and F-106, or the Soviet Yak series and later the MiG-31—can best be explained by the existence of separate “interceptor” commands like PVO Strany and the USAF Air Defense Command that wanted to select and buy their very own distinctive aircraft.

All this is now past, and it is a major advance to have abandoned obsolete role distinctions that imposed vast costs because of their dissimilar design, development, production, training and maintenance requirements. Now the time has come for another advance, away from tightly packed fighter-size aircraft, in which today’s sensors, communication devices, data processors and displays must be squeezed at great cost, to larger Versatile Combat Aircraft (VCA).

VCAs would be characterized by “plug-and-play” equipment racks and operating stations in the main cabin, longer unrefueled range and much greater endurance than any fighter-sized aircraft. They would, or at least could, also have any or all of the following characteristics:


• fuselage/wing fittings for optional dorsal, lateral and belly antennae;
• internal bay or bays for expendable sensors, ordnance and, possibly, recoverable UAVs;
• “smart” hard points for equipment pods and air-to-air and air-to-surface weapons;
• aerial refueling capability.
To be all that a VCA can be, it could not be smaller than a big executive jet with a stand-up cabin, but it could be as large as a C-5 or Airbus 380. VCAs could not reach supersonic speeds, nor could they be highly maneuverable. But they would have no need of either: The velocity and agility required tactically would be provided by their missiles, so they would not need to be duplicated by the platform itself.

Despite these limits, VCAs would not be particularly vulnerable. As with the VCA’s closest predecessors like the AWACS, J-STAR and Phalcon, all large, non-stealthy, non-agile subsonic aircraft, actual operational vulnerability would be much less than the apparent tactical vulnerability. Combat experience to date shows that, when flying at typical cruise speeds (Mach 0.8) at altitudes well above 30,000 feet, even airliner-type aircraft can usually evade interception by short-range fighters that are not already airborne, as well as protect themselves with electronic countermeasures (to which radars with circuitry-burning power levels could now be added). In addition, VCAs could protect themselves with air-to-air missiles, especially longer-range varieties. In due course, if VCAs are deployed, air-to-air missiles of ultra long-range are likely to be developed for them.

VCAs cannot be cheap, but they could be economical all the same, especially for countries that have geographically expansive operating requirements. The same individual VCA, not merely the same type of aircraft, could quickly be fitted out for any of several different roles. Any airframe can be converted given enough time and money, but the VCA would be designed for such modularity, taking only an hour or two for reconfiguration rather than weeks, months or years. With that kind of designed-in flexibility, VCA roles could include maritime surveillance, classification and surface strike; anti-submarine detection, location and attack; airborne early warning, and beyond-visual-range interception with long-range air-to-air missiles; airborne command, control and tactical direction of air, ground or naval forces; detection and classification of surface targets with Synthetic Aperture Radar; direct attack of surface targets in low-threat environments; detection of low-contrast targets via controlled UAVs; air-defense suppression, ECM and kinetic; airborne refueling, and all forms of electronic intelligence collection and some immediate analysis by on-board specialists and linguists.

The VCA would also be economical in another way. Because the same aircraft could perform functions now compartmentalized among different platforms, their capabilities would be fungible. VCAs could therefore be surged force-wide for any role for which operating crews, equipment and ordnance are available. That would directly offset the most obvious shortcoming of VCAs for smaller countries, that their high unit cost would restrict their numbers.

Beyond that, VCAs could be used synergistically, the same platform working in different roles simultaneously. VCAs fitted out for different roles could offer tactical and operational synergies without sacrificing airframe diversity. Some cost savings would be realized from the commonality in the acquisition, operation and maintenance of the platform itself, which would have the same engines, cockpit, flight-crew training, replacement parts and so on regardless of its role. Still more cost savings would flow from modification and modernization economies. The expense of fitting today’s wide variety of sub-systems and their components into the nooks and crannies of fighter-sized aircraft would disappear, as would the expense of modifying, upgrading or replacing those sub-systems and components within rigid volume and other functional constraints. With VCAs, modifications, upgrades, even total mission modernization or conversions, could be plug-and-play, or at least easily accommodated within the less-constrained main cabin.

For all these reasons, VCAs could advantageously complement or replace almost all current platform types, including fighters, especially for militaries with long-range operating requirements. At present, for the lack of an alternative, such militaries acquire inherently unsuitable jet fighters of very limited range and endurance.


Similar arguments can be made on behalf of a multi-purpose armored combat vehicle, without a main turret gun, to replace main battle tanks and the array of armored personnel carriers that accompany them. And the same reasoning applies to the arsenal ship concept, and to still other platforms for which the needed sub-systems, components and weapons are ready for production.

All such arguments for replacing the canonical systems of World War II predictably will be resisted for understandable but very costly institutional reasons—reasons almost always masked by seemingly reasonable objections focused on some shortcoming or other. Those confronting such objectives should keep in mind that almost every military innovation entails some potential loss of capability. The first arquebuses traded a lower rate of fire and shorter range than longbows in exchange for greater lethality. Their winning advantage, however, was ease of training: The longbow was best learned from childhood, while musketry could be learned in a week, allowing regiments to be raised at will.

For reasons not ultimately very different, UAVs could now advantageously replace more capable manned aircraft. VCAs could now replace fighters, as well as half a dozen specialized aircraft types. Multi-purpose armored combat vehicles could replace the big guns of main battle tanks. And arsenal ships could replace individually cheaper destroyers, as well as complement much more expensive aircraft carriers.

For all the diversity of these new platform configurations, they share in common the fact that the platform is designed to accommodate today’s sub-systems and weapons, instead of the other way around. They also share a design premised on the widespread use of distributed systems. This is the best way, perhaps the only way, to escape from the downward spiral of the procurement paradox. The alternative is escalating unit costs for fewer and fewer platforms, the likely net strategic effect being increasingly ineffectual military power in a world of increasingly unconventional challenges.

Wednesday, September 5, 2007

Count the Days, Not the Years, of Market Pullbacks

September 2, 2007

Fundamentally

Count the Days, Not the Years, of Market Pullbacks

By PAUL J. LIM

THE big fear on Wall Street is that the growing mess in the mortgage market may trip up the second-longest uninterrupted bull market in history, after the run-up from 1990 to 1997.

But would that be so terrible?

Granted, if this bull, which has rallied for nearly five years without a significant setback, morphs into an official bear market, investors would certainly have much reason for worry.

There have been 10 official bear markets — defined as a drop in equities of at least 20 percent — since 1946, based on the Standard & Poor’s 500 index of widely held stocks. Those plunges, on average, have erased nearly a third of the market’s value over 490 calendar days, according to S.& P. Even worse, the market has needed an additional 669 days, on average, to make up those grisly losses.

But what if the market sell-off doesn’t go that far? What if, instead of a bear market, stocks simply slip into a plain old correction?

Certainly, the odds are much greater that stocks are headed for a correction — defined as a loss of 10 percent or more — than a bear market.

Since 1928, there have been 87 corrections in the S.& P. 500, according to a recent tally by Ned Davis Research. That works out to slightly more than one a year, though since the end of World War II, there have been significantly fewer such downturns. In contrast, there have only been 23 bear markets over the last 80 years.

More important, corrections are far less destructive than many investors assume.

For instance, since 1946, corrections in the S.& P. 500 have driven down stock prices by about 14 percent, on average. Given that equities are already off by about 5 percent since July 19 — and have fallen as much as 11.9 percent if you count intraday highs and lows for the S.& P. 500 — the market may have already sustained a good percentage of its potential losses. (Again, this is if we’re headed for a correction and not a bear market.)

Even if this turns out to be a severe correction, the situation may not be all that bad.

Historically, corrections have lasted only about a third as long as bear markets. In fact, the 16 corrections in the S.& P. 500 since 1946 have lasted an average of only 148 calendar days. And several recent corrections have been far shorter.

For example, the three corrections in the late ’90s — in 1997, 1998, and 1999 — lasted only 51 days, on average. By comparison, the sell-off that began on July 19 is already 45 days old.

Investors may also be surprised to learn how quickly stocks recover their losses after a correction.

Indeed, since 1946, it has taken the market just 111 days, on average, to rise to pre-correction levels. “So it’s about eight and a half months total on the way down and then back up,” said Sam Stovall, S.& P.’s chief investment strategist.

Investors should take some comfort in that, given that they are supposed to be in equities for the long term. (In fact, they shouldn’t even be in stocks if their time horizon is only eight and a half months.) At the very least, Mr. Stovall said, the speed at which markets historically recover should give investors confidence “not to react so hastily to the current troubles.”

To be sure, no one is wishing a correction on this market. But corrections “are a healthy means of relieving the excesses in the market and of restoring a healthy respect for risk,” said James B. Stack, editor of the InvesTech Market Analyst, a newsletter published in Whitefish, Mont.

That has already happened in this sell-off. Consider that investors who had been betting big on volatile assets — like small-capitalization stocks and shares of companies in the emerging markets of Asia, Eastern Europe and Latin America — have lost much of their appetite for risk.

In fact, over the last month, shares of high-quality blue-chip domestic stocks have held up better than small-cap stocks. And mutual funds that invest in the stable developed markets of Western Europe have lost less than funds that invest in emerging-market stocks.

Some investors say they think that the market is already in correction territory, and for this reason: If you count the intraday highs and lows of the market and not just the closing prices, the S.& P. 500 declined by nearly 12 percent from July 19 to Aug. 16.

But the purists say this doesn’t count because market corrections have historically been defined by the closing values of the S.& P. 500 and other stock indexes. Still, even on that basis, the S.& P. 500 recently came within a hair of slipping into an outright correction: from July 19 to Aug. 15, the market tumbled 9.4 percent, based on the S.& P. 500’s closing prices.

OF course, whether or not we’re technically in a correction, a sell-off of this magnitude was long overdue.

Historically, corrections are supposed to be routine events. Yet it’s been about four and a half years since investors have lived through a good old-fashioned correction — at least one that didn’t devolve into a bear market.

The last official correction was from Nov. 27, 2002, to March 11, 2003. Over that short period, the S.& P. 500 slumped 14.7 percent.

But that correction, in particular, offers investors a good lesson. Even though you may be scared to stay the course amid rising volatility and falling stock prices, keep in mind that corrections can shift back into bull markets just as quickly as bulls slip into corrections.

Paul J. Lim is a financial writer at U.S. News & World Report. E-mail: fund@nytimes.com.

Monday, August 27, 2007

A Psychology Lesson From the Markets

A Psychology Lesson From the Markets
Economic View
By ROBERT J. SHILLER
August 26, 2007


IT is no surprise that the Federal Reserve’s discount rate cut has not entirely reassured investors. The Fed can stop a run on the banks, but it cannot control the speculative cycle — a cycle built on psychology and misperceptions that has been sweeping much of the world for the last 10 or 12 years.

I have worked with Karl E. Case, a professor of economics at Wellesley College, with help from the Yale School of Management, in conducting questionnaire surveys of recent home buyers. In Los Angeles and San Francisco in 2005, when actual home prices were rising more than 20 percent a year, we found that respondents anticipated big increases far into the future. At that time, the median expected annual climb for the succeeding 10 years was 9 percent.

This expectation would mean that a house valued at an already high level of $650,000 in 2005 would be worth more than $1.5 million in 2015. For most people in 2005, it would also mean that they should buy a house soon, or forever be excluded from owning one — and that it would be better to stretch and buy the most expensive house they could afford, to capture the huge profits of homeownership.

Now, of course, prices have been falling, and our survey over the last few months shows that in Los Angeles and San Francisco, the median 10-year expected price increase among recent home buyers has come down to 5 percent a year — a number that is likely to decline further if prices continue to drop. As price expectations fall, homeowners lose the incentive to pay off a mortgage on a home they are realizing is beyond their means. They decide to default. We thus have the beginnings of a mortgage crisis.

The problem is fundamental, tied to the imbalance caused by irrationally high home prices and declining optimism that the prices will go higher. Cutting interest rates will not change this basic situation.

The problem is fundamental because the speculative cycle afflicts much of the world. Housing booms have not occurred everywhere, but they have been commonplace since the late 1990s in North America, Europe, Asia and Australia.

We have also seen similar worldwide boom cycles in the stock market over the last 10 or 12 years. Many countries shared in the huge market booms that peaked in 2000, and just about every major stock market around the world has boomed since 2003.

Classical economics cannot explain this cycle, because underlying these booms is popular reaction to the price increases themselves. Rising prices encourage investors to expect more price increases, and their optimism feeds back into even more increases, again and again in a vicious circle. As the boom continues, there is less fear of borrowing heavily, or of lending heavily. In this situation, lower lending standards seem perfectly appropriate — and even a fair way to permit everyone to prosper.

Booms cannot go on forever. Downward price feedback sets in. That is when balance sheets become impaired and widening credit problems start to show up.

The puzzle is why this speculative cycle has occurred recently in so much of the world. What do all these countries share that drives them to speculative booms?

One might think that investor optimism is generated by rapid world economic growth that is using up scarce resources and driving up asset prices. Since 2004, the International Monetary Fund’s real per capita growth figures for gross domestic product worldwide have been fairly high: around 4 percent a year.

It is noteworthy that from 1995 to 2003, when these booms took root, that growth figure averaged only 2.4 percent a year. A good part of the extra growth since 2004 has probably been the increased spending caused by the speculative booms themselves.

The greatest recent economic successes have apparently been in China and India. Because these are the most populous countries, together accounting for 37 percent of the world’s population, their success has become an international symbol of spectacular growth.

But it is easy to overstate their importance. China’s and India’s economies are actually a tiny fraction of world G.D.P.— together only 7 percent. The popular impressions of suddenly rapid growth are thus mostly a perceptual error, like the optical illusions documented by psychologists.

The growth of capitalism around the world has caused trust in the social safety net to decline, even in the United States, where 401(k)’s are replacing traditional pensions.

People worry that they must increase their wealth to fend for themselves. One might think that this lack of trust would promote much precautionary saving, but world savings rates are not high over all. It has generally fit in better with popular perceptions of the booms to be smart investors, not great savers.

As we all try to adjust to a rapidly growing and increasingly capitalist world, we have been trying to discover who we are and how we fit into it. This has meant an enormous change in values.

Many people feel that they have discovered their true inner genius as investors and have relished the new self-expression and excitement. Investors across the world have been thinking that they are winners — not recognizing that much of their success is only a result of a boom. Declines in asset prices endanger this very self-esteem.

That is why it is so hard to turn around investor attitudes once a downward psychology sets in. The Fed and other central banks do not have lithium or Prozac in their bag of remedies, and so cannot control it.

Robert J. Shiller is professor of economics and finance at Yale, author of “Irrational Exuberance” and co-founder and chief economist of MacroMarkets LLC.