naked capitalism

The Financial Times’ Tony Jackson admits to having come to a bearish propensity from having trained under the dour Scots, but nevertheless thinks that pessimists, at least as far as the near-term economic outlook is concerned, may have a point.

Jackson goes through a quick and dirty list of Things That Could Cause Trouble. While none of his items are novel, they are mainly ones that haven’t gotten much attention in the press. Yet, that is.

From the Financial Times:

Contemplating the year ahead is, when you come to think of it, a slightly pointless exercise. It is not just that forecasts are generally wrong. More seriously, we tend to worry about stuff that never happens, while getting blindsided by events that nobody foresaw.

But financial markets are discounting mechanisms and forecasts are implicit in prices whether we like it or not. So here is my version, starting with a disclaimer.

I am naturally of a bearish disposition. This is not because I have the least aversion to wealth creation. Rather, I put it down to early training as an analyst in Edinburgh. The Scottish approach to investment is traditionally that of the surveyor rather than the estate agent: never mind the sea views, check the dry rot and subsidence.

With that in mind, the big bearish question for next year strikes me as whether the banking system’s problem is one of liquidity or solvency. The central banks can fix the former.

The latter can only be addressed the hard way.

One can lead to the other, as illustrated by the case of Northern Rock. This UK bank was perfectly solvent when first hit by a liquidity crisis and is now on a taxpayer life-support system.

As to whether any big banks will go bust next year, there is as yet no saying. But sticking to the bearish theme, let us tick off some factors which make it more likely.

First, defaults are set to rise. According to Standard and Poor’s, speculative-grade defaults in the US are now at an all-time low, at less than one per cent.

That compares with 10 per cent in 2001 and 12 per cent in 1990 – both recession years. But the proportion of bonds defined as distressed – that is, with spreads of more than 1000 basis points over Treasuries – is rising sharply and now stands at almost 5 per cent compared with 2.1 per cent a year ago.

That is stage one. Stage two – actual defaults – will duly follow.

At that point, enter one set of actors largely absent from the drama so far – the hedge funds. For years, they have been writing credit protection – in the form of derivatives – as an apparently foolproof way of getting cash flow. But as the Institutional Risk Analyst points out, they are not insurance companies. They do not have permanent capital or reserves. Instead, they have leverage.

So as the defaults come in, the hedge funds eat up their cash pretty quickly. That presents a headache to their counterparties – the investment banks. They will of course require more collateral as the situation worsens – but they cannot call in money which is not there.

On top of that, the investment banks face the continuing problem of structured investment vehicles, or SIVs. Some of those were funded by short-term commercial paper, and have had to dump assets – or get emergency funding from their bank sponsors – as that market dried up.

But according to Dresdner Kleinwort, a further $180bn-worth (£90.3bn) of SIVs are funded by medium-term notes rather than short-term paper. Some $40bn of that will need refinancing by April next year and a further $80bn by September. If the markets are still not open by then, the fire sale resumes.

There remains the separate question of loans created in the private equity bubble. Many of those are stuck on the banks’ books and in due course some of them will go bad.

Granted, the pain may in some cases be cushioned by the extraordinarily lax terms on which loans were issued. When you are in default, it helps a lot if you have no covenants to meet.

It also helps if you issued a so-called PIK (payments in kind) loan, whereby you jack up the principal instead of making interest payments. But none of that helps when you are actually bust.

A slightly scary case in point is Chrysler. It insists it is not in any financial trouble after its buy-out by Cerberus.

But according to the Wall Street Journal, its new boss recently told a meeting of workers: “Are we bankrupt? Technically, no. Operationally, yes.

The only thing that keeps us from going into bankruptcy is the $10bn investors entrusted us with.”

This is, as I said, a list of bear points and those of a more bullish temper could no doubt compile offsetting lists of their own. But on the basic question of the banks’ solvency, we are still in the dark, for the simple reason that much of the damage has not yet been inflicted.

Then again, as I also said, the stuff that gets you tends not to be what you worry about, but what sneaks up from behind. For us bears, that is not a particularly soothing thought either.

A 2002 article by Michael Prowse in the Financial Times addressed the question, “Is Inequality Good for You?” Normally, discussion of that topic involves issues of equity and efficiency. Those of a liberal bent contend that unequal societies undermine the legitimacy of authority. Those on the right argue that people are unequal, therefore results will be unequal (although the defenders of the US’s growing income disparity have to go through hoops to come up with a rationale for the fact that CEOs earn 400 times average wages). Conservatives also tell us that equality of opportunity means not meddling in outcomes, and the possibility of making it big (or merely doing better) is highly motivating and thus leads to more growth.

Having lived in more and less unequal societies (New York is almost third world in its extremes of wealth), middle class societies are far more pleasant. And it turns out this gut reaction may actually have a sensible foundation.

Prowse, citing the work of medical researchers, informs us that unequal societies make people sicker. And it isn’t due to the fact that the poor have worse diets and health care and that brings the averages down in societies with large income gaps. Once a country has achieved a first world standard of living, “….our income relative to others is more significant for our health than our absolute standard of living.”

It is also noteworthy that this research has gotten no attention in the business media in the US.

From the Financial Times:

Unequal societies will remain unhealthy societies, and also unhappy societies, no matter how wealthy they become’
We have grown accustomed to the health warnings issued by surgeon generals. “Smoking causes lung cancer is no longer a controversial proposition. But recent epidemiological research suggests that finance ministers, too, may some day be required to issue health warnings. There are good reasons to believe that policies that promote greater economic inequality – such as budgets that slash top tax rates – cause higher rates of sickness and mortality.

The adverse physiological consequences of absolute poverty have long been understood. We know poor nutrition, damp housing, lack of heating, excessive working hours and pollution cause a higher incidence of many diseases and chronic disorders. Policymakers understand the argument for trying to eliminate these gross forms of material deprivation, even when they lack the will or capacity to enact the necessary legislation.

By contrast, the argument that economic inequality in itself causes sickness and premature death remains controversial.
But the case is persuasive enough to deserve a wider public hearing. It implies that governments need to rethink their policy objectives: to worry less about the sum total of material output and more about the way that income and wealth are distributed.

It implies that if greater efforts are not made to counter growing inequality, the incidence of cancer, heart disease and other chronic disorders will remain needlessly high, regardless of the level of gross domestic product.

In Britain, these new arguments are most closely associated with Richard Wilkinson, a professor at Nottingham University’s medical school. Wilkinson has spent much of the past two decade painstakingly assembling the evidence for a link between inequality and sickness. But researchers elsewhere, such as Ichiro Kawachi and Bruce Kennedy of the School of Public Health at Harvard University, have independently confirmed many of his claims.

Those who would deny a link between health and inequality must first grapple with the following paradox. There is a strong relationship between income and health within countries. In any nation you will find that people on high incomes tend to live longer and have fewer chronic illnesses than people on low incomes.

Yet, if you look for differences between countries, the relationship between income and health largely disintegrates. Rich Americans, for instance, are healthier on average than poor Americans, as measured by life expectancy. But, although the US is a much richer country than, say, Greece, Americans on average have a lower life expectancy than Greeks. More income, it seems, gives you a health advantage with respect to your fellow citizens, but not with respect to people living in other countries.

We lack data on the relative health of the richest tiers in different countries, but it would not be surprising if even the wealthiest Americans paid a personal price for their nation’s inequality.

The solution to the paradox, argues Wilkinson, cannot be found in differences in factors such as quality of healthcare, because this has only a modest impact on health outcomes in advanced nations. It lies rather in recognising that our income relative to others is more significant for our health than our absolute standard of living. Relative income matters because health is importantly influenced by “psychosocial” as well as material factors. Once a floor standard of living is attained, people tend to be healthier when three conditions hold: they are valued and respected by others; they feel “in control” in their work and home lives; and they enjoy a dense network of social contacts. Economically unequal societies tend to do poorly in all three respects: they tend to be characterised by big status differences, by big differences in people’s sense of control and by low levels of civic participation.

In market societies, the wealthy regard themselves as p ‘winners” in life’s race. They enjoy high social status and considerable autonomy, both in the workplace and in their domestic lives. By contrast, people on low and moderate incomes are made to feel like “losers”. They have no symbols of affluence to flaunt, they occupy subordinate positions in the workplace and face a great deal of uncertainty and insecurity. The way this humiliating lack of status and control weakens their health is by putting them under much higher levels of stress than the better off.

One of the signs that people are under intense stress is the prevalence of behavioural pathologies such as obesity, alcoholism and drug addiction. Sweet and fatty foods may well serve as natural anti-depressants. That millions of prescriptions for Prozac and other mood-altering drugs are also sold just confirms that unequal, competitive societies generate high levels of anxiety.

A steep social health gradient is statistically visible even among the relatively privileged. In a study of British civil servants (where rank is precisely defined by a grading system), researchers found that junior support staff were four times as likely to die of heart disease as the most senior administrators. Even after allowing for all the usual risk factors such as smoking,

alcohol consumption, high blood pressure and cholesterol, some 60 per cent of the difference in death rates was unexplained. The sheer number of different illnesses in which health inequalities are recorded is another reason for believing that psychosocial effects are real. Some 65 of the 78 most common causes of death in men are more common among manual than non-manual workers. A factor that adversely affects all manual workers – such as lack of social status and autonomy – seems more likely to explain their greater vulnerability to so many different illnesses than any physical cause.

Experiments with other primates also appear to support Wilkinson’s arguments. For instance, researchers have manipulated the social status of macaque monkeys, while holding diet and other factors constant.

They have put high status monkeys from different troupes together so that some would have to decline in status. The stressed out, socially downgraded monkeys got ill and died prematurely in just the same way as socially marginalised humans.
A quirky item of medical history – uncovered by Robert Sapolsky, the biologist is also suggestive. In the century to 1930, corpses dissected in London medical schools were nearly always those of paupers. On the basis of these dissections, anatomists estimated the size of the human adrenal gland. When they occasionally saw the adrenal glands of the better off, they found that they were often oddly small, and they invented a new disease “idiopathic adrenal atrophy” – to explain the discrepancy. It was, of course, the adrenal glands of the paupers that were artificially enlarged: a result of lives lived under unremitting stress.

Inequality is associated with higher mortality in another striking way: through its impact on homicide rates. International studies have confirmed what the casual tourist has always known: unequal societies tend to be violent.

Thus Sweden and Japan have among the most egalitarian income distributions of developed countries, and they have correspondingly low homicide ~ rates. The US is one of the most unequal and also the most violent.

Kennedy and Kawachi, of Harvard University, found the same close correlation between violence and inequality among the 50 US states. The greater the disparity in household incomes, the higher the state homicide rate. Significantly, the relationship between property crime (such as burglary) and inequality is much weaker than the relationship between violent crime and inequality.

Why is this? The answer, according to Wilkinson and his US collaborators, is that violence is a social crime in a way that others are not. It reflects not a desire for personal gain but a perverse expression of the universal human desire for respect. They quote American prison psychiatrist James Giuigan, who wrote in a book on violence: “I have yet to see a serious act of violence that was not provoked by the experience of feeling shamed and humiliated, disrespected and ridiculed.” Violence is thus frequently an attempt to assert status on the part of those who feel they have no non-violent ways of commanding the respect of others, often because they are unskilled and illiterate and so incapable of advancing economically and socially.

Conversely, greater income equality is linked, internationally and within the 50 US states, with increased levels of social trust. In his influential research on civic participation, Robert Puttnam, the US sociologist, uncovered a strong correlation between equality and “social capital” (his composite measure of the degree to which people bond together socially).

The link makes sense. If people think of themselves as the equals of others, they are surely more likely to be public-spirited and to participate in civil and political projects. Participation matters because research indicates that people’s vulnerability to illness increases with social isolation.

There is one piece of the puzzle still missing: how and why does socially induced stress and anxiety cause higher rates of cancer, heart disease and other degenerative disorders? The answer comes in two parts.

Our pre-human ancestors evolved methods for coping with sudden physical threats – the so-called “fight or flight” response. This mobilises energy for muscular exertion by diverting resources from biological “housekeeping” functions – tissue maintenance and repair, inimnunty, growth, digestion and reproduction – inessential for a rapid response to danger. When the threats are short-lived, this diversion of physiological effort does little lasting harm. But with the chronic stress caused by feelings of social and economic inferiority, the body is put on a war footing for months or years. The health costs of neglecting the housekeeping functions escalate rapidly.

In effect, stressed-out social inferiors experience faster ageing than their more fortunate rivals.
But why didn’t our ancestors evolve ways of coping with socially induced stress? A possible answer is that stark differences in wealth and status are relatively recent. They probably date only from the beginnings of agriculture. Today’s hyper-competitive world reflects something that has emerged, metaphorically speaking, only in the last few minutes of human history: capitalism.

For the great majority of human pre-history, we were hunters and gatherers, and we lived in small egalitarian groups. We shared food and we reached decisions in a consensual manner. No wonder, then, that capitalism makes people feel so ill.
The significance of these ideas shouldn’t be underestimated. They reveal the true poverty of the “don’t mind the gap” argument that now finds favour even with centre-left political parties such as New Labour: the argument that inequality as such does not matter so long as we do something for the poorest.

Economic inequality is correlated with status differentials, with declining civic participation, and with lack of control for those at the bottom of hierarchies. Such adverse social environments create high levels of stress, anxiety, and insecurity as well as feelings of shame and inferiority. And these, in turn, cause higher rates of serious illness and death, including death as a result of violent crime.

Unequal societies, in other words, will remain unhealthy societies – and also unhappy societies no matter how wealthy they become. Their advocates those who see no reason whatever to curb ever-widening income differentials – have a lot of explaining to do.

Michael Prowse recommends… Unhealthy Societies: The Afflictions of inequality by Richard G. Wilkinson (Routledge £19.99/$30).

Mortality: The Social Environment, Crime and Violence by Richard G. Wilkinson A Ichiro Kawachi and Bruce P. Kennedy, Sociology of Health and Illness Vol. 20, No.5 1998.

Mind the Gap: Hierarchies, Health and Human Evolution by Richard G. Wilkinson (Weidenfeld £7.99/Yale $9.95).

Psychosocial and Material Pathways in the Relation between income and Health by Michael Marmot and Richard G. Wilkinson, British Medical Journal, May 2001.

Violence: Our Deadly Epidemic and its Causes by James Gilligan (Putnam £9.95/$12)

Wall St. Way: Smart People Seeking Dumb Money Eric Dash, New York Times

The Thinkers: Playing fair, even when it hurts in the pocketbook Pittsburgh Post-Gazette (hat tip Mark Thoma)

Top economist says America could plunge into recession The Times, “Robert Shiller, Professor of Economics at Yale University, predicted that there was a very real possibility that the US would be plunged into a Japan-style slump, with house prices declining for years.”

ATA: Top Ten (Bogus) Air Traveler Issues for 2008 Paul Kedrowsky. Your tax dollars at work.

More On Nature And Nurture Among Thoroughbreds The Stalwart

Five great holiday-week activities that don’t cost a lot MarketWatch. Another recession indicator.

Does the China investment corporation (CIC) have a coherent investment strategy? Brad Setser

Since I often take the Wall Street Journal to task on its reporting, I wanted to be sure to point out when they do a good job on topics of interest, per today’s page one story, “Lender Lobbying Blitz Abetted Mortgage Mess.”

The article describes the lobbying efforts of subprime lender Ameriquest and three industry associations of which it was a member. While it nails details of the efforts at the federal and particularly state level to neuter legislation that would have imposed higher standards on subprime operators, it doesn’t give any sense as to how large these contributions were relative to other financial services industry pet causes.

Similarly, the article suggests that these expenditures were effective. Yet the story also mentions,

At that point {October 2002}, opponents of the new {New Jersey} law got some help. Just as it had done in Georgia, Standard & Poor’s said it wouldn’t rate some securities containing loans from the state. In addition, federal banking regulators issued a series of regulatory orders banning states from applying state consumer-protection rules to federally chartered banks and thrifts, part of a turf battle between federal and state regulators. That put pressure on states to soften predatory-lending rules so federally chartered banks didn’t have an advantage over state-chartered ones.

“Put pressure”? It’s more accurate to say it made the state rules irrelevant. Federally chartered banks could offer subprime products to mortgage brokers and directly to customers. The fact that some state chartered banks would be constrained would have minimal impact on the availability of the product. And it would therefore be futile to keep the new laws in place, since their effect would simply be to restrict the activities, and likely profits, of state-chartered entities.

From the Wall Street Journal:

During the housing boom, the subprime industry succeeded at more than just writing mortgages. It also shot down efforts by some states to curtail risky lending to borrowers with spotty credit.

Ameriquest Mortgage Co., until recently one of the nation’s largest subprime lenders, was at the center of those battles. Working with a husband-and-wife team of Washington lobbyists, it handed out more than $20 million in political donations and played a big role in persuading legislators in New Jersey and Georgia to relax tough new laws. Those victories, in turn, helped blunt efforts by other states to crack down on reckless lending, critics of the industry contend.

Executives at Ameriquest, based in Orange, Calif., acknowledge that the company lobbied heavily against state lending restrictions, but say that other subprime lenders did so as well. In fact, a host of subprime lenders and banking trade groups, including Citigroup Inc., Wells Fargo & Co., Countrywide Financial Corp. and the Mortgage Bankers Association, spent heavily on lobbying and political giving.

Ameriquest, a unit of ACC Capital Holdings, has stopped making new subprime loans, and it has sold some operations and is winding down others. It is now a defendant in hundreds of lawsuits alleging mortgage fraud.

Data from federal and state campaign-finance records, Internal Revenue Service filings, and the National Institute on Money in State Politics show that from 2002 through 2006, Ameriquest, its executives and their spouses and business associates donated at least $20.5 million to state and federal political groups. In comparison, over the same time period, Countrywide Financial, another large subprime lender, gave about $2 million in campaign gifts, and spent an additional $6.7 million lobbying in Washington, records indicate.

Some of the giving by Ameriquest executives and associates was high-profile. President Bush received more than $200,000 for his 2004 re-election campaign, and Ameriquest founder Roland Arnall and his wife, Dawn, contributed more than $5 million to political organizations that backed the president. Last year, President Bush appointed Mr. Arnall ambassador to the Netherlands, and his wife took over as chairman of Ameriquest’s parent company. California Gov. Arnold Schwarzenegger’s campaigns received at least $1.4 million, along with stacks of tickets to a Rolling Stones concert that were used to lure big donors. A spokesman for Gov. Schwarzenegger said his decisions are not influenced by campaign contributions. Mr. Arnall declined to comment. The White House said Mr. Arnall was nominated because of his qualifications.

Much of Ameriquest’s efforts took place below the national radar, at the state level. State legislatures wanted to crack down on so-called predatory lending, which refers to the use of deceptive or unfair practices in the sale of high-interest loans, often to low-income borrowers who can’t afford them. In New Jersey, for example, lawmakers passed a strong predatory-lending law in 2003 that made it difficult for Ameriquest to continue doing business there.

Washington lobbyist Wright Andrews and his wife, Lisa, coordinated much of the industry’s lobbying. Mr. Andrews’s firm, Butera & Andrews, collected at least $4 million in fees from the subprime industry from 2002 through 2006, congressional lobbying reports indicate. Mr. Andrews didn’t represent Ameriquest directly. He ran three different subprime-industry trade groups: the National Home Equity Mortgage Association, of which Ameriquest was a member; the Coalition for Fair and Affordable Lending, which spent $6.3 million lobbying against state laws before it dissolved earlier this year, according to federal filings; and the Responsible Mortgage Lending Coalition.

In 2003, Lisa Andrews was appointed senior vice president for government affairs at Ameriquest. Her public-relations firm, Washington Communications Group Inc., claims credit on its Web site for coordinating the industry’s victory in New Jersey, as well as its overall strategy at the state level. Ms. Andrews left Ameriquest in 2005 and returned to her firm..

Ameriquest was founded by Mr. Arnall in 1979 as Long Beach Savings & Loan. He later shed all of the thrift’s operations except its retail-mortgage unit, which he renamed Ameriquest. During the refinancing boom of the 1990s, Ameriquest became a player in the business of lending to low-income homeowners. The company persuaded many homeowners to take cash out of their houses by refinancing them for larger amounts than their existing mortgages. Many of the new loans carried relatively high interest rates.

Settling Claims

Last year, ACC Capital, its parent company, agreed to pay $325 million to settle regulators’ claims that it charged excessively high mortgage rates and didn’t adequately disclose loan risks. Some of the state attorneys general who signed the settlement, including Greg Abbott of Texas, received campaign donations from the firm. Utah’s attorney general, Mark Shurtleff, received a $1,000 contribution and Rolling Stones tickets. A spokesman for Mr. Shurtleff says the attorney general was not directly involved in negotiating the settlement. A spokesman for Mr. Abbott notes that the settlement was also negotiated and approved by 48 other state attorneys general.

Ameriquest also handed out Rolling Stones tickets to state legislators in Georgia, Maryland, Nevada, Oregon, Utah, Washington and California, according to ethics records and local news accounts.

Federal lawmakers didn’t pose much of a threat to the subprime industry in recent years. Members of Congress received at least $645,000 in donations from Ameriquest and large sums from other big subprime lenders, Federal Election Commission records indicate. They debated new oversight of the industry, but took no action.

The states were a different matter. “What seemed to be developing in the states was that there was going to be a wave of legislation,” Mr. Andrews, the lobbyist, said in an interview.

In 2001, Georgia passed the Fair Lending Act. Among other things, it required lenders to be able to prove that a refinancing of any home loan less than five years old would provide a “tangible net benefit” to the borrower. Ameriquest began lobbying the state legislature to remove that provision, arguing the standard was too vague. Other lenders also complained about the law, as did Fannie Mae, the giant buyer of mortgages.

“Ameriquest was very, very engaged,” recalls Georgia state Sen. Vincent Fort, who authored the law. Mr. Fort says that Adam Bass, a lawyer for Ameriquest, lobbied him directly. The state senator says he accused Mr. Bass of victimizing poor minorities, which angered Mr. Bass. A spokesman for Ameriquest, speaking on Mr. Bass’s behalf, says the meeting “was a very candid conversation about complex policy issues.”

Mr. Andrews, the industry lobbyist, had roots in Georgia. He had attended college and law school there, and in the 1970s, had worked for Sam Nunn, then a U.S. senator from Georgia. Mr. Andrews got involved directly on the subprime matter, lobbying in his capacity as executive director of the Responsible Mortgage Lending Coalition, one of the subprime-mortgage trade groups he ran out of his Washington office. “I wouldn’t say it was a huge effort,” he says. “We were just part of the overall picture.”

Ameriquest began contributing to Georgia politicians. In December 2001, it donated $2,500 to Lt. Gov. Mark Taylor after he emerged as an influential figure in the debate, according to Georgia State Ethics Commission records. It followed up with another $2,500 in September 2002. Mr. Taylor says he remembers Ameriquest as one of the subprime companies that was lobbying, but doesn’t recall meeting anyone from the company or getting the contributions.

In October 2002, Ameriquest announced it would stop doing business in the state until the law changed. Shortly thereafter, Standard & Poor’s Corp. announced it would no longer assign credit ratings to many mortgage securities containing subprime loans from Georgia. The ratings agency said that under the new law, such loans, if found to be in violation of the law, might carry legal risk, potentially tainting the securities. Without credit ratings, such securities are virtually unmarketable. The change raised the possibility that subprime lenders would simply stop making loans in Georgia.

The subprime industry mounted a campaign against the Fair Lending Act. Within months, the Georgia Senate voted 29-26 in favor of a new law that eliminated for nearly all loans the tangible-net-benefit requirement opposed by the industry. The state House passed the law, 148-25.

Problems were also developing for the industry in New Jersey. The state Assembly there passed a similar law against predatory lending, the Home Ownership Security Act. It too contained a tangible-net-benefit rule, but it didn’t provide much guidance on how the standard would be applied. “The New Jersey law makes it impossible for anyone to be in compliance,” Mr. Bass, the Ameriquest lawyer, complained at an industry conference.

In October 2002, Ameriquest and Mr. Andrews’s lobbying firm contributed $4,500 to five New Jersey state senators, state campaign reports indicate. The American Financial Services Association, a subprime industry group that included Ameriquest, predicted the law would cause lenders to abandon the state. Nevertheless, in the spring of 2003, the bill passed the state Senate and was signed into law.

At that point, opponents of the new law got some help. Just as it had done in Georgia, Standard & Poor’s said it wouldn’t rate some securities containing loans from the state. In addition, federal banking regulators issued a series of regulatory orders banning states from applying state consumer-protection rules to federally chartered banks and thrifts, part of a turf battle between federal and state regulators. That put pressure on states to soften predatory-lending rules so federally chartered banks didn’t have an advantage over state-chartered ones.

The subprime industry set to work trying to roll back the New Jersey law. The National Home Equity Mortgage Association, one of the subprime groups run by Mr. Andrews, released a survey predicting that the law would reduce mortgages in New Jersey by $4 billion.

Ameriquest and Mr. Andrews’s lobbying firm began handing out campaign contributions. Among the recipients were John Adler and Gerald Cardinale, two state senators who had voted for the new law. In October 2003, Mr. Cardinale, a Republican, received a $2,200 donation from Ameriquest, according to state election records. In November 2003, Mr. Adler, a Democrat, received $1,200 from the lobbying firm, the records indicate. In early December, the two senators introduced a bill to make changes sought by the industry.

‘Remove Barriers’

“I don’t remember ever being lobbied by Ameriquest,” says Mr. Cardinale. “I do recall that we were trying to make it easier for folks to be able to access funds. And, in general, I feel it is a good thing for us to remove barriers to people being able to buy homes.” He says he doesn’t remember receiving any contributions from Ameriquest. “You guys think we know all of our contributors, but that’s usually on a staff level. I don’t frankly know who Ameriquest is.”

Mr. Adler says he doesn’t recall meeting anyone from Mr. Andrews’s lobbying firm.

That December, Neil Cohen, a state assemblyman who had voted for the new law, received a $500 donation from the lobbying firm, state records show. The Assembly’s Financial Institutions Committee, which was headed by Mr. Cohen, offered its own legislation to soften the lending law. Mr. Cohen couldn’t be reached for comment.

In 2004, as debate over the predatory-lending law dragged on, Ameriquest and Mr. Andrews’s lobbying firm together donated an additional $3,200 to Mr. Cohen, $1,100 to Mr. Cardinale and $1,300 to Mr. Adler, according to state records. Ameriquest gave $10,000 to the Democratic Party in the Assembly, $10,000 to Democrats in the Senate, and $7,000 to Senate Republicans, the records indicate.

Mr. Andrews’s wife, Lisa, then head of government affairs at Ameriquest, was also focused on New Jersey. On the Web site of her Washington public-relations firm, she says that she “built a coalition of mortgage brokers, mortgage bankers, appraisers, title companies, and others involved in home mortgage lending to create a grass-roots lobbying campaign that produced 7,000 emails and faxes to state policymakers in a six-week time frame.”

Rolling Back

In June 2004, New Jersey’s Assembly and Senate unanimously passed bills that rolled back parts of the earlier law, including the tangible-net-benefit rule. Mr. Bass, the Ameriquest lawyer, announced that the company would “be offering a full range of loans in New Jersey.” Thousands of New Jersey homeowners subsequently refinanced existing mortgages or took out new loans with Ameriquest before the subprime market tanked. Many of those loans are now in foreclosure.

After the victories in New Jersey and Georgia, the subprime industry and its lobbyists used similar tactics to fend off unfavorable laws in other states. Texas, for example, was debating new restrictions on home appraisers, whose overly generous valuations contributed to subprime-lending problems. ACC Capital, Ameriquest’s parent company, and its executives gave more than $350,000 to Texas politicians in 2006, including $100,000 to Gov. Rick Perry, according to state records. No new appraisal restrictions were instituted. A spokesman for Gov. Perry says ACC did not ask for the governor to take any action on behalf of the industry.

In the wake of the collapse of the subprime market, Mr. Andrews’s subprime lobbying business has withered. The three trade groups he ran are gone, and most of his subprime clients have stopped lobbying.

“I certainly was not aware of the degree to which many in the industry clearly failed to follow proper underwriting standards — the standards which they represented they were following to those of us who were lobbying,” Mr. Andrews says.

But he also faults the Federal Reserve for letting the industry get out of control.

“Personally, I think and have long felt the Fed should have done more early on,” he says. “But I don’t think anybody realized the level of problems that were going to come out in the last year or two. If you had said to me the industry was going to melt down, I would have said you were absolutely insane.”

An article in today’s New York Times,” Innovative Minds Don’t Think Alike, is oddly annoying, even though it makes a useful observation. Urganizations tend to develop routinized, and therefore hidebound, approaches, and involving an outsider is a useful way to shake things up.

Framed this way, the article is an argument for bringing in consultants and other advisors who have wide-ranging rather than narrow expertise. I’m glad to see this notion get an airing, because the trend over the last ten years has been towards narrow specialization, both in corporate hiring (talk to a headhunter if you have any doubts) and in the use of outside advisors.

Why is a narrow focus problematic? Too often, managers and hired guns try to fit a situation into a known framework, rather than understanding the terrain and then figuring out how to approach it. The danger is that people who think they understand the lay of the land are far more compelling than those who say they expect to mill about a bit before they ‘ll hone in on their approach (note they can probably set forth critical issues and possible scenarios in advance). Most organizations prefer clear, tidy processes, even if they lead to inferior outcomes.

So why do I object to the New York Times article? It’s old medicine in new bottles. Instead of pointing out that the friction of a different perspective can improve corporate problem-solving, the article focuses strictly on the issue of innovation.

As an aside, I am leery when people talk about creativity and innovation in a corporate context. The term is debased. Unless you work in an industry where creative talent is key to product/service development (think advertising or fashion), what passes for innovation is more likely to be tweaks of existing formats. Large companies require established routines to function; if everyone had a license to be creative and ignore rules, companies would collapse in the resulting disorder. But the grandiloquent label may be necessary to overcome internal resistance to change.

And the article goes for like-minded terminology inflation:

In her 2006 book, “Innovation Killer: How What We Know Limits What We Can Imagine — and What Smart Companies Are Doing About It,” Cynthia Barton Rabe proposes bringing in outsiders whom she calls zero-gravity thinkers to keep creativity and innovation on track.

Oof. First we have the tacit assumption that innovation is every and always a good thing. Worse, the outside expert has been transfigured into a “zero gravity thinker”. Phrase-making like that is why I am often embarrassed to admit I am a consultant.

Similarly, what does Rabe present as an innovative outcome? Consider:

While Ms. Rabe’s colleague had no experience with flashlights, she did have plenty of experience in consumer packaging and marketing from her years at Ralston Purina. She proceeded to revamp the flashlight product line to include colors like pink, baby blue and light green — colors that would appeal to women — and began distributing them through grocery store chains.

“It was not incredibly popular as a decision amongst the old guard at Eveready,” Ms. Rabe says. But after the changes, she says, “the flashlight business took off and was wildly successful for many years after that.”

I guess I know the wrong sort of women. They like macho black flashlights. But aside from that, this was the application of expertise from another industry. I’d call it cross disciplinary rather than innovative. For instance, a client I know in the financial services modeled the roles in its sales force on those used in high-tech industries to sell complex products. It was very successful, but they saw it as pragmatic. They knew the existing models didn’t fir them, and they went looking elsewhere for solutions.

Similarly, Rabe’s only solution is to bring in zero-gravity thinkers, um, consultants. Look, I benefit from third parties making a case for people like me, but she fails to consider that many times, the better solution might be to change recruitment patterns to get more divergent perspectives in house. The need for an outside party to act as catalyst may be a sign of too much homogeneity in staff backgrounds. One remedy is to give preference in recruiting for raw talent and previous accomplishments over directly relevant expertise. Superiors need to recognize that these new hires will need a bit more time, and maybe even some help, in getting up to speed in their role.

Nevertheless, the article does have a very useful discussion of the so-called curse of knowledge and offers a useful prescription at the close:

Look for people with renaissance-thinker tendencies, who’ve done work in a related area but not in your specific field…“Make it possible for someone who doesn’t report directly to that area to come in and say the emperor has no clothes.

“Renaissance thinker” is again over the top; the goal is to have someone who has general industry knowledge and sufficiently wide-ranging experience that they can draw on information and analogies from other fields.

From the New York Times:

It’s a pickle of a paradox: As our knowledge and expertise increase, our creativity and ability to innovate tend to taper off. Why? Because the walls of the proverbial box in which we think are thickening along with our experience.

Andrew S. Grove, the co-founder of Intel, put it well in 2005 when he told an interviewer from Fortune, “When everybody knows that something is so, it means that nobody knows nothin’.” In other words, it becomes nearly impossible to look beyond what you know and think outside the box you’ve built around yourself.

This so-called curse of knowledge, a phrase used in a 1989 paper in The Journal of Political Economy, means that once you’ve become an expert in a particular subject, it’s hard to imagine not knowing what you do. Your conversations with others in the field are peppered with catch phrases and jargon that are foreign to the uninitiated. When it’s time to accomplish a task — open a store, build a house, buy new cash registers, sell insurance — those in the know get it done the way it has always been done, stifling innovation as they barrel along the well-worn path.

Elizabeth Newton, a psychologist, conducted an experiment on the curse of knowledge while working on her doctorate at Stanford in 1990. She gave one set of people, called “tappers,” a list of commonly known songs from which to choose. Their task was to rap their knuckles on a tabletop to the rhythm of the chosen tune as they thought about it in their heads. A second set of people, called “listeners,” were asked to name the songs.

Before the experiment began, the tappers were asked how often they believed that the listeners would name the songs correctly. On average, tappers expected listeners to get it right about half the time. In the end, however, listeners guessed only 3 of 120 songs tapped out, or 2.5 percent.

The tappers were astounded. The song was so clear in their minds; how could the listeners not “hear” it in their taps?

That’s a common reaction when experts set out to share their ideas in the business world, too, says Chip Heath, who with his brother, Dan, was a co-author of the 2007 book “Made to Stick: Why Some Ideas Survive and Others Die.” It’s why engineers design products ultimately useful only to other engineers. It’s why managers have trouble convincing the rank and file to adopt new processes. And it’s why the advertising world struggles to convey commercial messages to consumers.

“I HAVE a DVD remote control with 52 buttons on it, and every one of them is there because some engineer along the line knew how to use that button and believed I would want to use it, too,” Mr. Heath says. “People who design products are experts cursed by their knowledge, and they can’t imagine what it’s like to be as ignorant as the rest of us.”

But there are proven ways to exorcise the curse.

In their book, the Heath brothers outline six “hooks” that they say are guaranteed to communicate a new idea clearly by transforming it into what they call a Simple Unexpected Concrete Credentialed Emotional Story. Each of the letters in the resulting acronym, Succes, refers to a different hook. (“S,” for example, suggests simplifying the message.) Although the hooks of “Made to Stick” focus on the art of communication, there are ways to fashion them around fostering innovation.

To innovate, Mr. Heath says, you have to bring together people with a variety of skills. If those people can’t communicate clearly with one another, innovation gets bogged down in the abstract language of specialization and expertise. “It’s kind of like the ugly American tourist trying to get across an idea in another country by speaking English slowly and more loudly,” he says. “You’ve got to find the common connections.”

In her 2006 book, “Innovation Killer: How What We Know Limits What We Can Imagine — and What Smart Companies Are Doing About It,” Cynthia Barton Rabe proposes bringing in outsiders whom she calls zero-gravity thinkers to keep creativity and innovation on track.

When experts have to slow down and go back to basics to bring an outsider up to speed, she says, “it forces them to look at their world differently and, as a result, they come up with new solutions to old problems.”

She cites as an example the work of a colleague at Ralston Purina who moved to Eveready in the mid-1980s when Ralston bought that company. At the time, Eveready had become a household name because of its sales since the 1950s of inexpensive red plastic and metal flashlights. But by the mid-1980s, the flashlight business, which had been aimed solely at men shopping at hardware stores, was foundering.

While Ms. Rabe’s colleague had no experience with flashlights, she did have plenty of experience in consumer packaging and marketing from her years at Ralston Purina. She proceeded to revamp the flashlight product line to include colors like pink, baby blue and light green — colors that would appeal to women — and began distributing them through grocery store chains.

“It was not incredibly popular as a decision amongst the old guard at Eveready,” Ms. Rabe says. But after the changes, she says, “the flashlight business took off and was wildly successful for many years after that.”

MS. RABE herself experienced similar problems while working as a transient “zero-gravity thinker” at Intel.

“I would ask my very, very basic questions,” she said, noting that it frustrated some of the people who didn’t know her. Once they got past that point, however, “it always turned out that we could come up with some terrific ideas,” she said.

While Ms. Rabe usually worked inside the companies she discussed in her book, she said outside consultants could also serve the zero-gravity role, but only if their expertise was not identical to that of the group already working on the project.”

This holiday week, I thought it might be a useful break from our usual programming to present ideas that had an impact on me and might be thought-provoking for you as well.

Today’s offering is on how pursuing objectives in a direct manner may not produce the desired outcome. Why? Because many systems are sufficiently complex that we can’t chart a simple course through them. We lack sufficient understanding, and worse, these systems change in response to our actions.

Instead, John Kay of the Financial Times in 2004 made the case for obliquity, which is going after goals indirectly. His article is an introduction to the concept; he doesn’t give guidelines as to when the roundabout route might be the best. Nevertheless, it’s an important reminder to linear thinkers that their approach isn’t always the best.

From the Financial Times:

If you want to go in one direction, the best route may involve going in the other. Paradoxical as it sounds, goals are more likely to be achieved when pursued indirectly. So the most profitable companies are not the most profit-oriented, and the happiest people are not those who make happiness their main aim. The name of this idea? Obliquity

The American continent separates the Atlantic Ocean in the east from the Pacific Ocean in the west. But the shortest crossing of America follows the route of the Panama Canal, and you arrive at Balboa Port on the Pacific Coast some 30 miles to the east of the Atlantic entrance at Colon.

A map of the isthmus shows how the best route west follows a south-easterly direction. The builders of the Panama Canal had comprehensive maps, and understood the paradoxical character of the best route. But only rarely in life do we have such detailed knowledge. We are lucky even to have a rough outline of the terrain.

Before the canal, anyone looking for the shortest traverse from the Atlantic to the Pacific would naturally have gazed westward. The south-east route was found by Vasco Nunez de Balboa, a Spanish conquistador who was looking for gold, not oceans.

George W. Bush speaks mangled English rather than mangled French because James Wolfe captured Quebec in 1759 and made the British crown the dominant influence in Northern America. Eschewing obvious lines of attack, Wolfe’s men scaled the precipitous Heights of Abraham and took the city from the unprepared defenders. There are many such episodes in military history. The Germans defeated the Maginot Line by going round it, while Japanese invaders bicycled through the Malayan jungle to capture Singapore, whose guns faced out to sea. Oblique approaches are most effective in difficult terrain, or where outcomes depend on interactions with other people. Obliquity is the idea that goals are often best achieved when pursued indirectly.

Obliquity is characteristic of systems that are complex, imperfectly understood, and change their nature as we engage with them. Forests have all these features. Fire is the greatest enemy of the forest. From the late 19th century, the policy of the US National Parks Service was of zero tolerance towards fire. Every outbreak, however small, would be extinguished. But the incidence of fire did not fall: it increased.

Computer simulation of fire control policies suggests the explanation. Most forest fires are small, and burn themselves out. In doing so, they remove combustible undergrowth, and create firebreaks that limit the spread of future fires. In 1972, the National Park Service determined a new policy: it would put out man-made fires, but allow natural ones to burn.
Sixteen years later, the largest fire known swept through Yellowstone National Park. In extremely dry conditions, several fires – some sparked by lightning, some by arsonists – joined together. The blaze was fought by 25,000 firefighters at a cost of $120m; more than a third of the park’s vegetation was destroyed.

Today’s guidelines allow forest rangers to use their judgment in deciding which fires should be tackled and which left to burn. Experience has shown that too much effort devoted to fire extinction is counterproductive. Time demonstrates, but only slowly, whether policy has gone too far in one direction, or the other. Forest management illustrates obliquity: the preservation of the forest is not best pursued directly, but managed through a holistic approach that considers and balances multiple objectives.

Forests are not the only systems structured in this way. Obliquity is equally relevant to our businesses and our bodies, to the management of our lives and our national economies. We do not maximise shareholder value or the length of our lives, our happiness or the gross national product, for the simple but fundamental reason that we do not know how to and never will. No one will ever be buried with the epitaph “He maximised shareholder value”. Not just because it is a less than inspiring objective, but because even with hindsight there is no way of recognising whether the objective has been achieved.

For most of the 20th century, ICI was Britain’s largest and most successful manufacturing company. In 1987, ICI described its business purpose thus: “ICI aims to be the world’s leading chemical company, serving customers internationally through the innovative and responsible application of chemistry and related science.

“Through achievement of our aim, we will enhance the wealth and well-being of our shareholders, our employees, our customers and the communities which we serve and in which we operate.”

ICI’s corporate portfolio had evolved over the decades – the company’s traditional strengths had been dyes and explosives, but its chemical expertise had taken it into other industrial feedstocks and agricultural fertilisers. After the second world war, the management of ICI concluded that in future “the responsible application of chemistry” was most likely to be found in pharmaceuticals. ICI recruited a team of able, young, academic scientists but the team was slow to bring returns.

The pharmaceutical division was a drain of ICI resources until, in the 1960s, the discovery of beta-blockers gave the company the first effective drug for controlling hypertension. More discoveries followed and, by the 1980s, pharmaceuticals had become the growth engine of the company.

In 1991, Hanson, the predatory UK conglomerate that had successfully acquired and reorganised sluggish British manufacturing businesses such as Ever Ready and Imperial Tobacco, bought a modest stake in ICI. While the threat to the company’s independence did not last long, the effects were galvanising. ICI restructured its operations and floated the pharmaceutical division as a separate business, Zeneca. The rump business of ICI declared a new mission statement: “Our objective is to maximise value for our shareholders by focusing on businesses where we have market leadership, a technological edge and a world competitive cost base.”

While the National Parks Service had moved from a narrow, focused objective to a broader holistic view of forest management. ICI made the opposite shift – from a grand vision of the responsible application of chemistry to a narrow concentration on established, successful activities. The aim of bringing benefit to a wide range of stakeholders was replaced by the specific objective of creating shareholder value from narrowly focused operations. The company translated this into an operational strategy by disposing of the company’s interests in bulk chemicals to acquire a niche group of speciality businesses: ICI, once the main supplier of chemical products to one third of the world, was reinvented as a smells company.

The outcome was not successful in any terms, including those of creating shareholder value. The share price peaked in 1998, soon after the new strategy was announced. The decline since then has been relentless. After two successive dividend cuts the company was ejected in early 2003 from the FTSE 100 index, the transition from industrial giant to mid-cap corporation had taken only 12 years.

ICI is not the only company for whom greater emphasis on corporate financial goals led to less success in achieving them. I once said that Boeing’s grip on the world civil aviation market made it the most powerful market leader in world business. Bill Allen was chief executive from 1945 to 1968, as the company created its dominant position. He said that his spirit and that of his colleagues was to eat, breathe, and sleep the world of aeronautics. “The greatest pleasure life has to offer is the satisfaction that flows from participating in a difficult and constructive undertaking,” he explained.

Boeing’s 737, with almost 4,000 aircraft in the air, is the most successful commercial airliner in history. But the company’s largest and riskiest project was the development of the 747 jumbo jet. When a non-executive director asked about the expected return on investment, he was brushed off: there had been some studies, he was told, but the manager concerned couldn’t remember the results.

It took only 10 years for Boeing to prove me wrong in asserting that its market position in civil aviation was impregnable. The decisive shift in corporate culture followed the acquisition of its principal US rival, McDonnell Douglas, in 1997. The transformation was exemplified by the CEO, Phil Condit. The company’s previous preoccupation with meeting “technological challenges of supreme magnitude” would, he told Business Week, now have to change. “We are going into a value-based environment where unit cost, return on investment and shareholder return are the measures by which you’ll be judged. That’s a big shift.”

The company’s senior executives agreed to move from Seattle, where the main production facilities were located, to Chicago. More importantly, the more focused business reviewed risky investments in new civil projects with much greater scepticism. The strategic decision was to redirect resources towards projects for the US military that involved low financial risk. Chicago had the advantage of being nearer to Washington, where government funds were dispensed.

So Boeing’s civil orderbook today lags that of Airbus, the European consortium whose aims were not initially commercial but which has, almost by chance, become a profitable business. And the strategy of getting close to the Pentagon proved counter- productive: the company got too close to the Pentagon, and faced allegations of corruption. And what was the market’s verdict on the company’s performance in terms of unit cost, return on investment and shareholder return? Boeing stock, $48 when Condit took over, rose to $70 as he affirmed the commitment to shareholder value; by the time of his enforced resignation in December 2003 it had fallen to $38.

In Yellowstone National Park, at ICI and at Boeing, the attempt to focus on simple, well defined objectives proved less successful than management with a broader, more comprehensive conception of objectives.

The 20th century saw the rise and fall of modernist rationalism in many activities. Nowhere was the change more visible, or the results more disastrous, than in architecture and town planning. In the modernist vision, technology emancipated builders from tradition and accumulated knowledge. Twentieth- century planners could redesign our environment from first principles.

Charles Jencks, the architectural commentator, announced that modernism ended at 3.32pm on July 15 1972, when demolition contractors detonated the fuses to blow up the Pruitt-Igoe housing project in St Louis, Missouri. Less than two decades earlier, the scheme had won awards for its pioneering, visionary architecture. Tower blocks were the supreme expression of Le Corbusier’s view that “a house is a machine for living in”. Corbusier himself designed the first such buildings, the Unite d’Habitation on the edge of Marseilles.

But a house is not simply a machine for living in. There is a difference between a house and a home. The functions of a home are complex and the utility of a building depends not only on its design but on the reactions of those who live in it. The occupants of the Pruitt-Igoe scheme, like those of similar buildings, were alienated by the isolation of a living environment that saw no need for accidental, unplanned social interactions. They showed no respect for its public spaces. The functionality of the blocks proved, in the end, not to be functional.

Communities are complex organisms, imperfectly understood, and their functioning depends on their social relations. Great architects implicitly understand obliquity, but obliquity is so important to the design of towns that the most successful towns have no designer at all. The planned city was conceived in the late 19th century. Baron Hausmann swept away the jumble of Paris streets that had developed over the centuries to create grand boulevards. From the 1920s to 1968, the powerful, autocratic Robert Moses controlled the physical environment of New York, driving expressways through apartments, offices and factories.

The zenith of these ideas was reached in planned cities such as the designed capitals of Brasilia, Canberra and Chandigarh. But all these cities are dull. They lack the vitality of real communities. As with tower blocks, their very functionality is dysfunctional.

The National Park officials who thought they could eliminate fire; the managers who thought they could reinvent ICI and Boeing; the architects who believed they could discard thousands of years of experience and redesign buildings on purely functional lines; the planners who attempted to rationalise the patchwork evolution of historic cities: all made the same mistake of underestimating the complexity of the system with which they dealt and the value of the traditional knowledge they inherited. And the answer to their problem is not better analysis and more sophisticated modelling, but more humility.

Such humility is not commonly found in the business world. Re-engineering the Corporation by Michael Hammer and James Champy became a New York Times bestseller in 1993. Hammer and Champy are as radical in aspiration as Le Corbusier: “Re-engineering means asking the question `If I were re-creating this company today, given what I know and given current technology, what would it look like?’ Re-engineering a company means tossing aside old systems and starting over. It involves going back to the beginning and inventing a better way of doing work.”

Obliquity gives rise to the profit-seeking paradox: the most profitable companies are not the most profit-oriented. ICI and Boeing illustrate how a greater focus on shareholder returns was self-defeating in its own narrow terms. Comparisons of the same companies over time are mirrored in contrasts between different companies in the same industries. In their 2002 book, Built to Last: Successful Habits of Visionary Companies, Jim Collins and Jerry Porras compared outstanding companies with adequate but less remarkable companies with similar operations.

Merck and Pfizer was one such comparison. Collins and Porras compared the philosophy of George Merck (“We try never to forget that medicine is for the people. It is not for the profits. The profits follow, and if we have remembered that, they have never failed to appear. The better we have remembered it, the larger they have been”) with that of John McKeen of Pfizer (“So far as humanly possible, we aim to get profit out of everything we do”).

Collins and Porras also paired Hewlett Packard with Texas Instruments, Procter & Gamble with Colgate, Marriott with Howard Johnson, and found the same result in each case: the company that put more emphasis on profit in its declaration of objectives was the less profitable in its financial statements.

Similarly the richest men are not the most materialistic. Sam Walton, founder and principal shareholder of Wal-Mart, the world’s largest retailer, drove himself around in a pick-up truck. “I have concentrated all along on building the finest retailing company that we possibly could. Period. Creating a huge personal fortune was never particularly a goal of mine,” Walton said. Still, five of the top 10 places in the Forbes rich list are occupied by members of the Walton family.

Henry Ford was sued by stockholders who resented his determination to expand his automotive business rather than distribute the profits. When they won their case, most of the dividend that the court required the Ford Motor Company to pay went to Henry himself. He used the money to buy back stock and regain freedom of operations. The dissatisfied stockholders would have done better to keep quiet.

Warren Buffett, the most successful investor in history, still lives in the Omaha bungalow he bought almost 50 years ago and continues to take pleasure in a Nebraskan steak washed down with cherry Coke. For Buffett: “It’s not that I want money. It’s the fun of making money and watching it grow.”

The individuals who are most successful at making money are not those who are most interested in making money. This is not surprising. The principal route to great wealth is the creation of a successful business, and building a successful business demands exceptional talents and hard work. There is no reason to think these characteristics are associated with greed and materialism: rather the opposite. People who are obsessively interested in money are drawn to get-rich-quick schemes rather than to business opportunities, and when these schemes come off, as occasionally they do, they retire to their villas in the sun.

And so, the greatest happiness is rarely achieved by those who set out to be happy. The development of psychology and neurophysiology gives us more insight into the real determinants of happiness. Author and psychologist Mihaly Csikszentmihalyi explores the nature of happiness by listening to what people say about their activities through what he calls experience sampling. He pages people frequently to write down structured reports of exactly how they feel about what they are doing at that moment.

Although we crave time for passive leisure, people engaged in watching television reported low levels of contentment. Csikszentmihalyi’s systematic finding is that the activities that yield the highest for satisfaction with life require the successful performance of challenging tasks. These moments are encountered as frequently in work as outside it, and they constitute the state of mind which Csikszentmihalyi describes as flow. “Flow tends to occur when a person’s skills are fully involved in overcoming a challenge that is just about manageable.”

Csikszentmihalyi’s formulation exactly parallels that of Boeing’s Bill Allen – “the greatest pleasure that life has to offer is the satisfaction that flows from participating in a difficult and challenging undertaking.” Flow is as characteristic of the successful business as of the contented individual.

Yet there are fundamental differences. While the quest for happiness is complementary – by achieving it we make it easier, not harder, for others to achieve the same goal – the development of business is competitive. Tolstoy claimed in Anna Karenina that “All happy families resemble one another, but each unhappy family is unhappy in its own way.”

However, the opposite is true in commercial life. Unhappy businesses resemble one another: each successful company is successful in its own way. Business achievement depends on doing things that others cannot do – and still find difficult to do even after others have seen the benefits they bring to the imitators. So the most profitable companies are those that are successful with major challenges – like Boeing’s creation of the jumbo jet or ICI’s development of a pharmaceutical division. For Csikszentmihalyi, flow is the accomplishment of a difficult task, involving the successful match of capabilities to environment. In the less elegant language of business gurus, Collins and Porras describe the same phenomenon in business as the achievement of “big hairy audacious goals”.

Companies that succeed in such challenges are disproportionately represented in the case studies of business schools. We don’t hear much about business innovators who adopted big hairy audacious goals and failed, although failure, not success is the norm. For every Bill Gates, Sam Walton and Warren Buffett, there are a hundred people with similar ambitions, and not necessarily much less talent, whose pictures will never be seen on the front cover of Fortune magazine.

Success through obliquity is a product of natural selection in an uncertain, but competitive, environment. It is almost certainly true that, on average, profit-oriented companies are more profitable than less profit-oriented companies. It is very likely that on average people who are interested in money are richer than people who are not. But at the same time that the most profitable companies are not the most profit-oriented, the richest people are not those most interested in money.

Outstanding success is the product of obliquity.

This oblique relationship between intention and outcome is the subtle, but frequently misunderstood, message contained in Richard Dawkins’ metaphor of the selfish gene. The gene is not actually selfish: the gene has no motive at all, in the sense in which we normally talk about motive. Genes that survive the processes of selection are those well adapted to their environment, and such adaptation was not the product of any conscious design. And this is also true of the forests we travel thousands of miles to see, the great capital cities of history, the traditions of classical architecture, and the development of great businesses. All of them are the product of evolution in a universe too complex and unpredictable for any of us fully to understand. All of them survive and prosper because they are well adapted to their environment.

The University of Sheffield Sports Engineering Research Group, after analysing David Beckham’s performance on the football field, announced in 2002 that they had discovered a physics genius. The scientists had identified the complex differential equations that need to be solved to bend it like Beckham. No doubt their computers are already crunching numbers to tell Jonny Wilkinson how to drop a goal.

But little research is needed to confirm that Beckham is not a physics genius. Solving equations of motion is a means of understanding what happens, but is not a means of making it happen. Similarly, the financial returns of a business record what it achieves but are not the means by which it is achieved. Successful companies do maximise long-term shareholder value, or at least create large quantities of it. But that does not imply they were any more capable of formally calculating the results of their activities than Beckham can. Still less can we infer that such calculations were the basis of their achievement.

Would Boeing really have benefited from careful analyses in the mid-1960s of the prospective return on investment from development of the 747? An analyst would have had to anticipate the oil shock, the globalisation of world markets and the development of the aviation industry through to the end of the century. Anyone who has built models of these kinds, or scrutinised them carefully, knows that the range of possible assumptions is always wide enough to allow the analyst to come up with whatever answer the person commissioning the assessment wants to hear.

ICI might have made calculations in the 1950s that estimated the market capitalisation Zeneca would have achieved in the year 2000. Their strategists could then have put that number into a discounted cash flow calculation to estimate a return on the company’s early investment in its pharmaceutical business. But no one would or should have taken such a calculation seriously.

The distinction between intent and outcome is central to obliquity. Wealth, family relationships, employment all contribute to happiness but these activities are not best conducted with happiness as their goal. The pursuit of happiness is a strange phrase in the US constitution because happiness is not best achieved when pursued. A satisfying life depends above all on building good personal relationships with other people – but we entirely miss the point if we seek to develop these relationships with our personal happiness as a primary goal.

Humans have well developed capacities to detect purely instrumental behaviour. The actions of the man who buys us a drink in the hope that we will buy his mutual funds are formally the same as those of the friend who buys us a drink because he likes our company, but it is usually not too difficult to spot the difference. And the difference matters to us. “Honesty is the best policy, but he who is governed by that maxim is not an honest man,” wrote Archbishop Whately three centuries ago. If we deal with someone for whom honesty is the best policy, we can never be sure that this is not the occasion on which he will conclude that honesty is no longer the best policy. Such experiences have been frequent in financial markets in the last decade. We do better to rely on people who are honest by character rather than honest by choice.

In a similar way, the statement “we look after employees because we care” is not the same as the statement “we have introduced new compensation arrangements because, having calculated the relative costs of benefits enhancements and staff turnover, and commissioned a consultant’s report on the policies of competitors, we believe it will produce a net enhancement of earnings per share”. Even if the pensions and healthcare benefits are the same, the response from those affected is different. That is why companies that put the second statement in their board papers and investor presentations typically put the first statement in their press releases and communications to employees. But people who work in a business generally know its nature well enough to see the instrumentality at work.

Marks and Spencer was famous for decades for the breadth of its staff welfare programme. In particular, the company pioneered the provision of high-quality meals at nominal prices. The policy did not originate in any nice calculation of costs and benefits. It was adopted when a shop assistant fainted as Simon Marks was making one of his legendary store visits. Marks discovered that her husband was unemployed and the family did not have enough to eat. Marks was not engaged in philanthropy – he did not offer to feed his employee’s family. Nor was his purpose the creation of shareholder value. Marks was making a sincerely felt statement about the kind of business he wanted his company to be. Such statements about the nature of the business defined the iconic company Marks and Spencer became. As at ICI and Boeing, Marks and Spencer was to sacrifice that status in the rationalist 1990s in the ultimately unsuccessful pursuit of growth in earnings per share.
You don’t prolong life much by adopting long life as your goal. Nor do you learn much about the sources of longevity by asking very old people how they did it. Medical interventions don’t have a large overall impact on life expectancy – medicine is to health what fire control is to forest management. The most important influences on life expectancy are environment and general health. We extend our lives most effectively, not through hypochondria, but by caring for our bodies and ourselves in a comprehensive, holistic manner.

Happiness is achieved in the same way. As John Stuart Mill said: “Those only are happy who have their minds fixed on some object other than their own happiness… aiming thus at something else, they find happiness by the way.”

The great cities of the world lift our spirits, not because some great designer set out to achieve that effect, but because of their lack of planning, their diversity and vitality, their unexpected encounters and conjunctions. And they evolve, not through conservative preservation or planned change, but by a process in which undistinguished buildings are torn down and only the best examples of each era are preserved.

Forest management is unexpectedly complex. The regimented plantation proved as unsuccessful as the planned city, and ecologists today are tearing such plantations down. Monocultural forests are not only dull to look at, but vulnerable to disease and fire. Managed woodlands are economically and environmentally superior. But no one knows the best way to manage a forest, or even what “best” means in this context. Our objective in a complex system is not to find the optimum, because no one can know before or after whether such an optimum has been achieved. We can and should be satisfied with an outcome that is good enough.

What is true of forests is equally true of businesses. The great corporations of the modern world were not built by people whose overriding interest was wealth, profit, or shareholder value. To paraphrase Mill: their focus was on business followed not as a means, but as itself an ideal end. Aiming thus at something else, they found profit by the way.

This is how Hewlett Packard described it: “Profit is a cornerstone of what we do… but it has never been the point in and of itself. The point, in fact, is to win, and winning is judged in the eyes of the customer and by doing something you can be proud of.”
Obliquity is relevant whenever complex systems evolve in an uncertain environment, and whenever the effect of our actions depends on the ways in which others respond to them. There is a role for carrots and sticks, but to rely on carrots and sticks alone is effective only when we employ donkeys and when goals are simple. Directness is appropriate. When the environment is stable, objectives are one dimensional and transparent, and it is possible to determine when and whether goals have been achieved. Obliquity is inevitable when the environment is complex and changing, purposes are multiple and conflicting, and when we cannot tell, even with hindsight, whether they have been fulfilled.

Balboa made the first transit of the American continent. The last great crossing was the completion of the Canadian Pacific Railroad, which runs almost 3,000 miles from Toronto to Vancouver. The most impenetrable stretch of the Rockies was the Selkirk Mountains. The builders of the railroad, faced with a costly detour, offered $5,000 and naming rights to anyone who discovered a pass. These incentives worked. On the Trans-Canada Highway today you cross the Selkirks through the pass named for the ambitious and intrepid Major A.B. Rogers. But even here, obliquity kicks in. The Rogers Pass is more or less parallel to the Panama Canal, and your westward journey across Canada is best accomplished by veering south-east to traverse it. But sometimes directness is the best solution. In the 1910s, after struggling to keep the Rogers Pass open in an area that often gets 100 metres of snow per year, Canadian Pacific bored a tunnel that runs straight as an arrow through Mount Macdonald.

As prime minister, Benazir Bhutto did little Jemima Kahn, Telegraph

Pakistan’s Instability Is Part Of Western Imperialism Culture of Life News

The burden of spending EconWeekly

The Bush Administration’s Dumbest Legal Arguments of the Year Dahlia Lithwick, Slate (hat tip Brad DeLong)

Download Uproar: Record Industry Goes After Personal Use Washington Post. The recording industry is now claiming that it is illegal to transfer music you purchased legally from a CD to a computer (hat tip Mies Economics Blog)

You’re wrong Assured Guaranty. You have that power too Accrued Interest. An extensive analysis of what Berkshire Hathaway’s planned entry into muni bond insurance means for the incumbents.

Michael Tomasky in The New York Review of Books uses two new releases to probe the question of whether the Republicans can restore their credibility and popularity. The first, Comeback: Conservatism That Can Win Again by David Frum lays out a tactical program of how the party can reposition itself towards the center. His ideas are sensible and appealing.

But Heilbrun notes that what Republicans can do and will do are two different matters. He focuses on the move of the G.O.P further to the right when the country is becoming more progressive in orientation, which looks like a self-destructive compulsion. The bulk of the review deals with They Knew They Were Right: The Rise of the Neocons by Jacob Heilbrunn which sheds light on this dichotomy. Tomasky also flags the possibility the G.O.P nominee may well be more conservative than Bush and the party will execute another “compassionate conservative” bait and switch.

The article gives a succinct and useful analysis of the interests that dominate the Republican party and why their faith is undimmed despite the failures they have generated. It makes sense of some of the oddities that have been on display during the Presidential campaign, such as the Republican candidates’ insistent efforts to out-macho each other.

From The New York Review of Books:

As the voting begins in earnest, what are we to make of the Republican candidates? That the “conservative base” is dissatisfied with the GOP field is probably the single most common observation of this presidential campaign season. The second most common observation is probably that the Republican candidate, whoever it turns out to be, is doomed to defeat. National Review ran a recent cover story positing not only that the GOP is likely to lose the presidency in 2008, but that the loss may mark the beginning of a long period of wandering in the wilderness as the party gropes to redefine itself after George W. Bush’s calamitous tenure. Ramesh Ponnuru and Richard Lowry write:

Conservatives tend to blame their travails on Republican politicians’ missteps and especially on their inability to communicate. But the public’s unhappiness with Republicans goes much deeper than any such explanation. A mishandled war, coupled with intellectual exhaustion on the domestic front, has soured the public on them. It is not just the politicians but conservative voters themselves who are out of touch with the public, stuck in the glory days of the 1980s and not thinking nearly enough about how to make their principles relevant to the concerns of today. Unforeseen events could yet change the political environment radically. As it stands, Republicans are sleep-walking into catastrophe.[1]

What would be a rational Republican response to this grim state of affairs? Given both the apparent ideological heterogeneity of the candidates and the soul-searching taking place even in the pages of National Review about how badly conservatism has failed the country, one might think that the GOP in 2008 would disclaim at least some of its current radical conservative positions and inch back toward the political center.

David Frum, the conservative analyst who formerly wrote speeches for Bush, proposes something along these lines (although he prefers calling it conservatism updated for the twenty-first century rather than centrism) in Comeback. To help the GOP recover from its present shabby state, for example, Frum preaches a “Green Conservatism” in which the GOP fights the Democrats for the allegiance of environmentally minded voters, going so far as to endorse a carbon tax. He also advocates a conservatism for the middle class that actually wants to do something about the problem of uninsured middle-class Americans. He even calls for a conservatism that respects the rights of prisoners, including “conjugal visits” and “enjoyable food.” He combines these with newfangled defenses of traditional conservative positions—for example, a softer opposition to abortion that emphasizes “education and persuasion rather than coercion, changes in attitudes and beliefs rather than changes in law and public policy.” More than once while reading Comeback, I nodded, thinking that the GOP could do worse than to listen to him. In urging a new course, he joins other conservative writers like Ross Douthat and Reihan Salam, who argued in The Weekly Standard in 2005 for a “Sam’s Club Conservatism” that makes economic appeals to working-class voters.

Whatever Frum may hope for, however, we have to deal with actually existing Republicanism, as it is being played out in the current race. And that Republicanism is quite the opposite: on nearly every issue, the major candidates have run hard to the right, exceptions (John McCain on immigration) being vastly outnumbered by the rule. All of the major candidates agree, among other things, on policy toward Iraq and Iran, on judicial appointments, and on low taxes for the well-off.

Conventional wisdom would assert that they have done so simply to pander to Republican primary voters, and that the nominee will move toward the center for the general election. He may well do so as a matter of political calculation. Just one or two slightly heterodox positions that reduce well to journalistic shorthand—on education, or, as Frum suggests, on the environment—should do the trick.

But the important question is not how the nominee will position himself next fall. Think, after all, about Bush’s talk of “compassionate conservatism” in 2000 and about how the national press fell for it. The important question is how he will govern should he win. And the generally ignored story of this race so far is that in truth, dramatic ideological change among the Republicans is highly unlikely. Despite Bush’s failures and the discrediting of conservative governance, there is every chance that the next Republican president, should the party’s nominee prevail next year, will be just as conservative as Bush has been—perhaps even more so.

How could this be? The explanation is fairly simple. It has little to do with the out-of-touch politicians and conservative voters Ponnuru and Lowry cite and reflects instead the central hard truth about the components of the Republican Party today. That is, the party is still in the hands of three main interests: neoconservatives; theo-conservatives, i.e., the groups of the religious right; and radical anti-taxers, clustered around such organizations as the Club for Growth and Grover Norquist’s Americans for Tax Reform. Each of these groups dominates party policy in its area of interest—the neocons in foreign policy, the theocons in social policy, and the anti-taxers on fiscal and regulatory issues.[2] Each has led the Bush administration to undertake a high-profile failure: the theocons orchestrated the disastrous Terri Schiavo crusade, which put off many moder-ate Americans; the radical anti-taxers pushed for the failed Social Security privatization initiative; and the neocons, of course, wanted to invade Iraq.

Three failures, and there are more like them. And yet, so far as the internal dynamics of the Republican Party are concerned, they have been failures without serious consequence, because there are no strong countervailing Republican forces to present an opposite view or argue a different set of policies and principles.

The two major American political parties have always been amalgams of factions, especially the Democratic Party, from its early tensions between Jacksonian frontier populists and Adams-descended Northern reformers up through the late-nineteenth-century disputes between the mercantilist “Bourbon Democrats” and the prairie populists led by William Jennings Bryan. Then came the uneasy New Deal coalition of Northern liberals and Southern segregationists, and finally, in our time, the sometimes bitter feuds between liberals and centrists. The Republican Party’s history is slightly less convulsive, partly because its initial factions such as Whigs and Free-Soilers found unity under Abraham Lincoln on the central question of slavery. But in time the Republican coalition came to include both staunchly pro-business and trust-busting interests; nearer our own era, there was also room enough within the party for domestic conservatives and moderates, supporters and foes of the New Deal, and foreign policy internationalists and isolationists.

Today’s Republican Party is different. It is essentially a faction: the conservative movement, which consists of the various branches described above, each with its different priorities. (We may lately add a fourth offshoot, the nativist anti-immigrant tendency, which embarrassed Bush last spring when it blocked the reasonable and comprehensive immigration bill the President supported.) Those branches, which of course overlap, are not sharply at odds with one another over fundamental questions, as the Democrats’ factions are on, say, trade, and where they disagree, they tend not to air those disagreements publicly, especially at election time.[3] There are a handful of vestigial Republican moderates; but they have no national power at all. The man who might have been able to change the party, the governor of the nation’s largest state, cannot by accident of birth run for president, so he has gone as far as he can. In Congress, Republicans who are the least bit out of step with the goals of the conservative movement, people who in a different party might have made attractive national candidates (most notably Nebraska Senator Chuck Hagel), are simply jumping ship and retiring, unable any longer to fight the obvious truth that the Republican Party and the conservative movement are one and the same.

The disarray following a loss next year might well embolden the moderate forces to stage a comeback. But suppose the Republican nominee wins next November, a possibility that is not as far-fetched as it may seem, particularly if some development in the Middle East or a national security threat were used to scare voters. No matter what the polls say today, a campaign built around scaring Americans into thinking that the Democrat will not protect them is one that always stands a chance of working, especially if that Democrat is a black man or a woman. Should that happen, there is no credible reason to believe that the neocons, theocons, and anti-taxers will hold any less power in the new administration than they have in Bush’s.

In foreign policy, despite the Iraq war, the neoconservatives still hold tremendous sway in GOP circles. Jacob Heilbrunn, a former New Republic writer who has written incisively about the movement over the years, explains why in They Knew They Were Right, his excellent new history of neoconservatism. Heilbrunn adroitly surveys the movement’s history, from the Trotskyist alcoves of the City College cafeteria up to the present day. With respect to the future, he argues that the neocons’ main potential competitors, the foreign policy realists, have not prepared for long-term battle the way the neocons have:

So it will take an insurgency inside the GOP itself to dislodge the neoconservatives. But whether the old guard in the GOP has the mettle for that battle is dubious. There has been no real attempt to create new generations of realists to replace the Scowcrofts and Bakers and Schlesingers. The contrast between the Nixon Center event honoring Brent Scowcroft in 2006 and the [American Enterprise Institute] dinner for Bernard Lewis was striking. At the former, elderly veterans of the Nixon, Ford, and Bush administrations reminisced about their glory days…. Meanwhile, at the AEI dinner, none of the neoconservatives displayed much doubt about their own influence. Slate’s Jacob Weisberg, for example, was dumbfounded by neoconservative serenity….

The extent to which the major Republican candidates, with the partial exception of Mike Huckabee, have backed the neocon worldview is striking. Exhibit A is of course Rudy Giuliani. The former mayor has organized his campaign around the fight against terrorism and to that end has assembled a hard-line foreign policy team led by Yale professor Charles Hill, a noted neoconservative and member of the Project for a New American Century (PNAC), the group that pressed Bush to invade Iraq after September 11. (Nine days after the attacks, Hill signed a PNAC letter arguing that refusal to invade Iraq “will constitute an early and perhaps decisive surrender in the war on international terrorism.”[4] ) Norman Podhoretz, who has a prominent spot on the Giuliani team, is still agitating for war with Iran, even after the early December release of the National Intelligence Estimate that demolished any rationale for such a strike. Podhoretz writes of his “dark suspicions” that the intelligence community was both seeking to undermine Bush and rushing to judgment on the basis of scant evidence.[5]

Giuliani has written, or at least put his name to, a bromide-laden piece in the September–October 2007 issue of Foreign Affairs—the kind of grand foreign policy statement that presidential aspirants feel obliged to make. The essay, which opens with the sentence “We are all members of the 9/11 generation,” embraces the basic neocon outlook that we are locked in a struggle to the death with forces of “Islamic fascism” whose adherents hate us for our freedoms, and capitalizes phrases like “the Terrorists’ War on Us” (twice in the first seven paragraphs). On Iraq, Giuliani elsewhere says that “I think we should give our troops a chance to succeed in Iraq. Our goal in Iraq is victory.”

McCain has positioned himself as one of the Senate’s leading hawks on Iraq, going out of his way to heap abuse on the Baker-Hamilton Iraq Study Group report a year ago, even before Bush made up his mind to reject its findings. In a recent debate, he said that in Iraq “we are succeeding…. Now we have a successful strategy. We can succeed. We will succeed.” His foreign policy team is somewhat more diverse than Giuliani’s (he says he talks to a few realists, such as Scowcroft), but it, too, includes many prominent neocons: William Kristol, Robert Kagan, and Max Boot; Gary Schmitt of the American Enterprise Institute; and Randy Scheunemann, a former director of PNAC who helped found the Committee for the Liberation of Iraq, an advocacy group that pushed for war against Iraq after September 11.

Romney’s advisers on foreign policy are less well known. They include Dan Senor, the former spokesman of the Coalition Provisional Authority in Iraq, and longtime CIA analyst Cofer Black, the point man for the US government’s counterterrorism policy during Bush’s first term, and now the vice-chair of Blackwater USA, the largest of the State Department’s “private security” contractors in Iraq. One of Romney’s more memorable utterances from this campaign was his vow to “double Guantánamo,” made last May at a forum when he was asked about interrogation techniques for terror suspects.

Mike Huckabee, until recently not considered a serious candidate, didn’t have the money in early 2007 to assemble any such team. That may be one reason why he has departed somewhat from the prevailing views. Huckabee’s major foreign policy statement came in an essay in the January– February 2008 issue of Foreign Affairs. The article made headlines when it was released in mid-December for its assertion that the Bush administration was guilty of an “arrogant bunker mentality” in dealing with the world. Some Bush foes praised Huckabee’s forthrightness, while other candidates, especially Romney, attacked him.

But the policies he describes would represent less of a departure from Bush foreign policy than his attention-getting phrase suggests. He is far more critical of Pakistan and President Pervez Musharraf than most neoconservatives, and he places somewhat more emphasis on negotiations with Iran than do Bush or Huckabee’s opponents. But he supports the administration’s sanctions against Iran. He endorses the same stay-the-course position on Iraq. And he sees the battle against terrorism in the same kind of cultural terms, although his rhetoric of choice is Southern Baptist rather than chastened leftist (i.e., the neocons): “America’s culture of life stands in stark contrast to the jihadists’ culture of death.”[6]

As a second-tier candidate, Huckabee was not expected to flash any great expertise on foreign policy, and he apparently didn’t make much of an effort to acquire it. A full day after the Iran NIE was released, Huckabee had to admit to a reporter that he hadn’t heard of it.[7] If Huckabee continues to be one of the top candidates, we should pay attention to his foreign policy pronouncements. It’s a good bet that he will undergo some crash tutorials and start to sound more like Giuliani and McCain.

he theoconservatives are thought to be on the defensive this election cycle, with their grip on the GOP loosening. In some superficial ways this is true. There is no candidate who passes every one of their basic litmus test issues, and, if Rudy Giuliani wins the nomination, the party will have selected a pro-choice nominee for the first time since 1976. Still, where is the countervailing force to the religious right in the party? As with the neocons, there is none. (Frances FitzGerald and other writers have observed a more liberal trend among some of the large evangelical churches; but right-wing evangelicals continue to dominate among Republicans.) There are also organizations like the Ripon Society, which tries to press moderate social programs within the party, and there are nominal blocs of libertarians, but these groups are vastly outspent and outnumbered.

The religious right—in the form of its umbrella organization the Arlington Group, formed in 2002—is certainly split and unenthusiastic about the presidential candidates. Pat Robertson has endorsed Giuliani; Richard Land, the head of the Southern Baptist Convention, has said he could never vote for Giuliani and would consider backing a third-party candidate if Giuliani is nominated. So the unanimity on Bush’s behalf we saw in 2000 and in 2004 will likely be gone. But as far as policy is concerned, the Christian right has only one overriding goal: a promise from candidates that they’ll appoint “strict constructionist” judges. And every one of the candidates, Giuliani included, has made that promise resoundingly and repeatedly, in public and presumably in private. As recently as November, Giuliani told the conservative Federalist Society that “we need judges who embrace originalism” and vowed that he would appoint justices in the mold of Antonin Scalia and Clarence Thomas.[8]

That, above all, is what the Christian right needs to hear. It is well worth remembering that when the next president is sworn in, John Paul Stevens will be three months shy of his eighty-ninth birthday. It seems unlikely that he would be able to outlast a Giuliani or Romney or Huckabee or McCain presidency. One more judge like John Roberts or Samuel Alito will mean not only the probable end of Roe v. Wade but of affirmative action (sharply curtailed already), efforts at school desegregation (school systems have resegregated to a surprising extent in recent years), and many other progressive social goals. All of the four major Republican candidates have vowed to see to these outcomes. Paradoxically, the personally pro-choice Giuliani, if elected, could go down in history as a hero to the Christian right—the president who finally ended Roe—in a way that even Ronald Reagan has not.

The candidates’ pledges about judges highlight an important point. Lack of enthusiasm is not the same thing as lack of power, and the religious right still has power in the nominating process. Consider Mitt Romney’s recent speech on religion. In the speech, billed as Romney’s “JFK moment” because he would squarely address issues raised by his Mormon faith just as Kennedy famously did with regard to Catholicism, Romney promised that he would uphold the Constitution, not Latter Day Saints doctrine. But he also seemed to embrace a test for Americanism that stipulated some kind of religious belief, ignoring the long-held principles, to which even George Bush has paid rhetorical heed, that religious freedom includes the freedom not to believe and that nonbelievers can be good Americans, too. Romney found his mark: while the speech registered as perfunctory or disappointing in most mainstream circles, James Dobson, the founder of Focus on the Family, called it “magnificent,” “passionate,” and “inspirational.” (Dobson has not yet endorsed a candidate.)

he third leg of the conservative movement is in many ways the most important and comprehensive: all conservatives agree on less government, lower taxes, and less regulation. And all the candidates have pledged to support these goals.

Frum reminds us that in the real world, the salience of tax-cutting as an issue has been steadily eroding in recent years:

When Republicans speak of “tax cuts,” they mean “income tax cuts.” Yet after almost three decades of income-tax cutting, most Americans no longer pay very much income tax. In fact, four out of five taxpayers now pay more in payroll taxes than federal income taxes. Some 29 million income-earning American households pay no income tax at all. By contrast, the notorious top 1 percent of taxpayers pay well over one-third of all U.S. income taxes. The top 1 percent may make a disproportionate amount of money. But they still cast only 1 percent of the votes.

One can quibble that Frum’s math is probably slightly off since higher-income citizens are more likely to vote than poor people. But he is correct that for most Americans there simply isn’t much more income tax to cut, and that poll respondents repeatedly prefer either deficit reduction or particular types of public investment, such as health care.

But the major Republican candidates give no sign that it may be time to shift to a different set of priorities. They all emphasize tax-cutting and deregulation as the centerpieces of their economic policies, including now McCain, who had opposed the Bush tax cuts in 2001 and 2003. Indeed, one gets little indication from their speeches and platforms that serious domestic needs even exist. In August, for example, Giuliani released a health care plan whose main feature is tax exclusions of up to $7,500 per person and $15,000 per family that buys a health care plan. In order to help a family buy insurance, he proposed $15,000 of its income would not be taxed. But in reality, most uninsured families would derive little or no benefit from this plan because their incomes are already below the taxable level regardless of whether they are taking the exclusion. Even for wealthier households whose tax burdens would be reduced, the savings would certainly not come close to the $10,000 to $12,000 per year that most households would have to pay for family coverage.

So what is the purpose of Giuliani’s plan? The journalist Ezra Klein characterized it with asperity, and accuracy:

Rudy Giuliani doesn’t have a health care plan. What he has is a pretext with which to attack the Democrats. Indeed, just about all you need to know about Giuliani’s thoughtfulness on the issue can be summed up by the following: In the speech introducing and detailing his new health care proposal, Giuliani refers to the “Democrats” six times. “Single-payer” is said eight times. “Socialized medicine,” or some variant thereof, makes nine appearances. “Uninsured” is never uttered—not once.[9]

The reason Giuliani cannot release a health care plan that makes a genuine attempt at insuring the uninsured is not resistance from “politicians” and “conservative voters,” as Ponnuru and Lowry claim. He cannot do so because the important interest groups—such as the Club for Growth—that influence Republican fiscal policy would write him off, and in fact oppose him vehemently, if he tried to.

As an example of courageous heterodoxy on economic matters, some have pointed to Huckabee, whose record as governor of Arkansas, when he increased some taxes and spending on education, did indeed place him at loggerheads with the Club for Growth, which is distrustful of his record. But this is fantasy. Huckabee—as he hastens to point out when pressed on this matter—was compelled by state law to balance the budget (state governments can’t run deficits or print money), and he was under court order to increase spending on education.

For the nation as a whole, Huckabee proposes a regressive and onerous national sales tax. Called, with the usual spin, the “fair tax,” Huckabee’s tax plan would add about 30 percent (by conservative estimates) to the purchase price of durable goods, many household items, and even automobiles.[10] It is arguably the most regressive tax plan put forward by any candidate. It comes as no surprise that despite the Club for Growth’s remonstrations, Huckabee is in good standing with Americans for Tax Reform, whose famous “pledge” not to raise taxes under any circumstances he has agreed to.

t is tempting to think that the Bush years have represented an apotheosis of conservatism, and that a future Republican administration would surely bring a kind of Thermidorean adjustment. It is also the case, obviously, that none of these men is George W. Bush and that each of them, as president, might at least be less stubborn, more interested in the details of policy, and less hostile to empirical evidence that does not support his preconceived notions.

But at the same time, one must remember that as far as movement conservatives are concerned, Bush has been something of a disappointment, and vast chunks of their plan for the country remain unrealized. The neocons will not quit wanting a preemptive strike against Iran, something the December NIE has seemingly ruled out for the rest of Bush’s term; they will welcome a fresh opportunity to push their case with an administration the public has not yet learned to distrust. The theocons still want Roe overturned, along with some other Warren Court precedents (watch, if the next president is a Republican, for a fresh assault on Warren-era decisions on criminal and civil procedure, for example Miranda v. Arizona). And for the radical anti-taxers’ tastes, the federal government is still far too large, its regulations far too numerous, and income tax and capital gains tax rates, even at their already reduced levels, far too high, not to mention the continued existence of that pesky Social Security system.

The Republican nominee, once he is named next spring, will undoubtedly tack toward the center during the general election campaign. But again, the important question is how he would govern. Presidents respond to the constituencies that put them in office, and a Republican president elected in 2008 will have been put in office by the factions that control his party. There is no reason to expect that he will defy those factions. Let us hope that in the long run, the Republicans outside them will decide to challenge their power.

The Los Angeles Times reports that California’s $250,000 cap on pain and suffering awards in medical malpractice lawsuits has proved to be more beneficial to doctors and insurers than legislators may have intended. Not only does the law reduce the amount of damages, but it has had the effect of deterring lawsuits, particularly involving elderly and low income patients. The reason? Aside from pain and suffering, the other basis for an award is lost income. With relatively small or no wage impairment, the cap is sufficiently low as to make these cases uneconomic for lawyers who take contingency fees.

The Times finds evidence that the level of the cap, unchanged since 1975, has led to a marked fall in malpractice suits in recent years, beyond what can be explained by improvements in medical practice or a decline in litigiousness. It seems the cap is forestalling legitimate lawsuits, not merely frivolous claims.

It is obviously hard to draw any kind of line between useful lawsuits (as in those that call attention to doctor and facility incompetence and are appropriate given the nature of the damages suffered) and ones that are not. And while the notion of pain and suffering creates issues of interpretation, eliminating them eliminating them would ignore an important form of harm. And contingency fees are problemmatic, since while they enable middle and lower income individuals to seek redress, and therefore serves as a check (and helps preserve the illusion of the fairness of the court system). Having awards based solely on lost income would mean that those who, say, treat only the elderly and the lower income are lawsuit proof.

From the LA Times:

Dave Stewart’s 72-year-old mother went to Stanford University Medical Center for double knee-replacement surgery in April. Four days later, she was dead.

To Stewart, an anesthesiologist, it seemed a classic case of medical malpractice. After the operation, his mother developed sharp abdominal pain that she described as “10 on a scale of 1 to 10,” according to her medical records.

The hospital failed to diagnose the cause of her pain and continued to treat her with narcotics. Her vital signs became unstable and she was moved to the intensive care unit, but she died of complications from an untreated bowel obstruction. State regulators cited the hospital in the case this fall.

Stewart and his two sisters decided to sue, and they approached two dozen lawyers. One after another declined to take the case, always for the same reason: It wasn’t worth the money.

In 1975, California enacted legislation capping malpractice payments after an outcry from doctors and insurers that oversized awards and skyrocketing insurance rates were driving physicians out of the state.

The law limited the amount of money for “pain and suffering” — usually the physical and emotional stress caused from an injury — to $250,000. There is no limit on what patients can collect for loss of future wages or other expenses.

Over the years, it has been easy to quantify the effects of the law, known as the Medical Injury Compensation Reform Act, or MICRA. In the years since the law was enacted, malpractice premiums in California have risen by just a third of the national average, and doctors say the law now helps attract physicians to the state. Proponents also say it discourages frivolous lawsuits.

Thirty states have enacted similar legislation. Two Republican presidential candidates — Mitt Romney and Rudolph W. Giuliani — have recently endorsed the approach as a possible national model.

It’s been harder to tally the law’s costs. Critics say it is increasingly preventing victims and their families from getting their day in court, especially low-income workers, children and the elderly. Their reasoning: The cap on pain and suffering has never been raised nor tied to inflation….

Several states have set their malpractice caps considerably higher than California’s because of worries that they affected poorer patients the most. Some state courts have begun to examine the fairness of their malpractice laws, especially those not tied to inflation. California lawmakers have rarely reconsidered the state’s malpractice legislation.

Yet a Times analysis of state court records, physician payment data and insurer financial records suggests that the cap is increasingly preventing families such as the Stewarts from getting their day in court.

Among the findings:

* Court malpractice filings have fallen in eight of the 10 most populous counties in California that track such information. In Los Angeles, they’re down 48% since 2001 to their lowest per-capita level in nearly four decades. In Orange County, they fell 29% over the same period

* At Kaiser Permanente, where members must resolve malpractice claims in arbitration rather than court, claims have fallen almost 20% since 2001.

* The number of payments to victims and their families across the state was down 24% since 1991, according to a review of a federal government database of nearly half a million claims. Nationally, the decline over the same period was 10%.

* The malpractice earnings of California insurers has far outpaced national averages in recent years. According to financial reports, insurers in the state have paid out just 39 cents of every premium dollar since 1991. The national average was 63 cents.

Proponents of the law attribute the state’s recent decline in malpractice lawsuits to several reasons unrelated to its award cap, including a slight drop in overall personal injury cases nationwide and a possible decrease in medical errors in recent years.

Some states have seen larger per-capita declines in malpractice cases than California, after they enacted caps on medical malpractice awards.

A spokesman for Kaiser Permanente said its drop in malpractice filings was the result of a company program begun five years ago in which doctors apologized to patients for errors rather than wait to fight the accusations in court.

Some malpractice victims and their families say the benefits of the law have swung too far in favor of doctors. Without accountability, some ask, what will keep physicians from making careless mistakes?….

Linda Fermoyle Rice, one of the state’s best-known malpractice lawyers, says the law often leads to difficult trade-offs.

“It has had the effect of making an infant who is severely injured more valuable than those who don’t make it, since families of children who die are limited to the cap,” said Rice, who is based in Woodland Hills. “It’s sad to say, but most attorneys I know won’t take a dead-baby case.”

A 2003 Rand Corp. report found that the law has reduced jury awards by 30%, and that the savings have come largely at the expense of severely injured or impaired patients.

On average, California juries (which are rarely informed of the cap during trials) awarded $800,000 in malpractice death cases from 1995 to 1999, but the amounts were later reduced to $250,000 under the law. This suggests that medical malpractice victims and their families could be reaping much larger payouts than the law allows. But proponents of MICRA say raising the cap could harm patients.

“Raising the MICRA cap would significantly increase healthcare costs, limiting patient access to doctors, hospitals and clinics throughout California,” said Lisa Maas, executive director of Californians Allied for Patient Protection, a trade group. “MICRA protects patient access to healthcare.”

San Diego obstetrician Philip Diamond is skeptical that the law is keeping patients from obtaining malpractice lawyers. But he acknowledged that limits on payouts do lead to trade-offs.

“If we raise the cap, where does that money come from?” he asked. “Any increase means a drop in access.”

The link between malpractice payouts and increases in doctors’ insurance premiums, though, remains unclear.

One of the largest studies done on the topic — by Dartmouth College researchers in 2003 — concluded that malpractice payments had risen in line with medical care costs, whereas doctors’ insurance premiums grew far faster — by double-digit percentages annually for some specialties.

To some, that suggests that recent malpractice premium increases may have had more to do with insurers’ business models and financial investments — including documented losses in their investment portfolios in recent years — than with their core businesses.

Nationally, the rise in malpractice premiums has slowed in recent years.

“Just 16.2% of insurers raised their malpractice premiums in 2007 compared to 77.3% in 2003,” said the Medical Liability Monitor, a newsletter based in Chicago.

Douglas Heller, executive director of the Santa Monica-based Foundation for Taxpayer and Consumer Rights, says the 1975 liability caps aren’t the reason that doctors’ insurance premiums have been relatively low in California. He says the reason is that, unlike other states, insurance is tightly regulated here. In a 1988 statewide vote, Proposition 103 rolled back all casualty insurance rates by 20% and required the approval of the state insurance commissioner for any rate increase.

Malpractice rates rose sixfold between 1975 and 1988 despite the state’s awards cap, Heller said, but have held roughly steady since Proposition 103′s passage.

Stewart, of San Diego, said he had long been a MICRA advocate, believing it was in the best interest of doctors and patients. Not anymore.

After he and his family got over the initial shock of losing their mother, they wanted justice. Most attorneys turned them down over the phone, although three agreed to meet in person. Last summer, the entire family and their 80-year-old father made the trip to San Francisco and Oakland for meetings.

One lawyer said he would take the case only if the family paid the expected $50,000 in trial costs upfront.

San Francisco lawyer Brad Corsiglia at first seemed interested but later sent a letter dated July 11, 2007, that read: “As you can understand, with a cap of $250,000, we are limited in the type of case we can take on a contingency fee basis to only those cases that involve catastrophic economic losses.” …..

Some state courts have struck down malpractice caps that didn’t rise over time. Last month, an Illinois circuit court judge ruled unconstitutional a 2005 state law that caps noneconomic damages in medical liability cases. The case is on appeal.

In 2006, a Louisiana appeals court ruled that its state malpractice cap, established in 1975, did not adequately compensate patients and needed to be raised to $1.6 million. The ruling was overturned this year by the state’s Supreme Court.

Some families who succeed at trial in California are often surprised at how little money they see in the end.

Becky Dessenberger’s 2-year-old son, Jacob, died at Children’s Hospital in Oakland in 2004 after surgery to repair a foot. Her son, who was suffering from bronchitis, was given a high dose of pain medication though the drug is known to cause slower breathing. He died the next day.

In 2006 the family settled with the hospital, which acknowledged no wrongdoing, for just under the $250,000 cap. After deducting for trial costs and lawyer fees, Dessenberger, 36, of Suisun City, said the family received “a little over” $100,000.

Dessenberger said no money would help ease her grief, but the small amount felt to her and her family like a slap in the face.

“Because he was a baby, this is all he was worth,” she said. “I think it is horrible. I don’t think it’s fair.”

This week, I’ve used the slowdown in business news as an opportunity to share some things that affected how I view the world.

I can’t recommend strongly enough that you watch the award-winning 2002 BBC documentary, The Century of the Self, by Adam Curtis (I caught it in a limited art house run in the US). We’ve featured the first three segments, “Happiness Machines” and “The Engineering of Consent.” and “There is a Policeman Inside All Our Heads: He Must Be Destroyed” earlier in the week. Today’s offering is the final part, “Eight People Sipping Wine in Kettering.”

Curtis said, “This series is about how those in power have used Freud’s theories to try and control the dangerous crowd in an age of mass democracy.” It focuses on how Sigmund Freud’s ideas were used by business and government, far more deliberately and extensively than one might imagine, during the 20th century to achieve what Freud’s nephew and creator of the public relations industry Eddie Bernays called “the engineering of consent.”

The series is timely given the start of the US presidential primaries next week. From the BBC description of the final segment:

This episode explains how politicians on the left, in both Britain and America, turned to the techniques developed by business to read and fulfil the inner desires of the self.

More important, it also shows how reliance on those techniques contributed to their move to the right.

I encourage you to watch a few minutes here, and then go over to Google Video, since you will see it in a larger scale format there.

Click here to view it at Google Video.

Noni Mausa: What’s With All the Shock and Surprise? Cactus, Angry Bear. A different take on the Bhutto assassination.

Peak 2007? Long or Short Capital

Buffett Signs Death Warrant For Ambac & MBIA Michael Shedlock

The Economics and Politics of Trade Economics and…

Africa aid wiped out by rising cost of oil Financial Times

Option ARM Tightening Tanta Calculated Risk

Fortune 1000 IT investments are riskier than capital investments PhysOrg. This is no surprise to anyone who has dealt with large IT projects.

Bush claims Senate’s pro forma sessions don’t count Daily Kos. Another assault on the Constitution.

Annals of Improbable Research to go Free Online CnetNews

Drake Management’s founders, Anthony Faillace and Steve Luttrell, have the pedigrees that go over well with investors. Both hail from BlackRock, and before that, Pimco. After a stellar 2006 for their largest fund, Global Opportunties, a global macro player, 2007 a large increase in assets under management was followed by a dramatic reversal, The fund is down 23.7% this year, and as a result, the managers have restricted redemptions.

Note that this is not Drake’s only fund; the firm manages $13 billion. But its multistrategy fund, the Absolute Return Fund, a os dpwn 11.5 percent in 2007 through November.

From Bloomberg:

Drake Management LLC suspended most redemptions from its largest hedge fund after losing 23.7 percent through November, according to a letter sent to investors of the New York-based firm.

Drake will meet about 25 percent of requested withdrawals from its $3 billion Global Opportunities Fund, which tries to profit from macroeconomic trends by trading bonds, stocks, currencies and commodities. The letter didn’t disclose how much investors had asked to withdraw at the end of the year.

“This decision was made only after we attempted to convince redeeming investors to voluntarily rescind their redemption requests,” said the letter, signed by Drake Management and sent out today.

The partial redemptions were made possible by an agreement with Drake’s banks, the letter said. The firm’s lenders would have been allowed to terminate transactions and seize collateral if net assets had fallen by 30 percent….

The firm’s assets more than doubled this year, after the Global Opportunities Fund advanced 41 percent in 2006. At the end of 2005, assets were $2.5 billion. This year Drake opened research offices in Miami, Sao Paulo and Istanbul.

The Global Opportunities Fund, managed by Faillace, has returned 13.4 percent a year on average since beginning trading on Nov. 30, 2002. That compares with a 13.1 percent gain by the CSFB/Tremont Global Macro Index.

Many commentators see the euro as the logical successor to the dollar as the reserve currency. Yet the Financial Times’ Lex column points out that most currency unions fail. However, the dollar is the product of of that very type of arrangement. Nevertheless, the piece serves as an important reminder against blindly assuming current trends will continue. Lex sees differential inflation rates among EU member nations (always a problem, since it is impossible to devise a monetary policy to suit all) as a growing source of stress.

From the Financial Times

Some last longer than others but most currency unions end in collapse.

In the mid-1700s, Massachusetts, faced with devaluation and inflation, broke from a monetary union of four New England colonies. A century later, the French-led Latin Monetary Union, which included Belgium and Italy, struggled along before being subsumed into the gold standard. The East Africa Currency Area blew up at the same time as sterling in 1977. Germany’s Customs Union and the monetary union of the US were rare successes. So history suggests that the euro’s chances of survival are not terribly high. The question, therefore, is when it might implode. That is hard to say but, at the margin, the currency’s appreciation during the past few years is not helpful. That is because, for the first time since the euro’s birth in 1999, the strong currency appears to be having a negative effect on growth in the core eurozone countries of France and Germany.

The main trouble is that the European Central Bank’s benchmark interest rate of 4 per cent is probably too low, given the overall inflationary environment – and definitely too low for the eurozone’s “periphery” countries. Ireland and Spain already have huge asset price bubbles due to their inability to set appropriate monetary policy.

The economies of some Baltic states, and others such as Bulgaria with currencies pegged to the euro, are overheating. Whether the pegs hold until these countries are welcomed into the eurozone is now open to question. Failure here could shift attention to imbalances elsewhere in the union.

Potentially slower growth across the eurozone would also hit tax receipts, putting already strained budgets under further pressure. In Italy, for example, burdensome government debt and a widening fiscal deficit leave no room at all for manoeuvre. If fiscal discipline begins to lapse, that is when the real trouble could start. So far, the euro is seen as a triumph, but all currency unions are tested from time to time. Further appreciation could well herald one of those periods.

The Financial Times reports that both institutional cash funds and money market funds, which are subject to more stringent requirements, are getting cash injections from their managers to offset losses. The story points out that not all salvage operations are made public, so the total is no doubt higher than the level cited in this story, and growing.

From the Financial Times:

More than 10 North American banks and fund managers have collectively injected $3bn into their money market and cash funds since October to stem losses.

Janus, the fund manager, this week became the latest to bail out its money market funds. It put in $109m to buy troubled asset-backed securities from its funds. Half a dozen firms have made similar moves.

The bail-outs, in the form of guarantees, credit lines and the buying out of troubled securities, are intended to stop funds falling below the $1 a share promised to investors. They show how seriously the parent companies take the reputational risk of “breaking the buck”.

Not all bail-outs have been made public but more are believed to be being drawn up. The extent of losses is not yet known.

BlackRock – which has been hired to manage Florida’s troubled cash investment fund – faced further pressure this week over one of its funds. Moody’s downgraded its credit rating on BlackRock’s institutional cash strategies fund to junk status after redemptions in the fund were suspended a few weeks ago.

Two other fund managers have suspended redemptions at money market funds.

Only one money market fund in the US has broken the buck – in 1994 – but, in effect, many funds have recently. Observers question how the funds can be properly valued, given that many of the asset-backed securities they hold are not trading.

Even conservative managers have been caught by the credit crisis. It takes only a tiny loss to push a fund’s value below 99.5 cents in the dollar, the point at which boards must take action.

James McDonald, a portfolio manager for T Rowe Price, said some of his firm’s funds had invested in the short-term paper of four structured investment vehicles – instruments that sell cheap, short-term debt to invest in longer-term assets with higher yields. But Mr McDonald thought the exposure amounted to less than 1 per cent in each fund.

“We have moved those securities to our ‘illiquid’ bucket in the fund until they start trading again,” he said.

T Rowe Price, known as one of the most conservative managers, values its securities daily rather than weekly. The firm would act if the fund’s value fell three-tenths of a cent below the $1 par value, Mr McDonald said.

The theme du jour, at least in the world of Dow Jones, is the sorry condition of the financial services industry. While the basic thrust is nothing new, some of the data point are revealing.

The Journal’s Heard on the Street column tells us that banks like Citigroup and HSBC are likely to sell business units next year, This is no surprise, but the article suggests that a lot of sales will come in the first half of next year. Presumably, the logic is that the markets will be somewhat less punitive about writedowns if the firms show they have ways to plug the leaks in their balance sheets. And in a deteriorating environment, it’s better to sell early before valuations get even worse. However, in an environment with a lot of merchandise on offer and strategic buyers sidelined by their own capital structure woes, that strategy may backfire.

From the story:

Why do we think a bottom is not yet nigh? Six analysts rate Citigroup a sell, eight a hold, and nine a buy. Analyst ratings are a lagging indicator. One study ascertained that the best time to buy a stock is when virtually all the analysts have a sell rating on it.

More interestingly, the Journal also reports that investment banks are cutting back on lending to hedge funds. Things are bad when you can’t give top notch service to your best clients. From the story:
Investment banks are cutting back on loans to hedge funds, eliminating some clients and raising borrowing fees for others.

The lenders are slimming their balance sheets after heavy losses in the debt markets in recent months. And, after taking multibillion-dollar write-downs, they also are becoming more cautious as the economy slows, according to people familiar with the situation.

“Banks aren’t in a position to be accommodating at the moment,” said Michael Hintze, chief executive of CQS, a London-based hedge fund with $9 billion under management.

If the change continues, it could put some pressure on the profits of the prime-brokerage units of the major banks, which make big money by lending to hedge funds, as well as helping the funds manage their cash and short stocks by borrowing and selling shares as a bet on falling prices.

The move also could put pressure on the returns of some hedge funds, which often rely on healthy doses of borrowed money, or leverage, to boost their returns.

“Leverage definitely drives returns,” says David Gold, an executive at Watson Wyatt Worldwide, which works with corporate pension plans on their hedge-fund investments.

In particular, Mr. Gold says quantitative funds — those that trade using certain computer models — are seeing their borrowing ability reduced, on the heels of the uneven performance of some funds this year. He says the move by the banks will have the biggest impact on smaller hedge funds.

“Groups like Morgan Stanley and Goldman Sachs will feed more leverage to their bigger, better clients,” Mr. Gold says…..

Prime brokers like Morgan Stanley, which has one of the largest businesses catering to hedge funds, have made repurchase agreements so expensive that some funds are going to rival firms to borrow money, according to people familiar with the matter…

Morgan Stanley isn’t alone in making lending rates more expensive for funds. Merrill Lynch & Co. also has been increasing its rates, a person familiar with the matter said.

This development has the potential to have interesting side effects. First, hedge funds have been a significant source of credit (they are the protection writers for over 35% of credit default swaps, and also have been active buyers of debt issues). Less lending to them will mean less credit market investment, which it turn will affect new issue pricing Second, scarcer and more costly credit will make the role of leverage in hedge fund returns more apparent, and will lead to underwhelming results at many firms.

Finally, MarketWatch tells us to expect more business bankruptcies next year. Corporate debt has been one of the few areas relatively unscathed in the credit markets. That is about to change. Note that the article focuses on public companies. Smaller, private firms are likely to show a more dramatic increase:

Market analysts warn that more U.S. businesses are likely to hang “going bankrupt” signs on their doors next year as the twinned blows of slower economic growth and pricey commodities force the weakest companies to seek refuge from creditors.

In a twist from this year’s trends, the pain is likely to spread from mortgage lenders, homebuilders and consumer-oriented firms – all areas that contributed to a 40% jump in bankruptcy filings in 2007 and are expected to play a role in 2008′s misery.

Next year, industries at risk for the biggest increases in Chapter 11 filings include electronics makers, energy miners like coal companies and agriculture firms, according to Global Insight.

Makers of durable goods like machinery are also more at risk and will likely contribute to a 13% rise in bankruptcies in 2008, says the private research firm, which bases its estimates on issuers’ credit quality and operating conditions….

On the macro front, new bankruptcy risk to makers of such goods as electronics and heavy equipment comes from an expected slowdown, or even recession, in the United States next year. For raw materials producers, say metals makers, that slowdown risk is combined with supply competition from new industrial juggernaut China.

Meanwhile rising raw material prices, from fuel to metals to grains, have raised cost pressures for makers of equipment and even some high-flying commodities producers.

“Outside of oil, whatever the ability there is to raise prices, the fact is that input prices are going up at a similar rate,” said Killion….

Meanwhile, analysts anticipate more companies in industries linked to housing will file for bankruptcy or follow the increasingly popular course of opting to sell their assets to a restructuring firm and then declare themselves out of business.

“Homebuilders will continue to be on the edge,” predicted Reginald Jackson, president of the American Bankruptcy Institute and a bankruptcy attorney at Vorys, Sater, Seymour and Pease LLP in Columbus, Ohio…..

Foreshadowing of more pain is playing out in the bond market, where ratings agencies are slashing credit outlooks to levels where, historically, the risk of default has been high.

Standard & Poor’s counted consumer products as the global sector with the highest risk of a defaulting on their credits, followed by retail/restaurants, and media and entertainment. Most of these are in the United States. Forest products, fourth on the list, had the most defaults in the United States during the 12 months until November.

Companies in these sectors have more ratings of B- or lower as well as credit watch negative or negative outlooks assigned by Standard & Poor’s.

“We think of those companies as being on a slippery slope with the potential to go into default,” said Diane Vazza, head of global fixed income research at Standard & Poor’s.

In general, default rates for riskiest borrowers are expected to rise. Standard & Poor’s estimates 56 speculative debt issuers will default in the next 12 months, a rate of 3.4% compared with less than 1% this year. The term “speculative” refers to the riskier borrowers whose debt falls below investment grade and is often called junk.

Moody’s Investors Service, for its part, anticipates the default rate to rise to 4.7% over the next 12 months.