Why Can’t We Admit That…

…Citigroup, parent of the once-proud Citibank and Salomon Brothers, is bankrupt?

…Berkshire Hathaway is genuinely threatened by a potential run on its credit, due to contractual provisions in its derivatives agreements that could compel it to post more collateral at exactly the worst time?

…if we are even talking about Berkshire Hathaway being at risk, then ANY company is at risk of a run on its credit?

…as well-intentioned as those in our Government might be, that most have no idea of how to address the issues that threaten our national prosperity and well-being?

…any institution for which buying a bank is even remotely logical will do so to gain access to TARP funds, whether necessary or not?

…spending on infrastructure to get people back to work while re-building and upgrading essential services is a useful expenditure of taxpayer funds?

…everyone is scared, from the top 1% of the wealth pyramid down to those doing everything in their power simply to get by?

Read it all, well worth it.

ON G-20 AND GM: ECONOMICS, POLITICS AND SOCIAL STABILITY

By George Friedman

The G-20 met last Saturday. Afterward, the group issued a meaningless statement and decided to meet again in March 2009, or perhaps later. Clearly, the urgency of October is gone. First, the perception of imminent collapse is past. Politicians are superb seismographs for detecting impending disaster, and these politicians did not act as if they were running out of time. Second, the United States will have a new president in March, and nothing can be done until he defines his policy.

Given the sense in Europe that this financial crisis marked the end of U.S. economic supremacy, it is ironic that the Europeans are waiting on the Americans. One would think they would be using their newfound ascendancy to define the new international system. But the fact is that for all the shouting, little has changed in the international order. The crisis has receded sufficiently that nothing more needs to be done immediately beyond “cooperation,” and nothing can be done until the United States defines what will be done. We feel that our view that the international system received fatal blows Aug. 8, when Russia and Georgia went to war, and Oct. 11, when the G-7 meeting ended without a single integrated solution, remains unchallenged. Now, it is every country for itself.

From Financial Crisis to Cyclical Recession

The financial crisis has been mitigated, if not solved. The problem now is that we are in a cyclical recession, and that every country is trying to figure out how to cope with the recession. Unlike the past two recessions, this one is more global than local. But unlike the 1970s, when recession was global, this one is not accompanied by soaring inflation and interest rates.

All recessions have different dynamics, but all have one thing in common: They impose punishment and discipline on economies run wild. This is happening around the world.

China, for example, faces a serious problem. China is an export-oriented economy whose primary market is the United States. As the United States goes into recession, demand for Chinese goods declines. Chinese businesses have always operated on very tight — sometimes invisible — profit margins designed to emphasize cash flow and to pay off debts to banks. As U.S. demand contracts, many Chinese firms find themselves in untenable positions, without room to decrease prices, lacking operating reserves and insufficiently capitalized. Recessions are designed to cull the weak from the herd, and a huge swath of the Chinese economy is ripe for the culling.

If the world were all about economics, culling is what the Chinese would do. But the world is more complex than that. A culling would lead to massive unemployment. Many Chinese employees live on Third World wages; indeed, the vast majority of Chinese have incomes of less than $1,000 a year. To them, unemployment doesn’t mean problems with their 401k. It means malnutrition and desperation — neither of which is unknown in 20th century Chinese history, including the Communist period. The Chinese government is rightly worried about the social and political consequences of rational economic policies: They might work in the long run, but only if you live that long.

Economic Restructuring vs. Stability

The Chinese have therefore prepared a massive stimulus package that is more of a development program to make up for declining U.S. demand. It aims to keep businesses from failing and spilling millions of angry and hungry workers into the street. For the Chinese, the economic problem creates a much larger and more serious issue. It is also an issue that must be solved quickly, and the amount of time needed outstrips the amount of time available.

This is not only a Chinese problem. Wherever there is an economic downturn, politicians must decide whether society — and their own political futures — can withstand the rigors recessions impose. Recessions occur when, as is inevitable, inefficiencies and irrationalities build up in the financial and economic system. The resulting economic downturn imposes a harsh discipline that destroys the inefficient, encourages everyone to become more efficient, and opens the doors to new businesses using new technologies and business models. The year 2001 smashed the technology sector in the United States, opening the door for Google Inc.

The business cycle works well, but the human costs can be daunting. The collapse of inefficient businesses leaves workers without jobs, investors without money and society less stable than before. The pain needed to rectify China’s economy would be enormous, with devastating consequences for hundreds of millions of Chinese, and probably would lead to social chaos. Beijing is prepared to accept a high degree of economic inefficiency to avoid, or at least postpone, the reckoning. The reckoning always comes, but for most of us, later is better than sooner. Economic rationality takes a back seat to social necessity and political common sense.

Every country in the world is looking inward at the impact of the recession on its economy and measuring its resources. Countries are deciding whether they have the ability to prop up business that should fail, what the social consequences of business failure would be, and whether they should try to use their resources to avoid the immediate pain of recession. This is why the G-20 ended in meaningless platitudes.

Each country is also trying to answer the question of how much pain it — and its regime — can endure. The more pain imposed, the healthier countries will emerge economically — unless of course the pain kills them. Ultimately, the rationality of economics and the reality of society frequently diverge.

Recession and the U.S. Auto Industry

For the United States, this choice has been posed in stark terms with regard to the dilemma of whether the U.S. government should use its resources to rescue the American auto industry. The American auto industry was once the centerpiece of the U.S. economy. That hasn’t been true for a generation, as other industries and services have supplanted it and other countries’ auto industries have surpassed it. Nevertheless, the U.S. auto industry remains important. It might drain the U.S. economy by losing vast amounts of money and destroying the equity held by its investors, but it employs large numbers of people. Perhaps more important, it purchases supplies from literally thousands of U.S. companies.

There can be endless discussions of why the U.S. auto industry is in such trouble. The answer lies not in one place but in many, from the decisions and makeup of management to the unions that control much of the workforce, and from the cost structure inherent in producing cars in the American economy to a simple systemic inability to produce outstanding vehicles. There might be varying degrees of truth to all or some of this, but the fact remains that each of the U.S. carmakers is on the verge of financial collapse.

This is what recessions are supposed to do. As in China and everywhere else, recessions reveal weak businesses and destroy them, freeing up resources for new enterprises. This recession has hit the auto industry hard, and it is unlikely that it is going to survive. The ultimate reason is the same one that destroyed the U.S. steel industry a generation ago: Given U.S. cost structures, producing commodity products is best left to countries with lower wage rates, while more expensive U.S. labor is deployed in more specialized products requiring greater expertise. Thus, there is still steel production in the United States, but it is specialty steel production, not commodity steel. Similarly, there will be specialty auto production in the United States, but commodity auto production will come from other countries.

That sounds easy, but the transition actually will be a bloodletting. Current employees of both the automakers and suppliers will be devastated. Institutions that have lent money to the automakers will suffer massive or total losses. Pensioners might lose pensions and health care benefits, and an entire region of the United States — the industrial Midwest — will be devastated. Something stronger will grow eventually, but not in time for many of the current employees, shareholders and creditors.

Here the economic answer, cull, meets the social answer, stabilize. Policymakers have a decision to make. If the automakers fail now, their drain on the economy will end; the pain will be shorter, if more intense; and new industries would emerge more quickly. But though their drain on the economy would end, the impact of the automakers’ failure on the economy would be seismic. Unemployment would surge, as would bankruptcies of many auto suppliers. Defaults on loans would hit the credit markets. In the Midwest, home prices would plummet and foreclosures would skyrocket. And heaven only knows what the impact on equity markets would be.

In the U.S. case, the healthful purgative of a recession could potentially put the patient in a coma. Few if any believe the U.S. auto industry can survive in its current form. But there is an emerging consensus in Washington that the auto industry must not be allowed to fail now. The argument for spending money on the auto industry is not to save it, but to postpone its failure until a less devastating and inconvenient time. In other words, fearing the social and political consequences of a recession working itself through to its logical conclusion, Washington — like Beijing — wants to spend money it probably won’t recover to postpone the failure. Indeed, governments around the world are considering what failures to tolerate, what failures to postpone, and how much to spend on the latter. General Motors is merely the American case in point.

The Recession in Context

The people arguing for postponement aren’t foolish. The financial system is still working its way through a massive crisis that had little to do with the auto industry. Some traction appears to be occurring; certainly there was no crisis atmosphere at the G-20 meeting. The economy is in recession, but in spite of the inevitable claims that we have never seen anything like this one before, we have. There is always some variable that swings to an extreme — this time, it is consumer spending — but we are still well within the framework of recent recessions.

Consider the equity markets, which we regard as a long-term measure of the market’s evaluation of the state of the economy. In January 2000, the S&P 500 peaked at 1,455. This was the top of the market. In July 2002, 18 months later, the S&P bottomed out at 935. Over the next five years it rose to 1,519 in July 2007, the height for this cycle. It fell from this point until Nov. 12, 2008, when it closed at 852.30. This past Friday, it was at 873.29.

We do not know what the market will do in the future. There are people much smarter than we are who claim to know that. What we do know is what it has done. And what it has done this time — so far — is almost exactly what it did last time, except that in 2000-2002 it took 18 months to do it, while this time it was done in about 16 and a half months (assuming it bottomed out Nov. 12). But even if the market didn’t bottom out then, and it falls to 775, for example, it will have lost 50 percent of its value from the peak. This would be more than in 2000-2002, but not unprecedented.

The point we are making here is that if we regard the equity markets as a long-term seismograph of the economy, then so far, despite all the storm and stress, the markets — and therefore the economy — remain within the general pattern of the 2000-2002 market at the 2001 recession. That recession certainly was unpleasant, what with the devastation of the tech sector, but the economy survived. At the same time, however, it is clear that things are balanced on a knife’s edge. Another hundred points’ fall on the S&P, and the markets will be telling us that the world is in a very different place indeed.

A massive bankruptcy in the automotive sector could certainly set the stage for an economic renaissance in the next generation. But at this particular moment in time (it’s no coincidence that the crisis in the U.S. automotive industry comes as we enter a recession), a wave of bankruptcies would dramatically deepen the recession. This probably would be reflected by the destruction of trillions more in net worth in the equity markets.

There is a powerful counterargument to bailing out the U.S. auto industry. This argument holds that the auto industry is a drain on the U.S. economy, that it will never be globally competitive, and that if it is dragged back from the edge, no one will then say it is time to push it to the edge and over. The next time it will be on the brink will be during the next recession, and the same argument to save it will be used. In due course, the United States, like China, will be so terrified of the social and political consequences of business failure that it will maintain Chinese-like state owned enterprises, full of employees and generation-old plants and business models. Clearly, short-run solutions can easily become long-term albatrosses.

The only possible solution would be a bailout followed by a Washington-administered restructuring of the auto industry. This causes us to imagine a collaboration between the auto industry’s current management and Washington administrators that would finally put Detroit on a path to where it can compete with Toyota. Frankly, the mind boggles at this. But boggle though we might, hitting the economy with another massive financial default, a wave of bankruptcies, massive unemployment surges and another blow to housing prices boggles our mind even more.

The geopolitical problem confronting the world at the moment is that it has been forced to offer massive support to the global financial system with sovereign wealth — e.g., via taxes and currency printing presses. The world might just have squeaked through that crisis. Now, the world is in an inevitable recession and businesses are on the brink of failure. A wave of massive business failures on top of the financial crisis might well move the global system to a very different place. Therefore, each nation, by itself and indifferent to others, is in the process of figuring out how to postpone these failures to a more opportune time — or to never. This will build in long-term inefficiencies to the global economy, but right now everyone will be quite content with that.

Thus the financial crisis became a recession, and the recession triggered bankruptcies. And because no one wants bankruptcies right now, everyone who can is using taxpayer dollars to protect the taxpayer from the consequences of mismanagement. And the last thing any one cared about was the G-20 concept for the future of the economic system.

This report may be forwarded or republished on your website with attribution to www.stratfor.com

James Gardner has a post up explaining how he and his team are looking at vendors coming to them with a new technology to try out. He makes a series of good points and I would encourage every vendor to read them closely. I can relate to all but one:

Some people, of course, will argue that this kind of thinking means that smaller companies (who simply don’t have the money to invest without commitment) are locked out of deals with a larger organisation. That probably true, and its too bad.

We actually seek innovative small companies, but that doesn’t mean we will pay for doing pilots either. Let me expand this point on pilots.

Here’s how we look at the value proposition:

We can be contacted by vendors, but often we contact them, especially when they are small and not mature for the enterprise market. As James said, we won’t even consider paying for a proof of concept or any other activity that requires us to spend resources (could be money, but more often time) to just see the light and be convinced of the value your product can add: this is your job and responsibility as a vendor. Your “cost of doing business”. So don’t ask anything at this stage, we are already spending an increasingly valuable asset on you: our attention. If we talk with you, especially if we called, we are genuinely interested, so don’t blow it up.

Assuming we know how we should, in theory, create value from your offering, we’ll need to test it, in our own specific and unique ecosystem. Your technology can be creating value for any other companies, if it doesn’t for us, then it’s of no use. That’s why we do pilots: to confirm that either the business value will be realized or that the technical risks can be mitigated (at a realistic cost).

A pilot is a small-scale deployment of the technology considered. It will often be similar to a full deployment technically, but we will offer it only to a limited set of users. Exceptions exist: for example when we think the value potential is important, but we are unsure how we will be able to realize it in our organization. We might want to do a full pilot here, open to any volunteer willing to try out. But in general, a pilot is a full deployment, used by a small subset of users and limited in time.

The point I want to make here is the pricing: we won’t pay for all this. But we are ready to offset the costs. Let me explain.

A pilot phase is an investment phase for both the vendor and the organization buying the product. The vendor is investing time and money to demonstrate the capabilities of its software in a unique ecosystem. The organization is investing a lot of time and money as well to deploy it internally, configure it, set up the pilot phase with business stakeholders, configure the tool, etc. It costs both sides, but as a rule it’s generally costing us more.

Pure investment, for both sides. Then hopefully the pilot is successful and the project moves to a full deployment. And both sides start reaping the benefits: the vendor as revenue, the organization as enhanced productivity.

What about small companies? Well, in our case, we are ready to offset the cost of the pilot. But we mean real cost. If you need to buy hardware, fine. If you want to bill us consultants’s time, nope.

The insistence of making profits right away is a good signal of how much value the product brings. Confident vendors are all too happy to provide all the support for the pilot for free, because they know we will want to move on to a global deployment. They are confident and jump on the occasion. If you’re trying to make a quick profit right at the pilot phase, then that tells us you are not confident you will bring value and want to book a quick profit. So yes, we use those attitudes as a signal to judge the quality of the product. It served us well.

Why expanding on all of this? Well, to drive home this point James is making for similar reasons:

I often wonder, when I sit across the table from a potential partner whether they realise this, or think we’re playing a negotiation game. I can assure you we’re not.

Believe us. We are not trying to play hardball. We just need to work within a large structure which adds some overheads. The cost of doing business with large companies is high, but then again the rewards are higher and we take part of the risk off the table by offsetting your cost. And don’t forget when you ask us to demonstrate commitment:

Here is another term I sometimes hear from vendors: “we will do something but you need to have skin in the game”. Since when did investing our time and resources in working with you not become skin the game? We have skin in the game from the first meeting.

Source: The proof of value

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No doubt the company The Economist touted as a model recently has won GE business. Professional for both consumers and large organizations. Impressive.

Here are a few must-read if you want to follow what’s going on, but be warned, this will elevate your blood pressure quite drastically:

Andrew Lahde, recently famous hedgie, closed its fund with a 866% return. Here’s an extract from his last letter to investors:

The low hanging fruit, i.e. idiots whose parents paid for prep school, Yale, and then the Harvard MBA, was there for the taking. These people who were (often) truly not worthy of the education they received (or supposedly received) rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government. All of this behavior supporting the Aristocracy, only ended up making it easier for me to find people stupid enough to take the other side of my trades. God bless America.

Go read the Epicurian Dealmaker’s pov. An insider take on what’s happening here. Extract of the finesse piece:

With both Congress and the New York Attorney General’s office crawling up the asses of major Wall Street firms with flashlights, Roto-rooters, and cattle prods looking for juicy little sound bites on excessive compensation for the Senate floor and the nightly news, it will be a long time indeed before investment bankers regain control of their compensation processes. If ever.

But something much more serious is at stake here. Here’s Barry on the $140B handed out illegally by the Treasury to banks under the form of tax breaks. Steve Randy Waldman follows suit:

But, today I am white-hot mad over AIG, and I need to vent. Yves Smith has done a beautiful job of describing the ridiculous awfulness of today’s “restructuring”. More importantly, she uses words with the appropriate intensity and valence: “banana republic”, “looting”, “Mussolini-Style Corporatism”.

Barry closes the loop today with this post. Are we witnessing the end of Wall Street as we know it, as Michael Lewis suggests? I still doubt it, but I would be happy to be wrong.

This great Nation will endure as it has endured, will revive and will prosper. So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself—nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.

—FDR Inaugural Address

We shall fight on the beaches, we shall fight on the landing grounds, we shall fight in the fields and in the streets, we shall fight in the hills; we shall never surrender…

—Winston Churchill

This sucker could go down.

—George Bush

Source: Nothing to Fear but Irresponsible Words
Update: Indeed, it went in the most unexpected way. Paul summarizes my feelings.

• Barry Ritholtz: CEO and director of research at FusionIQ, former Chief Strategist, etc. (full bio)
• Roger Ehrenberg: 17 years on Wall St, former hedge fund manager, angel investor, etc. (full bio)
• Howard Lindzon: Hedge fund manager, early-stage investor, etc. (full bio)

Subscribe to their RSS feeds, get updates and be part of both excellent information flows and robust communities. If you want more, follow their pointers. I’ve been reading them for a couple of years, and I feel grateful each time I read one of their posts.

It’s actually quite amusing how McKinsey concentrates on how to build competitive advantage and Gartner on years to mainstream. Of course, it’s marketing BS in one case and so-called analysis in the other, but Gartner’s stance isn’t particularly oriented towards action. They don’t provide anything meaningful on behavioral economics either.

THE MEDVEDEV DOCTRINE AND AMERICAN STRATEGY

By George Friedman

The United States has been fighting a war in the Islamic world since 2001. Its main theaters of operation are in Afghanistan and Iraq, but its politico-military focus spreads throughout the Islamic world, from Mindanao to Morocco. The situation on Aug. 7, 2008, was as follows:

The war in Iraq was moving toward an acceptable but not optimal solution. The government in Baghdad was not pro-American, but neither was it an Iranian puppet, and that was the best that could be hoped for. The United States anticipated pulling out troops, but not in a disorderly fashion.

The war in Afghanistan was deteriorating for the United States and NATO forces. The Taliban was increasingly effective, and large areas of the country were falling to its control. Force in Afghanistan was insufficient, and any troops withdrawn from Iraq would have to be deployed to Afghanistan to stabilize the situation. Political conditions in neighboring Pakistan were deteriorating, and that deterioration inevitably affected Afghanistan.

The United States had been locked in a confrontation with Iran over its nuclear program, demanding that Tehran halt enrichment of uranium or face U.S. action. The United States had assembled a group of six countries (the permanent members of the U.N. Security Council plus Germany) that agreed with the U.S. goal, was engaged in negotiations with Iran, and had agreed at some point to impose sanctions on Iran if Tehran failed to comply. The United States was also leaking stories about impending air attacks on Iran by Israel or the United States if Tehran didn’t abandon its enrichment program. The United States had the implicit agreement of the group of six not to sell arms to Tehran, creating a real sense of isolation in Iran.

In short, the United States remained heavily committed to a region stretching from Iraq to Pakistan, with main force committed to Iraq and Afghanistan, and the possibility of commitments to Pakistan (and above all to Iran) on the table. U.S. ground forces were stretched to the limit, and U.S. airpower, naval and land-based forces had to stand by for the possibility of an air campaign in Iran — regardless of whether the U.S. planned an attack, since the credibility of a bluff depended on the availability of force.

The situation in this region actually was improving, but the United States had to remain committed there. It was therefore no accident that the Russians invaded Georgia on Aug. 8 following a Georgian attack on South Ossetia. Forgetting the details of who did what to whom, the United States had created a massive window of opportunity for the Russians: For the foreseeable future, the United States had no significant forces to spare to deploy elsewhere in the world, nor the ability to sustain them in extended combat. Moreover, the United States was relying on Russian cooperation both against Iran and potentially in Afghanistan, where Moscow’s influence with some factions remains substantial. The United States needed the Russians and couldn’t block the Russians. Therefore, the Russians inevitably chose this moment to strike.

On Sunday, Russian Prime Minister Dmitri Medvedev in effect ran up the Jolly Roger. Whatever the United States thought it was dealing with in Russia, Medvedev made the Russian position very clear. He stated Russian foreign policy in five succinct points, which we can think of as the Medvedev Doctrine (and which we see fit to quote here):

First, Russia recognizes the primacy of the fundamental principles of international law, which define the relations between civilized peoples. We will build our relations with other countries within the framework of these principles and this concept of international law.

Second, the world should be multipolar. A single-pole world is unacceptable. Domination is something we cannot allow. We cannot accept a world order in which one country makes all the decisions, even as serious and influential a country as the United States of America. Such a world is unstable and threatened by conflict.

Third, Russia does not want confrontation with any other country. Russia has no intention of isolating itself. We will develop friendly relations with Europe, the United States, and other countries, as much as is possible.

Fourth, protecting the lives and dignity of our citizens, wherever they may be, is an unquestionable priority for our country. Our foreign policy decisions will be based on this need. We will also protect the interests of our business community abroad. It should be clear to all that we will respond to any aggressive acts committed against us.

Finally, fifth, as is the case of other countries, there are regions in which Russia has privileged interests. These regions are home to countries with which we share special historical relations and are bound together as friends and good neighbors. We will pay particular attention to our work in these regions and build friendly ties with these countries, our close neighbors.

Medvedev concluded, “These are the principles I will follow in carrying out our foreign policy. As for the future, it depends not only on us but also on our friends and partners in the international community. They have a choice.”

The second point in this doctrine states that Russia does not accept the primacy of the United States in the international system. According to the third point, while Russia wants good relations with the United States and Europe, this depends on their behavior toward Russia and not just on Russia’s behavior. The fourth point states that Russia will protect the interests of Russians wherever they are — even if they live in the Baltic states or in Georgia, for example. This provides a doctrinal basis for intervention in such countries if Russia finds it necessary.

The fifth point is the critical one: “As is the case of other countries, there are regions in which Russia has privileged interests.” In other words, the Russians have special interests in the former Soviet Union and in friendly relations with these states. Intrusions by others into these regions that undermine pro-Russian regimes will be regarded as a threat to Russia’s “special interests.”

Thus, the Georgian conflict was not an isolated event — rather, Medvedev is saying that Russia is engaged in a general redefinition of the regional and global system. Locally, it would not be correct to say that Russia is trying to resurrect the Soviet Union or the Russian empire. It would be correct to say that Russia is creating a new structure of relations in the geography of its predecessors, with a new institutional structure with Moscow at its center. Globally, the Russians want to use this new regional power — and substantial Russian nuclear assets — to be part of a global system in which the United States loses its primacy.

These are ambitious goals, to say the least. But the Russians believe that the United States is off balance in the Islamic world and that there is an opportunity here, if they move quickly, to create a new reality before the United States is ready to respond. Europe has neither the military weight nor the will to actively resist Russia. Moreover, the Europeans are heavily dependent on Russian natural gas supplies over the coming years, and Russia can survive without selling it to them far better than the Europeans can survive without buying it. The Europeans are not a substantial factor in the equation, nor are they likely to become substantial.

This leaves the United States in an extremely difficult strategic position. The United States opposed the Soviet Union after 1945 not only for ideological reasons but also for geopolitical ones. If the Soviet Union had broken out of its encirclement and dominated all of Europe, the total economic power at its disposal, coupled with its population, would have allowed the Soviets to construct a navy that could challenge U.S. maritime hegemony and put the continental United States in jeopardy. It was U.S. policy during World Wars I and II and the Cold War to act militarily to prevent any power from dominating the Eurasian landmass. For the United States, this was the most important task throughout the 20th century.

The U.S.-jihadist war was waged in a strategic framework that assumed that the question of hegemony over Eurasia was closed. Germany’s defeat in World War II and the Soviet Union’s defeat in the Cold War meant that there was no claimant to Eurasia, and the United States was free to focus on what appeared to be the current priority — the defeat of radical Islamism. It appeared that the main threat to this strategy was the patience of the American public, not an attempt to resurrect a major Eurasian power.

The United States now faces a massive strategic dilemma, and it has limited military options against the Russians. It could choose a naval option, in which it would block the four Russian maritime outlets, the Sea of Japan and the Black, Baltic and Barents seas. The United States has ample military force with which to do this and could potentially do so without allied cooperation, which it would lack. It is extremely unlikely that the NATO council would unanimously support a blockade of Russia, which would be an act of war.

But while a blockade like this would certainly hurt the Russians, Russia is ultimately a land power. It is also capable of shipping and importing through third parties, meaning it could potentially acquire and ship key goods through European or Turkish ports (or Iranian ports, for that matter). The blockade option is thus more attractive on first glance than on deeper analysis.

More important, any overt U.S. action against Russia would result in counteractions. During the Cold War, the Soviets attacked American global interest not by sending Soviet troops, but by supporting regimes and factions with weapons and economic aid. Vietnam was the classic example: The Russians tied down 500,000 U.S. troops without placing major Russian forces at risk. Throughout the world, the Soviets implemented programs of subversion and aid to friendly regimes, forcing the United States either to accept pro-Soviet regimes, as with Cuba, or fight them at disproportionate cost.

In the present situation, the Russian response would strike at the heart of American strategy in the Islamic world. In the long run, the Russians have little interest in strengthening the Islamic world — but for the moment, they have substantial interest in maintaining American imbalance and sapping U.S. forces. The Russians have a long history of supporting Middle Eastern regimes with weapons shipments, and it is no accident that the first world leader they met with after invading Georgia was Syrian President Bashar al Assad. This was a clear signal that if the U.S. responded aggressively to Russia’s actions in Georgia, Moscow would ship a range of weapons to Syria — and far worse, to Iran. Indeed, Russia could conceivably send weapons to factions in Iraq that do not support the current regime, as well as to groups like Hezbollah. Moscow also could encourage the Iranians to withdraw their support for the Iraqi government and plunge Iraq back into conflict. Finally, Russia could ship weapons to the Taliban and work to further destabilize Pakistan.

At the moment, the United States faces the strategic problem that the Russians have options while the United States does not. Not only does the U.S. commitment of ground forces in the Islamic world leave the United States without strategic reserve, but the political arrangements under which these troops operate make them highly vulnerable to Russian manipulation — with few satisfactory U.S. counters.

The U.S. government is trying to think through how it can maintain its commitment in the Islamic world and resist the Russian reassertion of hegemony in the former Soviet Union. If the United States could very rapidly win its wars in the region, this would be possible. But the Russians are in a position to prolong these wars, and even without such agitation, the American ability to close off the conflicts is severely limited. The United States could massively increase the size of its army and make deployments into the Baltics, Ukraine and Central Asia to thwart Russian plans, but it would take years to build up these forces and the active cooperation of Europe to deploy them. Logistically, European support would be essential — but the Europeans in general, and the Germans in particular, have no appetite for this war. Expanding the U.S. Army is necessary, but it does not affect the current strategic reality.

This logistical issue might be manageable, but the real heart of this problem is not merely the deployment of U.S. forces in the Islamic world — it is the Russians’ ability to use weapons sales and covert means to deteriorate conditions dramatically. With active Russian hostility added to the current reality, the strategic situation in the Islamic world could rapidly spin out of control.

The United States is therefore trapped by its commitment to the Islamic world. It does not have sufficient forces to block Russian hegemony in the former Soviet Union, and if it tries to block the Russians with naval or air forces, it faces a dangerous riposte from the Russians in the Islamic world. If it does nothing, it creates a strategic threat that potentially towers over the threat in the Islamic world.

The United States now has to make a fundamental strategic decision. If it remains committed to its current strategy, it cannot respond to the Russians. If it does not respond to the Russians for five or 10 years, the world will look very much like it did from 1945 to 1992. There will be another Cold War at the very least, with a peer power much poorer than the United States but prepared to devote huge amounts of money to national defense.

There are four broad U.S. options:

Attempt to make a settlement with Iran that would guarantee the neutral stability of Iraq and permit the rapid withdrawal of U.S. forces there. Iran is the key here. The Iranians might also mistrust a re-emergent Russia, and while Tehran might be tempted to work with the Russians against the Americans, Iran might consider an arrangement with the United States — particularly if the United States refocuses its attentions elsewhere. On the upside, this would free the U.S. from Iraq. On the downside, the Iranians might not want –or honor — such a deal.

Enter into negotiations with the Russians, granting them the sphere of influence they want in the former Soviet Union in return for guarantees not to project Russian power into Europe proper. The Russians will be busy consolidating their position for years, giving the U.S. time to re-energize NATO. On the upside, this would free the United States to continue its war in the Islamic world. On the downside, it would create a framework for the re-emergence of a powerful Russian empire that would be as difficult to contain as the Soviet Union.

Refuse to engage the Russians and leave the problem to the Europeans. On the upside, this would allow the United States to continue war in the Islamic world and force the Europeans to act. On the downside, the Europeans are too divided, dependent on Russia and dispirited to resist the Russians. This strategy could speed up Russia’s re-emergence.

Rapidly disengage from Iraq, leaving a residual force there and in Afghanistan. The upside is that this creates a reserve force to reinforce the Baltics and Ukraine that might restrain Russia in the former Soviet Union. The downside is that it would create chaos in the Islamic world, threatening regimes that have sided with the United States and potentially reviving effective intercontinental terrorism. The trade-off is between a hegemonic threat from Eurasia and instability and a terror threat from the Islamic world.

We are pointing to very stark strategic choices. Continuing the war in the Islamic world has a much higher cost now than it did when it began, and Russia potentially poses a far greater threat to the United States than the Islamic world does. What might have been a rational policy in 2001 or 2003 has now turned into a very dangerous enterprise, because a hostile major power now has the option of making the U.S. position in the Middle East enormously more difficult.

If a U.S. settlement with Iran is impossible, and a diplomatic solution with the Russians that would keep them from taking a hegemonic position in the former Soviet Union cannot be reached, then the United States must consider rapidly abandoning its wars in Iraq and Afghanistan and redeploying its forces to block Russian expansion. The threat posed by the Soviet Union during the Cold War was far graver than the threat posed now by the fragmented Islamic world. In the end, the nations there will cancel each other out, and militant organizations will be something the United States simply has to deal with. This is not an ideal solution by any means, but the clock appears to have run out on the American war in the Islamic world.

We do not expect the United States to take this option. It is difficult to abandon a conflict that has gone on this long when it is not yet crystal clear that the Russians will actually be a threat later. (It is far easier for an analyst to make such suggestions than it is for a president to act on them.) Instead, the United States will attempt to bridge the Russian situation with gestures and half measures.

Nevertheless, American national strategy is in crisis. The United States has insufficient power to cope with two threats and must choose between the two. Continuing the current strategy means choosing to deal with the Islamic threat rather than the Russian one, and that is reasonable only if the Islamic threat represents a greater danger to American interests than the Russian threat does. It is difficult to see how the chaos of the Islamic world will cohere to form a global threat. But it is not difficult to imagine a Russia guided by the Medvedev Doctrine rapidly becoming a global threat and a direct danger to American interests.

We expect no immediate change in American strategic deployments — and we expect this to be regretted later. However, given U.S. Vice President Dick Cheney’s trip to the Caucasus region, now would be the time to see some movement in U.S. foreign policy. If Cheney isn’t going to be talking to the Russians, he needs to be talking to the Iranians. Otherwise, he will be writing checks in the region that the U.S. is in no position to cash.

This report may be forwarded or republished on your website with attribution to www.stratfor.com

Gist: Neuroeconomy, neurofinance, behavioral economics and so on… All the fields at the crossroad of cognitive or neuro- sciences and other scientific disciplines are increasingly productive. The academics in these fields seek to understand how the brain is processing the information needed to make a decision. As it turns out, we must do with scores of “Cognitive Biases” that stem from our brain design and shape all of our perceptions and choices.

Impossible to eliminate, hard to even consciously correct, you can no longer ignore them: an increasing proportion of businesses have incorporated them into their decision making processes (ie these processes have been designed to correct any bias). If you don’t do it as well, you will soon lag your competitors.

Origins: Our brain perceives the world around us through heuristics, which are generally helpful but often lead us astray. Think of a heuristic as a shortcut your brain is taking to reach a decision. For example, your eyes send 2 distinct images to your brain, but what you perceive is a single one. It does the same with choices, though, and can mislead us.

At Stake

If you are involved in decisions or choices, you are influenced, often in the wrong way, by these biases. Their knowledge should be required for anyone involved in strategy (at the firm, business unit or small business level). Professionals in finance and asset management should also master this field. In both cases, this is increasingly happening and is now a required element to achieve a leadership position.

Actionable ?: Learn, this is the easy part. Than modify your decision-making processes to account for the known biases and heuristics. Any deep strategic choice or investment decision should be insulated, as much as possible (won’t be 100%), from these.

MORE DETAILS

Origins

Let’s use McKinsey’s Charles Roxburgh introduction to Cognitive Biases:

The brain is a wondrous organ. As scientists uncover more of its inner workings through brain-mapping techniques, our understanding of its astonishing abilities increases. But the brain isn’t the rational calculating machine we sometimes imagine. Over the millennia of its evolution, it has developed shortcuts, simplifications, biases, and basic bad habits. Some of them may have helped early humans survive on the savannas of Africa (“if it looks like a wildebeest and everyone else is chasing it, it must be lunch”), but they create problems for us today. Equally, some of the brain’s flaws may result from education and socialization rather than nature. But whatever the root cause, the brain can be a deceptive guide for rational decision making.

These implications of the brain’s inadequacies have been rigorously studied by social scientists and particularly by behavioral economists, who have found that the underlying assumption behind modern economics—human beings as purely rational economic decision makers—doesn’t stack up against the evidence. As most of the theory underpinning business strategy is derived from the rational world of microeconomics, all strategists should be interested in behavioral economics.

At Stake

We’ll use one example to convince you.

Consider this little experiment, imagining your the President of the US and have to make a choice:

Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimate of the consequences of the programs are as follows:

If Program A is adopted, 200 people will be saved.

If Program B is adopted, there is a 1/3 probability that 600 people will be saved and 2/3 probability that no people will be saved.

Which of the two programs would you favor ?

Now imagine, one year later, you’re faced with another tough choice:

Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimate of the consequences of the programs are as follows:

If Program C is adopted 400 people will die.

If Program D is adopted, there is 1/3 probability that nobody will die, and 2/3 probability that 600 people will die.

Which of the two programs would you favor ?

This is one of the experiments you’ll find in the seminal article in Science by Amos Tversky and Daniel Kahneman (full details in the references) on framing effects. Now, in reality, this experiment was done on different peoples to avoid them seeing that the probability structures are similar. The only difference is in the framing of the choice: problem 1 is framed in terms of gains (lives saved), and problem 2 is framed in terms of losses (deaths). Let’s consider the answers in the actual experiment:

Problem 1: A = 72% ; B = 28% / Problem 2: C = 22% ; D = 78% .

What does this means ? That when we are presented with a choice framed in terms of gains, we tend to be risk-adverse, and when presented with a choice framed in terms of losses, we tend to be risk-seeking. This cognitive bias is actually so powerful that it even makes surgeons choose a different type of operations based on how the probabilities of success are framed when presented to them. You read that well: surgeons will choose to operate you or not, based not primarily on the life and death probabilities but on how they’re framed. If for life and death matters, by highly trained physicians, the framing of the choices make them choose different solutions, ask yourselves how powerful it may be when considering your next business strategy choice (or how this person on your team is presenting the different options available…).

Actionable ?

Simply knowing the common biases is a start but obviously not enough. You have to incorporate them in your business processes. This is what Bridgepoint, a major private equity manager, did for their most important decisions: to invest or not in a deal.

When considering a major investment decisions, managers tend to discuss among them and to reach a consensus on what’s the best choice. This leaves them vulnerable to a number of cognitive biases such as groupthink, the confirmation bias, overconfidence, pseudocertainty effect, etc.

To counteract this, Bridgepoint’s investment process has been designed to minimize their effect. For each deal, they hold their meeting in “court room” mode, with two sides: the proponent of the deal and the devil’s advocate. The proponent is a partner supporting the investment. The devil’s advocate is another partner randomly chosen and tasked to convince the others NOT to invest in the proposed deal. The two sides have equal air time and the remaining partners may question them before voting. Of course, the devil’s advocate is actually judged and has objectives on how well he does a job essentially destroying the investment thesis.

This results in a brilliant way of taking decisions over major investments. One that should be followed even within large corporations on material investment decisions.

Example(s)/Exhibit(s)

I won’t go in details here. Instead, here are some resources where you’ll find scores of interesting and entertaining examples:

• Roxburgh. Hidden flaws in strategy. The McKinsey Quarterly (2003) (2): provides a nice business intro
• Lovallo et al. Distortions and deceptions in strategic decisions. McKinsey Quarterly (2006) (1): good follow-up with Dan Lovallo, an academic on the subject
• List of Cognitive Biases: wikipedia page listing the different cognitive biases, good reference list but each page is a bit light
• Kahneman et al. Delusions of success: How optimism undermines executives’ decisions. Harvard business review (2003) vol. July: very good as well
• Horn et al. Learning to let go: making better exit decisions. McKinsey Quarterly (2006) (2): good use case for a specific situation
• Horn et al. Beating the odds in market entry. McKinsey Quarterly (2005) (4): same for another case
• Predictably Irrational, Dan Ariely, 2008: great “entertaining” book by a top scholar. Start with this one if you like behavioral economics.

References

More on the academic side:

• Kahneman et al. Prospect theory: an analysis of decision under risk. Econometrica (1979) vol. 47 (2): seminal but not so easy
• Tversky et al. The Framing of Decisions and the Psychology of Choice. Science (1981) vol. 211 (4481) pp. 453-458: seminal and easy to read
• Maps of bounded rationality, Daniel Kahneman’s Nobel Prize lecture: very good and easy
• Judgment under Uncertainty: Heuristics and Biases, Daniel Kahneman (editor)
• Choices, Values, and Frames, Daniel Kahneman and Amos Tversky (editors)
• All the works of Daniel Kahneman, Amos Tversky, Colin Camerer, Dan Ariely, Georges Lowenstein, Drazen Prelec, etc. (google them!)

More MP ? Resources page. Suggestions, corrections ? Comment and I’ll update.