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Good Reading -- June 2010

Happy reading and happy Friday.


  1. If you liked Jared Diamond's books like I did, you'll probably like "The Rational Optimist" too. Interesting article referencing it here. Another one pasted at the very bottom ("Humans: Why They Triumphed").


According to fund research firm Dalbar, "Over the last 20 years [ended December 31, 2009] the average stock fund investor has had annualized returns of only 3.2 percent, compared with 8.2 percent for the Standard & Poor's 500 stock index." Most of that shockingly large difference is due to ill-timed buying and selling, according to the researcher, although certainly transaction costs also play a large role.


  1. May 2010 article by James Montier -- excellent as always.


  1. (3x) "Baupost's Klarman Sees Poor Outlook for Stocks," "Klarman: Why Investing is Like Chess" and "Legendary Investor is More Worried than Ever" -- very interesting for several reasons, namely that Klarman is (in my humble opinion) among the very best investors the world has to offer, and also that he rarely speaks in public, let alone with such stark pronouncements. Granted, he's normally pretty concerned and skeptical, if not outright bearish, but this is still fairly strong commentary.

  2. "Oil ETF Shares Go Nowhere as Crude Price Doubles" (chart attached) -- just another warning about the major dangers inherent in many of the ETFs floating around out there. As many have painfully learned in the index ETF market, using futures/forwards/derivatives of all kinds often lead to dramatically different results from those assumed or intended.

  3. Interview with Convicted (Financial) Felon Sam Antar (via Simoleon Sense) -- pretty interesting on a range of topics.

  4. "Carol Dweck's Attitude" -- I agree with Dweck's ideas and theories (namely, that "grit" matters and that people do best if they believe in their own control over thier behavior and their own responsibility for outcomes), although the nascent studies' results are mixed and it can obviously be taken too far. Still, interesting implications for parents, educators, and policymakers.

  5. "Easy Money, Hard Truths" -- a worthwhile David Einhorn essay on the fiscal and monetary challenges we face.

  6. "Bernie Madoff, Free at Last" (link only) -- a bizarre, and poorly written, look into the sick world of ultra fraud and prison culture.

  7. Buffett and Gates' request of their fellow billionaires (link only) -- the $600 Billion Challenge

  8. A sad-because-it's-true Monty-Python-style financial commentary.

  9. A timely reminder that the equity market can -- and indeed has -- bounced around without really going anywhere for years or even decades at a time.

Baupost's Klarman sees poor outlook for stocks

Tue, May 18 2010

* Klarman sees no gains for stocks this decade

* Klarman looking for commercial real estate bargains

* No plans to reissue coveted investing guide he wrote (Adds comment on book, background on Baupost)

BOSTON, May 18 (Reuters) - Star hedge fund manager Seth Klarman sees few bargains in the current environment and predicted on Tuesday that the stock market could suffer another lost decade without any gains.

"Given the recent run-up, I'd be worried that we'll have another 10 years of zero returns," Klarman, who rarely speaks in public, said at the CFA Institute's annual conference in Boston.

Current market conditions remind Klarman of a Hostess Twinkie snack cake because "everything is being manipulated by the government" and appears "artificial."

"I'm more worried about the world broadly than I've ever been in my whole career," Klarman said.

Klarman has 30 percent of assets at his $22 billion Baupost Group in cash, he said. He started the firm in 1982 with $27 million and has averaged 20 percent annual gains ever since. In 2007, amid the depths of the credit crash, Baupost had its best year, gaining 52 percent.

Inflation is a risk that Klarman said he is particularly concerned with given the government's high rate of borrowing to bail out the financial system. Baupost has purchased far out-of-the-money puts on bonds to hedge the risk, he said.

The puts, which Klarman said he viewed as "cheap insurance," will expire worthless even if long-term interest rates rise to 6 or 7 percent. But if rates rise to 10 percent, Baupost would make large gains, and if rates exceed 20 percent the firm could make 50 or 100 times its outlay.

Typically, Baupost focuses on out-of-favor stocks and bonds. Klarman cleaned up in 2007 and 2008 buying distressed debt and mortgage securities that later recovered.

One area Klarman said he is currently scouring for potential investments is private commercial real estate below the top quality. Publicly traded real estate investment trusts, however, have "rallied enormously" and are "quite unattractive," he said.

Copies of Klarman's long out-of-print investment guide, "Margin of Safety," sell at auction for $700 or more. Klarman said on Tuesday he has "no immediate plan" to reissue the book published in 1991 because he does not have enough free time to update it or even to write a fresh introduction. (Reporting by Aaron Pressman, editing by Matthew Lewis)

Klarman: Why Investing Is Like Chess

The deluge of government intervention has thrown a new level of complexity into the system. Anyone rushing to buy more shares or high-yield bonds should think twice, argues Baupost's Seth Klarman.

Investing, says Seth Klarman, used to be like checkers. Now it's like chess–a lot more complicated.

Mr. Klarman runs Baupost Group, a Boston-based investment firm with about $22 billion under management. For the uninitiated, he's a conservative value investor and one of the most highly regarded in the market. He doesn't share his market insights that often, so when he does it's worth listening. Tuesday morning he spoke at a conference for financial industry professionals at the CFA Institute in Boston, in a session hosted by my colleague Jason Zweig.

On the issue of checkers or chess, Mr. Klarman said he was trying to illustrate the way successful investing today involves complicating new factors and dimensions.

In particular, he is looking at the deluge of government interventions to prop up the financial system in the past couple of years and what those may mean down the road. And he is talking about the danger–not a certainty, merely a danger–that governments around the world will trash their currencies in a continuous free-for-all of "handouts and no taxes." The near-$1 trillion bailout in Europe is just the latest worry.

Where does this leave the ordinary investor?

Anyone rushing to throw more money into shares or high-yield bonds today should think twice. And anyone with a lot invested, especially if they are risk averse, might want to think about taking some chips off the table. Mr. Klarman warns that asset prices have risen too far, too fast, and returns from these levels may be poor. "Given the recent run-up, I would worry that we will have another 10 to 12 years of zero or nearly zero returns," he said. His firm is holding a remarkable 30% of its assets in cash.

On high-yield bonds, Mr. Klarman's group found terrific bargains during the financial crisis but that window has long since closed. "The rally's been indiscriminate," he said. "On the credit [i.e. bond] side it's been overblown. Things are now being priced for almost perfection." (In other words, the prices are already assuming rosy future scenarios. If things get worse investors will be in trouble.)

Most investors, Mr. Klarman warns, have rushed to embrace risk again as if the financial crisis never happened. "The lessons haven't been learned," he said. "People are back drinking the Kool-Aid again. It's very troubling." By keeping interest rates low and juicing stock markets with liquidity, the government is basically pushing people to speculate, he said. If there were another serious collapse, he said, many investors would be caught out–again.

On the macroeconomic outlook, Mr. Klarman is remarkably gloomy–even by the usual standards of conservative value managers. "I'm more worried about the world, broadly, than I have ever been in my career," he says. Governments are spending, borrowing and printing money far too freely. Whereas the Great Depression generation learned to live within their means, the Great Recession generation is taking the easy way out, he says. The Greek bailout is just the latest example. Inflation looks like the easy way out. "It's not clear that any currency is all that trustworthy," he says. "I worry about paper currencies."

He goes further, mistrusting some official data and actions. "We don't know the extent to which we have been manipulated," he says. He believes the official figures–particularly on inflation–are suspect. "We are being lied to."

Such sentiments have led to a stampede for gold, of course. But Mr. Klarman repeated cautions he has made before about investing in all commodities, including gold: They generate no cashflow, and so they are extraordinarily tricky to value.

Gold has also just hit new highs, he added. That should make value investors–who tend to look for assets that are on sale–very nervous.

Instead, to insure his clients' portfolio against the dangers of runaway inflation he has been using complex derivatives. Baupost, says Mr. Klarman, has been buying "out of the money" put options on long-term government bonds. These are bets that long-term interest rates will eventually rise sharply. Mr. Klarman says he is using the put options to buy cheap insurance in case long-term interest rates go into double-digits.

These things are far too abstruse for most ordinary investors, though perhaps not for the sophisticated. It's a shame that very few mutual funds open to the ordinary public are able to take these kinds of sensible steps.

So where does Mr. Klarman see opportunities for investors now? Very few, it seems. He said his firm is finding some bargains in the distressed area of commercial real estate. But he warned these were just in the private market: Publicly traded Real Estate Investment Trusts that invest in commercial real estate have mostly risen too far for his tastes, and offer poor value.

Investors always want to know what a sage like Seth Klarman thinks about assets today, but his most valuable advice is perennial. "We are highly opportunistic," he says. "I will be buying what other people are selling. I will be buying what is loathed and despised."

Hmmm. Europe, anyone?

Legendary Investor Is More Worried Than Ever


Seth Klarman is worth listening to, especially when markets go mad.

Mr. Klarman is president of the Baupost Group, an investment firm in Boston that manages $22 billion. His three private partnerships have returned an annual average of around 19% since inception in 1983—and nearly 17% annually over the past decade, as stocks went nowhere.

To measure Mr. Klarman's importance as an investor, you need only see the value his rivals place upon his words. You could have earned at least a 20% average annual return since 1991—better than twice the performance of the market—merely by buying and holding Mr. Klarman's book, "Margin of Safety": Published that year at a cover price of $25, hard copies now fetch up to $2,400.

But the professorial Mr. Klarman speaks in public about as often as the Himalayan yeti. He made an exception last Tuesday, when I interviewed him in front of a standing-room-only crowd of 1,600 financial analysts at the CFA Institute annual meeting in Boston. He then made another exception, speaking with me over the phone later to clarify points that he feared had been misconstrued.

Mr. Klarman specializes in buying securities that nauseate other investors. As the credit crisis exploded, he put more than a third of his assets into high-yield bonds and mortgage-related securities. I asked him what he had meant, in a recent letter to his clients, when he compared the financial markets to a Hostess Twinkie. "There is no nutritional value," he said. "There is nothing natural in the markets. Everything is being manipulated by the government." He added, "I'm skeptical that the European bailout will work."

Some members of the audience gasped audibly when Mr. Klarman said, "The government is now in the business of giving bad advice." Later, he got more specific: "By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can't stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate."

"We didn't get the value out of this crisis that we should have," Mr. Klarman told the audience. "For our parents or grandparents, it was awful to have had a Great Depression. But it was in some ways helpful to carry a Depression mentality throughout their later lives, because it meant they were thrifty with their money and prudent in their investment decisions." He added: "All we got out of this crisis was a Really Bad Couple of Weeks mentality."

You could have heard a pin drop as Mr. Klarman proclaimed, "I am more worried about the world, more broadly, than I ever have been in my career." That's because you can make good investing decisions and still end up with bad results if you reap your profits in currencies that do not hold their purchasing power, he explained.

"Will money be worth anything," asked Mr. Klarman, "if governments keep intervening anytime there's a crisis to prop things up?"

To protect against that "tail risk," said Mr. Klarman, Baupost is buying "way out-of-the-money puts on bonds"—options that have no value unless Treasury bonds plummet. "It's cheap disaster insurance for five years out," he said.

Later, I asked Mr. Klarman what he would suggest for smaller investors who share his worries.

"All the obvious hedges"—commodities and foreign currencies, for example—"are already extremely expensive," he warned.

Especially gold. "Near its all-time high, it's a very hard moment to recommend gold," said Mr. Klarman.

Mr. Klarman pointed out that his own ideas "on bottom-up opportunities in undervalued securities are more likely to be accurate than my top-down views on what's going to happen in the world at large." In other words, while you might want to insure against a disaster scenario, you shouldn't bet the ranch on it.

And, said Mr. Klarman, one of the best ways to protect against a decline in purchasing power is to buy whatever is "out of favor, loathed and despised." So forget about gold or other trendy hedges. Instead, wait patiently for markets—European stocks, perhaps—to get so cheap that they turn most investors' stomachs. Then you can pounce.

As Mr. Klarman put it, "Sometimes, when you can't figure out a good defense, the best thing to do is to go on offense."

Oil ETF Shares Go Nowhere as Crude Price Doubles: Chart of Day

2010-05-19 14:24:09.782 GMT

By David Wilson

May 19 (Bloomberg) -- U.S. Oil Fund LP’s investors have almost nothing to show for a 17-month rally in crude oil, which the exchange-traded fund is designed to track.

The CHART OF THE DAY compares the ETF’s share price with oil’s price in New York trading since Dec. 19, 2008, when crude fell to a four-year low of $33.87 a barrel. Oil was still more than double that price yesterday, when it settled at $69.41 a barrel, after tumbling as much as 20 percent this month.

U.S. Oil Fund rose only 1.2 percent during the same period, and even that relatively small gain may be fleeting. Before U.S.

exchanges opened today, shares changed hands for as little as $32.85, below its $33.06 close on the day oil set its low.

The ETF "is so far off the mark that it is almost criminal," Niels C. Jensen, managing partner of Absolute Return Partners LLP, wrote earlier this month in a letter to the fund manager’s clients.

Jensen, whose letter was titled "The Commodities Con,"

attributed the gap to the fund’s reliance on futures contracts to invest in crude. Futures prices usually rise as the time to delivery lengthens, a pattern known as contango. As a result, the fund suffers from negative roll yield, or losses tied to selling futures as they expire and buying later contracts.

Precious-metals ETFs typically don’t have this handicap because they own the underlying metal, rather than futures. The SPDR Gold Trust, for example, rose 31 percent in the 12 months ended yesterday. The fund’s shares climbed 0.3 percentage point more than gold futures traded in New York.

GuestPost: Fraud Girl Interviews Famous Financial Felon Sam Antar

May 9, 2010 No Comments

Hello Again –

On Monday, I had the pleasure of speaking with Sam E. Antar, the former CFO of Crazy Eddie who, in the 1980s, helped mastermind one of the largest securities frauds of its time. He eventually pleaded guilty to three felonies: conspiracy to commit securities fraud, conspiracy to commit mail and wire fraud, and obstruction of justice.

The following conversation involves a series of questions relating to fraud investigation and the misconceptions of white-collar criminals.

Do you have any additional questions for Sam Antar? Send me an email at fraudgirl [at]

See you next week…

-Fraud Girl

Copyright 2010 Fraud Girl @ SimoleonSense

You mention the quote “It takes one to know one” on your website and on your blog. Most people in the fraud catching industry are honest and good people. How can honest people shield themselves from believing the lies of these criminals?

It’s hard because you don’t know what a lie is until you’ve been exposed to it or until you’ve done it, and hopefully you don’t get exposed to it. Let me just say this. To discuss crime I have to be a little bit politically incorrect, so don’t get offended, alright?

Females for instance. Females are lied to more than men. It’s just a fact of the matter. Think of it this way, if you’ve gone out on dates with more than one guy, how many guys have told you anything, “You’re beautiful, you’re lovely, you’re smart, you’re intelligent. I want to spend the rest of my life with you”? No sex. Just to get to first base. I’m not saying you specifically; you can ask a lot of females that. Again, I’m not trying to be male chauvinist but that’s just the way it is.

Criminals themselves are charmers. We use deceit and charm to get what we want. In a lot a ways criminals are like some of the females I’ve had in my life too, they used deceit and charm.

Most of the forensic accountants I know are females. Generally speaking female forensic accountants, barring the fact they’re not criminals, are generally better than males. Women by nature are much more cynical and skeptical than men because women are taken advantage of in many ways in our society more than men.

I don’t know if you know Tracy Coenen, she writes on Fraud Files blog. She’s probably one of the best in the business. The only handicap she has is that she’s not a criminal, former criminal, ex-criminal, or retired criminal. I travel a lot and I meet a lot of people, and I find that generally females are just better forensic accountants because they’ve experienced being lied to more often than men.

If you lead a life where you live in a bubble, how can you expect to catch the crooks? At the next level up, who better then the people who commit the crimes?

Drug addicts, for example, are either in recovery or they are active, but they’re always drug addicts. And the best drug counselors are former addicts. If you take it one level further, the government does a lot of work with convicted felons. I do a lot of work for them. The government also uses criminals to help catch other criminals. It’s not very well publicized; the only movie that was ever done about it was “Catch Me If You Can”. But it’s kind of like a partnership between former evil and justice against current evil.

How can people go acquire the experience to really understand financial criminals? Do courses help? Is it just real life experience? What will help forensic accountants get through it?

It’s a combination of both. For example, The Going Concern blog recently did a thing about what is takes to become a forensic accountant. The problem is before you even get to the skill set necessary to be a good forensic accountant you need to get a double set of iron clad balls and triple thick skin because criminals fight back. We don’t play fair. We have no respect for you. We have no respect for your laws. We don’t have respect for your customs. In fact, your laws and customs make it easier for us to commit our crimes. It’s a paradox. The more humane the society is, the easier it is for criminals to commit their crimes. Humanity limits your behavior but it doesn’t limit our behavior because we’re immoral human beings.

You have to understand that to combat criminality, you have to have that set of iron balls. The rest of the stuff, double-check this, cross check that; that’s textbook stuff, anybody could learn it. What you’re asking me is, “Well how do we do it?” There are some people that are just wired in to do it. And again, I’m not trying to appear male chauvinist but if I am I don’t care anyway. But the point is that females are more, as a group, generally more wired to be forensic accountants, than men are. So if you know any females that are former criminals, or retired criminals they would make the best forensic accountants. And they would have the combination of on hand experience and genetics.

Why is our society built upon the “innocent until proven guilty”, “benefit of the doubt”, “trust and then verify” mentality?

Judeo-Christian traditions. It’s wired into us from our religion. It’s wired into our legal system. And that’s what makes America great. The problem that we have here is, the criminals don’t care about that. I don’t want to sound like a Fascist, or a Communist, or a Totalitarian; I’m not. I’ll leave the politics up to the politicians and the people that made the elections. But in the pure sense of stopping crime, in the pure sense of preventing crime…we have to make some very serious choices about how much freedom we have as a society. Otherwise we are going to have to tolerate a certain level of crime and hope that we can catch it.

People want to go after terrorists. People want tougher laws against money laundering. People want all kinds of things but when you put those laws together, there are also invasions of privacy that other people cry about. For instance, I am for profiling. I’m not for only profiling minority groups; I’m for profiling everybody. Because I believe that profiling helps prevent crime. But we as a society don’t want to do that because nobody wants to be labeled as a bigot or racist or an anti-Semite or whatever. Profiling is very, very, very important in trying to catch criminals.

In reading “No One Would Listen” by Harry Markopolos, I realized that there is some sort of persona that is given off by these criminals (i.e. Bernie Madoff). A 30-minute review of Madoff’s documents would have proven fraud — it’s not difficult. But who he was as a person completely took that away.

If you look at my blog and go to the Media Mentions tab. Look at the post on CFO Magazine, by Sarah Johnson on March 1st. It’s called “Now You Don’t See It”. I’ll read you the first paragraph:

“Auditors are less likely to find manipulated earnings when management directs their attention away from areas of financial statements that contain errors. Distraction and deception go hand in hand, whether in a magic act or at a dishonest company. Sam Antar, the ex-CFO of electronics retailer Crazy Eddie, kept auditors away from the company’s fraudulent practices in the 1980s in part by having his staff distract them with constant small talk and invitations to coffee and lunch.”

I actually did worse than that. I was a fraudster, matchmaker, and a pimp. The point being is distraction. Magic doesn’t really exist. We all know that you can’t really do magic. But what is magic really based on? Magic is based on distraction. Distracting somebody’s attention from something that is really going on. Small talk is very, very important. It distracts people. You see how politicians change the subject? That distracts people. We see how they argue on TV more about personalities than policy. That’s distraction. There are many ways to distract people. The easiest way to distract somebody is really with a smile because with a smile people increase their comfort level because you appear friendly to them. You appear charming to them.

The three rules of criminality: white color criminals consider your humanity as a weakness to be exploited in the execution of their crimes, we measure our effectiveness by the comfort level of our victims, and in order to increase our victim’s comfort level we have to build walls of false integrity around ourselves.

When we look at humanity with the presumption of innocence until proven guilty, that’s a Judeo-Christian tradition. That is giving somebody a benefit of the doubt. When you give somebody the benefit of the doubt, the criminal has the freedom of action. Your ethics limit your actions. It might make you into a better person, but it also makes it easier for criminals that commit their crimes.

The second part is comfort level; criminals measure their effectiveness by the comfort level of their victims. What did Bernie Madoff do? He was the president of NASDAQ, he was involved in a lot of so-called reform and regulation. People were comfortable with Bernie Madoff.

The third thing is that criminals build walls of false integrity around them to increase the comfort level of their victims. You got Bernie Madoff again, being the president of NASDAQ. These combinations set the stage for most of the crimes.

Colleges don’t teach people how they’re going to get screwed. They teach people how to succeed. Society doesn’t teach people how they’re going to get screwed. We don’t teach people what happens when the shit hits the fan (excuse the language).

We teach people how to earn a living and how to become better in their careers. We teach people more on a positive end but we don’t teach people too much on the defensive end. That’s something you learn from the streets. That’s the unfortunate part that we have today. We don’t have enough studies on criminal psychology.

We learn about psychology in general. Pavlov the dog, throws the food in front of the dog, saliva comes out of his mouth. It’s like a reflective instinct, or whatever.

We don’t know enough about the criminal psychology and how criminals play on your humanity. An example of the way that we play with your humanity is found in the movie, “The Devil’s Advocate.” See the movie “The Devil’s Advocate” with Al Pacino. The devil’s favorite sin is vanity. We all have vanity. We criminals really make you feel good about your self-esteem in many cases. “You’re smart. You’re beautiful. You’re a great investor. You’re smart enough to make this decision”.

White collar crime is psychological warfare. Most of it’s really done on the personal level and the major problem I see is not so much the techniques. Anybody can learn them. The problem is applying those techniques and part of applying those techniques is to get into the psychology of criminals so you can become more skeptical and cynical.

For most people, including myself, the first instinct is to trust the person. But it seems that we cannot put trust in anyone.

You should not trust anyone. I’m not saying to be a paranoid. For the professional world, you should not trust anyone. You know, let’s apply implied credibility here. I’ve taught the FBI, IRS, the Secret Service, Fortune 500 companies. And I’ve taught the Department of Defense. That’s implied credibility. Does that mean Sam Antar is not a crook? Do you understand? It doesn’t mean anything. I could use that implied credibility to scam even more people (and I’ve been accused of it by other scammers I’ve written about in my blog). Just because I do work for the government, and I do plenty of it, does that still mean I’m not a crook today? Of course not. If I tell you that I’m not a crook today, you should not believe me. Never take anything for face value.

Another concept is something called unexamined acceptance. Unexamined acceptant is you watch TV; you watch Fox news or CNN or MSNBC. You believe all the bullshit from the left, right, and the middle…everything they tell you. It may not be true. People do not independently verify information that they receive.

That’s one thing in education that I think is a huge problem. Everything is handed to you and it’s said to be right.

You can’t measure the kind of intellect you need to be successful, it’s very difficult, and it’s not black or white. It’s very subjective. We’re not teaching people, unfortunately, to think. How do you test somebody’s street instincts? It’s difficult. Criminals (1) don’t abide by laws (2) don’t care about you (3) they have the street instinct and (4) they have the same formal education you do.

They have a one up on us.

Actually it’s like going to bat in baseball with a 0 and 2 count no ball and two strikes and then you go to the plate. The criminal is the pitcher. That’s the problem we have.

It’s a huge problem. The cases I’m looking into are getting bigger and are getting worse…

You’re seeing most of these cases now because of a faltering economy. If the economy were good you wouldn’t even have known who Harry Markopolos was. He would still be writing letters to the SEC and they would still be ignoring him. Most crime is discovered only after it implodes.

In regards to why criminals perform the act. It’s usually about making more and more money. Do they stop and think, “I might get caught?”

Let me ask you this. Are you planning on not succeeding in what you’re doing? Are you going to school? Do you have a job?

I am planning on succeeding.

Yes, but are you planning on not succeeding?


Then why should criminals be any different?

To understand criminality, take the morality out of the equation. How many people open up small businesses every year. And how many people fail within the first 5 years? We know the risks involved and we take some precautions against that risk, in a very substantial way. Most of us, including criminals, are in denial of those risks. You’re thinking doing this interview, or writing your blog, etc. Criminals think in the same terms, just without morality. It’s just a project, it’s just another thing to do. It’s just regular business. Criminals have to enjoy work just like law-abiding citizens do. As a criminal, I enjoyed screwing other people. I wanted a rewarding criminals career. I’m not saying it to be arrogant. I’m saying it to explain to you that the criminal mind is really not much different than the regular mind if you take the morality out of the equation.

Do you think it’s pure arrogance? i.e. that they are more intelligent than the average person and they know they can manipulate them?

Average people are arrogant too but criminals have that combination of arrogance and high level of confidence that’s much more unique than an arrogant confident CEO of a company. So criminals have generally higher levels of arrogance or at least equal level of arrogance to some successful law abiding citizens but they have a much higher confidence level in accomplishing what they are planning to do. If the crimes were easy, then everyone would do it.

There are two types of crooks: the crossover crook and the born crook. The crossover crook is the guy like perhaps, Bernie Madoff. He had a few bad quarters and he tried to make it up by taking money from new investors to pay old. Circumstances made him a crook.

You have the other type of crooks. Organized white collar crime criminal groups…similar to the Mafia. The Mafia in New York is mostly of one heritage. When you have organized crime groups like that (and this is important) that shares the same ethnicity, same race, same religion, same social background. These are very highly cohesive groups who know how to effectively cover up their crimes and coordinate their communications with the outside world. Generally speaking, these are groups of people that were born into it. I was born into it. So these are the moral lethal combinations of criminals and too often we look at these kinds of groups in terms of violent crime and not enough in terms on non-violent white-collar crime.

And do you think that most of the criminals are more crossover crooks or born crooks?

I don’t have a statistic on it but the more successful criminals are the born criminals, not the crossovers, because the crossovers weren’t planning on a career in criminality. And try not to blame the circumstance. Everybody loves to play the victim game. We all live with some sin and temptation. Nobody in the world is without sin and temptation. Given the right set of circumstances, a lot of people could become criminals if the circumstance dictated.

Likewise, we have the born crooks that are basically bred to be criminals. By the time I got to college, they were paying me off to go to college because they wanted to get into more sophisticated crimes, my family. And then I ended up working for the accounting firm. The small accounting firm I was working for, when I had my CPA license, I was auditing Crazy Eddie’s books too. I was trained to be a crook from day one. And these are the more lethal crooks.

I know that auditors, analysts, and investors are asking the wrong questions. What questions should they be asking?

We don’t train people how to ask questions, who they ask them of, and how to handle the bullshit answers of criminals. Case in point, SEC with Bernie Madoff. Even if they asked the right questions, they didn’t even know how to handle his bullshit answers. They didn’t follow through.

We have to start teaching people the art of the interview. How to really do an interrogation. Interrogations are not like what you see on TV. The interrogation of the white-collar criminal is a series of interviews where they ask, in effect, the same question but in 20 different ways. They’re trying to see if you have a consistent reaction to it. Similar to when you can ask a question for a poll one way and get a completely different result if you slightly change the word combination to another way.

Do criminals justify the reasons for their actions?

No. Some people say yes, but I say no. We know right from wrong, come on. You think that me going to some college, that I didn’t know what was right from wrong? We just don’t care.

But there is no sort of rationalization for…

I think rationalization is for sissies, personally.

My latest post related the Lehman Brothers Repo 105 case to the Fraud Triangle. I wanted to see if I could catch them using those three elements. My strongest point was rationalization; because I did think that was the strongest defense they had because technically, they were in accordance with the rules.

It’s an excuse, not a rationalization.

From my point of view, their rationalization for their actions was, “we are in accordance with the rules, and therefore we are okay”.

That’s the cover story for what they did. Not the rationalization for what they did. Let me ask you, what’s incentive?

It’s something that drives you to do something. If you’re going to get paid more, or the stock price is going to go up, that would cause you to have more incentive to commit fraud.

Correct, but not entirely correct at the same time. Every example you gave me involved making more money and the problem that we have as a society, we too often associate incentive with only an economic incentive to commit crime. You can commit an economic crime and have no economic incentive. A guy can commit a crime to get in the sack with a girl or to impress his girl’s friend or to impress his other criminal peers. Criminals can commit a crime for a whole host of reasons of which money is part of the incentive but not the primary incentive. So if you want to take another look at Lehman… think in terms of incentives beyond the obvious signs that may not be there. It may not apply to Lehman but it applies to everyone else.

The second part is opportunity. Most people think of opportunity in terms of lack of internal controls, lack of external controls, lack of oversight, lack of checks and balances. You’re still missing the point. They’re all correct too. But you are the opportunity to allow us to commit the crimes. Your ethics, your gullibility, your lack of skepticism, your humanity, your vanity, your self esteem. We stroke your egos. You on a personal level, give us the opportunity to commit our crimes.

The third part is rationalization. In some cases, in most cases, there’s really no rationalization for the crimes. Criminals come up with excuses but they know what they’re doing and why they’re doing it. They don’t have to do it in most cases and that’s why I disagree with the rationalization concepts.

You can follow Sam Antar @ White Collar Fraud

Carol Dweck's Attitude

It's not about how smart you are

Carol Dweck says colleges could improve their students' learning if they relentlessly encouraged them to think about their mental skills as malleable, rather than as properties fixed at birth.

By David Glenn

Palo Alto, Calif.

Carol S. Dweck says that her graduate students here at Stanford University are hard-working, creative, and resilient in the face of failure. But she wouldn't call them smart.

Over the last two decades, Dweck has become one of the country's best-known research psychologists by documenting the follies associated with thinking and talking about intelligence as a fixed trait.

Most famously, Dweck and her collaborators have demonstrated that praising children for their intelligence can backfire. When young people's sense of self-worth is bound up in the idea that they are smart—a quality they come to understand as a genetic blessing from the sky—at least three bad things can happen. Some students become lazy, figuring that their smarts will bail them out in a pinch. Others conclude that the people who praise their intelligence are simply wrong, and decide that it isn't worth investing effort in homework. Still others might care intensely about school but withdraw from difficult tasks or tie themselves in knots of perfectionism. (To understand this third group, think of the Puritans: They did not believe they had any control over whether they were among God's elect, but they nonetheless searched endlessly for ways to display that they had been chosen, and they were terrified of any evidence that they were not.)

It is much wiser, Dweck says, to praise children for work and persistence. People nearly always perform better if they focus on things they can control, such as their effort, rather than things they cannot.

At the age of 63, Dweck wears an expression of perpetual amusement. She is petite and dressed in black, and after six years at Stanford her general gestalt is still more New York than California. (She was raised in Brooklyn, and she taught at Columbia University for 15 years before coming here in 2004.) Among her many small crusades is this one: She hates when people use "hard working" to signal faint praise in academic letters of recommendation.

"I'd like to change that culture," she says. "'Hard working' is what gets the job done. You just see that year after year. The students who thrive are not necessarily the ones who come in with the perfect scores. It's the ones who love what they're doing and go at it vigorously."

That's one tiny way in which Dweck's theories might change higher education. But she also has grander hopes. Colleges could improve their students' learning, she says, if they relentlessly encouraged them to think about their mental skills as malleable, rather than as properties fixed at birth. No more saying, "I can't major in chemistry because I'm just not wired for math."

Most of the evidence on this point comes from studies of younger students. Dweck herself spends a great deal of time these days acting as a consultant to public schools, especially middle schools. But she and others have also conducted several studies that suggest that college students, too, do better if they think of intelligence as flexible rather than frozen. In the next several years, Dweck hopes to develop a program that would train entering college students to adopt a "growth mindset," in regard to not only their intelligence but also their emotions.

The science here is not settled, however. Three recent studies have found that college students' beliefs about intelligence are not correlated with their academic performance—at least not in the straightforward way that Dweck's model proposes. The authors of those studies say they admire Dweck's work, but they are less hopeful than she is that college students' performance can be turned around with a simple intervention.

By her account, Dweck's own performance as a student was enthusiastic. When she arrived at Barnard College, she had a hard time settling on a major because she was enthralled by all of her courses.

"I loved everything," she says. "I loved sciences and I loved humanities. But ultimately I felt that in the humanities—you know, you're writing about things that already exist. But in the sciences you're discovering things that no one has known before. Ultimately I chose psychology because it seemed to combine science with things that I liked to think about. And I liked the idea that you could wonder about something, run an experiment, and have an answer a few months later."

What Dweck has wondered about for the last 40 years, more than any other single question, is how people cope with failure. In graduate school at Yale University, she became intrigued by Martin E.P. Seligman's model of "learned helplessness." In a famous series of experiments in the mid-1960s, Seligman and his colleague Steven F. Maier demonstrated that dogs that were subjected to random, uncontrollable electric shocks usually became helpless over time. That is, even if they were moved into an environment in which they could prevent the shocks by pressing a lever or doing some other trick, the dogs never learned to do so. The experience of random punishment had rendered these dogs passive, and immune to classical Pavlovian conditioning.

The Seligman experiments had a huge impact in psychology—but most of the early studies of learned helplessness in humans had to do with depression. Dweck went down a different road: She wondered if learned helplessness might interfere with students' academic performance.

To test that idea, Dweck asked a few dozen New Haven fifth graders to rearrange four colored blocks so that they matched the patterns shown on a set of cards. Such blocks are a staple of children's IQ tests, and they typically have two red sides, two white sides, and two sides that are diagonally split between red and white.

But in this case Dweck had rigged the game.

Each fifth grader was brought individually to a table with two amiable experimenters, whom we'll call Alice and Bob. The two experimenters alternated the presentation of the block problems according to a random sequence. For each of her problems, Alice gave the child a normal set of blocks. But Bob gave the child blocks with too many diagonally split sides—which meant that his problems were impossible to solve. Somewhat like the dogs in Seligman's experiments, Dweck's fifth graders were subjected to uncontrollable failure at random intervals.

Each child worked away at more than 30 of these problems—often solving Alice's, but never solving Bob's. The child had 20 seconds to do each problem, and he had some motivation to get them right. For each correctly solved problem, he was given a chip; with enough chips, he could choose from a pile of toys visible across the room.

At the end of the process came a twist. For the last two rounds, Bob quietly switched to a normal set of blocks and gave the child problems that he or she had successfully solved earlier in the experiment. (The patterns were rotated 90 degrees, so they may not have been immediately familiar to the child.)

Some of the children failed to solve these problems—or took much longer than usual to get them right—even though they had solved them correctly just moments earlier. These children seemed to have consciously or unconsciously persuaded themselves (not without reason) that they could never solve Bob's problems. Like Seligman's helpless dogs, they did not seem to notice or take advantage of the fact that their environment had become controllable. But other children did fine, solving Bob's last two problems with no apparent trouble.

It turned out that the children's performance on those last two problems was strongly predicted by their answers on a psychological questionnaire that Dweck had given them beforehand. The questionnaire, known as the Intellectual Achievement Responsibility Scale, is designed to determine whether a person credits or blames his own behavior for his academic results, or whether he attributes those outcomes to external agents. ("The teacher had it in for me" versus "I didn't study hard enough." Or "the instructions weren't written clearly" versus "I didn't read the instructions carefully.")

The fifth graders whose answers had been at the individual-responsibility end of the scale tended to do well on Bob's last two questions. By contrast, those who said they credited or blamed others were the ones who behaved helplessly when Bob's questions suddenly became soluble.

The questionnaire, which was originally designed by other scholars in 1965, doesn't have right or wrong answers, exactly. Sometimes in life the teacher really does have it in for you; sometimes the instructions really aren't written clearly; sometimes the colored-block problems are rigged. But like many other psychologists, Dweck believes that on the whole, people do best if they believe in their own control over their behavior and their own responsibility for outcomes. Her colored-block experiment was significant because it demonstrated that children who attribute responsibility for their academic performance to others seem to be vulnerable to learned helplessness.

In the real world, outside of mildly sadistic experiments like Dweck's 1971 block study, how and why do some children acquire that kind of helplessness? In many cases, Dweck believes, it is because children grow up hearing parental chatter—"Smart girl!" and "You're so good at math!"—that conveys the idea that intelligence is a fixed, innate quality, and therefore that they ultimately don't have much control over their academic successes and failures.

In a landmark series of studies with Claudia M. Mueller during the 1990s, Dweck demonstrated that praising children for their intelligence, rather than for their effort, often leads them to give up when they encounter setbacks. Such children tend to become preoccupied with how their performance compares with that of their peers, rather than with finding new strategies to improve their own work.

"In the nineties, the self-esteem gurus were telling parents and teachers to praise children as lavishly and globally as possible," Dweck says. "But from my research going back 20 years, I knew that it was the children who were overly concerned with their intelligence—who were even trafficking in that concept—who were the vulnerable ones." That element was something that Dweck began to explore in the years after her colored-block study; in a 1978 experiment with Carol I. Diener, Dweck found that children who described their own memory or intelligence in fixed ways were much more likely to give up on a difficult pattern-identification task than otherwise-similar children who did not make such statements.

Dweck and several colleagues believe that they have developed an effective system to help middle-school students avoid that morass and to think of their intelligence as "incremental" rather than fixed. Dozens of public-school systems have signed up to train their students using a program created by Dweck and Lisa Sorich Blackwell, her former student.

Could a similar intervention also work for college students? A few studies suggest that the answer is yes.

The most famous of those, as it happens, was done at Stanford a few years before Dweck's arrival. In the late 1990s, Joshua Aronson, who now teaches psychology at New York University, and two colleagues adopted Dweck's model by asking Stanford students to write letters to local middle-school "pen pals" that encouraged the younger students to persist in their studies. They were encouraged to tell the middle schoolers things like, "Humans are capable of learning and mastering new things at any time in their lives."

The point of this, of course, was to alter the Stanford students' beliefs about intelligence and learning, not the middle schoolers'. Relative to members of a control group, these Stanford students earned higher grades three months later, and were more likely to report that they enjoyed academic work. The effects were especially strong among African-American students, who were overrepresented in the study.

But some other studies of college students have failed to support Dweck's model. In a 2003 study of 93 students at University College London, scholars did not find any relationship between students' academic performance and their beliefs about the nature of intelligence. A similar result has come out of research at Temple University, where two scholars are leading a large National Science Foundation-supported study of student performance in introductory biology and chemistry courses. In the first two semesters of that study, the scholars have found no connection between students' theories of intelligence and their grades.

"We wrote our research proposal thinking that this was a good, solid hypothesis," says Jennifer G. Cromley, an assistant professor of educational psychology at Temple. "So in some ways we're still grappling with these early results."

One potential factor is that Temple is a less-selective institution than the colleges where the best-known previous studies have taken place. So differences among the Temple students' beliefs about intelligence might be swamped, for example, by differences in their baseline knowledge about how to navigate through college life.

"We're doing long interviews that are trying to contextualize the students' experiences," says Cromley's research partner, Erin M. Horvat, an associate professor of urban education. "At Temple, you have kids who say, 'It takes me an hour and a half to get here.' 'I work until 4 a.m.' Those are things we have to keep in our consciousness. Not all of these students are being taken care of by their parents. Not all of them know to visit the professor during office hours. They don't all know how to manage the institutional culture."

A more fundamental challenge to Dweck's model came in a study published online last year in the journal Self and Identity. In laboratory experiments conducted at the University of Michigan at Ann Arbor, scholars found that students with "incremental" beliefs about intelligence do not always behave as optimally as Dweck and her colleagues suggest.

In the Michigan studies, college-age subjects were brought into a computer lab and told that they would take a difficult word-association test. (The test was in fact difficult: In one of the studies, the subjects got an average of 0.86 out of 10 questions correct.) The studies wondered whether students' beliefs about intelligence ("entity" versus "incremental," in Dweck's terms) would affect how long they practiced before taking the test, whether they chose to listen to distracting music while practicing, and how they would explain their low scores after taking the test.

The answer turned out to be: It depends. The Michigan studies divided the incremental theorists (that is, the students who implicitly believed that intelligence is malleable) into two groups: Those whose sense of self-worth was tied to academic performance and those who didn't care so much about school. The latter group—those whose egos were not deeply invested in schoolwork—behaved as Dweck would have predicted. But among students whose self-worth was tied to academic performance, incremental theorists behaved similarly to students with "fixed" beliefs about intelligence. They avoided practicing, and they "self-handicapped."

For example, in one version of the study, the subjects were given either an easy or a difficult sample question from the test before they practiced. If they saw a difficult sample question, the incremental theorists who cared a lot about how they performed academically were more likely than any other group to choose distracting music when they practiced—presumably because they could later blame that distraction for their expected bad performance.

"In some cases, having an incremental theory might actually lead to dysfunctional behavior," says Jennifer Crocker, a professor of psychology at Michigan and an author of the study. "I think Carol is a great scientist, but in her writing you sometimes get the sense that having an incremental theory is a panacea, and it really doesn't seem to be."

Altering students' beliefs about the nature of intelligence may not help much, Crocker says, if they do not also reduce their general ego-investment in schooling. "A glib way of putting it is to say, 'Get over yourself,'" Crocker says. "If you want to stop acting in self-defeating ways, then think about how your schoolwork will help people outside of yourself."

Dweck says she agrees that holding an incremental theory of intelligence, in and of itself, doesn't cure all academic ills. "We now have a much fuller understanding of the mediators of this entire process"—that is, how beliefs about intelligence lead students to choose particular learning goals or to react emotionally to failures and setbacks. Each of those points along the chain, Dweck says, is an opportunity for intervention.

"We can really focus on all of the nodes of the process," she says.

Dweck is now expanding her work on how beliefs about intelligence interact with anxieties about stereotypes among women and people of color. (To some degree, she is filling the shoes of Claude M. Steele, the theorist of "stereotype threat" who recently left Dweck's department to become provost of Columbia.) She and a colleague are studying how a "sense of belonging" contributes to students' willingness to persist in science majors at Stanford.

"We're about to embark on an intervention with Stanford freshmen where we teach them a growth mindset and how to put it into practice," she says. "We're going to try to include their implicit theories about emotion as well as intelligence. Because it's clear that if you have a fixed mindset and you're afraid that you might be failing, you're having all kinds of emotional reactions that could stand in your way."

Humans: Why They Triumphed

How did one ape 45,000 years ago happen to turn into a planet dominator? The answer lies in an epochal collision of creativity. By Matt Ridley


Human evolution presents a puzzle. Nothing seems to explain the sudden takeoff of the last 45,000 years—the conversion of just another rare predatory ape into a planet dominator with rapidly progressing technologies. Once "progress" started to produce new tools, different ways of life and burgeoning populations, it accelerated all over the world, culminating in agriculture, cities, literacy and all the rest. Yet all the ingredients of human success—tool making, big brains, culture, fire, even language—seem to have been in place half a million years before and nothing happened. Tools were made to the same monotonous design for hundreds of thousands of years and the ecological impact of people was minimal. Then suddenly—bang!—culture exploded, starting in Africa. Why then, why there?

The answer lies in a new idea, borrowed from economics, known as collective intelligence: the notion that what determines the inventiveness and rate of cultural change of a population is the amount of interaction between individuals. Even as it explains very old patterns in prehistory, this idea holds out hope that the human race will prosper mightily in the years ahead—because ideas are having sex with each other as never before.

The more scientists discover, the bigger the evolution puzzle has become. Tool-making itself has now been pushed back at least two million years, and modern tool kits emerged very gradually over 300,000 years in Africa. Meanwhile, Neanderthals are now known to have had brains that were bigger than ours and to have inherited the same genetic mutations that facilitate speech as us. Yet, despite surviving until 30,000 years ago, they hardly invented any new tools, let alone farms, cities and toothpaste. The Neanderthals prove that it is quite possible to be intelligent and imaginative human beings (they buried their dead) yet not experience cultural and economic progress.

Scientists have so far been looking for the answer to this riddle in the wrong place: inside human heads. Most have been expecting to find a sort of neural or genetic breakthrough that sparked a "big bang of human consciousness," an auspicious mutation so that people could speak, think or plan better, setting the human race on the path to continuous and exponential innovation.

Ray Bartkus

Trade was the most momentous innovation of the human species; it led to the invention of invention.

But the sophistication of the modern world lies not in individual intelligence or imagination. It is a collective enterprise. Nobody—literally nobody—knows how to make the pencil on my desk (as the economist Leonard Read once pointed out), let alone the computer on which I am writing. The knowledge of how to design, mine, fell, extract, synthesize, combine, manufacture and market these things is fragmented among thousands, sometimes millions of heads. Once human progress started, it was no longer limited by the size of human brains. Intelligence became collective and cumulative.

In the modern world, innovation is a collective enterprise that relies on exchange. As Brian Arthur argues in his book "The Nature of Technology," nearly all technologies are combinations of other technologies and new ideas come from swapping things and thoughts. (My favorite example is the camera pill—invented after a conversation between a gastroenterologist and a guided missile designer.) We tend to forget that trade and urbanization are the grand stimuli to invention, far more important than governments, money or individual genius. It is no coincidence that trade-obsessed cities—Tyre, Athens, Alexandria, Baghdad, Pisa, Amsterdam, London, Hong Kong, New York, Tokyo, San Francisco—are the places where invention and discovery happened. Think of them as well-endowed collective brains.

Trade also gave way to centralized institutions. Around 5,200 years ago, Uruk, in southern Mesopotamia, was probably the first city the world had ever seen, housing more than 50,000 people within its six miles of wall. Uruk, its agriculture made prosperous by sophisticated irrigation canals, was home to the first class of middlemen, trade intermediaries.

As with traders ever since, increasingly it came to look like tribute as Uruk merchants' dwellings were plonked amid the rural settlements of the trading partners in the hills. A cooperative trade network seems to have turned into something more like colonialism. Tax and even slavery began to rear their ugly heads. Thus was set the pattern that would endure for the next 6,000 years—merchants make wealth; chiefs nationalize it.

Agriculture was invented where people were already living in dense trading societies. The oldest farming settlements of all in what is now Syria and Jordan are situated at oases where trade routes crossed, as proved by finds of obsidian (volcanic glass) tools from Cappadocia. When farmers first colonized Greek islands 9,000 years ago they relied on imported tools and exported produce from the very start. Trade came before—and stimulated—farming.

Go even further back and you find the same thing. The explosion of new technologies for hunting and gathering in western Asia around 45,000 years ago, often called the Upper Paleolithic Revolution, occurred in an area with an especially dense population of hunter-gatherers—with a bigger collective brain. Long before the ancestors of modern people first set foot outside Africa, there was cultural progress within Africa itself, but it had a strangely intermittent, ephemeral quality: There would be flowerings of new tool kits and new ways of life, which then faded again.

Recently at Pinnacle Point in South Africa, Curtis Marean of Arizona State University found evidence of seafood-eating people who made sophisticated "bladelet" stone tools, with small blades less than 10 millimeters wide, and who used ochre pigments to decorate themselves (implying symbolic behavior) as long as 164,000 years ago. They disappeared, but a similar complex culture re-emerged around 80,000 years ago at Blombos cave nearby. Adam Powell of University College, London, and his colleagues have recently modeled human populations and concluded that these flowerings are caused by transiently dense populations: "Variation in regional subpopulation density and/or migratory activity results in spatial structuring of cultural skill accumulation."

The notion that exchange stimulated innovation by bringing together different ideas has a close parallel in biological evolution. The Darwinian process by which creatures change depends crucially on sexual reproduction, which brings together mutations from different lineages. Without sex, the best mutations defeat the second best, which then get lost to posterity. With sex, they come together and join the same team. So sex makes evolution a collective and cumulative process in which any individual can draw on the gene pool of the whole species. And when it comes to gene pools, the species with gene lakes generally do better than the ones with gene ponds—hence the vulnerability of island species to competition with continental ones.

It is precisely the same in cultural evolution. Trade is to culture as sex is to biology. Exchange makes cultural change collective and cumulative. It becomes possible to draw upon inventions made throughout society, not just in your neighborhood. The rate of cultural and economic progress depends on the rate at which ideas are having sex.

Dense populations don't produce innovation in other species. They only do so in human beings, because only human beings indulge in regular exchange of different items among unrelated, unmated individuals and even among strangers. So here is the answer to the puzzle of human takeoff. It was caused by the invention of a collective brain itself made possible by the invention of exchange.

Once human beings started swapping things and thoughts, they stumbled upon divisions of labor, in which specialization led to mutually beneficial collective knowledge. Specialization is the means by which exchange encourages innovation: In getting better at making your product or delivering your service, you come up with new tools. The story of the human race has been a gradual spread of specialization and exchange ever since: Prosperity consists of getting more and more narrow in what you make and more and more diverse in what you buy. Self-sufficiency—subsistence—is poverty.

This theory neatly explains why some parts of the world lagged behind in their rate of cultural evolution after the Upper Paleolithic takeoff. Australia, though it was colonized by modern people 20,000 years earlier than most of Europe, saw comparatively slow change in technology and never experienced the transition to farming. This might have been because its dry and erratic climate never allowed hunter-gatherers to reach high enough densities of interaction to indulge in more than a little specialization.

Where population falls or is fragmented, cultural evolution may actually regress. A telling example comes from Tasmania, where people who had been making bone tools, clothing and fishing equipment for 25,000 years gradually gave these up after being isolated by rising sea levels 10,000 years ago. Joe Henrich of the University of British Columbia argues that the population of 4,000 Tasmanians on the island constituted too small a collective brain to sustain, let alone improve, the existing technology.

Tierra del Fuego, in a similar climatic and demographic position, experienced no such technological regress because its people remained in trading contact with the mainland of South America across a much narrower strait throughout the prehistoric period. In effect, they had access to a continental collective brain.

Further proof that exchange and collective intelligence are the key to human progress comes from Neanderthal remains. Almost all Neanderthal tools are found close to their likely site of origin: they did not trade. In the southern Caucasus, argues Daniel Adler of the University of Connecticut, it is the "development and maintenance of larger social networks, rather than technological innovations or increased hunting prowess, that distinguish modern humans from Neanderthals."

The oldest evidence for human trade comes from roughly 80,000 to 120,000 years ago, when shell beads in Algeria and obsidian tools in Ethiopia began to move more than 100 miles from the sea and from a particular volcano respectively. (In recent centuries stone tools moved such distances in Australia by trade rather than by migration.) This first stirring of trade was the most momentous innovation of the human species, because it led to the invention of invention. Why it happened in Africa remains a puzzle, but Steve Kuhn and Mary Stiner of the University of Arizona have argued that for some reason only Africans had invented a sexual division of labor between male hunters and female gatherers—the most basic of all trades.

There's a cheery modern lesson in this theory about ancient events. Given that progress is inexorable, cumulative and collective if human beings exchange and specialize, then globalization and the Internet are bound to ensure furious economic progress in the coming century—despite the usual setbacks from recessions, wars, spendthrift governments and natural disasters.

The process of cumulative innovation that has doubled life span, cut child mortality by three-quarters and multiplied per capita income ninefold—world-wide—in little more than a century is driven by ideas having sex. And things like the search engine, the mobile phone and container shipping just made ideas a whole lot more promiscuous still.

Matt Ridley writes about evolution and genetics. His latest book is "The Rational Optimist: How Prosperity Evolves."

Easy Money, Hard Truths


Are you worried that we are passing our debt on to future generations? Well, you need not worry.

Before this recession it appeared that absent action, the government’s long-term commitments would become a problem in a few decades. I believe the government response to the recession has created budgetary stress sufficient to bring about the crisis much sooner. Our generation — not our grandchildren’s — will have to deal with the consequences.

According to the Bank for International Settlements, the United States’ structural deficit — the amount of our deficit adjusted for the economic cycle — has increased from 3.1 percent of gross domestic product in 2007 to 9.2 percent in 2010. This does not take into account the very large liabilities the government has taken on by socializing losses in the housing market. We have not seen the bills for bailing out Fannie Mae and Freddie Mac and even more so the Federal Housing Administration, which is issuing government-guaranteed loans to non-creditworthy borrowers on terms easier than anything offered during the housing bubble. Government accounting is done on a cash basis, so promises to pay in the future — whether Social Security benefits or loan guarantees — do not count in the budget until the money goes out the door.

A good percentage of the structural increase in the deficit is because last year’s “stimulus” was not stimulus in the traditional sense. Rather than a one-time injection of spending to replace a cyclical reduction in private demand, the vast majority of the stimulus has been a permanent increase in the base level of government spending — including spending on federal jobs. How different is the government today from what General Motors was a decade ago? Government employees are expensive and difficult to fire. Bloomberg News reported that from the last peak businesses have let go 8.5 million people, or 7.4 percent of the work force, while local governments have cut only 141,000 workers, or less than 1 percent.

Public sector jobs used to offer greater job security but lower pay. Not anymore. In 2008, according to the Cato Institute, the average federal civilian salary with benefits was $119,982, compared with $59,909 for the average private sector worker; the disparity has grown enormously over the last decade.

The question we need to ask is this: If we don’t change direction, how long can we travel down this path without having a crisis? The answer lies in two critical issues. First, how long will the capital markets continue to finance government borrowings that may be refinanced but never repaid on reasonable terms? And second, to what extent can obligations that are not financed through traditional fiscal means be satisfied through central bank monetization of debts — that is, by the printing of money?

The recent United States credit crisis was attributable in large measure to capital requirements and risk models that incorrectly assumed AAA-rated securities were exempt from default risk. We learned the hard way that when the market ignores credit risk, the behavior of borrowers and lenders becomes distorted.

It was once unthinkable that “risk-free” institutions could fail — so unthinkable that the chief executives of the companies that recently did fail probably didn’t realize when they crossed the line from highly creditworthy to eventually insolvent. Surely, had they seen the line, they would, to a man, have stopped on the solvent side.

Our government leaders are faced with the same risk today. At what level of government debt and future commitments does government default go from being unthinkable to inevitable, and how does our government think about that risk?

I recently posed this question to one of the president’s senior economic advisers. He answered that the government is different from financial institutions because it can print money, and statistically the United States is not as bad off as some other countries. For an investor, these responses do not inspire confidence.

He went on to say that the government needs to focus on jobs now, because without an economic recovery, the rest does not matter. It’s a valid point, but an insufficient excuse for holding off on addressing the long-term structural deficit. If we are going to spend more now, it is imperative that we lay out a credible plan to avoid falling into a debt trap. Even using the administration’s optimistic 10-year forecast, it is clear that we will have problematic deficits for the next decade, which ends just as our commitments to baby boomers accelerate.

Modern Keynesianism works great until it doesn’t. No one really knows where the line is. One obvious lesson from the economic crisis is that we should get rid of the official credit ratings that inspire false confidence and, worse, are pro-cyclical, aggravating slowdowns and inflating booms. Congress has a rare opportunity in the current regulatory reform effort to eliminate the rating system. For now, it does not appear interested in taking sufficiently aggressive action. The big banks and bond buyers have told Congress they want to continue the current system.

As William Gross, the managing director of the bond management company Pimco, put it in his last newsletter, “Firms such as Pimco with large credit staffs of their own can bypass, anticipate and front run all three [rating agencies], benefiting from their timidity and lack of common sense.”

Given how sophisticated bond buyers use the credit rating system to take advantage of more passive market participants, it is no wonder they stress the continued need to preserve the status quo.

It would be better to have each investor individually assess credit-seeking entities. Certainly, the creditworthiness of governments should not be determined by a couple of rating agency committees.

Consider this: When Treasury Secretary Timothy Geithner promises that the United States will never lose its AAA rating, he chooses to become dependent on the whims of the Standard & Poor’s ratings committee rather than the diverse views of the many participants in the capital markets. It is not hard to imagine a crisis where just as the Treasury secretary seeks buyers of government debt in the face of deteriorating market confidence, a rating agency issues an untimely downgrade, setting off a rush of sales by existing bondholders. This has been the experience of many troubled corporations, where downgrades served as the coup de grâce.

The current upset in the European sovereign debt market is a prequel to what might happen here. Banks can hold government debt with a so-called zero-risk weighting, which means zero capital requirements. As a result, European banks stocked up on Greek debt, and sold sovereign credit default swaps, and now need to be bailed out to avoid another banking crisis.

As we saw first in Dubai and now in Greece, it appears that governments’ response to the failure of Lehman Brothers is to use any means necessary to avoid another Lehman-like event. This policy transfers risk from the weak to the strong — or at least the less weak — setting up the possibility of the crisis ultimately spreading from the “too small to fails,” like Greece, to “too big to bails,” like members of the Group of 7 industrialized nations.

We should have learned by now that each credit — no matter how unthinkable its failure would be — has risk and requires capital. Just as trivial capital charges encouraged lenders and borrowers to overdo it with AAA-rated collateral debt obligations, the same flawed structure in the government debt market encourages and therefore practically ensures a repeat of this behavior — leading to an even larger crisis.

I don’t believe a United States debt default is inevitable. On the other hand, I don’t see the political will to steer the country away from crisis. If we wait until the markets force action, as they have in Greece, we might find ourselves negotiating austerity programs with foreign creditors.

Some believe this could be avoided by printing money. Despite the promises by the Federal Reserve chairman, Ben Bernanke, not to print money or “monetize” the debt, when push comes to shove, there is a good chance the Fed will do so, at least to the point where significant inflation shows up even in government statistics.

That the recent round of money printing has not led to headline inflation may give central bankers the confidence that they can pursue this course without inflationary consequences. However, printing money can go only so far without creating inflation.

Government statistics are about the last place one should look to find inflation, as they are designed to not show much. Over the last 35 years the government has changed the way it calculates inflation several times. According to the Web site Shadow Government Statistics, using the pre-1980 method, the Consumer Price Index would be over 9 percent, compared with about 2 percent in the official statistics today.

While the truth probably lies somewhere in the middle, this doesn’t even take into account inflation we ignore by using a basket of goods that don’t match the real-world cost of living. (For example, health care costs are one-sixth of G.D.P. but only one-sixteenth of the price index, and rising income and payroll taxes do not count as inflation at all.)

Why does the government understate rising costs? Low official inflation benefits the government by reducing inflation-indexed payments, including Social Security. Lower official inflation means higher reported real G.D.P., higher reported real income and higher reported productivity.

Subdued reported inflation also enables the Fed to rationalize easy money. The Fed wants to have low interest rates to fight unemployment, which, in a new version of the trickle-down theory, it believes can be addressed through higher stock prices. The Fed hopes that by denying savers an adequate return in risk-free assets like savings deposits, it will force them to speculate in stocks and other “risky assets.” This speculation drives stock prices higher, which creates a “wealth effect” when the lucky speculators spend some of their gains on goods and services. The purchases increase aggregate demand and lead to job creation.

Easy money also aids the banks, helping them earn back their still unacknowledged losses. This has the perverse effect of discouraging banks from making new loans. If banks can lend to the government, with no capital charge and no perceived risk and earn an adequate spread, then they have little incentive to lend to small businesses or consumers. (For this reason, higher short-term rates could very well stimulate additional lending to the private sector.)

Easy money also helps the fiscal position of the government. Lower borrowing costs mean lower deficits. In effect, negative real interest rates are indirect debt monetization. Allowing borrowers, including the government, to get addicted to unsustainably low rates creates enormous solvency risks when rates eventually rise.

While one can debate where we are in the recovery, one thing is clear — the worst of the last crisis has passed. Nominal G.D.P. growth is running in the mid-single digits. The emergency has passed and yet the Fed continues with an emergency zero-interest rate policy. Perhaps easy money is still appropriate — but a zero-rate policy creates enormous distortions in incentives and increases the likelihood of a significant crisis later. It was not lost on the market that during this month’s sell-off, with rates around zero, there is no room for further cuts should the economy roll over.

EASY money has negative consequences in addition to the risk of inflation and devaluing the dollar. It can also feed asset bubbles. In recent years, we have gone from one bubble and bailout to the next. Each bailout has rewarded those who acted imprudently. This has encouraged additional risky behavior, feeding the creation of new, larger bubbles.

The Fed bailed out the equity markets after the crash of 1987, which fed a boom ending with the Mexican crisis and bailout. That Treasury-financed bailout started a bubble in emerging market debt, which ended with the Asian currency crisis and Russian default. The resulting organized rescue of Long-Term Capital Management’s counterparties spurred the Internet bubble. After that popped, the rescue led to the housing and credit bubble. The deflationary aspects of that bubble popping created a bubble in sovereign debt, despite the fiscal strains created by the bailouts. The Greek crisis may be the first sign of the sovereign debt bubble bursting.

Though we don’t know what’s going to happen next, the good news for our grandchildren is that we will have to face our own debts. If we realize that our own future is at risk, we might be more serious about changing course. If we don’t, Mr. Geithner and others might regret having never said never about America’s rating.

David Einhorn is the president of Greenlight Capital, a hedge fund, and the author of “Fooling Some of the People All of the Time.” Investment accounts managed by Greenlight may have a position (long or short) in the securities discussed in this article.

The 11-Year Itch: Still Stuck at Dow 10000


Will Dow 10000 turn out to be a long replay of Dow 1000?

Last week, the Dow Jones Industrial Average rose above 10000—again. Since March 16, 1999, when it first touched 10000 in intraday trading, the Dow has bounced over that threshold and back 63 times. This Friday, the index closed 219.6 points below where it stood exactly 11 years ago.

This isn't the first time stocks have been stuck on a seemingly endless pogo-stick ride. On Jan. 18, 1966, the Dow hit an intraday high of 1000.50. It broke through the four-digit barrier three more times that January and February, then faded. The Dow cracked 1000 again in 1972 and 1976, then fell back both times. Not until December 1982 did the Dow finally hurdle above 1000 and stay there.

Wall Street veterans even coined a term for the market's behavior: "quadraphobia," or the fear of a four-digit closing value for the Dow.

Of course, financial history doesn't repeat itself—and even when it rhymes, the sounds can be almost unrecognizable. Inflation, at roughly 7% annually, was much higher from 1966 to 1982 than it is today, devouring all the return on stocks. And during the 1970s, according to an analysis for The Wall Street Journal by Wharton Research Data Services at the University of Pennsylvania, the Dow captured only about 15% of the total value of U.S. stocks, versus 30% today.

Still, a look back at Dow 1000 may still help us think a little more clearly about Dow 10000.

During the bull market of 1982 through 1999 that separated the two periods, computers and the Internet took off and interest rates fell. Those forces lowered the cost of research and development, enabling U.S. companies to innovate at a remarkable rate.

But, the Wharton research shows, the periods before and after that—Dow 1000 and Dow 10000—feature falling rates of corporate investment in innovation. During the Dow 1000 period, the stock market stagnated because the economy and most businesses were stagnating, too.

Yet investors, spoiled by the strong growth of the 1950s, had driven stock prices up to 18 times earnings at the beginning of Dow 1000. Likewise, in 1999, as the Dow crossed 10000, the price/earnings ratio of the market rose above 33—double its long-term average. High expectations are one of the main foundations of low returns.

Investors need to remember that stock markets can go nowhere for ages, as they did in the U.S. from 1929 to the end of World War II, in Germany from 1900 through 1957, and in Japan since 1989. In my view, it is likely that U.S. stocks and bonds will underperform their long-term average returns for years to come.

But as likely as that scenario is, it is far from certain.

Just when almost everyone had concluded that Treasury bonds had to lose value, they gained 3% in the past month alone.

And back in 1982, just as the index lifted its head above 1000, the Dow had plenty of doubters. One told the Journal, "Investors have begun a state of euphoria and complacency." Another dismissed "the likelihood of a sustained recovery any time in the foreseeable future."

While it could be years before the Dow rises durably past 10000, no one will see it coming when it comes. So, just as I wouldn't advise anyone to be 100% in stocks, I wouldn't advise most people to have 0% either. And I think it is imperative to have a third to half of your stock money outside the U.S., where other markets—and currencies—may do better.

In November 1963, with the Dow at 740, the great investor Benjamin Graham declared that "in my nearly 50 years of experience in Wall Street, I've found that I know less and less about what the stock market is going to do but I know more and more about what investors ought to do."

Graham went on to counsel that investors should never have less than 25% or more than 75% of their money in the stock market—and that they should move toward the maximum as the market falls and toward the minimum as it rises. In late 1964, with the Dow just below 900, he advised keeping no more than 50% in stocks, and he reiterated that sentiment eight years later. My hunch is that he would probably say much the same around Dow 10000 as he did around Dow 1000.

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