Infomotions, Inc.Capitalistic Musings / Vaknin, Sam, 1961-

Author: Vaknin, Sam, 1961-
Title: Capitalistic Musings
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Tag(s): narcissist; economic; sam vaknin; market; inflation; innovation; volatility; insurance; players; financial; vaknin also; risk; moral hazard; differential pricing; economies; markets; price; competition; prices; resources; capital; hazard; technical analys
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Title: Capitalistic Musings

Author: Sam Vaknin

Release Date: June, 2005  [EBook #8214]
[This file was first posted on July 3, 2003]

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Language: English

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(c) 2002 Copyright Lidija Rangelovska.

Capitalistic Musings 


Sam Vaknin, Ph.D.

Editing and Design:

Lidija Rangelovska

Lidija Rangelovska

A Narcissus Publications Imprint, Skopje 2002

First published by United Press International - UPI

Not for Sale! Non-commercial edition. 

(c) 2002 Copyright Lidija Rangelovska.

All rights reserved. This book, or any part thereof, may not be used or 
reproduced in any manner without written permission from:

Lidija Rangelovska  - write to: or to

Visit the Author Archive of Dr. Sam Vaknin in "Central Europe Review":

Visit Sam Vaknin's United Press International (UPI) Article Archive

ISBN: 9989-929-37-8




I. Economics - Psychology's Neglected Branch

II. The Misconception of Scarcity 

III. The Roller Coaster Market - On Volatility

IV. The Friendly Trend 

V. The Merits of Inflation

VI. The Benefits of Oligopolies

VII. Moral Hazard and the Survival Value of Risk  

VIII. The Business of Risk

IX. Global Differential Pricing 

X. The Disruptive Engine - Innovation

XI. Governments and Growth 

XII. The Distributive Justice of the Market

XIII. The Myth of the Earnings Yield

XIV. Immortality and Mortality in the Economic Sciences

XV. The Agent-Principal Conundrum  

XVI. The Green-Eyed Capitalist 

XVII. The Case of the Compressed Image

XVIII. The Fabric of Economic Trust 

XIX. Scavenger Economies, Predator Economies

XX. Notes on the Economics of Game Theory

XXI. Knowledge and Power 

XXII. Market Impeders and Market Inefficiencies

XXIII. Financial Crises, Global Capital Flows and 

the International Financial Architecture 

XXIV. O'Neill's Free Dinner - America's Current Account Deficit

XXV. Anarchy as an Organizing Principle

XXVI. Narcissism in the Boardroom

XXVII. The Author

XXVIII. About "After the Rain"

Economics - Psychology's Neglected Branch 

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

It is impossible to describe any human action if one does not refer to 
the meaning the actor sees in the stimulus as well as in the end his 
response is aiming at. 

Ludwig von Mises

Economics - to the great dismay of economists - is merely a branch of 
psychology. It deals with individual behaviour and with mass behaviour. 
Many of its practitioners sought to disguise its nature as a social 
science by applying complex mathematics where common sense and direct 
experimentation would have yielded far better results.

The outcome has been an embarrassing divorce between economic theory 
and its subjects.

The economic actor is assumed to be constantly engaged in the rational 
pursuit of self interest. This is not a realistic model - merely a 
useful approximation. According to this latter day - rational - version 
of the dismal science, people refrain from repeating their mistakes 
systematically. They seek to optimize their preferences. Altruism can 
be such a preference, as well. 

Still, many people are non-rational or only nearly rational in certain 
situations. And the definition of "self-interest" as the pursuit of the 
fulfillment of preferences is a tautology. 

The theory fails to predict important phenomena such as "strong 
reciprocity" - the propensity to "irrationally" sacrifice resources to 
reward forthcoming collaborators and punish free-riders. It even fails 
to account for simpler forms of apparent selflessness, such as 
reciprocal altruism (motivated by hopes of reciprocal benevolent 
treatment in the future).

Even the authoritative and mainstream 1995 "Handbook of Experimental 
Economics", by John Hagel and Alvin Roth (eds.) admits that people do 
not behave in accordance with the predictions of basic economic 
theories, such as the standard theory of utility and the theory of 
general equilibrium. Irritatingly for economists, people change their 
preferences mysteriously and irrationally. This is called  "preference 

Moreover, people's preferences, as evidenced by their choices and 
decisions in carefully controlled experiments, are inconsistent. They 
tend to lose control of their actions or procrastinate because they 
place greater importance (i.e., greater "weight") on the present and 
the near future than on the far future. This makes most people both 
irrational and unpredictable. 

Either one cannot design an experiment to rigorously and validly test 
theorems and conjectures in economics - or something is very flawed 
with the intellectual pillars and models of this field. 

Neo-classical economics has failed on several fronts simultaneously. 
This multiple failure led to despair and the re-examination of basic 
precepts and tenets. 

Consider this sample of outstanding issues:

Unlike other economic actors and agents, governments are accorded a 
special status and receive special treatment in economic theory. 
Government is alternately cast as a saint, seeking to selflessly 
maximize social welfare - or as the villain, seeking to perpetuate and 
increase its power ruthlessly, as per public choice theories. 

Both views are caricatures of reality. Governments indeed seek to 
perpetuate their clout and increase it - but they do so mostly in order 
to redistribute income and rarely for self-enrichment. 

Economics also failed until recently to account for the role of 
innovation in growth and development. The discipline often ignored the 
specific nature of knowledge industries (where returns increase rather 
than diminish and network effects prevail). Thus, current economic 
thinking is woefully inadequate to deal with information monopolies 
(such as Microsoft), path dependence, and pervasive externalities. 

Classic cost/benefit analyses fail to tackle very long term investment 
horizons (i.e., periods). Their underlying assumption - the opportunity 
cost of delayed consumption - fails when applied beyond the investor's 
useful economic life expectancy. People care less about their 
grandchildren's future than about their own. This is because 
predictions concerned with the far future are highly uncertain and 
investors refuse to base current decisions on fuzzy "what ifs". 

This is a problem because many current investments, such as the fight 
against global warming, are likely to yield results only decades hence. 
There is no effective method of cost/benefit analysis applicable to 
such time horizons. 

How are consumer choices influenced by advertising and by pricing? No 
one seems to have a clear answer. Advertising is concerned with the 
dissemination of information. Yet it is also a signal sent to consumers 
that a certain product is useful and qualitative and that the 
advertiser's stability, longevity, and profitability are secure. 
Advertising communicates a long term commitment to a winning product by 
a firm with deep pockets. This is why patrons react to the level of 
visual exposure to advertising - regardless of its content.

Humans may be too multi-dimensional and hyper-complex to be usefully 
captured by econometric models. These either lack predictive powers or 
lapse into logical fallacies, such as the "omitted variable bias" or 
"reverse causality". The former is concerned with important variables 
unaccounted for - the latter with reciprocal causation, when every 
cause is also caused by its own effect. 

These are symptoms of an all-pervasive malaise. Economists are simply 
not sure what precisely constitutes their subject matter. Is economics 
about the construction and testing of models in accordance with certain 
basic assumptions? Or should it revolve around the mining of data for 
emerging patterns, rules, and "laws"? 

On the one hand, patterns based on limited - or, worse, non-recurrent - 
sets of data form a questionable foundation for any kind of "science". 
On the other hand, models based on assumptions are also in doubt 
because they are bound to be replaced by new models with new, hopefully 
improved, assumptions. 

One way around this apparent quagmire is to put human cognition (i.e., 
psychology) at the heart of economics. Assuming that being human is an 
immutable and knowable constant - it should be amenable to scientific 
treatment. "Prospect theory", "bounded rationality theories", and the 
study of "hindsight bias" as well as other cognitive deficiencies are 
the outcomes of this approach. 

To qualify as science, economic theory must satisfy the following 
cumulative conditions:

a. All-inclusiveness (anamnetic) - It must encompass, integrate, and 
incorporate all the facts known about economic behaviour. 

b. Coherence - It must be chronological, structured and causal. It must 
explain, for instance, why a certain economic policy leads to specific 
economic outcomes - and why. 

c. Consistency - It must be self-consistent. Its sub-"units" cannot 
contradict one another or go against the grain of the main "theory". It 
must also be consistent with the observed phenomena, both those related 
to economics and those pertaining to non-economic human behaviour. It 
must adequately cope with irrationality and cognitive deficits.

d. Logical compatibility - It must not violate the laws of its internal 
logic and the rules of logic "out there", in the real world. 

e. Insightfulness - It must cast the familiar in a new light, mine 
patterns and rules from big bodies of data ("data mining"). Its 
insights must be the inevitable conclusion of the logic, the language, 
and the evolution of the theory. 

f. Aesthetic - Economic theory must be both plausible and "right", 
beautiful (aesthetic), not cumbersome, not awkward, not discontinuous, 
smooth, and so on. 

g. Parsimony - The theory must employ a minimum number of assumptions 
and entities to explain the maximum number of observed economic 

h. Explanatory Powers - It must explain the behaviour of economic 
actors, their decisions, and why economic events develop the way they 

i. Predictive (prognostic) Powers - Economic theory must be able to 
predict future economic events and trends as well as the future 
behaviour of economic actors. 

j. Prescriptive Powers - The theory must yield policy prescriptions, 
much like physics yields technology. Economists must develop "economic 
technology" - a set of tools, blueprints, rules of thumb, and 
mechanisms with the power to change the " economic world". 

k. Imposing - It must be regarded by society as the preferable and 
guiding organizing principle in the economic sphere of human behaviour. 

l. Elasticity - Economic theory must possess the intrinsic abilities to 
self organize, reorganize, give room to emerging order, accommodate new 
data comfortably, and avoid rigid reactions to attacks from within and 
from without. 

Many current economic theories do not meet these cumulative criteria 
and are, thus, merely glorified narratives. 

But meeting the above conditions is not enough. Scientific theories 
must also pass the crucial hurdles of testability, verifiability, 
refutability, falsifiability, and repeatability. Yet, many economists 
go as far as to argue that no experiments can be designed to test the 
statements of economic theories. 

It is difficult - perhaps impossible - to test hypotheses in economics 
for four reasons. 

a. Ethical - Experiments would have to involve human subjects, ignorant 
of the reasons for the experiments and their aims. Sometimes even the 
very existence of an experiment will have to remain a secret (as with 
double blind experiments). Some experiments may involve unpleasant 
experiences. This is ethically unacceptable. 

b. Design Problems - The design of experiments in economics is awkward 
and difficult. Mistakes are often inevitable, however careful and 
meticulous the designer of the experiment is. 

c. The Psychological Uncertainty Principle - The current mental state 
of a human subject can be (theoretically) fully known. But the passage 
of time and, sometimes, the experiment itself, influence the subject 
and alter his or her mental state - a problem known in economic 
literature as "time inconsistencies". The very processes of measurement 
and observation influence the subject and change it. 

d. Uniqueness - Experiments in economics, therefore, tend to be unique. 
They cannot be repeated even when the SAME subjects are involved, 
simply because no human subject remains the same for long. Repeating 
the experiments with other subjects casts in doubt the scientific value 
of the results. 

d. The undergeneration of testable hypotheses - Economic theories do 
not generate a sufficient number of hypotheses, which can be subjected 
to scientific testing. This has to do with the fabulous (i.e., 
storytelling) nature of the discipline. 

In a way, economics has an affinity with some private languages. It is 
a form of art and, as such, it is self-sufficient and self-contained. 
If certain structural, internal constraints and requirements are met - 
a statement in economics is deemed to be true even if it does not 
satisfy external (scientific) requirements. Thus, the standard theory 
of utility is considered valid in economics despite overwhelming 
empirical evidence to the contrary - simply because it is aesthetic and 
mathematically convenient. 

So, what are economic "theories" good for? 

Economic "theories" and narratives offer an organizing principle, a 
sense of order, predictability, and justice. They postulate  an 
inexorable drive toward greater welfare and utility (i.e., the idea of 
progress). They render our chaotic world meaningful and make us feel 
part of a larger whole. Economics strives to answer the "why's" and 
"how's" of our daily life. It is dialogic and prescriptive (i.e., 
provides behavioral prescriptions). In certain ways, it is akin to 

In its catechism, the believer (let's say, a politician) asks: "Why... 
(and here follows an economic problem or behaviour)". 

The economist answers: 

"The situation is like this not because the world is whimsically cruel, 
irrational, and arbitrary - but because ... (and here follows a causal 
explanation based on an economic model). If you were to do this or that 
the situation is bound to improve". 

The believer feels reassured by this explanation and by the explicit 
affirmation that there is hope providing he follows the prescriptions. 
His belief in the existence of linear order and justice administered by 
some supreme, transcendental principle is restored. 

This sense of "law and order" is further enhanced when the theory 
yields predictions which come true, either because they are 
self-fulfilling or because some real "law", or pattern, has emerged. 
Alas, this happens rarely. As "The Economist" notes gloomily, 
economists have the most disheartening record of failed predictions - 
and prescriptions.

The Misconception of Scarcity  

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

Are we confronted merely with a bear market in stocks - or is it the 
first phase of a global contraction of the magnitude of the Great 
Depression? The answer overwhelmingly depends on how we understand 

It will be only a mild overstatement to say that the science of 
economics, such as it is, revolves around the Malthusian concept of 
scarcity. Our infinite wants, the finiteness of our resources and the 
bad job we too often make of allocating them efficiently and optimally 
- lead to mismatches between supply and demand. We are forever forced 
to choose between opportunities, between alternative uses of resources, 
painfully mindful of their costs. 

This is how the perennial textbook "Economics" (seventeenth edition), 
authored by Nobel prizewinner Paul Samuelson and William Nordhaus, 
defines the dismal science:

"Economics is the study of how societies use scarce resources to 
produce valuable commodities and distribute them among different 

The classical concept of scarcity - unlimited wants vs. limited 
resources - is lacking. Anticipating much-feared scarcity encourages 
hoarding which engenders the very evil it was meant to fend off. Ideas 
and knowledge - inputs as important as land and water - are not subject 
to scarcity, as work done by Nobel laureate Robert Solow and, more 
importantly, by Paul Romer, an economist from the University of 
California at Berkeley, clearly demonstrates. Additionally, it is 
useful to distinguish natural from synthetic resources.

The scarcity of most natural resources (a type of "external scarcity") 
is only theoretical at present. Granted, many resources are unevenly 
distributed and badly managed. But this is man-made ("internal") 
scarcity and can be undone by Man. It is truer to assume, for practical 
purposes, that most natural resources - when not egregiously abused and 
when freely priced - are infinite rather than scarce. The 
anthropologist Marshall Sahlins discovered that primitive peoples he 
has studied had no concept of "scarcity" - only of "satiety". He called 
them the first "affluent societies".

This is because, fortunately, the number of people on Earth is finite - 
and manageable - while most resources can either be replenished or 
substituted. Alarmist claims to the contrary by environmentalists have 
been convincingly debunked by the likes of Bjorn Lomborg, author of 
"The Skeptical Environmentalist".

Equally, it is true that manufactured goods, agricultural produce, 
money, and services are scarce. The number of industrialists, service 
providers, or farmers is limited - as is their life span. The 
quantities of raw materials, machinery and plant are constrained. 
Contrary to classic economic teaching, human wants are limited - only 
so many people exist at any given time and not all them desire 
everything all the time. But, even so, the demand for man-made goods 
and services far exceeds the supply. 

Scarcity is the attribute of a "closed" economic universe. But it can 
be alleviated either by increasing the supply of goods and services 
(and human beings) - or by improving the efficiency of the allocation 
of economic resources. Technology and innovation are supposed to 
achieve the former - rational governance, free trade, and free markets 
the latter. 

The telegraph, the telephone, electricity, the train, the car, the 
agricultural revolution, information technology and, now, biotechnology 
have all increased our resources, seemingly ex nihilo. This 
multiplication of wherewithal falsified all apocalyptic Malthusian 
scenarios hitherto. Operations research, mathematical modeling, 
transparent decision making, free trade, and professional management - 
help better allocate these increased resources to yield optimal results.

Markets are supposed to regulate scarcity by storing information about 
our wants and needs. Markets harmonize supply and demand. They do so 
through the price mechanism. Money is, thus, a unit of information and 
a conveyor or conduit of the price signal - as well as a store of value 
and a means of exchange. 

Markets and scarcity are intimately related. The former would be 
rendered irrelevant and unnecessary in the absence of the latter. 
Assets increase in value in line with their scarcity - i.e., in line 
with either increasing demand or decreasing supply. When scarcity 
decreases - i.e., when demand drops or supply surges - asset prices 
collapse. When a resource is thought to be infinitely abundant (e.g., 
air) - its price is zero.

Armed with these simple and intuitive observations, we can now survey 
the dismal economic landscape.

The abolition of scarcity was a pillar of the paradigm shift to the 
"new economy". The marginal costs of producing and distributing 
intangible goods, such as intellectual property, are negligible. 
Returns increase - rather than decrease - with each additional copy. An 
original software retains its quality even if copied numerous times. 
The very distinction between "original" and "copy" becomes obsolete and 
meaningless. Knowledge products are "non-rival goods" (i.e., can be 
used by everyone simultaneously).

Such ease of replication gives rise to network effects and awards first 
movers with a monopolistic or oligopolistic position. Oligopolies are 
better placed to invest excess profits in expensive research and 
development in order to achieve product differentiation. Indeed, such 
firms justify charging money for their "new economy" products with the 
huge sunken costs they incur - the initial expenditures and investments 
in research and development, machine tools, plant, and branding. 

To sum, though financial and human resources as well as content may 
have remained scarce - the quantity of intellectual property goods is 
potentially infinite because they are essentially cost-free to 
reproduce. Plummeting production costs also translate to enhanced 
productivity and wealth formation. It looked like a virtuous cycle.

But the abolition of scarcity implied the abolition of value. Value and 
scarcity are two sides of the same coin. Prices reflect scarcity. 
Abundant products are cheap. Infinitely abundant products - however 
useful - are complimentary. Consider money. Abundant money - an 
intangible commodity - leads to depreciation against other currencies 
and inflation at home. This is why central banks intentionally foster 
money scarcity.

But if intellectual property goods are so abundant and cost-free - why 
were distributors of intellectual property so valued, not least by 
investors in the stock exchange? Was it gullibility or ignorance of 
basic economic rules?

Not so. Even "new economists" admitted to temporary shortages and 
"bottlenecks" on the way to their utopian paradise of cost-free 
abundance. Demand always initially exceeds supply. Internet backbone 
capacity, software programmers, servers are all scarce to start with - 
in the old economy sense. 

This scarcity accounts for the stratospheric erstwhile valuations of 
dotcoms and telecoms. Stock prices were driven by projected 
ever-growing demand and not by projected ever-growing supply of 
asymptotically-free goods and services. "The Economist" describes how 
WorldCom executives flaunted the cornucopian doubling of Internet 
traffic every 100 days. Telecoms predicted a tsunami of clients 
clamoring for G3 wireless Internet services. Electronic publishers 
gleefully foresaw the replacement of the print book with the much 
heralded e-book. 

The irony is that the new economy self-destructed because most of its 
assumptions were spot on. The bottlenecks were, indeed, temporary. 
Technology, indeed, delivered near-cost-free products in endless 
quantities. Scarcity was, indeed, vanquished.

Per the same cost, the amount of information one can transfer through a 
single fiber optic swelled 100 times. Computer storage catapulted 
80,000 times. Broadband and cable modems let computers communicate at 
300 times their speed only 5 years ago. Scarcity turned to glut. Demand 
failed to catch up with supply. In the absence of clear price signals - 
the outcomes of scarcity - the match between the two went awry.

One innovation the "new economy" has wrought is "inverse scarcity" - 
unlimited resources (or products) vs. limited wants. Asset exchanges 
the world over are now adjusting to this harrowing realization - that 
cost free goods are worth little in terms of revenues and that people 
are badly disposed to react to zero marginal costs. 

The new economy caused a massive disorientation and dislocation of the 
market and the price mechanism. Hence the asset bubble. Reverting to an 
economy of scarcity is our only hope. If we don't do so deliberately - 
the markets will do it for us, mercilessly.

The Roller Coaster Market 

On Volatility and Risk 

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

Volatility is considered the most accurate measure of risk and, by 
extension, of return, its flip side. The higher the volatility, the 
higher the risk - and the reward. That volatility increases in the 
transition from bull to bear markets seems to support this pet theory. 
But how to account for surging volatility in plummeting bourses? At the 
depths of the bear phase, volatility and risk increase while returns 
evaporate - even taking short-selling into account. 

"The Economist" has recently proposed yet another dimension of risk:

"The Chicago Board Options Exchange's VIX index, a measure of traders' 
expectations of share price gyrations, in July reached levels not seen 
since the 1987 crash, and shot up again (two weeks ago) ... Over the 
past five years, volatility spikes have become ever more frequent, from 
the Asian crisis in 1997 right up to the World Trade Centre attacks. 
Moreover, it is not just price gyrations that have increased, but the 
volatility of volatility itself. The markets, it seems, now have an 
added dimension of risk."

Call-writing has soared as punters, fund managers, and institutional 
investors try to eke an extra return out of the wild ride and to 
protect their dwindling equity portfolios. Naked strategies - selling 
options contracts or buying them in the absence of an investment 
portfolio of underlying assets - translate into the trading of 
volatility itself and, hence, of risk. Short-selling and spread-betting 
funds join single stock futures in profiting from the downside.

Market - also known as beta or systematic - risk and volatility reflect 
underlying problems with the economy as a whole and with corporate 
governance: lack of transparency, bad loans, default rates, 
uncertainty, illiquidity, external shocks, and other negative 
externalities. The behavior of a specific security reveals additional, 
idiosyncratic, risks, known as alpha.

Quantifying volatility has yielded an equal number of Nobel prizes and 
controversies. The vacillation of security prices is often measured by 
a coefficient of variation within the Black-Scholes formula published 
in 1973. Volatility is implicitly defined as the standard deviation of 
the yield of an asset. The value of an option increases with 
volatility. The higher the volatility the greater the option's chance 
during its life to be "in the money" - convertible to the underlying 
asset at a handsome profit.

Without delving too deeply into the model, this mathematical expression 
works well during trends and fails miserably when the markets change 

There is disagreement among scholars and traders whether one should 
better use historical data or current market prices - which include 
expectations - to estimate volatility and to price options correctly.

From "The Econometrics of Financial Markets" by John Campbell, Andrew 
Lo, and Craig MacKinlay, Princeton University Press, 1997:

"Consider the argument that implied volatilities are better forecasts 
of future volatility because changing market conditions cause 
volatilities (to) vary through time stochastically, and historical 
volatilities cannot adjust to changing market conditions as rapidly. 
The folly of this argument lies in the fact that stochastic volatility 
contradicts the assumption required by the B-S model - if volatilities 
do change stochastically through time, the Black-Scholes formula is no 
longer the correct pricing formula and an implied volatility derived 
from the Black-Scholes formula provides no new information."

Black-Scholes is thought deficient on other issues as well. The implied 
volatilities of different options on the same stock tend to vary, 
defying the formula's postulate that a single stock can be associated 
with only one value of implied volatility. The model assumes a certain 
- geometric Brownian - distribution of stock prices that has been shown 
to not apply to US markets, among others. 

Studies have exposed serious departures from the price process 
fundamental to Black-Scholes: skewness, excess kurtosis (i.e., 
concentration of prices around the mean), serial correlation, and time 
varying volatilities. Black-Scholes tackles stochastic volatility 

The formula also unrealistically assumes that the market dickers 
continuously, ignoring transaction costs and institutional constraints. 
No wonder that traders use Black-Scholes as a heuristic rather than a 
price-setting formula. 

Volatility also decreases in administered markets and over different 
spans of time. As opposed to the received wisdom of the random walk 
model, most investment vehicles sport different volatilities over 
different time horizons. Volatility is especially high when both supply 
and demand are inelastic and liable to large, random shocks. This is 
why the prices of industrial goods are less volatile than the prices of 
shares, or commodities. 

But why are stocks and exchange rates volatile to start with? Why don't 
they follow a smooth evolutionary path in line, say, with inflation, or 
interest rates, or productivity, or net earnings?

To start with, because economic fundamentals fluctuate - sometimes as 
wildly as shares. The Fed has cut interest rates 11 times in the past 
12 months down to 1.75 percent - the lowest level in 40 years. 
Inflation gyrated from double digits to a single digit in the space of 
two decades. This uncertainty is, inevitably, incorporated in the price 

Moreover, because of time lags in the dissemination of data and its 
assimilation in the prevailing operational model of the economy - 
prices tend to overshoot both ways. The economist Rudiger Dornbusch, 
who died last month, studied in his seminal paper, "Expectations and 
Exchange Rate Dynamics", published in 1975, the apparently irrational 
ebb and flow of floating currencies.

His conclusion was that markets overshoot in response to surprising 
changes in economic variables. A sudden increase in the money supply, 
for instance, axes interest rates and causes the currency to 
depreciate. The rational outcome should have been a panic sale of 
obligations denominated in the collapsing currency. But the devaluation 
is so excessive that people reasonably expect a rebound - i.e., an 
appreciation of the currency - and purchase bonds rather than dispose 
of them. 

Yet, even Dornbusch ignored the fact that some price twirls have 
nothing to do with economic policies or realities, or with the 
emergence of new information - and a lot to do with mass psychology. 
How else can we account for the crash of October 1987? This goes to the 
heart of the undecided debate between technical and fundamental 

As Robert Shiller has demonstrated in his tomes "Market Volatility" and 
"Irrational Exuberance", the volatility of stock prices exceeds the 
predictions yielded by any efficient market hypothesis, or by 
discounted streams of future dividends, or earnings. Yet, this finding 
is hotly disputed. 

Some scholarly studies of researchers such as Stephen LeRoy and Richard 
Porter offer support - other, no less weighty, scholarship by the likes 
of Eugene Fama, Kenneth French, James Poterba, Allan Kleidon, and 
William Schwert negate it - mainly by attacking Shiller's underlying 
assumptions and simplifications. Everyone - opponents and proponents 
alike - admit that stock returns do change with time, though for 
different reasons. 

Volatility is a form of market inefficiency. It is a reaction to 
incomplete information (i.e., uncertainty). Excessive volatility is 
irrational. The confluence of mass greed, mass fears, and mass 
disagreement as to the preferred mode of reaction to public and private 
information - yields price fluctuations.

Changes in volatility - as manifested in options and futures premiums - 
are good predictors of shifts in sentiment and the inception of new 
trends. Some traders are contrarians. When the VIX or the NASDAQ 
Volatility indices are high - signifying an oversold market - they buy 
and when the indices are low, they sell. 

Chaikin's Volatility Indicator, a popular timing tool, seems to couple 
market tops with increased indecisiveness and nervousness, i.e., with 
enhanced volatility. Market bottoms - boring, cyclical, affairs - 
usually suppress volatility. Interestingly, Chaikin himself disputes 
this interpretation. He believes that volatility increases near the 
bottom, reflecting panic selling - and decreases near the top, when 
investors are in full accord as to market direction.

But most market players follow the trend. They sell when the VIX is 
high and, thus, portends a declining market. A bullish consensus is 
indicated by low volatility. Thus, low VIX readings signal the time to 
buy. Whether this is more than superstition or a mere gut reaction 
remains to be seen. 

It is the work of theoreticians of finance. Alas, they are consumed by 
mutual rubbishing and dogmatic thinking. The few that wander out of the 
ivory tower and actually bother to ask economic players what they think 
and do - and why - are much derided. It is a dismal scene, devoid of 
volatile creativity.

The Friendly Trend  

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

The authors of a paper published by NBER on March 2000 and titled "The 
Foundations of Technical Analysis" - Andrew Lo, Harry Mamaysky, and 
Jiang Wang - claim that:

"Technical analysis, also known as 'charting', has been part of 
financial practice for many decades, but this discipline has not 
received the same level of academic scrutiny and acceptance as more 
traditional approaches such as fundamental analysis.

One of the main obstacles is the highly subjective nature of technical 
analysis - the presence of geometric shapes in historical price charts 
is often in the eyes of the beholder. In this paper we offer a 
systematic and automatic approach to technical pattern recognition ... 
and apply the method to a large number of US stocks from 1962 to 

And the conclusion:

" ... Over the 31-year sample period, several technical indicators do 
provide incremental information and may have some practical value."

These hopeful inferences are supported by the work of other scholars, 
such as Paul Weller of the Finance Department of the university of 
Iowa. While he admits the limitations of technical analysis - it is 
a-theoretic and data intensive, pattern over-fitting can be a problem, 
its rules are often difficult to interpret, and the statistical testing 
is cumbersome - he insists that "trading rules are picking up patterns 
in the data not accounted for by standard statistical models" and that 
the excess returns thus generated are not simply a risk premium.

Technical analysts have flourished and waned in line with the stock 
exchange bubble. They and their multi-colored charts regularly graced 
CNBC, the CNN and other market-driving channels. "The Economist" found 
that many successful fund managers have regularly resorted to technical 
analysis - including George Soros' Quantum Hedge fund and Fidelity's 
Magellan. Technical analysis may experience a revival now that 
corporate accounts - the fundament of fundamental analysis - have been 
rendered moot by seemingly inexhaustible scandals. 

The field is the progeny of Charles Dow of Dow Jones fame and the 
founder of the "Wall Street Journal". He devised a method to discern 
cyclical patterns in share prices. Other sages - such as Elliott - put 
forth complex "wave theories". Technical analysts now regularly employ 
dozens of geometric configurations in their divinations. 

Technical analysis is defined thus in "The Econometrics of Financial 
Markets", a 1997 textbook authored by John Campbell, Andrew Lo, and 
Craig MacKinlay:

"An approach to investment management based on the belief that 
historical price series, trading volume, and other market statistics 
exhibit regularities - often ... in the form of geometric patterns ... 
that can be profitably exploited to extrapolate future price movements."

A less fanciful definition may be the one offered by Edwards and Magee 
in "Technical Analysis of Stock Trends":

"The science of recording, usually in graphic form, the actual history 
of trading (price changes, volume of transactions, etc.) in a certain 
stock or in 'the averages' and then deducing from that pictured history 
the probable future trend."

Fundamental analysis is about the study of key statistics from the 
financial statements of firms as well as background information about 
the company's products, business plan, management, industry, the 
economy, and the marketplace. 

Economists, since the 1960's, sought to rebuff technical analysis. 
Markets, they say, are efficient and "walk" randomly. Prices reflect 
all the information known to market players - including all the 
information pertaining to the future. Technical analysis has often been 
compared to voodoo, alchemy, and astrology - for instance by Burton 
Malkiel in his seminal work, "A Random Walk Down Wall Street."

The paradox is that technicians are more orthodox than the most devout 
academic. They adhere to the strong version of market efficiency. The 
market is so efficient, they say, that nothing can be gleaned from 
fundamental analysis. All fundamental insights, information, and 
analyses are already reflected in the price. This is why one can deduce 
future prices from past and present ones. 

Jack Schwager, sums it up in his book "Schwager on Futures: Technical 
Analysis", quoted by, :

"One way of viewing it is that markets may witness extended periods of 
random fluctuation, interspersed with shorter periods of nonrandom 
behavior. The goal of the chartist is to identify those periods (i.e. 
major trends)."

Not so, retort the fundamentalists. The fair value of a security or a 
market can be derived from available information using mathematical 
models - but is rarely reflected in prices. This is the weak version of 
the market efficiency hypothesis.

The mathematically convenient idealization of the efficient market, 
though, has been debunked in numerous studies. These are efficiently 
summarized in Craig McKinlay and Andrew Lo's tome "A Non-random Walk 
Down Wall Street" published in 1999.

Not all markets are strongly efficient. Most of them sport weak or 
"semi-strong" efficiency. In some markets, a filter model - one that 
dictates the timing of sales and purchases - could prove useful. This 
is especially true when the equilibrium price of a share - or of the 
market as a whole - changes as a result of externalities. 

Substantive news, change in management, an oil shock, a terrorist 
attack, an accounting scandal, an FDA approval, a major contract, or a 
natural, or man-made disaster - all cause share prices and market 
indices to break the boundaries of the price band that they have 
occupied. Technical analysts identify these boundaries and trace 
breakthroughs and their outcomes in terms of prices.

Technical analysis may be nothing more than a self-fulfilling prophecy, 
though. The more devotees it has, the stronger it affects the shares or 
markets it analyses. Investors move in herds and are inclined to seek 
patterns in the often bewildering marketplace. As opposed to the 
assumptions underlying the classic theory of portfolio analysis - 
investors do remember past prices. They hesitate before they cross 
certain numerical thresholds. 

But this herd mentality is also the Achilles heel of technical 
analysis. If everyone were to follow its guidance - it would have been 
rendered useless. If everyone were to buy and sell at the same time - 
based on the same technical advice - price advantages would have been 
arbitraged away instantaneously.  Technical analysis is about 
privileged information to the privileged few - though not too few, lest 
prices are not swayed.

Studies cited in Edwin Elton and Martin Gruber's "Modern Portfolio 
Theory and Investment Analysis" and elsewhere show that a filter model 
- trading with technical analysis - is preferable to a "buy and hold" 
strategy but inferior to trading at random. Trading against 
recommendations issued by a technical analysis model and with them - 
yielded the same results. Fama-Blum discovered that the advantage 
proffered by such models is identical to transaction costs.

The proponents of technical analysis claim that rather than forming 
investor psychology - it reflects their risk aversion at different 
price levels. Moreover, the borders between the two forms of analysis - 
technical and fundamental - are less sharply demarcated nowadays. 
"Fundamentalists" insert past prices and volume data in their models - 
and "technicians" incorporate arcana such as the dividend stream and 
past earnings in theirs.

It is not clear why should fundamental analysis be considered superior 
to its technical alternative. If prices incorporate all the information 
known and reflect it - predicting future prices would be impossible 
regardless of the method employed. Conversely, if prices do not reflect 
all the information available, then surely investor psychology is as 
important a factor as the firm's - now oft-discredited - financial 

Prices, after all, are the outcome of numerous interactions among 
market participants, their greed, fears, hopes, expectations, and risk 
aversion. Surely studying this emotional and cognitive landscape is as 
crucial as figuring the effects of cuts in interest rates or a change 
of CEO?

Still, even if we accept the rigorous version of market efficiency - 
i.e., as Aswath Damodaran of the Stern Business School at NYU puts it, 
that market prices are "unbiased estimates of the true value of 
investments" - prices do react to new information - and, more 
importantly, to anticipated information. It takes them time to do so. 
Their reaction constitutes a trend and identifying this trend at its 
inception can generate excess yields. On this both fundamental and 
technical analysis are agreed. 

Moreover, markets often over-react: they undershoot or overshoot the 
"true and fair value". Fundamental analysis calls this oversold and 
overbought markets. The correction back to equilibrium prices sometimes 
takes years. A savvy trader can profit from such market failures and 

As quality information becomes ubiquitous and instantaneous, research 
issued by investment banks discredited, privileged access to 
information by analysts prohibited, derivatives proliferate, individual 
participation in the stock market increases, and transaction costs turn 
negligible - a major rethink of our antiquated financial models is 
called for.

The maverick Andrew Lo, a professor of finance at the Sloan School of 
Management at MIT, summed up the lure of technical analysis in lyric 
terms in an interview he gave to's "Technical Analysis of 
Stocks and Commodities", quoted by Arthur Hill in

"The more creativity you bring to the investment process, the more 
rewarding it will be. The only way to maintain ongoing success, 
however, is to constantly innovate. That's much the same in all 
endeavors. The only way to continue making money, to continue growing 
and keeping your profit margins healthy, is to constantly come up with 
new ideas."

The Merits of Inflation 

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

In a series of speeches designed to defend his record, Alan Greenspan, 
until recently an icon of both the new economy and stock exchange 
effervescence, reiterated the orthodoxy of central banking everywhere. 
His job, he repeated disingenuously, was confined to taming prices and 
ensuring monetary stability. He could not and, indeed, would not second 
guess the market. He consistently sidestepped the thorny issues of just 
how destabilizing to the economy the bursting of asset bubbles is and 
how his policies may have contributed to the froth. 

Greenspan and his ilk seem to be fighting yesteryear's war against a 
long-slain monster. The obsession with price stability led to policy 
excesses and disinflation gave way to deflation - arguably an economic 
ill far more pernicious than inflation. Deflation coupled with negative 
savings and monstrous debt burdens can lead to prolonged periods of 
zero or negative growth. Moreover, in the zealous crusade waged 
globally against fiscal and monetary expansion - the merits and 
benefits of inflation have often been overlooked. 

As economists are wont to point out time and again, inflation is not 
the inevitable outcome of growth. It merely reflects the output gap 
between actual and potential GDP. As long as the gap is negative - 
i.e., whilst the economy is drowning in spare capacity - inflation lies 
dormant. The gap widens if growth is anemic and below the economy's 
potential. Thus, growth can actually be accompanied by deflation.

Indeed, it is arguable whether inflation was subdued - in America as 
elsewhere - by the farsighted policies of central bankers. A better 
explanation might be overcapacity - both domestic and global - wrought 
by decades of inflation which distorted investment decisions. Excess 
capacity coupled with increasing competition, globalization, 
privatization, and deregulation - led to ferocious price wars and to 
consistently declining prices. 

Quoted by "The Economist", Dresdner Kleinwort Wasserstein noted that 
America's industry is already in the throes of deflation. The implicit 
price deflator of the non-financial business sector has been -0.6 
percent in the year to the end of the second quarter of 2002. Germany 
faces the same predicament. As oil prices surge, their inflationary 
shock will give way to a deflationary and recessionary aftershock.

Depending on one's point of view, this is a self-reinforcing virtuous - 
or vicious cycle. Consumers learn to expect lower prices - i.e., 
inflationary expectations fall and, with them, inflation itself. 

The intervention of central banks only hastened the process and now it 
threatens to render benign structural disinflation - malignantly 

Should the USA reflate its way out of either an impending double dip 
recession or deflationary anodyne growth?

It is universally accepted that inflation leads to the misallocation of 
economic resources by distorting the price signal. Confronted with a 
general rise in prices, people get confused. They are not sure whether 
to attribute the surging prices to a real spurt in demand, to 
speculation, inflation, or what. They often make the wrong decisions. 

They postpone investments - or over-invest and embark on preemptive 
buying sprees. As Erica Groshen and Mark Schweitzer have demonstrated 
in an NBER working paper titled "Identifying inflation's grease and 
sand effects in the labour market", employers - unable to predict 
tomorrow's wages - hire less.

Still, the late preeminent economist James Tobin went as far as calling 
inflation "the grease on the wheels of the economy". What rate of 
inflation is desirable? The answer is: it depends on whom you ask. The 
European Central Bank maintains an annual target of 2 percent. Other 
central banks - the Bank of England, for instance - proffer an 
"inflation band" of between 1.5 and 2.5 percent. The Fed has been known 
to tolerate inflation rates of 3-4 percent. 

These disparities among essentially similar economies reflect pervasive 
disagreements over what is being quantified by the rate of inflation 
and when and how it should be managed.

The sin committed by most central banks is their lack of symmetry. They 
signal visceral aversion to inflation - but ignore the risk of 
deflation altogether. As inflation subsides, disinflation seamlessly 
fades into deflation. People - accustomed to the deflationary bias of 
central banks - expect prices to continue to fall. They defer 
consumption. This leads to inextricable and all-pervasive recessions. 

Inflation rates - as measured by price indices - fail to capture 
important economic realities. As the Boskin commission revealed in 
1996, some products are transformed by innovative technology even as 
their prices decline or remain stable. Such upheavals are not 
encapsulated by the rigid categories of the questionnaires used by 
bureaus of statistics the world over to compile price data. Cellular 
phones, for instance, were not part of the consumption basket 
underlying the CPI in America as late as 1998. The consumer price index 
in the USA may be overstated by one percentage point year in and year 
out, was the startling conclusion in the commission's report.

Current inflation measures neglect to take into account whole classes 
of prices - for instance, tradable securities. Wages - the price of 
labor - are left out. The price of money - interest rates - is 
excluded. Even if these were to be included, the way inflation is 
defined and measured today, they would have been grossly 

Consider a deflationary environment in which stagnant wages and zero 
interest rates can still have a - negative or positive - inflationary 
effect. In real terms, in deflation, both wages and interest rates 
increase relentlessly even if they stay put. Yet it is hard to 
incorporate this "downward stickiness" in present-day inflation 

The methodology of computing inflation obscures many of the "quantum 
effects" in the borderline between inflation and deflation. Thus, as 
pointed out by George Akerloff, William Dickens, and George Perry in 
"The Macroeconomics of Low Inflation" (Brookings Papers on Economic 
Activity, 1996), inflation allows employers to cut real wages. 

Workers may agree to a 2 percent pay rise in an economy with 3 percent 
inflation. They are unlikely to accept a pay cut even when inflation is 
zero or less. This is called the "money illusion". Admittedly, it is 
less pronounced when compensation is linked to performance. Thus, 
according to "The Economist", Japanese wages - with a backdrop of 
rampant deflation - shrank 5.6 percent in the year to July as company 
bonuses were brutally slashed.

Economists in a November 2000 conference organized by the ECB argued 
that a continent-wide inflation rate of 0-2 percent would increase 
structural unemployment in Europe's arthritic labor markets by a 
staggering 2-4 percentage points. Akerloff-Dickens-Perry concurred in 
the aforementioned paper. At zero inflation, unemployment in America 
would go up, in the long run, by 2.6 percentage points. This adverse 
effect can, of course, be offset by productivity gains, as has been the 
case in the USA throughout the 1990's.

The new consensus is that the price for a substantial decrease in 
unemployment need not be a sizable rise in inflation. The level of 
employment at which inflation does not accelerate - the 
non-accelerating inflation rate of unemployment or NAIRU - is 
susceptible to government policies. 

Vanishingly low inflation - bordering on deflation - also results in a 
"liquidity trap". The nominal interest rate cannot go below zero. But 
what matters are real - inflation adjusted - interest rates. If 
inflation is naught or less - the authorities are unable to stimulate 
the economy by reducing interest rates below the level of inflation. 

This has been the case in Japan in the last few years and is now 
emerging as a problem in the USA. The Fed - having cut rates 11 times 
in the past 14 months and unless it is willing to expand the money 
supply aggressively - may be at the end of its monetary tether. The 
Bank of Japan has recently resorted to unvarnished and assertive 
monetary expansion in line with what Paul Krugman calls "credible 
promise to be irresponsible". 

This may have led to the sharp devaluation of the yen in recent months. 
Inflation is exported through the domestic currency's depreciation and 
the lower prices of export goods and services. Inflation thus 
indirectly enhances exports and helps close yawning gaps in the current 
account. The USA with its unsustainable trade deficit and resurgent 
budget deficit could use some of this medicine.

But the upshots of inflation are fiscal, not merely monetary. In 
countries devoid of inflation accounting, nominal gains are fully taxed 
- though they reflect the rise in the general price level rather than 
any growth in income. Even where inflation accounting is introduced, 
inflationary profits are taxed.

Thus inflation increases the state's revenues while eroding the real 
value of its debts, obligations, and expenditures denominated in local 
currency. Inflation acts as a tax and is fiscally corrective - but 
without the recessionary and deflationary effects of a "real" tax. 

The outcomes of inflation, ironically, resemble the economic recipe of 
the "Washington consensus" propagated by the likes of the rabidly 
anti-inflationary IMF. As a long term policy, inflation is 
unsustainable and would lead to cataclysmic effects. But, in the short 
run, as a "shock absorber" and "automatic stabilizer", low inflation 
may be a valuable counter-cyclical instrument.

Inflation also improves the lot of corporate - and individual - 
borrowers by increasing their earnings and marginally eroding the value 
of their debts (and savings). It constitutes a disincentive to save and 
an incentive to borrow, to consume, and, alas, to speculate. "The 
Economist" called it "a splendid way to transfer wealth from savers to 

The connection between inflation and asset bubbles is unclear. On the 
one hand, some of the greatest fizz in history occurred during periods 
of disinflation. One is reminded of the global boom in technology 
shares and real estate in the 1990's. On the other hand, soaring 
inflation forces people to resort to hedges such as gold and realty, 
inflating their prices in the process. Inflation - coupled with low or 
negative interest rates - also tends to exacerbate perilous imbalances 
by encouraging excess borrowing, for instance.

Still, the absolute level of inflation may be less important than its 
volatility. Inflation targeting - the latest fad among central bankers 
- aims to curb inflationary expectations by implementing a consistent 
and credible anti-inflationary as well as anti-deflationary policy 
administered by a trusted and impartial institution, the central bank. 

The Benefits of Oligopolies  

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

The Wall Street Journal has recently published an elegiac list:

"Twenty years ago, cable television was dominated by a patchwork of 
thousands of tiny, family-operated companies. Today, a pending deal 
would leave three companies in control of nearly two-thirds of the 
market. In 1990, three big publishers of college textbooks accounted 
for 35% of industry sales. Today they have 62% ... Five titans dominate 
the (defense) industry, and one of them, Northrop Grumman ... made a 
surprise (successful) $5.9 billion bid for (another) TRW ... In 1996, 
when Congress deregulated telecommunications, there were eight Baby 
Bells. Today there are four, and dozens of small rivals are dead. In 
1999, more than 10 significant firms offered help-wanted Web sites. 
Today, three firms dominate."

Mergers, business failures, deregulation, globalization, technology, 
dwindling and more cautious venture capital, avaricious managers and 
investors out to increase share prices through a spree of often 
ill-thought acquisitions - all lead inexorably to the congealing of 
industries into a few suppliers. Such market formations are known as 
oligopolies. Oligopolies encourage customers to collaborate in 
oligopsonies and these, in turn, foster further consolidation among 
suppliers, service providers, and manufacturers.

Market purists consider oligopolies - not to mention cartels - to be as 
villainous as monopolies. Oligopolies, they intone, restrict 
competition unfairly, retard innovation, charge rent and price their 
products higher than they could have in a perfect competition free 
market with multiple participants. Worse still, oligopolies are going 

But how does one determine market concentration to start with?

The Herfindahl-Hirschmann index squares the market shares of firms in 
the industry and adds up the total. But the number of firms in a market 
does not necessarily impart how low - or high - are barriers to entry. 
These are determined by the structure of the market, legal and 
bureaucratic hurdles, the existence, or lack thereof of functioning 
institutions, and by the possibility to turn an excess profit. 

The index suffers from other shortcomings. Often the market is 
difficult to define. Mergers do not always drive prices higher. 
University of Chicago economists studying Industrial Organization - the 
branch of economics that deals with competition - have long advocated a 
shift of emphasis from market share to - usually temporary - market 
power. Influential antitrust thinkers, such as Robert Bork, recommended 
to revise the law to focus solely on consumer welfare.

These - and other insights - were incorporated in a theory of market 
contestability. Contrary to classical economic thinking, monopolies and 
oligopolies rarely raise prices for fear of attracting new competitors, 
went the new school. This is especially true in a "contestable" market 
- where entry is easy and cheap. 

An Oligopolistic firm also fears the price-cutting reaction of its 
rivals if it reduces prices, goes the Hall, Hitch, and Sweezy theory of 
the Kinked Demand Curve. If it were to raise prices, its rivals may not 
follow suit, thus undermining its market share. Stackleberg's 
amendments to Cournot's Competition model, on the other hand, 
demonstrate the advantages to a price setter of being a first mover. 

In "Economic assessment of oligopolies under the Community Merger 
Control Regulation, in European Competition law Review (Vol 4, Issue 
3), Juan Briones Alonso writes:

"At first sight, it seems that ... oligopolists will sooner or later 
find a way of avoiding competition among themselves, since they are 
aware that their overall profits are maximized with this strategy. 
However, the question is much more complex. First of all, collusion 
without explicit agreements is not easy to achieve. Each supplier might 
have different views on the level of prices which the demand would 
sustain, or might have different price preferences according to its 
cost conditions and market share. A company might think it has certain 
advantages which its competitors do not have, and would perhaps 
perceive a conflict between maximising its own profits and maximizing 
industry profits. 

Moreover, if collusive strategies are implemented, and oligopolists 
manage to raise prices significantly above their competitive level, 
each oligopolist will be confronted with a conflict between sticking to 
the tacitly agreed behaviour and increasing its individual profits by 
'cheating' on its competitors. Therefore, the question of mutual 
monitoring and control is a key issue in collusive oligopolies."

Monopolies and oligopolies, went the contestability theory, also 
refrain from restricting output, lest their market share be snatched by 
new entrants. In other words, even monopolists behave as though their 
market was fully competitive, their production and pricing decisions 
and actions constrained by the "ghosts" of potential and threatening 

In a CRIEFF Discussion Paper titled "From Walrasian Oligopolies to 
Natural Monopoly - An Evolutionary Model of Market Structure", the 
authors argue that: "Under decreasing returns and some fixed cost, the 
market grows to 'full capacity' at Walrasian equilibrium (oligopolies); 
on the other hand, if returns are increasing, the unique long run 
outcome involves a profit-maximising monopolist."

While intellectually tempting, contestability theory has little to do 
with the rough and tumble world of business. Contestable markets simply 
do not exist. Entering a market is never cheap, nor easy. Huge sunk 
costs are required to counter the network effects of more veteran 
products as well as the competitors' brand recognition and ability and 
inclination to collude to set prices. 

Victory is not guaranteed, losses loom constantly, investors are 
forever edgy, customers are fickle, bankers itchy, capital markets 
gloomy, suppliers beholden to the competition. Barriers to entry are 
almost always formidable and often insurmountable.

In the real world, tacit and implicit understandings regarding prices 
and competitive behavior prevail among competitors within oligopolies. 
Establishing a reputation for collusive predatory pricing deters 
potential entrants. And a dominant position in one market can be 
leveraged into another, connected or derivative, market.

But not everyone agrees. Ellis Hawley believed that industries should 
be encouraged to grow because only size guarantees survival, lower 
prices, and innovation. Louis Galambos, a business historian at Johns 
Hopkins University, published a 1994 paper titled "The Triumph of 
Oligopoly". In it, he strove to explain why firms and managers - and 
even consumers - prefer oligopolies to both monopolies and completely 
free markets with numerous entrants.

Oligopolies, as opposed to monopolies, attract less attention from 
trustbusters. Quoted in the Wall Street Journal on March 8, 1999, 
Galambos wrote: "Oligopolistic competition proved to be beneficial ... 
because it prevented ossification, ensuring that managements would keep 
their organizations innovative and efficient over the long run."

In his recently published tome "The Free-Market Innovation Machine - 
Analysing the Growth Miracle of Capitalism", William Baumol of 
Princeton University, concurs. He daringly argues that productive 
innovation is at its most prolific and qualitative in oligopolistic 
markets. Because firms in an oligopoly characteristically charge 
above-equilibrium (i.e., high) prices - the only way to compete is 
through product differentiation. This is achieved by constant 
innovation - and by incessant advertising.

Baumol maintains that oligopolies are the real engines of growth and 
higher living standards and urges antitrust authorities to leave them 
be. Lower regulatory costs, economies of scale and of scope, excess 
profits due to the ability to set prices in a less competitive market - 
allow firms in an oligopoly to invest heavily in  research and 
development. A new drug costs c. $800 million to develop and get 
approved, according to Joseph DiMasi of Tufts University's Center for 
the Study of Drug Development, quoted in The wall Street Journal.

In a paper titled "If Cartels Were Legal, Would Firms Fix Prices", 
implausibly published by the Antitrust Division of the US Department of 
Justice in 1997, Andrew Dick demonstrated, counterintuitively, that 
cartels are more likely to form in industries and sectors with many 
producers. The more concentrated the industry - i.e., the more 
oligopolistic it is - the less likely were cartels to emerge.

Cartels are conceived in order to cut members' costs of sales. Small 
firms are motivated to pool their purchasing and thus secure discounts. 
Dick draws attention to a paradox: mergers provoke the competitors of 
the merging firms to complain. Why do they act this way? 

Mergers and acquisitions enhance market concentration. According to 
conventional wisdom, the more concentrated the industry, the higher the 
prices every producer or supplier can charge. Why would anyone complain 
about being able to raise prices in a post-merger market?

Apparently, conventional wisdom is wrong. Market concentration leads to 
price wars, to the great benefit of the consumer. This is why firms 
find the mergers and acquisitions of their competitors worrisome. 
America's soft drink market is ruled by two firms - Pepsi and 
Coca-Cola. Yet, it has been the scene of ferocious price competition 
for decades. 

"The Economist", in its review of the paper, summed it up neatly:

"The story of America's export cartels suggests that when firms decide 
to co-operate, rather than compete, they do not always have price 
increases in mind. Sometimes, they get together simply in order to cut 
costs, which can be of benefit to consumers."

The very atom of antitrust thinking - the firm - has changed in the 
last two decades. No longer hierarchical and rigid, business resembles 
self-assembling, nimble, ad-hoc networks of entrepreneurship 
superimposed on ever-shifting product groups and profit and loss 

Competition used to be extraneous to the firm - now it is commonly an 
internal affair among autonomous units within a loose overall 
structure. This is how Jack "neutron" Welsh deliberately structured 
General Electric. AOL-Time Warner hosts many competing units, yet no 
one ever instructs them either to curb this internecine competition, to 
stop cannibalizing each other, or to start collaborating 
synergistically. The few mammoth agencies that rule the world of 
advertising now host a clutch of creative boutiques comfortably 
ensconced behind Chinese walls. Such outfits often manage the accounts 
of competitors under the same corporate umbrella. 

Most firms act as intermediaries. They consume inputs, process them, 
and sell them as inputs to other firms. Thus, many firms are 
concomitantly consumers, producers, and suppliers. In a paper published 
last year and titled "Productive Differentiation in Successive Vertical 
Oligopolies", that authors studied:

"An oligopoly model with two brands. Each downstream firm chooses one 
brand to sell on a final market. The upstream firms specialize in the 
production of one input specifically designed for the production of one 
brand, but they also produce he input for the other brand at an extra 
cost. (They concluded that) when more downstream brands choose one 
brand, more upstream firms will specialize in the input specific to 
that brand, and vice versa. Hence, multiple equilibria are possible and 
the softening effect of brand differentiation on competition might not 
be strong enough to induce maximal differentiation" (and, thus, minimal 

Both scholars and laymen often mix their terms. 

Competition does not necessarily translate either to variety or to 
lower prices. Many consumers are turned off by too much choice. Lower 
prices sometimes deter competition and new entrants. A multiplicity of 
vendors, retail outlets, producers, or suppliers does not always foster 
competition. And many products have umpteen substitutes. Consider films 
- cable TV, satellite, the Internet, cinemas, video rental shops, all 
offer the same service: visual content delivery. 

And then there is the issue of technological standards. It is 
incalculably easier to adopt a single worldwide or industry-wide 
standard in an oligopolistic environment. Standards are known to 
decrease prices by cutting down R&D expenditures and systematizing 

Or, take innovation. It is used not only to differentiate one's 
products from the competitors' - but to introduce new generations and 
classes of products. Only firms with a dominant market share have both 
the incentive and the wherewithal to invest in R&D and in subsequent 
branding and marketing.

But oligopolies in deregulated markets have sometimes substituted price 
fixing, extended intellectual property rights, and competitive 
restraint for market regulation. Still, Schumpeter believed in the 
faculty of  "disruptive technologies" and "destructive creation" to 
check the power of oligopolies to set extortionate prices, lower 
customer care standards, or inhibit competition. 

Linux threatens Windows. Opera nibbles at Microsoft's Internet 
Explorer. Amazon drubbed traditional booksellers. eBay thrashes Amazon. 
Bell was forced by Covad Communications to implement its own 
technology, the DSL broadband phone line.

Barring criminal behavior, there is little that oligopolies can do to 
defend themselves against these forces. They can acquire innovative 
firms, intellectual property, and talent. They can form strategic 
partnerships. But the supply of innovators and new technologies is 
infinite - and the resources of oligopolies, however mighty, are 
finite. The market is stronger than any of its participants, regardless 
of the hubris of some, or the paranoia of others.

Moral Hazard and the Survival Value of Risk  

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

Also Read:

The Business of Risk


Risk transfer is the gist of modern economies. Citizens pay taxes to 
ever expanding governments in return for a variety of "safety nets" and 
state-sponsored insurance schemes. Taxes can, therefore, be safely 
described as insurance premiums paid by the citizenry. Firms extract 
from consumers a markup above their costs to compensate them for their 
business risks. 

Profits can be easily cast as the premiums a firm charges for the risks 
it assumes on behalf of its customers - i.e., risk transfer charges. 
Depositors charge banks and lenders charge borrowers interest, partly 
to compensate for the hazards of lending - such as the default risk. 
Shareholders expect above "normal" - that is, risk-free - returns on 
their investments in stocks. These are supposed to offset trading 
liquidity, issuer insolvency, and market volatility risks.

The reallocation and transfer of risk are booming industries. 
Governments, capital markets, banks, and insurance companies have all 
entered the fray with ever-evolving financial instruments. Pundits 
praise the virtues of the commodification and trading of risk. It 
allows entrepreneurs to assume more of it, banks to get rid of it, and 
traders to hedge against it. Modern risk exchanges liberated Western 
economies from the tyranny of the uncertain - they enthuse.

But this is precisely the peril of these new developments. They mass 
manufacture moral hazard. They remove the only immutable incentive to 
succeed - market discipline and business failure. They undermine the 
very fundaments of capitalism: prices as signals, transmission 
channels, risk and reward, opportunity cost. Risk reallocation, risk 
transfer, and risk trading create an artificial universe in which 
synthetic contracts replace real ones and third party and moral hazards 
replace business risks.

Moral hazard is the risk that the behaviour of an economic player will 
change as a result of the alleviation of real or perceived potential 
costs. It has often been claimed that IMF bailouts, in the wake of 
financial crises - in Mexico, Brazil, Asia, and Turkey, to mention but 
a few - created moral hazard. 

Governments are willing to act imprudently, safe in the knowledge that 
the IMF is a lender of last resort, which is often steered by 
geopolitical considerations, rather than merely economic ones. 
Creditors are more willing to lend and at lower rates, reassured by the 
IMF's default-staving safety net. Conversely, the IMF's refusal to 
assist Russia in 1998 and Argentina this year - should reduce moral 

The IMF, of course, denies this. In a paper titled "IMF Financing and 
Moral Hazard", published June 2001, the authors - Timothy Lane and 
Steven Phillips, two senior IMF economists - state:

"... In order to make the case for abolishing or drastically 
overhauling the IMF, one must show ... that the moral hazard generated 
by the availability of IMF financing overshadows any potentially 
beneficial effects in mitigating crises ... Despite many assertions in 
policy discussions that moral hazard is a major cause of financial 
crises, there has been astonishingly little effort to provide empirical 
support for this belief."

Yet, no one knows how to measure moral hazard. In an efficient market, 
interest rate spreads on bonds reflect all the information available to 
investors, not merely the existence of moral hazard. Market reaction is 
often delayed, partial, or distorted by subsequent developments.

Moreover, charges of "moral hazard" are frequently ill-informed and 
haphazard. Even the venerable Wall Street Journal fell in this 
fashionable trap. It labeled the Long Term Capital Management (LTCM) 
1998 salvage - "$3.5 billion worth of moral hazard". Yet, no public 
money was used to rescue the sinking hedge fund and investors lost most 
of their capital when the new lenders took over 90 percent of LTCM's 

In an inflationary turn of phrase, "moral hazard" is now taken to 
encompass anti-cyclical measures, such as interest rates cuts. The Fed 
- and its mythical Chairman, Alan Greenspan - stand accused of bailing 
out the bloated stock market by engaging in an uncontrolled spree of 
interest rates reductions. 

In a September 2001 paper titled "Moral Hazard and the US Stock 
Market", the authors - Marcus Miller, Paul Weller, and Lei Zhang, all 
respected academics - accuse the Fed of creating a "Greenspan Put". In 
a scathing commentary, they write:

"The risk premium in the US stock market has fallen far below its 
historic level ... (It may have been) reduced by one-sided intervention 
policy on the part of the Federal Reserve which leads investors into 
the erroneous belief that they are insured against downside risk ... 
This insurance - referred to as the Greenspan Put - (involves) 
exaggerated faith in the stabilizing power of Mr. Greenspan."

Moral hazard infringes upon both transparency and accountability. It is 
never explicit or known in advance. It is always arbitrary, or subject 
to political and geopolitical considerations. Thus, it serves to 
increase uncertainty rather than decrease it. And by protecting private 
investors and creditors from the outcomes of their errors and 
misjudgments - it undermines the concept of liability.

The recurrent rescues of Mexico - following its systemic crises in 
1976, 1982, 1988, and 1994 - are textbook examples of moral hazard. The 
Cato Institute called them, in a 1995 Policy Analysis paper, 
"palliatives" which create "perverse incentives" with regards to what 
it considers to be misguided Mexican public policies - such as refusing 
to float the peso.

Still, it can be convincingly argued that the problem of moral hazard 
is most acute in the private sector. Sovereigns can always inflate 
their way out of domestic debt. Private foreign creditors implicitly 
assume multilateral bailouts and endless rescheduling when lending to 
TBTF or TITF ("too big or too important to fail") countries. The debt 
of many sovereign borrowers, therefore, is immune to terminal default. 

Not so with private debtors. In remarks made by Gary Stern, President 
of the Federal Reserve Bank of Minneapolis, to the 35th Annual 
Conference on Bank Structure and Competition, on May 1999, he said:

"I propose combining market signals of risk with the best aspects of 
current regulation to help mitigate the moral hazard problem that is 
most acute with our largest banks ... The actual regulatory and legal 
changes introduced over the period-although positive steps-are 
inadequate to address the safety net's perversion of the risk/return 

This observation is truer now than ever. Mass-consolidation in the 
banking sector, mergers with non-banking financial intermediaries (such 
as insurance companies), and the introduction of credit derivatives and 
other financial innovations - make the issue of moral hazard all the 
more pressing.

Consider deposit insurance, provided by virtually every government in 
the world. It allows the banks to pay to depositors interest rates 
which do not reflect the banks' inherent riskiness. As the costs of 
their liabilities decline to unrealistic levels -banks misprice their 
assets as well. They end up charging borrowers the wrong interest rates 
or, more common, financing risky projects. 

Badly managed banks pay higher premiums to secure federal deposit 
insurance. But this disincentive is woefully inadequate and 
disproportionate to the enormous benefits reaped by virtue of having a 
safety net. Stern dismisses this approach:

"The ability of regulators to contain moral hazard directly is limited. 
Moral hazard results when economic agents do not bear the marginal 
costs of their actions. Regulatory reforms can alter marginal costs but 
they accomplish this task through very crude and often exploitable 
tactics. There should be limited confidence that regulation and 
supervision will lead to bank closures before institutions become 
insolvent. In particular, reliance on lagging regulatory measures, 
restrictive regulatory and legal norms, and the ability of banks to 
quickly alter their risk profile have often resulted in costly 

Stern concludes his remarks by repeating the age-old advice: caveat 
emptor. Let depositors and creditors suffer losses. This will enhance 
their propensity to discipline market players. They are also likely to 
become more selective and invest in assets which conform to their risk 

Both outcomes are highly dubious. Private sector creditors and 
depositors have little leverage over delinquent debtors or banks. When 
Russia - and trigger happy Russian firms - defaulted on their 
obligations in 1998, even the largest lenders, such as the EBRD, were 
unable to recover their credits and investments. 

The defrauded depositors of BCCI are still chasing the assets of the 
defunct bank as well as litigating against the Bank of England for 
allegedly having failed to supervise it. Discipline imposed by 
depositors and creditors often results in a "run on the bank" - or in 
bankruptcy. The presumed ability of stakeholders to discipline risky 
enterprises, hazardous financial institutions, and profligate 
sovereigns is fallacious.

Asset selection within a well balanced and diversified portfolio is 
also a bit of a daydream. Information - even in the most regulated and 
liquid markets - is partial, distorted, manipulative, and lagging. 
Insiders collude to monopolize it and obtain a "first mover" advantage. 

Intricate nets of patronage exclude the vast majority of shareholders 
and co-opt ostensible checks and balances - such as auditors, 
legislators, and regulators. Enough to mention Enron and its 
accountants, the formerly much vaunted Andersen.

Established economic theory - pioneered by Merton in 1977 - shows that, 
counterintuitively, the closer a bank is to insolvency, the more 
inclined it is to risky lending. Nobuhiko Hibara of Columbia University 
demonstrated this effect convincingly in the Japanese banking system in 
his November 2001 draft paper titled "What Happens in Banking Crises - 
Credit Crunch vs. Moral Hazard".

Last but by no means least, as opposed to oft-reiterated wisdom - the 
markets have no memory. Russia has egregiously defaulted on its 
sovereign debt a few times in the last 100 years. Only four years ago 
it thumbed its nose with relish at tearful foreign funds, banks, and 

Yet, it is now besieged by investment banks and a horde of lenders 
begging it to borrow at concessionary rates. The same goes for Mexico, 
Argentina, China, Nigeria, Thailand, other countries, and the 
accident-prone banking system in almost every corner of the globe.

In many places, international aid constitutes the bulk of foreign 
currency inflows. It is severely tainted by moral hazard. In a paper 
titled "Aid, Conditionality and Moral Hazard", written by Paul Mosley 
and John Hudson, and presented at the Royal Economic Society's 1998 
Annual Conference, the authors wrote:

"Empirical evidence on the effectiveness of both overseas aid and the 
'conditionality' employed by donors to increase its leverage suggests 
disappointing results over the past thirty years ... The reason for 
both failures is the same: the risk or 'moral hazard' that aid will be 
used to replace domestic investment or adjustment efforts, as the case 
may be, rather than supplementing such efforts."

In a May 2001 paper, tellingly titled "Does the World Bank Cause Moral 
Hazard and Political Business Cycles?" authored by Axel Dreher of 
Mannheim University, he responds in the affirmative:

"Net flows (of World Bank lending) are higher prior to elections ... It 
is shown that a country's rate of monetary expansion and its government 
budget deficit (are) higher the more loans it receives ... Moreover, 
the budget deficit is shown to be larger the higher the interest rate 
subsidy offered by the (World) Bank."

Thus, the antidote to moral hazard is not this legendary beast in the 
capitalistic menagerie, market discipline. Nor is it regulation. Nobel 
Prize winner Joseph Stiglitz, Thomas Hellman, and Kevin Murdock 
concluded in their 1998 paper - "Liberalization, Moral Hazard in 
Banking, and Prudential Regulation":

"We find that using capital requirements in an economy with freely 
determined deposit rates yields ... inefficient outcomes. With deposit 
insurance, freely determined deposit rates undermine prudent bank 
behavior. To induce a bank to choose to make prudent investments, the 
bank must have sufficient franchise value at risk ... Capital 
requirements also have a perverse effect of increasing the bank's cost 
structure, harming the franchise value of the bank ... Even in an 
economy where the government can credibly commit not to offer deposit 
insurance, the moral hazard problem still may not disappear."

Moral hazard must be balanced, in the real world, against more ominous 
and present threats, such as contagion and systemic collapse. Clearly, 
some moral hazard is inevitable if the alternative is another Great 
Depression. Moreover, most people prefer to incur the cost of moral 
hazard. They regard it as an insurance premium. 

Depositors would like to know that their deposits are safe or 
reimbursable. Investors would like to mitigate some of the risk by 
shifting it to the state. The unemployed would like to get their 
benefits regularly. Bankers would like to lend more daringly. 
Governments would like to maintain the stability of their financial 

The common interest is overwhelming - and moral hazard seems to be a 
small price to pay. It is surprising how little abused these safety 
nets are - as Stephane Pallage and Christian Zimmerman of the Center 
for Research on Economic Fluctuations and Employment in the University 
of Quebec note in their paper "Moral Hazard and Optimal Unemployment 

Martin Gaynor, Deborah Haas-Wilson, and William Vogt, cast in doubt the 
very notion of "abuse" as a result of moral hazard in their NBER paper 
titled "Are Invisible Hands Good Hands?":

"Moral hazard due to health insurance leads to excess consumption, 
therefore it is not obvious that competition is second best optimal. 
Intuitively, it seems that imperfect competition in the healthcare 
market may constrain this moral hazard by increasing prices. We show 
that this intuition cannot be correct if insurance markets are 

A competitive insurance market will always produce a contract that 
leaves consumers at least as well off under lower prices as under 
higher prices. Thus, imperfect competition in healthcare markets can 
not have efficiency enhancing effects if the only distortion is due to 
moral hazard."

Whether regulation and supervision - of firms, banks, countries, 
accountants, and other market players - should be privatized or 
subjected to other market forces - as suggested by the likes of Bert 
Ely of Ely & Company in the Fall 1999 issue of "The Independent Review" 
- is still debated and debatable. With governments, central banks, or 
the IMF as lenders and insurer of last resort - there is little 
counterparty risk. 

Private counterparties are a whole different ballgame. They are loth 
and slow to pay. Dismayed creditors have learned this lesson in Russia 
in 1998. Investors in derivatives get acquainted with it in the 2001-2 
Enron affair. Mr. Silverstein is being agonizingly introduced to it in 
his dealings with insurance companies over the September 11 World Trade 
Center terrorist attacks.

We may more narrowly define moral hazard as the outcome of asymmetric 
information - and thus as the result of the rational conflicts between 
stakeholders (e.g., between shareholders and managers, or between 
"principals" and "agents"). This modern, narrow definition has the 
advantage of focusing our moral outrage upon the culprits - rather 
than, indiscriminately, upon both villains and victims.

The shareholders and employees of Enron may be entitled to some kind of 
safety net - but not so its managers. Laws - and social norms - that 
protect the latter at the expense of the former, should be altered post 
haste. The government of a country bankrupted by irresponsible economic 
policies should be ousted - its hapless citizens may deserve financial 
succor. This distinction between perpetrator and prey is essential.

The insurance industry has developed a myriad ways to cope with moral 
hazard. Co-insurance, investigating fraudulent claims, deductibles, and 
incentives to reduce claims are all effective. The residual cost of 
moral hazard is spread among the insured in the form of higher 
premiums. No reason not to emulate these stalwart risk traders. They 
bet their existence of their ability to minimize moral hazard - and 
hitherto, most of them have been successful.

The Business of Risk 

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

Risk transfer is the gist of modern economies. Citizens pay taxes to 
ever expanding governments in return for a variety of "safety nets" and 
state-sponsored insurance schemes. Taxes can, therefore, be safely 
described as insurance premiums paid by the citizenry. Firms extract 
from consumers a markup above their costs to compensate them for their 
business risks. 

Profits can be easily cast as the premiums a firm charges for the risks 
it assumes on behalf of its customers - i.e., risk transfer charges. 
Depositors charge banks and lenders charge borrowers interest, partly 
to compensate for the hazards of lending - such as the default risk. 
Shareholders expect above "normal" - that is, risk-free - returns on 
their investments in stocks. These are supposed to offset trading 
liquidity, issuer insolvency, and market volatility risks.

In his recent book, "When all Else Fails: Government as the Ultimate 
Risk Manager", David Moss, an associate professor at Harvard Business 
School, argues that the all-pervasiveness of modern governments is an 
outcome of their unique ability to reallocate and manage risk. 

He analyzes hundreds of examples - from bankruptcy law to income 
security, from flood mitigation to national defense, and from consumer 
protection to deposit insurance. The limited liability company shifted 
risk from shareholders to creditors. Product liability laws shifted 
risk from consumers to producers. 

And, we may add, over-generous pension plans shift risk from current 
generations to future ones. Export and credit insurance schemes - such 
as the recently established African Trade Insurance Agency or the more 
veteran American OPIC (Overseas Private Investment Corporation), the 
British ECGD, and the French COFACE - shift political risk from buyers, 
project companies, and suppliers to governments.

Risk transfer is the traditional business of insurers. But governments 
are in direct competition not only with insurance companies - but also 
with the capital markets. Futures, forwards, and options contracts are, 
in effect, straightforward insurance policies. 

They cover specific and narrowly defined risks: price fluctuations - of 
currencies, interest rates, commodities, standardized goods, metals, 
and so on. "Transformer" companies - collaborating with insurance firms 
- specialize in converting derivative contracts (mainly credit default 
swaps) into insurance policies. This is all part of the famous 
Keynes-Hicks hypothesis.

As Holbrook Working proved in his seminal work, hedges fulfill other 
functions as well - but even he admitted that speculators assume risks 
by buying the contracts. Many financial players emphasize the risk 
reducing role of derivatives. Banks, for instance, lend more - and more 
easily - against hedged merchandise.

Hedging and insurance used to be disparate activities which required 
specialized skills. Derivatives do not provide perfect insurance due to 
non-eliminable residual risks (e.g., the "basis risk" in futures 
contracts, or the definition of a default in a credit derivative). But 
as banks and insurance companies merged into what is termed, in French, 
"bancassurance", or, in German, "Allfinanz" - so did their hedging and 
insurance operations.

In his paper "Risk Transfer between Banks, Insurance Companies, and 
Capital Markets", David Rule of the Bank of England flatly states:

"At least as important for the efficiency and robustness of the 
international financial system are linkages through the growing markets 
for risk transfer. Banks are shedding risks to insurance companies, 
amongst others; and life insurance companies are using capital markets 
and banks to hedge some of the significant market risks arising from 
their portfolios of retail savings products ... These interactions 
(are) effected primarily through securitizations and derivatives. In 
principle, firms can use risk transfer markets to disperse risks, 
making them less vulnerable to particular regional, sectoral, or market 

Greater inter-dependence, however, raises challenges for market 
participants and the authorities: in tracking the distribution of risks 
in the economy, managing associated counterparty exposures, and 
ensuring that regulatory, accounting, and tax differences do not 
distort behavior in undesirable ways." 

If the powers of government are indeed commensurate with the scope of 
its risk transfer and reallocation services - why should it encourage 
its competitors? The greater the variety of insurance a state offers - 
the more it can tax and the more perks it can lavish on its 
bureaucrats. Why would it forgo such benefits? Isn't it more rational 
to expect it to stifle the derivatives markets and to restrict the role 
and the product line of insurance companies?

This would be true only if we assume that the private sector is both 
able and willing to insure all risks - and thus to fully substitute for 
the state.

Yet, this is patently untrue. Insurance companies cover mostly "pure 
risks" - loss yielding situations and events. The financial markets 
cover mostly "speculative risks" - transactions that can yield either 
losses or profits. Both rely on the "law of large numbers" - that in a 
sufficiently large population, every event has a finite and knowable 
probability. None of them can or will insure tiny, exceptional 
populations against unquantifiable risks. It is this market failure 
which gave rise to state involvement in the business of risk to start 

Consider the September 11 terrorist attacks with their mammoth damage 
to property and unprecedented death toll.  

According to "The Economist", in the wake of the atrocity, insurance 
companies slashed their coverage to $50 million per airline per event. 
EU governments had to step in and provide unlimited insurance for a 
month. The total damage, now pegged at $60 billion - constitutes one 
quarter of the capitalization of the entire global reinsurance market.

Congress went even further, providing coverage for 180 days and a 
refund of all war and terrorist liabilities above $100 million per 
airline. The Americans later extended the coverage until mid-May. The 
Europeans followed suit. Despite this public display of commitment to 
the air transport industry, by January this year, no re-insurer agreed 
to underwrite terror and war risks. The market ground to a screeching 
halt. AIG was the only one to offer, last March, to hesitantly re-enter 
the market. Allianz followed suit in Europe, but on condition that EU 
governments act as insurers of last resort.

Even avowed paragons of the free market - such as Warren Buffet and 
Kenneth Arrow - called on the Federal government to step in. Some 
observers noted the "state guarantee funds" - which guarantee full 
settlement of policyholders' claims on insolvent insurance companies in 
the various states. Crop failures and floods are already insured by 
federal programs.

Other countries - such as Britain and France - have, for many years, 
had arrangements to augment funds from insurance premiums in case of an 
unusual catastrophe, natural or man made. In Israel, South Africa, and 
Spain, terrorism and war damages are indemnified by the state or 
insurance consortia it runs. Similar schemes are afoot in Germany.

But terrorism and war are, gratefully, still rarities. Even before 
September 11, insurance companies were in the throes of a frantic 
effort to reassert themselves in the face of stiff competition offered 
by the capital markets as well as by financial intermediaries - such as 
banks and brokerage houses. 

They have invaded the latter's turf by insuring hundreds of billions of 
dollars in pools of credit instruments, loans, corporate debt, and 
bonds - quality-graded by third party rating agencies. Insurance 
companies have thus become backdoor lenders through specially-spun 
"monoline" subsidiaries. 

Moreover, most collateralized debt obligations - the predominant 
financial vehicle used to transfer risks from banks to insurance firms 
- are "synthetic" and represent not real loans but a crosscut of the 
issuing bank's assets. Insurance companies have already refused to pay 
up on specific Enron-related credit derivatives - claiming not to have 
insured against a particular insurance events. The insurance pertained 
to global pools linked and overall default rates - they protested.

This excursion of the insurance industry into the financial market was 
long in the making. Though treated very differently by accountants - 
financial folk see little distinction between an insurance policy and 
equity capital. Both are used to offset business risks. 

To recoup losses incurred due to arson, or embezzlement, or accident - 
the firm can resort either to its equity capital (if it is uninsured) 
or to its insurance. Insurance, therefore, serves to leverage the 
firm's equity. By paying a premium, the firm increases its pool of 

The funds yielded by an insurance policy, though, are encumbered and 
contingent. It takes an insurance event to "release" them. Equity 
capital is usually made immediately and unconditionally available for 
any business purpose. Insurance companies are moving resolutely to 
erase this distinction between on and off balance sheet types of 
capital. They want to transform "contingent equity" to "real equity".

They do this by insuring "total business risks" - including business 
failures or a disappointing bottom line. Swiss Re has been issuing such 
policies in the last 3 years. Other insurers - such as Zurich - move 
into project financing. They guarantee a loan and then finance it based 
on their own insurance policy as a collateral.

Paradoxically, as financial markets move away from "portfolio 
insurance" (a form of self-hedging) following the 1987 crash on Wall 
Street - leading insurers and their clients are increasingly 
contemplating "self-insurance" through captives and other subterfuges. 

The blurring of erstwhile boundaries between insurance and capital is 
most evident in Alternative Risk Transfer (ART) financing. It is a 
hybrid between creative financial engineering and medieval mutual or ad 
hoc insurance. It often involves "captives" - insurance or reinsurance 
firms owned by their insured clients and located in tax friendly climes 
such as Bermuda, the Cayman Islands, Barbados, Ireland, and in the USA: 
Vermont, Colorado, and Hawaii. 

Companies - from manufacturers to insurance agents - are willing to 
retain more risk than ever before. ART constitutes less than one tenth 
the global insurance market according to "The Economist" - but almost 
one third of certain categories, such as the US property and casualty 
market, according to an August 2000 article written by Albert Beer of 
America Re. ART is also common in the public and not for profit sectors. counts the advantages of self-insurance:

"The alternative to trading dollars with commercial insurers in the 
working layers of risk, direct access to the reinsurance markets, 
coverage tailored to your specific needs, accumulation of investment 
income to help reduce net loss costs, improved cash flow, incentive for 
loss control, greater control over claims, underwriting and retention 
funding flexibility, and reduced cost of operation."

Captives come in many forms: single parent - i.e., owned by one company 
to whose customized insurance needs the captive caters, multiple parent 
- also known as group, homogeneous, or joint venture, heterogeneous 
captive - owned by firms from different industries, and segregated cell 
captives - in which the assets and liabilities of each "cell" are 
legally insulated. There are even captives for hire, known as "rent a 

The more reluctant the classical insurance companies are to provide 
coverage - and the higher their rates - the greater the allure of ART. 
According to "The Economist", the number of captives established in 
Bermuda alone doubled to 108 last year reaching a total of more than 
4000. Felix Kloman of Risk Management Reports estimated that $21 
billion in total annual premiums were paid to captives in 1999.

The Air Transport Association and Marsh, an insurer, are in the process 
of establishing Equitime, a captive, backed by the US government as an 
insurer of last resort. With an initial capital of $300 million, it 
will offer up to $1.5 billion per airline for passenger and third party 
war and terror risks.

Some insurance companies - and corporations, such as Disney - have been 
issuing high yielding CAT (catastrophe) bonds since 1994. These lose 
their value - partly or wholly - in the event of a disaster. The money 
raised underwrites a reinsurance or a primary insurance contract. 

According to an article published by Kathryn Westover of Strategic Risk 
Solutions in "Financing Risk and Reinsurance", most CATs are issued by 
captive Special Purpose Vehicles (SPV's) registered in offshore havens. 
This did not contribute to the bonds' transparency - or popularity.

An additional twist comes in the form of Catastrophe Equity Put Options 
which oblige their holder to purchase the equity of the insured at a 
pre-determined price. Other derivatives offer exposure to insurance 
risks. Options bought by SPV's oblige investors to compensate the 
issuer - an insurance or reinsurance company - if damages exceed the 
strike price. Weather derivatives have taken off during the recent 
volatility in gas and electricity prices in the USA.

The bullish outlook of some re-insurers notwithstanding, the market is 
tiny - less than $1 billion annually - and illiquid. A CATs risk index 
is published by and option contracts are traded on the Chicago Board of 
Trade (CBOT). Options were also traded, between 1997 and 1999, on the 
Bermuda Commodities Exchange (BCE). 

Risk transfer, risk trading and the refinancing of risk are at the 
forefront of current economic thought. An equally important issue 
involves "risk smoothing". Risks, by nature, are "punctuated" - 
stochastic and catastrophic. Finite insurance involves long term, fixed 
premium, contracts between a primary insurer and his re-insurer. The 
contract also stipulates the maximum claim within the life of the 
arrangement. Thus, both parties know what to expect and - a usually 
well known or anticipated - risk is smoothed.

Yet, as the number of exotic assets increases, as financial services 
converge, as the number of players climbs, as the sophistication of 
everyone involved grows - the very concept of risk is under attack. 
Value-at-Risk (VAR) computer models - used mainly by banks and hedge 
funds in "dynamic hedging" - merely compute correlations between 
predicted volatilities of the components of an investment portfolio. 

Non-financial companies, spurred on by legislation, emulate this 
approach by constructing "risk portfolios" and keenly embarking on 
"enterprise risk management (ERM)", replete with corporate risk 
officers. Corporate risk models measure the effect that simultaneous 
losses from different, unrelated, events would have on the well-being 
of the firm. 

Some risks and losses offset each others and are aptly termed "natural 
hedges". Enron pioneered the use of such computer applications in the 
late 1990's - to little gain it would seem. There is no reason why 
insurance companies wouldn't insure such risk portfolios - rather than 
one risk at a time. "Multi-line" or "multi-trigger" policies are a 
first step in this direction. 

But, as Frank Knight noted in his seminal "Risk, Uncertainty, and 
Profit", volatility is wrongly - and widely - identified with risk. 
Conversely, diversification and bundling have been as erroneously - and 
as widely - regarded as the ultimate risk neutralizers. His work was 
published in 1921.

Guided by VAR models, a change in volatility allows a bank or a hedge 
fund to increase or decrease assets with the same risk level and thus 
exacerbate the overall hazard of a portfolio. The collapse of the 
star-studded Long Term Capital Management (LTCM) hedge fund in 1998 is 
partly attributable to this misconception. 

In the Risk annual congress in Boston two years ago, Myron Scholes of 
Black-Scholes fame and LTCM infamy, publicly recanted, admitting that, 
as quoted by Dwight Cass in the May 2002 issue of Risk Magazine: "It is 
impossible to fully account for risk in a fluid, chaotic world full of 
hidden feedback mechanisms." Jeff Skilling of Enron publicly begged to 
disagree with him.

Last month, in the Paris congress, Douglas Breeden, dean of Duke 
University's Fuqua School of Business, warned that - to quote from the 
same issue of Risk Magazine:

" 'Estimation risk' plagues even the best-designed risk management 
system. Firms must estimate risk and return parameters such as means, 
betas, durations, volatilities and convexities, and the estimates are 
subject to error. Breeden illustrated his point by showing how 
different dealers publish significantly different prepayment forecasts 
and option-adjusted spreads on mortgage-backed securities ... (the 
solutions are) more capital per asset and less leverage."

Yet, the Basle committee of bank supervisors has based the new capital 
regime for banks and investment firms, known as Basle 2, on the banks' 
internal measures of risk and credit scoring. Computerized VAR models 
will, in all likelihood, become an official part of the quantitative 
pillar of Basle 2 within 5-10 years.

Moreover, Basle 2 demands extra equity capital against operational 
risks such as rogue trading or bomb attacks. There is no hint of the 
role insurance companies can play ("contingent equity"). There is no 
trace of the discipline which financial markets can impose on lax or 
dysfunctional banks - through their publicly traded unsecured, 
subordinated debt.

Basle 2 is so complex, archaic, and inadequate that it is bound to 
frustrate its main aspiration: to avert banking crises. It is here that 
we close the circle. Governments often act as reluctant lenders of last 
resort and provide generous safety nets in the event of a bank 

Ultimately, the state is the mother of all insurers, the master policy, 
the supreme underwriter. When markets fail, insurance firm recoil, and 
financial instruments disappoint - the government is called in to pick 
up the pieces, restore trust and order and, hopefully, retreat more 
gracefully than it was forced to enter.

Global Differential Pricing  

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

Also Read:

The Revolt of the Poor


Last April, the World Health Organization (WHO), the World Trade 
Organization (WTO), the Norwegian Foreign Ministry, and the US-based 
Global Health Council held a 3-days workshop about "Pricing and 
Financing of Essential Drugs" in poor countries. Not surprisingly, the 
conclusion was:

"... There was broad recognition that differential pricing could play 
an important role in ensuring access to existing drugs at affordable 
prices, particularly in the poorest countries, while the patent system 
would be allowed to continue to play its role in providing incentives 
for research and development into new drugs."

The 80 experts, who attended the workshop, proposed to reconcile these 
two, apparently contradictory, aspirations by introducing different 
prices for drugs in low-income and rich countries. This could be 
achieved bilaterally, between companies and purchasers, patent holders 
and manufacturers, global suppliers and countries - or through a market 

According to IMS Health, poor countries are projected to account for 
less than one quarter of pharmaceutical sales this year. Of every $100 
spent on medicines worldwide - 42 are in the USA, 25 in Europe, 11 in 
Japan, 7.5 in Latin America and the Caribbean, 5 in China and South 
East Asia, less than 2 in East Europe and India each, about 1 in Africa 
and the Commonwealth of Independent States (CIS) each.

Vaccines, contraceptives, and condoms are already subject to 
cross-border differential pricing. Lately, drug companies, were forced 
to introduce multi-tiered pricing following court decisions, or 
agreements with the authorities. Brazilians and South Africans, for 
instance, pay a fraction of the price paid in the West for their 
anti-retroviral AIDS medication. 

Even so, the price of a typical treatment is not affordable. Foreign 
donors, private foundations - such as the Bill and Melissa Gates 
Foundation - and international organizations had to step in to cover 
the shortfall. 

The experts acknowledged the risk that branded drugs sold cheaply in a 
poor country might end up being smuggled into and consumed in a much 
richer ones. 

Less likely, industrialized countries may also impose price controls, 
using poor country prices as benchmarks. Other participants, including 
dominant NGO's, such as Oxfam and Medecins Sans Frontieres, rooted for 
a reform of the TRIPS agreement - or the manufacturing of generic 
alternatives to branded drugs.

The "health safeguards" built into the Trade-related Aspects of 
Intellectual Property Rights (TRIPS) convention allow for compulsory 
licensing - manufacturing a drug without the patent holder's permission 
- and for parallel imports - importing a drug from another country 
where it is sold at a lower price - in case of an health emergency. 

Aware of the existence of this Damocles sword, the European Union and 
the trans-national pharmaceutical lobby have come out last May in favor 
of "global tiered pricing". 

In its 2001 Human Development Report (HDR), the United Nations 
Development Program (UNDP) called to introduce differential rich versus 
poor country pricing for "essential high-tech products" as well. The 
Health GAP Coalition commented on the report:

"On the issue of differential pricing, the Report notes that, while an 
effective global market would encourage different prices in different 
countries for products such as pharmaceuticals, the current system does 
not. With high-tech products, where the main cost to the seller is 
usually research rather than production, such tiered pricing could lead 
to an identical product being sold in poor countries for just 
one-tenth-or one-hundredth- the price in Europe or the United States.

But drug companies and other technology producers fear that knowledge 
about such discounting could lead to a demand for lower prices in rich 
countries as well. They have tended to set global prices that are 
unaffordable for the citizens of poor countries (as with many AIDS 

'Part of the battle to establish differential pricing must be won 
through consumer education. The citizens of rich countries must 
understand that it is only fair for people in developing countries to 
pay less for medicines and other critical technology products.' - 
stated Ms. Sukaki Fukuda-Parr" the lead author of the Report.

Public declarations issued in Havana, Cuba, in San Jose, Costa Rica in 
the late 1990's touted the benefits of free online scholarship for 
developing countries. The WHO and the Open Society Institute initiated 
HINARI - Health InterNetwork Access to Research Initiative. Peter 
Suber, the publisher of the "Free Online Scholarship" newsletter, 
summarizes the initiative thus:

"Under the program, the world's six largest publishers of biomedical 
journals have agreed to three-tiered pricing. For countries in the 
lowest tier (GNP per capita below $1k), online subscriptions are free 
of charge. For countries in the middle tier (GNP per capita between $1k 
and $3k), online subscriptions will be discounted by an amount to be 
decided this June. Countries in the top tier pay full price.

The six participating publishers are Blackwell Synergy, Elsevier 
Science Direct, Harcourt IDEAL, Springer Link, Wiley Interscience, and 
Wolters Kluwer. The subscriptions are given to universities and 
research institutions, not to individuals. But they are identical in 
scope to the subscriptions received by institutions paying the full 

Of 500 bottom-tier eligible institutions, more than 200 have already 
signed up. Additional publishers have joined this 3-5 years program and 
most biomedical journals are already on offer. Mid-tier pricing will be 
declared by January next year. HINARI will probably be expanded to 
cover other scientific disciplines.

Authors from developing countries also benefit from the spread of free 
online scholarship coupled with differential pricing. "Best of 
Science", for example, a free, peer-reviewed, online science journal 
subsists on fees paid by the authors. It charges authors from 
developing countries less. 

But differential pricing is unlikely to be confined to scholarly 
journals. Already, voices in developing countries demand tiered pricing 
for Western textbooks sold in emerging economies. Quoted in the Free 
Online Scholarship newsletter, Lai Ting-ming of the Taipei Times 
criticized, on March 26, "western publishers for selling textbooks to 
third world students at first world prices. There is a "textbook 
pricing crisis" in developing countries, which is most commonly solved 
by illicit photocopying."

Touchingly, the issue of the dispossessed within rich country societies 
was raised by two African Special Rapporteurs in a report submitted 
last year to the UN sub-Commission on Human Rights and titled 
"Globalization and its Impact on the Full Enjoyment of Human Rights". 
It said:

" ... The emphasis on R & D investment conveniently omits mention of 
the fact that some of the financing for this research comes from public 
sources; how then can it be justifiably argued that the benefits that 
derive from such investment should accrue primarily to private 
interests? Lastly, the focus on differential pricing between (rich and 
poor) countries omits consideration of the fact that there are many 
people within developed countries who are also unable to afford the 
same drugs. This may be on account of an inaccessible or inhospitable 
health care system (in terms of cost or an absence of adequate social 
welfare mechanisms), or because of racial, gender, sexual orientation 
or other forms of discrimination."

Differential pricing is often confused with dynamic pricing. 

Bob Gressens of Moai Technologies and Christopher Brousseau of 
Accenture define dynamic pricing, in their paper "The Value 
Propositions of Dynamic Pricing in Business-to-Business E-Commerce" as: 
"... The buying and selling of goods and services in markets where 
prices are free to move in response to supply and demand conditions." 

This is usually done through auctions or requests for quotes or 
tenders. Dynamic pricing is most often used in the liquidation of 
surplus inventories and for e-sourcing.

Nor is differential pricing entirely identical with non-linear pricing. 
In the real world, prices are rarely fixed. Some prices vary with usage 
- "pay per view" in the cable TV industry, or "pay per print" in 
scholarly online reference. Other prices combine a fixed element (e.g., 
a subscription fee) with a variable element (e.g., payment per 
broadband usage). Volume discounts, sales, cross-selling, three for the 
price of two - are all examples of non-linear pricing. Non-linear 
pricing is about charging different prices to different consumers - but 
within the same market.

Hal Varian of the School of Information Management and Systems at the 
University of California in Berkeley summarizes the treatment of "Price 
Discrimination" in A. C. Pigou's seminal 1920 tome, "The Economics of 

"First-degree price discrimination means that the producer sells 
different units of output for different prices and these prices may 
differ from person to person. This is sometimes known as the case of 
perfect price discrimination.

Second-degree price discrimination means that the producer sells 
different units of output for different prices, but every individual 
who buys the same amount of the good pays the same price. 

Thus prices depend on the amount of the good purchased, but not on who 
does the purchasing. A common example of this sort of pricing is volume 

Third-degree price discrimination occurs when the producer sells output 
to different people for different prices, but every unit of output sold 
to a given person sells for the same price. This is the most common 
form of price discrimination, and examples include senior citizens' 
discounts, student discounts, and so on."

Varian evaluates the contribution of each of these practices to 
economic efficiency in a 1996 article published in "First Monday":

"First-degree price discrimination yields a fully efficient outcome, in 
the sense of maximizing consumer plus producer surplus.

Second-degree price discrimination generally provides an efficient 
amount of the good to the largest consumers, but smaller consumers may 
receive inefficiently low amounts. Nevertheless, they will be better 
off than if they did not participate in the market. If differential 
pricing is not allowed, groups with small willingness to pay may not be 
served at all.

Third-degree price discrimination increases welfare when it encourages 
a sufficiently large increase in output. If output doesn't increase, 
total welfare will fall. As in the case of second-degree price 
discrimination, third-degree price discrimination is a good thing for 
niche markets that would not otherwise be served under a uniform 
pricing policy.

The key issue is whether the output of goods and services is increased 
or decreased by differential pricing."

Strictly speaking, global differential pricing is none of the above. It 
involves charging different prices in different markets, in accordance 
with the purchasing power of the local clientele (i.e., their 
willingness and ability to pay) - or in deference to their political 
and legal clout. 

Differential prices are not set by supply and demand and, therefore, do 
not fluctuate. All the consumers within each market are charged the 
same - prices vary only across markets. They are determined by the 
manufacturer in each and every market separately in accordance with 
local conditions. 

A March 2001 WHO/WTO background paper titled "More Equitable Pricing 
for Essential Drugs" discovered immense variations in the prices of 
medicines among different national markets. But, surprisingly, these 
price differences were unrelated to national income. 

Even allowing for price differentials, the one-month cost of treatment 
of Tuberculosis in Tanzania was the equivalent of 500 working hours - 
compared to 1.4 working hours in Switzerland. The price of medicines in 
poor countries - from Zimbabwe to India - was clearly higher than one 
would have expected from income measures such as GDP per capita or 
average wages. Why didn't drug prices adjust to reflect indigenous 
purchasing power?

According to the Paris-based International Chamber of Commerce (ICC), 
differential pricing is also - perhaps mostly - influenced by other 
considerations such as: transportation costs, disparate tax and customs 
regimes, cost of employment, differences in property rights and 
royalties, local safety and health standards, price controls, quality 
of internal distribution systems, the size of the order, the size of 
the market, and so on.

Differential pricing was made possible by the application of mass 
manufacturing to the knowledge society. Many industries, both emerging 
ones, like telecommunications, or information technology - and mature 
ones, like airlines, or pharmaceuticals - defy conventional pricing 
theory. They involve huge sunk and fixed costs - mainly in research and 
development and plant. 

But the marginal cost of each and every manufactured unit is identical 
- and vanishingly low. Beyond a certain quantitative threshold returns 
skyrocket and revenues contribute directly to the bottom line.

Consider software applications. The first units sold cover the enormous 
fixed and sunk costs of authoring the software and the machine tools 
used in the manufacturing process. The actual production ("variable" or 
"marginal") cost of each unit is a mere few cents - the wholesale price 
of the diskettes or CD-ROM's consumed. Thus, after having achieved 
breakeven, sales revenues translate immediately to gross profits.

This bifurcation - the huge fixed costs versus the negligible marginal 
costs - vitiates the rule: "set price at marginal cost". At which 
marginal cost? To compensate for the sunk and fixed costs, the first 
"marginal units" must carry a much higher price tag than the last ones. 

Hal Varian studied this problem. His conclusions:

"(i) Efficient pricing in such environments will typically involve 
prices that differ across consumers and type of service; (ii) producers 
will want to engage in product and service differentiation in order for 
this differential pricing to be feasible; and, (iii) differential 
pricing will arise naturally as a result of profit seeking by firms. It 
follows that differential pricing can generally be expected to 
contribute to economic efficiency."

Differential pricing is also the outcome of globalization. As brands 
become ubiquitous and as the information superhighway renders prices 
comparable and transparent - different markets react differently to 
price signals. In impoverished countries, differential pricing was 
introduced illegally where manufacturers insisted on rigid, rich-world, 
price lists. 

Piracy of intellectual property, for instance, is a form of coercive 
(and illegal) differential pricing. The existence of thriving rip-off 
markets proves that, at the right prices, demand is rife (demand 
elasticity). Both piracy and differential pricing may be spreading to 
scholarly publishing and other form of intellectual property such as 
software, films, music, and e-books.

Consumers are divided on the issue of multi-tiered pricing tailored to 
fit the customer's purchasing power. Not surprisingly, rich world 
buyers are apprehensive. They feel that differential pricing is a form 
of hidden subsidy, or a kind of "third world tax".

On September 2000, conducted a unique poll - this time among 
customers - regarding differential pricing (actually, non-linear 
pricing) - showing different prices to different users on the same 

Forty two percent of all respondents though it was "discrimination" and 
"should stop" - but a surprising 31 percent regarded it as "a valid use 
of data mining". A quarter said it is "OK, if explained to users". The 
comments were telling:

"I work over 80 hours a week. As a small business owner, I may make 
good money, but does that mean I should be charged more than 
unmotivated individuals who are broke because they don't want to work 
more than 30 hours a week. I don't think so ... Should (preferred) 
customers disappear in (the) off-line world? Should Gold Cards or 
Platinum Cards disappear? ...

The interesting thing is that discrimination of pricing is very common 
in the insurance industry - the basis for actuarial work and in 
airlines - based on load factors. The key is the pricing available to 
groups of customers with similar profiles ... Simple supply and demand, 
competition from other suppliers should offset ... A dangerous policy 
to implement ... As a consumer I don't necessarily like it, (unless I 
get a lower price!). However, economically speaking, (think of a 
monopolist's MR curve) the ideal is to have each person pay the maximum 
amount that they are willing to pay."

The Disruptive Engine 

Innovation and the Capitalistic Dream

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

On 18 June business people across the UK took part in Living Innovation 
2002. The extravaganza included a national broadcast linkup from the 
Eden Project in Cornwall and satellite-televised interviews with 
successful innovators.

Innovation occurs even in the most backward societies and in the 
hardest of times. It is thus, too often, taken for granted. But the 
intensity, extent, and practicality of innovation can be fine-tuned. 
Appropriate policies, the right environment, incentives, functional and 
risk seeking capital markets, or a skillful and committed Diaspora - 
can all enhance and channel innovation. 

The wrong cultural context, discouraging social mores, xenophobia, a 
paranoid set of mind, isolation from international trade and FDI, lack 
of fiscal incentives, a small domestic or regional market, a 
conservative ethos, risk aversion, or a well-ingrained fear of 
disgracing failure - all tend to stifle innovation.

Product Development Units in banks, insurers, brokerage houses, and 
other financial intermediaries churn out groundbreaking financial 
instruments regularly. Governments - from the United Kingdom to New 
Zealand - set up "innovation teams or units" to foster innovation and 
support it. Canada's is more than two decades old.

The European Commission has floated a new program dubbed INNOVATION and 
aimed at the promotion of innovation and encouragement of SME 
participation. Its goals are:

"(The) promotion of an environment favourable to innovation and the 
absorption of new technologies by enterprises;

Stimulation of a European open area for the diffusion of technologies 
and knowledge;

Supply of this area with appropriate technologies."

But all these worthy efforts ignore what James O'Toole called in 
"Leading Change" - "the ideology of comfort and the tyranny of custom." 
The much quoted Austrian economist, Joseph Schumpeter coined the phrase 
"creative destruction". Together with its twin - "disruptive 
technologies" - it came to be the mantra of the now defunct "New 

Schumpeter seemed to have captured the unsettling nature of innovation 
- unpredictable, unknown, unruly, troublesome, and ominous. Innovation 
often changes the inner dynamics of organizations and their internal 
power structure. It poses new demands on scarce resources. 

It provokes resistance and unrest. If mismanaged - it can spell doom 
rather than boom.

Satkar Gidda, Sales and Marketing Director for SiebertHead, a large UK 
packaging design house, was quoted in "The Financial Times" last week 
as saying:

"Every new product or pack concept is researched to death nowadays - 
and many great ideas are thrown out simply because a group of consumers 
is suspicious of anything that sounds new ... Conservatism among the 
buying public, twinned with a generation of marketing directors who 
won't take a chance on something that breaks new ground, is leading to 
super-markets and car showrooms full of me-too products, line 
extensions and minor product tweaks."

Yet, the truth is that no one knows why people innovate. The process of 
innovation has never been studied thoroughly - nor are the effects of 
innovation fully understood. 

In a new tome titled "The Free-Market Innovation Machine", William 
Baumol of Princeton University claims that only capitalism guarantees 
growth through a steady flow of innovation:

"... Innovative activity-which in other types of economy is fortuitous 
and optional-becomes mandatory, a life-and-death matter for the firm."

Capitalism makes sure that innovators are rewarded for their time and 
skills. Property rights are enshrined in enforceable contracts. 

In non-capitalist societies, people are busy inventing ways to survive 
or circumvent the system, create monopolies, or engage in crime. 

But Baumol fails to sufficiently account for the different levels of 
innovation in capitalistic countries. Why are inventors in America more 
productive than their French or British counterparts - at least judging 
by the number of patents they get issued?

Perhaps because oligopolies are more common in the US than they are 
elsewhere. Baumol suggests that oligopolies use their excess rent - 
i.e., profits which exceed perfect competition takings - to innovate 
and thus to differentiate their products. Still, oligopolistic behavior 
does not sit well with another of Baumol's observations: that 
innovators tend to maximize their returns by sharing their technology 
and licensing it to more efficient and profitable manufacturers. Nor 
can one square this propensity to share with the ever more stringent 
and expansive intellectual property laws that afflict many rich 
countries nowadays.

Very few inventions have forced "established companies from their 
dominant market positions" as the "The Economist" put it recently. 
Moreover, most novelties are spawned by established companies. The 
single, tortured, and misunderstood inventor working on a shoestring 
budget in his garage - is a mythical relic of 18th century Romanticism. 

More often, innovation is systematically and methodically pursued by 
teams of scientists and researchers in the labs of mega-corporations 
and endowed academic institutions. 

Governments - and, more particularly the defense establishment - 
finance most of this brainstorming. the Internet was invented by DARPA 
- a Department of Defense agency - and not by libertarian intellectuals.

A recent report compiled by PricewaterhouseCoopers from interviews with 
800 CEO's in the UK, France, Germany, Spain, Australia, Japan and the 
US and titled "Innovation and Growth: A Global Perspective" included 
the following findings:

"High-performing companies - those that generate annual total 
shareholder returns in excess of 37 percent and have seen consistent 
revenue growth over the last five years - average 61 percent of their 
turnover from new products and services. For low performers, only 26 
percent of turnover comes from new products and services."

Most of the respondents attributed the need to innovate to increasing 
pressures to brand and differentiate exerted by the advent of 
e-business and globalization. Yet a full three quarters admitted to 
being entirely unprepared for the new challenges.

Two good places to study routine innovation are the design studio and 
the financial markets.

Tom Kelly, brother of founder David Kelly, studies, in "The Art of 
Innovation", the history of some of the greater inventions to have been 
incubated in IDEO, a prominent California-based design firm dubbed 
"Innovation U." by Fortune Magazine. These include the computer mouse, 
the instant camera, and the PDA. The secret of success seems to consist 
of keenly observing what people miss most when they work and play. 

Robert Morris, an Amazon reviewer, sums up IDEO's creative process:

- Understand the market, the client, the technology, and the perceived 
constraints on the given problem; 

- Observe real people in real-life situations; 

- Literally visualize new-to-the- world concepts AND the customers who 
will use them;

- Evaluate and refine the prototypes in a series of quick iterations; 

- And finally, implement the new concept for commercialization.

This methodology is a hybrid between the lone-inventor and the faceless 
corporate R&D team. An entirely different process of innovation 
characterizes the financial markets. Jacob Goldenberg and David 
Mazursky postulated the existence of Creativity Templates. Once 
systematically applied to existing products, these lead to innovation. 

Financial innovation is methodical and product-centric. The resulting 
trade in pioneering products, such as all manner of derivatives, has 
expanded 20-fold between 1986 and 1999, when annual trading volume 
exceeded 13 trillion dollar. 

Swiss Re Economic Research and Consulting had this to say in its study, 
Sigma 3/2001:

"Three types of factors drive financial innovation: demand, supply, and 
taxes and regulation. Demand driven innovation occurs in response to 
the desire of companies to protect themselves from market risks ... 
Supply side factors ... include improvements in technology and 
heightened competition among financial service firms. Other financial 
innovation occurs as a rational response to taxes and regulation, as 
firms seek to minimize the cost that these impose."

Financial innovation is closely related to breakthroughs in information 
technology. Both markets are founded on the manipulation of symbols and 
coded concepts. The dynamic of these markets is self-reinforcing. 
Faster computers with more massive storage, speedier data transfer 
("pipeline"), and networking capabilities - give rise to all forms of 
advances - from math-rich derivatives contracts to distributed 
computing. These, in turn, drive software companies, creators of 
content, financial engineers, scientists, and inventors to a heightened 
complexity of thinking. It is a virtuous cycle in which innovation 
generates the very tools that facilitate further innovation.

The eminent American economist Robert Merton - quoted in Sigma 3/2001 - 
described in the Winter 1992 issue of the "Journal of Applied Corporate 
Finance" the various phases of the market-buttressed spiral of 
financial innovation thus:

"1. In the first stage ... there is a proliferation of standardised 
securities such as futures. These securities make possible the creation 
of custom-designed financial products ...

2. In the second stage, volume in the new market expands as financial 
intermediaries trade to hedge their market exposures.

3. The increased trading volume in turn reduces financial transaction 
costs and thereby makes further implementation of new products and 
trading strategies possible, which leads to still more volume.

4. The success of these trading markets then encourages investments in 
creating additional markets, and the financial system spirals towards 
the theoretical limit of zero transaction costs and dynamically 
complete markets."

Financial innovation is not adjuvant. Innovation is useless without 
finance - whether in the form of equity or debt. Schumpeter himself 
gave equal weight to new forms of "credit creation" which invariably 
accompanied each technological "paradigm shift". In the absence of 
stock options and venture capital - there would have been no Microsoft 
or Intel.

It would seem that both management gurus and ivory tower academics 
agree that innovation - technological and financial - is an inseparable 
part of competition. Tom Peters put it succinctly in "The Circle of 
Innovation" when he wrote: "Innovate or die." James Morse, a management 
consultant, rendered, in the same tome, the same lesson more verbosely: 
"The only sustainable competitive advantage comes from out-innovating 
the competition." 

The OECD has just published a study titled "Productivity and 
Innovation". It summarizes the orthodoxy, first formulated by Nobel 
prizewinner Robert Solow from MIT almost five decades ago:

"A substantial part of economic growth cannot be explained by increased 
utilisation of capital and labour. This part of growth, commonly 
labelled "multi-factor productivity, represents improvements in the 
efficiency of production. It is usually seen as the result of 
innovation  by best-practice firms, technological catch-up by other 
firms, and reallocation of resources across firms and industries."

The study analyzed the entire OECD area. It concluded, unsurprisingly, 
that easing regulatory restrictions enhances productivity and that 
policies that favor competition spur innovation. They do so by making 
it easier to adjust the factors of production and by facilitating the 
entrance of new firms - mainly in rapidly evolving industries. 

Pro-competition policies stimulate increases in efficiency and product 
diversification. They help shift output to innovative industries. More 
unconventionally, as the report diplomatically put it: "The effects on 
innovation of easing job protection are complex" and "Excessive 
intellectual property rights protection may hinder the development of 
new processes and products."

As expected, the study found that productivity performance varies 
across countries reflecting their ability to reach and then shift the 
technological frontier - a direct outcome of aggregate innovative 

Yet, innovation may be curbed by even more all-pervasive and pernicious 
problems. "The Economist" posed a question to its readers in the 
December 2001`issue of its Technology Quarterly: 

Was "technology losing its knack of being able to invent a host of 
solutions for any given problem ... (and) as a corollary, (was) 
innovation ... running out of new ideas to exploit."

These worrying trends were attributed to "the soaring cost of 
developing high-tech products ... as only one of the reasons why 
technological choice is on the wane, as one or two firms emerge as the 
sole suppliers. The trend towards globalisation-of markets as much as 
manufacturing-was seen as another cause of this loss of engineering 
diversity ... (as was the) the widespread use of safety standards that 
emphasise detailed design specifications instead of setting minimum 
performance requirements for designers to achieve any way they wish. 

Then there was the commoditisation of technology brought on largely by 
the cross-licensing and patent-trading between rival firms, which more 
or less guarantees that many of their products are essentially the same 
... (Another innovation-inhibiting problem is that) increasing 
knowledge was leading to increasing specialisation - with little or no 
cross- communication between experts in different fields ...

... Maturing technology can quickly become de-skilled as automated 
tools get developed so designers can harness the technology's power 
without having to understand its inner workings. 

The more that happens, the more engineers closest to the technology 
become incapable of contributing improvements to it. And without such 
user input, a technology can quickly ossify."

The readers overwhelmingly rejected these contentions. The rate of 
innovation, they asserted, has actually accelerated with wider spread 
education and more efficient weeding-out of unfit solutions by the 
marketplace. "... Technology in the 21st

century is going to be less about discovering new phenomena and more 
about putting known things together with greater imagination and 

Many cited the S-curve to illuminate the current respite. Innovation is 
followed by selection, improvement of the surviving models, shake-out 
among competing suppliers, and convergence on a single solution. 
Information technology has matured - but new S-curves are nascent: 
nanotechnology, quantum computing, proteomics, neuro-silicates, and 
machine intelligence.

Recent innovations have spawned two crucial ethical debates, though 
with accentuated pragmatic aspects. The first is "open source-free 
access" versus proprietary technology and the second revolves around 
the role of technological progress in re-defining relationships between 

Both issues are related to the inadvertent re-engineering of the 
corporation. Modern technology helped streamline firms by removing 
layers of paper-shuffling management. It placed great power in the 
hands of the end-user, be it an executive, a household, or an 

It reversed the trends of centralization and hierarchical 
stratification wrought by the Industrial Revolution. From 
microprocessor to micropower - an enormous centrifugal shift is 
underway. Power percolates back to the people.

Thus, the relationships between user and supplier, customer and 
company, shareholder and manager, medium and consumer - are being 
radically reshaped. In an intriguing spin on this theme, Michael Cox 
and Richard Alm argue in their book "Myths of Rich and Poor - Why We 
are Better off than We Think" that income inequality actually engenders 
innovation. The rich and corporate clients pay exorbitant prices for 
prototypes and new products, thus cross-subsidising development costs 
for the poorer majority.

Yet the poor are malcontented. They want equal access to new products. 
One way of securing it is by having the poor develop the products and 
then disseminate them free of charge. The development effort is done 
collectively, by volunteers. The Linux operating system is an example 
as is the Open Directory Project which competes with the commercial 

The UNDP's Human Development Report 2001 titled "Making new 
technologies work for human development" is unequivocal. Innovation and 
access to technologies are the keys to poverty-reduction through 
sustained growth. Technology helps reduce mortality rates, disease, and 
hunger among the destitute.

"The Economist" carried last December the story of the agricultural 
technologist Richard Jefferson who helps "local plant breeders and 
growers develop the foods they think best ... CAMBIA (the institute he 
founded) has resisted the lure of exclusive licences and shareholder 
investment, because it wants its work to be freely available and widely 
used." This may well foretell the shape of things to come.

Governments and Growth  

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

 Also Read:

The Washington Consensus - I. The IMF


It is a maxim of current economic orthodoxy that governments compete 
with the private sector on a limited pool of savings. It is considered 
equally self-evident that the private sector is better, more competent, 
and more efficient at allocating scarce economic resources and thus at 
preventing waste. It is therefore thought economically sound to reduce 
the size of government - i.e., minimize its tax intake and its public 
borrowing - in order to free resources for the private sector to 
allocate productively and efficiently.

Yet, both dogmas are far from being universally applicable. 

The assumption underlying the first conjecture is that government 
obligations and corporate lending are perfect substitutes. In other 
words, once deprived of treasury notes, bills, and bonds - a rational 
investor is expected to divert her savings to buying stocks or 
corporate bonds. 

It is further anticipated that financial intermediaries - pension 
funds, banks, mutual funds - will tread similarly. If unable to invest 
the savings of their depositors in scarce risk-free - i.e., government 
- securities - they will likely alter their investment preferences and 
buy equity and debt issued by firms.

Yet, this is expressly untrue. Bond buyers and stock investors are two 
distinct crowds. Their risk aversion is different. Their investment 
preferences are disparate. Some of them - e.g., pension funds - are 
constrained by law as to the composition of their investment 
portfolios. Once government debt has turned scarce or expensive, bond 
investors tend to resort to cash. That cash - not equity or corporate 
debt - is the veritable substitute for risk-free securities is a basic 
tenet of modern investment portfolio theory.

Moreover, the "perfect substitute" hypothesis assumes the existence of 
efficient markets and frictionless transmission mechanisms. But this is 
a conveniently idealized picture which has little to do with grubby 
reality. Switching from one kind of investment to another incurs - 
often prohibitive - transaction costs. In many countries, financial 
intermediaries are dysfunctional or corrupt or both. They are unable to 
efficiently convert savings to investments - or are wary of doing so. 

Furthermore, very few capital and financial markets are closed, 
self-contained, or self-sufficient units. Governments can and do borrow 
from foreigners. Most rich world countries - with the exception of 
Japan - tap "foreign people's money" for their public borrowing needs. 
When the US government borrows more, it crowds out the private sector 
in Japan - not in the USA.

It is universally agreed that governments have at least two critical 
economic roles. The first is to provide a "level playing field" for all 
economic players. It is supposed to foster competition, enforce the 
rule of law and, in particular, property rights, encourage free trade, 
avoid distorting fiscal incentives and disincentives, and so on. Its 
second role is to cope with market failures and the provision of public 
goods. It is expected to step in when markets fail to deliver goods and 
services, when asset bubbles inflate, or when economic resources are 
blatantly misallocated. 

Yet, there is a third role. In our post-Keynesian world, it is a 
heresy. It flies in the face of the "Washington Consensus" propagated 
by the Bretton-Woods institutions and by development banks the world 
over. It is the government's obligation to foster growth.

In most countries of the world - definitely in Africa, the Middle East, 
the bulk of Latin America, central and eastern Europe, and central and 
east Asia - savings do not translate to investments, either in the form 
of corporate debt or in the form of corporate equity. 

In most countries of the world, institutions do not function, the rule 
of law and properly rights are not upheld, the banking system is 
dysfunctional and clogged by bad debts. Rusty monetary transmission 
mechanisms render monetary policy impotent. 

In most countries of the world, there is no entrepreneurial and 
thriving private sector and the economy is at the mercy of external 
shocks and fickle business cycles. Only the state can counter these 
economically detrimental vicissitudes. 

Often, the sole engine of growth and the exclusive automatic stabilizer 
is public spending. Not all types of public expenditures have the 
desired effect. Witness Japan's pork barrel spending on "infrastructure 
projects". But development-related and consumption-enhancing spending 
is usually beneficial.

To say, in most countries of the world, that "public borrowing is 
crowding out the private sector" is wrong. It assumes the existence of 
a formal private sector which can tap the credit and capital markets 
through functioning financial intermediaries, notably banks and stock 

Yet, this mental picture is a figment of economic imagination. The bulk 
of the private sector in these countries is informal. In many of them, 
there are no credit or capital markets to speak of. The government 
doesn't borrow from savers through the marketplace - but 
internationally, often from multilaterals. 

Outlandish default rates result in vertiginously high real interest 
rates. Inter-corporate lending, barter, and cash transactions 
substitute for bank credit, corporate bonds, or equity flotations. As a 
result, the private sector's financial leverage is minuscule. In the 
rich West $1 in equity generates $3-5 in debt for a total investment of 
$4-6. In the developing world, $1 of tax-evaded equity generates 
nothing. The state has to pick up the slack. 

Growth and employment are public goods and developing countries are in 
a perpetual state of systemic and multiple market failures. 

Rather than lend to businesses or households - banks thrive on 
arbitrage. Investment horizons are limited. Should the state refrain 
from stepping in to fill up the gap - these countries are doomed to 
inexorable decline.

The Distributive Justice of the Market 

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

Also Read

The Principal-Agent Conundrum

The Green-Eyed Capitalist

The Misconception of Scarcity


The public outcry against executive pay and compensation followed 
disclosures of insider trading, double dealing, and outright fraud. But 
even honest and productive entrepreneurs often earn more money in one 
year than Albert Einstein did in his entire life. This strikes many - 
especially academics - as unfair. Surely Einstein's contributions to 
human knowledge and welfare far exceed anything ever accomplished by 
sundry businessmen? Fortunately, this discrepancy is cause for 
constructive jealousy, emulation, and imitation. It can, however, lead 
to an orgy of destructive and self-ruinous envy.

Entrepreneurs recombine natural and human resources in novel ways. They 
do so to respond to forecasts of future needs, or to observations of 
failures and shortcomings of current products or services. 
Entrepreneurs are professional - though usually intuitive - 
futurologists. This is a valuable service and it is financed by 
systematic risk takers, such as venture capitalists. Surely they all 
deserve compensation for their efforts and the hazards they assume?

Exclusive ownership is the most ancient type of such remuneration. 
First movers, entrepreneurs, risk takers, owners of the wealth they 
generated, exploiters of resources - are allowed to exclude others from 
owning or exploiting the same things. Mineral concessions, patents, 
copyright, trademarks - are all forms of monopoly ownership. What moral 
right to exclude others is gained from being the first? 

Nozick advanced Locke's Proviso. An exclusive ownership of property is 
just only if "enough and as good is left in common for others". If it 
does not worsen other people's lot, exclusivity is morally permissible. 
It can be argued, though, that all modes of exclusive ownership 
aggravate other people's situation. As far as everyone, bar the 
entrepreneur, are concerned, exclusivity also prevents a more 
advantageous distribution of income and wealth.  

Exclusive ownership reflects real-life irreversibility. A first mover 
has the advantage of excess information and of irreversibly invested 
work, time, and effort. 

Economic enterprise is subject to information asymmetry: we know 
nothing about the future and everything about the past. This asymmetry 
is known as "investment risk". Society compensates the entrepreneur 
with one type of asymmetry - exclusive ownership - for assuming 
another, the investment risk.

One way of looking at it is that all others are worse off by the amount 
of profits and rents accruing to owner-entrepreneurs. Profits and rents 
reflect an intrinsic inefficiency. Another is to recall that ownership 
is the result of adding value to the world. It is only reasonable to 
expect it to yield to the entrepreneur at least this value added now 
and in the future. 

In a "Theory of Justice" (published 1971, p. 302), John Rawls described 
an ideal society thus:

"(1) Each person is to have an equal right to the most extensive total 
system of equal basic liberties compatible with a similar system of 
liberty for all. (2) Social and economic inequalities are to be 
arranged so that they are both: (a) to the greatest benefit of the 
least advantaged, consistent with the just savings principle, and (b) 
attached to offices and positions open to all under conditions of fair 
equality of opportunity. " 

It all harks back to scarcity of resources - land, money, raw 
materials, manpower, creative brains. Those who can afford to do so, 
hoard resources to offset anxiety regarding future uncertainty. Others 
wallow in paucity. The distribution of means is thus skewed. 

"Distributive justice" deals with the just allocation of scarce 

Yet, even the basic terminology is somewhat fuzzy. What constitutes a 
resource? what is meant by allocation? Who should allocate resources - 
Adam Smith's "invisible hand", the government, the consumer, or 
business? Should it reflect differences in power, in intelligence, in 
knowledge, or in heredity? Should resource allocation be subject to a 
principle of entitlement? Is it reasonable to demand that it be just - 
or merely efficient? Are justice and efficiency antonyms?

Justice is concerned with equal access to opportunities. Equal access 
does not guarantee equal outcomes, invariably determined by 
idiosyncrasies and differences between people. Access leveraged by the 
application of natural or acquired capacities - translates into accrued 
wealth. Disparities in these capacities lead to discrepancies in 
accrued wealth.

The doctrine of equal access is founded on the equivalence of Men. That 
all men are created equal and deserve the same respect and, therefore, 
equal treatment is not self evident. European aristocracy well into 
this century would have probably found this notion abhorrent. Jose 
Ortega Y Gasset, writing in the 1930's, preached that access to 
educational and economic opportunities should be premised on one's 
lineage, up bringing, wealth, and social responsibilities. 

A succession of societies and cultures discriminated against the 
ignorant, criminals, atheists, females, homosexuals, members of ethnic, 
religious, or racial groups, the old, the immigrant, and the poor. 

Communism - ostensibly a strict egalitarian idea - foundered because it 
failed to reconcile strict equality with economic and psychological 
realities within an impatient timetable. 

Philosophers tried to specify a "bundle" or "package" of goods, 
services, and intangibles (like information, or skills, or knowledge). 
Justice - though not necessarily happiness - is when everyone possesses 
an identical bundle. Happiness - though not necessarily justice - is 
when each one of us possesses a "bundle" which reflects his or her 
preferences, priorities, and predilections. None of us will be too 
happy with a standardized bundle, selected by a committee of 
philosophers - or bureaucrats, as was the case under communism. 

The market allows for the exchange of goods and services between 
holders of identical bundles. If I seek books, but detest oranges - I 
can swap them with someone in return for his books. That way both of us 
are rendered better off than under the strict egalitarian version. 

Still, there is no guarantee that I will find my exact match - a person 
who is interested in swapping his books for my oranges. Illiquid, 
small, or imperfect markets thus inhibit the scope of these exchanges. 
Additionally, exchange participants have to agree on an index: how many 
books for how many oranges? This is the price of oranges in terms of 

Money - the obvious "index" - does not solve this problem, merely 
simplifies it and facilitates exchanges. It does not eliminate the 
necessity to negotiate an "exchange rate". It does not prevent market 
failures. In other words: money is not an index. 

It is merely a medium of exchange and a store of value. The index - as 
expressed in terms of money - is the underlying agreement regarding the 
values of resources in terms of other resources (i.e., their relative 

The market - and the price mechanism - increase happiness and welfare 
by allowing people to alter the composition of their bundles. The 
invisible hand is just and benevolent. But money is imperfect. The 
aforementioned Rawles demonstrated (1971), that we need to combine 
money with other measures in order to place a value on intangibles.  

The prevailing market theories postulate that everyone has the same 
resources at some initial point (the "starting gate"). It is up to them 
to deploy these endowments and, thus, to ravage or increase their 
wealth. While the initial distribution is equal - the end distribution 
depends on how wisely - or imprudently - the initial distribution was 

Egalitarian thinkers proposed to equate everyone's income in each time 
frame (e.g., annually). But identical incomes do not automatically 
yield the same accrued wealth. The latter depends on how the income is 
used - saved, invested, or squandered. Relative disparities of wealth 
are bound to emerge, regardless of the nature of income distribution. 

Some say that excess wealth should be confiscated and redistributed. 
Progressive taxation and the welfare state aim to secure this outcome. 
Redistributive mechanisms reset the "wealth clock" periodically (at the 
end of every month, or fiscal year). In many countries, the law 
dictates which portion of one's income must be saved and, by 
implication, how much can be consumed. 

This conflicts with basic rights like the freedom to make economic 

The legalized expropriation of income (i.e., taxes) is morally dubious. 
Anti-tax movements have sprung all over the world and their philosophy 
permeates the ideology of political parties in many countries, not 
least the USA. Taxes are punitive: they penalize enterprise, success, 
entrepreneurship, foresight, and risk assumption. Welfare, on the other 
hand, rewards dependence and parasitism. 

According to Rawles' Difference Principle, all tenets of justice are 
either redistributive or retributive. This ignores non-economic 
activities and human inherent variance. Moreover, conflict and 
inequality are the engines of growth and innovation - which mostly 
benefit the least advantaged in the long run. Experience shows that 
unmitigated equality results in atrophy, corruption and stagnation. 
Thermodynamics teaches us that life and motion are engendered by an 
irregular distribution of energy. Entropy - an even distribution of 
energy - equals death and stasis. 

What about the disadvantaged and challenged - the mentally retarded, 
the mentally insane, the paralyzed, the chronically ill? For that 
matter, what about the less talented, less skilled, less daring? 
Dworkin (1981) proposed a compensation scheme. He suggested a model of 
fair distribution in which every person is given the same purchasing 
power and uses it to bid, in a fair auction, for resources that best 
fit that person's life plan, goals and preferences.

Having thus acquired these resources, we are then permitted to use them 
as we see fit. Obviously, we end up with disparate economic results. 
But we cannot complain - we were given the same purchasing power and 
the freedom to bid for a bundle of our choice. 

Dworkin assumes that prior to the hypothetical auction, people are 
unaware of their own natural endowments but are willing and able to 
insure against being naturally disadvantaged. Their payments create an 
insurance pool to compensate the less fortunate for their misfortune. 

This, of course, is highly unrealistic. We are usually very much aware 
of natural endowments and liabilities - both ours and others'. 
Therefore, the demand for such insurance is not universal, nor uniform. 
Some of us badly need and want it - others not at all. It is morally 
acceptable to let willing buyers and sellers to trade in such coverage 
(e.g., by offering charity or alms) - but may be immoral to make it 

Most of the modern welfare programs are involuntary Dworkin schemes. 
Worse yet, they often measure differences in natural endowments 
arbitrarily, compensate for lack of acquired skills, and discriminate 
between types of endowments in accordance with cultural biases and 

Libertarians limit themselves to ensuring a level playing field of just 
exchanges, where just actions always result in just outcomes. Justice 
is not dependent on a particular distribution pattern, whether as a 
starting point, or as an outcome. Robert Nozick "Entitlement Theory" 
proposed in 1974 is based on this approach. 

That the market is wiser than any of its participants is a pillar of 
the philosophy of capitalism. In its pure form, the theory claims that 
markets yield patterns of merited distribution - i.e., reward and 
punish justly. Capitalism generate just deserts. Market failures - for 
instance, in the provision of public goods - should be tackled by 
governments. But a just distribution of income and wealth does not 
constitute a market failure and, therefore, should not be tampered with.

The Myth of the Earnings Yield 

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

Also Read:

The Friendly Trend

Models of Stock Valuation 

Portfolio Management Theory and Technical Analysis Lecture Notes 

In American novels, well into the 1950's, one finds protagonists using 
the future stream of dividends emanating from their share holdings to 
send their kids to college or as collateral.  Yet, dividends seemed to 
have gone the way of the hoolah hoop. Few companies distribute erratic 
and ever-declining dividends. The vast majority don't bother. The 
unfavorable tax treatment of distributed profits may have been the 

The dwindling of dividends has implications which are nothing short of 
revolutionary. Most of the financial theories we use to determine the 
value of shares were developed in the 1950's and 1960's, when dividends 
were in vogue.  They invariably relied on a few implicit and explicit 

1. That the fair "value" of a share is closely correlated to its market 

2. That price movements are mostly random, though somehow related to 
the aforementioned "value" of the share. In other words, the price of a 
security is supposed to converge with its fair "value" in the long 

3. That the fair value responds to new information about the firm and 
reflects it  - though how efficiently is debatable. The strong 
efficiency market hypothesis assumes that new information is fully 
incorporated in prices instantaneously. 

But how is the fair value to be determined? 

A discount rate is applied to the stream of all future income from the 
share - i.e., its dividends. What should this rate be is sometimes 
hotly disputed - but usually it is the coupon of "riskless" securities, 
such as treasury bonds. But since few companies distribute dividends - 
theoreticians and analysts are increasingly forced to deal with 
"expected" dividends rather than "paid out" or actual ones. 

The best proxy for expected dividends is net earnings. The higher the 
earnings - the likelier and the higher the dividends. Thus, in a subtle 
cognitive dissonance, retained earnings - often plundered by rapacious 
managers - came to be regarded as some kind of deferred dividends. 

The rationale is that retained earnings, once re-invested, generate 
additional earnings. Such a virtuous cycle increases the likelihood and 
size of future dividends. Even undistributed earnings, goes the 
refrain, provide a rate of return, or a yield - known as the earnings 
yield. The original meaning of the word "yield" - income realized by an 
investor - was undermined by this Newspeak.

Why was this oxymoron - the "earnings yield" - perpetuated?

According to all current theories of finance, in the absence of 
dividends - shares are worthless. The value of an investor's holdings 
is determined by the income he stands to receive from them. No income - 
no value. Of course, an investor can always sell his holdings to other 
investors and realize capital gains (or losses). But capital gains - 
though also driven by earnings hype - do not feature in financial 
models of stock valuation. 

Faced with a dearth of dividends, market participants - and especially 
Wall Street firms - could obviously not live with the ensuing zero 
valuation of securities. They resorted to substituting future dividends 
- the outcome of capital accumulation and re-investment - for present 
ones. The myth was born.

Thus, financial market theories starkly contrast with market realities. 

No one buys shares because he expects to collect an uninterrupted and 
equiponderant stream of future income in the form of dividends. 

Even the most gullible novice knows that dividends are a mere apologue, 
a relic of the past. So why do investors buy shares? Because they hope 
to sell them to other investors later at a higher price. 

While past investors looked to dividends to realize income from their 
shareholdings - present investors are more into capital gains. The 
market price of a share reflects its discounted expected capital gains, 
the discount rate being its volatility. It has little to do with its 
discounted future stream of dividends, as current financial theories 
teach us. 

But, if so, why the volatility in share prices, i.e., why are share 
prices distributed? Surely, since, in liquid markets, there are always 
buyers - the price should stabilize around an equilibrium point. 

It would seem that share prices incorporate expectations regarding the 
availability of willing and able buyers, i.e., of investors with 
sufficient liquidity. Such expectations are influenced by the price 
level - it is more difficult to find buyers at higher prices - by the 
general market sentiment, and by externalities and new information, 
including new information about earnings.

The capital gain anticipated by a rational investor takes into 
consideration both the expected discounted earnings of the firm and 
market volatility - the latter being a measure of the expected 
distribution of willing and able buyers at any given price. Still, if 
earnings are retained and not transmitted to the investor as dividends 
- why should they affect the price of the share, i.e., why should they 
alter the capital gain?

Earnings serve merely as a yardstick, a calibrator, a benchmark figure. 
Capital gains are, by definition, an increase in the market price of a 
security. Such an increase is more often than not correlated with the 
future stream of income to the firm - though not necessarily to the 
shareholder. Correlation does not always imply causation. Stronger 
earnings may not be the cause of the increase in the share price and 
the resulting capital gain. But whatever the relationship, there is no 
doubt that earnings are a good proxy to capital gains. 

Hence investors' obsession with earnings figures. Higher earnings 
rarely translate into higher dividends. But earnings - if not fiddled - 
are an excellent predictor of the future value of the firm and, thus, 
of expected capital gains. Higher earnings and a higher market 
valuation of the firm make investors more willing to purchase the stock 
at a higher price - i.e., to pay a premium which translates into 
capital gains. 

The fundamental determinant of future income from share holding was 
replaced by the expected value of share-ownership. It is a shift from 
an efficient market - where all new information is instantaneously 
available to all rational investors and is immediately incorporated in 
the price of the share - to an inefficient market where the most 
critical information is elusive: how many investors are willing and 
able to buy the share at a given price at a given moment. 

A market driven by streams of income from holding securities is "open". 
It reacts efficiently to new information. But it is also "closed" 
because it is a zero sum game. One investor's gain is another's loss. 

The distribution of gains and losses in the long term is pretty even, 
i.e., random. The price level revolves around an anchor, supposedly the 
fair value. 

A market driven by expected capital gains is also "open" in a way 
because, much like less reputable pyramid schemes, it depends on new 
capital and new investors. As long as new money keeps pouring in, 
capital gains expectations are maintained - though not necessarily 

But the amount of new money is finite and, in this sense, this kind of 
market is essentially a "closed" one. When sources of funding are 
exhausted, the bubble bursts and prices decline precipitously. This is 
commonly described as an "asset bubble". 

This is why current investment portfolio models (like CAPM) are 
unlikely to work. Both shares and markets move in tandem (contagion) 
because they are exclusively swayed by the availability of future 
buyers at given prices. This renders diversification inefficacious. As 
long as considerations of "expected liquidity" do not constitute an 
explicit part of income-based models, the market will render them 
increasingly irrelevant.

Immortality and Mortality in the Economic Sciences 

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

The noted economist, Julian Simon, once quipped: "Because we can expect 
future generations to be richer than we are, no matter what we do about 
resources, asking us to refrain from using resources now so that future 
generations can have them later is like asking the poor to make gifts 
to the rich."

Roberto Calvo Macias, a Spanish author and thinker, once wrote that it 
is impossible to design a coherent philosophy of economics not founded 
on our mortality. The Grim Reaper permeates estate laws, retirement 
plans, annuities, life insurance and much more besides.  

The industrial revolution taught us that humans are interchangeable by 
breaking the process of production down to minute - and easily learned 
- functional units. Only the most basic skills were required. This led 
to great alienation. Motion pictures of the period ("Metropolis", 
"Modern Times") portray the industrial worker as a nut in a machine, 
driven to the verge of insanity by the numbing repetitiveness of his 

As technology evolved, training periods have lengthened, and human 
capital came to outweigh the physical or monetary kinds. This led to an 
ongoing revolution in economic relations. Ironically, dehumanizing 
totalitarian regimes, such as fascism and communism, were the first to 
grasp the emerging prominence of scarce and expensive human capital 
among other means of production. What makes humans a scarce natural 
resource is their mortality.

Though aware of their finitude, most people behave as though they are 
going to live forever. Economic and social institutions are formed to 
last. People embark on long term projects and make enduring decisions - 
for instance, to invest money in stocks or bonds - even when they are 
very old. 

Childless octogenarian inventors defend their fair share of royalties 
with youthful ferocity and tenacity. Businessmen amass superfluous 
wealth and collectors bid in auctions regardless of their age. We all - 
particularly economists - seem to deny the prospect of death. 

Examples of this denial abound in the dismal science:

Consider the invention of the limited liability corporation. While its 
founders are mortals - the company itself is immortal. It is only one 
of a group of legal instruments - the will and the estate, for instance 
- that survive a person's demise. Economic theories assume that humans 
- or maybe humanity - are immortal and, thus, possessed of an infinite 

Valuation models often discount an infinite stream of future dividends 
or interest payments to obtain the present value of a security. 

Even in the current bear market, the average multiple of the p/e - 
price to earnings - ratio is 45. This means that the average investor 
is willing to wait more than 60 years to recoup his investment 
(assuming  capital gains tax of 35 percent). 

Standard portfolio management theory explicitly states that the 
investment horizon is irrelevant. Both long-term and short-term magpies 
choose the same bundle of assets and, therefore, the same profile of 
risk and return. As John Campbell and Luis Viceira point in their 
"Strategic Asset Allocation", published this year by Oxford University 
Press, the model ignores future income from work which tends to dwindle 
with age. Another way to look at it is that income from labor is 
assumed to be constant - forever!

To avoid being regarded as utterly inane, economists weigh time. The 
present and near future are given a greater weight than the far future. 
But the decrease in weight is a straight function of duration. This 
uniform decline in weight leads to conundrums. "The Economist" - based 
on the introduction to the anthology "Discounting and Intergenerational 
Equity", published by the Resources for the Future think tank - 
describes one such predicament:

"Suppose a long-term discount rate of 7 percent (after inflation) is 
used, as it typically is in cost-benefit analysis. Suppose also that 
the project's benefits arrive 200 years from now, rather than in 30 
years or less. If global GDP grew by 3 percent during those two 
centuries, the value of the world's output in 2200 will be $8 
quadrillion ... But in present value terms, that stupendous sum would 
be worth just $10 billion. In other words, it would not make sense ... 
to spend any more than $10 billion ... today on a measure that would 
prevent the loss of the planet's entire output 200 years from now."

Traditional cost-benefit analysis falters because it implicitly assumes 
that we possess perfect knowledge regarding the world 200 years hence - 
and, insanely, that we will survive to enjoy ad infinitum the interest 
on capital we invest today. From our exalted and privileged position in 
the present, the dismal science appears to suggest, we judge the future 
distribution of income and wealth and the efficiency of various 
opportunity-cost calculations. In the abovementioned example, we ask 
ourselves whether we prefer to spend $10 billion now - due to our "pure 
impatience" to consume - or to defer present expenditures so as to 
consume more 200 years hence!

Yet, though their behavior indicates a denial of imminent death - 
studies have demonstrated that people intuitively and unconsciously 
apply cost-benefit analyses to decisions with long-term outcomes. 
Moreover, contrary to current economic thinking, they use decreasing 
utility rates of discount for the longer periods in their calculations. 
They are not as time-consistent as economists would have them be. 

They value the present and near future more than they do the far 
future. In other words, they take their mortality into account.

This is supported by a paper titled "Doing it Now or Later", published 
in the March 1999 issue of the American Economic Review. In it the 
authors suggest that over-indulgers and procrastinators alike indeed 
place undue emphasis on the near future. Self-awareness surprisingly 
only exacerbates the situation: "why resist? I have a self-control 
problem. Better indulge a little now than a lot later."

But a closer look exposes an underlying conviction of perdurability. 

The authors distinguish sophisticates from naifs. Both seem to 
subscribe to immortality. The sophisticate refrains from 
procrastinating because he believes that he will live to pay the price. 
Naifs procrastinate because they believe that they will live to perform 
the task later. They also try to delay overindulgence because they 
assume that they will live to enjoy the benefits. Similarly, 
sophisticated folk overindulge a little at present because they believe 
that, if they don't, they will overindulge a lot in future. Both types 
believe that they will survive to experience the outcomes of their 
misdeeds and decisions.

The denial of the inevitable extends to gifts and bequests. Many 
economists regard inheritance as an accident. Had people accepted their 
mortality, they would have consumed much more and saved much less. A 
series of working papers published by the NBER in the last 5 years 
reveals a counter-intuitive pattern of intergenerational shifting of 

Parents gift their off-spring unequally. The richer the child, the 
larger his or her share of such largesse. The older the parent, the 
more pronounced the asymmetry. Post-mortem bequests, on the other hand, 
are usually divided equally among one's progeny.

The avoidance of estate taxes fails to fully account for these patterns 
of behavior. A parental assumption of immortality does a better job. 
The parent behaves as though it is deathless. Rich children are better 
able to care for ageing and burdensome parents. Hence the uneven 
distribution of munificence. Unequal gifts - tantamount to insurance 
premiums - safeguard the rich scions' sustained affection and 
treatment. Still, parents are supposed to love their issue equally. 
Hence the equal allotment of bequests.

The Agent-Principal Conundrum  

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

In the catechism of capitalism, shares represent the part-ownership of 
an economic enterprise, usually a firm. The value of shares is 
determined by the replacement value of the assets of the firm, 
including intangibles such as goodwill. The price of the share is 
determined by transactions among arm's length buyers and sellers in an 
efficient and liquid market. The price reflects expectations regarding 
the future value of the firm and the stock's future stream of income - 
i.e., dividends.

Alas, none of these oft-recited dogmas bears any resemblance to 
reality. Shares rarely represent ownership. The float - the number of 
shares available to the public - is frequently marginal. Shareholders 
meet once a year to vent and disperse. Boards of directors are 
appointed by management - as are auditors. Shareholders are not 
represented in any decision making process - small or big.

The dismal truth is that shares reify the expectation to find future 
buyers at a higher price and thus incur capital gains. In the Ponzi 
scheme known as the stock exchange, this expectation is proportional to 
liquidity - new suckers - and volatility. Thus, the price of any given 
stock reflects merely the consensus as to how easy it would be to 
offload one's holdings and at what price.

Another myth has to do with the role of managers. They are supposed to 
generate higher returns to shareholders by increasing the value of the 
firm's assets and, therefore, of the firm. If they fail to do so, goes 
the moral tale, they are booted out mercilessly. This is one 
manifestation of the "Principal-Agent Problem". It is defined thus by 
the Oxford Dictionary of Economics:

"The problem of how a person A can motivate person B to act for A's 
benefit rather than following (his) self-interest."

The obvious answer is that A can never motivate B not to follow B's 
self-interest - never mind what the incentives are. That economists 
pretend otherwise - in "optimal contracting theory" - just serves to 
demonstrate how divorced economics is from human psychology and, thus, 
from reality.

Managers will always rob blind the companies they run. They will always 
manipulate boards to collude in their shenanigans. They will always 
bribe auditors to bend the rules. In other words, they will always act 
in their self-interest. In their defense, they can say that the damage 
from such actions to each shareholder is minuscule while the benefits 
to the manager are enormous. In other words, this is the rational, 
self-interested, thing to do.

But why do shareholders cooperate with such corporate brigandage? 

In an important Chicago Law Review article whose preprint was posted to 
the Web a few weeks ago - titled "Managerial Power and Rent Extraction 
in the Design of Executive Compensation" - the authors demonstrate how 
the typical stock option granted to managers as part of their 
remuneration rewards mediocrity rather than encourages excellence.

But everything falls into place if we realize that shareholders and 
managers are allied against the firm - not pitted against each other. 
The paramount interest of both shareholders and managers is to increase 
the value of the stock - regardless of the true value of the firm. Both 
are concerned with the performance of the share - rather than the 
performance of the firm. Both are preoccupied with boosting the share's 
price - rather than the company's business. 

Hence the inflationary executive pay packets. Shareholders hire stock 
manipulators - euphemistically known as "managers" - to generate 
expectations regarding the future prices of their shares. These snake 
oil salesmen and snake charmers - the corporate executives - are 
allowed by shareholders to loot the company providing they generate 
consistent capital gains to their masters by provoking persistent 
interest and excitement around the business. Shareholders, in other 
words, do not behave as owners of the firm - they behave as free-riders.

The Principal-Agent Problem arises in other social interactions and is 
equally misunderstood there. Consider taxpayers and their government. 
Contrary to conservative lore, the former want the government to tax 
them providing they share in the spoils. 

They tolerate corruption in high places, cronyism, nepotism, inaptitude 
and worse - on condition that the government and the legislature 
redistribute the wealth they confiscate. Such redistribution often 
comes in the form of pork barrel projects and benefits to the 

This is why the tax burden and the government's share of GDP have been 
soaring inexorably with the consent of the citizenry. People adore 
government spending precisely because it is inefficient and distorts 
the proper allocation of economic resources. The vast majority of 
people are rent-seekers. Witness the mass demonstrations that erupt 
whenever governments try to slash expenditures, privatize, and 
eliminate their gaping deficits. This is one reason the IMF with its 
austerity measures is universally unpopular.

Employers and employees, producers and consumers - these are all 
instances of the Principal-Agent Problem. Economists would do well to 
discard their models and go back to basics. They could start by asking:

Why do shareholders acquiesce with executive malfeasance as long as 
share prices are rising?

Why do citizens protest against a smaller government - even though it 
means lower taxes?

Could it mean that the interests of shareholders and managers are 
identical? Does it imply that people prefer tax-and-spend governments 
and pork barrel politics to the Thatcherite alternative?

Nothing happens by accident or by coercion. Shareholders aided and 
abetted the current crop of corporate executives enthusiastically. They 
knew well what was happening. They may not have been aware of the exact 
nature and extent of the rot - but they witnessed approvingly the 
public relations antics, insider trading, stock option resetting , 
unwinding, and unloading, share price manipulation, opaque 
transactions, and outlandish pay packages. Investors remained mum 
throughout the corruption of corporate America. It is time for the 

The Green-Eyed Capitalist  

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

Conservative sociologists self-servingly marvel at the peaceful 
proximity of abject poverty and ostentatious affluence in American - 
or, for that matter, Western - cities. Devastating riots do erupt, but 
these are reactions either to perceived social injustice (Los Angeles 
1995) or to political oppression (Paris 1968). The French Revolution 
may have been the last time the urban sans-culotte raised a fuss 
against the economically enfranchised.

This pacific co-existence conceals a maelstrom of envy. Behold the 
rampant Schadenfreude which accompanied the antitrust case against the 
predatory but loaded Microsoft. Observe the glee which engulfed many 
destitute countries in the wake of the September 11 atrocities against 
America, the epitome of triumphant prosperity. Witness the orgiastic castigation of avaricious CEO's. 

Envy - a pathological manifestation of destructive aggressiveness - is 
distinct from jealousy. 

The New Oxford Dictionary of English defines envy as:

"A feeling of discontented or resentful longing aroused by someone 
else's possessions, qualities, or luck ... Mortification and ill-will 
occasioned by the contemplation of another's superior advantages". 

Pathological envy - the fourth deadly sin - is engendered by the 
realization of some lack, deficiency, or inadequacy in oneself. The 
envious begrudge others their success, brilliance, happiness, beauty, 
good fortune, or wealth. Envy provokes misery, humiliation, and 
impotent rage. 

The envious copes with his pernicious emotions in five ways:

1. They attack the perceived source of frustration in an attempt to 
destroy it, or "reduce it" to their "size". Such destructive impulses 
often assume the disguise of championing social causes, fighting 
injustice, touting reform, or promoting an ideology.

2. They seek to subsume the object of envy by imitating it. In extreme 
cases, they strive to get rich quick through criminal scams, or 
corruption. They endeavor to out-smart the system and shortcut their 
way to fortune and celebrity.

3. They resort to self-deprecation. They idealize the successful, the 
rich, the mighty, and the lucky and attribute to them super-human, 
almost divine, qualities. At the same time, they humble themselves. 
Indeed, most of this strain of the envious end up disenchanted and 
bitter, driving the objects of their own erstwhile devotion and 
adulation to destruction and decrepitude.

4. They experience cognitive dissonance. These people devalue the 
source of their frustration and envy by finding faults in everything 
they most desire and in everyone they envy. 

5. They avoid the envied person and thus the agonizing pangs of envy.

Envy is not a new phenomenon. Belisarius, the general who conquered the 
world for Emperor Justinian, was blinded and stripped of his assets by 
his envious peers. I - and many others - have written extensively about 
envy in command economies. Nor is envy likely to diminish. 

In his book, "Facial Justice", Hartley describes a post-apocalyptic 
dystopia, New State, in which envy is forbidden and equality extolled 
and everything enviable is obliterated. Women are modified to look like 
men and given identical "beta faces". Tall buildings are razed.

Joseph Schumpeter, the prophetic Austrian-American economist, believed 
that socialism will disinherit capitalism. In "Capitalism, Socialism, 
and Democracy" he foresaw a conflict between a class of refined but 
dirt-poor intellectuals and the vulgar but filthy rich businessmen and 
managers they virulently envy and resent. Samuel Johnson wrote: "He was 
dull in a new way, and that made many people think him great." The 
literati seek to tear down the market economy which they feel has so 
disenfranchised and undervalued them.

Hitler, who fancied himself an artist, labeled the British a "nation of 
shopkeepers" in one of his bouts of raging envy. Ralph Reiland, the 
Kenneth Simon professor of free enterprise at Robert Morris University, 
quotes David Brooks of the "weekly Standard", who christened this 
phenomenon "bourgeoisophobia":

"The hatred of the bourgeoisie is the beginning of all virtue' - wrote 
Gustav Flaubert. He signed his letters "Bourgeoisophobus" to show how 
much he despised 'stupid grocers and their ilk ... Through some 
screw-up in the great scheme of the universe, their narrow-minded greed 
had brought them vast wealth, unstoppable power and growing social 

Reiland also quotes from Ludwig van Mises's "The Anti-Capitalist 

"Many people, and especially intellectuals, passionately loathe 
capitalism. In a society based on caste and status, the individual can 
ascribe adverse fate to conditions beyond his control. In ... 
capitalism ... everybody's station in life depends on his doing ... 
(what makes a man rich is) not the evaluation of his contribution from 
any `absolute' principle of justice but the evaluation on the part of 
his fellow men who exclusively apply the yardstick of their personal 
wants, desires and ends ... Everybody knows very well that there are 
people like himself who succeeded where he himself failed. Everybody 
knows that many of those he envies are self-made men who started from 
the same point from which he himself started. Everybody is aware of his 
own defeat. In order to console himself and to restore his self- 
assertion, such a man is in search of a scapegoat. 

He tries to persuade himself that he failed through no fault of his 
own. He was too decent to resort to the base tricks to which his 
successful rivals owe their ascendancy. The nefarious social order does 
not accord the prizes to the most meritorious men; it crowns the 
dishonest, unscrupulous scoundrel, the swindler, the exploiter, the 
`rugged individualist.'"

In "The Virtue of Prosperity", Dinesh D'Souza accuses prosperity and 
capitalism of inspiring vice and temptation. Inevitably, it provokes 
envy in the poor and depravity in the rich. 

With only a modicum of overstatement, capitalism can be depicted as the 
sublimation of jealousy. As opposed to destructive envy - jealousy 
induces emulation. Consumers - responsible for two thirds of America's 
GDP - ape role models and vie with neighbors, colleagues, and family 
members for possessions and the social status they endow. Productive 
and constructive competition - among scientists, innovators, managers, 
actors, lawyers, politicians, and the members of just about every other 
profession - is driven by jealousy.

The eminent Nobel prize winning British economist and philosopher of 
Austrian descent, Friedrich Hayek, suggested in "The Constitution of 
Liberty" that innovation and progress in living standards are the 
outcomes of class envy. The wealthy are early adopters of expensive and 
unproven technologies. The rich finance with their conspicuous 
consumption the research and development phase of new products. The 
poor, driven by jealousy, imitate them and thus create a mass market 
which allows manufacturers to lower prices. 

But jealousy is premised on the twin beliefs of equality and a level 
playing field. "I am as good, as skilled, and as talented as the object 
of my jealousy." - goes the subtext - "Given equal opportunities, 
equitable treatment, and a bit of luck, I can accomplish the same or 

Jealousy is easily transformed to outrage when its presumptions - 
equality, honesty, and fairness - prove wrong. In a paper recently 
published by Harvard University's John M. Olin Center for Law and 
titled "Executive Compensation in America: Optimal Contracting or 
Extraction of Rents?", the authors argue that executive malfeasance is 
most effectively regulated by this "outrage constraint":

"Directors (and non-executive directors) would be reluctant to approve, 
and executives would be hesitant to seek, compensation arrangements 
that might be viewed by observers as outrageous."

The Case of the Compressed Image

By: Sam Vaknin, Ph.D.

Also published by United Press International (UPI)

Also Read:

The Disruptive Engine - Innovation


Forgent Networks from Texas wants to collect a royalty every time 
someone compresses an image using the JPEG algorithm. It urges third 
parties to negotiate with it separate licensing agreements. It bases 
its claim on a 17 year old patent it acquired in 1997 when VTel, from 
which Forgent was spun-off, purchased the San-Jose based Compression 

The patent pertains to a crucial element in the popular compression 
method. The JPEG committee of ISO - the International Standards 
Organization - threatens to withdraw the standard altogether. This 
would impact thousands of software and hardware products.

This is only the latest in a serious of spats. Unisys has spent the 
better part of the last 15 years trying to enforce a patent it owns for 
a compression technique used in two other popular imaging standards, 
GIF and TIFF. 

BT Group sued Prodigy, a unit of SBC Communications, in a US federal 
court, for infringement of its patent of the hypertext link, or 
hyperlink - a ubiquitous and critical element of the Web. Dell Computer 
has agreed with the FTC to refrain from enforcing a graphics patent 
having failed to disclose it to the standards committee in its 
deliberations of the VL-bus graphics standard.

"Wired" reported yesterday that the Munich Upper Court declared "deep 
linking" - posting links to specific pages within a Web site - in 
violation the European Union "Database Directive". The directive 
copyrights the "selection and arrangement" of a database - even if the 
content itself is not owned by the database creator. It explicitly 
prohibits hyperlinking to the database contents as "unfair extraction". 
If upheld, this would cripple most search engines. Similar rulings - 
based on national laws - were handed down in other countries, the 
latest being Denmark. 

Amazon sued Barnes and Noble - and has since settled out of court in 
March - for emulating its patented "one click purchasing" business 
process. A Web browser command to purchase an item generates a "cookie" 
- a text file replete with the buyer's essential details which is then 
lodged in Amazon's server. This allows the transaction to be completed 
without a further confirmation step.

A clever trick, no doubt. But even Jeff Bezos, Amazon's legendary 
founder, expressed doubts regarding the wisdom of the US Patent Office 
in granting his company the patent. In an open letter to Amazon's 
customers, he called for a rethinking of the whole system of protection 
of intellectual property in the Internet age.

In a recently published discourse of innovation and property rights, 
titled "The Free-Market Innovation Machine", William Baumol of 
Princeton University claims that only capitalism guarantees growth 
through a steady flow of innovation. According to popular lore, 
capitalism makes sure that innovators are rewarded for their time and 
skills since property rights are enshrined in enforceable contracts. 

Reality is different, as Baumol himself notes. Innovators tend to 
maximize their returns by sharing their technology and licensing it to 
more efficient and profitable manufacturers. This rational division of 
labor is hampered by the increasingly more stringent and expansive 
intellectual property laws that afflict many rich countries nowadays. 
These statutes tend to protect the interests of middlemen - 
manufacturers, distributors, marketers - rather than the claims of 
inventors and innovators. 

Moreover, the very nature of "intellectual property" is in flux. 
Business processes and methods, plants, genetic material, strains of 
animals, minor changes to existing technologies - are all patentable. 
Trademarks and copyright now cover contents, brand names, and modes of 
expression and presentation. Nothing is safe from these encroaching 
juridical initiatives. Intellectual property rights have been 
transformed into a myriad pernicious monopolies which threaten to 
stifle innovation and competition.

Intellectual property - patents, content libraries, copyrighted 
material, trademarks, rights of all kinds - are sometimes the sole 
assets - and the only hope for survival - of cash-strapped and 
otherwise dysfunctional or bankrupt firms. 

Both managers and court-appointed receivers strive to monetize these 
properties and patent-portfolios by either selling them or enforcing 
the rights against infringing third parties. 

Fighting a patent battle in court is prohibitively expensive and the 
outcome uncertain. Potential defendants succumb to extortionate demands 
rather than endure the Kafkaesque process. The costs are passed on to 
the consumer. Sony, for instance already paid Forgent an undisclosed 
amount in May. According to Forgent's 10-Q form, filed on June 17, 
2002, yet another, unidentified "prestigious international" company, 
parted with $15 million in April. 

In commentaries written in 1999-2000 by Harvard law professor, Lawrence 
Lessig, for "The Industry Standard", he observed:

"There is growing skepticism among academics about whether such 
state-imposed monopolies help a rapidly evolving market such as the 
Internet. What is "novel," "nonobvious" or "useful" is hard enough to 
know in a relatively stable field. In a transforming market, it's 
nearly impossible..."

The very concept of intellectual property is being radically 
transformed by the onslaught of new technologies.

The myth of intellectual property postulates that entrepreneurs assume 
the risks associated with publishing books, recording records, and 
inventing only because - and where - the rights to intellectual 
property are well defined and enforced. In the absence of such rights, 
creative people are unlikely to make their works accessible to the 
public. Ultimately, it is the public which pays the price of piracy and 
other violations of intellectual property rights, goes the refrain. 

This is untrue. In the USA only few authors actually live by their pen. 
Even fewer musicians, not to mention actors, eke out subsistence level 
income from their craft.  Those who do can no longer be considered 
merely creative people. Madonna, Michael Jackson, Schwarzenegger and 
Grisham are businessmen at least as much as they are artists. 

Intellectual property is a relatively new notion. In the near past, no 
one considered knowledge or the fruits of creativity (artwork, designs) 
as 'patentable', or as someone's 'property'. The artist was but a mere 
channel through which divine grace flowed. Texts, discoveries, 
inventions, works of art and music, designs - all belonged to the 
community and could be replicated freely. True, the chosen ones, the 
conduits, were revered. But they were rarely financially rewarded. 

Well into the 19th century, artists and innovators were commissioned - 
and salaried - to produce their works of art and contrivances. 

The advent of the Industrial Revolution - and the imagery of the 
romantic lone inventor toiling on his brainchild in a basement or, 
later, a garage -  gave rise to the patent. The more massive the 
markets became, the more sophisticated the sales and marketing 
techniques, the bigger the financial stakes - the larger loomed the 
issue of intellectual property. 

Intellectual property rights are less about the intellect and more 
about property. In every single year of the last decade, the global 
turnover in intellectual property has outweighed the total industrial 
production of the world. These markets being global, the monopolists of 
intellectual products fight unfair competition globally. A pirate in 
Skopje is in direct rivalry with Bill Gates, depriving Microsoft of 
present and future revenue, challenging its monopolistic status as well 
as jeopardizing its competition-deterring image. 

The Open Source Movement weakens the classic model of property rights 
by presenting an alternative, viable, vibrant, model which does not 
involve over-pricing and anti-competitive predatory practices. The 
current model of property rights encourages monopolistic behavior, 
non-collaborative, exclusionary innovation (as opposed, for instance, 
to Linux), and litigiousness. The Open Source movement exposes the 
myths underlying current property rights philosophy and is thus 

But the inane expansion of intellectual property rights may merely be a 
final spasm, threatened by the ubiquity of the Internet as they are. 
Free scholarly online publications nibble at the heels of their pricey 
and anticompetitive offline counterparts. 

Electronic publishing poses a threat - however distant - to print 
publishing. Napster-like peer to peer networks undermine the 
foundations of the music and film industries. Open source software is 
encroaching on the turf of proprietary applications. It is very easy 
and cheap to publish and distribute content on the Internet, the 
barriers to entry are virtually nil. 

As processors grow speedier, storage larger, applications 
multi-featured, broadband access all-pervasive, and the Internet goes 
wireless - individuals are increasingly able to emulate much larger 
scale organizations successfully. A single person, working from home, 
with less than $2000 worth of equipment - can publish a Webzine, author 
software, write music, shoot digital films, design products, or 
communicate with millions and his work will be indistinguishable from 
the offerings of the most endowed corporations and institutions. 

Obviously, no individual can yet match the capital assets, the 
marketing clout, the market positioning, the global branding, the sales 
organization, and the distribution network of the likes of Sony, or 
Microsoft. In an age of information glut, it is still the marketing, 
the media campaign, the distribution, and the sales that determine the 
economic outcome. 

This advantage, however, is also being eroded, albeit glacially. 

The Internet is essentially a free marketing and - in the case of 
digital goods - distribution channel. It directly reaches 200 million 
people all over the world. Even with a minimum investment, the 
likelihood of being seen by surprisingly large numbers of consumers is 

Various business models are emerging or reasserting themselves - from 
ad sponsored content to packaged open source software. 

Many creative people - artists, authors, innovators - are repelled by 
the commercialization of their intellect and muse. They seek - and find 
- alternatives to the behemoths of manufacturing, marketing and 
distribution that today control the bulk of intellectual property. Many 
of them go freelance. Indie music labels, independent cinema, print on 
demand publishing - are omens of things to come.

This inexorably leads to disintermediation - the removal of middlemen 
between producer or creator and consumer. The Internet enables niche 
marketing and restores the balance between the creative genius and the 
commercial exploiters of his product. This is a return to 
pre-industrial times when artisans ruled the economic scene. 

Work mobility increases in this landscape of shifting allegiances, head 
hunting, remote collaboration, contract and agency work, and similar 
labour market trends. Intellectual property is likely to become as 
atomized as labor and to revert to its true owners - the inspired 
folks. They, in turn, will negotiate licensing deals directly with 
their end users and customers. 

Capital, design, engineering, and labor intensive goods - computer 
chips, cruise missiles, and passenger cars - will still necessitate the 
coordination of a massive workforce in multiple locations. But even 
here, in the old industrial landscape, the intellectual contribution to 
the collective effort will likely be outsourced to roving freelancers 
who will maintain an ownership stake in their designs or inventions.

This intimate relationship between creative person and consumer is the 
way it has always been. We may yet look back on the 20th century and 
note with amazement the transient and aberrant phase of intermediation 
- the Sony's, Microsoft's, and Forgent's of this world.

The Fabric of Economic Trust 

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

Economics acquired its dismal reputation by pretending to be an exact 
science rather than a branch of mass psychology. In truth it is a 
narrative struggling to describe the aggregate behavior of humans. It 
seeks to cloak its uncertainties and shifting fashions with 
mathematical formulae and elaborate econometric computerized models. 

So much is certain, though - that people operate within markets, free 
or regulated, patchy or organized. They attach numerical (and 
emotional) values to their inputs (work, capital) and to their 
possessions (assets, natural endowments). They communicate these values 
to each other by sending out signals known as prices. 

Yet, this entire edifice - the market and its price mechanism - 
critically depends on trust. If people do not trust each other, or the 
economic "envelope" within which they interact - economic activity 
gradually grinds to a halt. There is a strong correlation between the 
general level of trust and the extent and intensity of economic 

Trust is not a monolithic quantity. There are a few categories of 
economic trust. 

Some forms of trust are akin to a public good and are closely related 
to governmental action or inaction, the reputation of the state and its 
institutions, and its pronounced agenda. Other types of trust are the 
outcomes of kinship, ethnic origin, personal standing and goodwill, 
corporate brands and other data generated by individuals, households, 
and firms. 

I. Trust in the playing field

To transact, people have to maintain faith in a relevant economic 
horizon and in the immutability of the economic playing field or 
"envelope". Put less obscurely, a few hidden assumptions underlie the 
continued economic activity of market players. 

They assume, for instance, that the market will continue to exist for 
the foreseeable future in its current form. That it will remain inert - 
unhindered by externalities like government intervention, geopolitical 
upheavals, crises, abrupt changes in accounting policies and tax laws, 
hyperinflation, institutional and structural reform and other 
market-deflecting events and processes. 

They further assume that their price signals will not be distorted or 
thwarted on a consistent basis thus skewing the efficient and rational 
allocation of risks and rewards. Insider trading, stock manipulation, 
monopolies, hoarding - all tend to consistently but unpredictably 
distort price signals and, thus, deter market participation.

Market players take for granted the existence and continuous operation 
of institutions - financial intermediaries, law enforcement agencies, 
courts. It is important to note that market players prefer continuity 
and certainty to evolution, however gradual and ultimately beneficial. 
A venal bureaucrat is a known quantity and can be tackled effectively. 
A period of transition to good and equitable governance can be more 
stifling than any level of corruption and malfeasance. This is why 
economic activity drops sharply whenever institutions are reformed.

II. Trust in other players

Market players assume that other players are (generally) rational, that 
they have intentions, that they intend to maximize their benefits and 
that they are likely to act on their intentions in a legal (or 
rule-based), rational manner.

III. Trust in market liquidity

Market players assume that other players possess or have access to the 
liquid means they need in order to act on their intentions and 
obligations. They know, from personal experience, that idle capital 
tends to dwindle and that the only way to, perhaps, maintain or 
increase it is to transact with others, directly or through 
intermediaries, such as banks.

IV. Trust in others' knowledge and ability

Market players assume that other players possess or have access to the 
intellectual property, technology, and knowledge they need in order to 
realize their intentions and obligations. 

This implicitly presupposes that all other market players are 
physically, mentally, legally and financially able and willing to act 
their parts as stipulated, for instance, in contracts they sign. 

The emotional dimensions of contracting are often neglected in 
economics. Players assume that their counterparts maintain a realistic 
and stable sense of self-worth based on intimate knowledge of their own 
strengths and weaknesses. Market participants are presumed to harbor 
realistic expectations, commensurate with their skills and 
accomplishments. Allowance is made for exaggeration, disinformation, 
even outright deception - but these are supposed to be marginal 

When trust breaks down - often the result of an external or internal 
systemic shock - people react expectedly. The number of voluntary 
interactions and transactions decreases sharply. With a collapsed 
investment horizon, individuals and firms become corrupt in an effort 
to shortcut their way into economic benefits, not knowing how long will 
the system survive. Criminal activity increases.

People compensate with fantasies and grandiose delusions for their 
growing sense of uncertainty, helplessness, and fears.  This is a 
self-reinforcing mechanism, a vicious cycle which results in 
under-confidence and a fluctuating self esteem. They develop 
psychological defence mechanisms. 

Cognitive dissonance ("I really choose to be poor rather than 
heartless"), pathological envy (seeks to deprive others and thus gain 
emotional reward), rigidity ("I am like that, my family or ethnic group 
has been like that for generations, there is nothing I can do"), 
passive-aggressive behavior (obstructing the work flow, absenteeism, 
stealing from the employer, adhering strictly to arcane regulations) - 
are all reactions to a breakdown in one or more of the four 
aforementioned types of trust. Furthermore, people in a trust crisis 
are unable to postpone gratification. They often become frustrated, 
aggressive, and deceitful if denied. They resort to reckless behavior 
and stopgap economic activities.

In economic environments with compromised and impaired trust, loyalty 
decreases and mobility increases. People switch jobs, renege on 
obligations, fail to repay debts, relocate often. Concepts like 
exclusivity, the sanctity of contracts, workplace loyalty, or a career 
path - all get eroded. As a result, little is invested in the future, 
in the acquisition of skills, in long term savings. Short-termism and 
bottom line mentality rule. 

The outcomes of a crisis of trust are, usually, catastrophic:

Economic activity is much reduced, human capital is corroded and 
wasted, brain drain increases, illegal and extra-legal activities rise, 
society is polarized between haves and haves-not, interethnic and 
inter-racial tensions increase. To rebuild trust in such circumstances 
is a daunting task. The loss of trust is contagious and, finally, it 
infects every institution and profession in the land. It is the stuff 
revolutions are made of.	
Scavenger Economies, 

Predator Economies 

By: Dr. Sam Vaknin 

The national economies of the world can be divided to the scavenger and 
the predator types. The former are parasitic economies which feed off 
the latter. The relationship is often not that of symbiosis, where two 
parties maintain a mutually beneficial co-existence. Here, one economy 
feeds off others in a way, which is harmful, even detrimental to the 
hosts. But this interaction - however undesirable - is the region's 
only hope. 

The typology of scavenger economies reveals their sources of 

Conjunctural - These economies feed off historical or economic 
conjunctures or crises. They position themselves as a bridge between 
warring or conflicting parties. Switzerland rendered this service to 
Nazi Germany (1933-1945), Macedonia and Greece to Serbia (1992 to the 
present), Cyprus aided and abetted Russia (1987 to the present), Jordan 
for Iraq (1991 to the present), and now, Montenegro acts the part for 
both Serbia and Kosovo. These economies consist of smuggling, siege 
breaking, contraband, arms trade and illegal immigration. 

They benefit economically by violating both international and domestic 
laws and by providing international outcasts and rogues with 
alternative routes of supply, and with goods and services. 

Criminal - These economies are infiltrated by criminal gangs or 
suffused with criminal behaviour. Such infiltration is two phased: the 
properly criminal phase and the money laundering one. In the first 
phase, criminal activities yield income and result in wealth 
accumulation. In the second one, the money thus generated is laundered 
and legitimized. It is invested in legal, above-board activities. The 
economy of the USA during the 19th century and in the years of 
prohibition was partly criminal. It is reminiscent of the Russian 
economy in the 1990s, permeated by criminal conduct as it is. Russians 
often compare their stage of capitalist evolution to the American "Wild 

Piggyback Service Economies - These are economies, which provide 
predator economies with services. These services are aimed at 
re-establishing economic equilibrium in the host (predator) economies. 
Tax shelters are a fine example of this variety. In many countries 
taxes are way too high and result in the misallocation of economic 
resources. Tax shelters offer a way of re-establishing the economic 
balance and re-instating a regime of efficient allocation of resources. 
These economies could be regarded as external appendages, shock 
absorbers and regulators of their host economies. They feed off market 
failures, market imbalances, arbitrage opportunities, shortages and 
inefficiencies. Many post-Communist countries have either made the 
provision of such services a part of their economic life or are about 
to do so. 

Free zones, off shore havens, off shore banking and transshipment ports 
proliferate, from Macedonia to Archangelsk. 

Aid Economies - Economies that derive most of their vitality from aid 
granted them by donor countries, multilateral aid agencies and NGOs. 
Many of the economies in transition belong to this class. Up to 15% of 
their GDP is in the form of handouts, soft loans and technical 
assistance. Rescheduling is another species of financial subsidy and 
virtually all CEE countries have benefited from it. The dependence thus 
formed can easily deteriorate into addiction. The economic players in 
such economies engage mostly in lobbying and in political manoeuvring - 
rather than in production. 

Derivative or Satellite Economies - These are economies, which are 
absolutely dependent upon or very closely correlated with other 
economies. This is either because they conduct most of their trade with 
these economies, or because they are a (marginal) member of a powerful 
regional club (or aspire to become one), or because they are under the 
economic (or geopolitical or military) umbrella of a regional power or 
a superpower. Another variant is the single-commodity or single-goods 
or single-service economies. Many countries in Africa and many members 
of the OPEC oil cartel rely on a single product for their livelihood. 
Russia, for instance, is heavily dependent on proceeds from the sale of 
its energy products. Most Montenegrins derive their livelihood, 
directly or indirectly, from smuggling, bootlegging and illegal 
immigration. Drugs are a major "export" earner in Macedonia and 

Copycat Economies - These are economies that are based on legal or 
(more often) illegal copying and emulation of intellectual property: 
patents, brandnames, designs, industrial processes, other forms of 
innovation, copyrighted material, etc. The prime example is Japan, 
which constructed its whole mega-economy on these bases. Both Bulgaria 
and Russia are Meccas of piracy. Though prosperous for a time, these 
economies are dependent on and subject to the vicissitudes of business 
cycles. They are capital sensitive, inherently unstable and with no 
real long term prospects if they fail to generate their own 
intellectual property. They reflect the volatility of the markets for 
their goods and are overly exposed to trade risks, international 
legislation and imports. Usually, they specialize in narrow segments of 
manufacturing which only increases the precariousness of their 

The Predator Economies can also be classified: 

Generators of Intellectual Property - These are economies that 
encourage and emphasize innovation and progress. They reward 
innovators, entrepreneurs, non-conformism and conflict. They spew out 
patents, designs, brands, copyrighted material and other forms of 
packaged human creativity. They derive most of their income from 
licensing and royalties and constitute one of the engines driving 
globalization. Still, these economies are too poor to support the 
complementary manufacturing and marketing activities. Their natural 
counterparts are the "Industrial Bases". Within the former Eastern 
Bloc, Russia, Poland, Hungary and Slovenia are, to a limited extent, 
such generators. Israel is such an economy in the Middle East. 

Industrial Bases - These are economies that make use of the 
intellectual property generated by the former type within industrial 
processes. They do not copy the intellectual property as it is. Rather, 
they add to it important elements of adaptation to niche markets, image 
creation, market positioning, packaging, technical literature, 
combining it with other products or services, designing and 
implementing the whole production process, market (demand) creation, 
improvement upon the originals and value added services. These 
contributions are so extensive that the end products, or services can 
no longer to be identified with the originals, which serve as mere 
triggers. Again, Poland, Hungary, Slovenia (and to a lesser extent, 
Croatia) come to mind. 

Consumer Oriented Economies - These are Third Wave (Alvin Toffler's 
term), services, information and knowledge driven economies. The 
over-riding set of values is consumer oriented. Wealth formation and 
accumulation are secondary. The primary activities are concerned with 
fostering markets and maintaining them. These "weightless" economies 
concentrate on intangibles: advertising, packaging, marketing, sales 
promotion, education, entertainment, servicing, dissemination of 
information, knowledge formation, trading, trading in symbolic assets 
(mainly financial), spiritual pursuits, and other economic activities 
which enhance the consumer's welfare (pharmaceuticals, for instance). 
These economies are also likely to sport a largish public sector, most 
of it service oriented. No national economy in CEE qualifies as 
"Consumer Oriented", though there are pockets of consumer-oriented 
entrepreneurship within each one. 

The Trader Economies - These economies are equivalent to the 
cardiovascular system. They provide the channels through which goods 
and services are exchanged. They do this by trading or assuming risks, 
by providing physical transportation and telecommunications, and by 
maintaining an appropriately educated manpower to support all these 
activities. These economies are highly dependent on the general health 
of international trade. Many of the CEE economies are Trader economies. 
The openness ratio (trade divided by GDP) of most CEE countries is 
higher than the G7 countries'. Macedonia, for instance, has a GDP of 
3.6 Billion US dollars and exports and imports of c. 2 billion US 
dollars. These are the official figures. Probably, another 0.5 billion 
Us dollars in trade go unreported. additionally, it has one of the 
lowest weighted customs rate in the world. Openness to trade is an 
official policy, actively pursued. 

These economies are predatory in the sense that they engage in zero-sum 
games. A contract gained by a Slovenian company - is a contract lost by 
a Croatian one. Luckily, in this last decade, the economic cake tended 
to grow and the sum of zero sum games was more welfare to all involved. 
These vibrant economies - the hope of benighted and blighted regions - 
are justly described as "engines" because they pull all other 
(scavenger) economies with them. They are not likely to do so forever. 
But their governments have assimilated the lessons of the 1930s. 
Protectionism is bad for everyone involved - especially for economic 
engines. Openness to trade, protection of property rights and 
functioning institutions increase both the number and the scope of 

Notes on the Economics of Game Theory 

By: Dr. Sam Vaknin 

Consider this: 

Could Western management techniques be successfully implemented in the 
countries of Central and Eastern Europe (CEE)? Granted, they have to be 
adapted, modified and cannot be imported in their entirety. But their 
crux, their inalienable nucleus - can this be transported and 
transplanted in CEE? Theory provides us with a positive answer. Human 
agents are the same everywhere and are mostly rational. Practice begs 
to differ. Basic concepts such as the money value of time or the moral 
and legal meaning of property are non existent. The legal, political 
and economic environments are all unpredictable. As a result, economic 
players will prefer to maximize their utility immediately (steal from 
the workplace, for instance) - than to wait for longer term 
(potentially, larger) benefits. Warrants (stock options) convertible to 
the company's shares constitute a strong workplace incentive in the 
West (because there is an horizon and they increase the employee's 
welfare in the long term). Where the future is speculation - 
speculation withers. Stock options or a small stake in his firm, will 
only encourage the employee to blackmail the other shareholders by 
paralysing the firm, to abuse his new position and will be interpreted 
as immunity, conferred from above, from the consequences of illegal 

The very allocation of options or shares will be interpreted as a sign 
of weakness, dependence and need, to be exploited. Hierarchy is equated 
with slavery and employees will rather harm their long term interests 
than follow instructions or be subjected to criticism - never mind how 
constructive. The employees in CEE regard the corporate environment as 
a conflict zone, a zero sum game (in which the gains by some equal the 
losses to others). In the West, the employees participate in the 
increase in the firm's value. The difference between these attitudes is 

Now, let us consider this: 

An entrepreneur is a person who is gifted at identifying the 
unsatisfied needs of a market, at mobilizing and organizing the 
resources required to satisfy those needs and at defining a long-term 
strategy of development and marketing. As the enterprise grows, two 
processes combine to denude the entrepreneur of some of his initial 
functions. The firm has ever growing needs for capital: financial, 
human, assets and so on. Additionally, the company begins (or should 
begin) to interface and interact with older, better established firms. 
Thus, the company is forced to create its first management team: a 
general manager with the right doses of respectability, connections and 
skills, a chief financial officer, a host of consultants and so on. In 
theory - if all our properly motivated financially - all these players 
(entrepreneurs and managers) will seek to maximize the value of the 
firm. What happens, in reality, is that both work to minimize it, each 
for its own reasons. The managers seek to maximize their short-term 
utility by securing enormous pay packages and other forms of 
company-dilapidating compensation. 

The entrepreneurs feel that they are "strangled", "shackled", "held 
back" by bureaucracy and they "rebel". They oust the management, or 
undermine it, turning it into an ineffective representative relic. They 
assume real, though informal, control of the firm. They do so by 
defining a new set of strategic goals for the firm, which call for the 
institution of an entrepreneurial rather than a bureaucratic type of 
management. These cycles of initiative-consolidation-new 
initiative-revolution-consolidation are the dynamos of company growth. 
Growth leads to maximization of value. However, the players don't know 
or do not fully believe that they are in the process of maximizing the 
company's worth. On the contrary, consciously, the managers say: "let's 
maximize the benefits that we derive from this company, as long as we 
are still here." The entrepreneurs-owners say: "we cannot tolerate this 
stifling bureaucracy any longer. We prefer to have a smaller company - 
but all ours." The growth cycles forces the entrepreneurs to dilute 
their holdings (in order to raise the capital necessary to finance 
their initiatives). This dilution (the fracturing of the ownership 
structure) is what brings the last cycle to its end. The holdings of 
the entrepreneurs are too small to materialize a coup against the 
management. The management then prevails and the entrepreneurs are 
neutralized and move on to establish another start-up. The only thing 
that they leave behind them is their names and their heirs. 

We can use Game Theory methods to analyse both these situations. 

Wherever we have economic players bargaining for the allocation of 
scarce resources in order to attain their utility functions, to secure 
the outcomes and consequences (the value, the preference, that the 
player attaches to his outcomes) which are right for them - we can use 
Game Theory (GT). 

A short recap of the basic tenets of the theory might be in order. 

GT deals with interactions between agents, whether conscious and 
intelligent - or Dennettic. A Dennettic Agent (DA) is an agent that 
acts so as to influence the future allocation of resources, but does 
not need to be either conscious or deliberative to do so. A Game is the 
set of acts committed by 1 to n rational DA and one a-rational (not 
irrational but devoid of rationality) DA (nature, a random mechanism). 
At least 1 DA in a Game must control the result of the set of acts and 
the DAs must be (at least potentially) at conflict, whole or partial. 
This is not to say that all the DAs aspire to the same things. They 
have different priorities and preferences. They rank the likely 
outcomes of their acts differently. They engage Strategies to obtain 
their highest ranked outcome. A Strategy is a vector, which details the 
acts, with which the DA will react in response to all the (possible) 
acts by the other DAs. An agent is said to be rational if his Strategy 
does guarantee the attainment of his most preferred goal. Nature is 
involved by assigning probabilities to the outcomes. An outcome, 
therefore, is an allocation of resources resulting from the acts of the 
agents. An agent is said to control the situation if its acts matter to 
others to the extent that at least one of them is forced to alter at 
least one vector (Strategy). 

The Consequence to the agent is the value of a function that assigns 
real numbers to each of the outcomes. The consequence represents a list 
of outcomes, prioritized, ranked. It is also known as an ordinal 
utility function. If the function includes relative numerical 
importance measures (not only real numbers) - we call it a Cardinal 
Utility Function. 

Games, naturally, can consist of one player, two players and more than 
two players (n-players). They can be zero (or fixed) - sum (the sum of 
benefits is fixed and whatever gains made by one of the players are 
lost by the others). They can be nonzero-sum (the amount of benefits to 
all players can increase or decrease). Games can be cooperative (where 
some of the players or all of them form coalitions) - or 
non-cooperative (competitive). For some of the games, the solutions are 
called Nash equilibria. They are sets of strategies constructed so that 
an agent which adopts them (and, as a result, secures a certain 
outcome) will have no incentive to switch over to other strategies 
(given the strategies of all other players). Nash equilibria 
(solutions) are the most stable (it is where the system "settles down", 
to borrow from Chaos Theory) - but they are not guaranteed to be the 
most desirable. Consider the famous "Prisoners' Dilemma" in which both 
players play rationally and reach the Nash equilibrium only to discover 
that they could have done much better by collaborating (that is, by 
playing irrationally). Instead, they adopt the "Paretto-dominated", or 
the "Paretto-optimal", sub-optimal solution. Any outside interference 
with the game (for instance, legislation) will be construed as creating 
a NEW game, not as pushing the players to adopt a "Paretto-superior" 

The behaviour of the players reveals to us their order of preferences. 
This is called "Preference Ordering" or "Revealed Preference Theory". 
Agents are faced with sets of possible states of the world 
(=allocations of resources, to be more economically inclined). These 
are called "Bundles". In certain cases they can trade their bundles, 
swap them with others. The evidence of these swaps will inevitably 
reveal to us the order of priorities of the agent. All the bundles that 
enjoy the same ranking by a given agent - are this agent's 
"Indifference Sets". The construction of an Ordinal Utility Function 
is, thus, made simple. The indifference sets are numbered from 1 to n. 
These ordinals do not reveal the INTENSITY or the RELATIVE INTENSITY of 
a preference - merely its location in a list. However, techniques are 
available to transform the ordinal utility function - into a cardinal 

A Stable Strategy is similar to a Nash solution - though not identical 
mathematically. There is currently no comprehensive theory of 
Information Dynamics. Game Theory is limited to the aspects of 
competition and exchange of information (cooperation). Strategies that 
lead to better results (independently of other agents) are dominant and 
where all the agents have dominant strategies - a solution is 
established. Thus, the Nash equilibrium is applicable to games that are 
repeated and wherein each agent reacts to the acts of other agents. The 
agent is influenced by others - but does not influence them (he is 
negligible). The agent continues to adapt in this way - until no longer 
able to improve his position. The Nash solution is less available in 
cases of cooperation and is not unique as a solution. In most cases, 
the players will adopt a minimax strategy (in zero-sum games) or 
maximin strategies (in nonzero-sum games). 

These strategies guarantee that the loser will not lose more than the 
value of the game and that the winner will gain at least this value. 
The solution is the "Saddle Point". 

The distinction between zero-sum games (ZSG) and nonzero-sum games 
(NZSG) is not trivial. A player playing a ZSG cannot gain if prohibited 
to use certain strategies. This is not the case in NZSGs. In ZSG, the 
player does not benefit from exposing his strategy to his rival and is 
never harmed by having foreknowledge of his rival's strategy. Not so in 
NZSGs: at times, a player stands to gain by revealing his plans to the 
"enemy". A player can actually be harmed by NOT declaring his strategy 
or by gaining acquaintance with the enemy's stratagems. The very 
ability to communicate, the level of communication and the order of 
communication - are important in cooperative cases. A Nash solution: 

1. is not dependent upon any utility function; 

2. it is impossible for two players to improve the Nash solution 
(=their position) simultaneously (=the Paretto optimality); 

3. is not influenced by the introduction of irrelevant (not very 
gainful) alternatives; and 

4. is symmetric (reversing the roles of the players does not affect the 

The limitations of this approach are immediately evident. It is 
definitely not geared to cope well with more complex, multi-player, 
semi-cooperative (semi-competitive), imperfect information situations. 

Von Neumann proved that there is a solution for every ZSG with 2 
players, though it might require the implementation of mixed strategies 
(strategies with probabilities attached to every move and outcome). 
Together with the economist Morgenstern, he developed an approach to 
coalitions (cooperative efforts of one or more players - a coalition of 
one player is possible). Every coalition has a value - a minimal amount 
that the coalition can secure using solely its own efforts and 
resources. The function describing this value is super-additive (the 
value of a coalition which is comprised of two sub-coalitions equals, 
at least, the sum of the values of the two sub-coalitions). Coalitions 
can be epiphenomenal: their value can be higher than the combined 
values of their constituents. The amounts paid to the players equal the 
value of the coalition and each player stands to get an amount no 
smaller than any amount that he would have made on his own. A set of 
payments to the players, describing the division of the coalition's 
value amongst them, is the "imputation", a single outcome of a 
strategy. A strategy is, therefore, dominant, if: (1) each player is 
getting more under the strategy than under any other strategy and (2) 
the players in the coalition receive a total payment that does not 
exceed the value of the coalition. Rational players are likely to 
prefer the dominant strategy and to enforce it. Thus, the solution to 
an n-players game is a set of imputations. No single imputation in the 
solution must be dominant (=better). They should all lead to equally 
desirable results. On the other hand, all the imputations outside the 
solution should be dominated. Some games are without solution (Lucas, 

Auman and Maschler tried to establish what is the right payoff to the 
members of a coalition. They went about it by enlarging upon the 
concept of bargaining (threats, bluffs, offers and counter-offers). 
Every imputation was examined, separately, whether it belongs in the 
solution (=yields the highest ranked outcome) or not, regardless of the 
other imputations in the solution. But in their theory, every member 
had the right to "object" to the inclusion of other members in the 
coalition by suggesting a different, exclusionary, coalition in which 
the members stand to gain a larger payoff. The player about to be 
excluded can "counter-argue" by demonstrating the existence of yet 
another coalition in which the members will get at least as much as in 
the first coalition and in the coalition proposed by his adversary, the 
"objector". Each coalition has, at least, one solution. 

The Game in GT is an idealized concept. Some of the assumptions can - 
and should be argued against. The number of agents in any game is 
assumed to be finite and a finite number of steps is mostly 
incorporated into the assumptions. Omissions are not treated as acts 
(though negative ones). All agents are negligible in their relationship 
to others (have no discernible influence on them) - yet are influenced 
by them (their strategies are not - but the specific moves that they 
select - are). The comparison of utilities is not the result of any 
ranking - because no universal ranking is possible. Actually, no 
ranking common to two or n players is possible (rankings are bound to 
differ among players). Many of the problems are linked to the variant 
of rationality used in GT. It is comprised of a clarity of preferences 
on behalf of the rational agent and relies on the people's tendency to 
converge and cluster around the right answer / move. 

This, however, is only a tendency. Some of the time, players select the 
wrong moves. It would have been much wiser to assume that there are no 
pure strategies, that all of them are mixed. Game Theory would have 
done well to borrow mathematical techniques from quantum mechanics. For 
instance: strategies could have been described as wave functions with 
probability distributions. The same treatment could be accorded to the 
cardinal utility function. Obviously, the highest ranking (smallest 
ordinal) preference should have had the biggest probability attached to 
it - or could be treated as the collapse event. But these are more or 
less known, even trivial, objections. Some of them cannot be overcome. 
We must idealize the world in order to be able to relate to it 
scientifically at all. The idealization process entails the 
incorporation of gross inaccuracies into the model and the ignorance of 
other elements. The surprise is that the approximation yields results, 
which tally closely with reality - in view of its mutilation, affected 
by the model. 

There are more serious problems, philosophical in nature. 

It is generally agreed that "changing" the game can - and very often 
does - move the players from a non-cooperative mode (leading to 
Paretto-dominated results, which are never desirable) - to a 
cooperative one. A government can force its citizens to cooperate and 
to obey the law. It can enforce this cooperation. This is often called 
a Hobbesian dilemma. It arises even in a population made up entirely of 
altruists. Different utility functions and the process of bargaining 
are likely to drive these good souls to threaten to become egoists 
unless other altruists adopt their utility function (their preferences, 
their bundles). 

Nash proved that there is an allocation of possible utility functions 
to these agents so that the equilibrium strategy for each one of them 
will be this kind of threat. This is a clear social Hobbesian dilemma: 
the equilibrium is absolute egoism despite the fact that all the 
players are altruists. This implies that we can learn very little about 
the outcomes of competitive situations from acquainting ourselves with 
the psychological facts pertaining to the players. The agents, in this 
example, are not selfish or irrational - and, still, they deteriorate 
in their behaviour, to utter egotism. A complete set of utility 
functions - including details regarding how much they know about one 
another's utility functions - defines the available equilibrium 
strategies. The altruists in our example are prisoners of the logic of 
the game. Only an "outside" power can release them from their 
predicament and permit them to materialize their true nature. Gauthier 
said that morally-constrained agents are more likely to evade 
Paretto-dominated outcomes in competitive games - than agents who are 
constrained only rationally. But this is unconvincing without the 
existence of an Hobesian enforcement mechanism (a state is the most 
common one). Players would do better to avoid Paretto dominated 
outcomes by imposing the constraints of such a mechanism upon their 
available strategies. Paretto optimality is defined as efficiency, when 
there is no state of things (a different distribution of resources) in 
which at least one player is better off - with all the other no worse 
off. "Better off" read: "with his preference satisfied". This 
definitely could lead to cooperation (to avoid a bad outcome) - but it 
cannot be shown to lead to the formation of morality, however basic. 
Criminals can achieve their goals in splendid cooperation and be 
content, but that does not make it more moral. 

Game theory is agent neutral, it is utilitarianism at its apex. It does 
not prescribe to the agent what is "good" - only what is "right". It is 
the ultimate proof that effort at reconciling utilitarianism with more 
deontological, agent relative, approaches are dubious, in the best of 
cases. Teleology, in other words, in no guarantee of morality. 

Acts are either means to an end or ends in themselves. This is no 
infinite regression. There is bound to be an holy grail (happiness?) in 
the role of the ultimate end. A more commonsense view would be to 
regard acts as means and states of affairs as ends. This, in turn, 
leads to a teleological outlook: acts are right or wrong in accordance 
with their effectiveness at securing the achievement of the right 
goals. Deontology (and its stronger version, absolutism) constrain the 
means. It states that there is a permitted subset of means, all the 
other being immoral and, in effect, forbidden. Game Theory is out to 
shatter both the notion of a finite chain of means and ends culminating 
in an ultimate end - and of the deontological view. It is 
consequentialist but devoid of any value judgement. 

Game Theory pretends that human actions are breakable into much smaller 
"molecules" called games. Human acts within these games are means to 
achieving ends but the ends are improbable in their finality. The means 
are segments of "strategies": prescient and omniscient renditions of 
the possible moves of all the players. Aside from the fact that it 
involves mnemic causation (direct and deterministic influence by past 
events) and a similar influence by the utility function (which really 
pertains to the future) - it is highly implausible. 

Additionally, Game Theory is mired in an internal contradiction: on the 
one hand it solemnly teaches us that the psychology of the players is 
absolutely of no consequence. On the other, it hastens to explicitly 
and axiomatically postulate their rationality and implicitly (and no 
less axiomatically) their benefit-seeking behaviour (though this aspect 
is much more muted). This leads to absolutely outlandish results: 
irrational behaviour leads to total cooperation, bounded rationality 
leads to more realistic patterns of cooperation and competition 
(coopetition) and an unmitigated rational behaviour leads to disaster 
(also known as Paretto dominated outcomes). 

Moreover, Game Theory refuses to acknowledge that real games are 
dynamic, not static. The very concepts of strategy, utility function 
and extensive (tree like) representation are static. The dynamic is 
retrospective, not prospective. To be dynamic, the game must include 
all the information about all the actors, all their strategies, all 
their utility functions. Each game is a subset of a higher level game, 
a private case of an implicit game which is constantly played in the 
background, so to say. This is a hyper-game of which all games are but 
derivatives. It incorporates all the physically possible moves of all 
the players. An outside agency with enforcement powers (the state, the 
police, the courts, the law) are introduced by the players. In this 
sense, they are not really an outside event which has the effect of 
altering the game fundamentally. They are part and parcel of the 
strategies available to the players and cannot be arbitrarily ruled 
out. On the contrary, their introduction as part of a dominant strategy 
will simplify Game theory and make it much more applicable. In other 
words: players can choose to compete, to cooperate and to cooperate in 
the formation of an outside agency. 

There is no logical or mathematical reason to exclude the latter 
possibility. The ability to thus influence the game is a legitimate 
part of any real life strategy. Game Theory assumes that the game is a 
given - and the players have to optimize their results within it. It 
should open itself to the inclusion of game altering or redefining 
moves by the players as an integral part of their strategies. After 
all, games entail the existence of some agreement to play and this 
means that the players accept some rules (this is the role of the 
prosecutor in the Prisoners' Dilemma). If some outside rules (of the 
game) are permissible - why not allow the "risk" that all the players 
will agree to form an outside, lawfully binding, arbitration and 
enforcement agency - as part of the game? Such an agency will be 
nothing if not the embodiment, the materialization of one of the rules, 
a move in the players' strategies, leading them to more optimal or 
superior outcomes as far as their utility functions are concerned. 
Bargaining inevitably leads to an agreement regarding a decision making 
procedure. An outside agency, which enforces cooperation and some moral 
code, is such a decision making procedure. It is not an "outside" 
agency in the true, physical, sense. It does not "alter" the game (not 
to mention its rules). It IS the game, it is a procedure, a way to 
resolve conflicts, an integral part of any solution and imputation, the 
herald of cooperation, a representative of some of the will of all the 
players and, therefore, a part both of their utility functions and of 
their strategies to obtain their preferred outcomes. Really, these 
outside agencies ARE the desired outcomes. 

Once Game Theory digests this observation, it could tackle reality 
rather than its own idealized contraptions.

 Knowledge and Power 

By: Dr. Sam Vaknin 

"Knowledge is Power" goes the old German adage. But power, as any 
schoolboy knows, always has negative and positive sides to it. 
Information exhibits the same duality: properly provided, it is a 
positive power of unequalled strength. Improperly disseminated and 
presented, it is nothing short of destructive. The management of the 
structure, content, provision and dissemination of information is, 
therefore, of paramount importance to a nation, especially if it is in 
its infancy (as an independent state). 

Information has four dimensions and five axes of dissemination, some 
vertical and some horizontal. 

The four dimensions are: 

1. Structure - information can come in various physical forms and 
poured into different kinds of vessels and carriers. It can be 
continuous or segmented, cyclical (periodic) or punctuated, repetitive 
or new, etc. The structure often determines what of the information (if 
at all) will be remembered and how. It encompasses not only the mode of 
presentation, but also the modules and the rules of interaction between 
them (the hermeneutic principles, the rules of structural 
interpretation, which is the result of spatial, syntactic and 
grammatical conjunction). 

2. Content - This incorporates both ontological and epistemological 
elements. In other words: both "hard" data, which should, in principle, 
be verifiable through the employment of objective, scientific, methods 
- and "soft" data, the interpretation offered with the hard data. The 
soft data is a derivative of a "message", in the broader sense of the 
term. A message comprises both world-view (theory) and an action and 
direction-inducing element. 

3. Provision - The intentional input of structured content into 
information channels. The timing of this action, the quantities of data 
fed into the channels, their qualities - all are part of the equation 
of provision. 

4. Dissemination - More commonly known as media or information 
channels. The channels which bridge between the information providers 
and the information consumers. Some channels are merely technical and 
then the relevant things to discuss would be technical: bandwidth, 
noise to signal ratios and the like. Other channels are metaphorical 
and then the relevant determinants would be their effectiveness in 
conveying content to targeted consumers. 

 In the economic realm, there are five important axes of dissemination: 

1. >From Government to the Market - the Market here being the "Hidden 
Hand", the mechanism which allocates resources in adherence to market 
signals (for instance, in accordance with prices). 

The Government intervenes to correct market failures, or to influence 
the allocation of resources in favour or against the interests of a 
defined group of people. The more transparent and accountable the 
actions of the Government, the less distortion in the allocation of 
resources and the less resulting inefficiency. The Government should 
declare its intentions and actions in advance whenever possible, then 
it should act through public, open tenders, report often to regulatory 
and legislative bodies and to the public and so on. The more 
information provided by this major economic player (the most dominant 
in most countries) - the more smoothly and efficaciously the Market 
will operate. The converse, unfortunately, is also true. The less open 
the government, the more latent its intents, the more shadowy its 
operations - the more cumbersome the bureaucracy, the less functioning 
the market. 

2. From Government to the Firms - The same principles that apply to the 
desirable interaction between Government and Market, apply here. The 
Government should disseminate information to firms in its territory 
(and out of it) accurately, equitably and speedily. Any delay or 
distortion in the information, or preference of one recipient over 
another - will thwart the efficient allocation of economic resources.


3. From Government to the World - The "World" here being multilateral 
institutions, foreign governments, foreign investors, foreign 
competitors and the economic players in general providing that they are 
outside the territory of the information disseminating Government. 
Again, any delay, or abstention in the dissemination of information as 
well as its distortion (disinformation and misinformation) will result 
in economic outcomes worse that could have been achieved by a free, 
prompt, precise and equitable (=equally available) dissemination of 
said information. This is true even where commercial secrets are 
involved! It has been proven time and again that when commercial 
information is kept secret - the firm (or Government) that keeps it 
hidden is HARMED. The most famous examples are Apple (which kept its 
operating system a well-guarded secret) and IBM (which did not), 
Microsoft (which kept its operating system open to developers of 
software) and other software companies (which did not). Recently, 
Netscape has decided to provide its source code (the most important 
commercial secret of any software company) free of charge to 
application developers. Synergy based on openness seemed to have won 
over old habits. A free, unhampered, unbiased flow of information is a 
major point of attraction to foreign investors and a brawny point with 
the likes of the IMF and the World Bank. The former, for instance, 
lends money more easily to countries, which maintain a reasonably 
reliable outflow of national statistics. 

4. From Firms to the World - The virtues of corporate transparency and 
of the application of the properly revealing International Accounting 
Standards (IAS, GAAP, or others) need no evidencing. Today, it is 
virtually impossible to raise money, to export, to import, to form 
joint ventures, to obtain credits, or to otherwise collaborate 
internationally without the existence of full, unmitigated disclosure. 
The modern firm (if it wishes to interact globally) must open itself up 
completely and provide timely, full and accurate information to all. 
This is a legal must for public and listed firms the world over (though 
standards vary). Transparent accounting practices, clear ownership 
structure, available track record and historical performance records - 
are sine qua non in today's financing world. 

5. From Firms to Firms - This is really a subset of the previous axis 
of dissemination. Its distinction is that while the former is concerned 
with multilateral, international interactions - this axis is more 
inwardly oriented and deals with the goings-on between firms in the 
same territory. Here, the desirability of full disclosure is even 
stronger. A firm that fails to provide information about itself to 
firms on its turf, will likely fall prey to vicious rumours and 
informative manipulations by its competitors. 

Positive information is characterized by four qualities: 

1. Transparency - Knowing the sources of the information, the methods 
by which it was obtained, the confirmation that none of it was 
unnecessarily suppressed (some would argue that there is no "necessary 
suppression") - constitutes the main edifice of transparency. The datum 
or information can be true, but if it is not perceived to be 
transparent - it will not be considered reliable. Think about an 
anonymous (=non-transparent) letter versus a signed letter - the latter 
will be more readily relied upon (subject to the reliability of the 
author, of course). 

2. Reliability - is the direct result of transparency. Acquaintance 
with the source of information (including its history) and with the 
methods of its provision and dissemination will determine the level of 
reliability that we will attach to it. How balanced is it? Is the 
source prejudiced or in any way an interested, biased, party? Was the 
information "force-fed" by the Government, was the media coerced to 
publish it by a major advertiser, was the journalist arrested after the 
publication? The circumstances surrounding the datum are as important 
as its content. The context of a piece of information is of no less 
consequence that the information contained in it. Above all, to be 
judged reliable, the information must "reflect" reality. I mean 
reflection not in the basic sense: a one to one mapping of the 
reflected. I intend it more as a resonance, a vibration in tune with 
the piece of the real world that it relates to. 

People say: "This sounds true" and the word "sounds" should be 

3. Comprehensiveness - Information will not be considered transparent, 
nor will it be judged reliable if it is partial. It must incorporate 
all the aspects of the world to which it relates, or else state 
explicitly what has been omitted and why (which is tantamount to 
including it, in the first place). A bit of information is embedded in 
a context and constantly interacts with it. Additionally, its various 
modules and content elements consistently and constantly interact with 
each other. A missing part implies ignorance of interactions and 
epiphenomena, which might crucially alter the interpretation of the 
information. Partiality renders information valueless. Needless to say, 
that I am talking about RELEVANT parts of the information. There are 
many other segments of it, which are omitted because their influence is 
negligible (the idealization process), or because it is so great that 
they are common knowledge. 

4. Organization - This, arguably, is the most important aspect of 
information. It is what makes information comprehensible. It includes 
the spatial and temporal (historic) context of the information, its 
interactions with its context, its inner interactions, as we described 
earlier, its structure, the rules of decision (grammar and syntax) and 
the rules of interpretation (semantics, etc.) to be applied. A 
worldview is provided, a theory into which the information fits. 
Embedded in this theory, it allows for predictions to be made in order 
to falsify the theory (or to prove it). Information cannot be 
understood in the absence of such a worldview. Such a worldview can be 
scientific, or religious - but it can also be ideological (Capitalism, 
Socialism), or related to an image which an entity wishes to project. 
An image is a theory about a person or a group of people. It is both 
supported by information - and supports it. It is a shorthand version 
of all the pertinent data, a stereotype in reverse. 

There is no difference in the application of these rules to information 
and to interpretation (which is really information that relates to 
other information instead of relating to the World). Both categories 
can be formal and informal. Formal information is information that 
designates itself as such (carries a sign: "I am information"). It 
includes official publications by various bodies (accountants, 
corporations, The Bureau of Statistics, news bulletins, all the media, 
the Internet, various databases, whether in digitized format or in hard 

Informal information is information, which is not permanently captured 
or is captured without the intention of generating formal information 
(=without the pretence: "I am information"). Any verbal communication 
belongs here (rumours, gossip, general knowledge, background dormant 
data, etc.). 

The modern world is glutted by information, formal and informal, 
partial and comprehensive, out of context and with interpretation. 
There are no conceptual, mental, or philosophically rigorous 
distinctions today between information and what it denotes or stands 

Actors are often mistaken for their roles, wars are fought on 
television, fictitious TV celebrities become real. That which has no 
information presence might as well have no real life existence. An 
entity - person, group of people, a nation - which does not engage in 
structuring content, providing and disseminating it - actively engages, 
therefore, in its own, slow, disappearance.

Market Impeders and

Market Inefficiencies 

By: Dr. Sam Vaknin 

Even the most devout proponents of free marketry and hidden hand 
theories acknowledge the existence of market failures, market 
imperfections and inefficiencies in the allocation of economic 
resources. Some of these are the results of structural problems, others 
of an accumulation of historical liabilities. But, strikingly, some of 
the inefficiencies are the direct outcomes of the activities of "non 
bona fide" market participants. These "players" (individuals, 
corporations, even larger economic bodies, such as states) act either 
irrationally or egotistically (too rationally). 

What characterizes all those "market impeders" is that they are value 
subtractors rather than value adders. Their activities generate a 
reduction, rather than an increase, in the total benefits (utilities) 
of all the other market players (themselves included). Some of them do 
it because they are after a self interest which is not economic (or, 
more strictly, financial). They sacrifice some economic benefits in 
order to satisfy that self interest (or, else, they could never have 
attained these benefits, in the first place). Others refuse to accept 
the self interest of other players as their limit. They try to maximize 
their benefits at any cost, as long as it is a cost to others. Some do 
so legally and some adopt shadier varieties of behaviour. And there is 
a group of parasites - participants in the market who feed off its very 
inefficiencies and imperfections and, by their very actions, enhance 

A vicious cycle ensues: the body economic gives rise to parasitic 
agents who thrive on its imperfections and lead to the amplification of 
the very impurities that they prosper on. 

We can distinguish six classes of market impeders: 

1. Crooks and other illegal operators. These take advantage of 
ignorance, superstition, greed, avarice, emotional states of mind of 
their victims - to strike. They re-allocate resources from (potentially 
or actually) productive agents to themselves. Because they reduce the 
level of trust in the marketplace - they create negative added value. 
(See: "The Shadowy World of International Finance" and "The Fabric of 
Economic Trust"). 

2. Illegitimate operators include those treading the thin line between 
legally permissible and ethically inadmissible. They engage in petty 
cheating through misrepresentations, half-truths, semi-rumours and the 
like. They are full of pretensions to the point of becoming impostors. 
They are wheeler-dealers, sharp-cookies, Daymon Ranyon characters, 
lurking in the shadows cast by the sun of the market. Their impact is 
to slow down the economic process through disinformation and the 
resulting misallocation of resources. They are the sand in the wheels 
of the economic machine. 


The "not serious" operators. These are people too hesitant, or phobic 
to commit themselves to the assumption of any kind of risk. Risk is the 
coal in the various locomotives of the economy, whether local, 
national, or global. Risk is being assumed, traded, diversified out of, 
avoided, insured against. It gives rise to visions and hopes and it is 
the most efficient "economic natural selection" mechanism. To be a 
market participant one must assume risk, it in an inseparable part of 
economic activity. Without it the wheels of commerce and finance, 
investments and technological innovation will immediately grind to a 
halt. But many operators are so risk averse that, in effect, they 
increase the inefficiency of the market in order to avoid it. They act 
as though they are resolute, risk assuming operators. They make all the 
right moves, utter all the right sentences and emit the perfect noises. 
But when push comes to shove - they recoil, retreat, defeated before 
staging a fight. Thus, they waste the collective resources of all that 
the operators that they get involved with. They are known to endlessly 
review projects, often change their minds, act in fits and starts, have 
the wrong priorities (for an efficient economic functioning, that is), 
behave in a self defeating manner, be horrified by any hint of risk, 
saddled and surrounded by every conceivable consultant, glutted by 
information. They are the stick in the spinning wheel of the modern 


The former kind of operators obviously has a character problem. Yet, 
there is a more problematic species: those suffering from serious 
psychological problems, personality disorders, clinical phobias, 
psychoneuroses and the like. This human aspect of the economic realm 
has, to the best of my knowledge, been neglected before. Enormous 
amounts of time, efforts, money and energy are expended by the more 
"normal" - because of the "less normal" and the "eccentric". These 
operators are likely to regard the maintaining of their internal 
emotional balance as paramount, far over-riding economic 
considerations. They will sacrifice economic advantages and benefits 
and adversely affect their utility outcome in the name of principles, 
to quell psychological tensions and pressures, as part of 
obsessive-compulsive rituals, to maintain a false grandiose image, to 
go on living in a land of fantasy, to resolve a psychodynamic conflict 
and, generally, to cope with personal problems which have nothing to do 
with the idealized rational economic player of the theories. If 
quantified, the amounts of resources wasted in these coping manoeuvres 
is, probably, mind numbing. Many deals clinched are revoked, many 
businesses started end, many detrimental policy decisions adopted and 
many potentially beneficial situations avoided because of these 
personal upheavals. 

5. Speculators and middlemen are yet another species of parasites. In a 
theoretically totally efficient marketplace - there would have been no 
niche for them. They both thrive on information failures. 

The first kind engages in arbitrage (differences in pricing in two 
markets of an identical good - the result of inefficient dissemination 
of information) and in gambling. These are important and blessed 
functions in an imperfect world because they make it more perfect. The 
speculative activity equates prices and, therefore, sends the right 
signals to market operators as to how and where to most efficiently 
allocate their resources. But this is the passive speculator. The 
"active" speculator is really a market rigger. He corners the market by 
the dubious virtue of his reputation and size. He influences the market 
(even creates it) rather than merely exploit its imperfections. Soros 
and Buffet have such an influence though their effect is likely to be 
considered beneficial by unbiased observers. Middlemen are a different 
story because most of them belong to the active subcategory. This means 
that they, on purpose, generate market inconsistencies, inefficiencies 
and problems - only to solve them later at a cost extracted and paid to 
them, the perpetrators of the problem. Leaving ethical questions aside, 
this is a highly wasteful process. Middlemen use privileged information 
and access - whereas speculators use information of a more public 
nature. Speculators normally work within closely monitored, full 
disclosure, transparent markets. Middlemen thrive of disinformation, 
misinformation and lack of information. Middlemen monopolize their 
information - speculators share it, willingly or not. The more 
information becomes available to more users - the greater the 
deterioration in the resources consumed by brokers of information. The 
same process will likely apply to middlemen of goods and services. 

We are likely to witness the death of the car dealer, the classical 
retail outlet, the music records shop. For that matter, inventions like 
the internet is likely to short-circuit the whole distribution process 
in a matter of a few years. 

6. The last type of market impeders is well known and is the only one 
to have been tackled - with varying degrees of success by governments 
and by legislators worldwide. These are the trade restricting 
arrangements: monopolies, cartels, trusts and other illegal 
organizations. Rivers of inks were spilled over forests of paper to 
explain the pernicious effects of these anti-competitive practices 
(see: "Competition Laws"). The short and the long of it is that 
competition enhances and increases efficiency and that, therefore, 
anything that restricts competition, weakens and lessens efficiency. 

What could anyone do about these inefficiencies? The world goes in 
circles of increasing and decreasing free marketry. The globe was a 
more open, competitive and, in certain respects, efficient place at the 
beginning of the 20th century than it is now. Capital flowed more 
freely and so did labour. Foreign Direct Investment was bigger. The 
more efficient, "friction free" the dissemination of information (the 
ultimate resource) - the less waste and the smaller the lebensraum for 
parasites. The more adherence to market, price driven, open auction 
based, meritocratic mechanisms - the less middlemen, speculators, 
bribers, monopolies, cartels and trusts. 

The less political involvement in the workings of the market and, in 
general, in what consenting adults conspire to do that is not harmful 
to others - the more efficient and flowing the economic ambience is 
likely to become. 

This picture of "laissez faire, laissez aller" should be complimented 
by even stricter legislation coupled with effective and draconian law 
enforcement agents and measures. The illegal and the illegitimate 
should be stamped out, cruelly. Freedom to all - is also freedom from 
being conned or hassled. Only when the righteous freely prosper and the 
less righteous excessively suffer - only then will we have entered the 
efficient kingdom of the free market. 

This still does not deal with the "not serious" and the "personality 
disordered". What about the inefficient havoc that they wreak? This, 
after all, is part of what is known, in legal parlance as: "force 


There is a raging debate between the "rational expectations" theory and 
the "prospect theory". The former - the cornerstone of rational 
economics - assumes that economic (human) players are rational and out 
to maximize their utility (see: "The Happiness of Others", "The 
Egotistic Friend" and "The Distributive Justice of the Market"). Even 
ignoring the fuzzy logic behind the ill-defined philosophical term 
"utility" - rational economics has very little to do with real human 
being and a lot to do with sterile (though mildly useful) abstractions. 
Prospect theory builds on behavioural research in modern psychology 
which demonstrates that people are more loss averse than gain seekers 
(utility maximizers). 

Other economists have succeeded to demonstrate irrational behaviours of 
economic actors (heuristics, dissonances, biases, magical thinking and 
so on). 

The apparent chasm between the rational theories (efficient markets, 
hidden hands and so on) and behavioural economics is the result of two 
philosophical fallacies which, in turn, are based on the misapplication 
and misinterpretation of philosophical terms. 

The first fallacy is to assume that all forms of utility are reducible 
to one another or to money terms. Thus, the values attached to all 
utilities are expressed in monetary terms. This is wrong. Some people 
prefer leisure, or freedom, or predictability to expected money. This 
is the very essence of risk aversion: a trade off between the utility 
of predictability (absence or minimization of risk) and the expected 
utility of money. In other words, people have many utility functions 
running simultaneously - or, at best, one utility function with many 
variables and coefficients. This is why taxi drivers in New York cease 
working in a busy day, having reached a pre-determined income target: 
the utility function of their money equals the utility function of 
their leisure. 

How can these coefficients (and the values of these variables) be 
determined? Only by engaging in extensive empirical research. There is 
no way for any theory or "explanation" to predict these values. We have 
yet to reach the stage of being able to quantify, measure and 
numerically predict human behaviour and personality (=the set of 
adaptive traits and their interactions with changing circumstances). 

That economics is a branch of psychology is becoming more evident by 
the day. It would do well to lose its mathematical pretensions and 
adopt the statistical methods of its humbler relative. 

The second fallacy is the assumption underlying both rational and 
behavioural economics that human nature is an "object" to be analysed 
and "studied", that it is static and unchanged. But, of course, humans 
change inexorably. This is the only fixed feature of being human: 
change. Some changes are unpredictable, even in deterministic 
principle. Other changes are well documented. An example of the latter 
class of changes in the learning curve. Humans learn and the more they 
learn the more they alter their behaviour. So, to obtain any meaningful 
data, one has to observe behaviour in time, to obtain a sequence of 
reactions and actions. To isolate, observe and manipulate environmental 
variables and study human interactions. No snapshot can approximate a 
video sequence where humans are concerned. 

Financial Crises, Global Capital Flows and 

The International Financial Architecture 

By: Dr. Sam Vaknin 

The recent upheavals in the world financial markets were quelled by the 
immediate intervention of both international financial institutions 
such as the IMF and of domestic ones in the developed countries, such 
as the Federal Reserve in the USA. The danger seems to have passed, 
though recent tremors in South Korea, Brazil and Taiwan do not augur 
well. We may face yet another crisis of the same or a larger magnitude 

What are the lessons that we can derive from the last crisis to avoid 
the next? 

The first lesson, it would seem, is that short term and long term 
capital flows are two disparate phenomena with very little in common. 
The former is speculative and technical in nature and has very little 
to do with fundamental realities. The latter is investment oriented and 
committed to the increasing of the welfare and wealth of its new 
domicile. It is, therefore, wrong to talk about "global capital flows". 
There are investments (including even long term portfolio investments 
and venture capital) - and there is speculative, "hot" money. 

While "hot money" is very useful as a lubricant on the wheels of liquid 
capital markets in rich countries - it can be destructive in less 
liquid, immature economies or in economies in transition. 

The two phenomena should be accorded a different treatment. While long 
term capital flows should be completely liberalized, encouraged and 
welcomed - the short term, "hot money" type should be controlled and 
even discouraged. The introduction of fiscally-oriented capital 
controls (as Chile has implemented) is one possibility. The less 
attractive Malaysian model springs to mind. It is less attractive 
because it penalizes both the short term and the long term financial 
players. But it is clear that an important and integral part of the new 
International Financial Architecture MUST be the control of speculative 
money in pursuit of ever higher yields. There is nothing inherently 
wrong with high yields - but the capital markets provide yields 
connected to economic depression and to price collapses through the 
mechanism of short selling and through the usage of certain 
derivatives. This aspect of things must be neutered or at least 

The second lesson is the important role that central banks and other 
financial authorities play in the precipitation of financial crises - 
or in their prolongation. Financial bubbles and asset price inflation 
are the result of euphoric and irrational exuberance - said the 
Chairman of the Federal Reserve Bank of the United States, the 
legendary Mr. Greenspun and who can dispute this? But the question that 
was delicately side-stepped was: WHO is responsible for financial 

Expansive monetary policies, well timed signals in the interest rates 
markets, liquidity injections, currency interventions, international 
salvage operations - are all co-ordinated by central banks and by other 
central or international institutions. Official INACTION is as 
conducive to the inflation of financial bubbles as is official ACTION. 
By refusing to restructure the banking system, to introduce appropriate 
bankruptcy procedures, corporate transparency and good corporate 
governance, by engaging in protectionism and isolationism, by avoiding 
the implementation of anti competition legislation - many countries 
have fostered the vacuum within which financial crises breed. 

The third lesson is that international financial institutions can be of 
some help - when not driven by political or geopolitical considerations 
and when not married to a dogma. Unfortunately, these are the rare 
cases. Most IFIs - notably the IMF and, to a lesser extent, the World 
Bank - are both politicized and doctrinaire. It is only lately and 
following the recent mega-crisis in Asia, that IFIs began to "reinvent" 
themselves, their doctrines and their recipes. This added conceptual 
and theoretical flexibility led to better results. It is always better 
to tailor a solution to the needs of the client. Perhaps this should be 
the biggest evolutionary step: 

That IFIs will cease to regard the countries and governments within 
their remit as inefficient and corrupt beggars, in constant need of 
financial infusions. Rather they should regard these countries as 
CLIENTS, customers in need of service. After all, this, exactly, is the 
essence of the free market - and it is from IFIs that such countries 
should learn the ways of the free market. 

In broad outline, there are two types of emerging solutions. One type 
is market oriented - and the other, interventionist. The first type 
calls for free markets, specially designed financial instruments (see 
the example of the Brady bonds) and a global "laissez faire" 
environment to solve the issue of financial crises. The second approach 
regards the free markets as the SOURCE of the problem, rather than its 
solution. It calls for domestic and where necessary international 
intervention and assistance in resolving financial crises. 

Both approaches have their merits and both should be applied in varying 
combinations on a case by case basis. 

Indeed, this is the greatest lesson of all: 

There are NO magic bullets, final solutions, right ways and only 
recipes. This is a a trial and error process and in war one should not 
limit one's arsenal. Let us employ all the weapons at our disposal to 
achieve the best results for everyone involved.

 O'Neill's Free Dinner 

America's Current Account Deficit

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

Only four months ago, the IMF revised its global growth figures upward. 
It has since recanted but at the time its upbeat Managing Director, 
Horst Koehler, conceded defeat in a bet he made with America's 
outspoken and ever-exuberant Treasury Secretary, Paul O'Neill. He 
promised to treat him to a free dinner.

Judging by his economic worldview, O'Neill is a great believer in free 
dinners. Nowhere is this more evident than in his cavalier public 
utterances regarding America's current account deficit. As opposed to 
other, smaller countries, America's deficits have far reaching 
consequences and constitute global, rather than domestic, imbalances. 
The more integrated in the global marketplace a country is - the 
harsher the impact of American profligacy on its economy.

In a paper dated October 2001 and titled "The International Dollar 
Standard and Sustainability of the US Current Account Deficit", the 
author, Ronald McKinnon of Stanford University, concluded:

"Because the world is on a dollar standard, the United States is unique 
in having a virtually unlimited international line of credit which is 
largely denominated in its own currency, i.e., dollars. In contrast, 
foreign debtor countries must learn to live with currency mismatches 
where their banks' and other corporate international liabilities are 
dollar denominated but their assets are denominated in the domestic 
currency. As these mismatches cumulate, any foreign country is 
ultimately forced to repay its debts in order to avoid a run on its 
currency. But however precarious and over-leveraged the financing of 
individual American borrowers-including American banks, which 
intermediate such borrowing internationally-might be, they are 
invulnerable to dollar devaluation. In effect, America's collective 
current-account deficits are sustainable indefinitely."

In another paper, with Paul Davidson of the University of Tennessee, 
the authors went as far as suggesting that America's interminable 
deficit maintains the liquidity of the international trading system. A 
reduction in the deficit, by this logic, would lead to a global 
liquidity crunch.

Others cling to a mirror image of this argument. An assortment of 
anti-globalizers, non-governmental organizations, think tanks, and 
academics have accused the USA of sucking dry the pools of 
international savings painstakingly generated by the denizens of mostly 
developing countries. Technically, this is true. US Treasury bonds and 
notes compete on scarce domestic savings with businesses in countries 
from Japan to Russia and trounce them every time. 

Savers - and governments - prefer to channel their funds to acquire US 
government obligations - dollar bills, T-bills, T-notes, equities, 
corporate bonds, and government bonds - rather than invest in their 
precarious domestic private sector. The current account deficit - at 
well over 4 percent of American GDP - absorbs 6 percent of global gross 
savings and a whopping three quarters of the world's non-domestic 
savings flows. By the end of last year, foreign investors held $1.7 
trillion in US stocks, $1.2 trillion each in corporate debt and 
treasury obligations - 12 percent, 24 percent, and 42 percent of the 
outstanding quantities of these securities, respectively.

The November 2000 report of the Trade Deficit Review Commission, 
appointed by Congress in 1998, concluded that America's persistent 
trade deficit was brought on by - as Cato Institute's Daniel Griswold 
summarizes it - "high trade barriers abroad, predatory import pricing, 
declining competitiveness of core U.S. industries and low wages and 
poor working conditions in less-developed countries (as well as low) 
levels of national savings, (high rates of) investment, and economic 
growth - and exchange rate movements."

Griswold noted, though, that "during years of rising deficits, the 
growth of real GDP (in the USA) averaged 3.5% per year, compared to 
2.6% during years of shrinking deficits ... the unemployment rate has, 
on average, fallen by 0.4% (compared to a similar rise) ... 
manufacturing output grew an average of 4.6% a year ... (compared to 
an) average growth rate of one

percent ... poverty rate fell an average of 0.2% from the year before 
... (compared to a rise of) an average of 0.3%."

A less sanguine Kenneth Rogoff, the IMF's new Chief Economist wrote in 
"The Economist" in April: "When countries run sustained current-account 
deficits up in the range of 4 and 5% of GDP, they eventually reverse, 
and the consequences, particularly in terms of the real exchange rate, 
can be quite significant." 

Rogoff alluded to the surreal appreciation of the dollar in the last 
few years. This realignment of exchange rates rendered imports to the 
USA seductively cheap and led to "unsustainable" trade and current 
account deficits. The IMF concluded, in its "World Economic Outlook", 
published on September 25, that America's deficit serves to offset - 
actually, finance - increased consumption and declining private savings 
rather than productive investment.

Greenspan concurred earlier this year in "USA Today": "Countries that 
have gone down this path invariably have run into trouble, and so would 
we." An International Finance Discussion Paper released by the Fed in 
December 2000 found, as "The Economist" put it, that "deficits usually 
began to reverse when they exceeded 5% of GDP. And this adjustment was 
accompanied by an average fall in the nominal exchange rate of 40%, 
along with a sharp slowdown in GDP growth."

Never before has the current account deficit continued to expand in a 
recession. Morgan Stanley predict an alarming shortfall of 6 percent of 
GDP by the end of next year. The US is already the world's largest 
debtor having been its largest creditor only two decades ago. 

Such a disorientating swing has been experienced only by Britain 
following the Great War. In five years, US net obligations to the rest 
of the world will grow from one eighth of its GDP in 1997 to two fifths 
of a much larger product, according to Goldman Sachs. By 2006, a sum of 
$2 billion dollars per day would be required to cover this yawning 

Rogoff - and many other scholars - foresee a sharp contraction in 
American growth, consumption and, consequently, imports coupled with a 
depreciation in the dollar's exchange rate against the currencies of 
its main trading partners. In the absence of offsetting demand from an 
anemic Europe and a deflation-struck Japan, an American recession may 
well translate into a global depression. Only in 2003, the unwinding of 
these imbalances is projected by the IMF to shave 3 percentage points 
off America's growth rate.

But are the twin - budget and current account - deficits the inevitable 
outcomes of American fiscal dissipation and imports run amok - or a 
simple reflection of America's unrivalled attractiveness to investors, 
traders, and businessmen the world over?

Echoing Nigel Lawson, Britain's chancellor of the exchequer in the 
1980's, O'Neill is unequivocal. The current deficit is not worrisome. 
It is due to a "stronger relative level of economic activity in the 
United States" - he insisted in a speech he gave this month to 
Vanderbilt University's Owen Business School. Foreigners want to invest 
in the US more than anywhere else. The current account deficit - a mere 
accounting convention - simply encapsulates this overwhelming allure.

This is somewhat disingenuous. In the last three years, most of the net 
inflows of foreign capital into the spendthrift US are in the form of 
debt to be repaid. This mounting indebtedness did not increase the 
stock of income-producing capital. Instead, it was shortsightedly and 
irresponsibly expended in an orgy of unbridled consumption. 

For the first time in a long time, America's savings rate turned 
negative. Americans borrowed at home and abroad to embark on a fervid 
shopping spree. Even worse, the part of the deficit that was invested 
rather than consumed largely went to finance the dotcom boom turned 
bust. Wealth on unimaginable scale was squandered in this fraud-laced 
bubble. America's much hyped productivity growth turned out to have 
been similar to Europe's over the last decade. 

Luckily for the US - and the rest of the world - its fiscal stance 
during the Clinton years has been impeccable and far stronger than 
Europe's, let alone Japan's. The government's positive net savings - 
the budget surplus - nicely balanced the inexorable demand by 
households and firms for foreign goods and capital. This is why this 
fiscal year's looming budget deficit - c. $200 billion - provokes such 
heated debate and anxiety. 

Is there a growing reluctance of foreigners to lend to the US and to 
finance its imports and investment needs? To judge by the dollar's 
slump in world markets, yes. But a recent spate of bad economic news in 
Europe and Japan may restore the global appetite for dollar-denominated 

This would be a pity and a blessing. On the one hand, only a flagging 
dollar can narrow the trade deficit by rendering American exports more 
competitive in world markets - and imports to the USA more expensive 
than their domestic imperfect substitutes. But, as the late Rudi 
Dornbusch pointed out in August 2001:

"There are two kinds of Treasury Secretaries  those like Robert Rubin 
who understand that a strong dollar helps get low interest rates and 
that the low rates make for a long and broad boom. And (those) like 
today's Paul O'Neil. They think too much about competitiveness and know 
too little about capital markets ...

Secretary of the Treasury Paul O'Neil, comes from manufacturing and 
thinks like a manufacturer (who) have a perspective on the economy that 
is from the rabbit hole up. They think a weak dollar is good for 
exports and a hard dollar hurts sales and market share. Hence they 
wince any time they face a strong dollar and have wishy-washy answers 
to any dollar policy question."

The truth, as usual, is somewhere in the middle. Until recently, the 
dollar was too strong - as strong, in trade-related terms, as it was in 
the 1980's. Fred Bergsten, head of the Institute for International 
Economics, calculated in his testimony to the Senate Banking Committee 
on May 1, that America's trade deficit soars by $10 billion for every 
percentage rise in the dollar's exchange rate. 

American manufacturers shifted production to countries with more 
competitive terms of trade - cheaper manpower and local inputs. The 
mighty currency encouraged additional - mostly speculative- capital 
flows into dollar-denominated assets, exacerbating the current account 

A strong dollar keeps the lid on inflation - mainly by rendering 
imports cheaper. It, thus, provides the central bank with more leeway 
to cut interest rates. Still, the strength of the dollar is only one of 
numerous inputs - and far from being the most important one - in the 
monetary policy. Even a precipitous drop in the dollar is unlikely to 
reignite inflation in an economy characterized by excess capacity, 
falling prices, and bursting asset bubbles. 

A somewhat cheaper dollar, the purported - but never proven - "wealth 
effect" of crumbling stock markets, the aggressive reduction in 
interest rates, and the wide availability of easy home equity financing 
should conspire to divert demand from imports to domestic offerings. 
Market discipline may yet prove to be a sufficient and efficient cure.

But, the market's self-healing powers aside, can anything be done - can 
any policy be implemented - to reverse the deteriorating balance of 

In a testimony he gave to the Senate in May, O'Neill proffered one of 
his inimitable metaphors:

"All the interventions that have been modeled would do damage to the 
U.S. economy if we decided to reduce the size of the current account 
deficit. And so I don't find it very appealing to say that we are going 
to cut off our arm because some day we might get a disease in it."

This, again, is dissimulation. This administration - heated 
protestations to the contrary notwithstanding - resorted to blatant 
trade protectionism in a belated effort to cope with an avalanche of 
cheap imports. Steel quotas, farm and export subsidies, all manner of 
trade remedies failed to stem the tide of national red ink. 

The dirty secret is that everyone feeds off American abandon. A sharp 
drop in its imports - or in the value of the dollar - can spell doom 
for more than one country and more than a couple of industries. The USA 
being the global economy's sink of last resort - absorbing one quarter 
of world trade - other countries have an interest to maintain and 
encourage American extravagance. Countries with large exports to the 
USA are likely to reacts with tariffs, quotas, and competitive 
devaluations to any change in the status quo. The IMF couches the 
awareness of a growing global addiction in its usual cautious terms:

"The possibility of an abrupt and disruptive adjustment in the U.S. 
dollar remains a concern, for both the United States and the rest of 
the world ... The question is not whether the U.S. deficit will be 
sustained at present levels forever - it will not - but more when and 
how the eventual adjustment takes place ... While this would likely be 
manageable in the short term it could adversely affect the 
sustainability of recovery later on."

Another embarrassing truth is that a strong recovery in Europe or Japan 
may deplete the pool of foreign capital available to the USA. German 
and Japanese Investors may prefer to plough their money into a 
re-emergent Germany, or a re-awakening Japan - especially if the dollar 
were to plunge. America requires more than $1 billion a day to maintain 
its current levels of government spending, consumption, and investment.

There is another - much hushed - aspect of American indebtedness. It 
provides other trading blocks and countries - for example, Japan and 
the oil producing countries - with geopolitical leverage over the 
United States and its policies. America - forced to dedicate a growing 
share of its national income to debt repayment - is "in growing hock" 
to its large creditors. 

Last month, Arab intellectuals and leaders called upon their 
governments to withdraw their investments in the USA. This echoed of 
the oil embargo of yore. Ernest Preeg of the Manufacturers Alliance was 
quoted by the Toronto Star as saying: "China, for example, could 
blackmail the United States by threatening to dump its vast holdings of 
U.S. dollars, forcing up U.S. interest rates and undermining the U.S. 
stock market. Chinese military officials, he claimed, had included this 
kind of tactic in their studies of non-conventional defence strategies."

These scenarios are disparaged by analysts who point out that America's 
current account deficit is mostly in private hands. Households and 
firms should be trusted to act rationally and, in aggregate, repay 
their debts. Still, it should not be forgotten that the Asian crisis of 
1997-8 was brought on by private profligacy. Firms borrowed 
excessively, spent inanely, and invested unwisely. Governments ran 
surpluses. As the IMF puts it: "To err is human and this is as true of 
private sector investors as anyone else."

Anarchy as an Organizing Principle 

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

The recent spate of accounting fraud scandals signals the end of an 
era. Disillusionment and disenchantment with American capitalism may 
yet lead to a tectonic ideological shift from laissez faire and self 
regulation to state intervention and regulation. This would be the 
reversal of a trend dating back to Thatcher in Britain and Reagan in 
the USA. It would also cast some fundamental - and way more ancient - 
tenets of free-marketry in grave doubt.

Markets are perceived as self-organizing, self-assembling, exchanges of 
information, goods, and services. Adam Smith's "invisible hand" is the 
sum of all the mechanisms whose interaction gives rise to the optimal 
allocation of economic resources. The market's great advantages over 
central planning are precisely its randomness and its lack of 

Market participants go about their egoistic business, trying to 
maximize their utility, oblivious of the interests and action of all, 
bar those they interact with directly. Somehow, out of the chaos and 
clamor, a structure emerges of order and efficiency unmatched. Man is 
incapable of intentionally producing better outcomes. Thus, any 
intervention and interference are deemed to be detrimental to the 
proper functioning of the economy.

It is a minor step from this idealized worldview back to the 
Physiocrats, who preceded Adam Smith, and who propounded the doctrine 
of "laissez faire, laissez passer" - the hands-off battle cry. Theirs 
was a natural religion. The market, as an agglomeration of individuals, 
they thundered, was surely entitled to enjoy the rights and freedoms 
accorded to each and every person. John Stuart Mill weighed against the 
state's involvement in the economy in his influential and 
exquisitely-timed "Principles of Political Economy", published in 1848.

Undaunted by mounting evidence of market failures - for instance to 
provide affordable and plentiful public goods - this flawed theory 
returned with a vengeance in the last two decades of the past century. 
Privatization, deregulation, and self-regulation became faddish 
buzzwords and part of a global consensus propagated by both commercial 
banks and multilateral lenders.

As applied to the professions - to accountants, stock brokers, lawyers, 
bankers, insurers, and so on - self-regulation was premised on the 
belief in long-term self-preservation. Rational economic players and 
moral agents are supposed to maximize their utility in the long-run by 
observing the rules and regulations of a level playing field.

This noble propensity seemed, alas, to have been tampered by avarice 
and narcissism and by the immature inability to postpone gratification. 
Self-regulation failed so spectacularly to conquer human nature that 
its demise gave rise to the most intrusive statal stratagems ever 

In both the UK and the USA, the government is much more heavily and 
pervasively involved in the minutia of accountancy, stock dealing, and 
banking than it was only two years ago.

But the ethos and myth of "order out of chaos" - with its proponents in 
the exact sciences as well - ran deeper than that. The very culture of 
commerce was thoroughly permeated and transformed. It is not surprising 
that the Internet - a chaotic network with an anarchic modus operandi - 
flourished at these times. 

The dotcom revolution was less about technology than about new ways of 
doing business - mixing umpteen irreconcilable ingredients, stirring 
well, and hoping for the best. No one, for instance, offered a linear 
revenue model of how to translate "eyeballs" - i.e., the number of 
visitors to a Web site - to money ("monetizing"). It was dogmatically 
held to be true that, miraculously, traffic - a chaotic phenomenon - 
will translate to profit - hitherto the outcome of painstaking labor. 

Privatization itself was such a leap of faith. State owned assets - 
including utilities and suppliers of public goods such as health and 
education - were transferred wholesale to the hands of profit 
maximizers. The implicit belief was that the price mechanism will 
provide the missing planning and regulation. In other words, higher 
prices were supposed to guarantee an uninterrupted service. 
Predictably, failure ensued - from electricity utilities in California 
to railway operators in Britain. 

The simultaneous crumbling of these urban legends - the liberating 
power of the Net, the self-regulating markets, the unbridled merits of 
privatization - inevitably gave rise to a backlash. 

The state has acquired monstrous proportions in the decades since the 
Second world War. It is about to grow further and to digest the few 
sectors hitherto left untouched. To say the least, these are not good 
news. But we libertarians - proponents of both individual freedom and 
individual responsibility - have brought it on ourselves by thwarting 
the work of that invisible regulator - the market.

 Narcissism in the Boardroom 

By: Dr. Sam Vaknin 

Also published by United Press International (UPI)

Part I

Part II

 The perpetrators of the recent spate of financial frauds in the USA 
acted with callous disregard for both their employees and shareholders 
- not to mention other stakeholders. Psychologists have often 
remote-diagnosed them as "malignant, pathological narcissists".

Narcissists are driven by the need to uphold and maintain a false self 
- a concocted, grandiose, and demanding psychological construct typical 
of the narcissistic personality disorder. The false self is projected 
to the world in order to garner "narcissistic supply" - adulation, 
admiration, or even notoriety and infamy. Any kind of attention is 
usually deemed by narcissists to be preferable to obscurity.

The false self is suffused with fantasies of perfection, grandeur, 
brilliance, infallibility, immunity, significance, omnipotence, 
omnipresence, and omniscience. To be a narcissist is to be convinced of 
a great, inevitable personal destiny. 

The narcissist is preoccupied with ideal love, the construction of 
brilliant, revolutionary scientific theories, the composition or 
authoring or painting of the greatest work of art, the founding of a 
new school of thought, the attainment of fabulous wealth, the reshaping 
of a nation or a conglomerate, and so on. The narcissist never sets 
realistic goals to himself. He is forever preoccupied with fantasies of 
uniqueness, record breaking, or breathtaking achievements. His 
verbosity reflects this propensity.

Reality is, naturally, quite different and this gives rise to a 
"grandiosity gap". The demands of the false self are never satisfied by 
the narcissist's accomplishments, standing, wealth, clout, sexual 
prowess, or knowledge. The narcissist's grandiosity and sense of 
entitlement are equally incommensurate with his achievements. 

To bridge the grandiosity gap, the malignant (pathological) narcissist 
resorts to shortcuts. These very often lead to fraud.

The narcissist cares only about appearances. What matters to him are 
the facade of wealth and its attendant social status and narcissistic 
supply. Witness the travestied extravagance of Tyco's Denis Kozlowski. 
Media attention only exacerbates the narcissist's addiction and makes 
it incumbent on him to go to ever-wilder extremes to secure 
uninterrupted supply from this source.

The narcissist lacks empathy - the ability to put himself in other 
people's shoes. He does not recognize boundaries - personal, corporate, 
or legal. Everything and everyone are to him mere instruments, 
extensions, objects unconditionally and uncomplainingly available in 
his pursuit of narcissistic gratification. 

This makes the narcissist perniciously exploitative. He uses, abuses, 
devalues, and discards even his nearest and dearest in the most 
chilling manner. The narcissist is utility- driven, obsessed with his 
overwhelming need to reduce his anxiety and regulate his labile sense 
of self-worth by securing a constant supply of his drug - attention. 
American executives acted without compunction when they raided their 
employees' pension funds - as did Robert Maxwell a generation earlier 
in Britain.

The narcissist is convinced of his superiority - cerebral or physical. 
To his mind, he is a Gulliver hamstrung by a horde of narrow-minded and 
envious Lilliputians. The dotcom "new economy" was infested with 
"visionaries" with a contemptuous attitude towards the mundane: 
profits, business cycles, conservative economists, doubtful 
journalists, and cautious analysts. 

Yet, deep inside, the narcissist is painfully aware of his addiction to 
others - their attention, admiration, applause, and affirmation. He 
despises himself for being thus dependent. He hates people the same way 
a drug addict hates his pusher. He wishes to "put them in their place", 
humiliate them, demonstrate to them how inadequate and imperfect they 
are in comparison to his regal self and how little he craves or needs 

The narcissist regards himself as one would an expensive present, a 
gift to his company, to his family, to his neighbours, to his 
colleagues, to his country. This firm conviction of his inflated 
importance makes him feel entitled to special treatment, special 
favors, special outcomes, concessions, subservience, immediate 
gratification, obsequiousness, and lenience. 

It also makes him feel immune to mortal laws and somehow divinely 
protected and insulated from the inevitable consequences of his deeds 
and misdeeds.

The self-destructive narcissist plays the role of the "bad guy" (or 
"bad girl"). But even this is within the traditional social roles 
cartoonishly exaggerated by the narcissist to attract attention. Men 
are likely to emphasise intellect, power, aggression, money, or social 
status. Narcissistic women are likely to emphasise body, looks, charm, 
sexuality, feminine "traits", homemaking, children and childrearing.

Punishing the wayward narcissist is a veritable catch-22.

A jail term is useless as a deterrent if it only serves to focus 
attention on the narcissist. Being infamous is second best to being 
famous - and far preferable to being ignored. The only way to 
effectively punish a narcissist is to withhold narcissistic supply from 
him and thus to prevent him from becoming a notorious celebrity. 

Given a sufficient amount of media exposure, book contracts, talk 
shows, lectures, and public attention - the narcissist may even 
consider the whole grisly affair to be emotionally rewarding. To the 
narcissist, freedom, wealth, social status, family, vocation - are all 
means to an end. And the end is attention. If he can secure attention 
by being the big bad wolf - the narcissist unhesitatingly transforms 
himself into one. Lord Archer, for instance, seems to be positively 
basking in the media circus provoked by his prison diaries.

The narcissist does not victimise, plunder, terrorise and abuse others 
in a cold, calculating manner. He does so offhandedly, as a 
manifestation of his genuine character. To be truly "guilty" one needs 
to intend, to deliberate, to contemplate one's choices and then to 
choose one's acts. The narcissist does none of these.

Thus, punishment breeds in him surprise, hurt and seething anger. The 
narcissist is stunned by society's insistence that he should be held 
accountable for his deeds and penalized accordingly. He feels wronged, 
baffled, injured, the victim of bias, discrimination and injustice. He 
rebels and rages. 

Depending upon the pervasiveness of his magical thinking, the 
narcissist may feel besieged by overwhelming powers, forces cosmic and 
intrinsically ominous. He may develop compulsive rites to fend off this 
"bad", unwarranted, persecutory influences.

The narcissist, very much the infantile outcome of stunted personal 
development, engages in magical thinking. He feels omnipotent, that 
there is nothing he couldn't do or achieve if only he sets his mind to 
it. He feels omniscient - he rarely admits to ignorance and regards his 
intuitions and intellect as founts of objective data.

Thus, narcissists are haughtily convinced that introspection is a more 
important and more efficient (not to mention easier to accomplish) 
method of obtaining knowledge than the systematic study of outside 
sources of information in accordance with strict and tedious curricula. 
Narcissists are "inspired" and they despise hamstrung technocrats

To some extent, they feel omnipresent because they are either famous or 
about to become famous or because their product is selling or is being 
manufactured globally. Deeply immersed in their delusions of grandeur, 
they firmly believe that their acts have - or will have - a great 
influence not only on their firm, but on their country, or even on 
Mankind. Having mastered the manipulation of their human environment - 
they are convinced that they will always "get away with it". They 
develop hubris and a false sense of immunity.

Narcissistic immunity is the (erroneous) feeling, harboured by the 
narcissist, that he is impervious to the consequences of his actions, 
that he will never be effected by the results of his own decisions, 
opinions, beliefs, deeds and misdeeds, acts, inaction, or membership of 
certain groups, that he is above reproach and punishment, that, 
magically, he is protected and will miraculously be saved at the last 
moment. Hence the audacity, simplicity, and transparency of some of the 
fraud and corporate looting in the 1990's. Narcissists rarely bother to 
cover their traces, so great is their disdain and conviction that they 
are above mortal laws and wherewithal.

What are the sources of this unrealistic appraisal of situations and 

The false self is a childish response to abuse and trauma. Abuse is not 
limited to sexual molestation or beatings. Smothering, doting, 
pampering, over-indulgence, treating the child as an extension of the 
parent, not respecting the child's boundaries, and burdening the child 
with excessive expectations are also forms of abuse. 

The child reacts by constructing false self that is possessed of 
everything it needs in order to prevail: unlimited and instantaneously 
available Harry Potter-like powers and wisdom. The false self, this 
Superman, is indifferent to abuse and punishment. This way, the child's 
true self is shielded from the toddler's harsh reality.

This artificial, maladaptive separation between a vulnerable (but not 
punishable) true self and a punishable (but invulnerable) false self is 
an effective mechanism. It isolates the child from the unjust, 
capricious, emotionally dangerous world that he occupies. But, at the 
same time, it fosters in him a false sense of "nothing can happen to 
me, because I am not here, I am not available to be punished, hence I 
am immune to punishment".

The comfort of false immunity is also yielded by the narcissist's sense 
of entitlement. In his grandiose delusions, the narcissist is sui 
generis, a gift to humanity, a precious, fragile, object. Moreover, the 
narcissist is convinced both that this uniqueness is immediately 
discernible - and that it gives him special rights. The narcissist 
feels that he is protected by some cosmological law pertaining to 
"endangered species". 

He is convinced that his future contribution to others - his firm, his 
country, humanity - should and does exempt him from the mundane: daily 
chores, boring jobs, recurrent tasks, personal exertion, orderly 
investment of resources and efforts, laws and regulations, social 
conventions, and so on. 

The narcissist is entitled to a "special treatment": high living 
standards, constant and immediate catering to his needs, the 
eradication of any friction with the humdrum and the routine, an 
all-engulfing absolution of his sins, fast track privileges (to higher 
education, or in his encounters with bureaucracies, for instance). 
Punishment, trusts the narcissist, is for ordinary people, where no 
great loss to humanity is involved.

Narcissists are possessed of inordinate abilities to charm, to 
convince, to seduce, and to persuade. Many of them are gifted orators 
and intellectually endowed. Many of them work in in politics, the 
media, fashion, show business, the arts, medicine, or business, and 
serve as religious leaders. 

By virtue of their standing in the community, their charisma, or their 
ability to find the willing scapegoats, they do get exempted many 
times. Having recurrently "got away with it" - they develop a theory of 
personal immunity, founded upon some kind of societal and even cosmic 
"order" in which certain people are above punishment.

But there is a fourth, simpler, explanation. The narcissist lacks 
self-awareness. Divorced from his true self, unable to empathise (to 
understand what it is like to be someone else), unwilling to constrain 
his actions to cater to the feelings and needs of others - the 
narcissist is in a constant dreamlike state. 

To the narcissist, his life is unreal, like watching an autonomously 
unfolding movie. The narcissist is a mere spectator, mildly interested, 
greatly entertained at times. He does not "own" his actions. He, 
therefore, cannot understand why he should be punished and when he is, 
he feels grossly wronged.

So convinced is the narcissist that he is destined to great things - 
that he refuses to accept setbacks, failures and punishments. He 
regards them as temporary, as the outcomes of someone else's errors, as 
part of the future mythology of his rise to 
power/brilliance/wealth/ideal love, etc. Being punished is a diversion 
of his precious energy and resources from the all-important task of 
fulfilling his mission in life. 

The narcissist is pathologically envious of people and believes that 
they are equally envious of him. He is paranoid, on guard, ready to 
fend off an imminent attack. A punishment to the narcissist is a major 
surprise and a nuisance but it also validates his suspicion that he is 
being persecuted. It proves to him that strong forces are arrayed 
against him. 

He tells himself that people, envious of his achievements and 
humiliated by them, are out to get him. He constitutes a threat to the 
accepted order. When required to pay for his misdeeds, the narcissist 
is always disdainful and bitter and feels misunderstood by his 

Cooked books, corporate fraud, bending the (GAAP or other) rules, 
sweeping problems under the carpet, over-promising, making grandiose 
claims (the "vision thing") - are hallmarks of a narcissist in action. 
When social cues and norms encourage such behavior rather than inhibit 
it - in other words, when such behavior elicits abundant narcissistic 
supply - the pattern is reinforced and become entrenched and rigid. 
Even when circumstances change, the narcissist finds it difficult to 
adapt, shed his routines, and replace them with new ones. He is trapped 
in his past success. He becomes a swindler.

But pathological narcissism is not an isolated phenomenon. It is 
embedded in our contemporary culture. The West's is a narcissistic 
civilization. It upholds narcissistic values and penalizes alternative 
value-systems. From an early age, children are taught to avoid 
self-criticism, to deceive themselves regarding their capacities and 
attainments, to feel entitled, and to exploit others. 

As Lilian Katz observed in her important paper, "Distinctions between 
Self-Esteem and Narcissism: Implications for Practice", published by 
the Educational Resources Information Center, the line between 
enhancing self-esteem and fostering narcissism is often blurred by 
educators and parents.

Both Christopher Lasch in "The Culture of Narcissism" and Theodore 
Millon in his books about personality disorders, singled out American 
society as narcissistic. Litigiousness may be the flip side of an inane 
sense of entitlement. 

Consumerism is built on this common and communal lie of "I can do 
anything I want and possess everything I desire if I only apply myself 
to it" and on the pathological envy it fosters.

Not surprisingly, narcissistic disorders are more common among men than 
among women. This may be because narcissism conforms to masculine 
social mores and to the prevailing ethos of capitalism. Ambition, 
achievements, hierarchy, ruthlessness, drive - are both social values 
and narcissistic male traits. Social thinkers like the aforementioned 
Lasch speculated that modern American culture - a self-centred one - 
increases the rate of incidence of the narcissistic personality 

Otto Kernberg, a notable scholar of personality disorders, confirmed 
Lasch's intuition: "Society can make serious psychological 
abnormalities, which already exist in some percentage of the 
population, seem to be at least superficially appropriate."

In their book "Personality Disorders in Modern Life", Theodore Millon 
and Roger Davis state, as a matter of fact, that pathological 
narcissism was once the preserve of "the royal and the wealthy" and 
that it "seems to have gained prominence only in the late twentieth 
century". Narcissism, according to them, may be associated with "higher 
levels of Maslow's hierarchy of needs ... Individuals in less 
advantaged nations .. are too busy trying (to survive) ... to be 
arrogant and grandiose". 

They - like Lasch before them - attribute pathological narcissism to "a 
society that stresses individualism and self-gratification at the 
expense of community, namely the United States." 

They assert that the disorder is more prevalent among certain 
professions with "star power" or respect. "In an individualistic 
culture, the narcissist is 'God's gift to the world'. In a collectivist 
society, the narcissist is 'God's gift to the collective'".

Millon quotes Warren and Caponi's "The Role of Culture in the 
Development of Narcissistic Personality Disorders in America, Japan and 

"Individualistic narcissistic structures of self-regard (in 
individualistic societies) ... are rather self-contained and 
independent ... (In collectivist cultures) narcissistic configurations 
of the we-self ... denote self-esteem derived from strong 
identification with the reputation and honor of the family, groups, and 
others in hierarchical relationships."

Still, there are malignant narcissists among subsistence farmers in 
Africa, nomads in the Sinai desert, day laborers in east Europe, and 
intellectuals and socialites in Manhattan. Malignant narcissism is 
all-pervasive and independent of culture and society. It is true, 
though, that the way pathological narcissism manifests and is 
experienced is dependent on the particulars of societies and cultures. 

In some cultures, it is encouraged, in others suppressed. In some 
societies it is channeled against minorities - in others it is tainted 
with paranoia. In collectivist societies, it may be projected onto the 
collective, in individualistic societies, it is an individual's trait. 

Yet, can families, organizations, ethnic groups, churches, and even 
whole nations be safely described as "narcissistic" or "pathologically 
self-absorbed"? Can we talk about a "corporate culture of narcissism"? 

Human collectives - states, firms, households, institutions, political 
parties, cliques, bands - acquire a life and a character all their own. 
The longer the association or affiliation of the members, the more 
cohesive and conformist the inner dynamics of the group, the more 
persecutory or numerous its enemies, competitors, or adversaries, the 
more intensive the physical and emotional experiences of the 
individuals it is comprised of, the stronger the bonds of locale, 
language, and history - the more rigorous might an assertion of a 
common pathology be.

Such an all-pervasive and extensive pathology manifests itself in the 
behavior of each and every member. It is a defining - though often 
implicit or underlying - mental structure. It has explanatory and 
predictive powers. It is recurrent and invariable - a pattern of 
conduct melding distorted cognition and stunted emotions. And it is 
often vehemently denied.


T H E   A U T H O R


Curriculum Vitae

Born in 1961 in Qiryat-Yam, Israel. 

Served in the Israeli Defence Force (1979-1982) in training and 
education units. 


Graduated a few semesters in the Technion - Israel Institute of 
Technology, Haifa.

Ph.D. in Philosophy (major : Philosophy of Physics) - Pacific Western 
University, California.

Graduate of numerous courses in Finance Theory and International 

Certified E-Commerce Concepts Analyst.

Certified in Psychological Counselling Techniques.

Full proficiency in Hebrew and in English. 

Business Experience 

1980 to 1983

Founder and co-owner of a chain of computerized information kiosks in 
Tel-Aviv, Israel. 

1982 to 1985

Senior positions with the Nessim D. Gaon Group of Companies in Geneva, 
Paris and New-York (NOGA and APROFIM SA): 

- Chief Analyst of Edible Commodities in the Group's Headquarters in 

- Manager of the Research and Analysis Division 

- Manager of the Data Processing Division 

- Project Manager of The Nigerian Computerized Census 

- Vice President in charge of RND and Advanced Technologies 

- Vice President in charge of Sovereign Debt Financing

1985 to 1986

Represented Canadian Venture Capital Funds in Israel. 

1986 to 1987

General Manager of IPE Ltd. in London. The firm financed international 
multi-lateral countertrade and leasing transactions. 

1988 to 1990

Co-founder and Director of "Mikbats - Tesuah", a portfolio management 
firm based in Tel-Aviv.

Activities included large-scale portfolio management, underwriting, 
forex trading and general financial advisory services. 

1990 to Present

Free-lance consultant to many of Israel's Blue-Chip firms, mainly on 
issues related to the capital markets in Israel, Canada, the UK and the 

Consultant to foreign RND ventures and to Governments on macro-economic 

President of the Israel chapter of the Professors World Peace Academy 
(PWPA) and (briefly) Israel representative of the "Washington Times". 

1993 to 1994

Co-owner and Director of many business enterprises:

- The Omega and Energy Air-Conditioning Concern

- AVP Financial Consultants

- Handiman Legal Services

   Total annual turnover of the group: 10 million USD.

Co-owner, Director and Finance Manager of COSTI Ltd. -  Israel's 
largest computerized information vendor and developer. Raised funds 
through a series of private placements locally, in the USA, Canada and 

1993 to 1996

Publisher and Editor of a Capital Markets Newsletter distributed by 
subscription only to dozens of subscribers countrywide. 

In a legal precedent in 1995 - studied in business schools and law 
faculties across Israel - was tried for his role in an attempted 
takeover of Israel's Agriculture Bank.

Was interned in the State School of Prison Wardens.

Managed the Central School Library, wrote, published and lectured on 
various occasions. 

Managed the Internet and International News Department of an Israeli 
mass media group, "Ha-Tikshoret and Namer". 

Assistant in the Law Faculty in Tel-Aviv University (to Prof. S.G. 

1996 to 1999

Financial consultant to leading businesses in Macedonia, Russia and the 
Czech Republic.

Collaborated with the Agency of  Transformation of Business with Social 

Economic commentator in "Nova Makedonija", "Dnevnik", "Izvestia", 
"Argumenti i Fakti", "The Middle East Times", "Makedonija Denes", "The 
New Presence", "Central Europe Review" , and other periodicals and in 
the economic programs on various channels of Macedonian Television. 

Chief Lecturer in courses organized by the Agency of Transformation, by 
the Macedonian Stock Exchange and by the Ministry of Trade. 

1999 to 2002

Economic Advisor to the Government of the Republic of Macedonia and to 
the Ministry of Finance. 

2001 to present

Senior Business Correspondent for United Press International (UPI)

Web and Journalistic Activities 

Author of extensive Websites in Psychology ("Malignant Self Love") - An 
Open Directory Cool Site

Philosophy ("Philosophical Musings")

Economics and Geopolitics ("World in Conflict and Transition")

Owner of the Narcissistic Abuse Announcement and Study List and the 
Narcissism Revisited mailing list (more than 3900 members)

Owner of the Economies in Conflict and Transition Study list.

Editor of mental health disorders and Central and Eastern Europe 
categories in web directories (Open Directory, Suite 101, Search 

Columnist and commentator in "The New Presence", United Press 
International (UPI), InternetContent, eBookWeb and "Central Europe 

Publications and Awards 

"Managing Investment Portfolios in states of Uncertainty", Limon 
Publishers, Tel-Aviv, 1988

"The Gambling Industry", Limon Publishers., Tel-Aviv, 1990

"Requesting my Loved One - Short Stories", Yedioth Aharonot, Tel-Aviv, 

"The Macedonian Economy at a Crossroads - On the way to a Healthier 
Economy" (with Nikola Gruevski), Skopje, 1998

"Malignant Self Love - Narcissism Revisited", Narcissus Publications, 
Prague and Skopje, 1999, 2001, 2002

The Narcissism Series - e-books regarding relationships with abusive 
narcissists (Skopje, 1999-2002)

"The Exporters' Pocketbook", Ministry of Trade, Republic of Macedonia, 
Skopje, 1999

"The Suffering of Being Kafka" (electronic book of Hebrew Short 
Fiction, Prague, 1998)

"After the Rain - How the West Lost the East", Narcissus Publications 
in association with Central Europe Review/CEENMI, Prague and Skopje, 

Winner of numerous awards, among them the Israeli Education Ministry 
Prize (Literature) 1997, The Rotary Club Award for Social Studies 
(1976) and the Bilateral Relations Studies Award of the American 
Embassy in Israel (1978).

Hundreds of professional articles in all fields of finances and the 
economy and numerous articles dealing with geopolitical and political 
economic issues published in both print and web periodicals in many 

Many appearances in the electronic media on subjects in philosophy and 
the Sciences and concerning economic matters.    

Contact Details:

My Web Sites:

Economy / Politics:




After the Rain

How the West

Lost the East

The Book

This is a series of articles written and published in 1996-2000 in 
Macedonia, in Russia, in Egypt and in the Czech Republic.

How the West lost the East. The economics, the politics, the 
geopolitics, the conspiracies, the corruption, the old and the new, the 
plough and the internet - it is all here, in colourful and provocative 

From "The Mind of Darkness":

"'The Balkans' - I say - 'is the unconscious of the world'. People stop 
to digest this metaphor and then they nod enthusiastically. It is here 
that the repressed memories of history, its traumas and fears and 
images reside. It is here that the psychodynamics of humanity - the 
tectonic clash between Rome and Byzantium, West and East, 
Judeo-Christianity and Islam - is still easily discernible. We are 
seated at a New Year's dining table, loaded with a roasted pig and 
exotic salads. I, the Jew, only half foreign to this cradle of 
Slavonics. Four Serbs, five Macedonians. It is in the Balkans that all 
ethnic distinctions fail and it is here that they prevail 
anachronistically and atavistically. Contradiction and change the only 
two fixtures of this tormented region. The women of the Balkan - buried 
under provocative mask-like make up, retro hairstyles and too narrow 
dresses. The men, clad in sepia colours, old fashioned suits and turn 
of the century moustaches. In the background there is the crying game 
that is Balkanian music: liturgy and folk and elegy combined. The 
smells are heavy with muskular perfumes. It is like time travel. It is 
like revisiting one's childhood."

The Author

Sam Vaknin is the author of Malignant Self Love - Narcissism Revisited 
and After the Rain - How the West Lost the East. He is a columnist for 
Central Europe Review and eBookWeb , a United Press International (UPI) 
Senior Business Correspondent, and the editor of mental health and 
Central East Europe categories in The Open Directory and Suite101 . 

Until recently, he served as the Economic Advisor to the Government of 

Visit Sam's Web site at


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(c) 2002 Copyright Lidija Rangelovska.
Capitalistic Musings, by Sam Vaknin

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