Hawala, or The Bank That Never Was

Hawala, or The Bank That Never Was


by: Sam Vaknin, Ph.D.

I. OVERVIEW

In the wake of the September 11 terrorist attacks on the USA, attention was drawn to the age-old, secretive, and globe-spanning banking system developed in Asia and known as %26quot;Hawala%26quot; (to change, in Arabic). It is based on a short term, discountable, negotiable, promissory note (or bill of exchange) called %26quot;Hundi%26quot;. While not limited to Moslems, it has come to be identified with %26quot;Islamic Banking%26quot;.

Islamic Law (Sharia'a) regulates commerce and finance in the Fiqh Al Mua'malat, (transactions amongst people). Modern Islamic banks are overseen by the Shari'a Supervisory Board of Islamic Banks and Institutions (%26quot;The Shari'a Committee%26quot;).

The Shi'a %26quot;Islamic Laws according to the Fatawa of Ayatullah al Uzama Syed Ali al-Husaini Seestani%26quot; has this to say about Hawala banking:

%26quot;2298. If a debtor directs his creditor to collect his debt from the third person, and the creditor accepts the arrangement, the third person will, on completion of all the conditions to be explained later, become the debtor. Thereafter, the creditor cannot demand his debt from the first debtor.%26quot;

The prophet Muhammad (a cross border trader of goods and commodities by profession) encouraged the free movement of goods and the development of markets. Numerous Moslem scholars railed against hoarding and harmful speculation (market cornering and manipulation known as %26quot;Gharar%26quot;). Moslems were the first to use promissory notes and assignment, or transfer of debts via bills of exchange (%26quot;Hawala%26quot;). Among modern banking instruments, only floating and, therefore, uncertain, interest payments (%26quot;Riba%26quot; and %26quot;Jahala%26quot;), futures contracts, and forfeiting are frowned upon. But agile Moslem traders easily and often circumvent these religious restrictions by creating %26quot;synthetic Murabaha (contracts)%26quot; identical to Western forward and futures contracts. Actually, the only allowed transfer or trading of debts (as distinct from the underlying commodities or goods) is under the Hawala.

%26quot;Hawala%26quot; consists of transferring money (usually across borders and in order to avoid taxes or the need to bribe officials) without physical or electronic transfer of funds. Money changers (%26quot;Hawaladar%26quot;) receive cash in one country, no questions asked. Correspondent hawaladars in another country dispense an identical amount (minus minimal fees and commissions) to a recipient or, less often, to a bank account. E-mail, or letter (%26quot;Hundi%26quot;) carrying couriers are used to convey the necessary information (the amount of money, the date it has to be paid on) between Hawaladars. The sender provides the recipient with code words (or numbers, for instance the serial numbers of currency notes), a digital encrypted message, or agreed signals (like handshakes), to be used to retrieve the money. Big Hawaladars use a chain of middlemen in cities around the globe.

But most Hawaladars are small businesses. Their Hawala activity is a sideline or moonlighting operation. %26quot;Chits%26quot; (verbal agreements) substitute for certain written records. In bigger operations there are human %26quot;memorizers%26quot; who serve as arbiters in case of dispute. The Hawala system requires unbounded trust. Hawaladars are often members of the same family, village, clan, or ethnic group. It is a system older than the West. The ancient Chinese had their own %26quot;Hawala%26quot; - %26quot;fei qian%26quot; (or %26quot;flying money%26quot;). Arab traders used it to avoid being robbed on the Silk Road. Cheating is punished by effective ex-communication and %26quot;loss of honour%26quot; - the equivalent of an economic death sentence. Physical violence is rarer but not unheard of. Violence sometimes also erupts between money recipients and robbers who are after the huge quantities of physical cash sloshing about the system. But these, too, are rare events, as rare as bank robberies. One result of this effective social regulation is that commodity traders in Asia shift hundreds of millions of US dollars per trade based solely on trust and the verbal commitment of their counterparts.

Hawala arrangements are used to avoid customs duties, consumption taxes, and other trade-related levies. Suppliers provide importers with lower prices on their invoices, and get paid the difference via Hawala. Legitimate transactions and tax evasion constitute the bulk of Hawala operations. Modern Hawala networks emerged in the 1960's and 1970's to circumvent official bans on gold imports in Southeast Asia and to facilitate the transfer of hard earned wages of expatriates to their families (%26quot;home remittances%26quot;) and their conversion at rates more favourable (often double) than the government's. Hawala provides a cheap (it costs c. 1% of the amount transferred), efficient, and frictionless alternative to morbid and corrupt domestic financial institutions. It is Western Union without the hi-tech gear and the exorbitant transfer fees.

Unfortunately, these networks have been hijacked and compromised by drug traffickers (mainly in Afganistan and Pakistan), corrupt officials, secret services, money launderers, organized crime, and terrorists. Pakistani Hawala networks alone move up to 5 billion US dollars annually according to estimates by Pakistan's Minister of Finance, Shaukut Aziz. In 1999, Institutional Investor Magazine identified 1100 money brokers in Pakistan and transactions that ran as high as 10 million US dollars apiece. As opposed to stereotypes, most Hawala networks are not controlled by Arabs, but by Indian and Pakistani expatriates and immigrants in the Gulf. The Hawala network in India has been brutally and ruthlessly demolished by Indira Ghandi (during the emergency regime imposed in 1975), but Indian nationals still play a big part in international Hawala networks. Similar networks in Sri Lanka, the Philippines, and Bangladesh have also been eradicated.

The OECD's Financial Action Task Force (FATF) says that:

%26quot;Hawala remains a significant method for large numbers of businesses of all sizes and individuals to repatriate funds and purchase gold.... It is favoured because it usually costs less than moving funds through the banking system, it operates 24 hours per day and every day of the year, it is virtually completely reliable, and there is minimal paperwork required.%26quot;

(Organisation for Economic Co-Operation and Development (OECD), %26quot;Report on Money Laundering Typologies 1999-2000,%26quot; Financial Action Task Force, FATF-XI, February 3, 2000, at http://www.oecd.org/fatf/pdf/TY2000_en.pdf )

Hawala networks closely feed into Islamic banks throughout the world and to commodity trading in South Asia. There are more than 200 Islamic banks in the USA alone and many thousands in Europe, North and South Africa, Saudi Arabia, the Gulf states (especially in the free zone of Dubai and in Bahrain), Pakistan, Malaysia, Indonesia, and other South East Asian countries. By the end of 1998, the overt (read: tip of the iceberg) liabilities of these financial institutions amounted to 148 billion US dollars. They dabbled in equipment leasing, real estate leasing and development, corporate equity, and trade/structured trade and commodities financing (usually in consortia called %26quot;Mudaraba%26quot;).

While previously confined to the Arab peninsula and to south and east Asia, this mode of traditional banking became truly international in the 1970's, following the unprecedented flow of wealth to many Moslem nations due to the oil shocks and the emergence of the Asian tigers. Islamic banks joined forces with corporations, multinationals, and banks in the West to finance oil exploration and drilling, mining, and agribusiness. Many leading law firms in the West (such as Norton Rose, Freshfields, Clyde and Co. and Clifford Chance) have %26quot;Islamic Finance%26quot; teams which are familiar with Islam-compatible commercial contracts.

II. HAWALA AND TERRORISM

Recent anti-terrorist legislation in the US and the UK allows government agencies to regularly supervise and inspect businesses that are suspected of being a front for the ''Hawala'' banking system, makes it a crime to smuggle more than $10,000 in cash across USA borders, and empowers the Treasury secretary (and its Financial Crimes Enforcement Network - FinCEN) to tighten record-keeping and reporting rules for banks and financial institutions based in the USA. A new inter-agency Foreign Terrorist Asset Tracking Center (FTAT) was set up. A 1993 moribund proposed law requiring US-based Halawadar to register and to report suspicious transactions may be revived. These relatively radical measures reflect the belief that the al-Qaida network of Osama bin Laden uses the Hawala system to raise and move funds across national borders. A Hawaladar in Pakistan (Dihab Shill) was identified as the financier in the attacks on the American embassies in Kenya and Tanzania in 1998.

But the USA is not the only country to face terrorism financed by Hawala networks.

A few months ago, the Delhi police, the Indian government's Enforcement Directorate (ED), and the Military Intelligence (MI) arrested six Jammu Kashmir Islamic Front (JKIF) terrorists. The arrests led to the exposure of an enormous web of Hawala institutions in Delhi, aided and abetted, some say, by the ISI (Inter Services Intelligence, Pakistan's security services). The Hawala network was used to funnel money to terrorist groups in the disputed Kashmir Valley.

Luckily, the common perception that Hawala financing is paperless is wrong. The transfer of information regarding the funds often leaves digital (though heavily encrypted) trails. Couriers and %26quot;contract memorizers%26quot;, gold dealers, commodity merchants, transporters, and moneylenders can be apprehended and interrogated. Written, physical, letters are still the favourite mode of communication among small and medium Hawaladars, who also invariably resort to extremely detailed single entry bookkeeping. And the sudden appearance and disappearance of funds in bank accounts still have to be explained. Moreover, the sheer scale of the amounts involved entails the collaboration of off shore banks and more established financial institutions in the West. Such flows of funds affect the local money markets in Asia and are instantaneously reflected in interest rates charged to frequent borrowers, such as wholesalers. Spending and consumption patterns change discernibly after such influxes. Most of the money ends up in prime world banks behind flimsy business facades. Hackers in Germany claimed (without providing proof) to have infiltrated Hawala-related bank accounts.

The problem is that banks and financial institutions - and not only in dodgy offshore havens (%26quot;black holes%26quot; in the lingo) - clam up and refuse to divulge information about their clients. Banking is largely a matter of fragile trust between bank and customer and tight secrecy. Bankers are reluctant to undermine either. Banks use mainframe computers which can rarely be hacked through cyberspace and can be compromised only physically in close co-operation with insiders. The shadier the bank - the more formidable its digital defenses. The use of numbered accounts (outlawed in Austria, for instance, only recently) and pseudonyms (still possible in Lichtenstein) complicates matters. Bin Laden's accounts are unlikely to bear his name. He has collaborators.

Hawala networks are often used to launder money, or to evade taxes. Even when employed for legitimate purposes, to diversify the risk involved in the transfer of large sums, Hawaladars apply techniques borrowed from money laundering. Deposits are fragmented and wired to hundreds of banks the world over (%26quot;starburst%26quot;). Sometimes, the money ends up in the account of origin (%26quot;boomerang%26quot;).

Hence the focus on payment clearing and settlement systems. Most countries have only one such system, the repository of data regarding all banking (and most non-banking) transactions in the country. Yet, even this is a partial solution. Most national systems maintain records for 6-12 months, private settlement and clearing systems for even less.

Yet, the crux of the problem is not the Hawala or the Hawaladars. The corrupt and inept governments of Asia are to blame for not regulating their banking systems, for over-regulating everything else, for not fostering competition, for throwing public money at bad debts and at worse borrowers, for over-taxing, for robbing people of their life savings through capital controls, for tearing at the delicate fabric of trust between customer and bank (Pakistan, for instance, froze all foreign exchange accounts two years ago). Perhaps if Asia had reasonably expedient, reasonably priced, reasonably regulated, user-friendly banks - Osama bin Laden would have found it impossible to finance his mischief so invisibly.

The Macedonian Lottery

The Macedonian Lottery


by: Sam Vaknin, Ph.D.

Every conflict has its economic moments and dimensions. The current conflict in Macedonia perhaps even more so.

The USA and its Western allies regard Macedonia as a bridge between Greece, Bulgaria, Serbia and Albania. Hence the EU's plans for the revival of transport corridors 8 and 10 connecting these countries. If all goes well (and nothing has hitherto), railways will connect Bulgaria to Macedonia and river traffic will flow to Serbia from its southern neighbours. All this is envisioned in the Stability Pact. There are talks of an oil pipeline across Macedonia's territory. A pacified Macedonia is fairly crucial to Serbia's recovery and to the prospects of the whole region to attract FDI.

NATO is afraid of Turkish-Greek clashes in the aftermath of Kosovo and Macedonia. Turkey has increasingly cast itself in its ancient role of %26quot;protector of the Balkan Muslims%26quot;. Greece is the only Orthodox-Christian member of the EU and an old foe of the erstwhile Sick Man of Europe from which it won bloody independence at the beginning of the 19th century. Such clashes are likely to destabilize the southern flank of NATO and block the West's access to Iraq, the Middle East, oil-rich Central Asia, and northern China. This will seriously dent the new %26quot;Pacific Orientation%26quot; of the Bush Administration.

And what about the actual combatants?

Albanians and Macedonian crime gangs (in cahoots with kleptocratic and venal local politicians) regard Macedonia as a vital route for drugs, stolen cars, smuggled cigarettes and soft drinks, illegal immigrants, white slavery, and weapons dealing. These criminal activities far outweigh the GDP of all the adversary states combined. This conflict is about controlling territory and the economic benefits attendant to such control.

Crime and war provide employment, status, regular income, perks, and livelihood to many denizens of Macedonia, Albania, and Bulgaria. They constitute an outlet for entrepreneurship, however perverted. Fighting for the cause and smuggling often means travel abroad (for instance, on fund raising missions), five star accommodation, and a lavish lifestyle. It also translates into powers of patronage and excesses of self-enrichment.

Moreover, in ossified, socially stratified, ethnically polarized, and economically impoverished societies, war and crime engender social mobility. The likes of Hashim Thaci and Ali Ahmeti often start as rebels and end as part of the cosseted establishment. Many a criminal dabble in politics and business.

Hence the tenacity of both phenomena. Hence the bleak and pessimistic outlook for this region. The %26quot;formal%26quot; economies simply cannot compete. Jobs are not created, the educated are often bitterly idle, salaries are minuscule if paid at all, the future is past. Crime and politics (one and the same in the Balkan) are alluring alternatives.

Moreover, the NLA itself is not a monolithic entity. It is more like an umbrella organization with serious and fracturing differences of opinion regarding the ultimate goals the insurrection and the means to obtain these goals. Roughly, it is made up of one third veteran Kosovo fighters, some of them professional soldiers, who also fought in Croatia, or in the Foreign Legion. These people are bitter and disgruntled by what they see as the betrayal of the West in refusing to guarantee an independent Kosovo and the failure of the current Kosovar leadership to integrate them economically into the emerging polity there. Their motives are part emotional and part pecuniary. Another third is made of unemployed, young Albanians, mainly from Macedonia itself. Their fighting is self-interested. They get a monthly salary and perks and, lacking education and skills, they don't have much of a choice outside the killing fields. The rest are diehard, hardcore, idealists who either fervently espouse a Great Albania, or would like to take over Western Macedonian in a %26quot;constitutional coup%26quot; which will grant them their own police force, municipalities, institutions, universities, budgets, and semi-political structures. The NLA itself is not directly involved in criminal activities, though a few of its members are. But the money that finances it (from the Czech Republic, Switzerland, Germany, and the USA) is tainted by drug dealing, white slavery, illegal immigration, and the smuggling of everything illicit, from cigarettes to stolen cars, to weapons. In this they collaborate with politicians and criminals in Macedonia - both Albanian and Macedonian.

Being a politician in the Balkan is an extremely lucrative proposition. Both Albanian and Macedonian politicians will abandon the peace process if they believe it leads to electoral ruin. Given the current atmosphere, it doesn't pay to be a pacifist. Virulent nationalism is a guaranteed vote winner. The re-election ticket requires xenophobia, ethnic exclusivity, and radicalism. Here lies the future.

The European Bank for the Retardation of Development

The European Bank for the Retardation of Development


by: Sam Vaknin, Ph.D.

In typical bureaucratese, the pensive EBRD analyst ventures with the appearance of compunction: %26quot;A number of projects have fallen short of acceptable standards (notice the passive, exculpating voice - SV) and have put the reputation of the bank at risk%26quot;. If so, very little was risked. The outlandish lavishness of its City headquarters, the apotheosis of the inevitable narcissism of its first French Chairman (sliding marble slabs, motion sensitive lighting and designer furniture) - is, at this stage, its only tangible achievement. In the territories of its constituencies and shareholders it is known equally for its logy pomposity, the irrelevance of its projects, its lack of perspicacity and its Kafkaesque procedures. And where the IMF sometimes indulges in oblique malice and corrupt opaqueness, the EBRD wallows merely in avuncular inefficacy. Both are havens of insouciant third rate economists and bankers beyond rating.

Established in 1991, %26quot;it exists to foster the transition towards open market oriented economies and to promote private and entrepreneurial initiative in the countries of central and eastern Europe and the Commonwealth of Independent States (CIS) committed to and applying the principles of multiparty democracy, pluralism and market economics. The EBRD seeks to help its 26 countries of operations to implement structural and sectoral economic reforms, promoting competition, privatization and entrepreneurship, taking into account the particular needs of countries at different stages of transition. Through its investments it promotes private sector activity, the strengthening of financial institutions and legal systems, and the development of the infrastructure needed to support the private sector. The Bank applies sound banking and investment principles in all of its operations. In fulfilling its role as a catalyst of change, the Bank encourages co-financing and foreign direct investment from the private and public sectors, helps to mobilize domestic capital, and provides technical co-operation in relevant areas. It works in close co-operation with international financial institutions and other international and national organizations. In all of its activities, the Bank promotes environmentally sound and sustainable development.%26quot;

Grandiloquence aside, the EBRD was supposed to foster the formation of the private sector in the revenant wreckage of Central and Eastern Europe, the Balkan, Russia and the New Independent States. This it was mandated to do by providing finance where there was none (%26quot;bridging the gaps in the post communist financial system%26quot; to quote %26quot;The Economist%26quot;). Put more intelligibly, it was NOT supposed to transform itself into a long-term investment portfolio with equity holdings in most blue-chips in the region. Yet, this is precisely what it ended up becoming. It avoided project financing like the plague and met the burgeoning capital needs of small and medium size enterprises (SMEs) grudgingly. And it refuses to divest itself of stakes in the best run and most efficiently managed firms from Russia to the Czech Republic. In a way, it competes head on with other investors and commercial banks - often crowding them out with its subsidized financing.

One of its main mistakes, in a depressingly impressive salmagundi, is that it channelled precious resources to this budding sector (SMEs), the dynamo of every economy, through the domestic, decrepit, venal and politically manhandled banking system. The inevitable result was a colossal waste of resources. The money was allocated to sycophantic cronies and sinecured relatives (often one and the same) and to gigantic, state-owned or state-favoured loss makers. Most of it lay idle and yielded to its hosts a hefty income in arbitrage and speculation. As banks went bankrupt, they wiped whole portfolios of EBRD SME funds, theoretically guaranteed by even more bankrupt states.

Thus, the only segments of the private sector to benefit handsomely from the EBRD were lawyers and accountants involved in the umpteen lawsuits the EBRD is mired in. It is a growth industry in %26quot;countries%26quot; such as Russia. This is the melancholy outcome of indiscriminate, politically-motivated lending and of a lackadaisical performance as both lenders and shareholders. In the spirit of its first chairman, the suave and titivated Attali, the bank is in a constant road show, mortified by the possibility of its dissolution by reason of irrelevance. It aims to impress the West with its grandiose projects, mega investments, fast returns and acquiescence. In thus behaving, it is engaged in a perditionable perfidy of its fiduciary obligations. It lends to criminal managers, winking at their off-shore shenanigans and turning a blind eye to the scapegrace slaughter of minority shareholders. It throws good money after bad, cosies up to oligarchs near and far and engages in creative accounting. Instead of Westernizing the Easterners - it has been Easternized by them. Its sedentary though peregrinating employees are more adept at wining and at dining the high and mighty and at haughtily maundering in the odd, tangential, seminar - than at managing a banking institution or looking after the interests of their nominal shareholders with the tutelary solicitude expected of a bank.

Consider two examples:

MACEDONIA

The nascent private sector is nowhere to be found in the list of projects the EBRD so sagely chose to falter into here. The Electricity and Telecoms monopolies are prime beneficiaries as is the airport. The EBRD is also a passive shareholder in both big universal banks - until recently, conduits of state mismanagement. The SME and Trade Facilitation credit lines were conveniently divvied up among five domestic banks (one went belly up, the managers of two are under criminal investigation and one was sold to a Greek state bank). Despite vigorous protestations to the contrary, none of this money reached its proclaimed entrepreneurial targets. Two loans were made to giant local firms - the natural preserve of commercial lenders and equity investors the world over. The EBRD contributed nothing to the emergence of a management culture, to the development of proper corporate governance, to the safeguarding of property rights and the protection of minority shareholders here. Instead, it colluded in the perpetuation of monopolies, shoddy and shady banking practices, the pertinacious robbery titled %26quot;privatization%26quot; and the pretence of funding languishing private sector enterprises.

RUSSIA

Its 2 billion US dollars portfolio all but wiped out in the August 1998 financial crisis, the EBRD has now returned with 700 million new Euros to be - conservatively but not more safely - lent in major energy and telecom behemoths.

The historic, pre-1998, portfolio appears impressive. Almost 11 billion US dollars were generated by the EBRD's less than 4. The bottom line reads 94 projects. Yet, when one neutralizes the infrastructural ones (including the gas and energy sector) - one is left with less than 50% of the amount. Add %26quot;infrastructure-like%26quot; projects (water transportation and the like) - and less than 30% of the portfolio went to what can be called proper %26quot;private sector%26quot;. Moreover, even these investments and credits were geared towards traditional and smokestack industries: mining, food processing, pipelines, rubber and such. Not an entrepreneur in sight. And the EBRD's meagre loan-loss provisions and reserves cast serious doubts regarding the mental state of both its directors and its auditors.

To varying degrees, these two countries are typical. Development banks, like industrial policy, import substitution and poverty reduction, have gone in and out of multilateral fashion several times in the last few decades. But there is a consensus regarding some minimum aims of such bureaucracy-laden establishments - and the EBRD achieves none. It does not encourage entrepreneurship. It does not improve corporate governance. It does not enhance property rights. It does not allocate economic resources efficiently. It competes directly with other - more desirable - financing alternatives. It is not equipped to monitor its vast and inert portfolio. By implication it collaborates in graft, tax evasion and worse. It is a waste of scarce resources badly needed elsewhere. It should be administered a coup de grace. And its marbled abode - so out of touch with the realities of its clients and its balance sheet - should be sold to someone more up to the task. A bank, for instance.

The Myth of the Earnings Yield

The Myth of the Earnings Yield


by: Sam Vaknin, Ph.D.

Abstract

A very slim minority of firms distribute dividends. This truism has revolutionary implications. In the absence of dividends, the foundation of most - if not all - of the financial theories we employ in order to determine the value of shares, is falsified. These theories rely on a few implicit and explicit assumptions:

• That the (fundamental) %26quot;value%26quot; of a share is closely correlated (or even equal to) its market (stock exchange or transaction) price;
  
  

• That price movements (and volatility) are mostly random, though correlated to the (fundamental) %26quot;value%26quot; of the share (will always converge to that %26quot;value%26quot; in the long term);
  
  

• That this fundamental %26quot;value%26quot; responds to and reflects new information efficiently (old information is fully incorporated in it).
  
  

Investors are supposed to discount the stream of all future income from the share (using one of a myriad of possible rates - all hotly disputed). Only dividends constitute meaningful income and since few companies engage in the distribution of dividends, theoreticians were forced to deal with %26quot;expected%26quot; dividends rather than %26quot;paid out%26quot; ones. The best gauge of expected dividends is earnings. The higher the earnings - the more likely and the higher the dividends. Even retained earnings can be regarded as deferred dividends. Retained earnings are re-invested, the investments generate earnings and, again, the likelihood and expected size of the dividends increase. Thus, earnings - though not yet distributed - were misleadingly translated to a rate of return, a yield - using the earnings yield and other measures. It is as though these earnings WERE distributed and created a RETURN - in other words, an income - to the investor.

The reason for the perpetuation of this misnomer is that, according to all current theories of finance, in the absence of dividends - shares are worthless. If an investor is never likely to receive income from his holdings - then his holdings are worthless. Capital gains - the other form of income from shareholding - is also driven by earnings but it does not feature in financial equations.

Yet, these theories and equations stand in stark contrast to market realities.

People do not buy shares because they expect to receive a stream of future income in the form of dividends. Everyone knows that dividends are fast becoming a thing of the past. Rather, investors buy shares because they hope to sell them to other investors later at a higher price. In other words, investors do expect to realize income from their shareholdings but in the form of capital gains. The price of a share reflects its discounted expected capital gains (the discount rate being its volatility) - NOT its discounted future stream of income. The volatility of a share (and the distribution of its prices), in turn, are a measure of expectations regarding the availability of willing and able buyers (investors). Thus, the expected capital gains are comprised of a fundamental element (the expected discounted earnings) adjusted for volatility (the latter being a measure of expectations regarding the distribution of availability of willing and able buyers per given price range). Earnings come into the picture merely as a yardstick, a calibrator, a benchmark figure. Capital gains are created when the value of the firm whose shares are traded increases. Such an increase is more often than not correlated with the future stream of income to the FIRM (NOT to the shareholder!!!). This strong correlation is what binds earnings and capital gains together. It is a correlation - which might indicate causation and yet might not. But, in any case, that earnings are a good proxy to capital gains is not disputable.

And this is why investors are obsessed by earnings figures. Not because higher earnings mean higher dividends now or at any point in the future. But because earnings are an excellent predictor of the future value of the firm and, thus, of expected capital gains. Put more plainly: the higher the earnings, the higher the market valuation of the firm, the bigger the willingness of investors to purchase the shares at a higher price, the higher the capital gains. Again, this may not be a causal chain but the correlation is strong.

This is a philosophical shift from %26quot;rational%26quot; measures (such as fundamental analysis of future income) to %26quot;irrational%26quot; ones (the future value of share-ownership to various types of investors). It is a transition from an efficient market (all new information is immediately available to all rational investors and is incorporated in the price of the share instantaneously) to an inefficient one (the most important information is forever lacking or missing altogether: how many investors wish to buy the share at a given price at a given moment).

An income driven market is %26quot;open%26quot; in the sense that it depends on newly acquired information and reacts to it efficiently (it is highly liquid). But it is also %26quot;closed%26quot; because it is a zero sum game, even in the absence of mechanisms for selling it short. One investor's gain is another's loss and all investors are always hunting for bargains (because what is a bargain can be evaluated %26quot;objectively%26quot; and independent of the state of mind of the players). The distribution of gains and losses is pretty even. The general price level amplitudes around an anchor.

A capital gains driven market is %26quot;open%26quot; in the sense that it depends on new streams of capital (on new investors). As long as new money keeps pouring in, capital gains expectations will be maintained and realized. But the amount of such money is finite and, in this sense, the market is %26quot;closed%26quot;. Upon the exhaustion of available sources of funding, the bubble tends to burst and the general price level implodes, without a floor. This is more commonly described as a %26quot;pyramid scheme%26quot; or, more politely, an %26quot;asset bubble%26quot;. This is why portfolio models (CAPM and others) are unlikely to work. Diversification is useless when shares and markets move in tandem (contagion) and they move in tandem because they are all influenced by one critical factor - and only by one factor - the availability of future buyers at given prices.

Lessons in Transition

Lessons in Transition


by: Sam Vaknin, Ph.D.

Q: What have been the most successful approaches to attracting direct foreign investments: offering prospective investors tax breaks and similar benefits, or improving the overall investment climate of the country?

Empirical research has demonstrated that investors are not lured by tax breaks and monetary or fiscal investment incentives. They will take advantage of existing schemes (and ask for more, pitting one country against another). But these will never be the determining factors in their decision making. They are much more likely to be swayed by the level of protection of property rights, degree of corruption, transparency, state of the physical infrastructure, education and knowledge of foreign languages and %26quot;mission critical skills%26quot;, geographical position and proximity to markets and culture and mentality.

Q: What have been successful techniques for countries to improve their previously negative investment image?

The politicians of the country need to be seen to be transparently, non-corruptly encouraging business, liberalizing and protecting the property rights of investors. One real, transparent (for instance through international tender) privatization; one case where the government supported a foreigner against a local; one politician severely punished for corruption and nepotism; one fearless news medium – change a country's image.

Q: Should there be restrictions on repatriation of foreign investment capital (such restrictions could prevent an investment panic, but at the same time they negatively affect investor's confidence)?

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 %26quot;global capital flows%26quot;. There are investments (including even long term portfolio investments and venture capital) – and there is speculative, %26quot;hot%26quot; money. While %26quot;hot money%26quot; 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, %26quot;hot money%26quot; 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 countered.

Q: What approach has been most useful in best serving the needs of small businesses: through private business support firms, business associations, or by government agencies?

It depends where. In Israel (until the beginning of the 90s), South Korea and Japan (until 1997) – the state provided the necessary direction and support. In the USA – the private sector invented its own enormously successful support structures (such as venture capital funds). The right approach depends on the characteristics of the country in question: how entrepreneurial are its citizens, how accessible are credits and microcredits to SMEs, how benign are the bankruptcy laws (which always reflect a social ethos), how good is its physical infrastructure, how educated are its citizens and so on.

Q: How might collective action problems among numerous and dispersed small and medium entrepreneurs best be dealt with?

It is a strange question to ask in the age of cross-Atlantic transportation, telecommunication and computer networks (such as the Internet). Geographical dispersion is absolutely irrelevant. The problem is in the diverging self-interests of the various players. The more numerous they are, the more niche-orientated, the smaller – the lesser the common denominator. A proof of this fragmentation is the declining power of cartels – trade unions, on the one hand and business trusts, monopolies and cartels, on the other hand. The question is not whether this can be overcome but whether it SHOULD be overcome. Such diversity of interests is the lifeblood of the modern market economy which is based on conflicts and disagreements as much as it is based on the ability to ultimately compromise and reach a consensus.

What needs to be done centrally is public relations and education. People, politicians, big corporations need to be taught the value and advantages of small business, of entrepreneurship and intrapreneurship. And new ways to support this sector need to be constantly devised.

Q: How might access of small business to start-up capital and other resources best be facilitated?

The traditional banks all over the world failed at maintaining the balancing act between risk and reward. The result was a mega shift to the capital markets. Stock exchanges for trading the shares of small and technology companies sprang all over the world (NASDAQ in the USA, the former USM in London, the Neuemarkt in Germany and so on). Investment and venture capital funds became the second most important source quantitatively. They not only funded budding entrepreneurs but also coached them and saw them through the excruciating and dangerous research and development phases.

But these are rich world solutions.

An important development is the invention of %26quot;third world solutions%26quot; such as microcredits granted to the agrarian or textile sectors, mainly to women and which involve the whole community.

Q: Women start one-third of new businesses in the region: now can this contribution to economic growth be further stimulated?

By providing them with the conditions to work and exercise their entrepreneurial skills. By establishing day care centres for their children. By providing microcredits (women have proven to be inordinately reliable borrowers). By giving them tax credits. By allowing or encouraging flexitime or part time work or work from home. By recognizing the home as the domicile of business (especially through the appropriate tax laws). By equalizing their legal rights and their pay. By protecting them from sexual or gender harassment.

Financial Crises, Global Capital Flows and the International Financial Architecture

Financial Crises, Global Capital Flows and the International Financial Architecture


by: Sam Vaknin, Ph.D.

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 momentarily.

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 %26quot;global capital flows%26quot;. There are investments (including even long term portfolio investments and venture capital) – and there is speculative, %26quot;hot%26quot; money. While %26quot;hot money%26quot; 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, %26quot;hot money%26quot; 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 countered.

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 bubbles? 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 %26quot;reinvent%26quot; 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 %26quot;laissez faire%26quot; 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.

Economic Free Zones in Macedonia

Economic Free Zones in Macedonia


by: Sam Vaknin, Ph.D.

Question: Dr. Vaknin – is it true that you are the father of the Law of Free Economic Zones?

Answer: I participated in the dedicated and professional team, from many ministries and state organs, which prepared the law. The initiative – in collaboration with the delegation of the government of the Republic of China (Taiwan) – belongs to Dr. Milijana Danevska, the Minister of Development. Most of the work was done by her advisor, Ms. Zorica Doncevska long before I arrived on the scene. I did suggest a few amendments, some of which were accepted.

Question: What is a free zone?

Answer: There is an important distinction which the media is not aware of between FREE ZONES and FREE ZONE SITES.

To quote from the law:

%26quot;A free zone site represents a detached, enclosed and marked area of the territory of the Republic of Macedonia on which commercial activities are conducted under conditions prescribed by this and other laws and on which custom and other tax incentives determined by this law shall be applicable.%26quot;

%26quot;A Free Zone shall be established as trade associations conducting economic, technical, administrative, expert and other activities supporting the operations in the free zone sites.%26quot;

Question: Do other countries have free zones?

Answer: Dozens of other countries have free trade zones, free industrial zones, free industrial or technology parks, customs free zones, free transhipment zones and many other types of free economic zones. Our law allows for all these types of activities to exist. It is very broad and flexible and one of the best and most complete laws I have seen. As opposed to popular opinion, free zones exist even in rich countries such as the United Kingdom or the USA (although they are not called %26quot;free zones%26quot; there). It is true, though, that to poor and middle income countries, such as Macedonia, a free zone can be an important tool for economic development.

Question: Why do you use such cautious language, %26quot;can be%26quot;?

Answer: Because it is never enough to have a law. What matters is how it is implemented. There are free zones in countries as diverse as the Philippines, Tunisia, Costa Rica and Taiwan. In some places they are the engine of the economic locomotive, in other they are a drag on the local economy.

Question: So, the critics are right, free zones can be a bad thing?

Answer: The critics are wrong. Anything that has the potential of generating investments, encouraging entrepreneurship, creating new working places, enhancing exports and improving the balance of payments – should be implemented without delay. Free zones are potentially powerful economic engines of exports and growth and employment. Would it have been wise of us to ignore their potential?

Question: Can't free zones be used as tax havens, for smuggling or other criminal activities?

Answer: If the free zones are run by criminals AND (this is a cumulative condition) the authorities are inefficient or corrupt – of course it can. But our law is very strict on WHO will own and run the free zones. It is also very explicit about the precise functions and procedures to be performed by the authorities intended to ensure that the free zones are not abused. Free zones will be established only where and when they can increase employment, bring new technology and know how to the country and increase exports. An average of 65% of the goods and services produced in the zones MUST be exported or the developer might lose its licence. Additionally the law says that the businesses operating in the zone must use local manpower and prefer domestic suppliers where economically feasible.

Question: What is the Free Zones Directorate?

Answer: This is my favourite part of the law, the one I am most proud of. We introduced, for the first time in Macedonia, not only in theory, but in practice, the concept of %26quot;One Stop Shop%26quot;. All the business entities in the free zone will have one address to go to. They will no longer have to run for weeks between ministries, authorities, agencies and state organs. They will get everything they need from one central authority, from one address. All the relevant ministries and state organs will be represented there, with full authority to render all the services required by the free zones users. This is unprecedented. The ministers are worthy of the highest praise for being willing to participate in such an innovative approach. The law says:

%26quot;The Free Zone Directorate shall be responsible for… granting approvals of requests of developers for the establishment of free zones; provision of supervision and management of free zone sites through its branches; coordination of the activities of state organs and authorities and public enterprises within the free zone sites; planning and developing free zone sites and making sites available to developers; public relations, advertising and promotion of free zone sites; attracting developers and users to the free zone sites; registration of businesses and structures within the free zone sites; coordination of issuance of licenses, permits and approvals where and as needed, of product quality control and the issuance of certificates of origin by the members of the Directorate; Inspection of installations and working conditions within the free zone sites; convening a labour relations committee in which all labour disputes between employees and employers in the free zone sites are to be settled; the coordination of the issuance of export and import licenses; coordination of the prevention of smuggling; coordination of the safety and security of people and property in the free zones sites; Provision and maintenance of all public goods and utilities … conducting other activities associated with the functioning of free zone sites and especially the implementation of the %26quot;one stop shop%26quot; concept of management of the free zone sites; raising the required start-up capital.%26quot;

Question: So, from now on, any trade association can open a free zone?

Answer: Absolutely not. The developer must satisfy very strict and rigorous criteria to qualify. The law demands that it %26quot;…provide written proof of their financial ability matching their financial obligations under this Law either in the form of a performance bond or a bank document substantiating the availability of unencumbered funds in their account or audited financial statements%26quot; and %26quot;demonstrate previous experience and track record in trading or in the operating of free zone sites%26quot;.

The developers, in their application, must provide an environmental impact assessment, a marketing plan and a business plan or a feasibility study.

And the developer loses his approval if it enters bankruptcy procedures, if it is proven that he provided false material information in his request, If he failed to build and operate the free zone site in accordance with the stipulations of this Law or failed to submit one annual report.

Additionally, the developer pays 0.3% of the total turnover of the business entities in his zones.

I think these are relatively reasonable terms.

It will also not be that easy for the developer to do in the zone something other than what he undertook to do. Almost every substantial change requires a new approval. The law states: %26quot;Each change of a free zone shall be subject to the procedure for the establishment of a free zone … %26quot;Change%26quot; in this law shall mean: enlargement of the approved free zone site area; change in location of the free zone site; new activities are to be conducted in the approved free zone; each change in the composition of the developers (addition of new developer, change of corporate structure, take over, merger, acquisition, etc.) of the free zone; change of the period for existence of the free zone.

Question: Still, inside the zone – the developer is king. Actually, it is a kind of ex-territorial area, like an embassy?

Answer: I want to say it once and for all (because I heard this argument before):

A free zone is NOT an ex-territorial area. It is an integral and inseparable part of Macedonia. All the domestic laws of Macedonia apply there. It simply has different rates of customs and taxes. The over-riding status of the Macedonian domestic law is stated numerous times throughout the law. One example:

Article 20 says: %26quot;Free zone developers shall enact rules or pose conditions (hereunder referred to as %26quot;developer rules%26quot;) under which their free zone site will be operated and activities conducted, regulate internal order and prescribe separate measures for protection of the working and living conditions and the environment. BUT…

The developer rules shall not contradict all the applicable laws of the Republic of Macedonia, including their by-laws and regulations and all the international obligations of the Republic of Macedonia…. AND The developer rules shall be announced in the Official Gazette of the Republic of Macedonia after the approval given by the Free zone Directorate.%26quot;

Question: Aren't we offering too much by way of tax incentives? Aren't the revenues lost by the state worth more than the free zone will ever generate?

Answer: It is a very narrow point of view. Tax revenues are not the only thing we should consider. What about unemployment, technology transfers, export enhancement? These are invaluable in that they can revive the economy.

Compared to other free zones in other countries, we are offering mid-way concessions. We are by no means too generous. Additionally, to qualify to receive the tax incentives, the user must satisfy certain annual export quotas. It must prove that it generated NEW activities, not merely transferred activities from %26quot;mainland%26quot; Macedonia to the free zone %26quot;island%26quot;. It must show that it is not involved in criminal activities or bankruptcy procedures and so on. Only then is it eligible to enjoy the tax incentives.

Question: Which are?

Answer: The law says it best:

%26quot;Free zone users meeting the terms as in article 21 of this law shall be exempted from:

• Sales tax on products within the free zone site except for those products sold for final consumption within the free zone;
  
  

• Sales tax and VAT on goods imported into the free zone site for production purposes and for performing other approved activities in the free zone;
  
  

• Sales tax on services provided in the free zone immediately linked with export of goods and services;
  
  

• Profit tax for a period of ten (10) years from the day of commencement of activities in the free zone;
  
  

• Property tax for a period of ten (10) years from the day of commencement of activities in the free zone;
  
  

• All taxes otherwise applicable to any transfer of property or rights thereof between developers and users within the free zone.
  
  

Free zone users reinvesting in the capital assets of the free zone site shall be entitled to a reduced profit tax base for the amounts invested after the expiration of the 10-year period.

Free zone users shall be exempted from paying participations (contributions), taxes and other duties pertaining to use of land for construction, connection to the water supply, sewerage, heating, gas and power supply networks.

Free zone land may be leased to foreign investors for a period of fifty (50) years, with a possibility to extend the term to another twenty-five (25) years, pursuant to the law.

The developers of the free zone shall have the full right to sublet or rent parts of the free zones or structures thereon or rights thereof to the users.%26quot;

Question: Are the economic activities within the free zone restricted?

Answer: Every type of economic activity is allowed EXCEPT the activities explicitly forbidden by the law. These include: the trading of decayed, rotten, expired or infected goods or waste material detrimental to the environment or not fit for human or animal consumption; radioactive materials except those which are needed for industrial, medical and scientific research purposes under a valid license from the competent authorities; drugs, chemicals and biological materials and chemical and biochemical derivatives with the exception of those used in industrial, manufacturing, medicinal and pharmaceutical preparations, according to certificates issued by the Ministry of Health; arms, munitions, weapons and military explosives; goods or services which originate from countries or firms subject to boycotts, embargoes or blockades imposed by the competent national and international organs and authorities; goods or services that violate public morals, public defence, public safety and the security of the state; goods or services that violate the domestic laws and international treaties pertaining to intellectual and commercial property; practices, services and activities in contravention or violation of treaties, laws, regulations and directives regarding the protection of the environment in Macedonia.

Free zone users may apply standards, technical and quality norms of the destination country when manufacturing goods in the free zone intended for export.

Free zone users may set prices for their goods and services and will not be subject to laws and regulations pertaining to prices in the Republic of Macedonia.

Question: Will workers' rights be protected in such an environment?

Answer: Workers' rights are protected only by a good economy. In Macedonia, we have a lot of theoretical workers' rights. But the right to work is violated by mass unemployment and by gigantic wage and pension arrears. All the employers in the free zone shall sign a collective agreement with their employees. The collective agreement will oblige the employers and the employees to settle labour dispute through arbitration or mediation. The Directorate shall set up a labour relations committee to provide the employers and the employees with an arbitration and mediation mechanism.

Question: Thank you very much. Let's hope that free zones will fulfil all the expectations …

Answer: I will settle for half the expectations …

Thank you.

The Predicament of the Newly Rich

The Predicament of the Newly Rich


by: Sam Vaknin, Ph.D.

They are the object of thinly disguised envy. They are the raw materials of vulgar jokes and the targets of popular aggression. They are the Newly Rich. Perhaps they should be dealt with more appropriately within the academic discipline of psychology, but then economics in a branch of psychology. To many, they represent a psychopathology or a sociopathology.

The Newly Rich are not a new phenomenon. Every generation has them. They are the upstarts, those who seek to undermine the existing elite, to replace it and, ultimately to join it. Indeed, the Newly Rich can be classified in accordance with their relations with the well-entrenched Old Rich. Every society has its veteran, venerable and aristocratic social classes. In most cases, there was a strong correlation between wealth and social standing. Until the beginning of this century, only property owners could vote and thus participate in the political process. The land gentry secured military and political positions for its off spring, no matter how ill equipped they were to deal with the responsibilities thrust upon them. The privileged access and the insiders mentality (%26quot;old boys network%26quot; to use a famous British expression) made sure that economic benefits were not spread evenly. This skewed distribution, in turn, served to perpetuate the advantages of the ruling classes.

Only when wealth was detached from the land, was this solidarity broken. Land – being a scarce, non-reproducible resource – fostered a scarce, non-reproducible social elite. Money, on the other hand, could be multiplied, replicated, redistributed, reshuffled, made and lost. It was democratic in the truest sense of a word, otherwise worn thin. With meritocracy in the ascendance, aristocracy was in descent. People made money because they were clever, daring, fortunate, visionary – but not because they were born to the right family or married into one. Money, the greatest of social equalizers, wedded the old elite. Blood mixed and social classes were thus blurred. The aristocracy of capital (and, later, of entrepreneurship) – to which anyone with the right qualifications could belong – trounced the aristocracy of blood and heritage. For some, this was a sad moment. For others, a triumphant one.

The New Rich chose one of three paths: subversion, revolution and emulation. All three modes of reaction were the results of envy, a sense of inferiority and rage at being discriminated against and humiliated.

Some New Rich chose to undermine the existing order. This was perceived by them to be an inevitable, gradual, slow and %26quot;historically sanctioned%26quot; process. The transfer of wealth (and the power associated with it) from one elite to another constituted the subversive element. The ideological shift (to meritocracy and democracy or to mass- democracy as y Gasset would have put it) served to justify the historical process and put it in context. The successes of the new elite, as a class, and of its members, individually, served to prove the %26quot;justice%26quot; behind the tectonic shift. Social institutions and mores were adapted to reflect the preferences, inclinations, values, goals and worldview of the new elite. This approach – infinitesimal, graduated, cautious, all accommodating but also inexorable and all pervasive – characterizes Capitalism. The Capitalist Religion, with its temples (shopping malls and banks), clergy (bankers, financiers, bureaucrats) and rituals – was created by the New Rich. It had multiple aims: to bestow some divine or historic importance and meaning upon processes which might have otherwise been perceived as chaotic or threatening. To serve as an ideology in the Althusserian sense (hiding the discordant, the disagreeable and the ugly while accentuating the concordant, conformist and appealing). To provide a historical process framework, to prevent feelings of aimlessness and vacuity, to motivate its adherents and to perpetuate itself and so on.

The second type of New Rich (also known as %26quot;Nomenclature%26quot; in certain regions of the world) chose to violently and irreversibly uproot and then eradicate the old elite. This was usually done by use of brute force coated with a thin layer of incongruent ideology. The aim was to immediately inherit the wealth and power accumulated by generations of elitist rule. There was a declared intention of an egalitarian redistribution of wealth and assets. But reality was different: a small group – the new elite – scooped up most of the spoils. It amounted to a surgical replacement of one hermetic elite by another. Nothing changed, just the personal identities. A curious dichotomy has formed between the part of the ideology, which dealt with the historical process – and the other part, which elucidated the methods to be employed to facilitate the transfer of wealth and its redistribution. While the first was deterministic, long-term and irreversible (and, therefore, not very pragmatic) – the second was an almost undisguised recipe for pillage and looting of other people' property. Communism and the Eastern European (and, to a lesser extent, the Central European) versions of Socialism suffered from this inherent poisonous seed of deceit. So did Fascism. It is no wonder that these two sister ideologies fought it out in the first half of the twentieth century. Both prescribed the unabashed, unmitigated, unrestrained, forced transfer of wealth from one elite to another. The proletariat enjoyed almost none of the loot.

The third way was that of emulation. The Newly Rich, who chose to adopt it, tried to assimilate the worldview, the values and the behaviour patterns of their predecessors. They walked the same, talked the same, clad themselves in the same fashion, bought the same status symbols, ate the same food. In general, they looked as pale imitations of the real thing. In the process, they became more catholic than the Pope, more Old Rich than the Old Rich. They exaggerated gestures and mannerisms, they transformed refined and delicate art to kitsch, their speech became hyperbole, their social associations dictated by ridiculously rigid codes of propriety and conduct. As in similar psychological situations, patricide and matricide followed. The Newly Rich rebelled against what they perceived to be the tyranny of a dying class. They butchered their objects of emulation – sometimes, physically. Realizing their inability to be what they always aspired to be, the Newly Rich switched from frustration and permanent humiliation to aggression, violence and abuse. These new converts turned against the founders of their newly found religion with the rage and conviction reserved to true but disappointed believers.

Regardless of the method of inheritance adopted by the New Rich, all of them share some common characteristics. Psychologists know that money is a love substitute. People accumulate it as a way to compensate themselves for past hurts and deficiencies. They attach great emotional significance to the amount and availability of their money. They regress: they play with toys (fancy cars, watches, laptops). They fight over property, territory and privileges in a Jungian archetypal manner. Perhaps this is the most important lesson of all: the New Rich are children, aspiring to become adults. Having been deprived of love and possessions in their childhood – they turn to money and to what it can buy as a (albeit poor because never fulfilling) substitute. And as children are – they can be cruel, insensitive, unable to delay the satisfaction of their urges and desires. In many countries (the emerging markets) they are the only capitalists to be found. There, they spun off a malignant, pathological, form of crony capitalism. As time passes, these immature New Rich will become tomorrow's Old Rich and a new class will emerge, the New Rich of the future. This is the only hope – however inadequate and meagre – that developing countries have.

Dividing The Loot

Dividing The Loot


by: Sam Vaknin, Ph.D.

It is when the going gets better, that the going gets tough. This enigmatic sentence bears explanation: when a firm is in dire straits, in the throes of a crisis, or is a loss maker – conflicts between the shareholders (partners) are rare. When a company is in the start-up phase, conducting research and development and fighting for its continued, profitable survival in the midst of a massive investment cycle – rarely will internal strife arise and threaten its existence. It is when the company turns a profit, when there is cash in the till – that, typically, all manner of grievances, complaints and demands arise. The internecine conflicts are especially acute where the ownership is divided equally. It is more accentuated when one of the partners feels that he is contributing more to the business, either because of his unique talents or because of his professional experience, contacts or due to the size of his initial investments (and the other partner does not share his views).

The typical grievances relate to the equitable, proportional, division of the company's income between the partners. In many firms partners serve in various management functions and draw a salary plus expenses. This is considered by other partners to be a dividend drawn in disguise. They want to draw the same amounts from the company's coffers (or to maintain some kind of symbolic monetary difference in favour of the position holder). Most minority partners are afraid of a tyranny of the majority and of the company being robbed blind (legally and less legally) by the partners in management positions. Others are plainly jealous, poisoned by rumours and bad advisors, pressurized by a spouse. A myriad of reasons can lead to internal strife, detrimental to the future of the operation.

This leads to a paralysis of the work of the company. Management and ownership resources are dedicated to taking sides in the raging battle and to thinking up new strategies and tactics of attacking %26quot;the enemy%26quot;. Indeed, animosity, even enmity, arise together with bitterness and air of paranoia and impending implosion. The business itself is neglected, then derailed. Directors argue for hours regarding their perks and benefits – and deal with the main issues in a matter of a few minutes. The company car gets more attention than the company's main clients, the expense accounts are more closely scrutinized than the marketing strategies of the firm's competitors. This is disastrous and before long the company begins to lose clients, its marketing position degenerates, its performance and customer satisfaction deteriorate. This is mortal danger and it should be nipped in the bud.

Frankly, I do not believe much in introducing rational solutions to this highly charged EMOTIVE-PSYCHOLOGICAL problem. Logic cannot eliminate envy, ratio cannot cope with jealousy and bad mouthing will not stop if certain visible disparities are addressed. Still, dealing with the situation openly is better than relegating it to obscurity.

We must, first, make a distinction between a division of the company's assets and liabilities upon a dissolution of the partnership for whatever reason – and the distribution of its on-going revenues or profits.

In the first case (dissolution), the best solution I know of, is practised by the Bedouins in the Sinai Peninsula. For simplification's sake, let us discuss a collaboration between two equal partners that is coming to its end. One of the partners is then charged with dividing the partnership's assets and liabilities into two lots (that he deems equal). The other partner is then given the right of being the FIRST to choose one of the lots to himself. This is an ingenious scheme: the partner in charge of allocating the lots will do his utmost to ensure that they are indeed identical. Each lot will, probably, contain values of assets and liabilities identical to the other lot. This is because the partner in charge of the division does not know WHICH lot the other partner will choose. If he divides the lots unevenly – he runs the risk of his partner choosing the better lot and leaving him with the lesser one.

Life is not that simple when it comes to dividing a stream of income or of profits. Income can be distributed to the shareholders in many ways: wages, perks and benefits, expense accounts, and dividends. It is difficult to disentangle what money is paid to a shareholder against a real contribution – and what money is a camouflaged dividend. Moreover, shareholders are supposed to contribute to their firm (this is why they own shares) – so why should they be especially compensated when they do so? The latter question is particularly acute when the shareholder is not a full time employee of the firm – but allocates only a portion of his time and resources to it.

Solutions do exist, however. One category of solutions involves coming up with a clear definition of the functions of a shareholder (a job description). This is a prerequisite. Without such clarity, it would be close to impossible to quantify the respective contributions of the shareholders.

Following this detailed analysis, a pecuniary assessment of the contribution should be made. This is a tricky part. How to value the importance to the company of this or that shareholder?

One way is to publish a public tender for the shareholder's job, based on the aforementioned job description. The shareholder will accept, in advance, to match the lowest bid in the tender. Example: if the shareholder is the Active Chairman of the Board, his job will be minutely described in writing. Then, a tender will be published by the company for the job, including a job description. A committee, whose odd number of members will be appointed by the Board of Directors, will select the winner whose bid (cost) was the lowest. The shareholder will match these low end terms. In other words: the shareholder will accept the market's verdict. To perfect this technique, the CURRENT functionaries should also submit their bids under assumed names. This way, not only the issue of their compensation will be determined – but also the more basic question of whether they are the fittest for the job.

Another way is to consult executive search agencies and personnel placement agencies (also known as %26quot;Headhunters%26quot;). Such organizations can save the prolonged hassle of a public tender, on the one hand. On the other hand, their figures are likely to be skewed up. Because they are getting a commission equal to one monthly wage of the successfully placed executive – they will tend to quote a level of compensation higher than the market's. An approach should, therefore, be made to at least three such agencies and the resulting average figure should be adjusted down by 10% (approximately the commission payable to these agencies).

A closely similar method is to follow what other, comparable, firms, are offering their position-holders. This can be done by studying the classified ads and by directly asking the companies (if such direct enquiry is at all possible).

Yet another approach is to appoint a management consultancy to do the job: are the shareholders the best positioned people in their respective functions? Is their compensation realistic? Should alternative management methods be implemented (rotation, co-management, management by committee)?

All the above mentioned are FORMAL techniques in which arbitration is carried out to determine the remuneration level befitting the shareholder's position. Any compensation that he receives above this level is evidently a hidden dividend. The arbitration can be carried out directly by the market or by select specialists.

There are, however, more direct approaches. Some solutions are performance related. A base compensation (salary) is agreed between the parties: each shareholder, regardless of his position, dedication to the job, or contribution to the firm – will take home an amount of monthly fee reflecting his shareholding proportion or an amount equal to the one received by other shareholders. This, really, is the hidden dividend, disguised as a salary. The remaining part of the compensation package will be proportional to some performance criteria.

Let us take the simplest case: two equal partners. One is in charge of activity A, which yields to the company AA in income and AAA in profits (gross or net). The second partner supervises and manages activity B, which yields to the company BB in revenues and BBB in profits. Both will receive an equal %26quot;base salary%26quot;. Then, an additional total amount available to both partners will be decided (%26quot;incentive base%26quot;). The first partner will receive an additional amount, which will be one of the ratios {AA/(AA+BB)} or {AAA/(AAA+BBB)} multiplied by the incentive base.

The second partner will receive an additional amount, which will be one of the ratios {BB/(AA+BB)} or {BBB/(AAA+BBB)} multiplied by the same incentive base. A recalculation of the compensation packages will be done quarterly to reflect changes in revenues and in profits. In case the activity yields losses – it is better to use the revenues for calculation purposes. The profits should be used only when the firm is divided to clear profit and loss centres, which could be completely disentangled from each other.

All the above methods deal with partners whose contributions are NOT equal (one is more experienced, the other has more contacts, or a formal technological education, etc.). These solutions are also applicable when the partners DISAGREE concerning the valuation of their respective contributions. When the partners agree that they contribute equally, some basis can be agreed for calculating a fair compensation. For instance: the number of hours dedicated to the business, or even some arbitrary coefficient.

But whatever the method employed, when there is no such agreement between the partners, they should recognize each other's skills, talents and specific contributions. The compensation packages should never exceed what the shareholders can reasonably expect to get by way of dividends. Even the most envious person, if he knows that his partner can bring him in dividends more than he can ever hope for in compensation – will succumb to greed and award his partner what he needs in order to produce those dividends.

Public Sector Economies in Transition

Public Sector Economies in Transition


by: Sam Vaknin, Ph.D.

In the previous article, we described the various methods developed in the West to cope with the ever-burgeoning public sector.

Yet, economies in transition everywhere in the world have learned a lesson the hard way: not everything that is Western - necessarily fits their needs. Many Western techniques, methods, systems and ways of thinking cannot be applied in Macedonia, for instance.

The public sector is a great burden on economies everywhere.

It is mostly financed by collecting taxes from individuals and businesses.

Taxes are re-allocation of economic resources. Taxes are nothing but money transfers from one group of citizens (the taxpayers) to other groups: to those who cannot pay taxes (such as children and the elderly) and to those who would not pay taxes, the tax evaders. Taxes are a penalty paid by the more productive and honest segments of society. Small wonder that taxes have a bad reputation in the West. They are considered to be both unjust and inefficient.

But taxes are both necessary and inevitable. There is no better way to finance the operations of the government and of the public sector.

The more taxes collected - the heavier the involvement of the state in the economy. This involvement is measured as a percentage of the GDP - the Gross Domestic Product. As we mentioned in our previous article, the figures are frightening: governments consume from 19% (Singapore, Hong-Kong) to 59% (France) of the products and services produced in the economy!

Research shows that public spending of tax money is 6 times less efficient than the same money invested by the private sector. The two sectors: the Private and the Public compete on the same, limited, amount of resources. Every Denar paid to the tax collector is one Denar less invested in the formation of new businesses and one Denar less invested in private consumption.

We can safely state that taxes inhibit economic growth and increase unemployment.

So the current mood in the West is anti big government and anti taxation.

People evade taxes. About 13 - 25% of the total capital in the world is %26quot;black%26quot; capital, upon which taxes were not paid. It is estimated that Macedonian firms and individuals hold more than 1 billion USD in undeclared cash - against an official figure of 200 million USD in circulation in the whole Macedonian economy.

People openly refuse to pay taxes and they take their governments to court on these issues.

Governments are doing their best to simplify procedures and tax returns (=the forms on which income is reported).

In fiscal theory, we differentiate between progressive and regressive taxes.

A progressive tax is one which is larger - the larger the income is. A millionaire in a progressive tax system will pay much more (as a percentage of his income) than his driver.

A regressive tax is one that totally unrelated to the level of income. Both the millionaire and his driver will pay the same percentage of tax if they buy a car, for instance.

Governments have become desperate. They introduce one rate income tax systems: all incomes are taxed at the same rate, regardless of their size. They are switching from taxes on income (which are socially progressive in nature) to taxes on consumption (such as VAT - Value Added Taxes) which are socially regressive in nature.

The overall goal is commendable: to lower the burden of taxation to less than 20% of the GDP.

But obtaining this goal means that Governments will have to reduce their involvement in the economy and cut back on services and on the public sector.

This is not a very clever idea for economies in transition.

The public sector in economies in transition could and should be privatized only after three conditions have been met:

First, the establishment of a strong private sector. Individuals and firms in the private sectors are the consumers of electricity, water and phone services. Without a strong customer base, it would be very difficult to sell the PTT, the electricity company or the water companies to any private investor in reasonable prices. The public sector must become profitable to be sold to the private sector (=to be privatized). A losing company is not worth anything to an investor, unless he thinks that he can turn it around and make it profitable. The best way to do this is to increase its sales to a loyal and sizeable group of clients.

The second condition: the de-regulation of prices and the abolition of subsidies.

The state must exit forgo all levels of intervention in the finances of the public sector. It must not fix the prices of its products and services and it must not subsidize it. Subsidies and tax incentives thwart and distort the true economic and financial picture. They hinder the proper and correct valuation of the public sector firm by prospective investors.

An investor must feel certain that he will be allowed to fix any price for the goods and services sold by the public sector firm that he is buying. This is the way to profitability and financial health. The government does not need to worry:

If the investor will charge too high a price - his clients will go to his competition.

But what if there is no competition? What if electricity is supplied by only one electricity firm (a monopoly)? Who will the client revert to if the prices that he is charged are much too high?

This, precisely, is the third condition:

The opening of the marketplace to competition, both domestic and foreign.

To cancel all laws, regulations, rules, precedents which inhibit or prohibit competition. To eliminate tariffs, quotas, permits, licences and controls (barring those which relate to public health and to the protection of the environment).

Why should Macedonia have only one PTT? Why not six providers?

Why not allow anyone to produce electricity and sell it to the electricity company? Why to have only one electricity company?

Subject to the right regulations concerning safety and financial wherewithal - everyone should be allowed to do anything. Economic history shows that competition provides better goods and services at much lower costs.

It also shows that the public sector is a potential hub of inefficiency and sometimes blatant corruption.

%26quot;Lean and Mean%26quot; is the name of the game in today's economic environment.

The Public sector is fat and sluggish. It has no right to continue to exist.

Even private sector enterprises are %26quot;downsizing%26quot; (cutting their labour force considerably).

But certain functions can scarcely be transferred to the private sector. These functions are inherently non-profitable and non-profit motivated. They are usually performed by municipal, local and regional authorities.

The municipal (local) and regional part of the public sector has five sources of income at its disposal:

• It is empowered to collect taxes from individuals and from businesses - the size of which is normally linked to the (residential or office) space that they occupy.
  
  

• It is allowed to collect fees and charges which are fixed and relate to the provision of services such as: water supply, sewage, sanitation, posting commercial signs, parking and toll roads).
  
  

• It is authorized to levy fines on transgressors against municipal rules and regulations. The best known form of this kind of financing is the parking ticket.
  
  

• Mainly in the USA, local authorities are permitted to sell municipal bonds (%26quot;Munis%26quot;) to the public - through the Stock Exchange - and directly to institutional investors, such as pension funds.
  
  

The local authority which issued the bonds pays the bondholders from current income generated by tax revenues and from specific incomes generated to it by specific projects.

An example: a local authority wants to establish a water treatment facility.

It costs 100,000,000 USD. The Authority receives 60,000,000 from the government and sells 40,000,000 USD worth of bonds to the public via the stock exchanges.

Once the facility is built, it begins to supply water to the residents and to businesses. They pay for the water that they consume - and the income from the sale of the water goes to the bondholders. This income covers both the interest payable on the bond (=its coupon) and the money that the bondholders invested in the bonds themselves and which they have to recover.

* Lately, a new fashion is developing in public administration, called devolution.

It is the transfer of parts of the national budget directly to the local authorities or granting them the right to regulate their own fiscal (=tax) systems.

Devolution is a prime example of a mega-trend in human societies: that of the dismantling of Big Government. But this is subject for yet another article.

The Criminality of Transition

The Criminality of Transition


by: Sam Vaknin, Ph.D.

Lecture given at the Netherlands Economic Institute (NEI) on 18/4/2001

Human vice is the most certain thing after death and taxes, to paraphrase Benjamin Franklin. The only variety of economic activity, which will surely survive even a nuclear holocaust, is bound to be crime. Prostitution, gambling, drugs and, in general, expressly illegal activities generate c. 400 billion USD annually to their perpetrators, thus making crime the third biggest industry on Earth (after the medical and pharmaceutical industries).

Many of the so called Economies in Transition and of HPICs (Highly Indebted Poor Countries) do resemble post-nuclear-holocaust ashes. GDPs in most of these economies either tumbled nominally or in real terms by more than 60% in the space of less than a decade. The average monthly salary is the equivalent of the average daily salary of the German industrial worker. The GDP per capita – with very few notable exceptions – is around 20% of the EU's average and the average wages are 14% the EU's average (2000). These are the telltale overt signs of a comprehensive collapse of the infrastructure and of the export and internal markets. Mountains of internal debt, sky high interest rates, cronyism, other forms of corruption, environmental, urban and rural dilapidation – characterize these economies.

Into this vacuum – the interregnum between centrally planned and free market economies – crept crime. In most of these countries criminals run at least half the economy, are part of the governing elites (influencing them behind the scenes through money contributions, outright bribes, or blackmail) and – through the mechanism of money laundering – infiltrate slowly the legitimate economy.

What gives crime the edge, the competitive advantage versus the older, ostensibly more well established elites?

The free market does. When communism collapsed, only criminals, politicians, managers, and employees of the security services were positioned to benefit from the upheaval. Criminals, for instance, are much better equipped to deal with the onslaught of this new conceptual beast, the mechanism of the market, than most other economic players in these tattered economies are.

Criminals, by the very nature of their vocation, were always private entrepreneurs. They were never state owned or subjected to any kind of central planning. Thus, they became the only group in society that was not corrupted by these un-natural inventions. They invested their own capital in small to medium size enterprises and ran them later as any American manager would have done. To a large extent the criminals, single handedly, created a private sector in these derelict economies.

Having established a private sector business, devoid of any involvement of the state, the criminal-entrepreneurs proceeded to study the market. Through primitive forms of market research (neighbourhood activists) they were able to identify the needs of their prospective customers, to monitor them in real time and to respond with agility to changes in the patterns of supply and demand. Criminals are market-animals and they are geared to respond to its gyrations and vicissitudes. Though they were not likely to engage in conventional marketing and advertising, they always stayed attuned to the market's vibrations and signals. They changed their product mix and their pricing to fit fluctuations in demand and supply.

Criminals have proven to be good organizers and managers. They have very effective ways of enforcing discipline in the workplace, of setting revenue targets, of maintaining a flexible hierarchy combined with rigid obeisance – with very high upward mobility and a clear career path. A complex system of incentives and disincentives drives the workforce to dedication and industriousness. The criminal rings are well run conglomerates and the more classic industries would have done well to study their modes of organization and management. Everything – from sales through territorially exclusive licences (franchises) to effective %26quot;stock%26quot; options – has been invented in the international crime organizations long before it acquired the respectability of the corporate boardroom.

The criminal world has replicated those parts of the state which were rendered ineffective by unrealistic ideology or by pure corruption. The court system makes a fine example. The criminals instituted their own code of justice (%26quot;law%26quot;) and their own court system. A unique – and often irreversible – enforcement arm sees to it that respect towards these indispensable institutions is maintained. Effective – often interactive – legislation, an efficient court system, backed by ominous and ruthless agents of enforcement – ensure the friction-free functioning of the giant wheels of crime. Crime has replicated numerous other state institutions. Small wonder that when the state disintegrated – crime was able to replace it with little difficulty. The same pattern is discernible in certain parts of the world where terrorist organizations duplicate the state and overtake it, in time. Schools, clinics, legal assistance, family support, taxation, the court system, transportation and telecommunication services, banking and industry – all have a criminal doppelganger.

To summarize:

At the outset of transition, the underworld constituted an embryonic private sector, replete with international networks of contacts, cross-border experience, capital agglomeration and wealth formation, sources of venture (risk) capital, an entrepreneurial spirit, and a diversified portfolio of investments, revenue generating assets, and sources of wealth. Criminals were used to private sector practices: price signals, competition, joint venturing, and third party dispute settlement.

To secure this remarkable achievement – the underworld had to procure and then maintain – infrastructure and technologies. Indeed, criminals are great at innovating and even more formidable at making use of cutting edge technologies. There is not a single technological advance, invention or discovery that criminals were not the first to utilize or the first to contemplate and to grasp its full potential. There are enormous industries of services rendered to the criminal in his pursuits. Accountants and lawyers, forgers and cross border guides, weapons experts and bankers, mechanics and hit-men – all stand at the disposal of the average criminal. The choice is great and prices are always negotiable. These auxiliary professionals are no different to their legitimate counterparts, despite the difference in subject matter. A body of expertise, know-how and acumen has accumulated over centuries of crime and is handed down the generations in the criminal universities known as jail-houses and penitentiaries. Roads less travelled, countries more lenient, passports to be bought, sold, or forged, how to manuals, classified ads, goods and services on offer and demand – all feature in this mass media cum educational (mostly verbal) bulletins. This is the real infrastructure of crime. As with more mundane occupations, human capital is what counts.

Criminal activities are hugely profitable (though wealth accumulation and capital distribution are grossly non-egalitarian). Money is stashed away in banking havens and in more regular banks and financial institutions all over the globe. Electronic Document Interchange and electronic commerce transformed what used to be an inconveniently slow and painfully transparent process – into a speed-of-light here-I-am, here-I-am-gone type of operation. Money is easily movable and virtually untraceable. Special experts take care of that: tax havens, off shore banks, money transactions couriers with the right education and a free spirit. This money, in due time and having cooled off – is reinvested in legitimate activities. Crime is a major engine of economic growth in some countries (where drugs are grown or traded, or in countries such as Italy, in Russia and elsewhere in CEE). In many a place, criminals are the only ones who have any liquidity at all. The other, more visible, sectors of the economy are wallowing in the financial drought of a demonetized economy. People and governments tend to lose both their scruples and their sense of fine distinctions under these unhappy circumstances. They welcome any kind of money to ensure their very survival. This is where crime comes in. In Central and Eastern Europe the process was code-named: %26quot;privatization%26quot;.

Moreover, most of the poor economies are also closed economies. They are the economies of nations xenophobic, closed to the outside world, with currency regulations, limitations on foreign ownership, constrained (instead of free) trade. The vast majority of the populace of these economic wretches has never been further than the neighbouring city – let alone outside the borders of their countries. Freedom of movement is still restricted. The only ones to have travelled freely – mostly without the required travel documents – were the criminals. Crime is international. It involves massive, intricate and sophisticated operations of export and import, knowledge of languages, extensive and frequent trips, an intimate acquaintance with world prices, the international financial system, demand and supply in various markets, frequent business negotiations with foreigners and so on. This list would fit any modern businessman as well. Criminals are international businessmen. Their connections abroad coupled with their connections with the various elites inside their country and coupled with their financial prowess – made them the first and only true businessmen of the economies in transition. There simply was no one else qualified to fulfil this role – and the criminals stepped in willingly.

They planned and timed their moves as they always do: with shrewdness, an uncanny knowledge of human psychology and relentless cruelty. There was no one to oppose them – and so they won the day. It will take one or more generations to get rid of them and to replace them by a more civilized breed of entrepreneurs. But it will not happen overnight.

In the 19th century, the then expanding USA went through the same process. Robber barons seized economic opportunities in the Wild East and in the Wild West and really everywhere else. Morgan, Rockefeller, Pullman, Vanderbilt – the most ennobled families of latter day America originated with these rascals. But there is one important difference between the USA at that time and Central and Eastern Europe today. A civic culture with civic values and an aspiration to, ultimately, create a civic society permeated the popular as well as the high-brow culture of America. Criminality was regarded as a shameful stepping stone on the way to an orderly society of learned, civilized, law-abiding citizens. This cannot be said about Russia, for instance. The criminal there is, if anything, admired and emulated. The language of business in countries in transition is suffused with the criminal parlance of violence. The next generation is encouraged to behave similarly because no clear (not to mention well embedded) alternative is propounded. There is no – and never was – a civic tradition in these countries, a Bill of Rights, a veritable Constitution, a modicum of self rule, a true abolition of classes and nomenclatures. The future is grim because the past was grim. Used to being governed by capricious, paranoiac, criminal tyrants – these nations know no better. The current criminal class seems to them to be a natural continuation and extension of generations-long trends. That some criminals are members of the new political, financial and industrial elites (and vice versa) – surprises them not.

In most countries in transition, the elites (the political-managerial complex) make use of the state and its simulacrum institutions in close symbiosis with the criminal underworld. The state is often an oppressive mechanism deployed in order to control the populace and manipulate it. Politicians allocate assets, resources, rights, and licences to themselves, and to their families and cronies. Patronage extends to collaborating criminals. Additionally, the sovereign state is regarded as a means to extract foreign aid and credits from donors, multilaterals, and NGOs.

The criminal underworld exploits the politicians. Politicians give criminals access to state owned assets and resources. These are an integral part of the money laundering cycle. %26quot;Dirty%26quot; money is legitimized through the purchase of businesses and real estate from the state. Politicians induce state institutions to turn a blind eye to the criminal activities of their collaborators and ensure lenient law enforcement. They also help criminals eliminate internal and external competition in their territories.

In return, criminals serve as the %26quot;long and anonymous arm%26quot; of politicians. They obtain illicit goods for them and provide them with illegal services. Corruption often flows through criminal channels or via the mediation and conduit of delinquents. Within the shared sphere of the informal economy, assets are often shifted among these economic players. Both have an interest to maintain a certain lack of transparency, a bureaucracy (=dependence on state institutions and state employees) and NAIRU (Non Abating Internal Recruitment Unemployment). Nationalism and racism, the fostering of paranoia and grievances are excellent tactics of mobilization of foot soldiers. And the needs to dispense with a continuous stream of patronage and provide venues for the legitimization of illegally earned funds delay essential reforms and the disposal of state assets.

This urge to become legitimate - largely the result of social pressure - leads to a deterministic, four stroke cycle of co-habitation between politicians and criminals. In the first phase, politicians grope for a new ideological cover for their opportunism. This is followed by a growing partnership between the elites and the crime world. A divergence then occurs. Politicians team up with legitimacy-seeking, established crime lords. Both groups benefit from a larger economic pie. They fight against other, less successful, criminals, who wish to persist in their old ways. This is low intensity warfare and it inevitably ends in the triumph of the former over the latter.