Essentially, the United States said it would not treat Russia as a major partner in terms of economic recovery, and spurned the efforts of the Russian leaders. It was really the second attempt by Gorbachev. The first was with Reagan at Reykjavik when Gorbachev offered disarmament—Reagan turned it down—to join together, to construct a new world based upon a leading partnership between the United States and Russia. Now we are paying the price. The price will be nuclear. The price will be chaotic. And the price will be financial.

For Russians, especially the young reformers, it was confirmed when Clinton accepted the proposal to increase NATO close to Russian borders. That indicated, no matter what else was said, that Americans did not take Russia seriously enough. And the price will now be paid. I feel sad in rereading these pages because I was there and was a participant in the activity to bring about a different course.

Next month the Santa Fe Institute will host a major three-part lecture by Professor Brian Arthur on the economics of increasing returns. Several times in the past, I have commented here on increasing returns as being an important contribution to balance the notion of economics being a self-adjusting system. Economics of increasing returns suggests that those things that do well will do exceptionally well. But the counterpart to that—the economics of decreasing returns—should also be understood.

In the climate of the volatility that we have today it is essential to understand that those things that do badly will do increasingly badly. This is another way of expressing the same thing that George Soros talked about in his book on new reflexivity (The Crisis of Global Capitalism: Open Society Endangered), sometimes also glibly referred to as the self-fulfilling prophesy. It also means that where markets occur, economics will follow. Markets determine economics, not the other way around. So let us today think of the economics of decreasing returns as we struggle for stability in international financial systems.

There is a new order in Asia. All we have to do is look at the Asian stock markets to know that. Not only did the Asian tigers fall asleep—or worse, begin stealing food from one another—but Japan, the second wealthiest country in the world and our strongest partner in Asia, is dispirited and totally adrift.

China is the country that we thought would be the leader in Asia in the next century. It has happened now. We have made China dominant in Asia and it is scaring all of our Asian friends, the tigers and the Japanese, absolutely into a catatonic state.

When President Clinton went to China and confirmed publicly the one-China, two-systems policy, he couldn’t have made the Chinese leaders happier. They gave him a public press conference on Chinese television in exchange, because he said to them that China now has a free hand to deal with Taiwan. With a free hand, China, with its population and potential economic might, becomes the dominant force there. The United States has withdrawn.

So now the new order is in Asia, and it is greater China which received the gift on a platter from Bill Clinton. But what was supposed to be a symbolic visit was a major policy visit. I would bet not too many people in Washington know it yet.

Commentators remark with favor that the American investor remains devoted to the US bull market. In the first place, it is the wrong emphasis because individual investors respond to markets not by levels, but by time. The bull market that individual investors have participated in is essentially aged from the Battle of Midway in 1942. Two generations have taught us that equities are the place to have money. Therefore, we have taken money, which is essentially lunch money, and invested it in equities for a higher level of consumption. Investors have not been saving in the past several years. The American savings rate has gone down and, instead, we have counted on equity returns to give us savings. But no matter.

It will take a year or two of bad markets to convince people that the equity market is not the place for all of one’s retirement funds. I hope we don’t have a bad market, but it can happen and that is the right emphasis. It is important to think in terms of safety.

The shift of pension funds from defined benefit plans to the contributory plans essentially made people forget that what they really want is to have the money available at a time in which they need it. Individuals are not concerned about levels but they do respond to the water torture of declining markets over a longer period of time, not so much instant dunking.

Pension plans seem to be a source of stability for the market. Let me suggest quite strongly that it is just the reverse. In the event of a market decline, pension plans may be sources of instability for the American corporate system. The present actuarial assumptions for companies in many cases are in excess of 10 percent. These are unsustainable levels although they have been realized in the past seven or eight years while stocks and bonds have gone up in parallel.

However, if they are not realized, companies will, for the first time, have to start putting in cash in order to meet pension obligations. That they have not done. The expectations that rates in excess of 10% can be attained will not be met when interest-free rates will be at five percent or have actually fallen slightly. Furthermore, pension plans are invested typically in other American companies—not unlike the system in Japan, which has the interlocking of business ownership and business volatility—instead of adding to diversification in a diversification sense.

And finally, pension plans are debts of the company. That is, the pension obligation is the debt. The pension plan itself stands behind that debt, but in the first instance it is the debt of the company which adds to the volatility of the American corporate system. And they are expensive to run. In a bull market the salaries of everyone connected to financial services industries has gone up, including those for consultants, actuaries, investment managers, bankers and the like. We can see this as a source of instability on the downside, exaggerating the downside, just as we saw it as a source of strength on the upside when we had the upside.

A pension plan from the standpoint of an individual is their bedrock for retirement. In most cases, it was taken for granted for a long time. It was not even considered part of pay. After all, take-home pay was what counted, and behind that was Social Security or defined benefit pension plans which would be used someday.

We are in the midst of an awareness of a long fifty-year boom market . . . and an exuberant market for the last seven years. Individuals became aware that they could increase returns by investing in the stock market themselves. Companies were happy to get rid of the responsibility by shifting defined benefit plans to so-called defined contribution plans where certain payments would be made, but the individual was responsible for how that would be done. And in most cases the contributions went into equities. So now individuals in many cases have taken on the responsibility for their own outcomes. But I wonder if they realize that they have imperiled their retirement income. As yet we can’t tell because the market decline, although its extent is perhaps 20%, isn’t long enough.

But we can get into a condition in which interest rates are low, so even investments in short-term securities become not enough to support retirement, and investments in equities could produce considerably lower returns if we get into a long-term bear market. So the quest for higher returns has actually produced an increase in the instability of the system from the standpoint of the individual. Yes, that is the normal tradeoff, but I wonder how many people realize that they were making that tradeoff when the changes were made.

Americans have a propensity to lecture foreigners about what they, the Americans, think the foreigner should do within their own country. The latest episode of Japan bashing apparently took place on Friday night at a small dinner, which included Robert Rubin, the American Secretary of the Treasury, Alan Greenspan, head of the Federal Reserve, and Kiichi Miyazawa, the Japanese finance minister (who is also its 78-year-old former primer minister).

As the conversation could be conducted in English, it could be especially candid and free-flowing. Americans apparently leaked the conversation and indicated that Americans were blaming Japan for the world’s economic woes, and Japan should use its government to fix what the free market had apparently undone. The Japanese bristled at this. Lecturing to Orientals about what they should do never ever promotes the course that the lecturer believes should be followed.

So we are going public with our Japan bashing, and this indicates the very severe strains within the G-7 over what to do about the growing financial liquidity and quality problem. It is not going to be solved this way, by Americans taking the bashing initiative, and telling about it afterwards.

It is expected that, to be a politician, you have to lie to be elected; you have to lie to get financing; you do the best job you can; and then you have to lie again to be re-elected. So we are not surprised that Clinton has developed a lifetime pattern of lying . . . and he is good at it.

Similarly, we just heard the disclosure today that Anatoly Chubais, the well-respected Russian, lied in order to get $20 billion in financing from the IMF in June, saying if he had not lied, Russia would have collapsed then and the IMF would not have put $20 billion in. Similarly, he said it was normal for Yeltsin to lie about devaluation, and of course it has to happen.

So people expect sales people to lie in order to make their products seem better than others. And business people to lie to cover their bad performance—then, when they have time, to fix it.

But, increasingly, that is not going to go unchallenged by the networking and informal groups of the Internet. Lying by authority figures in packaged, canned presentations is completely challenged by the informal network of people who are well informed at the ground level. We are promoting a system of more full disclosure. And so the public appearance that you now see of lying, I think, will become a thing of the past in a world of disclosure, in a world of respect, in a world of instantaneous communication and transfers.

I am holding in my hand a matryoshka [nesting] doll of Yeltsin . . . and the Yeltsin era is over. We are entering a new period with Evgeny Primakov. Primakov is a compromise candidate and has no special policy . . . he is an administrator. The one policy that he promotes, that is unifying all of the parties in Russia, is that of a tough policy with the West. We brought that on ourselves, most recently with the expansion of NATO. So because of his tough anti-West stand, and Russia-first stand, Primakov is the candidate for prime minister, who will bring everybody together.

He has no economic policy, and yet we know what the economic policy has to be anyway. It has to be a bi-polar policy that wins back social support for the population, even if that is the old Soviet style. Similarly, it will be a somewhat freer financial policy than was true under Soviet communism, but certainly not as free as what we have seen in the recent past and with the Yeltsin government. There will be some clamping down on the banks and the oligarchs, but they will be allowed to run quite free and will not have to give back the money from their older business pursuits.

Primakov is not an anti-corruption candidate for the post in the way that Lebed was. Furthermore, it appears quite clearly that Primakov did not want the job. But he will provide a proper and graceful exit for Yeltsin. So it is a transition, but Russia is not solving its major problems, which include completion of privatization and moving on to the next phase—that has yet to be determined. We don’t know what the next phase is, politically or economically.

Much of the interest on the plus side recently has been in the fixed income market. While the stock market has been demonstrating volatility, and has been generally crashing in emerging markets around the world, the fixed income market in the US has been steadily strong.

We have had two aberrations at the same time. One is an inverted yield curve, where the long rates are lower than the short-term rates. The second is a flight to quality, with the quality-preference spread widening. That both of these happen at the same time is a precedent that one has to look back to deflationary periods, almost 100 years ago, to find. They have brought about the important capital call by Long Term Capital, which is under the leadership of Myron Scholes.

One of the smartest firms in the bond market has almost gone under by using backtesting and feeling it is very unlikely to have these two events happen at the same time . . . so much for backtesting. These aberrations are an indication that we are entering a quite unique period in our economic history.

The Clinton presidential campaigns and the operation of the White House give us wonderful examples of how to operate public relations and spin, and even damage control, because crises are always a part of any major endeavor. Something has happened. Now we have a case where the spin seems to be almost negatively induced. Perhaps it is because of the normal legal response, which is to only operate in defense rather than offense . . . and spin is essentially offensive.

It means getting in front of the problem. It means anticipating what will happen and pre-empting the responses from the other side, if there is another side. So we have a wonderful case example earlier of what to do, and now we have a series of dramatic examples of what not to do.

And the country is being put into a place where it does not want to be. It could be so easily solved, not in terms of the underlying conditions, but in terms of the appearance and spin which is so much a part of the media activity. It is too bad and extremely unnecessary.

Just as the failure of Peregrine—the most global and the best of the Asian global firms—signals that the Asian investment crisis is very serious, the end of an era, so does the impending failure of Long Term Capital—the best of the quantitative firms—signal the end of this phase of interest in quantitative investing.

The case of Long Term Capital, rumored to be in trouble for several months, has been broken in a cover story in the forthcoming Business Week. Intellectually, the firm was headed by Bob Merton and Myron Scholes, two recent Nobel Prize winners in economics. It engaged in what were supposed to be minimal-risk investment activities, but they made two very low-odds bets, on leverage, both of which hit at the same time.

In doing so they have reminded us that backtesting and linear investing do not work now at a change point. Instead, we are reminded that we have been in a generation-long period, in which I played some part, of acceptance of details about investments by ignoring major market trends—indexing is one of those; strategy selection by computer is another; trading practices is a third—by emphasizing the details and accepting the theories that one could achieve superior results if the trends remained the same.

But we may have had a turn of the trends now. Linear techniques are being disproved, and we have not yet determined which of the nonlinear techniques will work and how. Research there is too sketchy to apply. We have left one and we have not yet built the foundation of another.

It is a time of confusion and a time of sadness to see a firm with the skills of Long Term Capital leave the scene.

A key issue of the potential resignation of Yeltsin from the presidency is the possibility that he will require a grant of immunity from prosecution for the loss of State assets, through bribery and criminal channels, into privileged hands. Similarly almost all of the reformers are at risk for the same charge, the reformers whom many of us know.

The first shot may have been fired by the prosecutor in the city of St. Petersburg’s office. He has filed charges against Anatoly Sobchak who was mayor during the early period of the Russian federation, and before under Gorbachev. I have had a number of pleasant experiences with Mayor Sobchak. The most intensive was meeting him in Marinsky Palace, the City Hall, on the third day of the Russian coup. He and others, some of whom were friends, had stayed in the city hall for three days without sleep, guarding the city against a group of tanks under the command of the coup-forces on the outskirts of the city, who wanted to come in.

I’m tempted to sing a little ditty, "Money, Money, Money," from the Three Penny Opera, but I won’t because it would discourage those of you who are seeing this. Remember that the song said, "Money makes the world go round, go round, go round," and it does, but the theory of money is often misunderstood.

Many of us think of money as a thing, as a constant, as capital, and as something that can be preserved. We forget that money is not a thing. It is a promise amid a chain of other promises, and if any part of that chain breaks and cannot be replaced by some stronger action or force, or replaced within the chain itself, the chain is broken and the promises are no good.

Money is now shrinking on a global basis—shrinking very drastically, some estimates say, by $200 to $300 billion, or even up to a trillion dollars. And it is not so much that anything is happening to the capital; it is not. But rather, we are operating in a world where promises may not be kept, so money can go up and it can go down. Right now, it is going down and shrinking because we are doubtful that the promises can be kept.

Money needs to be understood, and we have to understand that it has its transient features.

There is an old rubric that says that money management firms deserve the clients they get . . . the best firms get the best clients and so forth. And so it is true also in politics and government service. Populations get the government servants and politicians they deserve. We have been in a period, in the last five years, of Senate hearings, confirmations and the like, and the pool of people for appointive offices has been shrinking.

A number of people, who would otherwise be candidates for high appointive office, cabinet posts and the like, have declined to do so, because they did not want to risk their reputations under the intense scrutiny that one must go through in order to achieve the post or even hold it. Now, politicians, as well, will undergo the same scrutiny—worse, in fact, because of new standards that have arisen--because of the Clinton case. We will subject politicians to a moral standard which few of us could pass. We have already had what may well be, in the case of George Bush, Jr., one of the first visible fallouts from this political process.

It is too bad, and we are all going to be the losers for it. It may affect us for a very long period of time, decades, if not a generation.

It was perhaps lost in the news shuffle, but President Clinton gave an outstanding speech at the Council on Foreign Relations meeting on Monday of this week.

It had about six or seven points, but there were three that were the most important. First, the United States could not expect to be an island of prosperity in a world of want. About 80% of the world’s population is wanting very badly now; about 60% of the world’s GNP is suffering continual decline, and we cannot expect to hold our prosperity under these conditions. Those problems are not being solved. Secondly, he commented on the institutions like the IMF and the World Bank that need drastic reforms. These institutions, along with the United Nations, are vestiges of the Bretton Woods conference and conditions of post-World War II. They are in very, very bad shape and are unable to meet today’s requirements. We may be too late to change them. They need to either wither away, to be replaced by something else, or be drastically overhauled. And third, he dedicated the United States to world growth. I hope those are not hollow words yet I fear they may be.

In a condition when the world is pulling more and more back to nationalism, dedication to greater degrees of foreign commitment may be necessary for American leadership, but it may well be behind the times. But it is essential. It was a good speech and it deserves to be listened to.

Within the next ten years, at least, and probably in the earlier part of that, I believe Marx will be resurrected as one of the great thinkers on capitalism. Much of his idea is encompassed in his simple formulaic expression, MV=PY . . . that is, money supply times its velocity equals price level times GDP in volumetric terms.

In this simple expression we can explain why, when money supply is increasing, confidence is going down. Or the institutions are structurally unable to perform (as they are in Russia) and velocity decreases. Or that prices do some very funny things. Volume usually contracts under these extreme circumstances. And so, using this expression, we keep in mind that we have two quantities to worry about, not just money supply, but also velocity. Velocity at the moment is shrinking. Prices are going to be sticky. Even though raw material input prices are going down, manufacturing costs have probably reached their maximum level, and we may well find later turmoil as companies attempt to gain greater and greater control over the labor component of manufacturing.

It might well be a turbulent time and it is difficult to expect much in the "y," volumetric increase in GDP, under these circumstances.

One of the tasks of the contrarian is to ask the questions that are so deeply embedded in our understanding and assumptions that they are not asked or even understood. I have three candidates . . . questions for which the answers may be helpful in guiding us to contrary answers.

The first: why is growth perceived to be the sole objective of economic enterprise? Is not stability also a possible objective? And growth comes with the possibility of volatility and risk in most cases. Let us think that stability may also be one objective, and that growth has come about as an objective because of a fifty-year expansion in bull markets.

Secondly, and I’ve commented on this before, the notion persists that time is continuous—that time flows, time moves on, time in any one period is connected with any other period—and that we have trends. Time, in fact, in physics, in science, may be discontinuous and unconnected with any other time period, and our assumptions about time having a root in the past leading to clues about the future may be wrong.

Finally, there is the notion of a built-in equity premium. After a fifty-year period of expansion we take for granted that equities will produce higher returns because they have in the past. And we think it is because they have higher degrees of risk.

Are we prepared for the time when risk produces lower returns for equities? Or that risk itself, on closer examination, is something other than volatility but rather risk of loss and risk of being knocked out of the game? So I challenge contrarians to ask those questions that are not even being considered and see what their list may be.

Here is an open letter from President Bill Clinton to House Speaker Newt Gingrich and Majority Leader Trent Lott.

Dear Newt and Trent:

In the "game of gotcha," you got me. And now the issue is a practical one of what happens next, how long it takes, and where do you want to go with it. It is in your hands. I encourage you to take whatever steps you are going to take, decisively and quickly, for the country. Here are the implications.

If this thing drags out with hearings I may well be appearing before Congress, standing at a table with Ms. Lewinsky, and we are asked to recreate the acts in public that were described on television. Seems far-fetched? Not really, based upon what has already happened. Do you want to be known in history as the party who set up such a scene and being known in history as the party which brought the government to a standstill during the time in which some of these acts occurred? And you would also be known as the party, perhaps, in time, that rolled back the national interest for campaign finance reform.

That is a heavy burden to take, particularly when action by the Congress to remove me would put Al Gore, a very well-qualified successor to me, and campaigner, in place to complete my term and undertake his own as the next millennium begins.

I am not sure that you want to carry those burdens on the Republican party’s "CV" as it goes into the next decade. So please think carefully of what these steps are, and let us get on with it.

Discussions will be taking place this week on what to do about Russia, economically. The most likely course is that the West will give up; they will not know what to do. Seemingly, by pumping money to the banking system from the IMF, it will merely pass through and get lost without affecting the economy.

There is another course and that is negative tariffs—in another word, subsidies. But let’s call it negative tariffs because it is easier to understand. The United States and others can target industries in Russia that need to be supported, somewhat as the industries that were supported by MacArthur in Japan, right after World War II. These industries can be high employment industries, and negative tariffs, can be used to subsidize the export of those goods into the United States. They might be tractors or cars; they might be software, services, financial services. Whatever they may be, those that have an employment base.

Let us target the industries that employ people, and get those going right away. Yes, the industries that will be hurt in the United States will scream, but it is worth it.

There is another thing that can be done, as well. Russia can issue a currency backed by something of solid value. It could have a plutonium-backed currency, not US-dollar-backed, not gold-backed, but plutonium-backed.

These two items together might have a chance at fixing that which seems unfixable.

We have all been raised to understand comparative advantage in economics, wherein, through globalization and free flow of capital, each of us learns to practice our own best specialty. By combining all of these separate agents, we produce the best results because everybody does what they can do best by their circumstances, skills and intelligence.

However, we don’t understand comparative disadvantage. Those people who are not only below the poverty line, but below the financial line—where the financial world does not reach them—and below the information line—where the free flow of information does not reach them—become an increasing social drag which must be taken care of. And with nationalization, we have an imperative to develop skills, which are very far from being those we wish to develop.

So now we may be entering a world of comparative disadvantage where, for social purposes, we must support those skills that are not the best. They may be the most local; they may be the most political. But, society as a whole must carry the burden.

In the past five years a new and extremely important field of asset management has grown up called risk control. A risk control manager’s job—often in the center of the position managers and asset managers—is to ensure that the diversification and covariances are in place so that dire results will not occur.

The risk control management process has to be severely challenged with the major story of Long Term Capital Management. All the models that are being used for risk control—and even to buy assets on the basis of small increments and be so confident that you take 90 to 1 leverage, or in the case of many well known institutions, leverage of at least six to one—are to be challenged. I don’t think we can be at all comfortable feeling that we have risk control in hand by looking at the past and thinking that the correlations are stable. They are not. When you are at the tails of events, the tails do not behave like multiples of the means.

Risk control by linear standards becomes nonlinear and we have disasters. Risk control, in the first instance, needs to be challenged, and we may have to go back to such old-fashioned practices as just not taking as much risk of loss.