FinanceProfessor.com

I HAVE NO IDEA WHY I WROTE THIS, BUT HAVE BEEN WANTING TO FOR SOME TIME.  Ignore it or not.  I guess I just wanted to have an answer when people ask me what I would do.   I do not claim any expertise in the area, but rather this is just trying to look at history and finance and come up with a solution to what is the largest problem facing the world today.  I am sure there are many better solutions, but this is one. 

I should preface it by saying (as those of you on the newsletter list know that some of the recent books that I have read are Six Nightmares  by Anthony Lake (which talked long and hard about Terrorism and responses), April 1865 (which also was at least partially centered on what could have happened had the South adopted a terrorism/guerrilla warfare approach), I two books just finished From Beirut to Jerusalem (written in 1989 by NY Times reporter Tom Freidman--I hear he has an updated version -who FWIW is Jewish), in which Israel is harshly attacked for its "Us Vs the World" mentality that  can become a self-fulfilling prophecy, and The Lexus and the Olive Tree also by Tom Freidman in which he plays up the open vs closed market idea.  So I am a bit biased in my thought pattern, but here goes: 

If you believe that this wave of terrorism is at least partially a revolt against globalization (I would say a last gasp attempt), it is working. (gee, Alan Dershowitz is right when he wrote Why Terrorism Works).  Why do I say that it is winning? People are not traveling as much, countries and even households are drawing back upon themselves, the economy has slowed, and there is a true sense of fear in many parts of the world. 

In some ways it is like a return to the Dark Ages.  Now of course it will never go back that far, but since marginal changes are what matter, I think everyone can say that, at least in the short run, terrorism is hurting the global economy and hence winning.  The cost of the terror defenses has been, and continues to be, very high.  Indeed I would argue that the total cost of fighting terrorism is higher than any other type of war.   (Here total cost of war is sum of economic, social, psychological, and in lives, although the number of lives lost is generally much lower than what is lost in other types of war). 

Beyond the monetary costs fighting terrorism, it is a difficult task on many levels.  For example consider the fact (look at Israel for proof) that for every terrorist killed, many more are willing to step into their place.  Thus a battle as such, or even a war, even if won, may lead to a larger war down the road.  Moreover, the security precautions are costly to the economy as is the added risk premium that investors demand.  And it must be noted that both sides of the fight are hurt, not just the eventual winner. 

Thus, the main point of this editorial is that the only way (in the long run) to win a terrorist war is to not fight one.  Robert E. Lee realized this, Sherman, Lincoln, and Grant realized this.  This is why the latter three offered such gentle terms of surrender and why the former "publicly" denounced Jefferson Davis’ plans to continue the war with what would now be called terrorism.

Now before that is misconstrued, it is not a blanket "turn the other cheek" policy of pacifism.  It is a statement that in the long run, the fighting will not, and almost can not, win a terror based war except at costs too high for most.

So since finance is life :-) it only makes sense to try to apply finance theory  to this problem and to find a win-win situation. 

In my corporate finance classes I often tell my students that the more I think about finance, the more convinced I become that at its heart  are two related concepts: information asymmetry and conflicts between various stakeholder groups. 

While the free market system definitely has its problems, it is much better than any other economic system.  The problems that exist moreover are generally derived from lack of information or improper incentives.  Take the well known cases of Enron and the like.  These happened not because people or the free market system is intrinsically bad, but because the various stakeholders did not know what was happening, a classical information asymmetry problem.

"But wait" you say "what about the problem of irrationality?" In economics and finance we generally assume people behave rationally.  Many believe there is nothing rational about terrorism.   Take for example suicide bombings. Sure they are irrational from our perspectives, BUT through the eyes of the terrorist, the bombings are often the only tool they feel they have to win the war they feel they have to fight. 

Try to imagine you and a some friends fighting the US. (Or for that matter try imagine being a Palestinian fighting Israel).  It makes the story of David and Goliath look like a fair fight.  The terrorist group, like the South at the end of the Civil War and dare I say the American Colonists in the Revolutionary War), can not win a traditional war.   So they turn to terrorism.  Taken from this perspective, terrorism is not only rational, but in the minds of the terrorist patriotic. (A la Nathan Hale's "I regret that I have but one life to give to my country" but in addition to "country" many terrorists would add religion.)

So why do terrorists want to fight us?  There are a myriad of reasons of course, but one enormous reason is that the people of these nations see us as the enemy--economically, militarily, socially, and in some cases even religiously.   Why?  Because we want them to change, because of jealousy, and because they often have been raised to believe that. 

This has to change. It will not be easy.  The developed world, but especially the US must be concerned with how our actions are perceived.  We really have to be on our best behavior, because like it or not, we are being watched by everyone.  (It is for this reason why the current debate on whether to ignore the UN is so important.  Fighting a battle on our own, no matter how justified, should be our last resort because even if we win the so-called battle, we may create a more hostile environment which may well spawn yet more terror attacks). 

So rather than fight, lets talk about finance :-)

While I am biased, I believe that economics (and finance) is at the heart of much of their anger.  Why?  It is not enough to say that those opposed to us are merely Islamic Militants.  Why?  Because we want to know what makes them militant.  It is not the Islamic religion.  Many Muslims are as peace-loving as anyone I have ever met.  We need to know what factors lead some to become militant.  If we were to run a regression on this, there would be many independent variables, but I have absolutely no doubt that economic wealth would be a strong predictor of militant behavior. In fact I bet a stronger predictor than religion which so often gets the blame.

The poorness of these nations plays several important roles.  It robs people of hope, it makes people cling to the past for fear of the future, it makes them distrust outsiders, it makes them convinced that the world is out to get them. Additionally since the poor have lower opportunity costs (less to lose) and lower opportunity costs to train and plot, they are more willing to give it all up to become a terrorist. 

The people in these poor nations are willing to believe their leaders and brand Westerners as the "bad guys" because their leaders represent to them security and something they know how to deal with.  Often they see him as their protector (Ex. Bin Laden) who was willing to give money when no one else was.  This relationship is then sustained by a lack of information. 

Two things that all of the terror states have in common (and there is such high multicollinarity I am not sure if the two can be ever be disentangled very well) are closed markets/media and a very poor populace.  For example:
per capita GDP in USD
Open markets:
US 36,200
Canada 27,700
Closed (or just recently opened) markets:
Lebanon 5,200
Syria: 3,200--which is now opening, I predict this number will rise sharply as further barriers are brought down
Iraq: 2,500
North Korea: 1000
Afghanistan: 800
source:http://www.cia.gov/search

It is not coincidence.  However, even here there are no easy answers.   If we accept the evidence that capitalism is the best way to economic success, the poorness of the nation then makes change to a better system (capitalism) even more difficult and more scary, which in turns makes the nation still poorer thereby lowering the likelihood of capitalism still further.  Macculloch and Di Tella have an article that concludes that capitalism is a leap of faith.  Switching to capitalism depends on a faith not only in your own abilities, but also the fairness of the economic game.  The ultra poor lack this faith on both fronts.  The resultant downward spiral further robs people of hope in this life and makes them more willing to fight for a "greater cause.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=361560

Like the anti-globalization protesters at any WTO meeting, many in these so called Terror-states, view business as a win-lose proposition.  (note there is a very very large difference in degree of the two protest groups! I do not mean for even a second to infer that protestors at anti-globalization rallies are terrorists (indeed they are playing a valuable role of making sure globalization is not steam rolling over the poor, what they fail to do is to assure that the poor are not left behind out of the fear of being steam rolled).  However, with the mindset that business is a zero-sum game, it is easy to blame the richer country for the problems of the poorer nations.   And while the richer nations are by no means free of fault, they are not the devil incarnate that many terrorists have been taught to believe.  Rich nations do not aim to make everyone like them (although it sometimes seems it), they do not want to exploit the poor, and we assuredly do not want to take over their countries for oil or anything else. 

Why not?  Because history has shown these actions to be inefficient. Need proof? Look at colonies of any nation you care to mention. 

As for exploiting other nations, this is a concern, but presuming no coercion and full disclosure, it is hard to have someone enter voluntarily into an exploitative transaction. 

And what about claims that we want their oil, or other resources?  Dramatically overstated.  Sure we want cheap resources, but we have no advantage in running their nation to get their resources.  Better to let them sell them to us.  We win and they win.  Again proof can be found in the finance arena: consider IBM.  While IBM uses light bulbs to light its office buildings, it has no plans to takeover a light bulb company.  Why?  It is inefficient. 

Putting everything together, what can be done to solve the root of the terrorism problem?  The common and easy answer is not much. But that leads to building fences (figuratively and literally).  While fence-building is much more effective in the short run at easing the symptoms of terrorism, in the long run it has a much higher cost, especially when opportunity costs and lost freedoms, are considered.. 
So a financial answer is to align incentives and to improve transparency.  By doing this we will take away the reasons they want to fight us. 

None of these cures is easy.  How to align incentives?  One way is to make war (and the flavor de jour terrorism) too costly.  This can be done in several ways.  Ex post, massive retaliation can be used.  This approach, practiced by the Israeli government, is not as effective as one would think.  Why?  One reason is that the culprit is often already dead (ex. a suicide bomber) and the punishment falls on innocent victims, a crime which makes the retaliation as bad as the actual act. (Think “An eye for an eye—pretty soon everyone is blind”).  Economic sanctions?  Again not effective as we would like to believe.  Sanctions punish the innocent more than the guilty--rarely is the ruling class and almost never the actual terrorist harmed.  What is more, the sanctions serve to make the nation even poorer and hence an even better breading ground for more terrorism. 

A better solution is to get to the root problems.  Take away their desire to fight us.  This is not easy in part because closed societies by definition do not have much access to the outside world.  A world where if opened would show that not only are we not out to get them, but that if they are willing, we can both be better off. 

So again why not apply financial theory?  What do we want?  Open borders and higher GDPs.  These leaders (and I use that term loosely, a more appropriate term may be anchors) are like entrenched management in a takeover battle.  They will fight the opening and desire to hide behind their borders while keeping their people poor and uninformed. 

The solution to excessive fighting in financial takeover battles is a golden parachute.  A golden parachute (also platinum) is an excessive severance pay packages that kicks in if the executive is removed from office after the takeover.  This thereby lessens the blow of losing control.  Could something like that work to lessen the blow of losing control of your country?  Probably.  For examaple "if you open your markets are removed from office in the next X years,, we will not try you for war crimes and will pay you X million a year.  (Imagine how the US Civil War may have ended if rather than publicly pushing for gentle peace, Lincoln had said that all Confederate Generals would be executed!  WOuld Lee have surrendered or headed to the hills and launched a terror campaign?  Fortunately we will never know. )
 
Or simply pay the leaders to do what we want.  While this sounds bizarre and in many ways unpalatable (yes it is pretty much a bribe, but done out in teh open), it would be cheaper to align incentives.  For example: “Open your borders to internet connections for all of your people and we will not only pay for the connections, but on top of that here is $10 million a year for you.”
 
Thus, I recommend that the developed world earmark $3b to improving internet access in Iraq, Afghanistan, Indonesia, N. Korea, and other poor nations on the condition that there is no censorship.  That would be an enormous step in reducing poverty and most likely improving relatiions and thereby reducing terrorism. 

While the added riches will win many of the "common" people, we can not afford to pay each of them.  There is another fear of globalization that we have not yet mentioned.  It is a fear that we all have to varying degrees.  The fear of change.  Globalization will mean change.  And change is always scary.  We are asking (indeed forcing if they want to compete globally) people to give up a lifestyle that they are comfortable with.  Add to this the high probability that many will be forced to change jobs (with the accompanying out of work time) as the newly globalized nation is forced to shift its resources to more highly valued uses, and it becomes a fear so great that some turn to anything (including terrorism) to combat the fear. 
How can we lessen this fear?  Again education will go a long ways.  Put yourself in the shoes of those in the poor nation.  You have heard you will be facing more competition.  And you know, if competition comes, you may lose your job, your livelihood, in some instances the only skill you know will soon be worthless.   If you are “let go”, what will happen to your family?  Will you be able to find a new job?  Can you glimpse that fear?  It’s real.

The economist in me says relax, it is only a temporary problem and while you may be out of work for a while, and need to be trained in other areas, these things are only temporary.  Which may be true, but if you have nothing to fall back on, temporary starvation seems much like a permanent problem. 

In the developed world, there is a safety net for these contingencies, there is not in many of these very poor nations.  One financially beneficial move might be for developed nations to help develop the necessary infrastructure to lessen the blow of unemployment and thereby reduce the fear of globalization. 

A drawback for all of these prescriptions is that they cost money and the benefits are not immediate.  But as finance people we can take NPVs, and we know about risk and return.  And Yes this may be seen as a hand-out and we all know that hand-outs are expensive, but in this case they are probably cheaper in the long run than other means of fighting terrorism. 

A second obvious problem is that it can be seen as rewarding bad behavior, but if Lincoln had held that same view, the North and South may still be fighting.