Nigerian frauds decoded: Why the success of scamsters lies in their dumbness

think like a freak

The following email just popped into my mailbox. Have you ever received a similar email?

My Dearest Friend,
I am MR. PAUL ARUNA, The chief auditor in bank of Africa (boa) Burkina Faso West African, One of our customers, with his entire family was among the victims of plane crash and before his death, he has an account with us valued at $27.2million us dollars(twenty-seven million two hundred thousand us dollars) in our bank and according to the Burkina Faso law, at the expiration of Ten years if nobody applies to claim the funds a grace of one year also will be given before the money will revert to the ownership of the Burkina Faso government.
My proposals is that i will like you as a foreigner to stand in as the next of kin or distant cousin for us to claim this money, so that the fruits of this old man’s labour will not get into the hands of some corrupt government officials who will later use the money to sponsor war in Africa and kill innocent citizens in the search for political power.
As a foreign partner which this money will be transfer into your account, you are entitle to 40% of the total money while 55% will be for me as the moderator of this transaction and 5% will be mapped out for any expenditure that may be incur during the course of this transaction. Please note that there will be no problem as my bank has made all effort through to reach for any of his relation but all was fruitless.
My position as the chief auditor in this bank guarantees the successful execution of this (deal) transaction.

Please send the following:
1) Your full name…..
2) Sex…..
3) Age…..
4) Country…..
5) Passport or photo…..
6) Occupation…..
7) Personal Mobile number…..
8) Personal fax number…..
9) Home & office address…..

Chances are you receive an email along these lines almost everyday or maybe even more than one a day. Instead of a chief auditor, as is the case with the above email, you might get an email from the widow of a billionaire or a deposed prince. While the details might change, the overall theme of such emails continues to remain the same.
As Steven D Levitt and Stephen J Dubner write in Think Like a Freak—How to Think Smarter About Almost Everything “In each case, the author[of the email] has rights to millions of dollars but needs help extracting it from a rigid bureaucracy or uncooperative bank.”
And this is where you come in. You will need to share your bank-account information along with other personal information. This will help the sender of the email “to park the money in your account until everything is straightened out”. As Levitt and Dubner write “There is a chance you will need to travel to Africa to handle the sensitive paperwork. You may also need to advance a few thousand dollars to cover up some up-front fees. You will of course be richly rewarded for your trouble.”
Does any of this tempt you to reply to your email? Most of us delete such an email as soon as we see the subject of the email. We don’t even bother to read it, before it goes into the junk box of our email account. This fraud is known as the Nigerian letter fraud (even though the email that I share at the beginning of this article has come from Burkina Faso.)
In fact, this is a scam that has survived the test of time. “An early version was known as the Spanish Prisoner. The scammer pretended to be a wealthy person who’d been wrongly jailed and cut off from his riches. A huge reward awaited the hero who would pay for his release. In the old days, the con was played via a postal letter or face-to-face meetings; today it lives primarily on the Internet,” write Levitt and Dubner.
Since the advent of the internet, the Nigerian scam has taken on a life of its own. But the question is all these years later, when the scam is pretty well known, do people really fall for it? Further, why haven’t these scammers gone around fine tuning their story? Why does almost everyone who uses an email continue to get emails with the same basic “sob” story when it comes to the Nigerian scam? And why does almost every scammer who sends out an email claim to be from Nigeria or some other West African country?
Cormac Herley of Microsoft Research decided to investigate this question. As he asks it in a research paper titled Why do Nigerian Scammers Say They are from Nigeria? “An examination of a web-site that catalogs scam emails shows that 51% mention Nigeria as the source of funds, with a further 34% mentioning Cˆote d’Ivoire, Burkina Faso, Ghana, Senegal or some other West African country…Why so little imagination? Why don’t Nigerian scammers claim to be from Turkey, or Portugal or Switzerland or New Jersey?”
Stupidity can’t be an answer. As Herley puts it “Stupidity is an unsatisfactory answer: the scam requires skill in manipulation, considerable inventiveness and mastery of a language that is non-native for a majority of Nigerians. It would seem odd that after lying about his gender, stolen millions, corrupt officials, wicked in-laws, near-death escapes and secret safety deposit boxes that it would fail to occur to the scammer to lie also about his location. That the collection point for the money is constrained to be in Nigeria doesn’t seem a plausible reason either. If the scam goes well, and the user is willing to send money, a collection point outside of Nigeria is surely not a problem if the amount is large enough.”
So what can possibly explain this? The Nigerian (or any other West African for that matter) scammer carrying out this fraud needs to send out many emails initially. Hence, the cost of contacting a possible victim is very low. But at the same time his chances of getting hold of a possible victim who he can engage in a conversation over email, are also very low.
“An email with tales of fabulous amounts of money and West African corruption will strike all but the most gullible as bizarre. It will be recognized and ignored by anyone who has been using the Internet long enough to have seen it several times. It will be figured out by anyone savvy enough to use a search engine and follow up on the auto-complete suggestions…It won’t be pursued by anyone who consults sensible family or fiends, or who reads any of the advice banks and money transfer agencies make available,” writes Herley.
That being the case why go through so much trouble? The Nigerian sending the email cannot know in advance “who is gullible who is not?”. As Levitt and Dubner put it “Gullibility is in this case an unobservable trait.” So what explains this?
Herley provides the answer. As he writes “Those who remain are the scammers ideal targets. They represent a tiny subset of the overall population…The initial email is effectively the attacker’s classifier: it determines who responds, and thus who the scammer attacks (i.e., enters into email conversation with). The goal of the email is not so much to attract viable users as to repel the non-viable ones, who greatly outnumber them.”
To put it in simple English, the scammer essentially wants to identify individual(s) who haven’t heard o
f the Nigerian scam. As Herley told Levitt and Dubner “The scammer wants to find the guy who hasn’t heard of it…Anybody who doesn’t fall off their chair laughing is exactly who he wants to talk to.”
Such a gullible individual is most likely to send across thousands of dollars to someone he does not know based just on an email about a lost fortune. And this is why the Nigerian scam continues to look so do dumb. Its dumbness is what makes it so successful.
As Herley puts it in his research paper “A less outlandish wording that did not mention Nigeria would almost certainly gather more total responses and more viable responses, but would yield lower overall profit. Recall, that viability requires that the scammer actually extract money from the victim: those who are fooled for a while, but then figure it out, or who balk at the last hurdle are precisely the expensive false positives that the scammer must deter.”

The article appeared on on August 17, 2014


(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)


The power of context

Vivek Kaul

We live in an era of instant coffee and analysis.
Even before something has happened, the analysis on why it has happened is ready. Given this, it leads to situations where we analyse using what we think is “common sense”.
But common sense does not always work. The simplest answer is not always the right one. Life can get a little more complicated than that.
Consider the story of a woman who the economists Abhijit V Banerjee and Esther Duflo met in the slums of Hyderabad. The economists recount this story in their book
Poor Economics-Rethinking Poverty & the Ways to End It: “A woman we met in a slum in Hyderabad told us that she had borrowed Rs 10,000 from Spandana and immediately deposited the proceeds of the loan in a savings bank account. Thus, she was paying a 24 percent annual interest rate to Spandana, while earning about 4 percent on her savings account.” Spandana is a micro-finance institution.
Common sense tells us that anyone in their right mind wouldn’t do anything like this. But the economists soon found out that there was a method to the madness, once they saw the context in which the woman was operating.
As they write: “When we asked her why this made sense, she explained that her daughter, now 16, would need to get married in about two years. That Rs 10,000 was the beginning of her dowry. When we asked why she had not opted to simply put the money she was paying to Spandana for the loan into her savings bank account directly every week, she explained that it was simply not possible: other things would keep coming up…The point, as we eventually figured out, is that the obligation to pay what you owe to Spandana – which is well enforced -imposes a discipline that the borrowers might not manage on their own.”
Once viewed in this context the story makes immense sense. The woman was borrowing at 24% and investing it at 4% in order to build a savings kitty for her daughter’s dowry. Of course,
prima facie this wouldn’t have seemed obvious at all. As Nicholas Epley writes in Mindwise: How We Understand What Others Think, Believe, Feel, and Want “The mistakes we make when reasoning about the minds of others all have the same central outcome: underestimating their complexity, depth, detail, and richness. When we’re indifferent to others, it’s easy to overlook their minds altogether, treating such people as relatively mindless animals or objects than as fully mindful persons.”
Epley gives a brilliant example of people who chose to stay back in in New Orleans when Hurricane Katrina hit the city in August 2005. The experts were at it with their instant analysis. As ABC News put it, “It’s hard to understand the mind-set of those who ignored evacuation orders.” Michael Chertoff, the Chief of Homeland Security said that those who stayed back made a “mistake on their part”. Psychiatrists suggested that there was a “certain amount of denial involved” on part of those who had chosen to stay back in New Orleans, given that they believed that they could handle the storm.
All these explanations sound pretty convincing, “but it does not resonate as well with the actual experience of most who left and stayed, because the broader context is not quite as easy to see.” It is simple to come to the conclusion that anyone choosing to stay back and take on a category 5 hurricane was not right in the head. But anyone who came to that conclusion ignored the context in which the people who had chosen to stay back, were operating.
As Epley writes “Compared to those who left, those who stayed were disproportionately poor, had geographically narrower social network, had larger families (both children and extended members), had less access to reliable news, and were considerably less likely to own a car.” And given this it was not easy for these people to just pack up and leave.
“If you had money to pay for an extended hotel stay, relatively small family to move, a car to get all of you there, or had far-away friends to stay with, you could
choose to leave. If you had no money for an extended hotel stay, no car to get you out, a large family to move and no long distance-friends to stay with, what choice did you have?” asks Epley.
Of course, people who analysed the situation did not understand this broader context. Given this, before passing judgements it is important to understand the context in which people are operating. People who chose to stay back when Katrina hit New Orleans, did not need convincing to leave the city, what they needed was a bus. As Epley puts it “Many who stayed wanted to desperately to leave but couldn’t. They didn’t need
convincing, they needed a bus.”
And what about the woman who borrowed money at 24% and invested it at 4%? What it clearly tells us is that there is a need for a savings solution which allows the poor to save on a daily basis. If they can discipline themselves to pay back micro-finance institutions every week, they can easily discipline themselves to save small amounts on a daily basis. Of course, there are financial institutions which cater to this market, but most of them are of dubious nature. Hence, there is a clear market out there for anyone who is willing to take the risk.

The article originally appeared in the Wealth Insight magazine August 2014

(Vivek Kaul is the author of Easy Money: Evolution of the Global Financial System to the Great Bubble Burst. He can be reached at [email protected])

The Role Of Family In Good Education Is Really Important: James Heckman


Professor James J. Heckman is the Henry Schultz Distinguished Service Professor of Economics at the University of Chicago, where he also serves as Professor in the University of Chicago’s Law School and Harris School of Public Policy. In 2000, Professor Heckman won the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (more commonly referred to as the Nobel Prize in Economics). In this interview he speaks to Forbes India on various aspects of education.

In India we have launched the right to education where we are trying to put children from poor families into good schools run by the private sector. Do you think this kind of approach will work?
I think engaging the private sector is always a good idea but I also think that you have to make sure that the private sector is fully responsive to a particular question. We know from my own experience in US that the private sector in early childhood education programmes can help respond to cultural, social and parental religious values that would adapt programmes to be where the children and parents want to be. The private sector can also generate funds and support outside the government
. So not only can it communicate information about diverse groups interest but it can also help finance those programs and raise support and also kind of shape the agenda in a way that is fully responsive to different elements of the society.
In India the poor have shown an increasing preference for paying a higher fees and shifting their children to private schools and this is what prompted the government to say that private schools have to take in a huge diverse population from different background both at the early education stage and later. Is it a good approach when 90% of the schools are actually run by the state?
I don’t want to pretend to be an expert on the Indian education. But I have seen some of the studies and I don’t think if they completely control for the issue of selectivity, which is that children attending private schools have parents who are more motivated. That is a problem that runs throughout the world and not just in India. But it does seem like the private schools are doing a better job, at least superficially, but again I haven’t studied the problem in depth.
You talked about this problem running throughout the world…
Look one thing we have found in American education and education in Chile and other countries is that when the private sector and the public sector coexist, in many cases the private sector can help the public sector become more responsive to the children. And so they compete. In that sense competition can promote quality in both public and private sector. John Hicks the famous economist talked about the benefits of monopoly. He said that benefit of monopoly was that a monopolist can live a quiet life. The monopolist doesn’t have to compete and I think that is probably equally true in education as it is in steel or any other activity
When you spoke about selectivity you seem to think that private schools may or may not be necessarily better but the kind of students that self select themselves into these schools may be giving them better results. Is that what you are trying to say?
Oh yes. The motivated parents are the ones trying to achieve better results for their children. And we know that parenting is an important part of success of schools. Good parenting can be a very powerful factor leading to the success of the child and may be we attribute too much credit to the school attended by the child and probably underestimate the powerful role of the parent and the motivation of the parent.
As an aside, are you aware of the Amy Chua’s Tiger Mom concept. Do you think it has a huge impact in the kind of student performances of children coming from certain communities?
Yeah, I think it is. I know she goes to extremes in proving her theory. There is a difference that we make sometimes between an authoritarian mother and an authoritative mother. And I think tiger mom sounds a little too authoritarian. What you want is the mother to be informed and provide guidance to the child and I think that is an important distinction. If you look at Asian communities in the United States, for example Indian or Chinese communities, a lot of those children come from those homes that are very highly motivated.
Can you tell us a little bit more about that?
James Flynn talked about the Flynn effect, where each generation has a higher score and IQ than the previous one, sometimes by a substantial amount. He asked the question that why was it that Asian American children that included Japanese Americans, Indian Americans and Chinese Americans, were doing so well in school? The initial feeling was that there was some superiority in terms of IQ of the Asian population. But when Flynn looked at the data he found that these children were more motivated. They were working harder, were doing more homework, their parents co-operated with them and so forth. So I don’t know if they were tiger moms but they were families that were staying with the kids, motivating the kids and that is really part of what gave the culture. So the role of the family is really important. And I think some of the advantage of one culture or one ethnic group over another is precisely that.
What do you mean by that?
For example in the United States now, we have many children from Mexican-American families and for whatever reason the value placed on education is much lower. It is not uncommon to allow their children to drop out of school. They see the role of their child as following them, as doing a certain kind of manual labour. They don’t have any aspirations, may be because that they think there is no chance for their children in those other occupations. Hence, a part of the whole notion has been to educate those parents about the value of higher education.
How much does the quality of early education impact how well an individual does in life?
Let me tell you that I have seen from US data and I think this may be true in other countries, that the gap in achievement tests scores that is present when people leave secondary school, most of that gap is present when they enter school and kindergarten. So the early preschool years are playing a huge role. And you say, well maybe that is genetics, the family is smarter. There are more advantaged parents and they have more advantaged children, and better performing children and the gap you see in tests scores at age six or age five is may be a genetic gap. That is when the intervention studies come along and show that you can close a lot of that gap by essentially giving disadvantaged families some of the same advantages that advantaged children have. So it is not purely genetic. That’s an old idea, in fact there is lot of work showing that environment plays a big role. Genes play a role, but its not all set by the genes.
Should students be given exams from a
very young age? Is there some research on that?
I would say yes because you want to be able to monitor and measure children through out their life time. And the reason why it is useful is it guides teachers and the parents about where the child is behind and needs special effort. But having said that, we also need broader measures of what a child’s achievement is. So we want to go beyond just the notion of a test score or reading or writing, but to have a broader inventory of things like what is sometimes called non-cognitive or character skills. Character plays a very important role and we can shape characters, parents shape characters, schools shape characters, peers shape characters and we have a way to measure it.
How important is class size when it comes to delivering education? How small or big should a class be?
The younger the child, the smaller the class size should be. So when you get to these very young preschools, it seems like a ratio of three children per one teacher is about the right size. I am talking about kids one year of age who are very demanding, so you really cant supervise them. However, when you get to higher levels of education, class sizes can grow and there the evidence on class size is a little bit weaker. Schools in the north east of Brazil did not even have a roof over their heads. They imagined trees, they had no text books. So spending more money on those schools turned out to be a very good thing. They had a huge number of students and a very small number of teachers. So smaller classes and more resources played a huge role in increasing the Brazilian quality of schooling. But if you were to move that discussion to Sao Paulo, just go south into a more urban area, then large classrooms per say were not the problem, even resources per say weren’t the problem. It was typically what happened to the kids when they walked into the classroom from the aspect of student disciple and so on, that was the problem. So I think the focus in the past has been on the class size and that may have been overstated.
Can you elaborate on that?
Some 15 years back I did some calculations and what we suggested was that if you reduced the teacher pupil ratio by the amount suggested in certain influential studies, what happened was you boosted the incomes of the children. But if you ask that did it pay for itself in terms of what the increased teachers salaries were and the increased numbers of schools that came with reducing pupil teacher ratio, it did not. It was actually more efficient to give the children money and put it in the bank than it was to give the children few more teachers or have more classroom size. So, I would say the more important thing is creating efficiency within the school system than just having fewer students per teacher.
Just to shift the field, I think you have been a bit of a skeptic on the ability of the markets ultimately delivering the best results, even though you come from the Chicago School…
Be careful now. Suppose a child is born into a poor family. The resources available to that child are not to the same extent as to what some other child is getting. And that child who gets poor resources by what is basically a luck of the draw is very bright. He had a great future possibly but isn’t able to realise it. Then the question is that is there insurance against this kind of possibility? If there can be, you can literally imagine a market where fetuses would be buying insurance against having bad parents. But that market doesn’t exist and the point is that there is a kind of market failure which is related to the accidental birth and I think that is a very traditional Chicago argument that the parents play a big role and the child cannot control the families that they are born into.
That’s a very interesting way of putting it…
What I said is the result of what many people including my former colleague now deceased Milton Friedman, had to say. Friedman was a very strong believer in public education and that has been forgotten. As a very poor child, he was the beneficiary of public school education. The point you want to make a distinction on is that education provides a very basic framework for human capability. Adam Smith said that himself. So, this is not at odd with any things in economics. And the point is, very poor parents, somebody living in a very rural area in India or China for that South America, it may well be that the parent cant afford or doesn’t have the resources or even access to education for his children. So there is a role for government in providing resources. But having said that there is still a huge role for the private sector in making sure that the resources are used effectively.
In India, we are debating a law about the value of specific quotas especially in higher education, jobs and other thing,s as opposed to affirmative action where a company or a higher educational institution is expected to seek diversity rather than actually fill up quotas. What is the global experience on this front?
There was a similar debate in Brazil and I actually participated in that debate. In Brazil they started putting affirmative action in place, in the sense that blacks would be given privileges to go to medical school, professional schools and they worked. And what also happened is that Brazil had largely been racially unconscious in the sense that they were many poor blacks but there were many poor whites too. True, there were more blacks than probably white but there were awful lot of whites in poverty as well. Now, what happened is as you created a level of racial consciousness, it turned out that many people who looked very European, once the orders were given were actually trying to find out evidence if they had one thirty second black, so they could somehow claim credibility. So I worry, I definitely don’t like discrimination. And discrimination is a serious thing. It is very harmful, it just denies dignity to people. But I think reverse discrimination also denies dignity too.
Can you elaborate on that?
We want a society that doesn’t discriminate so I don’t know if tilting the scale in another direction is so good either. I think we want fairness. But I would say this that inequality starts really early in life and if we want any kind of affirmative action then it is probably helping the disadvantaged-white, black, high caste, low caste and so on. I think probably the idea of giving the skills and capabilities to people that allow them to flourish is probably a much better policy than kind of mandating equality in the face of gaps in skills. And I am afraid what happens in some case is that unqualified people are promoted at positions that they can not satisfy and that creates negative image which can actually undo the intentions.

 The article originally appeared in the Forbes India magazine edition 

Global market bubbles: Raghuram Rajan will have the last laugh second time around


Vivek Kaul

The Federal Reserve Bank of Kansas City is one of the 12 Federal Reserve banks in the United States. Every year in August it organizes a symposium at Jackson Hole in the state of Wyoming. The conference of 2005 was to be the last conference attended by Alan Greenspan, the then Chairman of the Federal Reserve of the United States, the American central bank.
The theme of the symposium was the legacy of the Greenspan era. Those were the days when Greenspan was god, and hence, the economists who had turned up at the conference, were expected to say good things about him and his time as the Chairman of the Federal Reserve of United States, which had lasted close to two decades.
One of the economists attending the conference was Raghuram Rajan, who at that point of time was the Chief Economist of the International Monetary Fund. Rajan presented a paper titled 
Has Financial Development Made the World Riskier?” at the conference. 
As Neil Irwin writes in The Alchemists—Inside the Secret World of Central Bankers “Raghuram Rajan presented a rare moment of clarity at the 2005 conference. Rajan indeed had an astute understanding of the ways in which the financial industry, with misguided compensation policies that encouraged risk-taking, was making the world a more dangerous place: Bankers were paid big bonuses for making money in the short run even if they were betting poorly in the long run.”

Rajan in his speech also suggested that banks were not in the best shape as was being made out to be. As he put it The bottom line is that banks are certainly not any less risky than the past despite their better capitalization, and may well be riskier. Moreover, banks now bear only the tip of the iceberg of financial sector risks…the interbank market could freeze up, and one could well have a full-blown financial crisis.”
In the last paragraph of his speech Rajan said that “One source of concern is housing prices that are at elevated levels around the globe.” Rajan’s speech did not go down well with people at the conference. This is not what they wanted to hear.
Rajan recounts the situation in his book
Fault Lines – How Hidden Fractures Still Threaten the World Economy: “I exaggerate only a bit when I say I felt like an early Christian who had wandered into a convention of half-starved lions. As I walked away from the podium after being roundly criticized by a number of luminaries (with a few notable exceptions), I felt some unease. It was not caused by the criticism itself…Rather it was because the critics seemed to be ignoring what going on before their eyes.”
Rajan’s prediction turned out to be right in the end and a little over three years later in September 2008, the world was in the midst of a full-blown financial crisis, the impact of which is still being felt, almost six years later. Banks and financial
institutions about the go bust had to be rescued by governments all over the Western world. Also, in the aftermath of the crisis, Western governments and their central banks decided to print trillions of dollars in order to get their economies up and running again.
Now Rajan has sounded a warning again.
In an interview to the Central Banking Journal which was published a few days back Rajan said “The problems arising are not so much from credit growth, which is relatively tepid in the industrial markets and has been much stronger in emerging markets, but from asset prices due to financial risk-taking and so on. Unfortunately, a number of macroeconomists have not fully learned the lessons of the great financial crisis. They still do not pay enough attention – en passant – to the financial sector. Financial sector crises are not as predictable. The risks build up until, wham, it hits you. So it is not like economic growth, where unemployment offers a more continuous indicator.”
What Rajan is essentially saying here is that all the money printed and pumped into the financial system by the American and other Western governments has led to financial market bubbles all over the world. And these bubbles when they burst will lead to another financial crisis. As Rajan put it “We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost.”
Rajan went on to suggest that central banks have had a role to play in creating financial market bubbles all across the world. As he put it “The kind of language we hear is akin to gaming. Investors say, ‘we will stay with the trade because central banks are willing to provide easy money a
nd I can see that easy money continuing into the foreseeable future’. It’s the same old story. They add ‘I will get out before everyone else gets out’.”

In another interview to the Time magazine published on August 11, 2014, Rajan said “A number of years over which we, as central bankers, have convinced markets that we continuously come to their rescue and that we will keep rates really low for long — that we do all kinds of ways of infusing liquidity into the markets — has created markets that tend to push asset prices probably significantly beyond fundamentals, in some cases, and make markets much more vulnerable to adverse news.”
One of the reasons for the bubbles is the fact that compensation structures which encourage high financial risk-taking are back on Wall Street. The following table makes for a very interesting reading.bonus to profit ratio

Source: The Office of New York State Comptroller

In 2007 and 2008, the Wall Street firms faced huge losses. But their employees still got their bonuses. In fact, in 2007, the total bonus had stood at $33 billion. This, when firms had faced losses of $11.3 billion.
In the year 2009, the Wall Street firms made a profit of $61.4 billion because of all the bailout money given by the government. Even during the heydays of the bull run between 2003 and 2006, the firms had not made that kind of money.
Interestingly, if one looks at the bonus-to-profit ratio between 2003 and 2006, it stands at 1.55. For the period after the financial crisis, between 2010 and 2013, the ratio stands at 1.48. There is not much material difference between the two ratios.
What this clearly tells us is that the bonus paid as a proportion of profits continues to remain high among Wall Street firms. Hence, the “risk” that these high bonuses built into the American financial system continues.
As Michael Lewis writes in Flashboys: “Once the very smart people are paid huge sums of money to exploit the flaws in the financial system, they have the spectacularly destructive incentive to screw the system further, or to remain silent as they watch it being screwed by others.”
What Rajan had warned about in 2005 continues unabated and that has led to financial market bubbles all over the world. The real estate bubbles which played a major role in the financial crisis which started in September 2008, are also back with a bang. As Albert Edwards of Societe Generale wrote in a research note titled
Here we go again…and once again no-one is listening “We are in the midst of the mother of all housing bubbles.
The economist
Nouriel Roubini wrote in a November 2013 column “Now, five years later, signs of frothiness, if not outright bubbles, are reappearing in housing markets in Switzerland, Sweden, Norway, Finland, France, Germany, Canada, Australia, New Zealand, and, back for an encore, the UK (well, London). In emerging markets, bubbles are appearing in Hong Kong, Singapore, China, and Israel, and in major urban centers in Turkey, India, Indonesia, and Brazil.”
Over and above this the stock market in the United States continues to rise. As investment newsletter writer
Gary Dorsch puts it in a June 2014 column “The “Least Loved” Bull market is still running on steroids, even at 63-months old. The median lifetime of the Top-12 Bull markets is 55-months. So it’s lasted 8-months beyond its mid-life. A -10% correction hasn’t happened for the past 34-months, far beyond the average of 18-months between corrections.”
And when these bubbles start bursting all over again, as they are bound to do, there will be trouble along the lines Rajan has been talking about. He might have the “last laugh” second time around as well. Though until that happens he may still be the “
early Christian who [has] wandered into a convention of half-starved lions”.

The article was originally published on on August 14, 2014

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The extortionate privilege of the dollar

3D chrome Dollar symbolVivek Kaul

On May 31, 2014, the total outstanding debt of the United States government stood at $17.52 trillion. The debt outstanding has gone up by $7.5 trillion, since the start of the financial crisis in September 2008. On September 30, 2008, the total debt outstanding had stood at $10.02 trillion.
In a normal situation as a country or an institution borrows more, the interest that investors demand tends to go up, as with more borrowing the chance of a default goes up. And given this increase in risk, a higher rate of interest needs to be offered to the investors.
But what has happened in the United States is exactly the opposite.
In September 2008, the average rate of interest that the United States government paid on its outstanding debt was 4.18%. In May 2014, this had fallen to 2.42%.
When the financial crisis broke out money started flowing into the United States, instead of flowing out of it. This was ironical given that the United States was the epicentre of the crisis. A lot of this money was invested in treasury bonds. The United States government issues treasury bonds to finance its fiscal deficit.
As Eswar S Prasad writes in The Dollar Trap—How the US Dollar Tightened Its Grip on Global Finance “From September to December 2008, U.S. securities markets had net capital inflows (inflows minus outflows) of half a trillion dollars…This was more than three times the total net inflows into U.S. securities markets in the first eight months of the year. The inflows largely went into government debt securities issued by the U.S. Treasury[i.e. treasury bonds].”
This trend has more or less continued since then. Money has continued to flow into treasury bonds, despite the fact that the outstanding debt of the United States has gone up at an astonishing pace. Between September 2008 and May 2014, the outstanding debt of the United States government went up by 75%.
The huge demand for treasury bonds has ensured that the American government can get away by paying a lower rate of interest on the bonds than it had in the past. In fact, foreign countries have continued to invest massive amounts of money into treasury bonds, as can be seen from the table.
foreign debt US
Between 2010 and 2012, the foreign countries bought around 43% of the debt issued by the United States government. In 2009, this number was slightly lower at 38.1%.
How do we explain this? As Prasad writes “The reason for this strange outcome is that the crisis has increased the demand for safe financial assets even as the supply of such assets from the rest of the world has shrunk, leaving the U.S. as the main provider.”
Large parts of Europe are in a worse situation than the United States and bonds of only countries like Austria, Germany, France, Netherlands etc, remain worth buying. But these bonds markets do not have the same kind of liquidity (being able to sell or buy a bond quickly) that the American bond market has. The same stands true for Japanese government bonds as well. “The stock of Japanese bonds is massive, but the amount of those bonds that are actively traded is small,” writes Prasad.
Also, there are not enough private sector securities being issued. Estimates made by the International Monetary Fund suggest that issuance of private sector securities globally fell from $3 trillion in 2007 to less than $750 billion in 2012. What has also not helped is the fact that things have changed in the United States as well. Before the crisis hit, bonds issued by the government sponsored enterprises Fannie Mae and Freddie Mac were considered as quasi government bonds. But after the financial mess these companies ended up in, they are no longer regarded as “equivalent to U.S. government debt in terms of safety”.
This explains one part of the puzzle. The foreign investors always have the option of keeping the dollars in their own vaults and not investing them in the United States. But the fact that they are investing means that they have faith that the American government will repay the money it has borrowed.
This “childlike faith of investors” goes against what history tells us. Most governments which end up with too much debt end up defaulting on it. Most countries which took part in the First World War and Second World War resorted to the printing press to pay off their huge debts. Between 1913 and 1950, inflation in France was greater than 13 percent per year, which means prices rose by a factor of 100. Germany had a rate of inflation of 17 percent, leading to prices rising by a factor of 300. The United States and Great Britain had a rate of inflation of around 3 percent per year. While that doesn’t sound much, even that led to prices rising by a factor of three1.
The inflation ensured that the value of the outstanding debt fell to very low levels. John Mauldin, an investment manager, explained this technique in a column he wrote in early 2011. If the Federal Reserve of the United States, the American central bank, printed so much money that the monetary base would go up to 9 quadrillion (one followed by fifteen zeroes) US dollars. In comparison to this the debt of $13 trillion (as it was the point of time the column was written) would be small change or around 0.14 percent of the monetary base
In fact, one of the rare occasions in history when a country did not default on its debt either by simply stopping to repay it or through inflation, was when Great Britain repaid its debt in the 19th century. The country had borrowed a lot to finance its war with the American revolutionaries and then the many wars with France in the Napoleonic era. The public debt of Great Britain was close to 100 percent of the GDP in the early 1770s. It rose to 200 percent of the GDP by the 1810s. It would take a century of budget surpluses run by the government for the level of debt to come down to a more manageable level of 30 percent of GDP. Budget surplus is a situation where the revenues of a government are greater than its expenditure3.
The point being that countries more often than not default on their debt once it gets to unmanageable levels. But foreign investors in treasury bonds who now own around $5.95 trillion worth of treasury bonds, did not seem to believe so, at least during the period 2009-2012. Why was that the case? One reason stems from the fact nearly $4.97 trillion worth of treasury bonds are intra-governmental holdings. These are investments made by various arms of the government in treasury bonds. This primarily includes social security trust funds. Over and above this around $4.5 trillion worth of treasury bonds are held by pension funds, mutual funds, financial institutions, state and local governments and households.
Hence, any hint of a default by the U.S. government is not going to go well with these set of investors. Also, a significant portion of this money belongs to retired people and those close to retirement. As Prasad puts it “Domestic holders of Treasury debt are potent voting and lobbying blocs. Older voters tend to have a high propensity to vote. Moreover, many of them live in crucial swing states like Florida and have a disproportionate bearing on the outcomes of U.S. presidential elections. Insurance companies as well as state and local governments would be clearly unhappy about an erosion of the value of their holdings. These groups have a lot of clout in Washington.”
Nevertheless, the United States government may decide to default on the part of its outstanding debt owned by the foreigners. There are two reasons why it is unlikely to do this, the foreign investors felt.
The United States government puts out a lot of data regarding the ownership of its treasury bonds. “But that information is based on surveys and other reporting tools, rather on registration of ownership or other direct tracking of bonds’ final ownership. The lack of definitive information about ultimate ownership of Treasury securities makes it technically very difficult for the U.S. government to selectively default on the portion of debt owned by foreigners,” writes Prasad.
Over and above this, the U.S. government is not legally allowed to discriminate between investors.
This explains to a large extent why foreign investors kept investing money in treasury bonds. But that changed in 2013. In 2013, the foreign countries bought only 19.6% of the treasury bonds sold in comparison to 43% they had bought between 2010 and 2012.
So, have the foreign financiers of America’s budget deficit started to get worried. As Adam Smith wrote in
The Wealth of Nations “When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. The liberation of the public revenue, if it has been brought about at all, has always been brought about by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment [i.e., payment in an inflated or depreciated monetary unit].”
Have foreign countries investing in treasury bonds come around to this conclusion? Or what happened in 2013, will be reversed in 2014? There are no easy answers to these questions.
For a country like China which holds treasury bonds worth $1.27 trillion it doesn’t make sense to wake up one day and start selling these bonds. This will lead to falling prices and will hurt China also with the value of its foreign exchange reserves going down. As James Rickards writes in
The Death of Money “Chinese leaders realize that they have overinvested in U.S. -dollar-denominated assets[which includes the treasury bonds]l they also know they cannot divest those assets quickly.”
It is easy to see that the United States government has gone overboard when it comes to borrowing, but whether that will lead to foreign investors staying away from treasury bonds in the future, remains difficult to predict. As Prasad puts it “It is possible that we are on a sandpile that is just a few grains away from collapse. The dollar trap might one day end in a dollar crash. For all its logical allure, however, this scenario is not easy to lay out in a convincing way.”
Author Satyajit Das summarizes the situation well when he says “Former French Finance Minister Valery Giscard d’Estaing used the term “
exorbitant privilege” to describe American advantages deriving from the role of the dollar as a reserve currency and its central role in global trade. That privilege now is “extortionate.”” This extortionate privilege comes from the fact that “if not the dollar, and if not U.S. treasury debt, then what?” As things stand now, there is really not alternative to the dollar. The collapse of the dollar would also mean the collapse of the international financial system as it stands today. As James Rickards writes in The Death of Money “If confidence in the dollar is lost, no other currency stands to take its place as the world’s reserve currency…If it fails, the entire system fails with it, since the dollar and the system are one and the same.”

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The article appeared originally in the July 2014 issue of the Wealth Insight magazine

1T. Piketty, Capital in the Twenty-First Century(Cambridge, Massachusetts and London: The Belknap Press of Harvard University Press, 2014)

2 Mauldin, J. 2011. Inflation and Hyperinflation. March 10. Available at, Downloaded on June 23, 2012

3T. Piketty, Capital in the Twenty-First Century(Cambridge, Massachusetts and London: The Belknap Press of Harvard University Press, 2014)