Wall Street Lessons for Nuclear Deterrence

Before making financial decisions involving billions of dollars, one would think that CFO’s and investors might consider how their decisions would play out under different scenarios. But news coverage of a failed, multi-billion dollar market known as auction rate preferred securities (ARPS) shows that many blindly assumed that, what had worked in the past, would work forever.

This morning’s Wall Street Journal had an article (“Wrong-Way Financial Bets Have Hit Hard,” July 8, Pages C1 and C3) that exemplified this financial blindness when it said, “Wall Street firms … say no one could have foreseen the crisis that cratered the auction-rate securities market.” But, in reality, it was not hard to see the danger well before it materialized.

In September 2002, my broker encouraged me to buy ARPS as a “near money market investment” that paid higher interest rates. At first I took his advice, but in April 2004, after exploring some potential scenarios, and fully four years before the ARPS market cratered, I concluded that the risks were much greater than advertised and got out. All one had to do was ask some obvious questions [1] instead of relying on the mistaken, but widely-held belief that these securities would always function as they had in recent years.

That same danger applies to nuclear deterrence. Given that its success depends on world leaders behaving rationally, here are just two of the many questions that help illuminate the risk:

What if a world leader is not in his or her right mind during a crisis?

Mental illness can strike without warning, and even when a world leader appears mentally unbalanced, he often continues in his post. While Yeltsin is perhaps the most obvious such case, Richard Nixon’s mental stability was uncertain during the final days prior to his humiliating resignation. John F. Kennedy suffered from chronic back pain that led him to seek help from Dr. Max Jacobson, sometimes called “Doctor Feelgood” because of his frequent use of (then legal) amphetamines. (Jacobson’s medical license was revoked in 1975.) Stress-induced tunnel vision is to be expected in a crisis, and may account for otherwise inexplicable blunders such as Kennedy’s disastrous decision to proceed with the Bay of Pigs invasion. A number of other examples also could be cited.

Are deterrence and rationality compatible?

The following passage, taken from “Essentials of Post-Cold War Deterrence,” an originally classified 1995 USSTRATCOM report encourages irrational behavior to enhance deterrence:

Because of the value that comes from the ambiguity of what the US may do to an adversary if the acts we seek to deter are carried out, it hurts to portray ourselves as too fully rational and cool-headed. The fact that some elements may appear to be potentially “out of control” can be beneficial to creating and reinforcing fears and doubts within the minds of an adversary’s decision makers. This essential sense of fear is the working force of deterrence. That the US may become irrational and vindictive if its vital interests are attacked should be part of the national persona we project to all adversaries.

Just as CFO’s should have seen through the ARPS masquerade before they imploded, it would seem obvious that a strategy based on threatening to destroy civilization while appearing irrational, out of control and vindictive has a significant risk of failing catastrophically. Unless society questions the wisdom of risking its survival on such a house of cards, we will pay a far higher price than those who bought and sold ARPS. If you agree, please share this post with as many people as possible, or take whatever other action you feel would be most helpful for shaking society out of its ill-advised complacency.

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[1] For those interested in the details of the ARPS story: Unlike in a money market fund, investments in ARPS are not instantly available whenever you need them, but were supposedly tied up for only a week at a time. Auctions were held every Friday to set the interest rate for the next week. If I did not need cash, my ARPS would roll over for another week at the new interest rate set by the auction. Anytime I needed cash or became unhappy with the interest rate being offered, I could tell my broker not to roll over my ARPS and they would convert to cash at the next auction. Tying up my money for a week sounded like a small penalty to pay for the extra interest, so I took my broker’s advice and bought some ARPS.

But then I started to ask some questions: “What if an auction fails?” I asked my broker. He told me that had never happened, and that if there were insufficient bids, the underwriter would step in and bid for enough securities to make the auction work. That led to my next question: “What if the underwriter gets into financial difficulty and is unable to step in to make the auction work?” My broker told me that was extremely unlikely, but even then I’d be protected because penalties would kick in to reward me if my money were locked up for longer than the week to which I had committed. I decided to read the prospectus more carefully – something I should have done before getting into ARPS.

Sure enough, there were penalties, but they were inadequate. The interest rate I’d get if I were unwillingly locked into ARPS for longer than a week (and it could be much longer than a week) was higher than normal, but much less than was appropriate in the extreme situation we would then be experiencing. Once I realized this, I told my broker not to roll over any of my ARPS at the next auction and I have not owned any since.

About Nuclear Risk

I am a professor at Stanford University, best known for my invention of public key cryptography -- the technology that protects your credit card. But, for almost 30 years, my primary interest has been how fallible human beings can survive possessing nuclear weapons, where even one mistake could be catastrophic.
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