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FT: Organic mechanics

Economists talking about "efficient" or "perfect" markets remind Lord May of ecologists talking about "the balance of nature" 40 years ago, when ecosystems with a rich web of interactions were thought to be the most stable. Subsequent analysis has shown the opposite to be the case: the most robust systems can be decoupled into discrete components without collapsing.

Mathematical biology also helps to explain in retrospect why hedge funds, the institutions once thought to be at greatest risk of financial collapse, have survived the crisis in a healthy state. Compared with banking, the hedge fund sector is populated with relatively small, specialised players - the robust structure of a diverse ecosystem.

Organic mechanics

By Clive Cookson, Gillian Tett and Chris Cook

Published: November 27 2009 02:00 | Last updated: November 27 2009 02:00

W hat do you call a financier in search of the iron laws of human behaviour? Answer: someone with a bad case of "physics envy".

That is the peculiar psychological disorder diagnosed by Andrew Lo, a professor of financial engineering, as afflicting bankers and economists. Symptoms include a desperate search for the predictive certainty that comes from the hard sciences.

At least since the 18th century, economists have been borrowing from physics, redeploying everything from thermodynamics and the "conservation of energy" principle to the understanding of macroeconomics and the generation of fancy derivatives. The global financial crisis has, however, seen financiers cast their scientific net further as they try to understand what went wrong and how to make the banking system more stable in future. As a result, they are developing "biology envy".

Bankers and financial economists are working with mathematical biologists to learn lessons about resilience from natural ecosystems - from fisheries to forests - and from the spread of disease. The exercise is certainly of more than academic interest. Andrew Haldane, executive director for financial stability at the Bank of England, says the regulatory structure for banking may be shaped by studies now in progress that treat global finance as a "complex adaptive system" like a living ecosystem.

The outcome could determine whether the system is robust enough to survive another financial storm without casualties on the scale of Lehman Brothers and without the need for governments to spend thousands of billions of taxpayer dollars to prevent a collapse.

Some policy conclusions are already clear. One is that the banking system has become at the same time too complex and too homogeneous. The problem is that over the past 20 years or so almost all the big globally active banks diversified their holdings and risk, moving into increasingly complex (and opaque) financial instruments. Unfortunately for the stability of the whole system, banks all diversified their business lines in a similar way and, in the process, became inextricably interdependent.

"From an individual firm's perspective, these strategies looked like sens-ible attempts to purge risk through diversification: more eggs are being placed in the basket," says Mr Haldane. "Viewed across the system as a whole, however, it is clear now that these strategies generated the opposite result: the greater the number of eggs, the greater the fragility of the basket - and the greater the probability of bad eggs."

That is what a mathematical ecologist would have predicted if he or she had known what was going on in the world of finance. The tropical rainforest, for example, has so many interdependent species that it is more vulnerable to an external shock than the simpler ecological diversity of savannahs and grasslands.

Mathematical biology also helps to explain in retrospect why hedge funds, the institutions once thought to be at greatest risk of financial collapse, have survived the crisis in a healthy state. Compared with banking, the hedge fund sector is populated with relatively small, specialised players - the robust structure of a diverse ecosystem.

One distinguished mathematical biologist who is delving deep into the financial ecosystem is Lord Robert May, zoology professor at Oxford university and former president of Britain's Royal Society. The financial theorists have a lot of ground to make up, he says: "The more I hear about financial economics, the more I am struck by its similarity to ecology in the 1960s."

Economists talking about "efficient" or "perfect" markets remind Lord May of ecologists talking about "the balance of nature" 40 years ago, when ecosystems with a rich web of interactions were thought to be the most stable. Subsequent analysis has shown the opposite to be the case: the most robust systems can be decoupled into discrete components without collapsing.

Some were becoming concerned about systemic risk before the financial crisis erupted. The Bank of England started experimenting about five years ago with computer models of the banking system as an ecological network. The US National Academy of Sciences and the Federal Reserve Bank of New York launched a joint study in 2006 that brought together 100 experts to explore parallels between systemic risk in the financial sector and various fields of science and technology, from ecology to engineering. But the financial storm had set in by the time its conclusions were published.

Fisheries management has interesting parallels with financial regulation, says Lord May. For the past 50 years fish stocks have been managed on a species-by-species basis that aims to maximise the "sustainable yield" of individual fish such as cod or herring - an approach analogous to regulatory risk analysis that focuses on individual banks. But with the collapse of some important fishing grounds, marine scientists are coming to recognise that what really matters is the wider ecosystem and environmental context. You cannot protect cod, for example, without considering the sand eels, whiting, haddock, squid and other species on which cod feed.

Medical epidemiology is another fruitful borrowing ground for financial analysis. Just as epidemiologists trying to stem an outbreak of disease want to focus on identifying and vaccinating the most dangerous "super-spreaders" of infection, regulators need to control the damaging consequences for the whole banking network of the failure of large, interconnected institutions.

International banking rules such as Basel II have had the perverse effect of imposing the greatest capital restrictions on the smaller and less diversified banks that posed the least risk to the system, while the large "super-spreader" institutions were given more leeway. Borrowing an analogy from sexually transmitted disease, Mr Haldane says: "Basel vaccinated the naturally immune at the expense of the contagious; the celibate were inoculated, the promiscuous intoxicated."

Further insights are emerging from a collaboration between David Rand at Harvard university's programme for evolutionary dynamics and Nicholas Beale, who runs Sciteb, a London consultancy. "The fundamental requirement for the regulator is to ensure that the banks do not all diversify in the same way but rather we have 'diverse diversification'," Mr Beale says.

Their approach, rooted in mathematical models from evolutionary biology, "gives the real prospect of regulators being able to prevent dangerous 'herding', based on some simple, deep and new properties of financial networks", he adds. A key element of the new system would be to provide banks with a "systemic risk rating" for each asset class, in a way that would induce them to diversify in different directions.

T here is scope, too, for borrowing from epidemiology when it comes to gathering, analysing and communicating data. The World Health Organisation is constantly monitoring the globe for early signs of an epidemic of infectious disease - and if one breaks out, as Sars did in 2003 or swine flu this year, it provides vital information to governments, medical professionals and the general public. The banking world could do with an equivalent of the WHO, says Mr Haldane.

At the Massachusetts Institute of Technology, Prof Lo himself proposes that the US should set up a capital markets safety board to manage systemic risk, modelled on America's National Transportation Safety Board.

While the analysis of ecosystems is the latest attempt to harness mathematical biology to finance, such systems analysis is not confined to biology. Experts have also seen useful lessons for banking stability in the way engineers protect electric power grids from collapse. Some others fancy a move back to physics, on a more sophisticated level. Theories that have dominated finance are drawn from research that took place in academia many years earlier - and was often reworked at around the same time as the concepts were permeating finance.

The crude forms of the "efficient market hypothesis" developed in the 1970s began to refashion the banking world in the 1990s, by which time the academic branch of economics was moving towards more subtle forms of behavioural finance. Similarly, the forms of classical physics that have driven financial engineering have long been superseded by more complex theories, such as refinements of relativity and quantum theory.

If biology does not do the trick, some of the more subtle and advanced concepts in physics might yet be able to shed light on economics. Or so some of the disenchanted quantitative analysts hope.

Changing the hypothesis: why 'adaptive' trumps 'efficient'

Economists have always been keen to borrow principles from the hard sciences. In the 19th century Léon Walras and William Stanley Jevons both started their work with a view to importing the insights of physics into the economic sphere. Irving Fisher, the great neoclassical economist whose 1930s work has been rediscovered during this crisis, even wrote his doctoral thesis at the turn of the 20th century under the supervision of a physicist.

This tendency was given renewed impetus in the mid-20th century by Paul Samuelson's application to economics of mathematical principles derived from thermodynamics. The development of computers able rapidly to analyse data made the development of mathematically elegant economic models particularly desirable, driving the acceptance of concepts such as American economist Eugene Fama's efficient market hypothesis.

Most of the "quants" - financial mathematicians - who used such concepts to build financial models always knew that this project had serious flaws. Emanuel Derman, for example, a physicist turned financier who formerly worked at Goldman Sachs, is credited with playing a central role in the development of models in relationship to derivatives. Yet more than a decade ago, he was warning Goldman Sachs clients of the limitations of derivatives models - he compared their relationship to reality to that between a child's toy car and an actual automobile.

Mr Derman remains, to say the least, wary of the idea that efficient markets hypothesis can provide a "complete" guide to finance. "Unfortunately, absolute value theories don't work very well in economics," he wrote recently. "It's difficult or well-nigh impossible to systematically predict what's going to happen. You may think you know you're in a bubble, but you still can't tell whether things are going up or down the next day."

Such scepticism has not often been expressed quite so frankly. On the contrary, some quants have furtively revelled in the power that their apparently elite knowledge gave them. "The dirty secret of banking is that lots of bankers have always felt a bit insecure because they did not really understand how this stuff worked - so those who understood it were in a strong position," observes one banker.

However now that the crisis has exposed their shortcomings, the EMH and the entire model-based approach to finance are facing a radical rethink. A growing chorus of financiers, quants and economists argues that it is wrong to apply simplistic assumptions that underpin the physics-like models to people, since - unlike atoms, say - they can learn from each other and change in response to events. Changes may not happen in a neat, linear fashion.

Donald MacKenzie of Edinburgh university says the real problem with models is that bankers tend to view them as "cameras" that capture how the world works, like the camera that might photograph a physics experiment. Instead, he argues, they should be viewed as "engines" - since the presence of a model tends to change and drive market behaviour in a way that makes it impossible to assume that the past can predict the future.

Nevertheless, no alternative intellectual model - or source of inspiration - has emerged to offer a truly coherent alternative. George Soros, the former hedge fund manager, for example, argues that market participants need to embrace the idea of "reflexivity", to recognise that markets change in response to participants, and to accept that models are an "engine, not camera". However, turning this reflexivity theory into any investment manual or strategy has proved difficult.

Hence the move to look at branches of science beyond physics - and at biology in particular. Professor Andrew Lo of MIT has developed the adaptive market hypothesis, attempting to introduce the principles of evolution - competition, adaptation and natural selection - to his financial models.

Prof Lo believes that some of the features of human behaviour - such as loss aversion, overconfidence, overreaction and other behavioural biases - that are underappreciated by simpler models are, in fact, rational. These aspects of human behaviour, while not conforming to the caricature of homo economicus , may be optimal strategies for human behaviour that have been honed by millennia of evolutionary pressure.

Indeed, he takes this evolutionary process seriously: he is fond of pointing out to his audiences that they have both "mammalian" and "reptilian" brains that can be employed at different moments. Prof Lo believes that prices reflect not just information in the market place, but also deep-seated and slowly evolved human biases.

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ST: Turning disability into capability

Turning disability into capability

2 Dec 09

Finance Minister Tharman Shanmugaratnam was interviewed by Bruce Nussbaum of BusinessWeek at the ICSID World Design Congress on Nov 23. We carry today an edited excerpt of the interview, which took place at the Suntec City Ballroom.

How did Singapore create itself over the past 50 years, and come to be as it is today?

Our advantage is the fact that we are just a small piece of rock, nothing under the ground, no minerals. Only a collection of people, who were not meant to come together as a country. That has been our advantage, because our only basis for survival is to invest consistently in every talent and skill, and be willing to do something differently - different from other cities in Asia, and different from the rest of the world.

I was at the Marina Barrage recently with a group of residents from my constituency. The Barrage converts rainwater and sea water into a freshwater reservoir using advanced membrane technologies, developed over the years. It also uses the best foreign technologies - a Dutch company supplied seven massive pumps. People were flying kites on top of the structure, itself really beautiful. So it is now also a lifestyle venue.

It's an example of how we turn disability - the fact that we have no natural resources - into capability, using science and technology and by borrowing the best from the rest of the world. So I think that's at the heart of it: the vulnerability, the constant state of anxiety. That is the way we know we've got to be a little more ingenious than others.

What seems to be a very important issue here is generating local talent, bringing in external talent and integrating it. How does that work?

About one-third of our population is foreign-born, as it is in London. In New York, about 45 per cent of the adult population is foreign. But the big difference is that London is part of Britain, and only 10 per cent or less of the British population is foreign-born. New York is part of the United States, and the Americans know it is their country. We are both city and country, and that's our challenge.

We can survive only if we are a global city. We've got to be as open as other global cities, a place where people can spend part of their lives regardless of where they come from. But we've also got to be a country for our own citizens. That means managing this place not just as an economy or a conglomeration of businesses, but also as a society - an inclusive society that nurtures every citizen to reach his or her highest potential in life.

Singapore's success has come in large part from the technology and engineering-centred, top-down economic and social model. It is a model of efficiency. In 2003, the Economic Review Committee recommended remaking Singapore into a centre of creativity, originality and innovation. Now these capacities are associated with a different model - a human-centred, social science, bottom-up model. My question is how successful is Singapore today in making this transition to this current model?

We are doing more and need to do more to create an environment that depends on ideas coming up from individuals, and not just system efficiencies. We need the effervescence of ideas coming up naturally through the schools, through the polytechnics, our technical colleges or ITEs (Institutes of Technical Education) and our universities. The whole thrust of educational policy in the last decade has been to give these ideas and new types of talents the maximum chance of emerging.

It is a difficult exercise, because meritocracy is fundamental to Singapore, and standardisation comes very naturally to meritocracies. Standardisation is a disadvantage in education if we are trying to breed different types of talent. So how we break out of this is by creating different pathways from the mainstream, each of them meritocratic, where you have to show that you've got something different from the rest.

To get into the School of the Arts is highly competitive. But you are measured not just on your exam scores, but also on whether you can show through your track record and at the audition that you have something different. We are also doing it in the sciences, in design and applied technology, and in many public schools that are offering their own niches of excellence. Our schools and teachers are being given autonomy. We've learnt from the best private schools in the US and elsewhere, and brought the lessons into a publicly funded, meritocratic system. So it is this mix of planning, top-down support and ground-up initiative that's driving education.

We shouldn't try to be like someone else. Zurich doesn't try to be like San Francisco or London. It doesn't try to be like the most exciting cities. But Zurich attracts talent, especially talent with families. It's got its own edge, and it is a very attractive city.

We have to be ourselves. And that means not abandoning our strengths. I think our cardinal strength is our ability to integrate people of very different cultures, people who in fact started off with very different aspirations although we're now converging. That doesn't happen by chance. It happens through careful planning, and sometimes intrusive regulation.

There's nothing more intrusive than our rules: For example, requiring every public housing precinct and every block to have a spread of ethnic groups. That's also how you ensure that the primary schools around the corner have the spread of ethnic groups. And how we get a convergence of aspirations and a sense of sameness in each new generation. We can't leave these things to the market, or let things splinter the way we can all see happening in some other parts of the world.

It requires advance planning, and a consensus between the people and the Government - that this is the way we want to go. If we were a city among many in the country, it wouldn't matter. If San Diego goes down, Austin, Texas will come up or someone else comes up. But if we go down, the country goes down.

So it requires a steady hand, always looking over the horizon. We don't leave things entirely to chance. That's a disadvantage in some ways but it's also the way we survive and how Singapore stays relevant.

I was out birding yesterday with my wife and one of the places we went to look at birds was an old British air force base that has been transformed into a Singapore aerospace area. I wanted to ask you: What are the kinds of industries that you think Singapore should be getting into at the very high end of manufacturing?

First, we build on existing capabilities. The example you gave, of aerospace, is an interesting one. It's built on precision engineering and electronics capabilities, both existing industries. Existing capabilities don't die. We take them, build adjacent capabilities, develop new industries and jump onto new curves.

It's not something you can plan for well in advance, because you don't know how the world will change. But if you keep investing in your capabilities, businesses will grow.

ST Aerospace is now the leading company globally, in third-party maintenance and repair. It is not owned by an airline, and has no captive client. How did they do it without a national airline feeding them with contracts? By building capabilities.

What about the medical sphere? How is that doing?

It's a growth industry globally, and we are well positioned to participate in it. Companies in the biomedical field tell us the main advantage of Singapore is the fact that we are English-speaking and we have in the same laboratories and buildings people from all over the world. There's no formula but there's real advantage in bringing together people who've grown up differently and worked in different parts of the world.

I think heterogeneity now is a great driver of growth as opposed to homogeneity, which can actually dampen growth. And that is a major strength for Singapore.

Forty years after we started, it has turned out to be a great asset in a knowledge-based world. We are the natural place in Asia for Indians, Chinese and South-east Asians to feel at home.

What other industries do you think Singapore is into and should be into at that level?

The whole area of urban solutions is a massive opportunity. What is happening in Asia today and over the next 20 years is a tremendous social transformation and a huge challenge - making cities liveable, managing water resources and sanitation, keeping the air clean and the place green. This is something where Singapore has built up a solid experience, and something we can share and participate in.

Are you a little more optimistic today about the future of Singapore in the present global economy than you were perhaps a year ago, when things were pretty gloomy?

I'm more optimistic and it's not because we are past the worst of the crisis. There is tremendous opportunity coming up in Asia.

It is not just a story of Asia's rise, but about the East moving towards the West. It's about the huge infusion of knowledge and ideas that comes from borrowing practices from the West, in numerous fields. And it is also about the West moving to the East.

A few years ago, the global premiere of I La Galigo, a Buginese epic story about creation, took place in Singapore, before it was cast in Indonesia and the rest of the world. It is also interesting that Wu Guanzhong, one of the most significant artists in China and the world today, recently donated 133 of his best oil and ink pieces to Singapore. He did so because Singapore was where the East was moving to the West, and the West moving East.

That is our role as a global city in Asia. We are a meeting place, but never static, always borrowing ideas and influencing each other. And it will shape our society in ways that we cannot fully predict today.

The ICSID World Design Congress Singapore 2009 is a parallel event of the Singapore Design Festival, spearheaded by the DesignSingapore Council of the Ministry of Information, Communications and the Arts.

ST: Inequality is bad news for everyone

Inequality is bad news for everyone

2 Dec 2009

Economist Robert Frank says when the rich get richer, and the poor stay poor, life gets tougher for everyone. He advocates a progressive consumption tax which discourages wasteful spending, reduces inequality and pressure on the less well-off to keep up with others. — ST PHOTO: KEVIN LIM

WE MIGHT know it as the rat race; academia call it the ‘expenditure cascade’, but it amounts to the same treadmill.

In short: When the rich get richer, but the poor stay poor, life becomes tougher for everyone else.

Not that the rich intend that outcome but the bigger homes, flashier cars and nicer clothes they buy make everyone else raise his expectations. Soon, the less well off spend more too, but it’s a struggle to keep up because their income hasn’t grown as much.

Professor Robert Frank applied the term expenditure cascade to this unfortunate product of rising inequality, a phenomenon that could just as well apply here as it does in his native United States.

And while public policies to temper expenditure cascade seem a political impossibility in the US, Prof Frank believes Singapore could make an ideal test bed.

The Cornell University economist, who was in town two weeks ago to lecture at the Civil Service College, told The Straits Times: ‘Even if envy and jealousy were non-existent, there would still be perceptions of quality that depend on context. And so everybody would have a tendency to spend more when others spend more.

‘When everybody spends more on high quality things, the things that used to seem high quality don’t seem so any more.’

The award-winning 64-year-old academic says the effects of the expenditure cascade wouldn’t be that bad if it merely centred on items that were not crucial to survival.

‘The main problem is if you don’t match the spending of others like you, then sometimes that makes you less able to achieve basic goals.’

Take the case of the suit you wear to a job interview. If everyone spends more money on a suit to make a good impression, bucking the trend could mean losing your stab at the job, he says.

Or a home near a good school. Since the number of homes near popular schools is generally limited, parents bid up the prices of such homes to give their kids the head start in life.

‘If you don’t spend as much as people like you on housing, then your kids will go to below-average schools,’ says Prof Frank.

‘Most parents spend more even though they don’t have more, which means they would have to borrow more, save less and work harder.’

When everybody spends more, they all pay a higher price only to end up in the same positions in the social hierarchy as they were before. End result: Society ‘wastes’ a lot of money.

After all, some things in life are what economists call ‘positional goods’ – their value lies more in how they are ranked in relation to their peers.

Military hardware is one example – a country’s security is not guaranteed by the number of bombs it has, but by having a greater number of bombs than its neighbours.

Ironically, the educator also thinks that education itself can be a positional good.

‘A good education just means a better education than what others have,’ says Prof Frank.

The question, he says, is whether the skills learnt are essential to one’s job.

‘If the answer is yes, then the money is not wasted. But if the best jobs go to the people with the most education, but the education isn’t necessary to do the job, when you double the amount of money spent on education, the same jobs will go to the same people at the same salaries.’

Since it is human nature to want to get ahead, Prof Frank is under no illusion about curbing that instinct. Rather, he advocates a progressive consumption tax to reduce wasteful spending.

Instead of taxing people’s incomes, governments should tax incomes left over after subtracting savings. Since the biggest spenders are taxed more, the rich have the greatest incentive to cut expenditure, which in turn reduces pressure on those less well off.

The resulting tax extracted could then be put to more productive uses – ‘hiring teachers, or doctors, or fix the roads or build a new subway line’ – all items that increase the welfare of all citizens.

He thinks the idea has dim prospects in his home country, given how it is ‘politically paralysed’ by Republicans blocking attempts at social reform.

Singapore is a different story.

‘Singapore has been a leader in innovative policy change. It was among the first place to tax congestion… if there is any new idea with merit, it would have a better chance to be implemented here than anywhere else.’

He feels rising inequality should be a concern not just because of the spending pressure it puts on us all, but because of the way it affects our sense of well being.

Officials here are quick to point out that absolute incomes have risen for the majority over the years even though the incomes of top-tier earners are pulling away from the rest of the population.

Prof Frank sees absolute and relative incomes as being relevant in this area: ‘Both frames of reference are important. When people ask ‘how am I doing?’, they have two frames of reference – ‘how am I doing compared with before’, and ‘how am I doing compared to other people like me.”

Whether one’s progress in one area can be used to justify a deficiency in the other depends on the extent of either.

Studies elsewhere have drawn the link between people’s relative income levels and levels of happiness. Generally, richer people are happier than poor ones. Yet, when everybody’s incomes rise at the same rate, average levels of happiness stay fairly constant.

It does suggest that average levels of happiness can never be raised.

‘I think it’s possible,’ he says without hesitation. ‘Making the income distribution a little tighter takes some of the net pain out of inequality. You can’t change the fact that half of the population is in the bottom half, but the pain they suffer can be lessened if they are below average by a smaller amount.’

In other words, people will generally be happier if the disparity between the rich and poor was not so glaring. What about the argument that a more equal society would reduce the motivation for people to work hard?

‘There doesn’t have to be great inequality for people to want to work hard… In countries that have low inequality, gross domestic product (GDP) grows faster on the average,’ he says.

‘In the United States, GDP grew faster in the three decades after World War II than in the three decades that followed those, even though inequality was lower in the first three decades.’

In any case, free markets don’t always give the best results.

Before 1991, elite American universities agreed among themselves not to compete for the best students through merit-based scholarships in order to channel their money to truly needy students. But the US Justice Department charged them with violating anti-trust legislation, prompting them to end such cooperation.

What ensued was a free for all as universities tried to match each other’s scholarship offers to attract the highest-scoring students, which drained funds available for financial aid.

Prof Frank himself has seen this competition first hand. One of his four sons, Chris, was offered a generous scholarship of more than US$50,000 a year to study at New York University in 2005.

Chris, knowing his father’s position on this issue, didn’t know what to do. He asked his father for advice.

‘He’s a very good student. And I could afford to pay for his college. He was going to get to go whether he got a scholarship or not,’ says Prof Frank.

‘I said, ‘What do you think is going to happen if you tell them you don’t want the scholarship?’

‘He paused and said, ‘Well, they’re just going to give it to the next kid on the list.’

‘I said, ‘Yeah, that’s about right. So what should you do?’

‘He said, ‘I should accept the scholarship, and then if I am successful, I should make a big donation to NYU someday.”

There’s a tinge of pride in his voice as Prof Frank relates how his son struggled with the unfairness of the whole situation but just as quickly, he adds: ‘But it’s still a problem… It’s grossly unfair that some poor family wouldn’t get that.’

The moral of the story, he says, ‘is more competition isn’t always better’.

It’s like being spectators in a ball game. ‘If everybody stands to see better, then nobody sees better than if they were to remain seated.’

FT; American spy and diplomat admired in Beijing

American spy and diplomat admired in Beijing

By Jurek Martin

Published: November 21 2009 00:58 | Last updated: November 21 2009 00:58

Jim Lilley was the quintessential American “China hand”. He was born there, spoke the language fluently from childhood, spied against China for the CIA and ultimately became US ambassador in Beijing at the time of the Tiananmen Square massacres in 1989.

Perhaps his greatest diplomatic achievement was being held in the highest regard both by the Chinese government and its adversary Taiwan – he remains the only American to have served as head of US missions in both.

Quintessential China hand: Lilley

After Tiananmen, of which he was extremely critical, he lobbied his old friend and former CIA colleague, President George H.W. Bush, to temper US reactions.

In the early 1980s, when head of the American Institute in Taiwan, the de facto embassy, he successfully urged the Reagan administration, in which Mr Bush was vice-president, to resist Chinese pressure to cut off all arms sales to the island nation, implementing instead a gradual reduction.

His relationship with Mr Bush did much for his career. He had been CIA station chief in Beijing when Mr Bush was head of the mission from 1974-76, from which he was appointed to become director general of the agency. He always had a hotline to the future president and did not hesitate to use it.

James Roderick Lilley was born in 1928, in the coastal city of Qingdao, known for its German-run brewery. His father sold kerosene from a junk on the Yangtze River for Standard Oil and his mother was a teacher. The family, including his older brother Frank, lived comfortably in the international community and the two boys, attended by a Chinese nanny, were bilingual in Mandarin and English from an early age. He fondly remembered playing catch with a young occupying Japanese soldier, an experience similar to those recalled by the British author J.G. Ballard in his Shanghai-based Empire of the Sun.

The family returned to the US in 1940 and Jim duly followed his brother to Yale, while also serving for a year in the US Army at the end of the second world war, and later earned a master’s degree from George Washington University.

Frank Lilley, however, committed suicide just outside Hiroshima in Japan in 1946, a seminal event for Jim. As he wrote in his 2004 memoir, China Hands, Frank was “a dreamer, pacifist and philosopher”.

“I developed differently, eschewing romantics and excessive emotion and [was] inclined to deal with facts and forces as they presented themselves. I felt it was important to stay away from disillusionment,” he wrote.

These convictions led him, naturally, into the CIA in 1951, with the Korean War raging, as a self-described “foot soldier in America’s covert efforts to keep Asia from being dominated by Communist China”. For more than 20 years he ran agents, debriefed travellers and operated undercover himself all over Asia, culminating in his direction of the CIA’s “secret war” in Laos as the conflict in Vietnam turned sour.

His first formal ambassadorship, from 1986-89, was in South Korea, doubtless courtesy of Vice President Bush. The country was in turmoil in opposition to the authoritarian rule of President Chun Doo-hwan, who had seized power in a coup in 1979. There had been a massacre of protesting students in Kwangju, the opposition leader Kim Dae-jung had been jailed, and Mr Chun, who was admired by President Ronald Reagan, was considering imposing martial law.

The new ambassador took the unusual and controversial step of ingratiating himself with Mr Chun, unlike other foreign diplomats. This gave him the leverage he needed to deliver messages from Washington, which he had helped craft, warning the US would not support a further crackdown. The outcome was South Korea’s first democratic elections in 16 years and Jim Lilley’s reward was Beijing.

From the beginning, he liked to get around the Chinese capital on his bicycle, then the universal mode of transportation, and was able to talk reasonably freely with those he met. He sensed trouble was brewing but was powerless to stop what happened on June 4, 1989. He had no problems immediately calling a spade a spade, using the word “massacre” even when his own government was reluctant to use it for fear of offending the Chinese government.

He went beyond the verbal, too, though his frank dispatches from Beijing were often sent directly to President Bush. For a year, he housed the prominent dissident physicist Fang Lizhi in his embassy before he was allowed to leave China. He even criticised James Baker, the secretary of state, for a “bad miscalculation” in allowing US warships to pay a courtesy visit to Shanghai a month before Tiananmen because it may have left the impression with the Chinese leadership that the US would not object to any crackdown on the growing dissident movement.

But, in the aftermath, he mostly worked to keep Beijing-Washington connections on as even a keel as possible, not easy given the outrage expressed in America and around the world. He arranged for discreet visits of senior US officials to Beijing to offer assurances that the US still valued its relationship with China. When he left China in 1991, his farewell parties were attended by large crowds, a testament to the esteem in which he was held.

Subsequently, back in Washington, he occupied himself with a China consultancy business, a perch at a think-tank, public speaking and lecturing at US universities and writing his memoirs with his son. He died last week and is survived by his wife of 55 years, the former Sally Booth, and three sons.

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Economist: Secret sauce

Economics focus

Secret sauce

Nov 12th 2009
From The Economist print edition

China’s rapid growth is due not just to heavy investment, but also to the world’s fastest productivity gains

PRODUCTIVITY growth is perhaps the single most important gauge of an economy’s health. Nothing matters more for long-term living standards than improvements in the efficiency with which an economy combines capital and labour. Unfortunately, productivity growth is itself often inefficiently measured. Most analysts focus on labour productivity, which is usually calculated by dividing total output by the number of workers, or the number of hours worked. According to new figures published on November 5th, America’s output per hour worked has increased by 4.3% over the past year, thanks to big job cuts. Even more impressive is China, where labour productivity has risen by 7-8%.

The snag is that labour productivity is an incomplete gauge of efficiency. Firms can boost output per man-hour by investing more and equipping workers with better machinery. But once the extra capital spending is taken into account there may be little or no gain in overall economic efficiency. Part of the jump in America’s labour productivity during the “new economy” era of the late 1990s reflected a rise in investment as a share of GDP. The huge increase in China’s labour productivity in recent years is partly due to heavy investment rather than true efficiency gains.

A better gauge of an economy’s use of resources is “total factor productivity” (TFP), which tries to assess the efficiency with which both capital and labour are used. Once a country’s labour force stops growing and an increasing capital stock causes the return on new investment to decline, TFP becomes the main source of future economic growth. Unfortunately TFP is much harder to measure than labour productivity. It is calculated as the percentage increase in output that is not accounted for by changes in the volume of inputs of capital and labour. So if the capital stock and the workforce both rise by 2% and output rises by 3%, TFP goes up by 1%. Measuring hours worked is fairly easy, but different ways of valuing a country’s capital stock can produce different results.

The OECD publishes figures for its rich-country members. These show that since 1990, average TFP growth has been remarkably similar in America, Japan, Germany, Britain and France, at around 1% a year. A recent report by Andrew Cates, an economist at UBS, attempts to estimate TFP growth in emerging economies over the past two decades (see chart). He calculates that China has had by far the fastest annual rate of TFP growth, at around 4%. Probably no other country in history has enjoyed such rapid efficiency gains. India and other Asian emerging economies have also enjoyed faster productivity growth than other developing or developed regions. In contrast, productivity in Brazil and Russia has risen more slowly than in rich economies.

These figures undermine a common claim—that China’s rapid growth has been based solely on overinvestment. Sceptics like to compare China with the Soviet Union, where heavy investment also produced rapid rates of growth for many years before it collapsed. But the big difference is that TFP in the Soviet Union actually fell by an annual average of 1% over 30 years to 1988. In contrast China’s productivity has been lifted by a massive expansion of private enterprise, and a shift of labour out of agricultural work and into more productive jobs in industry. China’s average return on physical capital is now well above the global average, according to Goldman Sachs. A decade ago it was less than half the world average.

Why have the Asian economies led the pack? The most important determinants of longer-term productivity growth are the rate of adoption of existing and new technologies, the pace of domestic scientific innovation and changes in the organisation of production. These, in turn, depend on factors such as the openness of an economy to foreign direct investment and trade, education and the flexibility of labour markets.

Using a composite index of technology penetration and innovation (including, for instance, computers and mobile phones per head), Mr Cates finds a strong link between the rate of increase in an economy’s technological progress and its productivity growth. China’s level of technology is still well behind that in America, but it has seen by far the fastest rate of improvement over the past decade. This is not just because China started from such a low base but also because it is more open to foreign investment than many other emerging economies, including Japan and South Korea when they were at similar stages of development. China’s TFP growth is almost twice as fast as that of Japan and South Korea during their periods of peak economic growth.

An emerging advantage

UBS’s analysis suggests that the financial health of firms and governments also matters for productivity growth. Although TFP measures the extra gain in economic efficiency after taking account of the direct impact of a larger capital stock, weak balance-sheets constrain the availability of capital for new technology and innovation. The financial crisis may therefore reduce TFP growth in many rich countries. Some analysts also worry that future productivity growth in emerging economies will be curbed by slower growth in world trade and capital flows. But Mr Cates argues that healthier domestic balance-sheets in most emerging economies, along with continued rapid adoption of old and new technologies, should support robust productivity gains. He thinks that China, India, Indonesia and Brazil look particularly well placed. China’s surge in infrastructure spending will also help.

That said, even if China’s productivity growth remains faster than that of the developed world, it is likely to slow unless the government pushes ahead with bolder reforms. China’s growth is still too capital-intensive. Opening up the service sector to private firms and making it easier for workers to shift from rural to urban areas would result in a better allocation of labour and capital. That would help sustain rapid growth but would also make it more job-intensive. The resulting fall in labour-productivity growth might cause alarm among some analysts, but TFP would remain strong.

Copyright © 2009 The Economist Newspaper and The Economist Group. All rights reserved.

BT: Teaming up to stay ahead

Business Times - 31 Oct 2009 Teaming up to stay ahead MANUFACTURERS, logistics industry players and Spring Singapore are teaming up to prepare the industry for future challenges as they strengthen Singapore's supply chain management and transshipment hub capabilities. 'Singapore as a thriving transshipment hub will position us as an important global supply chain control tower. This will attract manufacturing and logistics companies to set up operations here. It is therefore imperative to continuously improve our supply chain capabilities to maintain our lead,' said Spring industry development group director Victor Tay at the signing of two Memoranda of Understanding (MOU) yesterday. The first MOU between the Singapore Manufacturers' Federation (SMa) and The Logistics Institute - Asia Pacific (TLI-AP) aims to identify, develop and promote the adoption of supply chain best practices among local manufacturers. SMa and TLI-AP will launch a competitive study for the manufacturing industry which will first form a high level task force to examine the external environments for threats and opportunities for Singapore, followed by the recommendation of some strategic programmes that will build on existing strengths within the manufacturing industry to spur the industry up the value chain. In the second MOU between TLI-AP, Singapore Logistics Association (SLA) and Spring, the partners will embark on a competitiveness study assessing Singapore's challenges and unique propositions as a transshipment hub. The industry-wide study will be conducted to uncover opportunities to strengthen Singapore's status as a transshipment hub against regional players in air and sea freight. Leveraging on Spring's LEAD Programme, SMa and SLA will gain insights from the competitive study to develop an industry roadmap with strategic projects that can be implemented for the entire industry. This could be either in terms of exploiting of new technologies and infrastructure or upgrading manpower capabilities and managerial competence. The outcome of both studies will also foster deeper understanding of industry trends and requirements so as to develop industry specific strategies. Copyright © 2007 Singapore Press Holdings Ltd. All rights reserved.

FT: Emirate re-engineered

Emirate re-engineered

By Andrew England

Published: October 22 2009 23:54 | Last updated: October 22 2009 23:54

Managed development: a labour ministry official inspects an Abu Dhabi construction site. At least $300bn in infrastructure and property projects are planned for the emirate

When Saeed Alromaithi’s friends phoned him at his new place of work, they would often have a chuckle. They could hear the clank of heavy machinery in the background or the roar of a steel plant’s furnaces. “They used to make fun of me when they called and heard all this noise,” says Mr Alromaithi, his blue work jacket and jeans a contrast to the pristine white robe that is the uniform of most of his fellow Emiratis.

EDITOR’S CHOICE

New dawn signalled for debt-ridden Dubai - Oct-07

Dubai strains to restructure debt - Sep-09

Downturn tests Dubai’s social tolerance - Sep-07

Change set in train for Dubai - Sep-02

Shuaa Capital’s chief resigns - Aug-12

Comment: Dubai needs law reform - Aug-10

Their reaction is not surprising. Since the 1970s, when a spike in oil prices brought wealth to the Gulf, its nationals have gained the reputation for avoiding work that might risk an encounter with sweat or dirt, preferring instead the air-conditioned office suites of, say, a state oil company or sovereign wealth fund. Governments provided social safety nets that hoovered up graduates and dealt out public sector jobs for life.

That is a phenomenon some of the region’s leaders now seem to have grasped is unsustainable as populations swell and they look to a future when oil runs out. The need to diversify economies and develop private sectors has become a common theme.

But Abu Dhabi – where Mr Alromaithi is vice-president of operations at Emirates Steel Industries – is pushing ahead with arguably the most ambitious programme of all. More than $300bn (€200bn, £181bn) worth of infrastructure and property projects have been announced for the UAE capital; billions more dollars are also being spent by state investment vehicles to tap into the latest technology and lure businesses to the emirate.

No longer the retiring, sleepy place that was happy to let the smaller Dubai grab attention with its mega-projects, Abu Dhabi plans to be an internationally recognised metropolis by 2030, with a mix of high-end cultural tourism, technology and other industries that are capital- and energy-intensive. It is benchmarking itself against what it describes as “transformation economies” such as Singapore, New Zealand and Norway – small countries that have pursued successful development models.

HOW TO DIVERSIFY

A capital that is avoiding many – but not all of Dubai’s errors

“We will learn from Dubai’s mistakes.” Thus spoke one of Abu Dhabi’s leading powerbrokers a few years ago as a new generation came to the fore in the emirate, keen to emulate the success – and avoid the pitfalls – of its brasher neighbour.

In many ways the United Arab Emirates’ capital has done just that. Dubai, built on trade even before the discovery of its modest oil reserves, has in recent decades turned itself into an entrepreneurial hub encompassing tourism, transport, services and finance. But, with its grand ambitions and dependence on debt, it has come somewhat unstuck during the credit crisis. By contrast, Abu Dhabi’s vast oil and investment wealth have given it the luxury of time and greater resources with which to plan.

While Dubai built beach resorts and city h

otels for tourists from Europe, the Gulf and Asia, the capital has foc

used on higher- spending leisure and, later, branches of the Guggenheim and Louvre museums are intended as a testament to that vision. Abu Dhabi has pursued industrial developments, from petrochemicals to steel, to tap into its cheap energy resources; Dubai has focused on services and trade.

But Abu Dhabi is also trying to move into sectors that helped Dubai to transform itself so successfully over the past decade, such as the media. The capital’s new and well funded film festival and art show compete with established events in Dubai – although the jury is out on whether these schemes will flourish in the same way. Finance could also become a pillar of the emirate’s diversification as it launches bespoke buildings in the Sowwah Square development aimed at the banking community. International institutions that set up in Dubai’s financial district are already wondering if they might have to open offices in the capital, which is the source for more business than indebted Dubai.

Yet the UAE capital has failed to avoid two of Dubai’s most obvious problems: clogged traffic and housing shortages. As in Dubai a few years ago, public transport has lagged behind population growth; inhabitants must wait another six years for a metro system.

When they meticulously planned the city’s future – but failed to deliver enough houses and offices to meet demand created by its myriad developments – Abu Dhabi’s new generation of leaders provided an unintended fillip for Dubai’s blighted property market. The area closest to the capital turning into a dormitory for Abu Dhabi workers willing to tolerate a three-hour drive each day for lower rent.
Simeon Kerr

In doing so, the emirate is targeting sectors that helped drive the Asian “tiger” economies, combined with construction projects that draw comparisons with brash Dubai. The difference is that Abu Dhabi’s greater oil riches mean it is doing so from a more solid financial position.

As young Emiratis produce high-technology components for customers including Airbus, say, Abu Dhabi could in future see wealthy tourists spending a day on a “cultural island” at the Louvre and Guggenheim museum offshoots it will host. Next, visitors might hop over to a space port and experience a sub-orbital flight. At least, that is the dream.

Few doubt that Abu Dhabi has the wealth to push forward with its goals. It is endowed with the world’s second-highest level of combined oil and gas reserves and production per head, after neighbouring Qatar, according to Moody’s, the ratings agency.

For decades, its rulers tucked away surpluses in the Abu Dhabi Investment Authority, generally regarded as the world’s largest sovereign wealth fund with estimated assets of around $400bn. Nominal gross domestic product per capita soared to $87,000 last year, making it one of the richest locations in the world.

Recent spending has reached far and wide in its quest for talent and expertise. Last month, Abu Dhabi added to its collection of assets when Advanced Technology Investment Company announced it was acquiring Chartered, the Singapore-based semiconductor manufacturer, in a deal with a total value of $3.9bn. Atic emerged from nowhere last year with the announcement that it was investing $2.1bn in a new US-headquartered semiconductor manufacturer with AMD . Atic is spending up to $6bn to build new fabrication facilities in Germany and New York.

The deals give Atic global exposure and a chance to take on Taiwanese chipmakers’ dominance of a market that requires the deep pockets that Abu Dhabi boasts. In less than a year, it has gone from zero to controlling 18 per cent of the industry’s outsourced contract manufacturing.

The target is to reach a 30-40 per cent market share within three to five years, acknowledging that it will take at least five years before there is a return on investment, says Ibrahim Ajami, Atic’s chief executive. A local fabrication facility is also part of his plans. “This is about bringing highly sophisticated people; this is about training a new generation of engineers, scientists, of operators and it’s about installing a complete new mindset of how we work and what we produce,” Mr Ajami says.

Atic is just one of a growing stable of investment entities pursuing similarly lofty goals. Deals by others such as Mubadala and Aabar include the acquisition of stakes in Daimler of Germany and Virgin Galactic, Sir Richard Branson’s space tourism project, as well as ventures with EADS, General Electric and Rolls-Royce.

The transformation under way can be traced to the 2004 death of Sheikh Zayed bin Sultan al-Nahyan, the UAE’s founding father. That ushered a new generation into power, led by Sheikh Khalifa bin Zayed al-Nahyan, UAE president and Abu Dhabi’s ruler, and Sheikh Mohamed bin Zayed al-Nahyan, the crown prince.

Sheikh Mohamed, a 48-year-old Sandhurst graduate, and a small group of trusted technocrats are seen as the driving forces behind the evolution. Mr Alromaithi at ESI can in many ways be held up as a model of what the leaders are seeking to achieve. The 34-year-old, a UAE flag on his hard hat, graduated in engineering in the US, took an office job with ESI’s parent company and then, looking for new challenges, moved to the steel plant itself, working his way up to the executive committee.

“We are looking at industries that have a high capital component and a high energy component and these are two competitive advantages we have,” says Khaldoon al-Mubarak, chief executive of Mubadala. “Then you look at the Emirati component and we are looking at industries that are not labour-intensive and here we are able to attract the right quality of Emiratis, train them and then put them in that cost mix.”

Yet the potential pitfalls ahead as Abu Dhabi attempts to move beyond basic industries such as steel and petrochemicals to increasingly technical areas are huge. One main issue will be Abu Dhabi’s limited human resources, as many senior officials already have multiple roles.

Then there is the UAE’s education system: so weak is it that about one-third of the higher education ministry budget is spent bringing high school graduates to a level where they can attend a local university. And while Singapore embraced dual citizenship to retain skilled workers over the long term, the UAE has yet to follow suit in spite of its already heavy reliance on expatriate workers.

Cyrus Behbehani, a senior Middle East executive at Morgan Stanley, the US investment bank, says that if setting up onshore semiconductor facilities were to be an independent undertaking, “it would never be economic or achievable”. But as part of a “global cluster and enterprise”, the odds that Atic will be able to execute such a transfer have dramatically increased. “This has similarities with the Korean conglomerates in the 1990s, focusing and investing heavily and counter-cyclically when others were down in the memory chip sector and then in the semiconductor sector,” Mr Behbehani says.

Another banker, however, predicts challenges for Abu Dhabi’s goal of establishing itself as a manufacturer of aerospace components in particular. “It’s not that you’re dislodging it from France. You’re actually competing against the Koreans,” he says. “Even if you have cost advantages with the west, I don’t see how you can have cost advantages over the east.”

Still, observers say that Abu Dhabi is right to be seeking to modernise – and that now is a good time to do so. The oil boom has topped up its investment war chest, and the global financial and economic crisis then meant it was one of the few left standing with capital to take advantage of depressed asset prices. Ultimately, though, the test will lie in implementation and execution – and whether the right sectors have been identified, as the emirate is starting virtually from scratch.

“It’s a bit like your three-year-old son saying he wants to become an astronaut and now he’s applying for an engineering degree. He might not prove to be quite so good at maths, or he might have vertigo,” says another international banker. “But it’s good to see him trying rather than saying ‘my dad is rich’ and asking for a new car.”

Government officials, who insist they should be judged over the long term, acknowledge the risks. “We have a clear vision but we are still learning so it will require fine tuning,” says one. “Some of our choices might turn out to be wrong but our wealth of natural resources gives us a cushion and the luxury of time.”

The alternative would be to live life within a closed economy, cash invested overseas and laws that guarantee Emiratis a government job “so you create a society where nobody needs to work”, he adds.

“Right now we are comfortable with our resources, but you see the likes of Argentina and Brazil 100 years ago, they had resources that disappeared, so we are preparing ourselves for the future. There are always issues with implementation, but this is the right path. It’s better to take the bitter medicine now, when you have the resources, than when you are forced to.”

Yet some Emiratis are concerned that they can already taste that medicine. The pace of development is prompting questions about whether nationals, which represent only about 20 per cent of the UAE’s population, risk being diluted by the arrival of ever more foreign workers and finding themselves, and their culture, pushed to the margins.

“OK, we have a semiconductor factory. Who will work there? They will bring more expatriates. [The pace of change] is not gradual, giving us enough time to be absorbed,” says a civil servant. “Just imagine 10 people in your home, eating your food, visiting your bathroom. You don’t have enough space.”

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FT: The genuine nobility of manufacturing

The genuine nobility of manufacturing

By Luke Johnson

Published: September 29 2009 22:01 | Last updated: September 29 2009 22:01

Something has been troubling me for a long, long time. I have a certain regret about the industries to which I have devoted my attention. I love fields like hospitality and the media, where I have spent much of my career. I understand how the economics work: restaurants and broadcasting can offer high margins and excellent cash flow, and providing diners and viewers with pleasure is hard to beat.

But a part of me would have loved to have been a genuine manufacturer. There is something authentic, something noble about making physical objects. It appears to me the essence of capitalism. Service and support sectors are all very well, but their output feels so much less tangible than a production business. Moreover, economies need balance: that way they are better equipped to ride out downturns.

Success in manufacturing needs at least four ingredients that are in short supply in countries like Britain. First, it needs patient capital – returns are rarely quick or indeed easy in many manufacturing spheres such as automotives, machinery or electronics. Second, it needs steady capital expenditure – unlike activities such as media, for example, which demands little. Third, it needs an army of sub-contractors and suppliers supporting the core fabrication. And finally, it needs engineering and technical skills in the workforce.

In truth, I have found service industries an easier and more certain path to profit than manufacturing. I served as a director and part-owner of a producer of large print presses, but the wild fluctuations in orders and work-in-progress were scary, and the quality of the global competitors was intimidating. Endless research and development expenses absorbed heavy amounts of cash flow. Low-cost foreign rivals can always undercut you. Meanwhile, regulation and taxation place an ever-greater burden on any factory owner. In this safety-first age, it often feels as if we have become almost too squeamish to cope with the grit and noise of manufacture.

But manufacturing matters not simply because of vaguely romantic notions about creating things. It provides well-paid blue-collar and professional jobs. It generates exports to help offset trade deficits generated elsewhere in the economy. It adds far more value pro rata than service industries. Every major plant fosters clusters of other businesses. And with R&D, patents, investment and original technology, it is possible to construct formidable barriers to entry for rivals.

And I think high-quality manufactured goods stimulate a pride and belief in industry and business that other outputs cannot match. Just look at how confident Germans are in their motor vehicles and machine tools.

Meanwhile, in the UK, our largest industry is financial services: what reputation does that profession have among the public? I would think it ranks alongside grave-robbing and arson in general esteem.

These days most manufacturing of scale needs to be global and best in class. That means great technology, a highly skilled workforce and solid leadership. And it probably requires investors and management to tolerate lower pay and returns than the rewards available in the City.

Government could do much to balance out these challenges – probably through favourable tax policies. I have never fully understood why lines of work such as property development, investment banking, hedge funds and private equity are so lucrative, and engineering much less so.

In almost any country, dealing in property, shares or companies will likely lead to riches far faster than running factories to produce the goods we all need. I would love an economist to explain to me the flaw in our system that leads to this far from ideal outcome.

Most intelligent entrepreneurs and executives desire to invest their work with meaning. They like the idea of improving the world while earning a living. And many of us who mostly shuffle paper secretly admire those in the Hard Industries, who manufacture things, in spite of all the obstacles.

lukej@riskcapitalpartners.co.uk
The writer is chairman of Channel 4 and runs Risk Capital Partners, a private equity firm

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FT: An enhanced vantage

An enhanced vantage

By James Wilson, Richard Milne and Gerrit Wiesmann

Published: August 16 2009 19:21 | Last updated: August 16 2009 19:21

One day this summer, Michael Bohndorf, a 69-year-old Deutsche Bank shareholder, travelled from his home on the Spanish island of Ibiza for a meeting in Frankfurt with one of the bank’s lawyers. There, he recalls, he received a “white gloves” welcome.

EDITOR’S CHOICE

China says Rio spying has cost it $100bn - Aug-10

Deutsche Bank finds four cases of surveillance - Jul-22

Deutsche Bank caught by ‘spying’ probe - Jul-20

Google executives face Milan trial - Jun-21

Editorial: Protecting privacy - Jun-21

Facebook applications raise privacy fears - Jun-18

“I was treated like the prince of Peru,” he says. “It was all ‘How would you like your tea, Mr Bohndorf?’”

If Mr Bohndorf, a German lawyer, found the deference exaggerated, it was not surprising. As both he and the bank’s own lawyer knew, the meeting was the consequence of much more unpleasant conduct by the bank: the use of private detectives to investigate him. In an operation that could have come from a spy novel, detectives allegedly arranged a holiday rental of the shareholder’s house to try to unearth information. He also claims a woman was sent as a “honey trap” to glean material about him.

Under scrutiny at the time, from the bank’s point of view, had been Mr Bohndorf’s criticism of Deutsche Bank and his potential links to Leo Kirch, a businessman who is one of its most dogged courtroom opponents. The tables are now turned. Germany’s largest bank has had to apologise to Mr Bohndorf (pictured below) – and give some humbling explanations about how it came to be involved in other possible violations of privacy that involved members of its own management and supervisory boards. It is also under investigation from financial and data protection watchdogs, while state prosecutors are considering whether there are grounds for a criminal probe. The bank says it has found four isolated incidents raising concerns but adds that senior executives did not know about the activities.

The bank is far from the only big company to have admitted overzealous surveillance. Deutsche Telekom used an independent security company to comb the phone logs of supervisory board members. Deutsche Bahn’s chief executive quit after the state-owned rail company admitted monitoring contacts between thousands of employees and suppliers. Lidl, a discount supermarket chain, spied on staff at work and logged information about their health.

Germany is not alone in its corporate spying scandals. In the US, Hewlett-Packard used private investigators who obtained the phone records of journalists . Recent UK revelations of methods used by detectives employed by the News of the World, the tabloid newspaper – hacking into voicemail messages – have highlighted ethical lapses in journalism.

But the quantity and seriousness of German cases call into question why Europe’s largest economy seems particularly prone to outbreaks of corporate spying. That, in turn, leads to scrutiny of the country’s attitude to privacy as well as its wider standards of corporate governance.

Moreover, in the German context – only two decades since the fall of the Berlin Wall brought the methods of East Germany’s secret police to light – such practices cause shock. A Deutsche Telekom director says: “Do we want to go back to the days of the Gestapo under Hitler or the Stasi in the DDR? Of course not. That is what makes this whole incident so distasteful.” Mr Bohndorf himself says: “This was not some corrupt little bank – this was Deutsche Bank. This stood for something, like the Bank of England. So could you imagine how disappointed and upset I was that [it] was using methods that we ... thought had been abandoned and did not exist any more. We learnt what happened in East Germany and everyone said that should never happen again.”

That Deutsche Bank should face such charges from an investor is not simply embarrassing. This and other cases have potentially damaging repercussions for the balance of trust between companies and those who have dealings with them.

Deutsche Telekom’s scrutiny of phone records raised doubts for millions of customers about the privacy of their call logs. When Lufthansa data on politicians’ use of frequent flier miles were leaked in 2002, there was shock at their use of such freebies – but also concern at the misuse of customer data. Deutsche Bank, revealing its suspicions about internal breaches, was quick to say no customers were involved, fearing repercussions from worried account holders.

How one company’s misstep led to a change in American law

In recent years great bluster has been generated over accusations that privacy laws or norms were broken by large segments of the US information brokering industry and the anti-terror efforts of the George W. Bush administration, writes Joseph Menn. But one misstep by a single big company produced tangible change.

Hewlett-Packard was engulfed in a spying scandal in 2006, after Thomas Perkins, a veteran HP director and venture capitalist, learnt his phone records had been obtained by private investigators retained by the technology company. Using a set-up similar to that used by Deutsche Telekom unearthed last year, Patricia Dunn, HP chairman, was trying to find out if members of her board had been speaking to the press about company strategy. After conferring with the company’s senior in-house lawyer and chief ethics officer, she signed off on a “pretexting” probe, where outsiders pretended to be the directors they suspected and their possible media contacts. This enabled private eyes to talk phone companies into releasing the calling records of Mr Perkins, director George Keyworth, and reporters for The New York Times and other publications. Ms Dunn got the information she wanted and accused Mr Keyworth, who admitted talking to news site CNet, though he said he revealed no secrets.

Mr Perkins was so outraged over these methods, he resigned. When HP’s regulatory filings claimed his departure had not been the result of a disagreement, he went to the Securities and Exchange Commission and begged to differ. After a cavalcade of investigations and disclosures, Ms Dunn, the senior lawyer and the ethics officer left HP.

The California attorney-general investigated and settled a civil court case over identity theft for $14.5m; the Federal Trade Commission took action against several of the investigators; HP agreed to new practices and paid millions to end shareholder suits last year. Criminal charges against most of those involved, including Ms Dunn, were dropped. Most significantly, her initial contention that pretexting was not illegal exposed it as a widespread practice, sparking a debate that included congressional hearings resulting in a federal law banning it.

“It was a fascinating episode that revealed how far determined board members, with the help of private investigators, could go to dig into the private communications of their colleagues,” says Marc Rotenberg, executive director of the non-profit Electronic Privacy Information Center.

Why do companies risk such compromising allegations? An inevitable conclusion is that they believe there is something to be gained or important interests to be protected. In the case of Deutsche Bank, whose chief, Alfred Herrhausen, was killed by a bomb in 1989, a desire to protect staff is logical. In one case it has acknowledged, it hired investigators to try to obtain a photograph of someone alleged to have made threats against senior managers.

Yet the instinct to protect led to a more serious privacy violation: security for Hermann-Josef Lamberti, the bank’s chief operating officer, was tested without his knowledge in 2007. Similarly, its anxiety about Mr Bohndorf – who attracted the attention of the chairman, Clemens Börsig, when speaking at the 2006 annual meeting – stems at least in part from its legal battle with Mr Kirch, who blames comments by the company’s former chief executive for the collapse of his media empire. The bank denies any wrongdoing by Mr Börsig.

Several cases are linked by a particularly German thread: the system of Mitbestimmung, or co-determination, under which workers have half the seats on most supervisory boards and a big say in decision-making. Some argue this leads to more leaking of sensitive information than elsewhere, whether by workers or retaliating executives. The former chairman of one of Germany’s largest companies says spying “is all the fault of co-determination”.

Deutsche Bank’s first admitted incursion into questionable surveillance, in 2001, was to try to plug a leak it wrongly thought could have come from a union representative on its supervisory board. Deutsche Telekom, which stepped up surveillance after leaks of planned job cuts, remains steeped in the factional culture of the state-owned monopoly it was: unions have a strong role and the part-privatised company is a popular target for public anger when it acts like a for-profit corporation.

A German director with extensive international experience says companies should be cleverer. “Most of the sensitive information with us is discussed beforehand by the capital side of the board and so we reveal only the absolute minimum needed to workers,” he says. Another former chairman says: “Obviously, co-determination is something we would rather not have. But blaming the workers for these scandals is rather convenient – the real fault lies with those who have ordered something seemingly illegal.”

A more dramatic hypothesis for the spy scandals is that Germany’s cold war divide has left it with thousands of underemployed detectives well schooled in the black arts. Many cases in the public eye involve contracted or subcontracted detective agencies. Deutsche Bank says all its incidents stemmed from “external service providers”: at one stage the bank apparently refused to support a proposal by an investigator to get an intern into a law firm used by Mr Kirch. Deutsche Telekom’s surveillance methods came to light after a security company in Berlin reminded the company that it had run computer checks on employees in 2005 and 2006.

The BDD, a German detective association, says members work to high legal standards and dismisses the idea that private investigators are Stasi throwbacks. But “there will always be a few black sheep”, an official acknowledges, adding that there are few restrictions on who can set up in the business. A US investigator says it is not enough for companies to be able to blame behaviour on outside contractors. “There should be no deniability,” he says.

If the sins of the past are reflected in the present, it could equally be because of how fiercely the concepts of data protection and privacy are defended in today’s Germany. Hesse, Deutsche Bank’s home state, enacted some of the world’s first data protection laws back in 1970. Germans are more hostile than many to the use of relatively commonplace security, such as cameras to monitor city centres.

An official at the country’s federal commissioner for data protection and freedom of information says Germans are more concerned by corporate privacy breaches than by state security measures. “People have realised that in some cases companies know more about them than the state or the police,” she adds. “The recent cases have been a wake-up call.”

The head of a European corporate investigation company says practices seen as reasonable elsewhere, such as background screening of employees, are tricky or illegal in Germany. The US investigator says: “There may well be instances that do not cross criminal or legal lines but are outrageous to the general public.”

Hartmut Mehdorn, Deutsche Bahn’s chief executive, insisted in vain that the company’s monitoring of staff was to fight corruption. A report commissioned by the country’s parliament said many methods used had been illegal and he quit in March.

Having unreasonable limits, the European corporate investigator argues, means some companies may feel it is not worth attempting to stay within them. “It is like setting the speed limit on motorways at 40 miles per hour. Why should people drive at 80 miles per hour if it is reasonable but still illegal? They may as well drive at four times the limit, since it is just as illegal.”

The data commission says most German practices are in line with standards across Europe – but it still sees a need for greater privacy protection in employment law. This is being strengthened from September 1 with a legal amendment but the commission says this will only be the “starting gun” for more changes after next month’s general election.

“We don’t want to stop companies fighting against corruption, for example. But we have seen how mistrustful citizens are about companies’ use of their data. For many companies, it might be better – a competitive edge – to be able to show strong data protection rules and win back trust. We should not see it as a disadvantage,” the official says.

With the BDD saying at least 70 per cent of commissions for its detective agencies are from companies, the balance between corporate security and personal privacy is unlikely to become easier to manage. The European corporate investigator says: “There are things that you need to do that are very difficult, if not illegal, in Germany. I suspect we will see more scandals in the future. The problem isn’t going to go away.”

Deutsche Bank has sacked two people over the spying and promised tougher control over outside security agencies but still faces probes into acts performed on its behalf by the external security providers.

For Mr Bohndorf, it is scarcely credible that top directors – Mr Börsig and chief executive Josef Ackermann (pictured at the top addressing an audience) – should be absolved of responsibility, in spite of the bank’s insistence that they did not know what was going on. “A bank has to rely on trust. What they did was breaking everything,” he says. “In all civilised countries they would resign if they had to admit spying on shareholders.”

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