John Cassidy Rational Irrationality

Annals of Economics
Rational Irrationality
The real reason that capitalism is so crash-prone.
by John Cassidy October 5, 2009


In finance, actions can be both individually prudent and collectively disastrous.

On June 10, 2000, Queen Elizabeth II opened the high-tech Millennium Bridge, which traverses the River Thames from the Tate Modern to St. Paul’s Cathedral. Thousands of people lined up to walk across the new structure, which consisted of a narrow aluminum footbridge surrounded by steel balustrades projecting out at obtuse angles. Within minutes of the official opening, the footway started to tilt and sway alarmingly, forcing some of the pedestrians to cling to the side rails. Some reported feeling seasick. The authorities shut the bridge, claiming that too many people were using it. The next day, the bridge reopened with strict limits on the number of pedestrians, but it began to shake again. Two days after it had opened, with the source of the wobble still a mystery, the bridge was closed for an indefinite period.

Some commentators suspected the bridge’s foundations, others an unusual air pattern. The real problem was that the designers of the bridge, who included the architect Sir Norman Foster and the engineering firm Ove Arup, had not taken into account how the footway would react to all the pedestrians walking on it. When a person walks, lifting and dropping each foot in turn, he or she produces a slight sideways force. If hundreds of people are walking in a confined space, and some happen to walk in step, they can generate enough lateral momentum to move a footbridge—just a little. Once the footway starts swaying, however subtly, more and more pedestrians adjust their gait to get comfortable, stepping to and fro in synch. As a positive-feedback loop develops between the bridge’s swing and the pedestrians’ stride, the sideways forces can increase dramatically and the bridge can lurch violently. The investigating engineers termed this process “synchronous lateral excitation,” and came up with a mathematical formula to describe it.

What does all this have to do with financial markets? Quite a lot, as the Princeton economist Hyun Song Shin pointed out in a prescient 2005 paper. Most of the time, financial markets are pretty calm, trading is orderly, and participants can buy and sell in large quantities. Whenever a crisis hits, however, the biggest players—banks, investment banks, hedge funds—rush to reduce their exposure, buyers disappear, and liquidity dries up. Where previously there were diverse views, now there is unanimity: everybody’s moving in lockstep. “The pedestrians on the bridge are like banks adjusting their stance and the movements of the bridge itself are like price changes,” Shin wrote. And the process is self-reinforcing: once liquidity falls below a certain threshold, “all the elements that formed a virtuous circle to promote stability now will conspire to undermine it.” The financial markets can become highly unstable.

This is essentially what happened in the lead-up to the Great Crunch. The trigger was, of course, the market for subprime-mortgage bonds—bonds backed by the monthly payments from pools of loans that had been made to poor and middle-income home buyers. In August, 2007, with house prices falling and mortgage delinquencies rising, the market for subprime securities froze. By itself, this shouldn’t have caused too many problems: the entire stock of outstanding subprime mortgages was about a trillion dollars, a figure dwarfed by nearly twelve trillion dollars in total outstanding mortgages, not to mention the eighteen-trillion-dollar value of the stock market. But then banks, which couldn’t estimate how much exposure other firms had to losses, started to pull back credit lines and hoard their capital—and they did so en masse, confirming Shin’s point about the market imposing uniformity. An immediate collapse was averted when the European Central Bank and the Fed announced that they would pump more money into the financial system. Still, the global economic crisis didn’t ease up until early this year, and by then governments had committed an estimated nine trillion dollars to propping up the system.

A number of explanations have been proposed for the great boom and bust, most of which focus on greed, overconfidence, and downright stupidity on the part of mortgage lenders, investment bankers, and Wall Street C.E.O.s. According to a common narrative, we have lived through a textbook instance of the madness of crowds. If this were all there was to it, we could rest more comfortably: greed can be controlled, with some difficulty, admittedly; overconfidence gets punctured; even stupid people can be educated. Unfortunately, the real causes of the crisis are much scarier and less amenable to reform: they have to do with the inner logic of an economy like ours. The root problem is what might be termed “rational irrationality”—behavior that, on the individual level, is perfectly reasonable but that, when aggregated in the marketplace, produces calamity.

Consider the freeze that started in August of 2007. Each bank was adopting a prudent course by turning away questionable borrowers and holding on to its capital. But the results were mutually ruinous: once credit stopped flowing, many financial firms—the banks included—were forced to sell off assets in order to raise cash. This round of selling caused stocks, bonds, and other assets to decline in value, which generated a new round of losses.

A similar feedback loop was at work during the boom stage of the cycle, when many mortgage companies extended home loans to low- and middle-income applicants who couldn’t afford to repay them. In hindsight, that looks like reckless lending. It didn’t at the time. In most cases, lenders had no intention of holding on to the mortgages they issued. After taking a generous fee for originating the loans, they planned to sell them to Wall Street banks, such as Merrill Lynch and Goldman Sachs, which were in the business of pooling mortgages and using the monthly payments they generated to issue mortgage bonds. When a borrower whose home loan has been “securitized” in this way defaults on his payments, it is the buyer of the mortgage bond who suffers a loss, not the issuer of the mortgage.

This was the climate that produced business successes like New Century Financial Corporation, of Orange County, which originated $51.6 billion in subprime mortgages in 2006, making it the second-largest subprime lender in the United States, and which filed for Chapter 11 on April 2, 2007. More than forty per cent of the loans it issued were stated-income loans, also known as liar loans, which didn’t require applicants to provide documentation of their supposed earnings. Michael J. Missal, a bankruptcy-court examiner who carried out a detailed inquiry into New Century’s business, quoted a chief credit officer who said that the company had “no standard for loan quality.” Some employees queried its lax approach to lending, without effect. Senior management’s primary concern was that the loans it originated could be sold to Wall Street. As long as investors were eager to buy subprime securities, with few questions asked, expanding credit recklessly was a highly rewarding strategy.

When the subprime-mortgage market faltered, the business model of giving loans to all comers no longer made sense. Nobody wanted mortgage-backed securities any longer; nobody wanted to buy the underlying mortgages. Some of the Wall Street firms that had financed New Century’s operations, such as Goldman Sachs and Citigroup, made margin calls. Federal investigators began looking into New Century’s accounts, and the company rapidly became one of the first major casualties of the subprime crisis. Then again, New Century’s executives were hardly the only ones who failed to predict the subprime crash; Alan Greenspan and Ben Bernanke didn’t, either. Sharp-dealing companies like New Century may have been reprehensible. But they weren’t simply irrational.

The same logic applies to the decisions made by Wall Street C.E.O.s like Citigroup’s Charles Prince and Merrill Lynch’s Stanley O’Neal. They’ve been roundly denounced for leading their companies into the mortgage business, where they suffered heavy losses. In the midst of a credit bubble, though, somebody running a big financial institution seldom has the option of sitting it out. What boosts a firm’s stock price, and the boss’s standing, is a rapid expansion in revenues and market share. Privately, he may harbor reservations about a particular business line, such as subprime securitization. But, once his peers have entered the field, and are making money, his firm has little choice except to join them. C.E.O.s certainly don’t have much personal incentive to exercise caution. Most of them receive compensation packages loaded with stock options, which reward them for delivering extraordinary growth rather than for maintaining product quality and protecting their firm’s reputation.

Prince’s experience at Citigroup provides an illuminating case study. A corporate lawyer by profession, he had risen to prominence as the legal adviser to Citigroup’s creator, Sandy Weill. After Weill got caught up in Eliot Spitzer’s investigation of Wall Street analysts and resigned, in 2003, Prince took over as C.E.O. He was under pressure to boost Citigroup’s investment-banking division, which was widely perceived to be falling behind its competitors. At the start of 2005, Citigroup’s board reportedly asked Prince and his colleagues to develop a growth strategy for the bank’s bond business. Robert Rubin, the former Treasury Secretary, who served as the chairman of the board’s executive committee, advised Prince that the company could take on more risk. “We could afford to seek more opportunities through intelligent risk-taking,” Rubin later told the Times. “The key word is ‘intelligent.’ ”

Prince could have rejected Rubin’s advice and told the board that he didn’t think it was a good idea for Citigroup to take on more risk, however intelligently it was done. But Citigroup’s stock price hadn’t moved much in five years, and maintaining a cautious approach would have involved forgoing the kind of growth that some of the firm’s rivals—UBS and Bank of America—were already enjoying. To somebody in Prince’s position, the risky choice would have been standing aloof from the subprime craze, not joining the crowd.

In July, 2007, he intimated as much, in an interview with the Financial Times. At that stage, three months after New Century’s collapse, the problems in the subprime market could no longer be ignored. But the private-equity business, in which Citigroup had become a major presence, was still thriving, and Blackstone, one of the biggest buyout firms, had just issued stock on the New York Stock Exchange. Prince conceded that a collapse in the credit markets could leave Citigroup and other banks exposed to the prospect of large losses. Despite the danger, he insisted that he had no intention of pulling back. “When the music stops, in terms of liquidity, things will be complicated,” Prince said. “But as long as the music is playing, you’ve got to get up and dance.”

The reference to the game of musical chairs was a remarkably candid description of the situation in which executives like Prince found themselves, and of the logic of rational irrationality. Whether Prince knew it or not, he was channelling John Maynard Keynes, who, in “The General Theory of Employment, Interest, and Money,” pointed to the inconvenient fact that “there is no such thing as liquidity of investment for the community as a whole.” Whatever the asset class may be—stocks, bonds, real estate, or commodities—the market will seize up if everybody tries to sell at the same time. Financiers were accordingly obliged to keep a close eye on the “mass psychology of the market,” which could change at any moment. Keynes wrote, “It is, so to speak, a game of Snap, of Old Maid, of Musical Chairs—a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops.”

Keynes’s jaundiced view of finance reflected his own experience as an investor and as a director of an insurance company. Every morning, in his rooms at King’s College, Cambridge, he spent about half an hour in bed studying the financial pages and various brokerage reports. He compared investing to newspaper competitions in which “the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.” If you want to win such a contest, you’d better try to select the outcome on which others will converge, whatever your personal opinion might be. “It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest,” Keynes explained. “We have reached the third degree, where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

The beauty-contest analogy helps explain why real-estate developers, condo flippers, and financial investors continued to invest in the real-estate market and in the mortgage-securities market, even though many of them may have believed that home prices had risen too far. Alan Greenspan and other free-market economists failed to recognize that, during a speculative mania, attempting to “surf” the bubble can be a perfectly rational strategy. According to orthodox economics, professional speculators play a stabilizing role in the financial markets: whenever prices rise above fundamentals, they step in and sell; whenever prices fall too far, they step in and buy. But history has demonstrated that much of the so-called “smart money” aims at getting in ahead of the crowd, and that only adds to the mispricing.

Markus Brunnermeier, an economist at Princeton, and Stefan Nagel, an economist at Stanford, obtained data from S.E.C. filings for fifty-three hedge-fund managers during the dot-com bubble. In the third quarter of 1999, they discovered, the funds raised their portfolio weightings in technology stocks from sixteen to twenty-nine per cent. By March of 2000, when the Nasdaq peaked, the funds had invested roughly a third of their assets in tech. “From an efficient-markets perspective, these results are puzzling,” Brunnermeier and Nagel noted. “Why would some of the most sophisticated investors in the market hold these overpriced technology stocks?” We know that many such investors had no illusions about the prospects of the financial products they traded. But their strategy was to capture the upside of the bubble while avoiding most of the downside—and, with timely selling, many of them succeeded.

Because financial markets consist of individuals who react to what others are doing, the theories of free-market economics are often less illuminating than the Prisoner’s Dilemma, an analysis of strategic behavior that game theorists associated with the RAND Corporation developed during the early nineteen-fifties. Much of the work done at RAND was initially applied to the logic of nuclear warfare, but it has proved extremely useful in understanding another explosion-prone arena: Wall Street.

Imagine that you and another armed man have been arrested and charged with jointly carrying out a robbery. The two of you are being held and questioned separately, with no means of communicating. You know that, if you both confess, each of you will get ten years in jail, whereas if you both deny the crime you will be charged only with the lesser offense of gun possession, which carries a sentence of just three years in jail. The best scenario for you is if you confess and your partner doesn’t: you’ll be rewarded for your betrayal by being released, and he’ll get a sentence of fifteen years. The worst scenario, accordingly, is if you keep quiet and he confesses.

What should you do? The optimal joint result would require the two of you to keep quiet, so that you both got a light sentence, amounting to a combined six years of jail time. Any other strategy means more collective jail time. But you know that you’re risking the maximum penalty if you keep quiet, because your partner could seize a chance for freedom and betray you. And you know that your partner is bound to be making the same calculation. Hence, the rational strategy, for both of you, is to confess, and serve ten years in jail. In the language of game theory, confessing is a “dominant strategy,” even though it leads to a disastrous outcome.

In a situation like this, what I do affects your welfare; what you do affects mine. The same applies in business. When General Motors cuts its prices or offers interest-free loans, Ford and Chrysler come under pressure to match G.M.’s deals, even if their finances are already stretched. If Merrill Lynch sets up a hedge fund to invest in collateralized debt obligations, or some other shiny new kind of security, Morgan Stanley will feel obliged to launch a similar fund to keep its wealthy clients from defecting. A hedge fund that eschews an overinflated sector can lag behind its rivals, and lose its major clients. So you can go bust by avoiding a bubble. As Charles Prince and others discovered, there’s no good way out of this dilemma. Attempts to act responsibly and achieve a coöperative solution cannot be sustained, because they leave you vulnerable to exploitation by others. If Citigroup had sat out the credit boom while its rivals made huge profits, Prince would probably have been out of a job earlier. The same goes for individual traders at Wall Street firms. If a trader has one bad quarter, perhaps because he refused to participate in a bubble, the results can be career-threatening.

As the credit bubble continued, even the credit-rating agencies, which exist to provide investors with objective advice, got caught up in the same sort of competitive behavior that had persuaded banks like Citigroup, UBS, and Merrill Lynch to plunge into the subprime sector. Instead of adopting an arms-length approach and establishing a uniform set of standards for issuers of mortgage securities, the big three rating agencies—Fitch, Moody’s, and Standard & Poor’s—worked closely with Wall Street banks, and ended up giving AAA ratings to financial junk. But under the rating industry’s business model, in which the issuers of securities pay the agencies for rating them, the agencies are dependent on Wall Street for their revenues.

Before Goldman Sachs, say, issued a hundred million dollars of residential-mortgage bonds, it would pay an agency like Moody’s at least thirty or forty thousand dollars to issue a credit rating on the deal. As the boom continued, investment bankers played the agencies off one another, shopping around for a favorable rating. If one agency didn’t think a bond deserved an investment-grade rating, the business would go to a more generously disposed rival. To stay in business, and certainly to maintain market share, credit analysts had to accentuate the positive.

The Prisoner’s Dilemma is the obverse of Adam Smith’s theory of the invisible hand, in which the free market coördinates the behavior of self-seeking individuals to the benefit of all. Each businessman “intends only his own gain,” Smith wrote in “The Wealth of Nations,” “and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” But in a market environment the individual pursuit of self-interest, however rational, can give way to collective disaster. The invisible hand becomes a fist.

In February of 2002, the Millennium Bridge was reopened. The engineers at Ove Arup had figured out how the collective behavior of pedestrians caused the bridge to sway, and installed dozens of shock absorbers—under the bridge, around its supporting piers, and at one end of it. The embarrassing debacle of its début hasn’t entirely faded from memory, but there have been no further problems.

It won’t be as easy to deal with the bouts of instability to which our financial system is prone. But the first step is simply to recognize that they aren’t aberrations; they are the inevitable result of individuals going about their normal business in a relatively unfettered marketplace. Our system of oversight fails to account for how sensible individual choices can add up to collective disaster. Rather than blaming the pedestrians for swarming the footway, governments need to reinforce the foundations of the structure, by installing more stabilizers. “Our system failed in basic fundamental ways,” Treasury Secretary Timothy Geithner acknowledged earlier this year. “To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game.”

Despite this radical statement of intent, serious doubts remain over whether the Obama Administration’s proposed regulatory overhaul goes far enough in dealing with the problem of rational irrationality. Much of what the Administration has proposed is welcome. It would force issuers of mortgage securities to keep some of the bonds on their own books, and it would impose new capital requirements on any financial firm “whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed.” None of these terms have been defined explicitly, however, and it isn’t clear what the new rules will mean for big hedge funds, private-equity firms, and the finance arms of industrial companies. If there is any wiggle room, excessive risk-taking and other damaging behavior will simply migrate to the unregulated sector.

A proposed central clearinghouse for derivatives transactions is another good idea that perhaps doesn’t go far enough. The clearinghouse plan applies only to “standardized” derivatives. Firms like JPMorgan Chase and Morgan Stanley would still be allowed to trade “customized” derivatives with limited public disclosure and no central clearing mechanism. Given the creativity of the Wall Street financial engineers, it wouldn’t take them long to exploit this loophole.

The Administration has also proposed setting up a Consumer Financial Protection Agency, to guard individuals against predatory behavior on the part of banks and other financial firms, but its remit won’t extend to vetting complex securities—like those notorious collateralized debt obligations—that Wall Street firms trade among themselves. Limiting the development of those securities would stifle innovation, the financial industry contends. But that’s precisely the point. “The goal is not to have the most advanced financial system, but a financial system that is reasonably advanced but robust,” Viral V. Acharya and Matthew Richardson, two economists at N.Y.U.’s Stern School of Business, wrote in a recent paper. “That’s no different from what we seek in other areas of human activity. We don’t use the most advanced aircraft to move millions of people around the world. We use reasonably advanced aircrafts whose designs have proved to be reliable.”

During the Depression, the Glass-Steagall Act was passed in order to separate the essential utility aspects of the financial system—customer deposits, check clearing, and other payment systems—from the casino aspects, such as investment banking and proprietary trading. That key provision was repealed in 1999. The Administration has shown no interest in reinstating it, which means that “too big to fail” financial supermarkets, like Bank of America and JPMorgan Chase, will continue to dominate the financial system. And, since the federal government has now demonstrated that it will do whatever is necessary to prevent the collapse of the largest financial firms, their top executives will have an even greater incentive to enter perilous lines of business. If things turn out well, they will receive big bonuses and the value of their stock options will increase. If things go wrong, the taxpayer will be left to pick up some of the tab.

Executive pay is yet another issue that remains to be tackled in any meaningful way. Even some top bankers have conceded that current Wall Street remuneration schemes lead to excessive risk-taking. Lloyd Blankfein, the chief executive of Goldman Sachs, has suggested that traders and senior executives should receive some of their compensation in deferred payments. A few firms, including Morgan Stanley and UBS, have already introduced “clawback” schemes that allow the firm to rescind some or all of traders’ bonuses if their investments turn sour. Without direct government involvement, however, the effort to reform Wall Street compensation won’t survive the next market upturn. It’s another version of the Prisoner’s Dilemma. Although Wall Street as a whole has an interest in controlling rampant short-termism and irresponsible risk-taking, individual firms have an incentive to hire away star traders from rivals that have introduced pay limits. The compensation reforms are bound to break down. In this case, as in many others, the only way to reach a socially desirable outcome is to enforce compliance, and the only body that can do that is the government.

This doesn’t mean that government regulators would be setting the pay of individual traders and executives. It does mean that the Fed, as the agency primarily responsible for insuring financial stability, should issue a set of uniform rules for Wall Street compensation. Firms might be obliged to hold some, or all, of their traders’ bonuses in escrow accounts for a period of some years, or to give executive bonuses in the form of restricted stock that doesn’t vest for five or ten years. (This was similar to one of Blankfein’s suggestions.) In one encouraging sign, officials from the Fed and the Treasury are reportedly working on the details of Wall Street pay guidelines that would explicitly aim at preventing the reëmergence of rationally irrational behavior. “You don’t want people being paid for taking too much risk, and you want to make sure that their compensation is tied to long-term performance,” Geithner told the Times recently.

The Great Crunch wasn’t just an indictment of Wall Street; it was a failure of economic analysis. From the late nineteen-nineties onward, the Fed stubbornly refused to recognize that speculative bubbles encourage the spread of rationally irrational behavior; convinced that the market was a self-regulating mechanism, it turned away from its traditional role, which is—in the words of a former Fed chairman, William McChesney Martin—“to take away the punch bowl just when the party gets going.” A formal renunciation of the Greenspan doctrine is overdue. The Fed has a congressional mandate to insure maximum employment and stable prices. Morgan Stanley’s Stephen Roach has suggested that Congress alter that mandate to include the preservation of financial stability. The addition of a third mandate would mesh with the Obama Administration’s proposal to make the Fed the primary monitor of systemic risk, and it would also force the central bank’s governors and staff to think more critically about the financial system and its role in the broader economy.

It’s a pity that economists outside the Fed can’t be legally obliged to acknowledge their errors. During the past few decades, much economic research has “tended to be motivated by the internal logic, intellectual sunk capital and esthetic puzzles of established research programmes rather than by a powerful desire to understand how the economy works—let alone how the economy works during times of stress and financial instability,” notes Willem Buiter, a professor at the London School of Economics who has also served on the Bank of England’s Monetary Policy Committee. “So the economics profession was caught unprepared when the crisis struck.”

In creating this state of unreadiness, the role of free-market ideology cannot be ignored. Many leading economists still have a vision of the invisible hand satisfying wants, equating costs with benefits, and otherwise harmonizing the interests of the many. In a column that appeared in the Times in May, the Harvard economist Greg Mankiw, a former chairman of the White House Council of Economic Advisers and the author of two leading textbooks, conceded that teachers of freshman economics would now have to mention some issues that were previously relegated to more advanced courses, such as the role of financial institutions, the dangers of leverage, and the perils of economic forecasting. And yet “despite the enormity of recent events, the principles of economics are largely unchanged,” Mankiw stated. “Students still need to learn about the gains from trade, supply and demand, the efficiency properties of market outcomes, and so on. These topics will remain the bread-and-butter of introductory courses.”

Note the phrase “the efficiency properties of market outcomes.” What does that refer to? Builders constructing homes for which there is no demand? Mortgage lenders foisting costly subprime loans on the cash-strapped elderly? Wall Street banks levering up their equity capital by forty to one? The global economy entering its steepest downturn since the nineteen-thirties? Of course not. Mankiw was referring to the textbook economics that he and others have been teaching for decades: the economics of Adam Smith and Milton Friedman. In the world of such utopian economics, the latest crisis of capitalism is always a blip.

As memories of September, 2008, fade, many will say that the Great Crunch wasn’t so bad, after all, and skip over the vast government intervention that prevented a much, much worse outcome. Incentives for excessive risk-taking will revive, and so will the lobbying power of banks and other financial firms. “The window of opportunity for reform will not be open for long,” Hyun Song Shin wrote recently. Before the political will for reform dissipates, it is essential to reckon with the financial system’s fundamental design flaws. The next time the structure starts to lurch and sway, it could all fall down. ♦

James B. Stewart | The Birthday Party: How Stephen Schwarzman became private equity’s designated villain

Profiles
The Birthday Party
How Stephen Schwarzman became private equity’s designated villain.
by James B. Stewart February 11, 2008

On June 18, 2007, Stephen A. Schwarzman, the chairman and chief executive of the Blackstone Group, and his driver approached the Fifth Avenue entrance of the New York Public Library. Schwarzman, a member of the library’s board, was being honored that night. To his dismay, television reporters and cameramen were milling on the steps and the sidewalk. He evaded them by using a side entrance. A TV cameraman managed to penetrate the cocktail party that preceded the ceremony, and Schwarzman was startled when the glare of a camera-mounted spotlight hit him in the face.

In the previous few weeks, he had become the designated villain of an era on Wall Street—an era of rapacious capitalists and heedless self-indulgence that had driven the Dow Jones Industrial Average to new highs, along with the prices of luxury real estate and contemporary art, while the incomes of ordinary Americans stagnated or fell. Blackstone, the partnership that Schwarzman founded, in 1985, with Peter G. Peterson, Secretary of Commerce under Richard Nixon and a former chairman and C.E.O. of Lehman Brothers, was a new type of financial institution: a manager of so-called alternative assets, such as private-equity, real-estate, and hedge funds—esoteric vehicles that barely existed when Blackstone began but now accounted for trillions in assets. Most of the investments came from corporate and public pension funds, endowments of universities and other nonprofit institutions, insurance companies, and rich people. Blackstone was the world’s largest manager of these alternative assets, with $88 billion. Its investors included Dartmouth College, Indiana University, the University of Texas, the University of Illinois, Memorial Sloan-Kettering Cancer Center, and the Ohio Public Employee Retirement System. It had taken control of a hundred and twelve companies, with a combined value of nearly $200 billion. It had just completed what was at the time the largest private-equity buyout ever, the purchase, for $39 billion, of Equity Office Properties, and was on the verge of acquiring Hilton Hotels.

Blackstone was also about to become the largest private-equity firm to offer shares to the public. A week before the library tribute, the company disclosed, as required by the Securities and Exchange Commission, that Schwarzman would receive $677.2 million in cash from the public offering and that he would retain shares worth an estimated $7.8 billion, making him one of the richest men in the country. Coming soon after the lavish and widely chronicled sixtieth-birthday party that Schwarzman had given himself in February, an unflattering profile on the front page of the Wall Street Journal, and strident calls from Congress to raise taxes on private-equity funds like Blackstone’s, the disclosures could only tarnish the public offering.

Nevertheless, investors were eager to buy shares. On June 21st, a heavily oversubscribed public offering was priced at thirty-one dollars a share, at the top of the projected range, causing Blackstone to be valued at $31 billion—not far behind the venerable Lehman Brothers. The next day, Blackstone shares, trading under the symbol BX, opened at $36.45 and closed slightly lower, at $35.06. Schwarzman’s friend James B. (Jimmy) Lee, Jr., a vice-chairman at J. P. Morgan Chase, sent him a congratulatory e-mail:


You were like Indiana Jones over the last few weeks. . . . They rolled giant boulders at you . . . fired poison darts at you . . . threw you into that giant snake pit . . . and yet you still found the grail, and got the blonde. . . . Bravo.

Schwarzman had demonstrated extraordinary timing. Just days before, two Bear Stearns hedge funds holding mortgage-backed securities collapsed—the first tremors of what became a full-blown credit crisis. By the end of the year, major financial institutions had recorded losses on mortgages and related financial instruments of more than a hundred billion dollars. The chiefs of Merrill Lynch and Citigroup lost their jobs. Citigroup, Merrill, Bear Stearns, Morgan Stanley, and UBS turned in near-desperation to sovereign wealth funds (funds held by governments) and rich investors in the Middle East and Asia for capital infusions.

In this chaotic environment, Blackstone had managed to avoid nearly all the pitfalls of subprime mortgages and mortgage-backed securities. It specializes in commercial, not residential, real estate. Indeed, its hedge funds are designed to profit from market turmoil, and the enormous assets that it manages deliver steady fees in good markets and bad. The stock peaked on its first day of trading, however; by mid-January, its value had been cut almost in half.

Schwarzman still had his cash from the offering, which turned out to be $684 million, but his Blackstone stake, worth $8.83 billion after the first day, was worth just $4.62 billion.

Schwarzman has made himself an easy target for critics of Wall Street greed and conspicuous consumption. He lives in splendor in Manhattan, and he has an expanding collection of trophy residences that are lavish even by the current standards of Wall Street. In May, 2000, Schwarzman paid $37 million—reportedly a record sum at the time for a Manhattan co-op—for a thirty-five-room triplex on Park Avenue that was once owned by John D. Rockefeller, Jr. In 2003, he paid $20.5 million for Four Winds, the former E. F. Hutton estate in Florida, which occupies a choice spit of land between the ocean and the Intracoastal waterway. Designed by the Palm Beach architect Maurice Fatio, the thirteen-thousand-square-foot, British-colonial-style estate was a designated historic landmark; local residents were startled when Schwarzman had the house razed. The ensuing fourteen-month wrangle between Schwarzman and his New York architects and the Landmarks Preservation Commission filled countless pages of testimony. It turned out that Schwarzman had got approval for a proposed expansion, and, as the house was dismantled, workers had numbered and stored everything so that it could be rebuilt in an expanded form. In 2006, he paid $34 million for a Federal-style house, on eight acres on Mecox Bay, in the Hamptons, that was previously owned by the Vanderbilt heir Carter Burden.

Schwarzman also owns a coastal estate in Saint-Tropez and a beachfront property in Jamaica. He typically spends summer weekends and August in East Hampton; July in Saint-Tropez; and winter weekends in Palm Beach. His children use the house in Jamaica; he rarely goes there. The five properties and their renovations appear to have cost Schwarzman at least a hundred and twenty-five million dollars. “I love houses,” he told me recently. “I’m not sure why.”

Whatever his indulgences, Schwarzman has always drawn a strict line between personal expenses and Blackstone’s business operations; colleagues say that he keeps a close watch on office spending. The company’s offices, on Park Avenue, are furnished with slightly threadbare traditional rugs and furniture and a mixture of modest prints and photographs. (The offices are scheduled to be renovated later this year.) Blackstone does not own a corporate jet. Instead, it uses Schwarzman’s private jet. (In 2006, the company paid him $1.54 million for the privilege.) Schwarzman must approve any other chartered flights. Partners pay for their own lunches; there is a twenty-five-dollar limit on dinner expenses for employees working at night. Even subscriptions to the Wall Street Journal are deemed personal expenses, and all the partners pay for their own. One exception has always been company events; Blackstone has a long history of opulent anniversary and closing dinners, often at the Four Seasons, which is referred to by some as the Blackstone cafeteria. Still, until recently Schwarzman had trouble getting a prime table in the Grill Room at lunch. According to a friend of both men, when Schwarzman asked Peterson why, his co-founder replied, “It takes more than just money.”

Another traditional measure of wealth is charitable activities and donations, and Schwarzman’s philanthropic activities have received wide notice. With a hundred and fifty million dollars from the public-offering proceeds, Blackstone established the Blackstone Foundation. Schwarzman has contributed to or raised money for a long list of nonprofit institutions, including the Frick Collection, the Whitney Museum, Phoenix House, the Red Cross, the Inner-City Scholarship Fund, the American Museum of Natural History, New York City Outward Bound, the Asia Society, and the Central Park Conservancy. His competitive instincts are as keen here as in business; he told me that every fund-raiser that he has chaired or at which he has been the honoree has set a new record. He is on the board not only of the New York Public Library but of the Frick and of New York City Ballet. Jimmy Lee jokes that his friend has received more accolades and raised more money for the Catholic Archdiocese of New York than any other Jew; Edward Cardinal Egan is a close friend. (Schwarzman has also raised money for the American Jewish Committee.) As chairman of the board of trustees of the Kennedy Center, in Washington, he shares a box every year with the President and the center’s honorees.

In America, board memberships and contributions to worthy causes in the arts and education have traditionally helped cleanse a man of any taint of new money and can temper populist resentment of great wealth. For someone of Schwarzman’s wealth and business prominence, affiliations with boards—which are stocked with the lawyers, bankers, and business executives who are Blackstone’s clients, potential clients, or advisers to them—are all but essential. A board member is expected to make contributions that roughly correlate to the size of his personal fortune. In Schwarzman’s case, this aspect of the pact has generated considerable controversy and ill will, especially given his overt displays of wealth.

Schwarzman pledged ten million dollars to the Kennedy Center, but the pledge was to be fulfilled over ten years, which gave it a present value significantly lower than ten million. According to a fellow member of the library board, “He has given, but not remotely what he could. A big capital campaign is coming up. We hope that he’ll give very generously.”

One of Schwarzman’s most controversial proposed gifts was to Yale, his alma mater, which, during the late nineties, agreed to name the freshman dining commons after Schwarzman in return for $17 million. Some people at Yale thought the commitment was in hand, but it emerged that Schwarzman’s gift would actually be a contribution to one of Blackstone’s investment partnerships on Yale’s behalf. No money would change hands until the fund was liquidated, and there was a risk that the investment might be worth far less than $17 million (although there was also the possibility that it would be worth more). Yale balked at trading a significant naming opportunity for what it considered a speculative commitment, and Schwarzman did not give the money. (The naming opportunity remains.)

The president of Yale, Richard C. Levin, won’t discuss the incident other than to say, “We’re still good friends.” He points out that Schwarzman has raised money for Yale as a member of the executive committee of the current fund-raising campaign and was co-chair of the New York region during the previous one. “He’s been supportive and enthusiastic.” Yale, of course, is hoping for generosity in the future. Levin says, “Now that he’s reached a new level of liquidity, we hope that he’ll become a world-class philanthropist.”

Schwarzman’s longtime friend Jeffrey Rosen, a Yale classmate who is now a deputy chairman at Lazard, defended Schwarzman’s cautious approach. “He believes he can compound the money at a higher rate than an institution can. By reinvesting it now, he’ll have more to give away. In five years, who knows how much he could have? Steve is at the dawn of his philanthropic stage. He’ll mature into this.”

Schwarzman himself says, “I’m thinking through how I want to approach that area of philanthropy. Assuming that Blackstone does well over time, and the credit markets recover, I’ll have significant resources for charitable activities.”

Schwarzman has seemed reluctant to embrace the time-honored relationship between wealth, class, good works, and self-restraint. Richard Beattie, a prominent lawyer who is also a longtime friend, told me, “Steve laughs about the old Wasp image—he doesn’t buy into that old-money standard. He thinks it’s ridiculous.” Schwarzman may be rethinking that view, however; he says that he is pondering a major gift, one likely to silence his critics, but that it would be premature to say more.

Schwarzman’s many friends stoutly defend his right to spend or give away his wealth as he sees fit. I spoke to a number of people who attended the sixtieth-birthday party; most felt that, as one friend put it, “it’s his money, and he should be able to do what he wants with it.” He added, “Isn’t this America?”

I knew Schwarzman in the nineteen-eighties, when he was at Lehman Brothers, but I hadn’t seen him for twenty years. Late last year, we met in the Blackstone offices on several occasions. Although he has gained weight, and his dark hair is now streaked with gray, he has the same dark eyes, and he exudes a restless intensity and an enthusiasm that belies his age. Before we sat down, he showed me around his office, an ample corner space, but modest by the standards of chief executives. Half of his desk is crowded with family photographs. Behind his chair, along the windows facing Park Avenue, are scores of photographs of him with prominent people, including President Bush and Laura Bush, the German Chancellor Angela Merkel, Cardinal Egan, Michael Bloomberg, Colin Powell, President Hu Jintao of China, Bruce Wasserstein, and the 2006 honorees at the Kennedy Center—Andrew Lloyd Webber, Zubin Mehta, Dolly Parton, Smokey Robinson, and Steven Spielberg.

As we began talking, he seemed defensive. Nearly everyone, including Peterson, had advised him to stay out of the news and to avoid reporters, but many of his friends and associates had already spoken to me, and he seemed to warm up when I asked him to recount his path from suburban Philadelphia boy to Wall Street billionaire. He has a vivid memory for details, whether it involves an anecdote from his first job on Wall Street or a troubled buyout or his first merger.

Schwarzman and his younger brothers, Mark and Warren, who are twins, grew up in the suburb of Abington; his mother still lives nearby. Schwarzman’s father came from a comfortably middle-class family of merchants in Philadelphia; his mother grew up poor, in the Bronx. Her father died when she was ten, and her mother worked to support the family. “My father was very bright,” Schwarzman says. “My mother had enormous drive. Put that together, and that’s my gene pool.”

Schwarzman attended Abington High School, where he played basketball and ran track. His height—he is five feet eight—worked against him, but he says he learned that by working and training harder than anyone else “you gain an advantage at the margin.” He ran sprints and cross-country. He likes to tell a story about how, early in one cross-country race, he slipped and broke his wrist. Determined to set a record for the course, he got up and kept running, his arm tucked against his side, and set the record. At the finish, his coach asked him what was wrong. “I broke my wrist,” Schwarzman said, then went into shock and was rushed to the hospital. In 2004, he donated a new football stadium to Abington High School—the Stephen A. Schwarzman Stadium.

Schwarzman’s father and grandfather ran a drygoods store, Schwarzmans, which sold bed and bath linens, draperies, and housewares. When Stephen was fifteen, he approached his father with a plan to open more stores and expand into a national chain, “like Sears.”

“That’s a bad idea,” his father told him. So he suggested expanding in Pennsylvania. Finally, he pleaded with him to open just one more store. All his ideas were rejected. “I’m very happy with my life as it is,” his father explained as Schwarzman kept badgering him. “I’ve got enough money to send you and your brothers to college. We’ve got a nice house and two cars. I don’t want any more in life.” Schwarzman found this incomprehensible. He turned to his mother. “That’s your father,” she said. “He’s happy!”

Schwarzman’s father retired at the age of seventy, after selling the store. It closed ten years later, the victim of mounting competition from national chains like Bed Bath & Beyond.

“I admired him,” Schwarzman said of his father. “He knew what he wanted and he achieved it. But that’s not for me. I wanted a much bigger stage. I didn’t know what it was, but I knew something had to be out there.”

When Schwarzman arrived at Yale, in 1965, he was drawn to superiors—certain professors and administrators—and to students who shared his sense of ambition and were likely to get ahead. “I’ve always been comfortable with people who run things, whether it was the principal of my high school or the president of the university,” Schwarzman told me. “I empathize with their problems, with their issues. I ask myself, How would I do that? It’s very easy if you think about what they think. It comes naturally to me.” His academic record wasn’t distinguished, and he often seemed impatient with intellectual pursuits. In his senior year, he was chosen by Skull and Bones.

The summer before his sophomore year, while recovering from a touch-football injury, Schwarzman decided to study classical music, a subject about which he knew almost nothing. He started with Gregorian chants and worked through the repertoire chronologically, listening to recordings and reading related texts. He studied every major work and every major conductor, often spending, he claims, eight to ten hours a day listening to the stereo system. By late summer, he had reached Tchaikovsky. He was especially captivated by the ballet music from “The Sleeping Beauty.” “I’d close my eyes and listen, and I could see dancing,” he recalled. Back at Yale that fall, he shared his newfound enthusiasm with the physicist Horace Taft, the master of Davenport College, where Schwarzman lived, and his wife, Mary Jane, who loved the ballet. The couple grew fond of him, and Mary Jane tutored him on the fine points of ballet and arranged trips to performances for him.

There were no dance performances on Yale’s all-male campus, but the New England women’s colleges were filled with aspiring dancers. It occurred to Schwarzman that with these women he could stage a dance performance, and charge admission. “Put attractive women in tights and you’d sell out,” he said. He got in touch with Walter Terry, the dance critic for Saturday Review, and persuaded him to attend. He scheduled the performance for a weeknight, when nothing else was competing for students’ attention. The event sold out, and Terry wrote about it in Saturday Review, in the issue of March 29, 1969. In the article, Schwarzman, asked about his future, said, “I can’t afford the arts right now. That takes money. So I’m going to a school of business administration.”

Schwarzman had majored in Intensive Culture and Behavior, an interdisciplinary subject, and hadn’t taken a single economics or accounting course. Law school or business school seemed a logical next step, but he had little sense of where either would lead. During his senior year, he had sent a letter to W. Averell Harriman, the wartime Ambassador to Russia and former governor of New York, who was serving as the President’s representative at the Paris peace talks. “There weren’t that many people in that era to admire, and I wrote him a letter saying I admired him and wanted to meet him,” Schwarzman recalled. Harriman, a fellow Skull and Bones man, invited him to lunch at his town house, on the Upper East Side, occasionally interrupting their talk to take calls from Cyrus Vance, in Paris. According to Schwarzman, Harriman asked him, “Young man, are you independently wealthy?”

“No, sir, I’m not.”

“Well, I am the son of a very rich man, which has made an enormous difference—that’s the reason you’re seeing me. If you have any interest in the political world, I advise you to become independently wealthy yourself.”

Schwarzman applied to several law and business schools. He was accepted at Harvard Business School. Feeling that he needed a break, he asked to defer his admission for a year.

To earn some extra money, Schwarzman worked for the Yale alumni office and then the admissions office. Larry Noble, a 1953 graduate who worked in the alumni office, introduced Schwarzman to others in Yale’s extensive alumni network, including his classmate Bill Donaldson, who was running an investment-banking firm, Donaldson, Lufkin & Jenrette. (Donaldson went on to become chairman and C.E.O. of the New York Stock Exchange and chairman of the S.E.C.) Schwarzman waited in the reception area for half an hour, watching as young bankers hurried past in shirtsleeves, followed by secretaries wearing short skirts and big gold earrings. “It seemed fast-moving, intense,” Schwarzman recalled. “Everyone seemed happy.” When Donaldson asked him why he wanted to work at the firm, Schwarzman replied, “Mr. Donaldson, I don’t even know what you do. But if you have such great-looking girls and intense guys then I want to do it.” Schwarzman was hired at a salary of ten thousand five hundred dollars, which, by his account, was “five hundred dollars more than anyone else in my class at Yale.” He quickly realized that he was unqualified. He left after six months, but, before leaving, he had lunch with Donaldson. “I’m sorry I didn’t make more of a contribution,” Schwarzman recalls saying. “If you don’t mind my asking, why did you hire me and waste your money?”

“It’s simple,” Donaldson replied. “One day you’ll be the head of this firm.”

“You must be kidding. Why?”

“It’s my instinct. You have something special and I want to bet on it.”

(Donaldson says that he has no recollection of such an incident, but he does recall telling Schwarzman that if he returned to the firm he would do well.)

Schwarzman met his first wife, Ellen Philips, during his second year at Harvard Business School, where she worked as a researcher and helped grade essays. She was the daughter of Jesse Philips, a wealthy Ohio industrialist. They were married in 1971 and had two children, Elizabeth, in 1976, and Edward, in 1979. Looking for a job after graduating, Schwarzman was shocked when both Goldman Sachs and First Boston turned him down, but he had offers from Lehman Brothers and Morgan Stanley. He claims that he was only the second Jew to get a job offer from Morgan Stanley, but he chose Lehman. Being at Lehman worked to his advantage. As one former Lehman banker describes the firm, “It was survival of the fittest. You produced the business and then you fought over the proceeds. It was every man for himself.” Bruce Wasserstein, then at First Boston, and soon to be regarded as the leading mergers-and-acquisitions banker on Wall Street, said to Eric Gleacher, the head of M. & A. at Lehman, and Schwarzman, “I don’t understand why all of you at Lehman Brothers hate each other. I get along with both of you.” To which Schwarzman replied, “If you were at Lehman Brothers, we’d hate you, too.”

Tropicana, an important Lehman client that was merging with Beatrice Foods, asked Schwarzman to represent the company in the sale, even though Schwarzman had never worked on a merger. (A Tropicana executive had been impressed by a bond presentation Schwarzman made, and felt that, despite his inexperience, he could explain complicated aspects of a merger to a relatively unsophisticated board.) The $488-million deal, in 1978, marked Schwarzman’s emergence as a lead banker in M. & A., a field that was growing, along with junk-bond empires and a new entrepreneurial breed, the corporate raider.

Schwarzman was too new and too young to rival M. & A. strategists like Wasserstein, but his work habits and his competitive drive impressed clients and other bankers and lawyers in that tightly knit world. A former Lehman colleague recalls a concert at Carnegie Hall that he and Schwarzman attended with their wives. As soon as the lights dimmed and the music began, Schwarzman opened his briefcase, pulled out a sheaf of papers, and began working. Though his wife chastised him at intermission, he resumed working as soon as they returned to their seats. He typically was awake by 4:30 or 5 A.M., and often worked until 10 P.M.—a habit that continues today. Schwarzman was a showman as well. Another Lehman colleague told me that once, when he and Schwarzman were to call on Harry Gray, then the acquisitive chief executive of the industrial conglomerate United Technologies, based in Hartford, they travelled to the meeting by helicopter and limousine. When the colleague asked why they didn’t simply drive or take the train, Schwarzman replied, “You have to make an impression. ‘If you want my time, I’m so valuable this is how I travel.’ ” According to Schwarzman, Gray and United Technologies became a significant Lehman Brothers client.

Schwarzman says that he consistently earned the highest bonus of anyone in his Lehman Brothers “class.” He was made a partner in 1978, just six years after arriving at the firm. In 1980, the Sunday Times ran a profile of Schwarzman, with the headline “STEPHEN SCHWARZMAN, LEHMAN’S MERGER MAKER.” In the office the next day, he was beaming and brandishing a copy. “He loved the publicity, loved the attention,” a friend recalls. At Lehman’s annual firm outing that spring, at a country club, his colleagues had a copy of the article printed on a framed mirror, so that Schwarzman’s face would be reflected whenever he read it.

In 1973, Peter G. Peterson joined Lehman as vice-chairman, and soon afterward became chairman and C.E.O. In addition to having been Nixon’s Secretary of Commerce, Peterson, a former chairman and chief executive of Bell & Howell, had headed Nixon’s Council on International Economic Policy and was a prominent member of the Council on Foreign Relations—a man very much in the postwar mold of an Averell Harriman, a John J. McCloy, or a Nelson Rockefeller, moving easily between private business and public service. He was sought after more for his contacts and his influence than for his business skills; in his work for Nixon, he had travelled incessantly and had got to know the chief executives of the world’s major businesses, often dropping their names in conversation. Peterson was a self-made man of an earlier generation, who had grown up in Kearney, Nebraska. His parents were Greek immigrants who ran a restaurant, where Peterson worked throughout his youth. He remembers people lining up at soup kitchens during the Depression and begging for food at the restaurant.

After investing much of his life savings in an equity stake in Lehman, Peterson discovered, three weeks after his arrival at the firm, that Lehman’s head trader, Lew Glucksman, had run up millions of dollars in losses, drastically depleting the firm’s capital and calling into question its ability to survive. The firm was in disarray. Recruited to help build up the roster of corporate clients, Peterson was suddenly made chief executive, mainly because, as one partner recalls, “he hadn’t been around long enough for anyone to hate him.”

Peterson’s instinct was to try to reconcile the warring factions. Urged by many to fire Glucksman, Peterson argued that Glucksman was a talented trader who had had only one bad year; instead, he named him to the management committee, and later promoted him to co-C.E.O. Peterson set up task forces to evaluate the firm’s strengths, weaknesses, and business plan, and asked Schwarzman to serve on one.

Schwarzman, who was twenty-seven, again demonstrated an extraordinary ability to ingratiate himself with an older man—Peterson was forty-seven—in a position of authority. Peterson recalls that Schwarzman was “extremely gifted, probably one of the two or three most gifted people I’ve met in the M. & A. world. More important, he had balance. He could make the major judgment calls. He knew when a C.E.O. needed to be called. He could gain their confidence better than anyone. I could bring in the business, but I couldn’t implement it. He was great at this, great to work with. He’d carry out the deal, and keep me informed.” Peterson recalls that his goal was to get to No. 2 or No. 3 in the M. & A. rankings. “I’d invite in a C.E.O.,” Peterson said. “I’d meet him, and then I’d invite Steve in for lunch. We got a lot of business this way.”

In 1983, Glucksman organized a luncheon to celebrate Peterson’s tenth anniversary at Lehman. The firm gave him a Henry Moore sketch, and Glucksman spoke enthusiastically of their relationship as co-C.E.O.s. By then, Glucksman’s trading operation was making record profits, and Peterson was credited with saving the firm. Business Week had run a cover story on the firm’s resurrection: “Back from the Brink Comes Lehman Brothers.” Five weeks later, Glucksman summoned Peterson to his office and told him that he had the votes to force him out. “I have to run the place by myself,” Glucksman insisted. Peterson asked if he could at least be given an opportunity to resign, and Glucksman refused.

Schwarzman urged Peterson to fight, insisting that they could rally enough support to block Glucksman. But Peterson saw no point in waging a civil war that might destroy the firm, and said that it was time to start something new. As part of his severance package, he insisted on generous stock options, which would be valuable if the firm was ever sold.

Peterson’s departure did not forestall civil war at Lehman Brothers, and within months the firm was losing money. Schwarzman, accurately gauging the ambitions of Peter Cohen, the chairman of American Express, to expand into the potentially lucrative field of investment banking, approached Cohen (a neighbor in East Hampton) and delivered a persuasive assessment of the benefits to American Express of buying Lehman. In 1984, just nine months after Peterson’s departure, Lehman was sold for $360 million. To many, it was Schwarzman’s most brilliant deal yet: he had enriched himself and his mentor while turning the tables on Glucksman and freeing himself to join Peterson in launching a new partnership.

Schwarzman initially refused to accompany Peterson in that new venture, because Peterson already had a partner, the investor Eli Jacobs, but Peterson and Jacobs soon quarrelled. This falling out cleared the way for Schwarzman to join Peterson, in 1985. Peterson and Schwarzman created a founders’ agreement that vested power in their hands alone, guaranteeing that one faction of partners couldn’t start a war over control of the firm. Peterson and Schwarzman had equal equity shares. Initially, they were going to call the firm Peterson & Schwarzman, with Schwarzman conceding top billing to Peterson, but Peterson argued that they needed something more institutional, or future partners would want their names added, leading to constant changes and an unwieldy name. It was Schwarzman’s idea to call it Black—schwarz, in German—stone, petros, in Greek. “I thought that was brilliant,” Peterson says.

“My job was to bring in business,” Peterson explains. He launched a direct-mail campaign, targeting a hundred chief executives, in which he declared that Blackstone would not back hostile deals and would have no conflicts of interest with investment-banking clients, since Blackstone had no investment-banking clients. According to Peterson, the effort resulted in retainer agreements with E. F. Hutton, Firestone, Union Carbide, Bristol-Myers, and Sony, whose chairman, Akio Morita, knew Peterson from his White House years. Peterson, in turn, joined the Sony board, solidifying his links with Japan.

Schwarzman and Peterson had bigger ambitions than a boutique firm: they wanted an institution with an array of businesses that could deliver a “comparative advantage,” the mantra of competition taught at Peterson’s alma mater, the University of Chicago. Schwarzman was also eager to expand into something less subject to volatile market cycles than M. & A. An obvious target was private equity, the new, sanitized name for the leveraged buyouts that had resulted in the scandals of the nineteen-eighties. Combining a merger-advisory business with a buyout fund was bold; leveraged-buyout funds were considered hostile to existing managements, and that was antithetical to Peterson’s insistence that Blackstone’s activities be strictly friendly to its corporate clients. But he and Schwarzman were convinced that a private-equity fund could be useful to established managements, too.

Shortly after they formed the company, a cautionary scandal involving Dennis Levine, who had been a Schwarzman protégé in Lehman’s M. & A. department, became public. Levine was an aggressive banker who had occupied the office next to Schwarzman’s, and who showed an uncanny ability to foresee hostile bids, which, in turn, often enabled Lehman to approach the target company to defend it. In 1986, Levine, who had left Lehman and was at Drexel Burnham Lambert, was arrested and charged with insider trading. This launched the biggest insider-trading scandal in Wall Street history. Levine agreed to coöperate with investigators, and eventually pleaded guilty to four felony counts. Among those implicated in the ensuing investigation were the arbitrager Ivan Boesky and the junk-bond financier Michael Milken. In short order came the collapse of Drexel Burnham, Milken’s firm and the principal force behind the takeover boom; the collapse of the junk-bond market; the savings-and-loan debacle, which was in part a consequence of junk bonds; and the 1990-91 recession.

According to Schwarzman, much of Levine’s insider trading had involved confidential information that he gleaned from his work at Lehman, including deals that Schwarzman had worked on. “Seldom have I felt so violated or betrayed,” Schwarzman said. “I personally talk to every class of first-year associates and analysts and tell them the story of Dennis Levine. I lecture them on what inside information is and how important it is to keep it confidential. Integrity is a core value. Dennis Levine helped drive that home for me.”

“Blackstone puts a huge emphasis on integrity,” Peterson told me. “We have a code of conduct, and every employee signs it every year. You have an affirmative responsibility to speak out about anything questionable, or unethical, you know about. If you don’t, you’re dismissed. In twenty-three years, we haven’t had one scandal.”

Despite the 1987 crash, the ensuing collapse of the junk-bond market, and the recession, the nineteen-nineties were the beginning of a golden age for private equity. As with leveraged buyouts, the power of private equity, and the wellspring of its remarkable profits, is leverage—the use of borrowed money. The private-equity fund raises capital from rich investors, often pension funds or large institutions. (The fund is “private” in that only invited investors are allowed to participate.) It uses the capital to buy an asset, typically a publicly traded company or a unit of a publicly traded company; restructures it financially to add layers of debt; manages it aggressively to cut costs and boost cash flow; then, after five to seven years, pays off the debt and resells the company or relaunches it on the public markets at an enormous profit. The power of leverage is vast: if you invest ten dollars in an asset and sell it a year later for twelve, you have earned twenty per cent. If you invest one dollar, borrow nine, pay a dollar in interest on the debt (an eleven-per-cent rate), and sell the asset for the same twelve dollars, your return is one hundred per cent.

Much as private-equity firms like to extoll the brilliance of their M.B.A.-holding partners and associates, this isn’t a difficult concept, which raises the question of why public companies don’t embrace the same high-leverage, high-profit model. The reason is that private-equity funds exist to generate capital gains, which are taxed at fifteen per cent; public companies focus on earnings, which are taxed at a much higher rate. Public companies are typically valued at a multiple of earnings, and the interest payments associated with high leverage may all but eliminate earnings. Private companies don’t report earnings. Freed from any preoccupation with quarterly earnings reports, private-equity firms like to praise their long-term perspective, but “long term” means between five and seven years, at which point they sell the asset to realize a capital gain and move on to new conquests. Most public companies are managed so as to exist in perpetuity. Even so, in recent years public companies have added huge amounts of leverage to their balance sheets, often by buying back their shares or taking on debt for acquisitions.

In addition to the turbocharging effects of leverage, private-equity operations like Blackstone benefit from an exceedingly generous compensation structure. The private-equity manager takes a management fee—two per cent is common—of the capital raised from the firm’s investors and twenty per cent of all gains (a stake known as “carried interest”), under the formula known on Wall Street as “two and twenty.” What’s left over is returned to the investors. The fees have no relation to the size or sophistication of the deal or the hours worked. Private-equity bankers reap the same twenty-per-cent carried interest on a multibillion-dollar deal as on one involving several million. A few firms have pushed higher, to twenty-five- and even to thirty-per-cent carried interest, but few have been willing to undercut the standard. Investors have tolerated the exorbitant fees, as long as they have been able to get results that surpass what they can earn in conventional stock and bond funds.

Several early Blackstone deals illustrate the firm’s strategy of combining high-leverage buyouts with M. & A. advisory work for established clients. In 1987, USX (the former U.S. Steel) was under pressure to raise its stock price in order to fend off the corporate raider Carl Icahn. To raise cash for a stock buyback, USX decided to sell its transport subsidiaries, which hauled iron ore and other raw materials into USX’s factories and finished steel out of them. It was an unglamorous, low-growth business, but it had a captive customer in USX and predictable cash flow to service debt. Peterson argued that Blackstone was friendly, whereas other bidders might prove little better than a raider, like Icahn. His argument prevailed, and USX sold the subsidiaries, for $640 million, to a company owned fifty-one per cent by Blackstone and forty-nine per cent by USX and the company’s managers. Blackstone invested just $13 million, with the rest in debt financing. USX used the cash to buy back shares, and Icahn eventually went away. According to Blackstone, the project ultimately generated a return of more than two thousand per cent.

Leverage greatly magnifies gains, but it exacerbates losses in equal measure. Recessions are especially treacherous. An early Blackstone employee, recalling 1990 and ’91, says, “These were tough years. Everyone was trying to prove themselves. The culture hadn’t jelled.” Though Schwarzman could be affable and charming—he called every partner on his or her birthday and sang “Happy Birthday”—he was impatient with failure and felt under intense pressure to prove himself. He sharply criticized employees like Steven Winograd and Brian McVeigh in front of others, forcing them out of the firm in the wake of bad deals. He clashed with Larry Fink, who departed with his money-management unit, BlackRock, which now manages more than a trillion dollars in assets. Roger Altman left to become Deputy Treasury Secretary in the Clinton Administration, and eventually started his own private-equity firm, Evercore.

Turnover among partners was relatively high. The stress and the long hours damaged Schwarzman’s marriage; he and Ellen divorced in 1990, though he remained close to his children.

In 1993, Schwarzman hired another refugee from Lehman Brothers, J. Tomilson Hill, the former co-chief executive, to run Blackstone’s fledgling offerings in the world of hedge funds, the third major prong in Blackstone’s expansion strategy. Hedge funds have been the fastest-growing financial vehicles of the past five years—there are some eight thousand—and are fuelled by the same quest for higher returns and low volatility that has driven the private-equity boom. Hedge funds got their name from investment strategies that sell stocks short, or “hedge” against a declining market, thereby generating high returns in both bull and bear markets, but they embrace many investment strategies. The only thing they have in common with private-equity partnerships is the two-and-twenty (or higher) fee structure. Only recently has Blackstone launched its own hedge funds; its focus had been on what is known as a “fund of funds” approach, meaning that it steered clients’ money into suitable hedge funds. In return, Blackstone takes a fee of one per cent of the assets. The combination of private-equity, real-estate, and hedge funds has given Blackstone a presence in all three of the major alternative-asset classes.

In 1993, Schwarzman was introduced to Christine Hearst, a glamorous forty-year-old who had recently been divorced from Austin Hearst, an heir to the Hearst fortune. Christine, an intellectual-property lawyer, grew up on Long Island, the daughter of a New York City fireman. The two were married in 1995, at Schwarzman’s Manhattan apartment, and the reception was held at the Frick Collection.

The severe decline in stock prices between March, 2000, and October, 2002, during which the S. & P. 500 dropped forty-nine per cent and the technology-heavy Nasdaq composite an astounding seventy-eight per cent, was devastating for the large financial companies, pension funds, and nonprofit institutions that depended on equity gains to finance their operations and to fund their obligations to retirees. The traditional investment mix of equities and bonds had served them well during the nineteen-nineties; now they found their asset values and endowments shrinking and, with them, the spending power that balanced operating budgets. Suddenly, the most desirable investments among institutions were those which, like hedge funds, private-equity, natural resources, and emerging-market funds, don’t necessarily track the stock market—so-called non-correlated assets.

Blackstone, too, struggled during the recession of 2001 and the collapse of the technology bubble, but not to the same extent as venture-capital firms and technology investors. As new money fled the stock market and poured into the firm, Schwarzman’s management style evolved, but only incrementally. Partners recall that, for all the firm’s success, Schwarzman acted as though they were only a deal away from failure. One person recalls a voice mail containing harsh criticism of a troubled deal that followed moments after the “Happy Birthday” call. A Blackstone investor recalls a golf outing with Blackstone partners where the game ended abruptly after the fifteenth hole, because Schwarzman expected his partners to be on time for the cocktail party. “It was ridiculous,” this investor says. “When he says jump, they jump. Still, I have to say they’re very disciplined in their business.”

Early on, Peterson agreed that the firm should have only one chief executive, and readily deferred to Schwarzman, a stickler for detail who chose the firm’s wallpaper and furnishings and interviewed every prospective employee. But, as the firm grew, Schwarzman came under pressure to delegate some management responsibilities and to carve out bigger equity stakes for both existing partners and new executives. Among those arguing for a change in course was Peterson, whose partnership with Schwarzman, perhaps inevitably, was increasingly strained. Although Schwarzman and Peterson had initially had equal equity stakes in the firm, over the years, as equity was awarded to other partners, those grants had come disproportionally from Peterson’s holdings. Peterson agreed that Schwarzman’s role merited a larger stake; indeed, he’d told Schwarzman that he wanted to spend less time at the firm and, in return, was willing to relinquish some of his equity. Still, the negotiations were painful. At one point, Peterson said that he would not give up any more, and he insisted on an agreement in writing. By the eve of the public offering, Schwarzman owned almost thirty per cent of the firm; Peterson’s interest had shrunk to eleven per cent.

Schwarzman and Peterson had different approaches to risk. Peterson was inherently more cautious, and Schwarzman found that every time Blackstone ventured into a new line of business he had to persuade Peterson to go along.

One banker who knows both men well explains, “At this point, there’s tremendous animosity between Steve and Pete. Steve gets the credit, but it was Pete’s Rolodex that built that firm. Pete gave and gave equity to accommodate more people, but Steve never gave. Pete may not be perfect. He encumbered the process. Steve did deserve the greater participation. But Steve never understood the importance of Pete’s broad-gauge nature.” A friend of Schwarzman’s put it this way: “The son eclipsed the father. Neither feels he’s gotten sufficient respect from the other.”

These tensions need to be kept in perspective: the Schwarzman-Peterson partnership, which has survived twenty-three years, is one of the most successful and enduring in Wall Street history. While conceding that there were some issues over equity shares, Schwarzman told me, “I have enormous respect for Pete, and we have a seamless relationship. Ours is the longest adult relationship in my life. We’ve never disagreed on any major issue. We do come at life from different points of view. He’s eighty-one—a different generation. He’s a good strategist and planner, a great thinker. We end up reaching the same conclusions.”

Schwarzman recognized that if he was to remain immersed in deals and larger strategic initiatives Blackstone needed a manager. In early 2002, he approached Hamilton (Tony) E. James, the tall, cerebral, patrician head of the investment-banking arm of Donaldson, Lufkin & Jenrette, which had recently been acquired by Credit Suisse First Boston. Already wealthy from the Credit Suisse First Boston deal, James, who had run his own operations for fifteen years, was planning to pursue personal interests, after helping with the merger. But Schwarzman courted him over a series of dinners at his apartment, and every meeting, James told me, “was more intriguing.” Schwarzman argued that Blackstone was outgrowing its entrepreneurial phase and needed more professional management. James had been deeply involved in all of Blackstone’s lines of business while he was at Donaldson. “People say Steve is a tough boss,” James said. “I don’t mind this; I’m happy to be accountable. Just give me the scope to run the business. He convinced me that I’d be empowered. If others didn’t like it, he’d support me one hundred per cent.”

James arrived in the summer of 2002, the stock market’s nadir. He streamlined operations, brought in new partners, imposed new screening standards for potential deals, and expanded committee oversight, so that deals weren’t based on one person’s judgment. He completed an internal evaluation called “Respect at Work,” aimed at boosting morale and coöperation. He worked to soften Blackstone’s aggressive image with clients and other dealmakers. “I didn’t want to be the most difficult partner—I wanted to get the first call,” he says. In contrast to Schwarzman, James worked toward consensus. “You can’t dictate,” he says. “I was more a guide than a leader.” To the surprise of many, Schwarzman delegated broad authority to James to run the firm.

Peterson gives James much of the credit for the firm’s recent success. “At my age, I can afford to be objective,” he told me. “Steve deserves credit. He’s aggressive, focussed, and growth-oriented. But Tony James is a remarkable manager. People love working for him. If you ask the top people why they’re here, they’ll tell you it’s because of Tony James.”

Blackstone’s alternative-asset businesses were not alone in benefitting from the extremely low interest rates and lax lending standards of the post-September 11th and post-Internet-bubble economy. Residential-real-estate values, which also benefit from high leverage, surged as well, becoming what is now widely conceded to be a bubble that rivalled or surpassed the Internet frenzy in magnitude. Not only were there billions of dollars in home refinancings as Americans drew cash from the rising value of their real estate; subprime lending—to borrowers who had bad credit records or who didn’t document their incomes, assets, or jobs—had soared in recent years. This huge expansion in risky loans was made possible by Wall Street banks such as Citigroup and Merrill Lynch, which bundled the loans together and parcelled out the resulting “collateralized debt obligations”—C.D.O.s—to investors eager for higher returns in a low-interest-rate environment. The theory was that any one of these loans was at high risk of default, but a large and diversified portfolio in which only a small percentage of loans defaulted was so safe that it merited an AAA rating from the credit agencies. Though these loans were hugely profitable for the banks that packaged and marketed them, Blackstone wasn’t tempted. Jonathan Gray, the co-head of Blackstone’s real-estate group, explains that subprime mortgages and related securities weren’t Blackstone’s area of expertise. “We invest in what we know and understand,” he said, noting that the firm has less than one per cent in residential real estate. Schwarzman tries to avoid business meetings when he’s in the Hamptons, but in June, 2006, Michael Klein, the chairman and co-chief executive of markets and banking at Citigroup, came over for lunch. Schwarzman and Klein tried to meet at least once a year outside the office to brainstorm, but this year’s discussion had taken on added urgency as stock markets soared and private equity reaped ever larger gains. Klein unveiled a detailed plan for taking the Blackstone Group public, in an initial public offering that, he argued, would value the company at an astounding $30 billion. This wasn’t the first time someone had broached the idea of going public—Goldman Sachs had been raising the issue for some time, especially after its own successful offering, in 1999. Schwarzman, who had taken so many companies public, had often pondered the possibility. Still, at that point no private-equity or other alternative-asset managers had taken their firms public. It was one thing for full-service investment banks like Goldman Sachs and Morgan Stanley to be publicly owned; they were closer to commercial banks than to private partnerships, and much of their income was fee-driven. But private-equity firms like Blackstone had long argued that their financial interests and incentives were identical to those of their investors: Blackstone partners, by investing in the same partnerships and having a carried interest, prospered when their clients did. If Blackstone was a public company, it would need to consider its shareholders’ interests along with those of its investors.

A public offering would also expose aspects of Blackstone’s business that even close observers could only guess at, such as its ownership structure, its partners’ equity shares, its compensation, and, most important, the exorbitant profits that Blackstone was earning, and, by extrapolation, the exorbitant profits of other private-equity and alternative-asset-management firms. At a time of growing discrepancies in income between the poor and the rich, how would the public react to these revelations? It also seemed peculiar that a private-equity firm, which championed the virtues of private ownership, would elect to go public.

Still, Michael Klein convinced Schwarzman that Blackstone could retain many of the benefits of private ownership, and that it would be able to align the interests of management and investors. Investors would continue to invest, Schwarzman felt, as long as Blackstone delivered superior results. Public ownership would generate capital for investment and expansion and a currency—common stock—that could be used for acquisitions. “Michael wasn’t the first to propose this, but he was the first who really understood the earnings power and the growth potential,” Schwarzman says. “I told him the only problem was that his valuation was too low.”

Peterson told me that he also discussed these issues at length with Schwarzman, including the fact that Schwarzman needed to be discreet about his own wealth. “I could have blocked this, but I didn’t,” he said. “Still, I told him, you’re going to be the focus of intense scrutiny. You’ll be the first. You’d better be prepared.”

As secret preparations went forward, at one point involving as many as a hundred and fifty auditors poring over Blackstone’s records, the buyout boom moved into high gear, with a record sixteen hundred announced deals in the first half of 2007 alone. Stock markets rose as many stocks were valued to include the premiums that a private-equity firm could be expected to pay. Banks competed aggressively to lend, and the spread between junk bonds and U.S. Treasuries—historically, a measure of investors’ tolerance for risk—reached an all-time low. In this potentially lucrative buyout environment, Blackstone began to hold back. “We were cautious in the so-called golden age,” Schwarzman says. “We were the least aggressive of all the big firms in the first half of 2007. We were very concerned about the high prices of deals and the vast amount of liquidity fuelling the boom—we had articulated this at an investor conference in May, 2006. Things always come to an end, and when they do they end badly. We only did two large deals—Hilton Hotels and Equity Office Properties.”

Despite Peterson’s advice to avoid personal publicity, Schwarzman began planning the party for his sixtieth birthday, which fell on February 14, 2007. Weeks before the event, the Times ran an article, by Landon Thomas, previewing the plans and speculating about the guest list: “MORE RUMORS ABOUT HIS PARTY THAN HIS DEALS.” The article also mentioned Schwarzman’s tradition of extravagant Christmas parties, including the most recent, which had had a James Bond theme, and featured models circulating dressed as “Bond girls,” with Schwarzman in a tuxedo. “Steve does not like little things, whether it’s deals, Christmas parties, or his own homes,” the investor Roland Betts, who is a member of the Yale Corporation, told the Times.

Schwarzman and his press spokesman tried to discourage the story, without success, and it came out just as the huge Equity Office Properties deal reached its climax. In the event, the scale of the party disappointed no one. Part of the cavernous Park Avenue armory was transformed into a large-scale replica of the Schwarzmans’ Manhattan apartment by Philip Baloun, the party planner who designed the Prince Charles gala at Lincoln Center. Replicas of Schwarzman’s art collection were mounted on the walls, including, at the entrance, a full-length portrait of him by Andrew Festing, the president of the Royal Society of Portrait Painters. Dinner was served in a faux night-club setting, with orchids and palm trees. Guests dined on lobster, filet mignon, and baked Alaska, and were offered an array of expensive wines. (Schwarzman himself doesn’t drink.)

The comedian Martin Short was the m.c.; he poked fun at his short, rich host. The composer-pianist Marvin Hamlisch played a number from “A Chorus Line.” Patti LaBelle sang a song written for Schwarzman, and Rod Stewart sang a medley of his hits, for a reported fee of a million dollars.

Fortune put Schwarzman on the cover of its March 5th issue, proclaiming him “Wall Street’s Man of the Moment: with a history-making deal and headline-making birthday party, Steve Schwarzman has become the symbol of a new era in finance. And that’s always a risky proposition.”

This kind of attention was exactly what Peterson had feared. “I’m a son of Greek immigrants,” Peterson told me. “For years, I’d shop at sales to save twenty-five per cent and take the shuttle to Washington to save money. I waited twenty-seven years to buy the apartment I wanted. Steve made fun of me, said it was irrational. Maybe he’s right. Steve is a different generation. They were brought up differently. They like to consume. They’re boomers. They want it all and they want it now. To hell with the future!”

On March 22nd, Blackstone filed a preliminary prospectus for an initial public offering, revealing that it had more than $78 billion in assets under management and listing its high returns. Two months later, an updated filing disclosed the existence of an investment by a sovereign wealth fund, the State Investment Company of China; it agreed to pay $3 billion for a non-voting stake of just under ten per cent. The Chinese investment—the first equity stake ever taken by the fund—immediately valued Blackstone at more than $32 billion.

On June 12th, Blackstone added the details that everyone on Wall Street had been waiting for: how much Schwarzman would make in the deal and how much of the firm he and Peterson owned. The prospectus disclosed that Schwarzman would take out $677.2 million from the offering and would retain a twenty-four-per-cent ownership stake, valued at nearly $8 billion, at the expected thirty-dollar-a-share offering price. Peterson would withdraw $1.9 billion, to be placed in a charitable trust, and would retain just a four-per-cent stake, valued at $1.3 billion. Tony James would withdraw $188.5 million and retain a 4.9-per-cent stake, valued at more than $1.6 billion.

“You have no idea what an impression this made on Wall Street,” a friend of Schwarzman’s who works at another bank says. “You have all these guys who have spent their entire lives working just as hard to make twenty million. Sure, that’s a lot of money, but then Schwarzman turns around and, seemingly overnight, has eight billion.”

Two days later, the Wall Street Journal ran a front-page story, by Monica Langley and Henny Sender, that recapped the now notorious birthday party, and quoted Schwarzman’s Palm Beach chef, who said that Schwarzman dined on four-hundred-dollar stone crabs and complained about an employee’s shoes because he found the squeak of their rubber soles distracting. The article quoted Schwarzman saying that his business philosophy is “I want war—not a series of skirmishes” and “I always think of what will kill off the other bidder.”

Schwarzman was wounded by the Journal article, which, he noted defensively, didn’t mention that he had sent the chef’s daughter to summer schools at Harvard and Yale and kept the chef on his payroll while he was undergoing treatments for cancer.

The combination of self-indulgence, seeming disregard for those less privileged, and militant hostility toward rivals inflamed many on Wall Street who were already envious of Schwarzman’s record and the additional fortune that he was about to gain.

The day after the Journal story appeared, Senators Max Baucus and Chuck Grassley proposed legislation that would subject private-equity partnerships like Blackstone, whose earnings had been taxed at the lower rate of “passive income,” to ordinary corporate income taxes. In the House, Charles Rangel proposed that carried interest be taxed at the ordinary income rate rather than at the lower capital-gains rate. The measure would effectively increase Blackstone’s tax rate from fifteen per cent to thirty-five per cent, seriously eroding its profitability, and, according to the Joint Committee on Taxation, would generate an extra twenty-six billion dollars over the next ten years.

On June 22nd, the opening day of trading, Blackstone shares reached a high of thirty-eight dollars. On a day that should have been the pinnacle of Schwarzman’s career, with an achievement likely to earn him a place among such figures of finance as J. P. Morgan and Andrew Carnegie, Schwarzman stayed away from the Stock Exchange and didn’t ring the traditional closing bell, apprehensive about further unflattering publicity. He had no plans for that night. His wife was on a long-scheduled African safari. He worked until after 8 P.M., then returned to his apartment and had dinner in the library, in front of the TV. He wanted to escape, perhaps with an episode of “CSI.” He clicked on the remote, and stumbled onto a live panel discussion on CNBC about him and the Blackstone offering.

“I stared at this in complete amazement,” Schwarzman said. “All I wanted was a normal private moment in front of the TV. I thought it was all over.” He sat for about ten minutes before turning the TV off, feeling odd and alone.

Within weeks of Blackstone’s offering, Wall Street was shaken by rising defaults in subprime mortgages, which exposed the inherent risk in all those supposedly safe, diversified C.D.O.s. Losses appeared throughout the global financial system, surfacing in everything from foreign banks to American pension funds, and even a few very safe money-market funds.

Although Blackstone avoided the mortgage and credit debacles that are expected to lead to more than two hundred and sixty billion dollars in losses, the resulting credit freeze caused asset values to plunge, credit to disappear, and leverage to decline, all of which affected Blackstone’s core businesses. Its earnings for its first two quarters as a public company disappointed investors, and its stock went down. Early last month, Blackstone couldn’t raise the financing for the buyout of the mortgage unit of PHH Corporation, which it had agreed to buy in 2007, and the deal collapsed. At the end of the month, Blackstone’s proposed buyout of Alliance Data Systems, for $6.8 billion, also collapsed, and A.D.S. is suing Blackstone to force it to complete the deal. The “bad ending” that Schwarzman predicted in 2006 seemed to be at hand.

“I’ve lived through periods of illiquidity before,” he said. “Asset prices come down. The economy slows or even goes into recession. Then the cycle re-starts. We buy at lower prices with less leverage. There are great opportunities for high returns—much better than the so-called golden age we’ve just come through. From our perspective, we see greater opportunities going ahead.”

When I was talking with Schwarzman in his office, I asked him how it felt to be the focus of so much negative attention.

He paused, and his look hardened.

“How does it feel? Unattractive. No thinking person wants to be reduced to a caricature.” He continued, “Why did this happen? We went public in June, 2007, at the top of a giant bull market, with a society undergoing rapid change. Globalization. Job dislocation. Middle-class anxiety. Private equity is seen as a symbol of the people who are prospering from a world in flux. That’s a lightning-rod situation.”

He said that “plenty of people” had tried to advise him on how extremely rich people are expected to behave—the charitable activities, the good works, the donations. “But you know what?” he said. “I don’t feel like a wealthy person. Other people think of me as a wealthy person, but I don’t. I feel the same as when I was a fifth-year associate trying to make partner at Lehman Brothers. I haven’t changed. I still think of Blackstone as a small firm. We have to prove ourselves in every deal. Every piece of paper is important. I’m always still trying.”

Schwarzman told me that in 1993, at forty-six, he was found to have a rare blood-protein deficiency that put him at risk of a blood clot or embolism, a condition that had killed his grandfather at the same age. He is tested every few weeks and takes a pill each day, which he says should help guarantee him a normal life span. Still, “it’s a reminder that life is fleeting,” he said. “Every day should be a good day. People fool themselves that they’ll be here forever. I get a daily wake-up call that that’s not true. We have limited time, and we have to maximize it. Live life intensely—I’ve always believed in that. I’m happy to be here. I was happy to make it to sixty. That’s the simple reason for the birthday party.” ♦

John Cassidy | Pump Dreams

The Political Scene
Pump Dreams
Is energy independence an impossible goal?
by John Cassidy October 11, 2004

In the predawn hours of October 6, 1973, on Yom Kippur, Egyptian and Syrian forces launched a surprise attack on Israeli positions in the Gaza Strip and the Golan Heights. Two weeks later, after the Pentagon had started airlifting matériel to Israel, to counter Soviet shipments to Egypt and Syria, King Faisal, of Saudi Arabia, cut off his country’s oil exports to the United States. Other members of the Organization of the Petroleum Exporting Countries, which had been founded in Baghdad thirteen years earlier, followed Faisal’s lead. Almost overnight, the price of crude oil doubled. Gasoline prices rose sharply, shortages developed, and a new phrase entered the American lexicon: “gas lines.” On November 7th, President Nixon, already under pressure from Watergate, addressed an anxious country, saying, “Let us set as our national goal, in the spirit of Apollo, with the determination of the Manhattan Project, that by the end of this decade we will have developed the potential to meet our own energy needs without depending on any foreign energy source.”

More than thirty years later, Nixon, Leonid Brezhnev, Anwar Sadat, Hafez al-Assad, and Golda Meir are all dead—and so is King Faisal, who was assassinated by his nephew in 1975—but energy independence has returned as a major issue. The price of crude recently touched fifty dollars a barrel, drivers in many parts of the country are paying more than two dollars a gallon for gasoline, and both Presidential candidates have been sounding uncannily like Nixon. “I want an America that relies on its own ingenuity and innovation—not on the Saudi royal family,” Senator John Kerry said in his speech at the Democratic Convention, in July. “And our energy plan for a stronger America will invest in new technologies and alternative fuels and the cars of the future—so that no young American in uniform will ever be held hostage to our dependence on oil from the Middle East.” President Bush has countered by pushing his own energy agenda, which includes a controversial proposal to begin drilling for oil in the Arctic National Wildlife Refuge, an idea that Congress has so far rejected. “We will make our country less dependent on foreign sources of energy,” Bush told the Republican Convention.

Although the Democratic and Republican energy plans differ widely, their underlying rationale is the same. In 2003, the United States consumed some twenty million barrels of oil a day, of which slightly more than half was imported from abroad, much of it from the Persian Gulf. By 2020, according to the Department of Energy, domestic oil producers will be meeting less than a third of United States needs, and the Gulf countries will be supplying up to two-thirds of the world’s oil. “This imbalance, if allowed to continue, will inevitably undermine our economy, our standard of living, and our national security,” the Bush Administration’s National Energy Policy Development Group warned in a May, 2001, report. “But it is not beyond our power to correct. America leads the world in scientific achievement, technical skill, and entrepreneurial drive. Within our country are abundant natural resources, unrivaled technology, and unlimited human creativity. With forward-looking leadership and sensible policies, we can meet our future energy demands and promote energy conservation, and do so in environmentally responsible ways that set a standard for the world.”

When energy independence is presented in this way, it is hard to object—who would advocate energy dependence?—but optimism and an appeal to American patriotism don’t add up to a coherent policy. Moving beyond rhetoric and actually trying to make America less reliant on foreign oil involves confronting powerful commercial interests, solving difficult technological problems, and convincing the American public that cheap fuel is not a birthright.

The two hundred and ninety million people who live in the United States make up just five per cent of the world’s population, but they consume a quarter of the world’s oil supply. For much of the twentieth century, the United States was the world’s largest oil producer, and its profligacy wasn’t a pressing problem. Today, however, we are only the third-largest producer, behind Saudi Arabia and Russia. In terms of proven reserves—oil deposits that are known to exist and are believed to be accessible at reasonable cost—we have slipped to tenth place in the international rankings, as reservoirs in Texas, Louisiana, and Oklahoma have started to dry up.

According to the oil company BP’s “Statistical Review of World Energy,” a recognized authority on these matters, at the end of 2003 the United States possessed thirty-one billion barrels of proven reserves, more than China and less than Nigeria. These figures have a straightforward implication: if the United States were forced to rely on its own resources, it would run out of oil in four years and three months. This calculation takes into account the Strategic Petroleum Reserve, which President Ford created in 1975, and which is stored at a number of sites in Texas and Louisiana. At full capacity, the reserve contains about seven hundred million barrels of oil—enough to keep the economy going for a few months during an emergency, such as the outbreak of a war that would cut the supply lines to the Middle East, but not nearly enough to keep gasoline prices low for a more extended period, which is what some politicians have suggested. “The purpose of the Strategic Petroleum Reserve, from its inception, was never to bring down the price of oil,” Larry Goldstein, the president of the Petroleum Industry Research Foundation, told me. “It was to minimize the economic dislocation during supply disruptions, unforeseen shocks to the market.”

The Bush Administration, which has proposed expanded tax breaks for drilling and exploration, apparently believes that there is plenty of oil yet to be discovered beneath the North American continent, a view not shared by the oil industry, which has cut back sharply on domestic drilling. Not so long ago, the deep waters of the Gulf of Mexico were considered a fertile exploration area. Lately, after much costly and frustrating drilling, it has proved something of a disappointment. Lee Raymond, the chairman and chief executive of ExxonMobil, was recently moved to comment that the company would have done better financially if it had given up after sinking a single well there.

The Arctic National Wildlife Refuge, on Alaska’s North Slope, is the new hope. The Prudhoe Bay oil field, one of the world’s biggest reservoirs, is just sixty miles west of the refuge. Surveys carried out by the U.S. Geological Survey suggest that anwr may contain about ten billion barrels of recoverable oil. If this estimate turns out to be reliable, and if exploration starts next year, in 2025 anwr could be generating about a million barrels of oil a day. This is a lot of fuel, but it dwindles next to our energy requirements. By 2025, according to the Department of Energy, Americans will be consuming almost thirty million barrels a day. With luck, an anwr oil field operating at full capacity could satisfy perhaps three or four per cent of that total, meaning that most of the oil we use would still have to be imported.

Senator Kerry’s ambitious energy plan, which doesn’t include drilling in the Arctic preserve, comes in two parts. The less publicized piece involves promoting natural gas and coal, two hydrocarbons that already meet about half of America’s energy needs, mostly in the form of fuel for power stations. Kerry says that he will build a gas pipeline from Alaska, where there are large deposits of natural gas, and invest ten billion dollars in modernizing antiquated coal plants.

These ideas have merit—global stocks of natural gas and coal are huge—but they don’t represent a panacea. As natural gas has come to be used more widely in the United States, we have started to import large quantities of it from foreign producers. America possesses just three per cent of the world’s known reserves; Iran, Russia, and Qatar together possess more than fifty per cent. There can be no guarantee that a future government in Tehran, Moscow, or Doha won’t seek to exercise its market power in the same way that opec did in the nineteen-seventies.

Coal is less subject to political uncertainty, and Nazi Germany demonstrated that it can fairly easily be converted to gasoline. It is still abundant in the United States and in many other countries that are short of oil, such as China and India and some European countries. Modern coal-fired power plants don’t emit nearly as much nitrogen oxide and sulfur dioxide, the two main sources of acid rain, as older plants do. However, burning coal inevitably generates carbon dioxide, the gas primarily responsible for global warming, which even the Bush Administration has now admitted is a genuine phenomenon. It is feasible to sequester the carbon dioxide, but scientists are divided about whether it will prove possible to store it someplace where it won’t get released into the atmosphere. Since 1996, Statoil, a Norwegian company, has been injecting about a million metric tons of carbon dioxide a year into an aquifer under the North Sea. “People like myself have a lot of confidence that this will work,” Bob Williams, a physicist at the Princeton Environmental Institute, told me. “But we can’t say it with certainty until we do a lot more experiments. Nobody is going to be convinced by one demonstration project in the North Sea. You don’t want CO2 to come up into your basement from an underground storage area.”

Many environmentalists see any attempt to prolong our dependence on hydrocarbons as dubious. The Apollo Alliance, an influential umbrella organization of Greens and trade unionists, is calling for the development of power derived from the sun, the oceans, and crops, which it says will enable the country to achieve energy independence within a generation. Senator Kerry has adopted some of the Apollo Alliance’s rhetoric, calling energy independence “the great project of our generation.” The second half of his plan, the conservation and alternative-energy part, includes a pledge to make sure that twenty per cent of America’s electricity comes from renewable energy sources by 2020. Since about ten per cent of the power supply already comes from alternative-energy plants—hydroelectric plants, mainly—this doesn’t sound like an overambitious target, and it hardly amounts to energy independence.

Yet, even getting to twenty per cent represents a big challenge. Power generated from waves, windmills, and solar panels is weak, intermittent, and expensive—at least twice the cost of electricity produced from coal or gas. When it is cold or dark, solar panels don’t produce energy; when it is calm, wind turbines don’t turn. To insure continuity of supply, renewable power plants have to budget for large amounts of overcapacity, a problem that isn’t going to disappear. And, although alternative energy is getting cheaper as technology improves, the same is true of energy generated from hydrocarbons. “He”—Kerry—“is asking for an awful lot without telling us how he’s going to get there and at what cost,” Robert Ebel, a veteran oil-industry executive who once worked for the C.I.A. and now heads the energy program at the Center for Strategic and International Studies, in Washington, said. “Where is the twenty per cent going to come from?”

There is another, more basic problem with Kerry’s proposals. Switching to renewable energy wouldn’t reduce oil imports much, because most power stations don’t run on oil, which is largely used for road and air transport. Developing a transport fuel that can compete with oil is an enormous challenge. For this reason, among others, many analysts regard the candidates’ endorsement of energy independence as a political diversion. “It makes absolutely no sense to talk about energy independence,” Ebel told me. “We cannot produce our way to energy independence, and we cannot use efficiency or conservation to achieve energy independence. It’s just not going to happen, at least in my lifetime.”

If the skeptics are right, what can be done? Some experts, such as Edward L. Morse, who worked in the State Department on energy issues during the Carter and Reagan Administrations, believe that new discoveries in Russia, Central Asia, and West Africa will eventually allow the United States to diversify its sources of petroleum. “The most recent giant field that was discovered was Kashagan, in Kazakhstan,” Morse told me. “That field probably has more oil in place than the total remaining known reserves of the United States. The exploitable resources in the former Soviet Union are probably on the same order of magnitude as those in Saudi Arabia and Iraq.”

Unfortunately, nobody knows for sure how much crude is buried in the Caspian region and Siberia, or how much it will cost to extract those reserves and transport them to world markets. Taking the planet as a whole, the rate at which oil is being discovered has slowed down since the nineteen-sixties, and some geologists believe that global production is about to start falling. Colin Campbell, a British geologist who used to work for major oil companies, has popularized this argument. “Understanding depletion is simple,” Campbell says on the Web site of the organization he founded, the Association for the Study of Peak Oil & Gas. “Think of an Irish pub. The glass starts full and ends empty. There are only so many more drinks to closing time. It’s the same with oil.”

The geological debate is difficult for an outsider to judge. All we know for sure is that proven reserves are concentrated in the Persian Gulf: Saudi Arabia (262.7 billion barrels), Iran (130.7 billion), Iraq (115 billion), the United Arab Emirates (97.8 billion), and Kuwait (96.5 billion). The only country in the Western Hemisphere that has reserves of comparable magnitude is Venezuela (78 billion barrels), which is also a member of opec and boasts a populist, left-leaning President, Hugo Chávez, who frequently rails against United States imperialism. opec oil, for all its geopolitical drawbacks, is cheap, easy to transport, and relatively clean if used efficiently.

One of the key strategic issues facing the United States is how to insure continued access to opec oil when other countries are also importing more fuel. During the past ten years, global demand for oil has risen by almost a fifth, with the greatest increases coming from India and China, which recently passed Japan to become the world’s second-largest consumer of crude oil.

The decision to invade Iraq represented one way to deal with the oil-dependency dilemma: direct American intervention. President Bush, a former Texas wildcatter, and Vice-President Cheney, the former chief executive of Halliburton, the world’s biggest oil-services company, both have an acute understanding of energy issues. In 1999, when Cheney was still at Halliburton, he gave a speech at London’s Institute of Petroleum in which he pointed out that by 2010 the world would probably need another fifty million barrels of oil a day. “So where is the oil going to come from?” Cheney asked. “While many regions of the world offer great oil opportunities, the Middle East, with two-thirds of the world’s oil and the lowest cost, is still where the prize ultimately lies.”

As Vice-President, Cheney was put in charge of the National Energy Policy Development Group, which, in its May, 2001, report, pointed out that the Persian Gulf region would “remain vital to U.S. interests.” The Bush Administration hadn’t publicly raised the possibility of invading Iraq, but in August, 2002, seven months before the war started, Cheney warned that Saddam would be able to seize control of the world’s economic lifeline if he acquired weapons of mass destruction: “Armed with an arsenal of these weapons of terror, and seated atop ten per cent of the world’s oil reserves, Saddam Hussein could then be expected to seek domination of the entire Middle East, take control of a great portion of the world’s energy supplies, directly threaten America’s friends throughout the region, and subject the United States or any other nation to nuclear blackmail.”

Cheney has since been criticized for exaggerating the threat that Saddam represented, but the geostrategic thinking that underpinned the energy portions of his speech was not new. It dated back to January 23, 1980, when President Jimmy Carter declared, in his State of the Union address, “Let our position be absolutely clear: An attempt by any outside force to gain control of the Persian Gulf region will be regarded as an assault on the vital interests of the United States of America, and such an assault will be repelled by any means necessary, including military force.”

Prior to the Carter Doctrine, the United States had exercised its influence in the Middle East through friendly governments in Saudi Arabia and Iran: the so-called “twin pillars” of American policy. But in January, 1979, a popular revolt toppled the Shah, and the new regime in Tehran tilted toward Moscow. Then, in December, 1979, the Soviet Union invaded Afghanistan. Following Carter’s speech, the Pentagon embarked on a lengthy military buildup in the Gulf, beginning with the creation of a Rapid Deployment Joint Task Force, which could be dispatched to the Middle East on short notice. In 1983, President Reagan went a step further, establishing a U.S. Central Command, based in Tampa, and charging it with defending U.S. interests in East Africa, the Middle East, and Central Asia.

When Communism collapsed, the U.S. military didn’t withdraw from the Persian Gulf. After the Gulf War of 1991, it stationed its forces in Saudi Arabia, the Muslim holy land, and built up its presence in Qatar and Turkey. Saddam, after surviving one American-led invasion, eventually fell victim to Washington’s willingness to project its power militarily, a point that Michael T. Klare, a professor at Hampshire College, in Amherst, Massachusetts, stresses in his new book, “Blood and Oil.” “From the vantage of officers and enlisted personnel in the U.S. Central Command, the invasion of Iraq is only the latest in a series of military engagements in the Gulf proceeding from the Carter Doctrine,” Klare writes. “This history helps to explain why the very first military objective of Operation Iraqi Freedom was to secure control over the oil fields and refineries of southern Iraq.”

The policy of direct intervention hasn’t worked as planned. In April, 2003, just weeks after the invasion of Iraq, Vice-President Cheney predicted that by the end of the year Iraq would be able to raise its oil output as much as fifty per cent over prewar levels. Before the war, the Iraqi National Oil Company was pumping about two and a half million barrels a day. Now, with the help of money, personnel, and equipment provided by the American government, it is pumping about 1.8 million barrels a day—at least, on those days when insurgent attacks on pipelines and storage facilities don’t force a cut in production. Early hopes of a surge in foreign investment that would enable Iraq to double or triple production in the next few years have turned out to be fanciful. Western oil companies are understandably reluctant to invest in a country that seems to be slipping toward civil war. “Iraq has great potential, but it also has great problems,” Robert Ebel said. “I would give them perhaps four, or four and a half, million barrels of production a day by the end of the decade—certainly not the six million barrels the Iraqis are talking about.”

To energy traders, what is happening outside Iraq’s borders is at least as important as what is happening inside the country. The Bush Administration’s decision to take military action has destabilized the rest of the Middle East, especially Saudi Arabia, and this has severely rattled the oil market. “People who trade oil futures in New York and London read ten articles saying that the Saudi regime is going to collapse, then they bid up the price of oil,” Robert Mabro, the chairman of the Oxford Institute of Energy Studies and an internationally renowned expert on oil, told me last week. “The fears may be exaggerated, but they are having a big effect on the oil price.”

Contrary to popular belief, the opec cartel, led by Saudi Arabia, no longer controls the price of oil, and hasn’t done so since 1986, when the price collapsed. The price is determined by the forces of supply and demand, operating through the futures markets in New York and London, where oil is traded like any other commodity. During the past couple of years, opec’s eleven members have raised their daily production by almost three million barrels to meet rising demand, and they don’t have much spare capacity left. Futures traders believe that another interruption in supply could lead to a crisis in the market. This has led them to bid up the current price by about fifteen dollars a barrel since the start of the year, an increase that is sometimes referred to in the markets as a security premium. “The recent terrorist attacks in Saudi Arabia and the continuing attacks on oil infrastructure in Iraq are largely responsible for the extant security premium in crude-oil prices,” John Kilduff, an energy analyst at the brokerage firm Fimat USA, said in recent testimony before the Senate Committee on Energy and Natural Resources. “Historically, Saudi Arabia has been the stalwart in terms of being able to fill production gaps when they have occurred. The mere idea that the kingdom may be the source of a supply disruption has caused available crude to become even more valuable in the face of such an uncertainty.”

By invading Iraq, the Bush Administration has unwittingly helped to create what its National Energy Policy was designed to avoid: rising oil prices that threaten to derail the economic recovery. When the price of fuel goes up, it acts like a tax on the economy, reducing consumers’ purchasing power and raising firms’ costs. After the oil-price shocks of both 1973 and 1979, the economy went into a recession. So far this year, the economy has continued to grow, but the rate of expansion has fallen, a development that Alan Greenspan, the chairman of the Federal Reserve, has largely blamed on rising oil prices.

In light of what is happening in the oil market and in the Middle East, many analysts believe it is time to reassess the Carter Doctrine and its Bush-Cheney variant. “I think we are pretty much at the end of the line,” Jeffrey Sachs, the director of Columbia University’s Earth Institute, who also serves as a special adviser to Kofi Annan, the United Nations Secretary-General, told me. “Saudi Arabia is pretty rapidly destabilizing. Iraq I don’t think we are ever going to get under control this way. And our relationship with Iran is poor and deteriorating. The idea that we are going to be the dominant military power of the Persian Gulf is an extremely unrealistic way to manage our affairs. I don’t have an automatic solution. I just think that this one—where we keep building up the military commitment because it keeps failing—is a loser.” A less provocative United States policy stance would involve reducing the American military presence in the Gulf while retaining a veto over what happens there. (American disengagement, which Senator Kerry sometimes seems to advocate, is neither realistic nor desirable.) “The only sensible policy in the Middle East for a superpower is one of benign protection,” Robert Mabro said. “ ‘Don’t misbehave, boys! If you start misbehaving, we might intervene.’ But we aren’t going to be there all the time.”

From an economic vantage point, a strategy based on Realpolitik makes sense. To meet the rising demand for oil in the coming decades, the Gulf states need to spend tens of billions of dollars on expanding their capacity, an enormous capital investment that is unlikely to materialize in a hostile environment. Some opec members already favor keeping the supply tight so that prices will stay high. As in the past, the West will have to rely on the Saudi government to be the voice of moderation. “If you are sitting on a very large reserve base, as Saudi Arabia is, you don’t want somebody coming along and saying, ‘We are really going to make a push to develop an alternative to the internal-combustion engine,’ ” Robert Ebel said. “You have a division of opinion within opec, but Saudi Arabia is big enough to call the shots.”

For decades, energy policy has been subject to a simple political divide: Republicans tend to favor increasing supply; Democrats tend to favor reducing demand. If this split ever made sense, it doesn’t any longer—something that Senator Kerry, to his credit, has grasped, despite his lack of candor about Middle East oil. “There is no single thing out there that is going to solve the problem,” Larry Goldstein said. “You have to focus on the supply side as well as the demand side.” Amy Myers Jaffe, a senior fellow at Rice University’s James A. Baker III Institute for Public Policy, who heads a joint task force on the future of energy with the Council on Foreign Relations, concurs. “A coherent policy has to be a combination of everything,” she said.

Considering Americans’ voracious demand for fuel, the first step is conservation. The measures that Bush and Kerry have proposed, such as providing tax breaks to people who buy gas-electricity hybrids and cars powered by hydrogen fuel cells, are halfhearted. (American carmakers have just started to market these vehicles, in very limited numbers.) A quicker and less costly way to conserve fuel would be to tighten up the Corporate Average Fuel Efficiency standards, which President Ford introduced. The fuel-efficiency requirements—27.5 miles per gallon for cars; 21 miles per gallon for light trucks—have hardly been raised since 1986. Moreover, many S.U.V.s are officially classed as light trucks, which means they are subject to less stringent requirements. If this loophole was closed, at least according to some estimates, demand for gasoline would drop by a million barrels a day—two-thirds of what we import from Saudi Arabia. Yet neither candidate has been willing to face down the auto industry and come out in favor of making the change.

Getting serious about conservation would be a lot more practical than talking about the “hydrogen economy.” In January, 2002, the Bush Administration launched its FreedomCAR Initiative, which was intended to produce an affordable hydrogen-powered automobile within ten or fifteen years. Not to be outdone, Senator Kerry has called for the establishment of a taxpayer-funded Hydrogen Institute, which, his campaign says, would “unite scientists and researchers to create a New Energy Economy by 2020.” These grandiose plans are unlikely to be realized. In his new book, “The Hype About Hydrogen,” Joseph Romm, a former Assistant Secretary of Energy in the Clinton Administration, points out that as far back as 1923 the British scientist John Haldane described an energy economy based on liquefied hydrogen stored in underground tanks. Since Haldane’s day, a great deal of scientific effort has been expended on hydrogen fuel cells, but hydrogen-powered cars are still underpowered, unreliable, and costly. Hydrogen itself is also expensive, because it rarely exists in pure form. The cheapest way to obtain it is to burn coal or natural gas, which produces hydrogen and carbon dioxide.

For this reason, if no other, many experts say that increasing the supply of fossil fuels is essential. “It can’t be our policy that we will never drill for energy in the United States, that we will never have any new import terminals for liquid natural gas, or that we don’t mine coalfields,” Jaffe said. Many people seem to be confused about where the power to light their homes comes from, she went on. “You have movements of canoeists that want to shut down every hydroelectric plant in the country. You have people who believe we shouldn’t renew the leases for nuclear plants. Nobody wants a liquid-natural-gas terminal near their home. They don’t want any drilling for natural gas or oil. The public is really not up to speed on energy issues.”

Many Americans also appear to believe that they are entitled to cheap fuel, regardless of how much they consume. When gasoline hits two dollars a gallon, they look for somebody to blame—this despite the fact that gasoline is still cheaper than it was in the nineteen-seventies, after adjusting for inflation, and that it costs a lot less than it does abroad. In the United Kingdom, for example, a gallon of gasoline costs more than five dollars.

No prominent politician will say it publicly, but from an energy perspective an extended period of higher fuel prices might well be just what the country needs. Many of the problems we now face can be traced to the nineteen-nineties, when oil prices collapsed. Between 1976 and 1985, when gasoline prices were high, drivers switched to smaller, less wasteful cars, and oil consumption fell by ten per cent. Once oil prices slipped back, Americans returned to their beloved gas-guzzlers. Between 1985 and 2000, the demand for oil rose by almost twenty-five per cent.

Higher energy prices would have many beneficial effects. Besides encouraging gasoline conservation, they would help the renewable-energy sector, which can’t compete at today’s prices, and they also would make it economical to start exploiting nonconventional supplies of oil, such as oil shale in the Rockies, tar sands in Alberta, Canada, and heavy oil in Venezuela’s Orinoco Belt. “Under any reasonable economic scenario, in twenty-five or thirty years we will be using more alternative fuels,” Jeffrey Sachs said. “We will be gasifying coal and we will be liquefying tar sands, and doing a lot of things that mean opec’s bargaining power will be reduced.”

The most straightforward way to keep energy prices up, and the one that most developed countries adopt, is to tax hydrocarbons—a policy proposal long regarded as political suicide in the United States. The federal tax on gasoline hasn’t gone up since 1993, when President Clinton raised it a paltry four cents a gallon. Americans prefer lower prices at the pump even if they have to pay hundreds of billions of dollars in taxes to support a U.S. military presence in the Middle East. Amy Myers Jaffe has calculated that the cost to taxpayers of oil-related military activities is equivalent to about ten cents per gallon of gasoline. “We are being taxed on energy in this country,” she said. “It’s just hidden.”

Given the public’s ignorance about energy issues, and the entrenched interests that dominate the industry, many analysts are skeptical about the prospects for change. Jaffe believes that it will take a repeat of what happened in the seventies to force meaningful reforms. Joseph Romm said, “If people cared about oil imports they would buy different cars. In response to 9/11, people started putting flags on their S.U.V.s and buying Hummers. That tells you something.”

Before any progress can be made, the political debate will have to move beyond the myth of energy independence. “Sooner or later, we are going to have a lot of hybrid cars, electric cars, and, perhaps, at some time in the future, we are going to have a hydrogen economy,” Robert Mabro told me. “But, until we get there, to talk about energy independence is foolish. The two candidates, with due respect, are lying to the people, or they don’t know what they are talking about.” ♦