OBSERVER, January 19 1997

The secret price of terrorism. Special report by Tim Sebastian: Cash for no questions - January 1981. After 444 days, the 52 American hostages in Iran are released. Hours earlier, the US government had paid a secret (and never previously revealed) Dollars 150 million ransom. They have been trading with terrorists ever since. Do the deals work?

By TIM SEBASTIAN

Luxembourg: obsessively discreet, conservative and low-profile ideal for the transaction that the Americans had in mind. Their troops had liberated it at the end of the Second World War and their spies had gone on to use it as a clearing house for covert financial operations.

Slowly and without fanfare, US government agencies had spent the Forties and Fifties moving their money around the hundreds of banks and finance houses of the tiny Grand Duchy. They became the cream of the clientele and got what they wanted most secrecy.

As he sat in his office in one of the city's financial giants, Jean Berthoud had reason to reflect on this ultra-special transatlantic relationship, as he carried out an order, telexed from Washington. The date was 18 January 1981 three days before the release of US hostages from their embassy in Tehran. (The 52 American hostages flew from Iran to Wiesbaden in West Germany after 444 days of captivity, minutes after Ronald Reagan was sworn in as fortieth President of the United States.)

As part of the deal, the Americans were unfreezing Iranian assets in the world's largest-ever transfer of private funds. But Berthoud had been given a different task. He was to pay over in freely convertible bearer bonds an $ 8 million ransom that has never before come to light.

Set against the billions that were legitimately in transit, this was indeed a tiny sum. But it ended up sending a very potent signal: under extreme conditions the US would deal with terrorists and hostage-takers and even buy them off. In years to come, that message resounded around the world's darkest corridors, received and understood by extremists of every conceivable stripe. A dangerous precedent had been set.

'We always knew,' says a former senior US government official, 'that four or five top Iranians were paid off over and above the unfreezing of assets. (Bill) Casey was head of the CIA, and would never have trusted his own people to handle it . . . that's why they would have arranged it abroad.'

But within the confines of Luxembourg, bankers were accustomed to th routine transfer of secret funds. In the confidential records of one finance house shown to the Observer, more than 30 unpublished accounts were identified as belonging to the Bank of England, as well as to the French Intelligence Service the DGSE. According to financial investigators, such accounts are frequently used by governments to fund their most delicate machinations. Berthoud was to learn that at first hand. He was instructed by the Federal Reserve in Washington to withdraw half the bonds from the deposits of two major US banks, and dispatch them to the Central Bank in Algeria the established conduit for the Markazi bank in Tehran. Berthoud then asked the Federal Reserve if permission had been obtained from the US banks. The reply caused him to raise both eyebrows. Washington had been unable to contact them but he was not to worry. A similar order was on its way from the Bank of England which would 'top up' and confirm Washington's request.

'Mine was just a small slice of the pay-off,' he says. 'At the time we believed the total ransom was around $150m. That was the figure being put about.'

As the day wore on, London did confirm its side of the transaction, clearing a further $3m but things went wrong in Algiers. The Central Bank told Luxembourg it had no idea what to do with the bonds and no authority to accept them. Tehran would have to intervene. Eventually, the bonds were dispatched, to the delight of the Iranians, who went so far as to request their own accounts with the finance house. They were tactfully turned down.

But by then, word was out among the terrorists and hostage-takers. There was money to be made from the US. For more than three months, the Observer has been investigating the covert contacts governments maintain with terrorists as well as attacks that have never been made public.

In some cases, the facts are sharply at variance with declared policy. A number of state officials, arms dealers and intelligence sources, who spoke to us on condition of anonymity, painted alarming pictures of a rising terrorist threat, deliberately suppressed by worried governments. Terrorists may not be able to bomb their way to public talks, but they can certainly get an audience in a safe house in the Irish Republic, or Switzerland or South America. As one British security source put it: 'Talk to terrorists? Of course we talk to terrorists. It would be wholly irresponsible not to do so.'

Here in Britain, the authorities draw a wavy line between meetings and negotiations and there's little regard for the methods of some European countries. Last month, after French accusations that Britain was being used as a base by Islamic terrorists, intelligence sources in London hit back.

'France,' said one official, 'has a fairly idiosyncratic approach to terrorism, and would tend to negotiate over the taking of hostages. They don't buy the line that if you pay ransom, you leave yourself open to more frequent attack.'

As one of the current targets of choice, with wide-ranging interests in Africa, France may well be more vulnerable than other European states. Algerian extremists have shown no hesitation in taking their grievances to the Paris railway system. But the potential threat is now known to have been much greater than previously admitted.

International arms dealers say that last year the French were allowed to 'find' a disarmed explosive device, left in a public place, as a sign that the terrorists meant business. The word from informed French sources was that it contained radioactive material which could have caused spectacular injuries and introduced an entirely new level of threat. 'Terrorists now have the capability to cause utter chaos on the streets of our capitals,' said one source. 'Yet they've also learnt a more subtle game. Show the authorities just a single device and they'll start paying to keep you from using it.'

But doling out extortion money is no long-term solution. It's fine for the terrorists who have lost some of their most important Eastern-bloc paymasters notably the Soviet Union and East Germany but once they have filled their coffers, the temptation to use newly purchased hardware may be irresistible. Disturbingly, today's terrorist groups have become more numerous and disparate and share no central control.

'Some of the traditional constraints, imposed by the old state sponsors, have gone,' says Dr Bruce Hoffman, expert in terrorism at St Andrew's University. 'Terrorist groups are more diffuse and amorphous right now. There's no great guiding hand, just a lot of very different groups and motivations.'

But there are plenty of things they do share, including funds and support from Iran, which, according to the US State Department, pays out more than $100m a year to terrorist causes. Last year, a report by the parliamentary human-rights group said Iranian assassins had killed 11 of the regime's critics outside the country during the first five months of 1996. But it's not clear where the orders came from. The government and the clerical factions frequently differ on methods and tactics. But none of them is idle.

'The dimensions of what's going on in the terrorist world,' says Hoffman, 'go far beyond what is generally reported.'

What is also unreported, according to arms dealers in the Gulf, is the virtual mass production by Iran of chemical and biological weapons, which poses western governments their most immediate security nightmare. The substances are often odourless and colourless, and thus undetectable by conventional equipment. They are also cheap and easily processed and a little goes a very long way. Stockpiles could already be in place in western capitals which may help explain US reluctance to unleash its forecast retaliation against Iran.

' The operation's in place,' says a high-placed expert. 'But they just don't want to do it.'

The same could be said for international measures against terrorism, redrawn last July in response to the explosion aboard TWA Flight 800. Leading industrialised countries, meeting in Paris, agreed a 25-point list of new measures but, as always, intentions outnumbered actions. France and America, never slow to disagree, clashed over whether to target countries or groups. The French Foreign Minister, Herve de Charette, ended up calling the US analysis, 'a bit simplistic and a bit outdated'. The result: no perceptible increase in international co-operation and a major upsurge in terrorist preparations.

Last month, arms dealers in the Middle East confirmed what western intelligence had already suspected: Six new terrorist training camps had been identified in Afghanistan, with Czechs, Scandinavians and Germans among the recruits. Run by Islamic extremists, in a country still wracked by civil war, they were said to be preparing for operations in Western Europe.

In late October or early November, two lesser-known members of the IRA Army Council were sighted in Libya, seemingly on a shopping trip to one of their traditional suppliers, Colonel Gaddafi. The Americans say he's reluctant to supply arms and explosives to certain causes, but is still regarded as a terrorist sponsor.

German authorities are reported to have identified a new group, replacing the now defunct Red Army Faction. So far, it is building up money and supplies. No attacks have yet been reported.

This information hardly points to all-out Islamic terrorism against the West. But it provides a snapshot of a rapidly developing crisis. It also helps explain the proliferation of all kinds of weapons on the black market, now being tracked by officials in Washington and London. Arms experts point to 'unprecedented nervousness' among the volatile Gulf states, with money and resources flooding out of the region. For some time, they claim, both the United Arab Emirates (UAE) and Saudi Arabia have attempted to play all sides and ride all horses. Intent on building up their international tourism, they're known to have been channelling substantial sums to the Palestinian extremist group Hamas, in an effort to buy it off and prevent terrorist atrocities on their soil. 'The region,' says Dr Hoffman, 'is in far more brittle condition than for many years.'

Nowhere is that more apparent than in Saudi Arabia, where extremists have targeted American military installations, more frequently than the US has admitted. Intelligence sources confirm up to half-a-dozen unreported attacks over the past year, but it's not clear if they produced additional casualties. The worst reported incident occurred last June when terrorists blew up part of a US army hostel. The Americans' reluctance to acknowledge the additional attacks reflects a sense of powerlessness and an inability to retaliate effectively. Moreover, there has been little assistance from the Saudi authorities. In one instance they convicted and executed their suspects before FBI investigators could even question them.

For now, the US policy is to play it all down. 'Why tell the public that something bad has happened but you can't do anything about it,' says an arms expert. 'It only encourages other groups. There could be a lot more of that in the future.'

The motive for the Saudi attacks is a growing hatred of the West in general and America in particular. Arms dealers report a dramatic rise in anti-western rhetoric with increasing calls for the West to be thrown out of the Gulf and denied access to the oil supplies. While that represents little more than the extremist position, it's now being parroted in traditionally more moderate circles. Americans are routinely accused of spreading conflict, pitting brother against brother, and trampling on the cultural sensitivities of the region.

In return, Washington has spent the past few years issuing some pretty blunt warnings. Early in 1994, following evidence of Sudanese involvement in the New York World Trade Center bombing, a US diplomat in Khartoum handed the Sudanese president an untitled and unattributable letter on behalf of his government. It carried no heading and was unsigned but the message was clear enough. 'While we did not publicly link Sudan to terrorist plots in the United States when we placed your country on our list of states that support terrorism, we are of course aware of Sudan's involvement . . . I have therefore been instructed to warn you that if there is a Sudanese hand in instigating or conducting such an act in the United States or against American interests anywhere in the world, there will be a harsh reaction. Our reaction could result in the international isolation of Sudan, in the destruction of your economy and in military measures that would make you pay a high price.'

Despite the simplicity of the note and the strength of its warning, the signs are that it went unheeded. Besides, with a US history of wavering commitments and covert deals, and secret Luxembourg accounts, the terrorists couldn't be sure if this time they meant it.

When it comes to solutions, law enforcement has no doubt at all that it could take on the terrorist groups and their leaders if granted the powers. That would mean, says a senior British police officer, taking the kind of measures that would be deemed brutal and undemocratic. 'You'd have to be saying to these people 'If you want to join a terrorist group, then we'll hunt you down anywhere in the world and kill you. We know who you are. We know where you are.' But it wouldn't happen. We'd just never be allowed to take them on.'

The weakness of the big powers was underlined yet again by the flurry of recent letter bombs sent to a Saudi newspaper in London and New York. Several people were injured. It pointed up the ease with which relatively small groups can penetrate western security and bring their cause to major cities.

'A bomb in London is worth about six in Damascus,' says a security source. 'That's the way they calculate this kind of thing.' What they have also calculated are the odds of successfully holding the world to ransom. And over the past few years, they've been steadily improving. It's already costing us more than you think. If you want to get a feeling for the process, go back to the Grand Duchy of Luxembourg and look out over the slow-moving waters of the River Alzette. You'll never see it move, but the chances are that some very clean money is flowing downstream to some very dirty causes. (Jean Berthoud's name has been changed for his own protection.)