CHAPTER 2
MODERN ALCHEMISTS AND THE SPORT OF MONEYMAKING
Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.
JOHN MAYNARD KEYNES
The capitalist ideal is to create money out of nothing, without the need to produce anything of real value in return. Wall Street has turned this ideal into a high-stakes competitive sport. Money is the means of scoring, and Forbes magazine is the unofficial scorekeeper issuing periodic reports on the “richest people,” ranked in the order of their financial assets. The player with the most assets wins. Because the scoring is competitive, no player has enough money so long as another player in the game has more.
Making money with no effort can be an addictive experience. I recall my excitement back in the mid-’60s, when my wife, Fran, and I first made a modest investment in a mutual fund and watched our savings grow magically by hundreds and then thousands of dollars with no effort whatever on our part. We felt as if we had discovered the philosopher’s stone that turned cheap metals into gold. We got a case of Wall Street fever on what by current standards was a tiny scale.
Of course, most of what we call magic is illusion. When the credit collapse pulled back the curtain to expose Wall Street’s inner workings, all the world was able to see the extent to which Wall Street is a world of deception, misrepresentation, and insider dealing in the business of creating phantom wealth without a corresponding contribution to the creation of anything of real value. It was such an ugly picture that Wall Street’s seriously corrupted institutions stopped lending even to each other for the very good reason that they didn’t trust anyone’s financial statements.
PHANTOM WEALTH
In business school, I learned the art of assessing investment options to maximize financial return. My teachers never mentioned that what we were really learning was to maximize returns to people who had money, that is, to make rich people richer. Nor did they mention that if pursued mechanically, the methods we were learning might result in the creation of phantom wealth. That concept didn’t exist.
Buried in the details of our calculations, no one asked, What is money? Why should we assume that maximizing financial return maximizes the creation of real value? I don’t recall whether such questions ever occurred to me. If they did, I would have kept them to myself for fear of being dismissed as hopelessly stupid.
PHANTOM-WEALTH EXUBERANCE
The illusions of Wall Street are captured in the titles and publication dates of popular books such as:
Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market (2000)
Dow 30,000 by 2008: Why It’s Different This Time(2004)
Why the Real Estate Boom Will Not Bust(2006)
Nor did our teachers ever point out, perhaps because they didn’t recognize it themselves, that money is only an accounting chit with no existence or intrinsic value outside the human mind. Certainly, they never told us that money is a system of power and that the more dependent we are on money as the mediator of human relationships, the more readily those who have the power to create money and to decide who gets it can abuse that power.
If we had been paying close attention, we might have noticed that many fortunes were the result of financial speculation, fraud, government subsidies, the sale of harmful products, and the abuse of monopoly power. But this was rarely mentioned.
It is easy to confuse money with the real wealth for which it can be exchanged — our labor, ideas, land, gold, health care, food, and many other things of value in their own right. The illusions of phantom wealth are so convincing that most Wall Street players believe the wealth they are creating is real. They are standing so far upstream, they may never see the babies floating downstream that the system they serve is throwing into the water.
The market, of course, makes no distinction between the dollars acquired through means that enrich society, those created by means that impoverish society, and those simply created out of thin air. Money is money, and the more you have, the more the market eagerly responds to your every whim. To believe that paper or electronic money is real wealth, rather than simply a coupon that may be redeemed for goods and services of real intrinsic value, is to accept illusion as reality.
Those who create and benefit from phantom wealth’s financial returns may never realize that their gain is unfairly diluting everyone else’s claim to the available stock of real wealth. They also may fail to realize that Wall Street and its international counterparts have generated total phantom-wealth claims far in excess of the value of all the world’s real wealth, thus creating expectations of future security and comforts that can never be fulfilled.
The Edmunds Fallacy
While doing the research in 1997 for The Post-Corporate World: Life after Capitalism, I came across an article in Foreign Policy by John Edmunds, then a finance professor at Babson College and the Arthur D. Little School of Management, titled “Securities: The New World Wealth Machine.” I was stunned. Foreign Policy is a highly respected professional journal with a strict review process. Yet here in its pages was an article recommending that the production of real goods and services should be regarded as passé because national economies can and should be organized around the inflation of financial-asset bubbles. The following is an excerpt:
Securitization — the issuance of high-quality bonds and stocks — has become the most powerful engine of wealth creation in today’s world economy. Financial securities have grown to the point that they are now worth more than a year’s worldwide output of goods and services, and soon they will be worth more than two years’ output. While politicians concentrate on trade balances and intellectual property rights, these financial instruments are the leading component of wealth today as well as its fastest-growing generator.
Historically, manufacturing, exporting, and direct investment produced prosperity through income creation. Wealth was created when a portion of income was diverted from consumption into investment in buildings, machinery, and technological change. Societies accumulated wealth slowly over generations. Now many societies, and indeed the entire world, have learned how to create wealth directly. The new approach requires that a state find ways to increase the market value of its stock of productive assets. [Emphasis in the original.]…Wealth is also created when money, foreign or domestic, flows into the capital market of a country and raises the value of its quoted securities. . . .
Nowadays, wealth is created when the managers of a business enterprise give high priority to rewarding the shareholders and bondholders. The greater the rewards, the more the shares and bonds are likely to be worth in the financial markets.…An economic policy that aims to achieve growth by wealth creation therefore does not attempt to increase the production of goods and services, except as a secondary objective.1
Professor Edmunds is telling government policymakers that they should no longer concern themselves with producing real wealth by increasing the national output of goods and services that have real utility. They should put all that aside. They can grow their national economies faster with less exertion by securitizing real assets so that investors can put them into play in financial markets and pump up their value to create gigantic asset bubbles.
At first I thought perhaps this was a parody intended to expose the irrationality of the exuberance surrounding the inflation of financial bubbles. Or might an editor with a droll sense of humor have let it through to see whether anyone was paying attention? But the next issue of Foreign Policy featured sober commentaries on the article by two other scholars, neither of whom took exception to the obviously flawed logic.
Rarely have I come across such a clear example of the widespread belief, seemingly pervasive on Wall Street, that inflating asset bubbles creates real wealth. Apparently, even the editors of Foreign Policy and their editorial reviewers failed to recognize what I’ll call the “Edmunds fallacy” for the sake of giving it a shorthand name. Asset bubbles create only phantom wealth that increases the claims of the holder to a society’s real wealth and thereby dilutes the claims of everyone else. Edmunds did not invent this fallacy, but its publication in Foreign Policy lent it new intellectual respectability and apparently stirred the imagination of Wall Street insiders.
THE POLICY PREFERENCE FOR PHANTOM WEALTH
In recent decades, the Federal Reserve has allied with the U.S. Treasury Department and Wall Street banks to give the creation of phantom wealth priority over the production of real wealth. Rather than attempt to dampen asset bubbles like the tech-stock bubble of the 1990s and the housing bubble of 2000s, the Fed pursued cheap money policies to encourage borrowing by speculators to support continuing inflation. The growing power and profits of Wall Street signaled the success of these policies.
Meanwhile, the U.S. industrial sector was decimated as production was outsourced to low-wage economies to increase share prices. In many cases, Wall Street inflated the stock prices of its favored companies, which then gave them the power to buy up other companies. WorldCom’s highly valued stock, for example, allowed it to purchase MCI and a dozen other companies. Later, the market turned down and WorldCom was forced into bankruptcy. Stock bubbles create major market disruptions.
The subprime mortgage boom was built on creating overvalued assets that served as collateral for more borrowing to create more overvalued assets. Federal bail-outs to save overleveraged financial institutions when the bubble bursts represent another resource-allocation distortion.
In his 2008 book Bad Money, the journalist and former Republican Party political strategist Kevin Phillips notes that the Edmunds article was widely discussed on Wall Street and implies that it may have inspired the securitization of housing mortgages.2 If it did, then measured by the costs to society of the fraud it helped to inspire, it might be judged the most costly academic thesis of all time.
The Edmunds article reminded me of a conversation I’d had some years earlier with Malaysia’s then minister of forestry. He told me in all seriousness that Malaysia would be better off once all its trees were cut down and the proceeds were deposited in interest-bearing accounts, because interest grows faster than trees. An image flashed into my mind of a barren Malaysian landscape populated only by banks, their computers happily whirring away calculating the interest on those deposits. This is exactly the kind of disaster to which the Edmunds fallacy leads.
No matter who or what inspired the securitization of housing mortgages, Edmunds’s logic is the underlying logic of Wall Street. Forget production and the interests of working people, communities, and nature. Focus on driving up the market price of financial securities by whatever means. The subprime mortgage debacle was a hugely costly test of a badly flawed theory.
Securitizing Subprime Mortgages
After the terrorist attacks of September 11, 2001, the U.S. Federal Reserve sought to counteract the resulting economic disruption by lowering interest rates. By July 2003, they were down to 1 percent, which was below the rate of inflation. The negative cost of borrowing set off a housing bubble and an orgy of leveraged buyouts. Wall Street investment banks invented creative instruments that justified the collection of fees for themselves, allowed them to pass the risks to others, and kept off their own books their position in what came to be called toxic assets.
The availability of cheap mortgages stimulated the housing market, which in turn inflated housing prices. The faster the bubble of easy profits grew, the faster new money flowed in to inflate it even more. Pundits and politicians, embracing the Edmunds fallacy, celebrated as wealth creation the growth in housing prices and sales financed by debt that borrowers had no means to repay.
Banks enlisted independent brokers to sign up borrowers, on commission. The banks bundled the mortgages into securities they sold to investment banks that sliced and diced them, packaged them into complex securities, and then sold them to hedge funds whose math wizards packaged them into even more complex securities that no one really understood.
These securities were “insured” against loss by other highly leveraged Wall Street institutions, such as AIG, which pocketed the premiums but kept only minimal reserves to cover potential losses, on the theory that housing prices could only go up. The investment banks and hedge funds that created the securities claimed that insurance eliminated the risk of holding such securities and hired ratings agencies to certify their claims. The securities were then sold to pension funds, endowment funds, mutual funds, and others as high-yield, risk-free investments. The players at each step along the way made a fortune from the collection of fees and commissions while passing the risks on to the next guy.3
In the home mortgage industry of an earlier time, local banks made loans to local borrowers and carried the risk on their books. If a homeowner could not meet the mortgage payments, the bank that made the loan bore the loss. This encouraged a careful review of mortgage applications to assure the financial solvency of the borrower.
In the “modernized” financial system, the bank captures a fee for signing up the borrower. Because the risk associated with a potential default is passed to others, the bank has no incentive to exercise due diligence, an obvious system design flaw. According to the famed international financier George Soros, “Credit standards collapsed, and mortgages were made widely available to people with low credit ratings. [Thus the term subprime mortgage.]…‘Alt-A’ (or liar loans), with low or no documentation, were common, including, at the extreme, ‘ninja’ loans (no job, no income, no assets), frequently with the active connivance of the mortgage brokers and mortgage lenders.”4 The norm was clear. Just get a signature on a mortgage document and collect the fee. The bigger the loan, the bigger the fee. No worry if the borrower can’t pay. That will be the next guy’s problem.
Of course, if worst came to worst, the government could likely be pressured into a bailout by the threat that if the government didn’t pick up the losses, retirees would lose their pensions, banks would stop making loans, and the economy would collapse.
The details are far more complex than what I’ve outlined here, but that is the essence of what happened. When obviously unqualified borrowers defaulted, the whole house of cards came tumbling down and the phantom wealth that Wall Street had created through mortgage securitization disappeared even more rapidly than it had magically appeared — as did the trillions of dollars of government bailout money that followed. The only winners were the bankers and financiers responsible for creating the crisis, who walked way with vast fortunes skimmed off as fees and bonuses, even after the bubble burst.
A Bubble Is Just a Bubble
Contrary to Edmunds’s “logic,” an asset bubble, real estate or otherwise, does not create wealth. A rise in the market price of a house from $200,000 to $400,000 does not make it more functional or comfortable. The real consequence of a real estate bubble is to increase the financial power of those who own property relative to those who do not. Wall Street encouraged homeowners to monetize their market gains with mortgages they lacked the means to repay except by further borrowing, which it then converted into worthless toxic securities and sold to the unwary, including the pension funds that many of those who borrowed against their inflated home values counted on for their retirement.
When the housing bubble inevitably burst, dazed homeowners walked away, many in financial ruin, from properties on which they owed more than the market value. Securities based on those mortgages lost value, and the overleveraged Wall Street players could not meet their financial commitments to each other. In the face of escalating defaults, the whole system of interlocking credit obligations collapsed and Wall Street institutions turned to taxpayers for a bailout.
The government responded with trillions of dollars in public bailout money. The recipient institutions held extravagant parties, increased executive bonuses and dividends, and financed acquisitions. The bailout money seemed to vanish as quickly as the phantom wealth of the housing bubble. Credit, however, remained frozen.
Debt Slaves to Wall Street
Why do we tolerate Wall Street’s reckless excess and abuse of power? In part, it is because so many people of influence have bought into the Edmunds fallacy. Many actively celebrate the Wall Street production of phantom wealth and our growing reliance on other countries to produce the goods and services we consume. By the prevailing story, we, the United States, serve the global economy by specializing in making money and consuming the goods that others produce. In the fantasy world of Wall Street, this all makes perfect sense.
If you have difficulty understanding the Wall Street logic, which is taught in many economics and finance courses, it may be because you are in touch with reality. No matter what Wall Street says, a bad loan is still a bad loan no matter how many times it has been sliced, diced, and repackaged into ever more complex derivatives certified by Standard & Poor’s as AAA.
Even more, however, we tolerate Wall Street and rush to bail it out because it controls the issuance of credit and thereby our access to money in a world that has made us dependent on money for almost every aspect of our lives. Furthermore, many of us depend on private retirement accounts that in turn depend on the success of Wall Street’s money games.
Here is a simple description of how the money-creation process works.
ALCHEMISTS IN EYESHADES
Most people think of accounting as a rather boring subject, but pay attention here, because nearly every dollar in circulation has been created by a private bank with a deceptively simple accounting sleight of hand. Understand how it works and you understand why our current system of debt money created by private banks for private gain makes it possible for a few people to acquire obscene amounts of unearned money while sticking the rest of us with the bill.
My college economics professors taught us that banks are financial intermediaries between savers and borrowers: A saver makes a deposit and the bank lends that money to a borrower to finance a business or home. But that isn’t the way it really works.
Unless you are holding a long-term certificate of deposit, you have immediate access to the money you deposit in your bank. If you borrow money from the bank, you also have immediate access to the funds in the account that the bank created in your name when it made the loan. When a loan is issued, the bank’s accountant enters two numbers in the bank’s accounting records: She records the borrower’s promise to repay the loan as an asset, and the money the bank puts into the borrower’s account as a liability.
At first glance, it looks like these entries cancel each other out, which in a sense is true. The key is that neither entry existed previously. With the accountant’s entries, the bank created new money from nothing in the amount of the loan principal and caused the amount of money in the economy as a whole to increase. At the same time, the borrower acquired a legal obligation to repay the principal with interest.
This, in fact, is how all money (except for coins and some special notes) is created. It should be noted that the bank-created money is purely electronic. There isn’t even a paper record.
Needless to say, granting banks the right to create money with a computer keystroke and then lend it out at interest makes banking very profitable, and Wall Street, which owns the banks, enormously powerful. Unless this power is limited and used with great care, it leads to financial instability and inequality, creates an economic growth imperative, and distorts economic priorities, all costs to society I explain in chapter 7, “The High Cost of Phantom Wealth.” The consequences can become truly devastating when banks discover the profit potential in putting this money-creation power at the service of financial speculators and predators engaged in the creation of phantom wealth and ignore the underlying assumptions of the debt/credit money system we have left it to them to manage.
FROM GOOD DEBT TO BAD DEBT
The debt-based money system that is the foundation of Wall Street’s control of the economy and society is based on an underlying logic. So long as its practice is true to that logic, the debt model of money creation can be a driving engine of real-wealth production — up to the point at which the economy encounters the limits of the planet.
Driven by greed and blinded by hubris, Wall Street forgot the logic and created a debt bomb that guaranteed economic and financial collapse.
The Logic of Productive Saving and Investment
The logic of the debt-based money system assumes that the financial system receives the savings of working people and in turn lends those savings to entrepreneurs and enterprises to finance capital investment projects that expand society’s pool of real wealth.
This logic assumes that savers are deferring immediate consumption so that the economic resources that otherwise would be directed to their consumption are instead devoted to creating new capital assets that support greater future production. It further assumes that the benefits of this new real wealth are shared equitably among those who contributed to its creation: The savers who defer their consumption receive a fair share as interest. The entrepreneurs who convert the savings into productive capacity receive a fair share as profit. The workers who provide the labor receive a fair share as wages, and the governments that provide the supporting infrastructure receive a fair share as taxes.
The operation of the financial system was more or less consistent with this logic from the 1940s through much of the 1970s. Then the orgy of deregulation described in chapter 5 allowed it to morph from a servant system into a predator system devoted to making money without the bother of financing productive enterprise.
The Illogic of Negative Saving and Consumer Debt
In October 2008, BusinessWeek called attention to what it called a gigantic credit bubble, “consumption that was not justified by income growth,” and estimated that for U.S. consumers the total gap between income and consumption over the previous ten years totaled some $3 trillion dollars.5 That gap was one of the many conditions for financial disaster resulting from the creation of phantom-wealth illusions but, of course, it was and continues to be highly profitable for Wall Street.
Anytime debt exceeds the capacity to repay it, there is a problem for someone. When the total debt of a society is greater than the total market value of all its real resources, it means that the expectations of the holders of the debt — for example people whose retirement savings are invested in supposedly safe derivatives based on toxic assets — cannot be fulfilled. The society faces the difficult task of determining whose claims and expectations will be fulfilled and whose will not.
In the current instance, there is a deeper issue. Business-Week was talking about consumer debt. The logic of the money system assumes that debt is a means by which savings are translated into investment in expanding productive output. In our current case, the money lent comes from an accounting entry, not from savings, and it is used to fund consumption, not production. The debt and the expectations of those who hold it grow exponentially, but actual production does not. This creates an ever-greater disconnect between expectations and the real wealth available to satisfy them.
It is the same situation when the government spends beyond its income to finance nonproductive consumption items such as an outsized military establishment and Wall Street bailouts. Deficit spending by government may be justified for investments in various forms of real productive capital, such as infrastructure, education, health, research, and environmental rejuvenation. These build the society’s productive capacity and thereby contribute to the creation of corresponding real wealth. By contrast, wars deplete real wealth, and Wall Street bailouts, in the absence of corrective structural reforms, simply revive the predatory phantom-wealth machine.
Although this may sound a bit complicated, the basics are simple. Borrowing for investment in productive capacity is a generally beneficial path. Borrowing for current consumption is bad because it creates no new value and creates debts that can only be rolled over into ever-greater debt that the borrower has no way to repay.
We are in trouble as a nation not because our expenditures exceed our income but because the excess expenditure is for consumption rather than for investments that support increased future output. Furthermore, we make up the difference between our consumption and our production with imported goods purchased on credit extended by the producing countries. The more we allow cheap products from abroad to crowd out domestic jobs and businesses, the more dependent we become on imports, the faster our foreign debt grows, and the faster our capacity to repay the debt declines.
These systemic imbalances create ever-growing instability on a path to ultimate collapse. It is also a path to a condition of permanent servitude called debt slavery, which I put in historical context in chapter 14.
The Language of Self-Deception
One of the main reasons we tend not to see such irrational and destructive dynamics is that the deceptions are built right into our language. We refer to speculation as “investment” and to phantom wealth as “capital.” The practice of equating money with financial capital comes from a time when savings, representing deferred consumption, were used to invest in new productive capacity. In the global casino economy, that idea of savings seems a bit quaint, yet we continue to use the old linguistic conventions.
This obfuscation of the language is an important contributor to the mistaken perception that as a global society we are getting richer, when in fact we are getting poorer in ways that put the future of our species at risk.
Wall Street, as economic system or syndicate, is extremely good at what it is designed and managed to do: make a few people fabulously wealthy without the exertion and distraction of producing anything of real value. From the perspective of the beneficiaries, money is money, and those who have lots of it can indulge themselves in luxuries beyond the imagination of the kings and emperors of previous times.
The major failing of the existing financial system from the perspective of its Wall Street beneficiaries is the tendency for asset bubbles to collapse and wipe out large portions of their asset statements, even forcing them to sell off estates, yachts, and private jets at fire-sale prices.
In the bigger picture, even when the bubbles are expanding, Wall Street’s gain is a net loss for the rest of the society because Wall Street’s growing claims on the real wealth of society dilute the claims of others. The social costs of growing inequality and the environmental costs of the related profligate consumption fall on those who don’t have the money to live in splendid isolation from the resulting social and environmental breakdown.
The idea that economic growth will bring up the bottom and finance environmental restoration has no substance. The so-called rising tide lifts only the yachts and swamps the desperate, naked swimmers struggling for survival, and no amount of money can heal the environment in the face of unrestrained growth in material consumption.
For the winners, it works out fine in the short term that growth in Wall Street financial assets plays out for the rest of society as growing inequality. A wealthy class needs a servant class, and what remains of the world’s real wealth need only be shared among the very rich.
Fortunately for the rest of us, there is an alternative to Wall Street phantom-wealth capitalism: a real-market economy.