It’s a shame the Fed doesn’t possess more Richard Fishers. Since the departure of Paul Volcker in 1987, the Federal Reserve has the unwelcome record of having gotten every single major decision wrong. Every time there has been a hint of a crisis, the Fed has acted like some senior court advisor to the Emperor of Planet Ponzi. The 1987 stock market crash, my liege? I’ll pump in liquidity. Asian financial crisis, sire? I’ll flood the place with dollars. A major hedge fund, LTCM, has gone bust, your majesty? I’ll organize a bailout. Dotcom bubble? Let’s watch it inflate. Even the September 11 terrorist attacks—surely a matter for the US security apparatus rather than its monetary authority—were taken as an excuse for monetary loosening.
Little wonder that inflation has been racing away. Little wonder that the Washington establishment has been ever more anxious to manipulate the data. Little wonder that we’ve seen crazy bubbles in the markets for housing, for shares, for mortgage assets—for pretty much anything that Wall Street can stick a price on. Governor Rick Perry, a Republican contender for the presidency, said, in response to a question from an Iowa voter,
If this guy [Bernanke] prints more money between now and the election, I don’t know what y’all would do to him in Iowa but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in history is almost treasonous in my opinion.12
If Governor Perry considers that threatening the chairman of the Fed is a way to advertise his suitability for high office, he has a few things to learn. But his anxieties are not as overblown as his rhetoric. Printing money destroys value. I have a bank note on my desk which confirms it.13
*
So much for the US government’s money management. But before we turn to the second engine that has powered the Ponzi scheme we’re examining—Wall Street—we should step across the pond to take a quick look at how public finance in the UK has fared in those years since the Bank of England was founded to fend off national disaster.
7
After Beachy Head
In writing about the United States, I happened to mention that modern public finance started with a sea battle fought by England against France beneath the white cliffs of the south coast. What I didn’t go on to discuss, however, was the longer-term implications of that sea battle for public finances in the UK—and for mastery of the modern world.
We start, as ever, with the data, shown here in figure 7.1. In the long century which followed the Battle of Beachy Head, Britain would experience a succession of wars with France, culminating in the defeat of Napoleon at Waterloo. Those wars were—or felt like—wars of existential importance. Whenever the country was at war, its debt shot up in relation to GDP. As soon as the war ended, debt began almost immediately to moderate. The one real exception was in 1815, when a long economic slump kept debt high for a few years, even though the country was, finally, at peace. Even then, however, once Napoleon was gone and the French threat with him, the country was eventually able to get on with running the world and paying back its debt. In 1913, just as that debt seemed all ready to disappear for ever, war came again—and then yet again in 1945. The ‘Hitler peak’ didn’t match the ‘Napoleon peak,’ but it came close. That’s what it costs to win wars for European dominance.
Figure 7.1: UK net debt since 1692
Source: www.ukpublicspending.co.uk.
Then, with the world war won, indebtedness started to decline. By 1991, the debt-to-GDP ratio stood at around 25%. The country faced no threats to its existence. The Soviet Union had collapsed. There were no French fireships in the Channel, no archdukes being assassinated in Sarajevo. The entire history of Britain since the time of James II suggested that the national debt would now vanish. It had come into being because of military crisis and been kept alive through three turbulent centuries by a succession of wars and alarms. But the country was now at peace; its economy was prospering; there was no famine, plague, or pestilence. The debt should have vanished.
But it didn’t. It ticked along, growing when it should have shrunk. The thinking of Planet Ponzi came to affect government, banks, and consumers alike—and debt grew on every front. That debt came to seem acceptable: an aspect of reality every bit as normal as delays on the Underground or summer drizzle. By 2007, the government deficit was running at 2.7% of GDP. That ought to strike you as a shocking fact. The government in power had presided over a decade of continuous economic growth. What possible justification could there be for borrowing money to sustain public spending? Yet the reckless spending of 2007 would soon seem like prudence itself.
When financial crisis struck, those seeds of indebtedness bloomed at an astonishing rate. In 2008, the deficit more or less doubled. In 2009 and 2010, it was running at more than 10% of GDP. In other words, for every £10 produced by an entire national economy, the government was borrowing more than £1. That’s a figure that makes sense if you’re in a life-or-death struggle to defend the nation—but to fund bailouts for the banks? To maintain bonuses in the City of London? To protect bank creditors, many of whom are foreign? It’s lunacy. Except perhaps in America and Ireland, no democratic country has ever imposed so great a burden on its ordinary citizens, for the benefit and protection of that country’s wealthiest elite. The worst kleptocrats of Africa and Asia must be watching in astonishment. They never knew it could be this easy.
You don’t have to take my word for these things. In his testimony to the House of Commons Treasury Select Committee in spring 2011, the Bank of England Governor, Mervyn King, commented: ‘The price of this financial crisis is being borne by people who absolutely did not cause it. Now is the period when the cost is being paid. I’m surprised that the degree of public anger has not been greater than it has.’1 He’s right. The country has grumbled, but it’s kept its anger largely in check. There are no gallows in Marble Arch, no mobs baying for blood in Belgravia. Not one of the multimillionaires who led their firms, and their country, into disaster have paid any meaningful price for their actions—either in fines or (my strong preference) in jail time.
What’s more, King went on to say—also correctly—that the impact on living standards would be long-term and severe. ‘The research makes it clear that the impact of these crises lasts for many years. It is not like an ordinary recession, where you lose output and get it back quickly. We may not get the lost output back for very many years, if ever.’2 It’s also inevitably true that the cost of fiscal austerity falls far more on the poor than on the rich.3 Mervyn King’s ‘lost output’ will be causing pain in Tottenham and Toxteth for years and probably decades after those in Chelsea and Cheltenham have forgotten about it.
Because these things are now well known, I won’t labor the point further. What I would add, however, is that the problems of lobbying are as entrenched in the UK as they are in the US—arguably more so. The Labour Party of Tony Blair and Gordon Brown was notoriously banker-friendly. The ‘light touch regulation’ on which those politicians prided themselves ended up doing unspeakable damage to the national finances. Yet the contemporary Conservative Party is more or less owned by the finance industry. According to the Bureau of Investigative Journalism, the financial sector is the source of more than half the Tory party’s political funding. If anything, that ratio has been increasing. Unsurprisingly, and according to the same source, the Tory-led coalition’s first year in office has seen a slew of tax changes all intended to help the most prosperous individuals in society.4
This shouldn’t come as any surprise. For all the apparently tough measures being taken to restrict the destructive power of the financial sector, money speaks louder than words. The fact is, when a single industry sector has governments so deeply in its pocket, it remains highly improbable that those governments are going to injure their donors. The Labour Party foolishly chose to sup with the devil, but may at least have learned its lesson. The Tory Party doesn’t simply sup with the devil
, it owes him board and lodging. The next financial crisis is already brewing today.
That’s the bad news. Yet, as we’ll see in a later chapter, the British government of today is well off in one crucial respect: it has a plan for deficit reduction—a plan which, to a large extent, is accepted across the political spectrum and the country at large. It’s well off in another respect, too. In the United States, a huge portion of the federal budget is taken up with mandatory expenditures: spending required by laws passed by a previous Congress. Since you need all the stars in alignment to alter those laws—you need dependable and simultaneous control of the House of Representatives, the Senate, and the White House, which rarely happens—political leaders are stuck with the implementation of laws they themselves might not have passed. I’m not against that. The Constitution of the United States worked pretty well for two hundred some years; but for two hundred some years, Planet Ponzi wasn’t in existence and wasn’t wanted. Naturally Congress would, from time to time, pass some dumb laws, but those laws didn’t threaten the basic solvency of the United States. In the last three decades, however, those mandatory expenditures have come to bankrupt the US. If you take seriously the unfunded liabilities on pensions and health care, the country is ruined: utterly unable to fulfill its future obligations.
Britain is not in that position. Parliament does not generally write laws that bind future parliaments, and if it did, the government—which almost always has a functional majority in the House of Commons—can simply change the law. So although the British government debt is absurdly high, although the deficit is a standing insult to every ordinary British citizen, although bankers must still be blinking with astonishment to find that they’ve got away with their heist, huge unfunded liabilities of the kind which are crippling the United States do not exist—or do not exist in the same way—in the United Kingdom. Unfunded liabilities that arise from mandatory healthcare spending in the US amount to almost $40 trillion, or about two-thirds of global GDP. The equivalent figure for the UK government is £0.00. There is no such liability. The same thing, more or less, with pensions. Though there will be a cost as the population ages, the government of the day won’t be bound by laws that it didn’t create and cannot change—and governments from Thatcher onwards have proved remarkably willing to make the necessary tough decisions on keeping pension spending down to sane levels. (It won’t surprise you to learn, however, that the government’s pension provision for its own employees is woefully underfunded to the tune of some 86% of GDP.)
Yet perhaps the most important point of this whole section of the book is the one with which I began this chapter. Planet Ponzi is an aberration. In the three hundred years since the Battle of Beachy Head, there have been good governments and bad governments, reckless spenders and cautious skinflints. Yet throughout the period, the only real increases in national indebtedness arose because of war. Not itty-bitty conflicts in faraway places, but conflicts that threatened the integrity of the nation. When the country wasn’t at war, it was paying back its debt. That’s how it ought to be and that’s how it always was. The mindset of Planet Ponzi is a new phenomenon, a temporary one, and one we need to destroy for ever. The country that once defeated Napoleon and Hitler deserves nothing less.
Part Two
Wall Street
8
A statistical anomaly
Assuming you have even the vaguest interest in the world beyond your door, you’ll be familiar with the concept of GDP or gross domestic product. It’s the basic measure of national income, the total value of goods and services produced in a given period of time. Nearly always, GDP is quoted as an aggregate figure, offering us a measure of the value created by an entire economy over a given quarter or year. Underpinning that aggregate figure is a massive amount of detailed data about every sector and subsector of the economy in question. These data are churned out, with an impressive degree of timeliness, by government statisticians, and large quantities of data are published or made available online. Yet these data have for a long time now contained an anomaly, whose nature lies at the heart of this book.
We begin with the concept of value added—a term of jargon, which just so happens to mean exactly what you think it ought to mean. So, for example, if a manufacturer sells a widget for $1.00, and the cost of his various inputs (raw materials, power, etc.) amounted to $0.40, his value added is equal to $0.60. In effect, it’s how much extra value the manufacturer and his staff added to those raw materials by processing them into finished goods and successfully marketing them to the end user. The concept allows us to explore who contributes what to economic value, and because government statisticians have compiled broadly the same types of data in broadly the same ways for a long time, it’s possible to see how those contributions have shifted over time.
Back in 1947, the US economy looked much as you’d think it would look. Agriculture was still a significant sector, contributing over 8% to national output. Manufacturing contributed more than a quarter of the total. Even transportation and warehousing chipped in almost 6%. By comparison, the finance industry wasn’t particularly important. Finance and insurance contributed just 2.4% of national prosperity. Their role—in supplying credit, handling cash, dripping a little oil on to the wheels of capitalism—was important, but humble.1
As time went by, the finance sector grew in importance. In the late 1940s, many people had no access to banking facilities. Many firms were only local. Credit markets were restricted. The sector needed to grow, and it did. By the late 1970s, finance and insurance were contributing around 4.7% of total economic output. The sector was still a small one, but no longer puny. Finance was starting to grow up.
In 1977, government statisticians responded to the changing makeup and complexity of the economy by introducing a set of more finely grained economic categories. Finance and insurance as a whole accounted for some 4.7% of the economy, but it was now possible to tell where that 4.7% came from. As you’d expect, ordinary retail and lending banks—‘Main Street’ banks, if you like—made up the largest single chunk of the sector, responsible for 2.45% of overall GDP. Insurance contributed 1.86%. The sector called ‘securities, commodity contracts, and investments’—what we know as Wall Street—accounted for a mere 0.34% of economic output. A sector that creates just 0.3% of a nation’s income is, evidently, tiny. The trucking industry was three times as important. Forestry and fishing was more important. In 1977, Wall Street made a few people rich. It raised some capital and it made some markets. But it did not contribute much to the economic pie.
Then things started to change, and change fast. By the early 1990s, the finance industry as a whole was generating over 6.5% of economic output, while Wall Street’s share of GDP had tripled to around 1%. Wall Street was still a minor player in the scheme of things, but a feisty one, a growing one. No other sector had grown at that rate. Even the computer industry, in the age of the PC and the mass-produced silicon chip, had not grown that fast.
That turbocharged growth was fueled by two principal ingredients. First, the advent of floating exchange rates in 1971 had gradually led to the dismantling of international controls on the movement of capital. As capital started to become ever more mobile, Wall Street firms were ideally placed to skim a little froth from the river of money as it passed on through.2 Secondly, Wall Street had perfected the art of ‘disintermediation.’ The term is ugly and obscure, but its meaning is startlingly simple. In the old days, if large borrowers—industrial companies, for example—wanted to borrow money, they were, on the whole, obliged to get it from banks. Banks, for their part, acted as middlemen: taking money on deposit from investors, lending it on, making a spread. That old system had worked well enough for a long time, but it was inefficient. New methods of accessing the international bond markets made it possible for would-be borrowers to go direct to investors. Investors got a better deal than they had done f
rom the banks. So did borrowers. Traditional corporate lending was a business in trouble, but Wall Street—the people who so energetically sold the benefits of securitization—was booming.
Naturally, because this was Wall Street, there were bound to be a few little hiccups along the way. The ‘mezzanine debt’ market—that’s the junk bond market to you and me3—provided a great way for poor-quality borrowers to reach investors. Unfortunately, Drexel Burnham Lambert, the firm that created the market, went bust and its star, Mike Milken, went to jail. So too did Ivan Boesky, an insider trader who was also fined an eye-popping $100 million. And one of the leading banks of the era, Salomon Brothers, was caught bilking the US Treasury and fined $290 million for its pains. And yes, the landmark deal of the era, the takeover of RJR Nabisco by KKR, a leveraged buyout outfit, was unwound after little more than ten years in a haze of cost and disappointment. But all this time Wall Street was booming.
The growth of the securities market was enthusiastically assisted by the regulators. In 1999 Congress and President Bill Clinton repealed the Glass–Steagall Act, which had, for seventy years, maintained barriers between lending banks and securities houses. Although there had been a small but growing market in credit-based derivative products in the 1990s, the rule changes of 1999 laid the groundwork for massive growth in that market. To regulators this looked like another win: furious innovation, big fees on Wall Street, new products for investors and corporations alike.
Now, of course, we know what that win turned into. A massive increase in leverage. The sale of crazy products to the wrong buyers supported by bankrupt counterparties. Weapons of mass financial destruction indeed, to quote Warren Buffett’s all-too-accurate description. By 2009, the last year for which we have complete data, Wall Street contributed 1.2% of total US economic output. The entire finance industry, including insurance, contributed 8.3%, more than three times what it had done in 1947. That’s a larger proportion of the total than you see in highly production-oriented economies, like Germany’s, but not hugely so. The financially oriented economies of Switzerland and Britain both have banking and insurance sectors relatively larger than their US counterpart.4
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