Agenda for a New Economy

by David C Korten

  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 r
ecognize 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 bo
nuses 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.