I was challenged recently to explain what happened to our economy in simple terms. I set myself a limit of 800 words, and as you can see I failed. But I like this essay and I hope you do, too. I don’t want to take out anything.
It’s all about the value of money. You can reach into your wallet and pull out a portrait of Jackson and say, “Here’s the value, it says 20 right there.” But money is much more than numbers you see on a bill or a 401k; no matter how you look at it, what it is all about is what we value as a culture. When something goes horribly wrong with money it’s because something went wrong with our values.
In finance, the center of the world used to be banking. It was a boring occupation based on taking deposits and paying an interest rate on them while loaning out the money at a slightly higher rate. The “spread” between the rates for loans and interest was where they made money. When rates started to change pretty rapidly, banks could still make money by keeping the spread relatively fixed.
The spread was often magnified greatly when the bank borrowed money cheaply from other banks or, ultimately, the Federal Reserve. They then loaned it all out at a slightly higher rate. The net worth of the what the bank has in is called capital” and the amount of money that they could get from the outside is called “leverage”. Traditionally, leveraging of no more than 9 to 1, meaning the bank had in 10% of its own capital, was normal. The key to it all was managing the “risk” or the chance that the person they loaned money to might not pay it all back.
This is boring stuff, I realize. So did banks. A series of theorists who won Nobel Prizes in Economics had other ideas as to how they make money – and a lot more of it, too. The focus was on risk because that’s where things often went wrong. If you could predict the chances of someone not paying you could come up with a way of insuring a pool of loans as a unit and not worrying about it. The cost of covering those defaults is known.
These became known as “Credit Default Swaps” because the risk of default was sold off to someone else to manage separately. It’s called a “derivative” because it’s one step removed from the market, a financial tool that serves only financial markets. The only problem with managing risk this way was that it presumes a normally functioning market, which is to say that we can assign a value to all the loans and the insurance against default on those loans because we know what people will pay.
This big assumption has failed us before. LTCM and Enron are the most obvious examples, but many “Hedge Funds”, comprised mainly of derivatives, have failed because they priced something wrong. But let’s ignore that for a while. Let’s ignore that other Nobel Prize winning theorists showed that the new instruments increased the risk to the whole system, too.
As we went through the 90s, these innovations created a tremendous amount of wealth. New start-ups that would never have had access to credit before got it, creating the first wave of the Tech Bubble. When many of them exceeded expectations, even more money poured in. Through Initial Public Offerings, the first sales of stocks, the risk of default started to be shared by the stock market. As long as there was more money coming in all the time the market was able to price the risk of default as well as it thought it could.
This is where values come into the equation, because the growing dollar value of this market made it possible for people to appear to make something from nothing. Much more money was made managing money than producing goods and services, meaning that talented young people went into finance. Energy was put into applying this magic to other areas, and nothing looked better than the mortgage market.
Mortgages are backed by something of value, a house, which in some parts of the USofA was where this money had been going into like crazy. They also have reliable payments that produce a steady stream of cash coming in, too. The principles of managing risk with the latest theories were applied to mortgages, and soon no one could get enough mortgages. The standards were relaxed to the point where anyone could get a home, and very quickly the value of homes started to climb everywhere. At the heart of it, however, was the idea that risk had been effectively eliminated – despite the fact that tremendous value was being created from nothing at all. Leverage at Citibank went up to 35 to 1, meaning they had only 2.8% of their own money in the machine.
In other words, the entire economy was based on a kind of Ponzi Scam not all that different from what Bernie Madoff ran.
Another statement of values came from Alan Greenspan’s Federal Reserve, the outfit that kept interest rates low during this period. Their reasoning was simple: if you buy a computer for $2k and 3 years later buy a new one for $2k, most of us would say that computer prices are flat. But the Feds saw that the new one had twice the power of the old one, meaning that computer prices fell by 50%. Got that? You can be twice as productive with the new computer so it’s worth twice as much – even if you spend your time on twitter. This is called “Hedonic Adjustment”, and it’s what kept money from the heart of the whole system cheap. There was no inflation if you do enough math on the numbers, forgetting that the numbers are supposed to reflect value.
It all ended rather abruptly last September when the market for Credit Default Swaps simply broke one day. Too many loans were coming in bad, so the insurance provided by a Credit Default Swap was going higher and higher in price – until no one wanted to touch any of them. Without this in place, the whole system collapsed. There was no new money being generated to feed the Ponzi Scam.
The value at the heart of all of this is the expectation of something from nothing. Old- fashioned banks managed risk from close at hand, partly because they had decent stake in the system; the new thinking was that risk could be managed by formulae and new financial instruments. In short, the value is that money does not come from work, but from other money. Seeing it generated spontaneously didn’t alarm, it delighted.
The new theories at the heart of all of this are not inherently bad or dangerous, but our lack of basic values is. The ability to loan money to risky ventures or people who don’t traditionally have access to it creates access to the economy that is vital, but using the same methods to create supposed wealth from nothing is dangerous.
It comes down to what we value. The value of the market is nothing more than our values as a culture and as a people. If we value labor and intelligence, we will put more money into those. When we value blindly playing games with money, we will have more of that. Ultimately, we have to ask ourselves what makes a sustainable life that is decent and good. What got us where we are today is a lack of basic values – not just in the market, but in our lives.