Dumb Money

Lots of stories this week about the impact of the financial markets on the "real" economy (and on financial institutions). The August Financial Times piece I discussed recently had posited a barrier between financial problems and the "real" economy that is already crumbling. The media is starting to use terms like "rampant securitization" and "summer from hell."

There's something Orwellian about this, as I've noted before - numbers don't lie, until they do; financial markets accelerate prosperity, until they don't; government regulation hurts the economy, until it saves it. We haven't gotten to that last part yet.

That FT piece was right about one big thing: the core issue is not some bad subprime debt but the opacity of debt instruments, which makes it impossible in many cases to calculate a given position's exposure, risk, and value. Lots of people, including professional investors with billions of dollars in their care, buy instruments they don't understand based on revenue and risk claims they cannot evaluate. Turns out Standard & Poor and Moody's, the core ratings services, couldn't evaluate them either.

How did we get here? Two factors are

• middle-class self-interest. 60 or 80% of the American public have not seen their incomes rise - corrected for inflation - since the late 1970s. So why not roll the dice for a little relief? Hell, working hard and paying taxes didn't get you ahead.
• Wall Street self-interest, leading to biased financial policy, irrational tax subsidies, and mighty retail snow-jobs.

When buyer and seller have the same interest in wishful thinking about endless increases, bubbles blow up real big. There is an endless supply of greater fools.

I could go on with attempts at Financial Realism. Look at the chart above, which show selected investment returns in real dollars in the 2000s (click on it to get the big version, and read the article). Think about the increasing share of productivity gains that go to investors rather than labor. Review a report showing that upward mobility in the US has declined (and is lower than in many social democratic countries.) Look at the small group at the very top who get investment returns of 30% annually in economies that grow less than 3%. Read articles about how the financial markets do not actually raise money for productive investment, but have turned money into a commodity in which they make speculative profits. Refer yourself to a recent version of this argument in Le Monde. The list goes on and on.

But reality rarely beats fantasy or desire. I was reminded of this again last night at a family dinner, where I heard a story about one of my near relations, a cabbie who's now about 70, a really friendly and basically decent working-class guy. In the mid-1990s he started talking to a customer in his L.A. cab, who was telling my relative about the fire sale going on in the radio spectrum. If he bought a unit for $4000 or so, he could double his money in a few months. And there were lots of units for sale if he wanted to make it really big.

My relative had about $250,000 in savings from the death of his mother-in law among other things, and this money was chugging along at 4% or so - a little ahead of economic growth. But why put up with 4% when you can easily make 40%? This after all is America! Only little people think small, and they deserve the little lives they get. So my family member didn't buy one unit, or five (spending say 10% of his savings). He bought every unit he could with his $250k. And never heard from this guy again, and lost it all.

So he saved some money again. Ten years later his wife goes to get her teeth cleaned, and her dentist tells her that he's set up an investment pool for buying new state-of-the-art equipment for his expanded practice. For a few select patients, he'll borrow their money and pay them 15% - every quarter! So she goes home, and pretty soon the two of them have sunk $50,000 or so - again 100% - into this equipment. The promissory notes roll in. One night the relative calls the family and says he's now got about $3 million or so.

Six months later one of us reads an article that this dentist is under investigation for fraud and has moved to the Bahamas, where he's set up a website so that his investors can watch their millions of dollars grow. Six months after that he's back in L.A., in jail, awaiting trial for fraud. And another $50k in cabdriver savings is down the drain.

You may conclude that my family is dumber than most. Well it is quite possible, but that doesn't explain the shift in working-class hopes from security through government protections (social security, Medicare, etc) to protection through instant wealth.

Part of it is pervasive dumbness about money. Some people fall for dentists who try to get their patients to buy their own non-existent equipment. Other people buy collatoralized debt obligations backed with whatever, they don't know, when they can barely define the word "collatoralized." Both people are dreaming, and the dream is dumb. But given the great majority's decades of stagnation, the dream is also quite understandable.

If we can't be realists about capitalism at least we could be Noir about it. The people selling to you - they care about them, and they don't care at all about you.