From superior product engineering to reckless financial engineering: that’s how America has declined from a society that makes goods to one that shuffles money around — obsessively gambling with excessive debt. This is the gist of two new books that have recently been on the New York Times best-seller list: Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, by Kevin Phillips, and The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash, by Charles R. Morris.
Since last fall, the federal government and Federal Reserve have thrown hundreds of billions of dollars at the U.S. economy and the credit markets, largely to bail out financial institutions that are too deeply in debt. These two books will help you understand where your tax money is going and why you are suffering from an anemic dollar and high inflation.
I asked four San Diego market pros about the books’ gloomy conclusions and got some interesting opinions. They agree the authors make good points but disagree with some of the findings.
Phillips points out that in the last 30 years, the percentage of the U.S. economy devoted to finance has doubled to 20, while the percentage devoted to manufacturing has halved to 13. We now have “Wall Street socialism,” he says. The money changers say they love free markets, but actually, corporate giants, including those on Wall Street, work hand in glove with the federal government in a mercantilist arrangement to avoid the discipline of truly free markets. The Federal Reserve was bailing out Bear Stearns customers — other Wall Street firms — when it put up $29 billion so JPMorgan Chase could buy Bear hurriedly before Asian stock markets opened. Stocks have risen moderately since that March caper. Of course they have: the Federal Reserve has told Wall Street to continue gambling with borrowed money. If it stumbles, taxpayers will pick up the tab.
The Federal Reserve even has a Plunge Protection Team that arranges an artificial manipulation of stocks when they tumble hard, according to Phillips. Also, the government understates the inflation rate; this permits the Federal Reserve to print money at a prodigious pace, thus propping up stocks. Phillips notes that some call former Fed chairman Alan Greenspan a “serial bubbler” — when the stock market bubble burst in 2000–2002, Greenspan lowered short-term interest rates to 1 percent to get a housing bubble going. Now Ben Bernanke has pushed short-term rates down to 2 percent. Look out for another bubble.
In the mid-1980s, public and private debt was 135 percent of the total economy. Now it’s a record 335 percent. The major villains are bewilderingly complex derivatives — all $500 trillion-plus of them sloshing around the world. The derivatives are essentially unregulated — in fact, many go unrecorded. Indeed, the reckless financial engineering is based on the University of Chicago/Austrian School belief that government regulation inhibits the economy. In the 1980s, that laissez-faire mentality took over from the Keynesian, pro-oversight approach that had been dominant since the 1930s.
Morris believes the Chicago/Austrian School is in its last throes among economists; even financial executives are calling for reregulation. (When their own money is at stake, they want to know where it is.) Wall Street’s obsession with exotic mathematicized instruments is at the root of the turmoil. These derivatives could implode. Like Phillips, Morris heaps contumely on Greenspan’s attempts to prop up the stock market, the excessive money and credit creation since the mid-1980s, and the wealth and income imbalance (for example, the richest 1 percent control 51 percent of the money in the stock market).
“It’s hard to swallow when a guy makes 50 million bucks because he laid off 1000 employees and boosted profits by buying back his company’s stock,” says E. James Welsh of Welsh Money Management in Carlsbad. “That money should be used for research and development.” But boards of directors approve such shenanigans because of “the good old boy network. There is an old saying: ‘Don’t confuse brains with a bull market.’ ”
Welsh agrees with the authors that excessive debt creation will cause problems. Between 1975 and 2000, credit grew faster than the economy by 2.4 percent a year. Between 2000 and 2007, annual credit growth was 3.7 percent higher than economic growth. “I don’t think we can see that kind of debt creation in the next 10 to 15 years,” says Welsh. “The economy will grow more slowly. There is less cash flow to service that debt.”
The Chicago/Austrian free market approach may be sinking for now, says Bob Snigaroff, president and chief investment officer of Denali Advisors, money managers. “Somebody said that we are all Chicago School on the way up and Keynesians on the way down,” says Snigaroff. “We all get exuberant when times are good, and there is a tendency for institutions and individuals to stretch the limit. Then we do need the occasional recession to keep everybody honest. That is the period we are in now.”
Arthur Lipper III of Del Mar, a veteran of Wall Street and international investing, is a believer in the free market. If there is such a thing as a Plunge Protection Team, it only works on the short term. “Any government meddling is distorting and frequently only postpones the natural direction of the markets,” says Lipper. “Given a choice between government regulation and free markets, I’d opt for free markets, as they are inherently self-correcting.”
But that doesn’t mean Lipper is against government oversight. Financial institutions trading complex instruments, and “using money other than their own, should have minimum capital requirements,” he says. He finds it deplorable that big banks have hidden derivatives off balance sheet, thus having inadequate reserves. “Making financial institution directors and senior executives personally liable for losses would curb speculation,” he says. He also notes that investment banks have become far too deeply in debt. “Greed-based competitive pressures to report ever-increasing profits was seen as justification for increasing leverage. It is and was misguided.”
La Jolla–based Richard Russell, author of the newsletter Dow Theory Letters, has been writing his investment advisory since 1958, longer than anyone in the business. Russell is often a doom-and-gloomer who would agree with the findings of Phillips and Morris. In fact, he does agree on many points: “The government is lying. The inflation figure is probably 7 to 10 percent,” he says. On May 14, the government said annual inflation is running at 3.9 percent. Russell agrees that public and private debt are too high: “There is no question. The whole country is overleveraged.” However, he doesn’t think there is a Plunge Protection Team. “The Federal Reserve provides market protection, but there is no blatant manipulation.”
Russell believes this is a bull market. “Eventually the whole thing will topple over” because of the factors cited by Phillips and Morris. “But it’s a question of timing. These are bear arguments now, but they are bear arguments too soon.”