An Apt Reflection of an Era

Throughout history, it has not been unusual to see major frauds come to light after bubbles have burst.

While the going is good, cheap money, accommodating counterparties, and the general rise in asset prices help to keep all sorts of shaky ships afloat. Later, when circumstances turn sour, the miscreants' luck runs out and things start falling apart.

To Paul Krugman, though, the recent discovery of one of the biggest scams of all time has more significance than its tabloid appeal.

In an Op-Ed for the New York Times, "The Madoff Economy," the Nobel Prize-winning economist asserts that the fraud was an apt reflection of an era of greed and hubris.

The revelation that Bernard Madoff — brilliant investor (or so almost everyone thought), philanthropist, pillar of the community — was a phony has shocked the world, and understandably so. The scale of his alleged $50 billion Ponzi scheme is hard to comprehend.

Yet surely I’m not the only person to ask the obvious question: How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?

The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it’s not just a matter of money: the vast riches achieved by those who managed other people’s money have had a corrupting effect on our society as a whole.

Let’s start with those paychecks. Last year, the average salary of employees in “securities, commodity contracts, and investments” was more than four times the average salary in the rest of the economy. Earning a million dollars was nothing special, and even incomes of $20 million or more were fairly common. The incomes of the richest Americans have exploded over the past generation, even as wages of ordinary workers have stagnated; high pay on Wall Street was a major cause of that divergence.

But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

Consider the hypothetical example of a money manager who leverages up his clients’ money with lots of debt, then invests the bulked-up total in high-yielding but risky assets, such as dubious mortgage-backed securities. For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

O.K., maybe my example wasn’t hypothetical after all.

So, how different is what Wall Street in general did from the Madoff affair? Well, Mr. Madoff allegedly skipped a few steps, simply stealing his clients’ money rather than collecting big fees while exposing investors to risks they didn’t understand. And while Mr. Madoff was apparently a self-conscious fraud, many people on Wall Street believed their own hype. Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.

But the costs of America’s Ponzi era surely went beyond the direct waste of dollars and cents.

At the crudest level, Wall Street’s ill-gotten gains corrupted and continue to corrupt politics, in a nicely bipartisan way. From Bush administration officials like Christopher Cox, chairman of the Securities and Exchange Commission, who looked the other way as evidence of financial fraud mounted, to Democrats who still haven’t closed the outrageous tax loophole that benefits executives at hedge funds and private equity firms (hello, Senator Schumer), politicians have walked when money talked.

Meanwhile, how much has our nation’s future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science, public service and just about everything else?

Most of all, the vast riches being earned — or maybe that should be “earned” — in our bloated financial industry undermined our sense of reality and degraded our judgment.

Think of the way almost everyone important missed the warning signs of an impending crisis. How was that possible? How, for example, could Alan Greenspan have declared, just a few years ago, that “the financial system as a whole has become more resilient” — thanks to derivatives, no less? The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolize men who are making a lot of money, and assume that they know what they’re doing.

After all, that’s why so many people trusted Mr. Madoff.

Now, as we survey the wreckage and try to understand how things can have gone so wrong, so fast, the answer is actually quite simple: What we’re looking at now are the consequences of a world gone Madoff.

Comments

[sackerson]

Since most of them have been allowed to Get Away With It (the general theme of our times in politics as well as economics), I hope the game restarts very soon, so I can join in on the wrong side.

[i on the ball patriot]

"How was that possible? How, for example, could Alan Greenspan have declared, just a few years ago, that “the financial system as a whole has become more resilient” — thanks to derivatives, no less? The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolize men who are making a lot of money, and assume that they know what they’re doing."

Krugman is a sell out, and this is a deviously lame and dumb ass rationale. This is an intentional global financial coup by the people that pay his salary and give him those cheap little awards. These guys know exactly what they are doing and the only thing they idolize is their own elite power.

Krugman should be wearing a prison suit for his complicity!

[Jon]

Will it be okay with you if I publish complete chapters from your books on my web site? I assume you'll have no problem with that. Thanks.

[tjo]

Want a glimpse of what's in our economic future? (It's not pretty.)

(1) The Government will continue to provide unlimited liquidity to banks (which will remain unnamed for fear of panicking depositors). But those banks will not eagerly make new loans with their cash infusion. Instead, they will hoard the money to cover future foreclosures and other anticipated losses.
(2) The Government will also continue to prop up other large institutions, noting that they are "too big to fail." However, these institutions will continue doing business as usual and will inevitably seek more money. When no more cash is forthcoming, market forces will cause them to fail.
(3) The flooding of the system with newly printed dollars will temporarily stem deflation, but a sudden inversion to hyperinflation will occur when confidence in the dollar falters. (After all, what collateral backs up all that paper--the full strength and resources of the bankrupt United States of America?)
(4) Unemployment will continue to rise and state and local governments will have record budget deficits. State funds providing unemployment payments will dry up and states will seek federal help.
(5) Our titanic economy is much larger than it was in 1929, resulting in a Greater Depression than the 1930s.
(6) There is no moral hazard: there is only power, politics, incompetence, spin and greed. But consumers, taxpayer, investors and voters will have the final word.
(7) Finally, and sadly, the largest tree in the forest will be cut down. The United State will lose its economic superpower status.

I told you it wasn't pretty. Take care.

[sglover]

Say what you will about the man's schemes and the wreckage they left, I gotta admire a pirate who goes by the name "Made Off".

[ssm]

While we become more and more aware of the evil, amoral, thieving nature of Wall Street, we also put more and more trust in yet another group of evil, amoral, thieving fools -- politicians, a.k.a., the government.

By far, the largest and most ominous ponzi scheme in the history of man looms large as the baby boom generation prepares to retire. All of the pains and woes of this current financial crisis will pale in comparison when the United States Government cannot make good on the payments it has promised.

Madoff's scheme was 50 billion, most of which never really existed because he made up the gains with a typewriter. The Federal Government's scheme is on the order of 50 Trillion with a 'trust fund' full of IOU's from the government to itself.

One of two things will happen:

1. We will elect honest responsible leaders and we will follow them responsibly by working hard, sacrificing, and saving to return to the prosperity that was established in the 19th century.

or,

2. A catastrophic collapse of the world economy will result under the weight of historic debt and stupidity resulting most likely in a catastrophic world war and some years later pockets of people will be humbled into working hard to make a living and will demonstrate again what actually produces economic success: hard work, living prudently, saving resources, and individual responsibility and honesty (most certainly NOT gigantic central government and control).

Which do you believe is most likely to occur?