The Scandal of Money: Why Wall Street Recovers but the Economy Never Does - George Gilder (2016)
Chapter 11. Main Street Pushed Aside
In the late autumn of 2015, a time of Trumpery and fantasy football, in the media and on the Internet, from all sides lamentations were heard for the plight of the American middle class.
The nation was in an economic slough. Defying five years of nominal “recovery,” GDP numbers still slumped. Productivity growth, the source of new income, was stalled at 0.5 percent, 75 percent below the post–World War II average.1 Interest rates—the money value of time—zeroed out the future and flattened savings, the source of all real investment, which remained sluggish. As job force participation rates sank back near 60 percent, real median annual household incomes continued their six-year slide, going from close to $60,000 in 2007 to $54,000 in 2014, well below their peak in 1989.
Economic pundits sought solace in the magic of monetary policy. Perhaps the Fed would raise interest rates, giving banks incentives to lend. Or perhaps it would continue its zero-interest-rate policy, maintaining business and household incentives to borrow. Or through some combination of quantitative easing with suitable “twists,” might it do both at once?
Experts from Larry Summers to Ben Bernanke cite the failure of previous remedies as the reason to continue them. If zero interest rates have not ignited a recovery yet, perhaps their continuation can prevent a new recession. Perhaps negative interest rates could be contrived, requiring holders of cash to buy stamps every month to attach to their dollars. If five years of quantitative easing—some $4.6 trillion worth of bond purchases—could not reverse the five-year decline in real median incomes, perhaps another year would yield a trickle-down effect. The middle class might finally benefit. Or perhaps adding to the Fed’s $1.7 trillion portfolio of mortgage-backed securities could rev up middle-class housing values.2 It sure worked last time.
The entire system is backing, blindly and unguided, into the future. While professors and politicians inveigh against the depredations of the “rich,” the rich, carefully disguised in bleached denim, slink away to their tax shelters. While the media are obsessed with immigration, immigrants decide to return home. And while Americans supposedly fret over the threat of foreign trade, the world suffers a rare seven-year 60 percent drop in the rate of trade growth in the midst of an alleged recovery.
The class-fraught rhetoric of both parties confirms an economy split along class lines, yet no class can prosper alone for long. We are all in this together, in a crucible of change up and down. A zero-sum game, in which any advance for some comes at the expense of others, zeroes out future growth for all. Middle-class prosperity consists not only in a sense of accomplishment and security but also in ownership and progress, in a productive triad of Main Street with Wall Street and Silicon Valley.
With the rise of the welfare state and the surge of payroll and healthcare taxes, wealth cannot consist of wages alone. Wages cannot sustain “middle-class” lifestyles, with traditional hopes for children and pensions for retirement. If the middle class isn’t sharing in the growing equity of American business, supported through local banks and Wall Street, wages can be a wall of worry and insecurity, one step away from joblessness and penury.
But Wall Street cannot long thrive while bureaucrats wage war upon its freedoms, repress its creativity in webs of rules, and tame it with upside caps and downside guarantees. Silicon Valley’s creativity needs a path through Wall Street and Main Street to an ascendant middle class and a peaceful and prosperous world.
During the boom years 1983–2000 under Reagan and Clinton, Main Street, Wall Street, and Silicon Valley meshed. Main Street prospered with the creation of millions of new businesses and some forty million net new jobs. Jobholders participated through their pensions in a Wall Street bonanza that ended with individual investors holding more than half the public shares of U.S. business. Spearheading the Wall Street expansion and the jobs boom were thousands of initial public offerings, from Apple and Genentech to Netscape and Qualcomm, the most lucrative coming from a carnival of invention in Silicon Valley.3 American creativity ramified through a globalizing world economy, with the number of poor people living at the subsistence level of less than a dollar a day, adjusted for inflation, dropping by 20 percent. Markets battened on two billion new entrants into the middle classes from China and other emerging nations.
All seemed to be well with the monetary regime, dubbed the “great moderation” by Alan Greenspan, the guru of growth. But beneath a placid surface, the worldwide monetary system was breaking down.
Toward the end of the millennium, the world plunged into an Asian monetary debacle, the dot-com crash, the telecom debauch, and the Russian ruble meltdown. A thousand telecom companies went bankrupt. Many causes are cited—prodigal Asian capitalists, criminal telecom accountants and CEOs, dot-com-bubble hysteria, sinking oil prices, and Russian corruption, but the real source was monetary volatility.
An unexpected deflation of the dollar—appreciating by some 30 to 40 percent between 1996 and 1999 against most currencies and by 57 percent against gold—brought down all heavily indebted companies and dollar-denominated commodities. Oil, for example, dropped 44 percent between January 1996 and December 1998, from $17.94 to $9.80, which means that the oil price of dollars rose 83 percent. Meanwhile, the dollar measured in gold rose 138 grams, from 241 grams at its low in 1996 to 379 grams at its high in 1999.
Just as inflation bails out debtors and rewards creditors, unexpected deflation punishes debtors, who have to pay back their loans with more-valuable dollars. All prices became questionable. As the dollar soared, the neural webs of a globalizing economy—its price system and trading rules—broke down into “hot money” cascades and central bank freeze-ups. The prime victims were the Asian crisis economies, which borrowed heavily to defend their currencies against “hot money,” and the global telecoms, which incurred huge debt to build worldwide fiber optic networks. Mandating fiber was the increasing video traffic of the ascendant Internet and its dot-com extravaganza.
The crash of 2000 downsized Silicon Valley and caused a collapse of small-business creation. But Main Street conjured with Wall Street to summon a new boom for the new century. Fueled by a stream of exotic securities backstopped by the federally supported insurers Fannie Mae and Freddie Mac, people began speculating on their own houses. Compensating for wage stagnation during this period was a national crescendo in real estate “equity,” rising in “real terms” by 40 percent between 2001 and 2006. Copycat globalization spread the syndrome from Florida to Spain and Iceland.
This “real” housing appreciation was another monetary illusion. Housing is a consumption good; its appreciation always depends on the rising value of production and entrepreneurship surrounding it. Government subsidies, guarantees, and mortgage banking games aim to use federal power to convert a consumption binge into a savings and investment boom. But investment means a yield in the future, paying off the debts, expanding the equity. Housing appreciation from subsidized credit and reduced down payments does not sustain future payment streams.
Under capitalism, credit expansion is no substitute for real savings. To save is not a mere accounting trick. It means to forgo consumption, put off spending, and invest time in productive learning. It is a process of accumulating the knowledge to create new value for the future. It means not merely bidding up the worth of existing buildings, but building up real wealth through tested new business knowledge.
Under capitalism, the middle-class Main Street passes through a global web of interconnections. The web of middle-class net worth embraces Wall Street and Silicon Valley, energy enterprise and medical progress, first-world innovation and third-world development, Brazilian coffee plantations and Korean electronics, Chinese manufacturing and Israeli invention. The Main Street middle rises through a combination of earnings, education, and capital gains around the world.
It begins with start-ups. Some 64 percent of the new U.S. jobs created between 2002 and 2010 came from twenty-three million small businesses with fewer than five hundred employees, companies that are the foundation of middle-class prosperity. In each of the four most recent U.S. recoveries, the small-business sector spearheaded the revival, growing sharply faster than the Fortune 500. In the lapsed lift-off since 2009, though, jobs at small firms have actually declined. Only large firms expanded employment.
The jobs that sustain middle-class prosperity feed on expanded enterprise and investment, equity and innovation. In the United States, some two-thirds of all stock market appreciation over the last thirty-five years came from companies supported by venture capital—what we call “Silicon Valley” for short, which now reaches from Palo Alto to Austin and even Tel Aviv. Most of the rest of our wealth creation reflects the process of globalization, as emerging economies like China and India duplicate the economic development of Europe and North America. Consolidating the gains are U.S. and European “platform companies” designing products to be manufactured in Asia and marketed around the world, with Western companies historically harvesting most of the profits.4
Without the synergistic triad of invention, investment, and distribution—Silicon Valley, Wall Street, and Main Street—the middle class decays. Policy-makers are right to focus on middle-class prosperity as long as they remember that middle-class growth depends on invention and high-tech immigration.
Silicon Valley in 2016 seems buoyant. In 2014 venture capital investment reached $48 billion, and in 2015 it rose still higher, to a level unseen since the 2000 peak. But the recent rise reflects the depth of the slump. The 2014 total is merely one-third of the $144 billion (in 2015 dollars) raised for twice as many companies in 2000.
More important is the allocation of 2015 venture funds. Seed-stage investments in start-ups dropped to their lowest level since 2002. There were fewer than half as many IPOs as in 2000, and they were focused on a few large deals. Meanwhile, in Silicon Valley, venturers ruminate on an incursion of “unicorns”—some 130 private companies now with official valuations close to a billion dollars apiece, for a total market cap approaching half a trillion dollars.
In the ordinary history of Silicon Valley, no private company but Apple obtained anything close to a billion-dollar market cap. Intel, Microsoft, Oracle, Cisco, and other Silicon Valley stars only reached that level through IPOs that led into long years of appreciation of their stocks as public companies. Most companies, including the most lucrative high-tech names—firms like Linear Technology and Applied Materials, Oracle and Sun Microsystems, Cisco, Amazon, and Qualcomm—were happy to go public at a market cap of a few score million. Even Microsoft did not reach near a market cap of a billion dollars until its IPO. Apple, which turned out to be the best stock of the last hundred years, went public at a valuation of $1.3 billion and eventually was valued by Wall Street at more than five hundred times that amount. Adjusted for inflation, Microsoft gained a comparable multiple in the public markets.
The bulk of the appreciation from these Silicon Valley IPOs thus went to Main Street, which held its shares through Wall Street in the form of pensions and stock holdings. Venture capitalists did well, but the broad middle class captured a large share of the returns.
By comparison, Facebook had an $80 billion IPO, from which the U.S. Securities and Exchange Commission “protected” the middle class by barring all but “qualified investors” from pre-IPO markets. The thousandfold gains from Facebook were reserved for the officially certified rich, the fortunate few venture capitalists and investors “qualified” as sufficiently well-off to make such a “risky” investment.
In the past, getting that gigabuck valuation required putting on a “road show” in which executives conjured up the company’s roseate future for major public investment companies that acted in behalf of middle-class stockholders. This start-up process of “going public” prepared an initial public offering for masses of investors around the globe. It has been the spearhead of U.S. economic growth.
Today’s “unicorn” valuations totaling hundreds of billions of dollars all took place without “going public.” Pre-public investors anticipate something like a sevenfold return in exchange for the risk and illiquidity of pre-IPO markets. Thus the unicorn valuations imply projected exits—“liquidity events” and greater-fool financings—seven times higher. If the public could be induced to buy these companies after the initial surge of their market cap, the anticipated harvest over the next few years would be a couple trillion dollars, most of it going to “qualified investors,” that is, the “rich.” The middle class would be holding the bag.
On the surface, the emergence of hundreds of companies with billion-dollar valuations is supremely promising. From Intel to Facebook, similar venture-based companies in the past have accounted for some 21 percent of our GDP and 60 percent of stock market capitalization. Venture companies are the prime source of American growth. But this time seems to be different. The chief concern is whether these “unicorns” portend a “new bubble.” Would these virtual worlds and software virtuosos pop and piffle like 1999’s dot-com web-vanities and Petco litter boxes?
“Software,” as the preeminent venturer Marc Andreessen says, “eats up the world.” Uber may transform urban transport, Pinterest may reinvent online advertising, Palantir may offer a radical advance in big data for security and even boast a billion in revenue and a role in finding Osama bin Laden. But folks may finally “swipe left” by Tinder and the scores of other multibillion bit-monkey mock-ups. The world may prove treacherous even for instant virtual hooker drone delivery systems.
Back in 1999, the exits opened out into capacious public markets through IPOs, then seven times more numerous than mergers and acquisitions (M&As) for tech companies. But today the rarities are IPOs, outnumbered by M&As twenty-two to one. Which means that the “greater fools” chiefly targeted by venture capitalists to buy their unicorns are not you and I and millions of others in a possibly hallucinogenic NASDAQ public market but rather a tiny elite of cagey bidders counseled by game theory quants. The oligopsonists include Facebook’s Mark Zuckerberg, Microsoft’s Satya Nadella, Google’s alphabetic Larry Page, Disney’s Robert Iger, Verizon’s Lowell McAdam, Amazon’s Jeff Bezos, Netflix’s Reed Hastings, and Apple’s Tim Cook. None seems a good bet for a gaggle of gulls.
What is really going on is the displacement of the open and rabble-run IPO market by an exclusive game of horse trading among the most exalted elite of “qualified investors,” the owners of the leviathans of the last generation of IPOs. Capped by such regulatory tolls and encumbrances as the accounting mazes of Sarbanes-Oxley, Fair Disclosure’s code of omertà, and the EPA’s “cautionary principle” barring innovative manufacturing, the new Silicon Valley confines ascendant companies beneath a glass ceiling. From Apple to Google, a few public giants dominate this private-company market since they are the only potential buyers. Within this confined space, every titan is more eager to purchase his start-up rivals than to compete with them.
Whitewashed and fitted out with shiny horns, the aspiring “unicorns” shuffle through the corrals of Sand Hill Road and the carrels of Cupertino, seeking sustenance from smart-set venture capitalists and international tech tycoons. With their high-calorie burn rates and weak revenues, these creatures survive on a continued boom in reveries.
The tycoons swipe left or swap right, sending the nags off to the races or back to the stables—or perhaps the glue factory. Whether this one-horn hippodrome of venture capital constitutes an expanding “bubble” or a balky bottleneck, it is a bad circulatory system for finance: a traffic jam on Route 101 with no easy exit to Wall Street.
Yet the New York Times and Vanity Fair tech scribe Nick Bilton reports that there is a redeemer on the horizon, filling the tech financiers and their clients with high hopes. It’s the Federal Reserve Bank: “The Fed’s decision to carry out multiple rounds of quantitative easing, in which the central bank stimulates the economy by buying securities, has flooded the system with cash.”5
So there we have it. The unicorn buyer of last resort will be the Fed. The “lender of last resort” for the financial system, the governmental guarantor for all the big banks and other “systemically important financial institutions,” the backup reinsurer for windmill Quixotes, ethanol pushers, and solar prospectors, the last ditch for Fannie Mae and Freddie Mac and other mortgage packagers, the default financier for the trillions of dollars of student loans, for veterans’ hospitals, for underfunded pensions and Medicaid reserves of the states, and above all for the proliferating securities and insecurities of the federal government, this same federal fount of funds and faith is also seen as the savior of Silicon Valley. What assures a soft landing for the hang-gliding unicorns is the Fed. Is the ultimate symbol of our predicament not a bailout for middle-class mortgages but a backup of imaginary money for mythical beasts?
In the new world of zero interest rates and quantitative ease, money migrates not to opportunity but to bureaucracy, not to creativity but to clout and cozenage, not to new 3-D semiconductors but to sleek Solyndras. Without real interest rates, funds flow to influence and precedence. Confined below the Fed’s ceiling, venture capitalists are left to play circle games with unicorns.
Only large companies can master the demands of the game, the need for foreign exchange hedges, transnational holding companies, legal specialists, complex securitizations, intellectual property swaps, private equity inversions, multiple stock classes, alternative energy entanglements, audit committees, double cross-checking accountant teams, diversity mandates, sexual harassment backside protectors, and other pettifoggery all crowding out the entrepreneurs.
The test of an entrepreneurial idea is its experimental and empirical truth, affirmed by profitability. In a knowledge economy, cash is valuable only if it is validated by real learning. That is the moral foundation of capitalist wealth and the only source of growth.
“Flooding the system with cash” is bad for the economy because it falsifies price signals and demoralizes capitalists by misrepresenting the outcomes of entrepreneurial experiments. If capital is free, businesses substitute it for labor, which becomes relatively costly. Money shufflers triumph over job creators.6 Growth slows, employment lags, and Silicon Valley becomes just another vector of the monetary state.
Worse, current monetary policy is fostering class war; it is profoundly unfair to ordinary workers as well as entrepreneurs. Zero interest rates rob future generations by bidding up the value of current government assets and privileges. A bubble of current assets inflated by near-zero-interest loans does nothing to fund the future. Retirees face a prospect of shriveled pensions and support and watching their children and grandchildren live slow-motion lives.
According to the Fed’s own data, from 2010 to 2015 some 62 percent of Fed money creation was recycled through the banks to the Treasury trough.7 More than 65 percent of the rest went to a few large corporations, which continued to use it to suck up their own shares at a rate of $25 billion per month.
Our Federal Reserve System, which gives twelve bankers a monopoly on money, is broken. Its fruits are low growth, a shrinking job force, inequality, inefficiency, and a hypertrophy of finance. Nonproductive elites capture the bulk of the returns from money manipulation under government guarantees, and the rest of the population lives on financial leftovers.
The Fed has become a fourth branch of government that alienates Main Street from Wall Street and Wall Street from Silicon Valley. Our society is breaking up into separate and suspicious tribes ruled by federal bureaucrats deciding what money is worth and who gets it.
Our aging Federal Reserve System starves both small businesses and Silicon Valley of the capital needed to grow jobs and wages. Fed policy translates into zero-interest-rate loans for the government and its cronies, and little or nothing for savers or small businesses. And it has transformed Wall Street from an engine of innovation into a servant of government power.