The Scandal of Money: Why Wall Street Recovers but the Economy Never Does - George Gilder (2016)
Chapter 12. Wall Street Sells Its Soul
The current world monetary and economic system favors this new Wall Street currency regime over both Main Street and Silicon Valley. Once associated with research, analysis, and support for the independent enterprises of America, the new Wall Street simply means giant banks informally nationalized by Washington.
Deutsche Bank, Goldman Sachs, Morgan Stanley, UBS, Citibank, JPMorgan Chase, and the rest, eminent institutions all, are full of dazzling financial prestidigitators. But they are too big to fail and too dependent on government to succeed. Their horizons are too short to foster entrepreneurial wealth and growth. The bulk of financial profits now comes from “proprietary trading,” with a time horizon measured in minutes and weeks rather than years and decades. They impart liquidity but not learning. They are profitable because of a vast transfer of wealth away from workers and savers to bankers.
These institutions insidiously thrive by serving government rather than entrepreneurs. Government policy now favors the short-term arbitrage and rapid trading of the big banks over the long-term commitments that foster employment and growth, leaving us with a predatory zero-sum economy that destroys the jobs and depletes the incomes of the middle class.
For most of us, wildly changing prices and currency values are a menace. They confuse enterprise and learning and thwart the enduring commitments and investments that shape our lives and prospects. But the new Wall Street—with its computer-driven trading—thrives on volatility, enjoying protection on the downside from the government. Gyrations in currency and stock values, whether up or down, mean opportunities for arbitrage and fast trading. The new Wall Street harvests these gains through cheap borrowing from the Fed and accelerated buying and shorting of currencies and securities. Main Street and Silicon Valley, on the other hand, want stable currencies for the benefit of work, savings, and long-term investment, with the upsides protected by the rule of law.
The new Wall Street mostly welcomes Luddite environmental regulations that thwart manufacturing and promote litigation. But regulatory overreach and litigation paralyze Main Street and all but the lawyered leviathans of Silicon Valley. Favoring financial power over entrepreneurial knowledge, government policies have crippled the American jobs machine that led the world in the 1980s and 1990s and sustained income growth for nearly all Americans.
The new Wall Street delights in the spiral of guaranteed loans to college students, which expand the ledgers of banks and the investible endowments of universities, while Main Street and Silicon Valley suffer from the debt-driven flight from marriage and entrepreneurship of entire generations of debt-burdened college graduates (or worse, nongraduates).1
When large companies buy up their own shares and the shares of their potential competitors, the price of the remaining shares may move up. But the benefit to elite company stock values comes at the cost of a stagnant economy, without new competition and learning, jobs and growth.
Part of the problem is what I call the “outsider trading scandal.” Hounded by government insider-trading witch hunts and “fair disclosure laws,” investors must follow the government rule of “Don’t invest in anything you know about.” The only thing governments want the public to invest in is the state lottery, “where no one knows more than you.”
Outside traders use market statistics and quarterly earnings correlations to guide ever more evanescent transactions. Since entrepreneurial learning comes from deep inside companies and requires intimate special knowledge, a ban on trading by anyone with inside knowledge impels investors away from close company analysis and productive finance.
In the face of the protean rules of the Securities and Exchange Commission and computerized investigations, it is simply foolhardy for a bank or hedge fund to base its public investments on real, unique inside knowledge. Nearly anyone who understands a company is barred from investing in it. Members of a company’s board of directors, for example, who can always be judged to possess some incriminating inside insight, are basically prohibited from buying shares in the companies they know best. They are safe only if they lose money. The SEC, astoundingly, favors boards that know nothing about the companies they rule and have no stake in them. Lawyers and accountants proliferate. The SEC thus stultifies investment by pushing it into the hands of arrogantly ignorant outside traders.
Even mutual funds and other stock market investors are increasingly shunning actual investigation of particular firms. Intimidated by regulators, many funds do virtually no analysis of companies beyond the computerized parsing of balance sheets and quarterly statements for data used in fast-trading algorithms.
Under this self-defeating regime, the returns have migrated to large conglomerateurs and private equity players who benefit from perfectly legal insider trading in every one of their investments. Cagey private equity investors now can make lucrative gains by taking small public companies private and removing all the costly government-imposed impediments of redundant legal compliance and accounting pettifoggery.
Warren Buffett’s Berkshire Hathaway and Jeffrey Immelt’s General Electric, to take two prominent examples, are not real corporations but legal inside traders that allocate investments among diverse company holdings that they understand intimately. Likewise, venture capitalists and private equity players never make an investment without intimate investigation of every inside nook and cranny.
Guided by deep inside knowledge, venture capital is the most valuable money in the economy. Launching learning curves across a wide span of innovations, venturers have seeded companies that now produce some 21 percent of America’s GDP, 65 percent of its market capitalization, and a probably underestimated 17 percent of its jobs.2
But venture capital represents a tiny proportion—less than 0.2 percent—of total capital. Deploying most capital are global conglomerates like Berkshire Hathaway and General Electric. They are a net positive force in the economy, but most of them contribute comparatively little of the innovation that yields real economic growth, jobs, and learning.
With little access to the venture capital or private equity game, the public at large is counseled to invest its money in “index funds.” These yield no more knowledge and learning than the state lotteries do. Purchasing a sampling of all the stocks in the market without any research on specific companies, indexers give the public some exposure to the gains of the inside-trading conglomerateurs. But they provide less than no benefit to the learning processes that create growth and wealth. Index funds are parasites on the research done by actual investors.
Index funds are even worse than they look because they base allocation not on the expected yield of the investment but on market capitalization. As companies grow overvalued, they become an ever-larger share of the holdings of the funds. The anomalous rise of Apple to the world’s most valuable corporation has saved the careers of thousands of managers. Momentum prevails until it stops. But as the economist Charles Gave of Gavekal puts it, “In a true capitalist system, the rule is the higher the price the lower the demand. With indexation, the higher the price, the higher the demand. This is insane.”3
Yet as pioneered by the laureled John Bogle at Vanguard and encouraged by the SEC’s insider-trading phobias, these parasitical and distortionary index funds directly extinguish knowledge and learning in the economy.4Vanguard now passively “manages” some $2.9 trillion of assets while contributing nothing to the investment process. Rather than investing in the market, they parasitically infest and congest it. Rather than creating wealth and jobs, they destroy them.
Dwarfing all positive investment by “inside traders” and knowledge brokers are the financial power brokers in the major banks. Thriving through leverage and arbitrage, fast trading and risk shuffling, they have long had access to virtually unlimited funds at near-zero interest rates, while the government has anointed most of them as too big to fail. In effect, the federal government, through the Federal Reserve and scores of other regulators, has socialized the downside of these institutions, enabling them to carry on what they call “creative risk taking.” But what in fact they do is cockeyed extension of ever more cantilevered loans and compound securities with only tiny slivers of actual equity at risk. Real entrepreneurial risk taking is totally unrelated to mere hypertrophy of leverage with implicit government guarantees.
During the doldrums decade of the dot-com crash and the great financial recession, 2000 to 2010, the socialized big banks feasted on zero-interest-rate money from the Fed, bought trillions of dollars’ worth of government bonds, and harvested the spread. From the Fed, they received over a trillion dollars of surreptitious largesse.5
These gains for bankers and governments were defrayed by the taxpayers and shareholders and even retirees through the zero-interest-rate policy.6 When something is free, only the well-connected get much of it. Main Street is far back in the queue. Zero interest rates resulted in easy money for highly leveraged Wall Street speculators, cheap money for the government, and a parched credit landscape for entrepreneurial small businesses. Some 2,600 community banks went out of business, too small to bail.
Velocity is frequency in money—how many times a dollar turns over in a year. Money is a wave phenomenon. Since the power of a wave rises with the square of its amplitude, large and long investments would be exponentially more significant than a series of small trades. Wavelets would be exponentially less potent than tsunamis. Thousands of fast trades do not add up to a program of high-impact investment for the economy.
Small and temporary anomalies are unsurprising and low entropy. Profits that reflect mere leverage or borrowing power do not usually contribute to the learning process. They reveal willingness to accept a level of calculable risk rather than singularities of creative learning. Such profits are predictable and thus low entropy.
The Stanford physicist and Nobel laureate Robert Laughlin has derided the elaborate efforts of scientists to find significance in the intrinsically transitory forms that arise on their computers during phase changes, such as bubbles in water on the brink of a boil.7 These computational figments have an analogue here in the outside traders’ search for momentary correlations. As Claude Shannon knew, in principle a creative pattern of data points—reflecting long and purposeful preparation and invention—is indistinguishable from a random pattern. Both are high entropy. Parsing of random patterns for transitory correlations fails to yield new knowledge. You cannot meaningfully study the ups and downs of the market with an oscilloscope. You need a microscope, exploring inside the cells of individual companies.
Currency values should be stable. In information theory terms, they should function as low-entropy carriers for high-entropy creations. But the oceanic currency markets are full of Laughlin froth to be parsed by computers for short-term anomalies. With leverage, these trades may accumulate to massive profits. But these profits do not contribute much to the processes of entropic learning that constitute all economic growth in an economy of knowledge.
A monetary reform could free banks from their current trivialization as government tools and make them once again crucial vessels of investment. In any banking system, the reason the maturities do not match is the divergence between the motivations of savers and the sources of the value of savings. Savers attempt to preserve their wealth in a liquid form, where they can retrieve it whenever they wish. But the laws of irreversible time ordain that money cannot stand still or uncommitted without losing value.
For its perpetuation and expansion, the wealth in banks is utterly dependent on long-term investments in perilous processes of learning—real investments in companies and projects that can fail at any time. The role of banks is to transform the savers’ quest for security and liquidity into the entrepreneurs’ necessarily long-term illiquidity and acceptance of risk. Without banks performing this role, economic growth flags and stagnation prevails, as Lawrence Summers and Robert Gordon observe.8
Explaining the sources of Britain’s dominance of world trade, the Victorian journalist Walter Bagehot pointed to the vastly larger agglomerations of capital in London banks:
A million in the hands of a single banker is a great power; he can at once lend it where he will, and borrowers can come to him, because they know or believe that he has it. But the same sum scattered in tens and fifties through a whole nation is no power at all: no one knows where to find it or whom to ask for it. Concentration of money in banks, though not the sole cause, is the primary cause which has made the money market of England so exceedingly rich, so much beyond that of other countries.9
Bagehot, the editor of the Economist from 1860 to 1877, saw the power of leverage as a force for economic diversity and dynamism, enabling small entrepreneurs to outperform established capital. He gives the example of a start-up using leverage to outperform an established company avoiding risk. Even while paying back its loan, or equity investment, the start-up can disrupt the established player by offering new and cheaper goods. “The egalitarianism of money,” he wrote, “how it likes ideas better than it likes established capital, is very unpopular in many quarters.”
“Banking is a profitable trade,” he concluded, “because bankers are few and depositors myriad. . . . No similar system arose elsewhere, and in consequence London is full of money and all continental cities are empty as compared with it.”
Bagehot compared banking with enterprise: “The banker must always be looking behind him seeing he has enough reserves. Adventure is the life of commerce, but caution—I had almost said timidity—is the life of banking. Merchants use their own capital rather than other people’s money.”
A key to the 2008 crash was some bankers’ discovery of the temptations of other people’s money when insured by government. Understanding this temptation, Bagehot warned against bailing out banks. “The cardinal maxim [of banking policy],” he wrote, “is that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.”
He commented on the inconsistency of central banking, even in that era, with a system of democratic government: “A bank of issue, which need not pay its notes in cash, has a charmed life; it can lend what it wishes, and issue what it likes, with no fear of harm to itself, and with no substantial check but its own inclination.” Bagehot had many ideas for a better system. But his final observation remains hard to deny. “Dependence on the [central bank] is fixed in our national habits.”
There is a difference, however. Bagehot was writing about a Newtonian world. The currencies central banks manage today have no anchor in gold and thus suffer from the same self-referential circularity that imperils all logical systems unmoored to outside foundations of reality. The U.S. Federal Reserve lives Bagehot’s “charmed life”: “It can lend what it wishes, and issue what it likes.” Its unmoored money can be manipulated at will in the interests of its sponsors in government and their pseudo-private cronies, selling their souls to the Fed.