The Smartest Guys in the Room by Bethany McLean & Peter Elkind

mclean_smartest.jpgAs sordid a tale of ego and excess as the RJR Nabisco buyout appears in Barbarians at the Gate (review here), at least there does not seem to have been anything illegal going on. Unethical, perhaps. Greedy, undoubtedly. The battle of megalomaniacs is what makes the saga so interesting twenty years later. But at the end of the day RJR and Nabisco still exist (though in decidedly different forms), they still have employees, and their shareholders were not left completely out in the woods.

None of this can be said for Enron, which essentially spontaneously combusted via bankruptcy in late 2001, and managed to take venerable Big Five accounting firm Arthur Andersen along with it into the oblivion of business history. The story of Enron's "amazing rise and scandalous fall" has been the subject of several books, including Kurt Eichenwald's Conspiracy of Fools. First on the scene were a pair of Fortune writers, Bethany McLean and Peter Elkind; McLean had reported on Enron for the magazine and had been amongst the first journalists to turn a more critical eye toward the company, as early as March 2001 (still years after folks should have noticed what a boondoggle it was). They published The Smartest Guys in the Room in October 2003, less than two years after the company went bankrupt. Two years later the book was made into a documentary by the same name.

The story begins near the end, with the January 2002 suicide of Cliff Baxter, a senior Enron executive who had resigned the previous May. He had also been one of the closest friends of former Enron CEO Jeffrey Skilling, who was still making the case that Enron was a victim, not a villain, in the recent turmoil:

More than anyone else, Skilling had come to personify the Enron scandal. Part of it was his audacious refusal, in the face of a dozen separate investigations, to run for cover. Alone among Enron's top executives summoned before a circuslike series of congressional hearings, Skilling had ignored his lawyers' advice to take the Fifth and defiantly spoke his piece. The legislators were convinced that Skilling had abruptly resigned as CEO of the company--just four months before Enron went belly up--because he knew the game was over. But Skilling wouldn't have any of it... "Enron was a great company," Skilling repeatedly declared. And indeed that's how it seemed almost until the moment it filed the largest bankruptcy claim in U.S. history.

The Smartest Guys in the Room is not just the story of Enron's fall. Rather, it takes the long journey all the way from the start, with a young Kenneth Lay cutting his teeth in the natural gas business, finally rising to the top of Houston Natural Gas in 1984. Convinced that deregulation of the natural gas industry was imminent, "Lay operated on one theory: get big fast." Fortune shined upon him in the figure of InterNorth, an Omaha-based pipeline company that offered to purchase Lay's company. Lay and his negotiation team obliged, "letting" InterNorth buy Houston Natural Gas, with a couple catches: they would have to pay a 50% premium on the current stock price, and Lay would have to take over the combined company within 18 months. Not a bad deal for Lay, though it got even better when Lay bullied the InterNorth CEO out almost immediately, with the help of consultants from McKinsey (including a young man named Jeff Skilling). Slowly but surely, Lay began to purge the InterNorth faction, install his own men, and even come up with a new name for the company:

After four months of research, the New York consulting firm Lay had hired had settled on Enteron in time for the merged business's first annual meeting, in the spring of 1986. But then the Wall Street Journal reported that Enteron was a term for the alimentary canal (the digestive tract), turning the name into a laughingstock. Though it meant reprinting 75,000 covers that had already been printed for the new annual report, the board convened an emergency meeting and went with a runner-up on the list: Enron.

Of course, it would only be 15 years before the name Enron itself became a laughingstock. As McLean and Elkind trace the rise of Enron, we see the entrance of major players like Skilling, Rebecca Mark (who ascends to lead the disastrous international division before resigning in disgrace... with $80M in cashed-in stock options), and financial "wizard" Andrew Fastow. Several themes quickly emerge: Enron executives think they are smarter than everyone else, believe they are entitled to live off the company's expense accounts, and have virtually no idea how to run a successful business. Take Mark's international division for example:

What one former international executive calls the "fatal flaw" in the business was the compensation structure. Developers got bonuses on a project-by-project basis. The developers would calculate the present value of all the expected future cash flow from a project. This was also the model the banks used to lend money. When the project reached financial close--that is, when the banks lent money but before a single pipe was laid or foundation was poured--they were paid.

No wonder the developers were so eager to move on to the next deal; they had no financial incentive to follow through on the one they'd just completed... It was crazy.. under this new pay arrangement, the only thing that matter was making the deal happen. The more deals Enron International did, and the bigger they were, the richer the developers got. The system encouraged international executives to gamble without risk. The deeper problem, one that emerged in later years, was that no one was held responsible for the operation of a project, yet it was the operation that produced the real money.

Yet preposterous as this was, it was not illegal. It was simply the sort of unbelievably bad decision-making that would normally scare off Wall Street and drive a company into bankruptcy. And yet Enron was just hitting its stride, and had years of double-digit growth ahead of it (McLean and Elkind have to sheepishly admit that Fortune named Enron the most innovative company six years in a row). How did that happen? It turns out that Skilling, incompetent though he might be at, you know, producing anything of value, was a master at manipulating Wall Street. He understood that financial analysts thrived on a company's financial data, its accounting. So that's where the growth and profits had to be. On paper:

Invariably, as the quarter drew to a close, Enron's top executives would realize they were going to fall short of the number they'd promised Wall Street. At most companies, when this happens, the CEO and chief financial officer make an announcement ahead of time, warning analysts and investors that they're going to miss their number. In other words, the reality of the business drives the process of dealing with Wall Street. Not at Enron. Enron's reality began and ended with hitting the target. And so, when the the realization took place that the company was falling short, its executives undertook a desperate scramble to fill the holes in the company's earnings. At Enron, that's what they called earnings shortfalls--"holes."

At first, a lot of the holes could be filled by accelerating deals, often conceding major negotiating points simply to get the papers signed before the quarter ended. But the bad business decisions kept adding up, and the holes kept getting begin. And thus the reliance on the number crunchers increased, until Enron was leaning "heavily on mark-to-market accounting to help reach its earning goals." In its simplest terms, the way Enron used this accounting method was so to immediately book on paper all of the earnings it expected to earn from a deal as soon as the deal was signed. Thus a 10-year deal projected to be worth $40M per year signed in 2001 could be counted as $400M in earnings in 2001 rather than as the money actually flowed in. The obvious problem is that such projections could be, and at Enron were, heavily manipulated; rosier projections equals bigger earnings. This would be somewhat alleviated if Enron had treated its anticipated losses in the same way, booking anticipated losses immediately even if the losses would not be realized all at once. But Enron never did that. Projected earnings were booked immediately, anticipates losses ignored forever:

At the end of each quarter, for example, Enron was supposed to write off its dead deals. To review what needed to be booked, [Enron Chief Accounting Officer Richard] Causey met individually with the heads of the origination groups. At one meeting, an executive recalled, Causey kept coming back to a dead deal and asking: Was it possible the deal was still alive?

Finally the executive took the hint--and the deal was declared undead. Enron deferred the hit for another quarter. "You did it once, it smelled bad," says the executive. "You did it again, it didn't smell as bad."

Causey is now in federal prison for securities fraud. But even his valiant efforts could only go on for so long before financial analysts noticed that things were not adding up. Of course, they would only notice if all this accounting were taking place on Enron's corporate balance sheet. And this is where Andy Fastow really shined:

[I]f it's impossible to mark the moment Enron crossed the line, it's not hard at all to know who led the way. That was Andrew Fastow, the company's chief financial officer... Fastow became Enron's Wizard of Oz, creating a giant illusion of steady and increasing prosperity. Fastow and his team were the financial masterminds, helping Enron bridge the gap between the reality of its business and the picture Skilling and Lay wanted to present to the world. He and his group created off-balance-sheet vehicles, complex financing structures, and deals so bewildering that few people can understand them even now. Fastow's fiefdom, called Global Finance, was, as Churchill said about the Soviet Union, a riddle wrapped in a mystery inside an enigma that was Enron's string of successively higher earnings.

Of course, eventually the whole thing unraveled. Many of Fastow's financial maneuvers were premised on the constant rise of Enron's stock price. As soon as a few short sellers and journalists started poking around in early 2001, and the stock prices stagnated and then dropped, it was mere months before the whole scheme collapsed. And with that collapse went thousands of jobs and tens of billions of dollars in vanished investments.

With good reason, McLean and Elkind end their narrative with the bankruptcy filing. At the time of the book's publication, the first wave of indictments had already been handed down to the likes of Lay and Fastow, but the authors had no way of knowing how these relatively novel prosecutions would turn out. It was months later that Fastow decided to enter his guilty plea and cooperate against his former colleagues in exchange for leniency for himself and his wife. Lay's trial would not take place until early 2006, when he and co-defendant Skilling would both be convicted of most of the numerous counts of conspiracy, false statements, securities fraud and insider trading lodged against them. Lay would die before his sentencing hearing, thus requiring the judge to vacate the convictions. Skilling was sentenced to more than 24 years and a $45M fine, but earlier this year the 5th Circuit ordered a new sentencing hearing while upholding the convictions. He's still looking at a likely double-digit term of confinement. Ironically, Fastow, probably the most personally culpable for the house of cards that came tumbling down in late 2001, was so cooperative that prosecutors lobbied the judge on his behalf; he'll be released in December 2011. Funny how those things work out.

It is also interesting to note the many parallel forces there were enabling the Enron scheme ten years ago and then the credit and subprime mortgage structure whose collapse rocked the markets last year. McLean and Elkind devote an entire chapter, titled "Everybody Loves Enron," to all the external forces that knowingly or negligently conspired to assist Enron's undeserved rise. Most obviously, the accountants were in on it. The banks and financial analysts were too busy getting rich off consulting fees to risk asking any questions about what in the world Enron actually did ("There was simply too much investment-banking business at stake not to have a screaming buy on the stock... the Chinese Wall had long since broken down, and during the bull market, analysts became increasingly instrumental in helping their firms land banking business.") The credit agencies' hands were dirty too:

[I]nstead of acting as the ultimate watchdog, the credit analysts unwittingly served the opposite purpose: they gave all the other market participants a false sense of security. Stock analysts and investors alike took solace in the fact that the credit analysts gave Enron an investment-grade rating... Thus did the responsibility to truly analyze Enron land nowhere. And thus the stock continued its climb.

Sounds awfully familiar, doesn't it? This too would almost be funny, if it was not so infuriatingly sad.

Barbarians at the Gate by Bryan Burrough & John Helyar

burrough_barbarians.jpgIt is not uncommon to see great works of fiction reprinted in anniversary editions celebrating either the date of publication or the centennial birthday of the author. See, for instance, the "50th Anniversary Editions" of On the Road and Lord of the Flies, or the "Steinbeck Centennial Collection." It is something else entirely, though, to see a hardcover anniversary reprint of a nonfiction title issued decades after the book's original publication. And with good reason: most nonfiction does not age well. Usually either the subject matter is no longer topical, or the underlying research has been surpassed by more recent scholarship.

Thus it is worth noticing when a nonfiction book does get the anniversary treatment. A title like The Joy of Cooking, which recently celebrated its 75th anniversary, is somewhat exempt from the obsolescence of most nonfiction titles, not that this diminishes the enduring popularity of that book. However, it is hard to think of a genre more prone to near-immediate outmoding than business current events. Just think, Charles Morris book on last year's credit crisis actually had to be retitled from The Trillion Dollar Meltdown to The Two Trillion Dollar Meltdown when it came out in paperback, as it was so quickly overcome by events.

That is a long way of saying that Barbarians at the Gates has a decent case behind its cover's claim to being the "Best Business Story of Our Time," based solely on the fact that it was republished in hardcover last year to mark the 20th anniversary of the leveraged buyout of RJR Nabisco. As the authors state:

When we wrote Barbarians at the Gate in 1989, it was a book about current events; now it's history. Some books age better than others. We'd like to think Barbarians has aged well. The book is still used in major business schools to teach any number of topics, from ethics to investment banking. In 1993 it was made into a movie on HBO. In 2002, fourteen years after its heyday, the RJR fight was dramatized once again in a documentary film on the History Channel.

I think there are several reasons for the book's lasting success. First, and most unfortunately, the subject matter has remained frighteningly topical. Sure, the details of the RJR Nabisco battle are no longer in the news, but the book's tales of conference room machismo and high-dollar financial manipulations have been seen again and again in the years since (perhaps most spectacularly in the saga of Enron, on which I will say more in my upcoming review of The Smartest Guys in the Room).

Second, though the book was written just a year or so after the events it describes, there is little chance of better research coming along; the authors, both reporters at The Wall Street Journal at the time, snagged in-depth interviews with seemingly every key player in the saga, providing a vivid behind-the-scenes perspective. They were able to reconstruct pivotal conversations based on the accounts of multiple participants, just like a fly on the wall. Finally and fundamentally, this is just a uniquely fascinating story with larger-than-life characters, and the authors tell it fabulously. They successfully meshed their thorough research with a suspenseful narrative normally reserved for works of fiction:

It was the night before the company's regular October board meeting, normally an occasion for the directors to dine informally with their chief executive, Ross Johnson, and get an update on corporate affairs delivered in Johnson's unique freewheeling style. But tonight the atmosphere was markedly different. Johnson had called every director and urged him or her to attend the dinner, which wasn't usually mandatory. Only a few knew what loomed before them; the others could only guess.

This board meeting, in which Johnson would propose to lead a leveraged buyout of the company he headed, is depicted in the book's opening chapter, though it takes nearly two hundred pages for the narrative to catch up. Johnson is at the heart of the story; leveraged buyouts, after all, normally depended on the cooperation of management in assisting the investment group in cutting costs, spinning off unprofitable businesses, and thus generating the huge profits expected from an LBO. Johnson's story is extraordinary on its own, depicting the Canadian businessman's late bloom and then meteoric rise, twice merging the smaller company he led (first Standard Brands, then Nabisco) into a larger company and then rising to the head of the combined operation.

But once the LBO gets rolling, Johnson largely loses control of the situation, with the arrival on the scene of Henry Kravis. Kravis, the self-proclaimed master of LBOs, did not like the notion that the largest LBO in history would take place without him. The majority of the book depicts the fight between Kravis' group and the management group to win the board's approval of their offer. This battle features all the worst of what American business has to offer: uncontrolled ambition, greed, preposterously immense egos:

While Cohen and Kravis glared over their coffee cups, Johnson decided to take matters into his own hands. He simply had to know if the Kravis bid was real and, if so , what it means for his management group. Johnson was nothing if not a quick read: He could tell Cohen was less than enthusiastic about sharing the deal of his life with Kravis. Both times Cohen and Kravis had spoken they had gotten into spit fights. Maybe it made sense to try some kind of partnership with Kravis. The only way to find out for sure, he reasoned, was to meet with Kravis himself.

But the time for handling such matters one-on-one had passed, and soon the story is one of rooms filled with bankers and lawyers, alternately negotiating the smallest details in a press release or coming up with financial projections to justify another couple billion dollars in their offer. In the end, of course, Kravis won. At least in the short term; by the late 1990s his firm divested its holding "with humble returns." Johnson, on the other hand, had resigned as CEO shortly after his group lost the bidding, walking away with a golden parachute worth $53 million. Still, as the authors point out in their new foreword, that "once-outrageous" amount seems practically "parsimonious" in light of the sums taken by today's CEOs, who can pull that much down in a yearly bonus. Or the amounts earned (read: stolen) by the folks at Enron. But more on them later in the week.

Andrew Carnegie by David Nasaw

nasaw_carnegie.jpgAndrew Carnegie was a man of many paradoxes. He was a giant in business, yet stood but 5 feet tall at the most. Audacious and ruthlessly oblivious of other perspectives in his professional life, he waited until his mother was dead to get married so as not to make her feel abandoned. Though he reached the pinnacle of industrial capitalism, he was more interested in being known as a man of letters and ideas than a man of wealth. He relentlessly pursued profits at the expense of his employees' salaries, jobs, and health and his competition's survival, and then spent his long retirement giving the money away.

In his 2006 biography of the philanthropic steelmaker, Andrew Carnegie, David Nasaw attempts to capture and consider these dueling aspects of Carnegie's personality, which reflect the transitional nature of his times:

Andrew Carnegie was a critical agent in the triumph of industrial capitalism surrounding the turn of the twentieth century. That much is undeniable. But the source materials I have uncovered do not support the telling of a heroic narrative of an industrialist who brought sanity and rationality to an immature capitalism plagued by runaway competition, ruthless speculation, and insider corruption. Nor do they support the recitation of another muckraking expose of Gilded Age criminality. The history of industrial consolidation and incorporation is too complex to be encapsulated in Whiggish narratives of progress or post-Edenic tales of declension, decline, and fall.

Carnegie himself credited his success not to any innate skill or divine selection, but to more or less being in the right place and the right time. He was born in the fall of 1835 in Dunfermline, Scotland, a town known then, as now, for its textile industry. His father was a skilled linen weaver who lacked either the ingenuity or the initiative to be successful at his trade, leaving Carnegie's mother to devise small business opportunities to support the family. They departed Scotland in 1848, settling in Allegheny, Pennsylvania, with family members who had preceded them. With the family impoverished, young "Andra" entered the work force at age 13. In short order, he was the main breadwinner:

There was something about the lad that inspired older Scottish men to entrust him with responsibilities he was not quite ready for. The Carnegies had relocated to an American manufacturing city filled with enterprising, upward-rising Scotsmen, ready and able to help out young landsmen. Andra's stint as a bobbin boy for Mr. Blackstock had barely begun when another Scottish expatriate manufacturer, John Hay, offered him a position for two dollars a week, almost double his wages.

Less than a year later Carnegie would move to a telegraph company where he worked as a messenger, then operator, before making the fateful move over to local office of the Pennsylvania Railroad, an association he would maintain for the duration of his career. Starting as a telegraph operator, secretary, and chief assistant to the superintendent, within a few years he was superintendent himself. The 1850s and 1860s were a great time to be in the railroad business, particularly when a railroad executive could invest in the very companies that were building or using the expanding railroad network:

In 1862 Carnegie invited Jacob Linville, the Pennsylvania's chief bridge engineer, and John Piper and Aaron Shiffler, also engineers, to join him, Scott, and Thomson in organizing a new company to build iron railroad bridges in Pittsburgh. The new company, Piper & Shiffler, was a fine example of nineteenth-century crony capitalism. Carnegie would oversee operations and finances from Pittsburgh. Scott and Thomson, who remained silent partners in the enterprise, would make sure the new company received lucrative contracts for iron bridges from the Pennsylvania and its affiliated companies. As he had become the modus operandi of their investment partnership, Carnegie held Scott's stock in his own name. Thomson's shares were put in his wife's name. Linville's participation in the company was also kept secret as, with Scott and Thomson, he remained an employee of the railroad.

The money Carnegie earns in such endeavors is immediately reinvested into new projects, a habit that Carnegie would carry with him into the steel business when he made the move in the early 1870s to put "all my eggs in one basket." Foreseeing the demand for steel railroad lines, Carnegie used his connections and insight in the railroad industry and his continual investment in better technology to claim for himself an enormous share of the booming steel business. He brought vertical integration to the business as well, buying the coke sources needed for steel production and building his own railroads to lower transportation costs. By the time he sold his various enterprises to the newly-created U.S. Steel behemoth, he was by some estimates the second-richest man who had ever lived.

Nasaw does not gloss over the costs the Carnegie empire imposed on its work force and competition. Ever obsessed with reducing costs and boosting profits, Carnegie successfully drove unions out of his steel and iron works, most spectacularly at Homestead in 1892. Nor does he glorify Carnegie the man. Carnegie was remarkably ego-centric, as surely most billionaires are (that's surely part of how one becomes a billionaire), yet needed affection from all quarters:

For all he had accomplished, Carnegie remained, at heart, the undersized outsider with the funny accent who had been uprooted from his home at age thirteen... In his adopted land, he was the intimate of a president in Washington, an ex-president in Princeton, mayors, governors, senators, and cabinet members, as well as Samuel Clemens, America's most famous writer... In Britain, his circle of acquaintances was, if anything, larger, grander, and more regal still. He had conquered every personal, corporate, political, and ancestral foe... It was not enough. His insecurities about class and status were legion. Now approaching seventy, and if not the richest, then surely one of the richest men in the world, he still sought out and gloried in the approval and recognition of his contemporaries.

Carnegie was also an unabashed name-dropper, "wanted to be known and honored not simply for what he had accomplished, but for the company he kept," and yet greatly overestimated the value others placed on his opinion. This was true in business, as demonstrated by his disastrous falling out with Henry Clay Frick, but even more so once Carnegie turned his attention to the cause of world peace. He hounded politicians on both sides of the Atlantic relentlessly in his quixotic, if noble, effort to bind the world's great powers to treaties of arbitration. It is somewhat sad to see him humored by these politicians merely because they desire his campaign contributions. It is even more tragic to see his lengthy quest for peace and his everlasting optimism rewarded by the outbreak of perhaps the most senseless and bloody war to date:

On November 25, 1914, he celebrated his seventy-ninth birthday as always by inviting reporters to his library for an extended conversation. He repeated as he had the year before that "the longer I live on this earth the more of a heaven it becomes to me," but he also "admitted that the war had shaken his proverbial optimism about the goodness of the world."

The main flaw of Nasaw's book is that it is simply too long. Or more to that point, it is bloated with details of vacations and other aspects of Carnegie's personal life that fail to shed light on the man or hold any inherent interest. Particularly painful are the many pages detailing the epistolary courtship between Carnegie and his eventual wife, Louise. I don't mean to seem unduly harsh, as surely most love letters are of little interest for those uninvolved. But the text really bogs down during the seven years it takes for Carnegie to make the leap into marriage. Part of the problem is that Carnegie, for all his fame and all his money, spent the majority of his long life in semi-retirement. He traveled, he read, he wrote, he entertained. Not the makings of a great narrative.

Some of the 800 pages would have been better spent exploring in more detail the various philanthropic endeavors that Carnegie's money has funded. Nasaw does a decent job mentioning the origins of organizations including the Carnegie Endowment for International Peace, the Carnegie Corporation, the Carnegie Institute, the New York public libraries, and Carnegie Mellon University. But he gives the barest hints of the achievements made by these groups in the nine decades since his death. Surely an epilogue, at the very least, could have provided such details. If the donation of his tremendous wealth was the "most important goal [Carnegie] had set himself," the paths his money traveled are certainly worth exploring.

Supercapitalism by Robert Reich

reich_supercapitalism.jpgFew members of the Democratic intelligentsia have both the liberal credentials and the government experience comparable to that of Robert Reich. He was a member of both the Carter and Clinton administrations, serving in Clinton's cabinet as a notable progressive voice in a team of centrists. His 2004 book, Reason, which I explored in a series of posts (1, 2, 3) was a road map for liberals to regain the political high ground on morality, economics, and patriotism, and much of what he wrote has proved successful in the past two federal elections.

So when Robert Reich writes a book on the clash between capitalism and democracy, it is worth paying attention. In Supercapitalism, published last year, Reich traces the changing face of capitalism in the late twentieth century, from the stable (if stagnant) oligarchical post-war manufacturing economy to the modern slash and burn Wall Street/Walmart economy, fueled by an unquenchable thirst for low prices and high profit margins. He deems the older system democratic capitalism, the new system supercapitalism. As the names suggest, Reich believes the rise of uber-capitalism, accompanied by both tremendous economic growth and rising inequality, has severely undermined the power of the political sphere:

Democracy means more than a process of free and fair elections. Democracy, in my view, is a system for accomplishing what can only be achieved by citizens joining together with other citizens--to determine the rules of the game whose outcomes express the common good... Yet democracy is struggling to perform these basic functions. As inequality has widened, the means America once used to temper it--progressive income taxes, good public schools, trade unions that bargain for higher wages--have eroded. As the risks of sudden loss of job or income have grown, the social safety net has become less reliable. More of us lack health insurance. As a nation, we seem incapable of doing what is required of us to reduce climate change... In all these respects, democracy has been unable to take effective action, or even articulate the tradeoffs and sacrifices doing so would entail.

Capitalism has become more responsive to what we want as individual purchasers of goods, but democracy has grown less responsive to what we want together as citizens.. The last several decades have involved a shift of power away from us in our capacities as citizens and towards us as consumer and investors.

Reich describes an era he deems "The Not Quite Golden Age," in which "a unique blending of capitalism and democracy" took hold in the United States in the thirty years after World War II, combining "a hugely productive economic system with a broadly responsive and widely admired political system."The features of democratic capitalism included independent regulatory agencies that "would assure companies a steady flow of profits and customers a steady price," complicity by a few huge corporations that preferred steady, stable profits with little competition, top executives who viewed themselves as "corporate statesmen" charged with "balancing the claims of stockholders, employees, and the American public," and powerful unions that would negotiate good wages and lucrative fringe benefits like health care and pensions. The economic prosperity of the 1950s, with the rise of the middle class, growing economic equality, and vast stability, seemed to validate the system.

There was parallel action in the political sphere, in which politicians "paid careful attention to local elites--small business that comprised the local chamber of commerce, for example, and to national organizations whose members were active in local chapters, such as the American Legion, the Farm Bureau, and union branches." This responsiveness to civic society was accompanied by government empowerment of "new centers of economic power that offset the power of the giant companies," including labor unions, farm cooperatives, and retail chains; this was dubbed "countervailing power" by John Kenneth Galbraith. It did not last:

Since the late 1970s, a fundamental change has occurred in democratic capitalism in America, and that change has rippled outward to the rest of the world. Capitalism has triumphed, and not simply as an ideology. The structure of the American--and much of the world's--economy has shifted toward far more competitive markets. Power has shifted to consumers and investors.

Meanwhile, the democratic aspects of capitalism have declined. The institutions that undertook formal and informal negotiations to spread the wealth, stabilize jobs and communities, and establish equitable rules of the game--giant oligopolies, large labor unions, regulatory agencies, and legislatures responsive to local Main Streets and communities--have been eclipsed. Corporations now have little choice but to relentlessly pursue profits. Corporate statesman have vanished.

Reich argues that the change was not caused by inflation, or the oil embargo, or Reagan's tax cuts, or deregulation, or globalization, or greed, or corruption, or countless other theories, which he calls "nonsense." While some of these played a role (particularly deregulation and globalization), they fail to explain why the change occurred when it did or why it took place in Europe and Japan as well as America. Reich suggests that the "real explanation involves the way technologies have empowered consumers and investors to get better and better deals--and how these deals, in turn, have sucked relative equality and stablity, as well as other social values, out of the system." In particular, he emphasizes the lowering of barriers to entry by new, smaller businesses, the advances in container shipping dramatically dropping the costs of international transport and increased specialization in production. The resulting competition, with no price controls or limits on competition, drove prices down; consumers will always take their business wherever the price is lowest.

At roughly the same time, "savers turned into investors, and investors turned active." They were no longer content with healthy, stable interest-bearing savings accounts. Instead, they began to put money into stocks, with mutual funds and pension funds in particular wielding enormous influence:

To lure or keep these collections of shareholders, CEOs had to do everything possible to raise the value of their companies' shares. They had no choice but to focus ever more intently on creating "shareholder value."

Thus we have have a simultaneous push for lower prices and higher profits; that means everything in between gets squeezed, and the results are always pretty: rising income inequality, job instability, market volatility, and lots of uninsured. In a particularly thought-provoking chapter, Reich argues that Americans really have no one to blame but themselves for the rise of supercapitalism. As consumers and investors, we support and benefit from a system that emphasizes low prices at the store/gas pump/dealership without foregoing high returns on our IRA/401(k) investments.

Reich takes a closer look at Wal-Mart, the target of much anti-corporate venom, and claims the company is simply being responsive to the market pressures that we as consumers and investors are placing upon it. He discusses the mercenary behavior of corporate executives, and suggests they if they are not doing anything illegal, they are doing only what the drive for profits demands. Not the sort of thing one might expect from Robert Reich. That's what makes it so provocative. At the same time, Reich recognizes that the citizen in many of us is troubled by these side effects of supercapitalism. Yet the consumer-investor seems to always win. Reich explains that:

[M]arkets have become hugely efficient at responding to individual desires for better deals, but are quite bad at responding to goals we would like to achieve together. While Wal-Mart and Wall Street aggregate consumer and investor demands into formidable power blocs, the institutions that used to aggregate citizen values have declined.

This includes regulatory agencies, labor unions, and local civic associations. In their absence, individual citizens are powerless to make much difference, and are unlikely to even try knowing they will be making personal sacrifices for little social gain. Instead, Reich argues that we must enact "laws and regulations that make our purchases and investments a social choice as well as a personal one." Examples he points to include laws that promote labor organizing, a transfer tax on stock sales to slow day trading, extended unemployment insurance, fair trade treaties, a more progressive income tax, and universal health care.

Reich recognizes the difficulty such an agenda faces in an era where the democratic process has become dominated by lobbying groups. He dedicates a whole chapter to exploring the history of lobbying, demonstrating that the fast majority of Capitol Hill (as well as courtroom) battles are not consumers vs. corporations, but corporations vs. other corporations. The insurance company vs. the pharmaceutical company; the telephone company vs. the cable company, and so on. What Reich details is that corporations have recognized that Washington is just another battlefield; politics is just capitalism by other means. In an environment where every penny counts, getting a good contract, a good regulation, or a good law out of Washington can make the difference. So investing in a Washington operation is just good business.

What the confluence of money and politics has done is made the government less responsive to our interests as citizens, rather than responsive to our interests as consumers and investors, something the corporations are already doing. Nevertheless, Reich dismisses the non-legal pressures that many have sought to place upon corporations. He examines the movement for "corporate social responsibility" and concludes it is a mere diversion, allowing corporations to get morale points for taking actions that were already in their interest:

All these steps may be worthwhile but they are not undertaken because they are socially responsible. They're done to reduce costs. To credit these corporations with being "socially responsible" is to stretch the terms to mean anything a company might do to increase profits if, in doing so, it also happens to have some beneficent impact on the rest of society.

Furthermore, with the emphasis on low prices and high profits, Reich argues that supercapitalism actually prevents companies from being socially responsible, because "[c]ompetition is so intense that most corporations cannot accomplish social ends without imposing a cost on their consumers or investors--who would then seek and find better deals elsewhere." Reich goes further, and suggests that current law makes it illegal for corporate executives to be beneficent with their shareholders' money. In the aftermath of the 2005 tsunami, President Bush boasted about the generosity of American CEOs; Reich says not so fast:

The assembled CEOs had not been generous--they had not contributed their own money. They had donated their shareholders' money. Presumably they had done so in the belief that their shareholders would benefit from the public relations value such contributions added to the firms' bottom lines. Otherwise, these CEOs would have violated their fiduciary duties and risked having their shareholders switch to other companies that didn't give away their money. Shareholders do not invest in firms expecting their money will be used for charitable purposes. They invest to earn high returns.

Reich derides the growing proclivity of politicians to use "public shaming" as a tactic for fighting bad corporate behavior. He goes through a series of examples, from oil companies with record profits to Yahoo and Google's cooperation with Chinese authorities, and argues that not only is this tactice ineffective, and a ppor substitute for legislation, it is fundamentally misguided:

Corporate executives are not authorized by anyone--least of all by their consumers or investors--to balance profits against the public good. Nor do they have any expertise in making such calculations. That's why we live in a democracy, in which government is supposed to represent the public in drawing such lines.

There's a lot here to argue with, and Reich certainly offers more descriptions of what is wrong than prescriptions for how to fix it. He also wrote this book before the last year's parade of corporate failures and government buy-ins/bailouts, which further entwine the fates of our democracy and our economy. But this is provocative stuff, much of it the sort of thing a liberal would expect from the Wall Street Journal and dismiss accordingly. He dismisses many of the tactics that liberal groups have been emphasizing in recent years, and promotes some that liberals might never consider (e.g. eliminating the corporate income tax to destroy the fiction of the corporation as a person). To see it come from Reich, and to read his justifications and purposes in urging just innovations as an end to the corporate income tax, is certainly eye-opening, and enough to put the ideas on the table for discussion.

The Conscience of a Liberal by Paul Krugman

krugman_conscience.jpgYesterday I discussed the chapter of Paul Krugman's The Conscience of a Liberal dedicated to his political and economic argument for prioritizing health care reform. This chapter comes near the end, and serves as Krugman's plan for reinvigorating and validating America's belief in liberal ideology. This is essential in light of the thesis of the book, which Krugman recognized might be "economic heresy;" that politics and government policy drive economic reality:

Can the political environment really be that decisive in determining economic inequality?... [W]hen economists, startled by rising inequality, began looking at the origins of middle-class America, they discovered to their surprise that the transition from the inequality of the Gilded Age to the relative equality of the postwar era wasn't a gradual evolution. Instead, America's postwar middle-class society was created.

The second and third chapters of the book trace this history, from what Krugman deems "The Long Gilded Age" from the 1870s until the New Deal, "a period defined above all by persistently high levels of economic inequality." Krugman then points to the great contrast posed by the 1950s, when economic equality was at its height; the poor were less poor, the rich were less rich. It was, Krugman argues, "The Great Compression." It was the era of the middle-class. Krugman argues that this was not driven simply by some natural market forces, as was originally believed:

The Long Gilded Age, they thought, was a stage through which the country had to pass; the middle-class society that followed, they believed, was the natural, inevitable happy end state of the process of economic development. But by the mid-1980s it was clear that the story wasn't over, that inequality was rising again.

While some continued to offer market-based explanations for these trends, Krugman looks elsewhere. He argues that "the Great Compression is a powerful antidote to fatalism, a demonstration that political reform can create a more equitable distribution of income--and, in the process, create a healthier climate for democracy." He goes through a variety of factors, including government support for unionization and rules established by the National War Labor Board, all quickly establishing an increased economic equality that remained stable for decades.

Krugman also demonstrates that once Republicans became resigned to the survival of the New Deal, with Truman's victory in 1948, politics became less acrimonious, with room for conservatives in the Democratic Party and liberals in the Republican Party (evidenced by significant overlap between the voting patterns of the centrists in each party, unheard of today).

Of course, if government policy can effectuate a dramatic rise in economic equality, it can also engineer the opposite. Much of the remainder of Krugman's book explores just that story: the rise of movement conservatives, their exploitation of cultural issues to distract voters as they tried to dismantle the New Deal, and the resulting return of vast economic inequality.

Krugman brings up Thomas Frank's What's the Matter With Kansas?, which I discussed last week. Unlike Frank, however, Krugman does not believe movement conservatives rode to power exclusively by converting working-class voters on cultural issues. Though he admits he was "bowled over" when he first read it, Krugman suggests that "voting has become more, not less, class-based over time, which is just what you'd expect given the change in the nature of the Republican Party."

Still, something has allowed movement conservatism to win elections despite policies that should have been unpopular with a majority of the voters. So let's talk about the noneconomic issues that conservatives have exploited, starting with the issue that Frank oddly didn't mention in that glorious rant: race.

Krugman discusses at length the racial component of the so-called "culture wars," and makes a convincing argument that movement conservative outrage over states' rights, welfare, and crime was little more than a series of dog-whistles to tap into conscious or subconscious racial biases and thus successfully sever the New Deal coalition between Southern whites and the rest of the Democratic Party. He also explores the role of the Red Scare, and the "Rambofication" of the Vietnam War, which retroactively claimed the American soldier had been stabbed in the back by weak-kneed liberals back home.

Fortunately, this movement has gone too far, played the race card and the culture war too often. What the 2006 mid-terms suggested, and the recent election has confirmed, is that America can no longer be scared into voting against its self-interest. As Krugman details, the Iraq War has cost the Republicans their credibility on national security. The country is growing less white, and whites are growing less racist. And Americans' views on homosexuality, women's rights, and other culture war issues are becoming increasingly liberal, particularly among the younger demographics. Thus we see the GOP increasingly marginalized as a regional party. No longer are Southern whites the base upon which to build a larger conservative coalition; instead, the lunatics have taken over the asylum.

Krugman's book is an exceptional effort at demonstrating the influence that political decisions can have on economic realities, charting the history of how that influence was wielded by liberals and conservatives in the 20th century, and suggesting a way forward for liberal ideology through progressive politics. Krugman proudly states that "Liberals are those who believe in institutions that limit inequality and injustice. Progressives are those who participate, explicitly, or implicitly, in a political coalition that defends and tries to enlarge those institutions." We are witnessing the rise of both.

The Trillion Dollar Meltdown by Charles Morris

morris_trillion.jpgYesterday I discussed Kevin Phillips' Bad Money, which was the first book on finance I turned to after the shock of this fall's crises on Wall Street. While the book had its strengths, it was really a regurgitation of Phillips' theories of American politics and economics as previously examined in several other books he has written, with a single chapter on securitization added in to tie his theories to current events. That chapter succinctly summarized the problem, but did not delve deep enough into the causes and consequences for my satisfaction.

The next book I turned to was Charles Morris' The Trillion Dollar Meltdown. Like Phillips' text, this was written in the aftermath of the credit crisis of summer 2007. But while it predates the bailout of Bear Stearns to the takeover of Fannie Mae and Freddie Mac to the collapse of Lehman Brothers, Morris' book provides such a cogent analysis of the underlying currents of the crisis that those who read it when published in March were surely not surprised by the events that followed.

Morris starts the book with a chapter titled "The Death of Liberalism," in which he gives a brief outline (including a reference to Kevin Phillips' The Emerging Republican Majority) of the decline of Keynesian liberalism, with "its central premise... that an economic intelligentsia could reliably employ government lever to achieve specific outcomes in the real world." In its place comes the rise of Milton Friedman's monetarism:

Monetarists taught that the supply of money was the product of the stock of money--just the sum of spendable coins, bills, checking accounts, etc.--times its turnover rate, or its velocity. Friedman's historical research showed that velocity was roughly constant, so government policy need concern itself only with the money stock.

As such, government regulation of anything other than the amount of money in the system was unnecessary at best, and more likely counterproductive. So the monetarists would have us believe. Morris takes us through the supposed triumph of the free-market after a sharp 1978 capital gains tax cut (which conservatives credit with the rise of venture capitalist investment; Morris says it was the growth of pension funds in the 70s) and Reagan's elimination of oil price controls (which conservatives credit with the fall in oil prices; Morris says it was the market doing its job over the course of the previous decade through efficiency gains and a recession). This faith in the free market was bolstered by a blinkered view of the economic gains made in the 1980s and 1990s, ignoring the lessons learned from the end of the leveraged-buyouts and the S&L crisis.

Morris lays out this history as an extended introduction to the new types of "investment technologies" that were largely responsible for a variety of economic crises from the late 1980s to late 1990s:

The new "quants" could carve up and reassemble old-fashioned asset classes so they were custom-fit to investor needs. Large-volume computerized trading could exploit tiny changes in stock prices or interest rates. Very broad new classes of complex, structured investment instruments revolutionized wholesale banking. All the new technologies and strategies harbored dangerous flaws that tended to reveal themselves only at points of great stress. Bigger, better, even more far-reaching versions of these strategies have now, in 2008, placed the entire global economy at risk.

Morris details the three "practice runs" that fit this model, from the 1987 stock market crash (portfolio insurance) to the 1994 mortgage crisis (collateralized mortgage obligations) to the 1998 collapse of Long-Term Capital Management (mathematical arbitrage models). Morris explains what ties all three crises together:

In the first place, all three of the crises developed in market pockets that were mostly outside the oversight of federal authorities. The relentless deregulation drive that started during the Reagan administration steadily shifted lending activities to the purview of nonregulated entities, until by 2006, only about a quarter of all lending occurred in regulated sectors, down from about 80 percent twenty years before...

A second fault line is a worsening of the "Agency" problem--or the problem of ensuring that an employee, a contractor, or a company performing a service doesn't act against your interest... But the new generation of mortgage banks sells off mortgages in weeks or months, brokers are usually compensated strictly from the fees they generate, and they often work with a customer entirely by e-mail or phone... As financial machinery fragments, Agency problems abound; in the brave new world of absolute markets, it is not only dangerously naive to trust your mortgage broker, but based on recent scandals in college tuition lending, even your student aid counselor...

Finally, a third dangerous trend is the increased dominance of investment decisions by mathematical constructs. The mathematics of big portfolios analogizes price movements to models of heat diffusion and the motions of gas molecules, in which uncountable randomized micro-interactions lead to highly predictable macro-results... But the analogies break down in times of stress.... Humans hate losing money more than they like making it. Humans are subject to fads. even the most sophisticated traders exhibit herding behavior... In other words, as all three of this chapter's crises suggest, in real financial markets, air molecules have a disturbing knack for clumping on one side of the room.

In the following chapter, Morris indicts Alan Greenspan's insistence on keeping the funds rate low (in fact, cutting it further to 1.00% for a full year) even after the second quarter of 2003 showed strong growth that would continue through 2004. He also goes after Greenspan's "resolute insistence on focusing only on consumer price inflation, while ignoring signs of rampant inflation in the price of assets, especially houses and bonds of all kinds." This became known as the "Greenspan Put," in which the Fed cuts interest rates any time the financial sector screws up and sends us toward recession: "No matter what goes wrong, the Fed will rescue you by creating enough cheap money to buy you out of your troubles."

With that in mind, Morris tackles the housing boom of 2000-2005. Unlike most housing booms, which are caused by demographic shifts (either increased birth rates, immigration, or mobility), Morris posits that the "2000s real estate bubble may be one of those rare beasts conjured into the world solely by financiers." But how did they do it?

Since houses are so leveraged, their prices are hypersensitive to changes in interest rates. As long-term rates trended steadily downward in the second half of the 1990s, the big banks plunged headlong into the refinancing, or "refi," business. It took a couple of years for consumers to catch on--extracting money from your house was an exotic concept. Banks mount lavish advertising campaigns to stoke their enthusiasm. Refis jumped from $14 billion in 1995 to nearly a quarter-trillion in 2005, the great majority of them resulting in higher loan amounts. Lower interest rates let you borrow more for the same monthly payment, pay off your old loan, and buy a new car with the difference.

That explains how consumers got on board, but that leaves the question of how banks got involved. Morris goes through the litany: automated credit scoring, automated underwriting allowing higher loan-to-income ratios, trimmed-back documentation requirements, and the advent of "devices to make housing more available to marginal credits" like ARMs, piggyback loans, and subprime loans. As we all know, this story does not end well:

As of the end of 2007, the industry borders on catastrophe. The housing boom is over: The widely followed Case-Shiller index of home resales shows that real home prices have fallen steadily throughout 2007. (As late as 2006, the forecasting consensus was that house prices never fall.) Delinquencies have been rising rapidly and, given the very low quality of recent-vintage loans, can only accelerate... Lender bankruptcies, with their attendant legal tangles, are spreading among the industry's erstwhile roman-candle growth stars.

All of this I can understand. This is relatively straightforward bad business practice, taking advantage of cheap money and loose regulations to pump up fees and commissions. But it also seems like a manageable problem. As Morris says, "[s]ubprime and similarly risky mortgages... still account for no more than 15 to 20 percent of all outstanding mortgages. Even assuming a high rate of delinquencies within that group, in the context of a $12 trillion economy, it looks like small potatoes." Exactly. Which is why it came as such a shock to me when this housing crisis started tearing down the giants of Wall Street.

To understand that "takes us to the heart of the giant credit bubble that we have so willy-nilly constructed." Morris outlines the creation of commercial mortgage-backed securities, followed by asset-backed securities for any asset that could be valued, and then collateralized debt obligations. The capstone to all this ingenuity, however, was the credit default swap:

To take a simple case: Suppose US Bank decides it is underexposed to credits in Southeast Asia. The old way to fix that was to buy some Asian bank branches or partner with a local bank. A credit default swap short-circuits the process. For a fee, US Bank will guarantee against any losses on a loan portfolio held by Asia Bank and will receive the interest and fees on those loans. Asia Bank will continue to service the loans, so its local customers will see no change, but Asia Bank, in Street jargon, will have purchased insurance for its risk portfolio, freeing up regulatory capital for business expansion.

Note the distinction of "regulatory capital," which refers to capital which is subject to a variety of government regulations. But the reason credit default swaps are called swaps, rather than insurance (which is what they are), is because insurance is highly regulated. Swaps are not. So all of this is going on with little or no supervision. To make matters worse, the only people who were asked to put their stamp of approval were the credit agencies:

The public may think of them as detached arbiters of security quality, like a financial Supreme Court. In fact, they were building booming, diversified, high-margin business. Between 2002 and 2006, for instance, Moody's doubled its revenue and more than tripled its stock price. Their core customers, however, were the big banks and investment banks, and since CDO bond ratings were usually heavily negotiated, it seems clear that the agencies slanted their ratings to please their clients.

The result of all this was to essentially take a tangible set of questionable debts (residential mortgages), repeatedly repackage them in dozens of complicated securities, the riskiest tranche of which the hedge funds would stake out absurdly leveraged positions (e.g. for every dollar of its own capital, the fund invests four more borrowed from one of its prime broker banks; in a risky tranche, this can multiple exponentially). Then, to get some protection from this risk, the banks and hedge funds sell each other credit default swaps and are on the hook for each other's risk; but since its not insurance, it does not have to be reported the same way.

In a sense, everybody's money was tied up in the same small subset of extremely risky loans; this led to great profits in the boom times, and the near destruction of the industry in the bust. Morris saw what was coming, and laid out a variety of end-game scenarios, including recession, and a credit meltdown, For those who read this book in March 2008, the events that followed were surely little surprised. Lehmann Brothers did not go bankrupt just because homeowners were not repaying the loans Lehmann Brothers made to them (though its ownership of subprime lender BNC Mortgage exacerbated the underlying problem). It went bankrupt because it left itself overexposed to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages (e.g. it kept the riskiest pieces for itself and sold the rest) and was tremendously over-leveraged, even beyond healthy levels of Wall Street leverage.

The only question is where it all stops. Morris points out a variety of issues still unresolved today, including credit card debt and credit default swaps. He also discusses other underlying problems facing the U.S. economy as it tries to stabilize and recover, including the "dramatic shift of taxable incomes toward the wealthiest people" over the past 25 years and the continued socialization of Wall Street risk. In a brief chapter entitled "Recovering Balance," he emphasizes the need for renewed regulation, and interestingly, the need for an overhaul of our health care system. These are little more than bullet points at the end of the book, but Morris hits the right tone, which is that if nothing else the current crisis requires "coming face-to-face with the past quarter-century's ruling ideology that expanding public resources is always wrong."

On a side note: in a twisted bit of irony, the events of this year were so cataclysmic that when Morris' book is published in paperback in February 2009, it will be titled The Two-Trillion Dollar Meltdown.

Bad Money by Kevin Phillips

phillips_bad.jpgWhen the turmoil in the financial sector exploded into full blown crisis with the collapse of Lehman Brothers in September, I found myself disturbingly unfamiliar with the basic subject matter of the ensuing debate. I had a basic understanding of the mortgage market, and knew enough about subprime loans and ARMs to have secured a 30-year fixed rate when we bought our condo. I also had a wealth of anecdotal information from my father in southern California about the skyrocketing home prices and the absurd practices of his neighbors, who were perpetually re-financing in order to put in pools or buy new cars with the equity from these inflated values.

But the terms "collateralized debt obligation" and "credit default swap" were meaningless to me. There was a time when I paid much closer attention to the financial world, but it has been a few years. It seems, though, that even if I had been paying attention, I might not have understood these subjects. They are essentially designed not to be understood. Because as soon as people started paying close enough attention, and realized what was going on, the bottom fell out.

Fortunately (and unfortunately), there were already a few books out that touched on this subject matter with a more popular audience in mind. Fortunately because I had something other than Wikipedia to rely on. Unfortunately because the reason these books had been published was that the crisis really first hit in July 2007 with the collapse of two Bear Sterans hedge funds (which I somehow failed to really notice). This gave book publishers enough time to get books into print by the spring. Yet federal regulators apparently did not act with similar speed; every step in the crisis that has unfolded since them seems to have caught them off guard, from the bailout of Bear Stearns to the takeover of Fannie Mae and Freddie Mac to the collapse of Lehman Brothers.

The first book I turned to was Bad Money by Kevin Phillips. Phillips has made a name for himself over the years for his prophetic analysis of American politics. His rise to prominence came with his 1969 book, The Emerging Republican Majority, which many believe foresaw the rise of Reagan and the conservative realignment (which appears to be over as of November 4, 2008). At that time, Phillips was a major Republican strategist, but over the years he has moved dramatically away from the party. Along the way, he has expanded the scope of his writing to include a focus on the interaction of money and politics, in such books as The Politics of Rich and Poor, Wealth and Democracy and most recently, American Theocracy, in which Phillips discussed the dangerous confluence of expanding debt, financial misbehavior, and the rising cost of oil.

In Bad Money, Phillips opens with a chapter on the rise of financial services and the decline of manufacturing in the U.S. economy. He starts there because it is only once we understand that financial services now account for 20% of America's GDP can we understand how deeply invested we have become in the success of this industry, how reliant we are on it for stability, and thus how important it is that it be properly regulated. This is not something most people understand, and Phillips suggests that government leaders want it this way; that's how they reassured us that a crisis on Wall Street need not become a crisis on Main Street, and thus little regulation was necessary. We know now how wrong that notion was.

Phillips digs deeper into the rise of financial services and suggests that this growth was systematically encouraged by Washington, by what he calls "financial mercantilism." By this, Phillips means the bailouts and socialization of credit risk going back almost three decades, from the 1984 rescue of Continental Illinois through the saving and loans crisis to the Mexican peso rescue to Long-Term Capital Management to the interest rate cuts of the early 2000s (Phillips' book came out too early to include this fall's mother of all bailouts):

After the financial markets' narrow escape in the stock market crash of 1987, some kind of high-level decisions seems to have been reached in Washington to loosely institutionalize a rescue mechanism for the stock market akin to that pursued on an ad hoc basis (by the Fed and the U.S. Treasury) to safeguard major U.S. banks from exposure to domestic and foreign loan and currency crises. Thus the coinage of the phrase "financial mercantilism." For Washington to have made such a tentative choice in 1988 was momentous. Finance became the chosen sector of the U.S. economy--the one that would be protected and promoted because it was too important to fail. Manufacturing would receive no such help, however excited members of Congress might get from time to time.

And it does not appear that the traumas of 2008 have changed anything yet. Just look at the disparate reactions from Republican leaders to the crisis on Wall Street and in the auto industry. The former merits a $700b bailout, the latter can't even get $25b.

Phillips follows this with a chapter on "Bullnomics" in which he reflects on the way that Americans have been manipulated to support an economic system that offers vast rewards to the elite and little for anything else. He touches on such things as the manipulation of the consumer price index and the rise of the prosperity gospel, in which religious Americans are taught that God wants them to be materially rich.

In Chapter 4, Phillips hits the subject I'd been looking for: securitization, which is defined simply as "the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security." It is through the repeated packaging and re-packaging of assets, particularly houses bought via subprime or exotic loans, that what might have been a troubling housing crisis came to nearly destroy the entire U.S. financial industry:

Instead of being kept on firm ledgers, mortgage loans could be stripped of risk by a derivative contract, or in most circumstances old off in a mortgage-backed security or structured CDO. The money received could be used for another loan or mortgage, then again--and again. Lending limitations became nonlimitations. However, as volume swelled, loan- and mortage-making standards dropped. Enticements to sign up marginal borrowers--through the "exotic" forms of mortgages little used boefore--took on an ever-larger role.

The growing disconnect between the broker writing the mortage and the hedge fund that would end up owning a leveraged piece of a CDO that contained the mortgage, destroyed the traditional incentives by which mortgages were made, e.g. a bank only lent money it reasonably expected would be repaid with sufficient interest. Phillips goes through a number of root causes for this phenomena, including the declining importance of depository institutions in the face of mutual funds, hedge funds, security brokers and others, all of which did business largely outside existing government regulations:

Small wonder that.. buyers worldwide found themselves with structured products that lacked (1) opacity and responsible description, (2) disinterested and careful credit ratings, (3) reliable markets to which they could be marked, and (4) practical testing under major credit-crisis conditions. Manufacturers negligent in these ways would be facing large fines or even jail terms.

This securitization process led to a downward spiral in the housing market, with the expansion of easy money and subprime loans, all of which were packaged up into complex CDOs and split a dozen ways so that no one knew how much anything was worth. When people finally started paying attention after the collapse of Bear Stearns, well... check your 401(k).

In the remainder of the book, Phillips reiterates his belief that American reliance on oil will prove to be a crippling failure in this century, with analogies to the decline of the inabilities of the Dutch Empire (reliant on wind and water) and the British Empire (reliant on coal) to adapt to new energy technologies. He further laments the weakness of the dollar, its vulnerability to foreign manipulation, and its dependence on being the principal currency for pricing oil, before a concluding chapter exploring the possibilities that we are seeing the initial signs of the United States as an empire in decline.

The major weakness of the book is that beyond the short chapter on securitization, this is just a regurgitation of what Phillips has already written. His analogy to the Dutch and British empires goes back at least as far as The Politics of Rich and Poor, which he published in 1990. The focus on the rise of the financial sector echoes that of Wealth and Democracy, the discussion of dynastic politics was covered in American Dynasty, and the chapter on peak oil and the dollar-oil nexus is straight out of American Theocracy. So while this serves as a decent first-line introduction to these topics, Phillips himself has recognized that each deserves a book of its own. Tomorrow, I will discuss a short text that serves as a better introduction to the financial crisis itself, Charles Morris' The Trillion Dollar Meltdown.

I Don't Want to Own AIG

Cesc FabregasFor not the last time, I'm sure, I strenuously disagree with one of Senator Obama's positions. This morning he released a statement seemingly supporting the U.S. bailout (read: taxpayer-funded purchase) of AIG. Now set aside the economic aspects of this transaction for a moment. The real horror here is that you and I now own the sponsor of the despicable Manchester United football club. With business decisions like dropping $100m on that worthless team, is it any surprise they couldn't stay afloat without our help?

Surely the U.S. taxpayer would be much better off owning a piece of Arsenal's sponsor, Emirates. After all, the airline is putting the fear of God into its industry, with annual growth in excess of 20% and profits in all but one of its twenty-two years in existence, including net profits of $1.37b last year. I may have to send the Senator a note about this. Fly Emirates!

Gas Prices

Gas price fluctuations are as mysterious to me as most economic indicators in this country. But while I generally accept that there is some sense to economics, simply above my level of knowledge, I confess to being truly flummoxed by local anecdotal evidence on the gas price issue.

While I spend most of the week in and around a military post, I spend my weekends in Atlanta. For months and months, particularly when gas prices hit their peak in the summer, I always filled up my tank around the post, where gas prices were consistently 20-30 cents cheaper than in Atlanta. If it was $2.89 per gallon in Atlanta, it would be $2.69 around here. This remained so consistent that I thought it was as close to a rule as gas prices allow.

But come the fall, when the end of summer driving led to a sharp decline in gas prices, the gap began to narrow. All of a sudden, gas was only 10 cents cheaper here. If it was $2.29 in Atlanta, it was $2.19 here. Alright, I said, perhaps the gas stations in Atlanta had just been taking advantage of the high prices during the summer, while the competition posed by AAFES gas stations kept the prices relatively low around the base (AAFES does pay tax on gas, unlike most other products, so there is only so low they can go).

This weekend, the whole theory exploded in my face. While driving around the city with my wife, we were both excited to see gas prices below $2.00 for the first time in months. She was disappointed when we accidently took a different route home and thus could not stop for $1.97 gas. When I got ready to drive back here last night, I saw that my tank was more than half full. So I decided to wait until I got down here to fill up, assuming that I would be welcomed by gas prices around $1.87 or so. Imagine my surprise, then, when I pulled into my favorite gas station and was greeted by a price of $2.09 per gallon!

As far as I am concerned, this heralds the end of the world and I am going to enjoy a real Dr. Pepper instead of a Diet Dr. Pepper before all of us cease to exist.

Foreclosures Jump

My parents live in California and own their home outright, a tremendous rarity in this day and age. In the last five years, my father watched as his neighbors re-financed their mortgages to add swimming pools and other improvements, riding the wave of low interest rates, interest-only mortgages, and 5/1 ARMs. He shook his head and told me that it was only a matter of time before the bank owned half the neighborhood. It looks like that time may be coming soon:

With real estate markets slowing and mortgage rates well above levels of recent years, times are getting tougher for homeowners - the number of homes entering into some stage of foreclosure is surging, according to a survey released Wednesday.

Some of the bellwether real estate market states are among the leading foreclosure markets. Florida, had more than 16,533 properties in foreclosure in August. That led all states and was 50 percent higher than in July and 62 percent higher than in August 2005.

California foreclosures are increasing at an even faster annual rate, up 160 percent since last year to 12,506. And the formerly red-hot Nevada market recorded a spike of 24 percent compared with July and a whopping 255 percent increase from August 2005.

And those who opted for fancy mortgages with all their bells and whistles, instead of the 30-year fixed rate (like my wife and I)?

For a homeowner with a 5/1 ARM (an adjustable rate loan with an initial fixed rate for five years that then adjusts annually) that's now resetting, the adjustment could add at least two percentage points to the interest rate. That could send the payment on a $200,000 loan up from about $950 a month closer to $1,200.

Or, as is much more likely in California, the payment on a $600,000 loan goes from $2,850 to $3,600. That's quite a chunk of change. I'm sure plenty of folks thought a 5/1 ARM would work great, as they'd never own the house that long. But with the housing market cooling, I am sure people are stuck in houses they can't sell, and now they have mortgages they can't afford. Sure makes the half-point they saved by getting an ARM seem silly, and the financed swimming pool seem downright insane.

The Price For Paying the Minimum

M
y father passed along a link to this table, illustrating a basic rule of credit finance that the vast majority of Americans likely fail to understand: the banks are trying to screw you. Here, they do so by lowering your minimum payment, naturally neglecting to inform you of the price of paying the minimum:

$5,000 balance on a credit card with an 18% annual rate.

Minimum payment, based on 2% of balanceMinimum payment, based on 4% of the balance
1st month's payment$100$200

Time to pay off

553 months, or 46.08 years

150 months, or 12.5 years

Interest owed$13,931.13$2,915.66

Just Did My Taxes

I used the free online filing offered by TurboTax. Just go to the IRS Free File home page, click "Start Now" and choose whichever company you want. I found TurboTax to be extremely easy, and would recommend it.

My results? A refund of more than $5k, and an overall income tax rate of just over 5%. Thank goodness for the Lifetime Learning Credit.

Stock Market Causation

Vance at Begging to Differ, in the midst of a post advising Democrats to limit their attacks on Bush to "legitimate issues" (reasonable advice) has this assertion regarding Wall Street:

The stock market performed well last year, and Bush's tax cuts and aggressive domestic spending were important keys to that performance.

Is that really true? Of all the things I took away from last weekend's investment reading, none was so clear as this: it is almost impossible to predict what stocks will do in any given future year, or understand why they did what they did in any given past year. In fact, the closest thing that I can find to a rule in stock market history is this: if it goes down for a while, it will eventually go back up. So if there were to be any causation argument for last year's stock market, it seems to me it'd go something like this:

The stock market performed well last year, and the fact that it had fallen dramatically the previous couple years was an important key to that performance.

If you wanted to assign credit for last year's improvement, it might go like this:

The stock market performed well last year, largely due to dramatic declines in previous years caused by President Bush's incomprehensible economic policy (or Clinton's, or the failure of oversight of corrupt corporate executives, or most likely, because before that it had gone up for so many years and had to come down eventually).

Anyhow, I've always been pretty skeptical of efforts to assign credit or blame for "this year's economy" or "last year's stock market", and have grown moreso since reading those books.

Investment Reading

While at my parents' house, my father and I discussed my investment strategies for the future. I'll be making enough money this summer that I wanted to finally wrap my head around the various general investment options, and specifically the retirement plans currently available. The two books he gave me to read, and which I can now highly recommend, are The Coffeehouse Investor by Bill Schultheis, and The Four Pillars of Investing by William Bernstein.

The latter book is much longer and more in-depth, but both books share a common theme: the investment brokerage business is very bad at its stated goals. Like so much in life, one needs to look beneath the surface and really understand the motivations of brokers, and doing so reveals several things: 1) As a group they are very bad at beating the market; 2) As individuals they are even worse, as the few who are lucky enough to beat the market in one year rarely repeat this performance, and 3) They don't make money by improving your investment returns, they make money by encouraging you to increase the number of transactions (more commission) and invest in load funds (more fees).

There's a lot to both books, far more than I can go into here. But it makes for very liberating reading. I for one hate following the market, and was always a bit apprehensive about trying to invest properly in an atmosphere that has always reminded me of a Las Vegas gambling freakshow. After reading these books, I am now confident in following my instincts: ignore television's talking heads, ignore the daily, weekly, and monthly columns by these people, and let common sense, basic economics, and a knowledge of financial history do all the work.