One question people never ask themselves that could drastically change their lives is: 'What is Money?' Once you figure out what money is, and what it represents, making it is far simpler. That doesn't mean it's easy. But it does clarify the challenge considerably. Image © Thinkstock
Yesterday, I explained how most of the people in the Occupy Wall Street protest haven’t yet realized the struggle isn’t between the rich and the poor – it is between the knowledge workers and manual workers, which Peter Drucker predicted in startling detail decades ago. Charles Hughes, a professor at Henderson State University, had reservations, saying:
The problem with this analysis is that it privileges only one set of skills: how to turn a buck. The young MBAs who delve into marketing, banking, and international economics and discovers the paths to power and the locations of the money spigots and devote their lives to amassing wealth like Scrooge McDuck are the ones considered successful.
He goes on to talk about how people like Steve Jobs should be glorified and how the liberal arts are not appreciated sufficiently.
[mainbodyad]In many of his points, I agree wholeheartedly. Emphatically, even. But I don’t agree that only one set of skills is valued in society – the MBA set – because I think to assert this requires operating from an incorrect premise that misunderstands the very nature of what money is. I think such a belief is driven by the “spotlight” fallacy mental model and causes people make the incorrect assumption that the top 1% consists solely of people like hedge fund managers, speculators, or Ivy League MBA’s freshly minted with trust funds and lessons in how to shut down factories. That’s not what the data shows. Those people do exist but they are the minority, garnering a disproportionate share of the headlines and news copy because the stories are infuriating and filled with drama, fights, struggles, and class warfare.
But this is a minor point because, again, I agree with most of his assertions and statements. Still, I saw the comment during lunch and I thought it might be a fantastic opportunity to educate a lot of people about the very nature of money, individual freedom, and choice. Before I could help it, it had turned into a 4,000+ word essay. I’m publishing it as a stand-alone article. You might want to scroll to the bottom of the page and click the “Print Friendly” button if you would find it easier to navigate such a long essay on paper rather than a computer screen.
The Fundamental Rule of Economics
To understand this response, you need to know what I personally took to calling the fundamental rule of economics. Here it is.
In a free and just society, if a man wants something, he must either create it himself or exchange with other people for something they desire or need.
For example, if he wanted a chicken to feed his family, he could either raise the chicken himself or trade someone for a chicken. In order to trade, he must have something of value; a good or service that another person finds valuable enough to desire. If the man is a skilled craftsman, he could offer to make a kitchen table. If the man is a skilled baker, he could offer apple pies. If the man is a lawyer, he could offer legal service. By exchanging one thing for another, the barter system rose.
There were two major problems with the barter system.
- First, it exposed everyone to counterparty risk. It turned every man into a bank. If you delivered a table for the promise of a chicken, yet the chicken farmer died, you were out a chicken unless you could “foreclose” on his chicken coup and take what was owed to you following his death. If he fell on hard times, you had to pursue him to collect your debt. This made long-term planning nearly impossible because you might desire to trade your product or service in the spring for something that was required in the winter.
- Second, the barter system made it impossible for all people to interact with all others. Instead, they were forced to create elaborate networks to ensure everyone got what he or she needed. If you want to trade for wool but the sheep herder doesn’t need your wheat and instead wants pork, you would have to find someone who wanted to trade a pig for grain so you could then return to the sheep herder and close the deal.
In response, our ancestors began using symbols and tokens to represent future claim checks on society. We called these symbols “money”. Some cultures used shark teeth, while others minted their own coins.
Our ancestors began to use an interchangeable system of symbols to represent claim checks on society. We call these tokens 'money'. Image © iStockphoto/Thinkstock
As long as the currency remained stable relative to the population, people could accept the token and know they would be able to redeem it for their own family’s needs at some point in the future. Unlike the barter system, you could have approached the sheep herder and used money from past sales of wheat to buy wool today.
This solved both the counterparty risk and the need to form complex transactions, greatly improving life so long as the society didn’t try to cheat by increasing the money supply. It opened up the world and civilization flourished because you didn’t need to know who you were doing business with as long as the currency he used was good, meaning more people interacted and trust was spread throughout the system rather than staying in insular communities. This is partly the reason ancient port towns and trading hubs were the pinnacle of advanced civilization, art, culture, and scientific achievement. When goods and ideas flow more freely, the result is better for mankind.
Switching from Barter to Money Didn’t Change the Fundamental Rule of Economics
This is the important point: Just because we switched from barter to symbols called money doesn’t change the basic truth that if you want something, you must either create it yourself or exchange with other people, providing them with a good or service that they desire or need.
The implication of that fundamental economic fact, which is really just a way of saying “what humans do and how humans behave”, is that every dollar spent in society represents a “vote”. A few moments ago, I enjoyed a bottle of Coca-Cola. In essence, I voted for two things:
I voted for the business that sold me the bottle, a local convenience store, despite the higher price of $1.50 because the 50¢ savings I could have achieved by going to a more distant discount retailer wasn’t worth the time and gas it would have taken for me to travel there. - I voted for The Coca-Cola Company because the refreshment and enjoyment I received from the soda was worth the money. Had the convenience store not had Coke, I would have gone elsewhere.
If Coca-Cola provides more value to me and billions of other citizens than Acme Soda does, it would amass an enormous fortune and command significant resources. That is good. That is just. That is right because Coke is providing more value to more people.
Our Society Isn’t Perfect, But We Get Better With the Passing Years
The corollary is that in a perfectly designed fair and just society, the wealth one accumulates would represent total sum surplus value provided to civilization. However, we do not live in a perfect society. But it is pretty damn close. Though abuse and immorality exists – e.g., the defense contractor that bribes a politician to get a kickback for a lucrative contract with taxpayer money – the American system overall gets it right 80% to 90% of the time so that the sin and folly crowd represent a minority of the capital accumulation.
On a side note, this is the reason I support:
- Excessively low taxes in most areas of life except in the case of an estate tax, which I think should be significant on fortunes of certain sizes because money should not be concentrated in the hands of those who didn’t earn it. That sort of resource allocation has a terrible historical record. That is, I think we should celebrate people like Bill Gates and Steve Jobs having billions upon billions of dollars. I think we should recoil at the idea of their great-grandchildren having that level of unearned wealth.
- Bringing back the usury laws that were repealed in the 1980’s limiting the maximum interest rate to a multiple above prime; the current system distorts the fundamental rule of economics.
- Wise, rational regulation in food, environmental, water, trade, anti-trust, and energy matters.
- Term limits for all publicly elected offices
- A ban on corporate person-hood
- The reinstatement of bankruptcy laws that allow student debt loan to be discharged. I consider the change in bankruptcy code that protected this class of debt as one of the most evil assaults on the middle class in the past 50 years.
It all goes back to creating a fair and just society. The government’s job is to act as a check and balance of power that offsets occasional abuses from other sectors of humanity.
The Fundamental Rule of Economics and the Value Placed Upon Liberal Arts
The implication of the fundamental rule of economics can be stated as follows:
How, and where, money accumulates throughout a free civilization represents what the people value most.
Sometimes, that isn’t good for the future of mankind. As Jon Stewart famously said, “there is a market for hookers and cocaine”. That doesn’t change the accuracy of the general rule. It holds true, as long as you account for certain economic models that include people who make very small amounts of scalable income on a per capita basis that aggregates into large total compensation. This leads to two core, basic, foundational beliefs:
1.) A man should be free to determine how his own money and time is allocated.
2.) Anything that I desire or need in life depends upon me getting it by providing value to society. It is not the job of an employer to “provide” a job. It is not the job of the government to force people to give me their claim checks through artificially influencing Congress or budgetary processes. It is not my family, friends’, parents’, or society’s fault if I do not have the things I desire. It is my fault because I’m not providing enough value to my fellow man commensurate with the cost of providing that value.
In my case, I went to school to study classical music on a vocal performance scholarship because I wanted to be a well-rounded person exposed to history, ethics, philosophy, religion, literature, and culture. Those were good for me and good for my soul. Right now, as I write this essay, I am listening to Vivaldi’s Magnificat in G Minor, first movement, and there is no doubt that four years of intense music theory and performance experience allow me to have a much richer appreciation for the complexity of what is happening in the work. This was valuable enough to me that I agreed to borrow a significant amount of money for future repayment; money that went to the professors and educators who spent their time and relied upon their experience to instruct me in this field. Again, I was voting with my dollars.
No Matter How Much I Love My Cause, It Does Not Give Me the Right To Infringe Upon the Rights of Others
But that is the key. That is the core. That is the overarching truth that is inviolate. I chose to give up future claim checks on society for that knowledge. Therefore, if there are not sufficient people making that same allocation decision, in a free society, the institution of classical music at which I studied should not survive because the only alternative is to force other humans to give up their resources, for which they worked and earned, to meet my consumption demands. Such blatant disregard for the freedom of others is the heart of immorality. It is theft. It is the very definition of sin.
We can talk about how music “lifts the human spirit” or “contributes the civilization” all we want. But unless people are cashing in the claim checks they received for value given to society in sufficient numbers to make the institution self-sustaining, it isn’t true. That leaves us with the alternative of forcing people to give up those same claim checks by compulsion.
In other words, I pay hundreds of dollars for symphony tickets to very good orchestras because 1.) I like cashing in some of the value I’ve created for society to “vote” for great musicians and artists, and 2.) there are not enough people relative to supply of seats to bring the cost down to more reasonable levels. I do not have a right to force the baker down the street or the school teacher in my hometown to subsidize my consumption desires because it must, by definition, come at the expense of their own needs and wants.
That does not mean that the arts should fail. Far from it! In fact, the biggest grant issued by the Kennon & Green Foundation this year was to an institution devoted to the liberal arts! The gift was several magnitudes larger than any other. That is because I value the liberal arts, and classical music, specifically. But again, it is my choice. I am acting as a free agent. I am only voting with what I earned. I am not forcing others to live by my rules and support my causes by depriving them of their own capital. I can try to persuade them to support causes that matter to me, such as the arts, but I cannot force them to do so.
The Knowledge Economy Will Benefit Those Liberal Arts Students Who Produce Great Content, Services, and Products
That is the theory behind new services like Kickstarter.com, which has already raised $100 million in cash for projects that people post on the site. Sometimes, these projects are varied and allow artists and content creators to pre-sell works without taking financial risks of their own, from “60 paintings about water in 60 days” to developing a web television series.
Services such as Kickstarter make it possible for people to convert their ideas into businesses. This means the most successful liberal arts principles, properly applied, are going to result in drastic wealth disparities because a brilliant, talented 14 year old might be making $100,000 from his or her bedroom, while the parents downstairs are on welfare. It's the nature of the new knowledge economy.
In this knowledge-based economy, the best, most talented in the field are going to rise to the top and take most of the income. A great project idea might get $50,000, like a solar system video game proposal I just browsed. A terrible idea will get zero. Nothing. Zip.
I celebrate this outcome because if you can’t convince people to give you money based on your work – that is, if you can’t provide them enough utility they want to trade with you – you need to find a different profession or, alternatively, learn to live with the income you have and stop complaining despite how difficult life is. Neither is a wrong choice. It is all about maximization of aggregate happiness. Following your bliss does not entitle someone to whine about the eternal presence of opportunity cost.
More bluntly: The old ethos of “work hard, and you’ll be rewarded for showing up and years of service” is dead. Instead, all of society’s rewards will flow to the best creators of content, products, and services, regardless of age, race, political affiliation, sexual orientation, religion, gender, or location. It’s going to be a fantastic frontier of progress if you are talented. If you are below average, which a significant minority of the population must be by definition, it is going to create a permanent underclass.
The 4 Lessons We Should Take Away from the Role of Money and the Liberal Arts
There are four takeaways from this:
- 1.) If an organization or individual is not financially self-sufficient it means that by definition he or she is not providing as much value from society has he or she is taken from it. E.g., If someone borrows $100,000 to attend art school, yet can’t create art sufficiently valued by society to generate enough sales to repay the debt, the net effect has been a negative on civilization. People only pay for what they find valuable and what gives them utility. There are a handful of exceptions to this rule that still fit within the economic model and are consistent with our principles but would require essays of their own (e.g., foster service in impoverished neighborhoods or free immunization for children of poor families).
- 2.) How people spend their money and time reveals their true priorities. Becoming upset about someone else’s allocation decisions is foolish and irrational. I don’t expect people to understand why I’d rather spend money on tickets to Baroque harpsichord concerts than NFL games. The fact that society doesn’t “value” my tastes and preferences doesn’t mean I should be able to force everyone else to live by my standards or desires.
- 3.) The liberal arts are valuable but you cannot survive, and should not be able to survive, on knowledge alone until you convert that knowledge into useable products and services that people want of their own free will. Let’s call this the “Steve Jobs” principle. Steve studied humanities and arts, calligraphy and philosophy. That was important for his personal enrichment. But it did not translate into a good living until he converted it into good for his fellow man. It is good and just that he had $7 or $8 billion. There is a lot of virtue in a system where such an outcome is possible. Unfortunately, some people are mentally wired in a way that if you point out the truth of their situation – that other people don’t value the products or services they are offering at the prices they demand – they translate it into “other people don’t value me“. They are not the same thing.
- 4.) Money does not equal holiness. To believe it does is to suffer from a particular American pathology. Instead, money equals past utility provided to civilization. Even if you believe the Koch Brothers are horrible people and have terrible priorities, the only reason they have their capital is because they have provided far more net value to society than others on a relative basis. Now, in the case of the Koch Brothers, if the reports of them breaking the law to secretly sell things to Iran, a terror-sponsoring nation, prove true, then they would fall into the exception of non-virtuous wealth and, in my opinion, should be sent to Federal prison. Law enforcement will sort that out sooner or later. That doesn’t change our general rule: People buy Angel Soft toilet paper and Quilted Northern toilet paper. People buy Dixie cups. People buy Sparkle paper towels. People buy Georgia-Pacific paper. People want nitrogen fertilizer for their farms to make food grow. The Koch Brothers sell these items. People value what they are selling so they exchange their money for the products. That is the source of the Koch Brothers’ claim checks on society. Toilet paper may not be glamorous but it provides more human utility than many art students trying to make a living selling paintings. On the other hand, some artists and musicians provide much more utility to society so they collect even more claim checks. The artists at Pixar created classics such as Finding Nemo and Toy Story. They transported people to new worlds and became staples in the lives of children everywhere. As a result, Pixar is worth more than Angel Soft and Quilted Northern. It is all about utility.
The Role of Government Is to Provide a Level Playing Field, But Not Equal Outcomes
In other words, you are seeing the Koch Brothers. I am seeing the toilet paper. It is the toilet paper that is providing utility and building civilization. As long as they continue to provide toilet paper to so many people on such an inexpensive basis, they deserve to have more money than a somewhat talented singer in a small town.
Koch Industries owns the companies that provide goods such as Dixie cups, Angel Soft toilet paper, Quilted Northern toilet paper, coffee lids, copy paper, etc. Most American homes buy the products the firm offers through its subsidiaries.
Why? More humans get utility from toilet paper than they would out of hearing our mediocre singer due to a biological hierarchy of needs. (And I say that as a classically trained musician who gives far more to music causes than he spends on toilet paper.) That is how a fair and just society should operate. Likewise, as long as more people identify with Britney Spears than they do with Renee Fleming, the former is going to earn more money than the latter. It goes back to utility; giving people what they want in a free exchange.
That is an important point. It is a vital point. Somehow, this American obsession with mammon as a god has led to people immediately equating wealth or a high income with righteousness or someone you’d be proud to have your child marry. A good man and a wicked man can both plant an apple seed and it is going to grow into an apple tree, providing fruit. A drug addicted, selfish, emotionally unstable musician might sell just as many albums as one who is a saint and feeds homeless people. You can be a terrible man who beats his children and throws puppies off overpasses and if you provide society more net value than your neighbors, you are going to generate more money. It is because money represents claim checks and votes. It does not represent goodness.
The best products and services on the whole win as long as the government is doing it’s job. In fact, I think aside from defense, one of the most important tasks “the people” have is maintaining a level playing field in consumer markets. Otherwise, the relationship between money and value breaks down whenever you get into totalitarian systems, such as Stalin’s Russia or Hugo Chavez’s Venezuela as well as in a corrupted form of capitalism called Crony Capitalism in which wealth flows as a result of kickbacks and bribes.
[mainbodyad]It may seem like the United States is suffering from the latter now but to assert that shows a remarkable lack of knowledge of this country’s history. We are far better than we have at any time in the past. That doesn’t mean we can’t get even better. Things such as protecting Net Neutrality from monopoly-like telecommunication companies is vital if we want our republic and economy to thrive.
How This Ties Into the Occupy Wall Street Movement
That is the reason when someone says, “The system only rewards a guy who can make a buck”, I hear, “The system just rewards a guy who can provide utility and value for other people in free exchanges without external coercion”. It is because of my liberal arts education I came to the same conclusion as the economists. It was that very liberal arts education that allows me to analyze and study the system, drawing my own conclusions. That knowledge alone isn’t what made me rich. It was the ability to convert those observations into tangible products and services that people desire. It was the Steve Jobs principle.
But getting back to our Occupy Wall Street discussion, you have the good, rational, wise people on one side arguing that money in politics is dismantling our system of freedom and working toward election reform so this can’t happen in the future. This is advisable policy. I hope they win. The fact that Congress still hasn’t passed a 50% payroll tax cut for everyone in the nation is proof that the corporate lobbyists are winning.
However, that is not the majority of men and women representing themselves on the We Are the 99 Percent blog. That site consists almost entirely of the bottom 20% of society; displaced manual workers who don’t realize they are fighting the wrong battle or misguided young people who borrowed large sums of money they couldn’t afford to repay to get degrees in subjects that might themselves be valuable but that they lack the talent or skill to convert into utility for civilization. That war, I maintain and reassert, is not between the rich and the poor. It is between the knowledge worker and the manual worker. The latter just doesn’t know it, yet. Until they realize it, they will live in squalor and poverty amidst some of the greatest affluence and wealth in the history of humanity. It doesn’t have to be that way.
Reader Comments (24)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
AEWIlliams
October 13, 2011
Beautiful
Gilvus
October 13, 2011
It's obvious from this article, your other blog entries, and your About.com articles that you're frustrated with how people (even smart, successful people) don't understand the nature of money. Is it because:
- Our educational system does not emphasize it enough, which reinforces the misconceptions passed down through the generations
- People in the ivory tower maintain information asymmetry in order to control the common rabble
- It takes too much thinking and people suffer from tall poppy syndrome or crab mentality (i.e. "if I can't have it, you shouldn't have it either")
- People would rather watch sitcoms and gossip about celebrities than learn how to solve their own problems
- All of the above
Been grading all night. I can only think in multiple choice now...
honest abe
October 14, 2011
Ok this is a good article for this who don't understand money. I agree with everything you wrote.
But I think it suffers from naivety. By no means do I think the OWS supports or understands what I am about to say but I think it partially explains the anger or at least the expanding support of the "movement".
I think you failed to focus on the most important part of this story:
Theft.
You assume that this is a small portion of wealth generation. You are mistaken. The financial industry accounts for 40% of all corporate profits as opposed to 10% in the early 1980s. It acts as a massive weight upon the remainder of the economy. This increase of 30% profits has been made without any additional risk imposed upon the banks as they have socialized the risk. This is the equivalent of me missing a cancer on a CT scan and asking my neighbors to pay the malpractice settlement cost. Oh, except that the cost is in the several trillion dollars.
The financial and insurance industries should be rewarded for the risk they take. If they intend to shift the risk to the public sector, then have done no "work" and added no "value" to the economy. They do not deserve the rewards. How does your analogy work when you put money into the vending machine yet no Coke comes out?
It upsets me that the movement has moved to a "soak the rich" philosophy. Ironically, those stewards of capitalism, "wall street" turned out to be the least capitalistic of all, so in that sense, Occupy Wall Street is a perfect name as like attract likes (welfare wannabees jealous of the welfare masters).
I would have never known this had I not run a business. My first few hires were based on intelligence. Now the first thing I look for is honesty. There is nothing rarer than an honest human, especially when there are trillions of dollars sloshing around.
I apologize for going into this rant on your blog but I think it is time for those of us who create, especially entrepreneurs, to realize that the bank handouts are going to hurt us more than anyone else...unless of course, you are a seller of cocaine and hookers.
Joshua Kennon
October 14, 2011
Replying to honest abe
Here is the long version: (for short version, see next comment)
Welcome to the site! Thanks for commenting for the first time!
I understand and I hear you. I also understand why you think I'm being naive but that is probably my fault because I avoided discussing the size of the financial sector head-on due to the fact the essay had already reached 4,000 to 4,500 words and I thought it was time to cut it short.
Instead, I offered the two end-solutions that would achieve those ends (shrinking the financial sector relative to the economy) without explaining them.
1.) Bring back the usury laws that limited interest rate expense to a multiple of the prime rate, like it was in 1980 (it wasn't an accident that is when you saw financial profits as a percentage of all corporate profits expand), and
2.) Bring back the ability of students to declare bankruptcy on student loan debt. Student loan debt is now in the trillion dollar plus range and exceeds loans for things like automobiles and credit cards.
Those solutions, which I discuss in the essay, would have a direct effect on shrinking the size of the financial sector relative to the economy as a whole.
In other words, I prescribed chemotherapy without telling you about the cancer. I didn't miss it on the CT scan. That's because I was too long winded as it was.
Here is where it gets interesting: The percentage of corporate profits attributed to the financial sector relative to the economy as a whole is vastly overstated. Take a look at the attached chart. It shows that corporate profits as a percentage of all domestic profits expanded from a long-term average of 15% or so to 45.8% as of December 2001. That's misleading and it is wrong.
In December 2001, many companies - especially our domestic industrial concerns - decided to engage in immoral "big bath" accounting maneuvers and used September 11th as an excuse to write-off accounting goodwill on their balance sheets. Companies that made cash profits in the billions reported net accounting earnings of negative billions of dollars. The banking industry, on the whole, wasn't able to do this as much as other segments of society so the percentage relative to the reported corporate profits ballooned artificially. I still remember reading the 10K disclosures of companies that had virtually zero exposure to New York, the travel industry, Wall Street, or anywhere else reporting enormous losses due to 'general economic' decline, giving them an excuse to throw out every bad decision they made during the dot-com boom.
Only the economists realized that the September 11th recession ended in November of that same year. A whopping 2 to 3 months. Employment was barely touched.
Furthermore, over the subsequent decade, much of the profits that the banking sector booked turned out to be vastly overstated. They weren't real. Mind you, many bankers thought they were real, but you had two counterparties reporting a profit on the same position of a derivative transaction! All of that was made up for with the write-offs in September of 2008, which showed bank profits as a percentage of the economy in the negative double digits. The equity holders of the banks that engaged in this practice were almost entirely wiped out, losing most, if not all, of their investment.
To adjust for that, you need to average the reported profits of the 2000 through 2008 period, the real estate bubble, with the losses than began to materialize in 2007, 2008 and beyond.
By adjusting for those factors in the outlier years, you get a better idea of what is really going on with the financial sector relative to the economy. Beyond that, most of the growth can be accounted for by three factors, some of which we already discussed:
1.) The usury laws creating compounding powers so that someone could pay a debt off 5x or 10x without lowering the principal balance. Some of this was fixed in the credit card reform act, which raised the minimum payments required.
2.) The student loan debt market exploding in size and being protected from bankruptcy risk so banks are assured to get their profit, or at least the ability to record the profit that is accruing on loans,
3.) The average American is more willing to borrow money than his or her grandparents, who lived through the Great Depression. Home sizes have nearly (not quite) doubled, even though the cost per square foot on an inflation-adjusted basis isn't really higher. The average family has two (2) cars compared to one (1) in prior generations, even though the inflation-adjusted cost of cars has fallen! For most people, they don't save, they finance with debt. That debt has to come from somewhere - someone has to write the check to the auto dealership or the home building company - so it comes from banks.
I place the onus not on the banks but on individuals. Why? A bank cannot make a loan unless someone requests the money. You cannot get your house foreclosed on if you don't have a mortgage. You can't lose your car if you don't have a car loan. It is not "theft" for a bank to take a house back if someone stops making the payments.
That is the cliff's notes version. If I tried to explain this in detail, the essay would have been 15,000 or more words. No one would have read it.
My personal opinion about The Occupy Wall Street crowd is summed up nicely by former President Bill Clinton:
“I think that, on balance, this can be a positive thing, but they’re going to have to kind of transfer their energies at some point to making some specific suggestions or bringing in people who know more to try to put the country back to work. Because I don't think that many Americans resent the success of people who make a lot of money fairly earned. I think what bothers people is the country has gotten so much more unequal under the last, over the last 30 years, and now that we’re in this fix, an enormous number of people have been out of work for more than six months, some of whom can’t get interviews because they’ve been out of work for more than six months, who always worked hard, always paid their taxes, did everything they were supposed to do, and made no contributions to the financial meltdown that caused their current distress. I think that is the heart of what they’re saying on Wall Street.”
honest abe
October 15, 2011
Replying to Joshua Kennon
You are an excellent writer. I agree that the profits weren't real and that the earnings were largely fictitious. But the mortgage lending crisis is not one that was a result of losses at the first tranche. It was due to losses at the derivative level.
There are 270 trillion dollars (theoretically less with netting, assuming counterparties like AIG could stay afloat without help through the turmoil, which they didn't) of derivatives which have exponentially grown since 2000. These derivatives generate large incomes for the writers of the products and it is understood now that the losses will be handed to the public. As much as the earnings were not real, the bonuses most certainly were. You offer good solutions. But the banks we are discussing, ie JP, GS, MS, C, AIG are not major mortgage lenders. They are "collaterizers" of debt. When a person takes out a loan they cannot pay back, their house is taken away, and their credit is destroyed forcing them to pay high interest rates; this is just. When the banks collaterized the debt, despite the fact that they "lost their bets" they still received their bonuses and now get to borrow at 0%!!! This is not just.
Joshua Kennon
October 15, 2011
Replying to honest abe
"As much as the earnings were not real, the bonuses most certainly were."
You are 100% right about that. I think there should be 5 year "clawback" agreement that holds bonuses for certain institutions in trust, or escrow. But, yes, you are absolutely correct. That is a huge problem. It creates a twisted incentive system that can take down the economy.
Re: Derivatives. Derivatives would be mostly easy to fix. You'd just need to have a central clearing house, like stock options, with predetermined leverage limits, transparent reporting, etc. You'd get into some trouble with the non-standard contracts, but most of the problem could be cleaned up quickly and simply. The only reason it hasn't is the lobbyists. The current system is too profitable for banks so they don't want to give it up. They need to be forced into a clearing house model.
But securitization? I'm still a bit stumped. Honestly, I haven't figured out how to solve the securitization issue. On one hand, it has all of the problems you described, on the other, it is vital for certain manufacturing businesses such as Harley-Davidson, who can finance motorcycles and sell the debt to Wall Street since they want to focus on making great bikes, not being a bank. It's especially important for fast-growing businesses that sell to customers on terms and can't afford to wait for the invoices to be collected ("factoring" accounts receivables, where they sell the debt off to a bank or investors at a haircut, giving them cash today).
The only proposal I've heard that made any sense was that banks should be required to hold a certain percentage of any mortgage they write and only be able to sell the remainder. That is, if they write a $100,000 mortgage, they might be required to keep $5,000 or $25,000, and sell the rest to other investors. That way, they are always exposed to the credit quality of the people to whom they loan money. A total ban on securitization would make it impossible to get, you know, "60 months no financing!" on cars or furniture since all of that money is provided by private label GE Money.
But otherwise, it's still on the "too hard" pile. Any thoughts on how to fix it?
honest abe
October 17, 2011
Replying to Joshua Kennon
Actually both derivatives and securitization would be better if the markets were transparent and if bonuses were tied only to long-term gains. Also they have to demolish any idea of Too big too fail. Because, if they don't we are living in a very crony system that has little to no relationship to capitalism. It doesn't make me feel any more comfortable knowing that the 2 banks that came out in best shape (goldman & jpm) are the ones with the most political clout.
Excellent suggestions btw.
guest
December 21, 2011
Replying to Joshua Kennon
Joshua, i had a question relative to this topic i sent in an email, please check it out, its about AIG bonuses etc
Joshua Kennon
October 14, 2011
Replying to honest abe
Here is the short version:
1.) It is incorrect to assume the Top 1% and Top 0.10% are made up disproportionately of those involved in Finance. For every 100 people in the Top 0.10%, which is $5 million or more, 82 of them are NOT involved in finance. Here is a visual representation of the breakdown: http://pinterest.com/pin/271099157/
2.) The financial sector as a percentage of the overall economy looks like it has grown on paper, but most of this is GAAP accounting manipulation (e.g., the post September 11th recession and the fake profits of the past ten years). The remainder can be made up by re-instating usury laws and bringing back the option for students to declare bankruptcy on their student loan debt. Ref: http://pinterest.com/pin/326755185/
3.) Most of the people who profited from "theft" lost everything. If you had a $10 million fortune in Wachovia, Bear Sterns, Lehman Brothers, AIG, Citigroup, etc., you were essentially wiped out. At the very least, it would take decades for your capital to return. The taxpayer saved these businesses and earned a $100+ billion profit in the process. Not only is that good, it saved Main Street, who would now be at Great Depression poverty levels. I don't agree with the term "theft" at all since it was free people engaging in free trade of their own free will. Instead, I call it "stupidity".
4.) The banks didn't cause the problems in a vacuum. A bank can only lend money if someone comes into a branch and asks for it. If someone loses their home, it is because they stopped making the contractually guaranteed payments. That isn't the bank's fault. People talking about losing homes in their family for 40 years or 70 years shouldn't have owed a penny against them. With the exception of service members, who are legally protected from foreclosures while deployed overseas, being thrown out of their house in violation of the law, the banks have done exactly what the promissory note spells out at the time of signing. It is not the bank's fault someone lost everything in the housing crash any more than it is the stock broker's fault someone invested poorly in equities or bonds. At the end of the day, each of us alone is responsible for our own actions.
For too long, the average American has lived far beyond their means, enabled by easy credit on cheap terms. They took no responsibility. The banks are as guilty as drug dealers, the borrowers as guilty as drug users. It was a relationship from which both benefited until the party ended. The guilty on the homeowner side were punished by losing their home; the guiltiest on the banking side were punished by losing most of their investment. Someone who put 100% of his net worth in, say, Bank of America a few years ago is now broke. He's watched most of his wealth disappear. Top management was thrown out of a job. The taxpayers got rich. The bank itself was saved but has lost enormous market share in areas such as mortgage underwriting, permanently hurting the brand. The American system works right 80% to 90% of the time.
honest abe
October 15, 2011
Replying to Joshua Kennon
1) I never said that Finance is a large proportion of the top 1%. The $ amount of income that is gained by theft is a large amount though. And it is too long to get into it here but there is a LARGE amount of theft at the higher levels; this is done be rewriting the rules. It is 100% legal. This is why you should always hire lawyers that charge $400 an hour. But, I do not think that it is indicative of a capitalistic free market system.
2) Ok so you may state the earnings are overinflated, but revenues are sharply up and the incomes of the bulge bracket bank employees was growing at a massive clip due to derivative growth.
3) This is absolutely FALSE. Ok, the Bear Sterns guys took losses. The Lehman guys were cannibalized by Nomura with better salaries, another ticking time bomb. AIG and Citi employees have done exceptionally well and this is well documented. And finally the two most lethal banks are without a doubt, JP Morgan & Goldman Sachs, whose employees received record year bonuses after the meltdown. Another separate discussion is, how did the govt decide who stays afloat and who fails?? AIG should have shut down. I have a problem with the banks coming to the public sector at the last minute and asking for $700 billion. And a problem with the fact that they again back to the same derivative games which means we will be bailing them out again. If they want the backing of the US taxpayer, they should stick to depository lending. I don't remember as a U.S. citizen ever being asked if I would like to use my taxdollars to pay for bonuses at banks for derivative traders!
4) Agreed 100%. The borrowers that failed to pay their loans should have their houses foreclosed upon and their interest rates should go up as the market dictates. I would think the same fair punishment should be applied to the banks also; not ZIRP.
What has happened is that the banks have gone from being a helpful useful part of society to one that is leaching capital from productive areas. Your Clinton quote summarized it best though. I don't think OWS believes as I do. I think it has turned into a soak the rich party. But I already see a few individuals formulating more specific answers to the problems I raised; I also like your ideas. Here is a good set of demands:
http://motherjones.com/kevin-drum/2011/10/matt-taibbis-advice-ows
Joshua Kennon
October 16, 2011
1. You're right.
2. You're right.
3. I would encourage you to rethink your understanding of how firms like AIG are structured. You might still believe, as you do, that they should have been shut down with zero bonuses. But there is no way in good conscious I could agree with you that AIG executives in different divisions shouldn't have received their bonus because to say that requires an enormous misunderstanding of the economics of what happened at the firm and how holding companies are structured. AIG was and is a holding company that owned a collection of businesses that happened to use, in some cases, the AIG name.
Imagine you created a company called Honest Abe Holdings, LLC and you had $1 trillion. You then bought ownership of Coca-Cola, Walmart, Starbucks, and Hilton Hotels, along with a ton of common stocks in other firms. Each company is run as its own business, with its own management, and its own risk profile. The only difference is that all of the stock certificates for each firm are in a bank vault and say they are owned by Honest Abe Holdings, LLC.
One day, you get the idea to setup Honest Abe Derivatives Trading, LLC as a new subsidiary. You open a tiny London office and hire a few people. Before long, those fools wrack up enormous losses that you agreed to cover at the parent company level.
Now, you are in a world of trouble. That means you have to either declare bankruptcy or get a bailout from the government, effectively wiping out the investors (which is what happened - AIG had to do a reverse stock split, otherwise the shares would be about the price of a pack of gum).
Meanwhile, over at Coca-Cola, you have a fantastic management team that has grown, increased profits, hired new workers, and hit record earnings for the year. They pay out most of those profits to the stockholder, which happens to be Honest Abe Holdings, LLC. Things are fantastic. They have no idea what is going on at the parent company level or over in London because, frankly, it's none of their business.
The idea that they - the guys at Coke - should suddenly not get the huge bonus checks they were promised for running their businesses well is absurd. They had no control over Honest Abe Holdings, LLC. They had no control over Honest Abe Derivatives Trading, LLC. They have contractually guaranteed payments to which they are entitled and they earned every penny. Their business is a separate legal entity with its own board of directors and its own management team. They have their own profits and losses.
The problem is, most people don't understand that "AIG" is not the same thing as its dozens of subsidiaries. They are individual companies with individual management teams and individual profit and loss statements. To punish the employees of one business for the misdeeds of another business simply because you share the same parent shareholder would be unfair. How would you feel if a company you worked for decided to cut your salary because one of the stockholders who owned shares were forced into bankruptcy? The world wouldn't function if there was that level of uncertainty in the system. You wouldn't stick around to be treated that way.
Plus, it would have been a disaster for us, the taxpayers. Imagine that someone came in and took over Honest Abe Holdings, LLC from the government and issued an edict from on high that the Coke team couldn't get paid more than $100,000 per year and they weren't going to get their bonus. These are the very people that were making money, not taking any crazy risks.
What's going to happen? At the very moment you needed that Coca-Cola team in place and churning out profit for you to use to plug the hole over at your derivatives business, most of the senior managers are going to resign! And they should. Why would any rational person stay in a job where they didn't receive money they were guaranteed by contract and that they had rightfully earned because someone else at a different company that you've never met and who has no role in your business screwed up? It's absurd.
I couldn't do that in good conscious. The only people responsible for the mess were the senior managers of the parent corporation and the derivatives subsidiary. Plus, the other managers at different businesses would have won the court cases, anyway, so the taxpayer via AIG would have been out not only the bonus money but the legal expense as well.
4. I think the list of demands you link to is very reasonable and wise. I can't disagree with any of them and I think you make very good points.
honest abe
October 17, 2011
Replying to Joshua Kennon
Ok I take your point about AIG. But as a doctor in Manhattan, I have a hard time finding any sympathy. During the past 4 years there have been several large hospital bankruptcies in the 5 boroughs. Hospitals function also as a collection of several separate PCs, ie corporations. When these hospitals shut down, do you think the doctors in the profitable PCs were bailed out? Do you think there was a massive severance package for these doctors?
I don't understand why the banking industry is immune. When you sign on to an investment bank, regardless of your position (even if you are a secretary), you have joined a system where you will be compensated better than in any other industry. You receive this increase in pay largely due to the fact that you take significant financial risk joining a financial firm. This has been known forever in Wall Street.
If you join a company whose parent explodes, you need to be left to the sharks. It is this process of creative destruction that makes capitalism unique. To keep any corporation in America alive via socializing is a massive blow to the idea of capitalism and questions whether the system works at all. An economic system is only so good if it holds up during a crisis. Otherwise, you seriously undermine the integrity of the system.
And although I don't think the public really understands all of this, I think they do know that when times were tough in their particular companies, they were let go rather quickly with little regard or concern for punishing those individuals directly responsible.
honest abe
October 17, 2011
Replying to honest abe
Why would any rational person stay in a job where they didn't receive money they were guaranteed by contract and that they had rightfully earned because someone else at a different company that you've never met and who has no role in your business screwed up?
By the way, this is exactly how most firings work in companies, ie, that's it. In some cases, no benefits when they go bankrupt. And, also the money in question has always been bonus money, which has always been an optional component and that is not by chance as anyone who has worked in the sector for 30-40 years can attest to.
Jacob Mast
October 16, 2011
Haven't read the whole article but I like it based on the first few lines. Think I'll print it and read more.
Jacob Mast
October 16, 2011
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No Cigar
October 20, 2011
There are several circumstances where the "value" of someone's services are distorted because the negotiation of value is less than arms-length:
CEO pay - is set by the BOD. But members of the BOD are effectively chosen by the CEO. BOD elections are not competitive (you don't get to choose between 2 or more candidates), and shareholders (mainly institutions these days) rubber-stamp the CEO's candidates. Who does the CEO choose? Oftentimes other CEOs, who obviously benefit themselves from a higher CEO pay scales. Other times the BOD is family, friends, and business associates. And in every case, the BOD are paid handsomely for their service. You scratch my back, I'll scratch yours....
The other case is public employee unions. These unions have gained a lot of political power. They hold major sway in city council & state legislature elections. When contract negotiations are held, the unions have far too much control over the other side of the table. That's a big reason why many states and localities are in such a financial mess.
I think your suggestion re: discharging student loan debt in bankruptcy is misguided. You invite "strategic default". The *real* question is why has the cost of education been increasing faster than inflation for decades, and what can be done about that? Secondarily, why do we continue to allow dubious (mostly for-profit) institutions to exploit vulnerable young people?
Joshua Kennon
October 20, 2011
Replying to No Cigar
Several of us were having a conversation about this exact thing on Facebook a day or so ago. Here was what I said there on the topic:
Looking at the numbers, there are a few root causes [of the rising cost behind schools]:
1.) Most, but not all, is due to salary and benefit levels for professors, staff, and administration. This is partly the result of the faculty having a union, whereas the students don't have a collective negotiating body to fight for lower tuition on their behalf. It's a power vacuum. This isn't the case at every institution; we're talking about higher education as a sector across the nation.
At many schools for every $100 in revenue, $60 goes to supporting salaries for staff and administration.
Then, you get into benefits. In the mid-1970's, for every $100 a college generated, $5 went to give benefits (not salary, just benefits) to professors. Today, that figure is $12. So not only is the pie much bigger, but the percentage of that pie going to faculty retirement, health, etc. is much higher than it was in the past. This is skewed highly in favor toward tenured professors with a large gap in pay for adjuncts.
But you know this instinctively. Imagine you are an administrator and you have an extra 10% in revenue. The faculty union is demanding a raise with inflation. That same amount could have gotten passed on to students as a tuition reduction. How many times have you heard of the student's winning? They don't have a voice at the table and the administration doesn't want a fight.
2.) The inflation-adjusted subsidies sent by taxpayers to public universities and colleges has fallen over the past decade, meaning tuition rates had to be increased to keep pace with existing service levels.
3.) Increased demand without an adequate increase in supply capacity has driven up prices. Back in the 1970's, not everyone was told to go to college. In all honesty, probably 1/3 of the people sitting in college seats shouldn't be there at all. It's not their strength. They should be in trade schools or art schools or other institutions based on their own talents and skills. That means you have more buyers "bidding" on the services of a school, giving them more pricing power.
That would be bad enough on its own but the buyers are using borrowed money that doesn't seem real to them in the beginning and the banks keep the spigot on because of the bankruptcy changes that made it impossible to declare on student loan debt. Easy credit has inflated the price of higher education in an unsustainable way. I cannot go on forever and I imagine that the disruption will be abrupt whenever it is addressed. Schools financed mostly with student loans rather than an endowment will be in a world of pain. There will be a widening split between 'rich' schools and 'poor' schools.
4.) What were considered luxuries in the 1970's are considered basic needs today. Students want air conditioned dorms, high speed Internet, gourmet coffee, smaller class sizes, one-on-one time with professors, etc. Not all of these are possible at every institutions, but over time, more schools have tried to move to these models to attract customers (students) in the marketplace, leading to an overall increase in the quality of the experience. Students pay for that.
I should mention, I don't think that the average college professor is a bad person or even that they are doing anything wrong. I've even considered teaching a graduate level course on finance (most of the textbooks have some of my writings in them somewhere, anyway). In fact, staff is acting rationally based on their own best interest.
Were I in their position, I'd be acting the same way.
The problem is *structural*. Just like Wall Street gets out of control in the absence of a countervailing force, all acting in their own best interest but at the cost of the greater society, so too are the collective bargaining groups in higher education. They are doing what it is good and right for their constituency. They just don't have a countervailing force so you get a winner-takes-all system with the loser being the tuition bill picked up by students. It's the same in finance, where winner-take-all people like me get the spoils of society simply because we're wired to understand systems, analyze probability, and move capital.
P.S. You could solve the problem easily. Pick an MBA student and promise them a 5% cut of any tuition reduction he wins on behalf of the student body during negotiations. Give him the power to contact students and organize protests. Tuition rates would fall. The incentive system had been changed. You'd have introduced a countervailing force.
Gilvus
October 20, 2011
Replying to Joshua Kennon
Your willingness to teach a graduate level course is admirable, but from what you've written about your habits, mentality, and the way you use your time, you probably wouldn't like it.
Of course, I don't know you nearly as well as you know yourself, and I see teaching at a university through glasses tinted by my own experiences. But there are many dirty secrets that are carefully swept under the rug, and many grievances that are strong enough to drive me out of the school, even though teaching is my passion. I'd be willing to elaborate further, but not in public discourse.
Joshua Kennon
October 20, 2011
Replying to Gilvus
I would be curious on your thoughts on the subject. If you ever feel like elaborating, you can use the Contact Form (it bypasses the spam filters and gets to me faster) at https://www.joshuakennon.com/contact-the-site/
Joshua Kennon
October 20, 2011
Replying to No Cigar
As for my belief we should go back to how student loans were treated prior to 2005 being misguided? That's nonsense. The United States survived for centuries without treating student loan debt as a "protected" debt immune from bankruptcy court. Those laws have only been in place since 2005. Nothing magical has happened in the past 6 years that would cause the world to unravel at its hinges because we reversed a law that was bought and paid for by bank lobbyists. It exists solely to provide a government guarantee of debt that, up until the recent government takeover of the student loan market, paid off for banks regardless of whether or not students could repay their obligations.
I'd even have no problem requiring all educational institutions taking Title IV funds to limit student loan debt as a portion of financing to a multiple of the average starting pay for a degree program. That way, a music major could only borrow 1/3 as much as an engineer. In the meantime, I'm thrilled with the 2010 Department of Education regulations that are going to tie Title IV funding to whether or not a program leads to gainful employment in a recognized occupation. That's going to make some of these for-profit schools that are really just parasites to the poor revamp their programs. It's good for society. I don't like the idea of making money by enslaving some optimistic kid who just wants a better life. That kind of behavior is sociopathic and evil.
Going back to reverting to prior-2005 student loan laws, if strategic default happened, which I imagine it would to some degree, the cost of the product would rise, making it harder to get credit. That would drain a decent amount of leverage out of the system and return to a true supply / demand curve where education loan pricing was based on demand and repayment probability. That is free market economics.
It would also act as a restraining force on the cost of tuition increases because schools would have to deal with declining revenue based on actual cash market economics not distorted by government intervention in loan pricing, which is what bankruptcy exemption is.
The 2005 law was a stupid idea then, it is a stupid idea now, and it will remain a stupid idea as long as it is on the books. It needs to be repealed. The 25-and-younger crowd is already going to have to deal with a declining worker-to-retiree ratio for social security funding. This shouldn't be another thing that they confront. Pricing it out of the market avoids a situation of debt slaves, which could (at some point) create social unrest.
And I say that as someone who has a significant portion of my retirement assets in bank stocks bought over the past couple of years on a highly opportunistic basis. I am, indirectly, the guy lending money on these student loans, especially if someone is getting their financing from Wells Fargo and U.S. Bancorp. If the United States economy is doing even remotely well a decade from now, I'm going to have essentially printed money from my office, all without having to pay a single penny in taxes on it because it's being held in retirement trusts and plans. Would reform lower my profits and returns? Sure. But it's the right thing to do. It's good for the economy, and my pocketbook, in the long-run. Otherwise, you're going to have an entire generation of students using an enormous portion of their income to service past debt that was an education bubble, dragging down aggregate demand. That is money they can't use to buy houses, cars, food, furniture, clothing, televisions, vacations, or start businesses.
I hope you don't take this the wrong way or as me being combative. I try to be diplomatic given the volume of messages I receive. This is just one of those topics that I see so much abuse in that I've drawn a hard line in the sand. I suspect there is also a degree of proximity that is riling me up because a few days ago, I read the 10K of a company that I used to respect enormously - as in, one of the greatest businesses of all time - only to discover that over the past decade, they've transformed themselves into a parasitic "educational" company that relies almost entirely on government student loan money to shove underclass students into "degree programs" without any regard to the potential of those students to repay the debt. It's a God damn racket and if our grandparents had seen it, they would have thrown people in jail. Now it's happening openly in the streets. And I hate the fact that I indirectly own part of this business through one of my other holdings.
honest abe
October 20, 2011
Replying to Joshua Kennon
apol?
Joshua Kennon
November 8, 2011
Replying to honest abe
Nope, but good guess. I actually need to getting around to studying them, again ... it's been a few years.
No Cigar
October 20, 2011
Replying to Joshua Kennon
The thing that has changed is the size of the debt. (Hence the uproar.) People are almost certainly more likely to default on larger loans. I'd bet that increasing defaults was probably the genesis of the 2005 law.
Besides being morally questionable, loan default is (by your own admission in paragraph 3) going to make it even harder and more expensive to get credit. Hardly a good thing for students overall, I'd say.
I can see your point regarding the crushing debt burden, and I agree something needs to be done. Limits on debt may make sense. By placing limits on total debt, you're probably going to put pressure on tuition, which would be a good thing.
James
October 20, 2011
Must be Washington Post as owned through Berkshire. The paper has gone down hill too.