1. What happened?
The stock chart for mid-September 2008 contains a stark vertical line. Over the weekend of September 13-14, Merrill Lynch had to sell itself at a once-unimaginably cheap rate to Bank of America, and in the early morning of Monday, September 15, Lehman Brothers filed for bankruptcy. That day the DJIA opened at 11,416 and headed straight down, ending the day at 10,917.
On Tuesday, the Federal Reserve lent the huge insurance company AIG $14 billion. That helped calm the markets, producing a bit of an upward blip in the Dow. There were wild zig-zags through the rest of the month as the market absorbed ever-changing news of money-market repercussions, government and Fed reactions, and overseas echoes of both. At the end of September, though, the index was a little lower than the bottom of that mid-month vertical line.
If September had been startling, October was devastating, bringing the Dow into the 8,000s. On October 11, the head of the IMF, Dominique Strauss-Kahn, spoke for many, saying: “Intensifying solvency concerns about a number of the largest US-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.”
2. What consequences?
What have been the consequences for the broader economy? (For “Main Street”)? Private-sector residential loans have disappeared (only Fannie and Freddie, now themselves overtly wards of Uncle Sam, finance home-buying at all), commercial loans too have virtually disappeared, states and municipalities find themselves under severe budgetary pressure, and the unemployment rate has stayed consistently above 9 percent quarter after quarter. Some of that is the result of the financial crisis itself; some of it may be the consequence of misbegotten reactions to the financial crisis.
3. What diagnosis?
The dominant diagnosis of the crisis is this: speculation (especially on the short side), leverage, deregulation, and greed. All are bad. We are being punished for those sins! Gordon Gekko has even returned to movie screens to hammer this point home.
An almost-amusing variant of that diagnosis is “let’s blame it all on Goldman Sachs,” a bit of corporate demonization most blatantly manifested by Matt Taibbi in his July 2009 article for Rolling Stone, starting with his “vampire squid” analogy. The Senate Permanent Subcommittee on Investigations was only slightly more subtle in those not-especially-enlightening hearings on Goldman that the Senators staged in April 2010.
The first step toward getting to a real diagnosis might lie in reversing that bias. One of the real problems facing the U.S. financial system in 2007-08 was that the other major private financial institutions weren’t sufficiently akin to Goldman Sachs. It was nearly the lone ant in a herd of grasshoppers.
In a broader context, though, the crisis of 2007-08 is a classic central-banking fiasco. Central banks, historically, are the disease for which they pretend to provide a cure. When a bubble bursts disastrously, the critical question is not why it burst – it burst because it was a bubble! – But how it could have been blown up into the dimensions that made its bursting so dire an event. The answer to that is here, as it is often, some version of the “greater fool” theory.
Sooner or later the greatest available fools will be the ones already in possession, and then the situation proves unsustainable, and unfortunate -- not just for them, but for a variety of counter-parties who have come to depend upon those who turned out to be the greatest fools. This is the dynamic that Greenspan enabled and even encouraged through monetary policy. Especially after the 1998 LTCM crisis, investors had the impression that the Fed would act as the greatest fool, and rescue any large institution in trouble as necessary.
Blaming, and cracking down on, leverage or speculation on this basis is rather like responding to an outbreak of rickets by cracking down on Vitamin D peddlers.
This is a trade book, not an academic treatise. Its audience consists of the (numerous) members of the general public who are intensely curious about what has happened to the U.S. economy in recent years and why.
This book will avoid some of the pitfalls, from the point of view of getting and holding the attention of that audience, that have befallen other books in this field. For example, Andrew Ross Sorkin, in Too Big to Fail (2009), buried his “inside story” under layers of trivia and would-be novelistic detail. Sorkin’s Chapter One begins, “The morning air was frigid in Greenwich, Connecticut. At 5:00 a.m. on March 17, 2008, it was still dark, save for the headlights of the black Mercedes….”
Gambling with Borrowed Chips will be quite sparing in its use of meteorological and astronomical detail.
It will also be broader and less personal in its focus than was Michael Lewis in The Big Short (2010).
Nonetheless, those books have sold, and they have sold to precisely the audience to which this book will appeal.
Some of the other books with which one might compare Gambling with Borrowed Chips are:
Woods, Thomas E. Meltdown. Washington, D.C.: Regnery Publishing, 2009.
Tett, Gillian. Fool’s Gold, New York: Free Press, 2009.
McLean, Bethany, and Joe Nocera, All the Devils are Here. New York: Portfolio/Penguin, 2010.
I covered some of the events of the lead-up to this crisis as a reporter (as did Tett, McLean, and Nocera), and that experience will help inform my analysis as it informs theirs. Nonetheless, this book will be distinct in important ways from those, notably in the underlying thesis, as discussed above.
The thesis, that speculation, even leveraged speculation, can be a good thing if disciplined by a hard-money policy, i.e. by the absence of central bankers’ mischief, is something this book has in common with Thomas Woods’. But my application of these ideas will be a good deal more thorough and rigorous than was Woods’ in Meltdown.
About the Author
I have been a member of the Connecticut bar since 1982. I am also the author of a history of modern philosophy, These Last Four Centuries (1988), and a study of the politics of Supreme Court confirmation fights, The Decline and Fall of the Supreme Court (1995). I am the co-author, with David E. O’Connor, of Basic Economic Principles: A Guide for Students (2000), a book aimed at grades 8 – 12.
In the 1990s I was the managing editor of a libertarian-themed journal of ideas, The Pragmatist. I wrote for the pioneering news organization HedgeWorld from 2000 to 2008, and learned to look at the financial world from the point of view of the hedge fund managers, investors, and their service providers. From 2008 to 2010, I wrote for The Hedge Fund Law Report, presenting legal and regulatory developments for fund managers and their counsel.
Table of Contents
Part One: The Value of Speculation
1.The old stigma: speculators as parasites
2. From Florence to Houston
3. Equity and Prop Desks
4. The Crisis of 2008
5. Commodities and Their Derivatives
6. Betting on Foreign Exchange
7. Accounting and Valuation
8. Corporations and Accountability
Part Two: Important Abstractions
9. Efficient Capital Markets, A Tidy Theory
10. The Much Sloppier Practice
11. On Greed and Money
12. A World Without a Monetary Superpower
Part Three: Some Policy Consequences
13. Bankruptcies and Rescues
14. Public and Private Pensions
15. Home Ownership
Lay out the theme of the book as described above.
Will quote William James, who in the late 19th century wrote: "See everywhere the struggle and the squeeze; and ever-lastingly the problem of how to make them less. The anarchists, nihilists and free-lovers; the free-silverites, socialists, and single-tax men; the free-traders and civil-service reformers; the prohibitionists and anti-vivisectionists; the radical darwinians with their idea of the suppression of the weak, -- these and all the conservative sentiments of society arrayed against them are simply deciding through actual experiment by what sort of conduct the maximum amount of good can be gained and kept in this world."
In this great higgle-haggle, we are all likely to misstep. Indeed, by somebody’s construction of the good, we are each certain to misstep. But beyond the various contending goods of the factions there is a meta-good, that of reconciling all these different human impulses, “making less” the struggle and the squeeze. That is the direction of progress.
End with concern that a very old and virulent stigma of the speculator as an anti-social parasite has re-emerged, a stigma that is a threat to progress.
Chapter One: The old stigma
Russian history. Dostoyevsky’s Raskolnikov and the death of a pawn broker. To the 20th century. Who were the kulaks? Their speculations, stigmatization, and death.
To the 21st century and the US. What is a CDS market? Consider a column Ben Stein wrote for The New York Times in March 2009. A short course in why derivatives, though in fact speculative, need not be so scary.
Chapter Two: From Florence to Houston
Introduce the idea of leverage, which has become closely intertwined with that of speculation. Medieval condemnation of usury. Savonarola. Time preference.
Brief history of ideas about debt and interest payments in the western world since then, taking in Luther, Calvin, Calvinism in the lowlands, the rise of London as a financial center and the views of the classical economists. The US. Theories of Henry George.
Conclude with a lesson one might draw from the rapid disappearance of Enron in 2000-2001. There are real dangers when finance becomes too disconnected from the physical world, when an excess of liquidity gives rise to dreams of infinite leverage.
Another lesson one might draw from Enron concerns the way that one much-maligned species of speculator, the short seller, fulfills a crucial ecological function creating accountability for corporate managers, who in the absence of active speculation would be better positioned to entrench themselves.
Chapter Three: Equity and Prop Desks
The equity/debt distinction as it plays itself out in corporate governance and the securities markets.
One critical role of speculation is that it uncovers the real value of assets. Specifically, the equity markets (and their speculators) reveal the value of an ongoing enterprise as its market cap. The difficulties caused by regulations that obscure that process, thus hiding the true value. Prices as data. Leonard Read’s pencil.
Chapter Four: The Crisis of 2008
Quote in this context the words of a Jacksonian Democrat in 1837. Newspaper editor William Leggett, denouncing Nicholas Biddle and the bankers who had followed his lead, writing: “[They] have used every art of cajolery and allurement to entice men to accept their proffered aid” which in turn led their borrowers to rush “upon all sorts of desperate adventures. They dug canals, where no commerce asked for the means of transportation; they opened roads, where no travelers desired to penetrate; and they built cities where there were none to inhabit.”
The result was that, inevitably, the bubble burst. The panic of 1837 that occasioned Leggett’s analysis led to a depression that continued until 1843.
Leggett would not have been surprised by the opening years of the 21st century. He might have been surprised, though, that in the long period between his time and our own an ideology of home-ownership-for-all had developed that compounded the extent of such artificial booms and the damage that the inevitable bust then works.
Chapter Five: Commodities and Their Derivatives
Speculation is not gambling. Gambling creates its own risk for the sake of the game. A gambler puts money on how a pair of dice will land. Nobody would even bother rolling those dice unless someone was putting money on them.
But consider orange juice futures, the subject of a memorable Eddie Murphy and Dan Ackroyd collaboration. Anyone investing in an orange grove, in the expectation of selling the fruit of his labors to the OJ market is taking enormous risks. The “dice” are meteorology on the one hand and fickle breakfasting-consumer preferences on the other. The producers can only hedge these risks to the extent that speculators are willing to take it from them.
Chapter Six: Betting on Foreign Exchange
History. Bretton Woods system, 1944-1971. Nixon closes the gold window. A “Tobin tax” and other dubious notions. Soros and the British pound in 1992. East Asian currencies later in the decade.
Time’s cover of “The Committee to Save the World,” inspired by US government and Fed reactions to the Asian currency crises. Why from such saving we need saving.
FX market is similar to, but distinct from, orange futures. The role the FX market plays in constraining central banks.
Chapter Seven: Accounting and Valuation
Pick up a thread from chapter three. If the free movement of equity prices can no longer serve its function of valuing an enterprise (because its freedom has been impeded) then what is the alternative? Accountants? Discuss the politicization of accounting.
Focus especially on the criticism the FASB received in 2009 over mark-to-market principles, i.e. the simple-seeming idea that companies should write down the value of their assets on their balance sheets if marketplace realities indicate those assets have been impaired.
By April 2009, the FASB had given in, issuing “staff positions” creating room to maneuver for companies that refuse to acknowledge the impairment.
How might accounting, and auditing, become a matter of a “race for the top” rather than the bottom?
Chapter Eight: Corporations and Accountability
The economics of shareholder voting and proxy fights.
Managements like staggered boards, a gambit through which the shareholders are allowed to vote in or out only one-third of the board at any one meeting. They justify this by talk of the preservation of continuity and experience. Research does not support the benefits of “continuity” achieved in this way.
There is a school of thought that talks of “directorial primacy,” i.e. it isn’t important that board elections matter, because if shareholders don’t like the way a company is run, they can sell.
One might as plausibly say that if you live in a home with a leaky roof and you don't like it, you can move. You can. But you, as owner of equity, also have the option of hiring a contractor who'll fix the roof. If your contractor proves dilatory in doing this job, you can fire him and hiring another. That's what shareholder activism is all about.
Chapter Nine: Efficient Capital Markets
The ECMH is the view that capital markets incorporate the available data more quickly than could any trader or participating institution. Thus, the effort to outsmart the market by working from one’s own research or hunches, or from the suggestions of the guy who cold-calls you in the evening with a hot tip … such efforts are bound to fail.
Though it has its roots in classical economics, the clear formulation of ECMH had to wait for 1965, and publications by Eugene Fama and Paul Samuelson.
Chapter Ten: The Much Sloppier Practice
ECMH is valid as a general rule. One of the inferences drawn from it in many quarters has been that most individuals and households should avoid stock picking, are better off participating in the capital markets only indirectly, as through broadly based mutual funds or ETFs. That inference is a good one, and for that lesson alone it is fortunate the ECMH has been broadly disseminated.
The reality, though, is sloppier than the theory. The reason markets are so efficient, after all, is that some speculators do manage to outguess it, as by finding arbitrage opportunities.
Chapter Eleven: On Greed and Money
Where do we go from here? The credit crunch of 2007 and the stock crash of 2008 are in the history books and time travel is impossible, so we only work forward.
We should be wary of a “hair of the dog that bit us.” We should refuse to resolve this hangover by easy-money nostrums and loose-accounting remedies, or by making it easier for corporate managers to entrench themselves. That dog will only get more rapid and bite still more devastatingly if we indulge him further.
We should abandon the system of central banking and fiat money. If we do, then sound money (which does not necessarily mean precious metal, but it does mean market-responsive money) will curb the excesses of leverage and speculation that we worry about. Within the limits that sound money will create, we can and should let the world move in its own way. Liberty works, and central planning fails, in the task of directing capital toward a variety of fruitful products, and co-ordinating the activities of innumerable individuals pursuing innumerable courses of life.
Chapter Twelve: A World without a Monetary Superpower
The United States has gotten away with a good deal in recent decades because the dollar has served as the numéraire of currencies. Thus, inflation in the U.S. serves as a way of lessening the significance of this country’s own dollar-denominated debt.
But this will not forever remain the case. The rest of the world is rather tired of dollar dominance. What will replace it is unclear. But the globe is a microcosm of the nation in this respect. The cheapening of the dollar is not a sustainable policy either here or abroad.
Remarkably, Robert Zoellick, president of the World Bank Group, one-time U.S. Trade Representative, one-time Goldman Sachs managing director, spoke in November 2010 about the need to “look beyond Bretton Woods.” The World Bank is itself of course a Bretton Woods institution, and looking beyond it in a comprehensive way may well mean the demise thereof. But that isn’t what Zoellick meant exactly.
What he did mean and why it is a straw in the wind.
Chapter Thirteen: Bankruptcies and Rescues
The bankruptcy code requires reform. As it is now structured it can create a run-on-the-bank mentality. One problem is that trustees have broad power to bring avoidance actions against anyone who recently acted as counter-party to a bank or other financial institution that thereafter became bankrupt. After the Refco fiasco in particular, a devil-take-the-hindmost ethos developed, in which the merest rumor that an institution may be in trouble inspires redemptions.
As for outright rescues, the Fed was right to worry about moral hazard in the case of Lehman Brothers, and wrong to throw aside that concern when AIG came calling the next day.
Chapter Fourteen: Public and Private Pensions
Despite the trend in recent years toward defined contributions, there are lots of traditional defined benefits plans around. Aging population, lots of retirees. Such plans find themselves pushed, like it or not, into a larger equity portfolio. This in turn gives them a greater role in corporate governance.
There are two broad possibilities. Either pensions will support (i.e. passively acquiesce in) existing management of the companies in their portfolio, or they will be activist investors. Intriguing questions arise in either case. In the former, this trend may further entrench such management, making more pressing the difficulties discussed in chapters 7 and 8.
A word about sustainability of social security.
Chapter Fifteen: Home Ownership
By 2010, large parts of the Republican Party seemed to be committed to overstating the role of the government sponsored entities (GSEs) in the housing boom and bust of 2003 – 2007. The fact is that the GSEs played a role, but they were not the driving force. As discussed above, especially in chapters four and 11, the Federal Reserve cheapened credit in order to get us out of the (fairly mild) recession of 2000 – 2002, and the lending generated by that cheapening was bound get to people who didn’t know what they were doing with it. That is what easy credit does. That would have happened even had there been no GSEs.
In fact, there were GSEs, and the shape that the crisis took had a good deal to do with their activities, and even more to do with the pro-housing ideology that reigns on Capitol Hill and protected them from inquiry. The shape of the crisis: not its existence or even its severity.
Chapter Sixteen: Energy
Something will in time replace the gas-burning internal combustion engine as the chief way in which people in much of the world get around. People have been discussing the issue of what that “something” will be for a long time. Why is it taking so long? Because the burning of hydrocarbons is an extremely efficient way of creating heat, and the proposed alternatives have so far generally been less efficiency (in some cases, notably ethanol, they have had the side-effect of destroying what would have been somebody’s inexpensive meal). It is because of that relative inefficiency that the ‘alternatives’ have had to win the support of government in the form of one subsidy piled on top of another.
Here, as in so many circumstances, central planning is the problem and entrepreneurship is the solution. Let a thousand entrepreneurial flowers bloom! And let them borrow. They will have to borrow. And of course, let speculators make those loans.
What government should do about energy directly is: nothing.
Chapter Seventeen: Conclusions
A broad social consensus that speculation is a valuable institution, as valuable as is the entrepreneurship it fuels, would constitute by itself one rather large forward step for our species.
The casino is a place of entertainment, because the risks are artificially generated. Nonetheless, since life is full of real risks, dice that throw themselves, the casino is also a model for some pragmatically successful and disastrous human attributes.
Gambling with borrowed money is a perfectly wholesome activity. Gambling with counterfeit or stolen money, though, is a crime.