Mark Twain
On November 15, 1971, an advertisement appeared in Electronic News in Santa Clara, California for a new electronic device. It was called the 4004. It was the first commercially available microprocessor that could make calculations on a silicon chip. It cost sixty dollars.
Although practically no one realized it at the time, this was “the big bang of a new universe of all-pervasive computing and digital communications”. The chips were powerful and cheap. They opened innumerable technological and business possibilities. They would transform the way people lived and worked around the world.
In the decades that followed, fortunes were made and lost as part of the transformation. Millionaires and billionaires were created. The proof that a “New Economy” had arrived was found in the good times of the prosperous 1990s. New profit possibilities appeared at every turn. Making money became a subject of universal interest as everyone rushed to take advantage of the new investment opportunities.
Emboldened by the amazing gains that were possible from the new technology, the financial sector’s investments went far beyond technology. It explored making money from money. The returns were amazing, but alas, they were unsustainable. The dot-com bubble burst in 2000, sparking the equivalent of a “nuclear winter” over Silicon Valley.
The party was over. The “wizards” of the dot-com era in Silicon Valley were forced to sober up after an era of "irrational exuberance". Computers might be transforming society, but it turned out that this “New Economy” was governed by some of the fundamentals of the Old Economy: customers and profits still mattered.
Yet despite the pain and waste caused by the bursting of the bubble, when it was over, valuable physical and institutional infrastructure for the new economy of computers and telecommunications had been put in place. Massive amounts of fiber optic cable had been laid. Firms had modernized their computer systems. In Silicon Valley, a vast social network had been built that could foster the next generation of economic players like Apple [AAPL], Amazon [AMZN], Salesforce [CRM] and Facebook [FB]. The process had been difficult, but in the end, the productive institutions of society had been remade.
A new bubble: real estate 2001-2008
By 2001, a kind of nuclear winter had come over Silicon Valley. But in the financial sector, things were different. The appetite for the amazing gains from great risk-taking remained unabated. During the dot-com frenzy, the financial sector had become disconnected from the real economy. The financial sector was no longer interested in the “boring” returns that came from producing goods and services for real customers. So the sector sought further new ways to get exceptional returns by making money out of money.
Within a few years, with the indulgence of the Federal Reserve, the financial sector was once again creating amazing gains from real estate, which were also, alas, unsustainable. When the crash came in 2008, Wall Street was able to avoid the “nuclear winter” that had afflicted Silicon Valley, with the help of a government bailout of the big banks.
Main Street was not so lucky. Large numbers of small and medium enterprises went bankrupt. Jobs were lost. Savings were destroyed. Real property values plunged. Houses went underwater and mortgages were foreclosed. Median incomes declined.
A large stock of unneeded housing had been built, but it was largely unproductive investment. Unlike the dot-com bubble with its excessive investments in fiber optic cable and start-up companies, the housing bubble left the economy in no better position to move forward or compete internationally. The housing that had been built was pure consumption that people couldn’t afford. Unlike the dot-com bubble, which in some ways had been a constructive bubble, the housing bubble had few positive elements, except for the financial ‘wizards’ who personally benefited from it. For the next five years, the stock of unused housing sat like a dead weight on the economy, holding it back.
As a result, the economy has remained in the Great Stagnation, running on life support with funding from the Federal Reserve. Yet as a consequence of cost cutting and with the help of free money from the Federal Reserve, large enterprises still appear to be profitable. The appearance, if not the reality, of economic well-being has been sufficient to make the stock market soar.
The new bubble 2008-2013: financial derivatives
In the crisis of 2008, the financial sector had happily avoided any kind of “nuclear winter”, despite its own excesses leading to the 2008 crash. Some firms were merged, but Wall Street remained largely unscathed. Huge bonuses continued to flow. There were moral recriminations for the excesses of the housing bubble, but no criminal prosecutions. The big banks were seen as too big either to fail or to jail.
Not surprisingly, Wall Street continued as before, unchastened by the setbacks to the economy as a whole. Despite a massive but ineffective effort at regulation in the Dodd-Frank law and the still-unfinished regulations, the financial sector has been able to continue pursuing “money made from money”.
This time, the bubble has taken the form of secret trading in derivatives. The notional value of this market is now more than $700 trillion, i.e. more than ten times the size of the entire world economy and a third larger than it was in 2008. Among other things, the toxic off-balance-sheet devices, known as “special purpose entities” made famous by Enron, have re-emerged as “variable interest entities” (VIEs). All the big banks are heavily involved. Even a supposedly safe and conservative bank like Wells Fargo [WFC] made around two-thirds of its profits in 2011 from secret trading in derivatives.
The financial sector is thus still largely disconnected from financing the real economy of producing goods and services for real live customers. The derivatives market resembles a gigantic gambling casino conducted in secret. No one, not even the banks themselves, or the bank inspectors resident within the banks, can fully know what is happening in the casino. As a result, no one can seriously evaluate the downstream risks being undertaken.
The gigantic derivatives bubble serves no social purpose. Flimsy guises such as “hedging risk” cannot justify a market ten times the size of the world economy. Unlike the dot-com bubble, which built physical and social infrastructure for the information/telecommunications society, or even the housing bubble which funded vast quantities of superfluous housing, the derivatives bubble funds nothing real. It is simply gambling for the sake of gambling. Money changes hands among the financial players. It is money chasing money.
Luckily for the financial sector, the banks have access to free money provided by the Federal Reserve to gamble with. The top talent in these firms is mainly devoted to “making money from money” in a zero-sum game with great risks, and few if any benefits, for the economy as a whole. The executives aren’t focused on the “boring” task of funding the production of goods and services for the real economy. They are busy making money for themselves.
Three different kinds of bubbles
Over the last forty years, we have thus witnessed three different kinds of bubbles: the dot-com bubble, the housing bubble and the derivatives bubble. Two of them have already popped, creating a “nuclear winter” for some of those involved. The third—the largest of them—has yet to pop. If it continues, the only questions are: when? and which segments of society will be afflicted by the new and larger “nuclear winter”?
The three bubbles have had increasing degrees of risk and diminishing degrees of social utility. The dot-com bubble funded much of the institutional and physical infrastructure for the new economy of computers and telecommunications. This was performed in a wasteful and ultimately painful manner, but it was on balance useful. The ensuing shock was severe for those involved but the overall economy recovered quickly.
The housing bubble funded a great deal of unnecessary housing. Some of that may ultimately prove useful, though it hasn’t made the economy more productive or prepared it for the future. It was essentially funding excess consumption. The shock for the global economy was so severe that, five years later, a full recovery is still not in sight.
The damage from a meltdown of part of the derivatives bubble will likely exceed the damage from either of the two previous bubbles, given the amount of money involved. And the derivatives market funds nothing of social value. It is simply money chasing money. In this respects, it resembles the Tulip Bubble of 1636 and South Seas Bubble of 1720.
The Tulip Bubble of 1636
The Tulip Bubble in 1636 was a brief period in the Netherlands during which contract prices for tulip bulbs reached extraordinarily high levels and then suddenly collapsed. The price of tulips skyrocketed because of speculation in tulip futures among people who never saw the bulbs. Fortunes were made and lost overnight. The bubble was purely speculative. It contributed nothing to the Dutch economy. It was money chasing money.
The South Seas Bubble of 1720
The South Sea Company was a British joint-stock company founded in 1711, created as a public-private partnership to consolidate and reduce the cost of national debt. The company was granted a monopoly to trade with South America, but the company never actually conducted any trade with profits. The company’s stock rose greatly in value as it expanded its operations dealing in government debt, peaking in 1720 before abruptly collapsing. It became known as the South Sea Bubble. It was in essence a gambling scam in which great fortunes were made and lost. It was money chasing money.
Constructive bubbles: canals, railways, steel, cars and dot-coms
These two bubbles are quite different from the five economic bubbles discussed in Carlota Pérez’s marvelous book, Technological Revolutions and Financial Capital (2002). Reading the book is an eye-opening experience.
Pérez’s thesis is that there has been a repeating pattern of capitalism that has occurred regularly over the last 250 years at intervals of around 50-60 years. Such bubbles can be constructive, provided that the financial sector is reined in, after the bubble bursts.
The Canal Mania of the 1790s
In first industrial revolution, beginning in the 1770s, mechanized factories began to transform the rural English economy. There was a rapid expansion of roads, bridges, ports and canals to support the growing flow of trade. In the 1790s, a Canal Mania emerged, as money flowed in to fund the exciting New Technology—canals--including hot money seeking refuge from the French Revolution. The investments funded canal after canal, including those that weren’t needed as well as those that were. The mania continued until the Canal Panic of 1797, after which the real economy took the lead once again. There was a lot of waste and pain, but in the end, the mania funded the infrastructure that remade the English economy.
The Rail Mania of the 1840s
Then there was the English Rail Mania of the 1840s. Sparked by transformational impact on society of rail travel, there was an amazing investment boom in railways. Everyone wanted to invest in this exciting “New Economy”. That is, until the Rail Panic of 1847. During the frenzy, some people became very rich while others went bankrupt and the poor were left behind. When the dust settled, England had built far more railways than could possibly be used. There followed a calmer period in which the overbuilt rail network was rationalized. The Rail Mania involved a lot of waste and pain but it was not all bad: it had funded infrastructure that once again remade the English economy.
The Steel Mania of the 1880s
After a period of relative economic calm, as the economies of the US and Germany moved to the fore, there was the Steel Mania of the 1880s and 1890s. At this time, the hot new technology was steel. A huge transformation of the world economy was under way with transcontinental trade and travel, accompanied by international telegraph and electricity.
Again, there was excited talk of “a New Economy”. Financial markets received a massive infusion of cash as money sought to make money out of money. Everyone wanted to be part of it. That is, until a series of crashes came in various forms in the US, France, Italy and Argentina. Chastened by the crashes, the financial sector in the US and Germany returned its focus for a while to financing the real economy, which stabilized things for a period. (The result was less happy for Argentina which ceased to be a major player in the world economy.) The Steel Mania involved a lot of waste and pain, but it funded the infrastructure for the new global economy.
The Roaring 1920s
Then in the early parts of the 20th Century, investors became excited by the prospects of mass production and Henry Ford’s auto industry that had the potential to once again transform society. Financial wizards appeared in droves to take advantage of the opportunities. By the 1920s, the stock market had swollen to become the engine moving the US economy. Investments were “guaranteed to grow” in an unending bull market. Everyone wanted to be in on it. That is, until the inevitable collapse came in 1929.
The ensuing recession was deep and prolonged, until the financial sector, with the “encouragement” of legislation like the Glass-Steagall Act, was reconnected with the “boring” real economy of firms producing goods and services for real customers. It took a while for the reconnection to take place. When it did, it, along with the World War, enabled a kind of “golden age” in the US economy in the 1940s and 1950s. (Things ended less happily for Germany, which had pursued a state-run economy and military expansion.)
A set of causal mechanisms
Pérez’s book explains that in these five relatively productive bubbles (canals, rail, steel, mass production, and dot-coms), clusters of innovations have come together to create technological revolutions, with astonishing new profit possibilities for those with eyes to see and money to invest.
This in turn gives rise to a financial frenzy, with an expectation of high returns and an over-investment in new profit possibilities. Controls on the financial sector are relaxed and a casino economy emerges. Hot money not only exploits the real opportunities created by the new clusters of technology but also sets out to “make money out of money”. The financial sector takes over, while the real economy, with its “boring” returns, is left behind. People begin to think that the extraordinary returns of the over-heated "New Economy" will continue in perpetuity.
The winners in the casino economy get richer and richer while the poor miss out: income inequality worsens. The financial frenzy pursues wasteful chimeras; greed and scams are rampant. Eventually a big financial crash—or series of crashes—occurs and the large parts of the economy come tumbling down. But in the process, genuinely better ways of organizing, managing and consuming have been put in place as a result of investments in the new technologies and institutions and the changed way of managing them.
If the crash is severe enough and the political leaders are wise enough, new institutional arrangements stabilize the economy. The real economy is put back at the center of the economy, with the financial sector in support. When this happens, a kind of “golden age” may follow, where economic growth rates are moderate but steady but the benefits widely shared. Wide segments of the population prosper and income inequality diminishes.
If the crash is not severe enough to awaken society from its illusions of perpetual exponential returns, or society’s leaders are not wise enough to put in place the institutional changes needed to rein in the rampaging financial sector, then various kinds of national decline can ensue.
- The casino economy may continue, with a deterioration of the real economy, worsening income inequality, and persistent financial crashes; or
- There may be an over-reaction to the excesses of the financial sector so that regulation stifles the financial sector, thus crippling the future evolution of the real economy; or
- The political arrangements may lead to a state-run economy with an extended decline (e.g. Nazi Germany).
The risks of the current derivatives bubble
The risks of the current gigantic derivatives bubble and the unchecked activities of the financial sector are enormous. Insight is provided by the example is the JPMorgan Chase debacle in 2012—the activities of the so-called London Whale. The proprietary trading—i.e. gambling on the likely movements of a share index—was being undertaken in the safest part of the bank that was supposed to be protecting the bank against risk. Instead the unit itself had become part of the gambling casino. The maximum “value at risk” was supposed to be $67 million. The eventual loss from the trading was more than $6 billion. The loss was thus 90 times larger than the value that management thought was at risk.
As Gretchen Morgenson writes in today’s New York Times, about the recent Senate report describing the incident:
“Its pages of e-mails, testimony, telephone transcripts and analysis show that traders in the bank’s chief investment office hid money-losing derivatives positions, if only temporarily; that risk limits created by the bank to protect itself were exceeded routinely; that risk models were changed to minimize losses; that bank executives misled investors and the public.”
It took JPMorgan’s management several months to figure out exactly what had happened. JPMorgan is arguably the most accomplished bank in terms of managing risk. What would be the risk multiplier in a less accomplished bank? Just 90 times like JPMorgan? Or 900 times? Or 9,000 times? Or even 90,000 times? No one knows, because the derivatives trading is conducted in secret.
The traders themselves don’t know the full extent of the risks. None of the players can see the whole picture. And why should they even care? If things go well, they will get their bonuses. If anything goes badly wrong, the government will be forced to bail the banks out.
Dodd-Frank hasn’t helped
The thrust of the Dodd-Frank law is to build firewalls around the commercial banks to protect them against a possible collapse. Quite apart from the fact that the meltdown of 2008 wasn’t caused by a commercial bank (Lehman Bros was not a bank), building a firewall around $700 trillion secret derivatives market is like building a firewall around an unsafe nuclear plant.
No firewall can protect against the direct and indirect effects of a meltdown of even a tiny part of such a gigantic bubble. Even if only a sliver of the market were to go bad, say, two percent, that would still be the size of the entire US economy. Cash-strapped governments are today in no position to bail out Wall Street yet again, even if they had the political will to do so. The derivatives bubble is thus a gigantic financial accident waiting to happen: it's “the mother of all bubbles”, with the risk of a vast and horrible “nuclear winter” to follow.
What’s different this time?
Despite similarities, no crisis is exactly alike. Reconnecting the financial sector to the real economy is proving more difficult now than before for a number of reasons.
- The financial sector is now global in scale; and almost too large for any single government to regulate.
- It is armed with a fallacious theory of the supremacy of bankers as the masters of the universe: the “dumbest idea in the world” that the purpose of a firm is to maximize shareholder value.
- It is protected by an army of lobbyists intent on diverting or deflecting any legislation or regulation that might get in the way of the casino economy.
- As a result of their success, it can make the legitimate claim that “Dodd-Frank adds costs without making us safer” in support of the illegitimate claim that “the effort at regulating the banks should stop.”
- The banks are nurtured by a government that believes that they are too big to fail and too important to punish for wrongdoing.
- The banks are funded by free money from the Federal Reserve.
- The banks are managed by executives who benefit from massive financial incentives to continue precisely doing what they are doing. As Upton Sinclair wrote, “It is difficult to get a man to understand something, when his salary depends upon his not understanding it.”
Nevertheless the choice for society is clear. If the financial sector remains in charge of the economy, we can look forward to increasingly severe crashes and overall economic decline.
Three key measures for managing risky financial bubbles
1. Distinguishing good from bad bubbles
The first step in dealing with these difficult issues is to distinguish between potentially productive bubbles like the investments in canals, railways, steel, autos and dot-coms and the socially unproductive bubbles like the Tulip bubble, the South Seas investments and now the Derivatives bubble. This can then focus attention on prudently containing the excesses of the former, while ending the latter.
2. The leadership challenge for regulators
Having made this distinction, the regulators can then get on with the urgent and vital task of reining in the rampaging financial sector. The banking sector needs to be reconnected with the real economy so that it plays a productive supporting role. In this regulatory activity, creating firewalls around the banks to protect them against the gigantic derivatives bubble should be seen as futile: the amounts of money are too large. Instead, trading in derivatives must be conducted in public so that the risks can be assessed and appropriate safety measures can be put in place.
3. The leadership challenge for bankers
The leadership challenge for bankers is to rejoin the real economy in creating steadily expanding financial opportunities and reducing risk for an ever wider circle of citizens and enterprises. This means in effect reinventing how banks make money.
The argument that commercial banking is a mature industry where banks can’t make money is a failure of courage and imagination, not some external reality. Just look at books and music and mobile phones and tablets. They were all said to be stagnant, mature industries, but when they were reinvented, they generated humongous amounts of money. Leaders in banking need to refocus talent currently working on risky self-interested activities into innovating for customers.
How?
Leaders in banking need to create:
- a banking sector whose goal is to continuously add value to its customers
- a banking sector that sees making money as the result, not the goal of its activities…
- a banking sector that deploys its very best talent in a continuous search to find new ways to secure the financial future of average citizens and make their lives better …
- a banking sector that cares profoundly about the well-being of its customers, seeing them as flesh-and-blood human beings, not as wallets to extract money from…
- a banking sector with products and services which are fewer in number, but which fit exactly the needs of its customers, even needs customers had never themselves imagined…
- a banking sector whose credit cards help customers pay down their balances and warn them of any late fees they may be about to incur…
- a banking sector whose managers and staff function as teams that are passionately committed to these goals …
- a banking sector that is totally transparent about all its activities, and proud to reveal how it conducts every aspect of its business…
- a banking sector that exists in a virtuous cycle of value creation, while also delivering superior financial results year after year, decade after decade…
Other sectors have done it.
So why not banks?
Why not now?
A note on Carlota Pérez’s brilliant book
This article draws heavily on Carlota Pérez's book, Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages which was written in 2002. I only came across it recently. Who is Carlota Pérez? She was born in Caracas in 1939. In 2006, she became Professor of Technology and Socio-Economic Development at Tallinn University of Technology in Estonia. She is a Research Associate at the University of Cambridge and a Visiting Senior Scholar at the London School of Economics.
Is it a book on economics? Or on finance? Or on technology? Or on sociology? Or on management? Or on leadership? Or on economic history? On or politics? The answer is yes: all of the above. That is one reason why the book has been largely ignored by almost all those academic disciplines. The book is too bold and wide-ranging for them to accept it as “one of theirs”. But no matter. Academics will eventually come to see how extraordinarily profound the book is and will have to adjust their disciplines to accommodate its thinking.
The book is guilty of other academic sins. It is simply and clearly written. Ouch! Worse: it is succinct—a mere 171 pages. And the succinctness is accompanied by precise details on the vast territory covered—the story of capitalism over the last 250 years. How dare Professor Pérez wear her erudition so lightly?
While academics may gnash their teeth, pragmatic leaders of all kinds—in politics, in management, in finance—can celebrate and use her book to guide their strategic decision-making in these perilous times.
I agree with W. Brian Arthur of the Santa Fe Institute in New Mexico when he wrote: “Before I read this book I thought that the history of technology was – to borrow Churchill’s phrase – merely ‘one damned thing after another’. Not so. Carlota Perez shows us that historically technological revolutions arrive with remarkable regularity, and that economies react to them in predictable phases.”
And read also:
Big Banks & Derivatives: Why Another Financial Crisis Is Inevitable
How Can Bankers Recover Our Trust?
The dumbest idea in the world: maximizing shareholder value
The science of changing pathologically asocial behavior
The five surprises of radical management
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Steve Denning’s most recent book is: The Leader’s Guide to Radical Management (Jossey-Bass, 2010).
Follow Steve Denning on Twitter @stevedenning
