The End of Growth: Adapting to Our New Economic Reality (10 page)

Here are obvious examples of the two kinds of investment motive. If you own shares of stock in General Motors, you own part of the company; if it does well, you are paid dividends — in “normal” times, a modest but steady return on your investment. If dividends are your main objective, you are likely to hold your GM stock for a long time, and if most others who own GM stock have bought it with similar goals, then — barring serious mismanagement or a general economic downturn — the value of the stock is likely to remain fairly stable. But suppose instead you bought shares of a small start-up company that is working to perfect a new oil-drilling technology. If the technology works, the value of the shares could skyrocket long before the company actually shows a profit. You could then dump your shares and make a killing. If you’re this kind of investor, you are more likely to hold shares relatively briefly, and you are likely to gravitate toward stocks that see rapid swings in value. You are also likely to be constantly on the lookout for information — even rumors — that could tip you off to impending price swings in particular stocks.

When lots of people engage in speculative investment, the likely result is a series of occasional manias or bubbles. A classic example is the 17th-century Dutch tulip mania, when trade in tulip bulbs assumed bubble proportions; at its peak in early February 1637, some single tulip bulbs sold for more than ten times the annual income of a skilled craftsman.17 Just days after the peak, tulip bulb contract prices collapsed and speculative tulip trading virtually ceased. More recently, in the 1920s, radio stocks were the bubble
du jour
while the dot-com or Internet bubble ran its course a little over a decade ago (1995–2000).

Given the evident fact that bubbles tend to burst, resulting in a destruction of wealth sometimes on an enormous and catastrophic scale, one might expect that governments would seek to restrain the riskier versions of speculative investing through regulation. This has indeed been the case in historic periods immediately following spectacular crashes. For example, after the 1929 stock market crash regular commercial banks (which accept deposits and make loans) were prohibited from acting as investment banks (which deal in stocks, bonds, and other financial instruments). But as the memory of a crash fades, such restraints tend to fall away.

Moreover, investors are always looking for creative ways to turn a profit — sometimes by devising new methods that are not yet constrained by regulations. A few of these methods were particularly instrumental in the build-up to the 2007–2008 crisis. As we discuss them, we will also define some crucial terms.

Let’s start with
leverage
— a general term for any way to multiply investment gains or losses. A bit of history helps in understanding the concept. During the 1920s, partly because the Fed was keeping interest rates low, investors found they could borrow money to buy stocks, then make enough of a profit in the buoyant stock market to repay their debt (with interest) and still come out ahead. This was called
buying on margin
, and it is a classic form of leverage. Unfortunately, when worries about higher interest rates and falling real estate prices helped trigger the stock market crash of October 1929, margin investors found themselves owing enormous sums they couldn’t repay. The lesson: leverage can multiply profits, but it likewise multiplies losses.
¹⁸

Two important ways to attain leverage are by borrowing money and trading securities. An example of the former: A public corporation (i.e., one that sells stock) may leverage its equity by borrowing money. The more it borrows, the fewer dividend-paying stock shares it needs to sell to raise capital, so any profits or losses are divided among a smaller base and are proportionately larger as a result. The company’s stock looks like a better buy and the value of shares may increase. But if a corporation borrows too much money, a business downturn might drive it into bankruptcy, while a less-leveraged corporation might prove more resilient.

In the financial world, leverage is mostly achieved with securities. A
security
is any fungible, negotiable financial instrument representing value. Securities are generally categorized as debt securities (such as bonds and debentures), equity securities (such as common stocks), and derivative contracts.

Debt and equity securities are relatively easy to explain and understand; derivatives are another story. A
derivative
is an agreement between two parties that has a value that is determined by the price movement of something else (called the
underlying
). The underlying can consist of stock shares, a currency, or an interest rate, to cite three common examples. Since a derivative can be placed on any sort of security, the scope of possible derivatives is nearly endless. Derivatives can be used either to deliberately acquire risk (and increase potential profits) or to hedge against risk (and reduce potential losses). The most widespread kinds of derivatives are
options
(financial instruments that give owners the right, but not the obligation, to engage in a specific transaction on an asset),
futures
(a contract to buy or sell an asset at a future date at a price agreed today), and
swaps
(in which counterparties exchange certain benefits of one party’s financial instrument for those of the other party’s financial instrument).

Derivatives have a fairly long history: rice futures have been traded on the Dojima Rice Exchange in Osaka, Japan since 1710. However, they have more recently attracted considerable controversy, as the total nominal value of outstanding derivatives contracts has grown to colossal proportions — in the hundreds of trillions of dollars globally, according to some estimates. Prior to the crash of 2008, investor Warren Buffett famously called derivatives “financial weapons of mass destruction,” and asserted that they constitute an enormous bubble. Indeed, during the 2008 crash, a subsidiary of the giant insurance company AIG lost more than $18 billion on a type of swap known as a
credit default swap
, or CDS (essentially an insurance arrangement in which the buyer pays a premium at periodic intervals in exchange for a contingent payment in the event that a third party defaults). Société Générale lost $7.2 billion in January of the same year on futures contracts.

Often, mundane financial jargon conceals truly remarkable practices. Take the common terms
long
and
short
for example. If a trader is “long” on oil futures, for example, that means he or she is holding contracts to buy or sell a specified amount of oil at a specified future date at a price agreed today, in expectation of a rise in price. One would therefore naturally assume that taking a “short” position on oil futures or anything else would involve expectation of a falling price. True enough. But just how does one successfully go about investing to profit on assets whose value is declining? The answer:
short selling
(also known as
shorting
or
going short
), which involves borrowing the assets (usually securities borrowed from a broker, for a fee) and immediately selling them, waiting for the price of those assets to fall, buying them back at the depressed price, then returning them to the lender and pocketing the price difference. Of course, if the price of the assets rises, the short seller loses money. If this sounds dodgy, then consider
naked short selling
, in which the investor sells a financial instrument without bothering first to buy or borrow it, or even to ensure that it
can
be borrowed. Naked short selling is illegal in the US, but many knowledgeable commentators assert that the practice is widespread nonetheless.

In the boom years leading up to the 2007–2008 crash, it was often the wealthiest individuals who engaged in the riskiest financial behavior. And the wealthy seemed to flock, like finches around a bird feeder, toward
hedge funds
: investment funds that are open to a limited range of investors and that undertake a wider range of activities than traditional “long-only” funds invested in stocks and bonds — activities including short selling and entering into derivative contracts. To neutralize the effect of overall market movement, hedge fund managers balance portfolios by buying assets whose price is expected to outpace the market, and by short-selling assets expected to do worse than the market as a whole. Thus, in theory, price movements of particular securities that reflect overall market activity are cancelled out, or “hedged.” Hedge funds promise (and often produce) high returns through extreme leverage. But because of the enormous sums at stake, critics say this poses a systemic risk to the entire economy. This risk was highlighted by the near-collapse of two Bear Stearns hedge funds, which had invested heavily in mortgage-backed securities, in June 2007.
¹⁹

FIGURE 9.
Amounts Outstanding of Over the Counter (OTC) Derivatives since 1998
in G10 Countries and Switzerland.
“Notional value” refers to the total value of a leveraged position’s assets. The term is commonly used in the options, futures, and currency markets when a small amount of invested money controls a large position (and has a large consequence for the trader). “Market value” refers to how much derivatives contracts would be worth if they had to be settled at a given moment.

Source: Bank for International Settlements.

I Owe You

As we have seen, bubbles are a phenomenon generally tied to speculative investing. But in a larger sense our entire economy has assumed the characteristics of a bubble or a Ponzi scheme. That is because it has come to depend upon staggering and continually expanding amounts of debt: government and private debt; debt in the trillions, and tens of trillions, and hundreds of trillions of dollars; debt that, in aggregate, has grown by 500 percent since 1980; debt that has grown faster than economic output (measured in GDP) in all but one of the past 50 years; debt that can never be repaid; debt that represents claims on quantities of labor and resources that simply do not exist.

When we inquire how and why this happened, we discover a web of interrelated trends.

Looking at the problem close up, the globalization of the economy looms as a prominent factor. In the 1970s and ’80s, with stiffer environmental and labor standards to contend with domestically, corporations began eyeing the regulatory vacuum, cheap labor, and relatively untouched natural resources of less-industrialized nations as a potential goldmine. International investment banks started loaning poor nations enormous sums to pay for ill-advised infrastructure projects (and, incidentally, to pay kickbacks to corrupt local politicians), later requiring these countries to liquidate their natural resources at fire-sale prices so as to come up with the cash required to make loan payments. Then, prodded by corporate interests, industrialized nations pressed for the liberalization of trade rules via the World Trade Organization (the new rules almost always subtly favored the wealthier trading partner). All of this led predictably to a reduction of manufacturing and resource extraction in core industrial nations, especially the US (many important resources were becoming depleted in the wealthy industrial nations anyway), and a steep increase in resource extraction and manufacturing in several “developing” nations, principally China. Reductions in domestic manufacturing and resource extraction in turn motivated investors within industrial nations to seek profits through purely financial means. As a result of these trends, there are now as many Americans employed in manufacturing as there were in 1940, when the nation’s population was roughly half what it is today, while the proportion of total US economic activity deriving from financial services has tripled during the same period. Speculative investing has become an accepted practice that is taught in top universities and institutionalized in the world’s largest corporations.

But as we back up to take in a wider view, we notice larger and longer-term trends that have played even more important roles. One key factor was the severance of money from its moorings in precious metals, a process that started over a century ago. Once money came to be based on debt (so that it was created primarily when banks made loans), growth in total outstanding debt became a precondition for growth of the money supply and therefore for economic expansion. With virtually everyone —workers, investors, politicians — clamoring for more economic growth, it was inevitable that innovative ways to stimulate the process of debt creation would be found. Hence the fairly recent appearance of a bewildering array of devices for borrowing, betting, and insuring — from credit cards to credit default swaps — all essentially tools for the “ephemeralization” of money and the expansion of debt.