Author Essays, Interviews, and Excerpts

The economy is a confidence game

jacket imageMark C. Taylor on the economic crisis:
Now we can see that the economy is a confidence game. With markets spinning out of control and liquidity frozen, analysts and commentators repeat again and again that the problem is that investors have lost confidence. What they don’t adequately stress is that this loss of confidence is fully justified.
In the past several decades, financial markets have become a sophisticated confidence game, and the people in the markets are latter-day versions of Herman Melville’s wily character in The Confidence-Man, duping passengers floating down the nation’s great artery, the Mississippi River, on the paddle-steamer Fidele. (Melville’s novel, appropriately, takes place on April Fool’s Day.)
What makes today’s crisis of confidence unique is its unprecedented scale, and the threat it poses to the current form of capitalism. In previous forms, industrial and consumer capitalism, people made money by buying and selling labor and material objects. In the modern era of finance capitalism, wealth is created by circulating paper with marks, backed by other symbols and still more symbols behind them, in a regression that is limitless as long as confidence in symbols endures.
This crisis of confidence goes beyond economics. The financial meltdown is a symptom of a profound crisis in our sense of reality, which is endemic to contemporary society and culture.

The line separating truth and illusion, the material and the immaterial, and the real and the virtual has been gradually eroding. In a world where Daily Show host Jon Stewart is widely regarded as the most reliable source of news, who can be sure what is real and what is fake? When the play of symbols has become the substance of global capitalism, what difference is there between the stock market and the art market?
Three developments that started in the late 1970s and early 1980s have created conditions for the current crisis: Computers have transformed communications and the mechanics of transactions. Economic policies have assumed that markets constantly self-correct to set appropriate prices. Political policies have limited the power of government to intervene in commerce.
Computers were first introduced to the trading floor for record-keeping in the late 1970s, but were not widely used as tools of financial decision-making for several years. Their full impact was not felt untilthey were networked. As the emerging system transformed money into electronic bits circling the globe at the speed of light, markets became prone to ever-greater volatility and risk.
Economic fundamentalism, meanwhile, blinded the country’s economic leadership to the size of the new risk created by technological power. Market fundamentalists embraced the market as an omniscient, omnipotent, and omnipresent force. Unfortunately, their god proved unworthy of their faith.
Financial engineers created new instruments—derivatives, repos, and swaps, to name three examples—aimed at insuring investors against the new instability. And alas, although they were profitable and useful for a time, these new risk-management instruments have severely worsened the volatility they were intended to insure against.
Government, meanwhile, rather than introducing new regulation suited to the new market, was ruled by a philosophy best expressed by Ronald Reagan in his first inaugural address: “Government is not the solution to our problem; government is the problem.”
On Sept. 30, 1981, Congress passed legislation intended to help foundering savings-and-loans banks by allowing them new freedom to sell their low-rate, long-term mortgage loans and to lend or invest the proceeds at higher rates. Mortgages could be bundled and sold as bonds through the Government National Mortgage Association (“Ginnie Mae”) or as mortgage-backed securities through the Federal National Mortgage Association (“Fannie Mae”).
These securities—in several classes with different levels of risk and return—were themselves combined and recombined, sold and resold, with such speed that their complexity began to defy analysis. Even the largest investors lost control over the risk that they were incurring or passing along. Neither borrowers nor lenders knew who owed what to whom.
Despite this, the trade in these increasingly abstract securities was so profitable that financial institutions, denying what they half-knew, went deeper and deeper into debt in order to further invest in them. Some banks were investing $50 of borrowed capital for every dollar they had on deposit, placing themselves and their depositors at radical risk in the event of a market downturn.
As speculation ran ever wilder, some lenders actually allowed borrowers to treat their new-style loans as collateral rather than debt, doubling down in what had now truly become a confidence game. When, belatedly, anxious lenders began to see through the game and require repayment, available collateral was more inadequate and risk of outright bankruptcy was greater.
A lender required to meet a margin call typically sells shares to raise cash, which could drive down the price further, starting a feedback loop that can destroy market value overnight. Panic can be as irrational as exuberance.
By the mid-1990s, warning signs were plain to see, but private investors and public officials alike turned a blind eye to the real character of the confidence game. Ideology reinforced greed and suppressed rational fear.
In his testimony before Congress in 1995, then Federal Reserve Chairman Alan Greenspan, rather than proposing appropriate new regulation, called for eliminating all margin requirements—requirements that capital be held in reserve to cover an unexpected decline in asset value.
“Removal of these financing constraints would promote the safety and soundness of broker-dealers by permitting more financing alternatives and hence more effective liquidity management …. In the case of broker-dealers, the Federal Reserve Board sees no public purpose in being involved in overseeing their securities credit.”
Government saw no reason to prevent even the biggest investors from betting the house. Today, we see real houses collapsing as a result.
War is too important to be left to the generals. The economy is too important to be left to economists like Greenspan. No government rescue of the economy can succeed unless it recognizes how profoundly the new capitalism differs from the old.
The current crisis of confidence is part of a broader crisis of values rooted in how we have come to understand reality itself. Time-tested truths are unraveling, and foundations that long seemed firm are crumbling. In contemporary philosophical terms, money has become virtual, unmoored from the “real” economy. Reality, however, doesn’t simply disappear. It is repressed only temporarily, eventually returning to disrupt what seemed to replace it.
The challenge is to turn this current threat into a long-term opportunity by fashioning new values and new regulations for a world in which realities are constantly changing and securities will never again be secure.
The world Melville imagined more than 150 years ago has become a reality today. In the microcosm of the Fidele, devious con men prey on credulous victims, who no longer know what is real and what is not.
Although the disguises have changed, the game has not. When values-financial, moral and religious-are based on nothing, redemption is impossible. We will not solve our economic problems until we unmask the disingenuous tricksters and reassess values that are not merely financial.
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Mark C. Taylor, chairman of the religion department at Columbia University, is the author of Confidence Games: Money and Markets in a World Without Redemption.
This piece originally appeared in Barron‘s on Monday, November 10, 2008. © Dow Jones & Co. Inc.