Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism
by Kevin Phillips
Getting It Wrong
A review by Robert M. Solow
Turmoil in the financial market and insecurity in the labor market -- we have plenty of both -- bring out good and bad books, like good and bad mushrooms after a rain. In the instance before us it is the financial market that is in turmoil, and this is definitely not a good book. The only nice thing I can say about Bad Money is that taking critical aim at our complex, overblown, and now evidently dangerous financial system is a fine idea. The trouble is that Kevin Phillips stays throughout at the superficial level of Chicken Little. Terrible things are happening, and will continue to happen; but despite a certain pretentious hinting at deeper understanding and a few loose references to historical parallels, there is nothing very enlightening to be found in these pages.
I will begin with a trivial but symbolic example: the title of the book. It comes from a common description of Gresham's Law, quoted opposite the title page: "Bad money drives out good money." Gresham's Law had a precise meaning in context. When money consisted of the circulation of metal coins, their intrinsic value was tied to the market value of the gold or silver or copper that they actually contained. (If a one-shekel coin contained less than a shekel's worth of silver, no one would bring silver to the mint; if the coin contained more, anyone with a fire and a pot could profit by melting it down.) Kings would occasionally cheat by minting underweight coins, and other crooks might shave a little metal off the coins that passed through their hands.
A knowledgeable person who had both full-weight, or good, coins and underweight, or bad, coins in his pocket would naturally use the bad coins in any transaction, if he could get away with it, and hang on to the good coins. Thus bad money would be found in circulation and good money in hoards. That is what Gresham meant by bad money driving out good money (that is, out of circulation). But none of this has anything to do with the contents of Phillips's book, not even metaphorically. He is entitled to call his book by any name he likes, of course; but the unexplained reference to Gresham's Law functions only as an unearned claim to arcane knowledge.
Later in his book Phillips says something different. Money is "bad," he maintains, when "a leading world economic power passing its zenith...lets itself luxuriate in finance at the expense of harvesting, manufacturing, or transporting things." This tends to lead to "runaway public and private debt, gross speculative biases, tenfold and twentyfold leveraged gambling, unchecked and barely regulated 'product' innovation, and a tendency toward periodic panics and instability" -- not to mention "bring[ing] the weakness of human nature to the fore." I also believe that the financial system has become too big and too opaque for the good of the economy that it is supposed to finance, and that it is by now at the margin more trouble than it is worth. But that characteristically overwritten passage, apart from having nothing to do with Gresham's Law, is merely an attempt to make adjectives sound like analysis.
Phillips points out, several times, that the financial services industry in the United States now originates a little more than 20 percent of GDP, as compared with about 12 percent for manufacturing. He thinks that this is way too large a share to be healthy, and that it suggests an economy excessively devoted to peddling complicated pieces of paper instead of producing real stuff. (Finance accounts for only 10 percent of GDP in Britain, by contrast, despite London's status as a financial center.) How would one know what the right size of the financial sector might be? A country might legitimately specialize in finance and sell its services to others, just as it might specialize in computer hardware or software. So big is not necessarily bad. But there is no discussion in Phillips's book of any constructive function that a right-sized financial sector would perform, so that the reader might be able to understand just how much is too much.
Every elementary economics textbook explains to the beginning student that a financial system is intended to perform two important functions in a modern economy. Somehow a nation's savings has to finance its investments in housing, industrial and commercial buildings and machinery, computers, inventories, and so on. The saving is done by a very large number of households and institutions, ranging from very small to very big. The investment is done by a smaller -- but still huge -- number of mostly medium-to-large business firms. The first function of the financial system is to "intermediate" in this process: to collect the savings in many forms -- bank accounts, mutual funds, insurance-company reserves, direct purchases of stocks -- and to allocate it to the firms and other entities that seem to have the most profitable ways to use it to build real capital. The financial sector, needless to say, collects a fee for this service: it pays savers less than it charges investors. (I omit international flows of saving and investment, as well as the financing of local, state, and national governments. The financial sector intermediates here, too.)
The investment decisions of businesses have uncertain outcomes. The businesses themselves cannot know how their long-lived investments will eventually turn out; and the ultimate savers know even less. And investment decisions generate real risks, as we are all now painfully aware. So do most other transactions intermediated by the financial system, though the risks may be tied only tenuously to the production and the distribution of goods and services. And so the second function of the financial sector is to arrange transactions that shift the bearing of commercial risks from those who are prepared to pay a fee to get rid of them to those who are less averse to risk and are willing to take them on in exchange for a fee. This is a complicated business, more or less by definition. It is full of surprises. Even the basic underlying risks are complicated, and reasonable people -- let alone the unreasonable ones -- may evaluate them very differently. The risks generated within the financial sector are even more complicated, more psychological, more open to manipulation, and harder to understand and value than those that arise from "real" events.
In addition to deploring the excesses of the financial system, it is worth noticing also that it often performs useful functions. Businesses finance a substantial fraction of their fixed investment from their own saved profits; but the capital markets do allocate the rest, maybe about half, just as the textbooks say. To take another example, the securitization of home mortgages, despite its obvious potential for toxicity, undoubtedly expanded the supply of capital to the mortgage market and reduced the cost of home ownership. The same financial innovation also permitted or encouraged the selling of some mortgages to predictably unqualified borrowers.
Could we redesign the mechanism to achieve most of the benefits of a broader supply of mortgage capital while sharply limiting the scope for predation and instability? This question calls for serious thought; but serious thought is not on Phillips's agenda. Still, it is worth noting -- and this is his sort of thing -- that when the Federal Reserve recently proposed some fairly anodyne improvements in the regulation of mortgage lending, the industry instantly opposed them as incipient socialism, and claimed implausibly that even the smallest regulatory safeguards would dry up the supply of loans.
Phillips's focus on the size of the financial sector is not wholly misplaced. Everyone must have noticed that the total sums at risk in the markets for complex derivatives are enormous compared even with the $14 trillion size of the national economy itself. In addition to financing and allocating the uncertainties that arise inevitably out of production and consumption decisions, modern financial engineering creates unlimited opportunities for bets that are only remotely related to productive activity, if at all. A can bet B that C will be unable to meet its obligation to pay D. (A may then try to manipulate the odds by spreading rumors about C's financial condition.)
Should the rest of us care if A and B want to gamble their fool heads off, whether on credit-default swaps or basketball games? If these were private arrangements between consenting (and rich) adults, one might say that it's their business and nobody else's. But in the world as it is, A and B seek leverage -- that is, they borrow from banks and others so that they can bet larger amounts than their own private capital would permit. Even a small return on the leveraged bet amounts to a large return on equity. And once the banking system is involved in a big way -- owning, and holding as collateral, assets whose likely value is hard to understand and impossible to calculate -- then we are all at risk.
For this reason, if things start to unravel, as in the case of securitized sub-prime mortgages, the whole credit mechanism can freeze up. Banks that do not understand their own balance sheets can hardly expect to understand the balance sheets of potential borrowers. The system can be so paralyzed as it unwinds those leveraged losses that it is unable to perform the financing of "real" economic activity that constitutes its redeeming social value.
The size and the complexity of the financial sector has other consequences, too. It is worth repeating that the most important consequence is the one just mentioned: the danger to the viability of the whole credit mechanism, including the plain-vanilla part that merely finances real capital formation. And since the total volume of bets, and bets on bets, can vastly exceed the amount of underlying "real" activity, and since the fees of those who manage and direct this activity are (roughly) proportional to the gross volume of assets they manage or direct, the hedge-fund operators and others may earn perfectly enormous incomes. (Margaret Blair of the Brookings Institution was one of the first to point this out.) If they are clever enough, and they are, they can arrange their compensation packages so that they batten on profits and are shielded from losses.
Moreover -- and this is definitely on Phillips's radar -- the fact that big-time financial operators make so much money, and spread enough of it around, gives them a lot of political clout with both parties. That is one reason why it will be so difficult to reform the system of financial regulation so as to provide adequate protection for the capital market as it goes about its useful functions. The same fact may also be part of the answer to the churchmouse's question: why does anyone who already has a billion dollars need a second billion? A bigger private jet attracts bigger birds.
Even the better parts of Phillips's book fail to give a serious account of what has happened in the capital market and the channels through which it affects the modern economy. And those parts are interspersed with passages of surpassing ignorance. One chapter is largely given over to an attack on the integrity -- not the accuracy but the integrity -- of the consumer price index. This would be scurrilous if it were not so silly. Phillips does not seem to understand what a consumer price index is. There is a graph showing that between 2000 and 2006 house prices (which are not included in the CPI) rose much faster than "owners equivalent rent" (which is). This is supposed to demonstrate that the Bureau of Labor Statistics was deliberately suppressing the bad news that ongoing inflation was really much faster than reported.
But asset prices do not belong in a consumer price index. Neither do house prices or land prices or stock prices. If I buy a house today, it would be senseless to count its whole cost as part of my consumption expenditure this year. In fact, at about the same time there was much talk, inside and outside the government, of "asset-price inflation" as something distinct from "goods-price inflation" and what should and might be done about it. The fact that house prices were rising faster than rents was quite analogous to a rise in the familiar price-earnings ratio for common stocks.
This is not the only such category mistake in the book. Phillips criticizes National Income and Product Accounts because they do not prominently display figures on the sharply rising volume of private debt. But this lapse is owed to the fact that the National Income and Product Accounts are about, well, national income and product. They are more like an income statement, and certainly not like a balance sheet. There is no reason, of course, why the Department of Commerce should not inform interested citizens about the standing volume of debt, but there is also no reason why the absence of those figures from the accounts should be treated as a dark conspiracy against the public. The debt figures are readily available in other government documents.
Phillips's discussion of "peak oil" is a little better, partly because there are fewer complications to juggle, and partly because he has a point. But it, too, is a little long on foreboding and a little short on clear thinking. "Peak oil" is the catchphrase for the belief that the world's annual production of crude oil has recently reached, or soon will reach, its practical maximum, to be followed by a gradual decline as the best underground reservoirs are depleted. (Production in the "lower forty-eight" U.S. states appears to have peaked in the 1970s.) There are experts on both sides of this technical issue, whose outcome has to depend on what will eventually be found in as-yet-unexplored or poorly explored regions of the world. But it is a convenient hook on which to hang geopolitical drama, and Phillips uses it as such.
Peak oil or no peak oil, the supply-demand balance in the world oil market is clearly shifting: world demand is increasing faster than world supply or availability. That is what really matters. The current run-up in price may contain a little speculative froth and some monopolistic maneuvers, but hardly anyone doubts that it reflects a long-term trend in relative scarcity, which is driven primarily by the fast-growing oil-importing economies of Asia (and by the inelasticity of supply). The limit to this trend probably depends more on the timing and the extent of the ultimate availability of alternative (non-oil) sources of energy than on either new discoveries of oil or on induced reductions of demand.
We know how a textbook market economy would allocate scarce supplies of oil. The price would rise to squeeze out the less productive uses of oil until the still-viable demands more or less matched the available supply at that price. The oil would go to those buyers, wherever they were, who could pay the high price and still turn a profit in their own business. Phillips points out that the oil market is not like that now and probably never was. He says that 75 to 80 percent of known reserves are controlled by state-owned national oil companies, in the Middle East, Africa, and elsewhere. These state enterprises are interested in making money. (It would be nice if they all wanted the money to further the economic development of their own countries.) But they exist to serve geopolitical interests as well, and this changes the game. In this world, access to oil is not simply a question of willingness to pay the world price; there is also the small matter of which side you are on.
Phillips has no trouble making the case that American foreign policy -- especially, but not only, regarding the Iraq war -- has been a costly mistake that will come home to roost in the coming struggle for access to oil. (He also insists that the main purpose of the Iraq war was control of Iraq's oil, but that this will backfire. He could have adapted the cliche: when they say it's not about the oil, it's about the oil.) And he makes much of scattered press reports that China systematically sews up oil deals in Africa, Iran, and elsewhere by linking them to sales of up-to-date military equipment. In the oil-scarce future, in other words, competition for access will be as much geopolitical as economic, and the odds are against the United States, with or without adventurism.
Then -- this is a book about bad money, after all -- Phillips turns to the dollar, and a certain amount of confusion descends. Some of it rests on the almost universal bad habit of treating the high exchange value of the dollar -- a "strong" dollar -- as a matter of national pride. "Defending" the dollar sounds a lot like defending Old Glory. Too many secretaries of the treasury, some of whom must have known better, have adopted that mantra, though they have usually refrained from acting on it. Phillips seems to share this error. At one point he describes China's accumulation of foreign-currency reserves, mostly dollars, as giving it "the wherewithal to defend [its] own currency." In a way, exactly the opposite is true: China acquired the dollars in order to "anti-defend" its currency, that is, to prevent its exchange value from rising; and those same treasury secretaries have been urging the Chinese to allow the renminbi (RMB) to strengthen, which is to say, to allow the dollar to weaken against the RMB. The weaker dollar of recent years has promoted the exports that have lately been keeping the American economy afloat. This is all about exports and imports, not about the rockets' red glare.
The foreign-exchange value of the dollar and the world oil market are indeed connected; there is no doubt about that. First and foremost, large American imports of very high-priced oil are a major factor in the large negative trade balance of the United States, currently about 5 percent of GDP. The rest of the world, especially oil exporters, must continue to acquire dollar assets in order to keep selling more than they buy. (This is the origin of those enormous sovereign wealth funds, almost all of which belong to oil-producing countries.) Phillips is right that, if any economic or geopolitical turn of events were to induce foreign government agencies suddenly to dump their dollar assets in favor of something else, the resulting capital-market and currency disorder would spell trouble for the United States. But it would also spell trouble for them. Foreign governments, including China, own all those dollar assets because doing so is seen to be in their self-interest, not ours. The nagging fear, as Phillips recognizes, is that sovereign motivations extend beyond the narrowly economic: the possibility of geopolitical blackmail, implicit as well as explicit, is not far-fetched. The trouble is, that seems to be all he sees. He misses the complexity.
The other oil-dollar connection comes from the fact that, by informal agreement of long ago, the price of oil is quoted by OPEC in dollars. This has consequences: if the dollar depreciates, as it has done, and nothing else happens, oil exporters find that they are inadvertently selling their oil for less purchasing power. A barrel is worth x dollars, and a dollar buys less goods in general, particularly goods produced outside the United States. In fact, buyers who have euros or yen find that the euro price or yen price of oil has fallen, because a euro or a yen buys more dollars. Naturally, then, the dollar price of oil will rise, as everyone has noticed. (So will the dollar price of many less conspicuous goods, for exactly the same reason.) This is not as big a deal as it may seem. If the price of oil were fixed in euros, as could come to be the case, then a depreciation of the dollar would bring no change in the euro price of oil. But the dollar price would still rise, because it now takes more dollars to buy one euro.
Phillips, however, goes on and on about this matter, because he identifies the role of the dollar as being some sort of index of American masculinity. The United States certainly does gain something from this convention, and it gains even more from the large holdings of dollars in the currency reserves of most countries. The gain may not be negligible, but it is not a major factor. U.S.-based banks probably do more business, and make more profit, than they otherwise would. And the net increase in the world's need to hold dollars functions something like a low-interest loan to the American economy. But if OPEC were to price its oil in terms of some basket of major currencies, which would make sense, nearly all of us would sleep just as well at night.
Phillips's last chapter, grandiosely titled "The Global Crisis of American Capitalism," begins with a burst of overblown prose:
Looking back a decade, we can now understand that a perverse incarnation of millennial utopianism crested in a form that critics have since labeled "market triumphalism" -- the belief that history was "ending" because near perfection had been achieved through the enthronement of English-speaking democratic capitalism. Smugness paraded across a bipartisan spectrum....To believers, the all-knowing, allcomprehending market hailed by initiates had always been incipient, always evolving toward some ultimate moment when the Dow Jones Industrial Average would cross 10,000 and breathless quantitative strategists at Morgan Stanley (or wherever) would imagine the first synthetic collateralized debt obligation. Millennial utopianism was happy to oblige.
There is, alas, more of such writing. Phillips thinks that this hubristic madness is handing the world economy over from America (and Europe?) to Asia, with incalculable consequences. A more sober view would recognize that the United States could not hope forever to grow faster than the large Asian economies (or eventually others). There is no evidence that God ever intended the United States of America to have a higher per capita income than the rest of the world for eternity. It is true that our failure properly to regulate modern financial engineering, together with the pursuit of a thoughtless and reckless foreign policy, has damaged our economy and weakened our position in the world. Phillips deserves some credit for banging away at this point. It is too bad that he has no taste for genuine analysis.
Robert M. Solow is Institute Professor of Economics emeritus at MIT. He won the Nobel Prize in Economics in 1987.
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