Making Money with Money is a Recipe for Disaster
A couple of years ago we considered buying a house in the Bay Area. My mortgage adviser explained: “As a non-resident, your interest rate will be slightly higher. I estimate around 6 percent. But the first three years you’ll only be paying 2 percent.”
“Two percent?” I asked in surprise. “What happens to the other 4 percent I’m not paying?”
He continued: “That’s added to the principal and in three years when your house has appreciated in value, we’ll refinance.”
As a businessman, I love an adventure, but this felt like an irresponsible one-way ticket to the Wild West. We didn’t buy the house. But I’ve since learned that millions of Americans have made use of such “opportunities.” The resulting debt bubble is now bursting and dragging the entire world into a financial crisis.
This isn’t the first time an investment bubble has burst. More to the point: Bubbles always do. Investment waves swell explosively until they suddenly crash. And the fall isn’t exactly a rhythmic progression. But past crashes left something valuable in their wake, despite the huge losses suffered by investors. Holland’s 17th-century “tulip mania” left us with a rich variety of beautiful flowers. When the railway investment bubble burst in the 19th century, the iron rails that were laid paved the way for the industrial revolution. More recently, the Internet boom went bust, teaching investors a painful lesson: That they could not continue to expect millions to be paid for every loss-making Internet company. Yet when that investment bubble burst, there was a new digital infrastructure in place that has greatly changed and improved our daily life and the global economy.
Which brings us to the problem with this mortgage bubble: Who has benefited? When the smoke clears and calm has been restored to the financial markets, will anything of sustainable value be left in its wake? I fear not. The American mortgages extended didn’t even lead to substantial growth in U.S. home ownership. The number of Americans currently living in their own home has increased only a few percentage points compared to 10 years ago. That small rise offers no explanation for an explosion in debt estimated to run to a quintillion dollars. No, the largest portion of that debt was consumed by Americans. And all that extra money wasn’t used to start innovative companies or finance interesting future developments like sustainable energy. It was simply eaten up.
At the same time, the creative mortgages that drove millions of people into unnecessary and unproductive indebtedness have become a plaything for the hedge funds and other predators of modern capitalism. These types of investment funds don’t directly invest in new products or services. The money goes into derivative investments that gamble on the development of underlying productive investments. The New York Times recently reported that an arbitrary company offering this type of fund, Paulson & Company (no relation to the Secretary of the Treasury), made 3.6 billion dollars last year by gambling on a decline in the value of mortgage-based products. So that means there are people making money betting that their fellow citizens will be unable to make their mortgage payments. This type of investment undermines society.
People have always gambled and we have special places for that: Casinos. But a stock market is meant to help finance companies. To facilitate productive economic development. Over the past 10 years the financial world seems to have lost sight of that crucial difference.
Goldman Sachs was always referred to as an investment bank. Ten years ago nearly half of its turnover came from financing mergers and flotations, which the corporate sector needs for healthy development. Last year Goldman Sachs reported turnover of $88 billion (profit for the nearly 400 partners: $11.5 billion) and almost 70 percent of that turnover came from “trading” (i.e. hedge funds, derivatives and other “creative financial instruments”) while only 16 percent was from the bank’s purported core activity: corporate financing. Surely this can’t be called an investment bank; it is an enormous gambling club that has created a great deal of economic turbulence.
Goldman Sachs was the uncrowned king of an era that urgently needs to end. Greed lurks behind every investment wave. Investors hope to be the first to make a lot of money on the introduction of a new service or product. But the current crisis is the result of a perverse type of investment: Making money with money. Ultimately, no one is the better for it.
If Steve Jobs makes a fortune selling Apple’s iPod, it may be considered excessive, but a whole lot of people are experiencing pleasure thanks to the invention. And one might question whether a professional football player should earn millions but masses of people enjoy his passes and touchdowns. There are millionaires and even billionaires we can be proud of. But in the past 10 years many fortunes have been made through debt creation via “creative” mortgages and mathematical programs and products that are incomprehensible to the average consumer. Not only the brightest business school graduates but even middle managers earned salaries into the millions without making a tangible contribution to the economy. Who can be proud of this type of millionaire? Worse still: In many cases these gambling troublemakers often hampered the efforts of real businesspeople and ordinary companies. There are many examples of companies that worked for generations only to have their efforts quickly destroyed by the activities of hedge funds.
There’s no point in closing the stable door after the horse has bolted. Undoubtedly, new regulations will be drawn up to prevent comparable excesses in future. But aside from better supervision and more rules, the most important outcome may be that the financial world will be forced to return to its core business: Supporting and facilitating the business sector in the interest of economic development that serves society. Making money with products and services is healthy. Making money with money is a recipe for disaster.
Jurriaan Kamp is the founder and editor of Ode Magazine, the magazine for intelligent optimists.