‘Extreme money could only beget a financial crisis’

The world is paying the price for losing sight of what money should be, a medium of exchange and a store of value, feels Satyajit Das. Instead, money has become akin to candy floss, full of air, which is driving growth and prices of financial assets, he writes in his latest book, Extreme Money. Yet, in trying to solve the problem, we are resorting to the printing presses, which is an older form of the same extreme money, the renowned author tells DNA in an email interview. Excerpts:

What made you write Extreme Money?
There have been a lot of books about the ‘global financial crisis’. I didn’t want to write another book on the crisis. There was already too much ‘crunch porn’ available.

I wanted to write a history of modern finance — how, since the demise of the post-war financial arrangements agreed at Bretton Woods in the early 1970s, the world had become ‘financialised’. I wanted to record the rise of debt and speculation — why and how that happened — from the viewpoint of an insider.

Most books about finance are written by journalists and academics and lack an intimate inside view. I wanted to offer a different perspective on this time, which is very interesting and now obviously very problematic. I wanted ordinary people to understand what happened and how this story may end.

What is ‘extreme money’?
Money is simply a medium of exchange and a store of value. Somehow, we lost sight of that. In modern economies, money moved from facilitating business and activity to driving everything.

Gillian Tett (Financial Times) called it candy floss money — which is spun sugar, consisting mostly of air. Financial engineering spun real money, expanding it into ever-larger servings —- candy floss money — which drove growth and prices of financial assets.

This is ‘extreme money’. Financiers invented astonishing games to spin this money and create a strange Ponzi prosperity out of it. Of course, in trying to solve the problem, we are resorting to an older form of extreme money — the printing presses. How that can possibly help is beyond my comprehension.

Archimedes said, “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.” You paraphrase it to write “give me enough debt and I shall make you all the money in the world”. Can you elaborate?
They say that as you get older, you come to understand the inherent disappointment of life. I guess in writing the book, I came to see that most financial engineering is based on increasing the level of debt and borrowing.

Private equity or leveraged buyouts, securitisation, derivatives and hedge funds — they all rely on increasing debt to try to boost returns.

What happened was that the flood of candy floss money, this wall of liquidity which was synthetically manufactured, came to drive the price of almost everything in the world in the last 20 or so years. Values of real estate, shares, commodities, even art works, came to driven by the amount that you could borrow.

Leverage enhances returns in percentage terms, but it works for both increases and decreases in the value of what is purchased. As the borrowing must be repaid in full with interest, leverage increases the risk of loss. People didn’t ever look at the downside risk.

You quote a director of Jardine Fleming as saying “giving liquidity to bankers is like giving a barrel to a drunk. You know exactly what is going to happen. You just don’t know which wall he is going to choose.” What does this mean in the context of the crisis?
The point is that the vast liquidity that was driving finance and economics was simply unsustainable. It was always going to end badly.

In small amounts, debt is useful. But we went well beyond that. People simply forgot that you are dependent on what the investment produces to pay interest and pay back the debt. You also need the asset to hold its value. A good example was the US housing market where people assumed that house prices can not only not decrease but will keep rising at 10-20% per annum.

I don’t think any of us really knew what would trigger it and how the massive debt bubble would unwind, but we knew it would.

The funny thing is people still don’t seem to get it. In Europe, leaders don’t seem to understand that some countries have more debt than they can service or pay back. Their plan to resolve the European debt crisis is simply to find new lenders and shuffle debt backwards and forwards.

You write, “In their song Once in a Lifetime... David Byrne and The Talking Heads asked the question of the times: 'How did you get that large automobile, the beautiful house, and the gorgeous wife?'” What’s this got to do with the financial crisis?
I think that in their song Once in a Lifetime, named one of the 100 most important American musical works of the 20th century by National Public Radio, David Byrne and The Talking Heads asked the question of the times: How did you get that large automobile, the beautiful house, and the gorgeous wife? How did you get here?

The answer was that ordinary people in many countries borrowed the money from people who thought you could pay it back.

Debt-fuelled consumption became the norm. Debt (once a source of shame) became an essential part of the modern lifestyle. Credit cards took “the waiting out of wanting.” Even the wealthy turned to debt, borrowing against assets to increase returns, making risky investments such as private equity and hedge funds. By 2007, the richest 5% in the United States were $1.67 trillion in debt, an increase of around 400% since 1989.

Interestingly, another Byrne — Rhonda Byrne, an Australian writer named by Time in its list of 100 people who shape the world — captured this new-age financial spirituality in her self-help work, The Secret. “There is truth deep down inside of you that has been waiting for you to discover it, and that truth is this: you deserve all good things life has to offer. You know that inherently, because you feel awful when you are experiencing the lack of good things. All good things are your birthright!”

People everywhere — individually and collectively — embraced this unique view of reality. We embraced financial engineering as it promised economic growth and ever increasing prosperity and higher living standard. Of course, we now have to pay the bill for all that and can’t.

Businesses have become rapidly financialised over the last 25-30 years. As you write in the book, “financialisation of industry quickly spawned jokes: “how many workers does it take for Toyota to make a motor car? Answer: four. One to design. One to build it, and two to trade the long bond.” How did this contribute to the financial crisis?
There are several aspects to this. Businesses changed and used financial tricks to show higher earnings. Enron and Worldcom were just the end of that road and the most extreme end of accounting and financial manipulation. But most firms now routinely engage in financial dealings to enhance profitability.

You can improve the real business. Business improvements are risky and very slow, akin to watching grass grow. Financial changes are easier, more predictable and, most important, quicker. Financial engineering — trading in financial products, reducing the amount of capital used by the business, decreasing the cost of that capital — replaced real engineering. Corporations now restructure constantly, acquiring and disposing of assets and companies.

Facing pressure from investors for quick tangible results, corporate managers and boards resorted to financialisation. Peter Drucker identified the reason: “Dealmaking beats working, dealmaking is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work… Dealmaking is romantic, sexy. That’s why you have deals that make no sense.”

These changes in business have a wider implication. True, growth comes from industrial innovation, new products and services, new markets. We came to believe by shuffling paper around, you could create wealth and profits. This became a deep-seated belief of society. Rather than making things, trained engineers joined banks to provide turbo-charged financial structures for companies.

Why do only skilled insiders get richer, running and rigging the financial game?
Few, self-interested industry participants are prepared to admit the unpalatable reality that much of what passes for financial innovation is specifically designed to conceal risk or leverage, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits.

The cement maker doesn’t know much about derivatives or complex financial products. Interestingly, neither do most professional fund managers. Knowledge is generally inversely related to complexity of the product they are buying.

So, skilled insiders who run the game do well. Until regulators and legislators understand and are prepared to address the central issues, no meaningful reform in the control of financial products will be possible.

You write that like Henry Ford, bankers are good at mass production, quickly adopting and developing a successful product. What do you mean by that in the context of the financial crisis?
Most financial innovations start off being useful. But bankers push the limits aggressively both in terms of volumes and complexity.

Securitisation is a good example. What is basically a sensible process to repackage loans and distribute risk better became totally debauched, in the end destroying a successful product. The capability to repackage all kinds of debt into highly rated securities that investors sought allowed the expansion of debt levels to reach epic proportions.

The reason is interesting. People set up this vast and expensive infrastructure to originate, structure and trade securitised debt. To feed this machine, they needed more loans — so they kept lowering lending standards until you made loans to ‘ham sandwiches’. This contributed to both the build-up in absolute levels of debt and also the deterioration in the quality of the loans.

It also contributed to the complexity of the linkages between participants. It ended up in the rating agencies rating structures using erroneous assumptions and poor models. That’s how industrialisation of debt contributed to the financial crisis.

In the chapter titled ‘False Gods, Fake Prophecies’, you write, “The professors may have been after some elusive truth but ended up as piano players in the whorehouse.” Can you elaborate?
Fundamentalism underlies modern finance and economics. We understood very little but needed to wrap things in this complex jargon and dense mathematics, all built on falsities and erroneous assumptions. It was the liturgy that gave a certain legitimacy to this new world.

The age of capital elevated economic theory to the status of an all-powerful religion. The central belief was the ability to create continuous growth and improved living standards, without destructive ‘boom-bust’ economic cycles. Policy makers and economists would achieve these outcomes by adjusting the economic flight controls. Finance, investment and risk were all defined to 16 decimal points and entirely comprehensible and under control.

Camouflaged as a ‘science’, the system was actually political ideology focussed on the role of markets and governments in economies. It was a mirage, a fata morgana: poetic crap, in short.

The world was not structured, comprehensible or controllable. Theories were narrative fallacies where unconnected data was rearranged into a plausible story after the fact to give it an identifiable explanation.

Academics may have believed in the pursuit of pure knowledge. Unfortunately, or may be fortunately, financiers were after more earthly gains. In business to manufacture financial products and sell them to clients for profit, financiers were oblivious to the theoretical nuances and debates. Theory and practice have always been occasional bedfellows on Wall Street. Financiers borrow and steal whatever bits and pieces of any cosmological theory and Sufi philosophy within reach.

The smart academics realised that their work was just “fluff” designed to justify certain things, which would happen anyway.

They were in that sense piano players in the whorehouse. The smart ones logically cut themselves a share of the action by working for investment banks or going into business for themselves. As Confucius observed: “The superior man understands what is right; the inferior man understands what will sell.”

As the financial crisis started to unveil itself, hedge funds lost big money. You write, “Hedge funds tried to calm investors’ anxiety and anger with literary gems.” Can you explain?
Investment genius is always little more than a short memory and a rising market. Hedge funds were masters of the universe. But when the problems started, their explanations for why they were losing money were priceless.

Griffin’s Citadel Funds, which lost $8 billion and was down 55%, said: “We did not foresee the financial disaster that was to unfold in September.”

Another moaned: “It is emotionally and financially draining that after eight solid years the fund should be so damaged by the failed global monetary system.”

Oaktree took a different tone: “We’re grabbing at falling knives…. We consider it our job to catch falling knives — in a careful, skillful manner.”

Another fund blamed regulators: “The next time anyone tells you, as the geniuses who run our financial system have done, that the ever rising prices of homes should be counted in savings, you should lean close to his/her ear and scream: IDIOT!” It seems everybody other than themselves was to blame.

I think the title of an article on hedge funds got it right: “Gaming the system: are hedge fund managers talented, or just good at fooling investors?”

Is the world learning the lessons of extreme money?
While it’s too early to tell, I think nobody has learned anything really.

We haven’t begun to reduce debt. What happened is that the private sector just passed on the debt to the public sector that is now experiencing serious solvency issues. It would not surprise me to see a series of major sovereign debt restructurings in the near future. We haven’t admitted that we cannot really control the economic machine, insisting instead that we can build better models and systems. We still believe that we can quantify and control risk.

Sadly, I think financialisation, debt and speculation are deeply entrenched in our economic, social and financial fabric. It is going to be very difficult to work our way out of this mess.

Didn’t Hegel observe that the only lesson of history is that no one learns the lessons of history?