Money from Nothing? The Illusion Behind the Magic

by David Korten

The ancient alchemist and modern Wall Street capitalist have much in common. The latter has achieved the modern equivalent of the alchemist's dream of turning cheap metals into gold. He creates money out of absolutely nothing and wholly free from exertion or the inconvenience of producing anything of real value.

Making money with no effort can be an addictive experience. I recall my excitement back in the mid-1960s, when Fran, my wife, and I first made a modest investment in a mutual fund and watched our savings grow magically by hundreds and then thousands of dollars with no effort whatsoever on our part. We got a case of Wall Street fever on what, by current standards, was a tiny scale.

Of course, most of what we call magic is illusion. When the credit collapse pulled back the curtain to expose Wall Street’s secret inner workings, we learned the extent to which Wall Street is a world of deception, misrepresentation, and insider dealing on a breathtaking scale. It was such an ugly picture that Wall Street’s seriously corrupted institutions stopped lending even to each other for the simple reason that no one trusted the other guy’s financial statements.

Much of what Wall Street celebrates as financial innovation involves borrowing to inflate the value of financial assets to create collateral to support more borrowing to further inflate the assets to create more collateral… Whether you call it a loan pyramid or a Ponzi scheme, it is a form of theft.

A responsible Federal Reserve would have raised interest rates to dampen asset bubbles like the tech-stock bubble of the 1990s and housing bubble of the 2000s. Instead, captive to Wall Street interests, it pursued cheap money policies to encourage and facilitate ever more borrowing by speculators to keep the bubbles growing.

Academics who never learned the difference between real wealth and phantom financial wealth published scholarly articles celebrating the discovery of the secret of effortless wealth creation. Back in 1997, I came across an article in Foreign Policy by John Edmunds, then a finance professor at Babson College and the Arthur D. Little School of Management, titled “Securities: The New Wealth Machine”. This is a defining quote:

"Historically, manufacturing, exporting and direct investment produced prosperity through income creation. Wealth was created when a portion of income was diverted from consumption into investment in buildings, machinery and technological change. Societies accumulated wealth slowly over generations. Now many societies, and indeed the entire world, have learned how to create wealth directly. The new approach requires that a state find ways to increase the market value of its stock of productive assets. [Emphasis in the original.] … An economic policy that aims to achieve growth by wealth creation therefore does not attempt to increase the production of goods and services, except as a secondary objective."

The thesis was so absurd that on first reading I thought it must surely be some sort of joke or parody intended to expose the irrationality of the exuberance surrounding the inflation of financial bubbles. In his 2008 book, Bad Money, the journalist and former Republican Party political strategist Kevin Phillips notes the Edmunds article was widely discussed on Wall Street and implies that it may have inspired the securitization of housing mortgages.

Contrary to the Edmunds “logic,” an asset bubble—real estate or otherwise—does not create wealth. A rise in the market price of a house from $200,000 to $400,000 does not make it more functional or comfortable. The real consequence of a real estate bubble is to increase the financial power of those who own property relative to those who do not. Wall Street encouraged homeowners to monetize their market gains with mortgages they lacked the means to repay except by further borrowing. It then converted these toxic mortgages into worthless toxic securities and sold them to the unwary, including the pension funds that many of those who borrowed against their inflated home values counted on for their retirement.

Why do we tolerate Wall Street’s reckless excess and abuse of power? In part, it is because so many people of influence have bought into the Edmunds fallacy. If you have difficulty understanding "economist speak," it may be because you are in touch with reality.

David Korten (livingeconomiesforum.org) is the author of Agenda for a New Economy, The Great Turning: From Empire to Earth Community, and the international best seller When Corporations Rule the World. He is board chair of YES! Magazine and co-chair of the New Economy Working Group. This Agenda for a New Economy blog series is co-sponsored by CSRwire.com and YesMagazine.org based on excerpts from Agenda for a New Economy, 2nd edition.