This blog provides politically motivated analysis of the nature of corruption in the American economic system. If we first endeavor to understand our nation's structural flaws, then we will be better able to correct or compensate for those flaws.

Wednesday, August 23, 2006

How Our Financial Markets Really Work

-Millions of investors buy into the technology bubble on the bad advice of analysts, then lose most of their savings.
-Employees spend their adult lives working for a corporation, only to watch their pension plans crumble in size and significance.
-Mutual funds let outside investors steal from their customers for a share of the loot.
-Hedge funds collect massive fees for months or years, then shut down overnight leaving investors with their capital in tatters.
-Borrowers are encouraged to take on more debt, then get squeezed into bankruptcy by rising rates.
-Loyal employees face layoffs when private equity firms take over a company and extract every penny and ounce of worth that they can find.

These and related stories occur everyday and are part of a severely corrupted financial system that is destroying the wealth of most Americans and the strength of the US economy. The mainstream media and industry experts are always quick to express outrage when incidents like these occur, acting as though the perpetrators are isolated cases and the crimes are not likely to be repeated. But observe the industry long enough and you'll find that corrupt acts occur regularly and throughout the financial system.

This entry describes many of the corrupting features of the American financial system and attempts to give a framework for understanding why corruption is so widespread and damaging. Understanding the systemic flaws is a first step toward protecting oneself and bringing about systemic change.

The Primary Function of the Markets
In the fairy tale world of capitalistic, free-market economies, the financial markets provide for the efficient allocation of capital. In the real world of corruptialistic, rigged-market economies, the financial markets provide for the efficient transfer of wealth from the working and investing masses to people in positions of power. There is enough productive capacity in the American financial system to sustain the popular myths in media, government and corporate circles, but corruption in the system is extreme and greatly undermines the economic security of the nation.

A Culture of Greed
A misplaced faith in the efficiency of the capital markets allows many to believe that their own corrupt actions are acceptable or even beneficial in a capitalistic economy. The myth states that a multitude of individual players, all acting in their own best interests drives a system toward accurate pricing and efficient use of capital. The reality is that good people are often corrupted by positions of power and learn to rationalize fraud, theft and waste in ways that pad their own pockets at the expense of others.

A culture of greed within financial institutions and in the executive offices of major corporations, creates an environment where bottom line results are what matters most, and how those results are achieved is secondary. While most high powered executives, brokers and traders don't see themselves as being corrupt or doing direct damage to the economy, the actions they take to further their careers and the interests of their employers are often very destructive.

Conflicts of Interest
When investment banks made most of their profits by underwriting stock and bond offerings, their analysts often faced pressure to pitch these securities to unsuspecting investors and money managers faced pressure to fill up client accounts with the same securities. This conflict of interest was widely abused during the technology bubble and exposed after it burst. Now investment banks make most of their profits by financing, investing in, and trading with hedge funds. Pressures within these banks now push analysts and money managers to support the new profit engines with conflicted advice and unscrupulous actions.

Short-Term Gain vs. Long-term Risk
A dominant feature of the American corrupitalistic system in recent years has been the shameless pursuit of short term objectives at the expense of long term success. Risk vs. reward is a standard equation in most business decisions, and taking on greater amounts of risk will typically offer higher rewards over the short term. Our financial system is structured so that managers are most often compensated based on short term performance measures and this encourages them to take on high levels of risk with investor capital.

On a national level the pursuit of short term rewards has led the country to bury itself hopelessly under a mountain of debt and impossible promises. On a corporate level it has resulted in the decreasing competitiveness of American industry. Politicians seek reelection and executives seek to boost their annual bonuses, but neither group has the long term interests of their constituents at heart.

Creative Accounting
Accounting rules allow a large amount of assumption and estimation when it comes to determining a company's bottom line. Creative accounting is a term to describe the way executives bend and twist the numbers to arrive at the results that meet their personal objectives. It takes place in industry as well as government with the result that nobody can really trust the quarterly and annual results presented in press releases. Worldcom went bankrupt after it was exposed for overstating profits by roughly $2 billion. The federal deficit numbers touted by the President are hundreds of billions of dollars less than the true deficit each year. Auditors are generally hired by the executives being audited, so the conflict of interests prevents truly independent accounting.

Corporate Governance
Shareholders of publicly traded companies generally do not have a valid say in how the companies are run. Executives choose their own slate of directors to watch over them and shareholders don't have any real choice in the voting. Shareholder proposals are regularly blocked from inclusion on voting proxies with the approval of the Securities and Exchange Commission. Indeed, the SEC's stated objective is to protect "shareholder confidence" rather then to actually protect shareholders. That way the people in positions of power are free to go on taking advantage of clueless investors.

Other People's Money
With Capitalism, money (capital) is the major source of power. People who own the companies decide how they are run. With Corrupitalism most of the owners of capital have entrusted it to money managers who use it to promote their own interests. Fund managers are compensated based on short term performance. There is little incentive to seek out management teams that run companies are pursuing sound, long-term goals. Meanwhile there is a strong incentive to invest in hot performers rather than sound values. Many companies run up debt by issuing corporate bonds and then using the money to repurchase stock. While this boosts the short term performance of a company's shares, it sets the stage for a complete collapse down the road. Pension fund, mutual fund and hedge fund managers together control most of the nation's wealth and their short-sighted vision becomes the nation's short-sighted vision.

Hedge Funds
Hedge funds can take the abuses of the mutual fund world to a much higher level. The standard hedge fund compensation scheme greatly rewards short-term performance with no penalty for long term failure, which encourages managers to take high levels of risk. Hedge funds are able to greatly magnify that risk by borrowing vast sums to increase the leverage of their investments. The tremendous quantity of money borrowed into existence by hedge funds has helped fuel inflationary pressures and has subjected the entire economy to great risks. When Long Term Capital Management got in trouble the Fed organized a bailout because it threatened to unwind over $100 Billion in loans and default on a good portion of them. That would have caused a substantial shock to the economy. Now the amount of money borrowed by hedge funds is in the trillions causing even greater economic distortions and posing far greater risks for the economy.

Wall Street
Executives of the big Wall Street institutions run the financial system to suit their own interests. They finance major political campaigns at early stages and determine who has a chance to be elected. They fund companies and industries in a manner that creates booms and busts within those industries, enriching executives while shareholders get fleeced. Wall Street firms typically let the masses of investors place their bets on whatever is the hot trend of the day, then they take the opposite side of those trades and influence the markets and news to make sure that the masses end up losing on those bets. Perhaps most importantly, Wall St. has a direct line to the Fed and every morning sends signals on interest rates that help ensure that their largest bets end up being the correct ones.

The Fed
The Federal Reserve System's goals are not to maintain full employment or contain inflation as stated in official literature. The Federal Reserve is a system of banks that promotes the narrow, short-term interests of bankers. It was established in 1913 and since then the economy has had a long period of inflation with economic booms and busts every few years. The government appoints many of the Fed's governors, but because Wall Street bankers have significant control over the political process, political appointments always serve the interests of Wall Street banks.

The Boom and Bust Cycle
Creating steady growth and preserving economic stability are not difficult objectives for policy makers to accomplish. However, we have had a destructive and endless cycle of economic booms and busts because they facilitate the transfer of wealth from the masses to the rich, powerful and well positioned.

In boom times, credit expands rapidly. Bankers create money out of thin air and loan it out to businesses, generating profits off of the interest income. Banking profits are highest when credit is strong and bankers are allowed to maximize their leverage and risk. The problem with this (from a bankers perspective) is that eventually just about everyone in the economy starts to benefit from the expanding credit and inflation and competition for scarce goods begin cutting into the benefits of being wealthy.

During economic busts, credit, jobs and cash are hard to come by. Businesses and individuals become insolvent and are forced to transfer their assets to their creditors. Well positioned wealthy individuals and bankers benefit by being able to acquire assets and goods when prices are depressed. They do not suffer from a bust because they have enough cash to weather the storm. When the next boom begins, they'll be ready to ride the next wave of asset appreciation.

Complexity and Waste
The American Financial system is complex and the prevailing myth is that this complexity provides security and strength. In truth the complexity is wasteful and provides cover for fraudulent activities. If investment options were simple, and markets were efficient, then investors wouldn't need or seek help from financial advisors, but fear of losses drives the masses of investors toward professional portfolio managers, who are likely to abuse their position in managing other people's money. The derivatives markets have been championed as a way of reducing risk, but in truth they've added far more systemic risk to the marketplace, by ensuring that all sectors will be hit at the same time in a downturn. These markets are complex by design, allowing firms to use creative accounting to book profits on opposing sides of trade to meet short-term profit objectives while increasing long-term risk.

Systemic Reform
To bring effective reform to the financial system we must address the corrupting factors I've described above. Conflicts of interest should be eliminated and transparency and simplicity restored. Failure to do so will lead to a further deterioration in America's economic competitiveness. Perhaps it will take an economic meltdown on the order of the great depression to get enough people behind a movement for change, but I believe change will eventually come as the word continues to spread. Until then, keep learning and spreading the message so that you can protect yourself from the financial system and prevent it from stealing the wealth of the people you care about most.

Saturday, July 22, 2006

The Militaryindustrial Complex and the Bankruptcy of the Nation

"In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the militaryindustrial complex...
We must never let the weight of this combination endanger our liberties or democratic processes. We should take nothing for granted. Only an alert and knowledgeable citizenry can compel the proper meshing of the huge industrial and military machinery of defense with our peaceful methods and goals, so that security and liberty may prosper together."

-from President Dwight D. Eisenhower's farewell speech

As corporate influence in American politics has grown, the political power of the militaryindustrial complex has grown. Policy and spending decisions have increasingly benefited the the defense industry to the detriment of American citizens. Every year we spend far more on our military than is needed or practical. Industry lobbyists also help push the nation into wars that generate additional profits for their employers.

According to this table, the US spends almost as much on defense and warmaking as the rest of the world combined ($522 billion vs. $561 billion). There is no defensible reason for military spending on this level. The US military has proven incapable of effectively occupying and controlling Iraq. It has done far more political damage over the past 20 years than good as militant groups around the world have sprung up on anti-American, anti-Imperialist sentiment alone. Nevertheless spending continues to increase because defense lobbyists have great pull in Congress and with the White House.

This site gives a good perspective on how large the military budget has become. To quote for perspective:

"The U.S. military budget request by the Bush Administration for Fiscal Year 2007 is $462.7 billion. (This includes the Defense Department budget, funding for the Department of Energy (which includes nuclear weapons) and “other” which the source does not define. It does not include other items such as money for the Afghan and Iraq wars—$50 billion for Fiscal Year 2007 and an extra $70 billion for FY 2006, on top of the $50 billion approved by Congress.)
• For Fiscal Year 2006 it was $441.6 billion.
• For Fiscal Year 2005 it was $420.7 billion.
• For Fiscal Year 2004 it was $399.1 billion.
• For Fiscal Year 2003 it was $396.1 billion.
• For Fiscal Year 2002 it was $343.2 billion.
• For Fiscal Year 2001 it was $305 billion. And Congress had increased that budget request to $310 billion.
• This was up from approximately $288.8 billion, in 2000."

My own points:
Final military costs for 2007 will likely be double the costs for 2000, showing an increase in the influence of industry lobbyists.
Cutting the military budget down to the size of the next largest nation would turn the "official" budget deficit into a surplus, although that ignores money looted from Medicare and Social Security trust funds.
Excessive military spending over the past 50 years has effectivelybankrupted the United States government.
The massive defense industry has become a huge portion of our distorted economy, severely undermining the competitiveness of American industry because of the tax burden.

Looking at the final Monthly Treasury Statement for fiscal 2005, it seems as though military spending is much greater than the above numbers would suggest because additional military spending is hidden in other departments:

Department of Defense = $474.436 Billion
Department of Energy (most of the Energy department's budget is based on helping the defense department develop weapons and clean up after itself):
-Weapons activites = $6.600 Billion
-Nuclear nonproliferation = $1.313 Billion
-Defense site acceleration completion = $6.152 Billion
Department of Veterans Affairs (We're running up large future costs in Iraq right now) = $59.556 Billion
Other Defense Civil Programs = $41.732 Billion (+ $35.354 billion in intrabudgetary transactions)
Executive Office of the President:
-Iraq relief and reconstruction fund = $7.338 Billion
International Security Assistance:
-Foreign military financing program = $5.302 Billion

The total is over $600 Billion, and that's just the items that are obvious in the monthly treasury statement. There are many other more subtle ways the government uses money to support the defense industry. It is simply staggering when you compare it to what the government spends on more important things:

Housing and Urban Development: $42.514 Billion
Education: $62.901 Billion
DoE-Science: $3.336 Billion

The good news is this can't go on forever. The treasury is reaching its breaking point and the Great American Ponzi Scheme has almost run its course. Hopefully the American public will be able to understand why its government has gone bankrupt and restore expenditures to a more reasonable balance when we start the economic rebuilding process.

Sunday, July 16, 2006

Dr. Loren Cobb referred me to an excellent report he co-wrote based on his experiences studying corruption in Latin America. It is brief, well written and does a very good job of illustrating how corruption is the result of vicious, self-perpetuating cycles. Here is a summary diagram from the report:

While the report focusses on corruption in developing nations, the ideas are enlightening when used in examining corruption in the American political and economic system. Specifically, corruption in the US is on the rise as a result of vicious self-perpetuating cycles. Examples:

-In America corporate political contributions have been a successful way of winning legislative favors, which has encouraged greater amounts of corporate contributions, which in turn purchases greater access to the legislative process.

-In America successful advertising campaigns help win elections, which creates a greater need for campaign raising campaign funds, which creates a greater need to grant favors to contributors, in order to be more competitive in future media based campaigns.

-In America a revolving door between political office and well compensated corporate positions has made winning the favor of large corporations a quick way to wealth for many politicians, encouraging more of this behavior with each new generation of elected officials.

-In America the media can attract more advertising revenue by promoting a corporate friendly agenda, consequently corporate friendly media continue to grow in terms of power and influence.

-In the American financial system executives are rarely punished for manipulating earnings reports and their compensation is often tied to short term performance objectives. Seeing how the system rewards short-sighted goals, more executives are encouraged to neglect the long term health of their companies in the pursuit of bigger bonuses.

Because corruption has been working for the corrupt, it has encouraged more corruption with each successive election cycle. The Presidency of George W. Bush seems to have been planned and executed with corruption as a founding principle. From the early days of his first run for presidency he was the best funded candidate with major backing by big oil, big pharma, defense contractors and Wall St. Not surprisingly his presidency has been a tremendous windfall for these industries.

If the Republican party continues to be successful in operating a corrupt regime, then we can expect both political parties to become even more corrupt in their operating methods in the future. Voter education and retaliation in the upcoming midterm elections is of great importance if we hope to reduce the role of corruption in American government. Voter education as to the nature of corruption in America is what this blog is about. If you find these ideas to be valuable, please share this link wherever you think it may help.

*Special thanks to Dr. Cobb and others for providing feedback on the initial blog entry here and on my message board at the Motley Fool. All comments and feedback are greatly appreciated.

Wednesday, July 12, 2006

Under Capitalism, we mainly had capital controlling the production of goods and the distribution of wealth. Under Corrupitalism, we mainly have people in positions of power controlling the production of goods and the distribution of wealth. There have always been elements of both systems within our economy, but over the last half-century the American economy has shifted along a spectrum from Capitalism toward Corrupitalism (and under George W. Bush's leadership, the power of the corrupt in the American economy has reached truly frightening proportions).

With Capitalism, labor is caught in a productivity trap. As increasing capital accumulation leads to productivity increases, there is less demand for labor. As population grows and resources become scarce, capital commands a greater share of wealth relative to labor. The gap between the rich and the poor and social unrest grow unless wealth is broadly distributed and workers have access to sufficient capital of their own.

With Corrupitalism, capital is caught in a liquidity trap. Too much money is created and distributed within the power base. Wealth and profits are taxed with the proceeds being distributed among the power base. It becomes increasingly difficult for outsiders to earn a return on investment that keeps up with inflation as the corrupt claim the greatest share of wealth relative to labor and capital.

The Capitalist model did not guarantee happiness for working people or even a decent standard of living for working people. Labor constantly battled against declining bargaining power. However, a more capitalistic society was generally efficient in the allocation and use of resources and tended to compete well in the global economy.

The Corrupitalist model is inherently inefficient. Resources and wealth are misallocated based on political purpose rather than economic need. Economic booms and busts are created and manipulated for the benefit of the well positioned. Government spending is directed toward the politically well connected. Industries are created and destroyed to serve the purposes of financiers. Corporations operate to generate the appearance of short-term profits and cash flow rather than growth and the long-term interests of shareholders. The result is a steady deterioration in the global standing of the the corrupt economy.

Understanding the nature of a corrupitalistic society requires understanding the nature of the power structure and the way wealth is redistributed within the system.
In our American Corrupitalist economy:
Power is held by elected and appointed government officials and exercised in the laws government creates and chooses to enforce.
Power is held by corporate executives and exercised in the way corporations are run in the short-term interests of the executives.
Power is held by investment banks and exercised in the way access to capital is controlled.
Power is held by central banks and exercised in the way money supply and interest rates are manipulated to create economic cycles and reduce real returns on invested capital.

Some brief examples of how our corrupitalistic system operates:

Our President's personal wealth is tied to the defense and oil industries. Consequently our nation is at war in an area of the world where control of oil resources is in question. The country is at war and wasting somewhere around $300 Billion per year in a manner that generates billions in profits for the defense and oil industries.

Corporate leaders and corporations spend millions annually on lobbying efforts to influence government policy makers. Sometimes the money is spent pushing for legislation that is a big windfall for entire industries, like the almost trillion dollar annual defense budget, or the multi-trillion dollar prescription drug benefit or the bankruptcy reform bill. Sometimes the money is spent on issues that affect the power of the executives of corporations, like stock options accounting standards or corporate governance issues. Either way, political power is secured by handing out economic favors to the elements within the corporate and political power base.

Executive compensation is often tied to short term performance objectives that go counter to the interests of investors. Loose accounting standards often enable managers to create the appearance of increased profits at the expense of future returns. A company can be milked for cash while assets are sold off and the company is gradually dismantled.

Wall Street's big investment banks can direct massive capital flows into any industry, creating sector booms and surplus capacity. They can destroy firms by creating too much competition and keep favored firms afloat by providing enough capital to survive difficult times. While firms are forced to operate at a loss or not operate at all, fees are generated on loans and services for the bankers, while financial strength is drained from an industry.

The Stay-In-Business model requires a steady supply bag holders to provide sufficient rewards for executives and bankers. During the tech bubble, dot-bomb companies stayed afloat as long as investors could be suckered into new stock and bond offerings. When the supply of investor funds began drying up, the companies folded, wiping out billions of doallars in imagined wealth while executives and undeerwriters retreated to count up their very real gains. The sub-prime lending racket now requires a supply of borrowers who agree to excessive interest rates and yield chasing institutional and foreign investors who purchase loans and mortgage backed securities. When defaults rise Wall Street will cease to provide financing and the sub-prime industry will contract as others have before. Then Wall Street will tally up this round of profits and move its financial leverage on to the next hot sector.

The Hedge Fund industry has been financed and provided with great leverage to serve the short term goals of investment bankers. Trading fees and interest income are passed on to the big banking houses in exchange for the power to manipulate markets and extract management fees from capitalist investors. In many cases, hedge funds have earned substantial, inflation-beating returns for investors, but in many other cases investors have been victims of fraud, mismanagement and bad luck. The individual profits and losses of hedge fund investors are not of great importance to the corrupitalists. What matters to them is that they can create as much money as they wish and use this money to fund an industry that feeds back hundreds of billions in profits to the corrupting enterprise. Wall Street's profits and executive bonuses are once again at record highs thanks largely to the hedge fund industry.

The Federal Reserve is perhaps the most powerful and most corrupt institution. It creates money and sets interest rate policy to suit the wishes of its member banks. By facilitating the creation of trillions of dollars in new money over the years, benefiting the member banks first and foremost, the Fed has created a backdrop of steady inflation that eats into the profits of capital. By allowing and enablng the banking sector to create far too much capital, the Fed has guaranteed lesser returns on invested capital. As a result, the nation's pension plans are only beginning to unravel. By eroding the financial health of working people, the status and bargaining position of workers further deteriorates, as does the condition of business enterprises outside the power structure.

Wall Street wielded great power early in this century. J.P. Morgan built great monopolies among a core group of capitalists and was able to control entire industries along with his allies. Capitalism became imbalanced, speculative debt levels soared, and the gap between rich and poor grew rapidly through the 1920s. After the great depression government sought to reign in Wall Street's power. During World War II, tremendous national savings and austerity redistributed wealth broadly and created the basis for rapid economic growth through the 50s and 60s.

However, over the last 50 years the economy has become steadily more corrupt and wealth has been squandered. As waste, fraud and abuse in both government and the private sectors rises, and as wealth and power become intrenched within the power structure, the country borrows ever more from foreigners to promote the illusion of wealth among investors and consumers. High consumption, high asset prices and increased economic activity are not representative of wealth when it is funded through tremendous debt expansion. National indebtedness to foreigners is rising by more than $1 trillion per year and is now racing past $9 trillion in total. The United States now imports roughly twice as much as it exports. Corruptialism has drained the nation of its competitive standing and left its economy at the mercy of foreign investors.

The existing power base now struggles to keep the economic status quo in effect. Economic growth must be generated through the continual creation of new money, even if it is invested inefficiently. Foreign debts must be expanded while foreign companies provide the goods and services the country can no longer produce for itself. The dollar's strength must be maintained, even while trillions of new dollars are added to the economy. Foreign capital must be attracted in the face of diminishing real returns, if not treasuries then corporate bonds or mortgage backed securities, if not those then real estate, intellectual property and entire companies. To continue attracting capital and maintain faith among consumers and investors, asset price inflation must be created, but consumer price inflation must be somehow suppressed. That task is becoming ever more difficult and requiring greater deceptions and distortions by our Government and the Fed. Power has has been used for the accumulation of great wealth, and power must be maintained within the corrupitalistic society to continue generating returns.

Eventually Corrupitalism must fail because of its inefficient nature. How it will fail, what the country will look like after its failure and what steps will taken to rebuild the economy are unknown at this point. Over the next twenty years those questions will all likely be answered.