Tiny Bubbles

by dday

The very good Joe Nocera has an interesting piece in the New York Times, which may read as a little cruel to some. His basic premise is that Bernard Madoff had accomplices in his crime, and they were also his victims.

At a panel a month ago, put together by Portfolio magazine, Mr. Wiesel expressed, better than I’ve ever heard it, why people gave Mr. Madoff their money. “I remember that it was a myth that he created around him,” Mr. Wiesel said, “that everything was so special, so unique, that it had to be secret. It was like a mystical mythology that nobody could understand.” Mr. Wiesel added: “He gave the impression that maybe 100 people belonged to the club. Now we know thousands of them were cheated by him.”

And yet, just about anybody who actually took the time to kick the tires of Mr. Madoff’s operation tended to run in the other direction. James R. Hedges IV, who runs an advisory firm called LJH Global Investments, says that in 1997 he spent two hours asking Mr. Madoff basic questions about his operation. “The explanation of his strategy, the consistency of his returns, the way he withheld information — it was a very clear set of warning signs,” said Mr. Hedges. When you look at the list of Madoff victims, it contains a lot of high-profile names — but almost no serious institutional investors or endowments. They insist on knowing the kind of information Mr. Madoff refused to supply.

I suppose you could argue that most of Mr. Madoff’s direct investors lacked the ability or the financial sophistication of someone like Mr. Hedges. But it shouldn’t have mattered. Isn’t the first lesson of personal finance that you should never put all your money with one person or one fund? Even if you think your money manager is “God”? Diversification has many virtues; one of them is that you won’t lose everything if one of your money managers turns out to be a crook.

There’s no question that the SEC failed in a core function to protect the investor from fraud. But did anybody really want them to step in? The market was overheated for so long that investors felt entitled to unrealistic returns. Those who trusted in Madoff didn’t want to know how the decisions were made or where the money was coming from. They were investing in another part of the shadow banking system, one that turned out to be as fraudulent as the supposedly regulated system of credit default swaps and collateralized debt obligations.

What Madoff did was a crime and the fact that he pulled it off for close to twenty years is an act of regulatory malpractice, but in the end, nobody – not least of which the investors themselves – wanted to pop the bubble anywhere on Wall Street. If it wasn’t ever-larger stock prices for the Pets.com sock puppet it was more mortgages to slice and dice into securities and sell everywhere. They made a fortune off of a phantom, and they certainly didn’t want anyone telling them it wasn’t real.

In another interesting perspective, Chadwick Matlin calls Bernie Madoff a hero, because he focused anger on an individual on Wall Street, as well as exposing the SEC and the whole regulatory apparatus. I don’t know if I totally agree with that, but what Madoff has done is uncover the danger of bubbles, and of endless belief in the power of small men who are mythologized into Masters of the Universe. It has made plain that when wealth is rewarded instead of work, when the economy tips out of balance and moving money becomes a growth industry, when free market fundamentalism reigns, greed takes over, and the endless desire for growth makes fools of us all. What Madoff has accomplished is to give recognition that we need what is being called at the highest levels a post-bubble economy.

The last point that I’d make — and I made this point to the Business Roundtable yesterday — it is very important, even as we’re focused on the financial system and the credit markets, that we are laying the foundation for what I’m calling a post-bubble economic growth market. The days when we are going to be able to grow this economy just on an overheated housing market or people spending — maxing out on their credit cards, those days are over. What we need to do is go back to fundamentals, and that means driving our health care costs down. It means improving our education system so our children are prepared and we’re innovative in science and technology. And it means that we’re making this transition to the clean energy economy. Those are the priorities reflected in our budget, and that is part and parcel with the short-term steps that we’re taking to make sure that the economy gets back on its feet.

In politics you sometimes need villains, and so calling out Bernie Madoff or the bankster CEOs is fine. It’s what they represent – an unsustainable bubble economy, based on cheap credit and over-leveraging and the illusion of wealth and prosperity – that is the real culprit, that took in all of us in one way or another. There’s no floor under our feet in such an economy, and so we have to rebuild that floor out of something heavier than air. It’s not going to happen quickly. But it has to happen now, with the necessary investments to get it going. This is why fixing what’s broken is not enough, and reinflating bubbles will only lead to them bursting larger.

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