[Peace-discuss] Madoff and the Global Economy

[John W.]

>From Business Week:

 Viewpoint December 14, 2008, 8:45PM EST
 Madoff and the Global Economy The world was told the U.S. was a low-risk,
high-return investment. But like the Wall Street trader's victims, we are
learning the truth

By Michael Mandel<http://www.businessweek.com/print/bios/Michael_Mandel.html>

For years, Bernie Madoff, all-around nice guy, pulled billions of dollars of
foreign and domestic money into his investment fund. His lure? He promised
the implausible combination of good returns and low risk—and people believed
him.

Painfully, the allegations of fraud surrounding the Madoff
affair<http://www.businessweek.com/investing/insights/blog/archives/2008/12/credit_crunch_u.html>are
also exposing the fundamental fallacy of the global economy. Like
Madoff's trusting investors, the rest of the world was willing to assume
that the U.S. economy as a whole was a low-risk, good-return investment.
This belief drove the entire structure of global trade and finance for the
past 10 years. And when the subprime crisis showed this assumption of low
risk to be false, the financial crisis resulted.

Consider this: Since the Asian financial crisis of 1997-98, the rest of the
world has been willing to lend money to finance the U.S.'s huge and growing
trade deficit. Not just small amounts of cash either: over the past decade,
the U.S. borrowed a cumulative total of $5 trillion from foreigners at
relatively low interest rates.
Why were foreigners so generous?

Without this flow of easy money into the U.S.,
globalization<http://bx.businessweek.com/globalization/>in its current
form would not have been possible. The U.S. was the consumer
of last resort, absorbing cars from Germany and Japan, electronics from
Taiwan and Korea, and clothes and furniture from China. The earth was flat,
and why not? Pluck a laptop from Taiwan and pay for it with a home equity
loan, which—if you trace back the connections—was at least partly funded
with foreign money, too.

The big unanswered question, for years, was why this money flow persisted.
Why the heck were foreign investors willing to lend the U.S. such large
amounts of money on such good terms? Economists and journalists spun out
hypothesis after hypothesis (we'll see more below), but there was no
agreement on why.

Now we see what happened. Wall Street firms—big operators like
Lehman<http://bx.businessweek.com/lehman-bros/>and relatively small
fish like Madoff—told foreign investors they could put
their money into the U.S.—the world's safest economy—and still make decent
returns. Madoff, of course, appears to have lied. He allegedly ran an
investment scam that has resulted in billions of dollars of losses reported
around the world, including $4 billion in Switzerland and $3 billion in
Spain.
Exporting 'low risk' Derivatives

But it wasn't simply Madoff. The Wall Street boom of recent years was built,
as far as I can figure out, on selling the low-risk story to foreign
investors<http://www.businessweek.com/bwdaily/dnflash/content/oct2008/db20081027_860032.htm>.
In fact, most of the financial innovations of recent years were about making
investments in the U.S. 'safer' for foreign investors. The enormous growth
of foreign exchange derivatives enabled those abroad to protect their U.S.
investments from exchange-rate fluctuations. The sudden increase in credit
default swaps <http://bx.businessweek.com/credit-default-swaps/> could be
used to protect foreign bond investors from problems with individual
countries. And collateralized debt obligations, which could be divided into
high-risk and low-risk pieces, increased the supply of low-risk investments
to be sold outside the U.S.

This low-risk, good-return story attracted investors from around the world.
One example: Lehman sold $2 billion in 'mini-bonds' to Hong Kong
investors,<http://www.google.com/hostednews/afp/article/ALeqM5juHlAUyJALuq1FTQJOxyj7DZEysg>including
many retirees.

However, the low-risk, good-return story simply wasn't true, for two key
reasons: First, the U.S. economy was supposed to be on the cutting edge of
innovation. Innovation through technological change, by nature, is a very
risky activity. Sometimes it pays off and sometimes it doesn't. If the
investment in innovation pays off, the economy booms, as it did during the
second half of the 1990s.
U.S. Regulation Failed

But innovation has fallen short in recent years. Biotech and nanotech still
have not come to fruition, and alternative
energy<http://bx.businessweek.com/renewable-energy/>is moving slowly.
As a result, the U.S. economy has fallen short of
expectations. The income isn't there, and the debt just piles up.

The second reason why the low-risk, good-return story wasn't true: the
breakdown of regulation. And that's where we come back to the alleged Madoff
scam. His was no complicated global securitization, based on black-box
rocket science. Instead, it appears to be a good old-fashioned Ponzi scheme,
enabled by a lack of government supervision.

What comes next? The fallacy is punctured. Globalization will be seen as
what it is—a game with risks that can't be wished away. And U.S. prosperity
will depend on the success or failure of its ability to innovate—not its
ability to tell an implausible story to foreign investors.

Mandel <Michael_Mandel at businessweek.com> is chief economist for BusinessWeek.
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