Paul Krugman: The Madoff Economy

The costs of “America’s Ponzi Era”:

The Madoff Economy, by Paul Krugman, Commentary, NY Times: The revelation that Bernard Madoff — brilliant investor (or so almost everyone thought), philanthropist, pillar of the community — was a phony has shocked the world, and understandably so. The scale of his alleged $50 billion Ponzi scheme is hard to comprehend.

Yet surely I’m not the only person to ask the obvious question: How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?

The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it’s … had a corrupting effect on our society as a whole.

Let’s start with those paychecks. … The incomes of the richest Americans have exploded over the past generation, even as wages of ordinary workers have stagnated; high pay on Wall Street was a major cause of that divergence.

But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

Consider the hypothetical example of a money manager who leverages up his clients’ money…, then invests the bulked-up total in high-yielding but risky assets… For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

O.K., maybe my example wasn’t hypothetical after all.

So, how different is what Wall Street in general did from the Madoff affair? Well, Mr. Madoff allegedly skipped a few steps, simply stealing his clients’ money rather than collecting big fees while exposing investors to risks they didn’t understand. … Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

We’re talking about a lot of money here. In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.

But the costs of America’s Ponzi era surely went beyond the direct waste of dollars and cents.

At the crudest level, Wall Street’s ill-gotten gains corrupted and continue to corrupt politics… Meanwhile, how much has our nation’s future been damaged by the magnetic pull of quick personal wealth, which for years has drawn many of our best and brightest young people into investment banking, at the expense of science, public service and just about everything else?

Most of all, the vast riches … undermined our sense of reality and degraded our judgment. Think of the way almost everyone important missed the warning signs of an impending crisis. How was that possible? … The answer, I believe, is that there’s an innate tendency on the part of even the elite to idolize men who are making a lot of money, and assume that they know what they’re doing.

After all, that’s why so many people trusted Mr. Madoff.

Now, as we survey the wreckage and try to understand how things can have gone so wrong, so fast, the answer is actually quite simple: What we’re looking at now are the consequences of a world gone Madoff.

Originally published at the Economist’s View reproduced here with the author’s permission.

4 Responses to "Paul Krugman: The Madoff Economy"

  1. GuestGian   December 24, 2008 at 7:42 am

    Layer on layer of experts, intermediaries, and other advisors. Swiss private banks, French bon-vivants cum financial “flair”, star cult, greed and tax evasion: so much for the “icing of the cake”…The fundamentals are as you say Dr. Krugman. Perfectly.

  2. K Subramanian   December 25, 2008 at 1:28 am

    The horde of US investors should not complain against Madeoff and his Ponzi empire. It was the herd mentality which drove a generation (two decades?) of Americans to take the shortest route to riches. Only those who did not have the cash (Hispanics,African Americans and pavement dwellers in San Francisco) did not succumb to the mania. Indeed, if they had the resources, they would have also rushed in.In many reports and analyses, there is an underlying assumption that Madeoff was special. He was not. He hid all his deals and shenagins to himself and did not share them even with his sons. His operating floor in the Lipstick building was not open to others. He created an aura of invincibility around him. He had socialites of of high standing (Speilberg?)as his clients. His renown as a computer wizkid helped him a lot in an age which had been driven to rely on computers as the saviour of mankind and led to abdication of prudence and common sense. This was what the major banks (some of them never slept!) did in their own way with exotic model-based derivatives, swaps,SPVs, etc which hid the risk from the investors. If you showed returns for some years,torrents of funds would rush in. How many of the bankers, investment advisers, rating agencies or even the US Fed or the Treasury understand the models used by banks and the claims about risk diversification? Sadly, those in charge like Alan Greenspan (not excluding Bernanke) encourged them as ‘innovations’ driving the free market, spreading the risk and making capital allocation more efficient. They now grapple with a situation where invisible snakes are still under grass and successive markets in financial instruments are collapsing or being resusitated by infusion of tax payers’ money. Madeoff’s style was different and he inspired the same trust other bankers did.All these may be traced to the failure of regulation. For some years, we in developing countries like India, were led to believe that the US Fed/Treasury had extra-ordinary capacity and skills to watch market developments on a daily basis through stress testing, etc and act. It is shocking to know that the emperor had no clothes.In India, we had the phsnomenon of companies promoting chit funds (short term securities) where the collection from new ivnestors would be used to pay off older investors. The pyramid expanded and collapsed on its own weight. The Reserve Bank of India acted, though rather late, and the ponzi scheme came to grief.Many of them have been arrested and are still in jail. It may also be recalled that Albania was rocked by the same method where money making had turned national with deeper involvement of politicians and Ministers. Its economy collapsed. Madeoff is not alone in history. America will witness more Badeoffs if it allows free hand to financial market, especially the hede funds. It is surprising that even after the exposure of Madeoff, there is no analyst who pleads for regulation. Perhaps, they think “the market could correct itself!” It is also likely that Madeoff would be let off the hook if he he resourts to plea bargaining!

  3. Mark Nockleby   December 25, 2008 at 6:54 pm

    I understand that fraud is criminal. I don’t see how being overpaid is a crime. Is it a crime to be paid high fees? Is it a crime to pay high fees?