Occupy Wall Street Has Little Right Except For the Target

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The "populist" protest movement "Occupy Wall Street" has certainly created enough buzz, partially from its disparate elements and lack of cohesive central message. It seems to be mostly anti-capitalism cloaked in the semantics of being against "greed" and for "justice", the usual straw men of the protest classes. However, I do think they have selected the right target, even if their rants are aimed in the wrong direction.

The protesters have labeled Wall Street as the capital of capitalism. It is a common misconception, one that is wholeheartedly embraced by the big banks and the banking system in general. Even the Federal Reserve, itself a creation of Wall Street, casts its public relations efforts in that light - that its monetary policies and framework are the fuel that runs the capitalist machine.

At some point in their history, the largest banks on Wall Street may have participated in a marginally capitalist system, but it has not been that way since at least the early 1990's (the transformation began in the 1960's). What the financial system has become today is one of monetarism, not capitalism. This is an entirely profound distinction that needs to be fully appreciated to unlock both long-term economic growth and a denouement for the now-monetized economy.

Last week, I wrote about the 1990's transformation of the banking system from one based on depository institutions and cash reserves to one predicated on balance sheet equity and wholesale money markets. In the move from the former to the latter, the transition away from a marginally capitalist system to a marginally monetarist system was completed. By the year 2000, marginal credit had become a function of investment banking and securitization - Wall Street.

The logistical mechanisms of credit creation under a depository system start with the central bank. Individual banks depend on the central bank to create deposits that can then be transferred and multiplied into loans. But each and every loan creation is fundamentally limited by the central bank (or a gold standard) enforcing an element of scarcity into the calculus of intermediation. If funding is scarce, intermediaries have to make careful choices about whom they lend to and at what terms. This process is changed by various central bank stances, of course. For example, if the central bank espouses "accommodative" policies, banks may be less careful in response to plentiful central bank money. But overall there is a practical and exogenous limit to credit production.

In the equity/wholesale money system, however, the practical limit on credit production is essentially endogenous and pro-cyclical. Loans are made without regard to central bank money/deposit creation. Instead, a loan is originated first, and then the bank obtains necessary funding from a wholesale market - Fed funds, eurodollars or repo. Since the Fed's entire monetary policy structure revolves around pegging short-term interest rates, it will create money to meet any and all demand just to maintain its target.

If wholesale markets experience high demand because these "balance sheet" banks are all creating loans at the same time, short-term interest rates will try to rise above that target. In response, the Fed essentially creates more money, making no further determination about the appropriateness of such a credit expansion since it believes it is consistent with its rate target. It has abandoned control of the money supply.

By changing the system in this direction, the central idea of money creation has been moved from the central bank to the collection of investment banks we call Wall Street. In this realm, the theoretical limits of credit creation are shifted from the central bank to borrowers . The only practical limits to credit production are finding enough borrowers (for given interest rate costs) and bank equity capital. The former is easily done, as there are always borrowers for some purpose, in most cases delinked from the real economy. The latter has proven to be a wholly insufficient braking force, proving instead to be not only pro-cyclical but also easily manipulated by accounting.

This is a fundamental change in the alignment of credit and the real economy. Essentially intermediaries are absolved of any duty for responsible credit policies. With the practical limit of credit moved to borrowers, in times where productive borrowers balk at adding additional credit, intermediaries will actively seek out alternate uses. In this way, the only concern of intermediaries is maximizing balance sheet capacity to obtain income statement profitability. When real economy borrowers withdraw from the system, credit production instead flows to asset prices, speculative activities or any other use that can quickly fill up a balance sheet.

Given this shift away from the marginal importance of deposits into the near-dominance of extremely short-term funding, the additional factor of liquidity has been promoted. Intermediation has always faced an inherent weakness in its mismatch between relative maturities of liabilities (shorter duration) and assets (longer-term and mostly illiquid), but the move toward wholesale money funding amplified this strain. Instead of using this rollover risk as a further constraint on this funding model, Wall Street instead went the other way and began to liquefy its asset base - again, always favoring balance sheet maximization.

To keep up active marketplaces meant a change in the profile of credit initiation. Loans were originated not on terms of the real economy (whether they could be repaid), but on terms of whether they would fit into a structure that would be accepted in a marketplace (subprime and NINJA loans are the most extreme examples). To obtain a truly liquid market meant finding enough buyers and sellers, even if that meant actively encouraging short sellers.

So we ended up with mortgage loans that made little economic sense and credit structures like the now infamous Abacus. Credit products and securitizations had to be attractive enough to shorts to bring a liquid marketplace together (long investors were always the easy part).

Wall Street only cared about keeping the entire credit chain moving onward and upward, booking maximum fees now (thanks to gain-on-sale accounting to off balance sheet structures) in a fit of extremely short-term thinking. This entire system encouraged rampant speculation at all points in the chain of intermediation because there was always money available to finance it. Whatever could maximize balance sheet capacity was prized, especially if profits could be booked today and the risks sold to outside investors.

This short-term, backward thinking is the opposite of capitalism. In this monetarist system, money is created with the intention of obtaining more money. It simply moves from one perception to another without any real regard to the real economy. Intermediaries are supposed to enhance the efficiency of an economy by deciding which economic projects receive scarce funding. In that way, banks are supposed to cull the bad ideas from the good - meaning sustainable projects would greatly outnumber the unsustainable kind, leading to long-term growth and productivity. That vital role intermediation once played in the real economy has been diminished to the point of insignificance now that the ability to create credit has been handed to investment banks that are essentially marketmakers.

The speculative excesses of the Wall Street institutions simply spread throughout the financial system. Without any practical constraints on lending, any and all economic projects have seen the light of day. From dot-com companies with no actual business plan to day trading to house flipping. These unproductive activities flourished and dragged more and more people into the processes, as the lure of easy money shifted incentives away from longer-term productive activities that typically require actual, sustained effort.

Given the choice of investing newly acquired money, say $200,000 for example, how many people in the year 1999 would have started a business vs. day trade? In 2005, how many would have been a house flipper? Even today, how many would eschew the long-term commitment of a new business project for the prospect of easy, short-term financial gain? Perhaps less now than those previous years as risk perceptions have begun to shift, but likely still a large enough number to demonstrate the need for more risk rebalancing. Those chasing easy financial gains only do so because there is enough money flowing through markets to make such gains look easy.

With so much money flowing through the speculative wash that is Wall Street, the real economy has had trouble competing. Productive endeavors are neglected or left on the drawing board - big companies spend hundreds of billions on stock repurchases rather than take the long-term leap (and income statement charge) on new technology or potential innovation. Whatever cash is not used to manage stock prices is kept on the company's balance sheet and invested in short-term liquid credit - the very repos and commercial paper that recycle all this business money back into the investment bank/wholesale money system rather than the real, productive economy.

It is a system that feeds into and onto itself simply because all the incentives are skewed away from productive capital projects. Those bastardized incentives exist and propagate because money is no longer a constraint and intermediaries no longer do the job they were started for. Economic paralysis is the logical conclusion of a system that has seen money go from a scarce commodity to the terminal financial object.

In the monetarist system, beneficial economic flow is based on the rising asset prices that everyone loves. The means to circulate money is the constant transferal of this paper, ephemeral notion of wealth. Asset prices become feedback loops of economic inefficiency where more and more money is needed to maintain them, at the neglect of real economy uses. Unfortunately, our transformed banking system meets this need all too well.

The problem of asset price circulation is that somewhere, somehow, someone gets stuck holding the bag. This is where money is decidedly nonneutral. It has the dastardly effects of benefiting those closest to the source, while impoverishing those that jump on the train toward the end. A system of asset price transferal is, at its heart, a system that transfers paper from those last in line to those in front. Eventually, enough end-of-the-liners get burnt and get out of line, finally and mercifully discouraging anyone else from joining the ponzi.

Then the entire system collapses back toward true productive potential. The problem for us now is that true productive potential has been neglected by this imbalance of speculation and credit creation (in addition to intentional dollar devaluation) for far too long. Thus the collapse is relatively large and protracted. But the solution is not to blame that productive potential and defile it further, rather the answers are to recognize its deficiency and the system that skewed values and incentives away from it.

The Wall Street protestors have glimpsed the location of the problem, but seem to have misidentified the characteristics. They do and should blame greed and money, but in the context of the banking system that exists in 2011 those are entirely separate concepts from capitalism. The self-interest of capitalistic productive endeavors is the rising tide that lifts all boats in a mutually beneficial exchange of labor and goods. The advantageous circulation of economic flow here depends on scarce money and relevant intermediation. It is the societal good of increasing labor specialization that results in overall prosperity, a good created and fostered by true capitalism and long-term, productive incentives.

Wall Street, as it is today and correctly identified by those protestors, creates nothing more than the illusion of prosperity that really consists of the protracted nonneutrality of money we call economic impoverishment and they identify as inequality.



Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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