A BROKEN ECONOMY - CAN TRUST BE RESTORED?

DAVID COLLETT
with Z E N D A C O L L E T T
 AT THE BEGINNING OF THE 21st CENTURY we again face another
severe economic crisis which threatens to cause suffering akin to that of the
Great Depression. How is this possible when we have reached such dizzying
heights in our ability to generate abundance? Will our seemingly limitless
progress be the cause of our demise?
You will enjoy the simplicity with which False Gods Fleece the Faithful
discusses the dominant causes of the current economic crisis and how we
failed to learn from the lessons of the past. This book tells you how and why
you have been deceived by many in positions of trust; why unemployment is
likely to increase in the coming years; why the values of your home, savings
and other investments are likely to decrease, all while your living expenses
continue to increase; and finally why many will be exposed to continuing
hardship despite the abundance surrounding them.
This book will not only empower you to participate with confidence in future
debates about the causes of the current crisis, but it will also tell you why the
solution is in your hands. Most importantly, this book will equip you to resist the
invisible forces which threaten to destroy all of us – greed, selfishness and man’s
apparent inability to share abundance.

This book provides an excellent insight into the current

economic crisis. In typically thorough fashion, David applies
his considerable forensic skills, to focus on the overwhelming
evidence available prior to the crisis, which was so patently
ignored by a self serving business and political leadership.”

- BRYAN HOPKINS -
Was the co-author of a leading and authoritative book on Generally Accepted Accounting
Practices. He is a former Chief Investment Officer of Old Mutual and ABSA Asset Management,
which controlled assets worth in excess of $50 billion. He currently sits on the board of various
listed companies.

ANCHORAGE INVESTMENTS
DAVID COLLETT is a Chartered Accountant
with more than 25 years experience in the field of
forensic investigation. He has acted as an expert on
many subjects such as business, investment and share
valuations; fair presentation in financial statements
and prospectuses; lax credit standards, credit risks and
professional liability. Over the past decade he closely
followed the financial markets. Through a series of
presentations made to the finance and investment
communities, he forecasted the collapse of financial
markets and the 2008 stock market crash. anchorage-investments.com
 CONTENTS

Acknowledgements..................................................................................................... 13

Foreword............................................................................................................................ 15

PART ONE: DÉJÀ VU - AN OVERVIEW OF THE MODERN WORLD

ECONOMY........................................................................................................................... 19
Introduction ................................................................................................................ 21

Chapter 1: The Great Depression................................................................. 23

Innovation and Productivity. ................................................................................. 23

Income and Wealth Inequality.............................................................................. 23
Credit Expansion. .......................................................................................................... 24
Deregulation and Monopolies............................................................................... 26
Real Estate and Mortgage Credit Growth....................................................... 26
The Share-Market Bubble of 1929..................................................................... 27
Economic Contraction and Consequences.................................................... 29
A Timeline of the Great Depression. ................................................................. 30
Important Changes Brought About by President Roosevelt
and World War II. .......................................................................................................... 32
The Pecora Investigation: The Shame of the Super Rich. .................... 33
The Plotters Who Nearly Changed History . ................................................ 37
8 | false gods fleece the faithful

Chapter 2: The Japan Crisis................................................................................ 41

Innovation and Productivity. ................................................................................. 41

Income and Wealth Inequality.............................................................................. 41
A Strong Japanese Currency .................................................................................. 43
Credit Expansion—1980s........................................................................................ 43
Growth in the Real Estate and Stock Markets............................................. 44
The Aftermath of the Japan Crisis....................................................................... 45

Chapter 3: The Current Crisis. ....................................................................... 49

General Overview of the Current Status of the World Economy. ... 49

Innovation and Productivity. ................................................................................. 50
Growing Income and Wealth Inequalities..................................................... 51
Credit Expansion. .......................................................................................................... 62
The Dot-com Bubble.................................................................................................... 64
The Residential Real Estate Bubble .................................................................. 66
Old versus New Banking Systems....................................................................... 66
New Innovations......................................................................................................... 67
Flawed Risk Models................................................................................................... 68
Spectacular Rise in House Prices........................................................................ 69
Collapse of Real Estate............................................................................................. 72
Fed Rate Cuts and Mortgage Rates..................................................................... 72
Housing Bubble Questions...................................................................................... 73
Pyramid Scheme......................................................................................................... 73
Important Bubble Factors in Maintaining the Pyramid Scheme........... 74
Faith in the Abilities of the Financial Institutions and
Their Creations........................................................................................................................... 74
Why Did the Risk Models Fail?. ............................................................................ 75
Lax Underwriting Standards................................................................................. 76
Rating Agencies ......................................................................................................... 77
Banks Join the Party by Leveraging .................................................................. 78
 contents | 9

The CDS Factor................................................................................................................ 79

The Stock Market Crash. ........................................................................................... 80
Response from the Authorities............................................................................. 81

Chapter 4: Dominant Causes of Major Crises. .................................... 83

Lessons from History.................................................................................................. 83

How Growing Wealth Inequality can Cause an Imbalance in
the Economy..................................................................................................................... 86
Model A : Example of a Closed Economy in the 1950s
and 1960s........................................................................................................................... 86
Model B : Example of a Closed Economy in the 2000s.......................... 89
Dominant Causes........................................................................................................... 98
Changes in Taxation.................................................................................................. 100
A Synopsis of the Effect of Growing Wealth Inequalities on the
Current Crisis................................................................................................................ 103
Is There a Solution to the Current Crisis?................................................... 104

PART TWO: THE ENEMY WITHIN. .................................................................... 105

Chapter 5: Master of Make Believe......................................................... 107

Madoff’s Ponzi Scheme........................................................................................... 108

Post-mortem.................................................................................................................. 112
Pervasiveness of the Culture of Make Believe.......................................... 113

Chapter 6: The Rise and Fall of the Financial Gods................... 115

Rise of the Financial Gods..................................................................................... 116

The Splendor of the Gods’ Financial Innovations.................................. 117
Profiting from the Housing Bubble ................................................................ 123
Collapse of the Financial Industry................................................................... 125
10 | false gods fleece the faithful

Achievement versus Compensation............................................................... 127

Countrywide Financial Corporation: Angelo Mozilo............................... 127
Lehman Brothers: Richard Fuld........................................................................ 129
Merrill Lynch: Stanley O’Neal............................................................................. 131
UBS: Marcel Ospel................................................................................................... 133
Royal Bank of Scotland (RBS): Sir Fred Goodwin...................................... 134
Legacy of the Fallen Gods...................................................................................... 135
Bonuses Criticized..................................................................................................... 136
Financial Gods Fight Back .................................................................................... 136
Doing God’s Work....................................................................................................... 138
The Best and the Brightest................................................................................... 143
Failure of Risk Management................................................................................ 144
Some Perspective on the Fallen Gods............................................................ 148

Chapter 7: Complexity and Transparency.......................................... 151

Bucky’s Giants. ............................................................................................................. 151

Federal Reserve Bank of the United States Defies
Transparency................................................................................................................. 153
The Financial Gods’ Hold on Power. ............................................................. 156
Transparency and Complexity in Financial Reporting....................... 160
Fair Value Accounting.............................................................................................. 163
Mark-To-Myth—A Real-Life Example........................................................... 166
Mark-to-Market. .......................................................................................................... 176
Defense Against the Gods of Complexity and Opaqueness. ............ 183

Chapter 8: The Shame of Credibility...................................................... 185

Plato’s Republic: The Myth of the Cave. ....................................................... 185

The Veil of Credibility.............................................................................................. 187
The Credible and the Incredible. ...................................................................... 190
Presumption of Credibility.................................................................................. 190
 contents | 11

The Credible Elite.................................................................................................... 193

The Contrarians....................................................................................................... 196
Credibility, Experts, and the Power of Groupthink............................... 198

PART THREE: IN PURSUIT OF A SOLUTION. ................................................. 203

Chapter 9: Concerns, Solutions, and Responsibilities............. 205

Cause for Great Concern. ....................................................................................... 205

Can the Current Crisis Be Resolved?.............................................................. 209
Government and Central Bank Intervention............................................... 209
The Contrarian View.............................................................................................. 211
The Authors’ View.................................................................................................. 212
What If We Fail?........................................................................................................... 219
A Creed for the Enlightened. ............................................................................... 220

Sources.............................................................................................................................. 222
 FOREWORD

For some of us, fighting for financial survival is nearly as stressful as

facing death. In our pursuit of making ends meet, many of us develop
tunnel vision. Our focus narrows to such an extent that we exert all of
our energy on the next paycheck, the next job, or the next deal. When
things get tight, we become fearful and sometimes compromise our
values in the hope that we might postpone our perceived demise.
From time to time, our hopes are buoyed by news of government
stimulus packages, stock market rallies, and optimism for an
economic recovery. In our daily struggle we cling to the promise of a
better tomorrow. We trust that those who rule over the economy are
doing a good job and that they have our best interests at heart.
Our trust, however, might be misplaced. In the world of capitalism
and free markets, the mantra is self interest—the survival of the
fittest. Few of those who hold sway over the fruits of the economy
have our interests at heart. In fact, anyone in the upper echelons of
business empires who shows too much empathy towards his or her
fellow citizens is often worked out of the system.
Nevertheless, the majority of Western society has embraced
capitalism and free markets. In the twentieth century, this ideology
has triumphed over all others. With the demise of the Soviet Union
and with China’s implementation of its own brand of free markets,
the victory of capitalism seems complete. We even accept the
drawbacks of capitalism because we have faith that the rules of the
game are being applied fairly. We believe that we all compete on a
level playing field under the watchful eye of democracy, in which
16 | false gods fleece the faithful

everyone gets the same opportunities to rise to the top. As long as

we are sufficiently disciplined, hard working, and dedicated, we too
can rise to the top. We trust the guardians of the system and believe
their promises to protect us. We are continually assured that those
at the top deserve to be there because they have worked harder and
therefore have achieved more.
But is the playing field really level? Does each one of us have a
fair chance to progress through hard work alone? Is our faith in the
so-called rainmakers and guardians of the system justified?
For the moment, let’s compare capitalism to a rose garden. Like
a rose garden it is tough, resilient, and has its seasons. Roses send
up vigorous new shoots from their base every year. With time,
however, these new shoots grow old, produce fewer flowers, and
become easy targets for pests and diseases. The bushes become
congested by inward-growing branches that prevent the sun from
reaching vital parts of the plant. This happens when the roses are
not pruned regularly. However, all is not lost—pruning the oldest
branches and cutting back the younger ones makes room for new
stems. In short, removal of formerly productive branches stimulates
vibrant new growth.
Capitalism is similar to a rose garden in many respects. When
capitalism is not pruned by regulatory oversight, restructuring,
or even liquidation, it becomes like rose bushes that grow out of
control. The disease of excessive greed soon infects it. When that
happens, it does not take long before cronyism takes root; a problem
that is difficult to eradicate once it has become established.
Democracy is the gardener that is supposed to prune capitalism
to ensure vigorous new growth; growth that is beneficial to all
participants. When democracy is not doing its job, the garden
of capitalism can quickly become tangled, overgrown, and
unproductive before finally becoming barren. More specifically,
the gardeners are represented by our elected officials, who are
supposed to act according to our wishes. But in real life, these
gardeners often ignore our wishes, preferring political and business
opinions to public opinion.
 foreword | 17

To make sense of our economic landscape, we must walk through

it with an inquisitive and open mind. This is a daunting task. The
sheer volume of the interconnected branches of the economy is
overwhelming. Information is often tainted by the favored ideology
or the popular economic philosophy of the day. The mechanics of
the economy is often presented as being more complex than it really
is. This is by design in some cases: such obfuscation is meant to
discourage us from taking part in the debate, which not only affects
our own future, but that of our families, our children, and our fellow
man. It leaves us at the mercy of those who supposedly grasp it all
and act as if they have ascended to the level of gods. These false
gods assume that they have the ability and right to dispense the
fruits of the economy as they deem fit. If we don’t stand up to them,
our share will become smaller and smaller until nothing is left.
But capitalism is not only about economics; it is more often about
power, greed, and manipulation. Unless we have the knowledge and
tools to guide us through the smoke and mirrors we often encounter,
we will remain at the mercy of those who think that they are the
masters of our universe. This book will take you on a short journey
through previous crises, analyze the current crisis, and demonstrate
the extent to which we are unable to learn from the past.
Neither the Great Depression of the 1930s nor the current
crisis can be described as periods of famine or of shortages of
goods and services. Rather the opposite is true. They were both
periods of initial abundance, where supply exceeded demand. The
1930s were, despite the abundance, a period of human suffering
and destitution for many. The toll of the current crisis has yet to
be tallied. As technology and productivity continually improve, the
very abundance they have produced might destroy the economic
fabric of society as we know it. This presents us with the greatest
challenge of all time—to ensure that this progress and abundance
are a blessing to all and not only to a privileged few. Our survival
might depend on finding the solution. This is what this book is
about—exposing how inequality and greed conspire to destroy the
progress of which we are capable, and what we can do to change it.
 60 | 1. déjà vu: an overview of the modern world economy

Table 3.f
Increase in the Amount of Debt of the Average Household
% Increase % Increase
Percentile of all 1962 1983 2004 
1962 to 1983 to
households ($’000) ($’000) ($’000)
1983 2004

Bottom 80% 24 24.5 2 59.2 142

Top 20% 43.5 87.7 102 158.63 81

Source: State of Working America

Table 3.f once again confirms the extent to which the amount
of debt taken on by the bottom 80% increased between 1983 and
2004. The bottom 80% have become substantially more dependent

Figure 3.4
Percentage Ownership of Each Category of Assets

100%
9.3% 9.2%
90% 15.3%

80% 34.6%

70%

60%

50%
90.7% 90.8%
40% 84.7%
Bottom

30% 65.4% Top 20%

15.3%

20%

10%

0%

Common Stock Non-Equity Housing Equity Total Net Worth

Financial Assets

84.7%
Bottom 80%

Top 20%

Source: The State of Working America

Total Net Worth

 m
DOMINANT CAUSES OF
MAJOR CRISES

Lessons from History

All three crises described in the previous chapters were preceded
by many similar economic factors and trends. Determining the
dominant cause or causes of the above crises is important, not
only to understand why they happened but also to find the most
appropriate solutions. There is still no consensus regarding the
dominant causes of either the Great Depression or the Japanese
crisis. There is even less agreement as to what solutions were
the most effective. To credit World War II with ending the Great
Depression obscures the economic factors that contributed
to the relatively prosperous period—more than two decades—
that followed.
Why did the United States succeed in overcoming the Great
Depression while Japan is still struggling to escape its 1990 crisis?
One obvious answer, but one that offers little information by itself, is
World War II. A more comprehensive answer is found by examining
the economic factors that dominated before and after each crisis. In
the case of World War II, certain factors were in play that were not
present in the Japan crisis.
The similarity of economic factors and trends that preceded each
of the three crises is discussed in previous chapters. In response to
84 | 1. déjà vu: an overview of the modern world economy

the 1990 crisis, Japan followed a recipe used by the United States
and other industrial countries in an attempt to resolve the Great
Depression. Japan’s deficit spending began to balloon in the 1990s,
but although the United States raised taxes during the 1930s and
1940s, Japan lowered taxes from 1990 onwards.
The lesson of the Great Depression and World War II was
that massive deficit spending by governments can play a role in
economic recovery. In response, the GDP of the United States and
of most other countries increased significantly and unemployment
dropped. But it is also clear from the relatively poor results
achieved by Japan in the 1990s that such huge deficit spending by
itself is not a sure resolution to a major crisis. The extent to which
Japan’s taxation strategy might have influenced its recovery will be
discussed later in this chapter.
Two things the World War II era did achieve for the United
States, in addition to GDP growth and lower unemployment,
was significant improvement in wealth inequalities. As income
inequalities continued to improve throughout the 1950s and
1960s, real GDP growth was at a record high, despite relatively
high tax rates.
Although Japan still has a comparatively low rate of unemployment,
unemployment has more than doubled since the 1980s and has not
yet returned to its previously low levels. Japan’s income inequality
improved continuously after World War II but has worsened
substantially since 1980 and shows no signs of reversing. From
the early 1990s Japan experienced one of the worst periods of
economic growth since World War II.
The United States experienced a substantial deterioration
in income inequalities since the 1980s, and in 2009 the unequal
income distribution reached pre-depression levels, with the top
1% of income earners taking 25% of all income (see discussion in
Chapter 3). From a historical perspective, it seems as if there is a
strong correlation between deteriorating income inequalities and
major crises, and conversely that there might also be a link between
improvement in income inequalities and subsequent recoveries. It
 dominant causes of major crises | 85

therefore makes sense to consider the potential effect that growing

income inequalities might have on economies over time.
There can be little doubt that factors like credit bubbles, asset
bubbles, irrational exuberance, banking crises, stock market
bubbles, and their subsequent collapses are closely linked to
major crises. This begs two important questions: does each factor
originate independently and does any one factor or combination of
factors inevitably lead to a crisis? As it seems that growing wealth
inequalities—especially income inequality—preceded most of
the above factors, we will look at the potential effect of wealth
inequalities on economic contraction as well as the roles of credit,
asset, and stock market bubbles in causing major crises.
The interaction between capital, labor, finance, savings,
productivity, taxation, investment, production, government and
private consumption, and economic growth is complex and very few
people, if any, have a complete understanding of the mechanics of
all these interactive processes. In order to provide some insight as
to why growing wealth inequalities are likely to create economic
imbalances, which then lead to major crises and economic
contraction, a simplified model will be illustrated. The model will
mainly focus on income from labor and investment; production;
and personal consumption. The model therefore does not attempt
to provide for all of the above interactive processes. This model
compares the trends of the 1950s and 1960s with trends observed in
the 2000s. Due to the fact that there are not sufficient data available
to ensure absolute accuracy in all respects, some assumptions are
made. In this way, the growing imbalances caused by growing wealth
inequalities and the role they play in the expansion and contraction
of an economy can be illustrated more easily.
Throughout this book, wealth inequalities and changes therein
are explained by comparing two groups: the bottom 80% and top
20% of income earners. There is no particular reason why one
could not split the groups differently, such as into the bottom 90%
and the top 10%, or even the bottom 99% and the top 1%. The 80
and 20% groups are used because historic data are more readily
86 | 1. déjà vu: an overview of the modern world economy

available and are commonly used to demonstrate the effects of

growing wealth inequalities on economies.

How Growing Wealth Inequality Can Cause an

Imbalance in the Economy
In Models A and B below, it is assumed that there is a closed economy
with a limited number of players. In addition, total household
income ($100) is assumed to be equal to the value of all products
and services produced by the economy and consumed by the two
groups (the top 20% and the bottom 80%). In the real economy,
savings, the government, private investment, imports and exports,
taxation, and various other factors also play a significant role. For
the sake of simplicity, however, these models will only address those
role players and economic factors that are considered necessary to
illustrate the impact of growing wealth inequalities.
Model A reflects a situation where income distribution is similar
to what was observed in the 1950s and 1960s. The bottom 80%
of households earned around 56% of total disposable income
and the assumption is made that they contributed 57% to total
consumption. Model B refers to the period from 2001 to 2004,
where the 80% group earned around 52% of total income but
contributed 62% to total consumption.

Model A
Example of a Closed Economy in the 1950s and 1960s

In Models A and B, the 80% group contributes mainly labor to

the Production Module, where goods and services are produced
for sale to the Personal Consumption Module. For this input, the
Production Module compensates them in the form of wages and
salaries. The top 20% also contributes labor to the Production
Module, but its main contribution is capital (finance, share capital,
etc.). For its contribution, the top 20% is compensated in the form
of salaries, interest, dividends, trading profits, and other forms of
remuneration associated with its capital investments.


HOUSEHOLD INCOME MODULE PERSONAL CONSUMPTION MODULE

$56 + $1 = $57 (BORROWED FROM TOP 20%)
Bottom Bottom
80% 80%
MOSTLY WAGES & SALARIES

$44 - $1 = $43 (LENT TO BOTTOM 80%)

56% $56 57% $57

Top 20% 44% $44 Top 20% 43% $43

Total Total
SALARIES, INTEREST
& DIVIDENDS
100% $100 100% $100

PRODUCTION MODULE
(GOODS AND SERVICES)
Compensation Sales

Capital $x GOODS & SERVICES

Goods & Services worth
$100
Labour $y

Total $100 $100

dominant causes of major crises
|

Model A
87
88 | 1. déjà vu: an overview of the modern world economy

The total compensation paid to the Household Income Module

in Model A comes to $100, of which the 80% group receives $56
and the 20% group gets $44. The 20% group receives a higher
portion of total income if measured by individual household
for mainly two reasons. The first reason is that it owns most of
the capital; more than 90% of all common stock and non-equity
financial assets (see Figure 3.4). The second reason is that
members of this group are compensated more for their labor
input due to their higher perceived value in producing goods and
services. The Household Income Module then decides how to
utilize this income. The 80% group spends its full income of $56,
plus $1 it borrowed, on the goods and services produced by the
Production Module. The 20% group spends $44 ($45 – $1) of its
income on the above goods and services and saves $1, which in
turn gets lent to the 80% group.
By looking at Model A, there seems to be no alarming imbalance
that threatens the above closed economy. The 80% group could
have conceivably serviced the cost (interest and capital) of the $1
it borrowed and the 20% group benefited by virtue of the interest
received. More importantly, there was a market for all of the goods
and services produced by the Production Module, which in turn
led to higher profits via dividends and interest. The system also
benefited labor via wages and salaries, because the Production
Module would employ all workers required to satisfy demand. In
reality, the 1950s and 1960s might even have had a more balanced
economy than the one provided in the model. America as a nation
had a relatively high savings rate and the economy, as measured
by the GDP, grew more robust in these two decades than it did in
the last two decades. Also, the growth in wealth (income and net
worth) was more evenly spread between the above two groups.
The situation has changed substantially in Model B. It is
assumed that the closed economy doubled in growth to $200.
It is further assumed that the Production Module increased
the value of goods and services due to greater innovation and
improved productivity.
 dominant causes of major crises | 89

Model B
Example of a Closed Economy in the 2000s
The total compensation paid to the Household Income Module in
Model B comes to $200, of which the 80% group receives $104, or
52%, and the 20% group gets $96, or 48%. The 20% group receives
a higher portion of total income as measured by household, for
reasons described in Model A. The Household Income Module then
decides how to utilize this income. The 80% group spends its full
income of $104, plus $20 it borrowed, on the goods and services
produced by the Production Module. The 20% group spends $76
($96 – $20) on the above goods and services and saves $20, which
in turn gets lent to the 80% group.
The imbalance in the closed economy of Model B is obvious. The
80% group’s share of total income has diminished substantially, and
it borrowed a substantial amount ($20) from the 20% group, which
enabled it to contribute 62% ($124) to the Personal Consumption
Module (see Tables 3.g and 3.h). The 80% group therefore
maintained a higher standard of living than that allowed by its
income from salaries and wages alone. On the other hand, the 20%
group benefited significantly from this arrangement. It received a
relatively greater share of total income as measured by household.
Its net worth was increased by way of savings and the rising value of
its investments (e.g., value of listed shares also increased). This was
mainly achieved by finding a market for all of the goods and services
produced by the Production Module, which led to higher earnings.
Without substantial lending by the 20% group and borrowing by
the 80% group, there was no market for 10% ($20/$200) of the
goods and services produced by the Production Module. If they
could not sell the 10% of goods and services, it would result in
overcapacity and less sales for the Production Module. That would
have translated into economic contraction and less compensation
to the Household Module.
The imbalance comes about because the production of goods
and services cannot be absorbed by the consumers (both the bottom
90 | 1. déjà vu: an overview of the modern world economy

80% and top 20%) without the top 20% affording ever-increasing
debt to the bottom 80%. As the 80% group’s debt increases every
year by the above $20, it becomes less likely that it will be able to
service it. These imbalances, however, would not have come about
if the 80% group still received 56% or more of total income and
consumed an equal percentage of goods and services. However, if
productivity increases and more goods and services are produced
by roughly the same resources—mainly labor and capital—and
the benefits of productivity are not shared equally between the
respective wealth groups, supply will overwhelm demand. This
growing gap between supply and demand can only be bridged by
growing credit, lower taxes, and negative savings.i
The imbalance reaches the breaking point when the 80% group
is unable to service its ever-increasing debt (see Table 3.h) and the
value of the collateral (mainly housing), on which the 20% group
relies, begins to collapse (see Figure 3.6). It is important to note
that in the real economy the gap between consumption and income
for the 80% group is not solely filled by credit alone, but also by
the use of savings. For the purposes of this example, the potential
contribution of negative savings by lower income groups to fill the
gap between demand and supply is not considered.
This collapse in the value of collateral is inevitable in a bubble
economy because credit fuels the rise in value, which in turn fuels
a further rise in credit (as collateral values increase) to the point
where it becomes unserviceable. This inability of the 80% group
to service its debts obviously has the potential to destroy the net
worth and income of both groups. The 80% group’s net worth
is destroyed by the decreasing values of its members’ homes,
while the value of their debt (mortgages and other forms of debt)
remains the same. In addition, as production is cut back and job
losses increase, the Production Module aims to cut costs in an
attempt to remain profitable, and to compensate the owners of
capital (share capital, bonds, debt, etc.). This further undermines
the 80% group’s ability to negotiate a higher price for its labor,

i When an individual, such as a retiree, uses his or her private savings for consumption.


HOUSEHOLD INCOME MODULE PERSONAL CONSUMPTION MODULE

$104 + $20 = $124 (BORROWED FROM TOP 20%)
Bottom Bottom
MOSTLY WAGES & SALARIES

80% 80%
$96 - $20 = $76 (LENT TO BOTTOM 80%)
52% $104 62% $124

Top 20% 48% $96 Top 20% 38% $76

SALARIES, INTEREST

Total Total
& DIVIDENDS
100% $200 100% $200

PRODUCTION MODULE
(GOODS AND SERVICES)
Compensation Sales

Capital $x GOODS & SERVICES

Goods & Services worth
$200
Labour $y

Total $200 $200

dominant causes of major crises
|

Model B
91
92 | 1. déjà vu: an overview of the modern world economy

and hence leads to even less income with which to buy goods
and services.
The net worth and income of the 20% group are also threatened
by the following disturbances.

1. The value of its stock investments might drop significantly in

value due to an expected decrease in future earnings,
2. The value of its debt investment deteriorates because of
increasing defaults by the 80% group and a drop in value of
the collateral for that debt, and
3. There is a decrease in income from bonuses, commis-sions,
and other compensation previously justified by high earnings.

The 20% group is further threatened by a lack of liquidity and by

insolvency because it or the vehicles (banks, insurers, etc.) in which
it is invested are highly leveraged in order to maximize profits.
Because neither party wants to buy the other’s assets above the
market value and because the sale of investments at market value
could make the seller insolvent, trading stops and the velocityii of
money in the economy slows. This happened to the United States
and most of the other developed countries in 2008.
If the Fed, other central banks, and governments did not step
in to save the 20% group and its investment vehicles, then the net
worth and income of all income groups could have suffered huge
losses. By supplying more than ample liquidity, at virtually no
cost, to this group’s various investment vehicles (mainly banks)
against their illiquid investments as security, the investment
vehicles started to trade among themselves, the Fed, and the US
Treasury. This trading increased the value of various investment
assets (especially shares and corporate bonds) in 2009, thereby
improving the net worth of the wealthiest owners of capital.
Despite receiving this extensive assistance from the Fed, credit
lines to most of the 80% group have been cut and the cost of
finance increased in many cases. The reasons are obvious: why
ii The number of times the total money supply in circulation is turned over or circulated
through the system in a given period.
 dominant causes of major crises | 93

lend to people who cannot service such debt, who have insufficient
collateral, or whose financial position will probably deteriorate
further due to increasing job losses? Neither was it sensible to
invest in further capacity as supply already exceeded demand.
Hence, trading with each other and the government was the
best option.

Further Analysis of the Above Models

In digesting the above, the following questions might arise.

Why doesn’t the 20% group spend more of its income on

consumption to make up for the loss of spending by the 80% group?
Wealthy households’ needs have a limit. It is similar to the law of
diminishing returns.iii For example, say a household has bought
four cars for each inhabitant. It is unlikely that there is a need
to buy a fifth or sixth car. Irrespective of his or her wealth, few
people want to buy 100 cars simply because they can afford to
do so. The same goes for food, clothing, electronic equipment, and
so forth. Once the needs of a family have been satisfied, it will tend
to save the balance of its income.
In the beginning phases of economic contraction, the wealthier
households might choose to increase their spending for a while
because of bargain prices. Alternatively, they might choose to
cut back on their own consumption because a significant part of
their spending might be discretionary (e.g. buying a boat) and a
sudden decrease in the value of their assets might make them more
cautious. On the other hand, most of those in the 80% group have
little discretionary spending and are more likely to have many
unsatisfied needs that they would satisfy if they could. Thus the 80%
group would increase spending and consumption substantially if it
had access to additional income or credit.
The unsatisfied needs of the 80% group make it an obvious
target for the owners of capital during economic expansion,

iii The law of diminishing returns states that for every unit that one consumes the added
benefit or satisfaction that one derives from it diminishes.
94 | 1. déjà vu: an overview of the modern world economy

especially when credit becomes cheap. Cheap credit is often a

function of interest rate policies, as determined by the central
banks (e.g., the Fed). Cheap credit often causes the value of assets,
such as residential real estate, to rise. As house prices rise, it
gives the owners of capital and savings the opportunity to supply
the 80% group with more credit since they can more readily risk
lending their capital against the rising value of collateral assets
(mainly housing). As credit becomes more affordable and more
available, spending and consumption increase. This in turn leads to
an expanding economy and often to higher asset prices.

Why does it lend more to the 80% group than can be serviced?
In times of growing wealth inequality, those who have the most
unsatisfied needs (e.g., the 80% group) have increasingly less and
less income to spend on consumption relative to the total goods
and services produced by the economy. The wealthier group (e.g.,
the 20% group) has more and more to save for investment. In short,
the owners of capital can produce more goods than the consumer
can afford or wants to consume. When central banks then lower
interest rates, the owners of capital will often find innovative ways
to give more credit to the 80% group, which is willing to spend
more on consumption if it were able. By supplying more and more
credit to the lower-income groups, larger markets for goods and
services are created, thereby enhancing income growth and the net
worth of the wealthiest groups.

Why does the production of goods and services escalate so rapidly

while the relative compensation provided to the 80% group
decrease substantially?
There are many reasons for this, but only those considered most
relevant will be discussed below.
As the efficiency or productivity of labor increases, more units
of goods and services can be produced with the same amount of
labor. The wealthiest group, which is generally in control of the
Production Module referred to above, is often not willing to increase
 dominant causes of major crises | 95

the compensation for labor in a manner commensurate with the

increase in productivity. This means that most of the benefits flow
to the 20% group, which has limited needs, while the 80% group is
now unable to consume the extra goods and services.
Although not part of the closed economy referred to above, the
outsourcing of labor-intensive processes to countries that have
much lower wages leaves those who have done the job previously
with less negotiating power to maintain or to increase their income.
Outsourcing, on the other hand, increases profits and thereby
the income and net worth of the wealthiest, who owns most of
the capital (share capital and non-equity financial assets). This
process obviously leads to further growth in wealth inequality and
increases the gap between what owners of capital can produce and
what demand can consume. An argument can be made that such
outsourcing spreads wealth more globally, and to some extent this
is true. But it worsens the problem globally because ever-lower
wages are paid to produce the same goods and services, which
increases the gap between supply and demand. This gap can only
be filled with credit, which inevitably leads to a new credit bubble.
A further factor is improvement in technology that diminishes the
value of labor. Mechanization, robotics, and information technology
are continuously competing with, and are in fact winning the war
against, human labor. But the eventual winners are once again the
wealthiest group; those who own the capital required to acquire
the necessary tools of mechanization, robotics, and information.
Although highly specialized labor, with the technical know how,
might benefit from this development, the vast majority of workers
do not. The only way to combat this phenomenon is to re-train
and to re-educate displaced laborers to ensure their value to the
production process.
Last but not least is the abuse of power. The richest and most
wealthy (mostly those in the top 1% income or net worth bracket)
exercise increasing influence over governments, regulatory powers,
public information, and various other facets of life that insure that
this group maintains the upper hand in competing for the fruits
96 | 1. déjà vu: an overview of the modern world economy

of the economy. This gives them a huge advantage over labor and
small to medium businesses, which can often only compete on the
fringes. This issue is probably one of the largest obstacles for a
long-term sustainable economic recovery. This issue will be dealt
with in more detail in the following chapters.

Is the 20% group homogeneous as far as income earnings and net

worth are concerned, or should one distinguish between groups
within this 20% group in order to identify which sub-group has the
biggest impact on wealth inequality?
When analyzing the top 20% group, one finds a large difference
in wealth measured either by income or net worth between the
80 to 90% group, the next 9% group, and the top 1% group. The
average net worth for the above three groups in the United States is
displayed in Table 4.a.
When comparing the net worth of the 80 to 90% group with the
average net worth of the 60 to 80% group,iv the average net worth
of the wealthier group exceeds that of the 60 to 80% group by a
factor of 2.37. The net worth of the next 9% group exceeds that
of the 80 to 90% group by a factor of 3.1, and the top 1% group
exceeds that of the next 9% group by a factor of 8.3.
The 20% group earned 48%1 of total income in 2004. The top
1% group’s share of total income is 17% by itself.2 This situation

Table 4.a
Average Net Worth of Wealth Groups
Wealth Group Average Net Worth (2004)

i. 60 to 80% group $243,000

ii. 80 to 90% group $576,000
iii. next 9% group $1,776,000
iv. top 1% group $14,791,000

Source: State of Working America

iv The 20% group between the bottom 60% and the top 20%.
 dominant causes of major crises | 97

worsened after 2004, and by 2009 the top 1% group earned 25%
of total income.3
The above illustrates the extent of wealth inequality, even within
the 20% group. One could certainly argue that the 80 to 90% group
is closer to the 60 to 80% group than it is to the next 9% group. It’s
also clear that the top 1% group is from another planet altogether.
A further analysis of the top 1% group would probably show even
larger wealth inequalities between the rich and the super rich.
One should also bear in mind that there is also wealth inequality
within the 80% group. In fact, the average wealth of the bottom
20% is negative, in other words the liabilities of some members
from this group exceed their assets.4 Also, the 60 to 80% group’s
average annual income exceeds the average income for the bottom
20% by 2.86 times.5
However, despite the above differences within the two main
groups, comparisons between the 80% group and the 20% group
are sufficient to demonstrate the extent to which wealth inequality
has increased, and to what extent it could cause imbalances in an
economy.

Why doesn’t the price of goods and services drop to a level where
the economy finds a new equilibrium between supply and demand?
Some prices do drop when imbalances caused by wealth inequality
lead to economic contraction, but a drop in prices cannot close the
gap between supply and demand unless the prices of goods and
services drop to a greater degree than do the wages and salaries
paid to the 80% group. In such a scenario, the top 20% group gets
a lesser share of the income cake. Such a measured drop in prices
to rectify the imbalances caused by wealth inequalities is unlikely
to occur in an economy that is under the control of the wealthier
classes. The wealthier classes would prefer to cut production. As
shown previously in Chapter 1, industrial production fell by 45%
between 1929 and 1932.
During a crisis with severe economic contraction, prices of
assets of all classes tend to drop first, followed by goods that are
98 | 1. déjà vu: an overview of the modern world economy

the subject of discretionary spending or that fall under the luxury

goods category. If price deflation sets in, lower prices could spread
to all goods and services. There are many reasons why price
deflation does not become the norm in economic contractions.
First, governments normally react with all available monetary and
fiscal measures to stop price deflation. The measures taken by the
US government to prevent a major price decline in agricultural
products during the Great Depression is one example, while the
Fed’s efforts to lower interest rates and to flood the markets with
liquidity in the current crisis is another. Furthermore, as shown in
Chapters 1 to 3, the aforementioned three crises were preceded
by growing monopolization and concentration of economic power.
When a major crisis occurs, the concentration of economic power
normally intensifies when competitors are either taken over or
liquidated. During such times, those business with the most access
to liquidity and capital—big businesses—have the best chance to
survive. An unintended, but nevertheless real, monopoly forms
due to the loss of smaller competitors. These monopolistic empires
exercise great control over prices that would otherwise have
dropped to a level that would bring an equilibrium between supply
and demand. Such monopolies decrease the production of goods
and services to protect profits and lower their input costs (such as
wages and salaries) to an even greater extent.

Dominant Causes
Growing wealth inequalities were most likely one of the dominant
causes, if not the dominant cause, of the current and previous crises.
Credit, housing, and stock market bubbles and their subsequent
collapses were also major factors. If one asks what caused the
above bubbles and subsequent collapses, it’s difficult to ignore the
imbalances caused by growing wealth inequalities.
As the growing imbalance between supply and demand fuels
credit growth to consumers, which in turn increases profits and
the net worth of the top wealth groups, not all surpluses or
savings are reinvested in the production of goods and services.
 dominant causes of major crises | 99

Nor does this always translate into credit to the lower income
groups. Some of these surpluses or savings are earmarked for
speculative investments in stocks and other financial assets that
are mainly traded between members of the top wealth groups.
This speculation, buoyed by increasing consumer spending,
often leads to irrational exuberance among the wealthier groups
that causes them to borrow from each other (mostly indirectly
through some form of investment vehicle). This borrowing is done
in order to leverage speculative investments, causing a bubble in
the value of most financial assets, such as stocks and mortgage
securities (see Chapter 6 for a more detailed discussion). As the
bottom 80% group starts to default on its debt and starts reducing
its consumption (less demand), less money filters through to the
wealthier groups’ speculative assets, causing a drop in value. When
these values drop beneath their debt values (amount borrowed
for investment), the wealthier group and its investment vehicles
are in trouble. Due to the group’s considerable influence and the
systemic risk that its financial hard times hold for the economy,
governments and central banks focus most of their financial aid
to this group. The rationale is that such assistance will trickle
down to the lower wealth groups. Preventing systemic risk has
merit, but the rest of the above argument lacks substance. This
measure at best only delays the inevitable unless the dominant
causes are addressed. A sustained recovery can only come after
the imbalances (supply versus demand, debt versus income)
caused by growing wealth inequalities are addressed. One way to
approach this issue is to focus on improving the value of human
capital in order to ensure a better distribution of income. Another
way is to institute measures to limit runaway credit bubbles.
Long-term sustainable recovery in the United States, and probably
most other industrialized countries, is unlikely unless this issue is
acknowledged and addressed.
100 | 1. déjà vu: an overview of the modern world economy

Changes in Taxation
Raising taxes is not a good idea in any economy as it might stifle
growth, but there might be times where it cannot be avoided. It is
probably a necessary ingredient in resolving significant inequalities
in wealth distribution. Higher taxes on the wealthier classes not
only give the government more room to restructure the economy
(e.g., by retraining of workers), but they also serve to assist in
repairing the imbalance in the economy. Taxation could serve as a
vehicle to redistribute wealth to the neediest consumer in order to
bring a better balance between supply and demand. World War II
brought about higher public spending and higher taxes, especially
on the wealthiest classes—a feat that would be difficult to achieve
in peacetime economies.
The top income tax bracket for US residents was lowered from
73% in 1921 to 25% in 1925.6 Many economists and tax analysts like
to say that the lowering of taxes is always beneficial to the economy.
To prove their point, they refer to the tax cuts of the 1920s and 1980s,
which they then correlate with larger tax collections and stronger
economic growth.7 In contrast, they will often refer to the 1930s,
when president Hoover and especially president Roosevelt pushed
marginal tax rates much higher, to above 70%. These higher taxes are
then correlated with the large deficits, higher unemployment, and
poor economic growth of the 1930s. But is this a fair and balanced
view of historical facts?
First, the prosperity and exceptionally good economic growth
of the late 1940s through the 1960s coincide with a period of high
tax rates. This fact contradicts any argument or theory to the effect
that high economic growth and prosperity can only exist in an
environment of low taxation.
Second, the 1929 stock market crash occurred in an environment
of very low tax rates that had prevailed since 1925. The economic
contraction that followed continued to worsen for nearly three
years while taxes remained at the 1925 level, and tax rates were
not increased until June 1932. By the end of 1932, the GNP had
 dominant causes of major crises | 101

already fallen by more than 30%, stocks had lost 80% of their
value since 1929, and unemployment rose to above 23%.8
Third, despite the tax increases of 1932 the free fall in GNP
and unemployment slowed in 1933 and the US economy did make
a recovery from 1934 to 1937, when jobless rates dropped from
25% to under 15% and both the GNP and the stock market
gradually improved.
Last but not least, the 2008 credit crisis was preceded by nearly two
decades of decreases in taxation in many of the major industrialized
countries. The United States lowered its top income tax rates from
73% in 1980 to 35% in 2006, and gave further tax rebates in 2008.
Due to further concessions for high-income earners, the effective
tax rate for the top 400 American income earners was below 20%
in 2008. Japan also dropped its top tax rates from 75% in 1980 to
65% in 1990, and then to 50% by 2000. Reducing the tax burden
neither prevented the crises nor solved them.
There can be little doubt that the lowering of taxes in the
1920s stimulated the economy by increasing demand, but at the
same time it probably also contributed to the overheating of the
economy. When the stock markets crashed in 1929 and the value
of most collateral assets (e.g., housing) dropped, credit contracted
and the boom was over. The economy simply could not be reignited
by further tax cuts or by issuing more credit. The stagnation in the
1930s came about because supply exceeded demand. The economy
could then only depend on demand as determined by the normalv
income of consumers, which was decreasing due to the growth
in unemployment.
The economic contraction of the 1930s, which followed the
stock market crash of 1929, was not caused by higher taxes.
Although higher taxes from 1932 probably stifled consumer
demand and economic growth to some extent in the short term, the
seeds of destruction that caused the deep economic contraction of
the 1930s were sown during the 1920s. The growing inequalities
in wealth, especially in terms of income distribution, caused an

v Income from mainly wages and salaries, but excluding credit.

102 | 1. déjà vu: an overview of the modern world economy

imbalance between supply and demand. This imbalance was

temporarily countered by making more and more credit available
to the consumer and by the lowering of taxes, both of which would
have increased disposable income and demand. However, neither
of these measures could neutralize the growing imbalance on a
permanent basis, and probably contributed to the stock market
bubble of the time. As capital provided by the wealthier classes
produced more goods and services than could be consumed by the
middle classes, the wealthy put their capital to more speculative
uses, such as the stock market. This probably played a major role
in the stock market bubble and the inevitable subsequent collapse.
What can we learn from this? Although significant tax reductions
preceded major crises, as shown by the Great Depression, the Japan
crisis, and the current crisis, this does not necessarily prove any
direct causal link between lower taxation and the ensuing crises.
What the above does show, however, is that higher taxes do not
necessarily cause economic harm, nor do lower taxes ensure
continued economic prosperity.
There might, however, be an indirect link between the lowering
of taxes and subsequent major crises. Lower taxes might over
time contribute to wealth inequalities and would probably serve
to mask (by increasing disposable income) the growing economic
imbalances that build up in periods that precede major crises.
The 1930s, and especially World War II, served as a consolidation
period wherein the economic imbalance, caused by growing wealth
inequalities of the 1920s, was adjusted to some extent. Whether higher
taxes, higher budget deficits, or World War II had any such intent
is debatable. Irrespective of intent, what we do know is that these
factors lead to an improvement in wealth distribution (especially in
terms of income distribution) and nearly full employment, and that
it probably laid the foundation for the prosperous decades of the
1950s and 1960s.
As wealth inequalities increased substantially beginning in
1980, the tax cuts since the early 1980s would have temporarily
stimulated consumer demand. But it probably also had the effect of
 dominant causes of major crises | 103

temporarily masking the growing imbalance between supply and

demand. This imbalance was caused mainly by wealth inequalities,
which started to worsen significantly in the 1980s and which
continue today. When taxes are cut during a period of expanding
credit and lower interest rates, the combination can push demand
to very high levels that are unsustainable in the long run. Capital
investment is stimulated, which in turn leads to an increasing supply
of goods and services. However, when taxes cannot be lowered
any further and credit cannot be expanded, consumer demand is
limited to normal consumer income. This inevitably leads to a drop
in demand, causing the economy to contract.

A Synopsis of the Effect of Growing Inequalities

on the Current Crisis
The growing inequality in income distribution referred to in
Chapter 3, and that began in the early 1980s and increased in
pace after 2000, caused a growing imbalance between supply and
demand. The bottom 80% group’s ability to consume a major part
(61.4% of total personal consumption; Table 3.g) of products and
services produced by the economy was stretched well beyond the
group’s share of income (earned 52.4% of disposable income). This
imbalance was alleviated by the extension of credit to consumers,
which increased annually. The amount of credit that can be given
to consumers, however, is limited to what an individual or group
can service from its income. From not later than 2000 onward, the
80% group took on more debt than what was serviceable from its
income. This was made possible by initially lower interest rates,
financial innovations, and lax underwriting standards supported
by a perception that the value of collateral, namely housing, would
continue to rise. As long as the value of housing collateral continued
to rise, the financial institutions kept the credit spigots open. When
consumers started to default on debt payments and house prices
started to drop at an increasing rate from 2007, credit to this group
was quickly frozen. In addition, the 80% group suffered severely
from job losses that negatively impacted its ability to service its
104 | 1. déjà vu: an overview of the modern world economy

debts and to spend. When the main engine for consumption stalled,
the writing was on the wall. As demand dropped, production was
curtailed, resulting in economic contraction. The banking crises and
the other bubbles referred to above also contributed significantly
to the current crises. Much was done to solve the latter but as long
as the 80% group remains in the emergency room, any recovery in
the economy will probably be limited and unsustainable.

Is There a Solution to the Current Crisis?

Possible solutions will be discussed in the final chapter of this book.
Before we proceed to the solutions, it is important to understand
why the economy is not really free and fair and why society is so
misguided and receptive to manipulation and deceit. We will also
look at the role played by the bankers, their innovative credit-
related products, their extraordinary compensation packages, and
the influence they and big business exercise over the economy and
society. These and many other factors might restrict us from coming
up with genuine, long-lasting solutions. In Part Two (Chapters 5
to 8) we will investigate these issues.
 the rise and fall of the financial gods | 143

The Best and the Brightest

David Halberstam made the phrase “the best and brightest” famous
in his 1972 book of that name.53

What was it about the men, their attitudes, the country, its
institutions and above all the era which had allowed this tragedy
to take place? They were after all “the best and the brightest,”
so why did it happen? . . . They had, for all their brilliance and
hubris and sense of themselves, been unwilling to look and learn
from the past.54

Halberstam asked these questions regarding US policy in Vietnam,

but his question is equally relevant today regarding the financial
crisis. If the talented bankers were the best and the brightest, why
did they fail so miserably to foresee or to prevent the crisis?
On what merits do they base their claim as the best and the
brightest? They may have high IQ scores and graduated cum laude
from the best universities, but so have many scientists, surgeons,
and programmers who work for a relatively small fraction of a bank
executive’s pay. They might argue that they have to take huge risks
in high-pressure situations, but more so do surgeons (median salary
of $300,000),55 fire fighters (median salary of $40,000),56 and senior
military fighter pilots (around $140,000). The only argument they
actually have is the amount of profits they claim to generate for their
firms. The question is, however, are they really that much better at
what they do than other talented traders who trade on their own
account, or do they simply excel due to the advantages bestowed
on them by the big financial institutions? They are probably not
that good without all the advantages that come with working for a
large and influential firm. If they could trade at a 98% win rate by
themselves, they probably would be doing so.
Their record speaks volumes regarding their actual abilities
to manage money. Many of the top executives destroyed more
value than they created between 2002 and 2008. In the process,
they acted at best foolishly, behaved irresponsibly, and in some
144 | 2. the enemy within

instances conducted business illegally. They lacked foresight and

panicked when a crisis hit their markets. They and their allies
threatened, squirmed, threw tantrums, and eventually had to rely
on the taxpayer to save them. They forced changes in accounting
rules and exchanged their rotten apples for cash at central banks.
As soon as they got back on their feet, they kicked the taxpayer out
of their business, keeping only their guarantees and nearly interest-
free loans from the Fed. Then they put their arms consolingly
around the taxpayer, explaining how happy they should be when
the bankers make fortunes—after all, the bankers are doing God’s
work. These men can hardly claim to be the “best and the brightest.”

Failure of Risk Management

Another important factor in the financial crisis was the failure of
risk management, not only in the financial sector but in many other
industries. Although there is general acknowledgement that a lack
of discipline in risk management contributed the credit crisis, few
are prepared to be specific about the real causes of its failure.
Relying on clever financial and mathematical models alone offered
little protection. Without understanding human behavior, such as
greed and the seeking of status, using the veil of false credibility, or
employing deception by way of complexity, risk management is at
the mercy of manipulating executives and trusted agencies.
Much reliance was placed on rating agencies, the credibility
of the firms that issued them and the protection bought in terms
of CDSs. Many of the securitized mortgage products and other
structured financial products (e.g., CDOs) were insured by the
issuers of CDSs. In her book, Fool’s Gold, Gillian Tettvii describes the
pressure exerted by major banks on the rating agencies.

Investors generally relied on ratings agencies to guide them
through this strange new land, which seemed a rational easy
solution to contending with the complexity. . . . Better still, they

vii Gillian Tett is a multi-award winning journalist who writes about global markets for
the Financial Times, and has a Ph.D. in social anthropology from Cambridge University.
166 | 2. the enemy within

legitimacy and credibility. They need them in order to justify their

huge bonuses and to obtain new capital. If financial institutions
are allowed to publish both versions—historical and fair value
accounting—the markets, investors, and shareholders will judge
them by their fair value anyway. The campaign against fair value
accounting will continue for some time, in order to give banks the
freedom to value assets as they deem fit and still appear credible.
Let’s assume for the moment it is sometime between 1996
and 2006: the markets seem to know no upper limit, profits are
soaring as measured by fair value accounting rules, share values
are increasing, and large bonuses are paid to bankers. Would
anyone expect these same role players to criticize fair value
accounting? Very few, if any, of the role players did. Fair value
helped banks, especially those involved with investment banking,
to show huge profits during the good times. Many financial
companies worldwide used their countries’ versions of fair
value accounting to maximize reported profits, justifying bonus
payments and touting their share prices in the meantime. They
used the latest market prices when it suited them and mark-to-
mythviii models when market values were not considered suitable
for valuing their investments.

Mark-To-Myth—A Real-Life Example

Let’s look at a real-life example of the type of reporting sometimes
employed.42 For the sake of simplicity, only the details necessary or
relevant to illustrate the mark-to-myth issue will be used. During
the late 1990s, a South African investment bank, Corpcapital
Ltd., acquired an investment in an internet start-up gambling
company Netainment (later called Cytech), which was based in the
Netherland Antilles and later in Belize.
The South African accounting rules allowed entities to value
certain assets at fair value (market value) and to include such
gains in their earnings reports. As market prices for the relevant
assets were not available, Corpcapital used a hybrid discount
viii A value that cannot be justified in terms of prevailing realities.
 complexity and transparency | 167

cash-flow model. The basics of such a valuation are that the

company must determine its future cash flow and the rate at
which it will discount that future cash flow back to the present
time. This formula forms the basis of most valuations when mark-
to-market is not possible. The formula attempts to determine the
market value by recognizing all relevant market factors that apply
to similar assets.
Although Corpcapital’s model was more complex than the one
presented below, it was based on the same principles. The most
basic formula for cash flow models is the following:

Value of investment = Future cash flow/Discount rate, or

V = F/D (author’s own abbreviations).

Now let’s assume that the actual current cash flow is $100 per
annum and a fair discount rate is 10% after considering all of
the relevant market factors. Let’s further assume that there is no
objective evidence that future cash flow will change from the $100
per annum. Based on the above equation,

V = $100/10%
V = $1000.

Assume next that the investment entity hopes to raise future cash
flow to $200. Realizing that such a future cash flow is highly unlikely
to be achieved; they attempt to justify it by raising the discount rate
from 10 to 12%, an increase of 20%. They then calculate the value
in year one as

V = $200/12%
V = $1666.67.

But let’s suppose that cash flow in fact slips to $80 in year two and
to $60 in year three. The value of the investment should then be
calculated as not more than the following:
168 | 2. the enemy within

V(end year 2) = F/D = $80/10% = $800

V(end year 3) = F/D = $60/10% = $600.

The investor, however, persists in his belief that he can improve

cash flow to $180 in year four. The investor therefore values the
investment as follows as at end of year three:

V = $180/12%
V = $1500.

One can then determine the extent of overvaluation by comparing

the following:

V(end year 2) = $1666.67 – $800.00 = $866.67

V(end year 3) = $1500.00 – $600.00 = $900.00.

If one assumes that the investor bought the investment for $1000,
he would post a profit of $500 ($1500 – $1000) instead of a loss
of $400 ($1000 – $600) at end of year three. Imagine now that the
investor acknowledges that his cash flow forecast F is too aggressive
but that because he upped the discount rate D by 20% from 10%
to 12%, one should still consider the valuation as correct. One does
not need to be a rocket scientist to know this is delusional thinking
and that the estimated profits generated in this manner (mark-to-
myth) cannot be justified.
But add complexity to the above, as was done in this case,
and you can probably convince most people, and even the watch
dogs of society, into accepting such higher valuations as fair and
reasonable. This is what seemingly happened in Corpcapital’s
valuation of Netainment. From Figure 7.1, see how future profit
growth F and revenues (red and green lines) of Netainment were
projected higher for valuation purposes, contrary to the downward
trend of actual profits and revenue (orange and blue lines).


$5,000,000

Source:
$4,500,000 Figure 7.1
$4,000,000

$3,500,000

$3,000,000

$2,500,000

Corporate Codes Website

$2,000,000

$1,500,000

$1,000,000

$500,000

$0
Revenue and Profit vs Actual Revenue and Profit
Netainment (Cytech) September 2001 Valuation Forecast

September 2001 Forecast - Revenue Trendline September 2001 Forecast - Revenue

complexity and transparency

September 2001 Forecast - Profit Trendline September 2001 Forecast - Profit

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Corpcapital Financial Statements (*) Actual Profit Actual Profit

Actual Revenue
169