Friday, April 13, 2012

Some Employ But Others Deploy

Who are the rich and what do they do with their money? This is a sample of the questions that have preoccupied us, human beings, since our cave dwelling ancestors started to bring home the wild boar with bacon inside it. Things have changed a great deal since then because wealth is no longer measured by what we see only; it is measured by a host of other sticks -- many of which are invisible to the naked eye. In fact, there are people who possess enough wealth to decorate a whole city if they so wish; and yet they choose to live so modestly as to appear average. It is that in today's world, wealth is stashed in bank accounts and kept in portfolios that contain securities, promissory notes and certificates -- all attesting to the ownership of properties such as real estate, precious stones and precious metals, private companies and what have you.

There are many reasons why and how some people get wealthy and other people don't; why and how some people lose their wealth and other people don't. But this is not what I choose to discuss in this presentation. Rather, it is how the people who have money under their control deploy it -- whether it is their own money or it is other people's money. And what I emphasize here is the extent to which these people make the wealth contribute to the employment of other people.

There are two basic ways to possess wealth in the modern world: either you own equity which gives you a return on your investment, or you own debt which is the money you lend to someone in return for the interest they pay you. When you own equity, you own all or a portion of an institution that creates wealth, preserves it or enhances it.

For example, a farm, a mine, a factory or a utility make the sort of tangible goods we use in our daily lives. Other enterprises such as a department store, a restaurant or a beauty salon perform the kind of services that we all need at one time or another.

As to the institutions that preserve wealth, there is the entire system of health -- ranging from the small clinic to the large hospital -- where human beings (most valuable resource) are made to feel better and kept alive. There is also the hospice where people who are down on their luck -- temporarily or permanently -- are looked after. And there are the firefighters, the police, the coast guard and the military that maintain order and save lives. And to run all this, there is the government in all its three branches: the legislative, the executive and the legal.

As to the institutions that develop the human resources, there are the schools, the universities, the laboratories, the various training centers, the clubs and so on.

When it comes to investing in debt as opposed to equity, you can lend your money to a government -- from the municipal to the federal -- or you can lend it to corporations or you can lend it to individuals.

People who have some level of sophistication in the field of investment prefer to maintain a balanced portfolio. This means they invest (deploy their money) in both equity and debt. In general, these people would have enough of it to be in both types of investment at the same time. But there are also people who invest in only one type or the other. They would be the people who have a narrow purpose they wish to fulfill or the people who have a mandate to invest the money put under their control in a prescribed way.

The crucial point I wish to accentuate here is that the relationship you develop with your investment will differ markedly depending on whether you invest in equity or you invest in debt. And the consequence is that your view of the economy will also differ dramatically. It is that when you invest in equity, you deploy your wealth in the institutions that employ the people who create the wealth. Sooner or later, you will come to realize what Henry Ford realized long ago; and this is that your employees are also your customers. Thus, if you want to sell what you produce, you must pay your employees enough so that they may afford to buy the products they make. This being the case, you also want the other employers to do the same with their employees. When this happens, you will sell your products to these employees as well; while your own will be buying their products. This means in the end that you and all the people who invest in equity will instinctively wish to see a thriving economy because it is in your interest.

On the other hand, if you invest in debt, you only worry about the solvency of your client. He could be in a business that does well in an economy that is thriving or he could be in a business that does well in an economy that is slumping. As long as he can pay you the interest, and as long as you expect him to return the principal when the time will come, you will be eager to do business with him. But there is more to it than that because if your investment in debt is safe at a time when the economy is slumping, you have the best of both worlds and have many opportunities open to you. It is that you will have the money to pluck assets in distress at a fire-sale price with the zest of a vulture that swoops down on a wounded prey.

The lenders of money and the business vultures call themselves capitalists. Maybe they are in the sense that they own some capital. But they are not capitalists in the sense of the word as it was originally defined -- and this is because they do not create wealth. These people do not make goods of any sort, and neither do they produce the kind of service that would be useful to someone. What they do is use (as a medium of exchange) goods made by other people, and they produce a type of service that is self-serving and nothing more. The truth is that these people are wired so differently from the entrepreneurs who create wealth, and their talent is so different that they can never adapt themselves to create real wealth even when they try. If and when they do try, the chances are that they will succumb to the temptation of exploiting the opportunities blowing their way and they will take advantage of the misery inflicted on other people. It is in their DNA.

For example, if a vulture who calls himself a capitalist buys a factory or any enterprise in distress, the chances are that he will not retool it to make it work more efficiently as he would say; he will fire many or all of its employees, break the company into small parts and sell these to the highest bidder. In the end, he will make a profit that is big or small not because he created something that was not there but because he destroyed something that was there but is no more. The net result is that he will have added to his wealth by subtracting something from someone else – from a number of other people. And the subtraction will be not just a little wealth; it will be to deprive these people of a job and deprive them of the ability to provide for their families. If you want to call this capitalism; call it the dark side of capitalism.

So then, how do the self-described capitalists hide or whitewash the dark side of their activities? They do it by accusing the people who criticize them of envy even when those who criticize are as wealthy as they, but have made their wealth by producing the sort of goods and services that society actually needs, is willing to buy and gladly pays for. If you look closely, you will find that the phony capitalists who used to score with their phony arguments are being unmasked, and they are gradually losing credibility among the general public.

As to the lenders of money, the methods they employ to add to their wealth are no less wretched. To get a deep understanding of this, we need to remember a few fundamentals relating to fiat money. For many thousands of years, the ancestors who brought the bacon home inside a wild boar bartered some of it with a neighbor for maybe an apple or a shell full of honey. Eventually these early people settled down to farm the land and domesticate the animals, a move that increased their wealth tremendously. Thus, the wealth they had was no longer restricted to what they consumed on a daily basis; it was something that had a “stored” value.

To reflect this new reality, our ancestors picked precious metals such as gold and silver, stored in them a nominal value and used them as a medium of exchange. This meant, they no longer had to exchange the liver of a boar for an apple because they could exchanged either of them for a piece of metal and vice versa. The convenience of this innovation was that they could now carry with them a small piece of metal to represent as much as a herd of sheep or a basketful of apples or a beehive.

Life developed further, and wealth increased so much more -- especially in the wake of the Industrial Revolution – that the precious metals proved to be insufficient to reflect the stored value of all the services produced on a daily basis, and all the goods in both the durable and non-durable categories. This reality necessitated the creation of another medium of exchange called paper money. It was also given the name fiat money which is a good thing because the exchange is now done not only with paper but also plastic cards and electronic transfers.

What is important to know is that a Central Bank in each jurisdiction has the task of “printing” and distributing this fiat money, which it does to designated commercial banks and other similar institutions. The Central Bank operates according to rules that are supposed to protect society and the economic system itself from fraud. The integrity of its operation is absolutely essential because someone who produces not even a grain of wheat could -- by a simple trick -- acquire enough fiat money to buy a silo full of wheat, an orchard of apples and a factory processing honey. This is a huge problem but the truth is that no system can be fully protected from someone determined to game it. And gaming the system happens all the time despite the punishment because the temptation to get rich quick is a powerful inducement.

Thus, it happens that the institutions through which the Central Bank distributes fiat money have become the centers of corruption where all sorts of schemes are hatched to game the economic system and give silos upon silos of wealth to people who are skilled in the art of playing games but do not have the IQ to produce a grain of wealth outside the cocoon in which they operate. In doing what they do, these people create mini bubbles that end up fusing together to become a giant bubble. This bubble then implodes and takes with it the whole economy, an event that results in tremendous hardship being inflicted on just about everyone. And believe it or not, they have the temerity to call this capitalism.

To understand how the game is played, we need to know that for the Central Bank to allow the granting of money to an individual or a corporation there must be a request to borrow. Such request is not made directly to the Central Bank but to an institution such as a commercial bank or a brokerage firm. These institutions are supposed to verify that the borrower has a good chance to repay the loan before they approve it. The trouble is that they can be corrupted, and thus fail to do the proper verification. This results in an increasing amount of money being borrowed and being used to buy a fixed amount of assets. What happens, therefore, is that the price of these assets inflates and thus creates the dreaded bubble. Those who know what is happening – and they are the lenders – sell first and trigger the general panic to sell. The bubble is pricked and the economy as a whole gets to suffer in consequence.

Like the vultures, the lenders of money are prone to creating services that are entirely self-serving. Like them, they call themselves capitalists. Like them, they call the people who criticize them envious. And like them, they are gradually losing credibility among the general public.

Sooner or later there will be such an outcry to reform the system that no one will be able to resist. And true reform will come at long last. Am I dreaming?