Calling the Bluff; K. M. Boudreaux

Lurking behind his clever rhetoric and amusing anecdotes are revealing lessons about what really happened on Wall Street. One of his most interesting points is that the explosion in the bond market in the 1980swas not the result of new-grown greed on Wall Street, but the consequence of government actions. Because of the worsening problem of inflation during the 1970s, the Federal Reserve, under Paul Volcker, was forced in 1979to abandon the no-win cycle of continually pumping money into the economy in order to reduce short-term interest rates, seeing rates rise eventually due to the resulting inflation, and increasing the money supply even further to start the whole cycle over again. Instead, the Volcker Fed allowed interest rates to fluctuate while controlling money supply growth. Because Katherine M. Boudreaux is a Senior Lecturer in the Department of Economics, Mary Washington College, Fredericksburg, Virginia.

bond prices vary inversely with interest rates, increased volatility of interest rates caused bond prices to change more rapidly and dramatically. At the same time, there was a tremendous increase in the demand for borrowed funds, with the biggest single borrower being Uncle Sam. Bonds are the sole source of borrowed funds for the federal government, and many businesses raise money with bonds as well. The increase in the demand for borrowed funds coupled with the vari ance in bond prices created tremendous opportu nities for entrepreneurs in the bond market, which had previously been a quiet backwater on Wall Street. When a market is volatile, investors want guid ance. Salomon Brothers specialized in providing advice in the heretofore boring bond market, act ing as a middleman. As the market struggled to adjust to the immense increase in government bor rowing in the early 1980s, investment bankers made a good deal of money advising and selling to borrowers and investors. Naturally, employment in this area grew because of the demand for such services.

The Growthof "Greed" Do these events signal that people became more greedy during Ronald Reagan's tenure in the White House? Of course not. Ever since the imposition of the Federal income tax, we have had tax accountants, tax lawyers, and tax preparers profiting handsomely. Rather than thinking of 32 THE FREEMAN • JANUARY 1991 these individuals as greedy wolves, we tend to think of them as protectors fighting off the incom prehensible, yet dangerously potent, edicts of the Internal Revenue Service. In fact, because govern ment continues to make complex changes in its tax code, this industry continues to have opportunities to profit, whereas the shakedown on Wall Street during the last few years signals that the bond mar ket has adjusted and above-normal profits have been dissipated. Similarly,change in government policy sparked a market in mortgage bonds. Thrifts and savings and loans (S & L's) were already in bad shape by the beginning of the 1980s. The inflation of the 1970s caught them with many long-term mort gages paying low, pre-inflation rates. With such a low cash flow, thrifts and S & L's couldn't attract depositors. So in 1981,Congress gave the industry a big tax break. In order to get it, however, the thrifts and S & L's were required to sell their exist ing mortgages.

Although many of these sales turned out to be unwise, they were prompted by the government's tax change, not by financial markets. In 1982, the government tried deregulation, but the industry, battered by the government's actions of the pre vious decade, weak from protection and regula tion, and invested in questionable assets with the proceeds from the mortgage sell-off, could not compete. Salomon Brothers helped the thrifts and S &L's find buyers for the mortgages and in the course of doing so solved one of the most perplexing prob lems in the mortgage bond market. Lewis is justly admiring of that invention. Despite the govern ment's attempts since the 1930s to establish a sec ondary market in mortgages, private mortgage bond placements were difficult because mortgages can be prepaid. In other words, when a homeown er moves and sells her home, she pays off the mort gage. The investor who bought the mortgage from the bank that loaned the money gets the money all at once. This unexpected pay-out can have adverse tax consequences. As a result, the true yield to the investor is altered. Because of this uncertainty, investors were reluctant to buy mortgages. With out buyers (a "secondary" market), banks were somewhat less willing to make mortgage loans.

A Salomon Brothers employee solved this prob lem by pooling mortgages and selling them in "tiers." Everyone who bought firsttier bonds got paid off before everyone in the second tier, and so on. With sophisticated statistical analyses, Salomon Brothers could predict with relative certainty when the investors in each tier would be paid. Inspired by the increase in the mortgages being offered by S & L'sto take advantage of the tax break, Salomon Brothers stimulated the demand for mortgage bonds. In turn, it became easier and less costly for people to purchase homes. So Salomon Brothers, and presumably other firms with expertise in the bond area, profited not because of an explosion of greed but because of changes by the government. Lewis explains these causes for those who care to pay attention and understand. He does not, however, analyze the labor market as clearly as he does financialmarkets.

MalignedMiddlemen Bond salesmen, such as Michael Lewis and the character of Sherman McCoy in Tom Wolfe's Bonfireof the Vanities,use the recommendations of bond analysts and their own experience to sell bonds. Lewis claims still not to understand what he was paid to do by Salomon Brothers. Perhaps this is a reflection of age-old negative feelings about middlemen. It is easy to see what the farmer does because the food on the plate is so obvious. But what exactly did the agricultural cooperative, the grocery wholesaler, and the supermarket do that justifies the difference between the price the farmer got and the price paid? The contributions of middlemen, which range from tangibles such as transportation to intangibles such as display, mar keting decisions, and advice, have provoked suspi cion since the division of labor became predomi nant in trading societies. Lewis is particularly disingenuous when it comes to his own background. His art-history major at Princeton and part-time jobs between college and graduate school are detailed to illus..

trate his lack of preparation. His master's degree in economics from the London School of Economics gets short shrift. Lewis says that his $46,000start ing salary,the same as what an M.B.A. would earn, felt like "lottery winnings." Perhaps this is profes sional sensitivity on my part, but I believe that a graduate degree in economics from one of the world's finest programs is at least as good as an M.B.A. More tellingly,however, Lewis misunder stands the theory of wage determination.

REFLECTIONS ON LIAR'S POKER 33 Michael Lewis, author ofLiar's Poker. People are not paid according to some intrinsic value of their product (a favorite idea of Marx's), or what they "deserve," as Lewis puts it, but according to the worker's physical productivity plus what people are willingto pay for the product. Thus, Madonna is paid an enormous sum because she sings and dances in a way that people find entertaining.Investors valued Michael Lewis' advice and services as a bond salesman in a market stimulated by the government, and so he earned a lot of money. Both Michael Lewis and Madonna may find their financial success astounding, but that hardly matters. Lewis plays a lot on his amazement that he was paid a high salary even when he first went out on a trading floor. It is true that there is what economists call a "learning curve," and probably Lewis' advice was not worth so much at first as it was after he had gained experience. However, Salomon Brothers was not irrational to pay rela tively high wages to Lewis when he was fresh out of school, because it is costly to adjust wages fre quently. For example, despite the fact that I was recently delayed at a service station by a new employee who did not know how to work the reg ister, I am certain that his wage wasn't different two days later when he knew how to do it. Even tually Lewis admits that the business he brought in generated far more revenue for his employer than he was paid.

All PartiesGain Lewis also never quite catches on to the fact that all willing parties to a bargain gain. He writes as though he is continually duping his customers, yet also writes of being tied in to some of Europe's largest money pools, run by people Lewis describes as "quick, aware, flexible, and rich." He indicates that he has customers who trust him. These contradictory ideas are not resolved. I sus pect that Lewiscannot quite get beyond his knowl34 THE FREEMAN • JANUARY 1991 edge that Salomon bought the bond at one price but he can sell it at another, higher price. Which is the real price? Isn't someone getting ripped off? Suppose I go to an auction and buy a piece of furniture. Later I sellit at a yard sale for more than I paid for it. Who's the loser here? The original owner could have withheld the piece if the auction price wasn't high enough, so he must have been satisfied. The yard-sale buyer must have thought the furniture was worth it because she paid the price. And I got something for transporting it from the auction, where the yard-sale buyer was not present, to a place and time when she was avail able. Everyone wins-there are gains from trade for everyone. This is the idea Lewis misses.

Lewis does offer some interesting insights into junk bonds and takeovers. He admiringly describes Michael Milken's role in providing capi tal to relatively small but high-growth firms who are shut out of bond markets. These high-yield ("junk") bonds turned out to be such good invest ments that the demand outstripped the supply. According to Lewis, Milken then conceived the idea of using junk bonds to purchase undervalued companies and put their resources to more effi cient use. But Lewis realizes that, contrary to some economists' specific belief and the unspecified public myth, markets are not perfectly efficient. Some takeovers fail because investors were wrong about the value of the company and the amount of debt that could be carried. The result is bankruptcy. A competitive market punishes such mistakes. The attempted takeover of Salomon Brothers as described by Lewis is an example of another type of failure. The "raider" in question is known for-gasp!-firing inefficient management. Not surprisingly, the existing Salomon management fought off the takeover with stockholder assets, costing both stockholders and employees. Recent trends in state legislation, unmentioned by Lewis, make it easier for existing management to engage in this unscrupulous behavior.

But which is worse-layoffs of inefficient employees in order to create a more profitable firm that the socalled raider needs, or the seemingly random layoffs made by inefficient management needing funds to pay for fighting the takeover? Lewis admits that after Salomon's rousing success in the early 1980s,the management missed some important calls and was overstaffed. Using stock holder assets and his personal friends on the board, the chairman saved his job. Thefirm did cut back, but the cutback was executed by the same folks who had engineered the firm into the current unprofitable position. Salomon couldn't even hold onto one of their most (in the author's own estima tion) profitable people-Lewis himself. What I learned from Liar'sPokerwas that ev~n a writer intent upon disguising reality can't cover up the government's role in events. Government actions inevitably have unintended consequences, many of them undesirable, many long-term. We should, for example, look to the government as well as the private sector, and well before the 1980s,if we want to understand the S & L crisis. I also learned that in order to make real-life behav ior conform to the popular conception of life on Wall Street, writers such as Lewis have to be able to fool themselves.

Far from being a condemnation of private behavior in the greedy 1980s,Lewis has presented us with convincing evidence that the government should stay far out of financial markets. Of course, to make the book a best-seller,he included a lot of juicydetails that disguisethis point. Michael Lewis is a smart guy, which is why he succeeded on Wall Street. So read his book-but call his bluff. Read between the lines. D Coming Next Month ••• • "Resurfacing the Road to Serfdom"· by Susan Marie Szasz • "Lessons from the Road: The Evolution of an Eatery" by John Baden • "The Charade· of Participatory Democracy" by Ridgway K. Foley, Jr.