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Part 1: "How Money is Created"

1) Introduction to Wizards of Money
2) Why this Name for the Series?
3) The Birth of the Federal Reserve
4) Misconceptions About Money
5) The Money Creation Process
6) Why Money is Undemocratic
7) The "Zero Sum Game"
8) Ancient Monetary Wisdom

This is your Money and Financial Management Series…but with a twist. My name is Smithy,
I’m from the land of Oz.

In response to the growth in business and personal finance shows at most media outlets,
including so-called public media, such as NPR and PBS, we bring you this new series on money
but "with a twist". In this series we will look beyond the latest DOW and NASDAQ ups and
downs, and past the hot stock tips, and see just how peculiar and undemocratic our monetary
system really is. The Wizards of Money will take a critical look at the mechanics of the capital
and debt markets, who makes the critical decisions that drive them, and how these markets then
effect everybody’s lives.

Humans have inherited a monetary system that fueled the industrial revolution, lost its
commodity backing during the Vietnam War and now travels by the trillions, over millions of
miles in a matter of nano-seconds. Physical currency notes are almost irrelevant having been
replaced by a system of bits and bytes accounting in complex networks. While money is just a
highly abstract measure and a medium of exchange our lives revolve around it and its
disappearance can bring trade to a grinding halt, collapsing whole communities. This ridiculous
situation is akin to a carpenter stopping work because he has run out of inches! Or a musician
calling it quits because she's run out of decibels!

Today, in part one, we'll examine that most peculiar activity known as "making money"; how
money is made and who makes it. We'll explore the mysterious money making process by first
exploring the origin, and role of, one of the most secretive bodies in the world, the Federal
Reserve System. We will also look at the role of the commercial banking system, and why it is
that the money origination process is quite unfair and undemocratic.

In future editions of Wizards we will look further into the workings of the Federal Reserve, and
its sole shareholders, the private banking industry. We will also investigate similarly secretive
bodies such as the Bank for International Settlements in Switzerland, the World Bank, the
International Monetary Fund, Central Banks in other countries, and most importantly how these
institutions interact with the stock markets.

Recent decades have brought with them a growing public awareness of the long-term costs of the
short-term profiteering legacy of the industrial revolution. Global Warming, Ozone Depletion,
and Acid Rain are now all household names. The current monetary system - the one inherited
from this same industrial revolution and the one in which we always "discount the future" - has
played a large role in such destruction of the environment. Many are asking the question - Can
we design monetary and economic systems that encourage preservation of the environment and
sustainable economies?

Along these lines, in later editions of Wizards we'll examine some of the fundamental flaws of
contemporary mainstream economic theory, that led to such environmental destruction. Then
we'll explore how emerging fields of economics, such as Ecological Economics, are addressing
some of these flaws and challenging the underpinnings of traditional theory.


The explanation of this will provide a good historical framework for this series, and remind us of
a time a hundred years ago when the American citizenry had a much better understanding of
their national monetary system and demanded active participation in it.

Today, however, for reasons that can only be speculated on, the majority of world citizens have
very little understanding of how the international monetary system works. Yet in this day and
age our lives are largely determined by our relationship to, and we are highly dependent on, the
international monetary system.

When you live and work amongst something day in, day out, you take it for granted. Just like
fish surrounded by water, many people seem to have stopped questioning the foundations of the
monetary system and go through life unaware that these foundations may be on very shaky
ground. Additionally those of us who work in finance have been "trained" to understand
economics and finance in a certain way, often blinding us to new ways of looking at money.
Many activists request reform and more economic fairness within the existing monetary system.
However there is evidence to support the position that problems of economic inequity are rooted
within the monetary system itself.

The name of this series, the "Wizards of Money" is derived from the title of a book written just
over 100 years ago, called "The Wonderful Wizard of Oz", by a journalist named L. Frank
Baum. Many believe this book to be a social commentary of the times. One of the most contested
issues of the era was the monetary system and whether America should stay on the gold standard
or move to a bi-metallic standard (meaning gold and silver). Gold would benefit the already rich
and powerful financiers of the northeast, who owned most of the gold, such as JP Morgan and
others. The bimetallic standard would make money more available to farmers and regular
workers and was backed by the Populist movement of the time. The monetary system was such a
popular public discussion item that talks on this issue drew crowds of ten of thousands from
across the country. Interpreters of the "Wizard of Oz" have suggested the following meanings of
characters and places in Oz:

• Oz, short for Gold Ounces, is probably short for the Gold Standard.
• The Wizardry in Oz may refer to the mysterious money making process itself.
• The YELLOW brick road to Oz, is probably the way to the gold standard.

• Emerald City is likely another word for WALL STREET, where the wealthy financiers
who owned most of the gold were based, and where green glasses (green for money)
were worn.
• Dorothy’s shoes in the original book were SILVER, not red as in the movie, and likely
represented the other component of the bimetallic standard.
• The man operating the Wizard possibly represents the financiers behind the presidential
candidate at the time who favored the Gold Standard. This candidate was William

"Wizards" of Money, as in Oz, is a most appropriate name for those who are responsible for the
mysterious money making process today. In this process, as we shall see, money is essentially
created "out of thin air". It is only the Wizards who get to practice this art, and they do so in the
absence public scrutiny which might ruin the magic.

The other main characters of Oz also have counterparts in US society at that time, that is, at the
start of the 20th century. Books such as "The History of Money" by Jack Weatherford (which
incidentally received rave reviews from Charles Schwab) cover this interpretation of Oz in more
detail. As it turned out, the Populist movement lost, McKinley was elected president and the
Gold standard defined the monetary system. But the US still did not have an effective central
bank system. At the instigation of financiers like JP Morgan and his right hand men, but most of
all from the sheer energy and genius of one Mr. Paul M. Warburg, that was all about to change.


The birthplace of the Federal Reserve System was not Wall Street or Washington as people
might think. The founders wouldn’t dare hold a monetary design meeting in a place where public
scrutiny might threaten the handiwork of the first Wizards. Rather the monetary system designers
chose to go to a state with a proven track record of loyalty to wealth accumulation as a priority
over the rights of the people. This was evident from the state’s long history of slavery, coupled
with such a remarkable devotion to gold that it uprooted its indigenous inhabitants and marched
them off to Oklahoma at the first smell of gold. What better place to design an undemocratic
monetary system based on the gold standard? This state was Georgia, and in 1910, a special
Wizard convention took place there on Jekyll Island. Duck-hunting was the excuse given for
having to go there. But numerous historical accounts of this event reveal that the duck population
remained fully in tact and, instead, the Federal Reserve System was designed. (Examples of this
account are in Frank Vanderlip’s Autobiography. Mr Vanderlip attended the secret meeting and
was President of National City Bank, which is now known as Citigroup today. Another account
was written by Bertie Forbes, in a publication called Current Opinion in 1916. He went on to
found Forbes Magazine. Interestingly today the Federal Reserve Bank of Minneapolis also has
this same account on its web site, so it is "Official History").

Three years later, during the week before Christmas 1913 when several representatives were
already on vacation, the US Congress slid through the Federal Reserve Act, thereby giving birth
to the Federal Reserve System. Today, though the gold standard is "no more", we still live with
the legacy of that Jekyll Island meeting and some of history’s real monetary wizards, particularly
Mr. Warburg. Needless to say, the system they designed had little (well, effectively no) room for
public input. It has survived fairly well, with the exception of the 1929 crash and subsequent
depression, because the general public trusts it. However, they do so mostly without
understanding it. This is a very interesting situation to have in a so-called democracy.

In later editions of the Wizards of Money we will look more closely at the founding of the
Federal Reserve System, its governance, and its relationship to congress, to the markets and to
the public in general. We will just note here a fact about Federal Reserve ownership that is
largely misunderstood by the general public. That is that the Federal Reserve is not a government
body. It is 100% owned by the private banking system. While its governors are appointed by the
President, their terms are for 14 years and the structure of appointments guarantees they
represent the very best interests of the wealthy.


4) SO, How is money created, and what role does the Federal Reserve and its member
banks play?
Lets start with some common misconceptions about money, and why they are not true:

Misconception 1: You make money by going to work, or by selling something.

FALSE: Nobody can make money except commercial banks (also called depository
institutions) and the Federal Reserve, which is owned by the commercial banking
industry. When you get paid for work it is merely a transfer of money that already exists.
It was, at some time in the past, created by the banking industry for a purpose for which
they saw fit to create (or really lend) money. The main reason people get a job is to get a
transfer of money from people who already have some.

When we talk about money here we mean money that can be used in all transactions and
in the repayment of all debts. This is what we are calling bank-money. However many
non-bank types of so-called "money" raising instruments are increasingly being used by
non-bank corporations to avoid direct contact with the bank money creating process. This
includes things like corporate bonds and shareholder equity, which expand on the bank
money supply, but all are completely dependant on, and rely on the confidence that they
can be liquidated for, "bank money". We might call this other stuff "near money". Since,
in our society, it is really bank money people seem to need for the basics of life, and these
other near monies are luxuries for people that have excess, we will focus just on bank
money in this edition of Wizards.
Misconception 2: Money has something to do with gold and Fort Knox.

FALSE: The monetary system USED to be backed by the gold standard until President
Nixon abolished the Gold Standard in 1971 during the Vietnam War. He did this because
there was not enough gold at Fort Knox, KY to back all the money that needed to be
created to fund the massive wartime expenditures. The axing of the gold standard backing
the US dollar led to the "floating" of most national currencies, which were no longer
pegged to a gold conversion standard.

This lead to phenomenal growth in speculation against international currencies, which

later led to massive economic and social crises in various countries that were speculated
against. Examples include the Mexican Peso crisis of 1994-95, the Asian financial crisis
of the late 1990s, followed by the Russian ruble crisis. Since the death of the gold
standard and the floating of most major currencies we have seen currency speculation
increase to an astonishing 98% of all international transactions. This means that "real
economic" transactions account for a mere 2% of international transactions, and we truly
live in the midst of a global casino. This data on currency speculation is derived from
data from by the Bank for International Settlements and summarized in the book "The
Future of Money" by Bernard Lietaer, Century Press.

Money supply and debt have exploded in the absence of gold convertibility and it is hard
to make sense of what money really means anymore. Money is no longer a store of value.
It is only a measure, an electronic accounting system of credits and debits, that has come
to be accepted world over as the only way of conducting trade. Each day several trillion
dollars travels the globe trying to attract more electronic credits for its owners.

Today's money is not backed by gold. It is now backed by nothing at all, except our trust
in the monetary system. This is ultimately a trust in those that create and control money –
the commercial banking system, and its major shareholders. The statement on all Federal
Reserve Notes "In God we Trust", is perhaps the most telling statement of this trust. For,
who would not trust something that appears to be so close to God?

Misconception 3: Money is Created by the Government Printing it.

FALSE: Today almost NO money is created by the government. Most of the total money
supply is created by banks making loans to the non-bank public. Almost all money (more
than 95% at any time) is created by the creation of a corresponding amount of debt.
Currency in circulation is just a very small proportion of the total money supply and it is
created by the Federal Reserve System, not the government. In truth, money is actually
created "out of thin air" by the commercial banks and their Federal Reserve System.

5) Exactly How Does Money Get Created?

Having gotten some of these misconceptions out of the way lets talk briefly about the
actual mechanics of money creation. Money creation happens in two main ways; First the
creation of base money, which is mostly physical currency notes, created by the Federal
Reserve. The second money creation process involves checking account or deposit
money created by the commercial banks, and which makes up most of the money supply.

Base money, also called high powered money, is created when the Federal Reserve
performs what are known as Open Market Operations. In this process the Federal Reserve
injects money by buying Government Securities, which then become debt owed by the
government (that is the American Taxpayer) to the Federal Reserve. And where does the
Federal Reserve get this money to buy the government securities? Well, it just makes it
up "out of thin air". The Federal Reserve has no budget, quite simply because it doesn’t
need one – it invents money whenever it needs it. In fact, almost all money we come by
has its basis in high powered money that the Federal Reserve invented at some time in the
past. Most of this base money is currency in the form of Federal Reserve Notes. The
Federal Reserve then creates a spurious "liability" on its balance sheet called Federal
Reserve Notes outstanding, and in return gets an asset in the form of government
securities, which the public must repay through the efforts of real work. Every time the
Federal Reserve creates or extinguishes base money the financial press and other
mainstream media reports it as a Greenspan interest rate announcement. This is not
technically correct but it does sound more palatable than saying that the Federal Reserve
just made some money up or just made some money disappear.

Once this base money is created, banks can create around 10 times this amount in
checking accounts and other deposits. They do this by making loans to the non-bank
public. A corresponding amount of checking account money is created for each new loan.
So most money is created just by bankers writing some new numbers on a piece of paper,
or these days, entering some new bits and bytes in computers, since money is really now
just a bunch of computer records. This means that when you go to borrow money to buy a
house or car, the money is really being created "out of thin air" by the bank, and being
credited to the checking account of the seller.

The bank has a distinct advantage in all this just by being a bank. For if you can’t pay the
loan through your hard work, they automatically get the house, and all they did was write
some numbers into the computer! From the bank’s perspective however, if you don’t pay
off the loan, they would have to write down their asset (i.e. your loan) and this would
effect the earnings they report. If lots of people did this the bank could go "belly up". So
you can see why they want to keep the house if you don’t pay your loan – they are taking
a financial risk too, albeit one created completely out of "thin air".

SONG/MUSIC: 10,000 Maniacs

6) Let's continue the discussion of unfairness in the banking system by exploring the
undemocratic nature of it.

Much of the unfairness to the non-bank public of this magical money creating process –
creating money out of thin air – really comes about because the general public has no
input into decisions about money creation. It is only bank managers and the Open
Markets Committee of the Federal Reserve Board that decide how much money gets
These decisions are all entirely closed to public input. Decisions on making new money
will be based on whether a lender can repay and how much interest the lender can bring
in, which is what creates bank profits. This means most money will be created to lend to
people that already have lots of previously created money, and lots of advantages in life.
Disadvantaged people will often be denied access to the money creating process, except
under exploitative circumstances which are likely to see high interest rates and/or
ultimate possession of their assets and resources by the bank. Alternatively the more
disadvantaged will have to seek money from non-bank entities that have already
accumulated lots of money, and this often also leads to exploitation.

What this also means is that money is NOT created for things most desired by society as
a whole. In fact it is often created for exactly the things that society does not want at all.
This includes projects that involve excessive destruction of natural resources like logging,
building power plants, mining, and so forth, because the bank realizes that such projects
are likely to bring back the money that will pay off the loans. It is also interesting to note
that money is almost NEVER created for the purpose of providing public goods, such as
education and healthcare, for such services will not pay the bank back. Rather these
services depend on recycled money through the tax system. Hence it is not surprising that
we have reached a situation where monetary value and social value are inversely
correlated. By this I mean that a good or service with a high monetary value in the private
property markets generally has a low social value. Conversely high social value goods
and services generally return a low monetary value. This is illustrated in the example
where public goods providers such as teachers are some of the lowest paid workers, yet
currency trading is perhaps the most lucrative profession there is, and has also become
one of the most socially destructive. It is reasonable to expect that this situation would be
largely reversed by taking social factors and public input into consideration at the point of
money origination.

It is clear that origination of money at commercial banks is undemocratic and so

encourages the creation of money (or loans) for many undesirable activities. But often
overlooked is the unchecked power of the Fed, the creator of Base Money. One of the
best reminders of this power is then Federal Reserve Governor Paul Volcker's hike in
interest rates in 1979 that triggered the Latin America debt crisis. This came at
tremendous cost to the people of Latin American countries. While the activities of OPEC,
the commercial banks and various dictators, played a major role in laying the foundations
of this crisis, the final push was decided at one committee meeting conducted behind
closed doors. The FOMC meetings have never been open to public input or scrutiny.
While summaries of meetings are posted almost immediately, the full transcripts of
FOMC are not even available until 5 YEARS after the event!

It's important to be concerned that the money origination process is not subject to
democratic accountability. Many of these problems could be remedied if the public had
more input into the decisions surrounding the origination of money. This requires an
entirely different paradigm for thinking about money than we have today. It is a very
complex problem and there are no simple answers. But at the very least it should be high
on the list of topics for public debate. In addition, once you understand the process for
creating money out of thin air, you begin to see that what banks and the Federal Reserve
do is not so difficult after all. Some hope for better money is starting to materialize from
the local and alternative monetary systems such as LETS and Ithaca Hours. These will be
discussed in later editions of "Wizards".


What is often overlooked about the monetary system, particularly by advocates of the
"trickle down" hypothesis, is that it is a ZERO SUM GAME, because our money is
entirely debt based. The more of a positive net money balance I have, the more of a
negative balance someone else has. I can put my positive balance to work earning more
money, while I either sit around and do nothing, or go and work for more money. So the
most likely situation for a positive balance person is that their positive balance will keep
growing. Also, in the zero sum game, this means that someone else’s balance gets more
negative. The negative sum person would be unlikely to get a loan to start their own
business, and so would have to go work for someone that already has money. Under
current wage structures and interest rates for "high risk" customers it would be difficult
for many negative balance people to ever get to a positive balance position no matter how
hard they work. They have the added disadvantage that they can’t put a positive balance
to work earning more money. Most likely their balances will get more negative, while the
people that already have money will get more money to balance out the zero sum game.

With positive money balances always earning a positive return on capital, combined with
no requirement for redistribution of wealth, which is implicitly prohibited by neo-liberal
policy because it eases such governmental intervention, the results are clear. The rich will
keep getting richer and the poor will keep getting poorer, and the more interest bearing
debt-money you "invest" in developing nations the worse (not better) the situation gets.
Those that believe that the "trickle down" effect will result from investment in poorer
(more negative balance) countries and neighborhoods demonstrate a very poor
understanding of the monetary system. In fact they believe in something that cannot
possibly materialize, and is evidenced by the consequences of investment in developing

This situation is compounded by the fact that the banking system must not fail. What this
really means is that the major section of the world banking sector - namely the Western
financial institutions - must not fail. This would actually be disastrous for rich and poor
alike, as in the great depression. To reduce risk of banking system failure (which
ultimately comes from sudden loss of confidence or trust in the system) institutions such
as the IMF and World Bank have evolved into mechanisms for preventing banking
system collapse. Unfortunately, however, what these mechanisms amount to is
transferring the cost that could collapse the banking system outside of the banking
system. And these costs end up being borne by those who have the least say in the
financial system. This actually distorts free markets where, ideally, investors take
personal responsibility for the risks they assume. Those that support so-called free market
ideology and think that today's markets are actually consistent with this ideology are
seriously misguided. They overlook the biases and distortions built into today's markets,
making them very inefficient and highly volatile.

Along these lines, it could be argued that much of the hardships forced upon the people
of Indonesia and other Asian countries after the Asian financial crisis were the result of
excessive risks taken by Western financial institutions in search of large returns or
profits. It turned out that if these institutions were to bear the full costs of the risks they
took leading up to the crisis then the whole financial system may have faced collapse.
Through the IMF bailouts they effectively passed these otherwise bankrupting costs to
parts of society that would not threaten the financial system, because they are not costed
in its accounts. This, as usual, meant the poor, workers and Mother Nature, who form the
balancing item of the biases built into today's unfree and inefficient markets.


What is surprising is that this knowledge is ancient wisdom and has been recorded in the
primary texts of the world’s major religions. The Old Testament of the Bible speaks of
the sin of usury and the concept of Jubilee, the period eradication of all debts. Most likely
this is from very similar realizations thousands of years ago.

It is ironic that the Federal Reserve Note bearing the statement "In God we Trust" is the
symbol of the system that so blatantly violates the key principles of this ancient wisdom
claiming to be God’s word itself.

If money is so abstract and does not store value, nor correlate with social value, couldn't
we change it to better satisfy our needs? This is what democratizing money really means
- and like all movements to further democracy it will no doubt meet with serious

That’s all for Wizards of Money #1.

Part 2: "Financial Risk Transfer"

1) Introduction to Financial Risk Transfer
2) Capital Buffers in the Global Casino
3) Risks Taken By Speculators and IMF Bailouts
4) Risk Transfer in Action - Asian Financial Crisis
5) IMF Bailout Prevention Solutions
6) Bank Supervision and the Basel Capital Accords

This is the second edition of the Wizards of Money, your money and financial management
series… with a twist. My name is Smithy and I’m from the Land of Oz.

In this second edition of Wizards we are going to take a look at Financial Risk Transfer. How do
the risks of the big gamblers of the financial system, like the Wall Street firms and the currency
speculators, get transferred to the public who have no say or gain in these gambling adventures?
How does this risk transfer work to increase income and wealth gaps globally, which then further
increase financial risk, which in turn exacerbate global income inequality, and the cycle starts
over again.

We will first look at how and why bodies like the International Monetary Fund (IMF) facilitate
such risk transfer, a timely issue given the upcoming protests set to take place at the IMF/World
Bank meeting in Washington, DC soon. Then we’ll see that these two bodies are simply a
necessary evil of a much bigger financial infrastructure.

Presently the big financial players are merrily increasing the financial risk to be transferred to the
public and the public is not noticing all that much. Rather, what many are noticing are the
consequences of risk transfers that have happened in the past and materialized through such
things as the IMF bailouts. Not too many concerned citizens are noticing the risk transfers that
are being set up right now for the public to digest in the future. This is not really their fault as the
mechanisms through which all this is done is not only shrouded in wizard secrecy, it is also
something of an Alice in Wonderland world once you get past the hurdles and pop in for a visit

The financial instruments through which speculators gamble are getting more and more complex,
and layer upon layer of instrument is forming. This surreal speculator world requires a whole
new vocabulary - things like options, swaps, naked calls, floors, caps and collars. Then they
seem to mate and have offspring like - swaptions, captions, knock-out options and roller coaster
swaps. Not even the players themselves really know what’s going on. They are just there for a
quick profit, and have stolen the best mathematical minds money can buy to help them do this.
Lets not go into the details of how these multiplying and magical instruments work. Rather we
note that their growing use makes economies more wobbly everyday, and that these financial
markets are becoming too complex to regulate. On top of this, for every regulation curtailing
speculator activity a new instrument materializes to circumvent it. In this way speculator
instruments multiply like new strains of bacteria, gaining resistance to the old treatments.

In Wizards 2 we’ll be taking a look at some of the ways banks are likely to further increase the
riskiness of their activities and be able to transfer the costs of those risks to those who can least
afford it. In this context it will be appropriate to look at the supervision of banks and we’ll ask
the question "Who is supervising the banks anyway, or are they just supervising themselves?"
The latter seems to be becoming more and more the reality. And at a time when the Wonderland
of Finance is becoming ever more complex and in need of supervision.

Finally we’ll take a look at some arrangements being made under the new Basel Capital Accord,
an effort sponsored by the Bank for International Settlements in Switzerland, to address the issue
of bank and speculator risk. The Bank for International Settlements (BIS) might be considered
the third arm of the major global financial institutions, the other two being the World Bank and
the International Monetary Fund, which have achieved widespread fame in recent years. In
comparison the BIS seems to be quite shy and gets very little public attention, which might make
one suspicious that it is up to no good. The BIS is owned by the central banks of the richer

Central banks in other countries are like the Federal Reserve here. That is, they are responsible
for monetary policy or, as we saw in Wizards 1, responsible for creating base money out of thin
air. The real activities of the BIS are extremely well shrouded in secrecy, as is the fine tradition
of the banking sector. I do not know anyone who knows what they really do. But one thing we
do know is that they host the discussions and rule-making about how countries should supervise
their banks to make sure they are not getting into too much mischief, which might in turn upset
the global financial system. While they host the international bank supervision meetings (closed
to the public, of course) the BIS says they are not responsible for the Basel Accords, which set
international bank supervision standards. This is most probably because supervision is much
despised in banking circles, and the banks would rather get rid of it so they could just supervise

2) Let’s Talk about "Capital Buffers" for Managing Financial Risks in this Global Casino

Recall that in the first edition of Wizards we spoke about how money is created and who creates
it. In that edition we discussed that all money is created "out of thin air" through the loan
creation process. For every amount of money there is a corresponding amount of debt owed to
the banking system.

But how much money can a bank create through the lending process? A lot of that depends on
how risky its loans are. Banks can create new loans (or bank money) up to a certain maximum
multiple of their shareholder capital – that is, the amount shareholders have invested in the bank,
which is also the excess of the bank’s assets over its liabilities. Remember a banks assets are its
loans to the public, and its liabilities are deposits of the public. Capital for a bank can be thought
of as a safety net – the more capital a bank has, the safer it is. That multiple of shareholder
capital that banks can create as money will depend on how risky the loans are they choose to
make. If they are very risky the multiple will be lower. Put another way, a bank that makes risky
loans will have to hold more capital (i.e. more of a safety net) as a percentage of total loans than
a bank that makes less risky loans.

Risky loans in this context means loans that are more likely to not be paid back in full, and this is
the financial risk "created out of thin air" we spoke about in the first edition of Wizards. If lots of
risky loans end up in default (that is, not paid back) then the bank reports this as a loss and
people start to lose confidence in the financial system, which can ultimately lead to financial
crises and sometimes collapse. So, although these risks are created "out of thin air" they can
create very real consequences because our whole global economy is tied to the financial system
and therefore is completely dependant on continued confidence in it.

Holding more capital for risky loans makes sense because capital is a buffer against unexpected
losses. If a financial risk results in a loss - just like if you lost at the roulette wheel - then you
have to dip into your capital (or safe money) supplies. Even if you love to gamble, when you go
to the casino, you don’t bet all of your life savings. You leave some of your money at home or in
your bank account so that if you lose all your bets that day, you will be able to tap into your
untouched savings the next day to buy food, pay rent – i.e. conduct business as usual. This is
exactly what banks must do to make sure they can remain viable entities in the long run. The
more risks you take with your money the higher a capital buffer you need because more risks
mean a higher probability of loss. For many banks these "risk based" capital levels were set
under the Basel Capital Accord of 1988. These capital accords are now being revised, and the
banks are complaining that they have to hold too much of a capital buffer.

Banks want to hold as little capital as possible, so that they can create a maximum amount of
loans (or money) that can bring in higher profits. From their perspective a safety net has an
"opportunity cost" which limits the profits they can make. "But aren’t they worried about not
having enough of a safety net if their bets go bad?", you might ask. Well, not if they are "too big
to fail" and the public will be called upon to bail them out if their bets go bad. This is where a
growing danger lurks for all of us. From a public interest perspective conservative (higher)
capital levels are a good thing. They help to prevent banks from taking excessive risks which
often lead to publicly funded bailouts to rescue them from insolvency.

3) Financial Risks Taken by Banks and other Speculators are on the Increase

Banks and other gamblers take excessive risks, of course, because higher risk investments bring
in higher returns. This means more profits for shareholders and higher bonuses for the CEO and
others. The disincentive for higher risks is that a risky investment is more likely to fail and you
could lose some or all the money you put in. High risk investing is exactly like gambling – in
fact it is gambling. Such speculation is of concern to the public because the gamblers are playing
with the financial system and currencies upon which all real economies are dependent, and
because the public is often called upon to bail out speculators to avert financial and economic

As income inequality grows, fewer people have more and more money to play with and so
financial activity becomes increasingly about speculation in the markets, through the Alice in
Wonderland world of speculative financial instruments alluded to earlier, rather than purchase of
real goods and services. Hence financial risk increases as income inequality grows. As we shall
see, this risk taking then often leads to devaluation of foreign currencies against the US dollar,
and publicly funded bailouts, whose costs fall disproportionately on the poor (or those who are
not major players in the global financial system). This widens the income and wealth gaps even
more, and further increases speculative activity and financial risks that will later trigger another
bailout. And so the cycle continues. This positive feedback loop has set the world on a very
dangerous path – dangerous to everyone.

As a key part of this feedback loop very serious problems have arisen because certain players in
the market know they will always get bailed out if the losses on their risky investments get too
big. This is known as "moral hazard" and many economists and business commentators have
noted that the International Monetary Fund poses such a moral hazard to the world’s largest
financial institutions who are now "too big to fail".
This problem is compounded further because the big players are getting even bigger through
global mergers and acquisitions in the wake of global financial deregulation. Furthermore, the
Asian crisis, caused by excessive financial speculation in the first place, bankrupted a slew of
Asian (including Japanese) banks. Many of these were then sold off (fully or partially) at fire-
sale prices to Western financial institutions who were just as responsible for the crisis due to
their unchecked speculative activity and who did not go bankrupt because they were key
beneficiaries of the IMF bailouts. It is ironic that these beneficiaries were the very same players
who instigated so much of the excessive risk taking that caused the crisis. This shows you just
how much the moral hazard of bailouts can distort what is supposed to be a "free market".

As noted, the public should understand how banks and other gamblers increase the risks in the
financial system, since the public always pays the price for excessively risky bets that go wrong
through various bailout mechanisms. This is exactly what happened during the US Savings and
Loans crisis of the 1980’s. Also, the public of effected countries pays for the IMF bailouts which
always come as a result of excessive risk taking in the financial markets and the realization that
some of the risk takers/gamblers (generally those on Wall Street) are just too big to fail.
Compounding this problem is the fact that speculators trade against other countries' currencies
and thereby instantly devalue the hard won earnings of many of the local people.

In what is probably a less understood and less publicized financial crisis, but one that recently
almost took down the entire US banking system, the Federal Reserve had to step in and arrange a
bail-out of the Long Term Capital Management Fund in 1998. While the public did not have to
fund this one, it came very close to this. The LTCM crisis revealed a shocking level of risks
taken by the US banks, and worse, a shocking lack of supervision of their gambling activities. It
is not comforting to know that the type of risk taking prevalent in the LTCM case is increasing,
and the supervisory bodies are doing little to stop it. These types of funds like LTCM, known as
"hedge funds", are the new trendy playthings of the wealthy - why, even Barbara Streisand is in
one! But they are completely unregulated on the premise that they involve "sophisticated"
investors, you see. This is exactly the reason they need regulation - for it's this very same
sophisticated speculation that later triggers bailouts. And its seldom the sophisticated speculators
who pay for the bailout mess they create.

Banks are supposed to manage risks to prevent themselves from going insolvent or losing market
confidence. Regulators and supervisors are supposed to be watching to make sure they actually
manage these risks both in their own interests and to avoid broader financial crises. In this
fashion the regulators should represent the public interest to ensure that banks are not taking such
excessive risks that the public may eventually have to bail them out to avert a financial disaster.
But more and more it seems that crisis prevention and exercise of the precautionary principle are
being pushed out the back door in favor of the wishes of a global finance sector that wants less
supervision. It prefers a system of cure (in the form of bailouts) after risk taking gets out of hand,
to the publicly preferred system of prevention whereby financial players take on less risk and
accept lower returns.

This preference for cure over prevention is encouraged by the bailout mechanisms.
One "cure" (or bailout) leads to another crisis down the track, leading to another bailout, another
crisis and so on. For every bailout income and wealth gaps increase, because the funding of the
bailout must come from places that are not accounted for in the financial system. This is simply
because the financial system would be put at risk if the full costs of the risk taking were born by
it. Then investors would lose confidence and the whole financial system may collapse. The costs
that do not appear on financial accounts are additional burdens to the poor and excessive natural
resource extraction. In effect, that is what funds bailouts so that the cost of the bailout will not hit
the books of the financial system. This is the mechanism whereby risk takers do not take full
responsibility for the risks they assume but rather pass that responsibility on to those outside the
financial system. This system of cure over prevention obviously provides higher overall returns
to the banking system than would a corresponding regulatory regime focused on prevention.

4) Lets Run Through A Case Study of Risk Transfer in Action

To better understand risk transfer let’s look at some of the aspects and drivers of the Asian
financial crisis.

Many identify the trigger of the crisis as the devaluation of the Thai Baht (the Thai currency).
This had been pegged to the US dollar, so that the baht would move in parallel with the US
dollar. At that time 25 baht was about the same value as 1 USD and the Thai Central bank was
trying to keep this exchange rate constant. A devaluation would mean that the value of 1 baht
would be worth less than 1/25 US dollar, or conversely a USD would buy more than 25 Baht.
Prior to this devaluation currency speculators (many of whom were with the big Wall Street
firms) were having a whale of a time performing what is known as arbitrage in transactions
involving the Thai Baht. Arbitrage means that speculators can make profits without taking risks.
For example in this case arbitrageurs were able to borrow money in US dollars at a low rate of
6%, change them into to Thai Baht and invest the Baht at a much higher rate of 12%. Because
the Thai Central Bank was trying to peg the Baht to the US dollar, after a certain time, the
Western gamblers could take their proceeds from the 12% investment, and exchange them back
at the original exchange rate into US dollars. Then they paid off the lower 6% loan and pocketed
the profits. I say that no risk was taken to get this return because no money was put at risk, it was
all borrowed and then guaranteed to be returned in full dollars by the Thai Central Bank. This
type of speculation puts pressure on, and drains, the reserves of the central bank whose currency
is being "attacked" and increases pressure for devaluation.

As noted, the Thai Central Bank was on the other side of all these bets trying to prop up the baht,
so that when the baht finally collapsed, in part due to this massive speculation, the central bank
was in very bad shape. Confidence is Asian markets fell and neighboring economies starting
falling like dominoes. When I say that the baht collapsed I mean that its value versus hard
currency, like the US dollar, fell dramatically. It is the local people of Thailand who then got
hammered by the subsequent devaluation. Their hard earned money was worth less when it came
to any goods or services made from imports.

The US dollar is the hard currency or reserve currency of the world now that the gold standard
has collapsed. Everything is measured in terms of the US dollar. And whereas banks once held
gold in their vaults to back their currencies, now they generally hold US dollars. This US Dollar
standard of money means that if the value of the US dollar ever collapses relative to other
currencies, it probably will result in collapse of the global financial system. This point might be
of interest to some anti-globalization activists, who might want to see if they can think up a
clever way to instigate massive trade against the US dollar. This method is very slick because it's
perfectly legal, nobody has to get arrested and it doesn't require any police beatings. But just a
word of warning before you try this - make sure you have another system of trade ready on the

Now, Back to the Asian Crisis: Around the time of this Thai baht arbitrage feeding frenzy JP
Morgan was, on the one hand, advising the Thai’s to devalue. But they were was also operating
in Malaysia and selling financial instruments to Korean banks that would lose money if the Thai
baht was devalued! So that’s how the Korean banks got immediately walloped by the
devaluation. The Koreans banks then started dumping a bunch of Brazilian bonds that they’d
been holding since one of the deals that ended a previous speculator induced crisis – the Latin
American debt crisis. The cost of borrowing shot up in Brazil and this stripped Brazil of a quarter
of its bank reserves in a single month. So then Brazil had a financial crisis on its hands. And so
on, and so on, the crisis spread. Meanwhile JP Morgan seemed to get out of everything just fine.
This interesting little story from the Asian crisis came from the book called "The Fed" written by
Martin Mayer and recently published by Free Press.

The western financial institutions were also over extended in loans to Asia because the 1988
Basel Capital Accord did not adequately set capital requirements for loans to banks in these
countries. They also did not differentiate between various types of commercial borrowers. Hence
the banks were incented to lend extensively to foreign banks where they could get higher returns,
and to more risky corporate ventures. Central banks of these Asian countries were putting their
countries financial reserves at risk by allowing their banks to invest them in high risk, high return
investments. And much of the loan activity of the time was around over-priced real estate
ventures, similar to what happened in our own Savings and Loan crisis. In summary the financial
risks taken by banks world over were huge, and the distribution of bank capital could not bear
the brunt of the costs if those risky bets should go bad.

As we know the bets went bad and various economies almost collapsed. Many of the financial
players did suffer huge losses and those losses were born by both Western financial institutions
and foreign players. However, as usual, the Western institutions escaped the gambling
extravaganza bearing a disproportionately small share of the costs. While a myriad of Asian
banks were allowed to collapse, not a single Western financial institution went under. At the end
of the crisis most major Japanese banks (and insurance companies) were technically insolvent
and later dependent on these western institutions to inject capital through acquiring ownership
rights – something the Japanese never welcomed to their banking system before. Banks collapsed
throughout the rest of Asia, the most dramatic case being Indonesia where we still have images
of the physical run on banks fresh in our minds.

The western institutions were not allowed to fail (as in the S&L debacle) because if they did, the
entire global financial system would go down with it. To prevent such a collapse the IMF
bailouts primarily work to ensure that the market does not lose confidence in the financial
system. Generally this translates into making sure that the larger financial system players are not
hit with large enough losses that could cause them to drop below minimum capital requirements,
go insolvent, or suffer a loss of confidence in them by investors and depositors. When the press
speaks of the bailouts they often say that this country or that got an IMF bailout package. This
really means that they receive funds from, or their debt is consolidated by, the IMF so that they
will not default on loans made to them by large western investors. In a true "free market" those
western institutions would bear those defaults and suffer the consequences, which would be
consequences for all of us, because we are dependent on the financial markets they dominate.

It is at this point that the IMF as loan consolidator, or lender of last resort, steps in with its
structural adjustment programs to somehow make the country generate the hard currency needed
to pay back the western investors who had loaned them hard currency. Because hard currency is
needed to repay the loans the country’s activities get directed toward exports and other things
that will bring in hard currency from those that have some – i.e. western investors and
consumers. The things that generate hard currency the quickest to repay these loans are the
exploitative labor and natural resource extraction practices that we see resulting from IMF
policies. These problems are compounded by the fact that the local currency has dropped in
value against the hard currencies.

5) This Sounds all Very Grim but Are there Solutions?

The above gives an overview of how very abstract, seemingly innocent, risky financial
transactions end up as costs born by those pretty much outside the financial system. Surely the
solution lies in the people creating their own monetary and trade systems and weaning
themselves away from dependence on the very risky, and destructive global financial system of
today. Why continue to trust in, and be a part of, a system that works against you?

Should the current global financial system collapse tomorrow the world would have no back-up
mechanism for continuing trade, and in all likelihood the resulting confusion and collapse of
order would result in massive catastrophe, maybe worse than Germany in the 1930s, and on a
global scale. The risk of global financial collapse continues to increase with increasing income
inequality. This leads to an increasing amount of financial activity being driven by those who
have so much excess money that the bulk of their transactions are speculative. This inequality
and these risks increase with each publicly funded bailout, which then further increases income
and wealth gaps. And so the cycle continues, with this positive feedback built in to make the
whole system more and more unstable.

Those who are currently actively involved in setting up alternative economies are actively
hedging their bets that the dominant system will eventually fail. They are certainly providing
hope for a more promising future.

6) Bank Supervision and The Basel Capital Accord

However, setting up alternative financial and economic systems in a meaningful way will take a
lot of time and effort. The existing global financial order will be with us until it either collapses
or people come up with an alternative, or both. In this time it's important for activists to
challenge the financial world on their trend towards increasing speculation and reliance on cures
for financial crises. Along this line of thinking it might be more fruitful to work towards
reducing the need for IMF bailouts, rather than just worry about them once they already exists.
That is – maybe people should also be focused on prevention as well as the specific nature of the
cure. Otherwise increasing speculative activity may end up increasing the frequency and severity
of IMF bailouts.

One of the best means of prevention of financial crises (and therefore IMF bailouts) is stricter
supervision of banks and other financial services companies, so that they don’t make too many
risky bets that destabilize the markets. This is in the best public interests of a public that depends
on stability of the banking system, and doesn’t have an alternative monetary system to fall back
on. Let’s just talk here about supervision of banking institutions and leave other financial
institutions to later editions of Wizards.

One would think that bank supervision would be done under the guise of a government body so
that there could be some democratic accountability of the supervisor, and some representation of
the public’s interests. Think again – Under the Gramm-Leach-Bliley Financial Services Reform
Act of 1999 the regulator of all bank holding companies in the US is the Federal Reserve. They
are also the supervisory body which will monitor bank’s risk taking activities and their
associated capital buffers under the new Basel Capital Accord. As we saw in Wizards Part 1 the
Federal Reserve is 100% owned by the private banking industry. So the banks seem to be
supervising themselves!

This doesn’t bode well for the idea of getting banks to behave better with respect to risk taking.
Apart from the issue of ownership, the conflicts of interest with respect to the "central bank" of a
country also supervising the banks are so profound that no other major industrialized nation has
dared to do it. In most other countries the central bank – the driver of monetary policy - and the
bank supervisor - trying to make sure the financial system is safe - are two entirely different

One the hand, the Fed, when it wants to increase the money supply would encourage banks to
take more risks to achieve this monetary goal. For example William McDonough, the president
of the Federal Reserve Bank of New York, is documented to have told an audience at a Group of
30 meeting at the IMF/WB meeting ,in 1998 in the midst of the worry about the Asian crisis,
according to Martin Mayer in "The Fed":

"If you’re a banker, go out and lend – you don’t have to cross every i and dot every t. If you’re a
bank supervisor, don’t criticize your banks for making loans, even if they’re loans you might not
have approved just a little while ago."

He was speaking there as a key player in monetary policy, not as a supervisor who should be
concerned about risks in the financial system. Mr McDonough, as the head of the New York Fed
is also vice-chair of the Fed's Open Market Committee, responsible for the creation of base
money out of thin air, as we saw in Wizards 1. Now, not only is Mr. McDonough now
responsible for supervising the activities and capital levels of the New York area banks, he is
now also the chair of the Basel Committee on Bank Capital requirements! In many cases his role
as central banker (and driver of monetary policy) will conflict with his role as both supervisor of
banks and chair of this capital committee – both of which SHOULD be representing the public’s
interests in bank risk taking.

Alan Greenspan, the Governor of the Federal Reserve Board, that overseas all the Federal
Reserve Banks, said in his bid for being the bank regulator of choice, that regulation by a
separate government body (such as the Office of the Comptroller of the Currency) devoted only
to managing safety and soundness of the banking system would "inevitably have a long term bias
against risk taking and innovation". He forgot to mention that these risks are usually born by the
public, so that such a focus of a supervisor would be quite appropriate. Unfortunately, Mr.
Greenspan, being raised as a prodige of, and assistant to, author Ayn Rand - during her Atlas
Shrugged phase - often forgets that there is a public to worry about. That is, until a public bailout
is needed of course.

The conflicts of interest and evidence of the "fox guarding the hen house" does not stop there.
The Board of the Federal Reserve Bank of New York always has the biggest New York bankers
on it. So it is not surprising that Sanford Weill, CEO of Citgroup is on the Board of the Federal
Reserve Bank of New York. The Federal Reserve Bank of New York is the Supervisor of
CitiGroup! As noted, the president of the NY Fed is also the chair of the Basel Committee setting
capital requirements that are supposed to protect the public from banks taking excessive risks for
excessive profits. So the supervisors and the supervised are pretty much one and the same.

The latest draft of the Basel Accord was released in 2000 for public comment until May 31,
2001. Around this time Mr. McDonough took over as chair of the Basel Committee coming up
with these capital (i.e. safety) requirements. Evidently the American bankers were starting to get
cheesed-off at some of the conservatism and safety margins proposed by the European
supervisors. So they thought they better step in and take over, as is the American way.

This change at the helm will probably bode well for the big bankers whose comments on the
proposed accords can be pretty much summed up as whining about how the proposed capital (or
safety) levels were just too high and how this would eat into their profit margins. It is especially
illustrative to look at Citigroup’s comments since, as noted, Citigroup is supervised by the
Federal Reserve Bank of NY, whose president chairs Basel, and on whose board CitiGroup has
representation. In this way it could be construed that, unless pressure is applied otherwise,
CitiGroup’s desire for holding less capital, and making the financial system more volatile and
risky will become a reality. The following is a quote from the response by Jay Fishman, COO of
Citigroup to the new proposed Basel Capital requirements for banks:

"We urge the Committee to keep in mind that although capital has an important role to play in
assuring safety and soundness by supporting a banking organization’s assets, it has a significant
opportunity cost". This means lower profits. This "would effectively translate into higher costs to
users of funds and/or lower returns to investors in organizations subject to the New Accord". He
goes on to say that this would end up "reducing competition and choice for customers of banks".
This is rather laughable given that the multitude of recent acquisitions of banks by Citigroup all
across the world has done more to reduce competition and choice that any capital requirement
Furthermore in appealing to competition, that bastion of the free markets, Mr Fishman forgets to
point out that his organization is a primary beneficiary of the IMF bailout mechanism, which is
more of a threat to competition and free markets than any supervisor could dream up.

Mr. Fishman, in his May 31st letter, calls for capital requirements to be primarily set by the banks
themselves, especially those "sophisticated banks" with "sophisticated risk management
techniques". Mmm - there's that sophisticated word again - its seems to be synomous with
regulation-free in the financial markets. Fishman forgets to point out that these fancy risk
management models failed completely to manage the risks of their bets in Mexico, Asia, Latin
America and Russia during the 1990’s.

Finally he argues that the increased disclosure requirements of the proposed new Basel Accord
will increase the costs to banks, and only serve to confuse everybody.

The comments of a bank that has the highest degree of moral hazard posed by the Bretton Woods
institutions, and hence the biggest incentive to take excessive financial risk, must surely be taken
with a grain of salt. However I fear that without the involvement of the NGOs fighting these
institutions the new Basel Accords and associated capital requirements will slip through with
exactly what the banks want. That is - more profits through higher financial risk taking that will
only serve to increase the frequency and severity of publicly funded bailouts and further
compound the transfer of wealth from the poor to the rich.

A full copy of the current Basel Accords and all public comments can be found on the Web at Only one anti-globalization NGO (that I can tell) submitted a comment with public
interest concerns. That was the Inner City Press/Communities on the Move, based in the Bronx,
NY. You can visit their Web sites at

That’s all for Wizards of Money Part 2.

Part 3: "Predatory Lending"

Introduction to "Banking on Poverty"
1. The "Science" Behind the Monetary System
2. The Federal Reserve and the Poor

This is the third edition of the Wizards of Money, your money and financial management
series… with a twist. My name is Smithy and I’m from the Land of Oz.

1. Introduction to "Banking on Poverty"

In this third edition of Wizards we are going to take a look at how banks bet that poverty will
pay off for them. We will be taking a close look at predatory lending whereby banks seeking high
returns prey on the poor who, as noted in past editions of Wizards, have little to no voice in the
financial system. We will also look at banks’ appetites for homes through this predatory lending
followed by the foreclosure process.

In this investigation of banks activities in low income neighborhoods it will be most

appropriate to look at the relationship between the father of the banks, the Federal
Reserve, and the poor. But before exploring the relationship between powerful creditors
(money creators) and low income people let’s first review some important points learned
from earlier editions of Wizards. We recall that money is created "out of thin air" by the
banks and the Federal Reserve System, and is not backed by anything at all but our trust
in the monetary system. We also recall from Wizards, Part 2 that, in the absence of
anything real actually backing money, the US dollar is the backbone of the international
monetary system. This trust in the US dollar is little more than a group psychological
phenomenon that could collapse simply by people starting to question the faith they have
in it.

Because people don’t stop to think about it too much the above realization can initially
cause some shock and confusion, and maybe also some hope. To get more comfortable
with this very different way of looking at money and to get a better understanding the
trickery and sleights of hand at work, there is an excellent text which was written in 1965
that you should be aware of. It is called "A Primer on Money, Banking and Gold" and I
would highly recommend this to those who wish for a more detailed technical
understanding of the mechanics that were described at a "big picture" level throughout
Wizards Part 1 on "How Money is Created".

This book was written by a Mr. Peter Bernstein all those years ago, when the monetary
system was still bound to the gold standard and so was actually a bit different than it is
today. Nevertheless Mr. Bernstein, who had a long and distinguished career in the
banking industry, including many years at the Federal Reserve, wrote the best text I have
ever seen on this subject. Even though the monetary system has lost its gold backing and
several other key changes have been made, much of this text is still relevant today.
Professor James Tobin, Nobel Prize Winner in Economics and famous among activists
for his Tobin Tax proposals, has also given the book much praise. It is very sad that such
books are not widely available, nor incorporated into the core school curricula so that the
monetary system could be clearly identified for what it really is. It is Mr. Bernstein
himself, who sums up this dilemma over educating people about the monetary system so
eloquently. He says in his book that when we "ask what the American Dollar is really
based upon, we would have to say that it exists essentially on promises and bookkeeping
machines. If anyone were to set up such a system by decree or legislation, it would
probably never work. Indeed, it is just as well that most people never stop to realize that
the money they earn for their efforts is only a number in a bookkeeping machine, or a
piece of paper convertible into nothing more than another number in a bookkeeping

The English word "credit" can be traced back to its Latin origins as being synonymous
with "belief, faith, confidence, and trust". While many bankers may be aware that this
trust is not well founded once you get past the smoke and mirrors surrounding money (or
credit) creation, it is not in their best interest to advertise this fact. This is because the
system works to their advantage. If public confidence in the monetary system is to be
shaken it will have to come from those hurt by it. But first they themselves will have to
get to the point of questioning the system they have placed their trust in. The growing
abuses of credit creation powers over the poor, and the growing awareness of these
abuses that we will discuss in Wizards today, may act as a catalyst to get people to this

In this edition we are going to go and chat with some people at the American Association
for Retired Persons (or AARP) who just gave some informative testimony to the Senate
Banking Committee about what some of the hungry banks have been up to lately. It
seems that after the Asian financial crisis the banks’ appetite for foreign adventures was
diminished for just a little while and they had to look closer to home for those high return
loans. The elderly must have seemed an attractive target market for their high equity
(mostly home equity), low income profiles. This is the type of thing that makes a
mischievous bank lick its chops, for such a demographic is a prime target for what is
known as "equity stripping".

We will talk more about equity stripping when we go visit the AARP. But to draw some
parallels with earlier editions of Wizards, this equity stripping is very similar to what
happens in foreign investing, followed by IMF bailouts. The big banks and financial
players (that is the ones too big to fail) whose loans start to default, but who can't have
the defaults hit their books, need someone to get the money out from somewhere. That’s
when the IMF steps in with is bailout packages and austerity programs to squeeze the
money out of the country that doesn't have any money ("hard" money that is). The IMF
completes its mission by "equity stripping" - selling off the real assets and labor of the
country to generate the cash to pay back the banks. In the domestic retail equity stripping
examples we'll look at today, we'll see that this is pretty much what shady banks do
directly to those easily preyed upon at home. We will also see that many of these shady
operators are actually subsidiaries of the large, well-established banks like Citigroup, JP
Morgan Chase and Bank of America.

Today’s study of predatory lending will take us to one of the cities where abusive lending
practices are some of the worst in the country, and the state with one of the most bank-
friendly foreclosure laws on the books. Interestingly it is also the place where the Federal
Trade Commission has recently filed suit against Citigroup for the predatory practices of
its subsidiary, Associates First Capital, in what could become the largest and most public
case against a predatory lender ever seen in this country. This location is Atlanta,

BREAK: Excerpt from Dr MLK Speech. Ebenezer Baptist Church. Atlanta GA. 1967
"Why I Oppose the War in Vietnam" speaking on radical change needed so that "men
and women will not be constantly beaten and robbed as they make their journey on life's
These are some words from Reverend Kind given at the Ebenezer Baptist Church in 1967
during his speech about the Vietnam War which, 3 years later and after his death,
received a Grammy Award for "Best Spoken Word Recording". We'll here some more
words later from his speech given in the same neighborhood of his church and home, and
where, today, predatory lending is so prevalent in Atlanta, and as we shall see is actually
rampant throughout the state of Georgia, and seemingly throughout the nation.

1. The "Science" Behind Our Monetary System

This predatory behavior of banks is most pronounced where there are easy targets. The
easy targets are the poor, but lets not just focus on the relationship between banks and the
poor. First we'll look at the relationship between the father of the banks, the Federal
Reserve, and the poor. And in order to do this we'll look at some of the principles or ideas
that might be influencing the behavior of those that "make money".

The famous extreme capitalist and private property advocate, Ayn Rand, who we
mentioned in the second edition of Wizards as the author of "Atlas Shrugged", once said
"If money is the root of all evil, then what is the root of all money?" This might make you
chuckle if you recall that Alan Greenspan, the Chairman of the Board of Governors of the
Federal Reserve, worked with her extensively on her book "Atlas Shrugged", released in
1957, which many right-wingers claim to be the most influential book since the Bible. In
subsequent years Greenspan also contributed to Rand's publication "The Objectivist".
Today Rand’s protégé is right at the center of all money, and perhaps her question is

Since money has become the backbone of so much of our social fabric and it is, after all
is said and done, just based on faith and belief in it, we better know something about the
beliefs of those at the center of it. That Greenspan has a long history in the banking and
finance sectors, including the obligatory stint at JP Morgan, is hardly surprising in the
world of central bankers. What is perhaps more worthy of attention is his service to Rand
in her work. This is evidence of his rigorous training in her philosophy, which is known
as "objectivism" and whose fundamental features seem to overlap extensively with
today's so-called neoliberal economic policy.

This philosophy of objectivism largely rejects the idea that capitalism and capitalists
should have any social goals at all, and promotes the idea that all acts and intentions
should be purely selfish. Not surprisingly Rand's work was a huge hit with the powers
that be in America at the time, hot on the heals of the McCarthy era. Her ideas are
actually very different to Adam Smith’s philosophy but we wont go into that here. In
coming up with her rather extreme, but very influential, theories it appears that Ms Rand
must have been skipping her physics lessons. If she had bothered to look into the
revolutionary developments in Physics that took place in the early 1900’s in the form of
Quantum Mechanics and Special Relativity her philosophy may have hit some stumbling
blocks. Both of these radical developments in physics shook the foundations of Western
thought premised on objectivity, independence of objects, the absolute nature of time,
and certainty. Gradually this new way of looking at the world, which has many parallels
with eastern religions, has replaced the old Newtownian (or classical) mechanics way of
looking at the world in physics, and is seeping its way into other sciences such as
chemistry and biology. A fabulous text on these developments in physics and their
parallels with Eastern Philosophy, written for the lay person, is the book called "The Tao
of Physics" by Dr. Fritjof Capra. 1975.

These days it seems that students of business and economics are also too busy to attend
physics classes, and this is one of the problems with having isolated disciplines of study.
Today it is the economists, business-people and politicians who are the furthest behind in
picking up on these turn-of-the century revolutionary developments in physics. The only
thing they gleaned from this scientific revolution was knowledge of how to make the
atomic bomb and blow things up in a spectacular fashion. What they could have learned
is some pretty interesting flaws in their own field of economics. Not only are today’s
mainstream economic theories, and philosophies like objectivism, outdated by being
based on the Newtonian or classical worldview, but these same outdated views are
reflected in our current monetary system. Nothing illustrates this better than having a
disciple of Rand at the helm of the Federal Reserve!

This digression into modern physics, while talking about the relationship between the Fed
and the poor, may seem rather odd. Nevertheless it brings home the point that money is a
social and psychological phenomena and so the beliefs and "science" adopted by those
that create money and control the monetary system must be scrutinized. In later editions
of Wizards we are going to explore further some of the foundations of contemporary
mainstream economic theory that are challenged by the worldview shift brought about by
modern physics, that the economists have yet to pick up on. It is rather ironic that
mainstream economics, claiming to be so scientifically based, ignores the developments
in the most objective of science of all. The emerging field of so-called Ecological
Economics is doing a much better job of incorporating modern physics.

Lets just note here that these changes in perspective, long incorporated into eastern
philosophy, force us to think about time differently, to always acknowledge the
interconnectedness of everything, and to recognize ever present uncertainty in everything.
The private property markets of today do not operate in this fashion. Rather they treat
people and objects as independent economic units, and discount the future as less
important than the present. Furthermore they have limited mechanisms for coping with

BREAK: Excerpt from Dr MLK Speech. Ebenezer Baptist Church. Atlanta GA. 1967
"Why I Oppose the War in Vietnam" talking about what a "true revolution of values"
would mean.

2. The Federal Reserve and the Poor

Under this old or classical world view central bankers use more or less traditional techniques for
exercising some control over the economy, and a large part of this is maintaining the confidence of the
markets in the monetary system. So people that don’t have much money don’t factor into central
bankers’ decisions very much at all. On the surface many might think that there is no relationship
between the Federal Reserve and the poor to speak of. However this ignores the interconnectedness of
everything and this is perhaps best considered within the context of the "Zero Sum Game" that we
spoke about in Wizards Part 1.

As income and wealth gaps have widened few people have more money, and the majority of the
people are getting less. Many of those that have accumulated lots of the money go looking for
lots of places to invest it, or gamble with it, so that it will make more. This has lead to an
explosion in non-bank financial institutions and the use of corporate bonds in lending. Neither
mechanism "creates money out of thin air" because the players don’t have a banking license. But
because the players have accumulated so much of the existing money they can become financiers
themselves by lending out the piles of dough they’ve accumulated. Thus, according to Martin
Mayer in the book "The Fed", only one fifth of commercial and industrial financing now comes
from the banks. The rest comes from people and non-bank institutions that have accumulated lots
of the existing money.

This has several implications. First the Fed’s powers over the market is more limited because
there are so many non-bank financiers, so the Fed has to do whatever it can to please these non-
bank markets and keep their confidence in the whole financial system alive. By necessity this
means always pleasing the people that already have lots of money. Second, banks go looking all
over the place for new people and entities to lend to since the domestic non-bank corporations
abandoned them. This search has been a big part of banks overseas lending adventures and the
phenomenal growth in lending to the sub-prime domestic markets over the past decade. The sub-
prime market is people with bad credit histories, which often correlates with low income. This
loan market has grown 300% from about 75 billion in 1993 to over 300 billion by 2000,
according to the Wall Street Journal. Previously the banks wouldn’t touch this market with a ten-
foot pole, but in their never-ending search for new borrowers, especially at high yields, this has
become a huge growth area.

In past years the practice of redlining has been common amongst banks, whereby banks mark
maps with a red marker for areas they would and wouldn’t lend to and these distinctions were
often made along racial lines. These days a similar map marking process might be used to
distinguish between prime and sub-prime markets – that is, who gets access to credit on
reasonable terms and who gets lumped into the sub-prime category which is where the
exploitative terms of credit prevail.

Public concern over discriminatory practices in lending and the limited availability of credit in
poorer neighborhoods lead to the passing of the Community Reinvestment Act (CRA) in 1977,
under which bank examiners are supposed to check bank’s record of meeting the credit needs of
the entire community including low to middle income groups. This means that the Federal
Reserve has some responsibility for this but, as already noted, the Fed is mostly concerned with
monetary policy, which means making sure that people that have the most money keep
confidence in the monetary system. So as Martin Mayer points out in "The Fed", "discrimination
against low income people in lending operations was a subject guaranteed to be of no interest to
the Federal Reserve System". And as Kenneth Thomas, a Wharton School lecturer on finance
points out, "banks are always happy with the ratings given by the easiest CRA grader in the
business", meaning that the Fed doesn’t take the CRA review of banks too seriously at all.

Mayer also notes in "The Fed" that "Both publicly and privately, the Fed has always refused to
acknowledge the existence of discrimination in any part of the American banking system."
Consistent with this observation the Fed has behaved rather anti-socially during the approval
process for mergers and acquisitions with respect to complaints filed with it regarding unfair and
exploitative lending practices. Basically it has ignored consumer complaints and public concerns
and nowhere was this more noticeable than during Citigroup’s recent acquisition of the huge
Mexican banking group Banamex.

The July 30th edition of the American Banker daily paper reported, in reference to the
Greenlining Coalition’s request for a hearing on the takeover, that "Comparing the Fed’s
approval to "Alice in Wonderland" where a verdict is reached before the trial, the SanFrancisco-
based umbrella group for 37 religious, minority and ethnic organizations said the hastily crafted
approval would embarrass even an old style Banana Republic Regime". That same issue of
American Banker contained another story about Citigroup’s alleged gag orders on ex-employees
about abusive and fraudulent practices in its sub-prime lending unit. We can hardly be surprised
by all this when, after all, Citigroup is the largest shareholder of the Federal Reserve Bank of
New York and its CEO is on this Fed bank’s board. The relationships between the Fed and the
big banks are all just too cozy for public comfort. In an observation that would meet with
approval in the Rand school of thought, Mayer concludes that "there are people in high places
who still believe government should not interfere with the freedom of contract between the loan
shark and the needy".

Before closing out this section on the relationship between the Fed and the Poor we should just
note the interesting results of one of Mr Greenspan’s recent data analysis projects. The June 4,
2001 edition of Business Week reported on a study commissioned by the Fed that found that
50% consumer spending in the year 2000 was attributable to the top 20% of income earners.
Also, amazingly, 80% of directly held equity or stocks was attributable to the top 20% bracket.
The conclusion of this study was that the economic boom of the middle to late 90’s was almost
entirely driven by the spending of the top 20% of earners, whose spending in turn was driven by
confidence derived from an inflated equity market. Now that the markets are sliding this
spending has stopped, we are sliding into recession, and layoffs are increasing in response to low
company earnings. What then is a Federal Reserve Chairman to do? It seems his role is to keep
the stock markets up and keep the top 20% - the speculator class - happy. So maybe it’s not just
that the poor are irrelevant to the Fed’s decisions, but the irrelevancy may run as high as 80% of
the American people! Not to mention the rest of the world.

Part 4: "Wizards and Warlords"

1. Introduction to Wizards and Warlords
2. A Tragic Day for the American Empire
3. The Role of Wizards and Warlords in Empire-Building
4. Special Wizard/Warlord Relationships of the American Empire
5. The Downfall of the Roman Empire and the Roman Monetary System

This is the fourth edition of the Wizards of Money, your money and financial management
series… with a twist. My name is Smithy and I’m from the Land of Oz.

1. Introduction

In this fourth edition of Wizards we are going to take a look at the special relationship
between the Wizard profession and the Warlord profession.

We will first talk about this partnership in relation to the horrific and tragic events that
took place on September 11, 2001. Then we will travel back just a short time - a hundred
years or so - and look at some Wizard/Warlord alliances of special note - especially those
that come in the form of brothers.

We will also go back a few thousand years to look at the Wizard/Warlord activities of the
Empire that so resembles today's American Empire that sometimes I even forget which
Empire I am in! The decline of many of history's great empires is associated with failures
in the Wizard/Warlord partnership that are common across the wreckages of many
civilizations. We will travel back in time to visit the Roman Empire, which bears so
many similarities with the following aspects of the American Empire: trade, monetary
system, labor relations, military activity, judicial and governmental system, foreign
policy, immigration, "globalization", and the fantasy-world of plenty and constant
entertainment for many of those residing at the center of the Empire. The list goes on.
Some of these aspects were covered in the July 1997 issue of National Geographic. In
Wizards today we will focus only on parallels of the Wizard and Warlord type.

Why, on earth shall we do such a thing, you might ask? I will answer that question with a
quote from the Roman Lawyer Cicero, a prominent lawyer in Rome around in the first
century BC. Even by that time Rome was a highly litigious society, similar to America
today, and lawyers had prominent roles in the governance of society, and in both
Wizardry and Warlordism. Cicero stated "Not to know what happened before we were
born is to forever remain a child".

Whoever could have imagined the collapse of Rome, perhaps the most powerful and
wealthy ancient empire? It climbed to such great heights that it had so far to fall. It
collapsed so spectacularly that "the West" then plunged into a period characterized by
strife, lack of cultural development, limited trade and domination by feudal lords - these
were the so-called "Dark Ages". Perhaps America, the most powerful empire of recent
times, and whose collapse nobody could imagine, has something to learn from the
collapse of its 2000 year old "look-alike" ancestor.

2. A Tragic Day for the American Empire

Nobody who saw the ABC interview with Howard Lutnick, CEO of the prominent bond
trading firm Cantor-Fitzgerald, on Friday, September 14th 2001 could ever forget it. Most
who saw it will surely forever be haunted by his statements about having to communicate
with 700 families about missing employees, and the images of these families holding up
photographs of lost loved-ones.

"The firm of Cantor Fitzgerald was commonly viewed as the core of liquidity for U.S.
financial markets", according to Larry Walker, Managing Director of EDS Financial
Industry Group, in a statement on the EDS web site after the September 11 terrorist
attacks on the heart of America. He goes on to comment on the implications of
September 11 for the world's monetary system "Cantor Fitzgerald … lost hundreds of
traders and other professionals in the disaster. These individuals represented an enormous
amount of intellectual capital with respect to issues affecting liquidity. Many believe that
such talent cannot be easily replaced and that the United States may soon experience
liquidity challenges." Later on he adds "Whatever happens with U.S. liquidity could have
a rippling impact around the world."

Cantor Fitzergald was reputedly responsible for 70% of the US Bond market, according
to the Guardian Observer September 16th edition. It is also a key component of the 25
primary bond dealers who act as counterparties to the Federal Reserve during its Open
Market Operations. And it's one of the three of those 25 who lost many employees during
the September 11th attacks. Recall from Wizards, Part 1 that Open Market Operations are
what the Federal Reserve does when it creates or extinguishes money by buying or
selling government securities or bonds. The counterparties to these transactions thus play
a fundamental role in the monetary system. The EDS concerns about liquidity just
mentioned refer to the concern about the "flow of money" or the "accessibility of money"
to conduct "business as usual" throughout the economy.

Today (late September, 2001) if you visit the web site of this prominent bond-dealer and
key component of the monetary system you will see no mention of trade at all. You will
instead see a list of hundreds of individual memorial services and information for friends
and family of lost and dead employees. Certainly nobody ever imagined this could

The amazing feat of the remaining Cantor-Fitzgerald bond-traders to return to work

within days of this tragedy is a tribute to the extraordinary resilience of the American
people, and helps one understand the spirit that created such a great empire. But it also
may indicate something more sinister at work that also showed itself in the majority of
the American public's response to the tragedy. To return to "business as usual" (both
financially and militarily) immediately after an incredible shock may provide a
comforting band-aid solution but it may only be a short-term solution. For, what if
"business as usual" is part of the problem? Then the underlying causes of the shock have
not been removed.

The return to "business as usual" was also marked by the reopening of the various NY
based stocked exchanges, accompanied by the customary speculative attacks against all
those operations already critically wounded by the attacks. Free markets were back at
work for the speculators who seemed to have no moral dilemmas about profiteering from
the crisis. Nobody got upset about their lack of patriotism.

But the markets are not really free for, as has been discussed in earlier editions of
Wizards, when big players get in trouble the public will bail them out. This will happen
with the airlines which is probably acceptable to many people. But what this
demonstrates is the overwhelming and disproportionate power of the shareholders, who
are able to absolve themselves of the cost of this catastrophe by dropping their shares like
hot-potatoes, while the public steps in to pick up the tab. As we say in the finance world,
they get mostly upside gain and limited downside risk. And as we saw with creditors and
IMF bailouts, in this case it is shareholders who do not bear the responsibility of the risks
they assume. With the public always standing by to fund bailouts nobody should pretend
that the markets are free and fair.

There is, however, one thing that the public cannot bailout, or otherwise be called upon to
take responsibility for. We discussed this in Wizards Part 2 and I am talking about the
value of the US Dollar. If market speculators had attacked the US dollar to any great
extent, as so many traders have attacked so many other currencies, serious world wide
financial economic troubles would have developed immediately. And no taxpayer bailout
can fix this. We already saw from the opening of the stock markets that speculators were
more than willing to not let human tragedy get in the way of maximizing return on
capital. So, if we have a free market for speculators, how come no speculator attack
materialized on the US Dollar?

The answer to this could be found hidden away on the second to last page of the Wall
Street Journal dated Monday, September 17th. Apparently "a gentlemen's agreement" had
been reached by the world's major financial Wizards to not attack the currency of the
Empire. Actually this was a good thing because it would have added massive instability
to an already tense situation. However what we learn from this is a bit frightening - that
the control of the lynchpin of the international monetary system is in so few hands that
such a "gentlemen's agreement" can be pulled off with extraordinary success.

September 11 was certainly an attack on the "Wizardry" of America - an attack at the

heart of the monetary and financial systems that dominate the modern world. It was an
action that, while imaginative, lacked the ingenuity and faith that would be required to
seek a peaceful and long-term solution to the worldly problems that this same financial
system is complicit in. It was a horrific act of desperation by persons who had given up
on peaceful solutions to their problems.
In the last edition of Wizards some excerpts from Reverend King's Vietnam War speech
were played. In that 1967 speech Dr King refers to a quote from John F Kennedy that
states that "those that make peaceful resolution impossible make violent revolution
inevitable". The corresponding attack on the Pentagon on September 11 perhaps indicates
the status of the attackers' feelings about possibilities of peaceful resolution to whatever
problems they may have had with the American Empire.

The fact that both the financial system (the Wizard world) and the military system (the
Warlords) were targeted on September 11th is not without significance. The two are
intimately related, and key components of many a successful human empire.

Break: Excerpt from King Vietnam War Speech on the true meaning of Non-Violence.

3. The Role of Wizards and Warlords in Empire-Building

Powerful warlords or a strong military are an obvious necessity for any great empire.
First they are needed for self-defense and second they are needed for the job of
plundering foreign lands. This is merely to state a fact about empire building - that any
empire that accumulates lots of riches does so by using lots of the resources from foreign
lands. The foreigners in these lands generally do not wish to donate these things to the
empire and therefore military action is often required to complete the acquisition.

However once the empire is established and acknowledged as quite powerful, the
empire's monetary system can take over much of this role of plundering without having
to kill as many people or expend as much military energy.

During Roman times, as the Romans conquered foreign lands and brought them into the
Empire, they installed puppet rulers or Roman Governors that represented the interests of
the rulers of the empire. The conquered foreign lands were known as the provinces of the
empire. The Romans would pretty much let the province alone so long as they had a
compliant governor in place and as long as they could trade with the foreigners to get all
the goodies they desired in exchange for the Roman currency. By issuing their own
currency (which was in the form of gold and silver coins) for trade the Romans had a nice
solution to the problem of getting access to foreign resources without further straining the
military. The military already had lots of work to do in putting down slave rebellions at
home, controlling troublesome provinces and conquering new lands not already in the

The people of the conquered lands were generally compliant even though they had to
give up their own sovereignty in the process. Trade with others in the Empire and the
pursuit of riches and luxuries traded around the empire, as well as the precious Roman
currency, kept most of the citizens of provinces pretty happy with this agreement for
many years. The Roman currency worked its magic so well that people all over the
Empire and outside it were mesmerized by its power, and piles of Roman currency were
found as far abroad as China and India many years after the collapse of Rome. Despite
the brutality of Rome in conquering new territories and in building an economy based
largely on slave labor, people trusted and traded in its currency and people all over the
world wanted to be Roman citizens - for it was the very embodiment of success and

Throughout history many a successful currency has been built upon a strong and brutal
military, and an economy based on slave labor. In return for this tremendous favor
provided by the Warlords, the Wizards of currency then go about providing many a favor
back to the Warlords. For the Warlords would get worn out and wiped out if they had to
continue the same level of military activity in already occupied lands. It is much more
efficient for the Empire to use some special magic in the form of a mesmerizing currency
that can be used throughout the empire for the trade in all goods and services. In that way
many will occupy themselves in the pursuit of the medium of exchange. Once a people
are mesmerized, this enables the Warlords to focus on new conquests and the putting
down of rebellions in the few but inevitable troublesome provinces.

During much of the Roman Empire many provinces were compliant with the Roman
ways, and appropriately mesmerized by the Roman currency and the all entertainment
provided by the Empire. However there were several provinces on the periphery that gave
Rome many a headache over their lost sovereignty. Perhaps the most notable of these was
the province of Judea, known today as Israel to some and Palestine to others. Much
military energy was expensed on maintaining the compliance of the province of Judea,
and Rome was not at all pleased.

Of course this is the place in space and time where the icon of today's very Roman-like
American Empire, a man known as Jesus Christ, lived out his life and was rather opposed
to the ways of the Romans. It is very interesting that, unlike most others around him,
Jesus appears to have understood that the Roman currency was little more than a tool of

One of the nicer and brighter Wizards of last century, John Meynard Keynes, once said
that he knew only three people in the world in his time that actually understood money.
This tends to be the case throughout many empires - that only a handful of people can see
through the wizardry of money. Of course this is what makes it so powerful. It is
fascinating that Jesus was actually one of the handful of people in Roman times that truly
understood the nature of Roman currency. Evidence of this is found in the Bible at Luke

The Roman Empire had their own secret agents, perhaps the equivalent of today's FBI
and CIA. Certainly they had much work to do in the troublesome province of Judea.
According to Luke 20 various leaders were quite upset that Jesus had driven out
merchants and traders from the Temple. Some secret agents were sent in to trick Jesus so
that the Roman governor could arrest him. They asked "Is it right to pay taxes to the
Roman government or not?". Jesus responded "Show me a coin. Whose portrait is this on
it? And whose name?" They replied "Ceaser's - the Roman Emperor's". Jesus then said
"Then give the emperor all that is his - and give to God all that is his". Most citizens in
the provinces trusted in their Roman currency so much that they thought they needed it
for the necessities of life, and were therefore upset by the Roman's collection of taxes. It
took a Jesus to point out that it was simply an instrument of control for the Roman

Today, of course, the US Dollar has a similar mesmerizing effect throughout the world.
Ironically this is the instrument of the very same Empire that holds Jesus as its savior. I
ask you to take a good look at our US Dollar of today. Certainly we see George
Washington on the one dollar bill, but I am always more intrigued by the other names on
it. Today you will probably see the names of Lawrence Summers or Robert Rubin in the
bottom right corner of the Washington side. Not emperors, but rather, one Chief
Economist of the World Bank and one Executive of the mega-Wizard collection known
as Citigroup. On the other side are all kinds of Biblical, Roman and religious symbols. A
very religious person might have reason to get upset about all the religious symbolism on
what is reputed to be the "root of all evil". But this symbolism is a key part of the
underlying wizardry. Perhaps we can go into more detail of the meanings of these
symbols in some other edition. But now we will discuss some important Wizard/Warlord
partnerships of today's dominant empire.

Break: "Filth from Rome" and "We are Occupied!" from Jesus Christ Superstar
Soundtrack, Australian Recording.

4. Special Wizard/Warlord Relationships of the American Empire

It is instructive to look at some of the key Wizard/Warlord relationships of today's

dominant empire during the period of its key wars that helped to make it an Empire. We
look at partnerships during the civil war, then the two world wars and then glimpse at
them during the cold and gulf wars.

America's civil war was certainly a key step towards its development into an empire, for
the split of this young nation in half would have hampered steps toward empireness, and
kept it occupied fighting amongst itself for many years. During such battles Wizards (in
the form of bankers) usually would work closely with the warlords to finance the war, not
from ideological concerns, but merely to make a profit for themselves. With this in mind
the Loan Committee of bankers, formed to finance the Union in the war, offered
Abraham Lincoln a loan of $5million at a whopping 12% interest rate. The chairman of
this committee was Moses Taylor, who was also the President of City Bank at the time,
which is known as Citigroup today.

Lincoln told the bankers to get lost and decided to issue his own debt-free, interest free
currency known as the "greenbacks". The wizards were not pleased at all that someone
would dare violate the traditional wizard/warlord alliance, and take over both
responsibilities for themselves, leaving the wizards without a war profit. I am certain they
feared for their future.

Eustace Mullins points out in his book "The Secrets of the Federal Reserve", published
by Bankers Research Institute, that the assassinations of both Presidents Lincoln and
Garfield followed radical statements or actions involving the medium of exchange.
Mullins is well known by those acquainted with his materials as something of a
conspiracy theorist but he has done some excellent research on the history of banking in
America and his findings really do make one think. According to a lawyer named Alfred
Crozier, who gave testimony before a Senate Banking Committee around the time the
Federal Reserve system was being readied for implementation, President Garfield had
stated shortly before his assassination "whoever controls the supply of currency would
control the business activities of all the people". He also reminded the committee that
Thomas Jefferson had warned a hundred years earlier that "a private central bank issuing
the public currency was a greater menace to the liberties of the people than a standing
army". So Jefferson attributed more danger to the Wizards of an Empire than to its
Warlords - which is very interesting! This maybe because the Wizards' power of control
is psychological, not physical and so can go largely unnoticed, and therefore continue
unchecked. But the power exercised by warlords is obvious and therefore more likely to
be challenged. Hence it is in the interests of any empire to replace physically forced rule
by warlords, by the psychological rule of wizardry, in lands where it has become practical
to do so.

After the embarrassment of the public's representative taking over wizardry during the
Civil War the bankers were very busy re-establishing their powers. After the civil war
strong alliances between various senators and bankers, and the concern over various
financial crises, helped create the Federal Reserve System by 1913 through the help of
special outings disguised as duck hunting. We spoke about this in Wizards Part 1 and the
Federal Reserve of Minneapolis has this history on its web site.

It came in very handy for the bankers of America that this system was in place just in
time for the First World War. At that time that Mr. Paul Warburg, who was a Governor of
the Federal Reserve Board, had been responsible for much of the design of the Federal
Reserve System and was one of the 20th century's most amazing Wizards.

Another powerful banker of the times, was a Mr. Eugene Meyer who was Chairman of
the War Finance Corporation which, according to the New York Times August 10, 1918
edition, had been planned by Mr. Warburg himself. These two chaps exercised
tremendous power and influence over the financing of war at the time, and made sure that
bankers were able to profit from the financing of war.

Interestingly Paul's brother, Max Warburg, was the head of the German Secret Service at
the time according to the Mullins book. There is no doubt that the Warburg brothers not
only represented a powerful Wizard/Warlord alliance in a single set of siblings but they
were clearly operating on both sides of the war, and for this they profited doubly! While
Paul Warburg was a Governor of the Federal Reserve Board of the US, the Warburg
family was financing the Kaiser in Germany. They also helped finance the Bolshevik
revolution in Russia. Mr. Mullins in his book "Secrets of the Federal Reserve" cites some
text from a December 12, 1918 US Naval Secret Service report that says that Warburg
"handled large sums furnished by Germany for Lenin and Trotsky. Has a brother who is
leader of the espionage system of Germany." In fact it is not unusual to see bankers
operate on both sides of a war - after all, it is not their job to be concerned with this
ideology or that, but simply to keep the medium of exchange flowing and to make a
profit for shareholders. Plus being on all sides of a conflict will enable them to quickly fit
into their appropriate Wizard role within the victorious empire.

Mullins also points out in his book that Woodrow Wilson did not really believe in his
own crusade to "save the world for democracy" by getting America involved in World
War I because Wilson had written much later that "the World War was a matter of
economic rivalry". Interestingly it was this World War that really saw the development of
the income tax system and the role of the Federal Reserve, operated by the bankers, as
fiscal agents of the government. Since then America has used the income tax system and
debt-money issuance as the primary way of financing wars from which both bankers and
many other corporations would profit. The Romans also similarly taxed their citizens in
all of their provinces as a primary means of financing their conquests.

The Warburg brothers were the most outstanding example of a Warlord/Wizard

relationship within a single set of siblings operating on both sides of the First World War.
They passed this baton on to a new set of brothers to take on this role for the Second
World War - that was the Dulles brothers.

Here is some interesting history from the Mullins book: A fellow named Otto Lehmann-
Russbelt wrote a book called Aggression in 1934, published by Hutchinson and Co. In
this book he says "Hitler was invited to a meeting at the Schroder Bank in Berlin on
January 4, 1933. The leading industrialists and bankers of Germany tided Hitler over his
financial difficulties and enabled him to meet the enormous debt he had incurred in
connection with the maintenance of his private army. In return he promised to break the
power of the trade unions. On May 2, 1933 he fulfilled his promise." Mullins goes on to
report that "present at the January 4, 1933 meeting were the Dulles brothers, John Foster
Dulles and Allen W Dulles of the New York law firm Sullivan and Cromwell, which
represented the Schroder Bank". This meeting and the Dulles brothers involvement in it
and the financing of Hitler was documented in the New York times on October 11, 1944
according to Mullins. It is widely acknowledged in many sources that the Schroder Banks
were the main financiers of Hitler. Alan Dulles' later career highlights included being
head of the CIA and a director of the Schroder Company. John Foster Dulles settled for
being Eisenhower's Secretary of State.

Not content with just being the star Wizard/Warlord brother partnership on both sides of
the Second World War the brothers Dulles continued to carry their skills into the cold
war, and into numerous other countries that saw what amounted to puppets of the
American Empire being installed throughout the Middle East, Asia, Latin America and
Africa. Whenever the people of these countries should elect their own representative
through the democratic process they would surely mysteriously be replaced through
various means if the leader looked at all like not being in business with Western
corporations for their pursuit of profit. While this might sound a bit harsh to the
uninitiated the public release of much relevant information in the past years through the
Freedom of Information Act reveals much of this CIA driven skullduggery in countries
across the globe. So the well read and well educated should not be seduced by the
alternative "beacon of freedom" descriptions of the Empire proposed by its current
President. Certainly the people of America have many freedoms that other peoples do
not, but as in Roman times, this comes at the cost of the lost freedoms of the millions we
can't see.

Well, later on, after the brothers Dulles were all worn out and had the necessary naming
of an airport after them, a new set of brothers, complete with a father as well, were
wanting to take over as the Empire's star Wizard/Warlord family.

This was the Bush brothers and father, but so far they have not been able to demonstrate
any talent on the Wizard side. Their appointed Wizard brother embarrassed the family by
revealing its shortfall in Wizard skills in a most spectacular way through the failure of the
Neil brother's Silverado Savings and Loans effort. Fortunately the evident lack of wizard
skills in the Bush family could be swept under the carpet quite quickly because the father
was the President of the American Empire. He was able to organize a quick bailout of all
failed S&L wizards with the assistance of the American publics' tax money. Ever since
that huge embarrassment the Bush's abandoned Wizardry altogether and have tried to
make up for their shortcomings by expanding all Warlord activities, which they have
some demonstrated talents in. I am certain I don't need to elaborate.

The family and ancestral links of both today's main Wizards and Warlords, and their role
on both sides of major conflicts, could be discussed for days and days. But now we must
go back to the Romans.

Break: "What Money Might Buy" Martha Davis

5. The Downfall of the Roman Empire and the Roman Monetary System

Interestingly the Roman Empire's equivalent of the Federal Reserve started out in a Temple devoted to
the Goddess Juno, the highest Roman Goddess, and not to any of the big brawny male gods. According
to Jack Weatherford's book entitled "The History of Money", the Roman goddess Juno represented the
genius of womanhood and was the patroness of women, marriage and childbirth. I think this is funny
because today the Federal Reserve, banking in general and the whole practice of modern wizardry is
primarily a male affair. Though the Federal Reserve has the obligatory affirmative -action type "girl seat"
on its Board it is presently unoccupied because either no females have been found appropriate for the
girl seat, or have no desire to be on it.

The goddess Juno had a few last names depending on which job she was doing. For example she
was Juno Lucina for protecting pregnant women and Juno Moneta as patroness of the Roman
state. Moneta came from the Latin word Monere which means "to warn" because the geese that
lived around the Juno temple honked loudly whenever invaders were nearby.

As patroness of the Roman state Juno Moneta had to preside over some stately activities such as
the issuing of money. The Roman denarius coin of 269 BC was manufactured in the Juno
Moneta temple and bore her image and last name "Moneta". This is where the name "money"
comes from.

Much of the Roman history of money above and in what follows comes from Jack Weatherford's
book "The History of Money" that we also mentioned in Wizards - Part 1. Other information also
comes from the History Channel's four part series on the Roman Empire. Weatherford writes that
Rome built the world's first empire based on money, rather than government, as the main
organizing principle. Most of the real commercial growth of Rome occurred during the so-called
Republican era, prior to the rise of Julius Ceaser in the 1st century BC, and the long line of
Emperors (or dictators) to follow.

The early Roman emperors were aware of how commerce and markets could be used to enhance
their imperial power. From Ceaser onwards the issuing of money was pretty much taken out of
the hands of the followers of the Godess Moneta and control was passed to the ruling Emperor
and minted coins bore his image. It was at this point that money was elevated from "medium of
exchange" to "tool of empire" and so the trouble began with the Roman Monetary System.

Thereafter trade increased and Rome increased its wealth by conquering other lands and
appropriating their resources. H.G. Wells wrote in "The Outline of History" that "Rome was a
political and financial capital … a new sort of city. She imported profits and tribute and very
little went out of her in return." The same might be written about New York City and
Washington DC in future history books. Wells then goes on to say of the speculative activity at
the time "Men made sly and crude schemes to corner it, to hoard it, and to send prices up by
releasing hoarded metals", speaking about the activities around money.

Roman Emperors got more money by conquering new lands and stealing their gold reserves,
which they would then spend to conquer new lands. Increased spending sometimes required
melting and reissuing more coins with the same amount of gold if not enough gold had been
stolen recently. This led to devaluation of currencies and by the 1st century BC the Roman
current was already devalued to one forth the value of the earlier Moneta denarius.

The Roman budget exploded following the conquest and robbing of many a European and
Middle Eastern territory, including many of those same places that the United States has troops
posted in today to ensure it's appropriation of modern gold - which is oil. Most of these budgets
were then used to finance more military conquests, the permanent troops that needed to be posted
in conquered lands, and "investment" in infrastructure in conquered lands. Those concerned with
today's World Bank might be amused with this latter aspect of the Roman Empire.

By the time of the Roman Emperor Trajan, who ruled from 98 AD to 117 AD, the Roman budget
exceeded its income from its profiteering and conquering activities. Rome was having some
difficulty meeting all the expenses of having to keep permanent troops in occupied territories and
numerous other expenses. The British Empire started having this same trouble in the 20th century
too, which pretty much forced it to hand the Empire Baton to its friends in America.

Trajan the Emperor was quite the investor in infrastructure. He even built the world's first indoor
shopping mall known as the Trajan Markets, and was responsible for huge investment in the
Empire's travel and communications networks. Emperors of this time also liked to spend lavishly
on "Romanizing" the conquered land with all the trappings of Roman culture that helped to
amuse and occupy the people of conquered lands. This included the coliseums and amphitheaters
that exported Roman entertainment throughout the empire. I suppose this had an effect of
warming the people of conquered lands to the Roman Empire, similar to the export of American
movies, television and other media. This also feeds back to help with mesmerizing people with
the power of the Empire's currency. Anti-globalization activists should be aware that the
phenomenon of so-called "globalization" is at least as old as the Roman Empire. Though we
don't hear too many stories about anti-globalization activists in Roman times, it is interesting to
wonder about them.

With all these expenses and the increasingly sophisticated tools desired by the military forces it
is no wonder the Emperors starting having massive budget shortfalls. They reacted in two main
ways. One way was to tax the citizens of the whole empire, including all the provinces, more and
more. The other way was to use the same amount of gold and silver to issue more and more
coins. The latter only caused terrible problems of inflation as the greater money supply just
forced prices up. The burdens of both of these tactics fall most heavily on the poor. And as with
the broader American Empire the gap between the rich and the poor continued to widen as poor
people were forced to sell off their real assets - animals, land, work tools, etc. - to pay their taxes.
The main difference in the American Empire's approach is that its efforts are funded mostly by
debt-money creation, which forms a sort-of tax on peoples abroad (mainly through interest), as
well as conventional taxes on citizens who live in the heart of the Empire. In the Roman Empire,
as with the American Empire, speculative activity probably came to dominate productive
activity, much of the latter being performed by slaves or low paid persons. Roman farmers and
small traders got screwed by all the taxes and unstable prices and went out of business.

The real economic infrastructure that had made the empire successful was collapsing as a result
of the policies implemented by the ruling emperors to fund the continued occupation of
provinces and infrastructure spending. The whole economy was shifted to providing more
luxuries for the ruling class while everyone else got poorer, in what was, and always is - a zero
sum game. Unrest and tensions built throughout the Roman Empire and the rulers could no
longer control it. They had already stolen everything from the citizens and the provinces, so they
ran out of funds to keep the empire going. The Empire could not sustain itself. It imploded from
inequality, recklessness and stupidity. At least the good Wizard of the 20th century, John
Maynard-Keynes, had the foresight to warn of this. But nobody seems to have listened.

The implosion of the Roman Empire was so complete that it took another one thousand years for
the money economy to return.
Today one might think that the modern equivalent of the ruling class of the Roman Empire are
the larger owners of the large corporations, and that debt plays a role similar to Roman taxes. I
leave the reader/listener to draw their own conclusions about what we have to learn from all this.

Please note that Wizards of Money has a web site at where you can
find the text of all episodes plus some more references and other information.

That's all for Wizards of Money Part 4.

Outro: "Reckless" Australian Crawl

Part 5: "Monetary Terrorism"

1. Introduction to Monetary Weapons
2. Relationship Between 20th Century Money and 20th Century Wars
3. The "Oil-Standard" Kicks Out the Gold-Link of Money
4. The Anatomy of a Currency Attack
5. The Unholy Trinity
6. Wall Street's Stealth Fighter - Dollarization

This is the fifth edition of the Wizards of Money, your money and financial management series… with a
twist. My name is Smithy and I’m a Wizard Watcher from the Land of Oz.

1. Introduction to Monetary Weapons

In this fifth edition of Wizards we are going to take a look at financial terrorism conducted by
western financial institutions even as they freeze the assets of a different kind of terrorist. In the
previous edition of Wizards we discussed the dual role of the military system and the financial
system in modern empires, and how both systems facilitate the appropriation of foreign resources
– the lifeblood of any empire. Today we will explore how certain currency regimes have come to
dominate in this arena, and take over from where various cold-war era military regimes left off.

While the world's eyes are focused on the so-called "war on terrorism" and various acts of
terrorism that come in the physical form, the US dollar and its primary wizards are busy
wreaking havoc in other nations. As of late October/early November 2001 Argentina is
struggling under the currency regime of mass destruction known as the "Dollar Peg". This is the
same mechanism that helped bring down the financial and economic infrastructure of Mexico in
1994/95, Thailand in 1997 and Indonesia in 1998 to name but a few casualties of this monetary

During the current "terror watch" some eyes have been checking on the sneaky attempts to pass
through the FTAA (Free Trade Area of the Americas). But little noticed is the spreading use of
stealth monetary weapon known as "dollarization", which could have an effect more severe than
any such trade agreement. On January 1, El Salvador began the new-year by taking the drastic
step of "dollarization" - which means making the US dollar the official currency of their nation.
Guatemala took steps to do this in May, but is not there yet. Ecuador has already dollarized, and
now Argentina's government says it would rather dollarize - i.e. throw out its own currency -
than devalue it to see itself out of its current debt crisis. Not only is Latin America coming under
US monetary rule, but other less powerful nations, for example the newly independent nation of
East Timor, are being pressured to dollarize.

As we saw in Wizards Part 1, even within the United States, money (or credit) creation in the US
dollar is not democratic, but rather is the domain of private bankers and the Federal Reserve. At
the international level dollarization and other monetary weapons take credit creation power
completely out of the hands of other nations and place it entirely with private financial sector of
the United States. Recall the words of President Garfield shortly before his assassination as we
discussed in Wizards Part 4 - "Whoever controls the supply of currency would control the
business and activities of all the people". If you believe this then it would seem that once
dollarization is in effect, the highly controversial free trade agreements are hardly needed.
Dollarization will do the job of such agreements without all the hassles and public outcries
associated with these documents that have to go through a more democratic process, little though
it may be. Such is the mystery surrounding money and monetary policy that lengthy trade
agreements get more attention than the simple move to formally adopt the currency of, and
relinquish all credit creation powers to, the super-power.

Dollarization gets little attention here because it can happen in foreign countries without any
approval of the United States government as is required for the international trade agreements,
and it is often adopted in countries without the approval or even knowledge of a great many of its
own people. Many countries probably feel that they are forced to dollarization because if they do
not comply with the ruling monetary regime, speculators will eventually attack their currency
anyway. This is a valid point for its seems that most nations in the developing world, other than
those cut-off from the international markets, have had their currencies attacked by speculators at
some point in the past decade.

In this way speculators do act like a military force, going to war against foreign currencies or
monetary systems, and pounding them with their might until they win. Just like the US-backed
military forces before them they have more and mightier weapons. In the case of a military
action during the cold war US-backed military forces could often physically attack a people until
they gave up because the former had the most access to the most powerful weapons. The same is
true of currency attacks by Wall Street firms (and their European counterparts). The major firms
that instigate the speculative attacks have access to more US dollars (or other hard currency such
as the Euro) than the central banks of many countries. Remember that the US Dollar is the
linchpin of the international monetary system and forms the "reserve" backing up most foreign
currencies. By having easy access to tremendous amounts of the mightiest monetary weapon in
the world, these Wall Street firms have, in almost all cases, forced foreign currencies to collapse
once they have initiated an attack.

Faced with problems brought about by overwhelming speculative attacks, as with overwhelming
military action, countries increasingly seem to give-up and go the way of "dollarization" to
eliminate the threat of currency attacks. This trend has profound implications as to lost
sovereignty, and a seemingly irreversible acceleration of the phenomenon labeled as
globalization. To understand this relatively new trend it is useful to look back into the history of
the international monetary system over the past century to discover how things got to this point.

2. Relationship Between 20th Century Money and 20th Century Wars

World War II and the events leading up to it saw profound changes to the international monetary
system and the mechanisms that countries would use to co-ordinate cross-border trade and
financing. The most famous of these changes came in the form of the Bretton Woods agreements
(named after the meeting place in the US where the agreements were drafted) which created the
International Monetary Fund and the World Bank. We shall just focus here on the IMF because
this has more to do with contemporary monetary attacks than does the World Bank. Much of
what follows comes out of an Economics text used by many trainee-Wizards in their studies
called "Economics" written by some real important Wizards - David Begg (Professor of
Economics, University of London), Stanley Fischer (from the IMF and World Bank), and
Rudiger Dombusch (Professor of Economics, MIT), and translated into plain language by me.

To understand what the IMF was really created for lets just take a peak at monetary
arrangements before the Great Depression. Up until this time many countries were on the gold
standard, whereby their own currency was backed by gold reserves at their central bank (The
Central Bank is the creator of base money for any currency.), and paper currency could be
converted to gold. Just as in Roman times this system meant that whoever had access to the most
gold could do the most investing and acquire extensive ownership in foreign resources, and this
was usually perfectly correlated with whoever had the most firepower and willingness to use it.
This made Britain both the primary military and financial power in the 19th and early 20th century
with a late boost coming from its discovery of gold in South Africa.

One of the main complexities of the international monetary system, which is the mechanism
through which all international trade and investing happens, is the determination of the value of
one country's currency against another, known as the exchange rate. For example the value of
today's Australian dollar to the US dollar could be expressed as an exchange rate of almost 2
Australian dollars to 1 US dollar, or 1 Australian dollar is worth 0.5 USD. Before the Asian
financial crisis the exchange rate was closer to 1 Australian dollar for 0.7 USD. So we say the
Australian dollar has since been devalued relative to the USD - it now buys LESS US dollars.
This means that it is now more expensive for Australians to buy US products, and Australian
products are cheaper for US consumers. The problem of managing exchange rates has troubled
international relations for the past 2 centuries and so far none of the management regimes have
worked out very well for the majority of people living outside the United States or Western

Any country involved in international trade would like their exchange rate relative to the
currency of trading partners to remain fairly stable and predictable and not to suffer sudden
shocks. For if their money suddenly loses value relative to other money their imports cost more
and if it gains value their exports are less competitive. The gold standard provided a way to
stabilize exchange rates because every currency was convertible into a single common
commodity - gold. Up until the Great Depression and under the gold standard there was allowed
a fairly free flow of capital between countries and this is what kept exchange rates stable.
However, on the downside, the central bank or the government of a country weren't easily able to
change their own money supply to deal with pressing domestic problems such as unemployment
and price inflation, because this supply was already fixed by gold movement. Also, financial
panics were more likely to collapse the whole system because everyone would rush to change
their money into gold and the whole banking system would start to break down.

For these and other reasons the gold standard for domestic money holders was abandoned by
most countries after the Great Depression. But this meant that there was no longer any natural
way to ensure stability of the exchange rates between countries. It was recognized from the
events leading up to the Great Depression and to World War II that some international agreement
was needed to create a more stable international monetary system, and one that was to exist in
the absence of a gold standard backing each individual currency. This is what gave birth to the

In the aftermath of World War II the United States was the dominant economic power because it
was basically the child of the pre-war powers who had their economic infrastructure destroyed
during the war. With the gold-standard gone it seemed to make sense to the powers-that-be for
the world to move on to a US Dollar standard, where the value of every currency would be set
against the value of the US dollar. In turn the US dollar was fixed against the value of real goods
by settings its value against gold as US $35 for an ounce of gold. This was called the Adjustable
Peg system and the IMF was created to administer this system and put out fires as needed.

Under the Adjustable Peg system then, many countries might hold US dollars, US government
bonds and gold to back their own national currency and keep their exchange rate fixed against
the US dollar. Central banks could redeem their US dollars for gold at the fixed price, and this
gold was stored at the famous Fort Knox. Exchange rates would be stable as long as demand for
US dollars remained fairly stable relative to demand for other currencies. Relative demand for
any country's currency versus others depends on relative flows of imports versus exports and
desire for investment domestically versus abroad. To keep things fairly stable, under the original
Bretton Woods agreement, there were restrictions on cross-border capital flows or investments
to help reduce sudden jumps in supply or demand for a currency that come with speculative
capital flows.

The capital controls were necessary otherwise speculators could have had a field day by betting
that a certain currency would go down by selling it off against the US dollar and thereby forcing
it to go down purely from their speculative activity. Large financial firms with access to lots of
US dollars could therefore force a foreign currency of a weaker country to collapse as they
desired. The earlier restriction on capital flows is a key point so please remember it because this
is a fundamental difference between the original Bretton Woods system and the commonly
named post-Vietnam "non-system" that allowed the sudden attacks on, and collapse of, Mexican,
Asian and Latin American currencies over the past decade. If a currency collapses people of the
effected country become a lot poorer very quickly and things are much worse if the country has
lots of debt denominated in, say USD. We have seen that when this happens economic policies
then introduced normally lead to increased poverty and unemployment, or employment at below
poverty wages, as well as a selling off of natural resources to the west at fire-sale prices. It is
interesting to note that the two things that brought down the stabilizing mechanisms of the
original Bretton Woods system were America's extensive cold-war military adventures and the
world's lust for oil (through the 1970s oil shocks).

Under the original Bretton Woods system with capital flow controls, the only thing that could
change the relative demand for a currency against the US dollar peg, was a serious trade
imbalance. That means a large imbalance between a country's imports and exports. For example,
if a non-US country's imports from the US exceeded its exports to the US by a lot then its
demand for US dollars exceeded the US demand for its currency. To make things balance it
could either devalue its currency or get US dollars somehow, say by selling gold or borrowing
US dollars. If a large temporary trade deficit came about the IMF could lend US dollars to the
country to stabilize its currency value while the deficit existed. But if it was permanent the IMF
would recommend a currency devaluation.

For informational purposes I should just say that this issue of management of trade deficits and
barriers to trade, and associated demand for currency, provides the link between the IMF and the
original GATT or General Agreement on Tariffs and Trade, which later metamorphosed into the
World Trade Organization or WTO. It is interesting that both agreements and institutions jointly
deviated drastically from their original post-WWII mission in the late 20th century after the
collapse of the original Bretton Woods system.

Under this original Bretton Woods system countries had some control over their own domestic
monetary policy so long as it didn't effect their balance of payments too much, and under capital
controls they were protected from excessive speculation. But then America's increasing military
activity throughout Latin America, Asia, and Africa in the 1960's and 1970's followed closely by
the OPEC oil price shocks radically altered the fundamentals of the monetary system throughout
the rest of the 20th century. This culminated in severe currency attacks on many of the nations
already wounded by the military apparatus several decades earlier. In fact it is almost as if the
earlier military efforts laid the groundwork for the later monetary attacks.

Break: "Doomsday Lullaby", Wendy Matthews

3. The "Oil-Standard" Kicks Out the Gold-Link of Money

To understand this point about the monetary attacks let us first understand how the original
Bretton Woods system collapsed. Throughout the 1960s the United States was spending massive
amounts of money (US dollars) abroad to fund various military operations that, while under the
guise of the "war against communism", was ultimately buying insurance on investments and
economic interests abroad. While certain capital controls existed to prevent speculative pressure
on currencies US investors still had many economic interests throughout these regions. A rise in
democracy may have nationalized natural resources, created land reforms and otherwise
collapsed the value of US investments. In turn this would have had serious ramifications on the
US stock exchanges and reverberated throughout the whole financial system. This big military
spending abroad on Vietnam and other adventures caused America to have a big and rather
permanent trade deficit and greatly increased the supply of US dollars abroad relative to US gold
reserves at home. President Nixon was forced to break the peg of the US dollar to the fixed price
for gold in 1971 and then the US dollar kept decreasing in value with respect to gold as the US
increased its military activities abroad. This caused a huge disturbance in the international
monetary system and soon the whole adjustable peg system had broken down. The IMF should
have disbanded at this time because its founding mission didn't exist anymore now that the
Adjustable Peg had broken down. .

Then OPEC came along and presented the world with its oil price shocks and a lot of large
nations started running significant trade deficits with the Middle-East because the price of oil
was now so high. This might have been oil's way of saying that now that the gold standard was
completely dead it would take over as the real good against which currency value should be
assessed, which was appropriate since much of the human fighting stopped being about gold and
became about oil. The oil shocks and America's military spending seem to have created pressure
to break down the system of earlier capital flow controls so that the Western countries could
balance their currency outflow from trade deficits with some inflow of capital from the OPEC
countries who were making the big oil profits.

So much money then rushed in to the West as so-called petro-dollars that many financial
institutions then turned around, in the absence of capital controls and the gold peg, and lent the
money as US dollar denominated debt to many Latin American countries to earn some higher
returns. Interestingly a lot of this debt incurred in Latin America was being used to fund the
purchase of military equipment by the US favored regimes to assist in the "war on communism".
But the expansion of the US money supply and the oil-shocks led to such bad inflation problems
that by the end of the 1970's the US Federal Reserve decided to reign them in by spiking up
interest rates, which is the same as shrinking the US dollar money supply. Many Latin American
borrowers were on variable interest rates and this spike in interest rates forced them to be about
to default on their US dollar loans.

This threat of default marked the rebirth of the IMF, who had lost its founding mission upon the
collapse of the Bretton Woods system during the Vietnam War, into a wholly new entity
governing today's monster of an international monetary non-system. To prevent financial panic
spreading to the West upon such defaults the IMF stepped in as lender of last resort to protect the
Western creditors from getting hit by defaults. By giving such a blessing to the reckless behavior
of international banks the IMF introduced serious distortions favorable to these banks in the form
of "moral hazard" that is still with us today. Moral hazard comes about when large investors are
enticed into excessive speculation by the knowledge they will get bailed-out if their bets go bad.

Under today's international monetary non-system we have free flow of capital and persistent
speculative attacks against economically weaker countries. To make matters worse these
countries have large amounts of US dollar denominated debt, much of which originated as the
petro-dollars, and the IMF has made itself understood to be there to back up the big Western
banks who get in trouble while speculating on these countries. This Moral Hazard combined with
the loss of the original capital flow controls has created a very bad situation for the majority of
people in the developing world.
So, how did a reasonably stable post-WWII international currency regime get so nasty? The
simple social answer is that too few people now have control over it and they are the ones who
benefit from the stupidity of the system as a whole. The more detailed technical answer can be
understood by looking at the anatomy of a currency attack conducted by Wall Street, and then
looking at what is known as the Unholy Trinity Dilemma.

4. The Anatomy of a Currency Attack

Recall that under the pre-depression era gold standard, exchange rates were automatically fixed,
and there were pretty free investment capital flows. But countries couldn't do very much about
their own money supply to help with domestic policy, unless they went out and dug up more
gold. Then under the post WWII real Bretton Woods system there were fixed exchange rates,
and countries had some ability to control their money supply for domestic policy purposes such
as unemployment and inflation. This was possible because there were controls on investment
capital flows.

But now after the collapse of the real Bretton Woods system there are few capital flow controls
and many of the smaller economies have tried to peg their exchange rate to the US dollar.
Smaller economies try and fix their currency relative to the US dollar because for most countries
the US is a major trading partner and because they want to attract funds from US investors so
they want their currency to appear stable relative to the USD. However, Wall Street attacks have
made this a recipe for disaster and regularly smashed smaller economies. Let's see how this

Let's suppose I am the Central Banker of a country called Ozlet and I peg my currency, called
Ozlettas to the US dollar so that 1 Ozletta = 1 US Dollar. I create and extinguish money in
exactly the same way as the US Federal Reserve does, and as we spoke abut in Wizards Part 1.
That is, if I want to issue more Ozlettas in to the banking system I go into the open market and
buy US dollars or US government securities. The seller of the dollars or securities gets Ozlettas
in return and new Ozlettas enter the banking system of Ozlet. Then the banks of Ozlet create
another, say, ten times this amount as bank money denominated in Ozletta just like we spoke
about with the US Banks and US dollars in Wizards Part 1.

Meanwhile, with free capital flow some US investors are starting to buy up stocks and bonds in
my country of Ozlet which brings some more US dollars into the country. Also the government
of Ozlet and some banks and traders might be borrowing some US dollars because of the lower
interest rates on them and to facilitate their own international dealings. Over time the borrowings
of US dollars from US banks gets quite large. Its gets especially large as the western investors
and the World Bank are encouraging my country to borrow more money for infrastructure
development so we can catch up with the West.

Then one day a 25 year old bright-spark called Jimmy, who just got an MBA at Harvard and now
works with a big Wall Street firm called Betters, Inc., heard a rumor about some indigenous
people in Ozlet, known as the Ozletistas, who were starting to demand land rights and better
working conditions. Jimmy goes to his boss and says that something bad is about to happen to
profit potential in Ozlet. He says"I think we should start selling our investments there". In fact,
lets not just sell our Ozlet stocks, lets also sell short on the Ozletta's to bet that the Ozletta is
going to drop in value against the US dollar. Selling a currency short means that Betters, Inc. will
enter into agreements to sell the currency at the today's price at some point in the future - the
price is 1 dollar for 1 Ozletta. They can't lose. If the Ozletta doesn't get devalued they lose
nothing. If it does get devalued to say 1 Ozletta for 0.5 dollars, then at the agreed date in the
future they can buy an Ozletta for 0.5 dollars and sell them for 1 US dollar according to the
original "short-selling" or forward contract.

Jimmy's boss, who barely remembers who or what Ozlet is, says "that’s a fabulous idea" after
finding out how much money they could make by being the first to start the attack. So Betters,
Inc sheds its Ozlet stocks and enters into contracts going short on the Ozletta. Other investors see
what's going on and say "Oh - I better get out of Ozlet before I lose my money". Once the attack
has started the only two things that can happen are that eiether the currency stays the same or it
will lose value. So it's safer for the investors to start pulling out and extra profitable for them to
also take short positions on the Ozletta. As the Ozlet Central Banker I want to prop up the value
of the currency and give investor's confidence that the dollar peg can be maintained, so I might
actually be on the other side of many of the shorting contracts. All of a sudden demand for the
Ozletta has dropped drastically versus the US dollars. As central banker the only way I can
maintain the value of the Ozletta is to keep demand up by buying Ozlettas in the open market
with my US dollar currency or bond reserves.

If the attack continues for long enough I know my US Dollar reserves will run out. While I am
buying up Ozlettas to keep their value I am taking them out of the money supply. The Ozlet
money supply is shrinking, interest rates are going up, investment is decreasing and
unemployment has shot through the roof. Riots are breaking out in the streets but I can't do
anything about it because I have to use all my reserves to keep the value of the Ozletta equal to
the US dollar, especially because our government has all this debt denominated in US dollars.
But the attacks keep coming. Soon my reserves are almost depleted, the Ozletta money supply is
shrunk and interest rates are sky high. This interest rate differential and the 1:1 ozletta:dollar peg
is encouraging a new type of bet against my country's currency that is further draining my
reserves. I can't keep the peg. I have to devalue my currency by half so that I can justify a
reasonable Ozletta money supply with my much depleted reserves. Wall Street wins! Jimmy, the
original instigator of the attack was going on pure speculation about my country that may or may
not have materialized. He will get rewarded for his attack with a promotion, and this will
encourage him to look for more attack opportunities.

In any case if Jimmy's information about the Ozletistas was correct all it is saying is that if my
country of Ozletta shows signs of real democracy and some redistribution of wealth, well, my
currency will be brought to its knees. This is exactly why the Zapatista uprising of 1994
culminated in the Mexican peso crisis. Sounds similar to the military attacks of the cold war,
called the "war on communism", doesn't it? When this happens I am left with a devalued
currency, more expensive imports, inflation, high interest rates, and probably unemployment and
a discontented public. But even worse Ozlet now has a huge US dollar denominated debt that has
essentially doubled in size with respect to my country's economy. Either the Ozlet government
will default on its debt or, as has happened under the IMF throughout the past two decades, the
IMF will come and help Ozlet "restructure things" so we will be able to pay off the debt. Usually
this means cutting spending on social goods to direct more funds to the debt that has doubled in
size relative to our own currency. It also means making my country more export oriented and
attractive to foreign investors to attract the US dollars to pay off the debt. Often this results in
sales of labor and natural resources at fire-sale prices.

5. The Unholy Trinity

In all of the above examples - under the gold standard, the original Bretton Woods systems and
the example of Ozlet under today's non-system it was clear that the following three things could
not simultaneously exist for any currency regime:

• Free Investment Capital Flow Between Countries

• A fixed exchange rate or peg to the US dollar
• Autonomous control over domestic monetary policy/credit creation

That these three cannot exist simultaneously is known as the Unholy Trinity Theorem and it is widely
documented throughout the mainstream economic literature and I will post some references on the
Wizards of Money web site

The Unholy Trinity is not such a big problem for the developed world because under free capital
flow they just let their currency exchange rates float and they don't wobble around too much
because they are the major industrialized nations. Where the Unholy Trinity has profound
implications is in the developing world where these smaller economies have tried to fix their
currencies to the US dollar to prevent excessive volatility that would come from constant
speculation. This has meant that the Central Banks of these countries can only use monetary
policy to manage the exchange rate and therefore it can’t be used to deal with pressing internal
issues. When these internal issues start to arouse suspicions of speculators the currency gets
attacked with tremendous force from Wall Street and the resulting devaluation will be sudden
and drastic and so will the IMF austerity measures that follow.

The sad facts are that the speculators may have known nothing about the country in the first
place and/or may just be reacting to some emergence of democracy in the developing nation.
Furthermore Wall Street has ultimate control over credit creation in the reserve currency that
these countries use to back their own national currency, and so it is always guaranteed to win
once an attack is started.

Argentina is now faced with such a crisis with its decade old dollar peg of 1 Argentine Peso to 1
US dollar, and over 100 billion of debt denominated in hard western currency. In order to
maintain the dollar peg the money supply has shrunk and interest rates are close to 30%.
Unemployment and poverty have risen, government spending has been shaved and the Argentine
people are not pleased. In a classic demonstration of the complete ignorance about foreign
nations that Wall Street speculators so happily attack based on their "wisdom" about them, the
Wall Street Journal ran a rather offensive article about the Argentine peso crisis in its October
26th edition. Typical of American ignorance about Argentina's history the article by Michael
Sesit in "The Global Player" section, could do little more than compare the current crisis with the
famous musical about the Peron dictatorship. It is quite frightening that the Wall Street crowd
with similar ignorance about foreign issues is the same crowd that gets to instigate the
speculative attacks that collapse currencies.

Even though widely acknowledged as a problem in mainstream economic circles the IMF refuses
to address the reality of the Unholy Trinity. Presumably this is because, while they may admit it
exists, it's actually been very profitable for Wall Street.

6. Wall Street's Stealth Fighter - Dollarization

Faced with the harsh reality of the Unholy Trinity, large outstanding US dollar denominated debt
and the subsequent need for US capital flow, coupled with exhaustion from Wall Street
speculative attacks, many countries' governments are just giving up and letting Wall Street have
it their way. They are abandoning all hope of maintaining their own national currency and
passing all monetary decisions over to the United States. They are, as the IMF is increasingly
recommending, agreeing to "dollarization". That is - throwing out their sovereign currency and
officially adopting the US dollar as their currency.

This solves the problem of fixed exchange rates and stops forever the Wall Street speculative
attacks causing devaluation, but it does so at tremendous cost to these countries. No longer do
they have any credit creation or monetary policy powers, or even the ability to act as lender-of-
last resort to their own banking system. They cannot use capital controls to protect themselves
from volatile capital flows because now all their money is "made in the USA". Rise in demand
for labor and environmental protections would be instantly met with a sucking out of the medium
of exchange like a vacuum cleaner, leaving only the debt behind. The control of the medium of
exchange that drives their future economic life belongs in the hands of the US banking system
and the Federal Reserve. Furthermore US banks may come to dominate their banking system and
thereby increase their influence on national governments. This is certainly not helped by the fact
that as well as being in control of US Monetary policy the Federal Reserve also plays the
somewhat conflicting role of umbrella financial regulator under the Gramm-Leach-Blily Act.

It’s a one way street and it seems headed for disaster. At this point it looks like Argentina will
either follow this path or devalue its own currency and default on its debt, or it will get bailed out
by the IMF who will then impose worse austerity programs.

On January 1, this year El Salvador took the path to dollarization. Only time will tell how this
will work, but the immediate effect was utter chaos according to an article on CorpWatch's
InterPress Service on Januray 5. With a great deal of poverty and a high illiteracy rate, the people
of El Salvador hardly knew what was happening to them as the old currency could no longer be
used and they didn’t know how to change into the new one. I guess that just shows how
democratic the decision was to dollarize.

While the IMF and Wall Street will push for Dollarization as a way to deal with the Unholy
Trinity dilemma that benefit them, others must realize that there are other solutions that are better
for the majority of the people. One obvious solution is to use capital flow controls to ward off
speculative attacks from Wall Street, and this has been used successfully by Chile and Maylasia
recently. Also possible is the development of monetary unions for groups of Asian and Latin
American countries, similar to the European Monetary Union, but this requires a Herculean
effort in terms of diplomacy and putting the long terms interests of these countries against the
short term gains possible for its leaders.

There is also the possibility of people and communities and activists and NGOs creating the
ultimate money resistance by setting up their very own currency regimes. We shall discuss this
further in the next edition of Wizards.

That's all for Wizards of Money Part 5. Please note that the Wizards of Money has a Web site at where you can get the text of Wizards episodes and find more

"Democratizing the Monetary System" ... Antidote to

1. The Activism-Money Paradox
2. Whose Monetary System?
3. Why do we Need Money?
4. Design and Implications of Democratic Money

This is the Wizards of Money, your money and financial management series…with a twist. My name is
Smithy and I’m a Wizard Watcher in the Land of Oz. This is Part 6 of the Wizards of Money Series and it
is entitled "Democratizing the Monetary System".

1. Introduction: The Activism-Money Paradox

In this sixth edition of Wizards we are going to take a look at the growing movement to
democratize money - that is people creating their own monetary systems and making credit
creation and distribution a democratic process, which is a radical change from the US dollar
based mainstream monetary system. In this edition we will hear some excerpts from a BBC
interview with a reformed currency trader, and we also interview the administrator of a small
but democratic version of the Federal Reserve, where a currency called "Bread Hours" is
growing in circulation in California.

Let's start this edition of Wizards with a paradox. Paradoxes make for excellent exercise
for the brain. A paradox is an apparent contradiction - a conclusion arrived at through
logic but whose end result doesn't seem to make sense. The resolution of a paradox often
results in new thinking about an issue and a head on challenge of the underlying

Suppose you are a non-profit organization that opposes income inequality and, in
particular, you oppose the structure through which that inequality comes about - namely
contemporary capital (or stock) markets and the international monetary system. The
people you think you are helping the most are those at the low-income end of the
spectrum. You probably acquired the status of, or are sponsored by, a 501 c3 organization
that can accept tax-deductible contributions primarily in the form of national currency, or
simply US dollars in this country.

Why does your organization need to raise US dollars? Because they need to trade - they
need labor, supplies and services to conduct their activism and advocacy activities. Much
of the labor might not require any US dollars, for those people that donate their time. But
usually there will be some positions and tasks for which US dollars are required, else the
task will simply not get done. Supplies and services that might be needed might come in
the form of travel expenses, stationary, computer equipment and so forth. The proper
method for acquiring such goods is through trade and certainly the quickest way to
complete these transactions is to exchange US dollars for the goods and services desired.

So then your organization has to decide how it will raise US dollars from the markets of
would be philanthropists. These people would have to agree with the organization's goals
of fighting income inequality brought about by contemporary capital and money markets.

Your organization will be most successful and have the most outreach in the shortest
period of time if it can raise a lot of money from a few people. But how did these people
get so much excess money that they can support you? Well, they are unlikely to be any of
the people you claim to be helping - that is the low-income people who probably don’t
have too much extra to spare. They are most likely to be higher income/wealth people
who have benefited greatly from contemporary capital and money markets - the very
thing your organization opposes.

So then, if you are very successful and raise lots of money to meet your goals - do you
think you will smash the system you oppose and destroy the system that made your major
funders wealthy enough to be able to contribute excess cash to you?

No way! All you did was change the path of the flow of money. The money bought the
goods and services you needed and then ended up back in the same system of capital
markets and the international monetary system you oppose. The same for the money you
spent on the people you were helping, which also ended up back in the same old
monetary system. Nothing fundamentally has changed - you might have raised some
awareness of the problems, and caused some headaches for the authorities - but that’s all.
No doubt if your motives were genuine your organization will have made some positive
change, but the underlying structure of the system - the mechanics of the capital markets
and the international monetary system - have not changed.

The contemporary monetary system depends on inequality for its survival. Importantly it
also depends on confidence that such inequality can be increased to bring in desired
return on capital. By participating in the monetary system and accepting funds originating
from, and going back to, the capital markets and international monetary flows, you
support this structure. By continuing to support the same monetary system you oppose,
you haven’t really challenged the root of the problem.
Break: "Working for the Enemy" Baby Animals

2. Whose Monetary System?

Whose monetary system is it then? Not yours!

We already discussed this in Wizards Part 1. The basic building blocks of contemporary
capital and money markets is just plain money - that legal tender that can be used in the
trade for all goods and services and in the repayment of all debts. Plain money is first
created by the Federal Reserve - who just makes it up "out of thin air", first as bank
reserves, and then later as currency or Federal Reserve Notes as the public demand more
cold hard cash. Secondly, and where most money is created, the private commercial
banks make about 10 times this amount as deposit or check account money simply
through the loan creation process, and again, "out of thin air". The public has no input
into either of these money or credit creation processes.

Ultimately the decisions on who gets access to credit and who gets it on reasonable terms
is decided on the basis of what loans will bring in to the shareholders of banks a return on
their invested capital at a level of around 20% in recent years. By this I mean that for
every 1 dollar of stock or equity capital that a shareholder invests in a bank they will get
back 1.20 after a year. This is called a 20% return on equity. While this is simply an
accounting profit - which is a purely abstract notion - these profits will translate into
wealth in the real sense of potential to buy goods and services, because everyone accepts
the US dollar as legal lender - good for all trade and in the repayment of all debts.
Therefore, in no way shape or form can the creation and initial distribution of the money
we so depend on be considered a democratic process. It is ultimately driven by the profit
targets desired by the major shareholders of banks, which is a very small segment of

On top of these money or basic debt markets sit more complex debt markets (outside the
banking system) and, of course, the rest of the capital markets (or stock markets), where
shareholders invest the US dollars they've accumulated in return for more of these dollars
in the future. In the case of all entities that raise money on the public stock exchanges
(known as publicly traded corporations) all company decisions will be primarily driven
by the need to meet shareholder expectations in terms of required return on capital.
Meeting shareholder expectation is necessary in order to retain access to the capital
markets. Access to the capital markets is the "make or break", the very requirement for
survival of a publicly traded company, and meeting shareholder expectations therefore
drives all decision making. Consequently the other main parties of a corporation - the
employees and the customers and other effected public - only have say in the corporation
to the extent that they can influence the shareholders. The shareholders are mostly
concerned with percent return on investment.
It is then fair to say that contemporary money and capital markets have built into them
powerful driving forces that must undermine democracy for their very survival. Capital
markets, which depend on accumulated money, could probably never be democratic
because they are necessarily driven by the demands of shareholders. But what about
money or credit - the basic medium of exchange? Can that be created democratically and
would that lead to a more democratic society, and a fairer society where people really did
have closer to equal opportunity? This is the subject of today's Wizards. But before we
discuss democratic money it is perhaps best to discuss why we might need money at all.

3. Why do we Need Money?

The primary reason we need money is because human societies have found it desirable to run
themselves using division of labor. In this way some people can occupy themselves providing the
things necessary for survival for the people in the society, such as food and shelter, leaving
others free to invent and produce things to make life easier and more enjoyable in the material
sense, such as electricity, transportation and so forth.

Without division of labor people would have to produce their own food, shelter and
warmth within their own family unit or small community. This would keep people busy
all the time occupied in these basic activities. Humans have achieved remarkable
progress through division of labor, which has been facilitated through some commonly
accepted medium of exchange, known as money. Money accepted for trade in all goods
and services facilitates trade with people outside of your immediate neighborhood.
Without money, and wanting to trade goods and services with a broad range of people,
humans would revert back to barter, which tends to result in very slow trade, small
amounts of trade and very slow technological developments.

The availability and flow of money seems well correlated with pace and direction of
technological development. Today, availability of money will depend on Federal Reserve
and commercial banking decisions, as well as the desires of the capital markets. Both
availability and flow will depend greatly on public confidence in the monetary system,
and the capital and debt markets built on top of it.

Ideally, in a democracy, the people would decide what pace and in which direction
technological development should go, and what activities should be encouraged and what
shouldn't. Then they could design their monetary system consistent with these values.

At one extreme is the system of limited trade and little technological development. If
people wanted this they could have no monetary system and everyone could go back to
agrarian-like barter societies. They could alternatively have no money and centralized
planning to force division of labor and development, but this tends to concentrate power
in too few hands, which is very dangerous and ends up being undemocratic.
At the other extreme they could have maximum technological development and the "fast
money" and fast pace of today that will accumulate lots of money if invested in such
development. However this will also tend to concentrate power in too few hands as
human activities get oriented around ensuring that return on capital is achieved to
maintain confidence in the system and its underlying monetary system.

Most likely the majority of humans in the present time would like a system somewhere in
between. One that provided a more advanced life than the agrarian societies and so
needed some division of labor, and perhaps some monetary system to facilitate such
development and avoid centralized control. But many would also like a system that
wasn't so driven by, and dependent on, rapid advancement and rapid consumption, but
rather tended to promote a more sustainable future.

People all over the world are in fact starting to design such monetary systems of their
own to help achieve the goals of their own societies. We will now listen to some excerpts
from the November 11, 2001 edition of the BBC's Global Business Report where the
growth in democratic money was being discussed. In this segment the BBC interviews
Bernard Lietaer, a former and reformed currency trader, who understands why we need
better money. We mentioned Mr. Lietaer in Wizards Part 1 as the author of the book
"The Future of Money".

Excerpt: BBC Global Business Report. November 11, 2001 Interview with Bernard
Lietaer. Transcript to be posted soon.

4. Design and Implications of Democratic Money

There is absolutely no reason why a group of people who wanted to trade goods and services amongst
themselves couldn't create their own monetary system. After all, money is just an arbitrary accounting
system of credits and debits that we have let the Federal Reserve and the private banks design for us,
rather than having any input ourselves. Using a democratic currency designed for a local, or similarly
ideologically inclined, group the benefits of the division of labor and trade in the group in that new
currency would accrue entirely to that group and would not be sucked into the mainstream capital
markets. Furthermore this kind of resistance to mainstream money, if conducted on a large enough
scale, has potential to put significant pressure on the mainstream monetary system and its associated
capital markets to change its ways. That is - it has the potential to force fundamental structural changes.

Contrary to some beliefs, it is not money that makes for the practical implementation of
capitalism - it is positive return on capital. The argument behind having positive return on capital
is "compensation for financial risk". The capital holder could have realized the full value of their
capital today by spending it on a real good but instead they invested it in something else where
they might lose the value of that investment, and so the argument goes that they should get
compensated for this risk. One of the main places where this argument fails is that the only risk
considered in this equation is financial risk to the capital investor. Completely ignored are social
or environmental risks this investment created which, if factored in and charged to the investor
(i.e. public risks charged back to the source), might make the properly risk-adjusted return
unattractive to the investor so as to discourage such investment.
A group of people might choose to create their own currency with zero interest to remove the
incentive and ability to accumulate excess capital over labor and goods input into the system.
This would provide for more equitable distribution and access to the medium of exchange, and
would remove incentive for excessive appropriation of natural resources. Then they may also
decide to create money through various means such as loans and grants made through some
democratic decision making process. A new currency could be created for trade within a local
community, or even across a broader geographic region with some other association - such as
members of a national coalition of NGOs working on similar issues.

We discuss all these issues and more in the following interview with Dina Mackin, the main
administrator of the Bread-hours currency. No - she's not the equivalent of Alan Greenspan for
Breadhours, because this money is created democratically and it has no duty to please Wall
Street. The technical and social challenges of implementing alternative currencies are not
insignificant and should not be underestimated. Also as we shall see in the following interview,
where such "currency independence" is most needed - that is, the developing world - it has not
only been successful but seen as a threat by the national central bank and government. As we
learn in the following interview this was the case with a successful local currency that flourished
after the 1997 attack on the Thai Baht (see Wizards 2 and 5 on this) and was shut down by the
Thai government in 2000.

Interview with Dina Mackin of the Breadhours Currency. Transcript to be posted soon.

Part 7: "The Money Cycle versus The Water Cycle"


1. Introduction
2. How Money Flows (plus 3 Step Exercise)
3. The Simple Money Cycle Model
4. The Market Meets Real Efficiency - Nature's Water Cycle
5. Enter the Humans and Their Crazy Monetary System
6. Banks, Land and Water

This is the seventh edition of the Wizards of Money, your money and financial
management series… with a twist. My name is Smithy and I’m a Wizard Watcher in the
Land of Oz.

1. Introduction

In this seventh edition of Wizards we are going to take a look at the very intimate
and certainly, very troubled, relationship between money and water. We will do
this by first navigating our way through a simple model of money flows - which
we shall call the Money Cycle. Then we'll circle through the Water Cycle and
remind ourselves of all that stuff we learned in elementary school … plus more of
the stuff they didn't tell us about.

Then we'll do something you don't see very much - we'll highlight the link
between money and water by identifying a point on both cycles where they are
firmly fixed to each other, and where its easy to see that what's good for one is
normally pretty horrible for the other. Throughout this episode of Wizards we'll
be hearing some water-cycle words of wisdom from Dr Vandana Shiva, Indian
scientist and activist, who gave a presentation at the Council of Canadians
International Forum on Conservation and Human Rights in June this year. Dr
Shiva has a new book coming out called "Water Wars", which is to be released in
February of next year.

The link between profiteering, corporate globalization and damage to the water
cycle should be fairly well-known to most people. Coverage of issues such as
water contamination, salinization of water supplies, acid rain and ecological
damage caused by dams have received widespread attention in recent years. And
there is no doubt these phenomena are the result of human activities driven by
economic pressures of paying interest on loans and meeting profit expectations of
shareholders – that is, this damage has been a consequence of the pressures of
contemporary capital and debt markets. Many realize that mainstream economics
forgot to factor in the environment and that economics must now change.

What we will focus on in this edition is how much such environmental destruction
is actually built right into the fundamental building blocks of the monetary system
and their associated capital markets. In fact, as we shall see, this link exists right
at the point of money creation.

The link between water and money was selected for this discussion because all of
us are made up of about two thirds water, we can't live without it and, today,
water is our most troubled natural resource. Water is shaping up to be the biggest
issue of the 21st century so we had better understand very well how money works
to disturb the water cycle. If this disturbance involves something fundamental to
the mechanics of the monetary system we had better know this too so we can
think about, as we discussed in Wizards Part 6, designing more water-friendly
monetary systems.

2. How Money Flows

Recall in Wizards Part 1 that we discussed how you and I don't just go out and
make money when we go to work or sell something. Instead we are just getting a
transfer of already existing money from people that have some. Unless these
people or companies are a bank then they didn't make money either - they also got
a transfer of some money that already existed. Money, you will recall, is just the
other-side, the mirror image, of debt. Money is created by the creation of a
corresponding amount of debt. Money, in its most basic and spendable (or liquid)
form, is created by banks making loans to the non-bank public.

As we discussed in Wizards Part 1, banks make money up out-of-thin-air by

making a loan to a borrower, which also becomes a deposit (or money) to the
recipient of these funds (say the seller of a house). So this means that when you
come by some money, say from your paycheck or by selling some furniture at
your yard sale, this money has already been through some kind of journey to get
to you. But at some time, maybe last week, or maybe 50 years ago, it started off
as a bank loan or a bank (or Federal Reserve) purchase of some asset. Then it has
traveled through many different human interactions of trade to get to you. It is
interesting to think about this.

Maybe the money you're getting today started its life for some purpose you think
is quite good. But maybe it started its life as funding for a dam or mining project,
and here you are with it today. Maybe it even started off as the funding for that
logging project that caused your favorite forest to be clear-cut and which caused
you so much distress. That seems like money some of us might not like very
much. So we better have a look at exactly what purposes money is being created
for and then we'll have a better idea of the history of the money we are condoning
and accepting today.

This is quite easy to do in a few simple steps.

Step 1: Go to the web site of the Federal Deposit Insurance Corporation at Go to the link to Historical Statistics on Banking and then
go to Commercial Bank Reports. Go to Table CB09, which gives you total assets
for Commercial Banks ( Total assets of
commercial banks at year end 2000 are $6.2 trillion dollars. If you also went to
the Savings Institutions links on the FDIC website
( you would see that the Savings
Institutions have total year end 2000 assets of $1.2 trillion.

Aside: As an aside here’s an interesting way to look at this data. Adding up the
total Commercial Banks and Savings Institution Assets would give a total of $7.4
trillion in bank assets. This is, of course, debt of the non-bank public (that’s us)
owed to the banks – this is in the form of mortgage, credit card debt and so-forth.
The way that money works this should mean that the total M3 money supply in
US dollars (that is the money that we non-banks can use in the trade for all goods
and services) should be close to this $7.4 trillion in bank assets. You can check
this by going to the Federal Reserve web site at,
clicking the link to Research and Data, clicking the link to Statistics, then go to
Table H.6 and click the link to money and debt stock measures. Click on Table 1
and look at the M3 money supply column. ( At the end of 2000,
this is $7.2 trillion, which is only 2% off the total bank assets or debt owed by the
public to the banks.

Step 2: Let's just focus on Commercial Banks since that’s where most money
(almost 85%) is being created. This total balance sheet of the commercial banks
gives us the breakdown of how today’s available bank money was created. We
see that $3.8 trillion, or 60% of it, is created as "Loans and Leases". The rest was
created for other assets owned by the banks such as investment securities and
bank real estate. So let’s drill down into these "Loans and Leases" since they
make up most of the money that’s been created. Go to Commercial Bank table
CB11 and you will see a breakdown of how this $3.8 trillion dollars was created.
Almost 50% was created for real estate purposes, mostly mortgages for residential
and commercial real estate purchases and development. Another 30% is for
commercial and industrial project purposes. And most of the rest is loans to
individuals, in the form of Credit Card and other personal debt.

Step 3: Combining this information we can see that almost half of the money
created by banks comes into existence for some kind of real estate transaction,
commercial or industrial project. We can extrapolate and say that about half the
money we use today came into existence for the purpose of some kind of
ALTERATION to NATURAL LAND and its associated natural resources. This
means the replacement of natural land with some kind of human development.

The US dollar based monetary system as we know it today is heavily dependent

for its survival on human alteration of the natural landscape. This provides the key
link between money and water.

3. The Simple Money Cycle Model

Let us build a simple model of the money cycle in our heads for the purposes of
discussion. The Wizards of Money web site at has a
diagrammatic representation of the Money Cycle we are about to discuss.
Similarly it has a diagram of the Water Cycle and of this critical link between the

Simple Model: Lets suppose in our simple model that all money is created as real
estate loans, either for developers who initially built houses, offices and shopping
centers, or for those who end up buying these buildings. Then money cycles
around the economy as follows:

Suppose a bank loan first gets made to a developer of 100 units to go out and
develop land. They then develop this land enough so that they can sell it at a high
enough price that they can both pay the interest of 10 units on that loan to the
bank as well as make a profit for their shareholders (say another 10 units). This
need to return both interest to the banks and a profit to their shareholders
encourages development above and beyond what would result in a zero interest
monetary system (similar to those systems we spoke about in Wizards Part 6).
Let’s say that the developer spent the 100 units of money he borrowed on some
workers to clear the land and at the brick store to buy the bricks for the house.

Let’s say that the workers and the brick-store owner spend all their money (100
units in total) at the Snazzy Furniture Store at the local mall. Snazzy puts this 100
units in its checking account at the same bank.

The developer sells the house to a buyer, which is you, for 120 units. You borrow
this full amount of money from the bank in order to buy the house. This money
gets put in the developer’s checking account. The developer pays back their 110
(which is the original 100 + 10 interest). The bank makes 10 units in profits which
it then distributes to its shareholders, and the developer makes 10 units in profits
which it also distributes to its shareholders. These shareholders then spend all
their money at the Snazzy Furniture Store which has become very popular. This is
also the store where you work at as a salesperson.

So at this point, bank loans total 120 to you, and there is also 120 in checking
account money floating around in the economy, which has all purchased goods at
the Snazzy Store, and is accounted for in Snazzy’s checking account. Over the
next few years you will earn this 120 from your job at the Snazzy store and will
be able to pay off your loan. Well…sort of. Let’s not forget that you need to pay
interest to the bank as well. So more money must be coming into the system from
other places that will enable you to get the total money you need to pay off the
loan plus interest.

To keep everything flowing enough money must be coming in, or being created,
to enable most people access to enough money to pay off their loans. This is not
true for all people, as a certain amount of bankruptcies are built into the system,
but you don’t want too many or even a few big bankruptcies as this would
threaten confidence in the system which would collapse it. Well, all this means a
constant supply of new money must be continuously created, and especially as
others are paying off their bank loans, and thus making money "disappear". Recall
that in our simple model we assumed that all money is being created by direct
land development or alteration, but in the real world its more like half, though
much of the other half is indirectly related to land alteration. So all this means
more real estate development or land alteration to create this money to keep
things flowing smoothly, keep confidence in it and keep it from collapsing.

In a way then, the money machine is sort of "eating up land" for its own survival.
The survival on the monetary system as we know it today depends on land
alteration, which in turn disturbs the water cycle.
But whatever is this going to mean for the water cycle? Surely the humans need
water more than they need money!

4. The Market Meets Real Efficiency - Nature's Water Cycle

Here are some excepts from Dr. Vandana Shiva's water speech to remind us first
about our relationship to water, and second, some simple truths about the water

Excerpt: Dr Shiva Water Words of Wisdom Part 1 (vs1.wav) - The water cycle is
the thing that links us together and Water Profiteers that need to go back to
Elementary School.

On the first topic of how the water cycle links us together over space, we must
also remember that the water cycle links us together over time, and that it doesn’t
just link humans together, it links together all life on earth. Sometimes I like to
look at a glass of water and ponder whether some of the molecules might have
been sweated out by dinosaurs millions of years ago, and a few others might have
been used to refresh a weary statue carrier on Easter Island some 2 thousand years
ago. Whatever we do to the water cycle today our dirty fingerprints will be all
over whatever the water cycle becomes for future generations. Furthermore the
water cycle is so complex, such an intricate piece of Mothers Nature’s handiwork
that we barely even understand it. We are still, and always will be, learning more.
So we can’t possibly know the consequences of significant human alteration to
the water cycle.

On the second topic - the elementary school water cycle lessons - well, on the off
chance that there are some water profiteers out there in the audience I drew on my
elementary school teaching resources and found this little tune to help us
remember the water cycle.

The Water Cycle Song

As we know from Grade 4 classes water evaporates from the ocean, lakes, rivers,
and is sweated out by plants and goes to the sky as a gas. Later it falls as rain or
snow, gets used by plants and animals - including the humans - and then goes
running down hills and mountains to the rivers and sea to start all over again.

Of course this is a huge oversimplification suitable for a 4th grader but it doesn't
much help us grown-ups see all the links between money creation, land alteration
and water cycle disturbance. Let’s consider some other parts of the water cycle
that will help.

Nature has figured out some excellent ways to moderate the flow of water to
manage flood and drought risk and also to clean water so that the waste of one
process can get all cleaned up and ready for another process. This all happens
through water's interaction with the land and with the ultimate Central Banker -
the Central Banker of Energy, the Sun.

Humans have absolutely no control over the Energy Central Banker. All they can
control is the things that store the sun's energy like plants and animals that eat
plants, and also they can go find the sources of other stored solar energy in the
form of old squashed dead plants and animals, called oil and coal. All these
activities plus all of the human monetary-system driven development of land
effect the land on earth, not the Energy Central Banker. So the land is what we
focus on in considering the link between the water cycle and the money cycle that
forms the basis of our economy.

The way that nature manages flood and drought risk is really through plants and
soils which are, of course, the very best of friends - the soils being largely made
up of decaying leaves and trees, and the plants needing the soils for food. The
soils store lots of the rain as groundwater and they are kept in place by tree roots.
Some of this water the trees might like for later when they get a bit thirsty, and
other ground water might fall to an underground aquifer or run off slowly into a
stream in the watershed.

Having lots of plants and rich soils in a watershed means that when there is lots of
rain the ground will soak up lots of the excess water and this will help mitigate
flood risk. When it's been a long time between rains you can rely on the
groundwater in the aquifer or the groundwater gradually seeping into a nearby
stream to provide a steady flow of water from earlier rains. This helps mitigate
drought risk.

As for nature’s water cleansing functions the trees keeping the soils in place
prevent excessive amounts of mud, clay, sand and salt from sliding into the
stream. The soils and the little microorganisms living in them are very fond of
waste products that most other living things would find rather unappetizing. Them
and other little critters living in or near the stream often perform water cleaning
and filtering functions that help to make the water useable for others. The trees
sweat off some water through evapo-transpiration helping to cool the stream area
so that all the critters that live there that have an important role in the water cycle
can stay at a nice temperature to do all their work.

Having such a water cycle on our planet makes a lot of sense given that gravity
would otherwise drain all the water to the salty sea and sea-water is not very
drinkable. This whole business of evaporation and rainfall to replenish all living
things that need fresh water is quite sensible and, of course, life as we know it
would not exist without an efficient water cycle. A prosperous human society
cannot exist without an efficient water cycle.
There's that efficiency word that people would have us believe that only markets
can provide. Let’s have a look at this. When the lassaie-faire marketeers go on
about the efficiency of the market they are talking about what they label as
"Pareto Efficiency". This is a sort of ideal allocation of resources amongst societal
members that matches supply to demand within a given set of parameters set by
society via the governmental body of the imagined democracy.

But that’s all very confusing isn't it. Let’s just talk about efficiency in plain
language that makes sense intuitively. At the end of the day markets and the
monetary system are all about allocating energy amongst the different participants
of a society - whether that energy be in the form of labor applied to a raw good to
make it into a product, the raw good itself such as food crops, or stored energy
such as coal and oil. And we know that all our energy comes from the sun and
that only plants know how to capture and store that energy directly.

All these being the processes of Mother Nature they obey what we humans have
interpreted to be the natural laws of physics, most especially they obey two
important energy laws - the First and Second laws of Thermodynamics - that have
never ever found to be violated by any process. Water obeys these natural laws.
Money, being a purely human abstraction, does not.

Those put off by what sounds to be complex laws invented by physicists should
not be deterred, for these are simple to understand laws of nature that get right to
the heart of the conflict between man and nature, and specifically to the conflict
between money and water.

The First Law of Thermodynamics is the Law of Conservation of Energy. This

says that the amount of energy in the universe is fixed and you can’t create new
energy or destroy existing energy. When it comes to the planet Earth, we get new
energy to the earth from another source in the universe, called the Sun. Apart
from all the energy that we have stored in and on earth and the daily dose of
sunlight we have no other energy available to us. This is perhaps the primary
reason humans have seen fit to develop markets - that is, to allocate this scarce
resource of energy.

If the laws of Thermodynamics had just stopped there, my, what a peaceful world
we would have! Under the conservation of energy I could just fill my car with
gas, stick a little collector in the exhaust pipe and recycle all the energy I just used
and fill my car back up, since I know that energy will be conserved. I’d only ever
have to buy one tank of gas in my life. I’d only have to buy one load of electricity
to heat my home for my whole life – I’d just recycle everything over and over.
Energy companies would go bankrupt, there would be no wars in the Middle East,
and the stock market would collapse because no-one could make money from
selling energy.
OK – there’s a catch. And that’s the very important Second Law of
Thermodynamics. The ENTROPY Law. The law that sits right at the heart of the
conflict between man and nature. ENTROPY is a measure of disorder – we shall
talk of it in terms of the usefulness of energy. Low entropy means very useful
energy. High entropy means quite useless energy – can’t use it for another
process, its not organized enough. The Second Law of Themodynamics says that
Entropy always Increases as energy is used. Therefore, once you have used all the
gas in your tank, even though the driving process left the same amount of energy
from the gas in the world, that energy has become pretty useless so that you can’t
re-use it. This law then really creates the scarcity of energy and the primary
motivation for using markets to allocate it.

The economists tell us that this will be done most efficiently if the conditions of a
free market are met. Presumably this means energy will be distributed more
efficiently since that ultimately is what the market is distributing. So how does the
market deal with the Entropy Law? The answer to that would be … Not at all!
While it is true that the Entropy Law contributes greatly to the scarcity that gives
rise to the need for markets you will not find the Entropy Law mentioned in
mainstream economics textbooks. Modern money and capital markets, and
contemporary economics have been built up IGNORING the most fundamental
laws of nature.

When it comes to the water cycle it is interesting to consider who runs things
most efficiently - the Markets or Mother Nature? Given that the most desirable
outcome of the water cycle, even from a human-centered point of view, is a
stable, secure flow of clean water one would have to conclude that Mother Nature
arranges the most efficient allocation of energy, for, in the natural processes there
are no waste products, and solar energy is used to its maximum. Every player in
the natural water cycle does some work in the water cycle and various related
nutrient cycles and their waste products get used as input into some other process
in these cycles. Nothing is wasted and everything fits together to form a whole
cycle that has evolved over millions of years and that we are the beneficiaries of
today. Nature's water cycle seems to have taken the Entropy law into
consideration and then optimized energy use within this boundary condition.

5. Enter the Humans and Their Crazy Monetary System

But then the Humans come along with their fears of scarcity, markets and monetary
system that ultimately depends on alteration of the land for its survival and for the
survival of the markets. But most alterations to the natural landscape then disturb Mother
Nature's maximally energy efficient water cycle in several common ways. These are
common things that have happened all across the globe:

o First, deforestation exposes soils and causes soils, sediment and salt to rush into the
stream at the next rainfall. You end up with salty water and/or sediment that kills off
lots of the plants and critters that had important roles in the water cycle such as water
o Second, the loss of soil and vegetation, coupled with impervious surface coverage such
as roads, car-parks and buildings means that water can no longer seep into the ground
as is very important in mitigating flood and drought risk. The frequency of flood and
drought increases.
o Human activity in watersheds (real estate, mining, logging, intense farming and so forth)
and the loss of filtering systems through the loss of vegetation and soils means more
and more pollutants are entering the water sources.
o The practice of building dams either for hydropower or for storing water in a place that
doesn't have enough, and the practice of channeling water to places that don't have
much, has been responsible for massive loss of aquatic life, flooding and drastic
alteration to affected watersheds and local water cycles.

Then the market-oriented humans come along and say "Well, now we have a water
problem. Let's use some market mechanisms to fix it." In fact a lot of the market-oriented
people go so far as to say - "Let's privatize water - that pure market solution will fix
everything". And they say this perhaps forgetting that it was market forces that got us
into this problem in the first place.

At this point it's worth hearing some more Water Words of Wisdom from Dr Vandana
Shiva's Canadian water speech.

Dr Shiva Water Words of Wisdom Part 2 (vs2.wav) - Human alternation of land and
saving the water cycle and (vs3.wav) - Water Freedom.

Are these market solutions as efficient as Mother Nature's way of managing and
distributing water? I think not because there is obvious waste in these market solutions.
For example in order to clean water that has been polluted by human activities some
electricity is needed, and this is extra energy that is simply NOT needed in the natural
process. Not only is extra energy needed but there are waste products produced by the
human processes, such as extra water treatment chemicals, that cannot be readily
absorbed by natural processes and so create waste. Add to this the fact that human
alteration of land has increased flood risk and drought risk that then gets adjusted for by
all these human constructions - holding ponds, gutters and so forth - adding more and
more energy input into the water cycle, that is in turn further disturbing the water cycle
through channelizing flow, which causes streambank erosion … and the list goes on.

Surely it would be hard to argue that markets can run the water cycle - that cycle
responsible for the stuff of life we so depend on - more efficiently than Mother Nature
can. Nature has had the opportunity to develop a most energy efficient water cycle
millions more years than the humans have, and we are after all, creatures of nature

All this is not to say that humans should not have markets for other things or should not
alter the land. Rather it is to say that humans might build a much better world and more
efficient use of energy if they just leave the water cycle up to the master of it. Ultimately
this would mean a paradigm shift in the way land is developed so as to retain enough
natural features in every watershed to retain Nature's energy efficient control over the
water cycle. Ideally this need to retain essential natural functions would enter into the
economy at the point of credit creation, or equivalently money origination.

Banks, Land and Water

Excerpt: Dr Shiva Water Words of Wisdom Part 3 (vs4.wav) - Start off with some
reminders about the World Banks relationship to land and water.

So what are the banks and other financial institutions doing about all this? In fact it's not
just the private financial institutions who should be paying attention it's also their
regulators and the central banks.

On this latter point it is interesting to study the composition of the Boards of Directors of
the 12 Regional Federal Reserve Banks to see what industries and activities might have
the most influence over central banking practices. Interestingly the highest concentrations
of representation outside of the bank sector are from the real estate/development industry,
and the energy and transportation industries. This is consistent with our earlier
observations of what activities really drive the monetary system. You can find a listing of
these directors on-line at, under General Info and List of

Let us turn our attention to the largest banking conglomerate of all, Citigroup. What are
they doing about all these environmental problems? On September 28, 2001 Citigroup
issued a press release entitled "Citigroup Selected as Component of Dow Jones
Sustainability World Indexes". The release goes on to say that "Companies included on
the DJSI World are … leading their industries by setting standards for best practices and
demonstrating superior environmental, social and economic performance." The article
then goes on to mention that Citigroup serves on the steering committee of the United
Nations Environment Program or UNEP, and that Citigroup seeks to "manage potential
environmental issues … and find financial value in environmentally sound business
transactions." Their statements in this press release are somewhat at odds with their
funding of environmentally destructive projects as documented on the web
site. Citiaction is a project of the Rainforest Action Network and various other NGOs.

Citigroup and other large international financial conglomerates have been fairly active in
UNEP's Finance Initiatives group established in 1997. You can find more information on
this initiative at The Swiss Bankers Association has also come out with some
very nice statements about doing business in an environmentally friendly manner.

While all these nice words from the banking sector might make some sleep more
soundly, others might be concerned about leaving monetary system reform up to the
bankers themselves. Especially since land alteration pressures lie right at the heart of
foundations of our mainstream monetary system.
Unfortunately the approach of the concerned bankers and the various Finance Initiatives
groups has been to see everything through profit and money tinted glasses. They think of
environmental problems in terms of dollar cost and often think of solutions in terms of
getting more profits in monetary terms. Thus, much work in the field of sustainable
economics often gets reduced to converting all natural processes into monetary
equivalents. Continuation of this practice could very well lead to a situation where
economic sustainability looks great on paper in terms of long term sustainable profits but
completely misses the prediction of, say, catastrophic alteration to the water-cycle -
increasing flood, drought and contamination risks.

To move from contemporary economics, which has historically ignored natural

destruction, and to a more ecologically sensitive "Ecological Economics" we MUST
move away from the practice of converting anything and everything to dollars terms in
order to analyze them. The necessity for this can be seen in the observation that money is
an abstract human invention that doesn't obey natural laws, but Nature does! For
example, when it comes to water, the PRIMARY measure for analysis should be water
indicators - say probability of flood, drought, contamination - NOT money. We can also
use energy itself as an indicator, since distribution of energy is so much of what our
markets are about.

After such analysis, and given that nature is the most efficient user of energy shouldn't
we use natural solutions (preservation, conservation) to complement and mitigate the
effects of human development, rather than energy intensive human mitigation efforts.
Having established the right balance between human development and natural land
features based on purely ENVIRONMENTAL indicators we can then bring money into
the picture based on ENVIRONMENTAL CONSTRAINTS and not the other way
around, as happens today. This approach finally would constrain the monetary system to
recognizing the Laws of Nature, which it has never done before. Finally money would
begin to respect the Entropy Law, the Second Law of Thermodynamics!

In summary, this would result in fundamental changes to the monetary system itself right
at the point of money origination - a much more radical approach than proposed by any
of the finance industry dominated groups such as the UNEP Finance Initiatives group.
But it is an approach that seems necessary.

That’s all for Wizards of Money Part 7. Please note that Wizards of Money has a web site
at where you can find the text of all episodes plus some more
references and other information.

Part 8: Trading Nature and "Cooking the Books"


1. Mirror Images and Accounting Basics

2. Accounting in Wonderland
3. The Making of the Enron Energy Empire
4. The Collapse of Enron

In this, the eighth edition of Wizards, we are going to take a look at what drives companies to
"cook the books" – or lie about their earnings, and we’ll investigate just how widespread this
problem might be. How much of the global economy is based on "smoke and mirrors" book-
keeping wizardry? Is such fake wizardry a genuine weak spot in the financial system that could
ultimately lead to a meltdown? These are interesting questions for people to ask and it is
especially useful for activists to identify such weak spots. Book cooking is a topical issue in the
wake of the implosion of the amazing disintegrating wizard collection known as Enron.

Both inside and outside the financial world people are asking the question "How many more
Enrons are out there?" In this episode of the Wizards of Money we will first look at the pressures
behind book-cooking with a glimpse at the Wonderland of Accounting. Then we’ll take a look at
the activities of the once mighty Enron empire, from its contributions to America’s energy policy
to its attempts to privatize the world’s water supply, and turn Mother Nature’s gifts - from the
weather to forests to wind – into tradable securities. Finally we look at the mechanics of the
accounting trickery that ultimately lead to its demise, enriching top executives while rendering
employees pension plans worthless.

We will look at the Enron collapse from a perspective that’s a bit different. We will see that one
of the primary forces driving the Enron collapse was the battle of the Enron giant’s desire to
privatize nature and turn all resources into tradable securities versus the public’s desire for fair
access to these goods. Interestingly one of the key markets involved was the water market that
we spoke about in Wizards Part 7 on The Money Cycle versus the Water Cycle.

In this episode we will interview a former Enron Trader and Risk Manager, hear some excerpts
from a January 2001 interview with the now disgraced former CEO of Enron and excerpts from a
recent Congressional Hearing on the Enron collapse.

You can get the full text of all Wizards and further references on the Wizards of Money web site

1. Mirror Images and Accounting Basics

Financial accounting runs the world. This is so simply because money and finance run the world. And we
have learned from our previous editions of Wizards that money is just an entry on a balance sheet. Base
money (currency notes) and bank money (bank deposits) make up what we will call the plain money
supply of the non-bank public. As we saw in Wizards Part 1 plain money is simply the equivalent of the
liability side of total bank balance sheets. On the other side of the banks total balance sheets we have
bank assets which corresponds to the liabilities of the non-bank public in the form of house mortgages,
car loans and credit card debts.

And so this process of mirror imaging continues right into all other forms of financial asset. Any
financial instrument is simply a balance sheet entry on two balance sheets – a financial
instrument is an asset of one person and a liability of another. In this fashion all financial
instruments – be it money, stocks, bonds, or options - have a mirror image somewhere in some
other book or in some other computer. All financial instruments exist merely as entries in a
computer or a book. Even the dollar bills we use have a mirror image liability on the Federal
Reserve’s balance sheet. Financial instruments other than plain money – say stocks and bonds –
have bookkeeping entries that are usually a claim on some other financial instrument – often
money – at some date in the future.

Any such bookkeeping entry can be used to generate future money, or can be transferred into
different bookkeeping entries, or can miraculously be transformed into a real good such as food
and clothing through the process of trade.

This is how the zero sum game financial system works. It is all based on the shuffling of mirror-
image numbers around on bits of paper and as bits and bytes around in computers. It is, of
course, quite bizarre that this number shuffling governs much of the world order and defines
social relations and access to the basics of life.

But the reason the number shuffling game has so much power is because people have so much
confidence in it as a way to define the social order and govern the distribution of real goods. Let
us look at this confidence in the number shuffling that runs the world from the perspective of two
different groups of people, and how these two groups come to have the confidence in this
number shuffling that keeps the financial system alive.

• For the low wage worker or unemployed person the dominant financial instrument in use is just
plain money, the instrument for which the underlying number shuffling of mirror image items
around balance sheets is less obvious. Confidence is maintained in this number shuffling system
partly through ignorance of the maneuvering that is actually going on to create and distribute
credits and debits, but mostly through sheer necessity. The latter arises because there are only
limited alternatives to money for distributing goods, but this is now changing with the growth in
community currencies as discussed in Wizards Part 6.

• At the opposite end of the spectrum are the very wealthy for whom plain money is much less
significant as a financial instrument. Plain money for this class is merely a transitory stage
between transactions in financial instruments and for converting financial instruments into real
goods and services. In today’s world of very large wealth gaps, the wealthy have accumulated
lots of excess financial capital. As in most past money-dominated empires they tend to "lend
out" this excess to finance other projects in return for more money in the future than they are
lending out today. So they might buy stocks or bonds which form familiar balance sheet entries
in the form of debt and equity to the borrower and stock issuer. The mirror image of these
bookkeeping items are, of course, assets on the wealthy person’s balance sheet.

For the financial system as we know it to survive it is this wealthy class, above all others, that
must keep confidence in the global number shuffling game. For, if they lost confidence – first
they would try and liquidate or sell all their financial instruments and hurry them into safer
assets, which would first be plain money.

But there isn’t enough money to liquidate all these assets which are claims on future
money. In this situation of mass selling the markets would actually freeze up and cause
some kind of financial meltdown.
This wealthy class can cause a financial collapse more easily than others because they
have the most financial assets and access to money on such a massive scale that they
could force change very quickly. This means that they must retain confidence in the
bookkeeping wizardry or number shuffling that goes on to account for stocks, bonds,
derivatives and so forth.

This need to maintain the confidence of the class that can most easily collapse the financial system is
what gives the profession of accounting its importance in the world. If enough people decided that what
accountants are doing is fake wizardry and trickery and not a true representation of what their
investment moneys will actually generate, the financial system will disintegrate just as completely as
Enron did in December 2001.

So it’s important for us to look at just what is going on in accounting wizardry.

The accounting mirror images for stocks and bonds run as follows. The holder of a stock or bond
will record them as an asset on their own balance sheet. This asset represents the value of future
cashflow or plain money from that stock or bond. The issuer of a bond, lets say some
corporation, will record the same instrument as a debt on its balance sheet and will record the
stock as shareholder equity. For any corporation the following equality always holds: Total
Assets = Total Liabilities (or debts) Plus Shareholder Equity. If shareholder equity gets too low,
meaning that asset values may not be able to cover liabilities due, the company may be forced
into bankruptcy.

Under both types of instrument – both stock and debt - the balance sheet items represent a
promise to pay out money at certain dates in the future. For a bond or other debt instrument these
dates are fixed AND debt and interest on debt for the company takes priority over payment to
any shareholders.

The ratings agencies such as Standard and Poors and Moodys rate corporate debt according to
the risk associated with repayment. A less risky bond gets an "investment grade" and risky bonds
get rated as "junk". On the stock side it is the stock analysts – usually part of the brokerage firms
or investment banks - who assess what a stock might be worth, whether it’s over or under-priced
based on expectations about future earnings.

Shareholders are entitled to all the money that’s left after all other expenses and debts are paid –
which is what we call profits. The value of a share in a company to the investor is the expected
value of future cash to come out of that company. Thus stock prices wobble around with
expectations of future really true earnings, in the form of real cash, anticipated to be generated by
a company. So, no matter how much accounting wizardry a company has going on to prop up
confidence in its stock, sooner or later it will have to demonstrate that it can actually generate the
cold hard cash expected to be generated in valuing its stock price.

Stock price levels are all about confidence – confidence that a company can generate an amount
of earnings in the future to justify paying this price today. Many companies are valued, often by
stock analysts, as a certain multiple of current earnings – the multiple being called the Price
Earnings Ratio or PER. The PER is pretty much set by market sentiment – which is pretty much
based on herd mentality. Company management therefore tries to "manage earnings" to make
sure investors don’t lose confidence in their stock, though companies usually don’t like to admit
that they "manage earnings" as opposed to "managing a business".

Earnings in a period are basically an accounting item, a bookkeeping entry. They do not
correspond to cash (or plain money) generated in that period, because in addition to cash,
earnings include all other movements in the assets and liabilities of a company. And these assets
and liabilities are themselves also values of expected future monetary cashflows, that may bear
no relation to actual money flows in the period.

Much accounting creativity goes into coming up with quarterly earnings that are reported to the
public through the quarterly company filings to the Securities and Exchange Commission or
SEC. Strong steady earnings have a psychological effect on the market of inspiring confidence in
a company, which leads to a strong stock value and the most desired outcome – easy access to
the capital and debt markets. Any company without easy access to the capital and debt markets is
likely to stumble and fail for, without such access, they may have problems growing their
business and paying bills as they fall due. Access to capital depends entirely on confidence that a
company will ultimately be able to generate the required returns for the investor in cold hard

Once just a bit of confidence is lost in a company, difficulty in getting access to capital is often
compounded by rating agencies and analysts downgrading companies and forcing even more lost
confidence. Access to capital becomes even more difficult, leading to more downgrades and so
the cycle continues. This downward spiral could keep feeding on itself to ultimately force a
company into bankruptcy. This is what happened with Enron – confidence that its numbers
represented reality was lost and the market came to the conclusion that Enron couldn’t generate
the future money that investors had originally expected. This started the downward spiral to

These features of the markets, especially the fear of getting onto this downward spiral, creates all
kinds of pressures for grooming quarterly earnings to be just what the market expects. We
already saw that falling short of market expectations can be quite disastrous, and exceeding them
too much is also dangerous because it raises expectations for future earnings. Therefore an ideal
world for management of a company is to keep earnings growing at a level exactly as the market
expects. And so we have so-called "managed earnings". The challenge then is to make sure the
market has confidence that those are, in fact, the REAL earnings – that they really represent what
the future holds in terms of generating cold hard cash.

This amazing area of wizardry known as "managing earnings" seems to be a luxury reserved
only for corporations. You and I don’t have the luxury of being able to massage our income
when we report to the IRS or apply for a mortgage. The pale faces of officials seen on TV after
the Enron implosion after mention that the "Enron problem" might be systemic most likely is due
to the widespread knowledge that – Yes, indeed companies do "manage earnings" even though
what they are supposed to be doing is managing a business. But its just one of those things
everyone knows, but nobody wants to talk about.
1. Accounting in Wonderland

To understand this better it is most instructive to run through the highlights of an article that
appeared in Fortune Magazine on March 8, 2001 entitled "Accounting in Wonderland" – where
reporter Jeremy Kahn goes down the rabbit hole with GE’s (General Electric) books.

Excerpt: "The Other Side of the Mirror". Stevie Nicks

The "Accounting in Wonderland" article begins as follows…

"General Electric is without a doubt one of the most beloved stocks in history. About the
worst criticism ever leveled at the illustrious company is that its stunning run of profit
growth – 101 straight quarters – is somehow artificial, the result of "managed earnings".
After all, the argument goes, GE never seems to have had a loss in one division that
wasn’t happily offset by a gain in another. Can such an extraordinary record really be the
result of an uncannily canny management – or is there a bit of accounting wizardry going
on behind the curtain?" GE denies such allegations and the revered Jack Welch, former
CEO of GE always said "GE manages businesses, not earnings".

In some interesting statements, that would have been very prophetic if said about Enron
at the time this article was written, reporter Jeremy Kahn goes on to say "If the
company’s core operations were ever to hit a rough spot … investors might not discover
it until its too late. Until very too late indeed."

Concerned about this accounting wizardry Kahn says he "dove into GE’s financial
statements and wound up having an adventure worthy of Lewis Carroll. When I landed, I
was in a place where little was obvious, nothing was simple, and no one – not even the
number crunchers at GE – seemed to know the difference between reality and fantasy".

"It’s an extremely difficult company to evaluate because there are so many moving parts"
says a GE analyst at Edmund Jones, ranging from television network NBC, to Jet Engines
and Light Bulbs, to the largest business of all, the financial empire known as GE Capital.
Kahn thought he’d start his investigation there.

This investigation led Kahn to find a series of transactions and cross-holdings between
GE Capital subsidiaries that not even the GE analysts on Wall Street understood. He goes
on to observe that "analysts who cover the stock are much like the guests at the Mad
Hatters tea party – blissfully oblivious to the illogic swirling around them." This special
practice in wizardry known as shuffling numbers around the subsidiaries and associates
to optimize earnings will be important for us to remember because it’s a key part of the
Enron saga. Only in Enron’s case its tricks involved invisible partnerships that didn’t
appear on the balance sheets – money would just appear from them and disappear and
reappear again.

Funny, Kahn found similar phenomena in the GE accounts. In his review of the losses
emerging from the bursting of the Internet bubble he noted that he had no way of figuring
out just how much money had gone down the tubes. This was "owing to … the Chesire
Cat Effect: Certain investments suddenly appear, disappear, and then reappear in GE’s
filing with the SEC. Meanwhile the value of some investments float, mischievously
disembodied from reality." Finally he got an admission out of GE spokesperson Gary
Sheffer who said "There were some errors in our methodology for calculating value" and
more errors were found in some of the mysterious disappearances and reappearances of
certain items. So how many accountants missed these mistakes he wondered? LOTS.

And as for the amazing smoothness of earnings, amidst lots of ups and downs in each
varied business unit, Kahn says he found it impossible to understand the so-called once-
off charges and gains that miraculously always offset each other to smooth out earnings
reported in the SEC filings.

It should be noted here that GE has won all kinds of awards for disclosure and
transparency. But what are we to make of all this, when even the analysts and
accountants aren’t seeming to understand what’s going on in the financial statements?
And what of the issue of conflict of interest between a company and its auditors who
review its accounts – are they really independent when they depend on the same
companies for their revenue stream?

Let’s listen to some of the concerns coming out of Congress during the Capital Markets
subcommittee hearing in the aftermath of the Enron collapse. This hearing was on
December 12th and in the following you will hear a member of this committee ask the
Chief Accountant of the SEC some pointed questions.

Excerpt: Accounting Issues. Capital Markets and Oversight Subcommittee Hearings

Dec 12th.

1. The Making of the Enron Energy Empire

Now lets focus on the amazing disintegrating firm Enron, to study exactly how its
accounting wizardry ultimately led to its demise. Before looking into the accounting
wizardry lets first look at what Enron was and how it grew to such great heights.

To start off lets hear the story straight from one of Enron’s most revered Wizards at the
start of 2001 when Enron was the darling of Wall Street. What follows is an excerpt from
a Motley Fool radio show interview with now-disgraced former CEO of Enron, Jeff

Excerpt: Motley Fool interview with disgraced-wizard Skilling

This bragging about Enron in the Motley Fool interview is notable for what it doesn’t
say. Notably Mr. Skilling forgets to mention the serious problems Enron was facing at the
time with its water privatizing extravaganza in Europe and its energy calamities in Brazil
and India. We will come back to this point in a minute but in order to understand these
troubled areas it is instructive to take a quick look at Enron’s involvement in the
California Energy Crisis, their attitudes to any kind of government regulation and public
goods, and their involvement in shaping the Bush administrations energy policy. First,
we’ll listen to a bit more of the Motley Fool interview with the disgraced Wizard Skilling
about the California Energy Crisis.

Excerpt: Motley Fool interview with disgraced-wizard Skilling – CA Energy Crisis

On this topic lets hear some more from the December 12 Congressional Hearing on
Enron from a Representative in the State of Washington, discussing the need for a better
look at Enron’s involvement in shaping America’s energy policy

Excerpt: Energy Policy Influence. Capital Markets and Oversight Subcommittee

Hearings Dec 12th.

The Enron board and senior management clearly despised any kind of government
regulation at all. In the United States, through Enron chair Ken Lay’s close ties with the
Bush Administration, Enron was able to have troubling rules crushed and eliminated by
its friends in government. This made all their US investments much more valuable.
Perhaps it was this ability to steam-roll over democracy in the United States that led
Enron to believe that it could squash regulation everywhere in the world and take over all
public goods for its own private profit.

Indeed this is the approach that Enron took to water and there is no shortage of evidence
to suggest that Enron wanted to privatize the world’s water – recall that we spoke about
this water market logic in Wizards Part 7. Thankfully, the water investments ultimately
played an important role in drowning Enron in its own arrogance. Why – those pesky
Europeans considered water to be a public good, even after Enron went and spent all this
money on water investments there. Similarly, politics and the desires of the pesky public
played a significant role in devaluing Enron’s energy investments in South America and

Oh No! Imagine if shareholders found out that all this money was spent on water and
offshore energy businesses and now these investments were proving to be worth not very
much. Then Enron would be in big trouble and people would realize it wasn’t the
powerful and important wizard it had been claiming to be all these years.

And so the accounting wizardry began!

2. The Collapse of Enron

A July 30th 1998 article in the Economist entitle "Wet Behind the Ears" begins "Allowing electricity to
come in contact with water is dangerous." The article then goes on to talk about the huge price that
Enron paid for Britain’s Wessex Water business and all the financial dangers that come with privatizing a
good that everybody else considers to be public.

A November 2000 edition of Democracy Now! Gave a pretty thorough account of the problems
that Enron was having with the government and people of India in its energy operations there, as
well as the close ties between Enron’s chairman Ken Lay and the Bush Dynasty.

References to both of these sources can be found on the Wizards of Money web site for people
who want a better understanding of these offshore deals and their associated problems.

Both of these sources appear to have identified two key financially troubled areas of Enron well
before Wall Street did. Evidently Enron thought it could carry its power over governments to the
rest of the world to make them behave the way Enron wanted them to – expecting this to happen
in Europe, South America and India. But Mr. Lay’s charms didn’t seem to work so well in these
arenas and Enron ended up having to stomach democratic forces in its offshore operations and in
the process was losing pots of money.

Frightened of being found out, frightened of being demoted from the throne belonging to one of
energy’s most powerful wizards Enron decided that honesty was the worst policy. It then cooked
up some bookkeeping wizardry to hide the losses and overspending on these disastrous offshore
investments that had been devalued by democratic forces.

As documented in the company’s Third Quarter 2001 SEC filing Enron set up some Limited
Partnerships to take the assets so troubled by democratic forces off of its books. One partnership
was called Whitewing Associates and it owned a special entity called Osprey which in turn
bought Enron’s troubled power operations in Europe and South America. Enron set up
Whitewing to borrow the money from outside third parties to buy the troubled offshore assets
and thus hide these disastrous investments from Wall Street. But the rest of the market wasn’t as
naïve as Enron in assuming that government regulation would soon be scuttled to provide
necessary returns on capital. The investors in Whitewing debt apparently thought the Enron
investments were pretty dodgy and demanded additional guarantees from Enron. It is these
guarantees that Enron management seemed to keep secret from everyone else and which
ultimately contributed to Enron’s demise.

The Whitewing investors – whoever they were – seem to be pretty savvy. In order to invest in
the Whitewing debt securities used to buy Enron’s troubled assets they demanded that Enron
agree to issue them extra Enron shares if the troubled assets were having problems generating the
cash needed to pay off the debt. But the investors wanted to cover every contingency and they
knew that even this guarantee would not be good enough if someday Enron wasn’t the golden
child of energy anymore and its stock price plummeted. They demanded the added guarantee that
if Enron stock fell below a certain price level and if Enron debt ever got downgraded to junk,
ALL the debt on Whitewing’s balance sheet would become immediately payable by Enron itself.

Enron did EXACTLY the same thing with its troubled water investments when the rest of the
world was saying that they thought water should be a public good. They set up the Atlantic
Water Trust and used it to set up a special entity called Marlin which was used to raise funds in
the form of debt securities. This was then used by Marlin to buy the troubled European water
businesses and take them off Enron’s balance sheet so that Enron didn’t have to reveal these bad
bets to The Street.

In this way Enron avoided taking huge losses on these bad bets to its balance sheets and Wall
Street continued to think that Enron was a powerful energy wizard. But people didn’t know
about all these costly guarantees granted by Enron in order to create the entities that took the
assets and associated debt off Enron’s books. Instead all they saw were miraculous gains on
these sales to the secret partnerships. Little did anyone know that one day the trickery would be
discovered and the debt was to all land back on Enron’s books and force it to go bankrupt.

All that it would take to trigger the chain of events was some small loss of confidence in the
company that could ultimately send it on the type of downward spiral we discussed earlier. At
some point on this downward spiral the "debt trigger" in the secret partnerships would be
released and things would get much, much worse.

The initial trigger was released around March 2001 when all the telecommunications companies
were getting into trouble because of over-investment in infrastructure. Enron, having invested so
much in bandwidth trading, had its share-price hit by this market’s down turn and by the
beginnings of a general recession. Also some of the brighter analysts were starting to notice that
since Enron was really mostly a trading company its Price to Earnings ratio should really be
much lower than it was and this also contributed to the share price’s downwards direction.

By Summer 2001 Enron’s share price had dropped to less than $40 per share which was below
the trigger thresholds on the guarantees on some of the secret partnerships. Enron management
was getting nervous that these deals might unravel and rear their ugly heads to the world. CEO
Jeff Skilling quit suddenly. Around the same time it was revealed that there was a whole slew of
other secret partnerships called LJM and LJM2. These were involved in all kinds of mysterious
relationships with Special Purpose Entities (SPEs) with names like Raptor, Chewco and JEDI.

These secret partnerships and SPEs were not on Enron’s balance sheet but had been run by
Enron’s CFO Andy Fastow who had been making handsome profits from them according to
several Wall Street Journal articles that ran in October. Enron revealed in its second quarter SEC
filing that Fastow suddenly got out of the partnerships, leading many to wonder not only what
these partnerships were but also what was going wrong with them that Fastow wanted out and
Skilling had quit Enron. In retrospect we understand that at this time certain triggers had been
flipped in the partnerships’ guarantees and the deals were starting to explode all over Enron’s
balance sheet.

Confidence in Enron was dealt a further blow when these partnerships had obviously started
falling apart bringing the bad investments and associated debts back onto Enron’s balance sheet.
By Halloween the SEC had launched a formal investigation.

Losses were so large and confidence so shot that Enron’s only hope would have been rescue
from the energy company Dynergy. But as more losses kept emerging and more injected cash
kept disappearing they too got nervous and called off the deal.
Standard and Poor’s finally downgraded Enron’s debt to junk and pushed all the triggers on the
Whitewing and Marlin entities so that all that debt on their balance sheets became immediately
payable by Enron.

Enron didn’t have the cash to pay the huge debts , nobody in their right minds would invest in
them, and they were forced to declare bankruptcy.

On December 4 about 4,500 employees of its Houston headquarters were marched out of their
offices and told to go home. For an inside look at what this roller coaster ride was like here is an
interview I did with Ogan Kose a former Enron employee in the Global Markets and also the
Risk Mangement area of Enron at its Houston headquarters a few weeks after the collapse.

Interview with Ogan Kose, former Enron employee.

For the holidays all lots of employees got was unemployment and worthless pension plans. The
responsible executives have been found to have enriched themselves and have declined to
present themselves for questioning. No justice appears to be on the horizon for the rest of the
employees. Here is an excerpt from the December 12 Congressional hearing describing how
much the Enron executives made out of this extravaganza.

Excerpt: Insider Trading. Capital Markets and Oversight Subcommittee Hearings Dec 12th.

Given the Enron managers’ fetish for Star Wars characters such as JEDIs and Chewbacca, there
is some comfort in knowing that this Evil Empire was defeated in part by the effect of overseas
governments representing people and people wanting to hold on to public goods. The irony is
that the home country’s government, which we are told is the only good empire these days, was
the closest ally of the evil energy empire throughout the whole saga.

That’s all for Wizards of Money Part 8. Please visit the Wizards of Money web site at for the full text of all Wizards episodes and for more references.

Part 9: "Jack and the Sweatshop"


1. Introduction
2. Jack and the Corporate Ladder
3. "It's all About Winning. Business is a Game"
4. The Globalization Guru and the Georgia PCB/Dioxin Problem
5. Science, The Well Capitalized Way

This is the Wizards of Money. Your money and financial management series… but with a twist.
My name is Smithy and I'm a wizard watcher in the Land of Oz.

This is Part 9 of the Wizards of Money Series and it is entitled "Jack and the Sweatshop".
1. Introduction

In this the Ninth Edition of Wizards we are going to take a look at the "Manager of the
20th Century" - Jack Welch - GE's CEO for the 20 years up until Fall 2001. In September
2001 Jack's much awaited autobiography entitled "Jack - Straight from the Gut" was
released with much fanfare. Business professionals are besides themselves with praise for
the book from Warren Buffett's comments that "All CEOs want to emulate him" to the
Chairman of SONY corporation's statement "Jack Welch, the brilliant business magician,
has finally disclosed his mysteries of management".

Since Jack is a "brilliant business magician" and since during his watch he transformed
GE's small credit company into GE Capital - the largest non-bank financial institution in
the world and almost half of the modern GE - he is definitely one of the most important
Wizards of the 20th Century.

In the midst of the gushing reviews of Jack's book, his career and management style it is
important to analyze his influence on corporate culture in America. From his ability in
the 1980's to turn mass firings of employees from an attack on communities into an
almost saintly act of saving companies from inefficiency, to the 1990's trend of
establishing high-tech sweatshops overseas, Jack has built a new model of the American
corporation. In this new model the only US employees are managers. These managers get
churned out at the "People Factory" in Crotonville, NY (also known as Jack's Cathedral)
and they manage the overseas units where the real work is done at optimal cost. The other
key part of the US operation is the Capital Factory - GE Capital - the company's own
mini-Wall Street.

With most real production done outside the corporation what does GE actually produce -
what is the measure by which GE is acclaimed to be the great success of the 20th century?
Is it great light bulbs, great engines, great electricity or something else? No it's
EARNINGS - GE is the best manufacturer of earnings in the 20th century. It has the
sexiest looking balance sheet and income statement book-keeping entries of all. Recall
that we spoke extensively about the earnings manufacturing business in Wizards Part 8.
You can get all past editions of the Wizards of Money at

In this edition of Wizards, as we look at the Cathedral that Jack built, we will be hearing
some excerpts of an interview Jack did with Bob Joss at a Commonwealth Club event on
November 12, 2001 with an audience of Stanford business students. At the other end of
the spectrum we will be hearing an interview I did on January 5, 2002 with Jessica
Lindberg, housewife and mother in Rome, Georgia on the banks of the PCB laden Coosa
River in Northern Georgia. She has been busy trying to get GE to clean up its mess in this
North Georgia town and she even confronted Jack at his final GE shareholder meeting as
Chairman about this issue.

To get this episode underway and to give a brief overview of Jack's career and what it
was all about I found a fictional story - I'm not sure where it came from - that has some
similarities with Jack Welch's story. The main character is also called Jack and a quick
telling of this fictional story should help you get a handle on Mr. Welch's saga in a quick
and easy-to-understand way. The fictional story is called "Jack and the Corporate

2. Jack and the Corporate Ladder

Once upon a time there was a young man named Jack. He lived with his father and
mother in Massachusetts and they were a family of humble means. Jacks father was a
railway conductor and always very busy trying to earn a living for his family. So Jack
spent a lot of time with his mother, whom he adored and who adored him.

One day Jack left his dear mother and set off for the markets to find a job. He found one
in the Land of GE. After some years of hard work, some GE merchants offered Jack a
trade that Jack didn't like - the same bonus level as his colleagues so he decided to quit.
But then a more crafty merchant offered Jack a handful of better treats - a larger bonus
and some special treatment in return for Jacks future loyalty.

Jack thought this was a pretty good deal and so he went home, banked his bonus and
nurtured his ambition. The next day he went back to work and saw a huge Corporate
Ladder in sight. An ambitious fellow, Jack began the long climb to the top.

Jack had heard that there were giants at the top of the Corporate Ladder that he might
have to fight. He considered it all a Big Game and he really wanted to win. He was
determined to deal with those giants.

Along the way up the Corporate Ladder Jack bumped into a giantish looking fellow
called Ronnie. Jack and Ronnie made good friends and both were determined to kill the
giants when they got to the top. For the giants interfered with freedom, they both agreed.
However, about a quarter of the way up, Ronnie was thrown off the Corporate Ladder.
The Land of GE had important contracts with the giants and Ronnie's constant chatter of
giant-killing was messing with these deals. Ronnie was determined to get to the top
another way - so he started to set his sites on becoming the main giant at the top himself.
Meanwhile Jack continued his journey to the top of the Corporate Ladder.

Finally Jack got to the top and there he could see huge amounts of riches and treasures in
this new land that he considered rightfully his. But there were some battles to be fought
and won in order to claim those riches for himself.

First there was the issue of giants. Not long after he arrived Jack bumped into the leading
giant of the land - only to find that it was Ronnie, who had also just made it to the Land
of the Top. Jack couldn't be more pleased. Together Jack and Ronnie vowed to rid the
land of the rest of the giants so the riches could be theirs.
Only there were a few other things in the way. Standing between them and the riches
were thousands of annoying little creatures that were also trying to get at bits of the riches
for themselves. These annoying critters were called jobs and Jack immediately set to
killing the ones he really didn't like and sending the rest to lands far, far away.

Subsequent to that Jack thought he better set up a People Factory so he could churn out
people to behave exactly how he wanted them to. Jack used the People Factory to build
something of an army to help him get across to the riches and wipe out any other
unexpected obstacles on the way.

More trouble arose when Jack and his army got to the Land of the Media where nasty
stories were spreading about Jack the Job-Killer and they even called him Neutron Jack -
for his ability to kill jobs and leave buildings standing. This really upset Jack - he was
only trying to get to what was rightfully his. He put a stop to all this by invading the Land
of the Media and taking over a good chunk of it for himself.

Over the next few years Jack and his army collected a hug amount of the riches for
themselves. But then came the big river crossing where they met a hostile giant who
wanted to take a bunch of their riches. Ronnie was no longer around to help them with
this giant. Jack and his army fought a long, hard, nasty battle for more than 20 years but
they finally lost and had to concede some riches.

Never mind, Jack and his army just went and found other riches they could take. Jack was
getting pretty old by this time and thinking about retiring from the Big Game when he
came across yet another hostile giant. This one was from a land far, far away and
approached Jack saying "Fee Fi Fo Fum, I smell the makings of a Vertical Monopoly".
This new giant seemed to exhaust Jack and he retired from his life of giant-killing with
all the riches he had accumulated along the way.

3. It’s all about Winning. Business is a Game.

Now back to the real Jack Welch. How does his mind work? How does he justify mass
layoffs, the pressuring of contractors to lay-off workers and move factories to Mexico,
the stingy wages in the high-tech sweatshops in India, and the constant denial that EPA
rated probable carcinogens are perfectly safe?

We'll let Jack explain this in his own words. Here is an excerpt from the November 12,
2001 Commonwealth Club interview with Jack Welch.

Excerpt from Commonwealth Club Interview: Jack in his own words: "It’s all about
winning. Business is a Game."

In his own mind Jack is unable to separate what he does from a baseball game or a good
golf game. Under his logic, the team can only do good if it beats everyone else. The
scorecard is the Earnings Report, the abstract has become the real and the real has
become completely abstract.

He doesn't know what it feels like to be on the receiving end of his business decisions - to
be laid-off, to work in an overseas sweatshop, or to live in a toxic wasteland that nobody
wants to cleanup. This "other side" is perhaps the losing team in Jack's mind. Certainly
the "losing team" in Jack's game doesn't see this business as a mere game.

Jack never mentions in his book, nor in his interview, the rather larger handicap he is
given by the American taxpayer in this game of business. Tax breaks, subsidies,
accounting wizardry, media ownership and your very own mini-Wall Street created
through years of favored access to credit can all help tremendously. To link this episode
in with Wizards Part 8, let's take a look at the aftermath of the Enron collapse for
example. In Wizards 8 we touched briefly on Enron's Power operations in India. Partners
in this operation were none other than GE Capital and the Bechtel Corporation. Why
them you might ask?

Well, for many years GE has taken advantage of the opportunities for high-tech
sweatshops in India. India has millions of well-educated, technically trained English
speaking people that cost peanuts compared to US workers. Consequently GE has now
exported all kinds of technical operations to India - from data entry, to accounting, to
customer service, to loans and claims processing and, of course, computer programming.
But for years Jack was frustrated - he had the cheap bodies in India - but he didn’t have
the electricity to power the high tech sweatshops. Similarly Betchel moved engineering
operations to India and the engineers needed electricity too. On Jack's September 2000
visit to India he is quoted by the Telegraph as saying "When you think of digitizing India
there will be a massive amount of power required and I pray to this government that you
have to push and push and push to invest in infrastructure."

The Enron/GE/Bechtel venture into Indian electricity production seemed to start off
promising enough. But in 2001 the main purchaser of this electricity, the Maharashtra
State Government, stopped paying its bills, partly contributing to Enron's problems. Then
with all its other problems Enron finally collapsed and things looked grim for the three
patrons of HighTech Sweatshop Electricity. Crying over their losses they all went to the
US government last month to ask for almost a quarter of a billion dollars compensation
from the US Taxpayer! Yes this is really true! Fact is Stranger than Fiction. A December
20, 2001 Dow Jones Newswire article that went almost completely unnoticed reported
that the three US giants had made a claim to the Overseas Private Investment
Corporation, an agency of the US government, for $200 million dollars in "expropriation

Well, that's Globalization for you!

4. The Globalization Guru and the Georgia PCB/Dioxin Problem

On the topic of Globalization, at the November 12 Commonwealth Club event, people
were allowed to ask questions. No - not the questions they really wanted to ask - don't be
silly! When it comes to questions to Business Gurus in the Free World the method runs as
follows - you submit them on paper in advance and then a committee decides which are
the appropriate questions, and then they get reworded to optimize their appropriateness.

And so it was with questions at this Commonwealth Club event even though it was a very
safe audience - Stanford business students. But then Jack had probably thought the
audience at the Annual Shareholders meeting in Atlanta earlier that year was probably
safe too, but a real question slipped through the cracks. We'll hear more on this later.

Anyway the following question on "Globalization versus Democracy" posed to Jack at

the Commonwealth Club event was probably the closest that one came to a real question.
Listen carefully to Jack's response.

Excerpt from Commonwealth Club Interview: Jack in his own words: Globalization

Let us take a good look at this issue of exporting world class environmental standards and
a little bit of a look at job exporting. We will now listen to an interview I did on January
5 this year with Jessica Lindberg, mother of two in the town of Rome, Georgia who
founded a group there called Citizens Action Network. Rome is in the Northwest corner
of Georgia, between Atlanta GA and Chattanooga TN. It is also not far from a town
called Anniston in Alabama that has received a lot of attention lately.

For about 40 years GE operated a medium transformer manufacturing plant in Rome

Georgia. For about half of those years it dumped its waste products into several landfills
and waterways of Rome. After NAFTA came into effect GE didn’t waste anytime. They
promptly moved operations to Mexico and left their PCBs (polychlorinated biphenyls),
dioxins (the killer chemical in Agent Orange) and many other chemical cocktails behind
as a reminder of their generosity to communities.

In contrast to Anniston, Alabama, the Husdon River in NY and Pittsfield MA, the Rome,
GA toxicity problems get scant media attention both in the mainstream and in
independent media. Yet this story is so important.

In the following interview note that the EPD is the Environmental Protection Division an
environmental enforcement agency of the GA STATE government. I started the interview
by asking Jessica Lindberg how she came to form the Rome, Georgia based Citizen's
Action Network.

Interview with Jessica Lindberg: Founder/Director of Citizen's Action Network

That was part of the interview I did with Jessica Lindberg of Citizen's Action Nework in
Rome, GA. After this interview I did some more research into the Atlanta lawyer
working for both the EPD on water issues and representing GE on the Rome PCB issue. I
found that this lawyer is from none other than King and Spalding, Sam Nunn's law firm.
The name of the lawyer in question is Patricia Barmeyer and before joining King and
Spalding she worked as the Assistant Attorney Gerneral for the State of Georgia. Ms
Barmeyer of King and Spalding does indeed represent GE in fighting EPD and EPA
decisions, and yes also works as a key advisor to the State of Georgia's EPD on critical
water issues. Oh yes, and King and Spalding also represented GE in squashing two class
action lawsuits against them for the dumping of PCBs in Rome, GA. So I stand corrected
- its not an old boys network after all - there's some old girls in it too!

5. Science, The Well Capitalized Way

With all these environmental problems GE has entered the business of funding medical studies in a big
way. Miraculously, even though there are numerous studies finding a link between PCBs and serious
health problems in animals all the GE funded medical studies find that humans and PCBs get along just

Let's here some of Jacks medical words of wisdom:

Jack on PCBs and Cancer

In response let's hear some more from Jessica Lindberg about the scientific studies in a world of
scarce financial capital:

Jessica Lindberg on Scientific Evidence and Financial Capital

So while government bodies can somehow find taxpayers contributions available for hundreds of
millions in "expropriation compensation" no government body can find the resources for a health
study desired by the taxpayers.

Never mind. After all, It's Just a Game.

That's all for Wizards of Money Part 9. Please note that the Wizards of Money has a Web site
located at

Part 9: "Jack and the Sweatshop"


1. Introduction
2. Jack and the Corporate Ladder
3. "It's all About Winning. Business is a Game"
4. The Globalization Guru and the Georgia PCB/Dioxin Problem
5. Science, The Well Capitalized Way
This is the Wizards of Money. Your money and financial management series… but with a twist.
My name is Smithy and I'm a wizard watcher in the Land of Oz.

This is Part 9 of the Wizards of Money Series and it is entitled "Jack and the Sweatshop".

1. Introduction

In this the Ninth Edition of Wizards we are going to take a look at the "Manager of the
20th Century" - Jack Welch - GE's CEO for the 20 years up until Fall 2001. In September
2001 Jack's much awaited autobiography entitled "Jack - Straight from the Gut" was
released with much fanfare. Business professionals are besides themselves with praise for
the book from Warren Buffett's comments that "All CEOs want to emulate him" to the
Chairman of SONY corporation's statement "Jack Welch, the brilliant business magician,
has finally disclosed his mysteries of management".

Since Jack is a "brilliant business magician" and since during his watch he transformed
GE's small credit company into GE Capital - the largest non-bank financial institution in
the world and almost half of the modern GE - he is definitely one of the most important
Wizards of the 20th Century.

In the midst of the gushing reviews of Jack's book, his career and management style it is
important to analyze his influence on corporate culture in America. From his ability in
the 1980's to turn mass firings of employees from an attack on communities into an
almost saintly act of saving companies from inefficiency, to the 1990's trend of
establishing high-tech sweatshops overseas, Jack has built a new model of the American
corporation. In this new model the only US employees are managers. These managers get
churned out at the "People Factory" in Crotonville, NY (also known as Jack's Cathedral)
and they manage the overseas units where the real work is done at optimal cost. The other
key part of the US operation is the Capital Factory - GE Capital - the company's own
mini-Wall Street.

With most real production done outside the corporation what does GE actually produce -
what is the measure by which GE is acclaimed to be the great success of the 20th century?
Is it great light bulbs, great engines, great electricity or something else? No it's
EARNINGS - GE is the best manufacturer of earnings in the 20th century. It has the
sexiest looking balance sheet and income statement book-keeping entries of all. Recall
that we spoke extensively about the earnings manufacturing business in Wizards Part 8.
You can get all past editions of the Wizards of Money at

In this edition of Wizards, as we look at the Cathedral that Jack built, we will be hearing
some excerpts of an interview Jack did with Bob Joss at a Commonwealth Club event on
November 12, 2001 with an audience of Stanford business students. At the other end of
the spectrum we will be hearing an interview I did on January 5, 2002 with Jessica
Lindberg, housewife and mother in Rome, Georgia on the banks of the PCB laden Coosa
River in Northern Georgia. She has been busy trying to get GE to clean up its mess in this
North Georgia town and she even confronted Jack at his final GE shareholder meeting as
Chairman about this issue.

To get this episode underway and to give a brief overview of Jack's career and what it
was all about I found a fictional story - I'm not sure where it came from - that has some
similarities with Jack Welch's story. The main character is also called Jack and a quick
telling of this fictional story should help you get a handle on Mr. Welch's saga in a quick
and easy-to-understand way. The fictional story is called "Jack and the Corporate

2. Jack and the Corporate Ladder

Once upon a time there was a young man named Jack. He lived with his father and
mother in Massachusetts and they were a family of humble means. Jacks father was a
railway conductor and always very busy trying to earn a living for his family. So Jack
spent a lot of time with his mother, whom he adored and who adored him.

One day Jack left his dear mother and set off for the markets to find a job. He found one
in the Land of GE. After some years of hard work, some GE merchants offered Jack a
trade that Jack didn't like - the same bonus level as his colleagues so he decided to quit.
But then a more crafty merchant offered Jack a handful of better treats - a larger bonus
and some special treatment in return for Jacks future loyalty.

Jack thought this was a pretty good deal and so he went home, banked his bonus and
nurtured his ambition. The next day he went back to work and saw a huge Corporate
Ladder in sight. An ambitious fellow, Jack began the long climb to the top.

Jack had heard that there were giants at the top of the Corporate Ladder that he might
have to fight. He considered it all a Big Game and he really wanted to win. He was
determined to deal with those giants.

Along the way up the Corporate Ladder Jack bumped into a giantish looking fellow
called Ronnie. Jack and Ronnie made good friends and both were determined to kill the
giants when they got to the top. For the giants interfered with freedom, they both agreed.
However, about a quarter of the way up, Ronnie was thrown off the Corporate Ladder.
The Land of GE had important contracts with the giants and Ronnie's constant chatter of
giant-killing was messing with these deals. Ronnie was determined to get to the top
another way - so he started to set his sites on becoming the main giant at the top himself.
Meanwhile Jack continued his journey to the top of the Corporate Ladder.

Finally Jack got to the top and there he could see huge amounts of riches and treasures in
this new land that he considered rightfully his. But there were some battles to be fought
and won in order to claim those riches for himself.
First there was the issue of giants. Not long after he arrived Jack bumped into the leading
giant of the land - only to find that it was Ronnie, who had also just made it to the Land
of the Top. Jack couldn't be more pleased. Together Jack and Ronnie vowed to rid the
land of the rest of the giants so the riches could be theirs.

Only there were a few other things in the way. Standing between them and the riches
were thousands of annoying little creatures that were also trying to get at bits of the riches
for themselves. These annoying critters were called jobs and Jack immediately set to
killing the ones he really didn't like and sending the rest to lands far, far away.

Subsequent to that Jack thought he better set up a People Factory so he could churn out
people to behave exactly how he wanted them to. Jack used the People Factory to build
something of an army to help him get across to the riches and wipe out any other
unexpected obstacles on the way.

More trouble arose when Jack and his army got to the Land of the Media where nasty
stories were spreading about Jack the Job-Killer and they even called him Neutron Jack -
for his ability to kill jobs and leave buildings standing. This really upset Jack - he was
only trying to get to what was rightfully his. He put a stop to all this by invading the Land
of the Media and taking over a good chunk of it for himself.

Over the next few years Jack and his army collected a hug amount of the riches for
themselves. But then came the big river crossing where they met a hostile giant who
wanted to take a bunch of their riches. Ronnie was no longer around to help them with
this giant. Jack and his army fought a long, hard, nasty battle for more than 20 years but
they finally lost and had to concede some riches.

Never mind, Jack and his army just went and found other riches they could take. Jack was
getting pretty old by this time and thinking about retiring from the Big Game when he
came across yet another hostile giant. This one was from a land far, far away and
approached Jack saying "Fee Fi Fo Fum, I smell the makings of a Vertical Monopoly".
This new giant seemed to exhaust Jack and he retired from his life of giant-killing with
all the riches he had accumulated along the way.

3. It’s all about Winning. Business is a Game.

Now back to the real Jack Welch. How does his mind work? How does he justify mass
layoffs, the pressuring of contractors to lay-off workers and move factories to Mexico,
the stingy wages in the high-tech sweatshops in India, and the constant denial that EPA
rated probable carcinogens are perfectly safe?

We'll let Jack explain this in his own words. Here is an excerpt from the November 12,
2001 Commonwealth Club interview with Jack Welch.
Excerpt from Commonwealth Club Interview: Jack in his own words: "It’s all about
winning. Business is a Game."

In his own mind Jack is unable to separate what he does from a baseball game or a good
golf game. Under his logic, the team can only do good if it beats everyone else. The
scorecard is the Earnings Report, the abstract has become the real and the real has
become completely abstract.

He doesn't know what it feels like to be on the receiving end of his business decisions - to
be laid-off, to work in an overseas sweatshop, or to live in a toxic wasteland that nobody
wants to cleanup. This "other side" is perhaps the losing team in Jack's mind. Certainly
the "losing team" in Jack's game doesn't see this business as a mere game.

Jack never mentions in his book, nor in his interview, the rather larger handicap he is
given by the American taxpayer in this game of business. Tax breaks, subsidies,
accounting wizardry, media ownership and your very own mini-Wall Street created
through years of favored access to credit can all help tremendously. To link this episode
in with Wizards Part 8, let's take a look at the aftermath of the Enron collapse for
example. In Wizards 8 we touched briefly on Enron's Power operations in India. Partners
in this operation were none other than GE Capital and the Bechtel Corporation. Why
them you might ask?

Well, for many years GE has taken advantage of the opportunities for high-tech
sweatshops in India. India has millions of well-educated, technically trained English
speaking people that cost peanuts compared to US workers. Consequently GE has now
exported all kinds of technical operations to India - from data entry, to accounting, to
customer service, to loans and claims processing and, of course, computer programming.
But for years Jack was frustrated - he had the cheap bodies in India - but he didn’t have
the electricity to power the high tech sweatshops. Similarly Betchel moved engineering
operations to India and the engineers needed electricity too. On Jack's September 2000
visit to India he is quoted by the Telegraph as saying "When you think of digitizing India
there will be a massive amount of power required and I pray to this government that you
have to push and push and push to invest in infrastructure."

The Enron/GE/Bechtel venture into Indian electricity production seemed to start off
promising enough. But in 2001 the main purchaser of this electricity, the Maharashtra
State Government, stopped paying its bills, partly contributing to Enron's problems. Then
with all its other problems Enron finally collapsed and things looked grim for the three
patrons of HighTech Sweatshop Electricity. Crying over their losses they all went to the
US government last month to ask for almost a quarter of a billion dollars compensation
from the US Taxpayer! Yes this is really true! Fact is Stranger than Fiction. A December
20, 2001 Dow Jones Newswire article that went almost completely unnoticed reported
that the three US giants had made a claim to the Overseas Private Investment
Corporation, an agency of the US government, for $200 million dollars in "expropriation
Well, that's Globalization for you!

4. The Globalization Guru and the Georgia PCB/Dioxin Problem

On the topic of Globalization, at the November 12 Commonwealth Club event, people

were allowed to ask questions. No - not the questions they really wanted to ask - don't be
silly! When it comes to questions to Business Gurus in the Free World the method runs as
follows - you submit them on paper in advance and then a committee decides which are
the appropriate questions, and then they get reworded to optimize their appropriateness.

And so it was with questions at this Commonwealth Club event even though it was a very
safe audience - Stanford business students. But then Jack had probably thought the
audience at the Annual Shareholders meeting in Atlanta earlier that year was probably
safe too, but a real question slipped through the cracks. We'll hear more on this later.

Anyway the following question on "Globalization versus Democracy" posed to Jack at

the Commonwealth Club event was probably the closest that one came to a real question.
Listen carefully to Jack's response.

Excerpt from Commonwealth Club Interview: Jack in his own words: Globalization

Let us take a good look at this issue of exporting world class environmental standards and
a little bit of a look at job exporting. We will now listen to an interview I did on January
5 this year with Jessica Lindberg, mother of two in the town of Rome, Georgia who
founded a group there called Citizens Action Network. Rome is in the Northwest corner
of Georgia, between Atlanta GA and Chattanooga TN. It is also not far from a town
called Anniston in Alabama that has received a lot of attention lately.

For about 40 years GE operated a medium transformer manufacturing plant in Rome

Georgia. For about half of those years it dumped its waste products into several landfills
and waterways of Rome. After NAFTA came into effect GE didn’t waste anytime. They
promptly moved operations to Mexico and left their PCBs (polychlorinated biphenyls),
dioxins (the killer chemical in Agent Orange) and many other chemical cocktails behind
as a reminder of their generosity to communities.

In contrast to Anniston, Alabama, the Husdon River in NY and Pittsfield MA, the Rome,
GA toxicity problems get scant media attention both in the mainstream and in
independent media. Yet this story is so important.

In the following interview note that the EPD is the Environmental Protection Division an
environmental enforcement agency of the GA STATE government. I started the interview
by asking Jessica Lindberg how she came to form the Rome, Georgia based Citizen's
Action Network.
Interview with Jessica Lindberg: Founder/Director of Citizen's Action Network

That was part of the interview I did with Jessica Lindberg of Citizen's Action Nework in
Rome, GA. After this interview I did some more research into the Atlanta lawyer
working for both the EPD on water issues and representing GE on the Rome PCB issue. I
found that this lawyer is from none other than King and Spalding, Sam Nunn's law firm.
The name of the lawyer in question is Patricia Barmeyer and before joining King and
Spalding she worked as the Assistant Attorney Gerneral for the State of Georgia. Ms
Barmeyer of King and Spalding does indeed represent GE in fighting EPD and EPA
decisions, and yes also works as a key advisor to the State of Georgia's EPD on critical
water issues. Oh yes, and King and Spalding also represented GE in squashing two class
action lawsuits against them for the dumping of PCBs in Rome, GA. So I stand corrected
- its not an old boys network after all - there's some old girls in it too!

5. Science, The Well Capitalized Way

With all these environmental problems GE has entered the business of funding medical studies in a big
way. Miraculously, even though there are numerous studies finding a link between PCBs and serious
health problems in animals all the GE funded medical studies find that humans and PCBs get along just

Let's here some of Jacks medical words of wisdom:

Jack on PCBs and Cancer

In response let's hear some more from Jessica Lindberg about the scientific studies in a world of
scarce financial capital:

Jessica Lindberg on Scientific Evidence and Financial Capital

So while government bodies can somehow find taxpayers contributions available for hundreds of
millions in "expropriation compensation" no government body can find the resources for a health
study desired by the taxpayers.

Never mind. After all, It's Just a Game.

That's all for Wizards of Money Part 9. Please note that the Wizards of Money has a Web site
located at

Part 10: "Back to the Twenties Through the Looking Glass -


1. Introduction
2. Regulatory Landmarks of the Great Depression
3. A Trip Back to the 1920s
5. The Gambling of the Guardians of the Public's Money

1. Introduction

This is the Wizards of Money, your money and financial management series … but with a twist.
My name is Smithy and I'm a wizard watcher in the Land of Oz.

This is the tenth edition of the Wizards of Money and it is entitled "Back to the Twenties
Through the Looking Glass - Steagall".

In this the 10th edition of Wizards we are going to take a look at the parallels between current
times and the late 1920s - the period just before the great stock-market crash of 1929 and the
subsequent Great Depression. We will see how it is that much of the regulation implemented
during the Great Depression to address the wild and unregulated behavior of big business during
the twenties has now been dismantled through de-regulation. Despite industry claims that such
regulation is out-dated and no longer needed for our fancy modern markets, we will see that, not
surprisingly, the dismantling of this regulation has once again given rise to exactly the dangerous
market behavior it was designed to stop.

Excerpt FDR Inauguration Speech 1933 - Reign in Bankers

This excerpt from FDR's 1933 speech helps remind us of a time when financial collapse caused
by unchecked and unregulated behavior of Wall Street gamblers forced America's political
leadership to publicly recognize the danger such activity poses to the public as a whole. But how
easily we forget these things. In the wake of the undoing of what became regulated during the
FDR administration the same old players are back to their same old tricks of the twenties. Hardly
discussed in all the coverage of the Enron Saga of the early 21st century is the discovery of the
extent of the wild and risky behavior of the biggest federally insured banks in the US - JP
Morgan Chase and Citigroup. If their involvement in financing various Enron activities is an
indication of their wheeling and dealing more broadly then we have a lot to be worried about at
the heart of the financial system.

In this highly deregulated market it is appropriate to look at the implications for another 1929-
style crash and the potential for a financial collapse. The 29 Crash followed the high stakes risk-
taking of lightly regulated powerful industries. One must consider - Would a financial collapse
of this scale be a good thing? - by being possibly the only way to change the global order? Or
would the first such collapse in the nuclear age bring more violence and destruction than any of
us ever thought possible? Of course nobody can answer these last two questions with any
certainty, but it is very important to consider what might go into the makings of a global
financial collapse and to plan for what is eventually going to happen anyway. It is not a question
of whether or not it will happen - as all financial systems eventually collapse, but the question is
- when.

To go on this journey we will hear some speeches from important figures from this time and we
will also visit with some people that actually lived through the twenties and are still able to tell
us about it today.

2. Regulatory Landmarks of the Great Depression

The Great Depression brought with it numerous regulatory landmarks that stayed with us for a
long time. Let's just talk about a sample of four of the major areas and the status of them today:

• Utilities Regulation: In 1935 the Public Utilities Holding Company Act or PUHCA was introduced
to provide national supervision of the gas and electricity utilities in order to prevent their
excesses of the 1920s. In the twenties big utilities had been buying up smaller ones, hiking up
consumer prices, expanding into unrelated businesses, loading up on debt, hiding losses from
investors, and milking their subsidiaries and affiliates to prop up their own earnings. Sound
familiar? Many people have reminded us of this law in the aftermath of the Enron collapse and
Enron's various exemptions from it amidst recent recommendations by everyone from the
Senate Banking Committee to the SEC to have this law repealed.

• Exchange and Accounting Regulation: The Securities and Exchange Commission (or SEC) was
established in 1934 under the Securities Exchange Act. During the 1920s there was effectively
no Federal oversight of the securities markets, and with the market rising in the 1920s, and
banks more than willing to lend for stock speculation, this created a recipe for disaster. The SEC
was created to oversee market players in the securities markets and to require truthful
quarterly reporting from publicly traded companies. By 2002 the effectiveness of the SEC in
enforcing "truth in reporting" is highly questionable as we have seen. This is in part due to
conflicts of interest rife throughout the financial world but also due the sheer complexity of
financial transactions available to all companies and the absence of regulation on the most risky
of financial transactions - those called derivatives trades.

• The Social Security Act: Before the Great Depression there was no federal safety net for
unemployed, disabled or retired persons. As often happens today the safety net was usually
picked up by various charities and religious organizations. But this safety net collapsed during
the Great Depression because of the collapse in confidence in the financial system. By necessity
and through public pressure that had built up over the years the Social Security Act was born in
1935 and provided for old-age and unemployment benefits. Today, of course, this depression
era safeguard is under attack with financial companies pushing for its privatization.

• The Heart of the Financial System: Finally the big one - the regulation of the system that stands
at the heart of the entire financial infrastructure - the banking system. The big act affecting the
banks and securities dealers was the Glass - Steagall Act of 1933 that brought radical changes
and better supervision to the banking industry. This act separated deposit banks, where
depositors expect to safely park their money, from more speculative players such as securities
dealers and investment banks that could make depositors' money disappear through careless
gambling - and did exactly this in the 1920s. The Federal Depository Insurance Corporation or
FDIC was set up in 1933 to provide insurance on depositors' funds in the event of bank failure.
This was necessary to restore confidence in the foundations of the monetary system - the banks
- that had just seen run after run, failure after failure, and depositors had seen their money
disappear right before their very eyes.

Interestingly, also at this time, various controls and regulations were put on the Savings and Loans
institutions. This was all to be undone when Ronald Reagan began his de-regulation kick in the 1980s. As
we now know the undoing of these regulatory checks and balances precipitated in the Savings and Loans
debacle of the 1980s that could have brought down the world financial system, except that the US
taxpayer saved the day with a high priced bailout. That is what Federal Insurance means - backed by the
US taxpayer. With the repeal of Glass-Steagall protections in 1999 nobody seamed to have remembered
the lessons of the 1980s, let alone the lessons of the 1920s!

These regulations of the banking system - the heart and soul of the financial system - will be the
focus of our show today. We will see how the gradual dismantling of them over the past 20
years, since Ronald Reagan took office in 1980 and culminating in the complete repeal of the
once mighty Glass - Steagall Act in 1999, is sending the banks straight back to be bigger
reflections of their 1929 former selves. Whatever are the implications of this? As already noted a
glimpse at what the future might hold already leaked out amidst the Enron crisis. We are only
just starting to understand the extent of the involvement of big federally insured banks in this
scandal, notably JP Morgan Chase and Citigroup - both of whom were able to form banking and
securities trading conglomerates after the repeal of Glass - Steagall.

3. A Trip Back to the 1920s

Much of the source material on the 1920s used for this episode of Wizards is actually from the
web-site of the Library of Congress. This site has a very extensive selection of original
documents scanned into electronic files and posted to the Web. For the 1920s era there is a
fascinating collection called "The Coolidge Era and the Consumer Economy" and links to this
are posted to Wizards of Money Web site at

Link to the Library of Congress 20s collection

Now let's get in our time machine and go back to the 1920s…

Excerpt - Einstein Speech…Language, Science and Goals

This is a rare recording of Albert Einstein. I inserted these words from Einstein because, of
course, Einstein was becoming a very famous person in this period known as the Roaring 20s
and he was traveling in the US to explain his amazing Theories of Relativity. These theories
made him the premier Time Traveler of Western History. In particular, his Special Theory of
Relativity provided the Western world with a radical new look at the concept of time, and it
implied strange time travel and time-space paradoxes. He notes in this speech the role that
science plays in the world, and that it is leaders who set the goals and priorities first and science
that follows, rather than the other way around.

Now imagine we are back in the twenties … World War I is over, the Republican Harding is
President and the decade started glumly with what is known as the Agricultural Depression.

Radio was the new mass communications medium of the 1920s. The Westinghouse Company
launched the first radio station KDKA in 1920 in Pittsburgh, Pennsylvania. Radio brought with it
great promises as the medium for free speech and democracy … but these promises were never
fulfilled in the twenties, as we shall see.

Campaign finance and corruption scandals rocked the Harding administration, the most famous
being the Teapot Dome Scandal, whereby government officials had secretly leased public oil-
fields to private interests in return for cash and other favors. Harding had an unfortunate incident
with some foodstuffs in 1923, he dropped dead and Calvin Coolidge became president and
served as such until 1928.

The Coolidge Administration favored deregulation, industry self-regulation and brought in tax
cuts to stimulate spending.

ATT, NBC, and CBS built huge radio networks across the country that grew rapidly in the last
half of the decade. These networks were all supported by advertising revenue and this tended to
"dumb down" the content so as not to offend the major revenue sources.

The public relations industry and major corporate propaganda campaigns were launched.
Spearheading much of this activity was a man named Edward L Bernays who wrote extensively
on "The Business of Propaganda" and helped Coolidge get elected in 1924. Advertising in
newspapers and radio claimed unprecedented proportions of print-space and airtime.

Various movements to encourage ever more spending were launched - such as the Better Homes
Movement, and various targeted Women's and Negro consumer campaigns were launched.
Marketing specifically to children kicked off with the first annual Macy's parade in NY in 1924.
Target marketing statistical analysis reached new levels of sophistication with the introduction of
the punch-card system.

America had reached new and amazing heights in consumerism!

Popular radio shows, the new talking movies and song/dance combos such as the Charleston
engaged millions and helped the decade become known as the "Roaring 20s."

The Chain Store was born. Sears, Roebuck and Company opened 324 stores nationwide between
1925 and 1929. Woolworths, Krogers, JC Penney, and Walgreens all spread stores all over the
country. Many loved the convenience but hated that the small local merchants were forced out of
The stock market climbed to new heights in the late 1920s, the ordinary American was
encouraged to invest their savings in the stock market and more Americans owned stock than
ever before. At the same time the proportion of Americans on incomes below the poverty line
continued to increase so that this proportion reached almost 50% by 1929 by some accounts.

Campaign finance was out of control with large companies like Dupont and General Motors
giving lavish contributions to both parties. In a magazine called "The Forum", in a July 1929
issue, a man called Norman Thomas wrote an article called "Plutocracy in the Saddle" about
business domination of government and calling the two party system the Tweedleduplicans and
the Tweedledeemocrats. He also went on to say about this system of two parties in the pockets of
big business "This is immensely better than having one dictator who might get shot or one party
which might provoke a rival organization based on principle. Two parties to stage a good show
annually and a roaring circus every four years to divert the people - what could be better? … A
devout and reasonably shrewd "captain of industry" who does not daily thank God for this great
gift of two parties, both his for the campaign contributions, is an ingrate. … Indeed its more
sophisticated leaders may sometimes reflect how much better it is to teach people how to read
and then give them what they should read, let them vote but control the parties through which
they vote, [rather] than, like the stupid Czar of Russia, to try to keep the masses illiterate and

In the latter half of the 1920s the Public Utilities were consolidating like crazy through a handful
of holding companies, and in the process were raising consumer prices. As people found out later
they were also taking on huge amounts of debt, overvaluing assets and hiding losses from

Corporate profits were soaring throughout much of the twenties generally thought to be due to
increased consumer spending, credit availability and increased efficiency.

But there was a large part of this story not being told lest it would offend the advertisers
providing the revenue to the radio stations and newspapers. This was that of the conditions and
wages of the non-union workers in the many factories - such as garments, candies, and so forth.
In general union membership declined drastically during the 1920s.

There were sweatshop activists in those days too. You can find some of their reports online at the
Library of Congress website. In one report by the Consumers League of New York entitled
"Behind the Scenes in Candy Factories" you can read about the appalling conditions of women
who worked in these factories and the wages of around $10-12 a week, which was considered
well below a livable wage. The authors actually went to work in these factories in order to learn
about these conditions. There were also reports documenting abuses in the garment industry and
a campaign to encourage labeling of garments with the conditions they were made in. This was
all in stark contrast to the glamorous images of these products portrayed in never ending streams
of advertising.

A network of consumer activism popped up around the country much of which was spearheaded
by a Nader-type by the name of Stuart Chase. In 1927 he co-authored a large study called "Your
Money's Worth" documenting the shoddiness of many mass-produced products, the false claims
in advertising and the trend for producers to make sure products would be replaced at frequent
intervals. Comparing the consumer to Alice in a nonsensical Wonderland he found advertising
industry correspondence with corporate clients that boasted that only 25% of purchases are based
on real need - the rest are the product of "salesmanship".

On the financial side, Andrew Mellon was Secretary of Treasury for the whole decade. He was
also one of the original founders of ALCOA - the Aluminum Company of America - exactly
where our Treasury Secretary of 2002 - Paul O'Neill - is from. And O'Neill is spookily sounding
a lot like his predecessor of the 20s!

A fellow named Benjamin Strong, a Morgan man, was the Director of the Federal Reserve Bank
of New York at the time. His informal and totally private agreements with the head of the Bank
of England, Sir Montague Norman, to help England stay on the gold standard led the Federal
Reserve to make harmful interest rate cuts in 1927 that created excessive stock market
speculation. This played a large part in the severity of the ultimate crash. This dealings between
Strong and Norman are documented in the diaries of Federal Reserve Board member Charles
Hamlin which are also readily accessible on the Library of Congress web site.

The British economist John Meynard Keynes was very critical of this move of England back to
the Gold Standard saying that "In truth, the gold standard is already a barbaric relic." This is
because the gold standard forced prices and wages to be set by international traders and
speculators, rather than the needs of workers and consumers. Today, these are still set by
international speculators in our current environment of free capital flow and domination by a
single reserve currency - the USD.

This move by the Federal Reserve in 1927 to lower interest rates to help England stay on the
gold standard encouraged stock speculators to borrow money at these low rates from the banks
and then plow these borrowed funds into the stock-market. The banks themselves were engaged
in a lot of these speculative activities because many of them also operated investment banking
and brokerage businesses. This speculation continued until 1929 when in August the Federal
Reserve raised interest rates.

Stock prices reached their peak in September - the Dow Jones Index having doubled in just over
a year. But then with the higher interest rates on borrowed speculative funds and nervousness
that stocks were overvalued, stocks started falling in October. Banks started calling in the loans
used to buy stock. On October 29, 1929 (Black Tuesday) the Dow-Jones Industrial Index crashed
enough to wipe out this doubling of the Dow. The Dow and the markets as a whole started on a
downwards spiral that bottomed out in 1932. Many people just couldn’t pay off their loans and
banks started going bankrupt all over the place from this and from the collapse of their own stock
investments. There was at this time NO Federal Insurance of bank deposits and people saw not
only their stock markets investments disappear, but also their bank accounts vanish. For, even
under the gold standard, bank money is nothing but the confidence that it can be used in trade.
When that confidence disappears, so does money, and so does everything you worked for and
transferred into those mysterious make-believe credits. If you need to refresh you memory about
why money is simply an abstract notion and how it comes into existence - you can revisit
Wizards of Money Part 1 entitled "How Money is Created".
America was still on the gold standard. So compounding all these problems the massive loss of
confidence in the banking system caused the worst thing of all for the financial system - a run on
banks - with people wanting to redeem their bank deposits and Federal Reserve Notes for gold.
But of course there isn't enough gold under fractional reserve banking and such a run on banks
will always collapse it. Expectation of bank collapse is a self-fulfilling prophecy, as it is with the
stock markets, and as it is with any currency.

When you have such lost confidence in the financial system, where there has just been complete
dependence on it, the whole monetary system collapses - money disappears because all it was
was confidence anyway. Everything - markets, trade, business, work - it all starts to grind to a

The financial house of cards collapses. And should we be afraid of what is - well, just a pack of

Excerpt - Alice and The Pack of Cards


Herbert Hoover was President at the time of the 1929 Crash. In the subsequent depression neither
his administration nor the Federal Reserve did very much to bring the country out of the
depression. This helped to get FDR elected and he took office in 1933.

As history goes whenever a famous leader says something really important about big business it
doesn't get remembered very well. Instead the large corporations who run the networks seem to
have an uncanny knack of extracting only the short phrases that don't hurt revenues and playing
them over and over again so that nobody will remember the important things that were said about
their advertisers.

And so it was with the FDR inauguration speech of 1933 where every man and his dog

"The only thing we have to fear is fear itself".

But how many people remember the other parts of the speech where FDR is talking about the
bankers and the Wall Street speculators? Such harsh criticism of the Wizards has never been
heard since from an American President!

I will play excerpts from this speech about the Wizards, but since the sound recording quality is
so poor I will then repeat these sections.

Excerpt from FDR 1933 Speech:

" And yet our distress comes from no failure of substance. We are stricken by no plague of
locusts. Compared with the perils which our forefathers conquered because they believed and
were not afraid, we have still much to be thankful for. Nature still offers her bounty and human
efforts have multiplied it. Plenty is at our doorstep, but a generous use of it languishes in the
very sight of the supply.

Primarily this is because the rulers of the exchange of mankind's goods have failed, through
their own stubbornness and their own incompetence, have admitted their failure, and
abdicated. Practices of the unscrupulous money changers stand indicted in the court of public
opinion, rejected by the hearts and minds of men.

True they have tried, but their efforts have been cast in the pattern of an outworn tradition.
Faced by failure of credit they have proposed only the lending of more money. Stripped of the
lure of profit by which to induce our people to follow their false leadership, they have resorted to
exhortations, pleading tearfully for restored confidence. They only know the rules of a
generation of self-seekers. They have no vision, and when there is no vision the people perish.

Yes, the money changers have fled from their high seats in the temple of our civilization. We may
now restore that temple to the ancient truths. The measure of the restoration lies in the extent to
which we apply social values more noble than mere monetary profit.

Happiness lies not in the mere possession of money; it lies in the joy of achievement, in the thrill
of creative effort. The joy and the moral stimulation of work no longer must be forgotten in the
mad chase of evanescent profits. These dark days, my friends, will be worth all they cost us if
they teach us that our true destiny is not to be ministered unto but to minister to ourselves and to
our fellow men.

Recognition of the falsity of material wealth as the standard of success goes hand in hand with
the abandonment of the false belief that public office and high political position are to be valued
only by the standards of pride of place and personal profit; and there must be an end to a
conduct in banking and in business which too often has given to a sacred trust the likeness of
callous and selfish wrongdoing. Small wonder that confidence languishes, for it thrives only on
honesty, on honor, on the sacredness of obligations, on faithful protection, and on unselfish
performance; without them it cannot live."

"And finally, in our progress toward a resumption of work we require two safeguards against
a return of the evils of the old order; there must be a strict supervision of all banking and
credits and investments; there must be an end to speculation with other people's money, and
there must be provision for an adequate but sound currency."

And so the process for implementing regulation to provide checks and balances and bounds on
the markets began. For it is only after such a collapse that the Wizards actually realize that their
success in their own game does ultimately depend on the people's willingness to play in it. The
regulatory blitz included all the landmark laws described above plus many more. The
regulations, of course, started first and foremost with the Rulers of the Exchange of Mankind's
goods and the Money Changers in their Temple.

The 1933 Glass-Steagall Act built a wall between banks - which are essentially the guardians of
the publics money and the brokers and investment banks - who are the primary gamblers in the
exchanges. This would prevent privileged bankers from gambling with other people's money to
make profits for themselves. Glass-Steagall also separated these institutions from insurance
companies who took on a completely different set of risks.

To restore confidence in the banks and therefore rebuild the monetary system 1933 also saw the
birth of federal deposit insurance under the FDIC or the Federal Depository Insurance
Corporation. This insurance would guarantee that depositors would get all or most of their
money back in the case of bank insolvency. It was realized that this insurance created a moral
hazard for banks. Because deposits were backed by the Federal Government banks had more of
an incentive to take more risks. They could get more deposits by promising a higher return to
depositors. With this money they could invest in riskier higher return assets to get higher profits
and the depositors wouldn't be too worried about this because they knew there was federal
insurance on their deposits. This realization brought in a law that forbade paying interest on
checking accounts so that banks couldn’t do this. The separation of banks and other financial
operations under Glass-Steagall also helped to prevent this undesirable risky behavior of banks.

Now let's fast forward to 2002 …

5. The Gambling of the Guardians of the Public's Money

Glass-Steagall protections from bankers gambling with the public's money are gone. The
restrictions on attracting deposits by paying interest on checking accounts are gone. BUT the

It is very interesting to study the memory loss that became evident during the final 1999 repeal
of the 1933 Glass-Steagall Act that had built a wall between banking and speculation to protect
depositors. It must be noted that Glass-Steagall had already been worn down to a low level of
effectiveness. In years before 1999 financial and legal craftiness had exploited every loophole
possible to circumvent Glass-Steagall. Regular deposit banking and lending, brokerage,
investment banking, and insurance were already overlapping by 1999 but this was still within
certain bounds imposed by Glass-Steagall.

When the Gramm-Leach-Blily Act kicked out Glass-Steagall it enabled the formation of
financial holding companies that could have interests across the spectrum of finance. The walls
between the important public service of credit creation and safe storage of deposit moneys, and
the speculative activities of brokerage and investment banking, were torn down. Not as far down
as they were in the 1920s … but getting there very fast.

The death of Glass-Steagall enabled the formation of the financial holding companies Citigroup
and JP Morgan Chase, among others. Citigroup formed with the 1999 merger of Citibank and
Travelers, who also owned the global investment banking and brokerage giant - Saloman Smith
Barney. JP Morgan Chase & Co. formed with the 2000 merger of investment banking/brokerage
giant JP Morgan and regular banking giant Chase Manhattan. These are the largest banking
institutions in the United States, and their deposits are backed by the US taxpayer.
In the Savings and Loans Debacle of the 1980s that followed deregulation of Savings and Loans
we learned very well what happens when you combine Federal Insurance of deposits, with
deregulation of the investment activity of banks. The bank is, in essence loaning out these
deposits to make these investments for their own profit. In this case this often involved over-
priced speculative, and even make-believe, real estate. The depositors weren't so worried about
the risks - the banks offered the potential for nice returns and well, the deposits were federally
insured. But when the asset side of the bank is too risky, or maybe even make-believe, there is
little backing for the deposit moneys which people think are safe and sound. These moneys
actually did disappear, just as in the Great Depression, due to the risky investments made by
banks in what turned out to be worthless investments. But because of the Federal Insurance on
the deposits in the Savings and Loans Debacle, the US taxpayer took on the responsibility of
making sure the depositors got their money back.

BUT now we enter the 21st century with two financial giants - JP Morgan Chase and Citigroup -
as busy as ever and the walls between safety and soundness in the monetary system, and
gambling in the equity markets, fading into the distance.

This is the BIG LEAGUES now, and only time will tell what will happen.

True, financial conglomerates must hold a separated set of assets against their banking deposits -
i.e. the public's money - and they have what is known as risk-based capital requirements on those
assets. This basically means that they hold an extra safety net of safe money and this safety net is
commensurate with the riskiness of the bank's investments.

BUT - and here is the big BUT that nobody seems to be noticing or worried about. Under the
new rules being set by the G-10 group of Central Bankers at the Bank for International
Settlements in Basel, Switzerland - for the first time since capital requirements came in after the
S&L debacle - large banks will be able to set these capital requirements for themselves within
the next few years.

Capital levels or safety nets of banks will be essentially self-regulated!

These new international bank supervision standards are called the Basel Capital Accords and I
spoke extensively about them in Wizards Part 2 on Financial Risk Transfer. Since that episode
came out the banks have managed to gain even more ground in their desire for self-regulation
because the public has taken absolutely no interest in this issue, even though it effects the safety
of all our bank deposits. And it's not as if all this is secret either - the goings on have been posted
to the Bank for International Settlements web site at for years. I think it's just that
its hard for people to understand. It must be admitted that the Basel Accord is not an easy read! I
will cover these recent and important developments in Basel at the Bank for International
Settlements in later editions of Wizards. While some concerned European citizens have picked
up on this tremendous development in bank "un-supervision" this issue remains entirely muted in
even the progressive and independent press of the country that produces the world's reserve
currency - the United States. Again I suspect its because people don't understand it. It's difficult
to appreciate such money issues when you've never been exposed to a financial collapse or a
monetary attack as most other countries have in the past few decades.
While you ponder the implications of self-regulation of the institutions we deposit our money in
at a time when they can both be banks and be gamblers, please also consider the revelations of
bank activity made during the Enron Scandal.

The Wall Street Journal reported on Tuesday January 15th that the SEC is investigating the role
of Citigroup and JP Morgan Chase in financing so many of Enron's risky activities and secret
partnerships. They are examining to what extent these banks help set up the partnerships and the
lack of disclosure the banks presented about their involvement. So far we know that JP Morgan
Chase has almost $3 billion exposure to Enron and Citigroup has disclosed over $1 billion
exposure but others suspect there is more. Yet not all the deals between Enron and the two
banking giants, particularly derivatives positions, have been fully unraveled and quantified.
Other banks that were also involved in the riskier securities or derivatives deals with Enron and
their secret partnerships were Bank of America, CS First Boston, Deutsche Bank and BNP-
Paribas. In particular JP Morgan Chase, Citigroup, CS First Boston and Wachovia were involved
in the financing of one of the most controversial secret partnerships of all - the LJM partnerships
- headed by Enron's CFO Andy Fastow and as reported on January 14th in the Wall Street
Journal. GE Capital was also involved in this but they are not a federally insured bank … and
they are also not very much regulated because of this.

A professor at the University of San Diego is quoted in the January 14th Wall Street Journal
article as saying "You can't do sophisticated limited partnership and credit derivatives without
the participation of the major banks".

A so-called sophisticated banker might say that this concern about banks self-regulating the level
of their own safety net is ridiculous because banks have built sophisticated risk management
models to help them manage their risks in an optimal fashion. Indeed the leader in building these
sophisticated risk management models is JP Morgan Chase who built the widely used and
distributed RiskMetrics system for managing financial risk. Wait! Then one opens the January
21, 2002 issue of BusinessWeek only to find an article entitled "The Perils of JP Morgan -
Enron, Argentina, Bear Market - A Year after the merger with Chase the bank is racking up
losses". The old JP is in trouble from extensive exposure to failed internet companies, teleco
companies, Enron and various foreign gambles. OK - so how well is this popular self-regulating
risk management software working? It doesn't sound good.

Great! Where does that leave the depositor who thought his/her money was safe. Where does that
leave the taxpayer who would have to foot the bill if one of these banks got in trouble? Or what
if the unthinkable happens - that the gambling activities of the banks cause such a huge loss in
confidence that bank money disappears like it did in the 30s and there isn’t taxpayer money to
bail out the banks.

The last scenario might be considered a stretch in this day and age because we are not on the
gold standard like we were when the Great Depression got underway. Roosevelt abolished gold
convertibility in 1933, and the gold standard was only used after that to set exchange rates with
other countries until 1971, when gold disappeared altogether from being a money standard.
Without anything real backing money, and with the USD as the reserve currency of the world,
the argument goes that if we ever had another panic like 1929 the Fed could pump liquidity into
the markets as needed. This means that the Fed can make money up (as we spoke about in
Wizards Part 1) as needed to avoid massive default on bank loans and the collapse in bank
investments that can make banks go under and people lose their deposits.

But there is no guarantee that this will work. If confidence in the markets and the banks is lost to
a large enough extent, the whole system may very well collapse, even though, actually
BECAUSE, the credits that make up money are 100% make-believe - the system only works
because people have confidence in it. Expectation that the system could fail is a self-fulfilling

OH, And there is one more thing that exists now that didn’t exist in previous near collapses of
the US Banking system - such as the S&L debacle, the 1987 Market Crash, and the Long-Term-
Capital-Management collapse of 1998. This new thing is the called EURO, the currency of the
European Union - and it gives people somewhere else to park their money if they decide the US
banks have gotten too risky. It also gives countries another reserve currency option, and some are
starting to take it.

The moral of today's story then...

Think carefully before you bank on the safety and soundness of the US banking system. Oh, and
maybe start planting some vegetables in your backyard.

That's all for Wizards of Money Part 10. Please note that the Wizards of Money has a web site
located at

Part 11: "House Lever-Edge at the Derivatives Casino"


1. Introduction
2. The "House Edge"
3. Leverage
4. Hedge Funds, Derivatives and Credit Default Swaps
5. Background on the Long Term Capital Management Saga
6. Story: "Because a Little Bug With the Asian Flu went Ka-CHOO"
Chapter 1: The Origins of a Financial Crisis
Chapter 2: The Extinction of Sneezing Bugs and Hot-Tempered Worms

This is the Wizards of Money, your money and financial management series, but with a twist.
My name is Smithy and I'm a Wizard Watcher in the Land of Oz. This is Part 11 of the Wizards
of Money series and it is entitled "House Lever-Edge at the Derivatives Casino".

1. Introduction
In this, the 11th edition of Wizards, we are going to take a look at the wild and crazy
world of financial derivatives through examining the role and dangers of leverage in our
modern society. Our adventure will end with a story called "Because a little Bug with the
Asian Flu went Ka-CHOO". You might have heard a similar story when you were a
child, but in this case the star of our story is the Long Term Capital Management Fund or
LTCM. LTCM was an unregulated hedge fund, addicted to risk and high on derivatives,
that could have easily sent us crashing into the next Great Depression in 1998, but for the
intervention of the Federal Reserve.

The quiet rescue of LTCM by our federally insured banks, combined with the fact that
LTCM was a private equity fund and hence shielded from public scrutiny, aided in this
potential catastrophe being confined to discussion among the financial elite. That we
came very close to a global financial collapse went almost unnoticed by the general
public. The ability to sweep this embarrassing incident, revealing the true nature of risks
emanating from the derivatives casino, under the rug thus prevented the regulatory
spotlight from being shone on either the casino or its most secretive dealers - the private,
unregulated hedge funds.

The keeping of the derivatives wizards behind the curtain has enabled them to come up
with newer, and potentially deadlier, games. The newest game on the block is called the
Credit Default Swap. Even the International Monetary Fund (IMF) is getting a bit
worried about this one!

But before we step in to discussion of derivatives and leverage, lets discuss the "House

2. The House Edge

Imagine you are stepping into a Casino in Vegas and imagine what you will see. In one
section you will walk past the slot machines and nearby will likely be the Keno Room
with the comfy chairs and table for all your free drinks. In a separate section there will be
the games that are more complex and harder to play such as BlackJack, Craps and the
like. Secured away upstairs or in some guarded area are the rooms for the high rollers.
Think of the socio-economic classes you are likely to find in each area - in general, lower
income people will be at the slot machines and in the Keno room and the highest income
people will be in the High Rollers Room. In the middle are those at the regular Black-
Jack and Craps tables.

Now ask yourself, given this distribution of class by game, which group has the worst
odds? Which group is likely to lose the most of what they wager? The Answer: The Keno
Players and Slot Machine Players. And not just by a small amount, by a very large
amount as evidenced by statistics reflected in what is known as the House Edge. I am
sure you might be surprised by the differentials if you haven't seen them before.
The House Edge is defined as the average amount that a player will lose as a percentage
of their initial bet in any game. This average is always positive by necessity, so that the
House can a make a profit and thereby stay in business, or, in other words, avoid
collapsing. The House Edge or Margin on an average bet is positive, and the rest of the
money wagered is simply redistributed amongst the casino players and that is what
gambling is all about. Those players that lose are simply passing on their funds to those
that win. That the House Edge is positive simply means that, on the whole, the losers lose
more than the winners win, and the House takes the difference for its efforts in arranging
the distribution of wagers. Without the House to provide this function there would be no
such gambling on such a large scale.

I got some data on House Edges from the web site of a professional gaming analyst. The
web site is called (which is no relation to the Wizards of
Money) and I recommend you look at it if you are interested in the most probable amount
of money you will lose if you hang out at the casino too long. Here's the house edge data:

Keno has the worst odds with a House Edge of a whopping 25%-30%! This means the
following - Let's suppose you go to the Casino one night with a 1,000 of your closest
friends (for statistical significance), and you all play Keno all night at a place where the
House Edge is 25%. As a group you will walk out of the Casino with 25% less than what
you came in with. Some of your friends will lose everything, while others may double or
triple their money, but on the whole the group has lost a quarter of what it started with.
You and your 1,000 friends have simply redistributed money between yourselves and
paid the house a whopping premium for the privilege of doing it on their premises with
all the wizardry that masks what is really going on.

Slot machines are next. You will lose, on average, between 5% and 15% of what you put
into a slot machine, depending on the Casino and the type of machine.

Craps is next, where you will lose, on average, between 1% and 15% depending on how
you play the game.

Your best bet is Black-Jack, as long as you know how to play, with a House Edge of less
than 0.5%, i.e. One half of one percent.

The very best bets, or best odds, will often be found in the High-Rollers room where the
House knows it has a smaller edge on a much larger base.

In a spooky kind of way, the social and economic relations of the seedy casino world
mimic the relations between humans and the financial markets in the broader world.

Consider the House in the broader world to be the financial markets themselves, backed
up by the banks and central banks who create the most basic forms of money. Consider
that for any attempt to generate returns a piece of your effort is going off to the financial
markets, or the House, in order to keep it going. Consider that the wealthier you are to
begin with, the higher are your chances of winning more money, and that the more
money you have the better the House treats you and the better the terms of credit, should
you wish to borrow from the House. Consider that the poorer you are the more expensive
it is to play, and the chances of positive returns are much lower.

But the real world situation gets worse. Now consider that the dealers are incented to win
for the House by participating in the gambles themselves. If the dealers want to borrow
from the House to play, that’s OK. They will get good terms of credit. If they lose too
much they get fired and you only keep the dealers that keep winning. To attract the very
best dealers you decide not to regulate them and so you don't keep track of what their
betting positions are, or even how much they borrowed from the House. Why they are
smart people - the best - some of them even came up with computer programs to predict
the unpredictable…How pure chance gambles will come out!

But then one day the smartest, most winningest dealer of all, a private equity fund, loses a
huge gamble, most of the wager having been borrowed from the House. There's no way
he can repay this loan to the House and the House looks like it could go bankrupt. But the
House can't fail! In order to avoid the Casino collapsing the Law of the Land says that all
casino players PLUS all those that have never been to the Casino in their lives must be
charged a certain amount to avoid the collapse of the casino. Now that's what I call a
House Edge!

3. Leverage

We all have a basic idea of what a lever is and what leverage is in the physical world.
Generally people will conjure up an image of leverage as being the ability to input a
small amount of force or energy, and get a much larger result at the other end. The
amplification of a small amount of input into a much larger output is facilitated by a
lever. One of the first levers we come across as a child is the seesaw, where you are able
to lift a person three feet off the ground - a feat you'd never achieve if you tried to lift
them with your own arms. The seesaw can bring with it great fun and a great return on
your investment in a visit to the park. But if it broke while you were playing on it, both
you and your seesaw partner would be in a much worse position than if you had simply
dropped the other person while trying to lift them directly, without leverage.

So too with any kind of leverage. Leverage can bring great benefits and higher expected
returns on any effort, but like anything that can increase your returns, it also increases
your risk. A sudden switch in the wrong direction of a highly leveraged system, by virtue
of the fact that leverage multiplies the force of any input, can bring disastrous
consequences, way beyond those possible in a less leveraged system.

The modern financial system is built entirely on leverage. The financial equivalent of
physical leverage is the use of debt to enhance returns. The whole monetary system has
been built on leverage ever since the invention of fractional reserve banking in the 1700s,
whereby banks expanded the money supply by continuously lending out deposits backed
by a much smaller reserve of real physical assets such as gold. But if there was ever a
loss of confidence in the banks, a run on banks would collapse the whole banking system,
thereby rendering money worthless. The collapse of the medium of exchange would then
grind all trade to a halt, plunging people into immediate poverty and massively increasing
all social tensions. Such a dramatic collapse of trade caused by monetary collapse would
not be possible without the leverage.

Today banking works a bit differently, whereby the amount of leverage in the banking
system is basically driven by capital requirements as we spoke about in Wizards Part 2 in
discussing the new Basel Capital Accords. Let us suppose you have a $100 to invest by
either depositing your money in a bank or becoming a shareholder of a bank. If you just
become a bank depositor you can earn 5% a year on your $100. But if you are a bank
shareholder, you get to borrow additional money from the depositors and lend this money
out at a higher rate, keeping the difference in interest rates for your own profit. Let's
suppose that for every $100 of shareholder or equity capital a bank has, it can borrow
$900 from its depositors and loan out the total $1,000 at a 7% interest rate. Then your
profit as a shareholder is calculated as follows:

INCOME: 1000 * 7% = $70 from people that borrow from the bank

less OUTGO: 5% * 900 = $45 to go back to depositors, whose money you just borrowed,
as interest on their deposits.

That leaves you with a clear $25 of profit on your $100 investment which is a 25% return
on investment. That's much better than the $5 or 5% you would get as a depositor and the
reason is quite simply, leverage. You could borrow 9 times your own capital investment
to make a much larger return than you could have done with just your own money. We
say that your leverage was 9, which is the ratio of debt to equity in your total investment.

But such leverage comes with many more risks than if you just invested your own $100.
One obvious risk is that some of the $1,000 borrowed from the bank will not be paid
back. If this amount is less than $100 plus any interest profits you make, then the loss
simply hits your investment, but the bank still has enough money to pay back the
depositors. But what happens if $100 or more, of the $1000 of bank loans don’t get paid
back. Then the bank will be insolvent or bankrupt and some of the bank depositors will
have lost their money. Well, unless there is a government bailout, that is. This is just the
type of loss that can trigger a further series of loan defaults and thereby start a chain
reaction of defaults, asset sales, lost confidence and mad panic, that can lead to financial

It is clear that the higher the leverage, or multiple of your own investment, you can
borrow from depositors to lend out then the higher your potential returns, but also the
higher the risk of potential catastrophe. For example if the bank's leverage was now 19
instead of 9, they could borrow $1,900 from depositors added to your $100 investment.
This huge leverage could bring a 45% return if nobody defaults on their bank loans and
interest rates stay the same. But the risk of losing $100 in the larger pool of bank loans is
now much greater and it's this loss that can cause bank collapse.
Financial leverage lies at the heart of the development of modern societies. It is the great
facilitator of our massive production and distribution of energy and goods, and our rapid
technological advancement. Without such leverage there would not have been enough
money to fuel the industrial revolution or the technological revolution as they happened.
Without the confidence in this highly levered system you would not have the cooperation
between people to get such big projects completed. Many people in the developed world
would not want to give up their modern luxuries nor, in fact, could many even survive
now without them. But this exposes another danger of financial leverage - that it has lead
the developed world into complete dependence on physical leverage created through
financial leverage. In our high-tech world we are used to easy access to massive physical
energies - food, electricity, transportation and so forth - for very little effort of our own.
Not only does the increased financial leverage increase the risk of a breakdown in the
system of trade, but a history of dependence on the physical leverage brought by financial
leverage could multiply the physical consequences of a financial collapse many times

One feature of today's financial markets, now that we are more than a generation away
from the Great Depression of the 1930s, is that the thrill of returns from leverage and the
excitement of greater technological advancement mask the reality of the risks imposed by
leverage. We have gone so long without a collapse, indeed partly due to various
innovations that have helped to put out fires that could have caused collapse, that
potential and systemic risks do not get the attention they deserve.

4. Hedge Funds, Derivatives and Credit Default Swaps

We know the banks are pretty highly leveraged and that these risks of leverage must be
controlled since the banks lie at the heart of the financial system. The way this leverage is
controlled so that risk of collapse is not too high, is to set limits on leverage
commensurate with the risks of the loans or investments any bank is making. This is what
the new Basel Capital Accord being discussed now at the Bank for International
Settlements (the central bank of central bankers) in Basel, Switzerland is all about. These
accords specify a certain amount of shareholder or equity capital or "safety net" (from a
depositors perspective) that banks hold as a function of the riskiness of their loans or
investments. Such a safety net sets a bound on leverage and provides protection for
depositors and taxpayers who are ultimately on the hook for massive bank failure.

But under the current adrenaline-fed mindset of the capital markets, even these controls
are continuously circumvented. Like I said earlier, one of the newest kids on the block, is
the Credit Default Swap or Credit Derivatives and they are being used to get around these
safety nets or caps on leverage.

A derivative on an underlying asset basically allows you to make a bet on the future price
of that underlying asset by betting just a fraction of the cost of that asset. The leverage
comes about because the instrument basically replicates borrowing or lending of the
underlying asset, without you ever having to physically own it.
Derivatives can help you manage risk if you already trade in the underlying asset. Let's
say you are wheat farmer worried about wheat prices. Then derivatives can be used to
buy insurance on wheat prices. Say if wheat prices go down, you can get compensated for
your loss by buying insurance in the form of something called a futures contract or even a
a "put option" on wheat. Your outlay for this protection is fixed - the cost of the insurance
premium - but it has removed the potentially larger loss of plummeting prices.

However, like all such things with a good use, there is a large downside. That is that the
leverage and potential returns available on derivatives attract speculators from all over
the globe to play and to become major dealers at the Derivatives Casino. This includes
what is known as the Private Equity Hedge Fund, capitalized by wealthy investors and
then often also borrowing many multiples of this capital from federally insured banks.
With this highly leveraged capital base they then enter into the highly leveraged and
potentially lucrative world of derivatives gambling. Private hedge funds are not regulated
on the grounds that their investors are sophisticated, and that regulators don't seem to
understand or be worried about the risks that depositors and taxpayers are exposed to by
the largest and most highly leveraged of these bodies. In addition the huge hundreds-of-
trillions-sized market known as the Over-The-Counter (or OTC) derivatives market is not
regulated. Of course, our banks themselves are among the major players and dealers at
this Casino.

Consider the young, unregulated credit default swap market, the newest, hottest game on
the block. This enables institutions that lend money to high credit risks to buy insurance
on those risks. For example, a bank with high loan exposures to certain lenders can pay a
premium to a third party for a credit default swap, a form of credit insurance, whereby the
bank would get reimbursed by the credit swap seller if the borrower defaulted. The bank
is thus able to take this credit risk OFF its balance sheet and thereby is no longer required
to hold the regulated amount of equity capital, or "safety net", against the risky credit
risk. This means that the bank can further increase its leverage. If the seller of the credit
default swap is not a bank, and especially if it is one of the unregulated hedge funds, then
there may be no capital requirements (safety nets, or leverage limits) on such credit
exposures. Therefore through the use of credit default swaps the overall financial system
safety net shrinks and leverage and associated risks of collapse are increased, as always
to be borne by depositors and taxpayers if things get too out of hand.

Add to this the fact that banks and others in need of credit protection are entering into
these swaps through the now famous off-balance sheet Special Purpose Vehicles to
remove the underlying transaction from public and regulator scrutiny. So it's very
difficult to tell what's going on, and where and what the real risks are.

On the issue of the private hedge funds, some important regulators would argue that
hedge fund operators perform an important function by helping build the base of counter-
parties for valid risk hedges at the other end, and by ironing out pricing anomalies. They
argue hedge funds should not be regulated for fear that this will add friction to these
functions and/or send them offshore. The same people often argue that OTC derivatives
also should not be regulated as they help ensure capital and risk get allocated efficiently
around the markets, which facilitates our economic prosperity. But these arguments
always ignore the larger risks being added to the system as a whole and the unfortunate
reality that the higher you climb up the ladder of leverage, the further you will eventually

Now lets hear from the Great Wizard Greenspan of the US Federal Reserve on these
issues from a March 7, 2002 report to the Senate Banking Committee. He talks first about
the risks of the US economy becoming increasingly dependent on abstract concepts rather
than on the production of real goods, and then about the risk/return trade-off of
derivatives and leverage.

Excerpt: Greenspan Testimony on Concepts, Derivatives and Leverage. March 7, 2002

While Wizard Greenspan gives a good picture of the uncertainty of the risks of massive
leverage he is also, on balance, in favor of it and the continued lax regulation of both
hedge funds and OTC derivatives markets. He argues that derivatives play an important
role of distributing risk efficiently and this helps build resilience into the markets against

That's true but he forgets that some shocks just can't be swallowed by the market and the
implications for the market are catastrophic due to the size of the underlying leverage
involved. How he could forget this I just don't know, for one such incident took place just
4 years earlier with the near collapse of the huge private, unregulated, hedge fund known
as Long Term Capital Management or LTCM.

5. Background On the LTCM Saga

That people do not understand the risks exposed by the LTCM saga is evidenced by the
much greater attention given to a recently collapsed derivatives player who did not pose
even a sliver of the threat to the financial system that LTCM did - that recently collapsed
player being Enron. LTCM was not allowed to collapse because this could have triggered
a major global financial collapse. The reason Enron was allowed to collapse was because
their collapse posed no such threat. Since LTCM didn't collapse, because it wasn't
allowed to, the lack of awareness of the risks exposed by it resulted in their being nothing
done to prevent another LTCM type calamity.

LTCM was started by 4 smarty-pants wizards with an amazing betting program that did
the impossible - it predicted the outcome of derivatives gambles. Two of the wizards had
even won a Nobel prize for their derivatives pricing theories that were widely used to
price transactions. Needless to say The Street thought they were geniuses and this gave
their hedge fund easy access to credit and the ability to borrow at rates of a much less
risky operation. Respectable banks and investors across the country wanted in on this
action that had returned stellar amounts in its first few years of operation. To this day, the
fancy bank capital requirements coming out of the Bank for International Settlements in
Switzerland still do not address the risks of lending to these unregulated hedge funds so
the banks were, and still are, feeding at the trough of all this gambling madness.

By mid 1998 LTCM had about $4 billion in equity capital and borrowed funds of about
$120 billion, a hefty leverage of about 30 times. But, amazingly, that leverage was
compounded further by another TENFOLD, by LTCM's off-balance sheet derivatives
exposures whose notional principle amounted to more than another $ 1Trillion! To be
clear, this notional principle does not represent the full amount owed to anyone but rather
the full value of assets underlying various derivatives transactions. The biggest bet that
LTCM had on its books in the summer of 1998 was to do with interest rates on
underlying bonds. The biggest bet that LTCM had its money on was predicting that the
difference between interest rates on risky bonds and interest rates on the safest of all
bonds, US Treasury Securities, would go down in the near future.

But in August 1998 Russia unexpectedly defaulted in its domestic debt, causing the
market to panic, sell off risky assets and rush into the safest investment - US Treasuries.
This pushed up the price of US Treasuries and pushed down the price of riskier bonds
which is the same as saying that interest rates on US Treasuries went down while rates on
riskier bonds went up. That is, the spread between risky bonds and US Treasuries
widened - exactly the opposite of the LTCM bets.

When you trade in derivatives and gamble that the price or rate on an underlying asset
will move in a certain direction you are said to be "in-the-money" when the price of that
asset is in line with the direction of your bet. You are "out-of-the-money" when the price
moves against the direction of your bet. Counter-parties see how much they are in or out
of the money by marking their positions to market on a regular basis. If you are out-of-
the-money your betting counter-party to your derivatives transaction, or your derivatives
clearing agent, will call on you to deposit some type of collateral with them in line with
the amount your bet is wrong or "out-of-the-money". This deposit serves as security
toward you being able to settle the full transaction on the agreed upon date in the
derivatives trade.

When the real world went in the opposite direction to the massive LTCM bets, LTCM
counter-parties were getting worried about getting their money from LTCM, especially
since LTCM was so highly leveraged. LTCM might be forced to liquidate its assets in a
fire sale in order to meet margin calls triggered by their sudden slide out-of-the-money.
Either they would have to sell off a massive amount of assets quickly to meet these large
calls, or, if they couldn't do this they would default. Either way a chain reaction of panic
would ripple through the markets.

Soon after the Russian default it became clear that LTCM's positions were such that it
had now lost most of its equity capital in just a few days. Not only were its bank loans
now at risk but if LTCM defaulted on meeting its margin requirements with derivatives
counter-parties, all counterparties would have immediate claims on LTCM and its many
derivatives positions would be shut down. This would have sent a wave a panic through
the derivatives markets because LTCM was such a big player, and this would probably
bleed into most other major financial markets.

If LTCM had to liquidate assets to meet margin calls then, because of the size of the
assets that needed to be sold, this massive sell-off would have depressed prices and
caused panic, pushing asset prices down even further. In turn, this would have hampered
LTCM's ability to meet its margin requirements, as well as its ability to repay the banks
they borrowed their gambling funds from. Compounding these problems was the
realization that many market players, including major banks and securities firms, made
"copy-cat" bets and their positions would be further harmed by an LTCM fire sale.

The Federal Reserve Bank of New York intervened and called together a consortium of
banks who were complicit in this hedge fund madness by both lending to LTCM for their
gambling needs and by being major players in the unregulated OTC market themselves.

It was decided that the bank consortium would lend MORE to LTCM, by lending them
the funds necessary to meet margin calls and prevent the massive panic that default
and/or massive asset sales would have caused. The thinking was that these loans would
tide over LTCM until its betting positions turned around, so the banks were thereby also
participating in the gamble (even more!). And therefore, unbeknown to all of us, the
public was also participating in the gamble. Who knows what would have happened if the
betting positions continued to get worse? The banks, and therefore their depositors,
would have been more and more on the hook for the LTCM gambles. But as things
turned out, LTCM gradually came back into the black and, through the combined
management of LTCM and the bankers, the LTCM gambles were eventually wound
down in an orderly fashion and a financial catastrophe averted.

Interestingly the LTCM founders and some of its investors and creditors blamed the
whole thing on a "distorted market". Apparently their gambling was perfect except for
these external forces.

Even more interesting is the fact that the general public to this day still has no idea how
close their lives came to changing drastically overnight in September of 1998, thanks to
the extreme leverage of 4 smarty-pants wizards with easy access to credit. No safeguards
were ever put in place to prevent future such incidents.

Shall we be content to leave it up to the markets and the bank regulators to continue with
the adrenaline driven speculation as is, and then put out fires as needed?

Of course there is no guarantee that their attempts to put out such leverage-induced fires
will always work. Indeed in the case of the LTCM saga if the betting positions didn't
change direction for an extended period our lives may well be very different today. We
were, as gambling goes, just plain lucky that it didn't get worse.

The real problems do not lie in external distortions that mess up bets. They lie in the
over-confident betting culture that on the one hand, has brought great prosperity to a
small proportion of the world's people. But the danger lies in the inability to appreciate
the balancing dark side of all this prosperity for the few. The dark side includes the lack
of prosperity for the many upon which such levers are built. But it also includes the huge
devastation that would result from the collapse of high financial and physical leverage
that we, on the prosperous side of the fence, are now completely dependent on.

No treatise on financial leverage would be complete without appreciation of the fact that
human financial and physical leverage has another dark side - its effect on the non-
humans and the natural ecosystems that support us. Always remember that the leverage
that supports us and benefits us can be turned against us with just a small amount of force
amplified many times by our own systems of leverage. All it requires is a small trigger in
the wrong direction, which may flip another switch in the wrong direction and before
long, this turn in an undesirable direction is multiplied by our massive human created
leverage. With that we go out with a fictional story based on one you might recall from
your childhood entitled "Because a Little Bug Went Ka-CHOO". I consider this book,
from the Cat in the Hat Books, to be Chaos Theory for Kids.

6. Story: Because a Little Bug With the Asian Flu went Ka-CHOO

Chapter 1: The Origins of a Financial Crisis

You may not believe it, but here’s how it happened,

One fine summer morning in rural Asia, a little bug with the Asian Flu, sneezed.

Because of that sneeze, a little seed dropped.

Because that seed dropped, a worm got hit.

Because he got hit, the worm got mad.

Because he got mad, the worm kicked a tree.

Because of that kick, a nut dropped off the tree.

Because that nut dropped, a turtle got bopped.

Because he got bopped, that Turtle named Jake, fell on his back with a splash in the lake.

Because of that splash, a hen got wet.

Because she got wet, that hen got mad.

Because she got mad, that hen kicked a bucket.

Because of that kick, the bucket went up.

Because it went up, the bucket came down.

Because it came down, it hit Farmer Brown.

And that bucket got stuck on his head.

Farmer Brown happened to be the President of the Regional Farmers Association.

Just before the bucket landed on his head he was on the phone to his banker trying to sort out
repayment terms for his fellow farmers since the weather had been unkind to the crop yields that
season. But the bucket slamming onto the farmer's head disconnected the telephone and made it
impossible for the banker to call back.

The farmer's wife was out gathering up the neighboring farmers to help remove the bucket from
her husband's head, so the banker couldn't call them either. The banker immediately jumped to
the conclusion that the farmers were all going to default on their loans. Word spread quickly
around the banking industry and pretty soon the international speculators caught wind of this and
started selling off their Asian currencies and investments for fear that a banking crisis was

The selling off of Asian currencies put downward pressure on their values and soon the Asians
had to devalue their currencies. This proved disastrous for the Asian banks whose assets were
mostly in local currencies, but who also had large US dollar denominated debt. Almost
immediately the major banks were near insolvency and a run on banks had started. The
expectation of the international speculators of a banking crisis was a self-fulfilling prophecy.

The Asian crisis then spilled over to Russia, already in a precarious position due to high levels of
debt. Before long the Russian government defaulted on its debt.

After this series of events the international speculative community was in a mad panic and began
what is known as a "flight to quality", selling down bonds of foreign governments and riskier
firms and buying up on the safer US government bonds. This pushed down the prices on foreign
bonds, and pushed up the prices on US treasuries. This is the same as saying that interest rates on
US bonds went down and those on foreign bonds went up. In the financial world we say that
spreads on foreign debt over US treasuries got bigger, or widened.

Back in the US, if you had been in the upscale town of Greenwich Connecticut, you might have
been woken by a loud scream upon news of the Russian default. For little did anybody know, the
massively leveraged hedge fund known as the Long Term Capital Management Fund or LTCM,
had bet a substantial amount of the worlds economy on the future narrowing of interest spreads
over US treasuries. But with the Russian default these spreads just got much, much wider.
In contrast to the Enron case, Federal Regulators and the US Federal Reserve realized that a
major financial catastrophe may result from not intervening in the LTCM case. LTCM's collapse
would have effected us all and caused the type of collapse that can cause a major depression.

In the subsequent months Wizard Greenspan was called before congress to discuss the LTCM
crisis, why the Federal Reserve stepped into the supposed "free markets" and what should be
done to prevent future LTCMs.. Perhaps one of the most dangerous outcomes of Wizard
Greenspan's testimony was his support of the continued lax regulation of both hedge funds and
the derivatives markets. In line with this, no regulation of these instruments was forthcoming.
Overall, the wild derivatives markets and hedge fund players got off lightly, indeed. More blame
was put on external factors than on the dangers of the extreme speculative behavior facilitated by
both derivatives and private, unregulated hedge funds.

Chapter 2: The Extinction of Sneezing Bugs and Hot-Tempered Worms

During the grilling of the Chief Wizard of the Federal Reserve over the LTCM Crisis and the
near collapse of the global economy, Congress wanted to know the real cause of the financial
crisis. They wanted to know the root causes so they could stop the possibility of any future such

Recall that our story started with the sneezing bug that caused a worm to kick a tree which then
triggered a series of events, that later ended in financial crisis.

Not wanting to blame the crisis on the unchecked gambling of smarty-pants wizards, their hedge
funds and derivatives bets for fear that this would be detrimental to the lucrative financial
markets, the Chief Wizard sought to place the blame on just the right external factors. He placed
blame squarely on the sneezing bug and hot-tempered worm that had originated the sequence of
events that triggered the Russian default, which upset the LTCM bets. He stopped short of
putting any blame on humans who are, after all, key market players and he also didn't want to
blame the chicken that kicked the bucket for fear that this could trigger massive short selling on
poultry futures at the Chicago Exchange. Bugs and worms, not having been commoditized,
securitized and bundled up into neat financial instruments by investment bankers, were safe
things to blame.

The Great Wizard then proceeded to imply that eradication of Asian sneezing bugs and hot-
tempered worms would be the most effective route to prevention of future financial crises. The
leaders of America, known to hang on every word of the Great Wizard, put the following as the
next item on their agenda. "Bring Resolution of Eradication of Asian Sneezing Bugs and Hot-
Tempered Worms to the next UN Security Council Meeting".

This was done and the UN Security Council passed the resolution without a peep of dissent. A
plan for eradication was immediately put into effect. The people of Asia near and dear to the
Asian forests tried to tell the UN of dire consequences that would come from this eradication.
But nobody listened. After all, the bugs and worms were responsible for a near global financial
collapse, and what could be worse than that?
Within a few years all the sneezing bugs and hot-tempered worms of Asia were gone. The
financial markets did tremendously for the major gamblers over the next few decades and not a
single negative incident threatened this blissful state. Everybody assumed that the markets would
be just fine now that the troublesome bugs and worms were gone.

But within a few years something funny was happening to the Asian forests. You see, the
sneezing of bugs was supposed to make seeds drop off in order to distribute seeds throughout the
forest for new growth. And the worms were supposed to be hot-tempered and go around kicking
trees to distribute their nuts around the forest floor. In this way, Nature had built a system of
controlled leverage so that a small force like a sneezing bug or a worm of short temper could
push the right levers to keep the forest going.

Mother Nature had been observing the whole human financial crisis saga with some amusement
knowing that the relatively young species really had not learned the art of controlled leverage at
all, and that this was their real problem. Eventually they would either figure it out or wipe
themselves out. Either way was quite OK.

Without the bug and worm seed distribution mechanisms the seeds only fell off when they were
dried up and dead. So the forest was essentially "fixed" so it couldn't produce more trees and
shrubbery. It took about three decades before the urban people finally realized the forests were
thinning. But it was too late. The thinning of the forests left them susceptible to pest and disease
outbreaks, and pretty soon the forests were collapsing. With forest collapse came major climate
changes and water related disasters of floods and droughts.

Financially these environmental disasters hit the balance sheets of the Japanese insurers who had
insured a good part of Asia's physical economic infrastructure. The problems of the Japanese
insurance companies then bled into the already troubled Japanese banking sector, and soon the
whole Japanese investment community was suffering. The Japanese, being the world's largest
foreign creditors, then began liquidating their foreign assets to meet cashflow needs at home and
stemming from the Asian forest collapse, and related environmental disasters.

Included in this sell-off were Japanese holdings of US Treasury Securities, which panicked other
investors who also started selling off US government bonds and rushing into gold. The safest of
the sovereign bonds had now been put into question. This pushed down the price of US
government bonds and spiked up the cost of borrowing for the US government. Since US
government borrowing is more about funding the military than anything else, the Pentagon was
essentially shut out of the credit markets for the first time ever!

Unable to raise capital, the Pentagon was unable to pay its bills to its dependent private defense
contractors. This then triggered massive defaults by huge defense companies on both their
corporate bond issues and their bank loans. While the Great Wizards had been claiming that
derivatives built more resilience into the market against financial shocks, in this unexpected
scenario derivatives made the problem much, much worse and triggered additional layers of
default risks and incredible panic. This panic forced more and more people away from the US
dollar and into gold. Gold went from $300 per ounce to $5,000 almost overnight.
The Federal Reserve who, as we know from Wizards Part 1, just makes money up out of thin air,
couldn't do very much because the linchpin of its success, the might of the US dollar, was now
disappearing before its very eyes. They pooled their gold resources with the US Treasury,
counted their ounces and then realized they only had enough to either keep the Pentagon going,
OR to bail out the now collapsed US Banking System. But they couldn't do both.

This gave birth to the Great Squabble between the Wizards of the Great Empire and its Warlords
that, for all we know, could go on for hundreds of years.

Meanwhile the people got tired of this squabbling and developed a healthy new interest in the
important work of worms and bugs. Amazingly enough, the Great Wizard of the now collapsed
Central Bank was rumored to have uttered at a recent party that he wished they had had some
ecologists on the Federal Reserve Board.

Part 12: "The Imperial Budget and the Mythical Lock Box"

1. Introduction
2. The Role of Taxation
3. The Relationship Between Tax and Money
4. Comparing Imperial Budgets
5. Imperial Financial Management
6. Social Security, Medicare and IOU's from the Government … to the Government
7. The Lock Box Myth and the Problems it Generates
8. Perhaps a New Religion is in Order!

This is the Wizards of Money, your money and financial series… but with a twist. My name is
Smithy and I'm a Wizard watcher in the Land of Oz. This is the 12th edition of the Wizards of
Money and it is entitled "The Imperial Budget and the Mythical Lock Box".

1) Introduction

In this the 12th edition of the Wizards of Money we are going to take a look at the biggest budget
in the whole wide world in the whole of history - that is, the $2 Trillion USD budget of the US

How does such a big Empire spend the money it collects from residents? In such a big and
complex budget is there any misleading accounting wizardry going on? We will look at these
and other questions by comparing the budget of the US Government to that of its 2,000 year old
ancestor, the Roman Government in the early years of the Empire. Then we will look at the role
of the US Treasury in managing the biggest budget in the world. Finally, we spend some time
dispelling the greatest Treasury Myth ever conceived of in the history of Imperial Budgeting -
that myth involving the so-called Social Security and Medicare "Lock Boxes". We will see that
these Lock Boxes or safety trusts do not, and indeed logically cannot, exist by going back to a
first principles understanding of what our money is. We will also discuss how the presentation of
these mythical trusts by various "spin doctors" has seriously distorted the public's understanding
of the funding for old age pension, medical and disability benefits. This has prevented productive
debate and problem solving on what could prove to be the very thing that could bring down the
Great Empire…Getting Old!

But first let's get started with what taxes are and what a government budget is, and then talk
about how the money we use relates directly to our taxation system.

2) The Role of Taxation

Of course one cannot talk about the role of tax without talking about the role of government
since tax is what funds everything a government decides to do. Regardless of what kind of
society you live in - dictatorship, communist, capitalist, democracy, semi-democracy - a
government will spend money on the following in various orders of priority:

• Militaries for self defense of the home country and possibly for control over other countries,
• Some type of system of law and order in the home country,
• Infrastructure for economic development,
• Human development - education, healthcare, and so forth,
• Foreign relations with other countries,
• Redistribution and economic insurance, or "safety net", for individual residents.

In the US the main redistribution function and associated safety nets look a bit more like a type of
"insurance" against personal economic disasters, whereby the risks of such events are spread across the
society as a whole. For example, the risks of no longer having access to money due to retirement or
disability - which is what Social Security covers - are borne by society as a whole, which has a much
larger capacity to bear that risk, than do the individuals likely to experience such events. As we saw in
Wizards Part 10, the drastic consequences of placing these risks on individuals to bear became
intolerable during the Great Depression, leading to the establishment of the Social Security system in
the first place.

The purpose of any insurance is to pool risks so that each individual in the pool lowers their own
risk of some crippling disaster for a small annual fee paid to the pool. Therefore any insurance
mechanism is necessarily re-distributive. "Insurance like" federal taxes such as Social Security
are more re-distributive than any private sector insurance because those with the highest ability
to bear the related risks (those with high incomes) get the lowest expected return on their
contributions to the system. In addition what is really happening, as we shall see in the last
section, is that current workers contributions are always paying for current retirees in the system
and there really isn't any "saving for the future" going on, as is so often presented to the
public.Such a progressive risk sharing mechanism could not work in the private sector, which is
why it was founded as a public system in the first place.

Many people in capitalist economies who argue for less government intervention in the market
economy seem to overlook the fact that the government creates the infrastructure for the markets
to function in the first place. Without government created legal and judicial infrastructure, even
the most basic contract would not be enforceable, except at gunpoint. Since our whole monetary
and trade systems are built primarily on contracts of agreement (with occasional input from
firepower), modern markets would not exist, and economic development could not happen,
without significant government intervention.

Those who also argue for an end to government sponsored re-distributive mechanisms either
overlook or dismiss the role of periodic redistribution in sustaining economic prosperity. As
noted by John Maynard Keynes in the 1920s, without government intervention in redistributing
wealth in suitable amounts you step on to a spiral of increasing inequality. The following is a
quote from Keynes' book "A Tract on Monetary Reform", written in the roaring 20's at a time of
a roaring increase in income and wealth gaps globally, that covers both the government's role in
market existence and in redistribution:

"Nothing can preserve the integrity of contract between individuals except a discretionary
authority in the State to revise what has become intolerable. The powers of uninterrupted usury
are too great. If the accretions of vested interest were to grow without mitigation for many
generations, half the population would be no better than slaves to the other half. Those who
insist that … the State is in exactly the same position as the individual, will, if they have their
way, render impossible the continuance of an individualist society, which depends for its
existence on moderation."

Normally the largest and most debated government spending items in any country at any time are
related to Military Spending, Social Spending, and Interest on Government Debt. We discuss the
three further later on when we compare the Roman Empire's budget to that of the modern
empire. But first we discuss the very much forgotten, ignored and taken for granted relationship
between money and tax.

3) The Relationship Between Tax and Money

Most residents of any country today will be charged taxes by their government on any income
they make in their private activities. Tax is the most common liability all people must meet and
therefore people like to earn all or some of their income, and accept payments in, a medium of
exchange, or form of money, that can be used to meet tax liabilities. It is also in the government's
best interest that people get paid in a medium of exchange that it accepts for tax payments, as
well as in banks' best interests that checks drawn on bank deposits are suitable to the State as a
form of payment to meet tax liabilities. Therefore, to the extent that people are agreeable to a
system of government taxation, everyone's best interests are served by a significant proportion of
money in circulation being that which is acceptable to the State to meet tax liabilities.

This is why our major medium of exchange today, the US Dollar, is created through what is
really a joint venture between the Treasury Department of the US Government, and the private
banking industry through their bank deposits, and the Federal Reserve's role in creating "high-
powered money" that we spoke about in Wizards Part 1. Federal Reserve Notes created by the
Federal Reserve System and blessed by the US Treasury as being legal tender for all debts
PUBLIC and private can be used to pay taxes, but most people use drawings on bank balances to
pay tax bills instead. The State, through its role in issuing banking licenses, regulating banks and
being the ultimate risk-bearer in the case of bank failure, blesses payments using bank-created
money, which are just electronic records, as being good and well for meeting tax liabilities.
Recall that we spoke about the creation of both Federal Reserve Notes and bank-created money
(which is most money) in Wizards Part 1.

The mature development of this system of State-blessed, bank-created money really came about
with the founding of the Federal Reserve System in 1913 and the re-introduction of Federal
Income Tax in this same year. These events both played a significant role in financing America's
involvement in World War I. Today's US Dollar money system, and the links between the State
and the private banking industry, were further strengthened by State action, such as Federal
Depository Insurance, after various learning experiences such as the '29 Crash and the Great
Depression as we spoke about in Wizards Part 10.

Today, many years later, we don't think about these interesting ties between what the State
accepts as payment for taxes, the money that banks create, and the money we get paid in for our
work. Instead we just take it for granted that it's all the same "stuff". But it took many years and
learning from financial collapses to get it to its present state and, indeed, part of its success and
stability is the fact that most people never stop to think about it.

So stable, so unquestioned and so unchallenged is the US dollar system today, that the US dollar
and promises to pay US dollars in the future by the US Treasury are without doubt the safest of
all financial assets in the world. Hence the US dollar and US Treasury bonds (promises by the
US Government to pay US dollars in the future) are known as the "risk-free" set of financial
assets. Risks of ALL other financial assets are higher and are measured against this "risk-free"
benchmark. Of course there are some risks - basically, that one day the US could fall off the
Empire throne and the USD will collapse in value, but there is no expectation of this in the
market so the USD retains its "risk-free" status.

When you think about saving for future retirement it is this status of the USD that is critical to
thinking about funding Social Security and Medicare. The understanding of State-sanctioned,
bank-created money at such a fundamental level lies at the heart of the Social Security/Medicare
debate and helps us understand the reasons that a publicly funded US pension system CANNOT
be pre-funded by an investment trust in financial securities. This basic understanding of money is
achievable for anyone, whether you have studied finance theory or not. We will come back to
these points in the last segment of this Episode, but please keep them in mind throughout the
discussion of State spending.

Now lets see how the US Government's 21st Century spending stacks up against the Roman
Empire's 1st and 2nd century spending.

4) Comparing Imperial Budgets

"The Imperial March"

There appear to be at least as many permutations and combinations available for presenting US
Federal Budget and Government Spending data as there are years that it would take you to count
to $2 Trillion dollars, which is about 60,000! (Note that [in the US] the number One Trillion is
One Million times by One Million, or 10 to the power of 12).[By the way, for the mathematically
inclined, the correct mathematical definition of One Trillion is One Million to the power of 3,
and the correct mathematical definition of One Billion is One Million to the power of 2. BUT in
America numbers work differently, and so it came to be that One Billion got redefined as One
Million to the power of 1.5, and One Trillion is redefined as One Million to the power of 2. The
effect of being the Imperial Power is that everybody else in the world has now had to adopt this
number convention].

How you would like to present the Federal Budget depends entirely on the bias you start with
and the point you are trying to make. Therefore it was decided in this episode of Wizards to
admit the bias up-front and then you can better decide what to do with the data. My bias in
looking at US federal spending was the thought that maybe we might just be the Roman Empire
woken up from a 1,500-year nap after thoroughly exhausting ourselves last time. To be sure, the
Roman Empire had many similarities with the modern US Empire - both being Empires built on
a combination of clever legal systems, hard-work, confidence, much brutality in military
conquest and extensive use of slave labor, coupled with a system of desirable, tempting, and free
entertainment to warm the masses to the Empire, as well as erratic spouts of helpful assistance to
the poor. Certainly also, a widespread Roman currency and trade system, and an extensive
taxation and government spending program were just as critical to the success of the Roman
Empire, as they are to today's American Empire. We spoke of many of these parallels in Wizards
Part 4.

The comparison of Imperial Budgets started with finding a Roman budget at a time around when
their leaders stopped being elected and instead were "appointed" and when ancestral lines of
Emperors became very popular. So I started with the early Empire days of the 1st - 2nd Centuries

A rather technical history book called "Money and Government in the Roman Empire" by
Richard Duncan-Jones, published by Cambridge University Press in 1994 explains an approach,
based on historical data from those days, to calculating the Roman budget in this period. The
total Roman budget was about $1 billion sesterces, a common Roman currency that started in the
BC years as about 1/4 of the Moneta denarius that we spoke about in Wizards Part 4. I was able
to get estimates for the Roman budget in 150 AD broken down into the following expenditure

Roman Empire Budget Distribution Source of Roman Data

Expense Item Percent Outgo

Military 70%

Civil Service - Judiciary, Police, Government Departments 10%

Social Spending 5%

Economic Infrastructure 5%

Other - Mostly Foreign Affairs 10%

I then compared this to US Actual Government Spending in the year 2001 (Total $1.9 Trillion)
by first subtracting both Social Security and Medicare (Total $0.6 Trillion) which have been
more than fully self-funded by separate taxes (the FICA taxes) since the early 1980s and that we
will devote the last section of this episode to. Then I also subtracted interest on public debt ($0.2
Trillion) for comparison purposes since the Roman Empire did not have a consistent, well
developed system of Sovereign debt issuance like the modern Empire does.

Some other adjustments I made to US Imperial Spending were to include Veterans Benefits,
Military Retiree benefits and Military Assistance to the Provinces (Countries) of Judaea and
Egypt (Israel and Egypt) with Military Spending. The inclusion of benefits to ex-military
employees is consistent with the way the Roman data was derived, and the inclusion of military
aid to Israel and Egypt was done because these were the two most expensive outer-Provinces to
maintain under both Empires.

I came up with the following distribution of expenses on a comparable basis derived from Table
26.2 of the full current Budget of the US Government, available in Spreadsheet Form by going to
the Office of Management and Budget Website at, click on Budget
link and go to Spreadsheets, then click on Detailed Functional Tables (Chapter 26). If you want
to see how I categorized the data, that will be posted on the Wizards of Money web site at OR go Directly to US 2001 Spending Breakdown OR Go to
Directly to OMB Detail Data

American Empire Budget Distribution

Expense Item Percent Outgo

Military 40%

Civil Service - Admin, Justice, Treasury, Fed Civil Retirees 10%

Social Spending - Medicaid, Food, TANF, Umempl, Housing, SI 30%

Physical and Economic Infrastructure 10%

Other - Education/Training, Research, Foreign Affairs 10%

Clearly the data indicates that social spending in the Roman Empire was generally at a very low
level. However social spending tended to happen erratically in much larger amounts, depending
on the Emperor of the day, and the need to win over public opinion.
What is clear from looking at the two budgets is that the current US budget has more regular
proportions of social spending, especially in comparison to military spending. However it should
be noted that the US budget looked much more Romanesque in earlier decades of last century,
notably during the 40s for WW2 and during the 50s in gearing up for the Cold War, where
military expenditures were close to, and sometimes even exceeded, the Roman proportion.

The move from a Romanesque budget of the 1950s to the current US spending distribution has a
lot to do with increased healthcare expenditures such as Medicaid, and the introduction of things
like the Earned Income Tax Credit, and changes to Unemployment, Housing and Food
Assistance Programs.

Note that most of these social spending items included in the 30% fall under the grouping of
"Means Tested Entitlements" which means that they make up the social safety net for people
whose income and assets fall below a certain threshold. The other primary social spending
benefits or social safety net items are Social Security and Medicare, which apply to Retired and
Disabled Persons and are not means tested. As noted earlier these benefits have been self-funded
through separate employer and employee contributions (known as the "FICA taxes") for the past
two decades. Because of the unique circumstances and confused public debate surrounding
Social Security and Medicare, the last section of this episode of Wizards is devoted entirely to

In general, rising medical costs affect both Medicare and the means tested healthcare
entitlements such as Medicaid. In fact, one of the Historical Data Tables in the Budget (Table
16.1) shows total government spending on all health programs to have increased from about 2%
of the Imperial Budget in 1962 to just over 10% by 1980, to almost 25% or one quarter of the
Imperial Budget by the year 2001! As anyone with a health insurance policy will also know,
health care costs under private sector coverage also continue to rise. Overall, an increasing
amount of America's total Gross Domestic Product (GDP - a measure of the total economy) is
spent on health care. To keep score of the size of an economy and the size of national income
people often talk about GDP or Gross Domestic Product. This measure of national income is also
equivalent to Annual Consumption Expenditure plus Government Spending plus Investment -
which are the only three places your money can go. That is, any income you get either goes to
taxes, you spend it or you invest it. US GDP is about $10 Trillion US dollars. Consumption
Expenditure makes up about 65% of GDP in total. Government spending makes up about 20% of
GDP or $2 Trillion dollars a year.

Today healthcare expenditure makes up about 14% of US GDP. About 30% of this is picked up
in Government Spending, the rest is in private spending. By the end of this decade healthcare
spending will be inching close to almost a fifth of the total Imperial GDP! America spends more
on healthcare as a percent of GDP than any other developed nation, but has less public coverage
for this cost and a large uninsured population. So the high spending on healthcare in the US must
be explained by something other than a general concern that everyone have adequate care.

To a very large extent the high level of American healthcare spending is a result of America
becoming victim of its own technological success, its sedentary lifestyle and a culture obsessed
with longevity, overcoming natural cycles and the desire to "stay young". The latter appears to be
common to inhabitants of Great Empires of the past. This cultural obsession, fed by medical
technologies far superior to those of any other country, may one day suck up so much of the US
economy that it wont be able to sustain Empire status. Indeed it is perhaps the very fear of this
that is really driving the attempt to redefine Social Security and Medicare that we shall talk about

Moving on to some of these other expense items, it should be noted that "Other Spending"
includes Foreign Affairs expenditure other than the expenses of maintaining the outer provinces
of Israel and Egypt, which are included in the Military item. Under both Empires so-called
"foreign aid" is or was an important part of keeping peace with peripheral provinces or countries.
Unlike Rome, the US Empire also successfully uses loans through various multi-lateral
institutions such as the IMF, World Bank and Inter-American Development Bank to maintain
optimal relations with peripheral sovereigns. This use of loans gets to one of the fundamental
differences between Rome and America - the role and leverage of the Empire's financial system.

Recall that we discussed the role of leverage in our modern financial system in Wizards Part 11,
and its part in driving both the industrial and technological revolutions. The US Empire's success
is largely due to the success, and complete faith in, its highly leveraged and purely fiat (meaning
that money has no storage or intrinsic value) monetary system. In contrast, the Roman Empire's
monetary system was almost entirely metal based and while there was easy access to credit for
the ruling classes this was not true for other classes. There appears to be much debate among
historians about what stopped the Roman Empire from having an industrial revolution. But
whatever one's opinion, surely a pre-requisite is a highly leveraged, and maybe purely fiat,
monetary system with sophisticated, widespread access to credit. But Rome never got to such
sophistication with its financial system. This provides us with another reason why its success
was always more driven by military conquest than anything else. In contrast, for the modern
American Empire, financial influence is on a par with military power, and both feed off each

The financial success of the American Empire has also made its tax collection process far more
efficient than any previous Empire, the biggest problem being with collecting from the rich.
Since the financial system is a fiat system, financial transactions can be purely electronic and
thus tax payment happens before many of us even get our monthly or fortnightly pay. Contrast
this with the resource intensive system of the old Roman tax collectors having to go door to door
to collect weighty coins and various goods such as wheat grains.

5) Imperial Financial Management

The role of the Treasury Department or Treasurer of any body is to deal with financial issues - to
collect income, to disperse expenditures, to maintain the books, see to the investment of
surpluses and the borrowing necessary to cover shortfalls. So to with the US Department of
Treasury that oversees the management of the biggest account in the world, that of the US
Government. The US Treasury Department overseas the main governmental revenue collector,
the IRS or Internal Revenue Service, the Bureau of Public Debt that manages government debt
issuance, and the US Financial Management Service, who manages "The Books".
It is important to appreciate that the accounts of a government do not look at all like the accounts
of any body in the private sector, be it a for-profit or a non-profit organization, or even an
individual. Indeed if you viewed the US government balance sheet through a private sector lens
you would immediately declare it bankrupt and wonder why US Government Bonds are
considered the safest assets in the world!

However the reason a government's balance sheet doesn't tell you what you need to know about
the safety of a government obligation is because it doesn't place a value on the right of a
sovereign to tax its residents. This right of the sovereign, held only by the sovereign, generally
makes obligations of the sovereign a safer investment than any private sector body licensed by,
or domiciled in, that same sovereign nation. Then, the higher the national income (or the tax-
base) in that country the higher the expected revenue to the sovereign body, and the more likely
it will be able to meet its own obligations (provided its debt levels stays within certain bounds).
Thus it comes as no surprise that the country with the largest economy and national income also
issues the least risky type of debt security - and in today's world that is the US Government.

The resulting easy ability for the government to both tax and to borrow facilitates the type of
military expenditure and infrastructure spending necessary for empire building and further
economic growth. Economic growth spurs further access to capital for military and infrastructure
expansion, and so the cycle continues. Any empire would then be very concerned about the
following two primary threats to this pattern:

1. Growing expenditures that increasingly take money away from the primary empire building and
maintenance expenditures (military and infrastructure investment).
2. Emerging empires with fast economic growth that could take your place.

And so it would be that some of the main concerns of Imperial Financial Management today are:

1. In the first category of competition for empire building funds are two main things: First is
terrorist actions that make economic infrastructure more expensive to maintain. The other is
the aging of the US population and increasing healthcare costs.
2. In the second category of emerging empires…China.

In this episode of Wizards we are focusing on the demands on the Imperial Budget coming from the
aging of the population and society's increasing medical expenses.

6) Social Security, Medicare and IOU's from the Government … to the Government

If you have a regular job and you look at your pay-stub you will see two deductions for FICA
taxes. FICA stands for Federal Insurance Contributions Act and covers two basic benefits for
retirees and disabled persons:

Social Security: Labeled as FICA-OASDI or Old Age and Survivors Insurance and Disability
Insurance. This provides pension benefits to retirees, survivors and disabled persons.

Medicare: Labeled as FICA-HI or Health Insurance. This provides medical insurance for retirees,
survivors and disabled persons.
Many people may be aware that the amount of money the government collects from us as and
our employers as the FICA taxes has exceeded the government's obligations in Social Security
and Medicare payments for the past few decades. This has been true since FICA taxes were
increased under the Reagan administration in 1983, curiously at a time when other Federal
Income Taxes were reduced. Then the question is "What has the government done with that
excess money?" and many people have gotten very upset to find out that the answer is that - its
all been spent on other things. About $1.4 Trillion of Social Security and Medicare Surpluses -
all spent elsewhere by the US Treasury.

Lets see why this is. Many people are upset because they think the government should have
"saved the money" for the future and often they are misled to believe this through the existence
of what are called the Social Security and Medicare Trusts, or sometimes more snazzily labeled
as the Lock Boxes. In what form could the government save the money? Perhaps:

• Keep it as US dollars or deposit it in a bank,

• Invest in the private sector, or
• Buy government bonds. I.e. write IOUs to oneself.

Let's look at the first possibility. If the government keeps the money as US dollars this is tantamount to
the Treasury intervening in monetary policy, which is the job of the Federal Reserve. The Treasury would
be essentially holding large sums of money out of the economy for many years, which would not make
sense at all. The Treasury could instead decide to deposit the savings in a bank thereby making the funds
available for use in the economy and draw on its deposits later as benefits fall due. But the banking
system is backed up by the government itself, so the promises of the bank to make good on depositors
funds is ultimately the promise of the government to itself. So why bother with all the banking fees! It
makes more sense for the government just to scribble a little note to itself - "I owe me $x trillions of
dollars", which is essentially what it does.

A similar argument applies to investing the funds in the non-government guaranteed private
sector. The private sector depends for its success on the stability and financial security of the
State. If the State collapses so does the private enterprise defined by the rules of the State. If
certain private enterprises collapse it shouldn't effect the State, except if there is massive
widespread collapse and then the State would step in to provide as many guarantees as possible.
So some ultimate risks are still born by the State. The main point is that investing in the private
sector carries with it higher risks than holding a government obligation. And the main point of
Social Security is to pass risk from those that can least bear it over to those that can. Private
investing without government guarantees completely removes this risk transfer feature of Social
Security and places private sector investment risks onto those who can least afford it.

Therefore, as nonsensical as it sounds, so long as there is a surplus collection, the most sensible
thing to do is for the Social Security and Medicare funds to pass over the excess funds they
collect each year to the Treasury for it to spend back into the economy. The Treasury then writes
an IOU to the trust fund to pay back the amount it just spent on something else. Basically the
Government is writing an IOU to itself. The government is writing out some little pieces of paper
that say "Dear Me, I owe me some money", and then they put the paper in a box, lock it up and
call it a safe "lock box" or trust fund.
Whether intentional or not, what effectively happened to the Social Security and Medicare
surpluses generated by the Reagan Era FICA tax increases and reductions in benefits, was that
they helped fund Reagan's big military build-up of the eighties. With a Federal Income Tax Cut,
but an increase in FICA taxes, the tax burden was made LESS progressive, and the loss in tax
revenues in the general Treasury account was somewhat offset by Social Security Surpluses.
This shifting of funds also enabled the government to replace borrowing from the private sector
(the markets), which it cannot default on without dire consequences, with a promise to "pay
back" the funds to Social Security and Medicare many years in the future when needed. This is a
much less serious promise than issuing debt to the private sector because future governments
may very well get away with reducing publicly funded social security benefits if they argue it
effectively enough. However the government cannot default on debt issued to the private sector
else it will send the markets into a tailspin (since it is the most risk-free asset) and thus send the
world's economy crashing.

Recently the Bush tax cut has compounded this trend of borrowing from Social Security and
Medicare to make up for lower general revenues and thereby fund other government
expenditures, and substitute borrowing from the markets with borrowing from Social

Only time will tell if these promises will be broken, but in the mean time it is important that
people understand the real funding issues and not get distracted by Lock Box accounting

7) The Lock Box Myth and the Problems it Generates

Central to understanding the Social Security dilemma is understanding what it means for the
government to write an IOU to itself. As discussed, a US government IOU is the lowest risk
asset, but the government being able to come good on this obligation ultimately depends on its
ability to collect taxes in the future to pay-off all these IOUs.

In reality, looking right through the wizardry of all these IOUs from the government to the
government in the so-called Lock Box or Trust Fund, what really happens with Social Security
funding is that the current base of taxpayers always fund the benefits for the current set of

Social Security and Medicare are, as we say in the pension and insurance world, funded on a
"pay-as-you-go" basis. This means that the obligations to be met this year will be funded by
revenues collected this same year - there is no pre-funding of benefits, and there cannot be, as we
have just argued. When it comes to being the Imperial Government, there is nothing safer to
invest in than yourself, and this is equivalent to depending on future tax revenues to meet all
future expenses, which means you fund everything on a pay-as-you-go basis. That is, taxes
collected from current workers always pay for the benefits of current retirees.

In reality the Trust Funds provide a mechanism whereby future general income tax revenues of
the government can be legally transferred to meet social security obligations in excess of Social
Security taxes if and when needed. It is a legal mechanism to facilitate possible future flow of
funds and nothing more. But there is no guarantee on benefits and current benefits are always set
by the law of the land of the day. But now we get to the problem of the liability being with the
government - that is, of course, that the government sets the law of the land! And so the
government can change the laws that specify benefits if it so decides.

Since the elusive Lock Box (or Trust Funds), stuffed full of government promises to itself, is
little more than a legal technically that doesn't get at the real issues of funding Social Security
and Medicare, it should not be the focal point of discussion.

However, unfortunately some of the leaders at the US Department of Treasury still frame
discussion around the mythical Trust Funds.

Treasury Secretary Paul O'Neill: Excerpt from March 26, 2002 Press Conference after the
release of the Social Security and Medicare 2002 Reports

Now lets hear from another Trustee [aptly named] Tom Saving, who correctly describes the real
problem that worries the government, and it's NOT funding shortfalls in the 2030s or in 2076!
What really worries the government is that within the next few years Social Security and
Medicare Costs will start competing for funds that would otherwise be spent by the government
on other things (say, military or other things), rather than supplying extra funds to these things
(as they have since the Reagan Era).

Social Security/Medicare Trustee Tom Saving: Excerpt from March 26, 2002 Press
Conference after the release of the Social Security and Medicare 2002 Reports

An finally we hear from a caller who called into a C-SPAN show that Tom Saving was on the
day after this press conference. He pretty much gets at the cold, hard truth of these trust funds.

C-Span Show with Tom Savings - a caller's explanation of the Social Security and Medicare
Trust Funds

Cutting through the Trust Fund Accounting Wizardry we might surmise that the real Social
Security and Medicare funding dilemma is this:

How do you fund the medical and retirement costs of an aging society and still keep
being the Great Empire?

As noted, in a pay-as-you-go system the current base of workers fund the retirees and the sick.
Translated into real goods and services this means that the current base of workers produce all
the good and services, not only for themselves, but also for an increasing proportion of non-
producers. The demographic trends driving an increasing ratio of non-workers needing support
to supporting workers are:

• Medical advances that mean people live longer, are retired longer and have higher medical
• Lower fertility rates keeping down the supply of new workers, and
• Impending retirement of the large baby boomers generation.

In the coming years, more and more of society's resources will be going towards supporting retirees and
increasing medical expenses for society as a whole (both workers and non-workers as we've already
discussed). This will be true whether benefits are funded in the public sector or the private sector, or
both. Thus, Private Savings accounts and privatizing Social Security cannot solve the problem and
discussion of these as a solution should also not be allowed to distract debate from the real issues. In
fact, putting current contributions into private accounts will make the current funding situation worse,
because these funds are now used to pay for current retirees and not "saving" for future retirees.

This increasing demand on society's resources creates great pressure on funds that might
otherwise go towards Empire building and maintenance (military and infrastructure), and will
likely lead to much slower economic growth. This is perhaps the real dilemma that keeps the
Emperors and their friends up at night.

Since many necessary Empire maintenance and building expenditures originate in the public
sector there is a very real danger that a good chunk of the publicly funded safety net could be cut
in the coming decades. Economic risks are thus passed back to those who can least afford them.
There is a very real concern that increasing total medical and pension costs will lead to an even
worse situation of services provided on an ability-to-pay, rather than a needs basis.

While it is true that both labor force productivity gains and further government borrowing from
outside the government could serve to meet some of these increasing obligations, it is not clear
that these could be sufficient to solve the problem and both can come with nasty side effects.

The point to be made here is that people need to be aware of what the real trade-offs are and that
public discussion should be about the real issues and not about some mythical Lock Box (or
Trust Fund) as is so often one by the Government's spin doctors.

Furthermore, even more dire a situation than the Social Security dilemma is the increasing share
of national expenditure devoted to healthcare, as alluded to earlier. This effects all of Medicare
funding, Medicaid funding, private medical funding and the ability of society to come up with a
solution to the uninsured problem in the midst of exploding health costs everywhere else.

Add to that the riskiness of national output, or GDP itself, with more and more of it being
conceptual and abstract services and thus able to disappear from the economy just as surely as
Enron disintegrated. Recall that in the last episode of Wizards (Wizards Part 11) we included
some words of caution from the Great Wizard Greenspan about the risks of the components of
GDP becoming increasing "conceptual".

And the final sting of the dilemma is this - If people were content for the projected increase in
healthcare and retirement to eat into Empire building and maintenance expenses then of course
the Empire itself is at risk. And when the Empire is a risk, so is the whole economic and
financial system through which these benefits are paid anyway.

So there are no easy answers. Well, except maybe …

8) Perhaps a New Religion is in Order!

In the deteriorating years of its Empire, Rome, ever practical, saw fit to rejuvenate its Imperial
Power using the cheapest and most efficient tactic - a new religion to rally the troops around.

Though the ruling Emperors and Governors wouldn't have known it at the time, Rome's
"business-as-usual" termination of a Messiah provided tremendous returns 300 years later as the
Empire was collapsing. After all, if you don't have money to pay soldiers, you can always rally
them around a new and appealing religion - for free!

In a few years or decades or centuries, the American Empire might also try its way out of its
dwindling Empire dilemma with a shot at a new religion. Apparently the existing dominant
religion so beneficial to, and kindly handed down from, the Romans themselves, isn't working
too well and only makes the longevity quest even worse. It seems that the "fire and brimstone"
warnings have really sunk in and everyone wants to delay as long as possible the taking of the
inevitable "perpetual nap". Perhaps a new religion could help alleviate this cultural trend to want
to live in one's earthly body well beyond what nature had intended for it. Inventing some
religious worship methods that involved physical exercise would be an added bonus.

The possibilities are endless. In any case, as silly as it all sounds, such tactics would probably
work much better than a Mythical Lock Box!

Part 13: "Bankruptcy Bill's Shoot-Out at the Social Safety


1) What Triggers Personal Financial Ruin?
2) "Beware the Stranger Bearing Gifts" … Invasion of the Credit Card Industry
3) If it's got an Income Stream … Catch it, Tame it and Securitize It!
4) Bank-Robbing Banks

This is the Wizards of Money, your money and financial management series, but with a twist.
My name is Smithy and I'm a wizard watcher in the Land of Oz. This is part 13 of the Wizards of
Money series and it is entitled "Bankruptcy Bill's Shoot-Out at the Social Safety Net".


In this the thirteenth chapter of Wizards, we are going to take a look at another Chapter 13 …
and a Chapter 7 and a Chapter 11 - these chapters are some of the main ways under federal law
to file for Bankruptcy. Importantly we will look at the strong relationship between the non-stop
credit offers we find stuffing our mailbox, e-mail and voicemail everyday, the innovative
financial Wizardry behind such offers and the rapid rise in personal bankruptcies. We'll examine
who does file for bankruptcy and what causes them to go bankrupt. Then we'll look at the new
Dream Bill of the Credit Card and Banking Industries - called "Bankruptcy Bill" - that looks set
to pass into law soon. Bankruptcy Bill is aimed at thwarting people's attempts to be caught in
that final, last-resort, safety net, known as the bankruptcy court. To help us understand both the
credit offer onslaught and the salient features of Bankruptcy Bill we'll talk to Margaret Howard,
a Law Professor at Washington and Lee University, and visiting scholar at the American
Bankruptcy Institute.

After a look at how people get robbed by credit cards and Bankruptcy Bill, we'll look at how a
small businesses can get robbed by a big bank. In the last section of this Wizards Chapter 13
filing, we'll talk to Greg Bates at Common Courage Press about how their money from book
sales was robbed by Bank One, a credit deletion service provided to them by the bank even
though they're not a customer!

But first lets talk about Bankruptcy Basics and the invasion of the Credit Card Monsters.

1) What Triggers Personal Financial Ruin?

One book that is an excellent source of information for understanding bankruptcy in America is a
book called "The Fragile Middle Class, American's in Debt" by Sullivan, Warren and
Westbrook. The authors have conducted extensive studies of bankrupt Americans in one of the
few comprehensive studies not funded by the credit card industry. Here is some of what they

• Up until the last year of their study period, which was 1998, Americans that filed for bankruptcy
were overwhelmingly middle class - above the bottom 20% but below the top 20% income
• About 80% were forced into bankruptcy due to an unforeseen event such as job loss, sudden
illness or injury, or divorce.
• Excessive credit card debt is increasingly a primary force propelling people into bankruptcy. In
the years to come this is likely to continue as a major driving force along with a new partner, the
wildly popular Home Equity loan.

Bankruptcy law is federal law. When someone files for bankruptcy they would file under either
Chapter 7, whereby many debts are forgiven, but many assets are also forgone. This provides
relief from aggressive creditors and enables the debtor to wipe the slate clean and start all over
again. Under a Chapter 13 filing, an "automatic stay" is granted whereby creditors can’t go
grabbing at your last bits of income and assets, and the court process will assist in coming up
with an agreed upon repayment plan. Chapter 13 enables a debtor to stop creditors in their tracks
while they come up with a more feasible repayment plan so that desired assets (like a home) can
remain with the debtor. Filing for personal bankruptcy under both Chapter 7 and 13 is intended
to provide some relief for debtors, and a chance for a fresh start, while it comes at some cost to
creditors such as banks and credit card issuers.

Over the years personal bankruptcies have been increasing faster than the population. On May
16, 2002 the American Bankruptcy Institute issued a press release stating that record levels of
bankruptcies had been achieved for the year ended March 31, 2002. Over that year a record 1.5
million American households filed for bankruptcy.

Several trends are driving this increase. One is the increasing number and size of gaps in the
social safety net, which one might otherwise be caught by on the way to this last resort option.
With a high number of people without adequate health insurance coverage, a sudden medical
emergency can push an individual or family over the edge and into bankruptcy court. More
often, it is unexpected job loss or disability that pushes people over the financial edge. Divorce,
especially for women who then care for children by themselves, accompanied by difficulty
collecting child support, is another common trigger. In fact there is evidence now that suggests
that single women head of households make up the largest group using the bankruptcy option. In
the absence of comprehensive publicly funded safety nets or public insurance to buffer
individuals against these shocks, with creditors pounding constantly on the door, and as drastic
as it seems, sometimes bankruptcy provides the only avenue of some relief.

Middle class debt loads have increased over the years. The "Fragile Middle Class" book points
out that the amount of debt relative to income that usually triggers a bankruptcy has remained
fairly constant over the years. But the number of bankruptcies is rising faster than the population.
This is because, on the whole, the middle class debt load relative to income is increasing,
meaning that more people are crossing that threshold that can trigger bankruptcy.

Several decades ago, on average, people didn't accumulate as much debt as they do today and so
they had more of a safety net of their own to weather the storm of any of these common financial
ruin triggers - which are job loss, sickness and injury, and divorce. But with the increasing debt
load, personal safety nets are disappearing right along with the vanishing public safety nets. The
increasing debt load has been driven both by increasing credit card debt and by home equity
loans in the midst of a strong property market. In addition, the financial ruin triggers themselves
are becoming more frequent, with globalization increasing job insecurity, higher divorce rates,
ever higher medical costs and higher education costs.

2) "Beware the Stranger Bearing Gifts" … Invasion of the Credit Card Industry

The sin of usury is well documented in the guidebooks of the popular religions. In the 1980s
these chapters of the Good Books may as well have been whited out. During the monetary
madness of the eighties and simultaneous high interest rates, religious warnings faced the
ungodly power known as "market-discipline". Usury laws of many states that capped interest
rates charged to consumers disappeared like magic and a new religion was born - a full blown,
non-stop, nirvana of credit accessibility everywhere you looked. The fact that creditors could
now charge huge interest rates meant that credit suddenly became widely available to people
who were once considered poor credit risks. A billboard here saying "Credit Problems, No
Worries!", a man with splendid manners on the phone greeting you with "Maam, you're pre-
approved for $5,000!" and a mailbox chock full of tens of thousands of ready made checks and
friendly letters saying "Congratulations, You're Pre-Approved! Sign Here".

And so the man with the nice manners and the friendly letters came to take the place of the holes
that appeared in the publicly funded safety net. If you couldn’t afford your medical bills, put
them on a credit card! Lost your job? Never mind - pay your rent and buy your food on credit. Of
course, this is one extreme of how credit is used, particularly by people in desperate
circumstances and with no other access to adequate money for the necessities of life.

In addition to this is the much more obvious and well-documented role of the credit frenzy in
fueling a consumer economy that grew like crazy throughout the eighties and nineties, and hasn’t
stopped yet. This widespread credit feeding frenzy feeds the consumerism that props up the
financial markets and, in turn, leads to greater capital accumulation ready to fund even more
access to credit for the poor and middle class, and so the cycle continues. It is a highly leveraged
"House of Cards".

Recall that we spoke about the role and dangers of excessive leverage in Wizards Part 11. Recall
that we also spoke about the "House Edge" - the amount that the House makes, on average, in
any betting game. The "House Edge" for the credit industry comes from the huge interest rates it
charges, and can get away with, thanks to the market's discipline of the bothersome religious
rules in the era of financial deregulation.

It is instructive to look at trends in the expansion of consumer credit over the past several
decades. Some good data is available on the Federal Reserve's web site at

[Go to, Click "Research and Data", "Statistics", G19 - Consumer

Credit]. In this data you will see that total consumer credit has now grown to $1.7 Trillion
dollars, which doesn’t even include home mortgages and home equity loans.

Provision of consumer credit dates back to the early 1900's when catalogue stores like Sears,
Roebuck and Company enabled consumers to buy goods on credit. "The Fragile Middle Class"
points to credit application forms in 1910 that ask sensible credit risk assessment questions such
as "How many cows do you milk?". During the Great Depression, General Electric or GE's now
monstrous unit, GE Capital - the largest of the non-bank financial institutions - was started as a
little consumer credit company to help Depression Era folks get access to the necessary
appliances for a modern life. In fact, if you look at the Federal Reserve's consumer credit data
you will see that right after the second world war non-financial business, primarily department
stores, were the largest providers of consumer credit by far.

Throughout the 1950's through the 1980's commercial banks took over as the primary suppliers
of consumer credit. But by 1989 a new "Wiz-Kid" emerged on the block and, as of today, the
Federal Reserve data shows that it has taken over the banks to become the major vehicle through
which consumer credit is now supplied. This vehicle is the handiwork of the bankers and
investment bankers themselves. It is also the one that snuck into the big hole left in the
crumbling social safety net while nobody was looking. For, in conjunction with the high interest
rates permissible today, the new Wiz-Kid invention is quite likely the very thing that has enabled
the provision of credit to people who really can't afford it - those in poverty or very near to it.
These are generally people least able to resist an offer of credit. They are also people who, in a
more balanced society, may have basic needs met by publicly funded social safety nets, rather
than through high interest loans.
Key to the profitability of lending to the poor is the fact that they desperately need access to
credit, often don't understand the impact of high interest, and therefore do not act at all like the
much touted "rational market player". The creditor can always win the arbitrage game played
against the irrational market player. For example, many credit card targets don't realize that
under the attractive minimum monthly repayment plan, a balance of just $2,500 might take more
than 30 years to pay off! Just like Keno and Slot Machines in our visit to the Casino in Wizards
Part 11, nowhere is the House Edge larger in the financial markets than in lending to the poor
without a usury cap.

3) If it's got an Income Stream … Catch it, Tame it and Securitize It!

This new Wiz Kid on the credit creation block is called the Securitized Asset. Included in this
same family are the mortgage-backed siblings known as Fannie Mae, Ginnie Mae, and Freddie
Mac, who you also may be acquainted with, and who will likely be guests on an upcoming
episode of Wizards.

To securitize a pool of consumer loans, lets say credit card debt, here's what happens:

• First, a bank, a group of banks and/or other credit card issuers decide they'd like to sell the
credit card debts owed to them by their customers. In return they will get some cash that they
can use for some new Wizard adventures.
• An investment banker packages all this debt together in a nice pool of credit card receivables,
using what is known as a Special Purpose Vehicle, and does some risk analysis to price the
bundled up debt. Then they sell the neat new packages of credit card backed securities for cash
in the markets, with the cash proceeds going back to the banks and issuers, less a handsome cut
for the crafty investment banker.

The new securities are then traded around the markets according to the whims of Wall Street.
This is pretty much what happens with mortgages as well. So whether you're paying of your
credit card or your house you actually never know who you are paying to from one day to the
next. You are just a little slice of income in a much bigger security.

The implications of pooling such risks across many issuers and many different bases of
borrowers are quite profound and provide many appealing features for investors in these
securities that are basically bundles of credit card receivables. By putting a vast number of credit
card receivables behind a security, risks of default are spread across the pool as a whole and the
cost of default is much easier to estimate. There are bound to be a handful of credit card holders
who will end up not paying their bills, but in such a large pool there will be enough of the ones
who keep paying their bills to make up for it. The high interest rates charged and paid by the
larger paying group more than makes up for the defaulters, leaving a handsome profit for the
investor in the bundled up security.

Thanks to these handsome profits, capital keeps flooding into these securities to fund ever more
daily credit card solicitations. Due to this ability to pool risks via securitization, combined with
saturation of credit in the middle class and the profits that come from uncapped interest rates,
credit solicitations are now flooding into the poorest of homes, the bottom 20% of income
earners. People in poverty are less able to resist such access to credit, and due to limited
experience with it, often don’t understand that the huge interest is a killer. Over the coming
years, it is likely that those wishing to file for bankruptcy will increasingly be the poor, in
addition to the ever increasing stream of middle class already filing in.

An important study done by the Federal Depository Insurance Corporation (FDIC, who we spoke
about in Wizards Part 10) is available at

This study documents the relationship between the removal of interest rate caps or usury laws in
the 1980s, the subsequent widespread availability of credit to all groups, and the resulting rapid
growth in personal bankruptcy filings since the 1980s.

It also gives us an interesting history of the role of usury laws. The FDIC study reports "Usury
laws perhaps have a more ancient lineage than any other form of economic regulation. … The
Greek philosopher Plato also condemned charging interest because he felt that it produced an
inequality of wealth and destroyed the harmony between citizens of the state. … As commerce
expanded and money lending became increasingly important, opinions about usury changed. The
Romans were more tolerant of usury and were one of the first societies to recognize interest and
set maximum legal rates for various types of loans. Throughout much of recorded history,
societies around the world have felt it was important to limit the interest rate that a lender can
charge in order to restrain lenders from taking advantage of borrowers."

Today, the modern American society has taken a step even beyond what the Romans would
tolerate, by deregulating interest rates and removing usury caps.

As a result, the credit monster extends it tentacles ever further into society and into that sector
that just might need bankruptcy protection the most. Just as it does so, the Credit Card industry
has almost nurtured into existence its Dream Bill - called Bankruptcy Bill. The Creditors' Dream
Bill makes access to that one final safety net, known as declaring bankruptcy, all that tougher to
get to. Meanwhile, Congressional and public debate over Bankruptcy Bill has barely focused on
the profound implications of all this.

The end result of making it harder for individuals to declare bankruptcy … Profit margins of
credit issuers, banks and investors in asset-backed securities go up, even as their base of credit is
still growing. Just when you thought it couldn't possibly get any bigger, the House Edge

So that we could get to know Bankruptcy Bill a lot better I spoke to Margaret Howard, a Law
Professor at Washington and Lee University in Washington DC who is an expert in bankruptcy
and commercial law. She is also visiting scholar at the American Bankruptcy Institute. I started
by asking her about the news of the record level of bankruptcies achieved over the past year.

Interview with Margaret Howard, Law Professor at Washington and Lee University

(25 minutes)
That was the interview I did with Margaret Howard, a Law Professor at Washington and Lee
University. Later on in our discussion Professor Howard also told me about the controversial
provision known as the "Homestead Exemption" whereby even after declaring bankruptcy, under
current law, in some states you can keep your home no matter what and creditors can't touch it.
This exemption seems to have come in rather handy for the Enron executives who recently seem
to have been doing a lot of home improvement, even as angry investors file law suits against
them. It might not surprise you to know that one of the States the Homestead exemption is
available is Texas, and another is Florida. Under a compromise reached in Congress, people in
these stated can still have their Homestead Exemption unless they are felons or convicted of
financial fraud.

We've seen how individuals and families can get robbed by banks and other creditors. Now lets
see how a small business can get robbed by a bank.

4) Bank-Robbing Banks

On April 2nd, a book distributor for small independent publishers, known as the LPC Group, sent
a letter out to its book publisher clients informing them that they were filing for Chapter 11
Bankruptcy because they had just been robbed … by a bank! The letter also told the publishers
that the money that was robbed had been due to the publishers for books sold to a wholesaler.

The bank that robbed them is a subsidiary of Bank One, a very large, quite profitable and well-
off bank, one of the largest in the country. LPC group, legally known as Publishers Consortium
Inc, is a customer of American National Bank and Trust Company of Chicago, a subsidiary of
Bank One acquired during its merger with First Chicago NBD during the late 1990's. They had a
business loan from American National and also a deposit account. This deposit account was used
to hold and then distribute funds from book sales of the small publisher clients. On April 1, some
monies came into this account from a wholesaler and were getting ready to be distributed back to
LPC Group's small publisher clients. But, all of a sudden, through the wizardry possessed only
by banks, the money vanished. The Bank took it! The money from the small publishers' book
sales was taken by the bank with apparently no notice to LPC or to the small publishers.

One of those small publishers who had their money stolen is Common Courage Press. Following
is an interview I did with Greg Bates at Common Courage Press about this strange Bank
Robbery …

Interview with Greg Bates at Common Courage Press about the Bank Robbery

(10 minutes)

After this interview I spoke with Doug Skalka, a lawyer in Connecticut representing the Bank.
He didn’t want to be recorded but told me the following.

• The LPC Group Loan from the bank was secured by the assets of LPC Group.
• The bank had a lien on all assets including inventory.
The heart of this bizarre case can be summed up as a disagreement over two disputed issues:

1) What caused LPC Group to be in violation of its loan agreement so that the bank could call it
in? I do not know the answer to this.

But the more important point for the publishers is:

2) What does the bank have a lien on? What are the assets of LPC group? Do they include the
proceeds of book sales? The publishers claim that such monies belong to them. After all, they
have already incurred all the expenses of publishing and putting the books together for
distribution in the first place.

Common sense would say that the money belongs to the publishers.

Nevertheless, as we already saw with Bankruptcy Bill, common sense is quite often set aside in
favor of vested interest when it comes to setting the Law of the Land under which the markets

That's all for the Wizards Chapter 13 Filing. Note that the Wizards of Money has a web site at

Part 14: "The Trade Federation and the InterGalactic

Banking Clan"

1. Introduction
2. The Deterioration of the Galactic Republic and the Emergence of the Trade Federation
3. A "Background Briefing" on GATS
4. A Huge Event in the History of GATS – European Union Member leaks the EU’s GATS
"Grab Bag" of Requests to Other Nations
5. The Ongoing Battle Between Corporations and States
6. How Breaking Your Own Rules Can Bite You in the Butt!

This is the Wizards of Money, your money and financial management series, but with a twist.
My name is Smithy and I'm a wizard watcher in the Land of Oz. This is part 14 of the Wizards of
Money series and it is entitled "The Trade Federation and the InterGalactic Banking Clan".

1. Introduction

In this, the fourteenth edition of Wizards, we are going to take a look at the Earthly
versions of the Star Wars Movies troublemakers known as the Trade Federation and the
Intergalactic Banking Clan, responsible for starting and financing the Clone Wars. Our
modern earthly descendants are known as the World Trade Organization and the US
Coalition of Services Industries, founded by financial services giants in the early 1980s.
These two bodies have formed strong alliances over the past two decades to bring us a
very special and powerful trade agreement known as the GATS – which stands for
General Agreement on Trade in Services. This agreement is said to cover international
trade in anything you can’t "drop on your foot" – that means anything from banking to
healthcare, childcare and education to communications and media to the postal service to
water treatment services.

As we will see, the GATS agreement poses significant threats to the future of critical
social services internationally and may empower corporations to challenge governments
over public funding of services such as education and healthcare. In this episode of
Wizards we’ll examine the implications of all this, see why GATS is now at a critical
stage of negotiations, and look at some leaked "shopping lists" from the European Union
that caused quite a stir in April this year.

But then…we’ll also see that the Earthly Trade Federation and Services Clans, while
demanding a huge grab-bag of goodies of the "can’t-drop-on-your-foot" variety, have
ended up shooting themselves in the foot. First, recent trade measures implemented by
the US to protect the steel and farming industries are themselves probably illegal under
existing trade agreements. Not surprisingly, the world outside America is fast losing
enthusiasm for lowering their own trade barriers further. Second, the recent wave of
corporate scandals across America has primarily come from the providers of services you
can’t drop on your foot – telecommunications (WorldCom and Global Crossing), energy
and water services (Enron, Dynergy and Vivendi), education (Edison Schools), banking
and brokerage (well – just about all the big ones!). The rest of the world is not amused!
They certainly don’t want such shady operators taking over their own services.

To get to know these trade issues better we’ll talk to Dr Pat Ranald at the Australian Fair
Trade and Investment Network, hear an excerpt from an Australian Broadcasting
Commission show call Background Briefing, and also hear the words of Democract
[corrected] ex-Senator Bob Kerrey and former US Treasury Secretary Robert Rubin
about the recent WTO-illegal moves of the US. We’ll also discuss a brief chat I recently
had with Ambassador Charlene Barshefsky, former US Trade Representative under the
Clinton Administration, about particular trade issues.

But first, to refresh your memory, or in case you thought the recent movies too cheezy for
your tastes – lets see how alliances between Trade Federations and Banking Clans can get
whole galaxies into a whole lot of trouble, based on a story from a galaxy far, far away …

2. The Deterioration of the Galactic Republic and the Emergence of the Trade Federation

This is from

"The Republic had enjoyed several centuries of growth and prosperity. It was inevitable
that its wealth would foster those with greed to match. The varied instruments of trade
and commerce banded together into galaxy-spanning organizations meant to aggrandize
their profits. Coalitions such as the Trade Federation, Corporate Alliance, Commerce
Guild, Techno Union and the Intergalactic Banking Clan consolidated their individual
markets under governing bodies of such size that they exhibited pull on the actions of the
Galactic Senate." They formed a separatist movement called the Confederacy of
Independent Systems, and geared up for war to destroy the Republic – "with promises of
reform and unyielding devotion to capitalism".

"The Trade Federation was a consortium of merchants and transport providers that
effectively controlled shipping throughout the galaxy. … It had attained enough clout in
the Galactic Senate, as if it were a member world".

"Helping control the incredible amounts of credits, dataries, and other forms of currency
flowing through the galaxy was the InterGalactic Banking Clan. This business entity
allied itself with the growing Separatist movement in the Galaxy, and IBC Chairman San
Hill personally committed his forces to the Confederacy of Independent Systems – in a
non-exclusive pact, of course." After all, he is a banker. "The IBC profited from both
ends of the clone wars", financing the efforts of both the Republic and the Confederacy
of Independent Systems.

And so began the Clone Wars between the Republic and the Independent Systems
Movement. These wars eventually culminated in the destruction of the Republic and the
formation of the Empire managed by the dark lord Darth Vader, once a Jedi Knight
trained in the pursuit of peace … but later tempted by all the attractions of the Dark Side.

The Imperial March…

3. A "Background Briefing" on GATS

Now, fast forward to the Trade Wars of the 20th and 21st centuries on Earth. Lets go to
1981 when, according to a briefing from the Transnational Institute (TNI) based in the

"the Chief Executive Officers of AIG, American Express and Citigroup concluded that
there was a need to form a broader business coalition to push the demand to include
"trade in services" in the GATT agenda. They mandated American Express Vice
President Harry Freeman to form a coalition of services industries that would reach well
beyond New York financial circles. In 1982 the US Coalition of Services Industries
(USCSI) was officially launched under Freeman’s chairmanship."

Note that the GATT is the General Agreement on Tariffs and Trade, and is basically the
umbrella agreement covering all these sub-agreements like GATS, which covers only
trade in services. These agreements are administered by the World Trade Organization or

The TNI document called "Behind GATS 2000" goes on to say "Between 1982 and 1985
USCSI worked closely with the US Trade Representative (USTR) and the Department of
Commerce to place services on the global trade agenda. In late 1983 the USTR submitted
a report to the GATT on the growing importance of services in the world economy… and
suggesting possible approaches to a new regime. When the GATT Uruguay Round was
launched in September 1986 … negotiations formally started on a multilateral regime for
trade in services within the GATT." This is the round of trade talks that ultimately gave
rise to the World Trade Organization (WTO) and the one in which the GATT (the
umbrella agreement) gave birth to an army of sinister-looking sub-trade agreements, one
of which was the GATS – covering services – and born in 1994.

The US services sector, spearheaded by the financial sector, had lobbied hard for this one
and they couldn’t be more pleased with their new baby, who is now eight years old. A
few years later the European services industries jumped on the bandwagon of lobbying
their governments hard for favorable provisions under the GATS. By June 30 this year all
WTO member countries had to submit their shopping "wish lists" to other member
countries. This means that they submitted a list of every service in other countries they
want their own corporations to get access to. The actual responses from countries will
start in March 2003. To date the discussion on "wish lists" and country positions have
been between big business and government, and definitely behind closed doors, with one
exceptional leak as we see in a minute.

There are four modes of services provision under the GATS – from e-commerce across
borders to a full commercial presence, which includes all foreign dierct investment
related to services provision. It is all the requests being made under this latter mode that
has lead many groups to conclude that GATS is largely a reemergence of the Multilateral
Agreement on Investment (MAI) in a new disguise. Recall that the MAI was shot down
in flames after the text of it was released to the public and spread across the Internet a
few years ago.

4. A Huge Event in the History of GATS – European Union Member leaks the EU’s GATS
"Grab Bag" of Requests to Other Nations

Speaking of leaked documents, the full text of the European Union’s GATS "wish list"
was leaked to the public in April 2002 causing an absolute uproar in many countries
around the world. Even though the EU demands on US services industries were pretty
heavy, we hardly heard a peep about this in the US media.

I found out more about this recently when I visited Australia. While there I heard an
excellent episode of a show called Background Briefing run on the Australian
Broadcasting Commission’s Radio National. The whole hour was devoted to GATS, and
here is an excerpt from it about the release of the EU GATS shopping list.
Excerpt from Background Briefing on ABC Radio Nation, produced by Tom Morton.

3 minutes.

That was an excerpt from ABC Australia’s show Background Briefing. That episode was
produced by Tom Morton.

The release of public documents that have come out of secret negotiations between
publicly funded officials and private interests can be quite shocking and can cause quite a
stir. They often get a lot of attention because of the realization of the extent of the
violation of the public’s trust, and the "giving away" of goods people thought were in the
public domain. But such leaks play a very important role in democracy and the system of
checks and balances needed to make it work. So too with these recently released
documents, which thoroughly shocked many and confirmed already existing suspicions
of others.

I will post a link to all these documents on the Wizards of Money web site at

One of the guests on this show was Dr Patricia Ranald of the Australian Fair Trade and
Investment Network. Since I thought she provided such good educational material I
decided to interview her for this Wizards of Money episode. Here is the interview I did
with Pat Ranald who helps us understand the GATS agreement and the dangers it poses
in more detail.

Interview with Pat Ranald of AFTINET

20 minutes

5. The Ongoing Battle Between Corporations and States

Under another agreement, the North American Free Trade Agreement or NAFTA, which is
already fully implemented, there is a special provision known as Chapter 11. This,
seemingly obscure, provision of NAFTA has received a lot of attention recently and journalist
Bill Moyers gave it some good coverage in his NOW show that runs on PBS back in February of
this year. I’ll put some links to this on the Wizards of Money web site at In that show it was explained that Chapter 11 of NAFTA enables a
corporation to directly sue a government for regulations or other government actions that
interfere with investments.

Whatever the intent of this provision its effect has been to encourage corporations to sue
governments over regulations that harm profits. To give you an idea of what’s going on and how
these provisions are being used here’s a sample of three cases that have been filed under NAFTA
Chapter 11.
1. UPS vs Canada Post: As discussed in the earlier interview, Canada Post, the Canadian
government funded postal system is being sued by UPS who claims that Canada Post engages in
a mail monopoly. UPS claims that Canada Post has an unfair advantage provided by its
monopoly infrastructure via a public system of post boxes and post offices. UPS wants access to
that same system or compensation for equivalent profits. No ruling has been made by the 3
member NAFTA panel.
2. Methanex Corporation vs US Government: This claim for $1 billion was brought by the main
supplier of methanol which is used to make a chemical known as MTBE, which is a fuel additive.
They were upset because the California State Government brought in a law that bans MTBEs in
gasoline because they had been found contaminating the water supply and causing health
problems. So they brought a claim under NAFTA for lost profits. No ruling has yet been reached
in this case.
3. Ethyl Corporation vs Canada: US Ethyl Corporation claimed that a Canadian ban on imports of
the gasoline additive MMT for use in unleaded gasoline was unfair expropriation. A Canadian
court subsequently found the ban to be invalid under Canadian law and a settlement was

Interestingly I had the opportunity to pose some questions about all this to Ambassador
Charlene Barshefsky, former US Trade Representative under the Clinton administration
at a meeting on May 30, 2002. I am an actuary and the Spring Meeting of the Society of
Actuaries was held at this time. She was the keynote speaker on May 30 and she spoke
primarily about, you guessed it, GATS! And also she spoke about how wonderful it
would be for the financial industry and how we, as financial professionals, should make it
clear what we want out of these agreements.

Not only is she a great big advocate of the direction GATS is taking but she is also on the
board of American Express, ultimately one of the founding fathers of GATS through its
founding role in the US Coalition of Services Industries. At the end of the "Go GATS"
pep talk I was the first to ask a question, because I really wanted to know about Chapter
11 of NAFTA. So I asked if she thought Chapter 11 was a big threat to regulation of
industry and democratic accountability. She replied that it was very controversial but it’s
intent was basically to prevent government stealing property. When I probed further into
this issue using the Methanex versus US case as an example of something different than
"stolen property" she responded that … No, that wasn’t really a NAFTA case, it had been
settled by state law.

I was soo confused that I just sat down and shut up at that point… What was she talking
about? It took me many months to find out. I sought information on these cases from the
Trade Representative’s office to no avail and then finally discovered that it’s the State
Department that usually defends these cases. You find a whole host of all the legal filings
on the State Department web site hidden away at…Looking
through these documents and also calling the State Department directly I discovered that
no ruling has yet been made in the Methanex case. In all likelihood, what Ambassador
Barshefsky did in her answer to me was confuse the Methanex case with the Ethyl
Corporation case, where the resolution of the contested law was purely a matter of
Canadian law, regardless of NAFTA. After all they both involved gasoline and
government names that start with a "C".
But my goodness, what is the world coming to when the former Trade Federation Chief
gets her cases mixed up! I rushed to order the tape of the session from the audio company
called AVEN, since the session was advertised as being one you could buy afterwards.
But they told me – at the last minute Ambassador Barshefsky refused to be recorded and
to have tapes made available. I’ll also put some links to the brochure for this session on
the Wizards of Money web site

How Breaking Your Own Rules Can Bite You in the Butt!

May 30, 2002 seemed to be chock full of interesting trade information. For, on that very same
day I also came across a discussion between former Treasury Secretary Robert Rubin, former
Nebraska Senator Bob Kerrey and former IMF chief Stanley Fischer who were talking at New
School University in New York. In that session which was aired on C-SPAN they basically came
right out and said that the US was breaking its own trade rules through the recently imposed steel
tariffs and farm subsidies. They were also quite candid about why the US will probably get away
with breaking its own rules. Here’s an excerpt – Bob Kerrey followed by Robert Rubin…

Robert Rubin and Bob Kerry discuss GATT-illegal steel tariffs and farm subsidies

C-SPAN recording at New School University, New York. May 30, 2002

3 minutes

That’s all for Wizards Part 14. Wizards has a web site at

Part 15: “Homeland Securitizations and Overseas Vacations” …

A Journey Through the Financial Twilight Zone

1. Introduction
2. The Twilight Zone … the "Other Dimension" of Financial Transactions
3. A Trip to the Financial Twilight Zone in a Special Purpose Vehicle
4. The Birth of the Mae Sisters and Cousin Freddie
5. The Securitization Atmosphere of the Investment Bankers
6. The Mechanics of the Special Purpose Vehicle
7. The Special Purpose Vehicles Parked at the Over-the-Counter Derivatives Casino
8. The Special Purpose Vehicle - Deluxe Version and the Banking Scandals
9. Securing Homeland Capital when Overseas Adventures Go Wrong

This is the Wizards of Money, your money and financial management series, but with a twist.
My name is Smithy and I'm a wizard watcher in the Land of Oz. This is part 15 of the Wizards of
Money series and it is entitled “Homeland Securitizations and Overseas Vacations”… A Journey
Through the Financial Twilight Zone.

1. Introduction

In this, the fifteenth edition of Wizards, we are going to take a look at the adventures that
financial institutions send their financial instruments on - both at home and abroad. On this
journey through the "Financial Twilight Zone" we'll look at some of the financial tricks receiving
attention in today's corporate and banking scandals, as well as the rescue packages available for
homeland capital getting into trouble in its overseas adventures.

On the issue of "Homeland Securitization" we will first look at the process known as
"Securitization", whereby anything that has a stream of cashflows emerging in the future can be
bundled up into a new financial security and sold for cash today. And that literally means
anything with a future stream of cashflows - from home loan and credit card repayments, to
David Bowie songs and football ticket sales, to health club membership fees, to insurance against
bad weather, and to the delivery of oil and gas by the now famous energy companies. We will
start with a look at the biggest Homeland Securitization market of all - that for home mortgages,
and some of its biggest players, from the banks to the mysterious bodies known as Fannie Mae
and Freddie Mac. We will look at the use of securitization and its associated "Special Purpose
Vehicles" as tools for regulatory avoidance and enhanced returns, and as the catalysts for Urban
Sprawl and daily Credit Card Solicitations. We'll also study the generation of what is known as
"Toxic Sludge" on federally insured bank balance sheets, the relationship between securitization
and the secret Over-the-Counter Derivatives Casino, as well as the hidden systemic risks that
don't get much attention.

In studying "Overseas Vacations" we will see how a summer trip to a Caribbean Island or a
Swiss chalet for the snow season can provide great regulatory relief for stressed-out financial
instruments securitized in the homeland. We take a critical look at the additional risks all this
regulatory avoidance poses for each of us as bank depositors and taxpayers.

2. The Twilight Zone … the "Other Dimension" of Financial Transactions

To get started we need to cross into a whole new dimension - the world in between the two end
points of a financial instrument or transaction. Just like the twilight zone wedged in between day
and night, this strange world in between a debt on my balance sheet and an asset on somebody
else's books, is occupied by a cast of characters the majority of people just quite can't see. You
might have heard some of the names, or some rumors about them, but you can never quite see
them clearly.

Before crossing into this "other world" underlying the financial system let's just get a taste of
how the regular daytime world we are used to interacts with this other dimension we can't see.

We all interact with financial instruments at one end or another of this mysterious twilight zone
of financial transactions. We do this by buying a home, shopping with a credit card, buying an
insurance policy, having a pension fund, or even going to watch a movie, or buying a book or a
CD. But few are aware that each such "every-day" action triggers a complex chain of events
rippling through the financial ether world.

For example, your home mortgage may have got bundled up with thousands of others, packed in
to a Special Purpose Vehicle and shuttled off to some remote island, split into 5 different
tranches, four of which have been bought and sold at least ten times in the market and one of
which ended up in the pension fund of your cousin in Chile. Layered on top of these five
tranches are hundreds of derivatives contracts, swapped over and again throughout the global
financial markets, one of whose positions was, quite by coincidence, taken by the insurance
company you bought a policy with when you took out your mortgage. In addition, you might be
interested to know that this insurance policy is actually no longer with the insurer you bought it
from. It's already off on a European vacation after being passed to a pool of European reinsurers
and, in the process of crossing the Atlantic Ocean, managed to drop the extra baggage of "safety
nets" required by US regulators to ensure the security of your future claims.

So … what's going on? To get started in understanding this "other dimension" you need to get
into a Special Purpose Vehicle to cross into the Financial Twilight Zone.

3. A Trip to the Financial Twilight Zone in a Special Purpose Vehicle

Having passed into the Twilight Zone in the only vehicle that can get you there, now you are
going to have a look around at the scenery and at the main players.

Entering the Twilight Zone, the first thing you will notice is that the atmosphere is thick with
financial securities and this takes the place of the regular air we are used to in the regular
daylight world. The quality and quantity of this twilight zone atmosphere is regulated by the
characters known as the investment bankers, who seem to be everywhere.

Traveling around the Twilight Zone you see some familiar faces … they look like the federally
insured banks that we are used to seeing during our daily lives, except that they are dressed a bit
differently and look very relaxed. Some - saying they are on a trip to Bermuda or the Bahamas -
are dressed in their shorts and swimming outfits. Others, dressed up in their skiing gear, say they
are touring the Swiss Alps. All in all, they say that the paths through places like the Caribbean
Islands and Switzerland make travel through the Twilight Zone a lot smoother. And certainly one
can easily see that, in this environment, the bankers are much more friendly and easy to get along
with than when you come across them in broad daylight. One thing that's a bit unsettling about
them though … When you look behind their banking houses you see piles of "Toxic Sludge" that
nobody in the Twilight Zone wants to talk about. When you question the bankers about whether
it's going to get cleaned up, the cheerful disposition suddenly vanishes and they give you a look
that clearly says "If you keep asking questions like that, you'll never make it back out into broad

Excerpt: Closing Statements, Twilight Zone Episode 52 1961. Rod Serling

Quickly moving on from that tense situation, you come across the insurers you are also used to
seeing in your daily life. They are dressed up in a similar fashion to the bankers though they are
not exactly as happy, they say, since they don't have the support of the federal deposit insurance.
However, it's the good deals from their mentors, the global reinsurers, that seems to cheer them
up a lot.

Over on the horizon you see two huge bodies, actually bigger than most of the bankers and
insurers dotting the landscape. You can't quite make them out, even when you get up close, but
they introduce themselves anyway as Fannie Mae and Freddie Mac. It's hard to tell what they
really are and the information you get from them is confusing. You ask them "Are you private
bodies or are you government bodies?" And you never get a straight answer. In fact every time
you ask, Freddie says private and Fannie says government. Then the next time you ask it’s the
other way around! As always, in travel throughout the twilight zone, investors are always
whizzing by, but when you ask them, they seem just as confused about the status of Fannie and
Freddie. So its best just to give up and move on.

Usually, if you are confused about the atmosphere of securitizations you can go ask one of the
investment bankers. For example, if you are confused about a certain type of financial instrument
you can ask them "Is that a debt, or equity, or maybe even a trading liability?" They'll usually
respond with something like "Well, that depends … What would you like it to be?" And they can
make exactly what you wish for - Just like Magic!

Excerpt: Closing Statements, Twilight Zone Episode 48 1961. Rod Serling

Moving along … we can just make out the outlines of some very dark objects, never seen in
broad daylight, called the Hedge Funds. They seem to congregate in and around a great big dark
building, also never seen in the daytime, called the Derivatives Casino. The car park at the
Casino is packed full with Special Purpose Vehicles. The bankers and insurers are often seen
coming and going into and out of this building - but only in the twilight zone, never in broad
daylight, of course, since the Casino doesn't exist in broad daylight.

At the center of the Twilight Zone is a complete black box, almost like a black hole. But instead
of everything being pulled towards it, what happens is that every time there is but a little ripple
emanating from the black box, it seems to cause a much bigger effect throughout the rest of the
twilight zone - first hitting the banks and then jolting Fannie and Freddie so that they sometimes
lose their balance. In this way, a little ripple from the black box, once it passes through the banks
and Fannie and Freddie, gets much magnified in its impact on the rest of the players. They call
this black box, of course, the Central Bank, or sometimes the Federal Reserve.

Such ripples that get magnified many times over can also come from other parts of the Twilight
Zone. Lots of times you can even see the implosion of one of the dark objects known as the
Hedge Funds or the crash of one of the larger speeding investors cause massive waves
throughout the Twilight Zone. Interestingly, ripples can also come from the daylight world that
we all live in, cross into this other dimension to cause massive destabilization then ripple back
out to the daylight world.
Well, I think that's enough of our visit for now. Once you get back in your Special Purpose
Vehicle and travel back into the regular daylight world where the regular people live, this
amazingly intricate "other world" known as the Financial Twilight Zone completely disappears
from view … but you know its still there.

Now that we are back out and can think clearly, lets talk in some detail about what we've just
seen … starting with the composition of the atmosphere - or the securities. But we can't do that
without first discussing those confusing objects called Fannie Mae and Freddie Mac that we just
met in the Financial Twilight Zone.

4. The Birth of the Mae Sisters and Cousin Freddie

Securitization in its modern form was, like many a financial invention, initially born out of
desperate times. Recall that in Wizards Part 10 we spoke of the regulatory blitz of the 1930's
during the Great Depression that brought in many new banking and stock market rules, such as
the Glass-Steagall Act and the Securities and Exchange Commission. Such regulatory blitzes
really only come along in times of utter desperation, like a complete financial and economic
collapse, and they only come along because they have to. Because you can’t get the economy up
and running unless you bring in some regulations to bring back confidence - the main ingredient
for a functioning economy. Restoring confidence in the financial system and stimulating credit
creation was a primary aim of the banking rules and federal deposit insurance implemented
during the Great Depression that was discussed in Wizards Part 10.

This was also the primary aim of another act we did not get to speak about in Wizards Part 10 -
that is, the National Housing Act of 1934. The National Housing Act saw the introduction of the
Federal Housing Administration, or FHA, whose primary function was to provide insurance of
home mortgage loans made by private lenders. This insurance meant that a lender would be
repaid by the government in the event of loss on default by mortgagees. During such hard
economic times this mandate of the FHA would stimulate credit creation by banks and other
lenders for investment in home building which, in turn, would provide more affordable housing
and create jobs and stimulate further economic growth. Simultaneously, the government
insurance backing would shore up confidence in the now shaken and much mistrusted financial

The practical implementation of this federal mortgage insurance took the form of the chartering
of a government corporation to buy and sell the mortgages that the government would insure.
The first such corporation was set up in 1938 and called the Federal National Mortgage
Association, also known simply as "Fannie Mae".

In 1968 they split Fannie in two and made a twin sister out of her that they called Ginnie Mae
(short for Government National Mortgage Association). Ginnie stayed with the government
doing what Fannie used to do and Fannie ventured off into the private markets. Fannie became
fully owned by private shareholders, yet with a Charter and Mandate specified by Congress.
Instead of complying with SEC rules and other rules that apply to private enterprises, Fannie is
instead regulated by the Department of Housing and Urban Development (or HUD) who tells her
basically what business to be in, and also by the Office of Federal Housing Enterprise Oversight
who monitors her financial stability. Occupying that special area of the Financial Twilight Zone
that is not quite government, not quite private enterprise, Fannie Mae is instead referred to as a
Government Sponsored Enterprise or GSE.

Before long it was thought that the Mae sisters were lonely and so they made up a cousin
officially called the Federal Home Loan Mortgage Corporation, but known as Freddie Mac, who
looks a lot more like Fannie than Ginnie. Freddie is another GSE or Government Sponsored
Enterprise, owned by private shareholders but regulated by HUD.

The job of Fannie and Freddie has been to provide an active secondary market for the home
mortgages of low to middle income families. That is, while they don't make home loans directly
themselves, they buy individual home mortgages from primary lenders such as banks and
mortgage companies, package together bunches of these loans and sell them back into the capital
markets as mortgage-backed securities. The primary objective of creating such active secondary
markets for these mortgages is to make sure that enough capital is available for affordable
mortgages for families with low to moderate incomes. Without the ability to sell off such
mortgages for cash to another party, banks and other lenders would make less loans in the low to
moderate income groups and/or charge higher interest rates for fear of default and burdensome

Up until the 1980s the mortgage-backed securities issued by these entities looked more like what
is known as simple "passthroughs", whereby an investor in a security issued by Fannie or
Freddie simply got a share of the interest and principal paid by the underling group of
mortgagees, with a guarantee on repayment provided by Freddie Mac or Fannie Mae. But the
deregulatory blitz of the 1980s ushered in the rise to power of the investment banking class and
the corresponding rapid development and population of that parallel world known as the
Financial Twilight Zone we got to visit earlier. And so began a totally new world of asset
securitization, the very stuff underlying this parallel financial universe…

Excerpt: Closing Statements, Twilight Zone Episode 51 1961. Rod Serling

5. The Securitization Atmosphere of the Investment Bankers

One of the problems with the "passthrough" type securities mentioned earlier is that the cashflow
stream is uncertain. It can be very long, with long fixed rate mortgages, and can also change
suddenly if interest rates drop and mortgagees decide to prepay their loans. This can make such
investments quite unattractive to say, long term investors such as pension funds and insurance
companies who are looking for guaranteed payments long into the future. Furthermore, shorter-
term investors might find these instruments altogether unattractive.

Investment bankers of the 1970s and 1980s invented a different type of mortgage backed security
to get around these problems. Basically, given a pool of home mortgages, you could come up
with a series of different tranches of securities or bonds or notes that you would issue against that
pool. The first, or senior, tranche from the pool would have a fixed interest rate and set principle
repayments and be the first set of cashflows to be paid out of the pool. The next tranche might
only get interest payments and then start getting principle only when the senior tranche is fully
paid off, and so on all the way down to the Z-tranche or the "toxic sludge" of leftovers that only
gets repaid once ever other tranche is repaid. The senior tranche is the most secure instrument
and so gets the lowest interest rate. The toxic tranche is more like a speculative investment and
has a high potential yield but also high risks associated with it. In this way, a pool of pretty
unglamorous and ordinary mortgages could give birth to a smorgasbord of different financial
instruments to suit anyone's tastes.

The wild capital markets of the 1980s thought this was just about the most fantastic monetary
invention since fractional reserve banking and they were wild about it! Fannie and Freddie alone
have grown to have trillions of dollars of home loans under their belts using this new wizardry.
Not only has this invention helped the GSEs - Fannie Mae and Freddie Mac - provide ever more
capital for home financing, it has also facilitated secondary markets in mortgage-backed
securities issued by various other bank and non-bank entities. This invention that was able to turn
the humdrum home mortgage into a slew of fancy securities to match anyone's desires multiplied
the attractiveness of mortgage-back securities many times over and, consequently, capital has
been flooding in to the mortgage market ever since. In retrospect then, you might put more blame
for the phenomenon of urban sprawl on the investment bankers than anyone else!

But the growth of the Financial Twilight Zone did not stop there! For it was soon realized that
anything with a future stream of cashflows could be bundled up in such a fashion and have a set
of designer financial instruments issued against that bundle. By the late 1980's auto loan and
credit card receivables were being bundled up in such a fashion. By the 1990s the securitization
market was extended to cover future record and movie sales, health club membership fees, tax
liens, life insurance policies and catastrophe insurance, to name a but a few. Name anything with
a future stream of cashflows, and it can be securitized! Notably, in the late 1990s we also saw
securitization become used more and more by banks to sell corporate loans off to the capital
markets. Citigroup and JP Morgan Chase's activities in this area have recently received a lot of
attention, as we shall discuss later.

Securitization is attractive to both the issuer and the investor in the new securities for various
reasons. We already talked about how these instruments have been designed to be attractive to
the investor. For the issuer - that is, the one who originated the mortgages or first hooked you on
a credit card - securitization has several attractions. One, especially so for banks, is to free up
regulatory capital, or the "safety net" for depositors that we spoke about in Wizards Part 2 and
11, so it can be used in the next Wizard adventure. It should be noted that the current rules
specifying the level of "safety nets" that bankers must maintain in the form of shareholder
capital, actually encourage banks to remove low risk assets from their books and retain the
higher risk assets. Another attraction of securitization is the removal of undesirable assets from
the balance sheet, and into "off balance sheet" vehicles. Other attractions include that
securitiztions issued through an SPV can be a cheaper way of raising capital and increasing
liquid assets, rather than having to go directly to the capital and debt markets.

What this explosion in securitization has done is to create an explosion in the availability of
capital for investment in whatever is being securitized. Hence we have seen an explosion in
credit card offers, home equity loans and basic home loans, auto loans, corporate financing,
media and entertainment financing, and so forth. Like placing the blame for the explosion in
urban sprawl in the past decade, you might also need to credit the innovative investment bankers
for all the credit card solicitations you get every day, as well the design of transactions that have
allowed corporations to hide debt, and construct other accounting wizardry.

So what does all this have to do with Special Purpose Vehicles and the fact that so many
characters in the Financial Ether seem to be hanging out on Caribbean Islands and Swiss Alps?
To understand this, we better get back to our Special Purpose Vehicle and look at the mechanics
of it.

6. The Mechanics of the Special Purpose Vehicle

The more traditional Special Purpose Vehicles, or SPV Version 1, work as follows. The party
with the loans or other receivables to be securitized is known as the originator and they transfer
these loans or receivables into a Special Purpose Vehicle to isolate them from the originator. The
SPV raises funds from the capital markets to pay for these transferred assets and this money goes
back to the originator. The way these SPVs raise funds is by issuing notes or securities in the
form of bonds to investors. Such notes or bonds then give these investors a claim on the assets
held by the SPV and, in theory, the claim is supposed to stop there. That is, in a true transfer of
risk via the securitization process there should be no extra claims on the originator. Part of the
reason for Enron's rapid demise last year was that, in this case, there was a contingent claim of
the investors back on the originator (Enron) in many of their SPV's. Based on recent regulatory
rulings from the main bank regulators, there seems to be some hidden guarantees lurking behind
bank securitizations, too - part of the "Toxic Sludge" we spotted earlier in the Twilight Zone.

The notes issued against the assets held in the SPV can be designed to give rise to the many
types of varieties of instruments to suit different types of investor needs, as we spoke about
earlier for mortgage back securities. But what's interesting here is that the highest risk tranche,
the equivalent of the Z-tranche for the mortgage-backed security, also known affectionately as
the "Toxic Waste" of the securitization, is often retained with the originator. That is, even though
it might look like the originator has gotten the assets and associated risks off of its balance sheet,
they actually retain the most risky part! And this is in addition to the toxic sludge hidden
guarantees we just spoke about that the bank regulators have recently issued statements on. The
behavior of both of these rapidly growing poisonous piles has not yet been tested in an economic
downturn, and it’s a hidden risk in the Financial Twilight Zone that nobody seems to want to talk

To avoid any extra taxes, regulations and disclosure rules associated with putting an SPV
between the originator and investor, especially the more regulated originators such as banks,
many SPVs are set up in favorable tax and regulatory jurisdictions. Hence the preponderance of
them in places like the Bahamas, Bermuda, Cayman Islands, Channel Islands and so forth. In
addition places like Switzerland and the Switzerland of Latin American, Uruguay, are favorite
places for limited taxes, regulatory avoidance and bank secrecy.
Here are some interesting words from Senator Carl Levin of the Permanent Subcommittee on
Investigations at the July 23, 2002 hearings on JP Morgan Chase and Citigroup's use of such

Excerpt: Senator Carl Levin "Wizards behind the Curtain" July 23, 2002 Hearing

We'll hear more on this hearing and what happened there a bit later.

7. The Special Purpose Vehicles Parked at the Over-the-Counter Derivatives


Recall on our journey through the Financial Twilight Zone we could just make out the figures of
the shady Hedge Funds and the outline of the Over-the-Counter Derivatives Casino with a lot of
Special Purpose Vehicles in the parking lot. What was that all about you might be wondering?

Recall that we spoke about the OTC Derivatives Casino in Wizards Part 11. There are several
types of derivatives games that might be played in conjunction with securitization. Let's just talk
about a couple of them:

First are the derivatives that might be used in relation to interest rates. Take for example the huge
pools of mortgages on the books at Fannie Mae and Freddie Mac. Fannie and Freddie are buying
pools of mortgages from banks (who issue the regular mortgages to regular people like you and
me) and then selling these cashflows off in the form of much different securities. The revenue
from the mortgages will come in over the lives of these mortgages, but their dues back to the
securities holders is often due in a different pattern, and often over a much shorter period than
the mortgages. If interest rates suddenly change direction Fannie and Freddie could find
themselves in a whole lot of trouble. So, they say, they hedge this risk by entering into some
offsetting gambles at the OTC Derivatives Casino. An interest rate derivative contract basically
says that your counter-party will reimburse you if interest rates move in a certain direction.

But how do we know that this hedging makes them safe and sound? They are not regulated by
the bank regulators nor by the SEC because of their special status in between something that's
government and something that's private. Furthermore the OTC derivatives market is not
regulated. How well hedged are Fannie and Freddie, and who are their counterparties - the big
US banks maybe? After all, they are the biggest players at the OTC Derivatives Casino. And
what about credit risks - Fannie and Freddie basically stand behind all these mortgages and bear
the risks of default of mortgagees. What potential risks does all this impose on the US bank
depositor and taxpayer?

On this topic, one of the biggest concerns arises from Fannie and Freddie's peculiar status of
being mostly private but partly government bodies. Therefore there has been a perception among
investors in their securities, and maybe their derivative counterparties (the banks) that Fannie and
Freddie would get bailed out by the US Taxpayer if they ever got in trouble. This may have lead
some "too-big-fail" players into risks they shouldn't be taking - but we have no way of knowing
with so much of these markets permanently operating in the Twilight Zone and never exposed to
the daylight.

Excerpt: Closing Statements, Twilight Zone Episode 46 1960. Rod Serling

There is a whole array of other derivatives gambles going on that, recently, have been causing
alarms to sound in the bank regulator circles. This includes the Toxic Sludge generated by
hidden guarantees (sort of like hidden insurance or derivatives) that can only be seen in the
Twilight Zone. Similar things reared their ugly heads in the Enron scandal, but we have heard
much less about them in terms of what the banks are doing and what the bank regulators have
lately been observing on the bankers' books. Shocked by the recent scandals the four main US
banking regulators issued a series of "Supervisory Letters" on May 23, 2002 about the so-called
Toxic Sludge (though they didn't call it that) they have found on the bankers books. The press
generally seems to have missed this. I'll post some links to the Supervisory Letters and
explanations on the Wizards of Money web site.

To learn more about this aspect of the bankers backyard toxic sludge it is informative to read a
May 23, 2002 Supervisory Letter issued by the Federal Reserve Board saying that over the past
few months the bank regulatory bodies "have become aware of a number of instances in which a
banking organization provided credit support beyond its contractual obligation to one or more of
its securitizations". The latter part means that these guarantees have been provided outside of
legal contracts, and hence away from the view of regulators and completely in the Twilight
Zone. What this means is that, while the banks are acting as if all risks underyling these
securitizations have been completely removed from their balance sheets (and hence they hold
NO associated safety net) they are in fact taking on invisible risks. In a way these hidden
guarantees behave like derivatives or insurance on the assets being securitized, and as such
hidden guarantees came back to haunt Enron, so they could the banks. Just what banks are taking
these risks, why they are taking them, and how severe the problem is, cannot be ascertained from
these Federal Reserve Supervisory Letters. But this issue should be watched closely.

8. The Special Purpose Vehicle - Deluxe Version and the Banking Scandals

In yet another type of derivative transaction, credit risk is the main focus. Not only have banks
and others been using Special Purpose Vehicles to securitize their corporate bond and loan
portfolios, but now they have come up with Special Purpose Vehicle Version 100 - the Virtual
Special Purpose Vehicle - to "effectively" transfer credit risk. These "synthetic obligations" now
come in many forms - from Synthetic Corporate Debt Obligations to Credit Linked Notes to
Credit Default Swaps. Without going into how these work, we just note that this is a very new
and rapidly growing area of the OTC derivatives market and has really caught worldwide
financial regulators by surprise, and actually made them extremely nervous. This market is so
new that it has not been tested in a down market and, already, we saw two such transactions blow
up in the big banks' face during the Enron Scandal.

Citigroup had set up a Credit Default Swap transaction through a Special Purpose vehicle called
Yosemite that was a focus of the July 2002 US Senate Inquiry into the role of banks in the Enron
Saga. At the end of the day the transactions through these vehicles which appeared to involve oil
and gas trades, enabled Enron to disguise true debt as the more appealing trading liabilities, and
thus made Enron look like they were in better financial shape than they actually were. Citigroup
opted for the Yosemite vehicle structure to enable it to pass the credit risks (or risk of default)
into the capital markets - they surely didn’t want to take such risks themselves! Perhaps they
already knew too much. While the Senate investigations did a good job at revealing this
accounting wizardry at Enron, so far neither the Senate, nor Congress as a whole, nor the general
press, have gotten themselves worried about the broader risks underlying the credit derivatives
market as a whole, and its total avoidance of the daylight in its five or so years of existence.

The following is an excerpt from the July 23, 2002 Senate hearing into Citgroup's role in the
Enron Saga. Included is a description of how the Yosemite vehicles were set up. What's
interesting here is that, while Senator Fitzgerald initially addresses his question to Maureen
Hendricks, a managing director on the Investment Banking side at Salomon Smith Barney, it is
in fact Mr Richard Kaplan, head of the Credit Derivatives division at Citigroup that has to step in
and explain the structure. After all, as is explained early on, the Yosemites were his babies - this
invention is only befitting of the deepest, darkest warps of the Twilight Zone.

Excerpt: Richard Kaplan, Head of Credit Derivatives at Salomon Smith Barney/Citigroup

explains the Yosemite Structure. Initial comments by Maureen Hendricks of Salomon Smith
Barney with some questions from Senator Fitzgerald. 5 minutes.

After hearing all this you might be wondering why investors would be wanting to take on this
credit risk by buying the Yosemite Notes. Interestingly, one of the conditions specified in the
offering prospectus was that investors WOULD NOT KNOW the details of the assets underlying
the Yosemite Notes. And these investors turn out be our trusted banks, insurance companies and
pension funds, with no doubt some big time hedge funds thrown in for good measure. It’s best to
let the bankers tell this story about the so-called "blind trust" notes:

Excerpt: Kaplan and Hendricks of Salomon Smith Barney tell us about "blind trust" notes in
the Credit Derivatives game and our pension funds not knowing what they're investing in.

Not to be outdone, JP Morgan Chase offered similar debt-hiding transactions to Enron through a
vehicle known as Mahonia based in the Channel Island Jersey and, as it turns out, owned by a
Charitable Trust. First we'll let Mr Delappina, Managing Director at Morgan Chase Bank NY
gives us a little refresher on structured finance, securitizations and how this applies to their
dealings with the Energy Companies.

Excerpt:Delappina of JP Morgan Chase Bank NY on Structured Finance

One of the conditions for Enron being able to treat these truly debt transactions as benign trading
liabilities for oil and gas trades, was that the intermediary Mahonia had to be independent of the
banks and independent of Enron. While Mr. Delappina dis a splendid job of painting us a picture
that that actually was the case, Senator Carl Levin of the Senate Investigative Committee soon
points out that this picture is not a very accurate one, and that in fact the Chase Bank did have
control over Mahonia via the so-called "Charitable Trust". Lets listen to this interesting exchange
between Delpinna and Levin at the July 23, 2002 Senate Hearings.

Exerpt: Senator Levin and Mr Delapinna from JP Morgan Chase paint different pictures of
the "Charitable Trust" involve in JP's Enron dealings.

Note: Due to time contraints on the Audio File, the following did not make it into the audio
version of Wizards Part 15 but will be covered in more detail later...

[9. Securing Homeland Capital when Overseas Adventures Go Wrong

The July 23, 2002 Senate hearings into the involvement of the two largest US banks in financing
various Enron scams rippled throughout the markets and placed the spotlight on the spookiest
risks these banks are exposed to, not the least of which being their massive OTC derivatives
exposures. Not to mention their exposures to emerging or developing countries, and large
remaining exposures to the Telecos and Energy companies.

Weeks after this hearing the country of Brazil, dealing with a falling currency, looked like it may
default on its debt. Given the almost $30 billion exposure of the biggest US banks to Brazilian
borrowers its probable that confidence in these banks would have been dealt permanent harm if
Brazil defaulted. According to an August 8, 2002 Wall Street Journal article, the banks put a lot
of pressure on the US administration to push for an IMF bailout of Brazil. Soon enough a sizable
$30 billion bailout package was offered to Brazil to help it stabilize its currency to prevent
default on its debt linked to the "hard currencies". These are the sorts of events that we spoke
about in Wizards Part 5. As anticipated by the US banks this helped restore confidence in them.

Within days, downward pressure was already back on the Real, the Brazilian currency. It will be
interesting to see if the big US banks reduced their exposure to Brazil following the IMF bailout
announcement, hence helping themselves while compounding Brazil's problems. It would also be
interesting to know if the speculative hedge funds, and the trading arms of the banks themselves,
are back to their usual tricks in the arbitrage game and attacking this weak currency. We spoke
about this common play, or form of monetary attack, in Wizards Part 5 - called Monetary
Terrorism. This arbitrage game basically drains out the bailout and other reserve funds from a
country very quickly and is a primary catalyst for the collapse of currencies.

As we've discussed in earlier episodes of Wizards, these bailouts also pose significant moral
hazard, whereby "too big to fail" banks take excessive risks with our deposits, knowing they will
always get bailed out. Hence the systemic risks throughout the global financial system are
increased with every bailout.

Whatever happens in Brazil and the rest of Latin America now, it certainly appears that much of
the rationale for this IMF bailout was aimed at financial security for the US Homeland.]
That's all for Wizards of Money Part 15. Note the Wizards of Money has a website at

Part 16: "There's a Generic in my Shark Fin Soup!"


1. Introduction
2. Predator-Prey Dynamics in the Drug Sea
3. Attack of the Generics! Meet the Shark Fin Curve
4. A Little Bit of US Drug History
5. The Anatomy of a Counter-Attack from Big Pharma
6. The Next Blockbuster Drug - What will it be? A "Youth Pill"
7. Market Failure of the Patented Medicine Model. HIV/AIDS rips in to China and Russia.
8. A Remedy for the Ills of the Current Medicine Model

This is the Wizards of Money, your money and financial management series, but with a twist. My name
is Smithy and I'm a wizard watcher in the Land of Oz. This is part 16 of the Wizards of Money series and
it is entitled "There's a Generic in my Shark Fin Soup!"

1. Introduction

In this, the sixteenth episode of the Wizards of Money, we're going to take a look at the world of
drugs - the legal ones, that is. The star of this episode is the only industry more profitable than
the commercial banking sector throughout the 1990s - and that's the pharmaceutical industry, of

We'll start with a look at the recent wave of pharmaceutical mega-mergers and what's driving
them … from the ominous "Shark Fin Curve", to the search for the elusive "Blockbuster Drug",
to the need for ever more shelf space. Then we'll look at the battles between the brand name drug
companies and the generic companies, governments, and the other big giants of healthcare - the
managed-care companies.

This journey through the shark-infested world of "legal drugs" will give us a good look at the
bizarre human behavior that results from allowing the capital markets and the patented medicine
model to dominate decision-making in one of the oldest of human pursuits…finding remedies for
human illness. Allowing this behavior to continue unfettered may very well end in the capital
markets giving themselves an incurable disease. For, while the capital that flows into drug
research and development is obsessed with a couple of shark fins on the horizon, it is failing to
notice the tidal wave swelling just over the horizon. This tidal wave is the global HIV/AIDS
crisis, already striking at the very thing the capital markets need to survive.

Far away, in the land where Shark-Fin soup is a high-priced legacy of Imperial times, HIV/AIDS
is rearing its ugly head. As the epidemic rips in to China, will the US be able to continue its
token level support for this crisis of the developing world? Or will this threat to the labor force of
a major trading partner provide the shock necessary to remind us that illness prevention and cure
is, after all, a social service that does not fit well into the confines of 20-year patent monopolies.
And will the exponential growth of HIV/AIDS in Eastern Europe and the former Soviet states,
right on the doorstep of the European Union, wake up the rest of the West to the need to either
act now, or risk losing their global marketplace?

Let's get started with a discussion of what's been going on in the world of patented drug

2. Predator-Prey Dynamics in the Drug Sea

A July 16, 2002 article in "The Economist" announced the union of the two drug giants Pfizer
and Pharmacia by opening "Depressed, bald-headed men with erectile dysfunction should be
especially pleased." The companies that make the world's leading treatments for baldness,
depression and Mothers Nature's way of telling gentlemen their reproductive years are over, have
combined to become the world's biggest legal drug giant. The Pfizer-Pharmacia combo boasts
over $50 billion in annual drug sales and spends about $7 billion a year on Drug R&D (Research
and Development), plus another $3 - 4 billion on drug advertising.

As in most industries, the capital markets drive the classic predator-prey dynamics of the
pharmaceutical sector. You either eat…Or you get eaten!

The Pfizer digestion of the smaller Pharmacia, announced in July 2002, was just the latest
episode in the struggle to the top of the food chain. Let's go back to 1995 when much of the
mega-merger madness was just heating up. In that year, Glaxo Holdings gobbled up Wellcome
Plc to form Glaxo-Wellcome. The following year the Swiss drug giant Novartis was formed out
of the merger of Ciba-Geigy and Sandoz. 1998 saw the creation of Aventis out of the fusion of
smaller drug companies and AstraZeneca from Astra and Zenenca. About a year later Pharmacia
& Upjohn thought Monsanto looked pretty tasty, so they swallowed them whole, only to spit out
the controversial agribusiness piece in August of this year. Also in 1999 we saw Pfizer swallow
Warner-Lambert. Glaxo-Wellcome and Smith-Kline-Beecham were fused together to form
GlaxoSmithKline in 2000. And just when we thought the mergers couldn't get any bigger - Pfizer
and Pharmacia announced their merger, pending regulatory approval, in July 2002 to outsize
GlaxoSmithKline, and become the biggest fish in the drug sea.

And there are rumors of yet more drug mergers on the horizon!

The modern pharmaceutical industry has its origins in the late 1800s when it became possible to
mass-produce compounds such as morphine and cocaine. By the early twentieth century drugs
and compounds were patented by various companies to protect their discoveries. A patent on a
branded drug or chemical gives the company a monopoly on sales of that chemical for a
specified period, enabling them to set high prices in the absence of competition. The argument
for patent protection is that it enables the developer to recover their investment in R&D plus a
profit, hence providing incentive to private industry to find new cures. However, in order for the
company to lure customers into buying such a high priced product they also need to spend a lot
of money on advertising and marketing to convince people that it’s a very special product. There
are many arguments both for and against the patent model for pharmaceutical development and
we shall revisit these later.

Today, the brand name drug companies look nothing like their chemical commodity
predecessors of the 1800s. New products require large investments in R&D and take a long time
to bring to market. The drug giants are dependent on patents, marketing and branding to make a
profit. Consequently, the pharmaceutical sector has more in common with the Hollywood movie
industry than with any public service provider - A new drug must become a profitable
"Blockbuster", or it's not worth the effort to develop it.

In contrast, generic drug companies spend comparatively little on R&D and advertising, existing
primarily to compete for market share based on price once a patent on a brand name drug has
expired. Once such a patent expires, generic companies can copy the drug and can afford to sell
it at a lower price (as low as a quarter of the branded drug price) since they don't have as much
R&D and advertising costs to recoup.

After roaring successes and record high profit levels throughout the 1990s, today we find that all
is not well in the world of blockbuster remedies. Ailments in the branded pharmaceutical sector
include looming patent expiries and the resulting competition from generic companies, a drug
R&D pipeline that is drying up, and angry governments, corporations, consumers and managed-
care companies tired of high drug prices.

These common enemies are forcing all these unions amongst the drug giants who hope that
consolidation will allow them to do more of their two favorite things at lower cost. These two
things are (1) Advertise and (2) Produce Blockbusters. The future dangers to the general public
of all this industry consolidation, in terms of even higher drug prices and, more seriously, the
lowered ability of the pharmaceutical sector to respond to real illness, are not getting much
attention. The latter is reflected not only in the untreated epidemics haunting the developing
world, but even here in the US, with increasing reports of shortages of basic medicines and
vaccines at many hospitals.

These problems are all compounded by the fact that drug companies are fighting dirtier and
dirtier to counter the 'Attack of the Generics'.

3. Attack of the Generics! Meet the Shark Fin Curve.

A story in the Wall Street Journal in June of this year about the birth of the much touted
heartburn drug Nexium gave many people their first good look at the importance of the "Shark
Fin Curve" haunting the pharmaceutical industry. You must know the Nexium ads, with a bunch
of middle aged folks standing around in some canyons that presumably represent an eroded
esophagus, all mumbling "I didn't know, I didn't know, I didn't know".

Insert: Nexium Ad

Well, I bet they didn't know this…The only reason Nexium exists is that its predecessor,
Prilosec, which is almost exactly the same - is coming off patent. It's sliding right down the other
side of the Shark Fin Curve. This eroded esophagus business is all about making the new
patented drug Nexium seem different to the one that will now be copied by the generics.

The Wall Street Journal article describes the Shark Fin Curve as the Sales versus Time graph of a
patented drug. It looks like an upside-down "V". As soon as a patented drug is launched,
revenues generated by it shoot up over time like the rising edge of a shark fin. But the minute it
comes off patent they plunge just as quickly as they rose, as the generic companies come in,
copy the drug, steel market share and force prices to drop. We'll talk more about Shark Fins and
eroded esophagi later when we look at some case studies of how the big drug companies fight
back against generic competition.

During the roaring 90s the pharmaceutical industry always seemed to be topping the charts as the
most profitable. We are all familiar with the Blockbuster Drugs who made this dream a reality
and have become celebrities in their own right - there's Viagra, Vioxx, Celebrex, Claritin,
Nexium, Prilosec, Lipitor, Rogaine, Zocor, Zoloft, Prozac, Paxil and Lamisil - to name but a few.
Some will be on patent for many more years but others are soon scheduled to come off patent.
Many patented drugs are simply 'me-too' drugs, designed to achieve the same effect as other
patented drugs, but really add little value to society as a whole. To overcome lost revenues from
patent expiries and the me-too drugs, each drug giant needs a certain number of new blockbuster
drugs emerging from the R&D pipeline every year. Massive advertising campaigns are then
designed to sell enough of the drug at a high enough price to recoup the R&D and advertising
costs plus a target profit level.

But the big pharmaceuticals, much to their dismay, are finding that the blockbuster drug cabinet
is bare, even after throwing piles of dough into the R&D bucket. Despite the extensive range of
the silliness of the illnesses for which blockbusters can be made to remedy, such as toenail
fungus and hair shortfalls, big pharma is still finding that it can't find enough new drugs to bring
to market. This makes them more desperate to maintain high revenues on existing patented
products, so they pour more and more funds into advertising and into fighting the generic
companies in court.

End Result: Profits are down in the pharmaceutical industry and the near future looks glum. And
we get to see even more drug ads!

Add to all this the following pressures on the drug giants:

• European governments dare to regulate prices of their precious Blockbusters,

• US State Governments are now cracking down on some of Big Pharma's desperate practices to
shut out the generics,
• Drug companies get pressure from managed-care companies to lower prices,
• Drug companies now face a whole new set of giants - a coalition of corporate giants called
"Business for Affordable Medicine" - whose healthcare expenses have been shooting up with
the cost of prescription drugs. This coalition includes such behemoths as General Motors and
Wal-mart (for example General Motors pays over $50 million a year just to buy the heartburn
drug Prilosec for its employees and they are not happy).

It looks like the drug companies, poor things, could use a dose of their own anti-depressants!
True to form, however, the pharmaceutical industry is not one to take all this lying down. It's
fighting back on all fronts, in a series of vicious attacks, coupled with consumer manipulation
that so characterize a desperate industry.

Before we study the attack strategy of big pharma, lets get to know the industry a little better and
the regulation that defines its operating parameters.

4. A Little Bit of US Drug History

Miracle drugs and pervasive drug advertising have been a staple of the American diet for both
the body and the mind for over a hundred years.

After more than 30 years of pressure for food and drug safety laws, the year 1906 finally ushered
in the landmark Pure Food and Drug Act, amid shocking disclosures of the use of poisonous
food additives and cure-all claims for worthless and dangerous patent medicines.

In 1927 the Food and Drug Administration (FDA) was formed as the regulatory arm of the
government charged with enforcing food and drug law. The pharmaceuticals lost their battle
against an overhaul in drug regulation in 1937, after a drug known as the Elixir of Sulfanilamide
killed over a 100 people, including many children. This paved the way for the passage of the
1938 Food, Drug and Cosmetic Act which, among other things, required new drugs to be shown
safe before they could be marketed. The Thalidomide scare of the early 1960s put pressure on
Congress to further strengthen drug regulation. Still, the brand-name companies continued to
prosper because they could set whatever price they wanted on patented drugs.

The year was 1984 when pharmaceutical companies first started seeing those shark fins emerge
on the horizon, with the passage of the landmark Hatch-Waxman Act. Prior to this, generic drug
companies had to perform the same rigorous testing on generic drugs that the companies with the
initial patent had to perform. This made competition from generics virtually a non-issue because
the investment required to get regulatory approval could only reasonably be recovered where the
producer could charge a sufficiently high price for the drug once approved. In practice, this
meant that the pre-Hatch-Waxman regulatory structure was heavily biased in favor of the
companies with drug patents - that is, the brand name drug companies.

The 1984 Drug Price Competition and Patent Term Restoration Act (often referred to as the
Hatch-Waxman Act) changed the drug competition landscape drastically by lowering the
regulatory hurdles for generic companies. It said that, rather than the generic companies
performing all the safety tests that the original company with the patent carried out, they just had
to show that the generic drug was chemically the same as the original drug, which had already
been tested. Finally, there was a feasible economic model for the generic industry. Once a patent
expired on a drug, they could replicate and sell that drug for a lower cost and still make a profit,
because their initial costs to get the drug to market were now much lower.

Well, that part of the 1984 law sounds pretty good for the consumer! But lets be realistic - Do
you really expect the government, especially during the Reagan administration, to turn its back
so abruptly on its buddies in the pharmaceutical industry just to create a deal for the consumer?
It is one of the oldest tricks in the regulatory book to create a law that looks pretty damn good to
the general public, but with some back door gifts to friendly private interests that are not obvious
to the general public until many years later. The Trojan Horse allowed into the 1984 regulatory
regime contained an army of methods for the brand-name companies to fight the generics,

• Extension of patent protection to make up for time lost in the FDA regulatory approval process
(hence the term "Patent Restoration").
• Ability to get multiple patents on drugs covering not only the chemical itself, but also all kinds of
preparation methods and techniques, making it harder for the generics to prove they had the
same drug. These patents could be staggered, such that when the patent on the main chemical
expired the patents on various methods and techniques were still in force.
• Wide ranging ability to challenge generic companies in the courts for patent infringement.

These back door methods available to keep patents going form a major arm of the strategy used by the
brand-name companies to ward off the threat from generics. And it is these very loopholes that
coalitions such as "Business for Affordable Medicine" and many congressional representatives are trying
to close.

In later years the arsenal was to be extended by the formation of the World Trade Organization
and associated revisions to international trade law that further strengthened patent protection of

Then, starting in about 1994, the brand name companies launched into a shameless, near
exponential growth in direct-to-consumer advertising of prescription drugs for reasons that
probably have to do with increasing pressure from generic competition and managed-care
companies. This strategy proved critical in the battle against the Shark Fin Curve. Nowadays,
barely an hour can go by on the TV without us hearing from our friends in Big Pharma.

Meanwhile, in other industrialized nations, the provision of universal healthcare means that drug
prices are largely controlled by governments. Drug companies have not been allowed such
freedom to either set prices for patented drugs or to advertise directly to the consumer.
Consequently the US consumer ends up not only paying for the privilege of being propagandized
by the drug companies at home, they also subsidize lower drug costs abroad where prices are
regulated by the government.

Put all these factors together and there's little mystery as to why prescription drug costs are
spiraling out of control in this country, increasing at about 15% a year!

5. The Anatomy of a Counter-Attack from Big Pharma

To understand where some of the most unsavory behaviors of the branded drug companies come
from, it is instructive to look at several case studies. We will look at two of the most frequently
referenced case studies, whose stories can never be told enough. Be sure to tell all your friends,
Case Study 1 - Blockbuster Nexium: The marketing of the heartburn drug Nexium by
AstraZeneca to counter the expiry of its patent on the similar drug Prilosec. Schering-Plough is
currently using similar tactics to convert people from the allergy drug Claritin coming off patent,
to the almost identical branded drug Clarinex.

Case Study 2 - Blockbuster Taxol: The tactics of Bristol-Myers Squibb to keep its monopoly
on the cancer drug Taxol, originally a gift from the taxpayer funded National Institutes of Health

These case studies come from a very educational series in the Wall Street Journal that has been
running throughout 2002 documenting the tactics of the pharmaceutical industry.

Case Study 1: Blockbuster Nexium, by AstraZeneca (WSJ June 6, 2002)

Thanks to their bad eating habits, American are notorious for stomach related problems, and this
has proved to be a gold mine for the drug industry. Stomach ulcer and heartburn drugs like
Prilosec, and Zantac before it, were the largest selling blockbusters of their time.

Insert: 1940s "American Stomach" Radio Ad

In 1995 AstraZeneca launched 'Project Shark Fin' to draw up a battle plan as its 6 billion-dollar-
a-year heartburn drug, Prilosec, was going to lose its patent in April 2001. After years of work,
the Shark Fin team came up with the rather unimaginative solution of launching a successor drug
that was basically the same as Prilosec, but would be under patent when Prilosec lost its patent.
They also used every loophole available in the Hatch-Waxman Act to construct a legal minefield
for would-be copy-cats, to extend the Prilosec patent as long as possible, and give AstraZeneca
more time to convert Prilosec users over to Nexium. The related legal battles over the Prilosec
patents continue to this day and are closely watched by those that follow drug prices.

To convert post-patent Prilosec users to its patented sibling Nexium, AstraZeneca spends about
$0.5 billion a year in adverting of this single drug, making it now the most advertised drug in the
US (taking over from Prilosec a few years ago). And, so far that's paid off handsomely, as 60%
of those switching from Prilosec are going to Nexium.

Nexium is one-half the Prilosec molecule and works pretty much the same, but it is just
chemically different enough to win a patent of its own. The marketing spin that Nexium is better
at dealing with eroded esophagus is good for converting Prilosec users that watch prime time TV
over to Nexium but, according to the Wall Street Journal article, is built on very shaky scientific
foundations. According to this article, four studies were commissioned to see if Nexium was
better at healing eroded esophagus. Two studies found it wasn't any better at all and the other
two found it was better only by a smidgen.

Based on that piddling bit of evidence we all get to hear about eroded esophagi and purple pills
with racing stripes on a daily basis!
Such tactics form a common strategy for maintaining revenue as drugs come off patent. A
similar strategy is being employed to convert users of the allergy drug Claritin to the new
patented Clarinex.

Case Study 2: Blockbuster Taxol, by Bristol Myers Squibb (WSJ June 5, 2002)

Bristol-Myers Squibb is currently being sued by 29 states for illegally delaying generic
competition of its blockbuster cancer drug Taxol and costing governments and consumers
billions of dollars, as well as costing lives. The basis of the suit is the claim that Bristol-Myers
Squibb misled the US Patent Office to delay generic competition on Taxol.

But it gets more offensive than this! You see, Taxol is derived from the bark of the Pacific Yew
tree and its pharmaceutical benefits were discovered not by Bristol-Myers but by the taxpayer-
funded National Institutes of Health. The NIH handed Taxol over to Bristol-Myers in 1991 as a
big gift. In return Bristol-Myers, who charges a hefty price for Taxol, has acted like a badly
spoiled child not wanting to share this gift with anyone, even ten years later.

Bristol-Myers Squibb, similar to what AstraZeneca did in setting up its minefield around
Prilosec, has used the trick of staggered patents of every technique and methodology used to
serve up Taxol to maintain its monopoly on the taxpayers' gift to them.

This is such a common strategy of counter-attack by the brand name companies against the
generics that state governments, consumers, companies and health insurers that end up footing
the bill for prescription drugs are themselves challenging it at every turn.

Poor Bristol-Myers Squibb! In addition to these lawsuits and angry governments, the planned
heir to the cancer drug throne, a drug known as Erbitrix, developed in a joint venture with
ImClone Systems, was rejected by the FDA and wound up in a sordid scandal with the queen of
good cooking - Martha Stewart. What are they going to do with the Shark Fin now?

These case studies were selected to give an idea of the desperate tactics used by the drug industry
to boost sales revenues. But, of course, the tactics don’t stop there. Following is a small sampling
of other techniques employed to keep sales revenues and drug prices high.

• Marketing to the medical profession. (Source: Kaiser Foundation Study, 11/2001) Drug
companies spend the vast majority of their direct marketing budgets (about 85% of them) not
on marketing directly to the public, but on marketing directly to doctors. This consists mostly of
giving doctors buckets full of free samples - about $8 billion worth in 2000 - noting that patients
who start on free samples often convert to paying customers. It also includes giving doctors free
dinners, sports tickets and other gifts, sponsoring conventions for them, and advertising in
medical journals. In all, marketing to the medical profession costs the drug industry about $14
billion a year.
• Advertising to consumers through pharmacies. (Source: WSJ 5/1/2002) This newest form of
direct-to-consumer advertising comes in the form of what looks like an educational booklet
from the pharmacy about various treatments for your particular condition. It's provided for free
when you purchase your prescription drugs, and looks like a public service provided by your
trusted pharmacy. The targeted consumer would have to get their magnifying glasses out to see
that these are actually advertisements from the branded drug companies. The trusted
pharmacies are, of course, amply compensated for their distribution efforts and access to their
databases for target marketing purposes.
• Advertising Agencies Participating in Clinical Trials: (Source: WSJ 6/3/2002) Believe it or not,
those same drug agencies that bring us the subliminal messages of eroded esophagi using big
canyons, are entering the business of performing clinical trials for their clients. This should lower
both advertising costs and expenses of clinical trials, for there is every incentive for the
advertising agency to find that their tested drug is just fantastic. After all, they will have an
exclusive on the advertising account once the product is launched.

As noted, these case studies and other techniques are just a small sampling of the techniques the
branded drug companies use to stay alive and profitable in the face of competition, decreased
innovation and increasing opposition from many quarters. There are many more strategies employed
and if you read the business press you can probably read about a new one just about every day. Indeed,
it is remarkable that the granting of 20-year monopolies and the gifts of publicly funded research can't
even help this industry solve its profitability problems, let alone that it increasingly fails to provide value-
added service to the public. Surely it is time to re-think the viability and sustainability of the branded
drug sector in its current form.

[ The following Section 6 was deleted from the audio version for continuity reasons, but you
might find it interesting...

6. The Next Blockbuster Drug - What will it be? A "Youth Pill"

As we've already seen, the blockbuster cabinet is currently looking pretty bare, and big pharma is
getting nervous. Many recent blockbusters act on certain enzymes to inhibit their production of
an undesired chemical that causes problems like high cholesterol. But the enzymes available for
such targeting are pretty much used up by now by all the existing blockbusters. In addition, it
will be hard to improve on existing treatments for the 5 main ailments that currently dominate
the top 20 drug lists - heartburn, arthritis, high cholesterol, high blood pressure and low spirits
(depression). So what next?

Operating in the favor of big pharma profitability is the aging of the rich world populations with
money to buy prescription drugs. This aging in the West will drastically increase per capita
spending on prescription medicines in the coming years. Finding effective medication for the
degenerative altzheimers disease or even osteoporosis would be like hitting the jackpot. But with
few warm leads on such cures, investing R&D monies in this area is certainly very risky.

In it's efforts to produce a blockbuster for the over 65s, the biggest drug giant Pfizer has recently
been working on the elusive "fountain of youth" pill, also known as the "frailty pill". By
stimulating the pituitary gland to produce more growth hormone, this drug aims to reverse the
degenerative process that comes with aging and make old people feel young again. Taking the
trend set by drugs such as Viagra, Rogaine and Paxil to a whole new level, this drug promises to
be the ultimate "lifestyle drug" for the baby boomer generation. But so far the clinical trials have
not produced the desired results.
Nevertheless, if the drug companies could get the youth pill to work then, by playing on one of
the deepest of human fears, they will have struck gold. Consumers might start taking such
medications at the first signs of old age and then be taking them for the next 50 years!

Another strategy we are likely to find followed more is the use of 'gene hunting', where
researchers try to discover the genetic roots of chronic diseases and thereby devise treatments.
But payoffs from gene technology are not expected for another decade or so.

In the midst of this current drought in the blockbuster drug pipeline, many industry watchers
have noted that increasing consolidation has actually made the drug industry less efficient at
producing more drugs.

But that's not the worst of it, by far. The patented medicine model, while contributing much to
the welfare of the western world over the past century, has itself aged and entered a seriously
degenerative phase. It is not making much sense in our globalized markets, and maybe it's time
for it to die out. Today, people all over the world, regardless of nationality, political ideology, or
wealth, should seriously be questioning the suitability and sustainability of the contemporary
patented medicine model. ]

7. Market failure of the Patented Medicine Model. HIV/AIDS Rips in to China and Russia.

The following, seemingly prophetic, quote from an 1851 edition of the The Economist describes
perfectly the degenerative phase the patented medicine model has reached by the start of the 21st

"The public will learn that patents are artificial stimuli to improvident exertions; that they cheat
people by promising what they cannot perform; that they rarely give security to really good
inventions, and elevate into importance a number of possible good can ever come of a
Patent Law, however admirably it may be framed."

This 1851 quote gives a good description of what has become of today's pharmaceutical sector
when viewed from a global perspective. Patents have certainly provided "artificial stimuli to
improvident exertions" or, put another way, wasteful spending. And there is no question that we
have seen the elevation "into importance a number of trifles", namely the blockbuster lifestyle
drugs such as Viagra, Rogaine, and various anti-depressants, as well as unnecessary drugs that
are virtually the same as a host of other drugs already on the market. All this takes places against
the backdrop of a developing world HIV/AIDS crisis that has resulted in up to 40% of the
population being infected in some African counties, and is now starting its exponential growth
throughout Eastern Europe, the former Soviet states, China and the rest of South-East Asia.

The West has remained largely unconcerned with the HIV/AIDS crisis in Africa. There have
been some nice efforts from various quarters but so far the response has been woefully
inadequate from those that can most afford to help. To put it bluntly, this is because the "self-
interest" component just isn't there. Africa is only a minor trading partner with the West, and the
West has relatively little economic interest in Africa. So far, all the help adds up to not enough,
and the disease continues to outpace efforts to stop it. Out of a $10 billion-a-year request from
the UN, the West can only bare to part with $2 billion to assist in dealing with the problem of
HIV/AIDS in the developing world. And, compared to other drug investment, relatively little
goes into finding a vaccine. If and when a vaccine is available, distribution of it will pose the
next major hurdle.

But now, there are increasing reports detailing the spread of HIV/AIDS throughout the former or
semi-communist, now market-directed, nuclear powered giants - Russia and China. A startling
report from UNAIDS, released in June 2002 entitled "HIV/AIDS: China's Titanic Peril" reveals
the state of the problem of HIV/AIDS in China. With 1-2 million people infected today, infection
rates have been increasing at more than 50% a year. Estimates of the number of people infected
by 2010 range between 10 and 20 million. The former Soviet states have seen a five-fold
increase in infections in the past three years, have more than 1 million people infected, and the
fastest spreading epidemic of all, according to a September 2002 UN Report. A survey from
British scientists released in June predicts that within 5 years, 1 in every 20 Russian adults will
be infected.

Both China and Russia are rapidly developing market economies. One is a major trading partner
of the United States, the other set to become one of the European Union. Lest you think this
development will help, think about the African nation of Botswana. Botswana was the golden
child of economic development of sub-Saharan Africa, financed largely by its mining industry
after it gained independence. Its first AIDS case was detected in 1985, then HIV/AIDS built
slowly for several years. By the 1990s it was spreading furiously throughout the general
population so that by 2002 it affects almost 40% of the entire population. Why so much worse
than the less developed sub-Saharan region, you might be wondering? Largely because of the
rapid economic development itself. The road networks that come with development, the mobility
of labor away from home and families that comes with globalization, and men leaving wives to
get work, all sped up the spread.

Now, many people in Africa think China and Russia look a bit like their countries did five to ten
years ago. But there's more. With Western style development comes rapid growth in drug use,
teenage sex, commercial sex and poverty. These increases are being observed across China,
Eastern Europe and Russia and the relevant populations are showing huge increases in infection.
In addition, the old social safety nets and health care systems have largely collapsed. In rural
China, the poverty of farmers has forced them to sell their blood for trade on the lucrative
national and international plasma markets. Millions of rural people participated in these
plasmapheresis programs in return for cash payments to supplement their ever-dwindling
incomes. In this process their blood was taken, pooled with that of lots of other people, and the
plasma separated from the red blood cells. The plasma is sold on the plasma market and the now
pooled red blood cells are then re-infused back into the pool of donors so that they can keep
giving blood at a high frequency. In such a process, all it takes is for 1 person in a pool of 100 to
have HIV and all 100 get it. This has greatly increased China's HIV problem. Add this to the fact
that population pressures and the preference for male children has created a dangerously high
and unnatural male to female ratio, plus the big taboo on discussion about sex in eastern cultures,
and you see a growing number of catalysts for disease spread.
China is currently the forth-largest trading partner of the US, likely to be the number 2 or 3
before too long, and with a strong chance of becoming number 1. With China joining the World
Trade Organization there's tons of capital wanting to invest in China. As residents and consumers
in the US, our lives are undeniably intertwined with those of the Chinese. So much of our own
purchasing power and hence, quality of life, is a direct result of the relatively low cost of labor in
China. As our population ages, more and more of the productive labor force we depend on will
be in countries like China. In this case, the economic interests of the US are very much tied up
with the well being of the labor force of China. If the US does for China's emerging epidemic
what it did for Africa, which was not very much, the consequences on the US economy could be
quite severe. Maybe this self-interest component is the only thing that can get the US to do what
it can well afford to do about this crisis in the developing world. Then, I am sure, a vaccine could
be found and distributed in no time at all.

Similar arguments apply about the relationship between Western and Eastern Europe. The
European Union has an added incentive. Since this is all happening right next door, the epidemic
may very well stretch into Western Europe if they don't help do something about it in a hurry.

8. A Remedy for the Ills of the Current Medicine Model

There is no point asking the branded drug industry for help. They just wont budge without a
monopoly and a profit stream, neither of which is a suitable incentive model for this global crisis.
It is heartbreaking to see the present $8 billion shortfall in the UN requests for HIV/AIDS
assistance, compared to the many tens of billions spent by the pharmaceutical giants on
advertising nonsense pills to us daily, suing the generics at every turn and developing medicines
that aren't really necessary. And we end up footing the bill for all this, be it in the form of our
taxes, higher health premiums or direct prescription purchases.

If global capitalism wants to save itself from its own worst enemy - which is itself - it better act
quick smart. Following is a prescription for the capitalists to save their global markets...

(1) Since the branded drug industry is wasting our time and our money and they are not helping
to solve the really big and important health problems, we can conclude they are a big inefficient
sector of the markets due to too many years of monopolies and taxpayer subsidies. They are
fired! That should make the markets more efficient. We will keep the generics, though.

(2) The generics can keep producing all existing FDA approved drugs in a patent free
environment. This should lower our total annual drug costs by about $80 billion a year.

(3) We will use about $15 billion of this for a prescription drug benefit for seniors (whose costs
are now much lower because all drugs are generics) and put some $15 billion towards insuring
the uninsured.

(4) We will set aside $30 billion for drug research and development in the public sector, to
replace what the private sector used to do, except with a more needs oriented approach. All the
scientists, researchers and administrative workers from the now extinct brand name companies
get new jobs at the new publicly funded research centers. Realizing that the biggest needs are in
the developing world and that our own economy is intimately tied to their well being in this
globalized world, we set the first $15 billion aside exclusively for HIV/AIDS vaccines and
treatments. The next $5 billion goes on tropical diseases, tuberculosis and so forth. Then the
other $10 billion will go into the most important things at home.

We still have $20 billion left.

(5) Of the people that used to work for the branded drug companies, we still have the marketing
people and lawyers sitting around idle, which is worrisome. Since the marketing people are
always telling us that they are not annoying and that they are instead providing the social service
of distributing important information, we have just the job for them! First they will be put in
decompression chambers and then some training will take place to retool them for a more
wholesome career. They will each be provided with 10,000 packets of condoms and sent all over
the world from India to the Congo to Russia to China to Brazil. Their job will be to sell the use
and advantages of condoms and safe sex to as many people in the developing world as possible.
This should be right up their ally. For years they have been walking into doctors offices with free
samples to give away and stories to tell. They will get compensated based on the preventative
practices adopted in their region. The total cost of the global prevention plan will be about $10

(6) The lawyers will be left on their own. They are inventive enough to find other ways to
occupy their time.

(7) Well, there's lots that can be done with the remaining $10 billion and I'll just leave that up to
your imagination.

That's all for the Wizards of Money Part 16.

Part 17: "Caught Between and Dock and a Sweatshop"


1. A "Toy Story"
2. The "Spartacus Problem"
3. Eliminating the Legacy of Harry
4. Back to the Docks of the 1930s
5. Life at the World's Largest Retailer and Importer From China (Wal-Mart)

This is the Wizards of Money, your money and financial management series, but with a twist.
My name is Smithy and I'm a Wizard Watcher in the Land of Oz. This is Part 17 of the Wizards
of Money series and it is entitled "Caught Between a Dock and a Sweatshop".

As the Holiday Season of 2002 approaches, this 17th edition of the Wizards of Money will look
at the path taken by the goodies that will end up under the Christmas Tree.

We start with the following analysis of Santa’s Business Model…

Although nobody really wants to tell their kids this, Santa does not start his journey at the North
Pole in December. He starts in China in about June. The majority of the elves making the holiday
gifts are migrants from rural China who Santa lures to the factory cities by the millions. Despite
its mythical appeal, Santa knows that carrying all this cargo by air is not economically feasible,
so the flying reindeer carrying the presents are really giant ships crossing the Pacific Ocean. The
ships get unloaded by the tallest breed of elves who, much to Santa’s irritation, use their height
to make demands on Santa. Once Santa gets past that barrier and the goods are trucked inland,
they end up getting stocked to the shelves by some of the lowest paid elves in this land of
holiday cheer. Since Santa is too fat to squeeze down the chimney he instead offers credit to
tempt people into the stores to get the goodies themselves. Finally, all this credit plus a bit more,
goes back to Santa in his home at the heart of the capital markets.

This snapshot of Santa’s business model provides a glimpse of some of the primary battles being
waged today in the ages old war between labor and capital. This episode will focus on the
following three contemporary battle-zones along Santa’s journey.

1. Chinese Toy Factories,

2. The Pacific Coast docks, and
3. Wal-Mart.

The laborers in these three regions of Santa’s journey – the start, the middle and the end - sit at
opposite ends of the spectrum in terms of securing a reasonable share of the fruits of their labor.
The laborers at the start and the end of the journey traveled by internationally traded goods have
almost no power to bargain with their employers, and consequently, are not getting their fair
share. The start of the journey is the manufacturing end, which is made up primarily of factories
in China. The end of the journey is the US retail stores, increasingly dominated the biggest retail
giant in history – Wal-Mart.

In the middle of the journey sit the Pacific Coast longshoreman - some of the highest paid
laborers today thanks to the gains made by the International Longshore & Warehouse Union
(ILWU) over several decades. Given the triumph of capital over labor at the retail and
manufacturing end-points of Santa’s journey, it is hardly surprising to see the forces of capital
now pulling out all stops to bring this middle point into line.

A "Toy Story"

Millions of us have to go through the process of shopping for holiday gifts for kids around this
time of year. Last week I went to Wal-Mart to buy some little trinkets that will delight my nieces
and nephews.
One toy was a Matchbox SUV. This cost only $1.47. Another toy was a "Bob the Builder" ball
since that’s a favorite of one of my nephews. The Bob the Builder ball was more pricey than the
Matchbox SUV, at $1.76. And, finally the most expensive item of all, a fancy little Barbie out-fit
for one of my nieces at $1.84. In all, it cost me $5.07 (before tax) to complete my holiday
shopping for two nephews and one niece.

But that's not all they'll be getting. You see, when me and my purchases got home, I couldn’t
shut them up! Busting to share their experiences, but too afraid to talk in the Wal-Mart store,
they gave a detailed account of their long journey from China, across the Pacific, and into the
Wal-Mart shelves. They told me of the things they saw along the way, while some companies
thought no one was looking.

First, the Barbie dress burst into tears when she recalled the conditions in the factory in China
where she was made. She said that most of the ladies there would never be able to afford
something as fancy as she, and yet they were working non stop with hardly any days off since
the busy season started in about June. One young lady in a factory was literally worked to death,
and the Barbie dress reminded me that this incident was covered in the Washington Post on May
13 this year. She said I better look it up.

The "Bob the Builder" ball, a young ball with a keen interest in unions, said that while he was
being stitched up he tried to find out something about attempts to organize unions in China. But
there was no talk on the job, so he waited till he saw something in the news when he got to the
US about how China's ruling Community Party had just ordered the extinction of something that
was starting to look like an independent labor union, since the only official unions in China are
operated by the Party run All-Trade Federation of Trade Unions. And Bob added, very
disappointed, this government union is about as corrupt as can be.

Pretty soon, the Matchbox SUV chimed in and stated that both he and the Barbie dress were
Mattel products and that I could find the Consumer Information number on their backs. He urged
me to call Mattel at this number to ask them some questions about their factories in China. I did
just this. However, when you call the Mattel Consumer Information number, where you are
supposed to be able to ask any question whatsoever about a Mattel product you bought, there is
apparently one question you can't ask. And that's about the conditions under which these
products were made. In no time at all I was whisked over to the Mattel Public Relations
department and got to speak with a Public Relations Vice President. The dress suspected it was
Barbie herself, but I wasn't quite sure. Anyway she was extremely nice and assured me that all
the information I needed was on the Mattel web site.

So me, the Barbie dress and the Matchbox SUV hopped on the internet and looked up Mattel's
site. We soon found that the Barbie Vice President at Mattel had told us a bit of a fib. The only
information on the Mattel site about its operations in China were two years outdated and also
there was no information about how its so-called "independent monitoring team" was selected or
compensated. We wanted to know these things and also wanted more up-to-date information
about the factories. So we spoke to the Barbie VP again and she said she would investigate the
matter and then get back to us. To this day she still hasn't called back and the poor little Barbie
dress sits by the phone in silence with a forlorn look, like she's been betrayed by one of her
heroes or something.

The toys later told me that their trip across the sea was pretty humdrum since they were stuffed
in containers in the dark. But when they got to the docks on the West Coast of the US all hell had
broken loose. There they bobbed up and down for 10 days without moving because the shipping
companies had locked out the dock-workers. After this long delay, the Bob the Builder ball
managed to pop himself out of the container long enough to ask a dock-worker what was going
on. He heard about their concerns that their union was under the attack of some very powerful
business interests, and some very crafty PR people who actually made it seem like the workers
had been on strike.

Finally, the toys made it to my local Wal-Mart store. After hearing all this stuff about freedom
and democracy in the Wonderland of America, boy, were they disappointed when they saw what
kind of lives some of the Wal-Mart workers had. And, after being in China for so long they
certainly recognized propaganda when they saw it.

I told the toys that I couldn't believe they were so cheap! Altogether they only cost me $5. But
then I realized this was not a very nice thing to say, even to a toy. So I didn't discuss their cost
with them anymore. Instead, later that week, I got some clarification on this issue from Bill
Meyer at the United Food and Commercial Workers union in Las Vegas, epicenter of labor
organizing for Wal-Mart.

Excerpt from Interview with Bill Meyer. UFCW Local, Las Vegas.

We'll hear more of this interview later on, along with an interview with Mike Leonard at UFCW
in Washington DC, heading up the National Wal-Mart Campaign.

But first, the little toys asked me to do a little history lesson on labor issues. So I thought I'd start
at a point in time a few thousand years ago.

The "Spartacus Problem"

Excerpt: Spartacus "March on Rome"

Big capital has been using two primary weapons against organized labor consistently for
thousands of years, namely propaganda and intimidation. The third – physical force – fell out of
favor in the 20th Century as the other two became increasingly effective and as the excesses of
physical force sometimes led to too much sympathy for labor and thereby undermined the
propaganda efforts. In the lands where electronic communications media are pervasive, this third
arm of Capital’s army is barely needed anymore.

Modern capital learned many lessons from the leaders of the great Roman Empire, built largely
upon the complete submission of labor. While Rome did not have unions to contend with, there
arose the occasional force that Rome feared most on the homefront – solidarity of the slaves,
spearheaded by the rare charismatic leader. The most famous slave organizer of Roman times
was, of course, Spartacus. Rome went to great trouble to use all these strategies to deal with the
organized slave problem.

Excerpt: Spartacus - Closing Crassus Speech

For intimidation purposes, the crucifixion of thousands of slaves from the Spartacus army along
the Appiann Way was remarkably effective. But even following the death of Spartacus, Rome
still had something of a "Spartacus problem" on its hands. After all, they didn’t want slaves or
cheap labor to get ideas about organizing, or to get high hopes that they actually could achieve a
better life. For this reason, Rome most probably went to a lot of trouble to eliminate the legend
of Spartacus.

So too it would seem for the great labor organizers that would emerge in the 20th century under
the American Empire. One of these was the Australian born Pacific Coast longshoreman Harry
Bridges, who was to have a profound influence on the improvement of labor conditions for
American workers, and whose union was to be one of the pioneers in getting benefits like
healthcare and pensions for workers. Yet, how many people have ever heard of him?

Eliminating the Legacy of Harry

Harry caused something of a modern day "Spartacus Problem". The first president of the
International Longshore and Warehouse Union, Bridges was one of the 20th century's most
effective labor leaders; a key figure in the General Strike of 1934 and in the lead-up to the
breakthrough National Labor Relations (or "Wagner") Act of 1935. His work in the ILWU and
other organizing bodies inspired a lot of workers to fight for a better life. Naturally, work begun
almost immediately to tarnish his name. Bridges was to suffer constant attacks and many
attempts at deportation, leading up to and during the McCarthy era.

And today, in line with the general decline of union power, his legend lives on only in the
margins. Furthermore, many of gains in getting benefits for workers pioneered by his union are
now either not available for non-union sectors or becoming a thing of the past in union sectors.

In order to understand the contemporary dispute on the Pacific Coast docks that President Bush
recently stepped into, and its significance well beyond these docks, we first go back in time to
the days of the Great Depression. In our trip back in time we will hear some excerpts from a
documentary called "From Wharf Rats to Lords of the Docks", a radio documentary produced by
the Harry Bridges Institute and Public Radio International about the life of Harry Bridges. A link
to this show will be placed on the Wizards of Money web site at

Back to the Docks of the 1930s

The docks that my little toys from China got unloaded on were certainly a tough place to work at
the start of the 1930s. Not only was pay lousy and the hours long, but the safety precautions in
place were dismal. To make matters worse, the way that workers got work was mostly through a
system of favoritism by the employers based on bribes and kickbacks. Men who hadn't
participated in this corrupt process may stand in line for hours a day and not get any work. And,
certainly anyone known to be an organizer, or have an interest in unions, could easily be passed
over for work. In that time at the start of the Great Depression the shippers had all the power and
the dock-workers had none.

Fed up with this situation and to put pressure on their employers for a fairer slice of the shippers
profits, the dock-workers up and down the Pacific coast, along with many other maritime
workers, went on strike in 1934. Harry Bridges, a dock-worker in his early thirties, was
appointed Chairman of the Joint Strike Committee of Maritime Workers.

A turning point came a day after Independence Day 1934 when two striking longshoremen were
killed by the San Francisco police. After this and a solemn funeral procession including tens of
thousands of workers across the city, public sympathy swayed towards the longshoremen. Not
too long afterwards, this evolved into a general strike in San Francisco, with many other unions
showing their solidarity with the longshoremen and also going on strike. Bringing commerce to a
screeching halt certainly put the national spotlight on the longshoremen's issues. Armed with the
support of the public and the other unions, the longshoremen had bargaining power and were
finally able to negotiate a contract that included better pay, and more reasonable hours. Very
importantly, it also included some control over the hiring process so that employers couldn't just
pick and chose employees based on their corrupt selection process. Later they would form a new
union called the International Longshore and Warehouse Union, with Harry Bridges as its first

The mid-1930's, in the midst of the Great Depression, was a time when the power of capital was
greatly weakened, and a chance for labor to make gains. And so it did. The victory of the
longshoremen and other maritime workers in the General Strike of 1934 was one example. But
perhaps the most significant national victory of that time was the passage of the landmark
National Labor Relations Act (also known as the Wagner act) of 1935.

The Wagner Act (or the original National Labor Relations Act) for the first time guaranteed
employees the right to self-organization, to form, join, or assist labor organizations, to bargain
collectively through representatives of their own choosing, and to engage in concerted activities
for the purpose of collective bargaining or other mutual aid and protection. To implement and
uphold these rights, the act created the National Labor Relations Board (NLRB). Before the
enactment of the NLRA, the federal government had refrained almost entirely from supporting
collective bargaining over wages and working conditions and from facilitating the growth of
trade unions. This Act facilitated the growth in trade unions and union membership over the next
two decades, which peaked sometime in the 1950s.

Never one to sit idly by and watch its power be weakened, the forces of capital and big business
set to work the day the Wagner Act came into force to dismantle the power of unions. The old
tricks of propaganda and intimidation were back in full force. And capital was back to full
strength by the end of World War II. And so the Taft-Hartley Act, an amendment to the National
Labor Relations Act in favor of big business was passed in 1947, even over the objections of
President Truman.
At this point the anti-union propaganda and activities of business of the past few decades
culminated in the frightening full-blown McCarthy era. For decades, successful union leaders
like Harry Bridges, who represented the best interests of their rank and file members, were
constantly under surveillance and investigation, harassed, intimidated, and of course, called
Communists. In addition, Bridges suffered numerous attempts to deport him back to Australia.

Nevertheless, through all this, Harry and the ILWU continued their work on behalf of the rank
and file longshoremen and today they are some of the most well compensated union workers.
According to the documentary "From Wharf Rats to Lords of the Docks", Harry and the ILWU
pioneered the establishment of employer sponsored benefits such as healthcare, dental care,
pensions and paid vacations.

Excerpt: "From Wharf Rats to Lords of the Docks"

Finally, as the McCarthy era was coming to a close and after 21 years of constant harassment,
Harry became a US citizen and the constant attempts to deport him came to a halt. Here's Harry
Bridges …

Excerpt: Harry Bridges Speech

Apart from its tools of propaganda, intimidation and the constant whittling down of the
effectiveness of the National Labor Relations Act, organized capital still had two more powerful
weapons up its' sleeve - ones that Organized Labor still has no counteroffensive for. These are
(1) Technology and (2) Overseas Labor.

By the nature of its work, the ILWU never really faced the latter to any great extent. But it has
faced the former on two major occasions. The first in the 1950s when "containerization"
technology entered shipping, culminating in the 1960 Mechanization and Modernization
Agreement between the shippers and the dock-workers. The ILWU dealt with this entry of
technology by acknowledging that the number of available jobs would decrease, ensuring that
new technology jobs would remain in the union and that workers who would be retired would
receive reasonable benefits. Overall there was an increase in wages and benefits. In this way the
current generation of workers shared in the gains made through the implementation of
technology, but they also passed on less union jobs to the next generation.

Excerpt: Harry Bridges Speech on Technology

The second major time the ILWU has faced the Technology issue is now, with the
implementation of technology to make the labeling and identification of cargo, and data entry
more efficient. Only now, organized labor has been under such fierce attack for so many years,
that the general power of unions is much weakened. Now it is harder even for the historically
stronger unions such as the ILWU to bargain with employers, and, as we shall see when we get
to the Wal-Mart issue, the National Labor Relations Act has become something of joke in terms
of protecting the worker's right to organize and bargain collectively.
It would seem that the ILWU would have liked to resolve the contemporary technology issue
using a compromise similar to the "M&M Act" as it is known, of 1960. But the shippers don't
seem to want to come to such a compromise. Regardless of the claims on either side about what
lead to the closing of the docks in October this year, there are two things that seem clear.

1. It was the Pacific Maritime Association, the association of employers, who instigated the lock
out. It was not a strike! However, it sometimes seems that this is how the media portrays it,
and, indeed many people seems to think this is what happened.
2. The ILWU appeared to have no intention of striking.

The business press claims that the ILWU might initiate a slowdown rather than strike, because
their compensation is already so high that they would not win public support, and this slowdown
led to the lockout. The union claims that the PMA (i.e. the shippers and port operators), possibly
with the help of the big retailers (like Wal-Mart) who import their Asian made goods through the
West Coast ports, are trying to bust or weaken the union.

Both arguments have merit. But it is the argument of the union that I find worthy of much
attention. For, if it is true then the implications are profound. The ILWU's arguments also
deserve more attention because they seem to have gotten so little press coverage. Few people
seem to have considered the broader implications of this case if indeed it is an attempt to weaken
or bust the ILWU. To understand this side of the story I recommend a radio show produced by
People Tribune's radio recently and I will post a link to this on the Wizards of Money web site.

It will be very interesting to see what happens next. Will the ILWU, for decades one of the
leading trendsetters in establishing gains for workers, come out of this process significantly

And how much do the big retailers, who import an increasing amount of their manufactured
goods from the newest member of the World Trade Organization through these docks, have to do
with all this?

A weakening of the ILWU would certainly deal a huge blow to the labor movement at a time
when it is battling the trend of the big retailers at home to lower standards in the ever growing
retail sector.

On that note, lets now take a good look at the biggest one of these retailers - Wal-Mart.

Life at the World's Largest Retail Giant and the Biggest Importer from China

Interview: Mike Leonard. National Wal-Mart Campaign Organizer. UFCW

Interview: Bill Meyer. Las Vegas UFCW Wal-Mart Organizer.

Part 18: "Where Wall Street Crosses Auburn Avenue"


1. Introduction
2. Atlanta's "Freedom Walk"
3. The Almost Forgotten History of Black-Owned Financial Institutions
4. Physical Desegregation, Financial Segregation
5. 1968: Dr King's Death and Ginnie Mae's Birth
6. The Predatory Pipeline: From the Home Buyer Back to Wall Street
7. The FHA Loan Pipeline
8. Progress in Clamping Down on Predatory Capital

This is the Wizards of Money, your money and financial management series, but with a twist.
My name is Smithy and I'm a wizard watcher in the Land of Oz.
This is the Part 18 of the Wizards of Money and it is entitled "Where Wall Street Crosses
Auburn Avenue".

Introduction Audio - Foreclosure Sale on the Fulton County GA Courthouse Steps & Excerpt
from Interview with Bill Brennan at Atlanta Legal Aid

1. Introduction

In this, the eighteenth edition of the Wizards of Money, we're going to look at what's driving
today's record rate of home foreclosures - from sub prime lending to abuses of the
homeownership programs initiated during the Great Depression.

Home foreclosure is the process whereby a mortgage lender takes over a property when a
borrower is late on loan payments. To study today's alarming trends, we'll need to follow the
capital being pumped into various lending abuses all the way back through the predatory
pipeline, and ending at the major Wall Street players. We'll examine the roles played by major
financial institutions, and those unregulated and mysterious things known as "Hedge Funds" and
"Special Purpose Vehicles".

We start our journey through the predatory pipeline in the city of Atlanta, one of the major
accumulation points for predatory capital, primarily in low income and minority neighborhoods.
We'll go back to a time when capital flows in this area worked very differently. Then we'll come
back to the present to follow the modern capital flows back to their source.

To understand the driving forces behind today's record foreclosure rates nationwide, we'll talk
with Charles Gardner, Director of the HUD Homeownership Center for the Southeastern United
States and we'll talk to Bill Brennan, Director of Atlanta Legal Aid's Home Defense Program.

But first, let's start with a walk around downtown Atlanta.

2. Atlanta's "Freedom Walk"

In December of 2002 there was much celebration in Atlanta over the fact that Georgia has now
produced two Nobel Peace Prize winners - Martin Luther King Jr and, most recently, former
president Jimmy Carter. In fact, the King Center and the Carter Center, dedicated to both the
memory and missions of these two Peace Prize winners, lie only about one mile apart and there
is a walking path connecting the two. This walk, starting on Auburn Avenue, birthplace of King
and home to the King Center, has been described as that from "Civil Rights to Human Rights" in
the local Atlanta news and follows a road called "Freedom Parkway".

"What a lovely walk!" I thought to myself on a recent sunny winter's day. So I started walking
along Auburn Avenue, ready for my Freedom Walk. However, somewhere along the way I
messed up and took a wrong turn. Pretty soon, none of the streets I was walking down looked
very much like a Freedom Parkway to me. Certainly financial freedom was not evident - instead,
foreclosure was, with some streets dotted with several homes in foreclosure.

Perhaps I was walking in circles, but later on in the day I ended up on the steps of the Fulton
County Courthouse in downtown Atlanta. Lining the steps throughout the day were a bunch of
mumbling lawyers with piles of papers that they were reading, one after the other just like this:

Excerpt: Fulton County Courthouse January 2003 Foreclosure Sale

These lawyers were auctioning off the thousands of Atlanta homes in foreclosure that hit their
books in the month of December. Most of the homes were going straight back to the banks. Don't
be fooled by the location of the auction - just because it takes place outside the courthouse,
"outside" is the operative word. There's none of this "getting your day in court" when it comes to
foreclosure here.

I got some foreclosure statistics from the Atlanta Foreclosure Report and did a little analysis on
where most of these homes were that were being auctioned off by the collection of mumbling
lawyers on the courthouse steps. Consistent with studies done on foreclosure in other cities, the
data showed the highest rates of foreclosure in predominantly African American neighborhoods.
Pondering all this, I departed the courthouse steps and headed back towards Auburn Avenue.

3. The Almost Forgotten History of Black-Owned Financial Institutions

Back along Auburn Avenue, I passed by the modern Atlanta Life Insurance Company building
and then, heading east towards the King Center, passed by many buildings in disrepair. You can
just make out the words on the signs of some of the buildings, and, if you know your history, you
can try and imagine what was going on in and around them years ago - for Auburn Avenue was
once the hub of black economic activity in Atlanta and a key source of capital for African

Along this stretch of Auburn you pass by the Apex Museum, and you can watch a movie called
Sweet Auburn - Street of Pride. Here's an excerpt:

Excerpt: Sweet Auburn - Street of Pride.

That excerpt from the Apex Museum's video "Sweet Auburn - Street of Pride", narrated by
Cicely Tyson and Julian Bond, includes a short history of some of the major black-owned
financial institutions that emerged during the early twentieth century, some of which are still
with us today. (The web site of the Apex Museum is

It's definitely not easy to read about the history of black owned financial institutions, for not very
much history has been written about them. Professor Alexa Benson Henderson at Clark-Atlanta
University wrote a book in 1990 called "Atlanta Life Insurance Company: Guardian of Black
Economic Dignity" where she described this hole in American history as follows ... "I was the dearth of sources, printed or otherwise, on many of the significant
individuals, groups and organizations that have been associated with black business development
in Atlanta and elsewhere. Sadly, many of these inspiring stories are lost forever."

The Atlanta Life book opens a window to a whole branch of US financial history that has been
largely ignored. Black-owned financial institutions sprung up in many places following the end
of slavery, initially taking the form of community and church-based mutual aid associations. In
the late nineteenth and early twentieth centuries there was no federal tax and no such thing as
social security, unemployment insurance, Medicaid and so forth. As always, those at the bottom
of the economic ladder were the most vulnerable to the contingencies of sickness, accident, job
loss, death or imprisonment of a breadwinner.

Out of this environment and out of necessity grew a slew of mutual aid associations in black
communities. In such a mutual aid group the cost of these risks is pooled by everyone paying a
small weekly or monthly premium. Out of this pool are paid the costs of the few that experience
the covered contingencies, such as death benefits to widows and orphans and weekly payments if
you get sick and can't work. In this way the community as a whole bears these risks. This
arrangement is more conducive to community development than having every member bear risk
individually, which would tend to bankrupt whole segments of society.

Out of this collection of mutual aid societies in the South ultimately grew several extremely
successful life insurance companies that, despite tremendous obstacles, are still with us today,
including Atlanta Life on Auburn Avenue and North Carolina Mutual, born in another hub of
black capital accumulation - Durham, North Carolina. These institutions have performed the near
impossible - surviving for a whole century and through a period of brutal segregation,
discrimination, the Great Depression and through having to win the confidence of their own
communities in black owned and operated financial institutions.

Around the time these insurance companies were starting to grow, another key segment of black
finance was emerging - the black owned banks. For example, Citizens Trust Bank opened up on
Auburn Avenue in 1921 to meet the credit needs of the black community, to promote savings
and the old-fashioned principles of "thrift", and to promote homeownership. Through all that
happened in the twentieth century, Citizens Trust Bank is also still with us today.

These and other black-owned institutions played a significant role in the accumulation and
distribution of capital in African American communities throughout the twentieth century. It is
no coincidence that the communities around them, such as the Auburn Avenue area, developed
into economic hubs. Banks and insurance companies pool deposits and premiums and then invest
them in things like home mortgages, office buildings and business loans. To the extent these
pooled funds were invested back into local communities, further economic development of the
communities was assured.

4. Physical Desegregation, Financial Segregation

Well, as the years went by and even as segregation continued, white financial institutions began
to see that money could indeed be made off black customers and they began to compete fiercely
for this business. Ronald H. Bayer's book "Race & the Shaping of Twentieth Century Atlanta"
sums up this situation as follows: "The success of these black institutions had proved to the white
financial community that blacks were good mortgage, bank and insurance risks. ... The decisive
factor has not been the [white] citizenry's quickened sense of charity or prosperity. As the men
along Auburn Avenue often murmur wryly ... "Dollars, you see, are not segregated".

Often with deeper pockets, bigger marketing budgets, more experience and privileged access to
the legislature, white financial institutions had many advantages in acquiring black customers, to
the detriment of the customer base of the black institutions.

As the era of state sanctioned segregation was coming to an end in the South in the 1960s and
70s, a different form of segregation was already rampant in both the North and South - financial
segregation. The dominance of white institutions providing financial services to black customers
soon led to a situation where accumulated capital from premiums and deposits were not being
reinvested back into those communities but, rather, flying away to ventures in other areas. In
such a situation capital is increasingly drained out of the local community.

5. 1968: Dr King's Death and Ginnie Mae's Birth

Social tensions in the aftermath of the assassination of the civil rights leader from Auburn
Avenue, Dr Martin Luther King Jr., created the necessary pressure for the passage of the Fair
Housing Act (also called the Dr. Martin Luther King Jr. Civil Rights Act) in 1968. This act
outlawed most housing discrimination and gave HUD, the US Government Department of
Housing and Urban Development, responsibility for enforcement.

On a related issue, this year also saw the birth of the government corporation known as Ginnie
Mae, the Government National Mortgage Association, who we met in Wizards of Money Part
15. Ginnie was charged with a very important task - to facilitate the flow of capital into home
loans for low and moderate income neighborhoods.

How did she do this, you might ask?

Well in 1934, during the New Deal regulatory blitz of the Great Depression, the National
Housing Act came into effect. This act established the Federal Housing Administration or FHA
to insure home mortgages. What this means is that the government provides a guarantee to
mortgage lenders in low-to-moderate income neighborhoods that they will get their money back
if a borrower defaults. These government guaranteed loans, known as FHA loans, encouraged
banks to make loans in many low-to-moderate income, and minority, neighborhoods, and this
loan program is administered by HUD.

Let's here some background on the FHA loan program from Charles Gardner, the Director of
HUD's Southeast Region home-ownership program. Since the current statistics show so many
FHA loans in foreclosure, we'll also hear about what happens when an FHA loan goes into
default, and the home is foreclosed on.

Excerpt from HUD Interview 1. 0.00 -3.00 & 12.30 - 15.00 (5.0)

As things turned out, the FHA loans by themselves still didn't encourage enough capital to flow
into home loans in these under-served neighborhoods and so Ginnie Mae was created in 1968.
As noted in Wizards Part 15, Ginnie would buy up lots of government insured mortgages, mostly
from the FHA program, and pool them together to create new securities known as mortgage
backed securities. Then she guaranteed timely payment of principal and interest to the investors
in these new securities. These new, pooled securities were very attractive lots of investors with
lots of capital to invest, such as insurance companies and pension funds.

And so Ginnie Mae began to facilitate the flow of more and more capital into the FHA loan
program serving low-to-middle income and minority communities. Her relatives known as
Fannie Mae and Freddie Mac were created as privately owned counterparts to facilitate the flow
of capital into conventional loans requiring a 20% down-payment, and not insured through a
government program.

Ginnie, Fannie and Freddie started something pretty revolutionary but, unknowingly, they had
also created a Monster! Before long the Investment Bankers along Wall Street caught on to the
art of doing what Fannie, Freddie and Ginnie had done and began pooling and making new
securities out of everything and anything that had cashflows that moved.

Securitization is the process of pooling together lots of individual debts like mortgages or credit
card debt or auto loans, and bundling them altogether to create new securities called asset-backed
securities. These new securities, backed by the cashflows generated from the pool, are more
attractive to investors than investing directly in individual mortgages and credit card debt.

The process of securitization has taken the financial world by storm and its rapid development is
perhaps the most important development in finance in a century.

Coming into the 21st century, securitization has been responsible for exponential growth in the
financing of things that otherwise may have only gotten dribbles of capital - from non-stop credit
card offers to predatory mortgages and home equity loans, to FHA loans - the list goes on and

To understand how securitization has facilitated predatory lending, we must travel along the
securitization pipeline and trace a home loan from the unsuspecting home buyer through the
mortgage broker, all the way back to Wall Street, the banking giants, the secret hedge funds, the
insurance companies and other investment funds.
We start our journey with a borrower in a low to middle income community. There are two types
of customers: Those that already have a mortgage and some equity in their homes, and first time

6. The Predatory Pipeline: From the Home Buyer Back to Wall Street

First we'll hear about the first type of borrower, the most likely target of the predatory lending
pipeline, from Bill Brennan, the Director of Atlanta Legal Aid's Home Defense Program.

Excerpt 1 from Bill Brennan Interview on Sub-Prime Lending (0-8.33) 8.5

The sub-prime loans we were talking about here should not be confused with FHA loans, which
are very different and which we will talk about separately.

The home loan process starts with the mortgage originator or broker. Many of these originators
are "fly by night" shops, often smaller operations, or seedy subsidiaries of the big banks. In cases
of fraudulent sales - falsified loan applications and the like - it's these players who are often
directly responsible for the fraudulent act. What many of these predatory loans have in common
is that the borrower finds an offer of credit attractive but does not understand the mathematics
behind the transaction. They mistakenly trust the lender to do the calculations for them and do
not realize they are paying too much for credit. When they can't afford their payments a few
years down the track, they will lose their home.

The shady originators are generally not well capitalized nor regulated, which is why so much
fraud happens at this point. Their primary sources of capital are the mortgage subsidiaries of the
big banks that buy the mortgages from these small operators.

The mortgage subsidiaries of the big banks, such as Chase Manhattan, Wells Fargo, Citigroup,
Deutsche Bank and Washington Mutual, buy up these mortgages in bulk and bundle them
together to create pools out of them in things called Securitization Vehicles or Special Purpose
Vehicles (SPV). The cashflows from the SPV, or pool, are then used to make new financial
instruments called asset-backed securities.

These asset-backed securities issued against a single pool of home loans come in several
varieties known as "tranches". The securities known as the senior tranches are the first to get paid
out of the home loan payments coming out of the pool. Then there are the most junior tranches
that get paid last. Hence the senior tranches are very safe investments and it's really the junior
tranches that bear the risk of default by borrowers and losses realized on foreclosure. Because the
senior tranches are safer investments they are very attractive to insurance companies and the like.
Because the junior or, sometimes called toxic, tranches are very risky and bear most of the risks
of default in the pool, they must offer very high returns to attract investors. This is exactly what
the investment vehicles known as the "hedge funds" love.

Hedge funds are unregulated, managed investment vehicles funded by the capital of the
extremely wealthy and designed to earn super returns for them. They are not regulated because
of the so-called sophistication and wealth of their investors. Because of this, they have no capital
requirements or safety net requirements - like the type of safety net that banks are required to
hold to protect depositors funds, and that we discussed in Wizards Part 2.

The role of hedge funds, and other investors who take up the risky tranches of securitizations, is
critical. Without them, securitizations would not be as prevalent as they are today because, in
order for the banks to reduce their own risks and front their profits on mortgage lending, they
have to be able to sell these risky tranches. The fact that both hedge funds and others in this
pipeline are not regulated means that safety and soundness of mortgage financing overall is
reduced, and that the profitability of it is greatly increased.

This system design, and its extraordinary profitability, have facilitated massive flows of capital
into sub-prime and predatory lending in the past decade. Ultimately, the primary reasons for the
high profitability of predatory lending are:

1) The information gap between the two ends of the pipeline. At one end you have the
borrower who knows little to nothing about the mathematics of finance. At the other extreme,
unbeknown to most borrowers, you have the masters of the most sophisticated financial system
that has ever existed. Such information gaps mean huge profits. This translates into extra
shareholder returns, over and above normal returns, of 20% or more on shareholder investments.
I'll post these calculations to the Wizards of Money web site at

2) Loan Values Less than Value of Home: This means that the lender really can't lose on
default and foreclosure and, again, risks are lower than what's priced into the interest rates on
these loans. In many cases the borrowers themselves are the primary bearers of risk, but the
pricing of the loans rewards lenders for the risk.

3) Avoidance of Legal Liability and Regulatory Restraints: Because most of the fraud
happens with the small mortgage originators, the big suppliers of capital are not held accountable
for it, and capital continues to flow to the next dodgy operator. Also, because banks securitize
the bulk of these loans they can profit from them up-front and sell the securities to unregulated
entities with no capital or "safety net" requirements. This makes the market more profitable.

Here's Bill Brennan again...

Excerpt 2 from Bill Brennan Interview on Sub-Prime Lending (20.25-20.55)

In the recent set of national and local foreclosure statistics it is clear that foreclosures related to
sub-prime loans are on the rise. And so are those related to FHA loans. Let's turn our attention to
what's going on in the FHA loan market.

7. The FHA Loan Pipeline

In the statistics for Atlanta, FHA loans in foreclosure account for about one third of all recent
foreclosures. Interestingly, I also noted that almost 20% of these were FHA loans that were
bought by subsidiaries of JP Morgan Chase & Co. Not only is Chase Manhattan one of the
largest issuers of the Ginnie Mae securities made from FHA loans, but JP Morgan Chase has
been employed by the government for years as the main pooling and banking agent for the whole
Ginnie Mae program.

This reminded me of an article I read recently in the Wall Street Journal about a home loan scam
in Pennsylvannia where homes were being over-appraised by fraudulent appraisers and
ultimately facing foreclosure because people couldn't afford the loans. The supplier of capital
here was Chase Manhattan Mortgage who claimed no knowledge of what was going on.

Over-appraising the value of homes lies at the heart of many FHA loan program abuses. You see,
in this case, the FHA insurance program guarantees that the lender will get all their money back
if they lose money on foreclosure, so over-appraising and over-lending that leads to foreclosure
can be very profitable.

I decided to ask HUD about what was going on with the high rates of FHA loan foreclosures in
Atlanta. Here's Charles Fowler:

Excerpt 2 from HUD Interview (4.13 - 5.20)

Bill Brennan at Atlanta Legal Aid had a lot more to say about what's going on:

Excerpt 3 from Bill Brennan Interview on Sub-Prime Lending (9.39 -12.31 & 13.30 - 15.05) 4.5

Then I asked HUD about why Chase Manhattan was such a popular name with the FHA loans in

Excerpt 3 from HUD Interview (10.40-12.00) 1.5

Again, Bill Brennan had a lot more to say

Excerpt 4 from Bill Brennan Interview on Sub-Prime Lending (15.26-20.25)5.0

Well, in the fight to stamp out both predatory lending and FHA loan abuses, some progress is
being made.

8. Progress in Clamping Down on Predatory Capital

On the HUD side of things, Charles Fowler told me about the HUD loss mitigation program on
FHA loans:

Excerpt 4 from HUD Interview (12.08 - 12.40)

Also, the day I visited HUD they released a new rule about holding lenders accountable for the
work of appraisers, which should help reduce over-valuations and the FHA abuse known as
"asset flipping".

Bill Brennan told me about some of the good lenders:

Excerpt 5 from Bill Brennan Interview on Sub-Prime Lending (20.56 - 22.58) 2

Finally, we also discussed the new Georgia Predatory Lending Law, the toughest in the country
and revolutionary in that it creates legal liability all the way up the predatory lending pipeline to
the big financial players and capital suppliers. Here's Bill Brennan discussing the law that he
worked with others for many years:

Excerpt 5 from Bill Brennan Interview on Sub-Prime Lending (23.50-27.55 & 28.50-29.50) 5

Finally, here's some words of advice:

- If someone offers credit aggressively, it's probably a great deal for them and a bad deal for you.

- Get to know your own credit score (known as the FICO score) and get a copy of your own
credit report form someone like Equifax, so that you known exactly what creditors know about

- Don't think of the mathematics of finance as a humdrum and dreary topic - because that type of
thinking is exactly what makes the predatory pipeline work! If people thought finance was as
exciting as the superbowl the dodgy sectors of finance would be devastated!

That's all for the Wizards of Money Part 18. Wizards of Money has a web site with references,
text and background materials at and also you can e-mail me at

Part 19: "The Education Sweepstakes"


1. The Remarkable Story of Risk - From the Halls of Baghdad to Twenty First Century Risk
2. The Skills for Playing in a Market Economy
3. The State of State Finances
4. Economic Development and Slot Machines
5. The Lotto Sweepstakes Sweeping the States
6. The Other Mae Family – Sallie, Nellie et al.
7. The Ultimate Risk Bearers

This is the Wizards of Money, your money and financial management series…but with a twist.
My name is Smithy and I’m a Wizard Watcher in the Land of Oz. This is the 19th edition of the
Wizards of Money and it is entitled “The Education Sweepstakes”.


In this, the nineteenth edition of the Wizards of Money, we are going to take a look at the
funding of education and the rise of the slot machine. With more federal dollars being diverted to
overseas conquests and the US states experiencing a severe budget crisis, some things have to
suffer. And one of these somethings happens to be education. "Never mind", say some states,
let’s just get those lotto balls rolling and slot machines ringing.

Insert: Casino/Slots/Governors Meddly (1minute)

Compulsory primary and secondary education in the United States is funded mainly by state and local
governments. Higher education is funded through a combination of state and federal aid programs, rich
parents, and overwhelmingly by the educated getting into a whole lot of debt. And for those shut out of
funding options in the civilian markets, education funding and job training have become the primary
reasons why people join the US military.

The squeeze on state and local budgets, compounded by the diversion of federal spending to war and
homeland security, seems to be turning the education system into a great big game of chance – the
“Education Sweepstakes”. If you don’t come to the market with accumulated wealth, even something as
simple as getting good healthcare is a bit like winning the lottery, and so is getting a good education.
Small wonder then, that the lotteries and casinos the states are expanding to plug their budget holes are
attracting more and more of those who can least afford to play.

Without a good education, it is much harder to face the daily battle with the trickster who lies at the heart
of both capitalism and the slot machines – RISK. The shifting nature of government spending is turning
the economists’ favorite theoretical relationship between risk and return on its head. For the markets to
work efficiently, an investor should only get high returns if they are taking on lots of risk, and conversely
they should expect low returns where risk is minimal. But increasingly, certain market players can get
huge returns by taking hardly any risk, simply by playing against others facing huge risks for low or
negative returns. Now government bodies, in their desperation, seem to be making this problem worse.
Sometimes they’re even the ones running off with the public’s money!

Insert: "Mass Cash" Song

The constant marketing of gambling and lotteries, whether it be over the internet, the television, the radio
or at the local store is the stuff of "genies and magic lamps, rooted in hopes, dreams and suspicions", so
said a report on gambling commissioned by the government as the last century came to a close. In this
edition of the Wizards of Money, we'll speak to one of the authors of this report, as well as an investment
banker in Maryland about the slot machine business, and a professor at the University of Nevada in Las

But first, speaking of that rascal called risk, let’s delve into the history of risk and why the business of risk
management is so important.

1. The Remarkable Story of Risk - From the Halls of Baghdad to Twenty First Century Risk

Ask yourself "What is the defining feature that lies at the heart of capitalism?" To that question many
people would probably answer “profits”. But it may be more correct to say that it is “RISK”. Profits are
compensation for taking risk. In a capitalist economy, individuals with accumulated capital either spend it
on something real or invest it, which really means lending it to some economic venture. When you invest
your money, you are putting your capital at risk for you might lose some or all of it. Investors are
compensated for this risk-taking by the potential for profits. This potential for return provides the incentive
for risk-taking, and it is this risk-taking that has lead to phenomenal economic growth in market

One of the downsides of this system is that individuals are required to bear many of the risks of daily
living themselves – the risks of devastating events like unemployment, sickness, accident and loss of
housing. In our current economy, some if this is alleviated through government safety nets and the
insurance markets, where risks can be transferred, but for a price. As government safety nets shrink and
more people find adequate insurance coverage prohibitively expensive, it becomes increasingly important
for individuals to develop their own contingency plans. In a market economy then, each player would do
very well to understand how to manage his or her risks, and how to take calculated risks.

Amazingly, many people do not pay much attention to this ever-changing, ever-elusive beast who runs so
much of our lives. Risk is sneaky – it likes to influence everything, but let something else take the credit
(or the blame!) for it. For thousands of years, much to its delight, Risk evaded human scrutiny as the
humans worshipped the sun, then the gods, then a single god, and, of course, the two permanent
occupiers of the human mind - fate and destiny.

But over the past thousand years various tools developed to measure risk and for humans to take some
control of this wild beast. These capabilities are ultimately what lead to our capital markets, and our
modern monetary system and it’s financing of the industrial and then technological revolutions.

Developments in Mathematics and developments in finance have been inseparable since the days when
merchants would use an abacus to calculate their trading gains.

But perhaps the real turning point occurred somewhere along the halls of Baghdad about a thousand
years ago. While Europe was still bumbling through the Dark Ages, an Arab mathematician named Al-
Khowarizmi laid the foundations for the basic arithmetic and algebra we use today, upon which most
subsequent mathematical theory would later be based. And part of his motivation was quite simply
practical - to facilitate trading. Imagine how things would have progressed if, instead of this development,
the world had stayed on the old Roman and Greek numbering systems, adding them up with an abacus
or pebbles in the sand!

It must have been at this point that risk was getting nervous that soon, not only would it be noticed, but
the humans might try and use it to their advantage.

As Europe woke up from its dark era and the renassaince began, the Europeans built on these
developments from the Arab Mathematicians and the equipment for dealing with risk and the
mathematics of finance began to develop. Initially, probability theory was born mainly as a result of
wealthy men’s fascination with games of chance. Accounting theory developed in Italy and facilitated the
flow of capital into business ventures. Then the mathematics behind insurance (or actuarial science)
began to develop to help manage the risks of overseas trade and financing vehicles such as annuities
issued by the English government to finance their budget deficits. Over the centuries the mathematics
behind trade and finance has developed as a tool to help investors take calculated risks and get capital to
flow in the direction of economic development, rather than catastrophic loss. Finally, the late twentieth
century saw the ultimate formalization of the practice of “risk management”, and today there are tools to
help us manage the risk/return trade-off for just about any risk we can imagine.

Risk has been caught and tamed for economic growth. (At least up till now. There’s no telling what’s
around the corner!).

2. The Skills for Playing in a Market Economy

For a market economy to be somewhat fair in providing opportunity, all market players must know how to
play and must be able to make sensible risk-return trade-off decisions. Where you have large segments
of society that participate but never really learn how to play, then they will be preyed upon by the more
knowledgeable players.

“Even more important than money itself is information about money”, so said a past CEO of Citigroup a
few years ago. Just as in a sports game it’s important for each player to know the rules of the market
game and to learn some skills and strategies to get to their desired outcome. Also of paramount
importance is to have some information on how other players are going to play the game.

Deregulation in both the financial and gaming sectors over the past few decades has created a situation
where the more sophisticated players can play directly against those that never even learned the rules of
the game, let alone strategy. And so over the past two decades we have seen the rapid rise of things
such as predatory lending, credit cards, and the focus of this Wizards episode - lotteries, slot machines
and casinos. All of these create a transfer of wealth from the poorer to the richer, based on the knowledge
gaps between the two groups, and at a time when government safety nets at the federal, state and local
levels are in pretty bad shape.

Capitalist economies have tried to prepare people for a life in the market economy through their education
systems. They have also tried, in varying degrees, to provide a safety net for those who do not have the
ability to withstand the risks of disability, illness, unemployment and so forth, to prevent them from being
shut out of the economy.

But the government funding for this safety net for handling risk and for the education system is shrinking
as states face budget crises and as federal spending is increasingly diverted to war and homeland
security. And more and more it seems that the funding gaps are to be funded by the winnings of this
market game played by the skilled players against the less educated players, just as the latter becomes
more tempted towards games of pure chance to change their situation.

Insert: Peron Lottery Song (0.5 minutes)

3. The State of State Finances

As you may have heard, most US states now face something of a budget crisis totaling almost $100
billion dollars in the coming year. Making matters worse, the Bush Administration, wanting to create more
room in the Federal Budget for war expenses, is imposing greater financial burdens on the states.

Unlike the Federal Government, the states are bound by their own constitutions to “balance the budget”,
meaning that they must bring in enough revenues through taxes and other means to match their

As we all know from arranging our own personal finances, to make these two sides match, states must
raise revenues or cut expenses, or both.

Here’s Jeff Hooke, an investment banker in the state of Maryland discussing how that state is going about
tackling its budget crisis:

Insert: Jeff Hooke 1 (2.5 minutes)

4. Economic Development and Slot Machines

The states must be looking upon slots as a gift from heaven. And so too are the private interests that run
the slots. Nowhere is the risk-return relationship more upside-down than in the slot machine business.

So enticing is the Slot Machine – it’s the perfect candidate for a tax you have when you’re not having a
tax. They have become so charming! .. Insert Regis Slot Machine ()… and so cute! Insert Addams Family
Slot Machine ().

And the closer you put the slots to large urban and suburban populations, the more dollars the slots
generate. Jeff Hooke helps us understand the economics of the slot machine business:

Insert: Jeff Hooke 2 (7 minutes)

Bill Thompson, a professor from the state whose primary export is slot machines, helps us understand the
impact of the gaming business on local communities:

Insert: Bill Thompson Vegas1 (3 minutes)

And while the huge returns from the low-risk slot business are attracting those with degrees from the Ivy
leagues and lots of capital to invest at one end, at the other end we have the slot player who, on average,
will, of course, lose money. That is, their expected financial return is negative. The so-called "House
Edge" on slot machines ranges from about 5% to 15% in some cases.
This House Edge is the proportion of money that you will lose, on average, if you keep pumping dollars
into the slot machine. It’s the pure profit cleared by the slot machine for its owners. Here’s the Maryland
investment banker Jeff Hooke, talking about this guest at the other end of the slot machine.

Insert: Jeff Hooke 3 (1 minute)

And Bill Thompson talks about national trends in this area Insert: Bill Thompson Vegas 2 (6 minutes)

No question, slots are bad bet if you're the one putting the dollars in. But the worst odds of all and the
most regressive tax of all, meaning that it’s a much higher tax for the poor than the rich, is, of course, the
State Lottery system.

Insert: CA Lottery Full + Song (1minute)

5. The Lotto Sweepstakes Sweeping the States

The history of lotteries is an interesting one and perhaps longer and more volatile than you might be

Recorded history shows that lotteries date back at least to the time of Julius Caesar. Around 100 BC the
Chinese created Keno, and more than a thousand years later Europe came out of the Dark Ages and
monarchies and governments set the trend of using lotteries to fund government spending.

Believe it or not, in the 1600s the English kings ran lotteries in London to help fund early colonies in
America. Later, lotteries were used by the founding fathers of America to fund the Revolutionary War. In
1776, in France, Louis XV appears to have started the trend for states to have a monopoly on lotteries for
reducing state deficits.

In the 1700s and 1800s, in the absence of an income tax system and a Federal Reserve System, lotteries
were a standard source of revenue for public and private spending. Fifty colleges and 300 schools were
constructed with the help of lottery proceeds, including even Harvard, Yale and Princeton.

But these lotteries, unregulated as they were, were a breeding ground for corruption and fraud. State and
federal governments decided to shut them down. By the end of the nineteenth century lotteries were
banned in most states, not to be seen again for many decades to come.

During the 1960s and 1970s lotteries began sneaking their way back onto the scene and lottery sales
reached about $1 billion by 1976.

In the late 1980s multi-state lotteries emerged and today 38 states have lotteries and total US lottery
sales are now at about $40 billion and growing fast. The majority of these states use the bulk of their
lottery proceeds to fund education.

No doubt about it, your expected return from playing the lottery is very negative. First the House Edge –
or the amount that goes into state coffers - is a whopping 50%, the largest House Edge of any chance
game. And your odds of winning the mega-millions prize are lower than the possibility that Martians with
land on your doorstep tomorrow. Of course, you wouldn’t know this if you listened to the States
advertising their lottery wares…
Insert: WA State Lotto

Here's Bill Thompson on Lottery Advertising and the Education Sweepstakes:

Bill Thomson Vegas 4 (2 minutes)

In 1999 the National Gambling Impact Study Commission put in place by the US Government,
commissioned a study on Lotteries entitled "State Lotteries at the turn of the Century". A section of that
report reads as follows "Promoting lotteries does more than persuade the pubic that playing is a good
investment. At one level the sales job may be viewed as values education, teaching that gambling is a
benign or even virtuous activity that offers a desirable escape from the dreariness of work and the
confines of limited means. Not only does lottery advertising endorse gambling per se, it may also endorse
the dream of easy wealth that motivates most gambling. Many ads are unabashedly materialistic with
winners basking in luxury and lives transformed. Yet this is not the materialism of hard work and
perseverance but rather of genies and magic lamps, rooted in hopes, dreams and suspicions".

Ironically it is the state governments, who we elect to represent us, who are responsible for feeding this
message of myths and magic back to us.

I spoke to Philip Cook at Duke University, one of the authors of the National Gaming Impact Study
Commission Lottery Study about the capital flows of the lottery..

Insert: Cook1 (6 minutes)

Then there is another question about lotteries and gaming in general, and that is whether cuts in the
social safety nets will actually drive people further into the gambling trap. Here's Philip Cook again…

Insert: Cook2 (4 minutes)

6. The Other Mae Family – Sallie, Nellie et al.

If you've watched any of the business and finance shows on TV lately, and seen the "quick picks" of the
wealthier players, you'll certainly notice that the gaming sector has become popular amongst the stock

And there is another big favorite that's emerged from the state budget crisis. And that's the student loan
market players - that is, the originators of student loans, and those that buy and sell student loans in the
secondary market and bundle them up into neat financial securities through the securitization process, as
we talked about in Wizards Part 15.

In most states the first expense item on the budget chopping block has been college education, passing
more and more tuition costs onto students themselves. Consequently, the student loan business is
booming. And here the major player is Sallie Mae, close friend and relative of Fannie Mae, Ginnie Mae,
Freddie Mac, Farmer Mac and that whole clan. And she's yet another one of those semi-government,
semi-private so called "Government Sponsored Entities" we discussed in Wizards Part 15. Similar to what
other members of her family do in the home loan market, Sallie Mae originates and buys a huge
proportion of student loans. Banks and other financial institutions are also major players in the student
loan market.

Through the Federal Family Education Loan Program, private investors get nice government guarantees
on the capital they invest in student loans. Here again is another example of the risk-return trade-off being
all upside-down. For no risk, private investors in these guaranteed loans can get a guaranteed return,
while the student taking out the loan bears the risk that they wont get a job with a high enough salary to
repay their skyrocketing tuition costs.
7. The Ultimate Risk Bearers

As bad as all this is, when it comes to getting a good education, the ultimate risks are born by those who,
for whatever reason, don't have access to education funding in the civilian financial markets. A number of
studies in recent years have demonstrated that the majority of people entering the military do so for the
benefits of education funding and job training. But they go for this promising return by taking on the
ultimate risk.

That's all for the Wizards of Money Part 19. Note that the Wizards of Money has a web site at where you can access the text, audio and references for all WOM episodes.

Part 20: "Caught Between and Dock and a Sweatshop"


1. The Holy Cartel & The Magical Price Range
2. A Party in Dallas
3. The Ancient Creature of "Old Europe" vs Fossil Fuel Industry
4. Energy Outlook

This is the Wizards of Money, your money and financial management series… but with a twist.
My name is Smithy and I’m a Wizard Watcher in the Land of Oz. This is the 20th edition of the
Wizards of Money and it is entitled “The Battle of the Dragons - Oil vs Insurance”.


In this, the twentieth edition of the Wizards of Money, we're going to look at why it's not easy
being green when everybody wants to be in the black! We'll discuss the relationship between
black gold, the future of the world's most powerful cartel, the changing climate and the powerful
industry that loses big bucks on bad weather.

First we'll discuss that ever important "oil price range" - that target price range per barrel of oil
within which both producers and consumers are happy to continue "business as usual". But we
can't discuss that without also talking about that thing at the heart of the oil markets so despised
in all our free market teachings - the cartel - in this case, the OPEC cartel, of course. Given
what's happened in Iraq and continuing US policy towards OPEC countries, we'll see where
OPEC might be headed in the future.

We'll look at the indications that the OPEC cartel may face tough times ahead and the outlook
for the fossil fuel industry in general. For, while they might be thinking their future looks pretty
rosy, they may be just about to meet their match.

You see, what has now become "old Europe" is also the home of another fearsome and ancient
creature of the capital markets that is none too pleased about the world's use of fossil fuels.
Despite all the denials in the US media, the huge global insurers and reinsurers accept climate
change as fact. Furthermore, they accept that climate change is induced by human activity. And,
climate change is costing them big bucks! As powerful advocates of the Kyoto Protocol and with
Trillions of dollars to vote with in the capital markets, the insurance industry has both the motive
and the power to do something about climate change.

For this journey though the oil and insurance markets we'll speak with an executive at the world's
largest reinsurer (Munich Re), with several oil markets consultants in the oil state of Texas, and
with the head of research at Greenpeace, who just had a party at the Exxon Mobil shareholders
meeting in Dallas Texas.

1. The Holy Cartel & the Magical Price Range

A cartel is formed when a dominant group of suppliers or producers of a product conspire to

keep prices artificially high. Basically, they conspire to hold back supply so that prices are held
above where they would fall if you allowed full competition between these producers.

The most powerful cartel in the world is, of course, OPEC - the Organization of Petroleum
Exporting Countries. It consists of 11 countries altogether and these are Saudi Arabia, Iran, Iraq,
Qatar, UAE, Kuwait, Nigeria, Algeria, Lybia, Indonesia and Venezuela.

For various reasons, OPEC does not want the price of oil to get too high, either. And so the price
of oil ends up being managed within a certain magical price range. I asked Professor Dermot
Gately, Professor of Economics at New York University to explain this magical price range:

Insert: Professor Gately Interview Segment 1

But the natural question to ask about OPEC these days is "What will happen to it now that
America - the worlds largest oil consumer - is running the place?" Isn't it bizarre that, for the first
time ever in the history of big cartels, the biggest customer of the cartel, the United States,
actually has a seat at the table of the cartel? The cartel is supposed to be in a conspiracy against
its customers! Often, when you have serious questions like this about oil, you find yourself going
to Texas for the answers. I posed this question to Professor Michael Economides, Professor of
Chemical Engineering and consultant to the oil industry, at the University of Houston:

Insert: Professor Economides Segment 1

I also decided to pose this question to a finance professor - Professor Craig Pirrong- at the
University of Houston, to see how the oil state's financial world feels about this tricky situation

Insert: Professor Pirrong Segment 1

2. A Party in Dallas

Well, while I was talking to these Oil State professors about the State of Oil, something
especially interesting was taking place in Dallas, Texas at the headquarters of Exxon Mobil. Here
were some different opinions about the future state of oil. I decided I better find out what was
going on, so I spoke to Kert Davies, the head of research at Greenpeace about the party they
were having in Dallas in the last week of May 2003.

Insert: Greenpeace Segment 1

These days, it's not just the environmental movement and some concerned shareholders going
into battle against the oil giants. Another set of equally formidable industry giants - the global
reinsurance companies - are starting to flex their muscles in this global battle for green fuels over
fossil fuels.

3. The Ancient Creature of "Old Europe" vs Fossil Fuel Industry

Reinsurance companies basically provide insurance to the direct insurance companies that we are
more familiar with, who insure our houses, cars and businesses. The two biggest of these - the
European based Swiss Re and Munich Re - provide insurance to insurance companies all over
the world, to limit the losses of those insurance companies, just like we limit out losses by
buying insurance on our house. Just like you have to go to Texas to talk oil, you have to go to
Switzerland and Germany to talk about important worldly insurance issues. I asked Thomas
Loster in the Geo Risks Research division at Munich Re in Germany what they think about
climate change.

Insert: Munich Re Segment 1

Apparently, not all insurers are quite so active in this mission to stem climate change, and it
seems that some of the US insurance companies are not so serious about slaying the fossil fuel

Insert: "Young Ones" Hippie Knight

Kert Davies from Greenpeace gives a summary of their experiences in working with the
insurance sector.

Insert: Greenpeace Segment 2

4. Energy Outlook

Quite undeterred by the finding of the UN Panel on Climate Change and the 30 years of study at
the big reinsurers, some consultants and researchers in the oil industry are determined to believe
that fossil fuels do not cause climate change. Here's Professor Economides from University of
Houston again.

Insert: Professor Economides Segment 2

Many oil industry analysts see the demand for, and use of, oil continuing to increase for decades
to come and can't see how transportation can get away from the fossil fuels. But, then again, so
people with wood chip cars and buses early in the twentieth century might have once thought
about their dependence on chopping down trees for transport. Like many people my age, I've
leant all I know about cars from the radio program "Car Talk" including the following:

Insert: CarTalk CLASSIC "Woodchip Burning Engines"

If people can go from using woodchip cars to gasoline cars, then who knows what could be next?

Professor Economides argues that much of the worlds current energy problems will be solved by
Natural Gas and Hydrogen fuels.

Insert: Professor Economides Segment 3

Professor Gately at NYU was a little more hopeful about the so-called "renewables".

Insert: Professor Gately Interview Segment 2

In the next part of this series we'll investigate [well, maybe] where the status of renewable really
stands and learn more about how, much to some people's amazement, the environmental
community is starting to work more with the investment community in the battle against fossil

That's all for Wizards of Money Part 20. Note that the Wizards of Money has a web site at where you can get the text of all episodes and further references.

Insert: Stevie "The Battle of the Dragon"


The Famous Munich Re Graph (of economic and insured loss trends) See Page 5 of

UN Environment Program Finance Initiatives Climate Change Working Group

Germanwatch Climate Change & Financial Sector Workshop

OPEC Munich Re Swiss Re GreenpeaceUSA

CarTalk CLASSIC - Wood Chip Burning Engines Full Audio

That's all for the Wizards of Money Part 20. Note that the Wizards of Money has a web site at where you can access the text, audio and references for all WOM

Part 21: "Playing Russian Roulette in The Carbon Markets"


1. Global Carbon Flows BC (Before Coal)
2. How the Carbon Accounts become Unbalanced
3. The World's First International Carbon Market
4. A Market Miracle?
5. English Ambitions
6. Tree Farms and Cow Farts "Down Under"
7. Back to the Dark Ages to See What the US is Up To
8. The Pivotal Role of Russia
9. Stuffing Your Wastes Under the Ground
10. Will the US be Left Out of Emerging Financial and Energy Markets?


In this, the twenty first edition of the Wizards of Money, we're going to look at the hottest
market on the globe. Well, it's actually the market designed to cool things down a bit - the global
carbon market.

While the US has developed a sudden fascination with the so-called "Dark Ages", a time when
the earth was much toastier than it is today, the rest of the world is looking forward and has
decided to do something about man-made weather impacts.

Most developed nations have now ratified the Kyoto Protocol of the United Nations Framework
Convention on Climate Change, including all 25 member states of the European Union, as well
as Canada and Japan. By ratifying the Kyoto Protocol on climate change, these countries have
pledged to reduce their greenhouse gas emissions by a significant amount over the next decade.
This pro-Kyoto world has given up on the main country that refused to ratify the Protocol - the
USA, who doesn't seem the least bit embarrassed by their noticeable gaseous emissions.

Forging ahead, the Kyoto team holds out hope that Russia will join them by year-end 2003,
which would finally bring the Kyoto Protocol officially into effect. In anticipation, this pro-
Kyoto world is gearing up for compliance and is implementing new regulations, markets and
market mechanisms - indeed a whole new way of doing business globally - that the US is now
being left out of.

This episode of the Wizards of Money will explore the developments in the global carbon
markets that have taken place mostly outside of the United States, and get very little attention in
this country. These developments include the world's first international market in carbon-based
financial instruments, national taxes and levies on corporate energy use, and even a tax on cow
farts and burps in New Zealand!

To get to know these new markets we'll talk to the director of global operations at in
London, the carbon emissions trading subsidiary of Cantor-Fitzgerald, to an energy specialist for
the Climate Action Network in Brussels and to the head of the Australian Petroleum Cooperative
Research Center.

But first, we'll start with a refresher on the cycle we can't afford to ignore anymore - the global
carbon cycle.

Song: "Carbon is a Girl's Best Friend"

1. Global Carbon Flows BC (Before Coal)

Just like with the water cycle that we spoke about in Wizards Part 7, in the carbon cycle, only a tiny
fraction of carbon on earth actually participates in the carbon cycle relevant to us terrestrial creatures.
And just like the water cycle, any carbon we have in our bodies today has certainly done the rounds over
thousands or millions of years: through plants, soils, other animals, the ocean and the atmosphere. And
you can forget property rights when it comes to carbon! When the carbon in us is ready to depart, it will
just go off and be somewhere else.

Before the industrial revolution got underway, global carbon flows ran as follows: Carbon in the air, stored
as carbon dioxide (amongst other gases), is used by plants in photosynthesis and becomes part of the
plant. Some of these plants get eaten by animals and the carbon in them is then used in various
molecules to make body tissue and to burn up energy. Other plants, or parts of them, like leaves, just get
old and die. This decomposition releases some carbon back to the atmosphere, as does the process of
respiration by animals. The other 99.9% of the world's carbon that didn't participate in this cycle just
stayed underground - mostly buried in the ocean, in sedimentary rock and in fossil fuels.

Before fossil fuel use by humans entered the scene, losses of carbon from the earth and into the air from
decaying vegetation and animal respiration, in the form of various gases such as carbon dioxide and
methane, were pretty much balanced by carbon storage or "sequestration" by plants during
photosynthesis. The carbon cycle chugged along in this balance between about 1000 AD and the early
1800s, and so the amount of carbon in the air stayed pretty constant over this time period since the
middle ages. To give you an idea of magnitude, this annual exchange was about 100 million gigatons of
carbon (where a gigaton is a billion tons), from the earth into the atmosphere, balanced by an equal
exchange from the atmosphere back to the earth.

Insert: Treebeard (LOTR, "The Two Towers")

2. How the Carbon Accounts become Unbalanced

But then came the industrial revolution, powered by the burning of carbon rich fossil fuels, and
accompanied by massive clearing of forest land for agricultural and other purposes. These two activities
have extracted another 7-8 gigatons of carbon out of the earth's sources per year, of which the oceans
and the world's forests have decided to absorb just over half of this release. So the remaining 3-4
gigatons of carbon has nowhere to go but into the air. Over the past 200 years, the level of carbon dioxide
in the atmosphere has risen by 30%, and the amount of methane has more than doubled.

An excess of carbon gases, like carbon dioxide and methane, are known to trap heat in the biosphere,
making things toastier for all of us. This so-called "global warming" has many known and unknown
impacts on climate.

That humans have significantly increased the amount of carbon gases in the atmosphere, and that these
gases do contribute to temperature increases is generally not in dispute between the two main parties on
either side of the Kyoto Protocol. What is under debate is the degree to which global warming is caused
by natural versus man-made factors. The fairly recently discovered indications that the middle ages may
have been warmer than the current ages, has the leadership in the US scrambling to promote studies to
show that natural causes are a primary contributor to climate change.
Satisfied that human activities are contributing to climate change, the countries that have now ratified the
1997 Kyoto Protocol on global warming are trying to do what they can to get as much as possible of this
excess carbon out of the atmosphere by implementing mechanisms designed to reduce overall carbon

The naysayers team, reluctant to give up their high carbon diets, led by the United States and Australia,
are diverting significant resources into figuring out how carbon wastes can be buried underground or in
the sea in a process known as artificial carbon sequestration. The US has also developed a sudden
interest in the climate endured by King Arthur and his Knights of the Round Table - when temperatures
were much warmer than they are today. If only they can understand why the mythical Knights were so
toasty, they can cast doubt on the idea that human induced greenhouse gases are largely responsible for
climate change.

Insert: Camelot

3. The World's First International Carbon Market

Sure, international markets for various forms of carbon products already exist. Why, there are markets for
diamonds, graphite, wood products and, of course, fossil fuels themselves. But now there's a new carbon

In this new carbon market a monetary value is assigned to a carbon gas emission allowance. Such an
allowance could only have a monetary value if there are a finite number of such emission allowances and
the total amount allowed in the market is close to, or even below, the total amount that is currently being
emitted. For this market to exist in the first place there must be someone or some body, most likely a
government body, that sets the total number of allowances for the market.

This is exactly what the European Union has done. It has used the "cap and trade" approach to moving
towards Kyoto targets, which for the EU, requires greenhouse emissions to get to 92% of 1990 levels by
the end of this decade.

As announced on July 23rd 2003, the European Commission has formally adopted a market structure for
a "cap and trade system" for carbon dioxide emissions that will begin operations at the start of 2005.
Under the EU emissions trading scheme the EU member states will set limits on carbon dioxide
emissions from energy intensive companies by issuing allowances for the amount of gas each is allowed
to emit. The total number of allowances will reduce each year until the final target is reached. This list of
companies includes approximately 10,000 companies accounting for about half of the EU's cabon dioxide
emissions and encompasses the following industries: steel, power generation, oil, paper, glass and

A company that is able to lower its emissions at relatively low cost, may sell its excess allowances and
hence, the argument goes, the emissions market will act as a catalyst towards finding lowest cost
emissions reduction solutions. Other companies that have difficulty meeting their targets inexpensively
can buy these excess credits in the market, at whatever the prevailing market price is. In effect then, they
are providing the financing to the seller of the credits for the seller's emissions reductions efforts, since
this was cheaper than reducing emissions in their own operations. And, if companies decide to neither
meet their targets nor buy credits in the market to offset their excess, they will have to pay large fines to
the government, well in excess of the market price of credits. Hence the incentives are there for
companies to either comply or buy credits, thus ensuring that the total amount of emissions will remain
below the target.

This method of allowing the market to cut emissions quickly where it is cheapest and easiest to do will
presumably have the least detrimental effect on the health of the economy, an issue largely driving the
US "flat-earth believer" approach to man-made climate change.
Insert: Interview

4. A Market Miracle?

It does seem like some kind of miracle that a bunch of 25 countries as diverse as the European Union
and who were at war with each other not so long ago, could unite over a proposal that is bound to bring
some shocks to their local economies. Even the European environmental community seems fairly
pleased with the EU's approach to global warming. But, like all such complex agreements involving so
many and varied parties and lots of different political interests, this one is not without controversy or room
for abuse.

During the discussions leading up to the 1997 Kyoto Protocol, some of the most controversial provisions
had to do with the ways in which companies and/or countries could accumulate excess greenhouse gas
credits other than by cutting emissions below their target level. Some of these so-called "Kyoto
Mechanisms" included:

- Creating "Carbon Sinks": Such as planting new forests, or even certain types of timber farming
- Joint Implementation Projects: Which means funding emission reductions projects in other
industrialized nations
- Clean Development Mechanisms: Which means funding "clean energy" projects in developing nations.

Many people fear that credit accumulation or emissions offsets gained under these methods may be the
most wide open for abuse and therefore may not bring about real change in the battle to stem the release
of greenhouse gases into the atmosphere.

The recently approved EU Emissions Trading Scheme, set to begin trading in 2005 did not provide for
these Kyoto Mechanisms.

However, a recent Directive proposes an amendment allowing two of these mechanisms - Joint
Implementation and Clean Development Mechanism Projects in other countries - as methods to
accumulate carbon emissions credits. Climate Action Network in Brussels discusses their concerns about
these mechanims:

Insert: Climate Action Network

Nevertheless, these developments in Europe have really made the EU the world leader in trying to stem
man-made contributions to climate change, and without these efforts it is possible that the Kyoto process
would have collapsed after the US took its sabbatical to study the Knights of the Round Table.

5. English Ambitions

Even though they will be able to participate in the EU emissions markets, in 2002 the United Kingdom set
up the first national emissions market of its own, similar to the EU "cap and trade" mechanism. The UK
actually plans to significantly exceed, or do better than, its Kyoto targets by the end of the decade and
they have gone further than just capping, trading and fining violators.

In 2001 the British government imposed a Climate Change Levy in the form of a tax on business use of
fossil fuel based energy sources. Relief on this tax can be gained by meeting certain targets in the
emissions trading program.

Insert: Director

6. Tree Farms and Cow Farts "Down Under"

Different countries face very different challenges in meeting their Kyoto targets. For less populated and
more agricultural-dependent countries like Australia and New Zealand, carbon dioxide emissions from
fossil fuel use are not the main problem areas.

Though one doesn't like to talk about these things in polite company, believe it or not, cow and sheep
burps and farts are a much bigger problem! Cattle and sheep grazing and their subsequent emissions of
smelly gases as by-products of the digestive process, contribute an abundance of the most potent of the
greenhouse gases - methane. In fact, farm animal farts and burps account for about one half of all
greenhouse gas emissions in New Zealand.

Unlike its less cooperative neighbor Australia, the country of New Zealand has ratified the Kyoto Protocol
and had to do something about these smelly air bubbles. In a move that was far less socially acceptable
than either the pops themselves or Britain's Climate Change Levy, the New Zealand government took the
drastic step of taxing farmers for the natural bodily functions of their farm stock - they introduced the
world's first tax on farting! A farmer's rebellion got underway immediately and it is unclear what will
happen next.

Insert: Cow Farts and Burps (maybe)

Across the Tasman pond, Australia has some similar problems, but more broadly faces the reality that
greenhouse emissions have increased over the last decade primarily due to land use changes, including
deforestation and agricultural practices. As forest land is cleared and burned to make way for agricultural
and other uses, and under certain types of agricultural practices, much carbon that was stored in plants
and soils is released back into the atmosphere.

This feature of Australia's greenhouse gas profile appeared to be partly responsible for a flurry of activity
witnessed at the Sydney Futures Exchange in the late 1990s as Australia was about to develop the
world's first derivatives market for carbon credits. Working with the State of New South Wales Forestry
Department and also closely with the forest investment divisions of global financial institutions such as the
US-based John Hancock Insurance Company, the stage was set for the first international market in
carbon futures, backed by the trees in new and growing forests in Australia.

These carbon-based instruments were to be based on the quite controversial provision in the Kyoto
Protocol whereby "Carbon Sinks" such as certain forests and forest management practices, can be used
to accumulate credits in carbon emissions trading programs. However, this world-first futures market
collapsed by the year 2000, mainly due to the controversial nature and uncertainties surrounding the
definition of Kyoto Forests and Carbon Sinks. It also didn’t help matters that Australia failed to ratify the
Kyoto Protocol.

7. Back to the Dark Ages to See What the US is Up To

In the final week of July 2003, while the EU was busy putting its final touches on the world's first
international carbon emissions market, certain high profile leaders in the US were continuing to
emphasize the importance of the climate of the middle ages and labeling the pro-Kyoto team as
"environmental extremists".

Perhaps the man most enamoured with the Dark Ages, is one Senator James Inhofe, a Republican
Senator from Oklahoma. He Chairs the Environmental and Public Works Committee. He spoke on the
Senate floor on Monday, July 28th, 2003 and here is some of what he had to say:

Inhofe on Senate floor

Later he had some extra words of wisdom about this big UN Conspiracy to share with CSPAN.

Insert: Inhofe on C-SPAN

Senator Inhofe is primarily funded by energy companies.

In his efforts to bring ocean views to his inland voters, President Bush ignores the absolute cuts in
greenhouse gases mandated by the Kyoto Protocol and has instead produced his own definitions of what
it means to cut greenhouse emissions.

Insert: Bush on GHG

8. The Pivotal Role of Russia

The Kyoto Protocol will become official international law when the emissions levels of countries that have
ratified the protocol amount to at least 55% of total emissions from the developed world. To date the
countries that have ratified Kyoto including all members of the EU, Canada and Japan account for about
44% of these total emissions. The US would add another 36% and Russia alone would add 17%. Hence,
while the US continues to avoid the Protocol, only Russia's ratification can bring it into effect.

Now, Kyoto targets are based on 1990 greenhouse gas emission levels, and this benchmark year is the
year before the collapse of the Soviet Union. The subsequent economic collapse in this region has meant
that, today, Russia's emission levels are actually about 30% lower than its Kyoto targets.

By ratifying Kyoto, the Protocol would become International Law and Russia would then be able to start
making money by trading its excess emission allowances on the new international carbon markets. Many
people view this as a sufficient incentive for Russia to ratify the protocol. However they had been counting
on US companies to be among the buyers in the markets, to help push up the prices of these credits. And
these buyers won't be there. Furthermore, it is possible that Russia may make its ratification of the
Protocol contingent upon entry into the World Trade Organization. So some very interesting dynamics are
playing out between the US, Russia and the EU on these critical issues over the next few months.

9. Stuffing Your Wastes Under the Ground

If the investigations of the warm temperatures in the Dark Ages bear no fruit, the US has at least a Plan B
and a Plan C. As the EU was announcing its implementation of the world's first International Carbon
Markets, the Bush Administration on July 25, 2003 ("Wall Street Journal") announced a new $100 million
climate change research plan. This project will deploy satellites and other technology to primarily study
natural causes of climate change, particularly the role of clouds.

If this fails to prove that global warming is all Mother Nature's fault, well, there is one more thing you can
do without having to cut down on fossil fuels - and that's to bury the extra greenhouse gases. A collection
of countries, led by the US and Australia, are cooperating on finding ways to sweep our extra greenhouse
gases under the proverbial rug.

You can expect to hear a lot more about this solution to global warming in the coming months and years.

Insert: APCRC

10. Will the US be Left Out of Emerging Financial and Energy Markets?

As the carbon markets emerge in other countries, you can expect to see the US-based investment banks
and brokers getting involved, despite the fact that the US is not a signatory to the Kyoto Protocol. You can
also expect some rumbles from multi-national companies based in Europe that also do a lot of business
in the US. Furthermore, the companies that have to start complying with the European rules and who are
spending money to comply, will be able to green-wash their image with some legitimacy. This, in
conjunction with growing shareholder activism on climate change in the US may apply significant
pressure for change in this country.
It is likely that even US based companies across the financial, energy, and other sectors will be
significantly impacted by the Kyoto Protocol, even without ratification by the US. There may also be a
concern from many companies that they are missing out on opportunities in new markets, such as the
carbon markets and new energy markets, because the US is not a party to the agreement.

Perhaps the US may end up stuck in the Dark Ages after all, if the rest of the world moves ahead quickly
without it.

That's all for Wizards of Money Part 21. Wizards of Money has a web site at
where you can get the text and references of all episodes.