Excerpted with permission of the publisher John Wiley & Sons, Inc. (www.wiley.com) from History of Greed: Financial Fraud from Tulip Mania to Bernie Madoff by David E. Y. Sarna. Copyright (c) 2010 by David E. Y. Sarna.
By David E. Y. Sarna
BUBBLES AND FRAUD
Henry Blodget was voted the number one Internet/e-commerce analyst on Wall Street by
, Greenwich Associates, and
in 2000. In 2002, then New York State Attorney General Eliot Spitzer published Merrill Lynch e-mails in which Blodget gave private assessments about stocks that conflicted with what he said publicly. In 2003, he was charged by the
Securities and Exchange Commission
with civil securities fraud, charges that he ultimately settled without admitting or denying the allegations. However, he consented to and paid a $2 million fine and $2 million in disgorgement and was subsequently banned from the securities industry for life.
Wall Street's Greedy Legacy
Since then, Blodget has made a living doing writing and analysis. Shortly after the crash of 2008, he wrote a long article for the
called "Why Wall Street Always Blows It" in which he tried to explain what happened in 2008, based on what was known at the time he wrote the article. Our views generally agree that greed and lack of government oversight had a lot to do with it. "The SEC fell asleep at the switch . . . we got greedy; we went nuts; we heard what we wanted to hear," he writes in his article.
However, he also believes that bubbles are inevitable in the capitalist system. He says: "Most bubbles are the product of more than just bad faith, or incompetence, or rank stupidity; the interaction of human psychology with a market economy practically ensures that they will form. In this sense, bubbles are perfectly rational -- or at least they're a rational and unavoidable by-product of capitalism."
Greed: Nature or Nurture?
In Blodget's view, greed is an innate part of human nature. In this, he follows Sigmund Freud, who wrote, "Culture has to call up every possible reinforcement in order to erect barriers against the aggressive instincts of men ... Its ideal command to love one's neighbor as oneself is really justified by the fact that nothing is so completely at variance with original human nature as this."
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However, Blodget also concludes that the human animal is naturally greedy and also arrogant. We think we are smarter than everyone else, and we take unfair advantage, so long as we think we can get away with it. In this same issue of the
, Virginia Postrel writes, in "Pop Psychology," basing her argument on experimental economics research by Vernon Smith and Charles Noussair, that if you put people in front of a market that is behaving a certain way, you are inevitably going to get a bubble. "People are just wired to create asset price bubbles," she says. In stating this, Postrel seems to subscribe to the literal understanding of the Biblical verse found in Genesis, "for the inclination in man is evil from his youth." Blodget appears to agree with her.
The Social Contract
, the famous French philosopher Jean-Jacques Rousseau (1712-1778) wrote that he believed that man was born innately good but that it was society that corrupted him.
Don Isaac Abarbanel, a fifteenth-century Jewish exegete, understood the verse in Genesis differently, and takes an intermediate view between these two positions: "When the Torah says that 'for the inclination in man is evil from his youth,' it is not referring to individual people, but to humanity ... Childhood is a turbulent time, a chance to experiment with reckless immaturity; adolescence is marked by rebellion and self-assertiveness. But with adulthood comes sensibility, settling down, and stability."
Abarbanel said, "The food had a sobering effect on mankind; God slapped humanity's face, demanding that they cut out the nonsense and just grow up! Well, after that, the lesson has been learned. Future generations will look back on the story with the pain we all feel about certain events of our teen years, and keep themselves in check. Thus, future catastrophes will be avoided."
Capitalism: You Can't Live With It or Without It
Although I agree with Abarbanel's view that future catastrophes can be avoided, I also know that greed drives Wall Street, and always has; in pursuit of easy money, rules are sometimes bent or broken.
Adam Smith, in
Inquiry into the Nature and Causes of the Wealth of Nations
(1776), described the origin of capitalism. He came up with the concept of "the invisible hand," whereby "the private interests and passions of men" are led in the direction "which is most agreeable to the interest of the whole society." As Robert Heilbroner said:
"Self-interest is only half the picture. It drives men to action. Something else must prevent the pushing of profit hungry individuals from holding society up to exorbitant ransom. This regulator is competition, the conflict of the self-interested actors on the marketplace. A man who permits his self-interest to run away with him will find that competitors have slipped in to take his trade away. Thus the selfish motives of men are transmuted by interaction to yield the most unexpected of results: social harmony."
In other words, competition acts as a brake on greed.
Capitalism is not about stealing, swindling, or screwing the little guy. On the contrary, capitalism is about the creation and exchange of value: It is about the individual improving his or her own situation by producing something of worth that improves the lives of others. True capitalism increases the good of the whole by creating an incentive for the individual to increase his or her own good.
Capitalism, as Winston Churchill told the British House of Commons, "is the worst economic system in the world except for all the others that have been tried."
Convicted felon Sam Antar (now reformed), whom we will read about in Chapter 6, said it well:
"The main pillar of our capitalist free market economic system, which is a cornerstone of our democracy, is the integrity of financial information. Without reliable financial information, capitalism cannot survive. The integrity of financial information can only be achieved through building blocks such as sound internal controls and independently verifiable financial information. The well educated, skilled, and experienced accountant is the first line of defense for the capitalist system."
Fraud and swindling disrupt the markets by compromising the integrity of financial information. This comes about when fraudsters and swindlers believe that they can get away with it.
The economic historian Charles Kindleberger believed that "swindling is demand-determined, following Keynes's law that demand determines its own supply, rather than Say's law that supply creates its own demand. In a boom, fortunes are made, individuals wax greedy, and swindlers come forward to exploit that greed." Kindleberger seems to me to be right on target.
Capitalism for Smaller - Company Stocks
Fraud and small public companies go together like bees and honey. A thoroughly disproportionate number of prosecutions involve smaller companies. The smaller stock fraud game, which we discuss at some length, is a play in several acts, with good guys and bad guys, winners and losers. It is part drama, part suspense thriller, part comedy, and, inevitably, several parts tragedy.
Like all plays, it has actors. Some, like the CEO of a company, play starring roles. Others, like accountants and lawyers, have important supporting roles. Promoters sometimes play the part of the jesters, but more often they play the role of the villains, and in some cases they play a starring role. The overall theme of the play is greed. Tremendous amounts of money are being made (and lost) every day in the markets for the low-priced, thinly capitalized stocks known as small-caps, micro-caps, or nano-caps depending on their size, and collectively as smaller-caps.
We don't know exactly how much is made by actors in the small-cap markets. However, hundreds of millions of dollars are conservatively estimated to be spent every day by investors (buyers) of low-priced stocks (those with a market capitalization, which is the share price times number of shares) of under $500 million. And remember, for every buyer there is a more-than-willing seller, so the gross annual profit for purveyors of penny stocks (which are the most easily manipulated but make up only a small portion of the overall market in manipulated securities) reaches into the hundreds of millions of dollars or even more, perhaps much more.
Them's the Crooks, Not Me
Now, be honest. If you have ever bought a stock, why did you buy it and not one of 10,000 others? Of course, you expected the price to go up. But why did you expect that the price would move up? Did you receive a hot tip from your brother-in-law? Did your broker want to reward you as a (supposedly) favored customer? Did you read something in an obscure place?
Whatever your reason, somehow you thought that you had the inside track on that stock, and that you knew something the market didn't. You thought you had an edge, and you wanted to take advantage of your special knowledge. So then you too have a bit (or a lot) of larceny in your heart, and you too want your unfair share of the market. You and I then have something in common; we're human.
While one can certainly debate whether man is inherently good or inherently bad, history, at least since the industrial revolution, has amply demonstrated that capitalism and a free-market economy create wealth and a high standard of living. Capitalism is compromised when there is inadequate competition, when information is not freely disseminated, or when fraudulent information is allowed to be passed off as genuine. That said, each of us hopes that we have (legal) access to information that others don't have, or that we have superior tools (better analysis, better judgment, and/or better intuition) so we can profit by buying when others are selling.
Inevitably, then, in capitalism there are winners and losers, but in a fair (swindle-free) system, we all have equal opportunity to become winners. Also inevitably, however, some will seek to load the dice, tip the scales, or unfairly influence the results. And that's when greed becomes criminal.