from the free audio series at
{website no longer valid last I checked)

Wizards of Money

by Smithy (smithy@mindspring.com)

Cover artwork (C) 1999 - 2002 www.barrysclipart.com


* How Money is Created
+ Introduction
+ Where does the title "The Wizards of Money" come from?
+ The Birth of the Federal Reserve
+ Misconceptions about Money
+ Exactly How Does Money Get Created?
+ Why Money is Undemocratic
+ Ancient Monetary Wisdom

* Financial Risk Transfer
+ Capital Buffers in the Global Casino
+ Risks Taken By Speculators and IMF Bailouts
+ Risk Transfer in Action - Asian Financial Crisis
+ IMF Bailout Prevention Solutions
+ Bank Supervision and the Basel Capital Accords

* Banking on Poverty
+ The "Science" Behind the Monetary System
+ The Federal Reserve and the Poor

* Wizards and Warlords
+ A Tragic Day for the American Empire
+ The Role of Wizards and Warlords in Empire-Building
+ Special Wizard/Warlord Relationships of the American Empire
+ The Downfall of the Roman Empire and the Roman Monetary System

* Monetary Terrorism
+ Relationship Between 20th Century Money and 20th Century Wars
+ The "Oil-Standard" Kicks Out the Gold-Link of Money
+ The Anatomy of a Currency Attack
+ The Unholy Trinity
+ Wall Street's Stealth Fighter - Dollarization

* Democratizing the Monetary System
+ The Activism-Money Paradox
+ Whose Monetary System?
+ Why do we Need Money?
+ Design and Implications of Democratic Money

* The Money Cycle versus The Water Cycle
+ How Money Flows
+ The Simple Money Cycle Model
+ The Market Meets Real Efficiency - Nature's Water Cycle
+ Enter the Humans and Their Crazy Monetary System
+ Banks, Land and Water

* Trading Nature and "Cooking the Books"
+ Mirror Images and Accounting Basics
+ Accounting in Wonderland
+ The Making of the Enron Energy Empire
+ The Collapse of Enron

* Jack and the Sweatshop
+ Jack and the Corporate Ladder
+ It's all About Winning. Business is a Game
+ The Globalization Guru and the Georgia PCB/Dioxin Problem
+ Science, The Well Capitalized Way

* Back to the Twenties Through the Looking Glass - Steagall
+ Regulatory Landmarks of the Great Depression
+ A Trip Back to the 1920s
+ The Gambling of the Guardians of the Public's Money

* House Lever-Edge at the Derivatives Casino
+ The House Edge
+ Leverage
+ Hedge Funds, Derivatives and Credit Default Swaps
+ Background On the LTCM Saga
+ Story: Because a Little Bug With the Asian Flu went Ka-CHOO

* The Imperial Budget and the Mythical Lock Box
+ The Role of Taxation
+ The Relationship Between Tax and Money
+ Comparing Imperial Budgets
+ Imperial Financial Management
+ Social Security, Medicare and IOU's from the Government to the Government
+ The Lock Box Myth and the Problems it Generates
+ Perhaps a New Religion is in Order!

* Bankruptcy Bill's Shoot-Out at the Social Safety Net
+ What Triggers Personal Financial Ruin?
+ Beware the Stranger Bearing Gifts" Invasion of the Credit Card Industry
+ If it's got an Income Stream Catch it, Tame it and Securitize It!
+ Bank-Robbing Banks

* The Trade Federation and the InterGalactic Banking Clan

+ The Deterioration of the Galactic Republic and the Emergence of the Trade Federation
+ A "Background Briefing" on GATS
+ A Huge Event in the History of GATS European Union Member leaks the EUs GATS "Grab Bag" of Requests to Other Nations
+ The Ongoing Battle Between Corporations and States
+ How Breaking Your Own Rules Can Bite You in the Butt!

* Homeland Securitizations and Overseas Vacations
+ The Twilight Zone the "Other Dimension" of Financial Transactions
+ A Trip to the Financial Twilight Zone in a Special Purpose Vehicle
+ The Birth of the Mae Sisters and Cousin Freddie
+ The Securitization Atmosphere of the Investment Bankers
+ The Mechanics of the Special Purpose Vehicle
+ The Special Purpose Vehicles Parked at the Over-the-Counter Derivatives Casino
+ The Special Purpose Vehicle - Deluxe Version and the Banking Scandals
+ Securing Homeland Capital when Overseas Adventures Go Wrong

* There's a Generic in my Shark Fin Soup!
+ Predator-Prey Dynamics in the Drug Sea
+ Attack of the Generics! Meet the Shark Fin Curve.
+ A Little Bit of US Drug History
+ The Anatomy of a Counter-Attack from Big Pharma
+ The Next Blockbuster Drug - What will it be? A "Youth Pill"
+ Market failure of the Patented Medicine Model. HIV/AIDS Rips in to China and Russia.
+ A Remedy for the Ills of the Current Medicine Model

* Caught Between and Dock and a Sweatshop
+ A "Toy Story"
+ The "Spartacus Problem"
+ Eliminating the Legacy of Harry
+ Back to the Docks of the 1930s
+ Life at the World's Largest Retail Giant and the Biggest Importer from China

* Where Wall Street Crosses Auburn Avenue
+ Atlanta's "Freedom Walk"
+ The Almost Forgotten History of Black-Owned Financial Institutions
+ Physical Desegregation, Financial Segregation
+ 1968: Dr King's Death and Ginnie Mae's Birth
+ The Predatory Pipeline: From the Home Buyer Back to Wall Street
+ The FHA Loan Pipeline
+ Progress in Clamping Down on Predatory Capital

* The Education Sweepstakes
+ The Remarkable Story of Risk - From the Halls of Baghdad to Twenty First Century Risk Management
+ The Skills for Playing in a Market Economy
+ State of State Finances
+ Economic Development and Slot Machines
+ The Lotto Sweepstakes Sweeping the States
+ The Other Mae Family - Sallie, Nellie et al.
+ The Ultimate Risk Bearers

* The Battle of the Dragons - Oil vs Insurance
+ The Holy Cartel and the Magical Price Range
+ A Party in Dallas
+ The Ancient Creature of "Old Europe" vs Fossil Fuel Industry
+ Energy Outlook

* Playing Russian Roulette in the Carbon Markets
+ Global Carbon Flows BC (Before Coal)
+ How the Carbon Accounts become Unbalanced
+ The World's First International Carbon Market
+ A Market Miracle?
+ English Ambitions
+ Tree Farms and Cow Farts "Down Under"
+ Back to the Dark Ages to See What the US is Up To
+ The Pivotal Role of Russia
+ Stuffing Your Wastes Under the Ground
+ Will the US be Left Out of Emerging Financial and Energy Markets?

How Money is Created


Your Money and Financial Management Series, but with a twist. My name
is Smithy, Im 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 everybodys 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

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

Where does the title "The Wizards of Money" come from?

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
* 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
* 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.
* Dorothys 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 McKinley.

"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 Birth of the Federal Reserve

The birthplace of the Federal Reserve System was not Wall Street or
Washington as people might think. The founders wouldnt 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 states 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 Vanderlips
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 historys
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.

Misconceptions about Money

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

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

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

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.

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 doesnt 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 cant 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 banks perspective however, if you dont 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 dont pay your loan they are taking a
financial risk too, albeit one created completely out of "thin air".

Why Money is Undemocratic

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 created, and importantly, FOR WHAT PURPOSES
MONEY SHOULD BE CREATED. 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


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 elses 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 cant 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 nations.

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.

Ancient Monetary Wisdom

What is surprising is that this knowledge is ancient wisdom and has
been recorded in the primary texts of the worlds 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 Gods word

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 resistance.

Financial Risk Transfer

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 well 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 yourself.

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 whats 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 well 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 well 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

Finally well 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 countries.

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

Capital Buffers in the 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 banks 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 dont 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 arent 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.

Risks Taken By Speculators and IMF Bailouts

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 crises.

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

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 worlds 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 1980s. 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

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.

Risk Transfer in Action - Asian Financial Crisis

To better understand risk transfer lets 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

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 sidelines!

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
Thais 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 thats how the Korean banks got
immediately walloped by the devaluation. The Koreans banks then
started dumping a bunch of Brazilian bonds that theyd 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

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 countrys 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.

IMF Bailout Prevention 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.

Bank Supervision and the Basel Capital Accords

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 dont 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 doesnt
have an alternative monetary system to fall back on. Lets 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
publics 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 banks 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

This doesnt 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 bodies.

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 youre a banker, go out and lend you dont have to cross every i and
dot every t. If youre a bank supervisor, dont criticize your banks for
making loans, even if theyre 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
publics 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 protegé 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 Citigroups 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, CitiGroups 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 organizations 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 could.

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

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 1990s.

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 www.bis.org. 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 www.innercitypress.org and

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 lets 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 dont 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 machine."

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 realization. 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. Thats 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.

Todays 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, Georgia.

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 highway". 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

The "Science" Behind the 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 Rands
protégé is right at the center of all money, and perhaps her question
is answered. 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 Smiths 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
1900s 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 todays
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 uncertainty.

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.

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 dont have much money
dont 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 dont 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 theyve
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 Feds 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 wouldnt 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
wouldnt 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

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 banks 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 doesnt 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 Citigroups
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 Coalitions request for a hearing on the
takeover, that "Comparing the Feds 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 Citigroups 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 banks 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
Greenspans 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 90s 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 its
not just that the poor are irrelevant to the Feds decisions, but the
irrelevancy may run as high as 80% of the American people! Not to
mention the rest of the world.

Wizards and Warlords

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

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.

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 happen.

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
stock 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

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

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 empire.

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 greatness.

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 Empire.

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 20:25.

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 Empire.

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.

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

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

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.

Monetary Terrorism

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 weapon.

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.

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

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 Europe.

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

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 IMF.

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

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.

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 happens.

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 "thats 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

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.

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 www.wizardsofmoney.org.

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 cant 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

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.

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.

Its 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 didnt 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.

Democratizing the Monetary System

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 assumptions.

The Activism-Money Paradox

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
dont 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 thats 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 havent really challenged the
root of the problem.

Break: "Working for the Enemy" Baby Animals

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 society.

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

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.

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

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.

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.

The Money Cycle versus The Water Cycle

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

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.

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

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 http://www.fdic.gov. 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
(http://www2.fdic.gov/hsob/hsobRpt.asp). 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
(http://www2.fdic.gov/hsob/hsobRpt.asp) you would see that the Savings
Institutions have total year end 2000 assets of $1.2 trillion.

Aside: As an aside heres 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 (thats 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
http://www.federalreserve.gov, 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. (
http://www.federalreserve.gov/releases/H6/hist/h6hist1.txt). 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 thats where most
money (almost 85%) is being created. This total balance sheet of the
commercial banks gives us the breakdown of how todays 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 lets
drill down into these "Loans and Leases" since they make up most of
the money thats 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. Break: "Before These Crowded
Streets" Dave Matthews Band

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
http://www.wizardsofmoney.org 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 two.

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

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). Lets 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.

Lets 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

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 developers 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
Snazzys 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. Wellsort of. Lets 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 dont 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!

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 cycle. 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 doesnt 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 Natures handiwork that we barely even
understand it. We are still, and always will be, learning more. So we
cant 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. Lets 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 natures 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. Lets 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 thats all very confusing isn't it. Lets 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

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
cant 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. Id only ever have to buy
one tank of gas in my life. Id only have to buy one load of
electricity to heat my home for my whole life Id 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 theres a catch. And thats 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 cant 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 cant 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.

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:

* 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
* 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.
* 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.
* 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 ourselves.

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

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

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 www.federalreserve.gov, under General Info
and List of Directors.

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
citiaction.org 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 unepfi.net.
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.

Trading Nature and "Cooking the Books"

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 well 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 well
take a look at the activities of the once mighty Enron empire, from
its contributions to Americas energy policy to its attempts to
privatize the worlds water supply, and turn Mother Natures 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 thats a bit
different. We will see that one of the primary forces driving the
Enron collapse was the battle of the Enron giants desire to privatize
nature and turn all resources into tradable securities versus the
publics 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.

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 Reserves 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 todays 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 persons 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 isnt 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 its important for us to look at just what is going on in accounting

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 its over or under-priced based on expectations about
future earnings.

Shareholders are entitled to all the money thats 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
dont lose confidence in their stock, though companies usually dont
like to admit that they "manage earnings" as opposed to "managing a

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

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
couldnt generate the future money that investors had originally
expected. This started the downward spiral to bankruptcy.

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 dont 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.

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 GEs (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 wasnt 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
companys 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 GEs
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". "Its 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 hed 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 its a
key part of the Enron saga. Only in Enrons case its tricks involved
invisible partnerships that didnt 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 GEs 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 arent seeming to
understand whats 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? Lets 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.

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 Enrons 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 Skilling.

Excerpt: Motley Fool interview with disgraced-wizard Skilling

This bragging about Enron in the Motley Fool interview is notable for
what it doesnt 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 Enrons 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,
well 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 Enrons involvement in shaping
Americas 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 Lays 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
worlds 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 Enrons energy investments in South America and India.

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 wasnt the powerful and important wizard it
had been claiming to be all these years.

And so the accounting wizardry began!

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 Britains 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 Enrons 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. Lays charms
didnt 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 energys 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 companys 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 Enrons 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
wasnt 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 Enrons demise.

The Whitewing investors whoever they were seem to be pretty savvy. In
order to invest in the Whitewing debt securities used to buy Enrons
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 wasnt 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 Whitewings 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 Enrons balance
sheet so that Enron didnt 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 didnt know about all these costly
guarantees granted by Enron in order to create the entities that took
the assets and associated debt off Enrons 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 Enrons books and force it to go

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 markets 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 prices
downwards direction.

By Summer 2001 Enrons 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 Enrons balance sheet
but had been run by Enrons 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 Enrons 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 Enrons balance sheet. By Halloween the SEC
had launched a formal investigation.

Losses were so large and confidence so shot that Enrons 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 Poors finally downgraded Enrons 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 didnt have the cash to pay the huge debts , nobody in their
right minds would invest in them, and they were forced to declare

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

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 countrys 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.

Jack and the Sweatshop

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 www.wizardsofmoney.org

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 Ladder".

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.

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: "Its
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 didnt 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!

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 Rules!

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 didnt 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

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!

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 fabulously.

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.

 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.

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
* 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.

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 SpeechLanguage, 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 business.

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 investors.

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

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

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 couldnt
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 halt.

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

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 remembers:

"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

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 couldnt 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

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 FEDERAL INSURANCE and

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

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

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

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
www.bis.org 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 isnt 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

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 prophecy.

OH, And there is one more thing that exists now that didnt 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

House Lever-Edge at the Derivatives Casino

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

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

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

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 www.thewizardofodds.com (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

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,
thats 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
unpredictableHow 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!


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

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

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 dont 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 collapse.

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 over.

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.

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 fall.

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 shocks.

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.

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

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

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

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

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

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.

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 heres 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

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 looming.

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

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 crises.

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

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

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.

The Imperial Budget and the Mythical Lock Box

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 Government.

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

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.

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

* 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.

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.

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 AD.

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 categories:

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

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 www.whitehouse.gov/omb, 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
www.wizardsofmoney.org 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 them.

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

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 other.

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.

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

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

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 empiresChina.

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.

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

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

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 Security/Medicare.

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 wizardry.

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 retirees.

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

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

* Medical advances that mean people live longer, are retired longer
and have higher medical expenses,

* 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

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

So there are no easy answers. Well, except maybe

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!

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.

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 found:

* 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 earners.
* 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 cant 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

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.

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 couldnt 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 hasnt 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

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 www.federalreserve.gov, 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
doesnt 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

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.

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 dont 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

An important study done by the Federal Depository Insurance
Corporation (FDIC, who we spoke about in Wizards Part 10) is available
at http://www.fdic.gov/bank/analytical/bank/bt_9805.html.

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

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 Increases!

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

(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-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

(10 minutes)

After this interview I spoke with Doug Skalka, a lawyer in Connecticut
representing the Bank. He didnt 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

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 operate.

The Trade Federation and the InterGalactic Banking Clan

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 cant "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

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 well
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

But thenwell also see that the Earthly Trade Federation and Services
Clans, while demanding a huge grab-bag of goodies of the
"cant-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 cant
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 dont want
such shady operators taking over their own services.

To get to know these trade issues better well 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. Well 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

The Deterioration of the Galactic Republic and the Emergence of the Trade

This is from www.starwars.com/databank/

"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

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

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 Netherlands: "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 Freemans 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 WTO.

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

The US services sector, spearheaded by the financial sector, had
lobbied hard for this one and they couldnt 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.

A Huge Event in the History of GATS European Union Member leaks the EUs GATS
"Grab Bag" of Requests to Other Nations

Speaking of leaked documents, the full text of the European Unions
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 Commissions 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 Australias 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 publics 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 www.wizardsofmoney.org

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

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. Ill put some links to this on the
Wizards of Money web site at www.wizardsofmoney.org. 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 whats going on and how these provisions are being
used heres 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
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 reached.

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 its 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 wasnt really a NAFTA case, it had been settled by state

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 Representatives office to no
avail and then finally discovered that its 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
www.state.gov/s/l/c3439.htmLooking 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

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. Ill 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. Heres an excerpt Bob
Kerrey followed by Robert Rubin

Robert Rubin and Bob Kerry discuss GATT-illegal steel tariffs and farm

C-SPAN recording at New School University, New York. May 30, 2002

3 minutes

Homeland Securitizations and Overseas Vacations

A Journey Through the Financial Twilight Zone

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.

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.

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

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 daylight."

Excerpt: Closing Statements, Twilight Zone Episode 52 1961. Rod

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 its 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

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.

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 cant 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 sector.

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 foreclosures.

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

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

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

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

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 its a hidden risk in the Financial Twilight Zone that
nobody seems to want to talk about.

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 vehicles.

Excerpt: Senator Carl Levin "Wizards behind the Curtain" July 23, 2002

We'll hear more on this hearing and what happened there a bit later.

The Special Purpose Vehicles Parked at the Over-the-Counter Derivatives Casino

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

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

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

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.

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

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 didnt 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. Its 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

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

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...

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

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.]

There's a Generic in my Shark Fin Soup!

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 course.

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 pursuitsfinding
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 monopolies.

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 eatOr
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 its 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

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'.

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 thisThe 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.

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, including: * 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

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, too!

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 60Nexium.

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,

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 dont 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...

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

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.

Market failure of the Patented Medicine Model. HIV/AIDS Rips in to China and

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 century:

"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 trifles...no
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 40in 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 502010 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 40population. 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

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 billion.

(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.

Caught Between and 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

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 on... ... 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

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

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

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

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 president.

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

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 weakened?

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.

Where Wall Street Crosses Auburn Avenue

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.

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.

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 Americans.

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: 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 discouraged...by 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

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.

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

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 20and 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

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 on.

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 homebuyers.

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)

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

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 20calculations 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

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.

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 20subsidiaries 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 foreclosure:

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

Well, in the fight to stamp out both predatory lending and FHA loan
abuses, some progress is being made.

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 you.

- 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!

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 Vegas.
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

The Remarkable Story of Risk - From the Halls of Baghdad to Twenty First
Century Risk Management

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 economies. 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

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

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

Risk has been caught and tamed for economic growth. (At least up till
now. There's no telling what's around the corner!).

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

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)

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 expenses.
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)

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

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!

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 5This 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

The Lotto Sweepstakes Sweeping the States

The history of lotteries is an interesting one and perhaps longer and
more volatile than you might be thinking. 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 50chance 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

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

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)

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.

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.

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

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.

The Holy Cartel and 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

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.

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 dragon:

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

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

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 www.wizardsofmoney.org where you can get the
text of all episodes and further references.

Insert: Stevie "The Battle of the Dragon"

Playing Russian Roulette in the Carbon Markets

Introduction 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

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

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

To get to know these new markets we'll talk to the director of global
operations at CO2e.com 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"

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

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 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")

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 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 emissions.

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

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 market.

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

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 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 cement.

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

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

Insert: CO2e.com Interview

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.

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: CO2e.com Director

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.

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

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 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 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.

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

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

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.

Mark Heily 2003-10-03