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Did Joseph Wharton Cause The US Financial Meltdown?

Mises Daily: Tuesday, October 21, 2008 by

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Joseph Wharton (1826–1909)
founder of the Wharton business school
co-founder of the Bethlehem Steel company

When the economic chips began to fall last winter, legislators on Capitol Hill spared neither time nor words informing us of their priorities: no matter what might happen in the financial markets, we were told, funding for student loans will continue to flow.

This is one promise from Washington we can take to the bank. Our government, representing the forces of goodness itself, isn't about to abandon that holiest of all cash cows, vulgarly known as the education industry. If there were such a thing as academic stock, only an idiot would sell it short. Americans are raised to believe there can be no such thing as a glut in sheepskins. The idea that any form of schooling can do harm is close to blasphemy.

The benefits of university are commonly equated to a panacea, a philosopher's stone, and a moral sponge bath rolled into one. As far as Barack Obama is concerned, a college degree is no different from a chicken in a pot or a car in the garage: everybody is supposed to get one — or several. The logical next step is the construction of institutions of higher learning near the nation's most porous border points, fully equipped to provide credentials to aliens of any status. That way newcomers won't be overwhelmed in an environment of such general erudition.

The dynamics of popular enthusiasm for formal education are roughly reflected in presidential history. George Washington's classroom education was sparse. His successor, John Adams, was a Harvard-educated lawyer. In the next century, seven out of 23 presidents never attended college. The 20th century saw only one of 19 presidents, Harry Truman, occupy the White House sans degree. The first chief executive elected in the new millennium possesses degrees from the best-known brand names in American learning: Harvard and Yale. President Bush is also the first man to preside over the United States with an MBA. We will never know what might have happened with an MBA in the White House when the market crashed in 1929; the pressing need for them had not yet been invented. The Master of Business Administration is the great American contribution to the ubiquity of postgraduate degrees. It was an honorific cooked up in the 1930s, an era when businessmen might have had reason to be wary of entitling themselves.

It is worth noting that among the most highly regarded presidents of the 19th century, only one, Thomas Jefferson, attended college or university. Abraham Lincoln, Andrew Jackson, and Grover Cleveland were all self-educated. These three are generally recognized as more original and independent than most of their executive peers.

Early leading American businessmen were far less likely to be well schooled than politicians. Our first millionaire, John Jacob Astor, had no formal training. The first really big player on Wall Street, transportation tycoon Cornelius Vanderbilt, took a notoriously wry view of pedagogy. He once famously remarked, "If I had an education, I would not have had time to learn anything else." The slogan fails to appear beneath his name at the university bearing it in Nashville.

Andrew Carnegie was a telegrapher and then worked his way up in the Pennsylvania Railroad; his book learning was extensive, but he acquired it from the library, not a blackboard. Jay Gould's experience as a surveyor and tannery manager served as his Wall Street apprenticeship. J.D. Rockefeller was a bookkeeper and a clerk. Henry Ford was a self-taught mechanic. E.H. Harriman learned his financial skills as a Wall Street flunky, and hence, J.P. Morgan dubbed him the "two-dollar broker." Of all early American magnates, Morgan was the only one with a college degree whose name is a household word today. And of the above mentioned, he was the lone standout who was born already rich.

"Americans are raised to believe there can be no such thing as a glut in sheepskins."

None of these facts justifies gratuitous attacks on the value of a college degree. But if certain kinds of diplomas are to qualify their holders for special opportunity to acquire wealth and power, then the performance of this elect is rightly subject to our utmost scrutiny. The evidence that the media are routinely indulgent of society's golden boys is ample if not overwhelming. The reciprocal arrangements between government and Wall Street are so pervasive that reporters and readers alike are long inured and oblivious to the blatancy of vested interest.

The members of this world-shaking club are linked, almost to a man, through alma mater. When we examine what is required for an ordinary applicant to enter America's most exclusive universities, it is difficult to understand why these skills are relevant to success in the marketplace. The ability to distinguish between several similar obscure words unlikely to be used in a lifetime may be unusual but how it could facilitate successful business strategy is less than apparent. The career benefits of youthful contacts made at America's most exclusive universities, however, are obvious to everyone.

What is a lot less obvious is what, exactly, are the talents of the guys who rise to the top of established business empires. A damned good lot of them seem to specialize in finding ways of producing revenue but not much of anything else. Well into the 20th century, journeymanship in a business was a natural route to an executive position in big-time corporate America. People with the hands-on experience in mechanics, sales, manufacturing, and agriculture were residing at the top of many fields of trade. As late as the 1950s, entrepreneurs with widely divergent perspectives arising from a vast array of influences and experiences held sway in American industry. Those back roads are almost unknown to anyone aiming at a pinnacle of commerce today.

People bound for upper management in large public companies have usually immersed themselves in a conformity campaign from high school and few of them ever emerge from it. They join large organizations and acquire the talent of enduring both maddening redundancy and contradictory policies. A life sentence of lengthy meetings begins at about age 16 for the future "success," ensuring that only masochists can couple their careers to an engine on the fast track. None of this takes the aspiring executive very far, though, without mastering the sublime art of the grovel. Genuine self-respect and human decency are the very qualities the modern leadership process is designed to purge. Upstanding individuals are as poisonous to the corporatocracy as kryptonite is to Clark Kent. Old-school "idea" men sank or swam on the profitability of the innovations they backed. Modern corporate stardom is a different game. The survivor must have the guts to wait for the risks taken by others to start paying off before deciding which side he was always on.

Leadership, in the corporate lexicon, is a process of finding pulpits above a captive audience of hapless peons. The White House, of course, is the ultimate pulpit. That it was reached by an MBA whose fortune was built on cronyism and public largesse is an irony even incumbents regents at Vanderbilt University appreciate. What percentage of similar men can weigh down the top of society before the structure begins to creak and twist in strong winds? Education, as a means of spreading uncommon abilities further down the line of aptitude, is a great boon to prosperity. But the use of college degrees as clubs to clear the field of otherwise able competitors is a desperate measure of control that, intentionally or not, rigs the competition. Still the MBA grip on corporatocracy has many loyal defenders ideating in the halls of think tanks, publishing in the rags and newspapers, and doing the TV circuit. Apparently it is possible for an executive to take a once-solvent, even thriving, company, turn it into a government dependent, and remain worthy of fabulous remuneration from stockholders.

Tales of big business have always included a healthy supply of sordid anecdotes. No number of them, though, ever seems to crack the mystique commonly associated with high finance. The idea that it is all so very arcane tends to overwhelm small investors' natural skepticism. But corporate glamour awes those in the thick of it as well. Every new rung on the ladder leaves executives feeling more delphic. Delusions of grandeur are at the heart of every leadership crisis.

As the economy heated up in the 1980s, boomer careers began to take off, along with their salaries. This dynamic meshed with individual-income-tax-shelter legislation in a way that dumped money onto the NYSE and the other exchanges. Between 1980 and 2000, the Dow Jones Industrial Average rose by over 1,000%. During this same period, the population grew by roughly 25% and average incomes slightly more than doubled. Clearly government inducement was a major factor. Still, the gurus and experts never hinted at any risk of overcapitalization. The conventional wisdom implied perpetual opportunity on Wall Street. When P/E ratios predictably went through the roof, as the pool of bidders for common stocks and other securities mushroomed over night, experts generally failed to take note of any relationship between those factors. This process was institutionalized by tax legislation.

Whatever the intentions, government action shifted huge amounts of capital into Wall Street products. Today a large percentage of the boomer generation is desperate that the Dow Jones Industrial Averages, buoyed by stock purchases for their retirement accounts, maintain present levels and advance. One of the things that kept investment bank employees busy over the last 25 years was inventing new ways to absorb so much funding.

In 2000, a New Jersey teenager, Jonathon Lebed, was pressured by the SEC to surrender $285,000 he had garnered in so-called pump-and-dump schemes. But it was difficult to understand how his methods were more morally compromised than those of some the most recognizable brokerage houses in the world. They almost invariably touted highly stocks their research departments "independently" assessed for market worth. Lebed, under any other pseudonym, was nothing more than "some random guy" on the Internet and certainly never enjoyed the cachet of a Morgan Chase, Bear Stearns, Goldman Sachs, Salomon Brothers, or any number of other name brands of the day. The SEC never suggested any of them surrender the billions, if not trillions, they gained in fees and other revenue from recommending stocks that temporarily bubbled. The uncredentialed are barred from fleecing gullible investors while licensed financial experts may even charge for their harmful advice.

"One of the things that kept investment bank employees busy over the last 25 years was inventing new ways to absorb so much funding."

In 1995, Britain's oldest merchant bank, Baring Brothers, was ruined by Nick Leeson, an arbitrageur who turned 28 one day before the company was declared insolvent. Leeson was not a college graduate. He was able to wreak fiscal havoc through a lengthy series of bad bets and the lax accounting supervision of his employer. Losses that had accumulated to 204 million pounds in December 1994 were quadrupled into the first 7 weeks of 1995. The process took nearly 3 years to reach fruition and through much of it Leeson was able to convince superiors of huge successes as the bank met his margin calls. Financial writers the world over were astounded that such an established institution could proceed so recklessly. The stakes were paltry, however, by comparison to the present crisis, which ultimately involved wagering against much larger odds.

The current situation was carefully engineered using the most sophisticated resources of thousands of the largest corporations in the world. It was based on a simple formula: everyone wants a nice house. American builders were able and willing to create this wealth. All that was lacking was the means to pay them. This was just the kind of metafiscal obstacle that the ivory towers of commercial philosophy were poised to surmount. Without the fetters of a gold standard, money (literally) is no object. What it is, at the temples of world finance in south Manhattan, defies any recognizable definition. Debt, theoretically, is a bottomless well of enrichment. The sin of Charlie Ponzi was thinking small.

We would expect the role of high finance in the real-estate market to involve providing credit in an organized fashion at a competitive price. Hypothetically, the invention of a financial "product" deriving regular revenue from mortgage payments could produce a sound arrangement. Instead, we found out that highly trained, sophisticated experts, with educational backgrounds enabling them to hold the rest of us in contempt, generally exercise the self-control of junior-high children in the throes of the latest fad. Somebody invented the mortgage-backed security and soon all of them had to have one of their own. All that was needed now was an endless supply of qualified home buyers.

The Harvard School of Business overestimated its students and forgot to offer a course on the limits of supply in this commodity. Soon the world financial markets were funding new home construction in the United States the way Yahweh dropped manna on the wandering tribes. The fact that American incomes lagged far behind the pace of housing prices didn't fit into the "business model" discussed in 25th-floor meetings on Wall or Nassau or William Street. This mystery was left to be plumbed by carpenters and their helpers during lunch as they raised another 4,500 square footer.

Zachary Karabell, on the Wall Street Journal Op-Ed ("Bad Accounting Rules Helped Sink AIG"), phrased things a bit differently:

What AIG was saying then, and what others from Lehman to Bear Stearns to the world at large have been saying since, is that the losses showing up aren't "real." Yes, the layer upon layer of derivatives built on the foundation of mortgages is mind-boggling. One reason that AIG had floated beneath the radar screen of the business media (relative to Wall Street investment firms) is that its business model is so complex and opaque that it is impossible to describe simply. It was briefly in the news in 2005, after it was accused of improper accounting by the SEC and the New York attorney general. Then it faded from view, until now.

"Reality," wrote American philosopher C.S. Pierce (who was something of an "expert" himself unfortunately), "is that whose character is independent of what anyone might think." Whether computer-generated models, paradigms, and virtual realities would have caused the logician (who died in 1914) to hedge or expand this definition we'll never know. But Mr. Karabell's succeeding paragraph doubtless would have been worthy of Pierce's attention:

Among its many products, AIG offered insurance on derivatives built on other derivatives built on mortgages. It priced those according to computer models that no one person could have generated, not even the quantitative magicians who programmed them. And when default rates and home prices moved in ways that no model had predicted, the whole pricing structure was thrown out of whack. (Emphasis added).

Alas, computer-generated models, like MBAs, were unable or unwilling to submit to a limitation as confining as a finite supply of money. "Facts are stubborn things" is a line that frequently crops up in Wall Street Journal editorials. Indifference to the actual size of the market for a product priced to require annual interest payments alone that, in many cases, nearly equaled average American income took stubbornness too. No one needed an advanced degree or even a computer to recognize the defects of a scheme that ignored such facts. But maybe we underestimate them; did Wall Street kingpins know all along that the problem would be resolved by simply printing more money? However random and anarchic the markets appear under a fractional-reserve central-banking system, the end results have unnerving consistency. The decision makers in government and commerce have a philosophy of liquidity that borrows from Homer Simpson on his favorite liquid asset: "Here's to alcohol: the cause of, and the solution to, all of life's problems."

Later in his article, Karabell says,

A few years from now, there will be a magazine cover with someone we've never heard of who bought all of those mortgages and derivatives for next to nothing on the correct assumption that they were indeed worth quite a bit.

That knowledge doesn't comfort anyone with assets retaining "underlying" value that is caught in a liquidity crunch. What it means is that Wall Street's obliviousness to fiscal reality has once again facilitated the concentration of private property into fewer hands. The bungling incompetence of our betters inevitably leads to the further enserfment of everyone. And in the meantime, the magnitude of the present crisis is undoubtedly serving as cover for countless varieties of new financial mischief.

Society's economic vigilantes are presently enraptured by the lofty abstractions of Bernanke, Paulson, and numerous senators whose righteous indignation is roused at last. Just how Uncle Hank garnered his towering cash cache from Goldman Sachs is irrelevant. That foundering Wall Street icon has been shored up by Warren Buffett in a way that is eerily reminiscent of Richard Whitney's purchase of 10,000 shares of US Steel in October of 1929. The experts just keep on giving and we'd better start asking how much more elite guidance we can stand. The important thing, they assure ever so reluctantly, is that the uncredentialed masses pony up. No one ever said that people who don't drag letters behind their names will be rendered slaves in this country. Properly educated businessmen mind what they do say as much as what they don't.

The latest line is that government bailouts are good investments. This comes from politicians, ex-politicians, TV personalities, and people who run the cocktail circuit from the west side of the District to the east side of Manhattan. "Remember Chrysler?" is the ubiquitous refrain. "We all made out big on that one." Skeptics might have difficulty recalling it as quite so clear cut. Sure, number three, of the one-time "Big Three," is still with us, but who got what out of that sweetheart deal remains hazy. Money passing back and forth from the amorphous fiscal blob in DC and listed corporations is as difficult to follow as a shell game. Finding our end of the "profits" is like trying to unravel one of the more enigmatic derivatives. So what everyone ends up doing is taking their word for it that all is soundly managed. "In five or ten years," the suits reassure us between cigar puffs, "everyone will be sitting pretty." The public is expected to sit blinking like a corporate mistress in a James Thurber cartoon.

Get a Real Education
"The experts just keep on giving and we'd better start asking how much more elite guidance we can stand."

Last March, when Congress began hearings on the credit crisis, Representative Tom Davis of Fairfax County, Virginia cautioned that highly compensated CEOs and ex-CEOs of ruined corporations should not be "sacrificed" like "virgins to a volcano." Thankfully, he was able to restrain himself from allusions to the crucifixion. With an MBA president, a Wall Street fat cat at Treasury, and an academician at the Fed, those lustful volcanoes will be settling for virgins into the indefinite future.

Barren harvest or no, the witch doctors of venture capital will be dancing in their leis, feasting on pork and poi, and making those ageless jokes about what all the poor people must be doing. We'll be slogging through traffic at $6 a gallon, hearing on C-Span that prosperity is just around the corner. Somebody about to catch the shuttle to New York — or back again to Reagan National — will be doing the talking.