In 2007, just as the housing bubble was about to burst, Newsweek senior editor Daniel Gross published a book called ‘Pop! Why Bubbles Are Great For The Economy.’ In it, he sought to correct what he considered to be a dangerous misunderstanding by proving that asset bubbles were not at all dangerous. They were in fact just the opposite. As the title suggests, he believed bubbles were “great”.
According to Daniel, capitalism needs bubbles to survive and function—it is through bubbles, he argued, that capitalism rapidly transforms economies during periods of “major technological or commercial innovation”. Bubbles are simply an expression of the Schumpeterian “creative destruction” that propels growth in a capitalist economy.
Of course, the global financial bubble popped soon after, and the taxpayers were left to bail out all the clever innovators.
THE CORPORATE VIKINGS
Following the spectacular collapse of the Icelandic financial miracle, which turned out to be one giant bubble, it is doubtful if many Icelanders would agree with Daniel’s characterisation of bubbles as “great”. However, most Icelanders would agree that the bubble was created by innovation—innovative accounting, that is. As it turns out, Daniel Gross overlooks the fact that among the types of “innovation” that flourish during bubbles are creative accounting and fraud. As John Kenneth Galbraith noted in his study of the roaring ‘20s and the 1929 stock market crash, bubbles provide ideal conditions for fraud and embezzlement. Charles Kindleberger in his classic history of financial crises, ‘Manias, Panics and Crashes’, goes one step further and argues that embezzlement, bubbles and swindles are inseparable.
In his account, John Kenneth Galbraith focuses on the “get rich quick” atmosphere that dominates during bubbles: people are willing to look the other way, so long as the good times keep rolling and the numbers on the stock ticker head ever upward. The expectation of ever-higher stock prices can also stimulate fraud in a different way. Arthur Levitt, former head of the American Securities and Exchanges Commission, has argued that accounting fraud during the internet bubble of the 1990s was caused by the emphasis on short-term gains in stock prices by a market dominated by day traders. Arthur, as well as Galbraith, Kindleberger and other scholars of financial bubbles, recognise that bubbles breed fraud. When everyone seems to be getting rich quickly, unscrupulous businessmen [and –women. For brevity’s sake we will stick to ‘businessmen’ throughout] resort to cooking the books in order to meet the market’s expectations—and in the uncritical atmosphere of easy riches, investors fail to look more closely, ignoring doubts and even red flags, fearing they might miss out on the next big thing.
THE SILENCING OF CRITICS
However, the Icelandic example shows us that there are other ways in which bubbles breed fraud. History has shown that every bubble is accompanied by its own ‘New Era’ philosophy, a belief that traditional rules no longer apply. These philosophies or religions usually come complete with their lists of proof that provide those who want to believe in constantly rising markets with evidence and justification for their faith.
In Iceland, this “New Era” philosophy was best articulated by free market fundamentalists, including Hannes Hólmsteinn Gissurarson and his disciples, who argued Iceland could become the richest country in the world by slashing taxes and regulations and by becoming a “global financial centre”. This new era philosophy then merged with a chauvinistic nationalism, ideas about the inherent superiority of Icelanders and Icelandic businessmen, allowing bubble promoters to blast critics for not “getting it”, for lacking faith in both Iceland and the free market.
It is impossible to explain what appears to have been widespread Enron scale accounting fraud, systematic market manipulation, insider trading, self dealing and other financial malfeasance that characterised the Icelandic market, without reference to this willingness to silence critics. When all is said and done, it was the celebration of investment bankers and oligarchs by politicians, the fawning profiles of financiers and corporate raiders in the daily press along and the utterly uncritical celebration of “the market” as infallible, which was the real problem and the root cause of the bubble, and much of the wreckage it left in its wake.
A good example of how this works is the case of FL Group. In 2004, a former DeCode executive named Hannes Smárason gained control of the airline Icelandair with the help of Baugur and Jón Ásgeir Jóhannesson. Icelandair was at that time one of the most solid companies in Iceland, and one of few airlines in the world that was consistently profitable. Hannes set about to transform the company, changing its name to FL Group to reflect his ambitious global plans. These plans turned out to be a classic corporate raid, as Hannes sold all hard assets out of the company, leaving only cash and equity in other companies, which was then leveraged in order to turn FL Group into an “investment company”. Of course the main investments were in the financial sector—primarily in Glitnir (which was turned into a personal ATM for Jón Ásgeir and associates at a later stage in the game). The markets celebrated and the stock price of FL Group rose more than 50% in six months.
But while the business strategy of Hannes Smárason found favour with the stock market, several members of the board of directors, as well as the CEO of the company, realised that something was wrong. Within the span of six months in 2005, the majority of the board and the CEO of the company resigned without any official explanation. Hannes brushed these resignations off as the stock market gave him a vote of confidence and the price of FL Group stock continued to rise. The media saw no reason to make a fuss, and at the end of 2006 Hannes was voted “businessman of the year” by the most widely read business weekly, Fréttablaðið’s The Market (it might bear noting that Fréttablaðið is owned by the aforementioned Jón Ásgeir Jóhannesson). By then, FL Group’s stock value had more than doubled since Hannes assumed the reins.
Needless to say, FL Group was among the first firms to declare bankruptcy in 2008, its shareholders losing all their paper gains. Several questions remain unanswered about large transfers from FL Group to offshore banking accounts, and Hannes Smárason has been sued by the resolution committee of bankrupt bank Glitnir for his role, and the role of FL Group, in the looting the bank.
There had been plenty of red flags—red flags that are not only visible with the benefit of hindsight, but should have been noticed by anyone paying attention at the time. Had the country not been caught up in bubble fever it is highly unlikely that Hannes Smárason would have been treated as some business genius, and more likely that someone would have noticed that there was reason to ask questions.
And who knows what red flags might have been noticed had the media and the public been more alert, and had they been more critical of the business elites? One can only wonder whether scoundrels like Hannes might have been stopped earlier had investors, the media and the general public not been blinded by their faith in the “Icelandic economic miracle”.
As we shift through the wreckage caused by the great debt bubble of the past years, the question arises of how best to avoid another bubble and inevitable crash. Understandably, commentators have focused on strengthening financial regulation, closing offshore tax havens and regulatory loopholes.
Reversing the trend toward increasing deregulation is important and necessary, but it is unclear if this would be enough if we fail to reassess our view of “the market” and its ability to correctly judge risk and apportion capital to worthy businesses. One would have thought that the hyping of financiers and internet wunderkinds and biotech researchers turned tycoons in the dot-com bubble would have forced some kind of soul-searching and a more critical attitude to the wisdom of the stock market. Instead, we plunged headfirst into a new bubble. If we want to avoid yet another one, we must adopt a more critical attitude to the market.
Renewing regulation of financial markets is also bound to run into opposition when the memory of the crash fades, unless we can abandon the misconception that the market is somehow infallible, always right, and that corporations and business tycoons are the best guardians of the public interest.
This is not to say that we should assume that all financial markets are just glorified casinos, and investment bankers all crooks who are out to defraud society. Rather, I argue that we need to keep in mind that the market is not some infallible judge of the inherent value of all things, and that when it comes to “price discovery” it can on occasion err quite spectacularly, and that we need to be aware that businessmen and large financial corporations only look out for their own interest, and that there is no reason to assume that these interests correspond to the interests of society at large. And that businessmen, like other people, are a diverse lot, and that some of them might be misrepresenting themselves.