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Wholesale Rip-off Part 3:The Music Man Syndrome

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This is part 3 of our monthly series about how money really moves in America, and thus how the financial services industry rips off average investors.  Part 1 & 2 are here, and here.  This series is a direct result of more than a decade in this industry with a close-up view of the rip-off it truly is.

Creating the Need

The best way to explain what was done to the American investor is to use the analogy of the movie “The Music Man”.  This 1962 musical starred Robert Preston as “Professor” Harold Hill an affable con man who arrives in the fictional town of River City Iowa.  The Professor plans to con the citizens of River City into paying him to create a boys’ marching band complete with instruments, uniforms and instruction books.  Once he does this and the instruments and uniforms have arrived he will skip town with their money.

Harold Hill does this by deliberately inciting fear amongst the citizens of River City.  A fear that their boys will fall into a life of sin because of the presence of a pool table in town.  He offers a marching band as the best alternative to avoid this sorry fate.  In short, he preys upon the citizen’s fear.  As for those who may wish to question his motives or tactics he simply co-opts them.

Does all this sound familiar?  It is almost to a tee what the financial services and banking class did to the United States, in conjunction with an all too willing government of course.  First you create the need.  You lay the groundwork for policy to be corrupted in favor of the politically well connected.  Then you stoke fear into the hearts of citizens. 

The analogy to the movie breaks down at this point because the effects were much more severe than simply being conned into investing in a marching band. The fear that was generated was both real and imagined.  It was imagined in the sense that none of these policy choices was necessary and in fact extremely damaging.  The fear was real in that the aftereffects of the policy choices produced severe ramifications that put people’s financial lives at risk and not coincidently forced investors into the hands of a waiting financial services industry.

Setting the Stage: The Corruption of Policy

If average people are such terrible investors, as we discussed last month, then why on earth should they find themselves in the equity markets?  The answer of course lies with your friendly government.  There are two gifts that the government bestows on us that force people into the markets: taxes and inflation.  Inflation is a tax as we shall see but every financial advisor will tell you that you must beat taxes and inflation to achieve your financial goals so that is how we shall frame the issue.

This is not the place for a discussion for the overall growth of government that makes taxes and inflation both possible and necessary (from the point of view of the government and its favored clients).  We will for purposes of this discussion take it as a given that we have a large and active government that interferes mightily with the market process.  And that this fact generates a flurry of lobbying activity on behalf of favor seeking interest groups.

Taxation and inflation seems relatively straightforward.  The government needs revenue, so they raise taxes and inflation causes prices to rise.  Therefore, an investor must get a return that beats both the level of taxation and the expected rate of inflation.  It seems clear enough that taxes are raised to provide the government revenue.  Inflation is considered by most, even policymakers, as something that just occurs.  Obviously, this cannot be the case as the government has a monopoly of money production and distribution.  Inflation in fact is best defined by an increase in the supply of money not necessarily an increase in prices. See Murray Rothbard’s Man Economy and State for a treatment of inflation.

The question then becomes who benefits from a policy of high taxation and high inflation?  Obviously, the government benefits from a high level of taxation in that they get more revenue to use to buy political power.  Less seen, however, is the fact that the government uses exemptions from high taxes to buy political favor.  In fact, it is this phenomenon that is more pervasive in our political system than simply high taxes. 

The number and complexity of tax credits, deductions and diversions is legion.  Tax credits are the most valuable.  They reduce your tax bill dollar for dollar by the amount of the credit.  Some of these include: the child tax credit; child and dependent care credit; elderly and disabled credit; lifetime learning credit; adoption credit; residential energy efficiency credits; and retirement savings contributions (for low-income families)

Deductions are not as valuable but still important in that they can reduce your taxable income by the amount of the deduction.  Some of these include medical & dental expenses (more than 7.5% of adjusted gross income); home mortgage points; charitable contributions; casualty & theft losses; contributions to retirement savings accounts; certain education and work-related expenses; and a myriad more.

Tax deferral is the other area where tax policy is designed to favor certain groups.  Among these are: the tax-free buildup of retirement accounts; the tax-free buildup of annuities (although these are funded with after-tax dollars) and the tax-free buildup of life insurance cash values. (Also of massive benefit is the tax-free treatment of life insurance proceeds to a beneficiary).

Behind each of these credits and deductions and deferrals is a political lobby that wants to see resources flow to their industry or cause.  This only works if there is a relatively high level of nominal taxation to begin with.  If you have a $100 deduction at a 10% tax rate, then the deduction is worth only $10.  If, however, you have a $100 deduction at a 40% tax rate it is worth $40.  You can see why the beneficiaries of deductions need high nominal tax rates.

 The same holds true for the specific tax advantages that accrue to the financial services industry.  Without high marginal tax rates, the deduction of retirement plan contributions is less attractive; without high rates the tax-free buildup of life insurance and annuities is not nearly as valuable; and why would an insurance person want the elimination of the inheritance tax when the tax-free passage of life insurance proceeds makes that product ever more attractive.

The upshot of all of this is that because of the polices put in place by the vested interests in the economy, more money and resources flow to these sectors of the economy than would otherwise be the case in a truly free market.  In the process, the high level of taxation both forces money to flow into the hands of money managers and financial advisors as well as creates an imperative for investors to strive for a yield large enough to offset those taxes.  Which is exactly the point of these policies.

This is also the case with inflation.   Inflation is, as indicated above, best defined as an increase in the supply of money.  This may or may not result in a general rise in the price level. (The determination of the overall price level is notoriously difficult to measure.  Inflation does alter relative prices causing booms in certain segments of the economy).  In the process this increase in the money supply, by virtue of how the money enters the system, causes the boom-and-bust cycle that the government would have you believe is extraterrestrial in nature. (See Ludwig von Mises Human Action Chapter 20 for a treatment of the business cycle).

The arguments in favor of a stable commodity based (gold) money supply are overwhelming but beyond the scope of this work.  For the purposes at hand we only need to look at who benefits from an inflationary policy.

Obviously, the government itself benefits from inflation by the fact that it can extract more resources from productive society than it would be able to through direct taxation.  That inflation is a tax cannot be gainsaid.  It is the shifting of resources from the productive sector to the non-productive governmental sector, nothing less.  It is done much more surreptitiously than direct taxation and without the political unpopularity of direct taxation.  The key is which interest groups the government can work with to achieve this shift.

It is how the money enters the system that confers maximum benefit on the powerful interest groups that control U.S. economic policy.  The government does not simply print money and distribute it to everyone equally.  If they could magically increase everyone’s cash holdings by say 5% overnight, it would in due course probably raise prices about 5%.  In the process, no one would be any better off vis. a vie anyone else.  That being the case, why would the government undertake such a policy?  Governments don’t act unless someone benefits from the activity, period.

So, who benefits most from an inflationary policy?  Primarily the first receivers of the newly created money benefit the most.  If the money supply is increased, then whomever gets it first has an advantage over those who get it later.  This is because they get the benefit of additional purchasing power before the effects of the inflation have taken hold.  As time goes on prices will tend to rise. (Which prices rise and how will be different from inflationary episode to inflationary episode).  As the inflation ripples through the economy the later receivers will have suffered the effect of higher prices before any increase in purchasing power.

Who then are the first receivers of newly created money?  Investment banks, commercial banks, financial services firms (the mutual fund and hedge fund complex), government contractors and government employees.  Who loses?  Most egregiously those on a relatively fixed income: pensioners; social security recipients and welfare clients.  As outlined by the economist Murray Rothbard:

In any economy not on a 100 percent commodity standard, the money supply is under the control of government, the central bank, and the controlled banking system. These institutions issue new money and inject it into the economy by spending it or lending it out to favored debtors. As we have seen, an increase in the supply of money benefits the early receivers, that is, the government, the banks, and their favored debtors or contractors, at the expense of the relatively fixed income groups that receive the new money late or not at all and suffer a loss in real income and wealth. In short, monetary inflation is a method by which the government, its controlled banking system, and favored political groups are able to partially expropriate the wealth of other groups in society. Those empowered to control the money supply issue new money to their own economic advantage and at the expense of the remainder of the population. Yield to government the monopoly over the issue and supply of money, and government will inflate that supply to its own advantage and to the detriment of the politically powerless.

This is exactly how it works in the U.S. system.  The Federal Reserve creates new money by simply entering it on their books electronically.  They inject that money into the economy by buying U.S. Treasury Bonds.  They do not buy them directly from the Treasury itself the way you or I could.  How would that benefit a key constituency?  The Treasury first sells the bonds to a group of about 20 “Primary Dealers” such as Goldman Sachs.  These investment banks then turn around and sell these bonds to the Federal Reserve.  However, they do not do so in a competitive way designed to get the government the best deal.  No, the Federal Reserve announces what it is going to buy and when.  This allows the investment banks to front run the Federal Reserve and sell the bonds for maximum profit (and maximum detriment to the public).  This is executed by the New York branch of the Federal Reserve which has had consistent connections to the investment bank community over the years.

In this way, the government injects money into the system in a way that benefits the politically connected crowd on Wall Street.  The money then ripples out from there.  Now that the money is in the financial services and investment sector it makes its way to hedge funds and mutual funds and insurance companies selling life insurance and annuities.  This has the effect of pushing up asset prices such as stocks, bonds and other investment products.  This will also tend to push up home prices, particularly at the high end.  All of this benefits the already wealthy.  The top 1% own a third of all stocks and the top 10% own two thirds of all stocks.

This, of course, does nothing for those who receive the new monies late or never.  Particularly hard hit are pensioners and the elderly who are on fixed incomes.  This is a double whammy on these individuals because this policy pushes interest rates down artificially and they tend to live off interest income.  Which then means they need to take greater risks to generate the same dollar income, which can lead to the loss of their investment capital.

This is a policy which also creates and fuels debt since it makes the interest rate so much lower than it would otherwise be.  This does not, however, help the poor.  Those most able to get a loan and go into debt are the wealthy since they are the most solvent and creditworthy.  This has been borne out by the massive increase in debt by both middle- and upper-class individuals as well as corporations over the last 40+ years.

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That in a nutshell is the core of who benefits from U.S. economic and monetary policy. That these policies benefited this sector of the economy is clear by the increasing “financialization” of the United States economy.  The employment and total sales of the financial sector grew from 10% of GDP in 1970 to 21% by 2019.  The United States was less about making things than making money from money.  Along with this the manufacturing sector fell from 30% of GDP in 1970 to 12% by 2021.  The economic effect was that real productive investment was starved at the expense of financial engineering projects that added nothing to the real output of the economy.  That all of this was fueled by an unnatural government intrusion into the workings of the market demonstrates that this was not the result of a true and honest capitalist market.  The moral effect of this policy is uniformly deleterious.  It is nothing more than a naked shift of money from the bottom to the top of the economic pyramid.  It is those politically connected groups receiving something for nothing.  This can only be accomplished, of course, if there is someone receiving nothing for something.

The outrage that exists at the bottom of the economic ladder has been muted by the opaque nature of this process. (This anger is, however, rising as the long-term effects of this policy in stagnating wages and tepid economic and job growth are increasingly felt by a besieged middle class).  The effect at the top of the economic ladder is almost as pernicious.  This policy has bred an acute sense of entitlement and privilege by those who benefit from it.  It has become wired into the DNA of this class of rentiers that this is a normal and righteous state of affairs. The longer a policy continues then the more it is seen as normal and just and any attempt to change it is seen as a direct threat which generates moral outrage and cries of “tyranny”.  All the effects that flow from this moral deformation become justified as a part of a “morally righteous” system.  This phenomenon is crucial to what happens next as it lays the groundwork for accepting without question the blatant ripping off of unsuspecting clients.  How this sense of entitlement and privilege manifests itself in the conduct of the selling of financial advice is the topic to which we turn next month. 

Praise Be to God

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