In a famous passage from his book The Great Crash 1929, John Kenneth Galbraith introduced the term bezzle, an important concept that should be far better known among economists than it is. The word is derived from embezzlement, which Galbraith called “the most interesting of crimes.” As he observed:
Alone among the various forms of larceny [embezzlement] has a time parameter. Weeks, months or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in—or more precisely not in—the country’s business and banks.
Certain periods, Galbraith further noted, are conducive to the creation of bezzle, and at particular times this inflated sense of value is more likely to be unleashed, giving it a systematic quality:
This inventory—it should perhaps be called the bezzle—amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times, people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances, the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression, all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.
Galbraith recognized, in other words, that there could be a temporary difference between the actual economic value of a portfolio of assets and its reported market value, especially during periods of irrational exuberance. When that happens, Galbraith pointed out, “there is a net increase in psychic wealth.” Why? Because the embezzler feels (and is) wealthier, while the original owners of the portfolio do not realize that they are less wealthy. Think, for instance, of the many investors duped out of their retirement savings by Ponzi schemes like that orchestrated by Bernie Madoff.
In such situations, because the collective perceived wealth of the conman and the assets’ original owners exceeds their collective real wealth, for a while the world appears to be a happier (and wealthier) place. As British economist John Kay later explained, “The joy of the bezzle is that two people—each ignorant of the other’s existence and role—can enjoy the same wealth.”
In this sense, the bezzle is created not just by Ponzi schemers, like Madoff, but also in the form of companies—like Enron, for example, or WorldCom—whose accounting frauds result in overvalued assets and excessively high stock valuations. Until the accounting frauds are uncovered, there is a collective increase in psychic wealth as the value of the bezzle rises.
Unfortunately, the bezzle is temporary, Galbraith goes on to observe, and at some point, investors realize that they have been conned and thus are less wealthy than they had assumed. When this happens, perceived wealth decreases until it once again approximates real wealth. The effect of the bezzle, then, is to push total recorded wealth up temporarily before knocking it down to or below its original level. The bezzle collectively feels great at first and can set off higher-than-usual spending until reality sets in, after which it feels terrible and can cause spending to crash.
Bezzle Without the Embezzlement
By itself, this was quite a useful concept, but in the 1990s, the vice chair of Berkshire Hathaway, Charles Munger, developed it into a far more important and subtle concept. The bezzle doesn’t need embezzlement to work, he pointed out. Anytime the reported market value of an asset or portfolio temporarily exceeds its real economic value (by which he meant the value of future returns on that asset), the economy goes through the same increase in psychic wealth followed by a decrease. As he explained in a 2000 speech,
Galbraith coined the “bezzle” word because he saw that undisclosed embezzlement, per dollar, had a very powerful stimulating effect on spending. After all, the embezzler spends more because he has more income, and his employer spends as before because he doesn’t know any of his assets are gone. But Galbraith did not push his insight on. He was content to stop with being a stimulating gadfly. So I will now try to push Galbraith’s “bezzle” concept on to the next logical level.
Munger went on to illustrate how rising asset prices, when they rise faster than rises in the underlying long-term economic value, can contribute to what he now renamed the febezzle—a clumsy word that has never stuck. Munger’s insight was that rising stock or real estate prices can generate income and wealth effects whether or not these rising prices reflect real increases in the earning capacity of these assets, that is to say in their real fundamental values. When they do reflect real increases in wealth, the increase in the investor’s wealth is matched by an increase in the real productive capacity of the economy. There is no false or distorted sense of wealth.
But when asset prices increase for reasons other than real increases in their productive capacity, something very different happens. The overall economy is no better off because there will be no corresponding increase in the productive capacity of that economy. The owner of such assets, however, feels richer—although only temporarily—because over the long term, asset prices eventually converge to a value that represents their real contribution to the production of goods and services.
When the perceived value of assets outpaces their actual economic utility, the psychic wealth of the economy once again rises, and because this rise is not associated with any corresponding rise in real wealth, it is only temporary (though, as Munger noted, this temporary phase can go on for a very long time). The point is that financial markets can create temporary impressions of false wealth very similar to those of Ponzi schemes without any need for an embezzler—a notion, by the way, that economist Hyman Minsky would have quickly recognized as a restatement of the third, Ponzi, stage of his Financial Instability Hypothesis.
The Bezzle Can Temporarily Boost GDP Growth
Unfortunately, as useful as this idea is, mainstream economists—except for a few economists like Kay—have had trouble incorporating the idea of the bezzle into much of their work. Most economists exhibit this blind spot not due to an inability to recognize that market prices can diverge substantially from assets’ fundamental value for long periods of time but rather because they are unable to model a system in which market prices are not also the best estimate of the true economic value of an asset.
More importantly, they find it difficult to accept the implications the bezzle has on the way economic activity is measured and GDP is calculated, with the bezzle distorting the relationship between economic activity and economic growth, mainly because—while the bezzle is being created—there is no way to distinguish between real income and/or profits and bezzle-boosted income and/or profits. Munger explained a very simple way this could happen, namely when rising stock prices feed temporarily into rising GDP:
If a foundation, or other investor, wastes 3% of assets per year in unnecessary, nonproductive investment costs in managing a strongly rising stock portfolio, it still feels richer, despite the waste, while the people getting the wasted 3% . . . think they are virtuously earning income. The situation is functioning like undisclosed embezzlement without being self-limited. Indeed, the process can expand for a long while by feeding on itself. And all the while what looks like spending from earned income of the receivers of the wasted 3% is, in substance, spending from a disguised “wealth effect” from rising stock prices.
That 3 percent per year that comes from the appreciation of the assets is converted into income, a process that is eventually reversed, Munger explained, when the reversal of the previous irrational rise in prices can no longer disguise the associated fees and wealth effects.
There are other ways the bezzle can affect GDP calculations. One way is through the commingling of real and speculative profits in business sectors in which buying and selling assets (such as land, commodities, and inventory) is part of normal business operations. When that happens, what should be recorded as a speculative rise in the price of an asset is recorded as an increase in operating earnings, which in turn increases the value-added component of the GDP calculation.
Another way the bezzle can slip into GDP calculations is by raising the market price of assets that in turn enable greater asset-based borrowing. As stock or real estate prices rise, for example, there is almost always a rise in household and business debt (at least part of which, by the way, is then plowed back into further raising prices).
Yet another way the bezzle can confound GDP calculations is by artificially lowering the cost of capital. When equity or debt has been bid to higher prices than will ultimately be justified by future returns, this reduces the cost of capital for businesses by effectively transferring a portion of the cost to owners of equity or debt. These lower capital costs encourage more commercial activity—including investment that otherwise would not be considered productive—than might otherwise be justified. Such lower capital costs also feed into higher business profits, which in turn boost the value-added component of GDP calculations.
Meanwhile, although these higher profits represent a transfer from investors, because of prices rising above their real value, investors not only don’t react to the transfers by cutting back on their own spending, but they actually feel richer and so they tend to spend more than usual. Over time, in other words, GDP growth is artificially boosted by a rising bezzle, which in turn is justified by rising GDP. The two elements reinforce each other in a seemingly virtuous cycle.
The Bezzle Always Reverses Eventually
But as Minsky explained, “over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.” Because the bezzle is, by definition, temporary (though it may last for a few years or even a decade or two), at some point the bezzle will be eliminated, and its elimination will reverse the earlier boost to the economy. When that happens, what appeared to be a virtuous cycle becomes a vicious cycle.
Typically, this can occur in one of two ways. The first (and most widely understood) way is when a financial crisis suddenly reverses the mechanisms underlying the creation of the bezzle, along with the debt creation that seems to fuel it. When that happens, the owners of the overvalued assets quickly and chaotically take large losses as the assets are written down. When John Mills wrote more than 150 years ago that “panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works,” he was effectively writing about the creation and subsequent elimination of the bezzle within a credit cycle.
But contrary to what most assume, the bezzle can also be eliminated much more slowly, as the gap between reality and the growth expectation implicit in the price of an asset is slowly amortized. When this happens, the loss associated with the bezzle is effectively eliminated through (often hidden) transfers that force the loss onto one economic sector or another. Regulators, for example, may bail out the losers—especially if they threaten the banking system—and then they may either raise future taxes to cover the bailout or distort interest rates in ways that allow banks to profit artificially at the expense of depositors and borrowers (as the Federal Reserve did in the 1980s when it engineered a steep yield curve to help bail out money center banks reeling from the Latin American debt crisis).
Similarly, Chinese regulators in the early 2000s effectively amortized the bezzle buried in the bad debt on the balance sheets of the country’s banking system (which probably amounted to an estimated 30–40 percent of GDP) by setting deposit rates so far below nominal GDP growth rates that banks and insolvent corporate borrowers could, just by rolling over the debt for ten years or more, reduce the real cost of the debt by more than an estimated 50–60 percent. Those losses were recouped by the banks that had funded the loans in the form of very low deposit rates.
In such cases, it is mainly ordinary households who pay for the reversal of the bezzle, either directly through taxes or indirectly through repressed deposit rates or even unemployment. Unfortunately, the history of bezzle suggests that, while ordinary households and workers absorb few of the benefits from the creation of bezzle, they tend to absorb most of the costs of its reversal: it is probably not just a coincidence that periods in which large amounts of bezzle are created and then destroyed seem almost always to experience rising income inequality. In other cases, businesses and investors may suffer losses and low returns on assets for many years. When that happens, it is those sectors that seemingly benefited from the bezzle who pay the costs of amortizing its reversal.
What matters is that the bezzle, and its elimination, will have the real impacts on the economy that Galbraith identified, only to a much greater extent than he imagined. While it is being created, the bezzle boosts growth by comingling (temporary) speculative profits and operating earnings and by setting off false wealth effects and greater borrowing. The resulting financial mirage instigates higher levels of investment than can be economically justified and encourages more spending than households and businesses can really afford. In this way, a period of rapid growth can become a speculative boom.
But while the bezzle is being amortized, the opposite happens: instead of artificially boosting growth when it is already high, this amortization depresses growth through forced debt repayment and negative wealth effects just as it is already slowing. Notice that the cost of amortizing the bezzle is proportionate to the degree of psychic wealth the bezzle had previously created: the more bezzle that is created, the more painful the adjustment. Notice, too, how self-reinforcing the processes of bezzle creation and bezzle amortization are. This, I would argue, is why investment and asset booms are almost inevitably followed by busts or lost decades.
The Many Faces of the Bezzle
Clearly, Galbraith’s bezzle concept is most useful economically not when it is limited to explaining embezzlement and Ponzi schemes but rather when it represents any substantial and persistent divergence between an asset’s real economic value and its perceived value. Minsky argues that this divergence is most likely to occur in economies with rapidly growing debt, and it is certainly hard to find examples of countries with systematic tendencies to grow the bezzle in which surging debt isn’t also present.
It might be helpful, at this point, to list the ways the meaning of the bezzle has evolved, and the various shades of meaning the term subsumes.
First, the original meaning of the bezzle, as Galbraith defined it, is a fraud committed during the irrationally exuberant part of the market cycle before the victim detects the fraud. Imagine if Madoff, for instance, embezzled $100 from one of his victims. Although no wealth has been created, Madoff feels $100 richer while his victim does not (yet) feel $100 poorer, so their collective recorded wealth seems to be $100 higher. Of course, this illusion is only temporary. Once the fraud is discovered, the perceived wealth of the victim declines by $100.
Second, however, it is important to note that not all forms of the bezzle require fraud. The term’s second meaning, as Munger explained, is when the secondary market value of an asset temporarily rises above any meaningful economic, or fundamental, value. It is, of course, very hard to know a priori exactly what the fundamental value of an asset is, as this depends on many factors, including predictions about future growth rates, but ultimately the real economic value of an asset today is the value of the economic income associated with it over the rest of its life. In the case of real estate, this value could be approximated by the equivalent rental income minus holding costs.
In that sense, the bezzle is the gap between the a priori and a posteriori values of an asset. When the market value of the asset today exceeds the value that it will generate in the future, asset owners will feel richer than they really are.
Perhaps the classic case in real estate was Japan in the 1980s, when the total recorded value of all the country’s commercial and residential property was equal to roughly four times the total equivalent value in the United States. For a while (until the 1990s, when Japanese land prices fell by 85 percent during the decade), the total recorded wealth for Japanese households collectively was boosted enormously by the overvaluation of its real estate (and further exacerbated by the overvaluation of everything from its stock market and golf club memberships to parking spaces and collectibles) with land holdings at their peak comprising 65 percent of Japan’s national wealth. But, as is always the case with the bezzle, this sense of wealth was only temporary, even if it lasted many years before reversing. Once prices adjusted, the wealth effectively disappeared.
Bridges to Nowhere
I would add a third variation on the bezzle, which in some cases can be by far the largest source of bezzle in an economy. This is when there is substantial overinvestment in infrastructure or manufacturing facilities that isn’t subsequently justified by the economic value created. Again, the most famous example of this is Japan’s notorious “bridges to nowhere,” although China has increasingly become the most representative example of this third type of bezzle, in which as much as half the growth in GDP in recent years may be a function of bezzle creation.
The way this works is straightforward. Some entity, usually associated with the government and therefore lacking hard budget constraints, spends, say, $150 to build a bridge or a railroad that ultimately generates only $50 in additional economic benefits for the region or country. If the project were correctly valued, there would quickly be a $100 write-down of the investment, after which the total recorded or perceived wealth in the country would once again be equal to its real economic wealth. But if the entity that built the bridge or railroad can continue carrying the project at cost, the collective recorded or perceived wealth of entities in that country is $100 greater than the real value of that country’s economy, even if it takes many years for this discrepancy to come to light.
This is likely to be by far the biggest source of bezzle in a country like China, and one of the consequences is the extraordinary surge in China’s debt ratios since the mid-2000s. If Chinese investment had been productive—meaning that if the value of the future economic benefits derived from the investment were equal to or exceeded its costs—increases in investment might have caused temporary increases in national debt ratios, but these increases would have soon been reversed as the growth generated by the investment caught up with and exceeded the associated debt-servicing cost. Yet in the past ten to fifteen years, Chinese debt has soared, and even accelerated, relative to GDP (which is itself overstated by the creation of bezzle), and this suggests that a substantial portion of this investment is bezzle.
Inflated Currency Values
Fourth, bezzle can also be created when speculative capital flows drive up the value of a country’s currency to unsustainable levels, causing those who earn income in that currency to feel temporarily richer, a feeling they then express in the form of higher consumption of foreign goods and more travel abroad. Any instructor at a fashionable ski resort in Europe or the United States, for example, can tell which currencies have recently risen most in value by noting which country is sending an exceptionally large number of visitors.
Finally, it is possible that certain assets whose value is not a function of their contribution to the production of economic goods and services, like very expensive art or collectibles, also create an impact very similar to the bezzle during times of rising prices. Kay expressed a similar point when he argued, tongue in cheek, that “The critic who exposes a fake Rembrandt does the world no favor: The owner of the picture suffers a loss, as perhaps do potential viewers, and the owners of genuine Rembrandts gain little.”
Why the Bezzle Matters to Economics
Minsky argued that one of the reasons mainstream economics seemed to do such a poor job of explaining modern economies was a tendency among economists to ignore money, banks, and balance sheet effects. But these elements should correctly be placed at the heart of economic analysis, he argued, and this meant, among other things, understanding how balance sheets created and destroyed value and how they lined up systemic procyclical and countercyclical tendencies across an economy.
Galbraith understood this, as many if not most professional investors and traders intuitively do. Galbraith’s bezzle is an artificial value that emerges from the ways in which balance sheets interact with speculation and create forms of money and value, but while the bezzle is created independently of the underlying operations of the economy, like many other balance sheet effects, it can modify—and in turn be modified by—the operations of the real economy. Kay makes the point forcefully:
The essential story of the period from 2003 through 2007 is that banks announced large profits and paid a substantial share of them to their traders and senior employees. Then they discovered that it had all been a mistake, more or less wiped out their shareholders, and used taxpayer money to trade their way through to new levels of reported profit.
The essential story of the eurozone crisis is that banks in France and Germany reported profits on money they had lent to southern Europe and passed the bad loans to the European Central Bank. In both narratives, traders borrowed money from the future. And then the future came, as it always does, turning the bezzle into a bummer.
From large amounts of “an increase in psychic wealth” provided by the systematic creation of bezzle to “turning the bezzle into a bummer,” understanding the role of bezzle in economics means understanding that it has at least four important consequences.
First, the bezzle represents recorded or perceived wealth that does not exist as real wealth (productive capacity), and as such it boosts collective recorded wealth above real economic wealth. This discrepancy gooses GDP growth in at least three ways. One way this happens is that bezzle creates a temporary wealth effect that boosts consumption and investment spending to a level higher than where either normally would have been. A second way is when part of this false wealth shows up either as higher income or higher profits for the entity that benefits from the boost in recorded wealth. A third way is when rising market values collateralize increases in borrowing that are then used either to raise prices further or to increase spending. It is not a coincidence that GDP growth rates are always higher than expected in periods during which a great deal of bezzle is being created.
Second, the reverse is true when the bezzle is directly or indirectly recognized and amortized, as it must eventually be. One or more sectors of the economy (households, businesses, local governments, farmers, or banks) must absorb the loss. As they do, the wealth effect reverses, their lower earnings or profits are reflected in lower-than-expected GDP figures, and they are forced to pay down the debt. Just as it is not simply a coincidence that bezzle is created mainly during economic booms, nor is it a coincidence that it tends to be recognized during economic downturns or financial crises.
Third, bezzle creation seems to be systemic. There are periods, in other words, when it seems that the operation of the financial system errs toward creating bezzle, and these times always seem to be followed by periods in which the bezzle is automatically wrung out of the system.
Fourth, as Galbraith especially pointed out, the bezzle has a self-reinforcing impact on growth in either direction. When it is being created, the illusion of wealth tends to reinforce growth and encourage the creation of more bezzle. When it is being amortized, it tends to inflict additional costs of financial distress on the economy, especially to the extent that it was financed by debt.
Bezzle Booms and Busts
The bezzle cannot be quantified, and it cannot even be proven to exist until after the fact. But while that makes it useless as a concept for a form of economics that values precision over accuracy, this doesn’t mean that its impact should be ignored. The balance sheet matters, and when there is a significant (albeit temporary) divergence between the perceived value of assets in an economy and their future contribution to the production of real goods and services—whether this divergence is created by fraud, irrational exuberance, or malinvestment and other forms of nonproductive investment—this divergence will change economic behavior and activity in ways that are not sustainable.
This is especially likely to be the case when an economy is locked for many years into the systematic creation of bezzle. When that happens, the economy will experience a period during which economic activity overstates the real underlying growth in productive capacity, followed by a period in which this overstatement is eliminated.
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