Red-Blooded Risk: The Secret History of Wall Street

Where Did They Put the Money?

One of the important economic functions of markets is capital formation. Capital is assets used to make more assets, most commonly, money used to make more money. If you own and live in a house, the house is an asset, but not a capital asset. If you rent it out to someone else, it becomes a capital asset. Left to their own devices, most people are content to use assets or let them lie fallow if they have no current need for them, to spend cash or to hoard it. Persuading people to rent out unused land or put cash in the stock market instead of spending it or hoarding it is part of what the finance industry does. Capital allows businesses to form and grow, and at the same time—hopefully—allows the provider of capital to achieve financial security.

It is also possible to create capital out of thin air. In the right circumstances, you can print up some paper money, lend it to an entrepreneur, and generate a productive cycle of exchange that creates a new company without ever putting up anything of value. We just saw how quants accomplished this trick on a massive scale from 1980 to 2007, doubling the available capital in the world without persuading people to give up existing assets. Assets do not have to be tangible, like houses or cars. The belief in future value is just as much an asset as a bar of gold is. John Kenneth Galbraith even pointed out that embezzlement creates capital, since both the embezzler (correctly) and the embezzlee (incorrectly) ...