Felix Salmon

Pascal-Emmanuel Gobry has a very smart response to my Wired story about IPOs.

Gobry has one main point. VCs aren’t bad for pushing their portfolio companies to grow at all costs he says; indeed, they have to be that way.

Breakthrough technology startups are different from other kinds of businesses in that they either create a new market or violently disrupt an existing one. This means that they almost invariably require to spend lots of capital in order to stake out a defensible market position against their numerous competitors. In particular, many technology markets have winner-take-most or winner-take-all dynamics, either because of network effects or economies of scale…

Felix writes that Groupon had a profitable Q1 2010 and “it’s easy to see how it could have grown steadily from that point onward.” Except that given the characteristics of the daily deal business, particularly the need for scale, what would have happened if Groupon had tried to “grow steadily” and profitably, is that the company wouldn’t be around anymore.

It’s LivingSocial that would have raised over a billion dollars and be worth $10 billion today, Groupon would have been sold for scrap like BuyWithMe and plenty of other daily deals also-rans, and Andrew Mason would be back to doing yoga on YouTube. Groupon would be a footnote.

This is a good point. If you think about big technology companies, they’re very frequently in markets with just one or two players: if you’re not the biggest, you won’t succeed at all. And so it makes sense, in such markets, to aggressively push to get as big as possible as early as possible. One way of looking at Apple vs Microsoft in the 1980s is that Apple concentrated on quality and failed, while Microsoft concentrated on quantity and succeeded.

But the fact is that the overwhelming majority of VC-backed companies don’t become Groupon or Facebook or Microsoft. Indeed, most of them don’t even IPO. As I note in the piece, 52 VC-backed companies went public last year; 429 were acquired.

It’s certainly true that Silicon Valley is full of ambitious men (and a handful of women) wanting to build enormous companies which will change the world. But from a public-policy perspective, that’s not actually the best way to run an entrepreneurial economy. For one thing, it artificially maximizes failure — many more companies fail than need to. And even the companies that survive do so in a brutal fashion: according to Harvard Business School’s Noam Wasserman, the majority of companies getting to their Series C funding round have already fired their founder from the CEO position, and 18% are on their third CEO or more. Here’s the chart from his book:

This is why smart entrepreneurs avoid VC funding where possible, and if they can’t avoid it, try to maximize the amount of control that they have. They tend to want to build and run their companies for the long term; their backers just want to get the fastest and greatest possible financial return. Those two interests are rarely aligned.

It’s incredibly easy to overestimate the importance of huge companies in the US economy. Here’s a chart showing the S&P 500 as a percentage of total US GDP: I’m not entirely clear exactly what the numerator is, but I’m comfortable saying that the 500 biggest companies in America collectively account for less than 20% of GDP, and quite possibly less than 10%. Meanwhile, the contribution of small businesses to GDP, while shrinking, is still well over 40%

Another way to look at this question is to compare US fight-to-be-number-one capitalism with the kind of capitalism practiced in undeniably successful countries like Germany, Korea, Brazil, and Japan. Those countries don’t have nearly as many world-beating behemoths as the US does, but overall their economies and current accounts are doing very well on a bedrock of medium-sized firms and family-owned corporations.

So in a way, Gobry is making my point for me. The IPO market and the VCs who feed off it are playing a game which might make a small number of people extremely rich, and which will create a very small number of hugely successful world-beating companies. They’re not playing a game which is good for founders; they’re not playing a game which is good for healthy, long-lived companies; and they’re not playing a game which is good for the economy as a whole. That’s kind of the point I’m making in the piece when I say that “Silicon Valley is full of venture capitalists who have become dynastically wealthy off the backs of companies that no longer exist”.

I agree, then, with Gobry when he says this:

Felix also notes that according to a study, most of the fastest-growing (in revenue) companies in the US aren’t venture-backed. Here’s the thing, though: you haven’t heard of most of those companies. Not to diss any of them, which we’re sure are great businesses founded by great entrepreneurs, but when you take the world-changing companies, the ones that come up with radically new products and create new markets or disrupt existing ones, almost all are venture-backed. Those are the breakthrough technology companies. There’s nothing wrong with other kinds of companies. But breakthrough technology companies operate in a specific way which means they will have a huge appetite for capital, which means they’ll need VC and IPOs.

I just disagree with Gobry if he thinks that placing long-odds bets on breakthrough technology companies is a sensible way of running an economy. And certainly the IPO market, and the stock market more generally, should exist to do much more than just serve that tiny sliver of corporate America.

Gobry has some secondary points, too. I simply disagree with him on the degree to which private markets will ever display the kind of correlations we’re currently seeing in public markets. That’s one advantage of private markets: they’re off-limits to index funds, which drive correlations ever upwards. And yes, the HFT algo-bots also serve to increase correlations in the stock market as a whole.

And to answer another of his questions, yes, I’m still worried about the way in which the move to private markets will essentially remove from most of us the opportunity to invest in America’s fastest-growing companies. I say in the piece that the US stock market worked very well from about 1933 to about 1998; there’s no reason we can’t somehow return to those halcyon days. But as Gobry and I agree, the stock market is broken right now, at least with respect to its primary function of providing equity capital to growing companies which need it.

Gobry thinks that I want to make it harder for companies to go public; that’s not true at all. One of the main things I complain about in my piece is that it’s so hard to go public, the role of injecting equity capital into early-stage companies has been taken on by the VC industry instead. We would be better off if that role reverted to the public markets, even as many entrepreneurs managed to fund medium-sized companies without putting themselves on an IPO path, thereby remaining closely held and being much less at the mercy of violent market swings. That’s how other successful companies do it, and that’s how many successful medium-sized US companies do it, too. And even huge ones, like Mars and Cargill. It worked in the past; it can work again in the future.

I have a piece in the latest issue of Wired magazine on the problem with IPOs in general, and technology IPOs in particular. In it, the JOBS Act comes across rather well:

It’s about to get easier for tech CEOs to ignore the IPO’s siren song. Legislation wending its way through Congress would change SEC rules, meaning no tech company would find itself forced to go public in the way that Facebook has. The bills, which have been supported quite vocally by a number of CEOs at pre-IPO companies in Silicon Valley, as well as VCs who want more control over the timing of their companies’ IPOs, would not count employees toward a company’s 500-investor limit. The legislation would also raise that limit to 1,000 shareholders.

I do think these changes to the 500-shareholder rule make perfect sense. Right now, companies like Facebook (and Google before it) tie themselves up in knots when it comes to giving equity to employees, handing out variations on the stock-unit theme rather than actual equity, just to get around this rule. That benefits no one, really. And ultimately they’re forced to go public anyway, with the timing imposed upon them by SEC regulations rather than being a matter of their own choice.

But this doesn’t mean that I’m a supporter of the JOBS Act more generally, which has been vehemently opposed not only by the usual subjects (Eliot Spitzer, Simon Johnson) but also by the much more centrist editorial board of the New York Times, which almost never saw a bipartisan bill it didn’t like. Even Bloomberg View has come out strongly against the act, in an editorial which, it’s worth remembering, is meant to broadly reflect the views of Mike Bloomberg personally. The SEC opposes it, as do former SEC officials like Arthur Levitt and a long list of consumer organizations.

A lot of the act is very hard to defend. The crowdfunding (a/k/a crowdmuppeting) part, for instance, seems very badly thought out: it’s certain to create a whole new class of startups which raise substantial sums on some Kickstarter-like platform, without having anything like the controls and staffing necessary to do the investor-relations job they’re letting themselves in for. On top of that, of course, there’s enormous scope for outright fraud here, given the lack of real penalties for issuers who lie.

Higher up the food chain, companies going public in an IPO could not only put out incomplete information in glossy sales pitches for themselves; they could also outsource that job to investment-bank analysts hoping their bank will win lucrative mandates down the road. There’s no good reason at all for this: it’s basically a way for unpopular incumbent lawmakers who voted for Dodd-Frank to try to weasel their way back into the big banks’ good graces and thereby open a campaign-finance spigot they desperately need.

I don’t fully understand the political dynamics here. A bill which was essentially drafted by a small group of bankers and financiers has managed to get itself widespread bipartisan support, even as it rolls back decades of investor protections. That wouldn’t have been possible a couple of years ago, and I’m unclear what has changed. But one thing is coming through loud and clear: anybody looking to Congress to be helpful in the fight to have effective regulation of financial institutions, is going to be very disappointed. Much more likely is that Congress will be actively unhelpful, and will do whatever the financial industry wants in terms of hobbling regulators and deregulating as much activity as it possibly can. Dodd-Frank, it seems, was a brief aberration. Now, we’re back to business as usual, and a captured Congress.

Super Freakonomics came out in 2009, and Ezra Klein was not impressed:

The problem with Super Freakonomics is it prefers an interesting story to an accurate one. This is evident from the very first story on the very first page of the book.

Under the heading “putting the freak in economics,” the book lays out its premise: Decisions that appear easy are actually hard. Take, for example, a night of drinking at a friend’s house. At the end of the night, you decide against driving home. This decision, the book says, seems “really, really easy.” As you might have guessed, we’re about to learn that it’s not so easy. At least if you mangle your statistics.

Klein then does a very good job of explaining where and how Super Freakonomics mangles its statistics.

So far so normal: Klein is far from alone in his bashing of the book. Indeed, American Scientist recently ran a column by Andrew Gelman and Kaiser Fung attacking the book’s m.o. And the book’s co-author, Stephen Dubner, has now responded to that column at astonishing and mind-numbing length (7,500 words).

Dubner says at the top of his post that he tends “to not reply to critiques”. But buried further down you’ll find this:

Gelman-Fung write that our argument was “picked apart by bloggers.” Their American Scientist article includes only a cursory bibliography and no footnotes or endnotes, nor do Gelman-Fung cite any specific sources in this case, so it’s unclear who those bloggers were and what they picked apart. From what I can tell, this is the main critique; its author is reputable but he has also written things like this (NSFW!), so he too seems to be in the business of attacking at any cost.

To be clear: Gelman and Fung accused Dubner of some slightly intellectually-dishonest practices. And in his self-defense, Dubner engages in some of the most egregious and blatant intellectual dishonesty I’ve ever seen on a blog.

There are lots of ways that Dubner might have responded to Klein; most of them involve mentioning him by name. Only one of them involves exhuming a drunken and deleted tweet from January 2008. If you look at the URL of the tweet (which is actually a screengrab of the tweet, since, you know, the original was deleted), you can tell that Dubner got there from this post. But Dubner doesn’t link to the post, just to the image of the tweet. Maybe because he knows that if he linked to the post, his readers would find this comment from Ezra Klein:

You’re absolutely correct that this was patently offensive. It was a private text message to friends, an inside joke we have because it’s so over-the-top obscene. It was never, ever meant to be public, and I’m deeply apologetic that it crossed that barrier. It’s not the sort of work I publish as a writer, and not what I seek to contribute to the discourse. The other examples of my writing, those that appear on my site, were meant to be in the sphere, to be argued with, even mocked. But the Twitter was ripped from my private life, and it was never meant to be brought out of the bar-like context in which it was born. Guess those privacy settings are more important than I realized.

In January 2008, Twitter was not the broadcasting platform it is today: it still felt much closer to its roots as a way for groups of friends to communicate with each other via text message. Today, we live in a world where the Freakonomics twitter account has 415,000 followers despite following nobody at all. But when Klein put out the tweet that Dubner’s linking to, the Freakonomics twitter account hadn’t even been created. In no sense at all was Klein “writing” something for public consumption and thereby demonstrating that he is “in the business of attacking at any cost”.

Now it’s possible that Dubner is unaware of Wonkblog, or of Klein’s Bloomberg View column, and therefore is unfamiliar with his actual mode of writing. Possible, but unlikely. What’s impossible is that Dubner believes that Klein’s rapidly-deleted tweet is in any way representative of his work as a whole.

It baffles me why Dubner would engage in a low and dirty and deeply dishonest ad hominem attack on Ezra Klein at all — let alone in the middle of a post in which he’s trying to defend his reputation. The only reason I can possibly think of is that, to coin a phrase, he seems to be in the business of attacking at any cost. Even when the cost paid is that people are sure to take him even less seriously now than they did before.

Update, 3/24: Dubner emails to say that he agrees the link was “unnecessary”, and that he has removed it from the post. In fact, he’s removed not only the link to the screengrab of the tweet, but also the link to Klein’s blog post, with the result that he now pretends to have no idea what the criticisms of his drunk-driving chapter are, even though he linked to them in an earlier version of the post.

The idea of buying equity in individuals rather than companies has occasionally been the subject of dystopian satire. And when Michael Lewis wrote in 2007 about a nascent attempt to set up a market in sports stars, he was far too early: Protrade closed in 2009, never having come close to achieving its dreams. (There are lots of echoes there of HSX, but that’s a different story.)

More recently, however, the idea’s been trickling back. In October 2009, entrepreneur and part-time professional poker player Rafe Furst invested $300,000 in a person he called “Marge”, in return for 3% of her future lifetime revenues. Rafe’s partner in this investment was another poker pro, Phil Gordon, and in a way it’s unsurprising that the deal came out of the poker world, where rich individuals regularly “stake” players in return for a share of their winnings.

Furst provided a three page Personal Investment Contract for anybody else who was interested in doing the same thing, but a couple of years later, in August 2011, he revealed that “Marge” was in fact his brother-in-law Jon Gunn. Now if you want to help out a family member, and you know they don’t have the money to repay a very large loan, and you have faith that they’ll make a fair amount of money in the future, and you have a very strong relationship with them, then this kind of a contract might be an interesting way to go. But I’m skeptical: such arrangements very rarely go as intended, and usually end in tears.

Still, other people heard Furst’s story and tried to do much the same thing. Saul Garlick and Jon Gosier set up a website asking for the Marge deal: $300,000 for 3% of lifetime earnings. Their friend Kjerstin Erickson doubled up, asking $600,000 for a 6% stake in himself. (Evidently, the present value of a 20-something entrepreneur is generally understood to be $10 million.)

Now, however, a mysterious website has appeared, called Upstart, offering “capital in return for a small portion of your future income”, and claiming to be “backed by Kleiner Perkins, NEA, and Google Ventures”. The site’s slogan is “The Startup is You”.

In a world where venture capitalists increasingly invest in a startup’s management team rather than in its business model or underlying idea, this makes sense. Find the entrepreneur and invest in the individual directly, thereby guaranteeing that you’ll have a stake in their success if and when they finally hit it rich on their fifth or sixth attempt.

But given the long and sordid history of VC-backed entrepreneurs, I would never advise anybody to take Upstart’s money. The legal advice alone that you would need to protect yourself would probably consume most of what you raised. And there are lots of practical reasons why accepting this kind of funding is a bad idea, too. For one thing, at least if Furst’s document, is any guide, you have to pay out not only on your income, but also on all of your other capital gains, even any inheritance you might get from family members. For another thing, you have to pay out a percentage of your gross pre-tax income, but you have to make that payment out of your post-tax income. And most importantly, it’s far from clear which if any expenses can be discounted. Let’s say you’re a self-employed entrepreneur who runs a business which makes a profit of $100,000 on gross revenues of $1,000,000. Do you have to pay out on the $1,000,000 or just on the $100,000?

Equally, I wouldn’t advise anybody to go down the buying-equity-in-people road, either. It just doesn’t smell right: there’s a whiff of indentured servitude about it, and it makes the concept of the rentier, living off someone else’s hard work, all too real. The investor is also essentially levying a tax on the individual, and I can absolutely see a successful legal defense saying that only the government has the right to levy taxes. More generally, I can’t imagine that the contract would ever be particularly enforceable. There’s nothing in Furst’s contract saying what happens if the individual simply refuses to pay any more money to the investor, but if the investor tried to sue, I wouldn’t fancy their chances in court.

This is an idea, it seems to me, which many people have thought about, and a brave few have tried, but which has never really gotten off the ground, for very good reason. If you want to invest, invest in a corporation. If you want to raise equity capital, then create a limited-liability corporation, and get people to invest in that. Corporations exist for good reason. Circumventing them by investing directly in people is an idea whose time will never come.

Many thanks to Paul Starobin for getting to the bottom of the question of journalists being paid by Wall Street to give speeches. This is one of those issues, a bit like the exact meaning of “off the record”, where everybody thinks they know what the standard is, but everybody also thinks it’s different.

It turns out there are lots of different standards. At one end of the spectrum you have the Wall Street Journal which simply bans its journalists from accepting speaking fees at all. Interestingly, it’s also the most influential financial news outlet, according to Gorkana’s recent survey. Second on the Gorkana list is Bloomberg, which also bans its journalists from accepting speaking fees, but loopholes can be found. Bloomberg View editorial board member Clive Crook, for instance, is not a full-time Bloomberg staffer, and thus feels free to accept such fees.

Third on the Gorkana list is the New York Times, which has a slightly messier and more nuanced approach to speaking fees: basically, you’re allowed to take them, but only from non-profit organizations like universities. And even that rule can be bent: when Joe Nocera gave a speech to a securities conference in Miami, New York Times spokesperson Eileen Murphy told Erik Wemple that “there is some flexibility to our guidelines around speaking engagements”.

Fourth on the Gorkana list is Reuters, which isn’t mentioned in Starobin’s story. Our policy is that “payment should not be sought or accepted”, but travel and lodging reimbursements may be accepted.

After that, it becomes more of a free-for-all. At the FT, both Gillian Tett and Martin Wolf can and do accept speaking fees from anyone they want; Tett’s income from such things is “well into the six figures”, she says, and she has chosen to give “most” of it to a UK charity. And the FT seems to be more the rule than the exception, if Starobin is to be believed:

Many journalists give paid speeches to businesses and business groups. And Wall Street, as it happens, is probably the top source of such engagements. Household names like Bank of America as well as obscure hedge funds, private-equity firms, and others in the financial world frequently hire journalists—including scribes who regularly cover Wall Street—to deliver speeches at events ranging from publicized conferences to small private dinners with select clients. Millions of dollars have flowed to journalists in speaking fees in recent years.

We’re moving to a world where brands are more personal than they are corporate — where the likes of Michael Lewis and Malcolm Gladwell and Jim Surowiecki and Bill Cohan and Bethany McLean and Sarah Ellison and Niall Ferguson and so on and so forth are self-employed freelancers for various publications, rather than being full-time employees. As such, they have to make up their own rules about speaking fees, and it’s incredibly easy when you’re in that situation to tell yourself that you would never be unduly influenced by corporate interests and that therefore no harm could be done by taking Wall Street’s dollar.

Given that all these other stars are likely to be happy accepting paid speaking gigs, it’s easy to see how employers like the FT and CNN feel the need to allow their stars to give paid speeches too. (Fareed Zakaria has a rack rate of $75,000, and has given speeches to a long list of financial firms, including Merrill Lynch and T. Rowe Price.)

So what should be done? The vision of Gretchen Morgenson tying herself up in ethical knots before deciding what she can and can’t do is not a particularly edifying one: there’s got to be a better way than this.

On occasion she gives paid speeches to universities, as Times policy permits, and sometimes she appears, for free, at financial-industry events—but not without doing due diligence. “I did recently participate in a one-hour question-and-answer session about the state of the economy and markets with about 50 clients of First Long Island Investors, a small, local registered investment advisory firm,” she said in an e-mail. “It does business only in New York and Florida, has 200 or so accounts, and does not conduct securities underwriting or trading for its own account. As such, it would not be a firm I would cover. I received no honorarium for my participation in this session and before I agreed to participate, I checked that the firm had not been subject to any regulatory or disciplinary actions.”

My feeling is that for full-time employees of media organizations, a single, named ethics chief should make final determinations in all cases where a journalist wants to give a paid speech. It’s silly to ask the journalists themselves to make such determinations unilaterally, since they’re the ones being paid. The rules could be written or unwritten, but at least there would be someone being clear about what is allowed and what isn’t. Alternatively a blanket ban, like the WSJ has, works just as well.

For freelancers, however, things become a lot more difficult. The NYT, for one, tries to hold its freelancers to the same standards as its full-time journalists, but that’s hard, especially when the NYT isn’t paying them nearly as much. At the very least, we need more disclosure. This is very telling:

With the notable exceptions of Gillian Tett, Michael Lewis, and Martin Wolf, most of the journalists I tried to talk to about their speaking appearances resisted comment, or would only talk anonymously—which is a little ironic. One prominent scribe pleaded not to be mentioned at all. (Sorry, no passes.) I still have the bite marks on my neck from a telephone conversation with another who demanded to know whether he was the target of a “hostile inquiry.”

If you’re not proud to be giving a paid speech, and happy to be open about that fact, then it seems to me you shouldn’t be doing it. And that applies whether you’re self-employed or not.

The latest sign that the Facebook IPO is going to be particularly bonkers comes from Jon Ogg, who has discovered a Facebook Fund over at SecondMarket.

This is odd, for a couple of reasons. For one thing, the SEC recently cracked down on two funds offering Facebook shares pre-IPO. (One of them was Felix Investments. No relation.) SecondMarket will obviously have learned from their mistakes, but why rock the boat like this? It’s pretty obvious the SEC isn’t a huge fan of people speculating in the pre-IPO markets.

More generally, SecondMarket has done a pretty good job of positioning itself as a way for people to trade shares in illiquid companies where they have no access to public markets.

This latest development, then, is more than a little off-brand for SecondMarket. Everybody knows that Facebook is going to IPO within a matter of weeks: it’s already started meeting with analysts. So if you want to sell your shares in the public markets, you won’t have to wait long.

But for some reason, there’s still a lot of institutional sell-side interest when it comes to Facebook. There’s a 180-day lock-up period after the IPO during which current shareholders can’t sell their stock, so if they miss the boat now, they won’t be able to sell until November or so. Clearly, that’s too long for some people to wait.

Meanwhile, there’s also buy-side interest in Facebook, from people who are convinced that they’re not rich or important enough to get an allocation of shares in the IPO. They’re not going to be able to flip their shares on day one: they, too, will be subject to the 180-day lock-up. But at least they’ll be buying in now, rather than after Facebook has already gone public.

So you can see where SecondMarket naturally comes in, here. There’s buy-side interest, there’s sell-side interest, and they’re a neutral intermediary broker-dealer which can provide weekly auctions where shares trade hand at a mutually acceptable clearing price.

But why the fund?

It turns out that SecondMarket is not like other auction houses. If I buy a Warhol from Sotheby’s, I write a check to Sotheby’s and they give me the painting. Meanwhile, Sotheby’s writes a slightly smaller check to the seller. I never deal directly with the seller. SecondMarket, however, refuses to face buyers and sellers in this manner. It acts more like a dating agency than an auction house: it works out who wants to transact with whom, and then ducks nimbly out of the way so that they can finish off the deal privately, facing each other.

And big institutional sellers, for one, are unhappy about this. If they’re selling $10 million of Facebook shares, they don’t want to have to sign lots of paperwork facing a long list of retail investors spending $200,000 or $400,000 on stock. SecondMarket tries to match up buyers and sellers in terms of the size of the deal they want, but right now the sellers all seem to be relatively big, and the buyers all seem to be relatively small. Which makes for awkward dates.

The obvious answer to this problem — insofar as it is a problem — would be for SecondMarket to act more like Sotheby’s, and face the sellers itself, while simultaneously selling the sellers’ shares to the buyers. But it didn’t go that route. Neither did it simply turn around to the sellers and say hey, if you want to play on our platform, you have to play by our rules, how much of a pain is it, really, to have to sign a dozen different identical sale documents rather than just one or two. One would think that’s why these companies employ lawyers.

Instead, SecondMarket created a fund. If you want to buy a relatively small amount of Facebook stock — say between $200,000 and $500,000 — then you’re no longer going to participate in the auction directly. Your only choice will be to place your money in SecondMarket’s Facebook Fund, which will buy shares on your behalf at the auction clearing price, and then hold on to those shares until 180 days after the IPO, at which point it will then transfer the shares to you, to do with as you wish. SecondMarket is going to continue its weekly auctions right up until the IPO; any smaller investors participating in those auctions will end up in this fund.

The cost of buying Facebook stock via the SecondMarket fund is double what other buyers pay: everybody pays SecondMarket a 3% fee when they buy stock, but participants in the fund will also pay a second 3% fee when they finally receive their Facebook shares, 180 days after the IPO.

All of the participants are still qualified accredited investors, with at least a million dollars to throw around or a salary north of $200,000 a year. And I’m pretty sure the minimum investment is still high, at $200,000. But this whole thing smacks of speculation to me, not to mention an attempt by SecondMarket to squeeze the last drop of revenue out of Facebook before it goes public.

Facebook has been incredibly lucrative for SecondMarket, despite (or maybe because of) the fact that it’s the exception to every SecondMarket rule, the single company traded on SecondMarket which isn’t itself a SecondMarket client. But this smacks of opportunism to me. I know that there are lots of people out there who are eager to buy shares in Facebook. But they’ll have their opportunity soon enough. The secondary market in Facebook shares right now serves no real public purpose at all. Instead, it’s just putting more money in the pockets of middlemen.

Have you bought your lottery ticket yet? The jackpot’s up to $241 million!

An interesting thing happens, when the jackpot gets this big: if you actually believe the $241 million figure, the expected return on your dollar is positive. The mean player, it turns out, is going to get paid out to the tune of $1.553 for every ticket they buy. In reality, sadly, the cash option is $170 million, which brings the expected payout to $1.149 per dollar spent, which means that after taxes, you still have to expect to lose money.

But all of that is moot: realistically, your chance of winning the jackpot is zero. Technically, it’s one in 175,711,536, or 0.000000569%. Which is statistically the same as zero. But it’s not psychologically the same as zero — and that’s what counts. When you buy your lottery ticket, it’s impossible not to dream of all the things which might happen if you won. (My dream now has to include the inconvenient fact that my winning lottery numbers will have been broadcast on YouTube.) The dream is pleasant enough to be worth a buck — at least to someone with a buck to spare, like me. In fact, it’s so pleasant that sometimes I won’t even check my lottery numbers, because I don’t like the opposite feeling of finding out I haven’t won.

And the occasional wager on the lottery is a lot less expensive, and a lot less damaging, than attempts to get rich quick in the stock market.

Which doesn’t mean there isn’t a dark side to the lottery — there is. It’s a horribly regressive tax on poverty, for one thing. I’m one of those people who think that they should be paying more in taxes, and by far the easiest way to funnel more of your income back to the government is to buy lottery tickets. It really is a voluntary tax. But the problem is that it’s paid overwhelmingly by poor people who can’t afford it, rather than by rich people like me who can.

And if you move from lottery tickets to scratch cards, something else happens — they pay out with enough predictability that they can actually be used for money laundering. Take your dirty dollars, buy a bunch of scratch cards, redeem the winners, and you’ve got nice clean legitimate money. If the games weren’t so incredibly lucrative for the states, they’d be made illegal in no time just for this reason alone.

So from a public-policy standpoint, lotteries are a bad idea. Assuming that they’re here for the foreseeable future, however, I’m going to continue to buy myself a ticket now and again, if I ever find myself in a place selling lottery tickets when the jackpot goes above $200 million. I’m doing myself no harm, I’m doing the state and the vendor a little bit of good, and hey, you never know. This blog could turn into the diary of a lottery winner.

Historically I haven’t been a fan of people saying that Apple should start paying dividends. I didn’t like it when Jon Fortt pushed it in 2007, and I didn’t like it when Arik Hesseldahl had the same idea in 2008. (Although by that point I did concede that “a modest dividend, tied to profits, makes perfect sense”.) Fast forward to 2012, however, and I think that Apple’s announcement is a perfectly sensible one, and if anything overdue.

The problem with most people asking for dividends and stock buybacks is that they generally have a pretty stupid argument, along the general lines of “If X declared a dividend, its stock would go up. Stocks going up are a good thing. Therefore, X should declare a dividend.”

That argument doesn’t even make much sense: if cash leaves the company and goes straight into shareholders’ pockets, the value of what’s left behind goes down, not up. If a company gives a bunch of money back to shareholders and its value goes up as a result, then it has much bigger problems than not paying dividends.

Apple’s stated reason to start paying dividends is simple: it has more money than it knows what to do with. Fortress balance sheets and strategic flexibility are all well and good, but there comes a point — around $100 billion, it would seem — at which you can buy anything you could conceivably desire, and still have more than enough money left over. So if Apple can’t use that money, give it back to shareholders, who surely can.

The stated reason for Apple’s stock buybacks makes perfect sense too. A large part of Apple employees’ compensation comes in the form of equity in general, and restricted stock units in particular. When those RSUs vest, all other shareholders get diluted. So to prevent that from happening, Apple’s going to buy back roughly as much stock as it’s issuing.

Now the kind of people who look at Apple as a stock first and as a company second are not going to be happy about this. And weirdly, leading that charge today is the Wall Street Journal, and its Marketplace editor Dennis Berman. Shortly after Apple’s dividend was announced, the flagship @WSJ Twitter account, with more than 1.5 million followers, told them all that “Apple’s cash pile exceeds the GDP of more than two-thirds of the world’s countries.” That’s a classic case of comparing apples with oranges: the cash pile is stock, while GDP is flow. And it’s exactly the kind of unhelpful and misleading statistic that the WSJ should be trying very hard to avoid.

Shortly afterwards, the same @WSJ account retweeted SmartMoney:

And the griping didn’t stop there.

It’s almost as if the WSJ doesn’t understand that Apple’s dividend yield is not under its control. Apple can set the level of its dividend; it can’t set the level of its share price. Is the WSJ really implying that Apple should wish for a lower share price, so that its dividend yield goes up? After all, at $10.60 per year, Apple’s dividend is fully 3% of where its stock was trading as recently as November. What’s more, at $9.9 billion per year, Apple’s dividend is very close to being the highest in the world. Here’s the league table, as of Friday:

If you look down this list, it’s not really the kind of company that Apple particularly wants to keep. AT&T is returning more than $10 billion a year to its shareholders; I’m sure that all of us who use its service could think of a few areas that money could easily be put to good use. And five of the top eight companies on this list are in the commodities business; the other three are telecoms. Not a single company on the list could realistically be considered a growth stock or a hotbed of innovation.

But the people who prefer financial engineering to, well, real engineering are never going to be happy with Apple’s conservatism. Dennis Berman made his own Cracker Barrel barb, and then followed up with this:

There is no reason for Apple to issue debt: companies issue debt when they can invest it and get a good return on their investment. But as we’ve seen from Apple’s cash pile, Apple has essentially nothing to invest in at all. So long as there’s a cash pile, issuing debt would only make that pile go up, rather than down, while forcing the company to pay interest for no good reason. Having a cash pile and issuing debt is a bit like having a CD and running a balance on your credit card: idiotic.

And Berman’s wrong if he really thinks that Apple could issue debt cheaper than the US government. Companies which can borrow more cheaply than the US government are a bit like those faster-than-the-speed-of-light subatomic particles: if you look more closely, they turn out not to exist after all. The US Treasury can borrow more cheaply than anybody else just because the US Treasury market is much more liquid than the market in any other fixed-income name. Which in turn is a function of the fact that there are $11 trillion of Treasury bonds outstanding. I think we can safely say that Apple’s never going to borrow anything near that much money.

Now Apple could, if it wanted, declare a monster special dividend, get rid of all its cash, borrow lots of money, use that money to buy back stock, and generally lever up in the name of financial engineering. That would be rather worrisome, I think, to the vast majority of Apple’s shareholders — and it would certainly be worrisome to any potential buyers of Apple’s bonds. Basically, Apple has two choices when it comes to debt. It can issue debt while it’s already sitting on lots of cash, which is redundant and stupid. Or it can get rid of all its cash before it issues debt, in which case it could no longer borrow at ultra-cheap rates, and it would lose a lot of strategic flexibility at the same time.

So well done to Tim Cook for announcing a sensible dividend at a sensible time, when Apple’s throwing off enormous amounts of cash and there’s nothing obvious to spend the money on. And well done too for ignoring the noise coming from the financial media, who think that his company is simply a stock price. It isn’t, and I sincerely hope Apple never ends up that way.

Ben Heller, a man who’s been trading CDS since before they were even called CDS, is out of the CDS market.

There have been rumblings about this market for a while: an FT article from March 9 quoted a series of unhappy people on both the buy side and the sell side.

One banker working on the Greek bond deal says: “I almost wanted CDS not to be triggered just so it would kill off the instrument and then we could set about designing something better to replace it.”

But with Heller going on the record about this, the pressure on ISDA to fix what is widely seen as a broken system is surely going to increase. Because he’s not alone.

“Many of the people you know from EMCA,” he tells me at the end of this video, “are people who are very focused on this issue and who are not going to let this one go.”

The world has long forgotten EMCA, an attempt by investors in emerging-market debt to team up and provide a united front in the face of attempted sovereign debt restructurings. But back when it was founded in 2000, it included all the biggest names in the emerging-market debt world, including Heller, who was then at HBK; Mark Siegel, at MassMutual; Abby McKenna, at Morgan Stanley Asset Management; Mark Dow, at MFS; and Mohamed El-Erian, at Pimco. The membership of Dow and El-Erian was particularly important, because they had both worked for many years in the official sector (Dow at Treasury, El-Erian at the IMF), and were taken seriously by policymakers.

EMCA never really got off the ground as an organization, partly because it turned out that policymakers, and their advisers, were more likely to pay attention to individual members than they were to respond seriously to carefully-honed collective statements. But clearly these people retain a certain amount of power: you can see that in the way that Greece’s new 2042 bond got quietly split up into 20 different bonds, each maturing in a different year.

Why did that happen? Because to a certain extent, the market is valuing Greece’s debt by working out how much money Greece is realistically likely to pay its bondholders over time, and then divvying up that value among the bonds outstanding. If some of the bonds have earlier maturities and some have later maturities, then more of the value will end up in the early-maturing debt, and less of it at the end of the yield curve. And so the value of the new 2042 bond is going to be lower, this way, than it would have been if it was the only bond being issued.

Why would creditors want a bond to trade lower? Because this way the 2042 bond becomes the cheapest-to-deliver bond when the CDS auction is held today, and the lower the price of the cheapest-to-deliver bond, the bigger the payout for anybody holding credit protection, including basis traders like Heller.

It seems to me that there were two opposing constituencies in the Greek default. One group, led by European policymakers, were very happy to see the CDS market get broken — they hate CDS, in exactly the same way that CEOs hate short sellers. The other group, led by fixed-income investors, wanted to make sure that the CDS market operated relatively smoothly and that the payouts were fair.

In the end, it seems, the buy-side won — but with the vivid realization that they had gotten lucky. Fixed-income traders never want to rely on luck and fortune when it comes to things as important as default protection. And so Heller, for one, is out of the market completely — unless and until ISDA does a root-and-branch revamp of its documentation. Which, if it happens at all, isn’t going to happen any time soon.

On Tuesday March 6, Apple shares opened at $523.66. On Thursday March 15 — eight trading days later — they opened at $599.61. Which means that over the course of those eight trading days, the market capitalization of Apple increased by more than 70 billion dollars.

Let’s put that in perspective: the market capitalization of Molson Coors is $8 billion. The market capitalization of Staples is $11 billion. The market capitalization of Yahoo is $18 billion. The market capitalization of eBay is $48 billion. The market capitalization of Nike is $51 billion. The market capitalization of Goldman Sachs is $63 billion.

Apple isn’t just worth more than those companies.  (In fact, it is worth more than double all those companies combined.) The point I’m making here is that if you take the amount that Apple was worth on Thursday morning, and subtract the amount that Apple was worth eight days earlier, the difference is more than the total value of any of those companies, up to and including Goldman Sachs.

To a first approximation, there was no news about Apple that emerged over the course of those eight days. The only real thing we learned was that the new iPad had sold out, which, well,  would have been more surprising if it hadn’t.

Now, however, there’s news — real, market-moving news, about what Apple’s going to do with its $100 billion or so in cash. As Chris Tolles drily puts it, that news is evidently “so huge that it propagated backwards in time”.

Apple stock closed on Friday at $585.57 per share, after a run-up all but unprecedented in the history of mega-caps. Back in November, when I was remarking on how cheap Apple seemed, the stock was $363 per share; since then it has added $208 billion in market cap. That’s more than the valuation of Google. So one way of looking at the crazy price action of the past couple of weeks is to chalk it up to the astonishing power of momentum.

Alternatively, you could just say that the stock market has been slow to price in what has been clearly evident since February 23, when Apple CEO Tim Cook said at the company’s annual meeting that Apple has more money than it needs, and that he and the board were nearing a decision about what to do with it.

But still, it is a little bit suspicious that Apple’s big announcement is coming immediately after one of the largest and fastest rises in market capitalization that the stock market has seen since the dot-com bust. Or even during the bubble, for that matter. Look at Apple in the famous context of Amazon. On December 16, 1998, when the stock was trading at $242, Henry Blodget put a price target of $400 on the company. On January 6, 1999, Amazon hit $400. Amazon had grown its market capitalization by $13 billion in 14 trading days, which means that its market cap was increasing at a rate of just under $1 billion per trading day. If you look at those eight days of Apple trading, by contrast, the company’s market cap was increasing at a rate of $8.9 billion per day.

Given how unusual it is for a company to see its capitalization rise so astonishingly quickly, it’s reasonable to raise an eyebrow at the timing here. On Monday, Apple will make its announcement, and the stock will rise, or it will fall. But if it falls, that won’t necessarily mean that the market is disappointed in what Apple is announcing. It might just mean that the announcement got more than fully priced in, over the course of the past couple of weeks.

Blaine Harden’s astonishing account of the life of Shin In Geun — a man born into a North Korean prison camp, who has lived pretty much the worst life imaginable — has received significantly less attention than the fact that This American Life has retracted its story about working conditions at Foxconn, which was based on Mike Daisey’s monologue. (If you don’t want to listen to the hour-long retraction, which is a masterpiece of the form, the transcript is available here.)

Daisey has attempted to defend his actions, using an end-justifies-the-means argument:

What I do is not journalism. The tools of the theater are not the same as the tools of journalism. For this reason, I regret that I allowed THIS AMERICAN LIFE to air an excerpt from my monologue. THIS AMERICAN LIFE is essentially a journalistic ­- not a theatrical ­- enterprise, and as such it operates under a different set of rules and expectations. But this is my only regret. I am proud that my work seems to have sparked a growing storm of attention and concern over the often appalling conditions under which many of the high-tech products we love so much are assembled in China.

Kevin Slavin has defended Daisey, too:

His skill in telling the story he told is responsible for the phenomenal amount of media around Chinese factory labor practices. Not the New York Times’ China bureau. Not Bloomberg Businessweek. Show me some reporters who were able to generate the same cultural engagement with the issue, will you?

Stories aren’t made out of facts. Storytellers use facts to reveal truth but they use a lot of other things too. And if ever I have to choose between facts and truth, I’ll take truth. It’s always a great story, and stories are the life inside the human mind.

It’s a lot easier to tell a great story if you don’t also need to be factual about things. Romeo and Juliet and Hamlet are fiction; Richard III and Henry V are mostly fiction, albeit based on historical events. And it’s precisely because they’re fictional — because Shakespeare was always storyteller first and foremost — that they’re still performed so regularly, all over the world, and that they have had such powerful emotional resonance with billions of people over the centuries since they were written.

But here’s the thing: Shakespeare never lied. He never sat down in front of thousands of people to tell a first-person story, over and over again, about events which he had simply invented. He never ended that story with an exhortation which would carry no weight if his audience thought the story was fiction:

When Apple would call journalists who had spoken to me, and tell them, “You know, I don’t know if you want to be associated with him. He’s kind of unstable. You know, he does work in the theater.”

I would keep my head down. And I would tell my story.

And tonight—we know the truth.

At the end of Daisey’s show, every member of the audience is given a sheet of paper with the heading “CHANGE IS POSSIBLE”. It includes Tim Cook’s email address, and urges the audience to, among other things, “think different about upgrading”. And one of the reasons why Daisey’s show has proved so popular — his This American Life episode was the most downloaded in the show’s history, even more than the squirrel cop — is that it combined great storytelling with a feeling that this is happening now and we should do something about it. It’s exactly the same formula used by Kony 2012, a project which is equally problematic.

My friend and Reuters colleague Rebecca Hamilton has written a great book, Fighting for Darfur, which should be required reading for anybody who has been drawn in by the Kony 2012 campaign. Or, for that matter, by Daisey’s monologue. Here’s what she wrote to me:

To build a mass movement quickly, it helps to have an over-simplified, emotive narrative with a single demand. It also helps to tells people that by doing easy tasks – sharing a link on Facebook, buying a bracelet — they can save lives. Central to the formula is that the agency of local actors gets downplayed to hype up the importance of action by outsiders. But all those ingredients inevitably lead to eventual failure when the simple solutions can’t fix the complex reality. The movement walks away, disillusioned. And in the meantime untold resources have been expended on solutions that have been out of step with what local activists need.

The fact is that the chief beneficiary of the success of Daisey’s monologue has been Mike Daisey, much more than any group of factory workers or underground trades unionists in China. Similarly, the chief beneficiary of the success of Kony 2012 has been Invisible Children, a US non-profit which spends its money mostly on making movies.

And this is where the justifications coming from Daisey and Slavin really fall down — in the idea that if you get a lot of westerners riled up about what’s going on in some far-flung part of the world, then that is in and of itself a Good Thing. Daisey has managed to convince himself that his interests are perfectly aligned with those of the workers at Foxconn. Even when he presents himself as some kind of savior in a Hawaiian shirt, bringing wisdom to the workers just by asking the right questions:

I’m just ad-hoc-ing questions, I’m asking the questions you would expect: “What village in China are you from? How long have you been working at Foxconn? What do you do at the plant? How do you find your job? What would you change at Foxconn if you could change anything?”

That last question always gets them. They always react like a bee has flown into their faces and then they say something to Cathy and Cathy says, “He says he never thought of that before.” Every time. Every time.

Of course it’s ludicrous to believe that someone working 12-hour shifts at a Foxconn plant wouldn’t start thinking about how the plant might be better run. But that’s the power of theater: its conventions are designed to encourage us to suspend such disbelief. And so we walk away thinking that Mike Daisey is bold and wonderful, and really did ask that question of Foxconn workers under the glare of gun-toting Chinese guards. (We now know that no Foxconn guards are armed: that bit, too, was made up.) And we think that the Chinese workers are so beaten-down and resigned to their miserable fate that they never even stop to think about how things might be improved.

And this is why I believe the story of Shin In Geun, despite the fact that its format is inherently treacherous. Both Shin and Harden have every incentive to exaggerate and to make things seem worse than they are; what’s more, there’s absolutely no way of fact-checking the vast majority of what’s in the story. But what’s missing from their tale is the white man’s burden: the idea that a white American like Mike Daisey or Jason Russell (or Jeff Sachs, for that matter) is a selfless hero, doing good for the poor and exploited in other continents.

What Daisey should have done is what Dave Eggers did when he wrote What is the What: make no pretense that everything is true, and trust in the power of his storytelling to carry the audience along. Instead, he lied — both to This American Life and to his audience.

I am telling you that I do not speak Mandarin, I do not speak Cantonese, I have only a passing familiarity with Chinese culture and to call what I have a passing familiarity is an insult to Chinese culture—I don’t know fuck-all about Chinese culture.

But I do know that in my first two hours of my first day at that gate, I met workers who were fourteen years old,

I met workers who were thirteen years old,

I met workers who were twelve.

Do you really think Apple doesn’t know?

This had a lot of resonance for me, when I first heard it, not least because I understand statistics. In order to meet underage workers who are happy to talk about how old they are within two hours of turning up at a factory gate, there need to be a lot of those workers. Many more than the official numbers suggest. But in fact Daisey did not meet underage workers outside the factory gates. (He still claims that he did, but his translator, who’s a much more reliable source, says that he didn’t. And as Evan Osnos says, that whole episode defies credulity in the first place.)

Daisey’s m.o., it’s now clear, was to go to China, talk to some people, and then write a monologue in which he felt free to incorporate anything he’d read about the plight of workers anywhere in the country, presented as a direct piece of first-person reportage. And there’s a good reason why that’s an underhanded and unethical thing to do, which is that even if Apple did everything Daisey’s asking of them, he could still go to China and return with the exact same monologue. With hindsight, Apple was absolutely right not to engage with Daisey directly, because he created a game they could never win. The only winning move, for them, was not to play.

Jack Shafer, then, is right to come down hard on Daisey. He concludes with this, about fabulists generally:

I have my theory: 1) They lie because they don’t have the time or talent to tell the truth, 2) they lie because they think they can get away with it, and 3) they lie because they have no respect for the audience they claim to want to enlighten. That would be an ideal subject for a one-man theatrical performance.

The irony is that this subject has already been explored in a one-man theatrical performance — one by Mike Daisey, no less. Daisey, you won’t be surprised to hear, is gentler on James Frey and JT Leroy than Shafer is on Daisey, blaming in significant part “the demands of personal storytelling” for their sins.

In any case, it’s clear that theatrical events are bad places to look for unvarnished truth. And in the set of “theatrical events” I absolutely include things like TED talks. Many people have asked, of the hilarious TED 2012 autotune remix, whether it’s parody or not. The answer is that it’s not parody at all. Rather, it’s the work of someone who has been entranced by TED’s theater, and who hasn’t yet woken up to realize that statements like “we can change the world if we defy the impossible” are less stirring than they are just plain stupid.

Real life is messy. And as a general rule, the more theatrical the story you hear, and the more it divides the world into goodies vs baddies, the less reliable that story is going to be. I’ll be very interested to read Harden’s book about Shin In Geun, to see how the guards and teachers in the prison camp are portrayed — to see whether they’re monsters or whether they themselves are victims of the North Korean regime. As we know from Primo Levi, prison camps will twist and subvert the ethics of all concerned. And even in this excerpt we can see real moral problems: Shin himself behaves with astonishing heartlessness towards his own parents and brother.

One of the central problems with narrative nonfiction is that the best narratives aren’t messy and complicated, while nonfiction nearly always is. Daisey stepped way too far over the line when he started outright lying to his audience and to the producers of This American Life. But all of us in the narrative-nonfiction business (I’ve written such stuff myself) are faced at some point with a choice between telling the story and telling the whole truth, or the whole truth as best we understand it. Someone like Michael Lewis will concentrate with a laser focus on the story: what he writes is the truth, but it isn’t the whole truth. And when you have a storyteller like Mike Daisey who considers himself a monologist rather than a journalist, even outright lies can find their way in to the story very easily.

Ira Glass says that This American Life should have scrapped the idea of doing a Mike Daisey show the minute he told their fact-checkers that he had no way of contacting his translator. But maybe the mistake was made even earlier, when This American Life decided that a theatrical monologue could ever be held to standards of journalistic accuracy. This one certainly couldn’t, and in that I think it’s more the rule than the exception.

One of the themes running through Noam Scheiber’s new book is the idea that professional technocrats have a tendency to take at face value much of what they’re told by Wall Street. Bankers are very good at capturing/flattering mid-level political operatives, although admittedly they’re less good at it now than they were before the crisis.

And certainly there’s no shortage of bankers who have gone into government and have then proceeded to advance the interests of the financial-services industry: Bob Rubin is the prime example.

As for legislators, it’s probably no surprise that representatives from places like New York or Charlotte or Delaware will be very friendly when it comes to the financial-services industry. But more generally the industry rains all-but-indiscriminate funds on lawmakers on both sides of the aisle, with impressive results.

If Bill Clinton’s economic team set the parameters of what you might call Rubinite economic orthodoxy, then Obama’s team has more or less stayed within those parameters: the few exceptions, from the like of Christy Romer, have had almost no real impact. If you want more heterodox ideas, then you’d actually be better off looking at the Bush years: first the massive, fiscally-disastrous tax cuts, then the equally massive and fiscally-disastrous wars in Afghanistan and Iraq, and finally the highly-interventionist policies of Hank Paulson during the crisis.

It must be emphasized, of course, that Dodd-Frank — pretty much the first and last bill to pass Congress since 1980 which the financial-services industry didn’t love — had a lot of support from Democrats, and very little support from Republicans. And all you need to do is look at George Bush’s nominees to the SEC to see how much appetite the last Republican president had for regulation with teeth. Meanwhile, Mitt Romney is quite open about the fact that he thinks the financial-services industry is just great, and that he’ll do anything he can to help it out.

So if you’re in favor of increased regulation of financial-services companies, then you’ll support Obama over Romney. But this is a lesser-of-two-evils thing, as Scheiber’s book points out. And interestingly, the more experience that a policymaker has had in and around Wall Street, the tougher that policymaker is likely to be. When Larry Summers was Treasury secretary, for instance, he pushed through the Commodities Futures Modernization Act and was basically a hardline deregulator. After he’d spent some time earning lots of money from banks and hedge funds, however, and returned to the Obama administration, he had much less time for what they wanted to do.

The Obama-era Summers stands between tough-on-Wall-Street former bankers like Gary Gensler, at the CFTC, and much easier-on-Wall-Street lifelong technocrats like Peter Orszag, who of course wound up taking a highly lucrative job at Citigroup, and Tim Geithner. To be honest, it’s not a particularly broad spectrum. Wall Street has always been very good at getting what it wants from the government, no matter which party is in power. Scheiber thinks that there’s a chance that Obama will get tougher in his second term; I’ll believe it when I see it. Because in general, if the board of Goldman Sachs has essentially no control over how Goldman behaves, then the SEC and the Federal Reserve have even less.

Greg Ip has a fantastic blog post on the subject of America’s GDP growth and the potential thereof. He’s talking about this chart:

The blue line, here, is actual US GDP. The green line is what’s known as “Potential Gross Domestic Product” — the amount of output that the Congressional Budget Office reckons that the US could produce, if it were running at full capacity. (Don’t be confused by the weird formula: potential GDP is released in real 2005 dollars, so I’ve multiplied that data series by the GDP deflator to convert it to nominal dollars. You’ll see why in a minute.)

The main worry in this chart, of course, is the fact that the blue line — actual GDP — is so far below the green line, which is where by rights we should be. Up until the Great Recession, the two series tracked each other very closely. Now, however, they diverge by some $890 billion. That’s $7,800 per household, per year.

Greg’s point is that the green line might well overstated: that the economy can’t in fact grow, sustainably, at the kind of pace that the CBO is assuming it can. As he puts it: “both the level and growth rate of American potential output is much lower than we think”.

I think this theory is entirely plausible. And to demonstrate why, I’m going to take the exact same graph above, but add one more data series to it — this time the amount of credit outstanding in America.

There’s a whole narrative in this chart. From 1970 through the beginning of the crisis in 2008, GDP grew at a pretty steady pace. But the amount of debt required to generate that output just got bigger and bigger — the rate of growth of the credit market was much faster than the rate of growth of GDP. In 1970, GDP was $1 trillion while the credit market was $1.6 trillion: a ratio of 1.6 to 1. By 2000, when GDP reached $10 trillion, the credit market had grown to $28.1 trillion: a ratio of 2.8 to 1. And by mid-2008, when GDP was $14.4 trillion, the credit market was $53.6 trillion. That’s a ratio of 3.7 to 1.

In other words, in order to keep up a steady rate of GDP growth, we had to saddle ourselves with ever more cheap and dangerous debt.

Then, suddenly, the growth of the credit markets screeched to a halt, and we had a major recession. And since then, the size of the credit market has been roughly flat.

It makes sense that if we needed ever-increasing amounts of debt to keep up that long-term GDP growth rate, then when the growth of the debt market stops, our potential growth rate might fall significantly.

I’m glad that we’ve finally put an end to the credit bubble, which had to burst at some point. But it’s naive to think that we can do so without any adverse effects on broad economic activity. So we might indeed have to resign ourselves to lower potential growth going fowards. If only because we’re taking ourselves off the artificial stimulant of ever-accelerating credit.

Sheila Bair has put her finger on the fundamental weakness of this week’s stress tests with a single statement:

“No distribution should have been approved that would bring the leverage ratio below 4 percent,” Bair, the former chairman of the Federal Deposit Insurance Corp., said yesterday in an interview. “With leverage of 25-to-1, during a crisis, these banks would likely suffer a run.”

Essentially, the stress tests model what might happen to bank balance sheets in the event of a major crisis — one which includes a peak unemployment rate of 13 percent, a 50 percent drop in equity prices, and a 21 percent decline in housing prices. The Fed wanted to make sure that all big banks would still have a capital base of at least 5% of their assets in that scenario, which is why it barred Citigroup from returning capital to shareholders. Citi comes out at 5.9% “assuming no capital actions after Q1 2012″, but that number drops to 4.9% “with all proposed capital actions through Q4 2013″.

But capital levels are only half of the equation; the other half is leverage. And look at the Tier 1 leverage ratio for the different banks under the stressed scenario, on page 27 of the PDF. Citigroup plunges from 7.0% now to just 2.9% after the stress, while Bank of America is much more robust, dropping from 7.1% to 5.3%. And here’s the scary thing: of all the big banks, it’s the ones with investment banking arms which fare the worst. There are 19 different banks listed; seven of them end up with a leverage ratio under 5% in a stressed scenario. Citi’s one; the others include Goldman Sachs (4.5%), Morgan Stanley (4.5%) and JP Morgan Chase (4.0%), its “fortress balance sheet” notwithstanding.

Now, picture yourself in the kind of crisis where stocks are down 50% and unemployment is up to 13%. And imagine that you discover that the counterparty you use for all your financial transactions is levered 25-to-1. You will change your counterparty. That’s known as a run on the bank, and it’s fatal.

In other words, banks don’t need to just survive the stress test; they need to be able to keep their customers in a stressed situation as well. If a bank comes near to insolvency, it will go bust, as its customers rush for the exits.

As Bair says, bank counterparties don’t look at sophisticated risk-based metrics in a crisis: they look at headline numbers like the leverage ratio.

“This underscores another weakness of the tests: They didn’t really stress liquidity,” said Bair, now a senior adviser at Pew Charitable Trusts, a Washington-based nonprofit. “The investment banks are particularly vulnerable to liquidity failures because they don’t have a large, core deposit base.”

Investment-bank counterparties can flee in a matter of hours; old-fashioned deposit runs tend to take a lot longer. Which means that investment banks should be held to a higher standard than commercial banks when it comes to the stress tests. Instead, they just need to show a liquidity ratio of more than 3%. That number’s too low.

Frank Partnoy makes a great point: the word “client” has been over-used by investment banks so much that by this point it “has become Orwellian doublespeak”. But the problem is much deeper than one of semantics. When all counterparties are considered clients, then that creates a corporate culture where all clients are considered little more than counterparties. And that, in turn, can be evil and poisonous.

Partnoy says that “the firm’s salespeople know who is a client and who is a mere a counterparty”, and to a certain degree he’s right. A sovereign wealth fund dealing with the equity derivatives desk is a counterparty; a private individual whose money is being managed by Goldman Sachs Asset Management is a genuine client. If you’re paying Goldman fees, you’re quite unlikely to be called a “muppet”, and no one in the firm is going to try to “rip your eyes out”.

But that doesn’t mean that Goldman will always be acting in your own best interest, rather than its own. Stockbrokers, famously, receive substantial fees from their clients, but don’t have a legal fiduciary duty to those clients, and do have a demonstrated tendency to steer their clients into the investments which end up paying them the highest commissions.

And even companies paying for M&A advice are sometimes victims of Goldman’s conflicts.

In other words, no one can complacently assume that they’re a favored client of Goldman Sachs and that therefore Goldman will be ripping off others on their behalf, rather than ripping off its own client. Not even people writing large checks to Goldman every quarter.

I’ve been talking to bankers in the days since Greg Smith’s op-ed came out, and there’s a pretty much unanimous feeling that bankers’ loyalty to clients, at least at Goldman and other big investment banks, has been declining across all aspects of the business, for many years.

Greg Smith was in equity derivatives — an area where it’s incredibly easy for salespeople to hide fees if they’re inclined to do so. In fact, it’s so much easier for a bank to build its fee into the pricing of complex bespoke products than it is to charge that fee directly, all banks do exactly that. It’s like buying “commission-free” currency when you go on holiday: you know full well that the bureau de change is still making money; it’s just making that money by giving you a bad price for your dollars, rather than by charging you a high commission.

But in a business devoted to making ever-increasing sums of money, it’s very easy for those hidden fees to get bigger and bigger over time. I talked to one former equity derivatives executive a couple of days ago, who said with surprising vehemence that in his day, the big clients were God: you built in fees, yes, but you never ripped them off or tried to steer them into something which was not in their best interest. Now of course what he was saying was self-serving, but I think it had an element of truth to it, too.

There’s been a lot of talk in the past couple of days about how Smith was not much of a star at Goldman: he was the sole person trading US equity derivatives in London, which is always going to be a marginal job at best, and he hadn’t risen very far up the greasy pole given how long he worked at the firm. Certainly it’s a bit of a stretch to call him an “executive” at Goldman, as that term is generally understood: he didn’t even have any employees. But at the same time, his relatively lowly position in the company is entirely consistent with a tale of a smart but ethical professional who didn’t make as much money for the firm as his peers did, just because he didn’t rip off his clients to the degree that they did.

All of which is to say that it’s worth taking Floyd Norris’s concerns seriously about the latest spate of deregulation in the securities markets. I think that there’s a lot to like in the JOBS act, especially the idea that we should stop forcing companies to go public just because they have 500 shareholders, including employees. Companies should be encouraged to give out equity to their employees, without worrying that if they do so, they’re on some kind of IPO train which can’t be derailed.

At the same time, however, there’s a lot of deregulation in the JOBS act which seems aimed primarily at giving banks a greater opportunity to make money, largely at the expense of investors in the primary markets. Mary Schapiro has some strong and important points: the primary markets are rife with information asymmetries, and someone needs to protect the interests of investors, rather than allowing banks to rip them off with legislated impunity.

All big banks are public companies. Public companies are always under a lot of pressure, from their own shareholders, to grow. But as a country, we have a public interest in seeing those banks shrink. The tension is clear. And if regulators try to get banks to shrink, the banks in turn are going to make even greater efforts to extract the highest profits possible from the businesses they retain. Which is another way of saying that they’re going to rip off their clients even more. So let’s be assiduous when it comes to regulation, because neither banks nor their boards are going to lift a finger to protect client interests. Not when they’re trying to maintain and maximize their own profitability.