Bull markets breed confidence that borders on complacency or even gullibility. When they start to fall, as they are doing right now, there is a sharp rise in mistrust as frauds are uncovered and shady deals condemned.
Why it matters: Regulators have signaled that they are more serious about cracking down on financial criminals than they have in decades. Such activity is unlikely to be hard to find.
Driving the news: Federal prosecutors in New York last month indicted hedge fund manager Bill Hwang on federal racketeering charges that could send him to prison for the rest of his life. The Justice Department is reportedly using big banks as its informants on Wall Street. And the SEC is doubling the size of its division dedicated to prosecuting crypto fraud.
- Be smart: “The repression of everything” seems to have arrived. The resulting headlines will only increase the degree to which ordinary Americans think the market is rigged against them.
Between lines: Hwang did not profit at the expense of others; in fact, he was the biggest loser in his plan. But losing money is not a defense.
- In cases like these, losing money may be precisely what causes suspicious activity to be discovered. The allegedly defrauded counterparties, ultra-sophisticated financial institutions that had their eyes wide open at all times, only realized something was wrong when they (and Hwang) lost billions.
- Prosecuting Hwang will be difficult and will take many years. In the world of cryptocurrencies, on the contrary, it is difficult not find exercise that flouts the securities law.
The panorama: In general, economies grow faster the more participants can trust each other. But there will always be bad actors who take unfair advantage of that trust.
- When the markets change, more investors tend to want to get their money out. That’s when fraud victims discover that the money has disappeared. The Bernie Madoff fraud is a prime example: it couldn’t survive the 2008 recession, as the higher Madoff marked his clients’ positions, the more likely they were to want to cash out.
- Until the moment of discovery, the money is gone, but the victim does not feel any loss. Economist John Kenneth Galbraith, writing in 1955, called this “net increase in psychic wealth” the bezzle, explaining that it invariably rises in bull markets, only to decline when “money is viewed with narrow, suspicious eyes.”
The bottom line: As John Mills wrote in 1867: “Panics do not destroy capital; they simply reveal how far it has previously been destroyed by its betrayal in hopelessly unproductive works.”