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Economic activity is affected by people’s perceptions of their wealth.
Loans are arranged and investments made based on perceptions of the value
of assets backing them up. Up until the day the Madoff scandal became public,
Bernie Madoff’s investors perceived the value of their holdings to be north of
$50 billion. Think of this as a pool of wealth that supported:
- Loans for real estate development
- Purchases of residences
- Gift and bequests to relatives
- Charitable gifts
- The activities of charitable organizations
- Payment of income taxes to state and local governments
- Personal spending
Then imagine that one day the existence of this wealth just evaporated. The economic activity supported by the
Madoff related wealth collapsed like an accordion. It was as if someone dropped a neutron bomb on the credit
capacity of his investors.