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The end of an era - The Ponzi Age

by rdf Thu Jan 15th, 2009 at 08:24:00 AM EST

For awhile people have been trying to name the Reagan-Bushes era by analogy to the Gilded Age, the Jazz Age, etc. Well recent events which have brought it to an abrupt end have revealed what it actually was: the Ponzi Age.

The real Ponzi Scheme now in the news is just a small example of the underlying story, which is based upon government encouraged private actions.

Here's a quick outline.

from the diaries. Jérôme


Ponzi Schemes require using the money from those who join later to pay back those who joined earlier along with the huge profits they were promised. It can continue as long as the new arrivals supply enough funds to keep those in the scheme happy. As time goes, on this number grows geometrically which is why it is also called a pyramid scheme, with those at the top (the original participants) being support by a bigger and bigger base.

In the US there was a shift in economic philosophy starting with Reagan. No longer was the ideal behavior one of tucking away money for the future, saving up enough for a down payment on a home, and depending upon a company run pension plan for one's old age.

Instead workers were encouraged (or forced) into becoming investors to supply the needs of their old age. Participation in the stock market used to be in the 10-15% range, but the creation of IRA's and 401K's has pushed this number to over 50%. This money flows into the financial sector every month and provides the fresh blood that a Ponzi scheme needs.

Along with the shift in savings allocation firms were encouraged (bribed by tax breaks) to shift their pension funds from bonds and other secure investments into the stock market and other risky activities. This added to the supply of fresh funds.

So much money has to go somewhere and since there are a limited number of stocks (and corporate bonds) issued there is competition to hold them. When there are many buyers and fewer sellers you get price inflation. This is exactly what happened. Over the past 40 years the stock market has risen to unprecedented heights, both as compared to earnings and as compared to yields from other investments. People were led to expect 15% or more returns on a steady basis, even though the long term average is more like 8%.

There is an old joke about two diamond dealers who keep selling the same stone back and forth to each other at ever higher prices, until one says he doesn't want to buy. Then the market collapses.

Much has been made of the huge rise in wealth inequality over this period, but the principle reason is because the wealthy have owned the type of investments that have seen the biggest rise up in price. If you own a million shares in a stock and it goes from $1 to $10 you are "worth" $9 million more. You housekeeper's IRA owns the same stock, but she only has $10 invested, she becomes $90 wealthier. Before the rise the wealth difference was $999,990, after 9,999,900 a huge increase in spread.

In the past decade or so the influx of money into the stock market from investors has slowed because many more people were already in the system. There was not the same rapid shift into these plans as before so the growth rate slowed. At this point the system was in danger of imploding. Fortunately for the financial sector, the shift to globalization occurred at the same time and the funds available expanded to include much of the rest of the world.

Now the financial markets had infusions of cash from China, Japan and elsewhere to buoy them up and the party continued for almost another decade. This has now, finally, slowed as well as these countries have started to need these funds for their own domestic purposes and as the yields and safety of their investments has become less secure.

The traditional economists have been thrown into a panic. First, their livelihood depends upon them promoting the virtues of Ponzi investing and, second, the "assets" which have been the basis of the wealth rise are shrinking. There is much talk about the dangers of deflation, but who does it really hurt? If you are a consumer and gasoline or TV's are cheaper in the future why should you complain? Even if you home is worth less, you still get to live in it and have the value that it provides. When you buy a new car it immediately goes down in value, but you continue to pay off the loan because you are still getting the same utility out of it as when it was first purchased.

There is also the argument that consumers will stop buying because they will be better off waiting since prices will be lower in the future. But modern electronics gets cheaper all the time and people buy it anyway even knowing that a better deal will be available later. There is a worth to having the use of a purchase now and not in the future that outweighs this type of calculation for many items. In addition necessities like food and clothing can't be put off, one has to eat and one can't walk around naked.

So the assets which are deflating are those held by the wealthy and these are the ones which they are really worried about going down. To go back to our millionaire and the housekeeper if things go back to the way they were originally she loses $90 and he loses $9 million. Who is worried?

Let's have a little honesty here, the aim of government and the economists who they employ is to preserve the Ponzi generated wealth by re-inflating the balloon as quickly as possible, but where is the fresh money supposed to come from? The average worker is already participating at a level which can't change much and foreign investors are moving elsewhere. So governments do what they always do in such cases, they print money and pump it into the economy. More money sloshing around means more available at the base of the Ponzi pyramid.

Can this work? Not over the long term. More money always leads to inflation which, while it makes apparent prices go up, does nothing for the real price of assets. In fact banks and other lenders hate inflation because they get back devalued currency. The reluctance of banks to lend the bailout funds shows that they understand that inflation is on the horizon and that lending money now is not in their interests. Economists have been predicting that inflation is under control because of the new understanding of fiscal and monetary controls. These are the same people who claimed that we were in a new era of continually rising asset values just a few years ago. Wrong then, wrong now.

The Gilded Age ended with the creation of the "progressive era" regulatory structures. The Jazz Age ended with the Great Depression. What will come now that the Ponzi Age is winding down?

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Ponzi Schemes require using the money from those who join later to pay back those who joined earlier along with the huge profits they were promised. It can continue as long as the new arrivals supply enough funds to keep those in the scheme happy....

....workers were encouraged (or forced) into becoming investors to supply the needs of their old age. Participation in the stock market used to be in the 10-15% range, but the creation of IRA's and 401K's has pushed this number to over 50%. This money flows into the financial sector every month and provides the fresh blood that a Ponzi scheme needs....

....firms were encouraged (bribed by tax breaks) to shift their pension funds from bonds and other secure investments into the stock market and other risky activities....

....So much money has to go somewhere and since there are a limited number of stocks (and corporate bonds) issued there is competition to hold them. When there are many buyers and fewer sellers you get price inflation....

....In the past decade or so the influx of money into the stock market from investors has slowed because many more people were already in the system.... Fortunately for the financial sector, the shift to globalization occurred at the same time and the funds available expanded to include much of the rest of the world.

Now the financial markets had infusions of cash from China, Japan and elsewhere to buoy them up and the party continued for almost another decade...

The stuff isn't much more complicated than that! I was describing something like that two years ago.

This Ponzi trap of debt/monetary expansions is not a new phenomenon for the civilization: it probably regularly occurs through centuries, since Babylon times. The humanity never learns... or does it? Could this trap be the most valuable secret of some behind-the-curtains deciders?

by das monde on Wed Jan 14th, 2009 at 10:17:59 PM EST
Wealth Creation, or a Ponzi Scheme?
by Michael Hudson

....the Good Lord evidently realized that not enough people had been reading Hyman Minsky's explanation of how financial cycles end in Ponzi schemes - the stage in which banks keep the boom going by lending their customers the money to pay interest and thus avoid default. So He sent Bernie Madoff to dominate the news for a week and give the mass media an opportunity to familiarize newspaper readers and TV watchers with just how Ponzi Schemes work. What Mr. Madoff did was, in a nutshell, what the economy as a whole has been doing under the moniker "wealth creation."

If the media were able to wait until as late in the financial collapse as last week to provide helpful diagrams about how Ponzi schemes need to keep on growing exponentially, it is simply because bad foreign financial news is not deemed newsworthy in North America. But Europe has been having its own run-throughs....

The best case study occurred two years ago. On May 9, 2006, Spanish police raided 21 homes and offices of Afinsa Fienes Tangibles SA, the world's largest postage-stamp dealer, and rival firm, Forum Filatélico. They charged eleven men with running a $6.4 billion pyramid scheme that took in some 343,000 investors - 1 percent of Spain's entire population, making the fraud one of the largest in Spanish history.

An economy either is in trouble or has lost its sense of balance when investors shy away from tangible capital formation in favor of buying postage stamps and similar collectibles. Unlike machinery and technology, stamps do not produce real goods and services. They have long since been printed and sold by the government, and will never be used actually to mail letters. However, stamps have shown themselves to be a great vehicle to attract savers who think that buying them can produce an exponential earnings growth - or more technically, "capital" gains....

The Spanish postage-stamp scheme seems to have taken off in 2003, the year in which Spain's free-market conservative government deregulated public insurance and oversight for non-financial investment funds. Afinsa Group bought two-thirds control of the New Jersey stamp and coin auction house Greg Manning and merged it with the Spanish auctioneer Auctentia to create Escala as the world's third largest auction house (after Sotheby's and Christie's). Escala moved its operations to New York City and listed its stock on the Nasdaq over-the-counter market. Despite the stock market's lethargic trend, the company's earnings showed such rapid growth that in just three years its share price soared from under $5 to $35, tripling in 2005 alone.

Afinsa's purchases accounted for 70 percent of Escala's profits, thanks largely to the fact that as its Spanish parent's sole supplier, Escala marked up its stamps by a reported 1,150 percent, out of all proportion to the usual 25 percent. Afinsa thus was carrying stamps for which it paid 58 million euros on its books at €723 million, over ten times their catalog values....

Afinsa paid its stamp investors an annual rate of 6 to 10 percent interest, beating most competing yields as the global financial bubble was pushing interest rates steadily downward.... To build up trust, Afinsa gave its clients post-dated checks for the gains that were promised. It also promised to buy back the stamps it sold, at the original price. This gave an appearance of liquidity to the normally illiquid market in stamps, fine arts and other collectibles.... These ploys convinced the majority to simply re-invest the money to buy yet more stamps, which the company held in its offices ostensibly for safekeeping and preservation.

Money poured in, giving stock-market investors in Escala much higher returns than the stamp-buying customers nominally were receiving. As one news report remarked, why buy stamps and coins when you can invest in companies dealing in them? But within a week of the arrests, Escala's stock plunged below $4 a share.

Then read on to recall how Mr Ponzi started his scheme with... European postal reply coupons.  

by das monde on Wed Jan 14th, 2009 at 10:35:40 PM EST
is that the Ponzi scheme applied mostly to assets, and not to wages and goods. If everything had been multiplied by 10 over the period, it would not have mattered - what was important is that some categories of things saw their prices increase by more than others.

Unsurprisingly, things owned by the rich (assets, especially financial assets) went up by more, and things of the poor (wages) went up less or not at all. Relative prices changed, and thus relative wealth (and power).

The fact remains that a large portion of the middle classes was bought off because its main asset (their house) went up at the "better" regime and it looked like they were doing fine after all. The problem is that they used that (fake) asset wealth to maintain consumption beyond their income level, and now this is all crashing down.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Thu Jan 15th, 2009 at 08:27:38 AM EST
I've posted about the increasing flow of money into the stock market before - and often get a response along the lines of "the number of stocks is not limited" but the reality is that the number of "investment grade" stocks is limited and certainly has not expanded in line with the amount of money coming in.

Just a little detail refinement for your narrative.

by Metatone (metatone [a|t] gmail (dot) com) on Thu Jan 15th, 2009 at 08:29:58 AM EST
I think there is a difference between a bubble and a Ponzi scheme, although one may shade into the other.

The South Sea Bubble and the Tulip craze did attract more and more investors as time went on, but all bubbles do that as those on the sideline see fortunes being made and decide to participate.

The Ponzi Age was created by the government as it forced investments into the stock market by changes in tax policy regarding retirement funds. People did not just jump into the market because it was going up, but were pushed into it as their funds were forcibly shifted from defined benefit plans to defined contribution ones.

Similarly people were trapped into home refinancing by loans which were predicated on the idea that they would be refinanced in a few years or the house sold. Alan Greenspan gave elaborate pseudo-mathematical explanations for why variable rate mortgages were better for borrowers. Banks made it difficult for buyers to even get conventional mortgages, something which is overlooked by those who want to blame greedy buyers for the problems.

Then there were the succession of changes to laws regulating the finance sector including the repeal of the Glass-Steagall law which prohibited banks for fooling around in equities. Rules for reserve requirements, reporting and oversight were all changed.

Pension plans could use their reserves in their main line of business and/or defer actual contributions if assets were increasing in price. Contributing to a pension plan later instead of now is the number one no-no of prudent investing.

Entities which wanted to avoid these changes and behave sensibly were handicapped since their returns would not be as high and investors would go elsewhere. Such firms frequently saw proxy challenges and their boards replaced. New management would engage in leveraged buyouts or take them private thus extracting all the cash and replacing it with debt.

The only way an entire economy can turn into a Ponzi scheme is if the government encourages it. A bubble is just ordinary greed and the excitement of seeing prices go up. This is much bigger and more sinister.

While bubbles may never go away, state-sponsored Ponzi schemes don't have to exist if governments are actually under the control of the people.

Policies not Politics
---- Daily Landscape

by rdf (robert.feinman@gmail.com) on Thu Jan 15th, 2009 at 09:00:50 AM EST
rdf:

A bubble is just ordinary greed and the excitement of seeing prices go up. This is much bigger and more sinister.

While bubbles may never go away, state-sponsored Ponzi schemes don't have to exist if governments are actually under the control of the people.

In most Bubbles, but not all - the Dot Com boom is an example - leverage or gearing provided by the deficit basis of "money as debt" is primarily responsible.

The deficit basis of our economy is a systemic issue, and my view is that - to turn the classic Bubble justification on it's head....

"This time it's Different".

This time the system is terminally fucked.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Thu Jan 15th, 2009 at 09:14:46 AM EST
[ Parent ]
I always enjoy your essays. You have a talent for articulating complex ideas and euphemism, in particular. You know with the business-end, so to speak, of language. Over all, I detect appropriate exasperation with the ethics of "wealth building" in the US but some confusion about method. When in doubt, construct a transaction model of one buyer, one seller.

I think there is a difference between a bubble and a Ponzi scheme, although one may shade into the other.

I think there is a difference. A "bubble" is a colloquial expression for price inflation. A price is synonomous with market value or fair value. Price inflation is a measure of what a buyer is willing to pay for a thing be it notional (e.g. a security) or tangible (e.g. real estate). A buyer may attribute all sorts of reasons to the cause of price inflation, depending on the quantity in question and the number of prospective agents involved in the exchange ("market"), but always because the buyer possess insufficient information to value a thing. A an auction exemplifies as well as a "peer-to-peer" dynamics of price movements and range of motives hidden by currency valuation (dollars, camels, females, children, etc).

Whether a buyer is able to pay is determined in the event of transaction. It's at that juncture economic institutions oblige, and may even assist, buyer and seller to settle the exchange as agreed. If either fails, he or she is liable to a legal challenge of fraud, a sort of breach in contract law. Everywhere.

"Greed" is a motive ascribed to fraud; it is the intent or compulsion to acquire more than one's "fair" (lawful) share. "Deregulation" is a euphemism for laissez faire jurisdiction and a failure to enforce lawfulness among obligators.

A "ponzi scheme" is a method to defraud a buyer. However the seller accomplishes the task, no transaction occurs; that is, the buyer does not receive the thing agreed to by the seller. Whether that thing is unearned income, profit, or wax candles is irrelevant. A "ponzi scheme" is differentiated from other methods because the seller represents him- or herself to the buyer as and assumes the fiduciary duties of the buyer's agent in an exchange with some third party. No stamps (Ponzi), no income or realizable appreciation* (Insull), no securities (Madoff) purchased.

Here is a curious idea: a security consultancy, I just found in a search.

You are quite correct, I think, to be wary of government strategies to mandate mass participation in capital markets that cannot and will not produce sufficient retirement income. "Easing" is inevitable.

-------
Insull's serial IPOs were funded largely by repo; he sold stock by mail during a "bubble" that "over-valued" what book value the utilities' established. Common shareholders expecting fixed income were wiped out in '29 by calls on the utilities' debt.

Diversity is the key to economic and political evolution.

by Cat on Thu Jan 15th, 2009 at 11:59:29 AM EST
[ Parent ]
I don't know if anyone has noticed this before, but there is a distinct resemblance between Ponzi schemes and positional goods as described by Fred Hirsch in Social Limits to Growth. See ManfromMiddletown's diary October 29 2007.


Sandwichman
by Sandwichman on Sat Jan 17th, 2009 at 01:02:32 AM EST


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