Monday, June 15, 2009

Ponzi Economics

It's being called by many names, all perfectly reasonable sounding: troubled assets relief, public-private investment, liquidity enhancement, the stimulation of aggregate demand, the minimizing of rollover risk, the normalization of credit markets, financial stabilization, quantitative easing, Keynesian economics, etc. When we look at the fundamentals, however, we see a much simpler, far more troubling picture.

Back in January, in some of my earliest blog posts, I was already referring to our entire financial system as "a huge Ponzi scheme":
Now, over and over again, we hear that the real problem facing us is the need to restore "confidence." But confidence in what? If a Ponzi scheme is a confidence racket, and if, as many are now beginning to realize, our whole financial system for a great many years now, has been little more than a huge Ponzi scheme, then the restoration of confidence can have only one purpose: the perpetuation of the bubble for as long as possible into the future. Which is in fact what the current "experts" seem to be telling us needs to be done -- only this time by the government, operating as a kind of legal surrogate for all the Bernie Madoffs who no longer have the funds to perpetuate their own versions of the scheme.
I was not alone. Here is economist Peter Schiff, as quoted in a Fortune article, also from last January:
"We have an economy that's based on the same principles as Bernie Madoff's investments," he says. "It's a Ponzi economy. It's not real. We don't save and we don't produce anything anymore. We simply borrow from the rest of the world, and then we spend it. We've had a giant party. We bought all these plasma TVs and iPods. We remodeled our houses and took vacations. But you know what? The bills are coming in."
In case you don't know who Schiff is, I suggest you take a look at this youtube video, a collection of his market predictions between 2006 and 2007, in which he stands alone among smirking, laughing, supremely overconfident Wall St. pundits, in predicting, with striking accuracy, the disaster that was to befall us in the Autumn of 2008.

I've been criticized for occasionally quoting with approval economists holding strongly conservative views, and Schiff, a Libertarian follower of Ron Paul, is no exception. However, while I definitely do not endorse either Paul or the Libertarian philosophy, this does not mean I can feel free to ignore such people when, on occasion, they get things right. In my view, the conservative position generally is, for the most part, simply laughable. But that doesn't prevent me, along with a great many liberal leaning economists, from agreeing with most Republicans regarding the futile and ultimately destructive nature of the Obama-Geithner-Bernanke "recovery" plan.

While I can agree wholeheartedly with Schiff's analysis of what went wrong, I cannot agree at all with his prescription for the cure: "Shrink the government radically, cancel all bailouts immediately, take plenty of tough medicine, and let the free market do its job - however harsh it may be for, say, autoworkers in the meantime." Schiff should know better, but is blinded by his ideology. It was the free-market, laissez faire, economics of the conservative/ libertarian ideologues that fueled the Ponzi scheme in the first place.

Regardless of what any of us might think regarding a possible cure (in my view NO cure is possible), it is important for all of us to take some time to think a bit about what Ponzi economics is and how it works. Once such a scheme gets started, there is only one way to perpetuate it: pulling in yet more money from yet more investors (aka "suckers"). New money from new investments is used to maintain the appearance of legitimacy by paying off on the old investments. When the returns are substantial, as they must be for the scheme to succeed, then everyone is happy and all progresses smoothly. It's only when it is no longer possible to raise new investment capital that the scheme collapses.

This is what happened to Bernie Madoff last Fall. And it is also what happened to the world financial system over the last several months. Money was being made simply on the basis of new money being invested, and when the source of such investments dried up, i.e., when the banks could no longer raise additional leverage, over and above the huge amounts they'd already raised, the resulting "credit crunch" brought down the entire system. There were no longer any new sources of cash to pay off on all the outstanding investments, loans and collateralized debt obligations (aka "toxic assets").

What the Obama administration wants to see is a financial system that got temporarily out of hand and overextended itself, which under ordinary circumstances would require a certain amount of government intervention to provide temporary liquidity until the imbalances in the system could be corrected. What I see is a Ponzi scheme that, at one point last summer seemed on the verge of total collapse until congress decided to pony up hundreds of billions to keep the thing afloat. Because by then it had become "too big to fail." Since then literally trillions more have been committed to the same effort, either through the sale of treasury bonds, the forced merger of failing institutions with (relatively) healthy ones, huge loan guarantees from the Fed, the totally irresponsible printing of dollars out of thin air, or the easing of accounting rules to give the false impression that failed institutions are actually solvent.

Call it what you will, "quantitative easing," "liquidity enhancement," "financial stabilization," whatever -- when new money, regardless of the source, continues to be fed into any Ponzi scheme, that scheme can be made to look very good indeed. What has been optimistically described as a turning of the corner, the beginnings of a full recovery, based on the appearance of various "green shoots," etc. is, to my eyes, simply the predictable effects of a Ponzi scheme enormously extended, and overextended, through the infusion of huge amounts of highly dubious cash.

At some point, however, the limit will be reached, the source of new funds and/or leverage will evaporate. And when that point comes, then, finally, the hour of full -- and final -- reckoning will be upon us.

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