Debtwatch No. 10: America’s Ponzi Schemes Unravel

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Named in mock hon­our of Amer­i­ca’s great­est swindler, a Ponzi Scheme is a finan­cial ruse that, for a time,  gen­er­ates appar­ent­ly great returns from an invest­ment that in fact pro­duces noth­ing. Ponzi Schemes ini­tial­ly appear to work because the pro­mot­ers pay ear­ly entrants seem­ing­ly fan­tas­tic returns, by the sim­ple expe­di­ent of giv­ing them mon­ey deposit­ed by lat­er entrants. So long as the Scheme con­tin­ues to grow, it can appear successful–and indeed indi­vid­u­als who get in and out before the Scheme col­laps­es can become fab­u­lous­ly wealthy.

Charles Ponzi was even­tu­al­ly exposed, impris­oned, and lat­er died in penury. But his ghost lives on, because in essence, there are two giant Ponzi Schemes at the heart of the Amer­i­can finan­cial sys­tem.

Pure Ponzi Schemes, like Ponz­i’s orig­i­nal enter­prise, don’t actu­al­ly pro­duce anything–and the pro­mot­er nor­mal­ly lives on the hog while it lasts, as did Charles him­self. In the aggre­gate there­fore, large sums of “investor” funds are lost: inher­ent­ly, the pro­mot­ers are bank­rupt, because from day one they have oblig­a­tions to those who have bought into the scheme that they can’t actu­al­ly meet. As a result, enor­mous debts are run up that can nev­er be repaid, and the bank­rupt­cies that result there­fore extend well beyond the orig­i­nal felons.

How­ev­er, there can also be hybrid schemes, where some real invest­ment occurs amid the shuf­fling of assets. That is the sto­ry with Amer­i­ca’s Stock and Hous­ing Mar­kets, which have grad­u­al­ly evolved from pro­duc­tive enter­pris­es to Ponzi Schemes.

The Ponzi aspect of these mar­kets is that the vast major­i­ty of share and house pur­chas­es do not actu­al­ly add to Amer­i­ca’s stock of either busi­ness­es or hous­es. Instead, they shuf­fle own­er­ship of pre-exist­ing assets on a sec­ondary mar­ket, with sell­ers attempt­ing to realise spec­u­la­tive cap­i­tal gains, and buy­ers enter­ing on a ris­ing mar­ket, antic­i­pat­ing fur­ther cap­i­tal appre­ci­a­tion in the future. The whole process is fuelled by bor­rowed mon­ey.

The shift from pre­dom­i­nant­ly pro­duc­tive to pre­dom­i­nant­ly Ponzi can be dat­ed to the ear­ly 80s, and Amer­i­ca has had four bub­bles in com­par­a­tive­ly rapid suc­ces­sion since then: the mid-80s Stock Mar­ket and its almost imme­di­ate off­p­sring, the com­mer­cial real estate bub­ble of 87–90; the Sav­ings and Loans fias­co; the Inter­net Bub­ble; and final­ly, the Sub-Prime Mort­gage Bub­ble. The sys­tem appeared to come through the first three rel­a­tive­ly unscathed, but in real­i­ty, the day of reck­on­ing was sim­ply delayed, as one debt-induced crunch was papered over by yet more debt.

As befits a Ponzi sto­ry, the alleged mon­ey-mak­ing scheme behind the final scam was the most absurd of all. The Sub-Prime Boom was a means to make mon­ey by lend­ing mon­ey to peo­ple who could­n’t afford to repay it. It did­n’t actu­al­ly work? Well blow me down…

The after­math to the col­lapse of a Ponzi Scheme is nev­er pret­ty. While suc­cess­ful spec­u­la­tors can repay their per­son­al debts incurred in a Ponzi process, soci­ety as a whole can only repay aggre­gate debt out of income: the pro­ceeds from sell­ing the goods and ser­vices those assets are used to pro­duce. With more and more bor­rowed mon­ey being used, not to finance the pro­duc­tion of new assets, but to enable some spec­u­la­tors to buy exist­ing assets from oth­ers, the debt bur­den on the entire econ­o­my inevitably increas­es. Thus, to the pain of the indi­vid­ual unsuc­cess­ful speculators–those who got in too late, or did­n’t get out in time–is added soci­ety’s gen­er­al suf­fer­ing, as the bur­den of debt repay­ment increas­es, with lit­tle or noth­ing to show for the addi­tion­al debt.

Of course, some real growth was trig­gered as Amer­i­ca’s Ponzi process­es gath­ered steam, since debt-financed spend­ing enabled cred­it-fuelled pur­chas­es of com­modi­ties and ser­vices. But debt grew much faster than the increase in out­put it spurred, sim­ply because most of the debt was not being used to actu­al­ly build future pro­duc­tive capac­i­ty. Debt-ser­vic­ing costs rose (even with falling inter­est rates), increas­ing the finance bur­den on the real econ­o­my, until ulti­mate­ly, we arrived at the chaos last two weeks: both Ponzi Schemes began to unrav­el.

Only in the after­math has it become obvi­ous to all and sundry, that what drove the appar­ent pros­per­i­ty while the Schemes were afoot was not finan­cial genius, or bril­liant inno­va­tion, or ster­ling industry–the usu­al sus­pects of the finan­cial pages while the boom lasts–but reck­less lend­ing and bor­row­ing. So let’s start with the aggre­gate debt pic­ture for Amer­i­ca, which shows vivid­ly just how much debt, and not “the usu­al sus­pects”, drove Amer­i­ca’s long boom (data in this part of Debt­watch comes from the lat­est Fed­er­al Reserve’s Flow of Funds report (June 2007, with data to March 2007, and the Office of Hous­ing Enter­prise Over­sight).

Aggre­gate debt, which had risen only mod­est­ly from 121 per­cent to 157 per cent of GDP over the 30 years from 1952 to 1982, explod­ed to over 360 per­cent in the sub­se­quent 25 years (Fig­ure 1).

Dur­ing the 30 years from 1952 to 1982, falling gov­ern­ment debt large­ly off­set ris­ing pri­vate debt; but from
then on, all class­es of lever­age in Amer­i­ca have risen.

Though gov­ern­ment debt is much high­er than in Aus­tralia, it is a dis­trac­tion to focus upon it even in Amer­i­ca: even though US Gov­ern­ment debt has risen recent­ly (due to both the bailout of the Inter­net Bub­ble and the Iraq War), it is still much low­er as a pro­por­tion of GDP than it was in the 1950s, and even than the recent peak it reached in the depths of the 1990s reces­sion.

As in Aus­tralia, the real debt sto­ry has been the expan­sion of pri­vate debt. Busi­ness debt has dou­bled (as a pro­por­tion of GDP) over the peri­od 1952–2007, house­hold debt has risen four­fold, and the debt of the finan­cial sec­tor has risen forty-fold. The real accel­er­a­tion, how­ev­er, began in the 1980s: the decade that marked Amer­i­ca’s tran­si­tion from a pro­duc­tive to a Ponzi soci­ety.

Fig­ures 3 empha­sis­es that, what­ev­er else might be blamed for the cur­rent cri­sis, gov­ern­ment debt is way down the list. Gen­er­al­ly it has risen and fall­en inverse­ly to the lev­el of eco­nom­ic prosperity–falling when the econ­o­my was boom­ing, ris­ing when in a slump (with a slight lag).

There is, how­ev­er, the notable excep­tion of the last six years since mid-2001. Though the econ­o­my has been in a (Ponzi-dri­ven) boom, gov­ern­ment debt has con­tin­ued to rise–no doubt pri­mar­i­ly fuelled by the fol­ly in Iraq, but also undoubt­ed­ly abet­ted by Bush’s tax cuts for the rich. At a time when the US Fed­er­al Gov­ern­ment could have at least have squir­reled funds that could lat­er be used when eco­nom­ic con­di­tions turned sour, it has instead com­pro­mised its own capac­i­ty to reflate its now debt-laden pri­vate sec­tor.

Busi­ness debt rose steadi­ly over the long peri­od of eco­nom­ic tran­quil­i­ty from 1952 till 1975. From then on, we have been in the age of finan­cial fragili­ty, and busi­ness debt has become wild­ly volatile, dri­ving the ups and downs in the busi­ness cycle.

Though house­holds debt grew rapid­ly from his­toric lows in the 1950s till the ear­ly six­ties, from then till the mid-80s, house­holds were large­ly silent part­ners in the Amer­i­can finan­cial sys­tem. Then in ear­ly 1984, when the 80s Stock Mar­ket Bub­ble began, house­holds began to bor­row big­time. House­hold debt rose rapid­ly from 46% of GDP in mid-1984 to 56% by the time of the crash in Octo­ber ’87. Its rate of growth slowed, until, remark­ably, after the 2000 mar­ket crash. Then the Sub-Prime hous­ing boom began, and house­hold debt grew faster than ever before, to stand today at over 95% of GDP.

The cor­re­la­tion between the growth in house­hold debt rel­a­tive to GDP and asset price lev­els is quite reveal­ing: the stock mar­ket rose dur­ing the 1950s as house­hold debt expand­ed, stag­nat­ed from the 1960s till the 1980s as house­hold debt remained flat, then took off dur­ing the 80s as house­hold debt grew rapid­ly. When the stock mar­ket bub­ble fal­tered, the cen­tre of spec­u­la­tion shift­ed to housing–as can be seen from the Case-Schiller house price index for LA (sim­i­lar results apply for the oth­er cities in this index).

Tech­ni­cal note: this com­par­i­son is not sci­en­tif­ic, and econo­me­tri­cians might well object that the data should be de-trend­ed, etc.. How­ev­er, accord­ing to con­ven­tion­al eco­nom­ic the­o­ry, there should be no trend at all to the ratio of debt to GDP: the fact that there is one, and it cor­re­lates to asset price infla­tion, is there­fore of inter­est.

One oth­er series that, in stan­dard eco­nom­ic the­o­ry, should not have any trend at all but clear­ly does, is the gear­ing of the finan­cial sec­tor itself. This has exploded–no oth­er word does the trend justice–from 2.65% of GDP when records began in 1952, to 109.8% in March 2007. This ratio has grown by 6.96% per annum for 55 years, and the cor­re­la­tion of this growth with a sim­ple expo­nen­tial fit is a stag­ger­ing 0.9962. Even Ponzi would be proud of that sus­tained rate of growth!

As for what the future might hold, though it is almost cer­tain that the Fed­er­al Reserve will low­er rates if the US Stock Mar­ket seri­ous­ly tanks, it beg­gars belief that this last Ponzi Scheme could be suc­ceed­ed by yet anoth­er one. Amer­i­ca might final­ly have to come to terms with its addic­tion to Ponzi Schemes, and like over­com­ing any addic­tion, it will be nei­ther easy, nor pain­less.

Meanwhile, Back in Australia…

Final­ly, lest any­one is think­ing “only in Amer­i­ca” about the Sub-Prime fias­co, Fig­ure 8 should pro­vide some food for a some­what deep­er thought…

To a man with a hammer, everything looks like a nail”

Pri­or to the mar­ket tur­bu­lence of the last two weeks, the most recent CPI data led mar­ket pun­dits to expect that the RBA will increase rates at its meet­ing this week. Even though the all mea­sures of infla­tion are with­in the RBA’s tar­get band of 1–3% p.a., the pun­dits believe the RBA will make a “pre-emp­tive strike” against infla­tion by rais­ing rates now, before infla­tion moves above its tar­get zone (the pri­ma­ry stim­uli to action were the rates of increase in the quar­ter­ly weight­ed and trimmed mea­sures, which at 0.9% are out­side the Bank’s zone).

This rais­es three issues:

  • whether–unlike WMDs in Iraq–higher future infla­tion might actu­al­ly be found;
  • what impact this pre-emp­tive strike might be; and
  • whether infla­tion is as big a threat to our eco­nom­ic well-being as the RBA’s empha­sis upon it implies.

Future inflation?

There are sev­er­al pos­si­ble sources:

  • the impact of capac­i­ty con­straints;
  • the relat­ed pos­si­bil­i­ty of upwards pres­sure on wages;
  • agri­cul­tur­al price prob­lems due to the impact of cli­mate change;
  • import­ed infla­tion via the ris­ing cost of oil; and
  • the pos­si­bil­i­ty of infla­tion due to a future depre­ci­a­tion of the cur­ren­cy from its cur­rent highs.

All the above fac­tors can­not be eas­i­ly dis­missed, so yes, fur­ther upwards move­ment in infla­tion is fea­si­ble.


Here I believe that the RBA is play­ing with fire. I have no doubt that, at the moment, increas­ing inter­est rates will damp­en infla­tion. My con­cern is that an inter­est rate rise will have a far greater depress­ing impact on the econ­o­my than the RBA antic­i­pates, because its mod­els ignore the role of debt.

With the inter­est rate as its sole pol­i­cy tool, the RBA is already in the posi­tion that Bernard Baruch par­o­died, that “if all you have is a ham­mer, every­thing looks like a nail”. But the real prob­lem is that it is hit­ting the inter­est rate nail with the ham­mer of debt, and that ham­mer is now too heavy to be ignored. Unfor­tu­nate­ly, the tech­ni­cal tools the RBA uses to assess the need for rate changes do ignore debt.

The RBA’s anti-infla­tion stance is guid­ed by the so-called Tay­lor Rule, which argues that there is an inverse rela­tion­ship between inter­est rates and infla­tion: put up inter­est rates, and infla­tion will fall. Typ­i­cal mod­els assume that the rate of inter­est con­trols the gap between actu­al and capac­i­ty out­put, and the infla­tion is a lagged func­tion of that gap. When the gap closes–as has hap­pened recently–then infla­tion will rise (as indeed has hap­pened).

With infla­tion as the RBA’s sole pol­i­cy tar­get, the Tay­lor Rule implies that the Bank should increase rates now, thus increas­ing the gap between actu­al out­put and capac­i­ty (or at least slow­ing down the speed at which the gap is clos­ing), and reduc­ing infla­tion.

Sim­ple Tay­lor Rule mod­els imply a lin­ear rela­tion­ship between a change in inter­est rates, and the result­ing change in infla­tion: rates up by x% implies infla­tion down by y% (with a lag). In real­i­ty, the impact of a change in rates on the econ­o­my depends not just on the change itself, but also on the lev­el of out­stand­ing debt.

This is acknowl­edged to some degree by the fact that the RBA now changes rates in 1/4 of a per­cent incre­ments, ver­sus the 1 per­cent incre­ments by which it moved upwards in the late 1980s. But one thing the Bank does­n’t appear to acknowl­edge is that, with debt, there can be a “tip­ping point” effect: the bur­den of debt ser­vic­ing can be so high that even a small increase in rates push­es the sys­tem into a down­ward spi­ral.

This is cer­tain­ly what hap­pened when ris­es in offi­cial rates pushed aver­age inter­est rates from 14 to 20 per­cent over 18 months between 1998 and 1990. Then, the inter­est pay­ment bur­den on the econ­o­my rose from 10.5 cents in the GDP dol­lar to its all-time high of 16 2/3rd cents–and the econ­o­my plunged into “the reces­sion we had to have”, with the Reserve forced to cut rates almost as fast as it had raised them. At the end of the rate cut­ting exer­cise, rates were 4.25 per­cent low­er than before the RBA attempt­ed to tame the 1980s bubble–and unem­ploy­ment was almost dou­ble its 1990 low.

I believe that the RBA risks a sim­i­lar case of overkill if it increas­es rates now. Inter­est pay­ments on pri­vate debt cur­rent­ly con­sume 14.77 cents in every GDP dol­lar. If the Bank increas­es rates by one quar­ter of one per­cent tomor­row, the inter­est pay­ment bur­den will break through the 15 cent bar­ri­er to be 15.27 cents per GDP dol­lar. There are only 15 months in Aus­trali­a’s eco­nom­ic his­to­ry where this bur­den has been high­er: between May 1989 and July 1990. Those are not par­tic­u­lar­ly aus­pi­cious months in the annals of Aus­tralian mon­e­tary pol­i­cy.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.