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.
Impact?
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.
