Greenspan should be miffed with what Madoff has achieved. So far, Greenspan has conveniently side-stepped the landmines he had created by blaming the financial disasters on complex derivatives and their domino effects. But what Wall Street insider Bernard Madoff has accomplished with his $50 billion swipe is to prove that old-fashioned Ponzi schemes are still very much part and parcel of the financial muddle the US is in. So rather than financial incompetence being the core issue as has been portrayed so far, Madoff has highlighted that it is as much a moral issue.

About 100 years ago, Charles Ponzi architected the basic scheme of paying out investors early from the principal of the late investors, creating the illusion of success that attracted further investors. Over the decades, several versions (pyramid schemes, chain letters etc.) of the Ponzi scheme have been created; but as history has proven, they all always end with a lot of patsys in the end.

The common thread among all the Ponzi schemes is that the returns to the early investors were not on the basis of investment returns of the principal and that the system was implicitly bankrupt for an extended period of time (perhaps even from the word ‘go’), before an explicit bankruptcy is forced due to liquidity concerns. But perhaps for the first time, with the likes of big banks being the victims, the hunters have become the hunted.

Pensions are not funded...

But as I mentioned in the beginning, Madoff’s $50 billion Ponzi scheme seems trivial compared to the multi-trillion dollar Ponzi scheme being engineered by the US Social Security Administration (US-SS). Under this scheme, there is no trust fund and the pension to the retired workers is paid out from the contributions of the current workers. There is only so long that such a system can work and according to a recent estimate by Prof Laurence Kotlikoff, a professor of economics at the Boston University, the unfunded liabilities (including Medicare) could easily total up to $70 trillion. The scheme of the US-SS surely has to be the Don John (“I am a plain-dealing villain”) of all Ponzi schemes, ie. open, acknowledged and yet scot-free.

Default through inflation

But why am I referring to the poor banks (literally) as being the ‘hunters?’ Because, despite the scale of the US-SS, the biggest Ponzi scheme ever orchestrated is the fractional reserve banking (FRB) system that we live with today. But before explaining why the very nature of FRB is a Ponzi scheme, we need to understand more about the nature of defaults in a
financial transaction.

There are two kinds of default: the first is the ‘default through bankruptcy’ that we are all aware of; but there is a more insidious second type which is ‘default through inflation.’ In this category, the investor gets paid back in debased currencies, but in terms of purchasing power, the effect is no different from the former. Because an investor is paid back in nominal terms, the effect (or in reality, the scam) is always not well understood by the unsuspecting public.

Buy why is FRB a Ponzi scheme? Because what banks lend from the current account deposits is money that they have no legitimate right to lend. The money kept in the current accounts is to be paid ‘on demand’ and by lending such depo-sits (excepting for the money in deposit at the Central Bank because of the CRR), banks create additional capital that have no paper backing, let alone gold backing the paper in the first place. The only way to prevent a run on the bank is through the Central Bank promise of providing the paper. But all that the Central Banks own is a printing press and what an investor would get under such a scenario is money whose purchasing power has been debased.

The only reason banks have gotten this far is because of the misplaced confidence of the general public in the banking institutions and the Central Banks. But we shouldn’t be surprised: Madoff survived for a decade and he didn’t exactly run a legitimate operation for the first nine years. It was a Ponzi scheme to begin with.

US-SS should have collapsed long ago had fair-value accounting rules been applied to the system. Yet it still continues to run its operation as a legitimate institution. So just because a system works for a long time (as the FRB has done), doesn’t in anyway guarantee the financial soundness of the operation. Like all Ponzi schemes, this too shall end.

On a moral note, ‘default through inflation’ is a far more heinous crime that ‘default through bankruptcy’ because the operations of the first kind are carried out either directly under or with the explicit guarantee of the government, and hence, the common public is much less suspecting as compared to Madoff’s scam.

Deficit spending another example

Notwithstanding the FRB, the most obvious example of ‘default through inflation’ type of Ponzi scheme has to be deficit spending by governments. This is true particularly for the US government today, but in general is valid for governments all over the world.

Government spending, almost by definition, does not generate adequate market returns (for reasons of sheer incompetence, if not downright corruption) and the only way that any government can return the borrowed money is by borrowing more money or by simply printing money, ie. inflation. That is the reason why deficit spending is always a bad option, even in good times but more so during economic downturns. At a time when capital is scarce, deploying the same in projects that guarantee inadequate returns is disastrous as this diverts scarce resources away from more attractive projects that would have been taken up by private entrepreneurs.

Mother of all Ponzi schemes

But the mother of all Ponzi schemes has to be the US economy itself. The very idea that one can borrow and consume to prosperity is as blatant a Ponzi scheme as it can get. Other nations that are holding the US debt can only be serviced by issuing more debt to some other country, or still worse, by printing money. Given the current outstanding US treasury holdings of other countries (running easily into several trillion dollars), the only option before the US is to ‘default through inflation’ for there is just no conceivable scenario of growth, savings and exports over the next decade that would allow for a legitimate repayment of the outstanding amount.

In the next few months, the Central Bankers who are asleep at the wheels today and holding on to the US dollars would probably wake up and realise the con game they have been tricked into. When they do so, they are yet again quite likely to blame laissez faire capitalism for all the problems, just as they are doing today for the credit crisis.

But the truthis just the opposite (read article US: The Coming Greater Depression, November 2008, IE, to understand why the credit crisis is a creation of Central Banks and not of free market capitalism). But for the Central Bank’s interventions in artificially undervaluing their currencies by buying US dollars, there would have been no accumulation of reserves in the first place. Little private demand for the US dollar has existed for the last two decades (given their increasing trade deficits) and this Ponzi scheme of borrowing to consume would have never come about in the first place.

Given all this, I am surprised that Madoff is being vilified in the US. After all, a country that once represented the spirit of ‘Life, Liberty and pursuit of Happiness’ is now nothing more than a gigantic Ponzi scheme. If Barack ‘trillion-dollar-deficit’ Obama were to do a Don John, he would well consider replacing the Statue of Liberty with a Statue of Madoff.