In Madoff We Trust

As the multi-billion dollar Ponzi scheme orchestrated by Wall Street insider Bernard Madoff unravels in the media spotlight, the nation is being presented with a rare opportunity to understand the true nature of many of our most cherished financial structures. Hopefully we have the wisdom to connect the dots.

Although the $50 billion loss engineered by Madoff is truly a staggering accomplishment (and was done using old-fashioned fraud rather than the mathematical wizardry that has characterized Wall Street’s recent larcenies) the size of the scheme pales in comparison to the multi-trillion dollar Ponzi structures run by the United States government. In fact, rather than looking to jail Madoff, President-elect Obama should consider making him our new Treasury Secretary. If not that, at least make him the czar of something!

Madoff’s inspiration came from Charles Ponzi, the Italian-born American immigrant who promoted an investment plan in the early 1900s’ that traded postal coupons. Rather than paying investors from legitimate investment returns, Ponzi hit upon the innovative idea of paying out early investors with money collected from new investors. By creating an illusion of success, interest in his investment plan ballooned. Over time the schemes have become known by many other names, such as chain letters or pyramid schemes. They are united by the fact that they always fail in the end.

When the influx of new investors inevitably slows to the point where distributions to current investors can no longer be maintained, investors look to withdraw funds. When this happens, the entire structure falls apart. The profits received by those who “invested” early as well as any funds skimmed off by the promoter, are offset by all the losses of those who came late to the party.

To a large extent, the same concept has driven the major asset bubbles of the last decade. Given the ridiculously high valuations seen by tech stocks and real estate during their respective booms, the only way the bubbles could be perpetuated was if newer “investors” could be found to pay even more outrageous prices (the greater fool). But when these new buyers balked, the whole structure crumbled. Although there was no Ponzi or Madoff to orchestrate these manias, the entire financial and economic apparatus of the country had successfully convinced the public that “investments” in tech stocks and condominiums were bullet proof and that the supply of new buyers was endless.

Unfortunately, the Ponzi economy doesn’t stop there. A chain letter is no more viable when run by governments than when run by private citizens. However, government orchestrated pyramids have the advantage of required participation. As a result, they can maintain the illusion of viability for several generations. But the longer such schemes operate the larger will be the losses when they ultimately collapse.

The Social Security Administration runs its “trust funds” with precisely the same methods used by Madoff and Ponzi. As money is collected by from current workers, the funds are then dispersed to those already receiving benefits. None of the funds collected are actually invested, so no investment returns are ever generated. Those currently paying into the system are expected to receive their returns based on the “contribution” made by future workers. This is the classic definition of a Ponzi scheme. The only difference is that Ponzi didn’t own a printing press.

The United States Government runs its own balance sheet based on the Ponzi principal as well. Our national debt always grows and never shrinks. As existing debt matures, proceeds are repaid by issuing new debt. Interest payments on existing debt are also made by selling new debt to investors. The whole scheme depends on an ever growing supply of new lenders, or the willingness of existing lenders, to continue to roll over maturing notes. Of course, as was the case with Madoff, if enough of our creditors want their money back, the music stops playing.

In Madoff’s case, the rug pulling was provided by the huge financial losses suffered by some of his clients in other non-Madoff investments. When enough of these clients looked to sell some of their apparently well-performing Madoff assets to help offset such losses, the scam collapsed. The same thing could befall the United States Government. Now that China and our other creditors are looking to spend some of their U.S. Treasury holdings to stimulate their own economies, look for a similar outcome with even more dire implications.

The main difference is that while Madoff took elaborate steps to conceal his scheme, the U.S. government operates in broad daylight. It truly is amazing how faith in government is so pervasive that many can believe that politicians will succeed where private individuals fail, and that governments are somehow immune to the economic laws that govern the rest of society. Like those unfortunate to have been duped by Madoff and Ponzi, the world is in for a rude awakening.

Comments

[sewells:]

While the basic point of this article is correct, it is incorrect to say that "None of the funds collected are actually invested, so no investment returns are ever generated." The Social Security excess is "invested" in a special class of Treasury bonds. This special class "earns interest". To truly understand how the fraud is perpetrated, you have to understand this point. The asset backing the special class of Treasury bonds is nothing but the ability of the government to tax in the future to repay the bonds. The actual dollars are pretty much spent right away instead of being invested in productive assets.

This isn't a minor point. The first thing about fraud is understanding what the fraud consists of. You can't do that without understanding the special class of Treasury bonds.

2008 Dec 17 07:20 AM

[investor88:]

An insightful analysis with a title to match "In Madoff we trust". More and more the US govt seems to be operating a Ponzi scheme with ever expanding debt; someday this cannot be sustained like any Ponzi scheme.

2008 Dec 17 08:11 AM

[Ferdinand E...:]

Since I dont live in the US now, maybe I have missed the point where Mr Madoff is concerned. But unless I am mistaken, what people do not understand is that Mr Madoff needed that money. The US that he grew up in is about the same as that I grew up in, where there were quite a few millionaires around, but absolutely no billionaires.

But now of course, knock on any door and a billionaire answers. Thus a gentleman like Mr Madoff works night and day to acquire a few million or so, and in the end finds out that he's just another face in the crowd. It must have been frustrating, and perhaps even insulting.

About a Ponzi scheme. In my finance book I explained it in the same manner that I explained it to my students, but it never occured to me that the US government was running one. Of course, I pointed out that Ronald Reagan's government had borrowed as much as all the previous governments in the US. The thing that irked me was that he probably borrowed some of that money from my wife and myself, but now I've come to the conclusion that that is what the 'Reagan Revolution' was essentially all about: stealing money from dumb foreigners.

Ferdinand E. Banks

2008 Dec 17 08:17 AM

[mavericks:]

Ponzi scheme is a bit of a misnomer since most of Madoff's investor's were with him for years and I would argue that it was probably his oldest clients who were least likely to pull money from him. What happened was that many investors were being paid out assumed 'profits' in monthly, quarterly or annual disbursements. Everyone thought it was like an annuity payment. Foundations needed disbursements for donations, individuals needed money for living expenses, fund of funds moved assets out for re-balancings. Since everyone got their checks like clockwork, nobody had any reason to doubt that the 'Jewish bond' was paying out its 10% profits while their principal was safe and sound. Unfortunately, Madoff wasn't making 10% so the '$50 billion' he managed was being widdled away each year by the billions which were being paid out.

2008 Dec 17 09:05 AM

[Stephen Kanitz:]

Absolutely correct. Unfunded Social Security and Medic Aid is a another form of Ponzi Scheme. Those that call it a "Pay as You Go System" forget that it works just like Maddoffs scheme. Late entrants pay for the rest. Great and rare article. Congrats.

2008 Dec 17 09:07 AM

[SPXplus10:]

On the other hand... what is an alternative (to the implicit pyramiding of SS)?

Consider: In a closed system where the costs can be (very roughly) divided into "maintenance of the retired class" and costs of the "safety net" for the working age class, it is not irrational to rely on the (presumably inflating) tax payments of the (presumably enlarging) working class to support the first class of costs.

The system fails only If the subsequent generation does not enlarge or if the tax payments do not inflate. (Even then, there are "automatic stabilizers: a reduced population in the subsequent generation reduces the costs of the second class of costs, ceteris paribus.) The bigger/more immediate flaw may result from the extended lifespans and the health care costs that are concentrated in that "extended" period.

Unfortunately, the combination of the baby boomer bubble running into the current spate of deflation tests (to the max) the robustness of the assumptions. (Throw in the hyperbolic health care cost increases, and the current strain on the system is very apparent.)

But over a long horizon, these "anomalous" periods should be exceptions - not the rule - and reliance on a printing press (to counter deflationary effects) may not be so sinful as implied.

Alternatives approach? One that offers as much of a "net net" benefit over 50 - 100 year horizons?

I hate to rely on the economist's paradox, but isn't a lot like the proverbial quarter on the sidewalk? (If there was a better alternative, it would be topic A of everyone's discussion right now.)

2008 Dec 17 09:17 AM

[Fabien Hug:]

There is still a small difference (I hope) other than transparency between the US gvmt and Madoff; the gvmt. doesn't do it to enrich itself

2008 Dec 17 09:18 AM

[Jonponwon:]

A brilliant analysis, and something I certainly did not think of. even though I knew that here in the UK the Government is operating a civil servants' pension fund it can never hope to finance in a few years time. And why? I now realise it is because of the Madoff principle. Moreover the Government is as culpable as Madoff because it knows it can never hope to fund these pensions. Collectively they belong in gaol. What is more they do in fact do it to enrich themselves. Is not their re-election by a duped populace a form of enrichment?

2008 Dec 17 11:06 AM

[oldsuretyguy:]

Excellent article and well written.

2008 Dec 17 12:51 PM

[CLH:]

The social security system is close to collapsing because people are no longer having 5 or 6 children--- meaning each set of parents would be paid in their old age by 3 or 4 children. Of course we have a party not smart enough to see this. They tell every person that nothing is wrong. Ponsi schemes are so easy to run (for a while).

2008 Dec 17 12:56 PM

[debtacid:]

I like the idea of Madoff as Treasury Secretary and we can just abolish the other branches of government to complete the worldwide Ponzi coup

2008 Dec 17 01:37 PM

[GeminiAtlas:]

The government doesn't do it to enrich itself per se, but to "empower" itself. The currency of the politicians is power where money is just a means and not the end. Thus the more debt they can load upon the taxpayer gains the pols more power because it will necessitate tax increases in the future to pay the debt or monetization of the debt via inflation which will also garner power over the masses as their money becomes worthless. Not that this makes any sense, since just like riches, power does not go into the next world. Legacies last a long time though, and the leadership of congress amongst other institutions of the past 50 years, I'm sure will leave a lasting legacy, not necessarily a bright one.

2008 Dec 17 02:09 PM

[Yogidad:]

Everyone knows the pyramid aspects of the social security system. It's taught in grade school and the commenters that say they never thought of it before - simply cannot be believed. The fact is that one way or the other the government (and therefore the taxpayers) are responsible for the welfare of the aged if they cannot pay for themselves. Social security is simply a way of creating some indivdual incentive and some individual control and autonomy in later-life - where possible. Everyone knows that the terms must be adjusted in the near future.
The only interesting part of the article is the very short discussion relating to of the stock market's similarities to a Ponzi scheme. Yes valuation bubbles are very close to a Ponzi scheme. And the lax enforcement of transparency and reporting regulations when the market is on a constant rise is fixable if we showed the will-power while the bubble is making everyone heady.

2008 Dec 17 02:50 PM

[Crude Oil T...:]

There is only proof of 1 billion being invested in any given year. May not be none of the funds, but pails in comparison to what investors piled into Madoff's fund.


On Dec 17 07:20 AM Steve Wells wrote:

> While the basic point of this article is correct, it is incorrect
> to say that "None of the funds collected are actually invested, so
> no investment returns are ever generated." The Social Security excess
> is "invested" in a special class of Treasury bonds. This special
> class "earns interest". To truly understand how the fraud is perpetrated,
> you have to understand this point. The asset backing the special
> class of Treasury bonds is nothing but the ability of the government
> to tax in the future to repay the bonds. The actual dollars are
> pretty much spent right away instead of being invested in productive
> assets.
>
> This isn't a minor point. The first thing about fraud is understanding
> what the fraud consists of. You can't do that without understanding
> the special class of Treasury bonds.

2008 Dec 17 03:48 PM

[Socialism c...:]

On Dec 17 02:50 PM Yogidad wrote:

> The fact is that
> one way or the other the government (and therefore the taxpayers)
> are responsible for the welfare of the aged if they cannot pay for
> themselves.

Why? And since when??? It is NOT the job of the government to provide our food, clothing, or shelter to us! That is OUR OWN job.

>Social security is simply a way of creating some indivdual
> incentive and some individual control and autonomy in later-life
> - where possible.

Um...exactly HOW does SS create individual incentive? It REMOVES individual responsibility, because those paying in are losing ability to use a portion of their earnings for their own future retirement needs...and are therefore made that much more dependent on others for those needs. It's a downward spiral in dependency!! Government NEEDS to create dependency on itself, because it FEARS not being necessary and being trimmed or eliminated!!

2008 Dec 17 05:09 PM

[Socialism c...:]

Peter, a big THANK YOU for continuing to trumpet the realities we are facing regarding entitlement government!! Anyone wishing to take a step towards personal empowerment and regaining control of government BY THE PEOPLE, please read up on the Fair Tax:

fairtax.org

We need to have the preemptive right to our OWN money, and be able to decide where it is best used, as well as IF and WHEN the government gets any of it. That is the way we can reign in free-spending government!!

2008 Dec 17 05:11 PM

[Jason Rines...:]

That's the real issue. These days it does. This has happened before in history, government/banking collusions/corruption. The Founding Fathers of the nation warned repeatedly of this and knew it would happen to our Republic (they understood human nature and studied Roman Republic). That is why they built in the right to bear arms into our framework, so that WHEN the day came, the citizenship had the power to reduce the government's power or restructure it.


On Dec 17 09:18 AM fabien hug wrote:

> There is still a small difference (I hope) other than transparency
> between the US gvmt and Madoff; the gvmt. doesn't do it to enrich
> itself

2008 Dec 17 05:31 PM

[Tony Petroski:]

The American government and its social security system is not a ponzi scheme. But it does depend on an ever-expanding population. The Japanese/European problem is a declining birthrate. Is that our future?

2008 Dec 17 09:27 PM

[Sigmund:]

In its general form, the Social Security System is comparable to a Ponzi scheme. If the government is truly beneficient, there is a limited problem. Here is where the great difficulty arises. What if the government is malicious because it is ignorant. We have a fiat currency, backed by the full faith and taxing power of the governement. We have an SEC that eliminated the up-tick rule for shrot selling, then imposed bans on short selling all the while declining to fully examine the operation of Pnozi scheme. We have a Treasury Department and a Federal Reserve System that combine to create cash so as to ameliorate any all economic slowdowns. Now there's a Ponzi scheme that is a marvel of sophistication. We have an insurance company that wrote credit default swaps contracts for which they made no capital reserves, moreover they did not have sufficient capital to honor the contracts should defaults occur. Now that strikes me as fraud. In our idealogue zeal to pursue free market capitalisim we seem to be ignoring that the concept of free market capitalisim does not mean that there are no rules. And there is the problem. Reasonable rules have either been erased or repealed. History will record this administration as being the most intellectually inept and incompetent in the history of our Federal Republic.

2008 Dec 18 08:58 AM

[Mike the Go...:]

I have long enjoyed Peter Schiff's illuminating and insightful economic commentaries. Another exceptional analysis. I remember the debates/arguments of Mr. Schiff and Larry Kudlow on CNBC and Kudlow has been buried under the accuracy of Mr. Schiff's forecast of over a year ago! I surprised that Mr. Kudlow continues the charade that he knows what he is talking about after that public humilation! Although I understand Mr. Schiff's tongue in cheek suggestion that we appoint Madoff as our new Sec. of the Treasury I believe that Obama's own potential candidate (T. Geister) for that same post fulfills any possible requirement as he is more than sufficiently "schooled" in the trick and treat scams of Wall Street given his past opportunities to witness firsthand the deceptions practiced in those steel and glass enclosed castles in the sky. For decades Wall Street has acquired the sharpest minds to combine to foulest elements of pump and dump schemes and the chidren's card game of Old Maid and Musical Chairs to separate the assets of investors into their engorged coffers for slary "compensation" and massive year end "bonuses". Rest assured that Wall Street firms' future viability is guaranteed through "mandatory" contributions from retirement accounts such as IRA's and 401 K's and the lobbying effort currently underway to "privatize" Social Insecurity accounts. Talk about required participation in government schemes! Remember that the US government has the only legal monopoly on the Ponzi apparatus via it's 1) control of Social Security contributions and 2)the lawful authority to create money out of thin air via the mechanism of the sale of US Government Bonds and 3) the operation of the technology of an electronic printing press with Ben Bernanke playing the wizard behind the curtain (frantically delivering TRILLIONS to Wall Street Investment Houses and blown up Banking institutions). The recent severe downdraft of the US dollar in the currency market from 88 to 78 and the concommitant rise in gold is the proverbial canary in the coal mine signal that our reliance of the goodwill of foreign investors to acquire our $2 billion a day debt is fast coming to an end. The United States is due for as mighty lifestyle change. Maybe Obama's election slogan: "Change You Can Believe In" will take on a whole new meaning and one that is not a very pleasant economic prospect for our nation! Can you say Greater Depression?

2008 Dec 18 09:51 AM

[Jeff Ferguson:]

The "Social Security" "Trust Fund" is funded with paper (apply whatever moniker you want) which is both an asset and a liability of the American people. In accounting terms the asset is offset by the identical liability since they are on the same balance sheet. Net value equals zero at all times. If such were not the case we could all make ourselves fabulously wealthy by sitting down with a piece of paper and a pen and writing an IOme $1 billion or more.

Social Security employs the classic ponzi/pyramid structure and it will ultimately fail, in historic fashion, despite the fact that the perpetrator can legally employ coercion or, failing that, violence in an effort to further the scheme.


On Dec 17 07:20 AM Steve Wells wrote:

> While the basic point of this article is correct, it is incorrect
> to say that "None of the funds collected are actually invested, so
> no investment returns are ever generated." The Social Security excess
> is "invested" in a special class of Treasury bonds. This special
> class "earns interest". To truly understand how the fraud is perpetrated,
> you have to understand this point. The asset backing the special
> class of Treasury bonds is nothing but the ability of the government
> to tax in the future to repay the bonds. The actual dollars are pretty
> much spent right away instead of being invested in productive assets.
>
>
> This isn't a minor point. The first thing about fraud is understanding
> what the fraud consists of. You can't do that without understanding
> the special class of Treasury bonds.

2008 Dec 18 04:32 PM

[Cap'n Mike:]

Golden Mike raises an issue I have expressed for some time: the US's coming downward adjustment in standard of living. We have tried to compete with (largely) Asians and other 3rd world workers on an 'equal' basis. Now, many more Americans will have to live in the tenement conditions that I've seen for decades in Japan, then Korea, Taiwan, etc., watching folks work well past dark to eke out a meager living.

Second, the damage from the Madoff exposure will extend way beyond the billions, but remains unspoken. It will cause a further erosion of confidence in the security of and trust in American investments; this atop a Chinese warning for us to live within our means. We will not see truthful, yet alarming stories in any mainstream media about the increased flight of foreign money from our shores, but it will be manifest in further decline of the dollar and our living conditions.

Perhaps the huge increase in gun sales is evidence that, once again, the American public is way ahead of Washington and knows of the coming threat, despite the shallow (or deceitful) words for our 'leaders'.

2008 Dec 19 12:08 AM