In Madoff We Trust 22 comments
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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.
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This article has 22 comments:
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.
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
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.)
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.
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.
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!!
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!!
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
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.
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'.