Robbing Peter

Is the entire financial system just one big pyramid scheme?

Listener: 21 February, 2009

: 21 February, 2009Keywords: Macroeconomics & Money;

: Macroeconomics & Money;Carlo Ponzi was an Italian migrant to the United States who, after a career of petty larceny and time in prison, thought there was an opportunity to make a fortune from arbitraging international postal reply coupons. The details of the scheme need not bother us – it proved too costly to work. It’s the way he ran it that caused all the fuss.

He told investors who entrusted him with their savings he would double their money in 90 days. Unable to meet the return, Ponzi paid them with the deposits that came in later (after allowing a generous margin for his own “expenses”).

Taken with their first success, many reinvested their monies, and others, impressed by the first payments, added to the inflow. It was unsustainable, of course. You may rob Peter to pay Paul, but when it is Peter’s turn to be paid, there may not be enough Penelopes to rob. The scheme collapsed, investors lost millions and Ponzi had another period in prison.

Ponzi died a pauper in 1949 but his name lives on. A Ponzi scheme involves early investors being paid out of the proceeds from later investor contributions.

Ponzi was not the first to run such a scheme, nor was he the last. At the end of last year, reputable New York financier Bernard Madoff confessed he had been running one; his investors may lose as much as US$50 billion ($95 billion). Ponzi kept such poor records that nobody knows how much he swindled.

A pyramid scheme is a variant because it relies on those early in the set-up taking the contributions of those who join later. Ponzi schemes infringe the law in various ways, and pyramid selling schemes are specifically illegal.

Recently, there have been claims that the entire financial system is a Ponzi scheme, although it would be more precise to call it a pyramid scheme. The argument goes like this: investors put their savings into the financial system. The financiers take a generous margin for their expenses and bonuses, and the remainder is invested in accounts, which gives investors the impression their -savings are intact and that they are getting a return. The price of the financial paper (or the asset that matches it, such as a house) becomes inflated, and a speculative financial bubble arises. However, the return ultimately depends on using others’ savings to fund withdrawals- of savings and profits. The bubble is unsustainable, of course. Eventually the new funds run out.

There is an element of truth to this, but first let’s clear away some falsehoods. A plain vanilla bank takes your savings, pools them with others and lends the funds at higher interest rates. This involves management costs, and since no matter how cautious a bank is it will make mistakes, there has to be a margin for bad debts. You could lend the money yourself, but a bank does it more cheaply and safely; you pay for its expertise and efficiency. Since our economic system requires investment and you would like a return on your savings, the banks are doing a useful job.

Unfortunately, it’s not always easy to distinguish plain vanilla banking from neopolitan financing. Sometimes even the stodgiest overseas banks cannot tell the difference, either. Their greed, and that of investors, led them to seek returns that, in hindsight, were too high to be sustainable. So the investments ended up in assets as valuable as Penelope’s accounts with Ponzi; you might say the toxic assets are worth pennies.

The financial system is different from a true Ponzi scheme because of the ambiguous line between vanilla and neopolitan finance. It’s possible to make a fortune quite legally from the fancy end of financing, even though it ultimately depends on getting out early with the contributions of those who stay.

The world is too busy dealing with the macroeconomic consequences of the bubble bursting to focus on the longer-term issue of how to prevent future bubbles, or how to ensure that when the next bubble bursts, it does not splatter the whole of the economic system.