The Bear’s Lair: The Ponzification of the World

Arrests have been made in China over a $7.6 billion Ponzi scheme involving a P2P (person-to-person, without the intervention of a bank) lender. My first response was: P2P lending in the Chinese banking system: what could possibly go wrong? My second, more thoughtful, insight is that distinguishing out-and-out Ponzi schemes from the world economy as a whole is becoming more and more difficult and may not mean much. With funny money as we have had since 2008, Charles Ponzi is simply an aggressive and successful entrepreneur.

The original Ponzi scheme, instituted in 1920, involved discounting postal reply coupons of other countries and redeeming them at par in the United States. It took advantage of the derangement of the world’s exchange rates after World War I, which had produced new arbitrages that would have been impossible before 1914. The postal coupons arbitrage business worked fine in theory, but not at the volumes Charles Ponzi claimed for it (it would have required 160 million postal reply coupons to be in circulation, instead of the 27,000 that were actually outstanding.) Hence Ponzi’s extravagant returns to early investors of 50% per month could only be paid out of money coming in later.

By the time Bernard Madoff’s much larger but less apparently lucrative scheme took off in the years to 2008, paying a mere 10-12% per annum to its investors over a long period appeared sufficient. Just like Ponzi’s original scheme, Madoff’s scheme involved paying new investors out of old returns, without any of the money being actually invested. Incidentally, the most severe financial danger to investors arose after Madoff was found out; the bankruptcy trustee has seized the returns of early investors who got out at a profit.

Similarly the Chinese Ezubao P2P lending operation, whose $7.6 billion scheme was revealed last week, promised investors returns of only 15% per annum, a rate they could probably have achieved by lending actual money to actual consumers – although I suppose not having an actual business cut down on unnecessary overhead. The company’s risk controller was quoted by Xinhua news agency as saying “95% of our projects are fake” – in which case why go to all the trouble and expense of having 5% real ones?

The most important change from Ponzi’s day is in the interest rate promised. In 1920, at a time when the United States was still on a Gold Standard, there was not a lot of spare cash sloshing about and so Ponzi was forced to offer exorbitant interest rates that crashed his scheme within months. Walter Bagehot may have claimed in the nineteenth century that 7% “would draw money from the moon” but in Boston in 1920 it took a lot more than that to attract investors to Ponzi’s enterprise.

With modern “funny money” monetary policies, that is no longer the case. 10-12% was enough for Madoff’s myriad of investors and even in China, where capital remains considerably scarcer than in the liquidity-flooded West, 15% returns appear to have been ample for Ezubao’s P2P lending money-pit.

This is a very important change. It’s a lot easier to find a scam that plausibly pays 10-15% than it is to find one that appears to pay 50% a month. What’s more, a Ponzi scheme that pays investors only 10-15% a year can grow much bigger than poor Ponzi’s pioneering effort and last for decades. With more opportunities to form Ponzi schemes and the lifespan of those Ponzi schemes greatly extended, it follows that a much larger proportion of the global economy than in Ponzi’s day is now devoted to Ponzi schemes.

Eight years of interest rates near or below zero even in nominal terms, and substantially negative in real terms, have exacerbated this tendency further, by intensifying investors’ search for yield. In this environment, even a 2% return can look attractive if it appears solid. For Ponzi scheme promoters, this gives them an enormous advantage: a scheme that offered investors only a 2% return and had modest overheads should be sustainable for almost half a century.

Negative interest rates, as the world’s central banks are attempting to promote, offer an even more exciting possibility: if interest rates are negative a Ponzi scheme with a zero return becomes attractive. By definition, such a Ponzi scheme never need run out of money, except for its administrative expenses. Indeed, if the Ponzi scheme promoter can leverage, borrowing at say minus 1% to goose the scheme’s return, it can even fund a moderate amount of administrative expenses also. That’s why, in a piece a few weeks ago examining a world without cash and with substantially negative interest rates imposed by central banks, I postulated that it would be possible to make money by building ziggurats, funding the costs of the religious observances in gigantic and beautiful (to Babylonians) buildings by the returns on the money borrowed to build them.

It should be noted however that a Ponzi scheme that is sustainable is by definition not a Ponzi scheme. It may be a pointless, wasteful futile investment that yields no return (though the Central Park Ziggurat will be much admired by lovers of eclectic architecture, and its Sunday afternoon human sacrifices will draw massive crowds.) However, it will be perfectly sustainable if borrowing costs are negative, provided it does not waste money beyond the interest earned on its borrowings. It will therefore blend seamlessly in with the rest of the economy.

We can therefore state a Ponzi Enlargement Theorem of monetary policy: prolonged low interest rates enlarge the number and durability of Ponzi schemes, until at some point, with risk free real interest rates at or below zero, Ponzi schemes become self-sustaining and cease to be Ponzi schemes (or, a mathematically equivalent statement, the entire economy becomes one vast Ponzi scheme.)

This explains the strange and troubling decline in productivity growth since the 2008 financial crash. As the Ponzi sectors of the economy expand, the productive sectors become a smaller and smaller part of the whole, and so productivity growth sinks towards zero, even though technological progress and human inventiveness continue as they have for two centuries. Robert J. Gordon’s new book “The rise and fall of American growth” is correct in its diagnosis that the U.S. economy has fallen into a productivity malaise, that if not treated will cause productivity to stop growing altogether and begin to decline, with consequent unpleasant effects on living standards.

Gordon is however wrong in his understanding of the disease’s underlying mechanism, and of the prospects for recovery. Far from being a result of an inexorable decline in U.S. and global inventiveness, the slowing in productivity is a result of decades of low or zero interest rates, and of the consequent Ponzification of increasing sectors of the economy. If interest rates are kept at current levels, Ponzification will indeed spread further, causing productivity growth to disappear altogether as Gordon predicts, and will eventually swallow the healthy parts of the economy completely.

Contrary to Gordon’s view, there is however a simple and well-understood cure for this disease of universal Ponzification. Simply raise interest rates to their natural level of 2-3% above the rate of inflation, and install one or more mechanisms keeping them there, effectively Volckerizing the Fed and other central banks and preventing the emergence of another Ben Bernanke. Then Ponzification will go into reverse.

Naturally, this progress will be very painful. The Ponzified sectors of the economy will need to collapse, as all Ponzi schemes eventually do, so that the dead wood of their false investment can be cleared for healthy investment to replace it. Losses to investors and the rest of us will be huge, but they will be worth it. Once investment has been re-directed into its proper channels productivity growth will be able to resume, as the Ponzified sectors will have been reduced to the bare residuum of fly-by-night crooks like Ponzi himself.

One further caveat: monetary policy reform will need to be accompanied by a mass bonfire of regulations. Otherwise too many of the new growth industries will be throttled at birth, being prevented from operating by some bizarre interaction between different weeds in the bureaucratic jungle of regulation.

Regulations that merely add costs to existing businesses make the economy less efficient, but they do not choke off new possibilities altogether. However, since about 1970 the bureaucratic jungle in the United States has been so thick that it has choked off large numbers of new industries that, had they come into existence, would today be major producers of wealth and jobs. (We would for example, absent regulation, have had at least two new generations of nuclear reactor design by now, with accompanying increases in power output and decreases in both costs and environmental danger.)

Charles Ponzi’s 1920 scam should thus be studied in depth. Just as Wilbur and Orville Wright’s clumsy flying machine was the precursor to infinitely more powerful and effective machines in the decades to come, so Ponzi’s primitive scheme was the precursor to modern Ponzi schemes many times larger, and more efficient in operating at ever-lower rates of return and thereby having enormously enhanced opportunities for growth and survival.

A Ponzi scheme encompassing the entire economy may seem an impossible dream, like a perpetual motion machine, but at present it is only one determined monetary easing away. Janet Yellen and her central banking colleagues should beware, lest they produce the apotheosis into universality of Charles Ponzi.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)