Modern money is being managed like a mutant Ponzi scheme

Andrew Sheng says when the originator of a scheme to pass on debt to others is also ‘too big to fail’ – like America – then the global economy is heading for some painful restructuring

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The dilemma today is that the US is the world’s largest “too big to fail” debtor, with gross international liabilities of US$31 trillion, equivalent to 40 per cent of global GDP. Photo: AFP

Published: 1:08pm, 4 Mar 2016Updated: 1:08pm, 4 Mar 2016

The global financial crisis is not over. The volatile start to the year showed that 2016 may be a precursor to the 10th anniversary of the 2007 subprime crisis, which itself evolved from the 1997 Asian financial crisis.

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Two terms came out of the crisis that we see almost every day, but which have not been explained well by modern financial theory. Most economists think of them as aberrations at the periphery of normal economic behaviour. In fact, “Ponzi schemes” and “too big to fail” lie at the heart of individual and social behaviour, which go a long way to explaining what is happening today.

A Ponzi scheme is a scam named after American Charles Ponzi, who sold the idea of making money from arbitraging the value of international reply coupons in postage stamps to a growing group of investors in the 1920s. He made money by getting new investors to pay the promised high returns to old investors. Of course, this is “borrowing from Peter to pay Paul”; when the music stops, everyone wants their money back. Ponzi schemes should in principle collapse naturally, because it is of course impossible to pay unusually high returns. By the time this is realised, the founder has usually run away to the Caribbean with a lot of other people’s money.

A foreclosure sign tops a “for sale” sign outside a property in northwest Denver in this 2007 photo. The number of homeowners receiving foreclosure notices hit a record high in the spring, driven up by problems with subprime mortgages. Photo: AP

The securitisation (packaging) of subprime mortgages into collateralised debt obligations, and turbocharging these into highly leveraged synthetic financial derivatives, then selling these to investors with a AAA credit rating, was a 21st-century Ponzi variant.

In simple terms, it’s like selling a box of rotting apples, getting a rating agency to say that the box is worth more than the individual apples, with a guarantee against losses by adding more (rotten apples). In the end, the investor will have bought only a box of rotting apples, with all his savings eaten up by those who sold the boxes (derivatives).

There are two fundamental elements of Ponzi operations – the promise of very high returns and the widening of the investor circle

There are two fundamental elements of Ponzi operations – the promise of very high returns (false expectations) and the widening of the investor circle. Variants of the Ponzi scheme can be found in asset bubbles and pyramid schemes, in which more and more investors are enticed in until they are the ones who bear the final losses. Like a game of musical chairs, the ones who did not get out when the music stops are the losers.

Ponzi schemes work by having the originator pass his losses to all his investors, in order to make money. Hence the more suckers, the bigger his profits, and the more people to share the losses.