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Ponzi Schemes

by @ 11:19 pm
Filed under: financial

The bad news on Wall Street today was Madoff's Ponzi scheme. This old trick works by paying off previous investors with money from new investors, thereby garnering a false reputation of handsome profits as long as new money keeps arriving, as in the adage: robbing Peter to pay Paul. Of course the problem is that the scheme eventually runs out of steam and as it unravels it leaves the investors at the tail-end of the cycle holding the bag.

This particular one had an apparent run over decades with losses to the tune of $50 billion. Many investors were large institutions such as banks and municipalities with fiduciary responsibilities to average folks. Most likely this will become another bailout liability for the taxpayers.

Of course Ponzi schemes are not just the domain of the greedy individuals. The subprime mortgage was another example of a Ponzi scheme perpetrated with the approval, and even encouragement, of the government wishing to expand homeownership at any cost. But it even goes further than that. The Social Security and Medicare programs are also Ponzi schemes of sorts. These entitlement programs are funded with the potential earnings of future generations.

The U.S. government's irresponsible borrow-and-spend cycles are also garden variety Ponzi schemes with the investors generally consisting of foreign governments. One could argue that the borrowing cycles are not so nefarious as the investor countries are well aware of the risks and they are even in some form complicit in the scheme, since they are also beneficiaries of this vicious cycle. But what will happen when the interest payment liability on the IOU's finally outstrips the government's revenues and China stops buying up more debt to protect itself? Hint: financial calamity on a global scale that makes the current crisis but a pleasant memory.

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