[Corp. Watch] Global finance is one big Ponzi scheme

[Corporation Watch]

The Ponzi Paradigm

  By Michael Hudson

(CounterPunch, Dec. 23, 2008) -- Last week the Good Lord evidently  
realized that not enough people had been reading Hyman Minsky's  
explanation of how financial cycles end in Ponzi schemes -- the stage  
in which banks keep the boom going by lending their customers the  
money to pay interest and thus avoid default.

	So he sent Bernie Madoff to dominate the news for a week and give the  
mass media an opportunity to familiarize newspaper readers and TV  
watchers with just how Ponzi schemes work. What Madoff did was, in a  
nutshell, what the economy as a whole has been doing under the moniker  
"wealth creation."

	If the media were able to wait until as late in the financial  
collapse as last week to provide helpful diagrams about how Ponzi  
schemes need to keep on growing exponentially, it is simply because  
bad foreign financial news is not deemed newsworthy in North America.

	Europe has been having its own run-throughs, headed by Spain -- which  
by no coincidence is now experiencing the biggest real estate bust  
outside of the post-Soviet economies.

	The best case study occurred two years ago. On May 9, 2006, Spanish  
police raided 21 homes and offices of Afinsa Fienes Tangibles SA, the  
world's largest postage-stamp dealer, and rival firm, Forum Filatélico.

	They charged eleven men with running a $6.4 billion pyramid scheme  
that took in some 343,000 investors -- 1 per cent of Spain's entire  
population, making the fraud one of the largest in Spanish history.

	An economy is either in trouble or has lost its sense of balance when  
investors shy away from tangible capital formation [such as investing  
in production] in favor of buying postage stamps and similar  
collectibles.

	Unlike machinery and technology, stamps do not produce real goods and  
services themselves. They have long since been printed and sold by the  
government, and will never be used actually to mail letters.

	However, stamps have shown themselves to be a great vehicle to  
attract savers who think that buying them can produce an exponential  
earnings growth -- or more technically, "capital gains", if we can  
stretch economic terminology far enough to call a stamp collection  
"capital."

	If value resulted merely from scarcity, then postage stamps, coins,  
and masterpiece paintings all would seem to increase almost  
automatically over time, just like most land does. But these trophies  
of wealth do not promote rising production, consumption or living  
standards.

	As stamps do not earn money by employing labor to produce goods and  
services, their price gains are neither profit nor capital gains as  
classically understood. They are what economists call a windfall.

	The Spanish postage-stamp scheme seems to have taken off in 2003, the  
year in which Spain's free-market conservative government deregulated  
public insurance and oversight for non-financial investment funds.

	Afinsa Group bought two-thirds control of the New Jersey stamp and  
coin auction house Greg Manning and merged it with the Spanish  
auctioneer Auctentia to create Escala, the world's third largest  
auction house (after Sotheby's and Christie's).

	Escala moved its operations to New York City and listed its stock on  
the Nasdaq over-the-counter market. Despite the stock market's  
lethargic trend, the company's earnings showed such rapid growth that  
in just three years its share price soared from under $5 to $35,  
tripling in 2005 alone.

	Afinsa's purchases accounted for 70 percent of Escala's profits,  
thanks largely to the fact that as its Spanish parent's sole supplier,  
Escala marked up its stamps by a reported 1,150 percent, out of all  
proportion to the usual 25 percent.

	Afinsa thus was carrying stamps for which it paid 58 million euros on  
its books at 723 million euros, or over ten times their catalog values  
-- which themselves are fictitiously high in any case, being published  
mainly for the benefit of stamp dealers to give their customers the  
idea that they are getting a good buy.

	But as Forum Filatélico's chairman, Francisco Briones, explained to a  
reporter from London's Financial Times: "It was 'normal' to charge  
clients such inflated prices because of the services provided ...  
including the custody and conservation of stamps."

	Afinsa paid its stamp investors an annual rate of 6 to 10 percent  
interest, beating most competing yields as the global financial bubble  
was pushing interest rates steadily downward. (Spanish government  
bonds paid only 3.5 percent.)

	To build up trust, Afinsa gave its clients post-dated checks for the  
gains that were promised. It also promised to buy back the stamps it  
sold, at the original price. This gave an appearance of liquidity to  
the normally illiquid market in stamps, fine arts, and other  
collectibles, where 25 percent commissions to auction houses are normal.

	These ploys convinced the majority to simply re-invest the money to  
buy yet more stamps, which the company held in its offices ostensibly  
for safekeeping and preservation.

	Money poured in, giving stock-market investors in Escala much higher  
returns than the stamp-buying customers nominally were receiving. As  
one news report remarked, why buy stamps and coins when you can invest  
in companies dealing in them? But within a week of the arrests,  
Escala's stock plunged below $4 a share.

	The denouement came shortly after Lloyd's of London withdrew from a  
1.2 billion euro policy to insure Afinsa's stamps. One of its experts  
noticed that if $6 billion really had been invested in stamps through  
Escala, it would have bought up all the investment-grade stamps in the  
world many times over.

	The fact that stamp prices did not reflect any such extraordinary  
buying implied that few bona fide stamp transactions occurred at all,  
and there had been a massive over-billing. As it turned out, most of  
Afinsa's stamps had no investment value. This explained why there were  
no receipts for transactions with Escala.

	The police found €10 million in 500 euro banknotes (worth about $650  
each at the exchange rate of $1.30 per euro) by breaking open a newly  
plastered wall at the Madrid home of Afinsa's main stamp supplier,  
Francisco Guijarro.

	What they could not find were any receipts for the stamps that he  
allegedly bought. And despite the remarkably high mark-ups charged for  
curating the stamp collection, it was rife with phonies, as Lloyd's  
had suspected.

	Concluding that the bills Guijarro had sent to Afinsa were just a  
cover for a money laundering operation, the prosecutors charged the  
family members and officers who controlled Afinsa with embezzlement,  
money laundering, tax evasion, fraudulent bankruptcy, breach of trust,  
and forgery.

	The arrests recalled memories of a more famous U.S. fraud involving  
postage stamps some 86 years earlier, in 1920, by Charles Ponzi -- the  
man who bequeathed his name to history in the form of Ponzi pyramid  
scheme.

	He is reported to have arrived in Boston in 1903 with only $2.50. Not  
speaking much English, he took menial jobs. Fired as a waiter for  
shortchanging customers, he moved to Montreal and became an assistant  
teller in an Italian immigrant bank, which grew rapidly by paying  
double the normal 3 percent rate of interest on savings accounts, but  
failed when its real estate loans began to go bad.

	The bank's attempt to give the impression of solvency seems to have  
given Ponzi the idea of paying interest out of new deposits rather  
than actual earnings. As long as clients felt they were receiving  
interest regularly, they tended to be calm about the principal balance.

	Ponzi was sent to a Canadian prison for forgery, and then was jailed  
in Atlanta for trying to smuggle Italian immigrants into the United  
States. After his release he moved back to Boston and got a job  
selling business catalogs.

	A Spanish customer sent him a postal reply coupon, which allowed its  
holder to buy stamps in another country for return mail [back to their  
country] rather than using the domestic currency to buy a stamp.  
Prices for these coupons were long out of date, having been set in  
1907 by the International Postal Union.

	World War I had drastically shifted exchange rates, which enabled  
buyers to pay a small amount in Britain -- or even less in Germany,  
with its depreciated currency -- and obtain a return-mail stamp that  
could be used to mail things from the United States to those countries.

	The mark-up on these tiny postal orders was large. An American penny  
could buy foreign stamp orders that could be converted into six cents  
in U.S. stamps, for a 500 percent profit.

	The problem was that it would take a truckload of such postal orders  
to make serious money. A million-dollar investment would involve 100  
million penny coupons -- which then would have to be converted into  
stamps and sold in competition with the U.S. Post Office, presumably  
at a discount, mainly in immigrant neighborhoods.

	Focusing on the principle of arbitrage rather than such laborious  
implementation, Ponzi explained to investors that he could make a 400  
percent gain after expenses. He promised that they could double their  
money in 90 days, pretending to take due account of the costs and  
shipping time from Europe to America.

	When his Securities Exchange Company paid early investors the high  
returns he had described, they spread the word to others. Ponzi's  
inflow of funds rose from $5,000 in February 1920 to $30,000 in March,  
and $420,000 by May.

	By July an estimated $250,000 a day was flowing into his firm, mainly  
from small investors who let their investments build up rather than  
taking out their money. Some people put their life savings into the  
plan, and even borrowed against their homes. Ponzi spent most of the  
money on himself, buying a mansion and bringing his mother over from  
Italy.

	The financial reporter Clarence Barron noted that if he really had  
invested the money as he told his investors he had done, Ponzi would  
have had to purchase 160 million postal reply coupons. Yet the post  
office reported that few were being bought at home or abroad, and only  
27,000 were circulating in the United States.

	Federal agents raided Ponzi's offices in August 1920, and did not  
find any postal reply coupons, just as Spanish police did not find  
investment-grade postage stamps in the scheme's 2006 replay.

	Ponzi was sentenced to prison yet again, but jumped bail and tried to  
make some quick money selling Florida real estate. He soon was  
recaptured, and was deported back to Italy upon his release in 1934.

	What Ponzi sold was hope, pandering to peoples' unrealistic desire to  
believe that a new way to make easy gains had been discovered, with no  
visible upper limit as to how long gains can persist in excess of the  
economy's own rate of growth.

	It is a measure of how much harder it is to make returns in today's  
world -- and hence, how little hope needs to be excited -- that  
whereas Ponzi promised to double his investors' money every three  
months, the Spanish stamp scheme paid only a 6 to 10 percent annual  
return.

	Neither fraud actually made any trading gains or profits, but simply  
paid investors out of new money coming in from fresh players. New  
inflows were treated as earnings. That's how pyramid schemes work.

	It was almost as if the Spanish operators had read one of the  
biographies of Ponzi that began to appear as observers noticed the  
common denominators between the global financial bubble of the 1990s  
and earlier bubbles.

	These bubbles provide a classic contrast between the real wealth of  
nations and what the business press these days calls "wealth creation"  
that simply takes the form of rising asset prices -- "capital gains,"  
most of which are land-price gains.

	No doubt stamp collectors would have viewed the bidding up of stamp  
prices as wealth creation if it actually had occurred. But all it  
would have achieved was to inflate the price of old stamps, much as  
the world's growing ranks of billionaires were bidding up prices for  
master paintings and modern art, designer furniture and beachfront  
homes.

	If all the economy's savings went into Rembrandts and Picassos, their  
price obviously would soar, just as putting $6 billion into postage  
stamps would have established higher plateau levels for stamp prices.

	The flow of funds into any category of assets bid up their prices.  
This is true most of all for land, one of the most universal economic  
needs and conspicuous-consumption status measures. But does this  
really "create wealth"? Do market prices reflect use values, living  
standards, and the progress of civilization?

	The requisite characteristic for such price gains is indeed scarcity,  
but not so much that there is not enough for large numbers of buyers  
to make a market. If psychological utility is the key, "scarcity" has  
value only as a compulsive acquisitive character -- wealth addiction.

	It means having what other people lack, with connotations of denial.  
Most money in search of mere scarcity is not going into trophies of  
the nouveau riches, but into the world's most abundant yet also most  
universal scarce resource: land.

	Nature is not making any more of it. Yet everyone needs land to live  
on, making it the object of personal and business saving par  
excellence. Even in today's post-industrial economies, land and its  
subsoil wealth represent the largest components of national balance  
sheets.

	But inasmuch as land cannot be manufactured, savings cannot increase  
its supply by active investment. This poses a traumatizing problem for  
economists. National income statistics count any money spent on things  
that are not consumed as saving.

	Following John Maynard Keynes, they define saving as equal to  
investment. This sows the seeds of confusion with regard to the  
character and preconditions of economic growth. Can we really call it  
"wealth creation" when society merely directs its savings into  
speculation rather than into building up productive capacity or living  
standards?

	Classical economists vacillated over whether to treat land as a  
factor of production, or as a legal property right (i.e., to construct  
a tollbooth around a given site and levy an access charge much like a  
user-tax).

	A factor of production contributes to production and income as more  
income is invested in it. A rent-yielding property reduces the  
economy's flow of income. In the latter case land is part of the  
institutional property system, not the technologically based  
production sector of the economy.

	What is beyond dispute is that real estate is highly political at the  
local level. Urban development tends to be shaped by insider dealing  
and lobbying to obtain low tax appraisals and influence public  
infrastructure spending to increase local property prices.

	It is axiomatic that the more economically powerful a sector of  
wealth becomes, the greater its political power to lobby for special  
tax advantages. At the national level, real estate uses part of its  
revenue to back politicians who give it a widening wedge of special  
income-tax favoritism.

	In the financial sphere, every bubble has been led by governments.  
Bubbles need to be orchestrated by opinionmakers, topped by public  
officials giving a patina of confidence. The "madness of crowds" is a  
euphemism designed to divert blame for this away from governments onto  
the public.

	In the United States, Alan Greenspan played the role of public  
bubblemeister during the dot.com boom, similar to that which Walpole  
had played in England's South Sea bubble and John Law in France's  
Mississippi bubble nearly three centuries ago, in the 1710s.

	Today's balance sheets confuse bubble wealth with real capital  
formation. "Investment" has become whatever accountants say they are.  
So have asset and debt values, given today's leeway for financial  
fiction.

	The practice of "marking to market" permits accountants to project  
hypothetical gains at astronomical rates of interest, or trivializing  
by discounting, applying purely mathematical functions that have lost  
all connection to realistic rates of growth. The result is that the  
financial sector itself has become decoupled from the "real" economy.

	The tragedy of our time is that saving today is being diverted in  
ways that are not only decoupled from real capital formation, but  
merely add to the economy's debt and property overhead.

	Suppose that Ponzi actually had bought International Postal Orders,  
and that the Spanish stamp companies actually had invested $6 billion  
in rare philatelic items and coins, driving up their price to create  
paper gains for the investors. To whom would they sell, in order to  
take their gains? (This is the proverbial "greater fool" problem.)

	More to the point, how would the broad economic effect of such asset- 
price inflation have been positive?

	The recent stock market and real estate bubbles are much like pyramid  
schemes in the sense that what is bidding up stock and property prices  
is an exponential inflow of new money from pension plans and mutual  
funds and bank credit (for real estate). Venture capitalists "cashed  
out" while corporate managers exercised their stock options.

	Even if mortgage-packaging companies had been honest in their  
appraisals of current price trends, the real estate bubble was  
nonetheless speculative and post-industrial.

	Financial managers endorse government policies that encourage the  
inflation of price for stocks and bonds, stamps and coins, and  
Rembrandts and modern art by claiming that this creates wealth and  
hence, by definition, pulls living standards and culture onward and  
upward.

	But what is wrong with this picture? For starters, it fails to define  
value as distinct from price, and windfalls and capital gains [i.e.,  
being at the top of the pyramid and cashing out] as distinct from  
earned income.

	It also neglects the fact that market prices rise and fall, but debts  
remain in place. And when debts cannot be paid, savings are wiped out.

	Hedge funds were making and losing money hand over fist, dwarfing the  
gains and losses made from stamp trading. A veritable market in crime,  
punishment, and beating the rap was in play.

	What does this have to do with true capital formation? Individuals  
are getting rich while the economy is polarizing between creditors and  
debtors, property owners and rent-payers.

	Unproductive investment occurs when it takes the form of speculation  
that leads to (temporary) windfall "capital" gains, and when it  
involves going into debt for real estate, stocks or bonds, or  
"collectibles."

	Unproductive credit occurs when commercial banks make loans that  
merely finance the purchase (and subsequent selling and re-purchase)  
of property, companies, or financial securities already in place.

	Two centuries ago, French followers of Count Henry St. Simon outlined  
an industrial system that was to be based mainly on equity financing  
(stocks) rather than debt (bonds and bank loans). Their idea was to  
make industrial banking a kind of mutual fund, so that claims for  
payment (and hence, the value of savings) would rise and fall to  
reflect the economy's earning power.

	The industrial banking that developed largely in Germany and central  
Europe differed from the short-term Anglo-American collateral-based  
trade credit and mortgage lending. But since World War I, global  
financial practices have been more extractive than productive.

	The consequence has been that debts on the economy-wide level have  
grown more rapidly than the ability to pay. Instead of reducing this  
debt overhead by earning their way out of debt, economies have sought  
to inflate their way out of debt.

	However, the mode of inflation is not the familiar rise in consumer  
prices, much less wage inflation. Rather, it is asset-price inflation,  
emanating largely from the United States.

	Since the gold-exchange standard gave way to the paper dollar in  
1971, the U.S. economy has become unique in being able to create  
credit -- and foreign debt -- without constraint. The result has been  
an unparalleled growth in debt relative to income, production and  
wages. This "debt pollution" has been likened to environmental  
pollution.

	We have entered an era in which financial markets resemble the stamp- 
buying funds. Governments have replaced industrial growth with purely  
financial wealth creation in the form of a real estate and stock  
market bubble.

	This has turned the economic universe upside-down relative to what  
the classical writers expected to result from the technological  
progress unleashed by the Industrial Revolution and its parallel  
agricultural, commercial and financial revolutions.

	Property and credit have become costs instead of a benefit,  
institutional forms of rent- and interest-extracting overhead rather  
than helpful inputs.

-----------------------

Michael Hudson is a former Wall Street economist, research professor  
at University of Missouri at Kansas City, and author of many books,  
including "Super Imperialism: The Economic Strategy of American Empire"