With all the world focused on the Madoff ‘Ponzi scandal’ fallout, it’s worth considering some of the other potential Ponzi schemes people have warned about.
One particular warning came from Milton Friedman regarding the USA’s very own social security regime. He described it in 1999 as nothing less than the ‘biggest Ponzi scheme on earth’.
As he explained:
The link between the payroll tax and benefit payments is part of a confidence game to convince the public that what the Social Security Administration calls a social insurance program is equivalent to private insurance, in that, in the Administration’s words, “the workers themselves contribute to their own future retirement benefit by making regular payments into a joint fund.”
Balderdash. Taxes paid by today’s workers are used to pay today’s retirees. If money is left over, it finances other government spending—though, to maintain the insurance fiction, paper entries are created in a “trust fund” that is simultaneously an asset and a liability of the government. When the benefits that are due exceed the proceeds from payroll taxes, as they will in the not very distant future, the difference will have to be financed by raising taxes, borrowing, creating money, or reducing other government spending. And that is true no matter how large the “trust fund.” The assurance that workers will receive benefits when they retire does not depend on the particular tax used to finance the benefits or on any “trust fund.” It depends solely on the expectation that future Congresses will honor promises made by earlier Congresses—what supporters call “a compact between the generations” and opponents call a Ponzi scheme.
Of course, economists have long debated the feasibility of Ponzi-esque schemes (when they are feasible, when they are not), especially on a government level. For example, some describe the ongoing US deficit – bankrolled by the constant reinvestment of surpluses held by trading partners – as another form of the concept.
There is, however, a theory to justify its ongoing existence. It’s called the no-Ponzi game condition - a constraint that prevents over-accumulation of debt, essentially by making sure debt does not increase asymptotically faster than the interest rate, and yet still allows for consumption smoothing in society.
This is explained by Philip Arestis and Malcolm Sawyer in their paper, titled “The intertemporal budget constraint and the sustainability of budget deficits”:
Blanchard and Fischer (1989) suggest that “Integrating this budget constraint and imposing the NPG condition this time on the government (that debt not increase faster asymptotically than the interest rate) gives an intertemporal budget constraint for the government.
In the case of government, its ability to borrow would be constrained by the willingness of the private sector to lend since the budget deficit is equal to private net savings. If the government sought to borrow more than the maximum amount of private net savings, then it would indeed be faced by a borrowing constraint. However, if the government practices ‘purposeful fiscal policy’ and seeks to run a budget deficit equal to private net savings (at the target level of economic activity), then it would not face this borrowing constraint.
According to the above, the ‘constraint’ (or no-Ponzi game condition) is equivalent to the point when debt rollover is no longer feasible – and this constraint is naturally observed by households and governments alike (or attempted to be observed).
Writing on the feasibility of the ponzi scheme regarding national debt rollover, Olivier J Blanchard from the Massachusetts Institute of Technology (MIT) with Philippe Weil from the European Center for Advanced Research in Economics and Statistics, however, also note the following:
In a dynamically efficienct economy, can a government roll its debt forever and avoid the need to raise taxes? In a series of examples of production economies with zero growth, this paper shows that such Ponzi games may be infeasible even when the average rate of return on bonds is negative, and may be feasible even when the average rate of return on bonds is positive. The paper then reveals the structure which underlies these examples.
So generally, while the riskless rate is positive, Ponzi debt recycling via new flows of capital from abroad is feasible (or for that matter when the riskless rate is lower than the growth rate). Once the riskless rate goes negative (a direction US treasuries are increasingly heading in) the Ponzi scheme may become unstuck – this is also the concern when the growth rate falls below the riskless rate.
But before worrying that the entire system will unravel, Weil and Blanchard prove there are exceptions even to that assumption. They explain (our emphasis):
Arguments as to whether governments can rollover debt are often cast in terms of a comparison of the average growth rate and average riskless rate. In a series of examples, we have shown that this may be misleading. The average riskless rate may be less than the growth rate while Ponzi games are infeasible, or it may be greater than the growth rate, while Ponzi games are feasible. Turning to the structure underlying those examples, we have shown that, even in economies in which equilibrium is dynamically efficient, Pareto suboptimality may also lead to the feasibility of Ponzi schemes. In thinking about the implications of Pareto suboptimality, we have focused in this paper on the suboptimality which comes naturally from the incompleteness of markets under uncertainty in overlapping generation models.
But there are many other reasons why actual economies may not be Pareto optima. Missing markets may be missing for reasons ranging from asymmetric information to transaction costs, leading for a potential role of public debt, and opening the possibility of Ponzi games. Distortions, from externalities to taxation, may also create wedges between risk adjusted interest rates and the social marginal product of capital. Thus, Ponzi games may be feasible. And if they are, they may—but need not—be Pareto improving.
Pareto improving (as explained by Wikipedia) by the way means that:
Given a set of alternative allocations of, say, goods or income for a set of individuals, a change from one allocation to another that can make at least one individual better off without making any other individual worse off is called a Pareto improvement. An allocation is Pareto efficient or Pareto optimal when no further Pareto improvements can be made. This is often called a strong Pareto optimum (SPO).
All that is based on the 80/20 rule – where economic forces generally lead to 20 per cent of invested input being responsible for 80 per cent of the results obtained. Put another way, 80 per cent of consequences stem from 20 per cent of the causes. A little bit like a pyramid scheme then where 80 per cent end up channelling wealth to 20 per cent (many losers, not so many winners).
So is the US government at risk of seeing its own ponzi-style debt rollover scheme unravel by breaching its natural constraints? According to Peter Schiff at Euro Pacific Capital, it is definitely coming close. As he explains:
The United States Government runs its own balance sheet based on the Ponzi principal as well. Our national debt always grows and never shrinks. As existing debt matures, proceeds are repaid by issuing new debt. Interest payments on existing debt are also made by selling new debt to investors. The whole scheme depends on an ever growing supply of new lenders, or the willingness of existing lenders, to continue to roll over maturing notes. Of course, as was the case with Madoff, if enough of our creditors want their money back, the music stops playing.
The main difference is that while Madoff took elaborate steps to conceal his scheme, the U.S. government operates in broad daylight. It truly is amazing how faith in government is so pervasive that many can believe that politicians will succeed where private individuals fail, and that governments are somehow immune to the economic laws that govern the rest of society. Like those unfortunate to have been duped by Madoff and Ponzi, the world is in for a rude awakening.
Buiter also identifies that the natural constraint (no-ponzi game condition) is more likely to be breached when the money base is expanded and rates go to zero. As he writes in his paper “Helicopter Money” published in 2004 :
As the stock of real money balances grows without bound, the nominal interest rate goes to zero and the present value of the terminal stock of real money balances becomes unbounded. Private consumption demand becomes unbounded and violates the economy-wide real resource constraint. Equivalently, for the household transversality condition in equation to be satisfied when the present discounted value of total available resources is unbounded requires uc(c, m) ‘ 0. This requires unbounded consumption and violates the aggregate resource constraint.
The only thing that can prevent the entire system from unravelling therefore is a helicopter drop of money. As Buiter explains, because fiat money is irredeemable it is considered tantamount to net wealth by a household. Therefore, any widespread perception that money expansion is only temporary may in fact result in the opposite effect – prolonging rather than resolving the liquidity trap.
The continuation of the liquidity trap, in turn, only adds pressure on the government’s own intertemporal budget constraints (or its no-Ponzi game condition). In a zero or negative riskless rate environment this potentially threatens the unravelling of the whole system or scheme.
Buiter says to avoid this, the government must erase any perception the effects of its helicopter drop may only be temporary – eliminate the idea that it may come back at some point with a giant vacuum cleaner to mop up the money it has just dropped. As he puts it:
If the interest rate on base money is zero, the flexible price level model supports a liquidity trap equilibrium only if the monetary authorities are expected to reduce the money stock to zero in the long run. In the New-Keynesian variant, a liquidity trap equilibrium is ruled out whenever the authorities are expected to keep the nominal stock of base money above some finite threshold level in the long run. Any positive long-run expected growth rate for the nominal stock of base money is sufficient to rule out a liquidity trap equilibrium. Liquidity trap equilibria are therefore possible as rational expectations equilibria only if monetary policies are strongly contractionary in the long run. With non-rational expectations – e.g. the incorrect belief that the monetary authorities will, in the long run, reverse and undo any past and present increases in the stock of base money – liquidity trap equilibria can exist for as long as these incorrect but irrefutable expectations persist.
All of which can presumably only have one possible effect – the eventual and long-lasting devaluation of the dollar.
Related links:
Kotlikoff’s sale of the century – FT Alphaville
Oi! OIS! – Willem Buiter’s Maverecon blog