Madoff and Government Ponzi Schemes

By Scoot Lee
Although the $50 billion loss engineered by Madoff is a staggering accomplishment, the size of the scheme pales in comparison to the multi-trillion dollar Ponzi scheme run by the United States government.

Madoff’s scheme must have been derived from Charles Ponzi, an Italian-born American immigrant who promoted an investment plan in the early 1900s’ that traded postal coupons. Rather than paying investors from legitimate investment returns, Ponzi hit upon the innovative idea of paying out early investors with money collected from new investors. He created an illusion of success and as such interest in his investment plan ballooned. Over time the schemes have become known by many other names, such as chain letters or pyramid schemes. The uniting factor of them all, is that they always fail in the end.

When new investors slows to the point where distributions to current investors are no longer as profitable, investors look to withdraw funds. When this happens, the structure falls apart. The profits received by those who “invested” early plus any funds skimmed off by the promoter, are offset by all the losses of those who came in to the party late.

The same concept has driven the major asset bubbles of the last decade. Ridiculously high valuations assigned to tech stocks and real estate during their booms, and the only way these bubbles could continue, was if newer “investors” could be found to pay even more outrageous prices. As new buyers balked, the whole scheme crumbles. Government pyramids have the advantage of required participation. As a result, they can maintain the illusion of viability for many generations. But the longer such schemes operate the larger the losses become and they ultimately collapse.

The Social Security Administration runs its “trust funds” with the exact same methods used by Madoff and Ponzi. Money is collected from current workers, those funds are then dispersed to those currently receiving benefits. Workers now paying into the system are expected to receive their benefits based on the “contribution” made by future workers. The only difference being Madoff's and Ponzi's schemes, is they don't own a printing press.

In reality, the major difference is that Madoff took steps to keep the scheme hidden, the U.S. government operates in the light of day. Yet its very telling how faith in government still goes largely unchallenged, and that government is immune to the same economic laws that govern the rest of society. Much like those duped by Madoff and Ponzi, the world is in for a rude awakening.

Government and economists have concluded erroneously in my opinion, the key to reversing the current financial free fall can be accomplished by stopping the plunge in home prices. But to accomplish the improbable task of re-inflating the housing bubble by pushind down interest rates to 4.5%. This is precisely the wrong solution to the housing crisis, however the one consistent among government during this economic crisis has been bad ideas. artificially suppressing mortgage rates will encourage risk taking and debt assumption at a time when consumers and lenders should be acting prudently. By setting rates below market levels, and buying mortgages that no private funder would want to touch, the government is creating a mortgage entitlement.

The obvious problem is the Government has no money. All it has is a printing press. So the more money it provides for cheap mortgages, the higher inflation will be for all Americans and cause the entitlement to become more costly to provide.

Many believe that since the government can borrow for 30 years at 3%, issuing mortgages at 4.5% is a winning trade. There are three problems with this idea. First, just because money is cheap does not mean we should borrow it-haven't Americans and the government at least learned that by now! Second, this analysis does not consider default related losses. Finally, there is no way the government would be able to borrow that much money for that length of time and rate without driving interest rates higher. The only reason long-term rates are so low now is that the government is borrowing on the short curve. So to pull off the trade, the government will have to finance it with treasury bills.

In the final analysis the market must be allowed to function. If real estate prices are too high they must be allowed to fall, regardless of the consequences. Lower prices are the market's solution to housing affordability. Government attempts to artificially prop up prices will have much more dire economic consequences then letting them fall. Until we figure this out, there will be no escape from the economic death spiral the government is setting in motion.

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