Terrance Heath

This Can't Really Be the Economy

Filed By Terrance Heath | December 22, 2008 2:30 PM | comments

Filed in: Living, Politics, Politics
Tags: economic policy, financial crisis, government bailout

I'm not an economist. I've never studied economics, beyond reading The Complete Idiot's Guide to Economics about a year ago. I've read about derivatives and had my mind blown by the concept of securitization and the idea that people not only sell debt, but chop it up into little pieces, mix those pieces up, and then resell them to other people. (And, wait a minute, debt has value?)

And all with no regulation or oversight?

Now, after following economic news this past year, it's like somebody pulled back the curtain and revealed the economy as little more than floating game of craps. And I find myself thinking, "You gotta be kidding me, right? This can't really be the economy. Can it? We gotta have something else, because you know what this sounds like to me?"

"Ponzi" Schemes

Ponzi schemes are a type of illegal pyramid scheme named for Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. Ponzi thought he could take advantage of differences between U.S. and foreign currencies used to buy and sell international mail coupons. Ponzi told investors that he could provide a 40% return in just 90 days compared with 5% for bank savings accounts. Ponzi was deluged with funds from investors, taking in $1 million during one three-hour period--and this was 1921! Though a few early investors were paid off to make the scheme look legitimate, an investigation found that Ponzi had only purchased about $30 worth of the international mail coupons.

Decades later, the Ponzi scheme continues to work on the "rob-Peter-to-pay-Paul" principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses. For more information, please read pyramid schemes in our Fast Answers databank.


But, like I said, I'm not an economist. So I thought, "Is it just me? I gotta be missing something," because even though it sounds like a ponzi scheme to me, a lot of very smart people seem to think this is a perfectly sensible basis for an economy.

Me, I always thought that to form the basis of an economy, you had to have people who make stuff -- stuff that other people could actually put to use -- and sell that stuff to other people. But this is so much of part of the foundation of our economy that we've got to go billions of dollars into hock to keep afloat the people who drove their companies into a ditch and took the economy with them.

People like Bernard Madoff, whose hedge fund fraud is a candidate for the record books.

Or maybe not.

Not so fast, says Janet Tavakoli, president of Tavakoli Structured Finance. On her company's Web site, Ms. Tavakoli suggests that Mr. Madoff has some competition for the top prize.

"The largest Ponzi scheme in the history of the capital markets is the relationship between failed mortgage lenders and investment banks that securitized the risky overpriced loans and sold these packages to other investors -- a Ponzi scheme by every definition applied to Madoff," she wrote. "These and other related deeds led to the largest global credit meltdown in the history of the world."

...The $1 trillion in write-downs that the banks have suffered since the credit crunch began last year dwarfs the $50 billion that Mr. Madoff supposedly said had been swindled from his investors.

Ms. Tavakoli argues that these two money-losing debacles have a few things in common -- including a major lack of transparency.

So, it's not just me.

It sounds like Tavakoli was right, too. The full price tag for the bailout thus far comes in at $8 trillion. Now, there's only been about $2.9 trillion of that amount has been spent, loaned or otherwise handed out, but we don't know who got it or on what terms, and the Fed won't tell us.

The Federal Reserve refused a request by Bloomberg News to disclose the recipients of more than $2 trillion of emergency loans from U.S. taxpayers and the assets the central bank is accepting as collateral.

Bloomberg filed suit Nov. 7 under the U.S. Freedom of Information Act requesting details about the terms of 11 Fed lending programs, most created during the deepest financial crisis since the Great Depression.

The Fed responded Dec. 8, saying it's allowed to withhold internal memos as well as information about trade secrets and commercial information. The institution confirmed that a records search found 231 pages of documents pertaining to some of the requests.

...Congress is demanding more transparency from the Fed and Treasury on bailout, most recently during Dec. 10 hearings by the House Financial Services committee when Representative David Scott, a Georgia Democrat, said Americans had "been bamboozled."

Makes sense, to me. I don't know much about Ponzi schemes or pyramid schemes, but it seems that in both cases the payouts always go to those at the top, and come from as the bottom (in this case, the rest of us), who generally don't know exactly who's the top or how much they're making off with.

How much the aptly named Mr. Madoff (pronounced, I kid you not, MADE-off) made off with is being investigated.

A busy stock-trading operation occupied the 19th floor, and the computers and paperwork of Bernard L. Madoff Investment Securities filled the 18th floor.

But the 17th floor was Bernie Madoff's sanctum, occupied by fewer than two dozen staff members and rarely visited by other employees. It was called the "hedge fund" floor, but federal prosecutors now say the work Mr. Madoff did there was actually a fraud scheme whose losses Mr. Madoff himself estimates at $50 billion.

...And the 17th floor is now an occupied zone, as investigators and forensic auditors try to piece together what Mr. Madoff did with the billions entrusted to him by individuals, banks and hedge funds around the world.

This is the question that's bothered me about the bailout. If companies are hundreds of billions of dollars in the hole, provided those dollars actually existed in the first place, then the money has to be somewhere. Right?

Maybe, maybe not. But regulators knew he was making tons of money, even when other firms weren't doing so well, because Madoff bragged to the SEC about how much he earned, even as he advised them on oversight. Somehow the SEC overlooked his shenanigans. But that's mostly likely because of his close ties to regulators.

How did we come to build such a significant chunk of our economy on this?

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Brynn Craffey Brynn Craffey | December 22, 2008 5:03 PM

Yeah, Terrance, and the $300 billion bailout that Congress has promised the failed financial institution who subscribed to these Ponzi schemes comes with no strings attached. CEO and executives are receiving their year-end mega-bonuses. Luxury junkets are proceeding as scheduled. Shareholders are depositing their dividends.

And once again, the American taxpayer foots the bill.

If Congress is expecting taxpayers to socialize the risk, I demand that we also socialize the profits, and give taxpayers a say in who gets how much of a bonus.

Where is the money? In the 1 and 0's of some foreign bank account controlled by those who have owned Bush and this administration since the get go, and the republican congress since Clinton.

Look into such people as Phil Gramm, former senator and all around nice guy, if you are a banker or stock market heavy wanting deregulation. Look at the corporate bankers on wall street who have been living large on 'funny' money that is based on no commodity beyond the slick imaginings of some market whiz kid. Our 'new' economy has been based on cobwebs and gossamer since who knows when; when they started 'playing margins', speculating on future market trends, derivatives and IPO's with hyper inflated values based on speculation and hope, rather than real growth projections.

We have gone from the "gold" standard to the "ghost" standard, since it is built on thin air.

That's right diddlygrl,
Currency is not backed by commodities, just paper, IOU's. I think this country is going to get much, much poorer and the entitlements will finally have to end because just printing the money and running up the deficit or expecting foreigners to continue to loan us the money is not going to last. It's just a dream, and it's very very serious. Politicians are good at selling themselves, but they don't have the answers when it comes to economics gone wild. The dollar is not backed by gold or silver, just fiat currency or paper.

Brynn Craffey Brynn Craffey | December 23, 2008 1:38 PM

Charles, there IS another solution. Raise taxes to fair levels on the wealthy, and make corporations who do business here pay income taxes.

At this time, more than 50% of corporations who profit from American consumers, who benefit from our infrastructure, stable society, hardworking employees, and consumers with a disposable income, pay NO income taxes.

That is simply wrong. If these two groups were both made to pay their fair share, the annual deficit would more than vanish.

Yes, Charles, this is an aspect that the pundits on TV don't talk about that much --- where is the $700 billion coming from? The govt is just printing it with nothing to back it up!

Under normal circumstances, this would be highly inflationary, but in an economy frozen almost solid, it won't be ... until later. What will the US position be in the world economy if five or ten years from now, the US Dollar is worth less than the Mexican peso?

The late Everett Dirksen, US Senator from Illinois, once had a cut e saying about Washington spending: "Gee, you spend a billion dollars here, and anothe billion there, and before long you realize that you are talking about real money."

I'd now like to suggest today's version of this saying: "You print a few $100 billion here, and you print another several $100 billion there, and before you know it, you aren't dealing in real money at all."

It's not just you. Paul Krugman said just about the same thing in a NY Times op-ed last week.

Ever since the creation of the Federal Reserve, a private central banking system, our economy has been entirely based on a house of cards.

Our government, regardless of the party in power, has refused to acknowledge that our IOU based economy can't go on forever. Artificial manipulation of interest rates, inflation of the money supply, massive deficit spending (by both parties but Bush has been particularly bad) and manipulation of people and businesses via tax policy (taxing savings, investment and production instead of consumption) have created the mess we're in, but this is really just a continuation of the stock market bubble. The bubble was just moved from the stock market to real estate.

Then the government makes things worse by mandating that banks use as much discretion against people who are less likely to pay (Community Reinvestment Act 1977, 1995) and via Government Sponsored Entities (Fannie Mae and Freddie Mac) who, because of their state sponsored status, were able to grow well beyond what a true free market competitive system would have allowed (the risk they held would have been spread amongst hundreds or more companies with varying levels of risk tolerance).

"Federal Housing Enterprises Financial Safety and Soundness Act of 1992 required Fannie Mae and Freddie Mac, the two government sponsored enterprises that purchase and securitize mortgages, to devote a percentage of their lending to support affordable housing."

We've proven over the past 100 years that Keynesian Economics doesn't work (Krugman is basically a Keynesian) and that the Austrians were probably correct. If anyone is really interested in this but doesn't want to get bored to tears by it, pick up a copy of Economics in One Lesson and Road to Serfdom. Especially important since schools have mostly taught Keynesianism and the "echo chamber" effect is so great.

Think about this. The total value of bail out money and loan guarantees is now over $46,000 per U.S. Household. $46,000?!! China now holds 10% of our country's debt obligations (they just surpassed Japan). This is nuts but shows how much of our supposed prosperity of the past 30 years was borrowed.

And the real debt number right is over $53 trillion. Google "IOUSA" or look for the 30-minute bit on YouTube to learn just how screwed we all are.

Regards to all.

Read 'The Shock Doctrine' by Naomi Klein and you will see that all of this economic mess we are in is intentional, and we are in for some serious shit

I was reading through here again and wanted to counter something Bryan Craffey posted.

Before I go into this though, it is important that everyone set aside their political bias and the rhetoric that gets thrown about as the two incumbent parties attempt to plunder on behalf of their own constituencies. Let's just logically look at things.

The United States has the 2nd highest corporate tax rate in the developed world (Japan's is higher). When we think about taxes being a "price" that is paid for government services, setting aside whether or not government SHOULD be doing everything it does, if the price moves beyond a certain threshold (overcoming the frictional barriers of moving) then those activities will be conducted in a place where the price is lower. While people will be quick to demonize this behavior, everybody benefits from lower prices which means they can expend dollars on other economic activity that they might otherwise not.

Also, we must consider where the taxes paid by corporations come from and what they do with their profits. The price of each item we buy contains a portion of the taxes that corporation will pay. When we talk about increasing taxes on corporations we are saying increase the cost of the things we buy OR decrease their profits (many don't have profits [GM, FORD, Chrysler, most airlines it seems .. why can't our own companies make any money in America? Another long discussion to have.])

Leftover profits, if the company is public, go to their shareholders or to grow the business. For most publicly traded companies those shareholders are large institutional holders like mutual funds, pension plans and other retirement vehicles. So, when these companies make money and they distribute dividends, A LOT of those dividends end up in people's retirement accounts (including police and school teacher pension funds). The value of those holdings also rises and falls based on earnings.

The next fact we must examine is that the total value of our government debt (current and future existing obligations) now surpasses (a) the value of EVERYTHING our country owns and (b) the earnings ALL OF US will make for the next 8 to 10 years. You can jack tax rates all you want, our elected officials have already bankrupted us and will now attempt to "inflate" their way out of the mess. Inflation of course hurts the poor the most as those at the top of the food chain get the benefit of the inflation (increase in the money supply without a commensurate increase in wealth or production) before the economy adjusts price levels upward to compensate for the devalued currency.

Besides, "The latest data from the Internal Revenue Service show that more than half of all federal individual income taxes—50.8 percent—are paid by the five percent of taxpayers who earn the most." (Tax Foundation)

Considering that infrastructure is not a very big tax item, these people (arguably) utilize the big budget line items of government the least which means we are basically transferring (plundering) from one group to another and we must remind ourselves that the Law is primarily purposed with avoiding plunder (Bastiat), not being a tool for such purpose as it largely is today.

I would argue that without the tax reductions of JFK and Reagan we might not have made it as far as we have. Unfortunately, under Reagan the necessary reduction in government bloat and expense didn't occur and our deficit exploded and has continued to (especially when intellectually honest and removing any current Social Security surplus from the numbers that politicians like to spin).

It is important that people not just parrot the rhetoric of the political class. Keep in mind that most of them are just parroting and haven't really thought for themselves.

Oy Vey!!!!!!!!!!!! Ithis story keeps getting better…... this perfect Ponzi scheme of Madoff (Made-Off) continues to fascinate the world. ….A true financial holocaust… He managed to lose or steal 50 billion dollars, which can't be easy to do no matter how hard you try….. with a busy looking stock-trading operation occupying the 19th floor, of his building…. and the computers and paperwork of Bernard L. Madoff Investment Securities (his name is on the door remember!) filled the 18th floor and on the 17th floor was Bernie Madoff's fraud center, occupied by another two dozen staff members but who must have been blinded by some sort of quantitative trading wizardry in order produce that mind-numbing 10-12%… lol ….It was called the "hedge fund" floor, where the scam was conceived…….. and nobody else knew?????????????? .not the other 2 dozen employees who worked there?????? I smell rotten lox..I actually feel bad for Charles Ponzi ..Ponzi scammers will have to change their name to “Madoff schemers”.and Mr.Ponzi will disappear into the federal prison files….... in researching more about hedge funds I came across a few books that were also fascinating... Hedge Fund Trading Secrets Revealed by Robert Dorfman... and Confessions of a Street Addict by Jim Cramer....both these books take you on a great ride about hedge funds how they make and lose millions…… and expose many other scam practices in this game. Dorfman actually teaches his strategies.

It's my understanding that Madoff's investment vehicle had nothing to do with hedge funds or being a hedge fund. The media largely doesn't know the difference. The New York Times did correctly point out though:

"Mr Madoff was not running an actual hedge fund, but instead managing accounts for investors inside his own securities firm."

Madoff basically had a part of his business that was supposed to be an investment management group, like a mutual fund but his initial trading strategy didn't work and instead of acknowledging the losses and shutting down he perpetrated this massive fraud and the myth that he was some kind of investment genius.

MANY of his investors, KNEW there was fraud involved, BUT, they thought it was a different fraud. They thought he was front-ending his order entry business (ie: getting an order from someone else for 100,000 shares of IBM and putting his own order in ahead of it, letting the large purchase up the stock price 1/8 or 1/4 of a point, then selling). This is how many thought he was getting those returns.

They were okay as long as the fraud was being committed to their benefit in better investment returns. Obviously, not all (or probably even most) thought this, but there were many who figured that is what he was doing.

Of course this kind of fraud goes undetected (or not acted on) by the SEC while they go after people who sell their stock after getting a phone call from someone they may or may not know well who just flat tells them "tomorrow we're going to do something to cost you hundreds of thousands of dollars". If a friend calls me up and says tomorrow the price of cars, a house, televisions or anything else is going up (or down) and you act on that information, nobody puts you in jail.

Also interesting that when we talk about Ponzi schemes, nobody puts Federal Government officials in jail over Social Security. The biggest Ponzi ever.

Milt, stop pretending. We know you're Dorfman, just trying to pump up your book. Get your story straight man.