And if you want the truth, here it is. We are still in the middle of a massive Ponzi scheme. Sure, the first phase is over. Governments bailed out the banks. Main Street paid for Wall Street’s excesses. But that doesn’t mean that the scheme is dead and finished with. It just means that the public sector chose to swallow the private sector’s debts. The debts are still there. The bad assets are still there. The same corrupt incentives are still in place. The same degree of profiteering. The same blindness to risk. The same astonishing tolerance for ever-increasing debt.
But don’t think all this means that things are as bad as they ever were. They’re not. They’re worse—much worse. Remember: Ponzi schemes can only operate because of their merry-go-round nature. New dummies providing the influx of funds to pay out the old dummies. But with each cycle, you need more and more dummies—and sooner or later, you’ll be all out of idiots. And when you reach that point, the mountain of debt will only have gotten higher, the clean-up operation more horrendous.
If you think I exaggerate, let’s take a quick tour of the first of our Ponzi scheme ingredients: exponentially increasing liabilities. If you ever see a set of figures which suggests exponentially increasing liabilities, you should think hard about whether or not you might be looking at a Ponzi scheme. A set of figures like those in figure 1.1, for instance.
Figure 1.1: US federal debt outstanding, 1940–2010
Source: Bureau of Economic Analysis, US Treasury, www.usgovernmentspending.com.
Data for fiscal year 2011 estimated.
This graph shows debt issued by the US federal government. It’s adjusted for inflation, so you’re seeing a real increase in total indebtedness, not simply an artificial effect generated by a rise in prices. But really, for the moment, I’d encourage you to put all such technicalities out of your head. If you don’t have an economics degree, don’t worry. If you aren’t a financial expert, it doesn’t matter. Just ask yourself whether this graph suggests that:
the finances of the US government are under control, which is what the government would want you to believe, or
that a Ponzi scheme is approaching its final death-rattle.
If you need a little help in answering that question, take a look at figure 1.2, which shows the federal deficit over time. In the Clintonian 1990s, the deficit hovered either side of the axis. Sometimes the government needed to borrow a little, sometimes it operated in surplus and repaid some of its borrowing. For present purposes, we don’t need to worry too much either way. The point is, net government spending was under control. Over on Wall Street, the first revolutions of the Ponzi scheme were getting under way, but in Washington, money was still reasonably sound (though there were, even then, huge accumulating liabilities which we’ll explore more extensively in a later chapter).
Figure 1.2: The US federal deficit, 1990–2012
Source: Congressional Budget Office. Data for 2011 and 2012 represent CBO projections.
In the George W. Bush years, things got worse. The federal government became habituated to borrowing. Taxes never covered spending—but still, even in 2004, the worst of those years, federal borrowing never breached the $500 billion level. And just as well: $500 billion is a lot of money.
Then came the credit crunch. Lehman, AIG, General Motors—the first, most colorful phase of the current credit crisis. In 2008, the deficit hovered close to $500 billion. The following year, it was approaching $1,500 billion, or $1.5 trillion if you prefer.
Just pause for a moment to consider how much money that is. Numbers that large become difficult to comprehend, because of the absence of obvious comparisons. So let’s look at some big numbers. Table 1.1 sets out some compiled by The Economist: Instead of thinking about the current US deficit in pure numerical terms, think about it in terms of what you could buy for $1.5 trillion. You could buy the entire global stock of monetary gold (that is, excluding gold worn as jewelry and the like). You could get close to buying all the farmland in the United States. Or maybe you’d prefer to diversify a little, in which case you could snap up the whole of Manhattan, the whole of Washington DC, all the military hardware owned by the US armed forces, the fifty most valuable sports teams in the world—and still be able to buy a controlling interest in Apple, Microsoft, IBM, and Google.5 That’s what $1.5 trillion is worth. And remember, that’s not what the government owes (it owes way more than that): it’s how much the government expanded its borrowing in one single calendar year. That was 2009. In 2010, it did the same thing—give or take the odd hundred billion—all over again. And 2011 is predicted to be worse.
Table 1.1: What you can buy for a trillion dollars or three
Source: ‘Who wants to be a triple trillionaire?’, The Economist, April 14, 2011.
In the years after 2011, the deficit is forecast to come down—we’ll look at whether it truly will in a later chapter—but remember, it’s not enough for the deficit to come down. For as long as the government is a net borrower, its debt is expanding. So for things to really start improving, the deficit has to turn negative. The approximately $1.5 trillion which the federal government borrowed in each of the years from 2009 to 2011 will need to be repaid. If it’s not repaid, it’s a Ponzi scheme—and a Ponzi scheme only ever ends one way.
But let’s broaden the scope of our enquiry. This book isn’t about the US federal debt, or even about the US government. It’s about the global economy: Planet Ponzi, not Potomac Ponzi. After all, maybe the federal government is in a mess, but perhaps the monetary authorities have a firm grip on things. Or perhaps things are in a mess in the United States, but they’re in better order elsewhere. Or perhaps the public sector is in poor shape, but the private sector is doing fine.
Figure 1.3: Total assets of the US Federal Reserve, 2001–2011
Source: Federal Reserve.
So let’s take a look. Let’s consider monetary policy. Figure 1.3 shows how the balance sheet of the Federal Reserve has changed over recent years.6 For a good long period, things were completely stable. The Fed’s assets burbled along at a shade over $800 billion. (Its liabilities, of course, are somewhat notional—unlike regular banks, the Fed can print money. Its biggest ‘liability’ is simply notes and coins in circulation.) Then, when the credit crisis struck, the balance sheet started expanding rapidly. From $800 billion to over $2,800 billion. That’s an increase of $2,000 billion—$2 trillion—in little over two years: more than enough to buy all the farmland in the US, or to buy yourself nearly five times as much military hardware as the American military possesses. Where does that increase come from? What financed it? The answer is that those assets were produced by magic. By printing money. The huge increase in the Fed’s balance sheet came from unelected officials choosing to spirit new dollars out of nowhere. And please notice one more thing. The biggest one-off increase in new money came in the immediate aftershock of the Lehman crisis, but the response has not been a one-off. The Fed’s balance sheet has been creeping up from late 2010 right through to mid-2011. Item one on our list of Ponzi ingredients was exponentially spiraling debt—and please tell me that you can look at these graphs and see any other pattern emerging.
As for the world beyond the US: there is a crisis in Europe. Greece is bankrupt, Ireland and Portugal not far behind. The bond market is currently raising serious doubts about the ability of Italy and Spain to fund themselves. Uncertainty has even started to lap at the shores of France, long seen as a ‘strong’ market and now just starting to be reappraised.
Perhaps North American readers will feel insulated from these uncertainties, but they shouldn’t. If one of the three most vulnerable countries—Japan, Italy, or Spain—detonates, the consequences will be felt globally. Bear in mind that Lehman Brothers owed only $0.75 trillion when it went under, and it had assets of over $0.6 trillion. Those sums are trivial in relation to the amounts now in question. Italy owes more than $2 trillion, Japan around
$10 trillion. Italy is, as you may have noticed, a low-growth, poorly governed, somewhat corrupt country with an organized crime problem and a wholly untested and unelected government. Japan is, as you may have noticed, an earthquake-prone country with an aging population, a stagnant economy, a two-decades-old problem with deflation, no energy security, no raw materials, a huge and increasingly assertive neighbor, and a political class that seems perennially unable to implement radical change. Oh yes, and a nuclear mess that isn’t cleared up and seems all set for a tragic replay.
As for the purported health of the private sector: don’t be fooled. At the time of writing, Bank of America, which is the largest bank by assets in the United States, has a stock market capitalization equal to just 25% of its book value.7 A company’s book value is the total accounting value of its assets less the total accounting value of its liabilities. The value of its liabilities is relatively uncontroversial: a company owes what it owes. The value of its assets, however, is much more uncertain. A bank may claim that (let’s say) its mortgage book is worth $10 billion, but perhaps impending delinquencies and defaults mean that its true value is nearer $9 billion, or $8 billion. The fact that the stock market’s coldly calculating eye values Bank of America at just one-quarter of its supposed financial worth speaks volumes about how little faith the market truly has in the firm. And Bank of America is far from unique. Citigroup and JP Morgan Chase also trade at a substantial discount to book value. In Europe, RBS is valued at less than a fifth of book value, Deutsche Bank and Paribas at little more than half. It’s is being reported that RBS is in line for a fresh injection of government funds.8
In short, in the course of this very brief introductory review we’ve found that the US government has exponentially spiraling debts, that the monetary authorities appear to be slaves to the same Ponzi-ish gods, that the debt crisis in Europe is profound and growing, and that some of the major pillars of the global financial sector are worth a fraction of what their accounts would seem to imply. I hope that those reflections at the very least give you pause for thought. Though my central claim is a big one, it’s hardly without evidence.
Naturally, however, we’re going to have to examine these things in more detail. We’re going to take that list of ingredients for a Ponzi scheme and tick them off one by one. Overvalued assets? Check. Deceitful accounting? Uh-huh. Slothful regulators? You betcha. Nor will we confine ourselves to the US. The Ponzi scheme in America may be bad, but it’s a whole lot worse elsewhere—among major nations, I’d say that Japan, Italy, and Spain are far less creditworthy, France and Britain not much better. Even China, with no significant debt at a national level, suffers from an opaque banking system, poor incentives, booming asset markets, and dangerously flawed accounting. We’ll look at all these things in due course.
But that lies ahead. The rest of this book is divided into four sections. The first three parts go through the grim accounting of Planet Ponzi. We’ll look in turn at Washington, at Wall Street, and at the wider world. We won’t only look at mounting debts—the liability side of our global balance sheet; we’ll look at the asset side too. Ponzi schemes are reliant on an ever-swelling basket of hopelessly misvalued assets. When we turn to look at some of the major markets around today, we’ll see misvaluation or bubbles on a gigantic scale. Misvaluation in the housing market. Misvaluation in the equity market. Misvaluation to a dangerous degree in the bond markets. Those things might sound dryly technical, but then things can’t get more dryly technical than CDO-squared structures in the subprime mortgage market. Those technicalities, however, ended up wrecking your economy and trampling your future. Sometimes technicalities matter.
Finally, Part Four looks at ‘Solutions.’ That’s a bad title, actually: there are no solutions. You don’t solve a Ponzi scheme; you end it. That means huge deleveraging resulting in huge losses: the resulting, wrenching dislocations are inevitable. There was no way the authorities could make right what Charles Ponzi did, or what Bernie Madoff did. People lost mountains of money, and all you can do at that stage is send the perpetrators to jail and start to repair the damage.
All the same, there are things that policymakers could do right now to limit the coming carnage. There are also things that you personally can do to protect yourselves and your families. They’re things that I’m doing too. This book holds back no secrets. There’s been too little candor for two decades and more, and truth remains the single best antiseptic. At the end of this book, I’ll set out a personal action plan for you to follow. But because books move more slowly than the financial markets, I’ll also keep you updated on my website, planetponzi.com. We’re in this together.
This book is about some complicated things, but I’m going to avoid complexities in talking about them. Unlike the magicians of dodgy accounting, I can say everything I want to say in clear, plain English. If you can handle the graphs we’ve already looked at, you can handle everything else that follows. (Well, OK, full disclosure: when we talk about financial derivatives or pension accounting, I do get a little technical, but not overly so. Those who are interested can explore the sources cited in the endnotes, which will supply greater detail, but there’s no need to do so. It’s your call.)
What’s more, I’m not going to throw any strange numbers at you. I’m going to source my data from impeccable official sources. In most cases, you can go straight to the internet and check my facts. Indeed, I invite you to do just that. The scheme has arisen because not enough people used their native common sense to check up on the claims of so-called experts. If we’re to escape the scheme with the minimum amount of damage, we need to change mindset. People need to become skeptics. We need to learn how to challenge authority, how to get a plain answer to a plain question and not rest until we’re entirely satisfied. At the beginning of this book there are three quotations. One of them is spoken by Jefferson Smith, the Jimmy Stewart character in Mr Smith Goes to Washington. Addressing the US Senate, Smith says:
I’m sorry, gentlemen. I know I’m being disrespectful to this honorable body, I know that. A guy like me should never be allowed to get in here in the first place. I know that. And I hate to stand here and try your patience like this, but either I’m dead right or I’m crazy!
You and I are the same. We’ve never run the government, a major bank, or the Fed; we’ve never borrowed a trillion dollars or ten. Yet by writing this book (for my part) and by engaging with its arguments (for yours), we’re doing as Jefferson Smith did: bringing common sense to bear in an arena that asks us to dispense with it. We’re right to insist. Either we’re dead right or we’re crazy.
In that Smithian spirit, let me tell you more about me and my qualifications. I’m a hedge fund manager, currently raising a new $500 million fund. I’ve been active in the financial markets for more than three decades. I’ve never touched subprime mortgages – I thought they were total crap the first time I encountered them, and I haven’t changed my mind since. In my three decades of work, I’ve had lots of experience, at lots of firms, in lots of market conditions, across three different continents.
And that’s not all. I’ve also sat close to the blast, too close for comfort. On the day the first major bankruptcy of the financial crisis was announced, I was sitting at my desk, working for a major London-based hedge fund firm. And, according to my Bloomberg news terminal, the firm I worked for had just gone bankrupt. It was the first major default of the financial crisis.
Normally, a trading room is a busy place. The phones are constantly ringing. A hundred conversations are happening simultaneously. People shout out for information. Jokes and banter fly around. Not that day. All my colleagues were seeing the same announcement as I’d just seen. Our clients and counterparties too. In an instant, we’d gone from being a busy, thriving firm with a million friends to the pariah nobody wanted to touch. I had friends from New York call me up and ask me if I we were closing, if I was out of work and wanting a job. They weren’t joking. And I was grateful for th
e offers.
At a time like that, you’d expect senior management to be all over the situation. Explaining, acting, taking command of the situation. Maybe that was all going on somewhere behind the scenes, but all I could see was an echoing absence. We didn’t get so much as an email from upstairs. It felt weird, unsettling, even frightening. Everyone working with me felt the same. It was an awful moment.
As things turned out, that initial news report was wrong. The firm managed a number of different funds, and it wasn’t the firm itself that had defaulted on its debt, but one of the funds it managed. (Not, I hasten to add, the one that I took care of. My investors made plenty of money; they usually do.) So as far as most of my colleagues and the broader market was concerned, life moved on. The bankrupt fund was ring-fenced and had no further impact on the firm. Everything else continued as normal.
But not for me. I’d long thought that the world had gone crazy. A giant credit bubble had been inflated and there was too much debt everywhere. Governments were borrowing too much. So were households. Worse still, banks, hedge funds and investors – the people who are paid to be the voice of prudence in these matters – had changed personality. There were far too many lousy assets being created, bought and sold. When I started out on Wall Street, bankers were there to guard credit standards. Now, far too much of the time, they were the people most actively trashing them. The almost-bankruptcy that passed by my desk that day – the silence that fell over that dealing room – felt like a warning of what lay ahead. I realized I needed to change my life. I’m no longer part of the firm whose fund failed that day. I’m now sure of being able to look after my investors because I’m my own boss: I make my own rules and set my own standards.
Planet Ponzi Page 2
