The Biggest Ponzi Scheme Ever Conceived


On the eve of the Fed’s new round of money printing, PIMCO’s Bill Gross sounded the alarm about how our public debt is financed. Pacific Investment Management Company, LLC. is the world’s largest private bond investor. This quote is from his Run Turkey, Run

Check writing in the trillions is not a bondholder’s friend; it is in fact inflationary, and, if truth be told, somewhat of a Ponzi scheme. Public debt, actually, has always had a Ponzi-like characteristic. Granted, the U.S. has, at times, paid down its national debt, but there was always the assumption that as long as creditors could be found to roll over existing loans — and buy new ones — the game could keep going forever.

Sovereign countries have always implicitly acknowledged that the existing debt would never be paid off because they would “grow” their way out of the apparent predicament, allowing future’s prosperity to continually pay for today’s finance.

Now, however, with growth in doubt, it seems that the Fed has taken Charles Ponzi one step further. Instead of simply paying for maturing debt with receipts from financial sector creditors — banks, insurance companies, surplus reserve nations and investment managers, to name the most significant — the Fed has joined the party itself. Rather than orchestrating the game from on high, it has jumped into the pond with the other swimmers. One and one-half trillion in checks were written in 2009, and trillions more lie ahead. The Fed, in effect, is telling the markets not to worry about our fiscal deficits, it will be the buyer of first and perhaps last resort. There is no need — as with Charles Ponzi — to find an increasing amount of future gullibles, they will just write the check themselves.

I ask you: Has there ever been a Ponzi scheme so brazen? There has not. 

When most Americans think about Ponzi Schemes, I’m sure it’s Bernie Madoff who comes to mind, not federal government financing. Bill Gross describes the similarities well, but you should also read this more formal definition from the Securities and Exchange Commission—

Charles_ponziWhat is a Ponzi Scheme?

A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.

Why do Ponzi schemes collapse?

With little or no legitimate earnings, the schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out.

How did Ponzi schemes get their name?

The schemes are named after Charles Ponzi (shown above left), who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. At a time when the annual interest rate for bank accounts was five percent, Ponzi promised investors that he could provide a 50% return in just 90 days. Ponzi initially bought a small number of international mail coupons in support of his scheme, but quickly switched to using incoming funds to pay off earlier investors.

Government bond issuance differs from run-of-the-mill Ponzi Schemes created to rip-off investors for private gain. In the government case future economic “growth” is assumed to pay for current financing needs, as Bill Gross points out. Taking a benign view, we might look upon such debt financing as a Ponzi Scheme undertaken for a good cause—higher standards of living in the future.

However, sometime in the last decade—we had a balanced budget in the year 2000—government debt financing grew disproportionately large just as the structural basis for economic growth was being undermined (e.g. by the Housing Bubble, by growing Medicare costs). With growth in doubt, as Gross said, there is no longer a sound basis for continuing the previous arrangement. The typical “benign” Ponzi Scheme governments routinely engage in has thus become a malignant cancer in the United States, and may now be perceived as a danger to those vested in it (listed below).

Ponzi Schemes collapse when participants refuse to roll over their investments, seeking to cash out instead. Alternatively, a Ponzi Scheme will collapse when new participants can no longer be found, and current investors refuse to up the ante. However, that’s not a problem in the case of our federal government now that our Central Bank has stepped in as the buyer of last resort. Smiley_glasses

Who are the major investors in the biggest Ponzi Scheme ever conceived? 50plusfinance.com took a recent snap shot. Here are the top 15 bond holders in reverse order by amount invested as of June, 2010—

15. Taiwan:  $130.2 billion
14. Hong Kong:  $137.8 billion
13. Carribean Banking Centers:  $159.1 billion
12. Brazil:  $165.0 billion
11. Oil Exporters:  $226.6 billion
10. Insurance Companies:  $260.6 billion
  9. Depository Institutions:  $273.7 billion
  8. United Kingdom:  $448.8 billion
  7. State and Local Governments:  $534.7 billion
  6. Pension Funds:  $643.8 billion
  5. Mutual Funds:  $648.6 billion
  4. Japan:  $836.6 billion
  3. China:  $868.4 billion
  2. Other Investors/Savings Bonds:  $1.266 trillion
  1. Federal Reserve and Intragovernmental Holdings:  $5.345 trillion

The amounts shown here are subject to constant change, so current numbers may differ for each type of bondholder. I described intragovernmental holdings in detail in my post Ten Trillion And Counting.

Most of you have probably seen various “dollar collapse” scenarios. There are more and more of these kind of stories surfacing on the internet now that the Fed is debasing the currency and monetizing the debt, public spending remains out of control, and Fed funds rate is stuck at the zero bound. I don’t simply dismiss such stories, but only want to remind you that each of them is a variation on the same theme— the collapse of the Ponzi Scheme Bill Gross describes.

I’ll take a closer look at dollar collapse scenarios in the near future. Until then, enjoy the weekend!

The Decline of the Empire