Michael Hudson: Wealth Creation, or a Ponzi Scheme?


http://michael-hudson.com/articles/financial/081223WealthCreationorPonzi.html <http://michael-hudson.com/articles/financial/081223WealthCreationorPonzi.html>

/Wealth Creation, or a Ponzi Scheme? /

/By Dr. Michael Hudson/

©ISLET/ /

/GlobalResearch
<http://www.globalresearch.ca/index.php?context=viewArticle&code=HUD20081223&articleId=11480>/


Decmber 23, 2008

Last week the Good Lord evidently realized that not enough people
had been reading Hyman Minsky’s explanation of how financial cycles
end in Ponzi schemes – the stage in which banks keep the boom going
by lending their customers the money to pay interest and thus avoid
default. So He sent Bernie Madoff to dominate the news for a week
and give the mass media an opportunity to familiarize newspaper
readers and TV watchers with just how Ponzi Schemes work. What Mr.
Madoff did was, in a nutshell, what the economy as a whole has been
doing under the moniker “wealth creation.”

If the media were able to wait until as late in the financial
collapse as last week to provide helpful diagrams about how Ponzi
schemes need to keep on growing exponentially, it is simply because
bad foreign financial news is not deemed newsworthy in North
America. But Europe has been having its own run-throughs, headed by
Spain – which by no coincidence is now experiencing the biggest real
estate bust outside of the post-Soviet economies.

The best case study occurred two years ago. On May 9, 2006, Spanish
police raided 21 homes and offices of Afinsa Fienes Tangibles SA,
the world’s largest postage-stamp dealer, and rival firm, Forum
Filatélico. They charged eleven men with running a $6.4 billion
pyramid scheme that took in some 343,000 investors – 1 percent of
Spain’s entire population, making the fraud one of the largest in
Spanish history.[1]

An economy either is in trouble or has lost its sense of balance
when investors shy away from tangible capital formation in favor of
buying postage stamps and similar collectibles. Unlike machinery and
technology, stamps do not produce real goods and services. They have
long since been printed and sold by the government, and will never
be used actually to mail letters. However, stamps have shown
themselves to be a great vehicle to attract savers who think that
buying them can produce an exponential earnings growth – or more
technically, “capital” gains, if we can stretch economic terminology
far enough to call a stamp collection “capital.”

If value resulted merely from scarcity, then postage stamps, coins
and master paintings all would seem to increase almost automatically
over time, just like most land does. But these trophies of wealth do
not promote rising production, consumption or living standards. As
stamps do not earn money by employing labor to produce goods and
services, their price gains are neither profit nor capital gains as
classically understood. They are what economists call a windfall.

The Spanish postage-stamp scheme seems to have taken off in 2003,
the year in which Spain’s free-market conservative government
deregulated public insurance and oversight for non-financial
investment funds. Afinsa Group bought two-thirds control of the New
Jersey stamp and coin auction house Greg Manning and merged it with
the Spanish auctioneer Auctentia to create Escala as the world’s
third largest auction house (after Sotheby’s and Christie’s). Escala
moved its operations to New York City and listed its stock on the
Nasdaq over-the-counter market. Despite the stock market’s lethargic
trend, the company’s earnings showed such rapid growth that in just
three years its share price soared from under $5 to $35, tripling in
2005 alone.

Afinsa’s purchases accounted for 70 percent of Escala’s profits,
thanks largely to the fact that as its Spanish parent’s sole
supplier, Escala marked up its stamps by a reported 1,150 percent,
out of all proportion to the usual 25 percent. Afinsa thus was
carrying stamps for which it paid 58 million euros on its books at
€723 million, over ten times their catalog values – which are
fictitiously high in any case, being published mainly for the
benefit of stamp dealers to give their customers the idea that they
are getting a good buy. But as Forum Filatélico’s chairman,
Francisco Briones, explained to a reporter from London’s Financial
Times: “It was ‘normal’ to charge clients such inflated prices
because of the services provided . . . including the custody and
conservation of stamps.”

Afinsa paid its stamp investors an annual rate of 6 to 10 percent
interest, beating most competing yields as the global financial
bubble was pushing interest rates steadily downward. (Spanish
government bonds paid only 3.5 percent.) To build up trust, Afinsa
gave its clients post-dated checks for the gains that were promised.
It also promised to buy back the stamps it sold, at the original
price. This gave an appearance of liquidity to the normally illiquid
market in stamps, fine arts and other collectibles, where 25 percent
commissions to auction houses are normal. These ploys convinced the
majority to simply re-invest the money to buy yet more stamps, which
the company held in its offices ostensibly for safekeeping and
preservation.

Money poured in, giving stock-market investors in Escala much higher
returns than the stamp-buying customers nominally were receiving. As
one news report remarked, why buy stamps and coins when you can
invest in companies dealing in them?[2] But within a week of the
arrests, Escala’s stock plunged below $4 a share.

The denouement came shortly after Lloyd’s of London withdrew from a
€1.2 billion policy to insure Afinsa’s stamps. One of its experts
noticed that if $6 billion really had been invested, it would have
bought up all the investment-grade stamps in the world many times
over. The fact that stamp prices did not reflect any such
extraordinary buying implied that few bona fide stamp transactions
occurred at all, and there had been a massive over-billing.

As matters turned out, most of Afinsa’s stamps had no investment
value. This explained why there were no receipts for transactions
with Escala. The police found €10 million in €500 banknotes (worth
about $650 each at the exchange rate of $1.30 per euro) by breaking
open a newly plastered wall at the Madrid home of Afinsa’s main
stamp supplier, Francisco Guijarro. What they could not find were
any receipts for the stamps that he allegedly bought. And despite
the remarkably high markups charged for curating the stamp
collection, it was rife with phonies, as Lloyd’s had suspected.
Concluding that the bills Senor Guijarro had sent to Afinsa were
just a cover for a money laundering operation, the prosecutors
charged the family members and officers who controlled Afinsa with
embezzlement, money laundering, tax evasion, fraudulent bankruptcy,
breach of trust and forgery.

The arrests recalled memories of a more famous U.S. fraud involving
postage stamps some 86 years earlier, in 1920, by Charles Ponzi –
the man who bequeathed his name to history in the form of Ponzi
pyramid scheme. He is reported to have arrived in Boston in 1903
with only $2.50. Not speaking much English, he took menial jobs.
Fired as a waiter for shortchanging customers, he moved up to
Montreal and became an assistant teller in an Italian immigrant
bank. It grew rapidly by paying double the normal 3 percent rate of
interest on savings accounts, but failed when its real estate loans
began to go bad. The bank’s attempt to give the impression of
solvency seems to have given Ponzi the idea of paying interest out
of new deposit inflows rather than actual earnings.[3] As long as
clients felt they were receiving interest regularly, they tended to
be calm about the principal balance.

Ponzi was sent to a Canadian prison for forgery, and then was jailed
in Atlanta for trying to smuggle Italian immigrants into the United
States. After his release he moved back to Boston and got a job
selling business catalogs. A Spanish customer sent him a postal
reply coupon, which allowed its holder to buy stamps in foreign
countries for return mail rather than using domestic currency to buy
a stamp.

Prices for these coupons were long out of date, having been set in
1907 by the International Postal Union. World War I drastically
shifted exchange rates, enabling buyers to pay a small amount in
Britain – or even less in Germany with its depreciated currency –
and obtain a return stamp order that was good in the United States.

The markup on these tiny postal orders was large. An American penny
could buy foreign stamp orders that could be converted into six
cents in U.S. stamps, for a 500 percent profit. The problem was that
it would take a truckload of such postal orders to make serious
money. A million-dollar investment would involve a hundred million
penny coupons – which then would have to be converted into stamps
and sold in competition with the U.S. Post Office, presumably at a
discount, mainly in immigrant neighborhoods.

Focusing on the principle of arbitrage rather than such laborious
implementation, Ponzi explained that he could make a 400 percent
gain after expenses. He promised that investors could double their
money in 90 days, pretending to take due account of the costs and
shipping time from Europe to America. When his Securities Exchange
Company paid early investors the high returns he had described, they
spread the word to others. Ponzi’s inflow of funds rose from $5,000
in February 1920 to $30,000 in March, and $420,000 by May. By July
an estimated $250,000 a day was flowing into his firm, mainly from
small investors who let their book credits build up rather than
taking out their money. Some people put their life savings into the
plan, and even borrowed against their homes.

Ponzi spent most of the money on himself, buying a mansion and
bringing his mother over from Italy. The financial reporter Clarence
Barron (publisher of Barron’s) noted that if he really had invested
the money as he told his investors he had done, Ponzi would have had
to purchase 160 million postal reply coupons. Yet the post office
reported that few were being bought at home or abroad, and only
27,000 were circulating in the United States.

Federal agents raided Ponzi’s offices in August, but did not find
any postal reply coupons, just as Spanish police did not find
investment-grade postage stamps in the scheme’s 2006 replay. Ponzi
was sentenced to prison yet again, but jumped bail and tried to make
some quick money selling Florida real estate. He soon was
recaptured, and was deported back to Italy upon his release in 1934.

What Ponzi sold was hope, pandering to peoples’ unrealistic desire
to believe that a new way to make easy gains had been discovered,
with no visible upper limit as to how long gains can persist in
excess of the economy’s own rate of growth. It is a measure of how
much harder it is to make returns in today’s world – and hence, how
little hope needs to be excited – that whereas Ponzi promised to
double his investors’ money every three months, the Spanish stamp
scheme paid only a 6 to 10 percent annual return. Neither fraud
actually made any trading gains or profits, but simply paid
investors out of new money coming in from fresh players. New inflows
were treated as earnings. That’s how pyramid schemes work.

It was almost as if the Spanish operators had read one of the
biographies of Ponzi that began to appear as observers noticed the
common denominators between the global financial bubble of the 1990s
and earlier bubbles. These bubbles provide a classic contrast
between the real wealth of nations and what the business press these
days calls “wealth creation” that simply takes the form of rising
asset prices – “capital gains,” most of which are land-price gains.

No doubt stamp collectors would have viewed the bidding up of stamp
prices as wealth creation if it actually had occurred. But all it
would have achieved was to inflate the price of old stamps, much as
the world’s growing ranks of billionaires were bidding up prices for
master paintings and modern art, designer furniture and beachfront
homes. If all the economy’s savings went into Rembrandts and
Picassos, their price obviously would soar, just as putting $6
billion into postage stamps would have established higher plateau
levels for stamp prices.

The flow of funds into any category of assets bid up their prices.
This is true most of all for land, one of the most universal
economic needs and conspicuous-consumption status measures. But does
this really “create wealth”? Do market prices reflect use values,
living standards and the progress of civilization?

The requisite characteristic for such price gains is indeed
scarcity, but not so much that there is not enough for large numbers
of buyers to make a market. If psychological utility is the key,
“scarcity” has value only as a compulsive acquisitive character –
wealth addiction. It means having what other people lack, with
connotations of denial. Most money in search of mere scarcity is not
going into trophies of the nouveau riches, but into the world’s most
abundant yet also most universal scarce resource: land. Nature is
not making any more of it, and global warming in fact threatens to
take away thousands of miles of prime seashore sites. Yet everyone
needs land to live on, making it the object of personal and business
saving par excellence. Even in today’s postindustrial economies,
land and its subsoil wealth represent the largest components of
national balance sheets.

But inasmuch as land cannot be manufactured, savings cannot increase
its supply by active investment. This poses a traumatizing problem
for economists. National income statistics count any money spent
that is not consumed as saving. Following John Maynard Keynes, they
define saving as equal to investment. This sows the seeds of
confusion with regard to the character and preconditions of economic
growth. Can we really call it “wealth creation” when society directs
its savings merely into speculation rather than into building up
productive powers or living standards?

Classical economists vacillated over treating land as a factor of
production or as a legal property right to extract a tollbooth
around a given site and levy an access charge much like a user-tax.
A factor of production contributes to production and income as more
income is invested in it. A rent-yielding property reduces the
economy’s flow of income. In the latter case land is part of the
institutional property system, not the technologically based
production sector of the economy.

What is beyond dispute is that real estate is highly political at
the local level. Urban development tends to be shaped by insider
dealing and public infrastructure spending to increase local
property prices and lobbying to obtain low tax appraisals. It is
axiomatic that the more economically powerful a source of wealth
becomes, the greater its political power to lobby for special tax
advantages. At the national level, real estate uses part of its
revenue to back politicians who give it a widening wedge of special
income-tax favoritism.

In the financial sphere, every bubble has been led by governments.
Bubbles need to be orchestrated by opinion makers, topped by public
officials giving a patina of confidence. The “madness of crowds” is
a euphemism designed to divert blame away from governments onto the
public. In the United States, Alan Greenspan played the role of
public bubblemeister similar to that which Walpole had played in
England’s South Sea bubble and John Law in France’s Mississippi
bubble nearly three centuries ago, in the 1710s.

Today’s balance sheets confuse bubble wealth with real capital
formation. “Investment” has become whatever accountants say they
are. So have asset and debt values, given today’s leeway for
financial fiction. The practice of “marking to market” permits
accountants to project hypothetical gains at astronomical rates of
interest, or trivializing by discounting, applying purely
mathematical functions that have lost all connection to realistic
rates of growth. The result is that the financial sector itself has
become decoupled from the “real” economy.

The tragedy of our time is that saving today is being diverted in
ways that are decoupled from real capital formation, but merely add
to the economy’s debt and property overhead. To distinguish wealth
from overhead, this book starts with real estate, and then reviews
the stock market, advance saving for pensions and health care via a
flow of funds into the stock market to create capital gains. My aim
is to show how different the actual economy is from what economic
textbooks teach. Economic statistics have been hijacked to the cause
of special-interest pleading. All but lost from sight is the common
weal.

Suppose that Ponzi actually had bought International Postal Orders,
and that the Spanish stamp companies actually had invested $6
billion in rare philatelic items and coins, driving up their price
to create paper gains for the investors. To whom would they sell, in
order to take their gains? (This is the proverbial “greater fool”
problem.) More to the point, how positive would have been the broad
economic effect of such asset-price inflation?

The recent stock market and real estate bubbles are much like
pyramid schemes in the sense that what is bidding up stock and
property prices is an exponential inflow of new money from pension
plans and mutual funds (for shares) and bank credit (for real
estate). Venture capitalists are “cashing out” while corporate
managers exercise their stock options.

Suppose that mortgage-packaging companies are honest in their
appraisals of current price trends. The real estate bubble is
nonetheless speculative and postindustrial. The analogy is found
when financial managers endorse government policies that encourage
the inflation of price for stocks and bonds, stamps and coins,
Rembrandts and modern art by claiming that this creates wealth and
hence, by definition, pulls living standards and culture onward and
upward.

What is wrong with this picture? For starters, it fails to define
value as distinct from price, windfall and capital gains as distinct
from earned income. It also neglects the fact that market prices
rise and fall, but the debts remain in place. And when debts cannot
be paid, savings are wiped out.

On May 9, 2006, the price of Escala shares fell by half as news of
the police raids spread. By Friday its stock was down almost 90
percent. On Monday it jumped by 50 percent, from $4.34 at Thursday’s
close to $9.45 a share. Hedge funds were making and losing money
hand over fist, dwarfing the gains and losses made from stamp
trading. A veritable market in crime, punishment and beating the rap
was in play.

What does this have to do with true capital formation? Individuals
are getting rich while the economy is polarizing between creditors
and debtors, property owners and rent-payers. Unproductive
investment occurs when it takes the form of windfall “capital”
gains, and when it involves going into debt for real estate, stocks
or bonds, or “collectibles.” Unproductive credit occurs when
commercial banks make loans that merely finance the purchase of
property, companies or financial securities already in place.

Two centuries ago, French followers of Count Henry St. Simon
outlined an industrial system that was to be based mainly on equity
financing (stocks) rather than debt (bonds and bank loans). Their
idea was to make industrial banking a kind of mutual fund, so that
claims for payment (and hence, the value of savings) would rise and
fall to reflect the economy’s earning power. The industrial banking
that developed largely in Germany and central Europe differed from
the short-term Anglo-American collateral-based trade credit and
mortgage lending. But since World War I, global financial practices
have been more extractive than productive.

The consequence has been that debts on the economy-wide level have
grown more rapidly than the ability to pay. Instead of reducing this
debt overhead by earning their way out of debt, economies have
sought to inflate their way out of debt. However, the mode of
inflation is not the familiar rise in consumer prices, much less
wage inflation. Rather, it is asset-price inflation, emanating
largely from the United States. Since the gold-exchange standard
gave way to the paper dollar standard in 1971, the U.S. economy has
become unique in being able to create credit – and foreign debt –
without constraint. The result has been an unparalleled growth in
debt relative to income, production and wages. This “debt pollution”
has been likened to environmental pollution. It is the financial
equivalent of global warming.

We have entered an era in which financial markets resemble the
stamp-buying funds. Governments have replaced industrial growth with
purely financial wealth creation in the form of a real estate and
stock market bubble. This has turned the economic universe
upside-down relative to what the classical writers expected to
result from the technological progress unleashed by the Industrial
Revolution and its parallel agricultural, commercial and financial
revolutions. Property and credit have become costs instead of a
benefit, institutional forms of rent- and interest-extracting
overhead rather than helpful inputs.

*Notes*

[1] “Spanish dealers raided in stamp probe,” “Fears grow for
lifetime savings” and “World of collecting comes into focus,”
Financial Times, May 10, 2006, and “Stamp groups ‘ran Spain's
biggest scam,’” ibid., May 12, 2006. See also “Stamp-Selling Firms
Charged With Fraud By Spain Authorities,” The Wall Street Journal,
May 12, 2006.

[2] Escala Trades Up, MSNBC.com, May 16, 2006: Rich Duprey,
“Investors buy into the auction house’s claim that it avoided
criminal charges”; THE MOTLEY FOOL, MSNBC, May 10, 2006: Rich
Duprey, “Escala Is Stamped Out: The company’s stock falls more than
50% after a raid by Spanish authorities,” and “Afinsa denies
‘insolvency’ claim,” BBC, May 11, 2006.

[3] See Wikipedia, “Charles Ponzi,” based mainly on Mitchell
Zuckoff, Ponzi's Scheme: The True Story of a Financial Legend
(Random House: New York, 2005).

*Michael Hudson* is a former Wall Street economist specializing in
the balance of payments and real estate at the Chase Manhattan Bank
(now JPMorgan Chase & Co.), Arthur Anderson, and later at the Hudson
Institute (no relation). In 1990 he helped established the world’s
first sovereign debt fund for Scudder Stevens & Clark. Dr. Hudson
was Dennis Kucinich’s Chief Economic Advisor in the recent
Democratic primary presidential campaign, and has advised the U.S.,
Canadian, Mexican and Latvian governments, as well as the United
Nations Institute for Training and Research (UNITAR). A
Distinguished Research Professor at University of Missouri, Kansas
City (UMKC), he is the author of many books, including Super
Imperialism: The Economic Strategy of American Empire
<http://www.amazon.com/exec/obidos/ASIN/0745319890/counterpunchmaga>
(new ed., Pluto Press, 2002) He can be reached via his website,
mh@xxxxxxxxxxxxxxxxxx <mailto:mh@xxxxxxxxxxxxxxxxxx>

*Contact*
mhmichael-hudson.com
www.michael-hudson.com <http://michael-hudson.com/>



__,_._,___
.

Loading