Charles Ponzi and Bernie Madoff Would Have Been Proud of the Ponzi Schemes of 2021

Bernie Madoff, the man who ran the biggest Ponzi scheme of all time, died in jail on April 14, 2021, fifteen days shy of turning 83.

A Ponzi scheme is a fraudulent investment scheme in which older investors are paid by using money being brought in by newer ones. It keeps running until the money being brought in by the newer investors is greater than the money being paid to the older ones. Once this reverses, the scheme collapses . Or the scamster running the scheme, runs away with the money before the scheme collapses. 

The scheme is named after an Italian American, Charles Ponzi, who tried running such an investment scheme in Boston, United States, in 1920. He had promised to double investors’ money in 90 days, which meant an annual return of 1500%. At its peak, 40,000 investors had invested $15 million in Ponzi’s scheme.

Not surprisingly, the scheme collapsed in less than a year’s time, under its own weight. All Ponzi was doing was taking money from newer investors and paying off the older ones.

Once Boston Post ran a story exposing his scheme in July 1920, many investors demanded their money back and Ponzi’s Ponzi scheme simply collapsed, as money being brought in by newer investors dried up, while older investors had to be paid.

Madoff was smarter that way. His scheme gave consistent returns of around 10% per year, year on year. The fact that Madoff promised reasonable returns, helped him keep running his Ponzi scheme for decades. But when the financial crisis of 2008 struck, it became difficult for him to carry on with the pretence and the scheme collapsed.  

As I wrote in a piece for the Mint newspaper yesterday, Madoff was Ponzi’s most successful disciple ever. While Ponzi’s investment scheme started in December 1919, it collapsed in less than a year’s time in August 1920. On the other hand, documents suggest that Madoff’s scheme started sometime in the 1960s and ran for close to five decades.

Nevertheless, both Madoff and Ponzi, would have been proud of the Ponzi schemes of 2021. The only difference being that the current day Ponzi schemes are what economist Nobel Prize winning Robert Shiller calls naturally occurring Ponzi schemes and not fraudulent ones like the kind Ponzi and Madoff ran.

A conventional Ponzi scheme has a fraudulent manager at the centre of it all and the intention is to defraud investors and take the money and run before the scheme collapses. A naturally occurring Ponzi scheme is slightly different to that extent.

Shiller defines naturally occurring Ponzi schemes in his book Irrational Exuberance: 

“Ponzi schemes do arise from time to time without the contrivance of a fraudulent manager. Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere. When prices go up a number of times, investors are rewarded sequentially by price movements in these markets just as they are in Ponzi schemes. There are still many people (indeed, the stock brokerage and mutual fund industries as a whole) who benefit from telling stories that suggest that the markets will go up further. There is no reason for these stories to be fraudulent; they need to only emphasize the positive news and give less emphasis to the negative.”

Basically, what Shiller is saying here is that the stock markets enter a phase at various points of time, where stock prices go up simply because new money keeps coming in and not because of the expectations of earnings of companies going up in the days to come.

Ultimately, stock prices should reflect a discounted value of future company earnings. But quite often that is not the case and the price goes totally out of whack, for considerably long periods of time. 

A lot of money comes in simply because the smarter investors know that newer money will keep coming in and stock prices will keep going up, and thus, stocks can be unloaded on to the newer investors. Hence, like in a Ponzi scheme, the money being brought in by the newer investors pays off the older ones. In simpler terms, this can be referred to as the greater fool theory.

The investors buying stocks at a certain point of time, when stock prices do not justify the expected future earnings, know that greater fools can be expected to invest in stocks in the time to come and to whom they can sell their stocks.

Of course, this is not the story that is sold. If you want money to keep coming into stocks, you can’t call a prospective fool a fool. There is a whole setup, from stock brokerages to mutual funds to portfolio management services to insurance companies selling investment plans, which benefit from the status quo. Their incomes depend on how well the stock market continues to do. 

They are the deep state of investment and need to keep selling stories that all is well, that stocks are not expensive, that this time is different, that a new era is here or is on its way, that stock prices will keep going up and that if you want to get rich you should invest in the stock market, to keep luring fools in and keep the legal Ponzi scheme, for the lack of a better term, going.

 — Bernie Madoff 

This is precisely what has been happening all across the world since the covid pandemic broke out. With central banks printing a humongous amount of money, interest rates are at very low levels, forcing investors to look for higher returns. A lot of this money has found its way into stock markets. The newer investors have bid stock prices up, thus benefitting the older investors. The deep state of investment has played its role.

Of course, the counterpoint to whatever I have said up until now is that unless new money comes in, how will stock prices ever go up. This is a fair point. But what needs to be understood here is that in the last one year, the total amount of money invested in stocks has turned into a flood. Take the case of foreign institutional investors investing in Indian stocks.

They net invested a total of $37.03 billion in Indian stocks in 2020-21. This was almost 23% more than what they invested in Indian stocks in the previous six years, from April 2014 to March 2020. This flood of money can be seen in stock markets all across the world.

Clearly, there is a difference, and the stock market has worked like a naturally occurring Ponzi scheme, at least over the last one year.

This Ponziness is not just limited to stocks. Take a look at what is happening to Indian startups…oh pardon me…we don’t call them startups anymore, we call them unicorns, these days. A unicorn is a startup which has a valuation of greater than billion dollars.

How can a startup have a valuation of more than a billion dollars, is a question well worth asking. I try and answer this question in a piece I have written in today’s edition of the Mint newspaper.

As mentioned earlier, there is too much money floating all around the world, particularly in the rich world, looking for higher returns. Venture capitalists (VCs) have access to this money and thus are picking up stakes in Indian startups at extremely high prices.

Many of these startups have revenues of a few lakhs and losses running into hundreds or thousands of crore. The losses are funded out of money invested by VCs into these unicorns.

The losses are primarily on account of selling, the service or the good that the startup is offering, at a discounted price. The idea is to show that a monopoly (or a duopoly, if there is more than one player in the same line of business) is being built in that line of business and then cash in on that through a very expensive initial public offering (IPO).

As and when, the IPO happens, a newer set of investors, including retail investors, buy into the business, at a very high price, in the hope that the company will make lots of money in the days to come. Interestingly, IPOs which used to help entrepreneurs raise capital to expand businesses, now have become exit options for VCs. 

If an IPO is not possible, then the VC hopes to unload the stake on to another VC or a company and get out of the business.

In that sense, the hope is that a newer set of investors will pay off an older set, like is the case in any Ponzi scheme. Of course, this newer set then needs another newer set to keep the Ponzi going.

The good thing is that when investors buy a stock of an existing company or in a new company’s IPO, they are at least buying a part of an underlying business. In case of existing companies, chances are that the business is profitable. In case of an IPO, the business may already be profitable or is expected to be profitable.

But the same cannot be said about many digital assets that are being frantically bought and sold these days. There is no underlying business or asset, for which money is being paid. Take the case of Dogecoin which was created as a satire on cryptocurrencies.

As I write this, it has given a return of 24% in the last 24 hours. An Indian fixed deposit investor will take more than four years to earn that kind of return and that too if he doesn’t pay any tax on the interest earned.

Why is Dogecoin delivering such fantastic returns? As James Surowiecki writes in a column: “There is no good answer to that question, other than to say Dogecoins have gotten dramatically more valuable because people have decided to act as if they’re more valuable.”

As John Maynard Keynes puts it, investors are currently anticipating “what average opinion expects the average opinion to be.” Carried away by the high returns on Dogecoin, the expectation is that newer investors will keep investing in it and hence, prices will keep going up. The newer investors will keep paying the older ones. That is the hope, like is the case with any Ponzi scheme, except for the fact that in this case, there is no fraudulent manager at the centre of it all.

Of course, the only way the value of Dogecoin and many other cryptocurrencies can be sustained, is if newer investors keep coming in and at the same time, people who already own these cryptocurrencies don’t rush out all at once to cash in on their gains.

If this does not happen, as is the case with any Ponzi scheme, when existing investors demand their money back and not enough newer investors are coming in, this Ponzi scheme will also collapse.

– Charles Ponzi 

Given this, like is the case with people who are heavily invested in stocks, it is important for people who are heavily invested in cryptos to keep defending them. Of course, a lot of times this is technical mumbo jumbo, which basically amounts to that old phrase, this time is different.

But this time is different is probably the oldest lie in finance. It rarely is.

And if dogecoin was not enough, we now have investors going crazy about non-fungible tokens (NFTs), which in simple terms is basically certified digital art. As Jazmin Goodwin points out: “For example, Jack Dorsey’s first tweet is now bidding for $2.5 million, a video clip of a LeBron James slam dunk sold for over $200,000 and a decade-old “Nyan Cat” GIF went for $600,000.” The auction house Christie sold its first ever NFT artwork for $69 million, in March.

In a world of extremely low interest rates and massive amount of printing carried out by central banks, there is too much money going around chasing returns.

There aren’t enough avenues and which is why we have financial and digital assets now turning into naturally occurring Ponzi schemes, giving the kind of returns that the original Ponzi scamsters, like Ponzi himself and his disciple Madoff, would be proud off.

Madoff’s scheme delivered returns of 10% returns per year. Ponzi promised to double investors’ money in three months or a return of 100% over three months. As I write this, Dogecoin has given a return of more than 600% over the last one month.

Here’s is how the price chart of Dogecoin looks like over the last one month.

Source: https://www.coindesk.com/price/dogecoin.

 

Ten Things to Remember While Buying a Home

This piece emerged out of a couple of WhatsApp conversations I had over this weekend, along with a few emails that I have received over the last few months.

From these conversations and in trying to answer the emails, I have tried to develop a sort of checklist of things to keep in mind, while buying a home. Of course, as I have said in the past, when it comes to personal finance, each person’s situation is unique, and which is why it’s called personal finance.

Nevertheless, there are a few general principles that can be kept in mind. Also, this list like all checklists, is complete to the extent of things I can think of.

So, let this not limit your thinking and the points that you need to keep in mind.

Here we go.

1) If you are buying the house as an investment (not in my scheme of things, but nonetheless), please learn how to calculate the internal rate of return on an investment. Believe me, you will thank me for the rest of your life.

Also, keep track of the cost of maintaining a house and other costs that come with it. Only then will you be able to know the real rate of return from investing in a house.

Otherwise, you will talk like others do, I bought it at x and I sold it at 2x, and get lost in the big numbers, thinking you have made huge returns. While this sort of conversation sounds impressive, it doesn’t mean anything.

2) Don’t buy a house to generate a regular income. The home rentals in the bigger cities have come down post covid. Even if they haven’t, the rental yields (rent divided by market price) continue to be lower than what you would earn if you had that money invested in a fixed deposit (despite such low interest rates).

Of course, the corollary here is that as a landlord you choose to declare your rental income and pay an income tax on it. Many landlords prefer to be totally or partially paid in cash and choose not to pay any income tax. 

3) From what I have been able to gather from my conversations, people in a few cities are still flipping houses. In fact, the trick is to invest before a project gets a RERA approval and then sell out as soon as the approval comes through. This reminds me of the old days when the builder never really knew the people who ended up living in the homes that had been built.

Anyway, if you are flipping homes, do remember that many people caught in the real estate shenanigans of 2009 to 2011, are still waiting for their homes. Many of them are investors. So, if you are flipping homes, do take some basic precautions like not betting your life on any one deal. As the old cliche goes, don’t put all your eggs in one basket. 

4) Also, do remember that you are an individual and the builder is a builder. While many stories of David beating the Goliath have come out in the media, many more stories of Goliaths having crushed Davids, never made it to the media.

It was, is and will remain, an unequal fight. Do remember that. For a builder this is the life that he leads, you, dear reader, on the other hand, have many other things to do. And you are looking for a home to live in, not a builder to take on. So, be careful.

5) One question that I often get is, which bank/housing finance company should I take a loan from. I don’t think this should matter much. Most big banks and housing finance companies charge similar interest rates. As we say in Hindi, bus unees bees ka farak hai.

So, go to the financial institution which seems to be the most convenient to you.

6) One story being pushed in the media is that you should buy a home now because interest rates are low. Among many dumb reasons for buying a home, this is by far the dumbest. Interest rates on home loans are not fixed but floating interest rate loans. If the cost of borrowing for banks and housing finance companies goes up, so will the interest rate on floating rate home loans.

No one can predict which way interest rates will go in the medium to long-term (That doesn’t stop people from trying. Many economists build careers around this). So, currently, the interest rate on a home loan is around 7% per year or thereabouts. If you are buying a home, make sure that you have the capacity to keep repaying the EMI even at an interest rate of 10% per year. This is very important.

7) How do you structure the amount you pay for the home? What portion of the home price should be a downpayment? What portion of the home price should be your home loan? These are very important questions. The answer varies from person to person. Nevertheless, the one general principle I would like to state here is that don’t dip into your retirement savings as far as possible to pay for the downpayment.

It might seem like a good idea with retirement far away and your parents encouraging you to do so because they did the same and it worked out fine for them. Nevertheless, do remember that on an average the current generation will live longer than its parents, and the family support that your parents had or will have in their old age, you may never have.

8) Also, from the point of diversification, it makes sense not to bet all your savings on making the downpayment for a home. Do remember, no job or source of income is safe these days. Further, do ensure that at any point of time you have the ability to pay six to 12 EMIs, without having a regular source of income.

Other than being able to continue repaying your EMI, it will also help you have some time to look for a job or another source of income, if the current one goes kaput.  Money in the bank, buys you time, which helps you make better decisions in life.

And most importantly, if your EMI is more than a third of your take home salary or monthly income, rest assured you are in for trouble on the financial front.

9) If you want to buy a home to live in, go for a ready to move in home. I have seen completion dates for RERA approved projects going beyond 2025 in Mumbai.

The other advantage with a ready to move in home is that some people are already living there and if there is some problem with the building (not a huge deal in India) then there are many more people who have a stake in solving the problem (as convoluted as this might sound). As always there is strength in numbers. 

10) Finally, be sure why you are buying a home. You want to live close to your place of work. You want your child to have some stability in life. You don’t like the idea of moving homes, every couple of years. And so on.

But please don’t buy a home because your parents, in-laws, extended family or relatives, expect you to do so and it gives them something to chat up on or some meaning to their lives. These are financially difficult times and making the biggest financial decision of your life to impress others, isn’t the smartest thing to do possibly.

To conclude, as I said in the beginning this isn’t a complete list by any stretch of imagination. Each person’s situation is unique. Also, you may not end up with a tick mark on all these points mentioned above and you may still end up buying a home. But the advantage will be that you will know clearly where you are placed in the financial scheme of things.

The points essentially help you think in a structured way to arrive at a decision. They do not make the decision for you. That you will have to do.

PS: Don’t know if you noticed that the terms house and home, have been used at different places. Hope you appreciate the difference between the two. 

On Confidence

Around mid-November 2020, I spoke to a bunch of macroeconomics students at IIM Ahmedabad on data in economics. After I had spoken, one of the questions asked was how can we use data to say things with absolute certainty (or something along similar lines).

My simple straightforward answer to the question was that we can’t. Over the years, economists had ended up portraying their subject as a science simply because it has a lot of mathematical equations built into it. But macroeconomics was always more of an art. Hence, we could say things with a reasonable amount of confidence, but never with total confidence.

I don’t think the student was convinced about what I said. And I don’t blame him for it because in the world that he lives in, economists, investors, analysts, politicians and just about everyone speaking to the world at large, is saying things with total confidence.

Let’s take the case of economists. Their economic growth forecasts are made to the precision of a single decimal point.

If we talk about investors, they forecast a stock market index reaching a particular level in a certain amount of time, with total confidence.

Analysts forecast the price of a stock or a commodity reaching a certain level at a certain point of time.

And let’s leave politicians out of this. Untangling their confidence levels will take a book.

The trouble is all this confidence comes in a world that keeps rapidly changing, where if we stick to our ideas all the time, we will largely turn out to be wrong.

As Dan Gardner writes in Future Babble—Why Expert Predictions Fail and Why Believe Them Anyway:

“The simple truth is no one really knows, and no one will know until the future becomes the present. The only thing we can say with confidence is that when that time comes, there will be experts who are sure they know what the future holds and people who pay far too much attention to them.”

And people pay far too much attention to experts who predict/forecast/comment confidently simply because confidence convinces. The audience is looking for a buy in and nothing helps get that more than the confidence of the expert talking.

Also, in these days of the social media, many a time we are simply looking for a confirmation of something that we already believe in. If the expert ends up saying something along those lines, he tends to become our go to man. Our echo chambers are really small.

Let’s take the case of the investor Rakesh Jhunjhunwala, a man known to make confident bold statements when it comes to the Indian economy and the stock market. He recently forecast that India will overtake China in the next 25 years. As he put it: “You may call me a fool… but I can tell you one thing – India will overtake China in the next 25 years.”

The media and the investors as usual lapped it up, without putting that simple question to him: How?

The Indian gross domestic product (GDP) in 2019 was at $2.94 trillion. And that of China was at $11.54 trillion (World Bank data, 2010 constant US dollars). What this means is that if Chinese GDP stagnates at its current level for the next 25 years, India still needs to grow at 5.62% every year for the next 25 years to get where China currently is.

So, the chances of something like this happening are minimal, given the current state of things. But Mr Jhunjhunwala might know something that ordinary mortals like you and I, probably don’t.

The funny thing is that the Big Bull, as the media likes to call him, has made similar such forecasts in the past, which have gone horribly wrong. In October 2007, he had forecast that the Sensex will touch 50,000 points in the next six to seven years.

And he is not the only one making such forecasts. In June 2014, the domestic brokerage Karvy had forecast that the Sensex will touch 1,00,000 points by December 2020.

People making a living out of the stock market (or any other market for that matter) have an incentive in saying that future will be better than the present is. Many analysts make a living by simply doing this on the business news TV channels, on a regular basis.

The media looking for bold headlines to run, laps it up. And the investors who are more like sheep ready to be slaughtered, follow the sheep in front of them.

In fact, the trick is to make bold bigger forecasts and not small ones. I mean, if you currently forecast that Sensex is going to touch 55,000 points this year, no one is going to pay interest. But if you say Sensex is going to cross 1,00,000 points by 2023 or 2024, everyone is going to sit up and take interest.

An excellent example of this is Jhunjhunwala’s 2014 forecast on the stock market index Nifty touching 1,25,000 points by 2030.

Of course, if he turns out to be right, everyone will be dazzled by the forecast he had made. If he turns out to be wrong, no one will remember. Did you remember that Karvy had forecast the Sensex touching 1,00,000 points by December 2020? That’s how the game is played.

Big investors are trying to drive up stock prices, so that their investment portfolios can also gain in the process, which is why they publicly need to be seen as being confident.

A similar game is now played on the social media where traders claim to have generated a humongous amount of return in a short period of time. Of course, there is no way to verify this, except believing him or her.

This is accompanied by other confident predictions of how the future is going to be. The idea is to sell some training programme that they are offering. And no one is going to buy a training programme from a trader who doesn’t sound confident.

For the economists, the game is a little different. They tend to treat their pet theories as gospel. So, an economist who believes in free markets will keep parroting the free market line on everything.

As Scott Galloway writes in his excellent book Post Corona—From Crisis to Opportunity:

“The libertarian argument… is that…regulation and redistribution is inefficient, that left to its own devices the market will regulate itself. If people value clean rivers, the argument goes, they won’t buy cars from companies that pollute. But history and human nature shows that this does not work.”

An excellent example of this is the river Ganga in India, which people keep polluting despite the fact that at the same time they look it as a holy river.

Galloway offers a few more examples. “Nobody wants to see children working eighteen hours a day in a clothing factory, but at the H&M outlet, the $10 T-shirt is an unmissable bargain… Nobody wants to die in a hotel fire, but after a long day of meetings, we aren’t going to inspect the sprinkler system before checking in.” The point being that some sort of regulation is necessary.

There is economic theory and then there is how things play out in real life. As Adam Grant writes in Think Again—The Power of Knowing What You Don’t Know: “In theory confidence and competence go hand in hand. In practice, they often diverge.”

Other than continuing to believe in their pet theories, there is one more reason for economists to portray confidence. Over the years, they have sold their subject as a science, if not to others, at least to themselves in their heads. I mean the first step before convincing anyone else is to convince oneself first.

Hence, the economic growth figure is forecast to the precision of one decimal point. I have always wondered about how economic growth, which is something very complex and is impacted by so many factors, can be forecast in such a precise way.

Now, this is not to say that the forecasting economic growth is not important. It is very important, simply because without that governments and corporations won’t be able to plan for the future.

Without knowing the economic growth number for the next year, a government wouldn’t be able to forecast its fiscal deficit or the difference between what it earns and what it spends expressed as a percentage of the country’s GDP. Without forecasting the fiscal deficit, the government wouldn’t know what kind of money it has to borrow in order to meet this gap. Without the government knowing the government’s borrowing target, the country’s central bank won’t be able to set the country’s monetary policy. And so on.

Nevertheless, the world would be a much better place if the economists started forecasting in ranges. Like, in 2020-21, the Indian economy is likely to contract by 8-10% or even 8-9%, rather than saying something as specific like the Indian economy is likely to contract by 8.3%.  In this scenario, the governments could also forecast a range when it comes to their fiscal deficit.

As John Maynard Keynes is said to have supposedly remarked: “It is better to be roughly right than precisely wrong.”

Hence, forecasting ranges and pointing towards the right direction is more important than being extremely precise about the economic growth.

As Tom Bergin writes in Free Lunch Thinking—How Economics Ruins the Economy:

“If economic models or theories can point us in the right direction and give us a reasonable estimate of the scale of a force or impact, they’re helpful. For example, if consumers are building up levels of personal debt that will require ever-rising house prices and wages to sustain – think the United States in 2006 –economists don’t need to tell us exactly how much a drop in GDP this situation will likely result in. If they can simply show the risks are unsustainable and material, this can prompt and inform government action and protect society.”

I learnt this the hard way. In 2013, when I first started writing about real estate, looking at the situation at hand, I started predicting a real estate bust very confidently. In the years to come, I turned out to be partly right, with parts of the country seeing a substantial fall in prices.

But the deep state of Indian real estate (the bankers, the builders and the politicians) essentially ensured that a real bust never really came. Of course, having learnt from this, now I point out more towards the perils of owning real estate at a price you cannot really afford because that is point people looking to buy a house to live in, essentially need to understand.

Also, one can more confidently say that the real estate sector will continue to remain moribund in the days to come, than confidently predict a bust. As far as investors are concerned, the real estate story has been over for a while.

Sometimes the confidence of economists comes from the prevailing narrative. As Daniel Acemoglu and James A Robinson write in Why Nations Fail – The Origins of Power, Prosperity and Poverty:  

“The most widely used university textbook in economics, written by Nobel Prize-winner Paul Samuelson, repeatedly predicted the coming economic dominance of the Soviet Union. In the 1961 edition, Samuelson predicted that Soviet national income would overtake that of the United States possibly by 1984, but probably by 1997. In the 1980 edition, there was little change in the analysis, though the two dates were delayed to 2002 and 2012.”

Of course nothing of this sort happened, and the Soviet Union broke up in December 1991. But those were the days, and the narrative framed around the success of the Soviet style of economics, driven by its Five-Year Plans, was very popular. Samuelson was not the only one to be seduced by it. In fact, an entire generation was.

Interestingly, the economist Phillip Tetlock has carried out extensive research on experts and their predictions. Gardner, from whose book I have quoted above, documents this in Future Babble.

As he writes:

“Tetlock recruited 284 experts— political scientists, economists, and journalists—whose jobs involve commenting or giving advice on political or economic trends…Over many years, Tetlock and his team peppered the experts with questions. In all, they collected an astonishing 27,450 judgments about the future.”

It turned out that the expert predictions were no more accurate than random guesses. As Gardner writes: “Experts who did particularly badly… were not comfortable with complexity and uncertainty. They sought to “reduce the problem to some core theoretical theme.” This means that they had this one big idea and they stuck to it, without trying to realign their view to the new information coming in.

An excellent example of this is all the gold bulls who came out of the woodwork post the financial crisis of 2008. They talked about gold reaching very high price levels (The highest I encountered was $55,000 per ounce).

As a journalist I interviewed many such individuals and the confidence they had in their forecasts was amazing. In that round, gold didn’t even touch $2,000 per ounce. But the audience lapped the interviews I did. Why? Because these experts exuded confidence in their interviews, even though they eventually turned out to be wrong.

In 2012, when I turned into a freelance writer, I exuded the same confidence on gold while writing about it. And when the prices actually started to fall, it sort of struck at a core belief I had developed over the years and it took me a couple of years to get around to the whole thing.

As Grant writes: “When a core belief is questioned… we tend to shut down rather than open up. It’s as if there’s a miniature dictator living inside our heads, controlling the flow of facts to our minds.” This is referred to as totalitarian ego and a decade later I can see this ego among many bitcoin experts, whenever one questions the entire idea of bitcoin as money, and that has me worried.

Now getting back to Gardner and Tetlcok. Experts who did better than the average of the group that Tetlock had recruited had no template or no big idea. They tried to synthesise information from multiple sources.

As Tetlock writes: “Most of all, these experts were comfortable seeing the world as complex and uncertain—so comfortable that they tended to doubt the ability of anyone to predict the future. That resulted in a paradox: The experts who were more accurate than others tended to be much less confident that they were right.”

This explains why most business TV news anchors, podcasters, YouTuber, social media influencers, etc., who are popular, sound very confident. They believe in this one big idea, which sounds sensible to people, irrespective of whether it is right in the real world or not, and they keep hammering it over and over again, to their audience.

It also explains why guys who are normally right about things aren’t really popular with the media or the public at large. This is simply because they are not totally confident about what they are saying. They have their ifs and buts built into what they say and are constantly revising the information in their heads. And as and when they feel like it, they are ready to revise their views as well. This constant revision comes across as lack of confidence to the world at large. Tetlock called such experts foxes and experts who believed in that one big thing as hedgehogs.

The categorisations were from an essay written by political philosopher Isaiah Berlin, in which Berlin had recalled a small part of an ancient Greek poem. “The fox knows many things… but the hedgehog knows one big thing.” After knowing this, it is easy to figure out who is a fox and who is a hedgehog.

As Gardner writes:

“If you hear a hedgehog make a long-term prediction, it is almost certainly wrong. Treat it with great skepticism. That may seem like obscure advice, but take a look at the television panels, magazines, books, newspapers, and blogs where predictions flourish. The sort of expert typically found there is the sort who is confident, clear, and dramatic. The sort who delivers quality sound bites and compelling stories. The sort who doesn’t bother with complications, caveats, and uncertainties. The sort who has One Big Idea.”

Hence, the kind of expert found in the media is the kind of expert who is more likely to be wrong. One of the key findings that emerged from Tetlock’s data was: “The bigger the media profile of an expert, the less accurate his predictions are.”

In a world filled with confident forecasts, this is a very important point that needs to be kept in mind. If we really need to make sense of the world we are in, we need to figure out who the foxes are and follow them, however mentally disconcerting it might be. The hedgehogs need to be discarded.

Central Banks, Helicopter Money and How Not to Spot Bubbles

The idea for this piece came after reading the latest edition of Dylan Grice’s fantastic newsletter Popular Delusions. It took my mind back to some stuff I had written about, a while back, in the second volume of the Easy Money trilogy. Now what do they say about the more things change the more they remain the same?

Anyway, Grice’s latest newsletter starts with a comment made by Jerome Powell, the current Chairman of the Federal Reserve of the United States, the American central bank.

As Powell said on CNBC:

“The big picture is still that we’ve seen … three decades, a quarter of a century, of lower and more stable inflation and we’ve seen really the last decade be characterized by global disinflationary forces and large advanced economy nations struggling to reach their 2% inflation goal from below.”

He further said:

“If the economy reopens, there’s quite a lot of savings on peoples’ balance sheets… you could see strong spending growth and there could be some upward pressure on prices. Again though, my expectation would be that that would be neither large nor sustained.”

How do we interpret the above statements in simple English?

1) What Powell is basically saying here is that all the money printing carried out by central banks across the world over the last decade, hasn’t really led to high inflation. In fact, the inflation has constantly been less than the 2% level targeted by the Western central banks (a disinflationary environment as Powell put it).

And he is right. Take a look at following graph which basically plots inflation in the United States, as measured by the core personal expenditures index excluding food and energy. This is the index followed by the Federal Reserve when it comes to inflation.

Since 2008, the year when the financial crisis broke out, the only year in which inflation in the US touched 2%, was 2018. Clearly, the trillions of dollars printed by the Fed since then haven’t led to a high inflation at the consumer level.

I clearly remember that when the Fed started printing money post the breakout of the financial crisis, many writers (including yours truly) said very high inflation was on its way as too much money would end up chasing the same amount of goods and services, and this would drive up prices. But nothing like that happened. (The good bit is that the newspaper I wrote all this in, has since shutdown. So, finding evidence of it won’t be easy :-))

2) Powell also said that while he expects some inflation as people go back to leading normal lives once again post covid, but that’s not something to worry about because it would neither be large nor sustained. Hence, Powell expects the inflation to rise and then settle down.

This leads to the question why inflation has continued to remain less than 2% all these years through much of the Western world, despite the massive amount of money printing that has been carried out.

In an essay written in 1969, the economist Milton Friedman came up with the concept of the helicopter drop of money. As he had written in the essay:

“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community.”

The idea here was to distribute money to the public, so that they got out there and spend it, in the process creating inflation and economic growth.

The money printing carried out by the Federal Reserve and other central banks in the recent past and since 2008, was supposed to be a version of this helicopter drop. Of course, there was no helicopter going around dropping money directly to citizens, but central banks printed money and pumped that money into the financial system by buying bonds.

This was supposed to drive down interest rates. At lower interest rates people were supposed to borrow and spend, as they had before the financial crisis, and companies were supposed to borrow and expand.

The hope was that the increased spending would create some inflation and some economic growth along the way, like a helicopter drop is expected to.

The trouble with this argument is that it doesn’t take a basic factor into account, which is, when the money is being dropped from a helicopter, who is standing under it. The point being that people standing under the helicopter are likely to collect the money before others do and this changes the situation.

In fact, this possibility was first observed by Richard Cantillon an Irish-French economist, who lived in the seventeenth and the eighteenth century, before the era of Adam Smith as well as helicopters. Clearly, economists of the modern world, have forgotten him, which is hardly surprising given that economists these days rarely read any history.

When central banks print money, they do so with the belief that money is neutral. So, in that sense, it does not really matter who is standing under the helicopter when the money is printed and dropped into the economy, but Cantillon showed that money wasn’t really neutral and that it mattered where it was injected into the economy.

Cantillon made this observation based on all the gold and silver coming into Spain from what was then called the New World (now South America). When money supply increased in the form of gold and silver, it would first benefit the people associated with the mining industry, that is, the owners of the mines, the adventurers who went looking for gold and silver, the smelters, the refiners, and the workers at the gold and silver mines.

These individuals would end up with a greater amount of gold and silver, that is, money. They would spend this money and thus drive up the prices of meat, wine, wool, wheat, etc. Of course, everyone in the economy had to pay these higher prices. ((I came to know of this effect from Dylan Grice, after having interviewed him many years back and then starting to read his newsletter regularly).

The Cantillon effect has played out since 2008. When central banks printed and pumped money into the financial system, the large institutional investors, were the ones standing under the helicopter.

They borrowed money at cheap rates and invested across large parts across the world, fuelling stock market and bond market rallies primarily, and a few real estate ones as well.

As economist Bill Bonner put it in a 2013 column:

“The Fed creates new money (not more wealth … just new money). This new money goes into the banking system, pretending to have the same value as the money that people worked for. And people with good connections to the banks take advantage of the cheap credit this new money creates to aid financial speculation.”

After the large institutional investors came the corporates, who were expected to borrow money and expand, and create jobs and economic growth in the process. What they did instead was borrow money to buyback their shares.

When companies announce a decision to buyback their shares, it pushes up the possibility of their earning per share going up and this leads to higher stock prices, benefitting the top management of the company who owns company stock. Of course, the company ends up with lesser equity and more debt in the process. But that is a problem for a later date, by which time the top management would have moved on.

So, instead of consumer price inflation, what the world got was asset price inflation, with the values of financial assets, totally out of whack from the underlying fundamentals.

This dynamic has played out again since the beginning of 2020, in the post-covid world. Once the covid pandemic broke out, central banks decided to print and pump money into the financial system, like they had after the financial crisis. The US Federal Reserve has printed more than three trillion dollars and the Bank of Japan has printed more than 100 trillion yen, in the last one year.

And guess who was standing beneath the helicopter this time around? …

But along with this something else happened. The governments of the Western world also decided to send cheques directly to people, so that they could spend money directly and help boost economic activity. .

The trouble was with the pandemic on, people were stuck at homes. Hence, the money got saved and invested. Along with the institutional money, retail money also flowed into financial markets all across the world.

This has sent prices of financial assets soaring. As of March 2, the total market capitalization of the US stock market stood at 191.5% of its gross domestic product. The long term average of this ratio is 85.55%.

As Grice puts it in his latest newsletter:

“As the stock market makes new all-time highs… The IPO market is hot, credit markets are hot, commodity markets are hot, the crypto markets are hot. Everything, it seems is hot.”

Of course, other than the inflation as the Fed likes to measure it, which continues to be under 2%. And given that, all is well.

In every era when the prices of financial assets go up substantially, people forget history. This is not the first time that the Fed and other central banks are ignoring financial inflation and looking only at consumer price inflation.

Something similar happened both before the dotcom and telecom bubble, which burst in 2000 and 2001, and the sub prime and real estate bubble, which burst in 2007 and 2008. The Fed kept ignoring the bubbles while waiting for the inflation to cross 2%. This time is no different. (For details you can refer to the third volume of the Easy Money trilogy).

Inflation targeting as a policy, worked when inflation was high and central banks wanted to bring it down. This happened right through the 1980s and the first half of the 1990s.

Since the mid-1990s, inflation has been low in much of the Western world thanks to Chinese imports and outsourcing. As Niall Ferguson writes in The Ascent of Money – A Financial History of the World: “Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labour kept down US wage costs.”

This has led to inflation targeting being used in reverse. Instead of trying to control inflation, Western central banks have been trying to create it, using the same set of tools.

As Gary Dugan, who was the CIO, Asia and Middle East, RBS Wealth Division, told me in a 2013 interview:

“We got inflation which was too low. So, we have changed it all around to actually try to create inflation, rather than to dampen it. I don’t think they know what tools they should be using. The central banks are using the same tools they used to dampen inflation, in a reverse way, in order to create it. And that is clearly not working.”

What was true for 2013 is also true for 2021. The playbook of central banks continues to remain the same. As I wrote in a recent piece for the Mint, the whole situation reminds me of the Hotel California song, where The Eagles sang, you can check out any time you want but you can never leave.

The trouble is that along with the money printing there is something else at play this time around. A large part of the global population has been stuck at their homes for more than a year. As they get vaccinated and start living normal lives again, a huge amount of pent-up demand is going to hit the market .

This might lead to inflation as the bond market investors have been fearing for a while, given that supply is not expected to keep up with demand. A higher inflation will mean higher interest rates, something which is not good for the stock market as a whole.

But there is another important factor that needs to be kept in mind. People will be spending their savings . And this means that they will be cashing in on their investments, be it stocks, bitcoin or whatever.

The greater the pent-up demand that hits the market, the higher will be the savings that will be cashed out on and more will be the pressure on the financial markets.

This is an important dynamic that investors need to keep in mind this year.

Bitcoin Without Monetary Ambition is Just Another Ponzi Scheme

There has been a lot of talk around the government banning bitcoin and other cryptocurrencies.

In fact, as the finance minister Nirmala Sitharaman recently told the Rajya Sabha: “”A high-level Inter-Ministerial Committee (IMC) constituted under the Chairmanship of Secretary (Economic Affairs) to study the issues related to virtual currencies and propose specific actions to be taken in the matter recommended in its report that all private cryptocurrencies, except any virtual currencies issued by state, will be prohibited in India.”

There is no scope for confusion in this statement. It’s saying that the government is gearing up to ban all cryptocurrencies including bitcoin. The only cryptocurrencies it will allow are those issued by it. (A government issuing a cryptocurrency is a joke, but then let me not go there for the time being. We will tackle it as and when it happens).

If bitcoin and other cryptocurrencies are banned by the government then all the bitcoin brokers through which investors trade, will need to shut down. Hopefully, the government will allow investors some sort of an exit option.

Of course, if you are trading bitcoin through a broker then you are speculating and do not really believe in the philosophy with which bitcoin was designed and launched (even if you think you do).

Satoshi Nakamoto, the creator (or creators for that matter, given that we don’t know), didn’t like the ability of the government and the central banks to create paper money out of thin air by printing it (or creating it digitally for that matter).

As he wrote on a message board in February 2009: “The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.”

This happened in the aftermath of the financial crisis that broke out in September 2008, after which the Western central banks started printing massive amounts of money to drive down interest rates, in the hope of people and businesses, borrowing and spending money, in order to revive their respective economies.

Nakamoto looked at a central bank’s ability to debase paper money (by creating it out of thin air), as an abuse of the trust people had in it. And Bitcoin was supposed to be a solution for this breach of trust; a cryptocurrency which did not use banks or any third party as a medium and the code for which has been written in such a way that only 21 million units can be created.

The moment you are using a broker to buy bitcoin, you become a part of the conventional financial system and you really don’t remain anonymous anymore as was the idea originally.

A few bitcoin believers who have interacted (a fairly euphemistic word) with me on the social media have told me that there are ways of continuing to buy and sell bitcoin, even if the government bans them. So, they are really not perturbed by the idea of the government banning bitcoin.

The trouble with this argument is that if you continue to trade bitcoin after the ban, you are breaking the law. You might feel that the law isn’t fair, but a law is a law. One way of continuing to trade bitcoin is to legally move money abroad (up to a limit of $2,50,000) and use that money to trade bitcoin.

While this is possible, at some point of time the need to bring money back to India might arise, so, under what head of income will one declare it? If the gains are substantial, won’t the taxman come calling in these days of big data? (Or even if you regularly keep moving a good amount abroad every year).

Believers might still figure out ways to get around the system, but for most normal souls this is not worth the trouble. This is something that the bitcoin believers haven’t gotten their heads around to (yes, yes, yes, have fun stay poor).  Like one individual told me that he can simply bribe the taxman (I mean, yes, you can also do hawala and get your money in cash).

Another factor that needs to be kept in mind here is that the government in the next few years is going to be desperate for tax revenues. I guess I will leave this point here.

The bitcoin brokers in India are desperately trying to spin the usefulness of bitcoin in many interviews in the mainstream media. In fact, in one interview, Sumit Gupta, CEO & Co-Founder of CoinDCX, pointed out that there are 75 lakh bitcoin investors in India. A report in The Times of India puts the number at 1 crore. No source has been provided for these numbers.

The interesting thing is that Gupta feels that “there is a lot of confusion in calling bitcoin as cryptocurrency and not calling it an asset.” He wants bitcoin in India to be considered as an asset and be regulated. He doesn’t want it to be considered as money.

If something like this where to happen, it changes quite a few things.

When an investor buys a company’s stock, he is buying a share in the future earnings of the company. When he buys mutual funds, he is indirectly buying stocks or other financial securities issued by companies or even something like gold. When he buys gold, he buys gold.

When he buys derivatives, he is either hedging against price fluctuation or speculating on the price of a certain commodity. When he buys real estate he buys a home to live in or as a physical asset to profit from in the years to come. I mean one can go on and on here.

(Charles Ponzi on whom the Ponzi scheme is named). 

What does one buy, when one buys bitcoin as an investment asset? Nothing. It would be fair to say that if you take out bitcoin’s or for that matter any other cryptocurrency’s ambition to emerge as a parallel form of money out of the equation, it simply becomes a Ponzi scheme. (Don’t think Gupta realised this while making the point that he did). (You can read why I think bitcoin will never be money, here and here).

A Ponzi scheme is a financial scheme, where a fraudulent promoter promises very high return in a very short period of time to investors. He has no business model to earn this money in order to deliver returns.

The money being brought in by the second set of investors is used to pay off the first set. Or they are encouraged to roll over. As the news of high return spreads, more and more investors get sucked into the scheme, with the greed of earning potentially very high returns driving their investment.

This continues until the money being brought in by the new set of investors is less than the money being redeemed to the older set. Then the scheme collapses. Of course, most promoters disappear with the money before reaching such a stage.

Bitcoin without monetary ambitions is exactly like that. Money being brought in by newer investors pushes the price up, given the limited supply and prices go up very quickly, allowing existing investors to benefit.

As long as money being brought in by fresh investors is higher than money being taken out by existing ones, bitcoin keeps going up. When the equation changes, just like in a Ponzi scheme, bitcoin price crashes.

It’s basically the Ponzi scheme structure of bitcoin which explains its huge volatility on the price front. On February 21, the price of bitcoin was $57,434. Six days later on February 27, it was down by nearly a fifth to $46,345. Or take the period of six days between February 15 and February 21, when the price of bitcoin rose by a fifth (or 20%) to $57,434.

Of course, unlike normal Ponzi schemes, there is technology and thinking behind bitcoin and other cryptocurrencies. But that doesn’t make them any less a Ponzi scheme.

Given this, it’s time that the government steps into ban bitcoin and other cryptocurrencies. India has enough Ponzi schemes to deal with already. There is no point in adding more to the list.