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.

 

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.

Too much debt, too little growth and too low interest rates

 

 
Vivek Kaul

The financial crisis that started in September 2008, after the Wall Street investment bank Lehman Brothers, went bust, led to the economic growth stagnating in large parts of the world.

The central banks around the world tackled this by cutting interest rates to very low levels. The hope was that at low interest rates people would borrow and spend. At the same time, corporates would use this opportunity to borrow and expand. And this would lead to economic growth coming back. QED.
But that is not how things panned out. Instead of prospective consumers borrowing and spending money, large institutional speculators borrowed money at low interest rates in large parts of the Western world and invested it in financial markets all over the world. This excessive inflow of “easy money” has led to bubbles in financial markets in large parts of the world.

This point is made in the latest annual report of the Bank of International Settlements (BIS) based out of Basel in Switzerland. The BIS is often referred to as the central banks of central banks. As the BIS annual report for the financial year ending March 31, 2015 points out: “very low interest rates that have prevailed for so long may not be “equilibrium” ones, which would be conducive to sustainable and balanced global expansion. Rather than just reflecting the current weakness, low rates may in part have contributed to it by fuelling costly financial booms and busts. The result is too much debt, too little growth and excessively low interest rates. In short, low rates beget lower rates.”

This is a very interesting point. What BIS is saying is that low interest rates have led to very little economic growth. At the same time the total amount of global debt has gone up (as can be seen from the accompanying chart). In order, to tackle this low economic growth rate, the central banks have either cut interest rates further or maintained them at their low levels. In fact, several central banks in Europe have also taken their interest rates into negative territory i.e. you have to pay money in order to deposit money with them. Hence, lower interest rates have led to further lower interest rates without creating much economic growth.

As can be seen from the accompanying table, the total global debt has touched around 260% of the global gross domestic product (GDP). In 2008, it was around 230% of the global GDP. It’s a weird economic world that we live in. While the low interest rates did not lead to economic growth as was expected, they did lead to financial market booms.

Interest rates sink as debt soars

As Gary Dorsch of Global Money Trends newsletter puts it in his latest column: “Cheap money encourages more debt and creates financial booms and busts that leave lasting scars on the economy. They underpin both the potentially harmful high risk-taking in financial markets, while subduing risk-taking in the real economy, where investment is badly needed. And while increases in interest rates could cause stock prices to fall, – the likelihood of turmoil is only increased by waiting.”

Long story short—the longer the era of easy money continues, the worse the crash will be, as and when it comes. This is a point that the BIS makes it in its report as well, where it says: “Risk-taking in financial markets has gone on for too long. And the illusion that markets will remain liquid under stress has been too pervasive. But the likelihood of turbulence will increase further if current extraordinary conditions are spun out. The more one stretches an elastic band, the more violently it snaps back.”

This basic elastic-band analogy should tell us very clearly how delicately poised the global economy is with all the excessive debt that has been built up over the last few years, in the hope getting economic growth going again.

The BIS feels that the era of easy money and very low interest rates needs to be reversed as soon as possible. “Restoring more normal conditions will also be essential for facing the next recession, which will no doubt materialise at some point. Of what use is a gun with no bullets left? Therefore, while having regard for country-specific conditions, monetary policy normalisation should be pursued with a firm and steady hand,” the BIS annual report points out.

The question is will the central banks take the risk of raising interest rates in the days to come. The economic recovery (whatever little of it has happened) continues to remain very fragile. And will any central bank governor (or Chairman) take the risk of killing even that by raising interest rates? As John Maynard Keynes once said: “’Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

It is also worth asking here if central banks will sacrifice the short-term for the long-term? As the BIS report points out: “Shifting the focus from the short to the longer term is more important than ever. Over the past decades, it is as if the emergence of slow-moving financial booms and busts has slowed down economic time relative to calendar time: the economic developments that really matter now take much longer to unfold. Meanwhile, the decision horizons of policymakers and market participants have shortened. Financial markets have compressed reaction times and policymakers have chased financial markets more and more closely in what has become an ever tighter, self-referential, relationship.”

The Federal Open Market Committee (FOMC) of the Federal Reserve of the United States is meeting over July 28-29, 2015. Many experts have said time and again that the Federal Reserve will raise interest rates this year. The Fed chairperson Janet Yellen has hinted at the same as well. Let’s see if FOMC comes around to doing that.

The column originally appeared on The Daily Reckoning on July 29, 2015

Central banks are now printing money to repay themselves

3D chrome Dollar symbolIn a recent report titled Debt and (not much) deleveraging the McKinsey Global Institute found that between 2007 and the second quarter of 2014, the total global debt had grown by $57 trillion. The total global debt as of the second quarter of 2014 stood at $199 trillion or 286% of the global GDP.
Government debt constituted a significant portion of this. The total government debt all around the world had stood at $33 trillion as of 2007. It has since jumped to $58 trillion, a jump of $25 trillion, at the rate of 9.3% per year.
What is interesting is that a lot of this government debt is owed to central banks. “Today, the central banks of the United States, the United Kingdom, and Japan hold 16, 24, and 22 percent, respectively, of government bonds outstanding in their countries,” the McKinsey report points out. Governments borrow money by selling bonds.
In the aftermath of the financial crisis that broke out in September 2008, central banks in developed countries started printing money. The idea was to flood the financial system with a lot of money and drive down interest rates. At lower interest rates more people were expected to borrow and spend. This would benefit businesses and in turn the overall economy.
In order to pump the printed money into the financial system the central banks bought both government as well as private sector bonds. And that is how they have ended up with massive holdings of government bonds on their balance sheets.
The central banks of the United States as well as the United Kingdom have stopped printing money and buying bonds. Nevertheless, central banks of a few other countries continue to print money and buy government bonds.
The Bank of Japan is mandated to buy 80 trillion yen worth of government bonds every year against 50 trillion yen. Starting in January 2015, the European Central Bank has also decided to buy up to €720 billion of government bonds in a year. So, in that sense central banks continue to accumulate bonds at a rapid rate.
A central bank gets paid interest by the government on the government bonds that it has in its kitty. This interest that a central bank gets paid is a part of the profit that it makes. The profit is remitted back to the government. Hence, what this means is that the government is basically paying interest to itself on its debt.
“In a sense, this debt is merely an accounting entry, representing a claim by one part of the government on another. Moreover, all interest payments on this debt typically are remitted to the national treasury, so the government is effectively paying itself,” the McKinsey report points out.
If the money that governments owe to their central banks is not taken into account, things start to look a little different. The government debt to GDP ratio in the United States falls from 89% to 67%. In the United Kingdom the number similarly falls from 92% to 63%. In case of Japan, the drop is huge—from 234% to 94%.
What these numbers also tell us is that central banks are printing money to repay themselves. How did this astonishing situation arise? Take the case of Bank of Japan. The Japanese central bank prints money and buys government bonds directly from the government. This helps the government finance its increased expenditure. A part of this expenditure is also repaying the bonds which are maturing. A part of the maturing bonds are held by Bank of Japan. Money is fungible, and hence that means that the Bank of Japan is printing money to repay itself.
This is a weird situation. As John Truman Wolfe writes in Crisis by Design, The Untold Story of the Global Financial Coup, a book published in mid-2010: “How bizarre is it that instead of simply printing the money themselves, governments ‘chose’ to borrow it from their respective central bank. The United States is currently $16 trillion in debt—and the debt is growing at the rate of $49,000 a second! Last year’s interest on the debt here was $454,000,000,000—Why borrow money from the Fed ([which] simply creates it out of thin air by making a book entry and clicking a mouse) when the government could simply print its own without borrowing it and paying interest on it.”
It is now being said that this situation can be set right given that the debt owed to central banks is ultimately an accounting entry. As the McKinsey report points out: “Whether central banks could cancel their government debt holdings is unclear… Another option that has been suggested is to replace the government debt on the central bank’s balance sheet with a zero-coupon perpetual bond.”
A perpetual bond would mean that the government will have to never repay the bond, at the same time it won’t have to pay any interest on it given the zero coupon. While this sounds fancy, this would still mean a default by the government. Governments defaulting on their debt has happened regularly in the past. “Today’s rich European nations, including England and France, defaulted repeatedly from the 14th to the 18th centuries (France did it eight times). Latin American economies defaulted repeatedly in the 20th century, and Argentina has done it once in the 21st. The most recent sovereign debt restructuring was in 2012 in Greece,” the McKinsey report points out.
And any default or a semblance of a default won’t go down well with financial markets all over the world. “Any such move could create backlash in the markets and, in some countries, by policy makers.”
A financial market backlash would mean that bond yields will go up, which in turn will push up interest rates. This is something that the governments of the Western economies can ill-afford at this point of time. Any move up in interest rates will have a negative impact on the economies, which are floundering at this point of time.
Given this, even though it is just an accounting entry, getting out of central bank debt won’t be so easy for western governments.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on Apr 13, 2015

What central banks can learn from the Indian cricket team

BCCI

A few days back, a list of thirty probables who could make it to the Indian cricket team for the 50 over cricket World Cup scheduled in Australia early next year, was declared. Interestingly, only four out of the 15 players who had played for India in the 2011 World Cup, made the cut.
This disbanding of the Class of 2011 led to a lot of nostalgia in the media.
In one such piece published on www.cricinfo.com, the writer said: “The class of 2011 has been well and truly disbanded. Only four have made it through to the 2015 list…For the rest, all we have for now are memories.”
I sincerely feel that instead of being nostalgic about the entire thing we should be happy about the situation. The selection of players is just about the only thing that is currently right about Indian cricket, which remains surrounded by a whole host of controversies.
The players who did not perform over the last few years (the likes of Virender Sehwag, Gautam Gambhir, Zaheer Khan, Harbhajan Singh, Munaf Patel and Piyush Chawla who played in the 2011 World Cup) have fallen by the wayside and have had to make way for a new set of players.
And that is how any market should operate. The non-performers need to be weeded out and not rescued. Nevertheless, that is not how the world at large operates. A great example of this are the financial firms all over the world, which had to be rescued by central banks in the aftermath of the financial crisis that started in September 2008, around the time the investment bank Lehman Brothers went bust.
As Nigel Dodd writes in
The Social Life of Money: “Since the collapse of Lehman Brothers in September 2008, the world’s major central banks have been plowing vast quantities of money into the banking system. The U.S. Federal Reserve has made commitments totalling some $29 trillion, lending $7 trillion to banks during the course of one single fraught week…The U.K. government has committed a total of £1.162 trillion to bank rescues. The European Central Bank has made low-interest loans directly to banks worth at least 1.1 trillion.”
Scores of financial institutions across the United States and Europe were bailed out, nationalized, or simply merged to ensure that they continued to survive. If these financial institutions had not been rescued, the trouble would have spilled over to other financial institutions and from there to the general economy. This would have had a negative impact on the economic growth of the countries which they belonged to. Hence, it was necessary to rescue them. This was the explanation offered by central banks and governments which came to their rescue.
Soon after the central banks came to the rescue of financial institutions a quotation “supposedly” from Karl Marx’s
Das Capital went viral on the internet: “Owners of capital will stimulate the working class to buy more and more of expensive goods…until their debt becomes unbearable. The unpaid debt will lead to bankruptcy of banks, which will have to be nationalized, and the State will have to take the road which will eventually lead to communism.”
As Dodd puts it: “The passage appeared on countless blogs…The quotation was a fake.” Nevertheless, whoever wrote it summarised very well how things had turned out in the aftermath of the financial crisis.
The move to rescue financial firms all over the world built in a huge amount of moral hazard into the financial system. As
economist Alan Blinder puts it in After the Music Stopped : “ [the]central idea behind moral hazard is that people who are well insured against some risk are less likely to take pains (and incur costs) to avoid it.”
Moral hazard, other than encouraging the insiders of the financial system to take on increased risk gives them the impression of the financial system being a safer place to do business in than it actu­ally is. This is because the financial firms assume that in case of a crisis, the government(s) will come to their rescue. And this is not good for the financial system as a whole.
Interestingly, in the aftermath of the financial crisis, the American government passed the Dodd–Frank Act. The Act, prohibits government bailouts and the form of support that the Fed used to bailout AIG and other financial institutions. In fact, when he signed the bill into law, Barack Obama, the President of the United States said: “The American people will never again be asked to foot the bill for Wall Street’s mistakes.” He went on to add that in the time to come, there would be “no more taxpayer-funded bailouts.”
But former Federal Reserve Chairman, Alan Greenspan, does not buy this at all. In his book
The Map and the Territory, Greenspan writes that “most of the American financial system would be guaranteed by the US government,” in the event of the next crisis. He explains his reasoning through an example.
On May 10, 2012, J.P. Morgan, the largest bank in the United States, reported a loss of $2 billion from a failed hedging operation. The loss barely reduced the bank’s net worth. And more than that, the shareholders of the bank suffered the loss and not its depositors. Nevertheless, the loss was considered to be a threat to the American taxpayers and Jamie Dimon, J.P. Morgan’s CEO, was called to testify before the Senate Banking Committee. Why did this happen?
As Greenspan writes: “The world has so changed that this…loss was implicitly considered a threat to taxpayers. Why? Because of the poorly kept secret of the marketplace that JPMorgan will not be allowed to fail any more than Fannie and Freddie have been allowed to fail. In short, JPMorgan, much to its chagrin, I am sure, has become a defacto government sponsored enterprise no different from Fannie Mae prior to its conservatorship.”
Fannie Mae and Freddie Mac were government sponsored financial firms which the United States government had to take over in early September 2008. Greenspan further points out that: “When adverse events depleted JPMorgan’s shareholder equity, it was perceived by the market that its liabilities were effectively, in the end, taxpayer liabilities. Otherwise why the political umbrage and congressional hearings following the reported loss?”
To conclude, this also explains to some extent why global financial firms have been borrowing money at rock bottom interest rates, and investing them in “risky” financial markets all over the world. They know that if things go wrong, the central banks and the governments are likely to come to a rescue.
As Anat Admati and Martin Hellwig write in
The Bankers’ New Clothes: “It is very difficult for governments to convincingly commit to removing these guarantees. In a crisis it will be even more difficult to maintain this commitment and provide no support to institutions that are deemed critical for economic survival. Once a crisis is present, it may even be undesirable to do so, because letting banks fail in a crisis can be very damaging.”
Or as the Americans like to put it You ain’t seen nothin’ yet”.

The article originally appeared on www.equitymaster.com as a part of The Daily Reckoning, on December 10, 2014