Modern Capitalism: How Is This Different Than a Ponzi Scheme?

Introduction: The Ponzi Scheme

If you Google “Ponzi Scheme” you will get this result:

“Ponzi scheme (n): A form of fraud in which belief in the success of a non-existent enterprise is fostered by the payment of quick returns to the first investors from money invested by later investors”

Running a Ponzi Scheme is illegal. It is illegal because it is considered a form of fraud, that the perpetrator of the scheme deceives investors with false statements about the nature of the business and what produces the returns. While the perpetrator may tell their clients that they are investing in a certain type of security, or financial product, or focused on some hot new industry sector, they are in fact just finding new investors to buy into the scheme, using the new investor's capital to pay returns to the original investors, which gives the illusion of investment returns. This process is repeated as long as possible, but it inevitably leads to a crash of the operation when the perpetrator cannot find enough new investors to pay back the old ones.

The man himself, Charles Ponzi. I trust him (image from biography.com)

Unfortunately when I , the cynic that I occasionally am, think of a the dominant economic philosophy of the Western world, I come up with pretty much the same description.

Looking at the current banking business model, no doubt the heart of our capitalist economic system, it is roughly the same idea with a few key differences. Modern banks are considered to be real businesses despite the fact that they essentially do the same thing as a Ponzi scheme, take capital from one person and give it to another. They rearrange money. They do have a different (and I will say more intelligent) approach in that their profits are not derived from simply lying to customers. They do that too, and they do turn quite a bit of profit from their fee structures which more adversely affects their poorer customers... but anyway. The essence of their business is charging interest for loaning money to others at a greater rate than they pay it out to their investors using the difference to pay their expenses and collect some profit. It is still rearranging money, just buying and selling it a different prices, a game of arbitrage. But at least it usually has the effect of extending the longevity of the operation.

The bank's business model essentially outsources the task of finding more areas of monetary growth to their borrowers, whereas the Ponzi scheme relies on its internal sales/investor recruitment efforts team, thereby spreading out the risk. Thus, there are higher odds that the borrowers will repay their loans with interest than the Ponzi scheme has of continuing to find enough new investors buying in, especially with the immodest interest rates Ponzi schemes have to pay out. But the banking business still relies on the same flawed principle as a Ponzi scheme, that perpetual growth is possible.

If one day enough of the bank's borrowers, each in search of their individual growth, cannot repay their loans, because they can no longer find enough avenues to turn the money into more money, the bank will fail. Social Security in the US, by the way, works exactly the same way. The current generation of employees (the new investors) pay for the benefits of the retired folks who had previously paid into the system (the original investors). The current generation will only get their money back if another future generation continues to work and pay into the system. If in future generations there is not enough new labor and therefore new social security revenue to pay out the current retired persons, then the liabilities will exceed the assets and the system will go bust. Banks, Social Security, and Ponzi schemes all rely on perpetual growth.

I'll add here that the largest and most infamous Ponzi scheme in US history never collapsed, as such. According to Forbes, Bernie Madoff began running his scheme in the 1970s all the way until late 2008 when he confessed to his sons that it was all a lie. He was never actually caught, he just confessed one day. The scheme didn't crumble until he was arrested and everyone realized there wasn't enough money to pay all the investors back. The point of this being that it is possible to pass off a shrewdly-run Ponzi scheme as a legitimate investment fund for decades.

The Illusion of Growth

Intuitively, I think most people would agree unlimited growth is not possible. While the universe is expanding, no new matter or energy is being created, it is just moving farther away from the center. The Earth, more specifically, only contains so much stuff and any gains or losses of matter are immaterial. We can transform and reshape the stuff we have, and we certainly do that in rather incredible ways, but we are definitely rearranging and not creating wholly new matter. The sun, perhaps the one exception, is expected to continue to provide energy for another billion years and that is enough time for me to say it's basically unlimited. All other economic inputs, however, are limited.

So aside from processes derived from sunlight, the economic (read: on paper) growth that we have been experiencing since the fifteenth century when Western society started accounting on paper for all this economic activity, has actually been rearrangement and an on paper monetization of stuff that already existed. An example here will help in understanding this concept: An oil reserve existed underground beneath an area of land stolen from a group of natives who lived there. On paper, when the natives lived there the oil reserve is worth nothing. Then a company pays a small fee for ownership or extraction rights to the government which claimed the land, and suddenly and magically the land and the oil reserve now have economic value – specifically the company would record on their balance sheet the value of the land as the price of the small fee and the government would also record revenue for the fee received – though all that actually happened was some papers promising various things were signed and exchanged between the company and the government. On paper growth has occurred but the objective reality is that nothing has happened. Value was simply given to something which previously had not been valued.

The process continues as oil is extracted and barreled as crude oil and it is now worth more. Then it gets treated and refined into various products like gasoline and it is worth even more as it can now be used to power an automobile. Value, in an economic sense, has without a doubt been created at each step in this process, as evidenced by the fact that other people will pay more for a gallon of gasoline than they will a gallon of unextracted crude oil still in the ground. But I find it hard to call this “growth”.

One reason it's hard to call this growth is that when this process is done we have consumed something with potential value, the oil reserve, and converted it to something of no value, CO2 in the air and other worthless bi-products. So while the company(ies) involved in that process can claim economic growth, they gave new monetary value to something which previously had none, but also consumed a resource making it no longer possible to use that resource again. Gross Domestic Product (GDP), the measure of a nation's economic activity, goes up further providing an illusion of growth, but the total ability of the Earth's resources to provide value has now been diminished, which offsets that perceived growth. More simply put, economic activity is a zero-sum game, nothing new is created without the destruction of something else.

This has been the repeated pattern of human economic history, consuming and monetizing more and more natural resources, but leaving the earth with less and less. This is not growth, but rather a transfer or re-arrangment of unmonetized resources into monetized but consumed resources. Some point toward technology as a source of real growth. But usually new technology both consumes natural resources and also cannibalizes older previously monetized industries, replacing old technology with new, but on a net basis still not creating real growth. Growing human populations account for more and more human consumption which gets recorded as economic growth, but again this is just the process of consuming more and more resources of which there is a finite supply. Like a Ponzi scheme, this is not sustainable in the long run. Those input resources will invariably run out.

Jenga!

My favorite analogy for our current dominant economic philosophy is the Jenga tower, a game where blocks are removed from the tower and placed on top growing the height of the tower, which some could perceive as growth, but which simultaneously decreases the stability of the entire tower. The game ends when an attempt to retrieve a block from the middle of the tower and place it atop leads to a false move which collapses the tower.

In real life, periods of high economic growth are usually followed by crashes and contraction. We have seen it happen over and over again in a major way every several decades. The more we continue to rearrange useful resources into consumed waste and valueless matter, the closer we get to another, likely greater, collapse.

In nearly every case the health of banks and financial institutions, again, the heart of a capitalist economy, weaken significantly if not collapse entirely, investments can't be repaid, loans are recalled, and capital (the oxygenated blood of a capitalist economy if you'll graciously allow the heart analogy to continue) is unable to flow to areas of need in the time of crisis. Economic collapse ensues and someone somewhere yells “Jenga!”

Pictured: A metaphor for political policy's current effect on the economy 

Is Collapse Inevitable Under This System?

Well, technically, no, but it would be really hard to avoid. It is the equivalent of putting the blocks back where they were in the Jenga tower, which is harder than the original game. But before we can even attempt that we'd have to agree to actually change the goal of the game we're playing. Unless we start playing another game, to deprioritize growth, this pattern of collapse is going to strike again soon.

Why Will It Fall?

We have created great sums of waste and consumed so many of our natural resources that we will soon reach an environmental and economic tipping point. I am uncertain if it is going to be environmental or economic disaster that will strike first, but the two are so closely intertwined that there isn't too much point making a distinction. When this disaster strikes, our capital will be extended into sectors which will stop producing returns and it will become difficult to allocate capital in the ways required to keep the main structure in place.

When the world stops finding resources to monetize and areas for economic growth the growth will naturally stop. The problem is that the transition from periods of high growth to periods of low or no growth is usually painful. When growth slows available capital becomes scarce, business go bankrupt, individuals lose their source of income. For the most part this will all work itself out naturally... which certainly does not mean peacefully. It's how every Ponzi scheme ends.

My current bet on the trigger point for our next collapse is that due to a combination of environmental and economic reasons clean water will becoming scarce in several major localities around the same time. People will start getting sick, and industries which dependent on clean water or those people will be unable to function and there will be a domino effect of things that rely on those industries being unable to function. There will be significant civil unrest which will spread to other locations, and a lot of suffering and hardship will be had. Like a Ponzi scheme, it will be depletion of a required input (new investors or clean water) that triggers the collapse. 

It could also be caused by the bursting of some other economic bubble, which has the same qualities of a Ponzi scheme, a perception of value which gets backed by capital, where there actually is none. And when that perception disappears, the value and invested capital disappears with it. Either way, when it happens resources will be unable to make their way to areas of need in time and poor people, particularly, without capital stores will be unable to gain access to resources essential for survival.

The transition may go more smoothly than that. Perhaps the supply and demand curve for clean water, still just as an example, will shift such that prices to retain/produce clean water will go so high that the allure of profit will shift capital into full scale research, production, and distribution of clean water in time and everything will be fine. I remain skeptical though that this will all go down without serious strife. Our governments and major capital holders have shown an unwillingness to make any significant changes to the system in order to prevent disaster. Even when there are warning signs, those capable of  (read: responsible for) making changes typically only do so reactively, after the fact, and after the damage has been done.

No-Growth?

A no-growth, or de-growth economic environment is possible. I said earlier that banks are dependent on perpetual growth, but that's not 100% true. In theory, there is no problem with 0% interest rates or stagnant GDP. Interest rates are usually a reactive indicator of real economic growth, not a driver. If GDP reaches a level where there is enough output that people have all their needs met, there isn't any need for more. Banks should also be able to survive in no-growth environments. There is no reason they can't play their same arbitrage games with low or even negative interest rates (e.g. borrowing at -4% and lending at -1% still provides a 3% margin).

Economist point to Japan -- a country that has been economically stagnate for most of the last two decades and is finding it increasingly difficult to continue to discover ways to record more economic growth. Interest rates in the country have been below 1% since the mid-1990s, spending most of the time near and even below 0% -- as an economic failure. Call me dense, but I don't really see the problem with no-growth. The trouble, and the reason our system requires growth,  is that the transition from high growth to no-growth often means a lot of investments will not pay out, which is what makes the banks particularly vulnerable.   

Is There Anything We Can Do Now?

In the aftermath of a crash, people are always more aware of the negative effects of the over-consumption and turning of resources into waste. But what should the people of 2019 do about this problem? As much as possible, we need to start puttng our Jenga tower back to its original solid form.

By aligning economic incentives we can form a system which emphasizes the long-run sustainability of resources and the environment over short-run profits. It is entirely possible to find ways to ensure our resources are not wasted, but rather further altered into something useful. It's possible that we could have a sustainable economy where resources are used over and over again not in a single progression from raw material to waste, but in a cycle, perhaps one that pushed forward by the virtually unlimited energy from the sun I noted earlier.

The emphasis on converting waste into consumable resources could be made possible by aligning economic incentives such that it becomes cheaper for companies to re-use waste, instead of raw materials, as their economic inputs. I have previously outlined how we can use markets to have polluters internalize costs and pay for the right to pollute at what would be considered an acceptable level.

The primary objective of the new system is that GDP growth rate should no longer be the central measure of a healthy economy. That will lead us off a cliff. Sustainability must be prioritized. I have not yet put together all the details of this sustainable system but people are certainly working on it. These people need to be listened to. However, the implementation of economic incentive alignment with sustainability can begin now.

In the meantime, let's just hope our Jenga tower is more stable than it feels and that nobody knocks it over anytime soon.

A Final Note
I don't intend this as a knock on capitalism, but merely to show that it has limitations and imperfections. Unfettered, unaltered, and unregulated capitalism can be just as disastrous as any other economic system. I believe that capitalism, and the democratic ideals it lends to capital, is a tool that should be used to solve these problems. The idea is to adjust the goals of markets, not in the way they operate, but just so that their negative consequences (as determined by society) are borne within that market. This will create a capitalism that doesn't blindly chase capital growth, but rather factors principles and morals into the equation. If aligned correctly this new capitalism will chase the most ethical and moral allocation of capital.