Ponzi Scheme, Pyramid Scheme, Bubble, and the Importance of Endogenous Growth
There has been a lot of discussion in the media about Ponzi schemes. In fact, some economists have been debating whether we were facing a system-wide Ponzi scheme as financial imbalances that rely on new investors (including those overseas) could not last forever. A scheme needs a schemer, but this, of course, is not the case for the financial system at a macro level. If we look at practices at a micro level, including the situation in the housing market, fraudulent practices and schemers did exist.
So What is a Ponzi Scheme?
A Ponzi scheme is an investment operation that involves paying abnormally high returns to investors out of the money paid in by subsequent investors, rather than from the profit from any real business. The perpetuation of high returns requires an ever-increasing flow of money from investors, which is eventually unsustainable.
In a Ponzi scheme, the schemer acts as a “hub” for the victims, interacting with all of them directly and claiming some esoteric investment approach. This is different from a better known scheme called a “pyramid scheme” where recruiters benefit directly and make explicit claims that new money will be the source of payout for the initial investments. Both schemes will lead to an inevitable collapse.
What About a Bubble?
A bubble is different in that it exists in an open market without schemers In the case of a bubble, as long as buyers are willing to pay ever-increasing prices, sellers can get out with a profit. This follows the line of the “greater fool” theory, as manifest in dot-coms and housing in the past ten years. Bubbles can arise without any fraud at all, being caused by money supply expansion beyond what genuine capital investment supports, and in this case would mimic a Ponzi or Pyramid scheme, with expanding credit taking the place of an expanded pool of investors.
Many areas of financial imbalance in the system share the characteristic that smooth operations would rely on continued inflows from participants (domestic and/or international). There may be no schemer here, but the results for the system are the same – an ultimate collapse once the limit of finite resources is reached.
Restoring Sustainable Growth
The current crisis is a testimonial that the U.S. economy needs to refocus on endogenous growth in order to restore growth sustainability. This can be achieved by restoring domestic savings, improving the rate of technological progress and increasing productivity. Policy measures can have an impact here, particularly in the areas of research and development, education, and innovation incentives, among others. It is also important for the financial sector to play its role as an intermediary and facilitator for the real sector in order to achieve a higher and sustainable rate of return via endogenous growth, rather than focusing on short-term strategies that do little to enhance productive capabilities and are eventually unsustainable.
Without a doubt, it is difficult to tell what lies ahead by looking at the rearview mirror. Right now the economy is undergoing painful adjustments from bubbles and fraud. Most of the economic issues facing us today still fall within the context of basic economic logic we’ve learned in history. The applications and details may differ, yet principles remain unchanged. In 55 BC Roman orator and politician Cicero pointed out:
“The national budget must be balanced. The public debt must be reduced; the arrogance of the authorities must be moderated and controlled. Payments to foreign governments must be reduced, if the nation doesn’t want to go bankrupt. People must again learn to work, instead of living on public assistance.”
This is a statement made over two millennia ago. Sound familiar? There are plenty of reasons to be a good student of history.
Here I offer a New Year’s resolution for the economy: regroup, rebalance, and refocus on endogenous growth. We need to be accountable for our children; we need to strengthen our industrial base through innovations; we need sustainable growth, not just growth.
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