Andrew Sheng, Distinguished Fellow of Asia Global Institute, sees painful restructuring ahead for the global economy.
The global financial crisis is not over. The volatile start to the year showed that 2016 may be a precursor to the 10th anniversary of the 2007 subprime crisis, which itself evolved from the 1997 Asian financial crisis.
Two terms came out of the crisis that we see almost every day, but which have not been explained well by modern financial theory. Most economists think of them as aberrations at the periphery of normal economic behaviour. In fact, "Ponzi schemes" and "too big to fail" lie at the heart of individual and social behaviour, which go a long way to explaining what is happening today.
A Ponzi scheme is a scam named after American Charles Ponzi, who sold the idea of making money from arbitraging the value of international reply coupons in postage stamps to a growing group of investors in the 1920s. He made money by getting new investors to pay the promised high returns to old investors. Of course, this is "borrowing from Peter to pay Paul"; when the music stops, everyone wants their money back. Ponzi schemes should in principle collapse naturally, because it is of course impossible to pay unusually high returns. By the time this is realized, the founder has usually run away to the Caribbean with a lot of other people's money.
The securitization (packaging) of subprime mortgages into collateralised debt obligations, and turbocharging these into highly leveraged synthetic financial derivatives, then selling these to investors with a AAA credit rating, was a 21st-century Ponzi variant.
In simple terms, it's like selling a box of rotting apples, getting a rating agency to say that the box is worth more than the individual apples, with a guarantee against losses by adding more (rotten apples). In the end, the investor will have bought only a box of rotting apples, with all his savings eaten up by those who sold the boxes (derivatives).
But the Ponzi element in modern finance should be understood alongside another phenomenon - the too-big-to-fail dilemma. We all know that if we borrow US$1,000 from the bank, we are in trouble if we can't repay. But if we borrow US$1 billion from the bank and can't repay, it is the bank that will be in trouble. Thus, if a Ponzi scheme reaches the scale of "too big to fail," it has to be "rescued," because if everyone had bought the Ponzi product, everyone ends up the loser.
This is the essence of modern money. Advanced-country central banks can engage in quantitative easing to bail out banks that are losing money, because their banks are too big to fail. The difference between quantitative easing and a Ponzi scheme is that the interest rate promised in the former is near zero to negative, but the escalation of scale is the same. I call these Qonzi schemes.
In theory, in a closed economy, if you print too much money, you get higher inflation. However, in a world with excess production capacity, you would not get high inflation, because there are many more people in the emerging economies willing to hold reserve currencies like the US dollar, euro and yen. Under globalization, the smaller reserve-currency countries like the euro zone and Japan can engage in quantitative easing, because instead of getting inflation, their currencies depreciate against the dollar. The losers call such action a "beggar-thy-neighbour" policy.
In other words, countries whose currencies depreciate gain by passing "losses" to others, because they gain a competitive trade advantage. But if everyone depreciates at the same rate, the whole world ends up with more deflation. Remember, when the Ponzi music stops, all losses are realised. As Warren Buffett said, when the tide goes out, you know who has been swimming naked.
There are two fundamental elements of Ponzi operations - the promise of very high returns (false expectations) and the widening of the investor circle. Variants of the Ponzi scheme can be found in asset bubbles and pyramid schemes, in which more and more investors are enticed in until they are the ones who bear the final losses. Like a game of musical chairs, the ones who did not get out when the music stops are the losers.
Ponzi schemes work by having the originator pass his losses to all his investors, in order to make money. Hence the more suckers, the bigger his profits, and the more people to share the losses.
Technically, a Ponzi scheme is sustainable if the new funds that come in actually deliver good returns, but because the Ponzi promises a return higher than anyone can actually deliver, most end up as fraudulent schemes.
The dilemma in the world today is that the US is the world's largest "too big to fail" debtor, with gross international liabilities of US$31 trillion, equivalent to 40 per cent of world gross domestic product. In a world where interest rates are near zero, the threat of the Federal Reserve raising rates causes capital flight into the dollar. But a dollar that also yields a near-zero interest rate, with the inability to reflate due to political constraints, plays exactly the deflationary role of gold in the 1930s. Hence, a strong dollar is deflationary on the whole world.
As geopolitical tensions rise, flight into the dollar causes its own deflation. The latest US net international investment position is a deficit of US$7 trillion at the end of 2014, sharply up from a deficit of US$1.3 trillion in 2007. A strong dollar in which the US would run even larger current account deficits is clearly unsustainable for the US and its creditors.
During the Asian financial crisis, countries with net liabilities of over 50 per cent of GDP got into crisis. But the US is the "too big to fail" country in the international monetary system.
Further quantitative easing will not solve this dilemma. The only solution is painful structural adjustment by all concerned. This is why investors are so downbeat.
Consequently, I see no alternative but to reach a new Plaza Accord to ensure that the dollar does not get too strong, with a concerted effort to have global reflation. Otherwise, watch out for more "Qonzi schemes."
This article first appeared in the South China Morning Post on March 4 as Modern Money is being managed like a mutant Ponzi scheme
The views expressed in this article are the author's own and do not necessarily reflect Asia Global Institute's editorial policy.
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