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Alokesh Majumdar

Alokesh Majumdar on whether the US economy is a giant Ponzi scheme

IN THE US, growth is at the expense of ever increasing deficits. The US' economic power comes mainly from the big consumer market. This consumer binge is increasing the debt levels and making the savings rate negative. The much-hyped technology lead of the US does not translate into either higher productivity per head or higher output per head.

This is ascertained by recent research papers. This big US consumer market is served by the rest of the world (China, Japan and the UK being the major trade partners). But to be a big supplier to the US, a tacit understanding is that a major portion of the profits of the suppliers is used to buy US treasury and other securities. Why else would approximately half of US treasury bonds outstanding be owned by non-US entities (especially, other governments)?

So, in effect, suppliers give credit to American consumers through the US Government, which acts as an intermediary. This arrangement is favourable to the US as there is an implicit understanding in financial markets that US treasury bills are the only risk-free instruments in the world. This zero-risk nature of debt enables the US Government and its consumers get credit at the lowest rate.

One might ask why US debt is considered the only risk-free instrument in the world? The explanation lies in historical reasons. After the Second World War, when Europe and Japan were being rebuilt, the major powers of the world agreed to this norm, as it was convenient to all concerned and the US helped in the rebuilding process. At that time, US debt may have been risk-free but definitely not now.

The US economy has the looks of a Ponzi scheme because it has to consume more and more to be able to get credit from rest of the world. As long as the deficit was controllable, the dollar remained strong on stronger growth prospects (the foundations of which are quite dubious) and all was fine.

Now with the consumption binge saturating, further growth is coming from growing deficits which, along with the budget deficit caused by lower tax revenue collections, will ensure that the dollar falls till US exports start picking up again. Meanwhile, a falling dollar would result in a catch-22 situation for suppliers to the US, who hold huge amounts of government and other dollar-denominated debts and are obliged to buy more of the same from further sales to the US.

The securities are like depreciating IOUs. Would any supplier like to get depreciating IOUs for all their manufacturing and trading efforts? Thus, at some point during the downturn, the suppliers will have to target other markets, which would be to the detriment of further inflows to the US. This will stop credit flows to the US and the insane consumption boom.

Thus, the Ponzi scheme will fail. The rest of the world will start trading more with each other, for which they will get hard currency . Asia, with its large number of consumers, is the market of the future. The Asian governments, flush with funds, should set aside their differences and develop their own Pan Asian consumer markets with their own suppliers to these markets.

China has about 15.7 per cent of the world's total reserves (ex-gold) and India's share is 2.6 per cent. So, money is not a problem. While China has embarked on an export-oriented model with high dependence on the US market, India has the opportunity to take a different route and develop its own markets.

The US debt, at a few trillion dollars, is already so huge that the Treasury will soon have to issue more instruments simply to be able to pay the interest on existing notes. If the US Government were a company, it would definitely be a candidate for potential bankruptcy.

In the context, the US debt cannot be considered risk-free? Also, 70-80 per cent of world's non-gold reserves held by various governments are in the form of dollar-denominated assets, compared to the US' share of world trade at 26 per cent. This can be attributed to the perception that the dollar is risk-free and the huge faith governments and businesses all over the globe place on it.

The recent fall of the dollar in the financial markets should make governments and businesses rethink this dollar perception. Also, any close inspection of US government accounts, with its high debt, increasing unemployment and lower tax reciepts, should make all holders of dollar-denominated securities jittery. A serious re-weighting of currency holdings is called for by surplus generating countries and businesses.

This naturally invites attention to desired (that is, relatively risk-free) destinations of investible surpluses. If one sets store by the parameters of balanced economy and economic and political stability, quite a few countries can be considered as potential investment destinations.

Norway, for instance, stands out with virtually no foreign debt and reserves — comprising also the Norwegian Oil Fund owned by the Norwegian Government — aggregating $165 billion. Norway is one of the largest oil producers and hardly has any political or social problems. Bonds issued by Norwegian Government (which has a higher yield) appear to be quite attractive in the present situation.

Much of the reserves of China, Hong Kong, Japan, Taiwan and Singapore, which together add up to around $1,100 billion, are parked in low-yielding US treasuries. The war with Iraq is in effect being financed by these countries. The reasons for this is pure trade; these Asian giants want to protect their trading partner, the US, and not lose their export competitiveness by bringing the reserves home and allowing their currencies to strengthen.

The question is how long can this Ponzi scheme last with the US economy in its current condition?

Europe as a trading block is a bigger economy than the US. So, why should not Asian central banks buy higher yielding euro bonds? Also, why cannot a country's reserves be kept in currencies in proportion to their expected import demands in the near term, rather than in dollars? The military might of the US cannot be sustained without subsidies from these Asian nations.

Illegal pyramids

PONZI schemes are a type of illegal pyramid scheme named after Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s.

Ponzi, thinking that he could take advantage of differences between US and foreign currencies, used to buy and sell international mail coupons. Ponzi told investors that he could provide a 40 per cent return in just 90 days compared with 5 per cent for bank savings accounts.

Ponzi was deluged with funds from investors, taking in $1 million during one three-hour period — and this was 1921.

Though a few early investors were paid off to make the scheme look legitimate, an investigation found that Ponzi had only purchased about $30 worth of the mail coupons.

Decades later, the Ponzi scheme continues to work on the "rob-Peter-to-pay-Paul" principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses.

(Source: www.sec.gov)

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