Modern Ponzi Theory
Recently, some overconfident economists have advanced the idea that the United States government should not bother trying to rein in its Budget deficit. In the press, the leading overconfident economist is Stony Brook University economics professor Stephanie Kelton, the proponent of the heterodox thesis she calls Modern Monetary Theory. Within the economics profession, the leading overconfident economist is Olivier Blanchard, who as President of the American Economic Association recently laid out an argument intended to persuade his fellow orthodox economists.
Most people, including Kelton and Blanchard, sow confusion on how deficit spending works. My purpose here is to provide clarity.
It helps to draw a distinction between real stuff and financial instruments. When I give you a Bitcoin or a picture of a dead President and you give me a cookie or a foot massage, I am giving you a financial instrument and you are giving me real stuff.
It is best to think of financial instruments as promises. That is obvious when the financial instrument I use is a personal IOU (I owe you). When I use money, I am using a promise that is socially constructed. There is a self-reinforcing consensus belief in the United States that the picture of a dead President that I gave you in exchange for a cookie can in turn be used whenever you want to exchange at a fairly predictable price for some real stuff.
Next, consider three types of exchanges:
- When we exchange real stuff for other real stuff, it is called barter. No highly-developed economy can run on barter. Barter transactions are a mere curiosity today.
- When we exchange real stuff for promises, it is called economic activity. Government statisticians try to tabulate and sort these transactions in what are called the National Income Accounts, which give us the estimate known as GDP.
- When we exchange promises for other promises, it is called finance.
In a sense, all financial instruments are socially constructed. I only accept a financial instrument because I believe in the future that financial instrument can be exchanged for real stuff.
The Asteroid Scenario
As a thought experiment, suppose that there were an asteroid headed for our planet next week, with nothing we could do about it. It is going to destroy life as we know it. You would love to enjoy a last fling by spending all of your financial assets, but you would not be able to do so, because nobody wants to be holding financial instruments if the world is about to end. As a result, all financial instruments, including money, would be worthless. With the asteroid scenario, we would revert to barter.
How a Ponzi Scheme Works
Suppose that I do some financial transactions. That is, I give personal promises in exchange for money. I do this with Ahmed, and I do this with Barbara. I then take the money and exchange it for real stuff.
Now, suppose that I cannot really keep my personal promises. When Ahmed and Barbara come and ask me to honor my personal promise with money, I cannot do it. I appease Ahmed by writing a new personal promise that makes him content, and I appease Barbara by giving her money that I obtained by making a personal promise to Carlo. I also give personal promises to Denise and Elbert, and I take their money and exchange it for real stuff.
I can keep doing this as long as I can find new people to accept my personal promises. This is known as a Ponzi scheme. Such a scheme collapses when you run out of new people who are willing to accept your promises.
The collapse of a Ponzi scheme is necessarily sudden and unpredicted. If everyone understood that I were engaging in a Ponzi scheme, then no one would accept my promises and I would have to stop. The scheme can only proceed as long as I can tap into people who are not aware that it is a Ponzi scheme.
When ordinary finance goes as planned, promises typically are redeemed. When they are not redeemed, it is because of some visible event, such as a failed business venture.
But sometimes what starts out as ordinary finance degenerates into a Ponzi scheme. That seems to be what happened in the Bernie Madoff scandal. At first, his asset-management firm was earning returns for clients. But when the returns fell off, he paid existing clients out of funds received from new clients.
Government spending ultimately buys real stuff in the private sector. When the government sends someone a Social Security check, the recipient can exchange the government promise for real stuff.
Government taxes ultimately take away real stuff from the private sector. When you pay taxes, that leaves you with fewer resources to pay for real stuff.
Just like you or me or Uber, the government can get more real stuff than it collects by issuing promises. It might make promises that are paid back with interest, in which case they are called bonds. Or it might make promises that pay no interest, in which case they are called money. (An esoteric point, of interest only to economists, is that bank reserves held at the Fed, which we consider to be money, now pay interest.)
Some very important promises that the government makes are embedded in entitlement programs. You may not have a written, contractual promise from the government to provide you with Social Security and Medicare, but when you retire you will be pretty cheesed off if you don’t get those benefits. And you will have one of the most powerful lobbies in the whole country, the American Association of Retired Persons, standing read to punish any politician who dares to try to cut your benefits.
If the United States government is capable of keeping all of its promises, including promises to repay its debt and promises to continue entitlement programs, then it is engaged in ordinary finance. If it is not capable of meeting its promises, then government finance has degenerated into a Ponzi scheme. Opinions on that currently differ. Most of us are behaving as if we expect the government to keep meeting its promises, even though some analyses suggest otherwise.
The best analysis of the financial outlook for the U.S. government comes from the Congressional Budget Office. And some experts believe that the CBO reports show that the government will not keep all of its promises.
If these experts are correctly interpreting the CBO projections, then the U.S. government is running a Ponzi scheme. As with any Ponzi scheme, the collapse, when it comes, will be sudden and unexpected.
The collapse of the Ponzi scheme will entail a loss of confidence in the financial instruments issued by the government. This would include a loss of confidence in the future value of money. Just as in the asteroid scenario, people would be trying to get rid of money as fast as they can. Countries that have experienced hyperinflation are illustrations of this. Hyperinflation results in a collapse in ordinary economic activity, and people can be forced to revert to barter.
Risking the Collapse of Civilization
The orthodox overconfident economist says that the U.S. government can run larger budget deficits financed by bonds, because the interest rate on those bonds is currently very low. The heterodox economic overconfident economist says that the government can get an even lower interest rate by issuing money instead of bonds.
If the overconfident economists are right, then larger deficits could bring us the benefits of whatever real stuff the government might fund with more spending (minus any real stuff that spending “crowds out”). If the overconfident economists are wrong, then larger deficits will lead to a more rapid and dramatic collapse of a Ponzi scheme, perhaps ending civilization as we know it. That strikes me as a rather adverse combination of risk and return.