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Neil H. Buchanan

Financial Fraud, Ponzi Schemes, and Legitimate Economic Policies: Misunderstandings of, and Overreactions to, the Financial Crisis and the Great Recession


Thursday, December 2, 2010

"Inside Job," a new documentary film from director Charles Ferguson, examines the reasons behind the financial crisis that gripped the world in late 2008, a crisis that brought on the worst economic downturn since the Great Depression, and that continues to inflict pain on untold millions of people in the United States and around the world. Ferguson's film explores the policies that led to the crisis, examines the people who were involved in the policy decisions both before and after the crisis hit, and highlights the surprising lack of criminal investigations -- much less indictments or convictions -- in the wake of this very avoidable crisis.

The elements of the story will be familiar to those who have followed financial headlines. Still, the documentary format allows Ferguson to assemble the disparate pieces of the puzzle into a coherent narrative. While his story is admittedly somewhat conspiratorial, the evidence rather strongly supports his conclusions. I did not agree with all of the film's points -- especially its dismissive treatment of the Troubled Asset Relief Program (TARP), which was actually a huge success, and which ended up costing the public only $25 billion, rather than the $700 billion price that had originally been advertised. Even so, the film offers an important contribution to the public's understanding of a very confusing subject.

At my local independent theater in Ithaca, New York, I attended a screening of the film that was followed by a question-and-answer session led by Cornell Law professor Robert Hockett. Listening to a relatively well-educated audience discuss the film was fascinating, because it was a vivid reminder of just how confusing financial matters can be.

In this column, I will discuss some issues that were a source of considerable misunderstanding among that audience, and that have been widely misunderstood in the political and media arenas as well. In the midst of a bewildering turn of global events, people can be forgiven for looking for culprits. And there definitely are culprits. Even so, there is a regrettable temptation now to view all policy choices as somehow fraudulent. If we throw out the baby with the proverbial bathwater, however, we will foreclose important policy options that can help us to weather this storm.

Finance and Frauds: Debt Need Not Be a Bad Thing

Finance is an inherently tricky subject. After all, the fundamental activity behind every financial transaction is merely the trading of promises, written on pieces of paper, rather than the trading of goods and services. If I open a simple savings account, I have made a loan. I am the creditor (with money owed to me), and the bank is the debtor (owing me money), with a legal instrument defining the terms under which I will be repaid, possibly with interest.

The dizzying array of financial instruments is simply a set of variations on this theme. One person gives money to another person, in return for a promise of money at some future date. Sometimes, both parties promise to act in the future, rather than the present. Once those pieces of paper come into existence, other people might want to "buy" them. For example, a bank that once made a loan to be repaid in ten years might want its money back at an earlier date, giving it an incentive to sell the loan to someone who is willing to wait until the end of the financial contract into which the bank had entered.

This is finance. Some people are in debt to other people, and the pieces of paper that memorialize those debts are potentially available to be traded among the public. Therefore, one of the most important lessons not to learn from the financial crisis -- a lesson that members of the audience in Ithaca, and many others as well, seem to believe -- is "Debt is bad."

Debt is neither bad nor good. Debt is only a problem at the individual level if it cannot be repaid; and it is only a problem at the societal level if it leads to widespread defaults, panics, and financial crises.

The problem in 2008, therefore, was not simply that there was a lot of debt. The problem was that debts had been issued in a poorly-regulated financial sector. In other words, the people who guarantee that the bank that holds your savings account is a legitimate operation, and similar people who perform supervisory functions for all other forms of financial transactions, stopped fully doing their jobs. They allowed debts to be issued that should never have been issued; and they allowed the responsibility for bad debts to be shifted onto innocent (or, at least, uninformed) parties.

In other words, the problem was that the financial-regulatory system permitted fraud on a massive scale. Some might even say that the regulatory system actually came to encourage fraud. Of course, if the laws are changed such that a bank is allowed to engage in deceptive practices, then its activities cannot be prosecuted. Such banks and their bankers are still, however, responsible for having brought into existence debts that destabilized the system and destroyed many people's lives -- while enriching themselves.

From Frauds to Ponzi Schemes: A Specific Crime Becomes a Buzzword, But the Use of the Buzzword Is Highly Misleading

The type of fraud that permeated the global financial system prior to 2008 -- and that still exists, to a distressing degree -- was thus a rather simple type of deception. Ratings agencies, in return for handsome fees, gave top marks to financial instruments that were worthless. Mortgage originators put people who were eligible for regular loans into high-priced, subprime loans. This led to catastrophe, for which we are all still paying.

One of the favorite buzzwords in financial circles over the last few years has been the "Ponzi scheme." Every manner of financial transactions and policies has lately been described as a Ponzi scheme, by which the speaker often appears to mean nothing more than "something that I don't like." This is unfortunate, because it has become far too easy simply to hurl this insult, without understanding the difference between legitimate financial transactions and the real problem of fraud.

One straightforward definition of a Ponzi scheme is "an investment swindle in which early investors are paid with sums obtained from later ones in order to create the illusion of profitability." Named after an early-20 th-Century swindler, such a scheme is fraudulent because there is no set of circumstances under which its organizers can honor all of their promises to all of their investors. In a Ponzi scheme -- also known as a pyramid scheme -- each tier of investors is paid by bringing in yet another tier of investors (larger in number), who in turn must be paid off by bringing in even more suckers. With a finite population of potential investors, this scheme is unsustainable. It is certainly a unique type of fraud, and it remains illegal.

This is quite different from a non-fraudulent investment plan. When I lend money to my bank, I do so in the confidence that the bank is obligated under law to engage in financial planning -- planning that will allow its legitimate earnings on its own investments to pay for my principal and interest. Similarly, when I invest money in a company's common stock, I do so because I believe that the company has a business plan that will allow it to pay dividends and increase the value of my stock in a fair, open market. The Ponzi scheme is merely one of many ways that those expectations can be defeated by unscrupulous -- and poorly-regulated -- financial players.

As I noted above, however, the label "Ponzi scheme" is now being broadly misapplied. During the recent election campaign, for example, some Republican candidates were describing the Social Security system as a Ponzi scheme. The idea is apparently that, because Social Security is designed to link generations, with each working generation paying for its parents' retirement (knowing that its own retirement will, in turn, be paid for by its own children), Social Security is the equivalent of bringing in tiers of new investors to prop up a scheme that cannot be sustained in the long term.

Nothing could be further from the truth. As I have described in several FindLaw columns (most recently on September 2 of this year), the basic pay-as-you-go structure of Social Security is a sensible, sustainable form of financing a retirement system. In fact, the supposed "fully- funded" alternatives to Social Security also rely on future workers being brought into the work force, because someone must be working if retirees (no matter where their funds come from) are to be able to eat, and otherwise sustain themselves, without working.

Even if the worst predictions about Social Security's finances were to come true, moreover, the problem would not be that such a system cannot possibly be sustainable; it would be that the particular benefit and revenue rules were miscalibrated. That is not a Ponzi scheme. It is, at worst, a correctable mistake.

Is Monetary Policy Itself a Ponzi Scheme? Of Course Not.

During that question-and-answer session back in Ithaca, one questioner outdid the "Social Security is a Ponzi scheme" canard by arguing that monetary policy itself is a Ponzi scheme. He argued, along lines that I have seen elsewhere in media commentary, that the Federal Reserve is engaged in something inherently fraudulent and unsustainable when it creates money.

Those who make this analytical error then tend to oppose the Fed's "Quantitative Easing" monetary policy. From their perspective, because the Fed is now engaging in a second round of easing, we are to imagine that the Fed is bringing in new waves of suckers to bail out the earlier investors.

The Fed's new policy is, however, nothing new or special. It involves having the Fed buy long-term bonds, in order to bring down the interest rate on longer-term debt. When longer-term debt is more affordable, people and businesses will find it more tempting to buy houses, pay for college, expand businesses and payrolls, and do all of the valuable and, in many cases, socially beneficial things that can be done with borrowed money.

The only unique thing about Quantitative Easing is that the Fed is buying longer-term bonds than it usually buys, because interest rates on short-term debt are already near zero (and have been for several years). If the Fed is going to have any success in expanding the economy

-- and such expansion is essential, in light of Republicans' (and some Democrats') unwillingness to consider further stimulative fiscal policy -- Quantitative Easing is our only hope. There is certainly nothing unsustainable about this, nor does it require new tiers of investors to pay off earlier ones.

One objection to any kind of monetary policy is that it is "creating money out of thin air," or "turning on the printing presses." This however, is nonsense, as I argued last year in another FindLaw column. Money is fundamentally a human invention; and whether we collectively decide that we will accept paper, tobacco, gold, stones, or any other form of payment to transact our business, the fact remains that no form of money has an intrinsic value. Gold discoveries can destroy fortunes (while making others), and gold as well as every other alternative to paper money is subject to even greater vicissitudes than is printed currency.

The Fed's primary role in the economy is to adjust the supply of money to prevent sudden shocks to the economy -- both positive and negative. Changing the money supply by buying bonds is simply how the Fed's job is done. Money creation is anything but fraudulent. To the contrary, it is an essential part of bringing about the recovery that we all hope to see very soon.

The Fed can, of course, do its job poorly. It can create too much money, leading to inflation; or it can create too little money, leading to stagnation. It is abundantly clear, however, that the current Fed has erred too much in the direction of tolerating stagnation.

In short, the current debate about all types of government policies has been polluted by misunderstandings about debt, fraud, "mere paper," and the new bogeyman, Ponzi schemes. There are plenty of important issues to sort out in our financial affairs, both in terms of bringing wrongdoers to justice, and in putting in place better regulatory protections going forward.

Dealing with those issues, however, requires us at least to understand that our basic structures -- for creating money, for financing retirement, for regulating financial markets, and for everything else that goes into a modern economy -- are fundamentally sound. In the midst of so much misery and uncertainty, that is very good news.

Neil H. Buchanan, J.D. Ph. D. (economics), is a Visiting Scholar at Cornell Law School, an Associate Professor at The George Washington University Law School, and a former economics professor.

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