Triggerband Web Journal

After the stock market declined sharply in September and October of 2008, it was revealed that investment manager Bernard Madoff had been running a giant Ponzi scheme for decades which allegedly stole $50 billion from his investors. But is it the biggest Ponzi scheme ever?

Ponzi schemes “work” by promising and posting unreasonably high returns on investments, and funding payouts with money brought in from new investors. The schemes inevitably lose money over time because payouts to both investor and investment manager exceed revenues. Usually, Ponzi schemes are short-term cons. However, if performed artfully, they can last for a very long time.

Surprisingly, the characteristics of a Ponzi scheme apply to the stock market itself. To maintain the value of stock, investors must believe there will be future demand for that stock. And future demand itself depends on the belief that there will be more future demand. This is true of many assets, but in the case of stock investments, most investors have little use for the assets other than later selling them for a profit.

Monetary dividends from stock investments are far too low to justify their value. Dollar for dollar, bonds pay much higher returns. And as a practical matter, most investment funds and virtually all small investors have no use for the voting rights of common stock. It takes a lot of shares for your vote to count in a large corporation, and even then you probably want those who are more involved with the organization making decisions.

I need to clarify that stock ownership itself is not a Ponzi scheme, only trading on an open stock exchange. When you own stock you own a piece of a corporation. With it, you have the right to vote and you are entitled to a portion of earnings paid out each year. The value of the right to share in profits and make decisions should equal the fair market value of stock.

In the case of publicly-traded corporations, their stock is typically valued higher because public trading adds an element of speculation. This fact becomes apparent when a corporation “goes public,” meaning it allows its stock to be freely traded in a stock market. Share values can spike (although it is not guaranteed) and the corporation’s current owners and executives often enjoy a windfall, for two reasons.

First, offering shares for sale in a public exchange drives up the value of the shares the owners and executives already own. Second, when investors purchase the newly issued shares, their investment money goes directly to the corporation, which becomes more valuable as a result. If you think this infusion of cash justifies the heightened stock values, keep in mind that in a Ponzi scheme the infusion of cash from new investors merely perpetuates the scheme. It cannot turn losses into gains nor reconcile the book value of investments with their real value.

Caught red-handed

Many economists think the mortgage and credit crisis caused the recent stock market collapse. In actuality, the credit crisis had no more to do with causing the collapse, than the collapse itself had to do with causing Mr. Madoff’s Ponzi scheme.

The mortgage crisis has instead revealed fundamental instability in the stock market. Values on paper were too high, and as shocking as it is to witness trillions of dollars in assets vanish over a period of several weeks, understand that those assets were never really there.

Government intervention

When millions of Americans suddenly have reduced assets resulting from drastic losses in their stock portfolio, they effectively have less cash because they can no longer sell their investments for the same amount of money they could several months ago. The Federal Reserve Bank can now print large amounts of currency without an immediate risk of corresponding inflation. The federal government is able to use this money to purchase toxic mortgages, bailout companies, and stimulate economic growth.

However, more currency does not equal more value; we must add valuable goods and services to our economy to sustain growth. If we try to force growth by speculating in stocks and printing currency, we are setting our economy upon a weak foundation – one that will be subject to more crises and a prolonged recession.

I know corporations need a way to quickly raise capital. I know investors claim future growth is the justification for otherwise unjustifiably high stock prices. I know market values have climbed more or less steadily since the great depression. But could it be that a time will come when the world’s largest Ponzi scheme collapses, losses are measured in trillions, and everyone wonders why the signs were ignored? Could it be that time has already come?

Alexander Typaldos, JD