Thursday, December 04, 2008

Toiling at the Pyramid

I was no more perceptive than anyone else; during the bull market years [of the late 1990s] some people did send me letters claiming that major corporations were cooking their books, but - to my great regret - I ignored them. However, when Enron - the most celebrated company of its time, lauded as the very model of a modern business enterprise - blew up, I immediately saw the implications: if such a famous and celebrated company could have been a Ponzi scheme, it was very unlikely that the rest of U.S. business was squeaky clean. In fact, it quickly became clear, the bubble years were both the cause and effect of an epidemic of corporate malfeasance. Paul Krugman, The Great Unraveling (p. 26) - Quoted in Wikipedia

"That’s how we got here — a near total breakdown of responsibility at every link in our financial chain, and now we either bail out the people who brought us here or risk a total systemic crash." Thomas Friedman - NYT
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The US driven, world economy appears to many to be a pyramid scheme. There is nothing new about financial pyramids, what is new is the sheer size of this one. There are things whose very magnitude make them difficult to process. Things like the size of the bailout, the size of the US current account debt, or the size of Angelina Jolie's lips immediately spring to mind. This universal pyramid, the one that is collapsing around our ears at this moment, is bigger than all of that.

One of the largest pyramids up till this great American cum-universal one was the scam perpetrated on the Albanian people not long after the collapse of Communism. The poor Albanians at least had the excuse of knowing absolutely nothing about money, investment, capitalism or much else besides raising goats and the "thought" of Enver Hoxha. (post-pyramid Albanians have learned a lot about trafficking prostitutes and stolen cars. Will we be so lucky?)

While researching the idea of comparing the Albanian pyramid of 1996-97 and ours of today, I came upon a wonderful old report from the International Monetary Fund. It was written in 1999 by Christopher Jarvis, at that time the Senior Economist in the IMF's Policy Development and Review Department. I recommend reading the whole thing, but there are some parts that I would like to quote extensively because they give a quite succinct and effective description of what a pyramid is, what effects its collapse can produce and some curiously sensible advice on what do about the situation. I say curious, because you will see that the advice given by the IMF to the Albanians is quite different from what advice they give when a pyramid explodes close to home.

First, let's see Jarvis's description what effects the bursting of a nationwide pyramid can have:
The pyramid scheme phenomenon in Albania is important because its scale relative to the size of the economy was unprecedented, and because the political and social consequences of the collapse of the pyramid schemes were profound. At their peak, the nominal value of the pyramid schemes' liabilities amounted to almost half of the country's GDP. Many Albanians—about two-thirds of the population—invested in them. When the schemes collapsed, there was uncontained rioting, the government fell, and the country descended into anarchy and a near civil war in which some 2,000 people were killed.
Then he goes on to explain in detail how it all came about... here is a choice and strangely familiar bit which I've taken the liberty of underlining:
The regulatory framework was inadequate, and it was not clear who had responsibility for supervising the informal market. Even after the approval of a banking act in February 1996 that appeared to give the Bank of Albania the power to close illegal deposit-taking institutions, the central bank could not obtain the government's support. Indeed, the government was supportive of the companies: senior government officials frequently appeared at company functions, and, in November 1996, even as the pyramid schemes began to crumble, the prime minister and the speaker of the parliament accepted medals in honor of the anniversary of one of the companies. During the 1996 elections, several of the companies made campaign contributions to the ruling Democratic Party. There were allegations that many government officials benefited personally from the companies.
When it all collapsed the poop really hit the fan:
By March 1997, Albania was in chaos. The government had lost control of the south. Many in the army and police force had deserted, and 1 million weapons had been looted from the armories.(...) The interim government inherited a desperate situation. Some 2,000 people had been killed in the violence that followed the pyramid schemes' collapse. Large parts of the country were no longer within the government's control. Government revenues collapsed as customs posts and tax offices were burned. By the end of June, the lek had depreciated against the dollar by 40 percent; prices increased by 28 percent in the first half of 1997. Many industries temporarily ceased production, and trade was interrupted. Meanwhile, the major pyramid schemes continued to hang on to their assets, proclaim their solvency, and resist closure.
Of course in the United State looting armories wouldn't be necessary as much of the population is already armed to the teeth.

Finally in Albania all was well: the IMF and the World Bank saved the day. Here's how:
(T)he newly elected parliament passed a law, drafted with assistance from the IMF and the World Bank, mandating the appointment of foreign administrators from international accounting firms to liquidate the schemes.

The administrators appointed under the new law were required to report regularly to the government but otherwise had complete independence. They were given broad powers to carry on the companies' businesses, pay their debts, sell their assets, fire staff and managers, seize the assets of individuals connected with the schemes, and hire experts to trace assets abroad. (...) It took several months to dislodge the owners, partly because the administrators needed their cooperation in finding the companies' assets. The administrators did not gain full control of all of the companies until March 1998. Owners who had not fled were jailed, and whatever assets remained were prepared for sale. But much had been lost already.
This next part may sound strangely prescient and familiar to our ears:
Few studies have been done on the macroeconomic effect of pyramid schemes on the scale of those in Albania, which, fortunately, are extremely rare. The closest analogy to such schemes is the asset bubble, whose economic impact is due to changes in perceived wealth. As a bubble expands, people believe themselves to be better off than they actually are, and their demand for goods and money increases, leading to a deterioration in a country's external current account as well as increased output or accelerated inflation or both. If the bubble attracts foreign investors, capital inflows might be sufficient to fund the current account deficit. After the bubble bursts, perceived wealth falls dramatically. Demand for goods and money, as well as output and inflation rates, can be expected to decrease, while the current account balance is likely to improve.
Again, thanks to the Albanians docilely downing the wise medicine the IMF prescribed, everything turned out more or less ok, but check the parts I've underlined:
The long-term effects of the pyramid scheme phenomenon are likely to be limited, reflecting not only the resilience of the Albanian economy but also—and, perhaps, most important—the government's adjustment efforts and its refusal to bail out depositors. Prices and wages are extremely flexible in Albania; as a result, the government was able to cut real public sector wages substantially in 1997 (by leaving nominal wages unchanged), and the economy suffered no loss of competitiveness when the lek appreciated. The new government's willingness to tackle the budget deficit and undertake long-overdue structural reforms was also crucial. However, the social effects were profound.
Next comes a long section detailing the prevention and cure of these situations, which if read in the light of the American government's, recent bi-partisan behavior, is a real gorge raiser (I just can't resist underlining some of it):
Albania's experience contains some important lessons for other countries. There are steps governments can take to make the growth of pyramid schemes less likely. These include establishing a well-functioning formal financial system, setting up a regulatory framework that covers informal as well as formal markets and has clear lines of responsibility for supervision and action, and tackling general governance problems. Although preventing pyramid schemes is not the most important reason for establishing good governance, the Albanian experience is a powerful reminder of the social costs of unchecked criminality. (...) The government should make it clear from the outset that it will not compensate depositors for their losses. If this is not done, the fiscal costs are likely to be ruinous, and the moral hazard considerable.
As Alice in Wonderland said, "I give myself such very good advice".

After the bailout and the huge stimulus in the planning it certainly will never be possible for any US government... or the IMF... or the World Bank, to ever advocate fiscal orthodoxy again with a straight face.

Obviously if the American establishment is not willing to ask of its citizens the austerity it has always demanded of the citizens of other countries, then all its moral authority and prestige has vanished. "Do as I say, not as I do" has never been a formula for successful leadership.

This recession, how it came about and how it is being handled is America's Berlin Wall.

But, be of good cheer!

Nothing goes on forever, no hay mal que cien aƱos dure, ni cuerpo que lo resista, the USA is going to spend quite some time in purgatory to atone for its sins, that is all and that is a lot.

I am not as pessimistic as James Kunstler or even Peter Schiff, but when a Ponzi scheme collapses there is pain and when, (here the USA is Albania on steroids) an entire country is a Ponzi scheme the pain is very great.

When that country prints the world's currency of reference, the quantity and duration of that pain is difficult to calculate, but America has fertile soil, natural resources and a large, young, highly educated, population that is not afraid of hard work, so sooner or later things will work out. DS

1 comment:

Anonymous said...

You are one of my daily reads, David. Thanks so much for your insights into our changing reality.

Regarding the issue of Ponzi schemes/Ponzi dynamics, I want to direct you to Stoneleigh's recent piece for the Automatic Earth Website (If you don't know this should check it out)...Its worth reading