Enterprise or Ponzi

The difference between an enterprise and a Ponzi scheme

We have already observed how modest regular savings enhanced by ‘the miracle of compound interest’ can result in the accumulation of substantial wealth –  but where does this abundance come from? Can such a thing possibly be legitimate? – The answer is… sometimes it is, and sometimes it isn’t. If it arises ultimately from a stake in an enterprise which is authentically creating wealth then this is legitimate. If not, then it is a scam of some sort – a form of theft, eventually at the expense of others who have produced genuine value.

Let’s look at some simple examples of the creation of value:

• a farmer creates value by sowing, tending and harvesting to produce wealth (recall that we defined wealth as ‘things people want’) in the form of food
• the carpenter creates value by shaping and assembling wood to produce wealth in the form of furniture
• a blacksmith creates value by working hunks of iron to form them into tools and fittings
• an author creates value by composing stories to produce wealth in the form of entertainment, education or inspiration; as do performing artists and athletes
• even an ‘honest broker’ can provide genuine value by connecting suppliers and purchasers, if they are saving either of them trouble, uncertainty or expense in seeking each other out.

All of these activities require two things: one is capital, and the other is a supply of energy.

By capital, I mean a specific form of wealth that has the capacity to create further wealth. For example, the farmer needs capital in the form of land, buildings, tools and so on. The carpenter needs capital in the form of a workshop, tools, equipment etc. In addition to this fixed capital, an enterprise also needs working capital – stocks of raw materials, partially completed work, and finished goods awaiting sale. An entrepreneur starting out in business will have to purchase the capital which they need to operate. If they haven’t got the resources to fund that themselves, then they have two options: they can either borrow the money to purchase this capital, or they can sell part ownership of the enterprise to investors. When the business makes a profit on its activities, this profit can benefit the investors – either by paying interest on the loan or by distributing dividends to the shareholders.If the investor wishes to reap the benefits of compound interest, then they would use the dividends or interest payments to purchase more shares or bonds. If a business has scope for expansion, then it may reinvest at least part of its profits in more equipment, larger premises etc rather than distributing dividends to its shareholders. In this case the shareholders benefit by owning a portion of the larger business, which is generally reflected in a higher price of the shares. For example, the shares in the Ford Motor Company were held by Henry Ford and his family and associates from the time of its foundation in 1903 until 1956 when 22% of the shares in the company were sold to the public on the stock exchange. The profits over that period had not been distributed, but had been reinvested in larger factories and distribution networks, so that the value of the company as a whole had grown from the initial investment of a few thousand dollars to a company valued at $2,920 million.

In January 1978, a group of investors paid $517,500 for a 17.5% share in the year-old Apple Computer Inc, which enabled the company to ramp up the production and marketing of the Apple II desktop computer. Sales of these grew exponentially and the profits were ploughed back to increase the capacity of the operation. By the time the shares were offered to the public two years later, the holdings of those original investors were worth over $195,800,000. Had they retained their shares in full to this day, they would now be worth around $140 billion. This is all accomplished by assembling components into products that people want, and selling them at a healthy profit margin which is constantly re-invested into the expansion of the operation.

On the other hand, we can find many examples of activities which pretend to be a real business but are generating no real wealth.As J K Galbraith commented, “From time to time, a new seer will arise claiming to have uncovered the secret to money and to its indefinite multiplication, but invariably it turns out to be some variant of an ancient fraud, possibly dressed up in a novel guise.”

One common example is the type of operation known as a Ponzi scheme – named after Charles Ponzi who who operated a notorious scheme in the 1920s, although it wasn’t a novel concept at that time: similar fraudulent operations had been common in the 19th century, and some are described in the novels of Charles Dickens.  The basic principle is that investments are solicited with the promise of abnormally high returns. Initially these returns are paid out, thereby substantiating the credibility of the operation and encouraging investors to tell others about this apparently wonderful opportunity. However  there is no real business activity taking place and these dividends are simply made from the money which the investors themselves had provided. As long as new  participants are being attracted to the scheme these payments can continue, as well as the scheme operators extracting funds for themselves. But when the supply of new participants dries up – as sooner or later it must – the money available for payouts is rapidly exhausted and the investors wake up to the reality that they have lost  everything. There is usually some plausible, but vaguely stated, suggestion of the methods that are being employed to generate these exceptional returns. For example Charles Ponzi claimed that he could buy postal return coupons in Italy which could be redeemed for a higher value of postage stamps in the US, and promised that he could provide a 50% profit within 45 days. A moment’s reflection would uncover several flaws in this proposal, but that did not prevent thousands of people being taken in by him, and losing over $20 million.

The most recent large-scale example of a similar process was Bernie Madoff’s investment company, which collapsed in 2008 with losses to investors of $50 billion. Madoff had started out as a stock trader and manager of an investment fund. However he falsified the returns that he was making on the operations to attract more clients, paying dividends out of the capital in classic Ponzi fashion, and the scheme unravelled when customers tried to withdraw their holdings following the 2008 banking crisis. Madoff was given jail sentences totalling 150 years. The Enron and World.com scandals were Ponzi schemes in effect, as the ever-escalating share prices were predicated on expanding profits that turned out to be non-existent.

I would say that the entire sub-prime mortgage fiasco had the essential characteristics of a Ponzi scheme. Naive investors, including pension funds and charitable foundations, were persuaded to buy complex financial instruments that had been categorised as high-quality secure bonds with superior yields. Yet these instruments rested ultimately on thousands of home loans sold  – at introductory teaser rates – to people who would not conceivably be able to repay or service them. Yet nobody has been held to account for this, and the perpetrators of the schemes have been protected from the consequences of their own folly by subsidies from the taxpayer.

Other examples of economic activity where no real wealth is being created are pyramid schemes and gambling. Essentially these are ‘zero-sum’ games where there is no more wealth at the end that there was to start with, but some have won and some have lost. In fact they are in reality ‘negative-sum’ games since there is always some cost involved in participating. When I speak of gambling, I am not just referring to traditional games of chance such as blackjack or roulette; financial speculation such as day-trading stocks or currency has exactly the same structure – nothing new is created and it’s a zero-sum activity.

There’s a good case to be made out that state pension schemes are a Ponzi scheme: there is no fund created to finance the obligations, and current payments are made from today’s contributions. Hence the stresses to the system when we have an ageing population supported by the taxes levelled on a shrinking workforce.

Finally it is worth reflecting on the shift in banking practice away from business expansion loans and into home mortgages. Whereas the former facilitated the creation of new wealth, the latter simply siphons money from the house purchaser into the profits of the bank. More detail on this, and the example in the previous paragraph in a later section.

This essay will form part of my forthcoming book The World in 2100: What might be Possible for Humanity?  When we return to the ‘Wealth’ thread, the next topic will be The Nature of Capitalism in its Various Incarnations.

If you haven’t already done so, you can register to receive a free review copy just before it goes on general sale later this summer. Registering will also take you straight to Chapter 1 – The Foundations which will give you more idea of what the book will cover.