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Ponzi Schemes: Legal and Illegal

Nicole Stoneleigh describes a key feature of our current economic situation as a large credit expansion, which can also be described as excessive claims to underlying wealth. Through loans, then, multiple people believe they own, or have a claim on, a given unit of real wealth (production of goods and services). This system can work only if economic growth continues, allowing the money-supplying bottom of the Ponzi pyramid to expand. Like a Ponzi scheme, a debt-based economy that depends on economic growth operates relatively smoothly as long as it keeps moving and growing. The moment it is forced to stand still, though, it topples.

Here’s an example from my industry (home remodeling) that helps me make sense of this. Part of the contracting process is to take a downpayment on work before it begins. This money is to be set aside for purchasing materials and for financing the labor until a certain point in the job (at which a progress payment will be due). Before these purchases are made or labor expenses come due, one big downpayment can inflate the bank account, and make the contractor feel like profits may be good.

Unfortunately, if one goes by the bank balance, a downpayment can mask the loss of profit on current jobs, and it is indeed impossible not, occasionally, to depend on future profits or, with a significant and perilous difference, revenue, to help a company get through a slow stretch or an underpriced job. If one large downpayment can not only keep the machine running despite real losses, but even cause things to appear profitable, imagine what multiple downpayments can do! A growing business that is increasing sales and contracts can run for extended times with significant loses on completed jobs (costs higher than revenue), as long as downpayments for future work are sufficient to cover all costs. If I am losing money on jobs with $20,000 gross this month, the downpayments for next month's $40,000 worth of jobs will easily cover even significant losses.

This model, however, can fall apart in the matter of weeks should there be even a minor and temporary interruption in new sales and downpayments. In fact, depending on the degree to which the cost of the jobs are greater than the price for which they were sold, and thus the degree to which they were being financed by future work, even a slowing in the rate of sales growth can lead to collapse. This among the many reasons that the fail rate for businesses like mine are around 85% over 3 years.

While with careful bookkeeping, it is possible to track the profit or loss rate on each job, and the extent to which one is borrowing on future jobs (actually a felony under Wisconsin’s “theft by contractor law”). This, unfortunately, is precisely where the analogy with our national and international financial system becomes most prescient. For there is no illusion that as a nation we are not in fact borrowing on the future, on wealth not yet created, on profits for work not yet begun, to finance national and personal debts (these debts, clearly, are the simple product of costs exceeding revenue, what a contractor might refer to as a “goose-egg."). The principle difference, though, is that so enshrined in our institutions is the promise of future growth, that spending its downpayment in not only entirely lawful, it has come to be seen as a political and economic imperative.

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