Was Our Whole Economy One Giant Ponzi Scheme?

It was perhaps inevitable that we ended 2008, the year we learned we were up the creek, with a great financial scandal: the Madoff Ponzi case.

What is even more remarkable is the way in which the alleged fleecing of wealthy people and charities - investors who should have known better or employed people who did - of many billions of dollars serves as a mirror for the broader culture. It shows how we went wrong and where we are left, now that we realize our errors.

The main difference really is that the purported victims, or enablers, or co-fantasists of the trader Bernard Madoff say they found out their wealth was illusory all of a sudden, whereas for most people in the English-speaking world, this is happening little by little.

Madoff, for those of you just waking after a long winter's nap, is accused of defrauding investors in funds that he promised would deliver a suspiciously steady 12 percent or so a year in good times or bad of as much as $50 billion. The authorities say he has confessed to running a pretty simple Ponzi operation: paying out "earnings" to those who demanded them using new commitments of cash from those who wanted in. And of course, given that the man could "make" heady sums with no risk in all markets, the cash flowed in and the redemption calls were, for a long time, manageable.

Madoff has not appeared in court to answer the charges formally. But that there was one man, or a man with confederates perhaps, who was willing to engage in a harebrained fraud that was mathematically doomed to failure would not be that surprising, sadly. That an army of either rich, sophisticated investors or their highly paid advisers played along and believed that they were growing rich is far more interesting.

One point, highlighted by Tim Lee of the consultancy pi Economics in Stamford, Connecticut, is that the $50 billion headline figure is about as inflated as California real estate prices were a year ago. That $50 billion is likely to turn out to be not the amount lost but the amount people wrongly thought they had. It is likely that the actual strategy followed by Madoff could return little more than Treasury notes minus fees; in other words he could make for you what you could get for yourself with no help but then pay himself handsomely for the gymnastics.

That implies that a lot - for long-time investors, the vast majority - of the "money" invested and now "lost" with Madoff was about as notional as a credit default swap contract with a man you met outside the bus station downtown. Much of the money never existed, other than on the attractive and no-doubt glossy statements sent by Madoff.

It was simply what people would have had if he had been a genie.

And it is in this way that we are all Ponzi limited partners: We too thought our retirement funds and houses were growing miraculously, though ours was an illusion fueled by debt rather than fraud, and we too made plans based on those asset values that now stand in ruins.

"The financial system as a whole has had the characteristics of a Ponzi scheme if we look at it fundamentally," said Lee, who was very early in warning about deflation.

"By this I mean that we should think about the true value of assets as being derived from the future flow of goods and services that the assets can lay claim to or produce. If market prices of financial and real estate assets rise a lot but there is no increase in the ability of the economy to provide goods and services in the future, then the apparent increase in wealth is illusory."

That means that savings must rise, and expectations about the kind of growth and income that capital can safely command must fall. The process of everyone's figuring that out over the next year or so will be a continued hole in the side of the stock market and, despite the risks inherent in Treasury securities because of quantitative easing and fiscal stimulus, a boon to holders of government debt.