Madoff affair: why capitalism needs Ponzi schemes

Posted on Tuesday 16 December, 2008
Filed Under Economics

 

THE MADOFF affair illustrates the socialist case concerning the nature of capitalism more completely than a dozen polemical pamphlets ever could. It’s just a shame that Nicola ‘Superwoman’ Horlick and HSBC didn’t listen to the far left while they still had the chance. Turns out we could have saved you a few bob, guys.

Indeed, if it wasn’t for the fact that we are almost certainly listening to the giant splashing sound of hundreds of thousands of working class people’s pensions being pissed up the wall, this fiasco would almost be funny.

Apologists for the system will no doubt insist that Madoff was a one-off bad ‘un; any attempt to argue that the doings of his bent hedge fund highlight a dynamic inherent in capitalism itself will be derisively dismissed as just another attempt to belittle the legitimate role of financial markets on the part of those who habitually sneer at wealth creation.

My guess is that this contention will be proven spectacularly wrong in the months ahead. All manner of chicanery, imposture, deceit, duplicity, guile, swindling, brazen mountebankery, plain old fashioned peculation and fraud on a gargantuan scale are sure to come to light in 2009.

What is the crime of robbing a bank – Berthold Brecht famously asked in The Threepenny Opera – compared to the crime of founding one? God knows what he would have made of hedge funds.

Anybody unaware of what a Ponzi scheme was a few days ago will now have undergone a crash course on their inner workings, following the exposure of Mr Madoff’s nefarious activities. What relatively few will yet realise is that capitalism as we have known it in recent decades has effectively rested on one giant Ponzi scam.

Probably the first economist to provide a serious theoretical grounding to that line of thinking was the late Hyman Minsky, a radical Keynesian rather than a Marxist. Minsky it was who developed a taxonomy of financial structures, which he argued may be classified as ‘hedged’, ‘speculative’ or ‘Ponzi’.

A hedged structure can comfortably service its debts, interest and principal out of current income; a speculative unit can meet interest payments, but either has to sell assets or raise new loans to pay back the principal; a Ponzi unit needs to borrow to pay back past borrowing.

In periods such as the 1920s or the early 2000s, where cheap credit is readily available, people lose fear of indebtedness. Why not borrow money on your house, when the only way for the housing market is up?

The problem is, any shock to a highly leveraged structure – be it a business, a household or a national economy – makes it impossible to service debts that seemed reasonable at the time they were taken out. Speculative units go Ponzi and the whole thing falls over.

That is what economists call ‘a Minsky moment’, and what has the Great Crash of 2008 been if not the greatest Minsky moment since 1929? The Madoff moment is only a Minsky moment in sharp relief, and the implications are truly system wide.

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