Ending the Era of Ponzi Finance

Ending the Era of Ponzi Finance

          
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Ending the Era of Ponzi Finance

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  • The Origins of the Ponzi Scheme

    The developed world’s Ponzi scheme is caused by record-high levels of public and private debt. And it is exacerbated by huge unfunded liabilities that will be impossible to pay off owing to long-term changes in developed-world demographics.

    Record Levels of Private and Public Debt. Since the Second World War, debt levels in the developed economies have continually risen, with a notable increase since 1980. According to a study by the Bank for International Settlements (BIS), the combined debt of governments, private households, and nonfinancial companies in the 18 core countries of the OECD rose from 160 percent of GDP in 1980 to 321 percent in 2010. In real terms, after inflation is taken into account, governments have more than four times, private households more than six times, and nonfinancial companies more than three times the debt they had in 1980.

    There is, of course, nothing wrong with taking on debt, as long as that debt is invested to create additional economic growth. In recent decades, however, the vast majority of debt has not been used to increase future income but to consume, to speculate in stocks and real estate, and to pay the interest on previous debt. One indication of this trend: during the 1960s, each additional dollar of new credit in the U.S. led to 59 cents in new GDP; by the first decade of the new century, that same dollar of credit was producing just 18 cents in new GDP.

    These rapidly rising debt-to-GDP levels are a sign of the growing share of what the late economist Hyman Minsky termed “Ponzi financing” in the global economy. Minsky distinguished three types of credit-based financing, determined by the financial strength of the debtor:

    • Hedge financing, in which the debtor has sufficient cash flow to pay interest and to pay back the principal.

    • Speculative financing, in which the debtor can service the loan—that is, he or she can pay the loan interest that is due but not repay the principal out of income cash flows. Therefore, the debtor needs to continuously roll over liabilities by contracting new debt in order to meet the obligations on maturing debt.

    • Ponzi financing, in which the debtor doesn’t have enough cash flow to cover either the principal or the interest. While hoping that the asset will rise faster in value than the total financing cost, he or she must borrow even more to meet the interest payments. The ultimate goal is to be “bailed out” by selling the asset to the next buyer.

    Today the developed world looks for a “next buyer” to take over its excessive debt load. Unfortunately, there is no such buyer in sight. The Ponzi scheme will have to be unwound.

    How much money are we talking about? The amounts are extraordinary. The threshold for sustainable government debt is a debt-to-GDP ratio of roughly 60 percent. Applying that threshold to nonfinancial corporate debt and private-household debt as well gives an overall “sustainable debt-to-GDP ratio” of 180 percent. Currently, the amount of debt above that level is approximately $11 trillion for the U.S. and €7.4 trillion for the Eurozone.

    Although it is nearly five years since the onset of the financial crisis, we are still just beginning to unwind these massive sums. So far, only Italy, Japan, and the U.S. have started to deleverage. (See Exhibit 1.) In the case of the U.S., this deleveraging of the private sector is mainly the result of defaults, not of actually paying back loans.5 Other highly indebted economies such as the U.K., Spain, and France are still piling up additional debt.

    exhibit

    Unfunded Liabilities. As bad as the excessive debt burden is, however, it is only part of the problem. The developed world’s Ponzi scheme is greatly exacerbated by the hidden liabilities of governments and companies, especially when it comes to age- or health-care-related spending.

    The basic approach to paying for such costs has not changed much since the invention of social insurance by Germany’s Chancellor Bismarck in 1889: the younger generation pays for the older generation. Bismarck lived until 83, but such longevity was the exception at the time. The average life expectancy then was 37 years for men and 40 years for women, while insurance was paid only from the age of 70 onwards. Thus, relatively few workers could expect to enjoy payments from public insurance.

    Over the past century, however, life expectancy has doubled and fertility rates have declined by more than half in the developed world. In 1880, the median fertility rate among women in today’s G-7 countries of Canada, France, Germany, Italy, Japan, the U.K., and the U.S. was 4.6; today, it is at or below the rate of natural reproduction of 2.1, with rates in Germany, Italy, and Japan as low as 1.4.

    At the same time, the retirement age has been lowered significantly—so much so that the number of retirees supported by the working population has grown precipitously. In Germany, the old-age dependency ratio (that is, the number of persons age 65 or above per 100 persons of working age) was 14 percent in 1950; it is 31 percent today. And it will increase to 57 percent by 2050. In other words, every retiree will need to be supported by fewer than two fully employed people. In Japan, the dependency ratio was only 8 percent in 1950; it is 35 percent today and will climb to 70 percent by 2050. By the end of this century, there will be at least a 50 percent dependency ratio in most developed countries. (See the sidebar “Would You Want to Pay?”)

    Stephen G. Cecchetti, Madhusan S. Mohanty, and Fabrizio Zampolli, “The Real Effects of Debt,” Bank for International Settlements (BIS) Working Paper No. 352, September 2011.
    Hyman P. Minsky, “The Financial Instability Hypothesis,” in The Elgar Companion to Radical Political Economy, Philip Arestis  and Malcolm C. Sawyer, eds. (U.K.: Edward Elgar Publishing, 1994).
    In 2011, BCG calculated a debt overhang of €6.1 trillion for the Eurozone and €8.2 trillion for the U.S. The new calculation is comparable for the U.S. and 21 percent higher for the Eurozone, reflecting the growth of Eurozone debt since 2011. See Collateral Damage: Back to Mesopotamia? The Looming Threat of Debt Restructuring, BCG Focus, September 2011.
    For historical fertility rates, see “Children per Women Since 1800 in Gapminder World,” Gapminder, October 1, 2009. For current fertility rates, see U.S. Central Intelligence Agency, The World Factbook 2012.
    For population forecasts by age group, see United Nations, World Population Prospects, 2010 revision, June 2011.

    Would You Want to Pay?

    As the size of the workforce in developed societies declines and the number of retirees increases, the key question becomes: how much is the younger working population able—and, more important, willing—to pay? The German sociologist and economist Gunnar Heinsohn has devised a simple thought experiment to demonstrate just how large the burden might be.

    • Imagine 100 new babies that represent Germany’s future workforce.

    • Of course, the necessary fertility rate to keep the population constant is about 2.1, whereas Germany’s fertility rate is only 1.4 on average. So that means that out of 100 babies needed to maintain a constant population, 33 are not born at all.

      U.S. Central Intelligence Agency, The World Factbook 2012.
    • The future workforce represented by the remaining 67 babies is further reduced by emigration. During the next 40 years, 4 of them will emigrate to other countries, reducing the number to 63.

      Approximated as the cumulative net migration out of Germany since 1970 (excluding the former German Democratic Republic before 1991) over the average population of Germany, 1970–2010 (excluding the former German Democratic Republic before 1991), according to the German Federal Statistical Office’s migration statistics.
    • Nine of the remaining 63 individuals will be functional illiterates—that is, they can read or write individual sentences but cannot handle complex texts. They risk being dependent on transfer payments and will contribute little to future growth.

      University of Hamburg, “Leo Level One Study: Literacy of Adults at the Lower Rungs of the Ladder,” press brochure, Spring 2011.
    • Given the expected old-age dependency ratio of 57 percent, the remaining 54 individuals who are active members of the workforce will have to pay for 36 retirees, as well as for the 9 functional illiterates—fewer than 2 fully employed people per dependent.

      The old-age dependency ratio of 57 percent in 2050 is calculated using the population forecasts by age group in United Nations, World Population Prospects, 2010 revision, June 2011. Given this ratio, the 54 Germans of working age (63 minus 9 illiterate) will support 36 people age 65 and over (57 percent of 63).

    Will the 54 accept such a burden? The high taxes they would have to pay could well mean that the true number of German emigrants will be higher. After all, a country like Canada, with a relatively favorable ratio of 63 workers to 31 retirees and correspondingly lower social costs per capita, would be a highly attractive destination.

    See Gunnar Heinsohn, “Die Schrumpfvergreisung der Deutschen: Deutschland verschläft den Kampf um Talente,” Frankfurter Allgemeine Zeitung, June 25, 2010. All figures have been updated with most recent data.

    The financial implications of this growing welfare burden are dramatic. According to another BIS study, even in a benign scenario in which current deficits were reduced to precrisis levels and age-related spending was frozen at current levels of GDP, public debt would continue growing at a significant rate. Only Germany and Italy would be able to stabilize their debt levels in such a scenario. (See Exhibit 2.) Nor are states and local governments immune. In the U.S., for example, one estimate puts the unfunded liabilities for city and state employees in the neighborhood of $3 trillion to $4 trillion.

    exhibit

    Private companies that provide fixed-benefit pensions are also confronting significant underfunding of their pension promises. In 2011, the S&P 500 companies had combined unfunded liabilities of more than $500 billion; liabilities of the European Stoxx 600 were more than €300 billion. For some companies, unfunded liabilities are equivalent to more than 50 percent of their market capitalization. In the current environment, it is highly unlikely that larger investment returns will automatically solve the problem. Such companies will have to fund the gap out of current cash flow, cut their liabilities by offering diminished lump-sum buyouts (as GM and Ford have recently done)—or partially renege on their promises, as the public sector will inevitably do.

    Meanwhile, private households have relied too long on rising home-asset prices and the promises of politicians and corporate managers instead of putting aside dedicated funds for retirement. In some countries, private households need to deleverage precisely at a time when they should be building up assets for the future. What’s more, the aggressive monetary policies of the leading central banks, designed to stimulate economic growth, have had the perverse side effect of reducing interest income and expected future returns as asset values become inflated, forcing households to increase their savings even more.

    Stephen G. Cecchetti, M.S. Mohanty, and Fabrizio Zampolli, “The Future of Public Debt: Prospects and Implications,” Bank for International Settlements (BIS) Working Paper No. 300, March 2010.
    Robert Novy-Marx and Joshua D. Rauh, “Public Pension Promises: How Big Are They and What Are They Worth?The Journal of Finance, July 2011.
    S&P Capital IQ, “Pension and Other Post-Retirement Benefits,” as reported for fiscal year 2011.