Good Ponzi Schemes?

The current Buttonwood column from The Economist continues the discussion that Hyman Minsky started back in the 1970's, a topic that has garnered increasing attention from economists around the world in recent months after the subprime mortgage meltdown became front page news.

Minsky theorized that there were three kinds of finance in a capitalist economy - hedge finance, speculative finance, and Ponzi finance - the latter named after Charles Ponzi, one of the greatest swindlers of all time.

Wikipedia has an excellent summary of both financial crises and Mr. Ponzi. The connection between the two is becoming clearer with each passing day and with each new revelation of mortgages originated for those with little ability and less intention to repay.

Ponzi finance is viewed by Minsky as a sort of "risk end-game", where, participants accept higher returns while ignoring risks that are known to exist.

In the case of the current housing bubble, credit was extended by mortgage lenders in the belief that even if the borrower ran into financial difficulty, perpetually rising home prices would bail out even the most egregious borrowers as they would be able to sell at a higher price and everyone would walk away with money in their pockets.

This worked well until home prices stopped rising.

Ponzi finance is best typified by the Ponzi Master himself, Alan Greenspan, who recently said that if home prices "would go up 10 percent, the subprime mortgage problem would disappear."

Amazing but true.

The current Buttonwood column asks the question that is sure to appear in economic textbooks years from now - whether there is such a thing as a "good Ponzi scheme". That is, whether markets that are just a confidence game can lead to a greater societal good.

Ponzificating
CHARLES PONZI was a likeable man. That helped him persuade American investors in 1920 that he could deliver returns of 50% in just 45 days by exploiting a loophole in the pricing of international postal coupons. In a way, he was advertising an early version of an arbitrage fund.

In reality, the loophole could not be practically exploited. So Ponzi exploited his customers instead. He could deliver returns only by taking money from new investors to give to his early backers. But although he died in poverty, the Italian immigrant achieved immortality of a sort: fraudulent moneymaking operations are often known as Ponzi schemes.
...
Ponzi's original scheme was fraudulent from the start. But even if he had found some exploitable anomaly in the financial system, his rationale was flawed. Because he offered such a high rate of return over such a short period, claims on the “Bank of Ponzi” would quickly have reached ridiculous levels.

So perhaps there are good and bad Ponzi schemes. Good schemes will do more than funnel money from latecomers to early takers, allowing the foremost to prosper at the expense of the hindmost. And they will not allow claims to increase too fast. That was the big mistake of John Law, the pioneer of paper money in early 18th-century France. Law's system eventually collapsed, but he did have the insight that the creation of credit might increase trade, and thus general welfare.
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The American housing market seems to be suffering from the unravelling of a Ponzi-type system. Subprime loans were offered on generous terms that, implicitly or explicitly, depended on rising house prices. The banks that made these loans bundled them up and sold them in the credit markets to investors, eager for high yields. This was supposed to make the financial system more secure by dispersing risk more widely.

But look what is happening now. The buyers of these loans are asking the original mortgage-writers to buy them back. But these homelenders do not have the money to do so. The confidence that sustained their balance sheets has evaporated, leaving many in dire trouble.
...
As lending standards tighten, consumer demand could suffer, possibly prompting a recession in the United States. No one knows when the credit cycle will end, he says. But the pyramid is beginning to look a bit top-heavy.

The question of whether the recent housing mania is The Biggest Ponzi Scheme Ever has been bandied about outside of the mainstream media for years now.

It's nice to see the same question being asked by writers with wider audiences, though the new twist was entirely unexpected.