Friday, June 25, 2010

Rolling over Government Debt and Debt Monetization: A Ponzi Scheme?

The meme that government debt is just a Ponzi scheme seems to be an especial favourite of Austrians, libertarians and other free market supporters. I note that it often seduces people of different political persuasions too. I have also met it on the Cynicus Economicus blog.

Unfortunately, the idea that government debt is a Ponzi scheme, or that rolling over/monetizing government debt is a Ponzi scheme, collapses after some careful analysis.

Here is the definition of a Ponzi scheme from Wikipedia:

A Ponzi scheme is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned. The Ponzi scheme usually entices new investors by offering returns other investments cannot guarantee, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from investors to keep the scheme going.

So a Ponzi scheme has these characteristics:
(1) The scheme requires new and greater amounts of private investors’ money perpetually to work. To be successful, the Ponzi schemer must go deeper and deeper into debt perpetually. He can never obtain the needed money from another source.

(2) The Ponzi criminal uses the money he obtains from investors for his or his criminal associates personal gain or to pay their investors’ returns.

(3) A Ponzi scheme is a fraud: investors do not know that the Ponzi schemer is paying them returns from their own money or money paid by subsequent investors. The Ponzi criminal is secretly and fraudulently conducting his operations by lying to his investors by claiming he is investing their money.

(4) The returns on a Ponzi scheme are usually abnormally high and short term, often 20% or higher.

(5) The Ponzi schemer has no significant actual profit or income from sources other than his investors’ money.
In light of all this, I wonder why people so readily think government borrowing is a Ponzi scheme.

There are five possible ways in which government debt or rolling over government debt might be considered a Ponzi scheme. However, when we examine these factors below comparing Ponzi schemes to government debt we can see that the Ponzi scheme analogy fails:
(1) The government has the power to roll over debt. This involves taking money from a new buyer of a bond and giving it to the previous owner. There is a general similarity here with the need of a Ponzi schemer to obtain new investors’ money to make his scheme work, but the similarities end here. The crucial fact people forget is that the government is the entity that has the power to create money. No Ponzi schemer has the power to create money. The Ponzi schemer goes deeper and deeper into debt perpetually, and can never obtain money from another source. But the government is not “financially” constrained (even though it faces real limits to the amount of money it can inject into the economy via deficits and retiring debt). Modern Monetary Theory (MMT) tells us that our government has no need for money borrowed from the markets to spend. It has the power of debt-free fiat money creation, and can do so whenever it wants. No private institution or individual has this power. A government that is sovereign in its own currency has obligations that are safe, precisely because its central bank has the power to buy back bonds from the secondary markets by creating new money or (if necessary) creating money for budget deficits. Creating “new” money this way is not debt at all. It is new fiat money (if inflation rises, that can be cured with budget surpluses or taxes). So the fundamental link between new sources of funding and debt (essential to a Ponzi scheme) is cut. Furthermore, history shows that, unless severe output or supply shocks happen (or other exceptional circumstances like reparations or sanctions), a country that returns to strong growth will see the government’s debt to GDP ratio fall and the possibility of unsustainable accumulation of debt disappear, unlike a Ponzi schemer who must continue to find private investors to make his fraud continue to work.

(2) The government does something extremely important with the money it borrows: it pays for public infrastructure, defense, social services, funding of R&D, education, and law and order. A Ponzi scheme fraudster does nothing of social value with his investors’ money (incidentally, if you know of a Ponzi schemer who donated his ill-gotten gains to charity, please do give me the details!). In contrast to the Ponzi scheme fraud, we enjoy fundamental benefits from government debt. In times of recession or depression government spending saves our economy from debt deflationary spirals and mass unemployment and collapses in output. No analogy with a Ponzi scheme here I am afraid.

(3) Government tells us precisely what it is spending our money on in the coming year’s budget, openly and in detail. A Ponzi schemer lies to you about what he does with your money. But there is no a secret about how the government will spend your money. You actually have influence over it. Furthermore, people vote governments in and out: so the voting population has a direct voice in determining what their money is spent on. We can vote for higher or lower taxes as well. If you are an investor wanting to buy government bonds, you will know exactly what the government is doing with your money in the budget. You are perfectly well aware that the government might roll over debt frequently. But it is your free choice to buy bonds. Many people do. In contrast to this, Ponzi schemers are by nature secretive fraudsters. There is no analogy here at all.

(4) Government bonds offer quite low returns (not ridiculously high ‘Ponzi’ style returns) compared to other investments, precisely because they are so safe. Your average Ponzi scheme offers a 20% return or higher. In contrast, US Treasury bills (T-bills) that mature in one year or less do not pay any interest directly. Rather, these Treasury bills are sold at a discount of their face value and give a return on maturity. At the end of June (2010) the average yield for one-year Treasury bills was 0.30%. The coupon rate on a new issue of 2 year US Treasury bills was 0.625%. The coupon rate on new five-year T-bills was 1.875%.
The yield on the benchmark 10 year US Treasury notes (which of course is a long term investment) has fallen from 3.14% to 3.07%. The government is not now and does not offer “Ponzi” style returns. No analogy to be found.

(5) Government does not always roll over debt, but pays back bonds with tax money, its real and guaranteed income, which is growing with the population and economy. The government therefore has a vast income which could be raised simply through increasing taxes. Ponzi schemers have no such income: they are just borrowing more money from private markets endlessly.
Look carefully at the points above. In four of the five points, there is no analogy.

Only if there were valid analogies in all of the points above, or at least in more than half (i.e., in three or four of them), could you seriously make the case that government debt is like a Ponzi scheme. In no sense can you make this case.

The conclusion must clearly be that government debt is not a Ponzi scheme.

In a very limited way in point (1) there is a similarity, but even that comparison is weak.

Why, then, do people persist in the idea?

The answer is simple: most people are simply committing the fallacy of composition.

This logical fallacy happens when someone concludes that what is true of one part (or parts) of a whole must therefore be true of the whole, even though there is no justification for the claim.

The reasoning of the “government debt is just a Ponzi scheme” argument is like this:

Argument 1:
1. Rolling over debt is analogous to the Ponzi scheme that pays investors back with newly invested money.
2. Government debt often relies on rolling over debt in a way analogous to the Ponzi scheme.
3. Therefore, government debt is a Ponzi scheme.

However, this syllogism is as flawed and unsound as this argument:

Argument 2
1. All atoms are invisible to the naked eye.
2. Cats are made up of atoms
3. Therefore, cats are invisible to the naked eye.

Anyone can see that this argument is unsound.

The formal reason is that both arguments commit the fallacy of composition, and argument (1) does so because it ignores points (2) to (5) made above where I compare government debt with a Ponzi scheme. In points (2) to (5), there is no analogy with a Ponzi scheme. And in even point (1) the analogy is very weak.

Anti-government ideologues and apologists for free market economics might like to subscribe to the “government debt is a Ponzi scheme” view, but there is no reason why the rest of us should accept such deeply-flawed and illogical thinking.


The commentator “George” on the Cynicus Economicus blog has also asked this question:

you fail to address some of my key points. Namely denying that your article comments on bank nationalization and government manipulation of bond [yields] read like a ‘Ponzi’ scheme of money creation.

A Ponzi scheme does not “create” money. The Ponzi schemer has no power to create money at all, but must obtain further money from investors. Since money creation is not a characteristic of a Ponzi scheme, even the definition of a “Ponzi scheme” here is confused.

Moreover, government intervention to control yields has nothing to do with a Ponzi scheme. The government offers quite low returns on its bonds. It can offer a coupon rate and then intervene to maintain the yields on bonds at this coupon rate or above it if it wishes. There is no fraud involved. The Ponzi scheme, by contrast, offers ridiculously high returns by secretive fraud. Bond investors can shun new purchases of government bonds if they wish to.

In a previous blog post I argued that

if my plan to nationalize the banks that accepted bailout money were implemented, then they could also purchase the issuance of new government bonds with the excess reserves they have at the Bank of England. This would help to keep yields down. The Bank of England’s £200 billion quantitative easing policy ended in February 2010, but there are still a lot of excess reserves in the system. These reserves are sufficient for new loans to be given to creditworthy borrowers as well as additional purchasing of government bonds when the private sector does not take them up.

The banks in the UK were on the verge of collapse in 2008. By their own stupidity, incompetence and the flawed regulatory system, they nearly destroyed the financial system and required billions of dollars in taxpayer money. We now read that the total cost of the UK financial interventions could be between £70 billion to £140 billion (see “Cost of UK financial sector bailout could hit £140 billion,” 3 March 2010).

I say that the banks pay the government back with interest. And they owe us much more for the lost employment, lost growth, foregone output and social misery their stupidity caused.

This would be my first option: the government can cut its budget deficit by taking excessive profits from the banks.

The second option (as I have described above) is for the banks to help keep yields down through more purchases of government debt.

In no sense is this a Ponzi scheme. It’s forcing the banks to give the public back something for the billions the public gave to the banks in the first place.

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