Fiscal Responsibility and the ‘Greater Fool’ Theory

Many people the world over lived in a Ponzi bubble economy for more than a decade. They applied the Greater Fool Theory in the false belief that they would always be able to sell their house or their stocks or bonds or other highly leveraged assets to “bigger fools” than they were for buying them in the first place. Words: 1230; By: Lorimer Wilson

Bernie Madoff Ponzi Schemer

Who was Ponzi?
Charles Ponzi, a Bostonian with an eye for get-rich quick schemes back in 1918, identified an arbitrage situation which he promoted as being able to generate sizeable returns for those who invested with him. He delivered on his promise by making his close friends and a small circle of investors very rich, very quickly, and, as word spread among the wealthier citizens of Boston, they began lining up to invest. Regretfully, when anything looks too good to be true, it probably is and it was.

As a result of Ponzi’s infamy his name has been immortalized to describe any fraudulent investment scheme where the money from later investors is used to pay the early investors and so on right up until the moment the whole thing collapses on itself. Sound familiar? Yes, 90 years later the 50 billion dollar Madoff pyramid collapsed – a Ponzi scheme if ever there was one! Now may well be the time to lay the Ponzi name to rest and replace it with the infamous word ‘Madoff.’ Time will tell. 

But Ponzi and Madoff were not the only ‘investors’ who were conning those around them. We must not forget the tens of millions of Americans and others worldwide who were deploying their own ‘greater fool theory” that there was really nothing to worry about because there always would be a ‘greater fool’ than them out there somewhere who would still lend them money, buy their over-priced house, over-valued stocks, etc. to keep their financial house of cards from collapsing.

Below is my enhanced version of how Nouriel Roubini once described it*: 

The ‘Greater Fools’ Amongst Us
1. When you put zero down on the ‘purchase’ of your house and thus had no equity in your house (and re-financed your mortgage each and every time it went up in value) your leverage was literally infinite and you were playing a Ponzi game hoping a ‘greater fool’ than you would be there to buy your house when the time came for you to buy yet another house that you could not afford. 

2. When the bank sold you a mortgage for zero down on the basis of a NINJA (no income, no job or assets) liar loan, with interest only for a while, with negative amortization, and an initial teaser rate, the bank was playing a Ponzi game. They were hoping that you would stay employed; that you would be able to afford the eventual increased mortgage payment; that you would be able to sell the house for more than its original value; that you would always honor the terms of the mortgage. They were even ‘greater fools’ than you were. 

3. When private equity firms engaged in leveraged buy-outs with excessive debt-to-earnings ratios they were Ponzi firms playing Ponzi games – all “greater fools” hoping that future earnings would just grow and grow in future years with no likelihood of declining. 

4. When our government issues trillions of dollars of new debt to pay for a severe recession and to socialize private losses it becomes a Ponzi government hoping that the Chinese and other foreign purchases of their debt will continue doing so regardless of the value of the U.S. dollar vis-à-vis their respective currencies and the level of interest paid. How foolish to expect foreign governments to be ‘greater fools’ than ours. 

5. When our country spends more than it raises in taxes and thus runs an endless string of current account deficits and becomes the largest net foreign debtor in the world it becomes a Ponzi country hoping that foreigners will be even ‘greater fools’ and continue to finance their conspicuous consumption. 

6. When consumers consumed more than their income year after year (i.e. a household with negative savings; a government with a budget deficit; a firm or financial institution with persistent losses; a country with a current account deficit) they were playing the ultimate Ponzi game hoping that some ‘greater fool’ would come along and bail them out. 

These households, firms and banks and the government itself can be characterized as ‘Ponzi borrowers’ who need to borrow more to repay both principal and interest on their previous debt and, such being the case, need ever-increasing prices of the assets they have invested in to keep on refinancing their debt obligations. What fools they all were to expect that some ‘greater fool’ knight in shining armor would come along and wave a magic sword and make it all go away. Instead, they all must recognize that they will be forever poorer but, hopefully, more fiscally responsible in the future. 

With the average house having fallen in price to such an extent that it is no longer feasible to use it as an ATM to finance Ponzi consumption, with equity prices still below their levels in the spring of 2008 and with credit being hard to come by, the party is over for households, banks and non-bank highly leveraged corporations.

Gold Put ‘Foolish’ Investments to Shame in 2009
Most of the ‘wealth’ that supported the massive leveraging and overspending in the economy was nothing more than fake bubble–driven wealth perpetuated by society’s belief in the Greater Fool Theory. Thank goodness for hard assets such as gold bullion and other precious metals which stood up remarkably well during those tumultuous times: gold: + 24% in 2009 and silver: + 49%. 

Were You One of the ‘Greater Fools”?
Now that the bubbles have burst it is clear that the emperor had no clothes and that we were the naked emperor. A rising bubble tide was hiding the fact that millions of Americans (and others worldwide) and their banks were swimming naked and the bursting of the bubble was the low tide that showed just who had been caught with their ‘pants down’ i.e. just who really was the ‘greater fool’. 

As a result, many households, financial and non-financial firms and government, may well spend the next decade in debtor’s prison having to tighten their belts to pay for the losses inflicted by a decade of reckless leverage, over-consumption and risk taking. What fools we have been for living beyond our means all these years and taking no fiscal responsibility for our future well-being in the false hope that there always would be a ‘greater fool’ out there than us. 

Indeed, the American dream of Life, Liberty and the Pursuit of Happiness (and let’s not forget Wealth) has been nothing more than a glorified Ponzi scheme. Let us all look at ourselves in the mirror and finally admit, at least to ourselves, that many of us were the “greatest fools” imaginable!

*http://ftalphaville.ft.com/blog/2009/03/12/53535/nouriel-roubini-is-a-ponzi/

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