Irving Underhill 1 Wall Street 1931
Today we take you back all the way to November 26 2008 (remember the good old days when everyone was scared as a squirrel?), when Nicole Foss wrote “From the Top of the Great Pyramid”. In those days, just like we do today, we didn’t only report on what was happening, but we also addressed the reasons why.
Most people see pyramid schemes as limited to Charles Ponzi, Bernie Madoff or the occasional chain letter they may once have received. But in reality, Ponzi’s are everywhere around us. As Nicole writes, all empires are grounded in pyramid dynamics, and that includes the American empire. And – the vast majority of – our pension systems. And our entire credit-driven economies, in which 50% of credit is – or used to be until recently – created by banks when they approve mortgage loans. So another look at “the dynamics of pyramids” might be a good idea.
Nicole Foss: Everyone has heard of pyramid, or Ponzi, schemes. In their simplest form they are short-lived deliberate frauds where a small number of existing members are paid from the buy-in of a larger number of newer members until the supply of newer members is exhausted, whereupon they collapse. Typically, the founders, and perhaps a few others who got in early and out before it was too late, end up making a lot of money at the expense of later entrants, who end up holding the empty bag. There are always many more losers than winners.
What most do not realize, however, is that Ponzi dynamics are far more pervasive than people think. There are many human systems that ultimately rest on the buy-in of new entrants, and every one of them will ultimately meet the same fate, although it can take far longer for complex constructions than for simple pyramid frauds.
What allows a more complex pyramid to last for longer than a simple one is a supplementary source of funds to pay members, besides merely the buy-in of newer members. The more such sources there are, legitimate and otherwise, the more complex the pyramid can become and the longer it will last, as the apparent on-going success of early entrants will attract many more new ones. There’s nothing like seeing one’s friends and neighbours seemingly making a lot of easy money for a long time to eventually overcome the mental defenses of even the most skeptical.
Following the collapse of communism in Eastern Europe, there was a spate of such schemes – notably MMM in Russia, Caritas in Romania, Jugoskandic and Dafiment Bank in Serbia, TAT in Macedonia, and VEFA Holdings, Xhafferi, Populli, Gjallica and several others in Albania. They were the topic of my academic research at the time. All of these lasted for quite a long time, and some paid out spectacular returns for much of that time. For instance, the Albanian funds , or quasi-banks, began by paying out 3-5% per month over a 6 month term and were eventually paying out 10% per month (and briefly much more as an interest rate war ensued very late in the game).
They were able to do this temporarily because the income from the buy-in of new entrants was supplemented by revenue from drug smuggling, oil sanctions busting, money laundering, gun running, human trafficking and a thriving trade in car theft from across Europe. There was some revenue from legitimate business interests, but not much in a country that survived mainly on a combination of remittances and politically supported criminal activity. Ironically, Albania was the darling of the IMF at the time.
Over time, approximately 80% of the Albanian population was drawn into the pyramids, often selling their only real property in order to invest and then depending on the pyramids for all their income. When the inevitable happened, the vast majority of the population was completely dispossessed. Although many had realized that there was something too-good-to-be-true about their ‘investments’ they had succumbed to greed “in the belief that they were in the hands of properly structured criminality”, as The Guardian newspaper put it in February 1997. The population believed, erroneously, that there was an implicit guarantee from the government, which was conspicuously and intimately entwined with the activities of the various funds.
In the developed world, there are many examples of pyramid dynamics where there is no intent to defraud at all – where even the founders really don’t understand the underlying logic of their business model taken to its logical conclusion. Direct marketing, for instance, is essentially pyramid-based – depending on an ever-increasing network of sales people, each of whom receives a percentage of their income from those they can attract into the business.
If these businesses can no longer grow by attracting new salespeople, then they are ultimately finished, but as they cannot grow perpetually (or eventually everyone in the country would end up making a living selling these products to each other), they are inherently self-limiting. They can last for many years thanks to legitimate business revenues, but not forever. Early entrants will always do very well, at the expense of later ones, and the last tiers will certainly lose their stake.
Large economic bubbles, typically formed in dominant economies during periods of manic optimism (see McKay’s Extraordinary Public Delusions and the Madness of Crowds), have the same underlying dynamic. Without continual buy-in from new money – new investors or more money from existing investors – they cannot grow, and when they can no longer grow, they will collapse. Although grounded initially in legitimate business activity, they morph into structures where one has to question the motives and understanding of key individuals. In some cases there may be intent to defraud, but what is far more common is a characteristic recklessness as to the risks those in control are prepared to take with other people’s money.
In their latter stages, such structures hollow out, feeding on their own internal substance as they lose the ability to attract new investment. In the terminal phase, there is the appearance of great wealth, but it is virtual, and therefore extremely ephemeral. The next step is implosion, as the virtual wealth disappears – where the claims to wealth generated through leverage that exceed the amount of underlying real wealth are extinguished en masse. Enron was a prime example, and on a much larger scale, so is the derivatives market. Bubbles, like all Ponzi structures, are inherently self-limiting and will always collapse in the end.
At the largest scale, empires are also grounded in pyramid dynamics, which is why they too have a limited lifespan. They grow by assuming control, either politically or economically, of new territories, positioning themselves to cream off surpluses from an ever-expanding geographical area in a form of involuntary buy-in. In the past political control through invasion or physical colonization was more common, but latterly globalization has enabled the development of a sophisticated system of economic control based on international debt slavery, supplemented with economic colonization for the purpose of resource extraction.
Both resources and financial surpluses, in the form of perpetual interest payments, could be efficiently extracted from the periphery and accumulated at the centre, where they led to the development of an unprecedented level of socioeconomic complexity.
Such wealth conveyors in favour of the economic centre, at the expense of the hinterland, are the very heart of empire, but without continual expansion to feed rapidly developing central complexity, they eventually fail, leaving the centre unable to sustain its existing complexity level. As with economic bubbles, empires hollow out in the latter stages, consuming their own substance in a catabolic manner in order to compensate for the inability to strengthen wealth conveyors sufficiently quickly to keep pace with the expanding requirements of the centre.
As the hinterland is increasingly stripped of wealth and resources, and burdened with the increasing environmental impact of its own exploitation, an increasing fraction of it is left too impoverished to sustain a minimum level of internal order. In modern times we speak of failed states without realizing why many of these states are failing, or the impact that an increasing number of failed states will ultimately have on our own standard of living.
Wealth conveyors are breaking down, and no amount of financially squeezing the population in the central economies can compensate for the loss of that ability to accumulate wealth from virtually the whole world. The vast majority of the central population will be brutally squeezed as the elites try to hang on to their own privileged position, but this can only sustain a very small, and rapidly shrinking, fraction of the population, and at great cost.
We are living through the collapse of the final – and all-consuming – economic bubble at the end of the American empire.
This article was originally published on November 26 2008. See here for original comments section.
This article addresses just one of the many issues discussed in Nicole Foss’ new video presentation, Facing the Future, co-presented with Laurence Boomert and available from the Automatic Earth Store. Get your copy now, be much better prepared for 2014, and support The Automatic Earth in the process!