Sunday, 6 March 2005

Legalised Pyramid Schemes

The Malta Independent of Sunday

Pyramid schemes are illegal. They are financials scams where intelligent, crooked minds sit at the top of a scheme and roll it out, extending its base where an expanded lower level make payments to the narrow levels on top as they engage a new wider base layer.

In theory, such pyramid schemes could keep going on in perpetuity if the base always keeps adding a new broader layer. But in practice it never works that way. At some point the momentum slows down and when it would be impossible to engage a fresh broader base layer the whole scheme collapses. The large majority of the late entrants will lose their money invested with foolish greed, while the few on top count their riches.

Strange as it may seem we are witnessing two situations which have some features similar to illegal pyramid schemes but which are not only legal but essentially promoted by governments.

Let’s look at the largest of these schemes promoted by the sole superpower, the
United States of America. Everybody who has the slightest economic knowledge agrees that the current level of US deficit in public finance and in the balance of payment is unsustainable. Commonly referred to as the twin deficit they re-inforce one another.

The Bush administration has switched the budget surplus inherited from the
Clinton era into the largest public finance deficit ever. But in the process it has cushioned the economic downturn resulting from the tech bubble aftermath, and has primed the US economy to grow at a consistent four per cent p.a. creating jobs and attracting investments which leaves developed European economies gaping as they struggle with high unemployment and low growth.

The strength of the US economy creates a huge gap between investment and savings, which translates itself into a monumental deficit in the balance of payments, producing contra balance of payments surpluses mostly originating under the rising Asian sun, not least China.

Normally such huge imbalances are self-correcting through fluctuating rates of exchange mechanisms. This time however, something like a pyramid scheme is being created to beat the market. Most Asian countries running surpluses in trade balances with the US, mostly Japan, China and Korea, have either completely pegged their currencies to the US dollar or, in case of Japan, force their Central Bank to intervene regularly in the foreign exchange markets to keep their currencies tracked with the US currency.

In order to keep their domestic economies growing on export demand to the
US, these countries are quite willing to continue buying US dollar finance paper at low interest rates, knowing that they could incur currency losses as the value of the dollar is crushed by the weight of the external deficit. For these Asian countries the benefit of stable, weak exchange rates exceed the costs of reserve accumulation. China relies on rapid export-led growth to absorb labour surplus of hundreds of millions of low-skilled workers from its vast agricultural sector into the modern industrial traded sector.

In turn, the US, fast economic growth and accelerated investments is cheaply financed by Asian countries accepting to buy US dollar paper at low interest rates, keeping long term rates stable or indeed falling; forcing the Federal Reserve Chairman Alan Greenspan, on unstoppable trend to increased short-term rates slowly but consistently, to label such a phenomenon of non-responsive long term interest rates as a conundrum.

How long can this artificial anti-market arrangement keep its cosy scratch my back I scratch yours arrangement going on? No one really knows. Views vary from a whole generation to just a few months. When ultimately the currencies of surplus countries in Asia will have to respect market pressures and unpeg from the dollar in order to contain domestic inflation raising domestic interests in the process ( China has a domestic interest rate of just 2.5 per cent whilst it is growing at nine per cent!) these Asian central banks will incur exchange losses running into several hundred billions on their US dollar reserves. Losses so huge could blow their economies away.

Last week the mere mention by the Central Bank of Korea of their desire to diversify their reserves away from the over-concentration of the US dollar brought a sharp instant fall of two pwe cent in the value of the US dollar until the same Korea bank clarified that they have no intention to start selling their dollars but that diversification will be sought through future accumulations. The international pyramid schemes being operated by the
USA and the exporting countries of Asia has become as fragile as that.

We have a similar pyramid scheme going on domestically with government debt and the Maltese lira. We have a poor government among quite a prosperous population. When I say poor government I refer to the organisation not to the individuals who run it. When I say prosperous population it does not mean that everyone is prosperous but that on average the population has a decent and improving standard of living.

How does the pyramid scheme work here? The poor government organisation feeds the prosperous population by annually spending one hundred million plus liri more than it can resource through its normal inflows. This continues to enrich the population who are only happy to lend the deficit back to the government so that the latter can continue to spend and enrich them. In the process the people running the government can gain political support from the majority of the population who mistakenly believe that the pyramid scheme can continue forever and that they can continue to lend the poor government and suck it back into their bank account with no time limit.

How long can this go on? How long will the prosperous population remain willing to lend back their riches to the poor government as they see the economy stagnant and the government selling its family silver purely to plug its gaping financial holes? It could go on until doubts creep in on the sustainability of the pyramid scheme. And this sustainability issue could be given a huge shock in our attempt to join the Euro.

Unless we can do within a short time what we have neglected to do over a long time, unless we cut the very essence of the pyramid scheme with the poor feeding the rich, we will never make it to the Euro and the pyramid scheme will collapse as people start shifting their Maltese liri to Euro whether or not we decide to join.

Pyramid schemes, by whatever name they are referred to, whether legal or illegal, have one thing in common. In the end they collapse and the many will be hurt while the few will count their riches. It will not be any different here or globally when the US dollar and deficits unravel.

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