Pyramid Schemes

When I was 18, I saw an ad that said something like “Make $500 a week selling a revolutionary product!”. The product was a package of “life-changing” nutritional supplements: pills, elixirs, powders, etc. The ad said to go to an address for a meeting on a certain evening. Out of curiosity, I went.

The meeting was in a big room in a community center, rented for the occasion. First, there was a speech promoting the life-changing product and the potential for selling it. Then various people in the crowd stood up and gave testimonials about how the product had changed their lives: they were healthier, wealthier, having more sex, etc.

Of course, it was a multi-level marketing scheme. To join, you had to buy a batch of the product, and then you were supposed to use it yourself, sell it to others, and recruit others to sell under you, in which case you would get a percentage of their sales.

At the time, I had never heard of such schemes, but I was not fooled. I understood that it was a scam, but I stayed to the end of the meeting. It was interesting. I was amazed at how many people signed up for it. The nutritional supplements were probably of little value, but they were not the real product. It was the scheme itself that people were selling, and buying.

Multi-level marketing is a type of pyramid scheme. A pyramid scheme is an investment scheme in which the returns on investment come from new investors, not from any productive enterprise. I am using the term in a broad sense to refer to any scheme or process in which returns are only generated by new investors. Pyramid schemes can be deliberate conspiracies, but they can also emerge from crowd dynamics, without top-down organization.

Why do people fall for these schemes? The uncharitable answer is that people are stupid. The more charitable answer is that people are not very good at understanding complex systems, especially ones involving feedback loops. They join because they see a pattern. They see that others have made money by doing X, and so they do X.

There is a little more to it than that, but not much. Pyramid schemes are like ideologies. They give people a sense of belonging, and the illusion of intellectual superiority. The ordinary person desperately wants to be somebody, and the pyramid scheme sells him that illusion, for a while.

The economic and financial history of the last 20 years has been dominated by pyramid schemes and their collapses. They were mostly self-organizing. They involved some deliberate fraud from people in high places, but the biggest role was played by the greed and stupidity of the ordinary person.

Let’s start with the internet stock bubble of the late 1990s. Stocks had been growing in popularity for savings/investment since the early 1980s. There had already been some big successes for computer companies. In the 1990s, it became apparent that the internet was going to have a revolutionary impact. People started buying stocks related to the internet, computers and communications technology.

Before I go on, I should explain what a stock is. It is a share in a company. Stocks return money to shareholders by paying dividends. But stocks don’t always pay dividends, and many people buy stocks not for dividends, but because they expect them to go up in price.

During the 1990s, stock market investing became popular among ordinary people, to a degree that hadn’t been seen since the 1920s. People became obsessed with changes in stock market indexes such as the DJIA or the S&P 500. This gave them a pretense of knowledge. People came to believe that stocks should provide returns by going up in price: that this was their normal and proper behavior. It is a rather absurd idea that people should be rewarded simply for buying and selling stocks. But that became the conventional wisdom.

The Federal Reserve helped promote this view of the stock market as a free money generator. When there were stock market crashes or corrections, the Fed lowered interest rates a little bit, which usually had the effect of reversing price declines in the stock market. People came to believe in the idea of the Fed as a central manager of markets whose role is to maintain the growth of stock prices, even though that isn’t part of the Fed’s mandate (and shouldn’t be).

In a sense, the stock market itself is a pyramid scheme, at least to the extent that people expect to get returns from price increases rather than dividends. For every seller, there must be a buyer. If a stock investor makes money from a price increase, the money comes from a new investor. It does not come from the company that issued the stock. It is just a transfer of money from the buyer to the seller.

The internet stock bubble involved people buying stocks from companies that had never generated a profit, and might never generate a profit. People bought stocks in the hope of future price increases. For a while, that was a self-fulfilling expectation. The expectation of price increases caused demand for stocks to increase. Growth in demand caused growth in prices, and vice versa. It was an amplifying feedback loop. People saw others getting rich, at least in theory, and they wanted to join in.

Eventually, the bubble burst, as they always do. At some point, the flow of new investment slowed down, causing prices to stop increasing, which caused demand to start falling, which caused prices to fall. There was a big crash when the feedback loop reversed direction. Many people lost a lot of money.

The bubble had also made some people very rich. It was a wealth transfer. The big winners were the executives and employees of internet companies, who took a lot of money from investors, often led lavish lifestyles, and never made a profit or returned any wealth to shareholders.

Wealth is not created by price increases, and wealth is not destroyed by price decreases. The bubble created the illusion of wealth, and the crash destroyed that illusion.

The crash was followed by a recession, partly because a lot of resources and labor had been diverted into unproductive enterprises by the bubble. The recession deepened after the 9/11 attacks. The Federal Reserve reacted by lowering interest rates and keeping them low for a long time. That helped create the next big pyramid scheme: the housing bubble.

Again, I call it a pyramid scheme because, like the internet stock bubble, returns were based on money from new investors, not on returns from productive enterprises. The same feedback loop between demand and price increases drove up the price of houses. For years, house prices grew and demand increased. That is the opposite of how prices work for consumables. Higher prices for wheat will lower the demand for wheat, not raise it. For assets that are viewed as investments, however, increasing prices can generate increased demand for some period of time. But not forever.

The media hyped the housing market, and helped to perpetuate fallacies about it that were very similar to the fallacies they had perpetuated about the stock market a few years earlier.

The biggest such fallacy is simply that up is good and down is bad. This simplistic view of markets is nonsense, of course. High prices are only good for those who want to sell. They are bad for those who want to buy. Price increases do not create wealth. But whenever asset prices went up, the media reported it as good news, and whenever asset prices went down, the media reported it as bad news. They ignored the basic fact that for every seller there must be a buyer. The media would often talk about how people were getting richer, as if everyone owned a house. Meanwhile, many people were losing their hope of ever owning a house, due to rising prices.

Media hype helped to create the bubble by reinforcing, rather than correcting, the natural stupidity of the masses. The media acted as a stupidity amplifier: feeding back popular misconceptions to the masses.

It shouldn’t take much intelligence to figure out that for every seller there must be a buyer, and thus we can’t all get rich from price increases. But people are prone to these delusions, especially in crowds. The ordinary person believed in the myth that houses are magical wealth generators, just as he had believed the same thing about internet stocks a few years earlier.

Eventually, the demand for houses slowed down, and prices stopped increasing. At that point, a lot of people suddenly wanted to sell, which caused prices to fall, causing demand to fall further, etc. Like the internet bubble, the housing bubble collapsed by the same feedback loop that created it, running in reverse.

The housing bubble was much bigger than the internet stock market bubble, and it had more serious consequences. People usually borrow to buy houses. During the bubble, banks and other institutions had issued a lot of mortgages, often with very low down-payments. Those mortgages were now in high risk of default. Many people could not pay for the houses they had bought with borrowed money, and were walking away from their mortgages. Many banks and other financial institutions found themselves insolvent, because they had lent money to people who couldn’t pay it back.

After the bubble burst, the media struggled to find a new narrative. I remember how they eventually came up with the explanation that the problem was caused by complicated financial instruments and greed on Wall Street. That was partially true, but it was still very misleading. They did not want to blame the individual real estate investors, who were just as greedy as the investment bankers. They downplayed the role of the Fed. They did not accept any share of the blame for misleading the public. They often said that “No one could have seen this coming”, even though many people did see it coming and loudly predicted it.

After the housing crash and the ensuing financial crisis, governments around the world stepped in to bail out banks and other financial institutions, and in some cases individual home-buyers who couldn’t pay their debts. This was robbing the responsible and productive to give to the irresponsible and unproductive. Governments used a combination of borrowing and printing money to finance the bailouts.

Where did the money come from? Savers. If the government borrows money on the bond market, it is asking for voluntary contributions from savers. If the government prints money (usually by having the central bank create money to buy government bonds) then it is confiscating wealth from savers by inflating the currency. Either way, the money comes from saving.

The point of saving is to consume less than you produce during one period of time, so that you can consume more than you produce during another period of time. Borrowing has the same function, but with the order reversed. Savers lend money to borrowers, with the expectation that the borrowers will pay them back later. This is very useful. A person can borrow money when young to get an education and buy a house, then pay that money back during middle age, then save money for his retirement by lending to younger people, and then live on his savings during his retirement. During the early and late periods of his life, he consumes more than he produces, but that is balanced by producing more than he consumes during middle age.

Even if you stuff dollar bills into your mattress, you are implicitly lending money to others. Stuffing money into a mattress is taking money out of circulation, which increases the value of the money in circulation. This gives everyone else a little more spending power. If you put money in a bank, the money is lent to others who spend it. If you buy a stock, another person gets the money and spends it on something. If you buy a corporate or government bond, the corporation or the government will spend the money on consumption today.

This system is extremely beneficial when it works, but it can be exploited in various ways. If savings are diverted to unproductive people or unproductive enterprises, they will simply be lost. Saving depends on a fundamental principle: that those who borrow must later produce more than they consume, so that the savers can redeem their savings.

After the 2008 financial crisis, there was a long and deep recession. Governments around the world not only bailed out the losers, they also tried to stimulate the economy with low interest rates and high government spending, financed with money creation.

I think Keynesian stimulus can work in certain cases to bootstrap the economy to a higher level of consumption and production. But it only works if it is rarely used. If Keynesian stimulus is used all the time, the economy slows down and becomes stagnant. You can see that with Japan’s long period of stagnation, and in what happened in the US and Europe after the housing bubble. Prolonged Keynesian stimulus prevents the repricing and reallocation of assets, and thus it prevents the restructuring of the economy. It perpetuates economic failure.

The debts created during the housing bubble were not erased by bankruptcy, but instead were largely transferred onto the balance sheets of governments and central banks, which are government proxy agents. Then governments borrowed or printed yet more money to stimulate their economies, without success.

That’s how we went from a housing bubble to a sovereign debt bubble. Governments around the world borrowed a lot of money, used it mostly to finance spending on welfare programs, and justified it in terms of Keynesian stimulus. Governments have no conceivable way of paying back those debts. They need to borrow or print more money every year.

At some point, every pyramid scheme comes to an end. A government can’t finance itself forever by borrowing or printing money. Borrowing eventually leads to bad credit and higher interest rates, even for governments. Printing money eventually leads to price inflation. Both are vicious cycles. Every year, the government needs to borrow or print more money to pay interest on its debt and to deal with rising prices.

Whether they borrow or print, the money comes from savers. Governments are confiscating wealth from the young to support the old, and from the productive and responsible to support the unproductive and irresponsible. It is difficult to avoid participation in this scheme, because governments can confiscate wealth by taxing or printing money. However, by doing so they discourage people from being productive and responsible. They discourage people from creating wealth or saving for the future. At some point this pyramid scheme will also collapse.

Government debt is not the biggest pyramid scheme, however.

There is an even bigger pyramid scheme, which is economic and population growth. For years, we have relied on economic and population growth to pay back the debts of the previous generation. A growing economy and growing population made it easy for people to save. It caused the stock market to go up, as more people entered it and as companies grew, justifying price increases. It made house prices go up, as more people entered the housing market, competing for real estate. It allowed governments to accumulate debt, because they also had a growing tax base. Growth was a subsidy to people saving for retirement and also to governments. But the Earth has limited resources. Populations and economies can’t grow forever.

Eventually, these pyramid schemes will come to an end. The people left holding the bag will be the younger generations. They will face a much bleaker future than their parents.