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Is it just a great big ponzi scheme? Promises, promises!

Is it possible that banks, stocks, bonds, and pension funds are just a great ponzi scheme?

So much in the financial industry is based on expectations of continuous economic growth. Our system operates on a large number of promises and nearly all of these promises are rooted in the same assumptions – low default rates, low interest rates, and positive economic growth over long periods of time.

In a ponzi scheme, everyone experiences seemingly high returns in the good times. But when times turn bad, it is revealed that there never was as much money as promised. Everyone's wealth seemingly evaporates.

Modern western financial markets have striking similarities to the classic ponzi scheme.

For example, pension funds and retirement plans promise riches to everyone upon retirement, yet do not actually have the funds to deliver on this promise. Instead, pension funds assume a certain long term positive growth, and promise to deliver future amounts. In the meantime, pension contributions (new investors money) are used to pay out retirement benefits (old investors). This is classic ponzi.

Even something as simple as a savings account at a bank is supported by nothing more than promises. Due to modern fractional reserve banking and leverage, the bank does not actually have the money listed as your account balance. Your account balance is the bank's liability (promise) to you. If a large number of depositors simultaneously demand their money back, the bank may be unable to pay: the money doesn't exist, and it never did exist.

These points are food for thought. Unfortunately, it is more than just an academic exercise as recent events have demonstrated to us that many institutions underpinning our financial system are in fact insolvent and unable to deliver on promised wealth.

I strongly suspect that stock markets, bond markets, pension funds and banks amount to nothing more than a great ponzi scheme. I suspect that while things look fine under “positive growth” conditions, when growth halts or reverses it will suddenly become apparent that the money and wealth simply does not exist.

Assumptions of perpetual growth

Nearly all financial managers, and indeed all pension funds, operate with the assumption that economies will continue to grow perpetually. Perpetual positive growth mathematically translates to exponential growth in absolute terms (due to compounding), which is already a warning sign for anyone with a scientific background. Nothing in the physical world grows exponentially without encountering a breaking point.

Many of their growth forecasts and models are based on the 1982-2000 period, which sets some very great expectations for stocks, bonds, and interest rates. It is not a coincidence that these years coincided with the productive years of the Baby Boom generation, the dominant population demographic.

After studying market history and economic fundamentals, and based on my background in science and engineering, I have arrived at the conclusion that there are serious constraints that will prevent this perpetual economic growth.

Constraints on perpetual global growth

What will give first?

Opinions differ on which of the above factors is most likely to halt global growth. The events since July 2008 suggest to me that the financial system is definitely breaking down due to excessive leverage and debt. The unwinding of some derivatives collapsed Wall Street in a matter of months, wiping out America's giant financial industry. Currently, leverage is as high as ever and debt has grown since the start of the crisis, suggesting to me that the unwinding process is far from over.

Which of those “constraints” will ultimately halt growth? Take your pick. These factors are all significant and interrelated. My logic and intuition tell me that the factors stacked up against us are significant enough to require us to change our ways of conducting business and investment.

Implications for investors

Even if I am wrong, and industry does continue to expand perpetually, there is still value in considering the risks posed by the above constraints. Non-mainstream investment strategies may be considered diversification, hedging, or insurance.

Each investor has to research these topics and arrive at their own conclusions. Here are some questions you should ask yourself: What happens when the Baby Boom generation tries to cash out the wealth that they have “accumulated” (promised themselves)? Will the young working generation produce enough income to support these promises and growth forecasts? What if economic growth does not continue positively as assumed? Can debt and leverage keep increasing to infinite levels?

The articles I post on this site will present some ideas for what to do now, and how to prepare for the future.

- Perpetual Bull

June 18, 2009