Con Game

Posted January 8, 2011

Categories: Articles

I’m sitting in Starbucks the other day eavesdropping on the conversation at the next table. A man in a suit is trying to sell something to a couple. I’m having a difficult time determining the product. But the pitch is familiar enough. By buying a large number of these items and selling them to their friends, neighbors, and colleagues, the couple will unleash their inner entrepreneur. They’ll make a modest investment and, in no time, score a lot of money.

The man in the suit produces a lot of shiny, colorful pamphlets from his briefcase. He tells the couple about how much money he’s made. He tells stories of other lucky couples. He exudes confidence.

I’m tempted to lean over and tell the couple to clear out before they lose their nest egg. They’re on the verge of getting sucked into a typical pyramid scheme. You probably know the routine. New participants invest their money in the hopes of a big payout, but only after they’ve enlisted a whole new tier of investors. These entrepreneurial scams — also known as multi-level marketing — usually revolve around a product that has special qualities, like Brazilian acaí berries or megavitamins. The recruits end up spending a lot of money on books or DVDs or expensive trainings. The payout is minimal. At Amway, perhaps the most famous multi-level marketing system, distributors make on average only $115 a month, and that doesn’t count how much they put out for Amway’s “tape of the week” or trips to conventions.

Financial scams, like Bernie Madoff’s multi-billion-dollar investment fraud, operate according to a similar pyramid structure. The scammers lure in people with impossibly high rates of return on their investment. The suckers often get some return on their initial outlay, which only spurs them to throw away more of their money. In the end, a small group of initial investors makes a fortune, the founding fraudster might or might not go to jail, and everyone else loses big.

In both the entrepreneurial and the financial pyramid scams, the magic ingredient is confidence. The investors believe in the financial guru or in the person who initiates them into the marketing chain. And, of course, the investors are confident that they’ll make lots of money. In some cases, as in the pyramid schemes that ripped through the former communist world in the 1990s, many investors even knew about the fraud but believed that they could get in and get out with a bag of money before the whole thing collapsed.

This confidence flies in the face of the economist’s hoary truism: there’s no such thing as a free lunch. If it looks as though the rate of return is impossible, it is impossible. If it looks as though you’ll be making money by doing practically nothing, think again. Only the already-rich get richer by doing practically nothing. Yet there’s no shortage of pyramid schemes out there. Confidence keeps them afloat.

But confidence also drives the official economy. Last week, Standard & Poor’s downgraded the U.S. credit rating from AAA to AA-Plus. The Obama administration was taken aback, since it was pushing through a compromise on the debt ceiling precisely to avoid such a scenario. The U.S. stock market dropped precipitously. And suddenly it wasn’t just progressive economists and commentators talking about a double-dip recession. Even former White House economic advisor Larry Summers gave the economy a 33 percent chance of taking a second major plummet. As a major reason for this potential downturn, Summers cited “declines in business and household confidence.”

Let’s go back to Starbucks. The U.S. economy is the man in the suit. The couple represents your typical investors. And the person at the nearby table is Standard & Poor’s, who has just leaned over to whisper to the couple that maybe everything that the guy in the suit is saying is not 100 percent kosher. Of course, the investors should have picked up some clues earlier on. After all, they’re meeting in a Starbucks, for goodness sake, not a real office. The guy in the suit is adept at not answering tough questions. The materials they’re looking at contain way too many exclamation points!! They should have cleared out earlier.

Depending on how greedy or deluded they are, even the warning from the nearby table might not destroy the confidence of this couple. Like many Americans, they believe that they can strike it rich, even at a time of high unemployment, declining social services, and constricted federal investments. Or maybe the couple doesn’t really trust the advice they’re getting from the other table (Standard & Poor’s, after all, notoriously screwed up by not raising any red flags during the sub-prime mortgage crisis). At least the guy in the suit is promising something, which is more than what the banks and employment agencies are offering these days.

If the analogy holds, then the U.S. economy is…a giant pyramid scheme?

It’s a tempting conclusion. Maybe Bernie Madoff didn’t go to jail after all and was installed instead as the secret head of the Council of Economic Advisors. During this period of grave economic difficulty, U.S. corporations have made unprecedented profits. In 2010, corporate profits accounted for 14 percent of national income, the highest proportion ever, according to Commerce Department figures. Companies are, quite frankly, rolling in cash: “While the U.S. government is running record deficits, chief executive officers have more money than ever after boosting cash for 10 straight quarters to $963.3 billion, 58 percent more than in December 2007 near the start of the credit crisis,” writes the San Francisco Chronicle. The truly depressing part of the story is that these companies are not using their profits to hire more workers. They’re either sitting on the cash or investing it overseas. Meanwhile, small businesses have been hit hard by the crisis, and workers have been hit harder still.

In normal times, the tax system or government services would level the playing field. But with Bush-era tax cuts for the wealthy and historically low taxes on dividends and capital gains still in place, public redistribution of resources is actually going the other way to widen inequality. And now the tea partiers and their fellow travelers are using the debt ceiling as a way to hack away at social programs. The U.S. economy is turning into a pyramid scheme. What else do you call a mechanism not for the production of goods and services or the generation of common wealth but only a means for the unscrupulous to become unbearably rich?

Pyramid schemes fail when confidence dries up. Investors get tired of waiting for their promised dividends. Entrepreneurs eventually figure out that they are spending more money than they are taking in. As long as the confidence game attracts new marks, then the pyramid remains standing. But when the sources of new money disappear, the scam lies exposed.

The Obama administration has tied itself into a pretzel to prove that things are getting better, that there’s good reason to be confident. The administration has touted the latest job figures, which aren’t particularly promising. It has pointed out that the other two ratings agencies have kept the United States at AAA. The stock market’s nose dive is certainly troubling, but volatility has become the hallmark of Wall Street of late. Administration officials have been all over the news “voicing confidence.”

The Obama administration can’t, however, ignore China, which holds over $1 trillion in U.S. debt. “China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s dollar assets,” reads an editorial from Xinhua, China’s government-run news service.

Internationally, the use of the dollar as the chief world currency sustained a degree of confidence in the U.S. economy. But the reign of the dollar might be soon to end. The head of the Dagong Global Credit Rating, a Chinese version of Standard & Poor’s, recently predicted that the dollar will soon be “gradually discarded by the world,” and the “process will be irreversible.” Never heard of the Dagong Global Credit Rating? It downgraded U.S. crediting rating before Standard & Poor’s did. Once again, the Chinese were out in front of us.

The Chinese are understandably upset by this turn of events. For a decade, America has been essentially eating a free lunch: lavishing money on the military, fighting several wars concurrently, and cutting taxes on the wealthy. We assured our investors that we knew what we were doing. We showed them lots of pretty documents. We made plenty of impressive promises. Now the investors are getting antsy. They’re worried that the second dip will be much deeper than the first. The Chinese will take a hit, but they’ll also probably take over the restaurant. And I can confidently assure you that it won’t be Larry Summers or Timothy Geithner who’ll be in the kitchen washing dishes to work off all those “free” lunches. But that’s the only thing I have confidence in these days.

Indecent Proposals

Let’s see if I get this straight. We invade Iraq. We kill countless people. We send the country into a downward spiral of violence and corruption. The economy is a mess. Millions of refugees have been displaced, internally and externally.

And Dana Rohrabacher (R-CA) wants the Iraqis to pay us for all this?

“In order to prevent a failed state in Iraq or a state that remains completely dependent on its U.S. backer, the United States must clean up the mess that it made,” writes Foreign Policy In Focus contributor Fatima Al-zeheri in The Ongoing Costs of the Iraq War. “Washington should cut military spending and use a small portion of that money to help Iraqis rebuild their country, assist uprooted citizens in returning home, and create a transparent and democratic political system. Many of the losses that Iraq has suffered cannot be compensated. But the United States must still try to make things right. And that means, despite what Dana Rohrabacher has demanded, that Washington, not Baghdad, pay the Pottery Barn bill for damages incurred.”

In Congress, the hawks hope to balance the budget without cutting military spending. Leon Panetta has replaced Robert Gates as the new defense secretary. So far, Panetta looks as though he will do his best to defend his domain. “Leon Panetta, the new Pentagon chief, got through his confirmation hearings the newfangled way: by revealing as little as possible about what he’d do in office,” writes FPIF contributor Miriam Pemberton in Will Panetta Help the State Department? “He tipped his hand a bit more last week by calling ‘completely unacceptable’ the across-the ­board military cuts planned in the event the next debt deal fails.”

Essential Proposals

Somalia is now suffering from drought on top of its civil war. FPIF contributor Khadija Ali has an important political proposal: bring in the women.

Somali political structures and clan organizations are dominated by men. Yet women are critical peacemakers in the country and essential to any sustainable form of economic development. Also, “Somali women lead more than 50 percent of the local NGOs delivering humanitarian assistance,” she writes in Women’s Exclusion Worsens Somali Crises. “So, having women in important political positions will lead to transparency and accountability in the delivery of humanitarian aid to the vulnerable population. Therefore, women must be appointed as advisors, strategists, actors, planners, and managers of humanitarian assistance.”

Finally, in our FPIF Pick this week, FPIF contributor Vivian Yang looks at a set of recommendations to improve U.S.-Chinese relations. In her review of a new book by Michael Swaine, she writes that “Swaine believes that the current global imbalance is caused by excess liquidity in the U.S. economy. Thus, the debt problem can be addressed more efficiently through proper U.S domestic economic policies rather than putting pressure on Beijing.”

Putting pressure on Beijing? From now on, you can count on Beijing to put pressure on Washington.

FPIF, August 9, 2011

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