Now we know: the booming economy was a huge Ponzi scheme

Bernard Madoff’s $50 billion Ponzi fraud is now legendary. Yet the fabric on which our entire credit explosion rested was just as illusory as Madoff’s investment fund. It existed in appearance only.

The toxic financial instruments, so neatly packaged by investment houses before being sold on to other players in the global game of pass-the-parcel, were nigh worthless from the start. They were lent spurious credibility by the two unchallenged assumptions on which every Ponzi scheme depends: (a) that no one would actually check the quality of the constituent debts; and (b) that the creation of such instruments and their onward sale could continue without natural limit.

Only in dreamland could that credit bubble have expanded unchecked

Only in dreamland could that credit bubble have expanded unchecked, at the same time sending asset prices, notably property, spiralling ever higher. But even that dream would have been shattered when the pseudo-zillionaires were suddenly confronted by the inability of the real economy to create goods and services in step with their apparent expansion in wealth. Time to wake up.


A familiar pattern

Parallels abound. A closed pension scheme that promises retirement returns based on assumed but unachievable equity and income growth can match those promises only by locating new funding sources – or by stealing from other funds, such as taxes, as in the case of privileged public sector pension schemes. Private sector final salary schemes may look fine, but can only deliver on the assumption that the employer can meet its mounting pension fund liability and remain solvent.

It’s been an education for everyone – from the lowliest credit card juggler to the global hedge fund wizard whose sophisticated investors were admitted to Bernie Madoff’s circle of elite 12-per-centers. The magic works, but only for a time. Like the Wizard of Oz, Madoff forbade anyone to peek behind his protective curtain.

As ever, there are many lessons. On the negative side, there is no longer any justification for believing that the beleaguered trio of regulation, governance and audit can provide any reliable safeguard against a powerful belief system that takes on the provenance of received wisdom, no matter how utterly false it turns out to be.

As former chairman of the Nasdaq stock exchange and SEC adviser on market regulation, Madoff was a classic example of the regulator who goes on to make his fortune while still wearing a halo of rectitude. The migration of regulators to highly remunerated positions in the private sector, from which they are able to “advise” on the course of sensitive investigations, is now an acknowledged feature known as the “revolving door”.

Ten years ago informed commentators were on record as observing that Madoff’s investment returns were, quite literally, impossible to achieve legitimately. Yet Madoff’s personal status outweighed innumerable alerts and tip-offs to regulators so emasculated that they had effectively become facilitators.

As for governance based on non-executive vigilance, this too is powerless when there is little grasp of the technical complexity in a company’s operational engine room, still less as a safeguard against excessive executive rewards geared to results unmatched by cash flows.


Under-achieving audits

Ever come across that well-known audit firm Friehling & Horowitz? No? Well, they were the auditors of the giant Madoff Securities. They had no other clients, practised out of a cubicle in a downtown New York mall and their formidable manpower consisted of a secretary, a retired 78-year-old living in Florida and a curious character who “wore tight pants and tie-dyed shirts”.

Would any of the major audit firms have been more likely to uncover the gigantic Ponzi scam being orchestrated over at least two decades? Given that there appears to be no coherent accounting record of (a) amounts invested; (b) by whom; (c) income credited; (d) investment returns remitted; or (e) redemptions, the only practical outcome of any audit would have been a monumentally explicit disclaimer.

The scale of the Madoff losses was nowhere near the fabled $50 billion since that sum includes the vast notional returns that his investors thought they had achieved. That money never existed, so it can hardly have been “lost”.

Let me repeat the positive message: to the extent that a rise in market prices of financial and real-estate assets exceeds the ability of the economy to provide a commensurate level of goods and services, any apparent increase in wealth is illusory