When Things Fall Apart

The second largest Ponzi scheme in history

Reading this story makes me wonder if there could be anyone else out there doing this right now that just hasn’t been caught yet.  Someone who keeps borrowing money, spending it and then borrowing more to pay it back.  Someone whom everyone just assumes will always be able to pay the money back just because they always have, even though they keep getting further and further in debt and have to borrow more and more to keep up.

Charles Ponzi

Charles Ponzi

When we make a macro model in economics there is an important element known as a no Ponzi game constraint which must be included.  Basically this says that the government has to eventually pay back whatever it borrows with interest, or in other words: as time approaches infinity net government debt must approach zero.  Without this the model cannot be identified because the government would just spend as much as it wants all the time and not worry about how to pay it back.

When I first learned of this constraint (two years ago in econ 509) my immediate question was “does anyone believe this actually holds?”  The professor looked at me like nobody had ever asked that question before.  It has to hold, or course, because if it didn’t the government wouldn’t be able to borrow in the first place since nobody would loan to someone if they didn’t think they would eventually pay it back.  Well as we can see from the case of Mr. Madoff, in reality this constraint doesn’t have to hold.  People just have to believe it will hold.  Which is easy to do when nobody is questioning it.

Currently U.S. treasury bonds are considered the safest investment in the world.  I wonder what would happen if one day people woke up and no longer felt this way?  I imagine the tax rate that would be required to pay off the national debt if suddenly nobody was willing to loan to the government. I wonder what the Chinese would do if we told them “sorry we don’t have the money.” When markets collapse they don’t do so gradually giving everyone time to get most of their money out and they don’t usually warn you six months in advance so you can rush a preventative action plan through congress.  At least not so long as nobody in Washington is reading TSJ. (=