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Comment by pg | Hacker News Reader

He's mistaken. There is a real structural difference between a Ponzi scheme and an investment fund.

And as for the high incomes of money managers, it seems reasonable to pay someone a lot to manage a huge fund. So much is at stake that it would be a false economy to hire someone cheap.

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But what Krugman is highlighting here -- and Nicholas Taleb has done in more detail previously -- is that fortunes have been made pursuing strategies that are net losers for investors and society.

All you have to do is make sure the giant losses occur just 1 year out of N. It doesn't matter that the one year's losses wipe out the other N-1 year gains; you've already collected your fees and quite possibly retired, and there's no claw-back of your cut.

A reasonable aim of financial technology is to ameliorate the risks that could obscure or destroy truly productive activities. But the same tools can easily be used to do the opposite, construct net-wealth-destroying strategies which enrich only money managers.

To cook up such a strategy purposefully is a crime, and the classic ponzi scheme is the blatant extreme case. But many other strategies based on collecting fees during the upswing of an unsustainable bubble, while being insulated from the downswing, are close cousins of the full ponzi. That the loot is laundered through ostensibly legitimate investments (like mortgage securities this time around) is a convenient consensus cover story; it helps even the perpetrators believe they are providing valuable investment services rather than just a scam.

This view doesn't indict all investment activity/funds as being similar to ponzi schemes. But an awful lot of this most recent financial-services boom appears to have been like a ponzi skim.

(Despite the truth I see in this column, I would not trust Krugman's suggested solutions, which are likely to be heavy on new regulation. Ultimately capital has to learn to protect itself, with novel compensation schemes that disincentivize the 'year N explosion' pseudo-ponzi strategies.)

fortunes have been made pursuing strategies that are net losers for investors and society

That seems unavoidable. It's the same in most industries. You have to pay top baseball players high salaries, even though there's no guarantee they'll do well after you hire them.

To cook up such a strategy purposefully is a crime

Is it, actually?

There are no guarantees, of course. Sometimes chance breaks the relationship between results and rewards. And, sometimes crime pays.

But the degree matters. If looting and destruction is occasionally rewarded, it can be a manageable expense. If it dominates the industry, even if not via conscious malice, we've got problems. What if every high-paid 'top baseball player' for 10 seasons running was a bust? Then something in scouting or compensation would have to change, a lot.

Is it [a crime], actually?

Yes. A manager who promises investors the possibility of positive return, but knows he has purposefully designed things so that the investors are guaranteed to ultimately lose, while the manager gains, has at the very least engaged in criminal fraud.

So to pull off net-losing strategies within the law, a manager should deceive himself as well as his investors. Fortunately for this class of managers, a whole industry of external rationalizations was spawned by the potential profits.

There would be something very wrong if every baseball team managed to lose every match.

But the value of baseball comes from entertaining, not from winning, so I'd rather put it this way:

There would be something very wrong if you would suddenly realize that every game you saw in the last ten years had unconsciously bored you to death.

Take something like day trading, where a company is out of all positions at/after the close each day. Every transaction they engage in is zero-sum. No wealth is being created, but tons of people are wasting time on it (destroying potential wealth).

I don't think the case of day trading is covered by the baseball player analogy.

> So much is at stake that it would be a false economy to hire someone cheap.

This is probably net true, but maybe there is a also a flip side: do these products exhibit some negative price elasticity? (i.e. a fund that charges high fees and pays it's managers highly may actually be more attractive than one that is cheaper but otherwise identical). Given the intangibility and the expectationary-nature of the product, it is possible.

Ten years ago, if you invested with a balanced portfolio ( 40% CD's, 40% index funds, and 20% real estate trusts) you not only would have failed to make money, you would have actually lost money in real terms. Meanwhile, the financial sector comprised 50% of all corporate profits. The bonuses were not rewarding managers for investing prudently, the entire sector was making money off of legalized theft.

Would have? It's did in my case. But you're picking the ten year period that supports your argument. What matters is whether you're right for most ten year stretches, and I'm pretty sure you're not.

It's not that uncommon for a particular asset class to lose money for a decade. But a basket comprising the safest investments from the major asset classes should never lose money over a 10 year period. Nor should CD's lose money over a 10 year period. If they do, it's a sign the financial system has serious problems. And if the average investor is losing money, while those running the show ( Wall St., the Ivy League endowments, Robert Rubin, Rahm Emmanuel ) are making more than ever, it's a sign the financial system is not only fubarred, but down right corrupt.

The underlying issue is the dilution rate of the dollar. From 1998 to 2008 the money supply was diluting at ~10% a year. With the money supply growing that fast, and CD's are paying only ~3% a year, holding anything other than dollars seems like a good idea. So people speculate in stocks, gold, oil, real estate - anything that dilutes at a lower rate than dollars. But most people aren't good at speculating, so they lose money.

No government running a sound money system should be diluting at 10% a year. It's simply inexcusable.

We're discussing the conduct of money managers over the last few years, not the stock market in general. What matters for that purpose is not whether he's right for most ten-year stretches; it's whether he would be right for most stretches in which money managers played martingale games as widely as they have in the last few. (If you limit it to ten-year stretches, you can game the metric by adjusting the frequency of the negative outcome to once per century.)

Since the expectation (integral of probability density times outcome) of such games can be net-negative, he might be. It depends on how prevalent those games are.

There's another angle, too. What matters for the economy as a whole is not one player's expected outcome, but the sum of the expected outcomes over all the players.

It would be hard to find a 10-year stretch post Great Depression with less regulation on banks. Here's a video that was on CSPAN of the former CEO of Wells Fargo, with a detailed breakdown of every regulation that was lifted since he started (with Citigroup, if I remember from when I saw this on TV) in the 70's:

http://fora.tv/2008/10/21/Richard_Kovacevich_Evolution_of_th...

Kurgman makes the point (briefly) that the incentives for hedge fund managers are only given for short term performance. That incentive means that they can look for strategies that won't blow up for a few years and make bank the whole time.

It's not Ponzi, but it's not in the interest of investors (unless their money's in short-term enough to miss the implosion).

There is a similarity between a ponzi scheme and the bubble created by the financial system: it works only as long as you find fools to trust it, and the last one to get out loses.

Even though the cheap one will do substantially better, over the long run, than most of the expensive ones?(Index funds vs. managed funds: the record is clear).

You are relying on an idea that there are these brilliant, highly sought after individuals that outperform the 'one step bellow' individual.

Is this the case?

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