Every society and every institution rests heavily on trust. There is active trust, the result of “trust, but verify.” I call this stage one trust. Then there is stage two trust, which I call default trust: “Trust, and assume that someone else has verified.” Next, there is stage three trust, which I call blind trust: “Trust, because there is nothing else worth trusting.” Then there stage four trust, which I call tooth fairy trust: “Trust, despite all evidence to the contrary.” This form of trust is the foundation of all Ponzi schemes.

Bernard Madoff took advantage of this final form of trust. He ran what is said to be a Ponzi scheme of $50 billion. Or was it only $17 billion? The initial reports are sketchy.

The magnitude of these numbers boggles the imagination. How could anyone who is regulated by the Securities & Exchange Commission run up bogus numbers of $17 billion, let alone $50 billion?

More to the point, if Madoff could do this, of what value is the Securities & Exchange Commission? The SEC in this case has fostered the second form of trust: “Trust, and assume that someone else has verified.” This form of trust is the most insidious, because it creates a widespread mentality of trustworthiness when such trust is not deserved. It reduces the investing public’s suspicions.

Whenever widespread regulation by government agencies lulls investors to sleep, investors make investments that they would not otherwise make. Managers of what are called trust funds defer responsibility for doing the necessary due diligence. They can legally hide behind this excuse: “We invested our clients’ money only in investments regarded as prudent.”

Prudent is as prudent does. From October 2007 until today, prudent investments have taken a financial bath. All the way down, the well-funded investment advisors kept telling their clients, “Now is not the time to panic. Now is not the time to sell stocks. Use this as a buying opportunity. Buy on the dips. Maintain a well-balanced portfolio of stocks and high-grade corporate bonds. Hold Fannie Mae and Freddie Mac bonds. They are recognized worldwide.”

The hypesters on Tout TV screamed: “This market is close to the bottom. Buy now!”

Government officials issued no warnings. They even denied what should have been obvious.

In a long, detailed, and devastating article in the New York Times, the authors savage the Bush Administration for its refusal to do something about Fannie and Freddie as early as February 2003. The article, in typical Times fashion, lays no blame on Congress, especially Barney Frank, who promoted home ownership for low-income constituents who could not possibly have afforded to buy homes under anything like normal, i.e., low-inflationary times.

The article tells the story of Armando Falcon, Jr., who ran the tiny and impotent Office of Federal Housing Enterprise Oversight. This was supposed to be an official verifier. Like virtually all government verifiers, it was expected never to call attention to problems with anything remotely connected to the Federal government. These organizations exist to foster stage two trust: “Trust, and assume that someone else has verified.” The Times reports: “In February 2003, he was finishing a blockbuster report that warned the pillars could crumble.”

Mr. Falcon’s report outlined a worst-case situation in which Fannie and Freddie could default on debt, setting off “contagious illiquidity in the market” — in other words, a financial meltdown. He also raised red flags about the companies’ soaring use of derivatives, the complex financial instruments that economic experts now blame for spreading the housing collapse. Today, the White House cites that report — and its subsequent effort to better regulate Fannie and Freddie — as evidence that it foresaw the crisis and tried to avert it. Bush officials recently wrote up a talking points memo headlined “G.S.E.’s — We Told You So.” But the back story is more complicated. To begin with, on the day Mr. Falcon issued his report, the White House tried to fire him.

This was a typical government response. Whistle blowers are regarded as traitors in every organization. The government is no exception. Mr. Falcon was blowing the whistle on a pair of over-leveraged government-related but poorly regulated organizations. Falcon was the head of an organization set up to regulate these two massive swindles, but he was never supposed to blow the whistle. He therefore broke an unofficial rule. He was going to be taught a lesson.

Mr. Falcon survived, but resigned in 2005. He was replaced by James Lockhart, an old high school friend of President Bush. On his watch, Freddie and Fannie purchased $400 billion in sub-prime loans and alternative mortgages, marketing these packages to investors. By mid-March, 2007, both companies faced bankruptcy. But the Treasury Department did nothing. Treasury now ran policy. Its conclusion: no problem.

But Mr. Lockhart continued to offer reassurances. In a July appearance on CNBC, he declared that the companies were well managed and “worsts were not coming to worst.” . . . . Mr. Lockhart defended himself, insisting in an interview that he was aware of the companies’ vulnerabilities, but did not want to rattle markets. “A regulator,” he said, “does not air dirty laundry in public.”

This is the heart of the matter. It always has been. It always will be. Government regulatory agencies invariably become agents of the organizations that officially are being regulated. This is the heart of stage two trust: “Trust, and assume that someone else has verified.” This trust is fostered by the government and by the agencies supposedly being regulated. The regulatory agencies’ real economic function is to increase trust, where trust is not appropriate, in order to dupe the public.

At this stage, investors’ trust moves to stage three: “Trust, because there is nothing else worth trusting.” Investors bid up the assets’ price. This is the bubble phase of the market.

STAGE FOUR TRUST

Bernard Madoff was able, on paper — paper issued by his company — to generate 15% returns, year after year. It is not yet clear how he was able to fool accountants. That he did fool them points to the nature of the beast. We are living in an economy that is one gigantic Ponzi scheme.

The most famous one is Social Security. It is known to be a Ponzi scheme by anyone who examines its funding. This has been known for a generation. No one cares, least of all government accountants. Medicare is an even larger Ponzi scheme. Yet Warren Buffett assures us that the American economy can grow its way out of the looming unfunded liabilities of these two organizations. All it will take is a little prudence — an asset which retains its low price in Washington only because there is so little demand.

When the best and the brightest insist that there is no major problem with the two largest Ponzi schemes in history, the public has moved to stage four trust: “Trust, despite all evidence to the contrary.”

Madoff took advantage of a mindset that is so widespread today that voters, investors, and politicians not only believe in tooth fairy economics, they take active steps to ridicule those who call attention to the evidence to the contrary.

Madoff also understood marketing. The late Mac Ross once told me this secret of marketing.

There are two ways to market something: the community college way and Harvard’s way. The community college sells education on the basis of price. “It’s the best deal around. Act now!” Harvard sells a marginally superior form of education by telling people that they just don’t qualify. “We aren’t going to accept you, but if you really want to waste your time, you can mail in an application.”

Madoff adopted the Harvard approach. Alexandra Penney, one of his victims, describes her dealings with his firm. She had become a millionaire author.

I suddenly had a lot of money. I was in my late 40s, and I felt that I was just too old to have it in a plain old bank account. But I was a creative person, not a savvy investor, so I asked around and talked to my smartest friends with Harvard and Wharton MBAs. There appeared to be a secret society of Madoff investors. A friend who was older, wealthier, and more established somehow got me in. I’ve always had good luck, and I thought it was another stroke of good fortune to be invested with the legendary Bernard Madoff.

Ah, yes: access to the inside track! There is a dream of every wanna-be investor. Find the next Warren Buffett and let him handle your money. Yes, Buffett’s Berkshire Hathaway can be bought on the New York Stock Exchange. All it takes is about $100,000 a share. But that is not good enough for investors in dreams. She wrote: “There appeared to be a secret society of Madoff investors.” Yes, yes, that’s it! Get on the inside!

Every month I got detailed statements, and my money looked to be growing around 9 to 11 percent. It didn’t seem greedy because I knew other people who were making 15 or 20 percent. I thought, “This is just a very smart investor.”

On the contrary, he was just a very smart con man — a con man who plugged into stage four trust. But he did not do this on his own. He got a lot of help from the confidence industry’s friends: government agencies that operate their own Ponzi schemes, creating widespread trust in impossible dreams.

The woman who was conned by Madoff thought she was rich. She no longer thinks so. She lived high on the hog. She no longer will. This scares her.

First, she always wanted to be an artist. She used her money to buy a studio in New York City. If she ever made a living with her art, she does not say. It’s too late now. The recession has killed the art market.

The art market, as everyone pretty much knows, is dead. If I can’t sell my work, I am going to have to find some way to make money.

Indeed, she is. Here is the former editor of Self magazine who is going to have to find herself in a competitive environment. This will not be easy. She must now make adjustments in her lifestyle.

I’ve lived a great and interesting life. I love beautiful things: high thread count sheets, old china, watches, jewelry, Hermes purses, and Louboutin shoes. I like expensive French milled soap, good wines, and white truffles. I have given extravagant gifts like diamond earrings. I traveled a lot. In this last year, I’ve been Laos, Cambodia, India, Russia, and Berlin for my first solo art show. Will I ever be able to explore exotic places again?

Frankly, Ms. Penney, the rest of us really don’t care. We have problems of our own. She goes on.

Since this happened last Thursday, I have barely left my apartment, I haven’t been out for dinner; haven’t bought groceries. Can’t remember the last time I ate a full meal. Food, which is one of my most favorite things in the world, has become meaningless.

The reality of Ponzi schemes eventually comes to this, whether the victims are rich or poor. Reality intrudes.

The entire Western world is trapped in a Ponzi scheme sold by politicians: free lunches in our golden years of retirement. Social Security will provide this. Socialized medicine will provide this.

I spoke with a health insurance agent last week. He had come at my request to discuss Medicare B. This is the physician-coverage section of Medicare. Medicare A covers hospitalization. This new Plan B will give me free prescriptions, which I don’t take. It will give me access to any physician’s office at $5 per visit. I will get partial dental care. All I will pay is about $1,000. In my previous location, northern Mississippi, my agent said in 2007 the average payment per enrollee per year was over $6,000. This is a region with a low cost of living.

This is a Ponzi scheme. As the population ages, there will be too many recipients and too few new entrants into the scam. We know what is going to happen. But the best and the brightest say we are wrong, that everything is covered, that experts have verified everything, that we will grow out way out of this.

TRUST IS RUNNING LOW

The stock market in 2008 proved to 401(k) investors what I had told my readers in March 2000: the stock market is not going to provide positive returns any longer. The dreams of millions of investors have not been smashed — not yet. They will be, but not yet. The dreams have been called into question. There is real doubt that the stock market will recover fast enough to give investors their golden retirements.

The 401(k) programs are also Ponzi schemes. They depend, not on economic growth to provide wealth, but rather new investors in the stock market. Earnings are insufficient to provide the income required to provide a comfortable retirement. After deducting fund expenses, until 2008, earnings were zero or close to it. The dream of easy retirement always rested on the sale of shares to newcomers. This is Ponzi scheme financing.

American households are net dis-savers today. They have been for almost a decade. Who is going to buy the shares of retirees? Not the coming generation.

Trust in stocks as a way to wealth is fading. This is a good thing, because the trust was always misplaced.

What will replace this fading trust in stocks? Another problem: When people sell their shares in the final phase of the falling stock market, pushing stocks lower, who will buy them? Who will believe that, after nine years of losses, discounting for price inflation 2000—2009, that stocks will ever recover? In final sell-offs, pessimism is widespread. This pessimism will be justified. Where will the productivity come from in our new age of monetary base inflation, corporate bailouts, and trillion-dollar annual Federal deficits?

Who will buy a Chrysler today? Who will buy General Motors shares? Who will trust the hypesters on Tout TV, when they say to buy shares? Buy with what? Their viewers are down 40% or more, and the decline may not be over.

CONCLUSION

The American dream, as with any dream, is based on trust. But trust, to be maintained, must eventually be confirmed by reality. The economic reality today is stagnation, rising unemployment, falling home prices, and bankruptcy.

Reality is catching up with stage four trust.

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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