It’s all a pyramid scheme

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The traveling salesman walked into the hotel, laid a $100 bill on the counter, and asked to see a room for the night.

While the salesman was upstairs, the hotel owner took the money and went to the farmer to settle his debt. The farmer took the money to the carpenter to pay his bill for some repairs. The carpenter went down the road to the grocery store to bring his past due account up to date. The grocery store owner then went to see the innkeeper to settle his obligation for a company party held at the hotel.

The salesman returned to the front desk, informed the owner that he would not stay at the hotel, put the $100 bill back in his pocket and left.

As a result of these financial transactions, the net worth of each individual was increased by $100 as their debts were paid off. The town’s economy saw an increase in its net worth as $500 of debt was eliminated.

The increase in economic activity occurred in the past and no additional money came into the economy from the salesman’s visit. The point is that in a “closed economy” like the one from my silly story, there cannot be any real economic growth. No matter how much business is transacted between the parties mentioned, the town’s economy will never be any larger than it is today. While a potential increase in population through births will grow the size, the per capita GDP is unlikely to ever change.

The fact is that all growth is based on the same basic idea of a “pyramid scheme” in that new participants must continuously be brought into the system. Exporters sell goods aboard and bring in new cash to spend in the local economy. Local companies that invest abroad eventually return at least a portion of their profits to be spent locally. Obviously, foreign investment and remittances contribute to the pyramid scheme of economic growth.

We commented that the Philippine Stock Exchange index has risen from 1,000 to near 8,000 in the past 14 years. However, the reason for that is because new money has come investing in stocks. The approximately P16-trillion market capitalization—or value—of the stock market did not happen by magic. It is because over those 14 years, approximately P13 trillion worth of shares have been bought. Or, put another way, approximately P13 trillion has been put into the stock market.

The sort of legal definition of a pyramid scheme is a form of investment in which each paying participant recruits two further participants, with returns being given to early participants using money contributed by later ones. So what is the difference with the stock market?

If you bought shares of PLDT back in 2002 at P230, the reason the price went to P3,450 in 2014 was because other participants contributed to the price increase after you did. If you bought a prime property in Makati 30 years ago for P3,000 a square meter and it is now worth P250,000, it is because of the “late participants”.

You can say this is a result of supply and demand and that is true. But if the Philippine economy was the same size as 30 years ago, there would not be any demand above P3,000 per sq m.

An open economy that allows money to flow in and out—like the Philippines—brings in new participants and money. The Philippine economy has increased nearly 750 percent since 1980. Cuba’s closed economy, which restricts money flow, increased by 400 percent. The USSR economy—another closed one —grew by 175 percent between 1965 and 1989.

It is not a matter of “globalization”. It is allowing money to flow wherever it wants to flow.

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E-mail me at mangun@gmail.com. Visit my web site at www.mangunonmarkets.com. Follow me on Twitter @mangunonmarkets. PSE stock-market information and technical analysis tools provided by the COL Financial Group Inc.