Ponzi scheme

The high returns that Ponzi schemes advertise require an ever-increasing flow of money from investors. Once the flow of new investment stops, the scheme is doomed to collapse.

The scheme is named after a man who became notorious for using the technique, Charles Ponzi, an Italian immigrant in 1903 to the United States. The manner of Ponzi's initial scheme was actually fairly crude, one of the apparent reasons being that he himself believed that he had found a way to legally generate large profits.

Today's schemes are considerably more sophisticated, but the idea behind every Ponzi scheme is to exploit the basic human trait of greed.

Example scenario

An advertisement is placed promising extraordinary returns on an investment – for example 20% for a 30 day contract. The precise mechanism for this incredible return can be attributed to anything that sounds good but is not specific: "global currency arbitrage", "futures trading", "high yield investment programs", or similar.

With no "proven track record", only a few investors are tempted, usually for smaller sums (say $5000). Sure enough, 30 days later, the investor receives $6000 – the original capital plus the 20% return ($1000). At this point, greed starts to overcome reason: the investor will put in more money, and, as word begins to spread, other investors grab the "opportunity" to participate. More and more people invest, and see their investments return the promised (and quite large) returns.

The reality of the scheme is that the "return" to the initial investors is being paid out of the new, incoming investment money, not out of profits. There is no "global currency arbitrage", "futures trading", or "high yield investment" actually taking place. Instead, when Investor D puts in money, that money becomes available to pay out "profits" to investors A, B, and C. When investors X, Y, and Z put in money, that money is available to pay "profits" to investors A through W.

One reason that the scheme works so well is that early investors – those who actually got paid the large returns – quite commonly keep their money in the scheme (it does, after all, pay out much better than any alternative investment). Thus those running the scheme don't actually have to pay out very much (net) – they simply have to send statements to investors that show how much the investors have made by keeping the money in what looks like a great place to earn a high return.

The catch is that at some point one of three things will happen: (a) the promoters will vanish, taking all the investment money (less payouts) with them; (b) the scheme will collapse of its own weight, as investment slows and the promoters start having problems paying out the promised returns (and when they start having problems, the word spreads); or (c) the scheme is exposed, because much of the "assets" that are on the accounting records of the so-called enterprise do not (cannot) really exist.

Examples of Ponzi schemes

In the 1980s, a simple version of the Ponzi Scheme, known as the "Airplane Game" (a distributed Pyramid scheme), was perpetrated on a number of college campuses in the United States. The victims were typically college undergraduates, whose lack of financial understanding made them easy prey.

In first half of the 1990s, the Bennett Funding Group defrauded investors of $700 million, the largest known Ponzi scheme in the United States. Investors were told the funds were to finance leases on office equipment.

In 1997 the government of Albania officially endorsed a series of pyramid investment funds. When the inevitable end came, the people of Albania, who had lost $1.2 billion, took their protest to the streets in a revolt that toppled the government.

In the late 1990s, Bill Hickman, Sr., along with members of his family, defrauded dozens of residents of Pottawatomie County, Oklahoma, along with investors from as far away as California out of many thousands of dollars. When the fraud was uncovered, he was charged and pled guilty in both Oklahoma and Federal Courts of charges including obtaining money by false pretense and securities fraud. He has been sentenced to 160 years in state prison.

In 2000, a Ponzi scheme perpetrated by Scientology minister Reed Slatkin came unravelled when SEC regulators became aware that Slatkin was not a licensed investment advisor. Slatkin had raised some $200 million from over 500 wealthy investors, mostly Hollywood celebrities and his fellow scientologists.

Are national retirement programs Ponzi schemes?

Some have argued that many national social security systems, such as the Social Security system in the United States and the National insurance system in the United Kingdom, are actually large-scale Ponzi schemes. One example is conservative economist Thomas Sowell in his book, Applied Economics ISBN 0-465-08143-6.

Sowell and others point out that, under these national systems, incoming payments, made up of taxes and/or other kinds of non-voluntary contributions, are neither saved nor invested. Instead, current contributions (from one set of individuals, due benefits at a later time) are used to pay for current benefits (to another set of individuals, earlier contributors), much like a Ponzi scheme.

Proponents of Social Security change in the U.S., such as Sowell, claim that this "pay-as-you-go" system has begun to show its inherent flaws as North American demographics trend toward more pensioners and fewer workers, because of declining birth rates and increasing life expectancy.

Some argue that Social Security is even worse than a Ponzi scheme in one respect, in that investors in the latter at least have a legal right to their money returned (even though in practice they are most likely to lose it when current contributions dry up). But those paying into Social Security have not the slightest legal claim on the money they pay in, according to the 1960 U.S. Supreme Court decision in Flemming v. Nestor: the court explicitly ruled that paying into the system does not make receiving benefits a "contractual right."

Retirement programs run by national governments, though they involve the taxes paid in by workers being redistributed to pensioners, nevertheless differ in a number of basic features that are usually found in Ponzi schemes, but are not fundamental to them:

• Retirement systems, like Social Security, are openly declared for what they are. In a genuine Ponzi scheme, the perpetrators falsely claim that there is some business that generates the promised revenues. In Social Security, people know where the money comes from, and actuaries supply written predictions of future cash in-flows and out-flows.

• Retirement systems promise a stipend to the country's retired persons, not the quick and exhorbitant profits to current investors that Ponzi schemes invariably offer.

• Retirement systems rely on the taxing power of the state to ensure continuous funding. In practice, this taxing power has been used primarily for dedicated revenues (taxes), although in theory general tax revenues could be used to supplement worker payments into the systems. (Historically in the U.S., Social Security has almost always been in surplus, so this has never been an issue.) If the political process were used to raise required contributions via retirement taxes, or to reduce benefits (including raising the retirement age), either across the board or just for the better-off, there would certainly be opposition from those who would pay more or get less, but politicians have only those two choices (plus borrowing) if revenues are inadequate.

• In the long run, retirement systems pay out an approximately equal amount to what was paid in, per contributer, plus interest. (In the short run, pension surpluses can be used to cover a government's current general-revenue shortfall, as has been happening in the United States since Social Security contribution rates were increased in 1983.

• Retirement systems are in many ways insurance rather than investment systems. A person who dies before retirement gets no money back (regardless of what he/she paid in). Someone who lives to a very old age continues to get payments regardless of the amount of money he/she has paid in. And someone disabled, even at a relatively young age (well before he/she can make significant payments into the system, or have significant private investments), still receives payments until the end of his/her life.

• Unlike in a Ponzi scheme, government receipts (taxes) and payouts (entitlements) can be calculated quite accurately in the short term (five to ten years), and predicted (with a range of assumptions) for periods beyond that timeframe. A sudden collapse is therefore unlikely.

There is a superficial analogy between pyramid or Ponzi schemes and pay-as-you-go insurance programs in that in both money from later participants goes to pay the benefits of earlier participants. But that is where the similarity ends. A pay-as-you-go system can be visualized as a simple pipeline, with money from current contributors coming in the front end and money to current beneficiaries paid out the back end. So we could image that at any given time there might be, say, 40 million people receiving benefits at the back end of the pipeline; and as long as we had 40 million people paying taxes in the front end of the pipe, the program could be sustained forever. It does not require a doubling of participants every time a payment is made to a current beneficiary. (There does not have to be precisely the same number of workers and beneficiaries at a given time--there just needs to be a stable relationship between the two.) As long as the amount of money coming in the front end of the pipe maintains a rough balance with the money paid out, the system can continue forever. There is no unsustainable progression driving the mechanism of a pay-as-you-go pension system and so it is not a pyramid or Ponzi scheme.

...

If the demographics of the population were stable, then a pay-as-you-go system would not have demographically-driven financing ups and downs and no thoughtful person would be tempted to compare it to a Ponzi arrangement. However, since population demographics tend to rise and fall, the balance in pay-as-you-go systems tends to rise and fall as well. During periods when more new participants are entering the system than are receiving benefits there tends to be a surplus in funding (as in the early years of Social Security). During periods when beneficiaries are growing faster than new entrants (as will happen when the baby boomers retire), there tends to be a deficit. This vulnerability to demographic ups and downs is one of the problems with pay-as-you-go financing. But this problem has nothing to do with Ponzi schemes, or any other fraudulent form of financing, it is simply the nature of pay-as-you-go systems.

See also