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A Ponzi scheme is a fraudulent investment operation that involves paying returns to investors out of the money raised from subsequent investors, rather than from profits generated by any real business. The scheme is named after the discoverer of 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 generate (legally) large profits. Today's schemes are considerably more sophisticated.
The idea behind the Ponzi scheme exploits 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 Ponzi went from anonymity to being a well known Boston millionaire in six months using such a scheme in 1920, with profits to come from exchanging international postal reply coupons. He promised 50% interest (return) on investments in ninety days. About 40,000 people invested about $15,000,000 (they would get back about a third of this).
More recently, 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.
Are state pensions Ponzi schemes? It has been suggested that some state pension systems, such as the U.S. Social Security system and the U.K. State pension systems are actually large-scale Ponzi schemes. Under these systems, incoming payments (taxes or other kinds of non-voluntary contributions) are not saved or invested to pay for future benefits. Instead, the taxes (perhaps with some general government revenues) are used to pay for current benefits.
State pension systems, though they are pyramid schemes, lack a number of basic features that define Ponzi schemes, and so are somewhat different:
- There is no belief that there are large profits coming from something; rather, it is clear that these are pay-as-you go systems, where workers (at any given time) are providing money to those who have retired.
- A Ponzi scheme offers high short-term returns in order to entice new investors, whose money is needed to fund payouts to early investors. Once the illusion of high returns shatters, the flow of new investors stops and the scheme collapses. By contrast, a state pension system relies on the tax power of the state to ensure continuous funding.
- State pension systems are in some way 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.
- Because 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, there will never be a sudden collapse.
- General tax revenues can be used to supplement worker payments into the systems, although many taxpayers will be unhappy with such supplementation. Similarly, benefits can be reduced through the political process, either across-the-board or by reducing benefits to the well-off, although there will clearly be opposition by those who will get less.
On the other hand, if the next generation is much smaller than the previous one or if the life-span increases sufficiently, the scheme no longer works and the promises cannot be fulfilled. Instead, the pensions must be cut dramatically and/or the taxes must be raised enormously.
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