What’s the difference between a good Ponzi scheme and a bad Ponzi scheme?

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Bernard Madoff appears to have operated a Ponzi scheme, in which money from new investors was used to pay off those who got in earlier. But there are other, perfectly legitimate financial endeavors that share this same basic model.

The most obvious is Social Security (and James Pethokoukis has already nominated Madoff for Social Security Commissioner). Today’s taxpayers contribute money that is funneled to today’s Social Security recipients, and hope that tomorrow’s taxpayers will put in enough money to fund their retirements. Something similar is true of government finance in general: Those who buy Treasury securities and municipal bonds do so on the assumption that future taxpayers (and bond investors) will keep pouring in enough money to allow governments to make good on their commitments.

This applies not just to government finance. Wall Street too depends on a continual stream of new investors appearing on the scene to take securities off the hands of today’s investors. And when everybody tries to take their money back at once, the system stops functioning—as we’ve seen over the past few months.

So what’s the difference between these widely accepted arrangements and the reviled Ponzi scheme? Well, one is that the government can compel future taxpayers to contribute more if things aren’t working out so well—which has happened repeatedly with Social Security. But there are limits to this approach. Raise taxes high enough and either the economy suffers or taxpayers find ways to avoid paying—or both.

No, the crucial element would seem to be that good Ponzi schemes have some means of tapping into economic growth. As economist Paul Samuelson wrote back in the 1960s, with regard to Social Security, “A growing nation is the greatest Ponzi game ever contrived.” (This was in a Newsweek column, but Newsweek doesn’t appear to have it online.) You’re relying on future taxpayers/investors to pay off current ones, but there will either be more of those future taxpayers/investors or they’ll be more affluent (preferably both), so it all works out okay. Or something like that.

I guess another crucial element is that the promised return on investment be reasonable. The late and now-acclaimed economist Hyman Minsky differentiated between hedge finance, speculative finance and Ponzi finance:

Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows …. Speculative finance units are units that can meet their payment commitments on “income account” on their liabilities, even as they cannot repay the principle [sic] out of income cash flows. Such units need to “roll over” their liabilities: (e.g. issue new debt to meet commitments on maturing debt). Governments with floating debts, corporations with floating issues of commercial paper, and banks are typically [speculative] units.

For Ponzi units, the cash flows from operations are not sufficient to fulfill either the repayment of principle [sic] or the interest due on outstanding debts by their cash flows from operations.

I speculated Monday, albeit without using properly impenetrable Minskian jargon, that Madoff’s operation probably progressed through the years along the path from hedge to speculative to Ponzi. It’s clear now that the mortgage lending business in the U.S., previously a pretty legitimate enterprise, moved into Ponzi territory for a few years earlier this decade. And it turns out that even Charles Ponzi based his scheme on an arbitrage play that he truly believed would, with enough resources, turn a real profit for his investors. There’s a teensy bit of Ponzi in—certainly not all—but most of us.

Update It strikes me after reading plukasiak’s comment that another crucial difference—probably the most crucial—between legit endeavors like Social Security and Ponzi schemes is that the former disclose exactly what they’re doing. The Social Security Administration isn’t promising some magical font of future investment returns. It is simply promising future retirees a claim on the income of future workers.

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