WHY DO PONZI SCHEMES KEEP WORKING?

We might ask ourselves—why after unmasking so many Ponzi schemes over the last two centuries, do they continue to work?

Ponzi schemes work because there is an entity in a position of authority that people trust, that "would never do that.” These blind believers (the dupes) are the target of the scheme. But even knowing this intellectually, in day to day life there are so many entities we do business with that normal people would not have the time (nor specialization) to check every single one.

And so by a combination of the citizenry’s necessary faith in society, and con-entities hiding amongst many legit-entities, Ponzi schemes survive.

THE MADOFF PONZI

Let's look the largest (revealed) Ponzi in history, which was run by Bernie Madoff. Why was this able to work? It worked because Madoff was the former chairman of NASDAQ, on the board of the regulatory body NASD, and had run his own investment firm since 1960.

Madoff's firm designed the computer technology that would eventually become the NASDAQ stock exchange, and at one point was the largest buyer/seller on that exchange. He was also chairman of the board at the regulatory body the National Association of Securities Dealers. Plus his firm mostly managed money for charities. This guy must be legit, right? I mean questioning him would be like questioning the security exchange and regulatory bodies themselves! It would make you sound like a "conspiracy theorist," crazy right?

And yet external analysts had been proving his firm's returns were mathematically impossible for years. So the math trumped perception? No, actually there was never any regulatory action, and the corporate media turned the story down. It eventually ended because extreme market volatility shock-tested Madoff's "business model," liquidity dried up (long-term charity investors unexpectedly needed their money back early), and the scheme was revealed.

Note: during this same time I was working in subprime, and from 2003-2007 called out their junk-mortgage securitization model as unsustainable, also to no industry response. This should not surprise us I guess, as in schemes of this magnitude the system supports the system.

THE U.S. GOVERNMENT'S SOCIAL INSURANCE PONZI

In my paper "The Mathematical Certainty of U.S. Government Default" I presented the case that the U.S. government is bankrupt. While there are numerous reasons for that, the largest drivers are the social insurance programs (social security and medicare), which are by definition Ponzi schemes. 

A Ponzi scheme is an investment operation where payouts are made to older investors, by bringing in new investors, not by favorable financial operations (which may secretly be enduring heavy losses). And this is precisely the scheme behind these USG programs—citizens loan money expecting to get it back when they are old, but the USG spends it all in the current year (generating a 100% loss on the citizens' investment), then decades later when the payouts come due, the USG pays using contributions from new investors. It has been accurately termed a "generational Ponzi" by economist Laurence Kotlikoff.

In a Ponzi the con-entity focuses resources on marketing to new investors, because without this constant flow of new money, the losses become apparent and the scheme collapses. But in the case of the USG they have this rigged—your participation in the Ponzi is not voluntary, you literally go to prison if you do not contribute! Despite participation by the citizenry being mandatory, the USG expends great effort to project confidence around the world. In finance text books the term "risk-free rate" is used in when speaking of USG debt (treasuries); this rate represents the lowest available interest rate due to these securities supposedly being free of default-risk. Young investors all over the world are indoctrinated with this "risk free" thinking in MBA/CFA programs. Thousands of government accountants do what they can to smooth over the numbers. The corporate media projects an image of the world being a risky place for investing, and the U.S. being a low-risk haven, especially treasuries! And there is much propaganda passed around about how "the U.S. government has never defaulted" and "America always pays her debts." After all, this aura of an entity being beyond question is mandatory if a Ponzi scheme is to be successful.

What I find interesting are the responses of industry professionals when confronted with the math proving the USG is bankrupt. Over the last ten years I've talked to many competent people in the finance industry about this. Yet overwhelmingly the responses are not mathematical, "oh, you forgot to carry the 1," but rather emotional and trust-based. The most common responses include "but the United States is the largest economy, has largest military, can print money, could never default, treasuries are risk-free" and so forth. But do these statements disprove the math? These people believe so deeply in the USG, that it is beyond thinkable it could default. Trust is more powerful than math!

And this is exactly what makes the U.S. government the perfect Ponzi, and thus how it has been able to become the largest one in the history of civilization (losses on social insurance are currently valued at $49T by the USG itself, that's 75,000% greater than Madoff's losses of $65B). It's this blind faith that the entity knows what it is doing and is beyond question, and the assumption present at the base of all industry models that it's a can't-lose bet, that makes the Ponzi work. Since investors view it this way, the con is able to bring in a seemingly endless stream of new investors, to cover prior losses. These trusting investors include existing citizens, immigrants desperate to get in on the action, and buyers of public debt such as corporations, state governments, and foreign governments. And when these sources temporarily dry up, the federal government just buys its own debt!

The perfect "perpetual Ponzi"?

THE LONGER IT GOES, THE LARGER THE DAMAGE

In summary, Ponzi schemes work because of trust—the larger and more credible the individual or institution the greater the trust, and the more effective the scheme. This explains why when highly educated finance professionals (who know all about Ponzi schemes and mock the dupes) are presented with math saying they are the dupes in a Ponzi as well, their existing belief in institutions is so strong that they must deny. 

Now we can also see why this Ponzi is so exceptionally dangerous. In a normal-sized scheme the losses eventually become too large to hide, and the scheme is unmasked. The system-wide damage could minor, or at least somewhat contained with Madoff (who spread significant damage). But with the U.S. government able to print money and bring in a thus far non-stop march of domestic and global investors (some involuntarily)—the debt and interest on the debt is able to snowball for decades, hidden "off balance sheet"—and the eventual shortfall grows to an incomprehensible number.

The greatest risk is actually not the damage to the creditors; old people and public debt holders—but the damage to the entire global financial system when the largest Ponzi in history inevitably unravels.


FURTHER READING

Kotlikoff, L. (2011). Deficit Accounting is a Generational Ponzi Scheme. The Fiscal Times.

Kotlikoff, L. (2014). America’s Ponzi scheme: Why Social Security needs to retire. PBS News Hour.