Monday, December 22, 2008

Why Ponzi Schemes Work

Charlie Ponzi would certainly have understood what Bernie Madoff was doing. Now that it’s known how Madoff made off with over $50 billion in investor capital, everyone is voicing righteous anger and outright astonishment over how such a thing could have happened. My hypothesis for today is that, if you scratch the surface of an early Madoff investor, you will probably find someone who suspected that they were at the top of a pyramid scheme. My enduring hypothesis is that people who buy into pyramid schemes in the early stages usually know more than they will ever admit, and in fact, part of the appeal of Ponzi schemes is that early investors think they have the inside track because they’re either first in line, or else sufficiently high on the pyramid to avoid disaster. Ponzi schemes work on greed as much as ignorance.

About 30 years ago, my wife and I got suckered into one of those early Amway presentations where you were invited into some guy’s living room for a social get together, only to discover that you’d been ambushed when the party host started drawing lines and circles on an easel board. I don’t mean to imply that Amway ever was a Ponzi scheme, but from the earliest days it certainly was a business plan with a pyramid-type structure. That night at the Amway presentation, the presenter repeatedly stressed that the people who opted-in early would reap financial rewards far greater than those who joined the party at a later date. My wife and I didn’t take the bait, but I noticed that those who joined up that night had the confident look in their eyes of a fast zebra who knows that the lions will only get the slowpokes that are trailing behind.

Ponzi schemes are the ultimate triumph of short term profit and expediency over long term accountability (see my blog of 12/18), and in that respect, you could make the case that most corporations, as well as the United States Government, look at things in much the same way as the man who sets up a Ponzi scheme. The differences, here, are only in degree, not essence. As our nation now racks up deficits in the trillions of dollars, we all go along with it because, at some level, we all see ourselves as high on the pyramid, and we know that the base of the pyramid— those future generations who will inherit the debt— won’t come along until after we’re dead and gone. It’s for this reason that I, personally, would feel a lot better if the whole shell game was being orchestrated by Bernard Madoff instead of Henry Paulson.

See also: Recession or Depression (12/18)

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