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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. It
is illegal in most countries. The scheme is named after Charles Ponzi, an
Italian immigrant to the United States. The manner of Ponzi's initial scheme
was actually fairly crude, and the schemes are considerably more
sophisticated in the present day.
The idea behind the Ponzi scheme is fairly straightforward, and exploits
that basic human tendency: greed. The scheme then perpetuates itself using
envy. Although there are variations, here is a classic scenario:
An advertisement is placed somewhere 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 any number of causes, such
as "global currency arbitrage", "futures trading" or anything else that
sounds sufficiently plausible.
Initial investors are usually wary, but eventually someone will invest a
small sum (say $5000). Sure enough, 30 days later, the investor receives
$6000 - their original capital plus 20% ($1000). At this point greed
subsumes reason, and the investor will rush to raise a larger investment.
Also typically at this point word begins to spread, and other envious
investors will clamour for the opportunity to participate. Soon numerous
people will have made $2000 on a $10000 investment, and people are starting
to mortgage their houses to raise more capital.
The reality of the scheme is that the "return" is being paid out of the
incoming investment money. As Investor B invests $10000, $2000 of that is
taken to pay the return to Investor A who invested a month earlier. This
obviously makes no sense financially.
However, the catch is that at some point in time the scheme will vanish,
typically at a point where a "critical mass" of capital has been achieved,
and the operators disappear taking all of the capital amassed with them. A
sad aspect of this is that typically all of those who actually made a
"profit" at an earlier stage of the scheme will have (voluntarily)
re-invested that money back in, so they lose it anyway.
A common variation involves a smaller return for a short-term investment
(say 10% over 30 days), but a fantastic return for a longer investment (say
200% after six months). Once the intial trust has been achieved after making
the shorter term gain, people are far more likely to leave their funds for
this longer period. This naturally gives the operators more time to plan
It has been suggested that some state schemes, e.g. the U.S. Social Security
and the U.K. State pension schemes bear disturbing resemblances to Ponzi
schemes in their mode of financing. This is because benefits are paid from
taxes currently being collected, rather than from the taxes previously paid
by the current beneficiaries. This also explains why the aging of the Baby
Boomer generation presents a threat to the U.S. Social Security system: as
more of the Baby Boomers retire, there will be more people collecting social
security benefits than there will be workers paying taxes for social
security benefits. However, critics of this view point out that the income
and outgo from Social Security is sustainable because the returns from
Social Security are not high enough to cause the system to run out of money.