Sustainable flows and investment victims: Ponzi vs. pensions

March 13, 2009

Bernie Madoff was sent to jail yesterday after he pleaded guilty to operating the world’s largest Ponzi scheme. His investment advisory firm had provided unusually and consistently high returns on clients’ investments, which turned out to be bogus, meaning that he wasn’t in fact investing the money, but instead paid out the money he got instantly to others who had trusted their money to him earlier.

Pension schemes are sustainable as long as there is more money flowing in than flowing out.* The technique is to take the money from the new contributors and give it to the old ones.

Madoff is in jail. European governments are on trial.

1.    Spot the difference.
2.    Is such a scheme necessarily wrong? Under what moral and calculative circumstances is it right?
3.    Compare with the current bank meltdown. Under what circumstances is a bank a Ponzi scheme? These schemes don’t invest the money into anything, instead they churn it right back out, but not to the same people who gave it. There is nothing on the asset side, only liabilities. Banks also take people’s money and give it to other people to use)? Banks that are going bankrupt today did invest, but their assets turned out to be worth next to nothing, so in the end they couldn’t satisfy their creditors. Is there a lesson here for financial intermediation and the length of financial circuits?

*Pay-as-you-go pension systems work by collecting social security contributions from active employees and use it to pay out pensions that are currently due.

8 Responses to “Sustainable flows and investment victims: Ponzi vs. pensions”

  1. danielbeunza Says:

    Ah, pensions. The next frontier in financial unrest, and certainly an area of huge interest for the social studies of finance. The analogy seems appropriate and is intriguing, although i confess I don’t know enough about pensions to go further.

    To me, what has always been a mystery is how do Ponzi schemes get exposed. To the extent that they are based on a loop, in principle they should be able to keep looping with no problem. What is it that stopped Madoff? And will the same type of contingency be a problem for European pensions?

  2. p Says:

    Pay-as-you-go pension systems are sustainable because the state has the power to make people put more money in the system (though taxes, contributions…) — Madoff didn’t have that power. Pension systems are ultimately a contract between generations: everyone knows how the system works and what to expect from it (unlike Ponzi schemes).

    Now, you could argue that any bubble can be thought of as a particular kind of Ponzi scheme. Asset prices go up only as long as more money is flowing in… The difference is that a Ponzi scheme is a system orchestrated by a single actor (an actor who knows that the system is unsustainable), while a bubble comes from multiple actor’s unrealistic expectations of increases in asset prices. In a way, bubbles are just decentralized Ponzi schemes…

  3. zsuzsannavargha Says:

    Daniel, the European problem is shrinking tax base on the income side and growing number of pensioners on the expense side. The biggest issue is aging population. A crisis only sets an already existing “time bomb,” as it is known, to a closer charge-off.

    p, right, but the power of the state is not a constant. I was thinking about the history of introducing large-scale pension systems. From historical work on passports or any other state surveillance systems, it seems that these kinds of all-inclusive operations are not easy to do; so the Prussian state probably didn’t just impose the pension system from one day to the next while the population cheered on. I suspect piecemeal, with lots of suspicion from citizens and violence from authorities (in the best tradition of labor history). And the power to sustain mandatory contributions is also questioned pretty regularly.

    I really like the idea of asset bubbles as decentralized Ponzi schemes. Another dimension of difference is what Daniel referred to: bubbles are not exactly clandestine, they get exposed; and yet they are not official like pension systems, either.

    Ponzi schemes seem to be more durable and last longer than bubbles. Madoff’s is debated but either started in the 1980s or in the 1990s, while the real estate bubble is said to be post-2000.

  4. p Says:

    Zsuzsanna, point well-taken: the legitimacy of Social Security is a socio-historical construction and should not be taken for granted. I just find it ironic that we’ve been hearing more and more of these comparisons between Social Security (or more generally pay-as-you-go pension systems) and Ponzi schemes in recent months, coming mostly from conservative economists and commentators — to the point that the Social Security Administration had to respond to this argument on their website (http://www.ssa.gov/history/ponzi.htm)… perhaps out of fear that this comparison would have a performative effect by undermining the legitimacy of the system! But interestingly, conservative economists never compare the stock-market bubble to a Ponzi scheme…

  5. zsuzsannavargha Says:

    p, Thanks for the link. The comparison can be used for political purposes very easily. My goal here was to provoke thoughts about circuits of money (Ponzi schemes being the prototype for short-circuited flow), and about what makes Ponzi schemes so scandalous and social security systems so vulnerable.

    Daniel’s question was when do Ponzi schemes get exposed. From the Soc Sec Admin’s example of a Ponzi scheme that paid 100% profit and lasted less than a year, it seems that the length of a scheme depends partly on setting the profit rate and on timing the payouts. If you promise to pay 100% profit paid out over a short term and/or at random withdrawal, then you won’t be able to keep pace with getting new clients, so the cycle is short.

    But Madoff’s lasted at least a decade or much longer. His art seems to have been to find a rate of return that is low enough so he can keep up with the payouts by acquiring new clients, and low enough to be believable compared to market rates but still exceptional.

    An irony: If the pay-as-you-go systems are criticized because intergenerational transfer is not fair to individuals who contribute and may not get their share (due to demographic changes or state budget constraints), the solution has been to encourage individual financial responsibility, each citizen to save towards their own future. A lot of those who invested in Madoff’s scheme were doing exactly that–not only individuals but also institutional investors, even pension funds.

  6. Elena Says:

    Zsuzsi,
    there is a really interesting comment today in the New Yorker. It discusses a bit the issue of Social security and Medicare. Apparently, there is a group called Get America Working! which has been pushing for a switch in the way these programs are funded – instead of taxing jobs, they propose taxing things such as pollution, oil imports, and interestingly, ‘excessive consumption’. That way you don’t have to rely on future generations to subsidize retirement and health care benefits, but also you don’t tax something that you want more of, i.e. jobs. Instead, you tax undesirable activities. It sounds really interesting. Here is the article:
    http://www.newyorker.com/talk/comment/2009/03/23/090323taco_talk_hertzberg

  7. zsuzsannavargha Says:

    Thanks Elena, that is very interesting. The usual debates on social security always assume that the revenues are tied to active workers’ income. Let’s see if this new calculus is taken up.


  8. […] similar question was raised on this blog in an earlier post about Ponzi schemes, pension systems, and banks. The question seems to be, how is it determined […]


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