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.