Mr. Ponzi was a charming con-artist who operated about a century ago in the United States and Canada. He enticed investors to contribute new money to his investment scheme (100% return in 90 days), skimmed a portion for his luxurious needs, and used the remaining money to pay off prior investors. The system worked marvelously until it collapsed and people realized that his postal reply coupon investments could not produce the profits that supposedly paid off early investors.
More recent “Ponzi” examples include Bernard Madoff as well as hundreds of others, plus the Alan Harper character in season 8 of “Two and One Half Men.” However Ponzi schemes are not limited to private investments. Governments engage in similar plans and have the advantage of declaring them legal. As with private plans, they work until they collapse, although their government granted legality increases their longevity.
Perhaps Charles Ponzi deserves recognition as the patron saint of central bankers and politicians. Consider these systems that are similar to Ponzi schemes:
- SOCIAL SECURITY: Current workers contribute a percentage of their wages into the Social Security system. Retiring workers collect benefits paid by current contributions from existing workers. If there were no current workers there could be no payout since all previous contributions have been spent. Is this a retirement system or a Ponzi scheme?
- SOVEREIGN DEBT: For example, a government annually spends a trillion currency units more than its income. It borrows the difference (deficit spending). A portion of the annual expenses is used to pay interest on debt accrued in previous years. Debt is never retired, but always rolled over as new money repays older investments. Since 2008 much of the new money has been “printed” and not collected as tax or other revenue due to the weak economy. The total debt has increased rapidly. Unfortunately, there are consequences from the creation of trillions of currency units – eventually the cost of living for all who must use the currency units is increased.
- FRACTIONAL RESERVE BANKING – a simple example: A bank receives a deposit of 1 billion currency units and creates from nothing 10 billion currency units. The bank lends those 10 billion units to a hedge fund, who deposits 1 billion currency units back into an account at the bank. The bank collects interest on 10 billion units and repeats the process with other depositors and other loans.
The old investor (original deposit) has been repaid with new money created in the fractional reserve banking scheme. This works until too many depositors want their deposits returned about the same time (bank run), or the loans can’t be repaid. (Think 2008 crisis, Cyprus 2013, or Greece today). Unfortunately, the depositor will discover that he is an unsecured creditor of the bank and that his deposit is not “his money” but a liability of the bank which might not be repaid. FDIC and government guarantees only go so far.
IN THE END …
Ponzi schemes work until they can no longer continue since they are based on a shaky business model. Ask yourself:
- Can enough new investors be found such that ever increasing old investments plus supposed earnings will be paid back – forever?
- If the number of workers supporting retirees is declining, can new contributions from those workers support an increasing number of retirees – forever?
- If currency units can be created practically without limit in a fractional reserve fiat banking system, can we expect the value of currency units to remain constant – forever? Instead we know the increased number of currency units in circulation increases prices. For instance, a cup of coffee might cost 5 cents before massive currency increases and $2 or $5 or $50 after such massive currency creation.
What should we do to hedge against the massive increase in the number of (Ponzi-like) currency units? Hard assets such as gold, silver, diamonds, land, and real estate may protect you from the devaluation of currency units.
Gold and silver are long-term insurance to help protect from Ponzi economics and devaluing currency units.
Gary Christenson
The Deviant Investor
