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Is Everything a Ponzi Scheme? A Closer Look

On Wednesday, we ended class on the assertion that Bitcoin is in fact a Ponzi Scheme. Some of us have heard of the famous Bernie Madoff case, or have some other background knowledge on schemes, but what is a Ponzi Scheme, really? How does it operate? In this blog, we dive into Ponzi Schemes, explain how Bitcoin is effectively a scheme in and of itself, but question other institutions in our country, such as Social Security, and explore elements within them that make them similar to Ponzi Schemes themselves.

In short, a Ponzi Scheme is investment fraud. A man, such as Bernie Madoff, or a company will lure in investors with the promises of major payoff down the road. The schemer will then attract more investors and pay back the initial investors with the newer investors money, boasting of their success in the market relative to their “competitors” who are actually investing the money. From then on, the cycle repeats, and the scheme grows, with each wave of new investors paying off the “investments” of those who came before them. Not a single real investment is made--the whole thing is fraud--the schemer gets rich, the newest investors get scammed, and the whole scheme unravels and collapses when it runs out of new investors to supply cash for its previous investors.

Bitcoin is a complicated and confusing new form of “digital currency” that operates on the dark web. In theory, it brings down the cost of buying goods online. People purchase Bitcoins because they believe their worth will eventually skyrocket as it becomes more common. The first people who went in on bitcoin tend to hoard their own bitcoin for this reason, waiting for this skyrocket in value and popularity. They recruit new investors in bitcoin and encourage them to spend all their bitcoin in order to facilitate this. In short, past investors are waiting to cash in on newer investors spending for their own financial gain--sound familiar? For this reason, many economists come to the conclusion that Bitcoin has become nothing more than a Ponzi Scheme. While it may have been intended to be a shining beacon in the growing trend of digital currency, Bitcoin has faltered, has suffered extreme volatility and recent depreciation in value, and could turn out to be a giant scheme, leaving countless losing significant amounts of their own money.

Thinking now of some elements Ponzi Schemes in terms of other things we have learned about this past semester, why isn’t Social Security considered to be a Ponzi Scheme? Retired people, people who used to be in the labor force, are profiting off of tax revenue from people currently in the labor force. The government literally takes your tax money with the promise of payoff up to 45 or 50 years down the road. We have even discussed how Social Security is going to run into trouble as the workforce shrinks down and the system runs low on taxpayers to support the system. This sounds dangerously close to a Ponzi Scheme. But why is it not a Ponzi Scheme? Certainly every taxpayer in America hasn’t been duped by a mere scheme since before the Second World War, right? Right.

Before we explain why social security is not a Ponzi scheme, let’s delve a bit deeper into the political elements of social security that make it appear to be a Ponzi scheme. Essentially, political gain made it expedient for politicians to promote the social security early in its development. It provided big payouts to retirees when the workforce was still large enough to bear the burden of the newly retired. As John C. Goodman says in his Forbes article titled “Why Was Social Security Designed like a Ponzi Scheme?”, “This [early year revenues that are much higher than the required payout] means that (like a chain letter), politicians can give retirees in the early years more than what was promised. They can also spend the extra revenue on other programs that confer benefits on their constituencies.” To put it in short, at the beginning of social security politicians gain valuable political capital by going above and beyond promises made at the onset of social security. However, political gain does not dictate a shift in policy until the well begins to run dry - a shift we’re beginning to see now. While political expediency did make social security into a perhaps inefficient system, it did not make a Ponzi scheme - as the next paragraph explains.

Social Security is not a Ponzi Scheme.  In real Ponzi Schemes, such as Madoff’s, everything on the books is fraud, and no real investments of any kind occur. The Social Security Administration describes Social Security as follows: “It would be most accurate to describe Social Security as a transfer payment--transferring income from the generation of workers to the generation of retirees--with the promise that when current workers retire, there will be another generation of workers behind them who will be the source of their Social Security retirement payments.” Ponzi Schemes, the investors’ money isn’t being invested in anything at all, but for Social Security, there are extremely detailed financial reports put out annually about the system, ensuring that no fraud occurs. So in conclusion, while Social Security may look somewhat like a Ponzi Scheme on the surface, this could not be further than the truth. When the government takes your money for Social Security, it is really investing it and putting it towards the cause it says it is going to. It is not fraud; it is not a Ponzi Scheme.

Questions:

  1. What makes a Ponzi Scheme a Ponzi Scheme? How does it operate
  2. Research the Bernie Madoff case of 2008, how is this case exemplary of why such schemes eventually are doomed to collapse?
  3. Taking this information about Bitcoin into account, why should you be weary of just buying into Bitcoin today?
  4. Senator Rick Perry called Social Security a Ponzi Scheme during the GOP debates, why is he incorrect? What about the makeup of Social Security would lead people to believe him?
  5. Can you think of any other systems that may appear in some ways to be a scheme, while not being a scheme in actuality?

Sources:

Robert Griffin
Matt Marshall

12 thoughts on “Is Everything a Ponzi Scheme? A Closer Look

  1. richardsonw20

    A Ponzi Scheme is an investment scam. The "schemer" promises new investors high rates of return with little to no risk. They use the money from the new investors to pay off the early investors and this process continues until it cannot anymore. Ponzi schemes are doomed to collapse because they require a constant flow of money coming in so that the organization can continue to pay off peoples returns on their investments. When the money stops coming in, they are unable to pay their investors and eventually collapse. We should be wary of bitcoin for many reasons. One reason is that it is not backed by any government or institution at all. This draws some people in, but pushes most away because of the fraud and other crimes that it fosters. There is also no security for the networks that handle bitcoin. Social security is not a ponzi scheme because it is backed by the united states government. Unless some horrible catastrophe happens and an entire generation is killed, there will be another working class to come after us that pays social security once we are retired.

    Reply
    1. Khang Truong

      Governments are unique only in that they are recognized as such by their peers. This buys a certain degree of legitimacy, but there doesn't seem to be any intrinsic benefit in being "backed" by governments. Let us not forget that Zimbabwean dollars were also backed by a government. Things did not turn out well.

      In contrast to this we have a system that by its design cannot suffer hyperinflation. Money is not issued by a central authority, but by an algorithm within the blockchain that "mints" less and less BTC as time passes.

      Reply
  2. Khang Truong

    I would disagree with the argument that Bitcoin is a ponzi scheme. Ponzi schemes are designed so that money is funneled back towards initial investors. If we look at Bitcoin, we see no such mechanism; the currency has no central authority that would allow for that. Furthermore, the purpose of the currency is not to invite other people into the system as in a Ponzi scheme. The currency has a set of legitimate uses that make it useful beyond simply generating money out of thin air. Bitcoin users find value in its decentralization, security, and anonymity. Perhaps the largest counter-indicator of a Ponzi scheme is the fact that the currency is stabilizing. Yes, we're seeing some major fluctuation, but the recent drop was tiny compared to what has happened in the past. One thinks of the security breech at Mt. Gox a few years ago; the fallout of that disaster was far greater. This can be attributed to more widespread recognition of BTC's utility, as well as the architecture of the currency, which reduces block chain rewards by half every four years.

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  3. laniere20

    A ponzi scheme occurs when someone promises to invest your money, but is really using your money to pay off previous investors. Hopefully, there will still be some new investors around to help pay you back before the ponzi scheme unravels, leaving many investors in financial trouble.
    What is so shocking to me about the Bernie Madoff ponzi scheme is that it did not start off as a scheme. He had a few bad years and instead of being honest he tried to recover, but just continued to commit fraud until it crashed down on him.It sounds as though the original Bitcoin investors are worried about getting their money back and are trying to recruit new investors so the they money can be used to pay back the original investors. It makes me wonder whether the original investors are aware of the fraud but are still hoping to get their money back. Social security seems like a ponzi scheme because younger generations are basically paying for the older generation to live. The government is aware of this preconception and therefore keep detailed accounts of the returns of social security. While it may seem like a scheme, it is not and it a necessary part of taxes.

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  4. mcconnellm20

    A ponzi scheme occurs in the context of investment. Someone promises that they will invest your money with barely any risks. Those people then take that money and pay off previous investors. This cycle continues until the scheme unravels and collapses when there are no new investors who will invest their money. I think that we should be wary of buying into Bitcoin today. As previously mentioned, Bitcoin should not be trusted as it was recently hacked. However, it makes sense that Bitcoin is simply just a ponzi scheme. The first people will save their bitcoin for their own personal gain later on down the road. Then they bring in new investors who then spend their bitcoin. When these new investors spend their bitcoin, the previous people who were saving their bitcoin will now gain from the new investors spent bitcoin. One of the main reasons why it is hard to believe that Social Security could be a ponzi scheme is because it is backed by the United States Government. The government is taking the money and putting it towards what it is saying it is going to in terms of investment. Since there are detailed reports released yearly about Social Security, it would be hard away for the government to get away with a ponzi scheme.

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  5. murrayc20

    Well, social security in theory may be similar to bitcoin, but in real life it is very different. For one, it is set that every citizen of the US must pay social security taxes. As mentioned in the blog, Bitcoin is a digital currency that operates on the dark web; its use is optional and sketchy unlike laws set by the governement. It could be argued that both bitcoin and social security promise money in the future that you technically may not get, but the people are more likely to confront the governement and get what they deserve if it affects the whole nation. If you invest in bitcoin and do not get your money in the future, it was your choice and that risk comes with any voluntary investment.
    Social security is concrete and written down and has worked for decades. Bitcoin is invisible and new, making it have a higher risk for failure.

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  6. Ellie Bradach

    I think that a Ponzi Scheme is the intentional use of investment money for personal gain. These schemes are created knowing that individual investors will not get positive returns or any returns for that matter. Someone creates basically a fake company or organization and then takes the money was invested. Ponzi Schemes like the Bernie Madoff case of 2008 are doomed for collapse because without getting any returns, people will eventually pull out their investments not to mention the legal trouble associated with such schemes. I am wary to buy Bitcoin today because of their reputation and lack of trust between individual investors and the company.
    Social Security is not a Ponzi Scheme because it is not the intentional misuse of investments for the gain of the government. It is understandable to confuse Social Security as a Ponzi Scheme because the government realizes that the money will run out and people will not get a return on their investment. In similar ways, college can be seen as a Ponzi Scheme. Washington and Lee costs a lot more than if I had gone to a state school, but I will probably graduate with the same degree no matter what institute I attended. How could my much more expensive investment in this school be worth it?

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  7. Julia Moody

    A Ponzi scheme operates by taking new people's investments and paying the old investors with this money, as if they are having great financial success. They use this facade of success to attract new investors who think they are going to have a big pay off in the future. They then take their money and pay the previous investors, and this process happens over and over again. They don't keep any of this in the books, because of course it is highly illegal. The people behind the Ponzi scheme will continue making money until they can't secure new investors, and then they won't be able to pay back the previous round of investors. They will lose money and everyone will realize that they have been operating under illegal procedures the entire time.

    One should be weary of buying into Bitcoin today because the people encouraging others to buy into Bitcoin are already heavily invested and waiting for its worth to skyrocket. This is similar to a Ponzi scheme because the original investors are falsely (but confidently) predicting Bitcoin's success and waiting for more people to buy in. The original investors will only make money if more people invest in Bitcoin so they are biased and doing whatever they can to be successful.

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  8. bashamc20

    Bitcoin has created a sort of unpredictable international spectacle, as the currency is relatively uncharted territory. The technological necessities to maintain a digital currency like Bitcoin have only existed recently, and no other products like Bitcoin have flourished to its extent. The value of 1 Bitcoin (BTC) has increased dramatically recently, but its uncertainty and instability has raised concern for many investors and economic spectators alike. Some argue that Bitcoin as a kryptocurrency is just as valid as any other currency, while some have argued that the worth of a Bitcoin is effectively nothing. I would not personally go as far as to qualify Bitcoin as a ponzi scheme, nor would I lump it in the same category as currency like USD, GBP, EU, etc. I would think Bitcoin can more aptly described as a digital value-holding commodity. Much like a stock, this value of each unit of this commodity can vary. In this way, Bitcoin is largely like a high-risk, high-yield stock market investment. As Bitcoin is uncharted territory I do not know what to expect for its murky future; perhaps its international usage will surge, or perhaps its value will tank.

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  9. the prof

    Ouch. It looks like I wrote a long comment and failed to post it! WordPress doesn't create an automatic backup of drafts.

    • Social Security was sold to Congress in the 1930s as a standalone program, but in fact was not set up to actually function as one. Even in the 1930s most Congressmen were lawyers, not people with business backgrounds, and they were above all politicians. They paid a lot of attention to the package, but let technically adept staff craft the details. I've seen no evidence that today's Senators and Representatives are any different. Most seem to believe in the myth that Social Security is an entity somehow separate from the rest of the Federal government. The reality is that money is fungible.

    • In particular, the tax rate has only been adjusted a few times. So in most of the past 80 years Social Security generated an operating surplus. Today it's running a deficit. To be a true standalone program it would have had to have a tax rate that adjusted automatically every year or so in accordance to the number of people working and hence paying taxes relative to the number of retirees collecting monthly payments. Instead we've had periodic large changes in the tax "dedicated" to Social Security rather than regular small ones. Again, money is fungible and the social security tax is simply one of the many taxes that fund the government.

    • Unlike a Ponzi scheme, Social Security does not depend on a greater fool showing up to let you cash out. Participation is compulsory. Paying taxes is compulsory. If at some point your grandparents suddenly begin receiving a smaller monthly payment, it will be because Congress chose to let that happen.

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  10. mizeo20

    I reject the notion that Bitcoin is a ponzi scheme. Simply by definition, a ponzi scheme is "a form of fraud in which belief in the success of a nonexistent enterprise is fostered by the payment of quick returns to the first investors from money invested by later investors." Yes, we have seen hacks in the past; yes, until recently, its sole purpose was for purchasing illicit items anonymously; however, we are seeing this notion change. We are seeing increased speculation, increased regulation, and a decrease in hacks. I feel like the notion that Bitcoin is a ponzi scheme is ignorant because that is ignoring the fact that some actually see value in Bitcoin, especially in the underlying technology of blockchain. Year over year, we have seen volatility in Bitcoin, though overall we have seen appreciation. Hedge funds are starting to take notice. There are rumors of an ETF for Bitcoin. Top hedge fund managers in the world claimed that once Bitcoin hit 6k per coin it would fail. They were wrong. It hit 7k a month later. Perhaps Bitcoin is not a smart investment, but I would not say that it is a ponzi scheme. It fails to meet that definition.

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  11. litvaka20

    A Ponzi Scheme allows some to garner significant wealth by beginning a cycle wherein investors believe they are investing in something that is doing very well. In reality, it is just a chain of investors that are paying back the original investors and so on. This becomes a problem because eventually there will be no new investors to pay off the old investors and the scheme falls apart. However, this is not what is happening with Social Security because, as this blog noted, there are services that result from this government program. The issue arises due to the growing population that will require Social Security benefits, but less people will be in the working population to supply the funds for these benefits. On another note, one might be weary of investing in Bitcoin because it relies on new investors in order to sustain the past investors. Due to its volatility and depreciation in value, there is a possibility that investing in Bitcoin could lead to major losses if there becomes a lack of investors. While this may not be a Bernie Madoff type of Ponzi Scheme, it still has the potential to collapse if investors believe they will lose their money.

    Reply

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