Ponzi Schemes

Steven Dutch, Natural and Applied Sciences, Universityof Wisconsin - Green Bay
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Ponzi Schemes

Charles Ponzi probably never intended to end up in jail, much less the dictionary, when he launched a scheme to bilk investors by paying them with the money gained from new victims. But he was caught in 1920. Outright criminal Ponzi schemes depend on the perpetrators being able to escape and evade capture or find refuge in some country that will shelter them.

It's doubtful that Bernie Madoff started out with the intent of running a Ponzi scheme. 'Let's see, I'm wealthy and respected. What's missing? 'I know!' he shouts, slapping his forehead so hard he loses consciousness, 'I'll launch A Ponzi scheme. That way every day will tingle with the excitement of wondering whether my world will collapse in ruins and I'll be dragged off to prison while simultaneously being reviled by the whole world.' No, he probably really believed he was such a savvy investor he could consistently outperform the market. Like a 'system' gambler in Vegas, he believed he was brilliant when he had merely been lucky. And when the scheme did begin to go sour, he probably told himself it was just a temporary downturn and soon the old mojo would return and he'd be able to pay off all his investors. Eventually, he probably just hoped to die before it all fell apart.

Pyramid schemes vary in legality but are fundamentally the same as Ponzi schemes in that they depend on future gains to pay present rewards. Illegal pyramid schemes involve recruiting future investors, paying current investors a commission for each new victim they recruit. Generally, the people running the scheme pose as investors and pay themselves first. Legal ones typically involve selling and recruiting new sales agents. They are legal because the company is selling something of value, and it is possible for sales agents to earn money, but the real money is in recruiting additional players. Morally, these are indistinguishable from Ponzi schemes in that sooner or later the possibility of future growth is gone. Eventually everyone who can be recruited will be, everyone who will buy the product has bought it, and when that happens, the last tier of recruits are stuck, with no possibility of expanding their operations or recovering their investments.

And here'sthe ugly economic reality. All growth schemes that assume indefinite future growth are Ponzi schemes. Because nothing can grow forever in a finite world, and when growth stops, people who were hoping to make future gains are stuck.

That'sindefinite growth. If you invest in something with the awareness that it will not grow indefinitely and you are prepared to deal with the end of growth non-destructively, that'snot a Ponzi scheme. If you take your profits and retire on them or reinvest them, that's what capitalism is all about. On the other hand, if you're the sort of investor who sells off the company'sassets and puts its employees out of work when the roller coaster ride is over, you're slime. And fundamentally you're a Ponzi schemer because you plan to hop from one profiteering venture to the next while doing nothing to make the growth sustainable.

Compound Interest

It has been known almost since compound interest was invented that it cannot grow forever. Something - war, devaluation, or inflation - will come along to offset it. Say you'd invested one cent at 1% interest per year, compounded annually, in the year 1 AD. By now it would be worth $.01 x (1.01)^2009 = $4,804,408.53. Okay, handsome return, but maybe not unreasonable. Now visit a reputable coin shop (because fake ancient coins abound) and try to buy a Roman coin that was worth about a cent in Roman times. Will it cost you $4.8 million? Not likely. $20, maybe $100 if it'sin very good condition, but not $4.8 million.

Now suppose the interest rate was 2%. Now your cent would be worth $1,895,592,883,959,335.15 or something like 30 times the total GDP of the earth. Go ahead, try and collect. At $1000 per ounce, that would be 1,895,592,883,959 ounces of gold. Gold is measured in troy ounces (31.1 grams or 1.1 conventional ounces) so that's 58,952,939 tons of gold. Since the total amount of gold ever mined is around 150,000 tons, you could not be paid in gold.

But this is just silly, believers in compound interest object. Nobody ever holds an investment for 2000 years. Exactly. And when the investment is cashed in, the growth stops. The money might be consumed, it might be reinvested, and the new investment might rise or fall, but the essential point is that guaranteed indefinite growth is impossible.

The reason compound interest has been a useful tool is that for the last 500 years or so economies have grown more or less steadily. If interest rates are set to match the growth of the economy, then people who invest in the economy by buying stocks or bonds, or opening savings accounts, or buying real estate, are rewarded somewhat proportionally to the growth of the economy. And wages grow so wage earners reap some of the benefits of growth. But when growth spurts stop, some people get left holding the bag. People who bought investments hoping to see them rise get brought up short. Wage earners who counted on keeping good paying jobs all their working lives get rude shocks.

Over the last 500 years the engines of economic growth have included trade, territorial expansion, technology, population growth, generation of new needs and wants, and information. None can continue to grow indefinitely. The whole world is now claimed territorially. Space is potentially an arena for long term growth, but not at present costs. Information might seem to be an exception in that it is abstract. But information requires storage and retrieval capabilities. Libraries regularly discard books because they need shelf space; the digital equivalent is not hard to foresee.


Limits to the growth of science and technology have been predicted and failed so many times that many people have come to assume that there can be no limits. But all ideas consist of a finite number of bits of information. If you happen to know of an idea that consists of an infinite number of bits, e-mail it to me. 'The sun is a star' consists of 17 characters, counting spaces (which convey information by telling us that one word ends and another begins). In standard ASCII format, each character contains 8 bits, so that sentence contains 136 bits of information (The actual information content is hard to pin down. On the one hand, there may be more economical coding systems. On the other hand, there's 'overhead.' You have to know what the letters and words mean). The total number of combinations of 136 bits is 2^136 or 8.7 x 10^40. That's a lot of ideas, but all but a miniscule proportion, like 'pglNb gTRdf kmnhg,' which also contains 136 bits, are meaningless. The number of possible ideas may be staggeringly large, but it is finite. And the number of possible ideas will be further limited by the size of our information storage and the complexity of our brains. At some point there will be ideas so complex our brains cannot process them, and ideas that cannot even be summarized meaningfully in terms that our brains can process.

And exponential growth means that numbers get very big real fast. Every possible rate of growth has a doubling time, approximately 70 years divided by the annual percentage rate of growth. 87 per cent (7/8) of the total growth will happen in the final three doublings and 99.9 per cent (1023/1024) in the last ten.

Technology may be limited ultimately by our needs being satiated or by running out of resources. Although supersonic airliners are perfectly possible, the few ever built have been retired and there are no plans for new ones. Dubai's half mile high skyscraper was technically possible fifty years ago; in fact Frank Lloyd Wright proposed a mile high skyscraper in 1956. Nothing that big has ever been attempted because of financial objections, and even the viability of Dubai's tower is questionable. It is not at all out of the question that we will decide we do not need to return to the moon, or even have manned space flight.

The archetypical exponential growth in technology is Moore's Law, the idea that computing power doubles about every two years. Pretty much everyone in computing is mathematically literate enough to realize this sort of expansion can't continue indefinitely. The question is how to keep the growth going as long as possible. The ultimate limit is probably set by reducing bit storage to atomic levels. Estimates of when an ultimate limit will be reached range from decades to centuries. It might turn out that Moore's Law will be limited more by our perceived need to store information. And even when we do hit the limits of Moore's Law, we will have achieved amazing levels of computational power and information storage.


A piece by Paul Harris in the Guardian (guardian.co.uk) for October 4, 2009 is titled 'Will California become America's first failed state?' It details the budgetary morass facing California and includes the usual array of responses from right and left. From the left we hear that taxes need to be raised to preserve California's rich array of beneficial programs. From the right we hear that taxes are too high, the regulatory climate is negative, and social programs and salaries are excessive. All the reasons I have seen given for California'smalaise, both right and left, are valid. Which one to choose depends on what you're willing to sacrifice to gain something else. None of them address the real problem. California has been a failed state for many years. Like Bernie Madoff's early investors, Californians could overlook the impending crash because the money was still coming in and nobody much cared where it would come from a decade hence.

My family moved from Maine to California - literally - in 1961 and settled in the San Francisco Bay Area in the East Bay. At that time there was still some open land between towns, and you could still see a little of what California might once have been like. The population was about to overtake New York's, but at 18 million, it was only half of today's. My guesstimation is that the perfect time to have lived in California was right after World War II, when personal mobility was good, real estate prices were sane, and even Los Angeles was pretty livable (although its first serious smog episode came in 1943). The population in 1945 was about 9 million, a quarter the present size.

Over the years I lived there plus frequent returns, I watched all the old farms disappear and formerly open marginal land was filled in by housing developments. Fortunately, governments in the Bay Area established a large network of regional parks to preserve open land. More irritating by far was the simple crowding. There are a few corners of California I might choose to live in if I ever decide to go back, but none near any large cities. Even tiny and remote Alpine County, a place I had thought was as immune to urban sprawl as any, is at risk, not from California cities, but from Carson City to the north.

California, ultimately, was a gigantic Ponzi scheme, paying for today with tomorrow's income. My family moved from Maine and had very New England ideas about money, and one of the first things my father noted with disgust is how soon after payday his co-workers were borrowing money. 'A dollar down, a dollar a week, and the rest of your life to pay,' he sneered. (I originally wrote 'snorted,' but my father didn't snort. He could, however, sneer with the best of them.) And governments at all levels were in on it. They eagerly sought development, which would bring in new residents, which would increase the tax base, which would enable them to offer better services, which would attract more residents..... Developers stood to make money, local governments stood to make money, bureaucrats stood to make money since growth meant career advancement (as well as some of the more crass and less legal ways to earn money from development), politicians stood to get re-elected (and bribed) and residents favored growth because it meant more people to share the tax burden, more customers for their businesses, as well as inflated resale values for their homes. Farmers and ranchers welcomed development because they could sell land at big profits.

The first hint that it might not be sustainable came almost 100 years ago when Los Angeles, then only a small city (100,000 in 1900, or about the size of present Green Bay, Wisconsin), began running out of water. The city water commissioner, William Mulholland, realized that water was the limiting factor in the city'sgrowth and urged the city to buy up water rights in the then (and still) sparsely populated Owens Valley. California keeps its cities supplied with a massive system of aqueducts and reservoirs, with water supply officials keeping a nervous eye on the Sierra Nevada snow pack each winter. California may have enough water to supply its cities and irrigate farm land. It doesn't have enough for frivolous uses like watering lawns.

But eventually California is limited by its physical size. Even though there are still some very empty places in California, the full places are very full indeed. Places that were 10 minutes away twenty years ago are half an hour away now. Undeveloped lands that served as unofficial playgrounds in 1970 are houses and malls now. Open ranch land that offered scenery a short drive out of town is now built over. Apologists for growth argue there is still plenty of open space, as there is. But the places where people actually live are becoming less livable. More and more people decide there are equally livable places elsewhere, in Utah, Idaho and Montana. The question is not, how many people can we cram into a county, but how many people will we cram in before moving in becomes unattractive? Bakersfield has 300,000 people, not an absurdly large city, and is surrounded by open land for expansion, but it used to offer clear views of the Sierra Nevada on most days. Now air pollution blocks the view all but a few days a year. And when people decide it's not attractive to move in any more, growth stops. Taxes rise. People and jobs move out. Taxes rise even more to provide services to those who can't afford to move. More people and jobs leave. See Detroit for details, although many California cities, like Stockton, in 2009 have statistics to match Detroit.

San Francisco, which was the second largest city in California in 1960, has seen itself overtaken first by San Diego, and then San Jose, because it has the ultimate space constraints: occupying the tip of a peninsula. So its population remains locked at about 800,000. It has survived by a Darwinian process of selecting people willing to live in crowded conditions at exorbitant rent, and politically liberal enough to pay high taxes to support those who cannot afford the insanely high cost of housing. In a state of 37 million and a nation of 300 million, I guess we ought not be surprised to find 800,000 people willing to do that, especially if the reward is to live in a place with the culture and physical setting of San Francisco. They are even willing to put up with spectacular incompetence, as Benjamin Wachs and Joe Eskenazi pointed out in "The Worst-Run Big City in the U.S.: Spend more. Get less. We're the city that knows how." in SFWeekly.com on December 14, 2009. But if you think that's a general recipe that will apply everywhere (except for the incompetence part), guess again.

Ducking Malthus

Thomas Malthus, dubbed the "gloomy prophet," is famous, or notorious, for his observation that the exponential growth of population inevitably outstrips the means of production. Some unknown wag wrote "Song of Malthus: A Ballad on Diminishing Returns":

To get land's fruit in quantity
Takes jolts of labour ever more,
Hence food will grow like one, two, three....
While numbers grow like one, two, four....

For nearly 200 years, economists have pointed out that Malthus did not foresee the Industrial Revolution, the rise in wages, improvements in agricultural production, and so on. In Malthus' day, an optimist would look forward to the end of starvation in Europe. To worry about eradicating hunger globally would have been viewed as Utopian to the point of hallucination. And so it is fashionable in many circles to speak as if we can evade Malthus' predictions indefinitely. There are ways we can foresee that, if not indefinite, could forestall a crisis for a very long time, long enough that it would not be irresponsible to ignore limits for a long while.

In the Star Trek universe, for example, people have apparently limitless energy, replicators, and new planets to colonize. Just maybe, we can solve our energy needs by developing fusion or building space-based solar energy collectors. Replicators are not as near on the horizon, though rapid three-dimensional printers capable of fabricating any imaginable object are improving in capabilities dramatically. With enough energy we could distill sea water and end the overuse of natural water sources.

But it makes sense to relax a bit only if the technology is available. If we have a cheap way of distilling sea water, then we could feel okay about building houses with lush lawns and swimming pools in the desert. But building them, thenhoping the technology eventually becomes available, is simply stupid. It's like driving your car until it runs out of gas in the expectation that someone will open a gas station at the spot you get into trouble. Or like the story of the guy who jumped off the Empire State Building, and as he passed each floor, said "so far, so good."

As for colonizing space, in fifty years we have sent about 500 individuals into space (a few thousand if you count individual trips). Just to keep pace with existing population growth, we would have to send about 250,000 people a day into space. That's Birmingham today, Norfolk tomorrow, St. Petersburg the day after, then Louisville, Anchorage, Bakersfield.... Just to stay even. And a society that decided the Apollo Program was too expensive is going to do this?

What about the oceans? The world's fisheries are on the verge of collapse. Increasingly, consumers are buying fish that were dismissed as trash fifty years ago. When spokesmen for the fisheries industry gush about fisheries stocks doubling in some places in recent years, they mean they've grown from one per cent of what they were fifty years ago to two per cent.

The Ultimate Ponzi Scheme

The ultimate Ponzi scheme is believing that population can continue to grow indefinitely.

As an American, I find it refreshing to see we don't have a global monopoly on stupidity. Canadian Diane Francis wrote "The Real Inconvenient Truth " in the Financial Post for Tuesday, December 08, 2009 and got these replies, which pretty much make up a rogues' gallery of denial games about limits on growth.

Hakuna Matata

More people mean more markets, more taxpayers, more pension payers, more inventors. All we have to do is learn to live more modestly, not stop living or stop others from being born.

No problem, mon! We're running the world as a Ponzi scheme and we like it just fine. This writer doesn't mean he should live more modestly. That will be for future generations. After all, what have they ever done for us?

Serutan: It's Nature's Spelled Backwards

What all you pointy headed intellectuals fail to realize is that you are not in control of these things. As much as your egos would like you to believe that you can control the environment, population growth, etc. A pandemic of some sort is inevitable, and that is what has WHO wringing its hands over H1N1. There is nothing they can do. When the problems of the world become to strong, nature will take over and wipe millions and possibly even billions from the face of the earth.

I kinda sorta doubt that if he or a loved one gets caught up in one of these pandemics, that he'll be cool about letting nature take its course. Millions or billions will die in a pandemic. Whatever. Just as long as I don't have to get involved. Idea, move from Canada to the U.S., get sick, and let nature run its course.

Not in my Job Description

Which are you, Ms. Francis? Crazy, evil, or stupid? Pick one. Pick several. But don't feed us garbage about how the world is overpopulated and we need to stop reproducing. The fact that your beloved economic planners can't deal with six or nine billion is their own fault. Maybe if people like you would stop imposing your will on me and mine, we could all just get to producing things that are useful to mankind, unlike your ridiculous screed above.

See, my job is just to consume stuff. Your job is to keep me supplied with creature comforts and to solve problems without involving me. This guy is a middle class welfare bum. He may be earning his keep, but actual problem solving? That's somebody else's job.

Oh, Canada

I'm only 27 and I have one little boy already. There are at least 2 more to come. All will be raised CANADIAN, PROTESTANT, and PROUD. This is how we maintain OUR homeland for OUR people.

Canada has many things to be proud of. This, however, is not one of them. Isn't there a mine field in Afghanistan that needs clearing?

Let's Combine Short Sightedness And Racism

Not quite. What we need are for white western countries to significantly increase their birthrates and for muslim (sic) countries to drastically lower theirs. White people make up less than 15% of the world's population and its only going to go lower with the 1.5 babies per woman birthrates that are so typical in Europe and Canada. We need more European children or western civilization is dead!!!!

With people like this shaping public policy, Western civilization is dead anyway.

Ms. Francis, you obviously have not thought that issue through. One child police across the board for all nations give the already population -rich countries an unfair advantage.. We need more caucasians at this point.. I advocate to educate the overpopulated countries and not drain the economy with fraud and deception.

Facts? We Don' Need No Stinkin' Facts

Follow this if you can, "The world's population would drop from its current 6.5 billion to 5.5 billion by 2050, according to a study done for scientific academy Vienna Institute of Demography. -By 2075, there would be 3.43 billion humans on the planet. By this rate in 2100 the population would be 1.36 billion, and by 2125 the Earth would be De-populated. This is where its all heading with the Liberal loonies

Because by 2100 people will have forgotten how to have sex, apparently.

Ms. Francis, your pathological belief system advocates an end to human freedom for the tyranny of an all-powerful state regulating who shall live or die. The God of whom the Bible speaks loves humanity and made the earth re-sustaining for humans to flourish. Your world view resents this and demands the oppression of humans under government tyranny, concocting the manmade global warming hoax to that end. Your cause will fail as we who love liberty defy your ideology's schemes.

Hmmm... wasn't there a parable about wise and foolish virgins, where the wise ones foresaw running out of resources and the foolish ones didn't? Of course, we don't take the Bible literally when it hints at things we don't want to talk about.

Diana Francis, Please show you're serious by volunteering your own suicide. Thanks!

Show me you're serious about the need to lose weight by starving yourself to death. Because restraint and moderation always lead to extremes.

The Ponzi Scheme That Isn't

Ironically, one scheme that critics love to label "Ponzi" is the exactly opposite of a Ponzi scheme: Social Security.

Think of Bernie Madoff. True, he could pay off a few people who decided to cash out, but if large numbers of people had decided to leave, he'd have been stuck because he simply didn't have the money. Every Ponzi scheme promises to pay investors with money it doesn't have yet. It spends everything that comes in keeping the charade going.

Social Security has the money on hand. Ahh, says the critic, but it's all in the form of IOU's, because Congress has dipped into the fund. Well, unless you have an oil tank and a grain silo in your back yard, all your wealth is IOU's. Your bank account and IRA are bytes in a computer. The cash in your mattress is pieces of paper which you hope people will take in exchange for stuff you need. Gold? Well, unless you actually have gold bars or coins, what you have is pieces of paper promising to give you gold. And even if you do have gold, better hope things don't get really desperate. Because I won't trade the last seat on a lifeboat for any amount of gold. ("Psst, buddy, want some gold? Toss the guy next to you overboard.")

Now early in its history, Social Security did pay benefits in the expectation of getting future income. This happened when the program was first beginning and there were a lot of people joining and not too many drawing benefits. So any competent actuary could (and did) keep the system solvent.

Now right now, Social Security is facing a squeeze because Baby Boomers are retiring. There are plenty of viable strategies for dealing with it, like removing caps on contributions and limiting benefits. But the only way Social Security can go bankrupt is for people to elect politicians who let it. So if you're afraid you'll never get Social Security, that's up to you.

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