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The schemers claim to have found a good way to make money. But instead of actually making money from it, the scheme makes money by new investors. The schemers say that the new investors will get a bigger share of the money back for investing more. The investors then find new people to help the original schemer's cause.
Once a Ponzi scheme gets going faster, the system will always fail, or "crash". This is because the later the new investors join in, the harder it is for new investors to make much money. It gets harder because more people have to be found, and finding people is dangerous and costs money.
The scheme will stop one of three ways. One, by the early investors eventually running away with their investors' money. Two, by government officials finding out about it, and arresting people. Three, by the original schemer not being able to give out the money they promised, and the investors calling those authorities.
The scheme was named after Charles Ponzi. He used the scheme after emigrating from Italy to the United States in 1903. (Ponzi didn't invent the scheme, though. Charles Dickens wrote a book in 1857 called Little Dorrit, about a scheme like this. The scheme is very general, and probably very old.) However, Ponzi's scheme was so big that it became the most popular. His original scheme was based on arbitraging international reply coupons (using countries' money-exchange rates to make money) for postage stamps. But, money soon stopped being invested in coupons, and went to early investors, and a lot to Ponzi himself..
Even now, several Ponzi schemes are run online as HYIPs (High Yield Investment Program).
More examples[change | edit source]
People advertising Ponzi schemes often use impressive words, that are actually very vague. Examples are:
- Hedge Futures Trading (taking a good risk)
- High-yield investment programs (gives you back a lot of money)
- Offshore Investment (makes money easily in other countries)
Schemers often depend on investors not actually knowing about economics. The Madoff scandal of 2008 showed that even sophisticated people like bankers can fall for them, though. People are fooled by the schemer seeming to have financial skill or reputation.
Sometimes the schemers claim that money can only be made if the investment is kept a secret (away from the authorities or public). For example, Bernard Madoff only allowed one accounting firm, run by his brother-in-law, to perform audits (keeping track of money) on his hedge fund, claiming it had to be kept a secret.
With the investment being so vague, few investors are tempted. Thirty days later, the investor gets his investment back plus 20%. The investor will be very happy, and will tell others to join in. The new investors will see the first investor's success, and believe the scheme. However, the "return" is all from the newest investors at the time, not the real productive cause.
One way this works so well is from early investors re-investing. This is when the original schemer gets the early investors to re-invest. The schemer can send "statements", saying how much more money the investors can make from re-investing.
Schemers also try to make sure new investors can't take their money back, by making tighter rules on the new financial plan. However, they often have a few investors say they kept their money, making the investment look solvent (productive and good).
However, the scheme will end in one of these ways:
- The schemer will run away with the money they got.
- The schemer will run out of the money that they promised. This is called liquidity and makes people panic and demand their own money, similar to a bank run.
- The scheme is exposed because of the schemer not hiding the scheme well enough from the authorities
What is not a Ponzi scheme[change | edit source]
- A multilevel pyramid scheme is similar to a Ponzi scheme in some ways. Both rely on fake financial promises and getting lots of money back. But, there are differences:
- In a multilevel scheme, the second "level" of investors find their own investors to make a third "level", each profiting directly from the next level. Ponzi schemes "center" around the original schemer.
- Multilevel schemes only brag about the money the investors from getting new investors. This makes multilevel schemes look good to poor people. Ponzi schemes brag about having special connections with hard-to-find sources. This makes Ponzi schemes look good to rich people
- Multilevel schemes "crash" faster. This is because multilevel schemes depend completely on finding new victims. Ponzi schemers can just tempt early investors to reinvest the money they've gotten.
- A bubble: A "bubble" is about re-selling. A bubble is when people buy up all of a product they can, to re-sell it all at a higher price, as many times as they can. The bubble "pops" when buyers stop buying the product, and re-selling are stuck with product they paid too much for. (The product can be anything.) As long as buyers keep paying more, re-sellers can keep making money. Bubbles don't even need central schemers, because people can do this accidentally. (For example, land prices can "bubble" this way. Prices can increase from wanting to build close to big neighborhoods. Once there's no more new land, re-sellers are stuck with their land.) Bubbles are often said to be based on the "greater fool" theory (depending on people who are "fooled" into paying "greater" prices). But really, according to the Austrian Business Cycle Theory, bubbles are caused by giving extra money supply (loans) to buyers for a certain kind of transaction, and in this case would qualify as a Ponzi scheme. In this case, the loan-givers are the schemers, making money from the losing re-sellers.
- "Robbing Peter to pay Paul": This is when people with debt borrow money to pay their debt, and borrow more money to pay back that debt. This is not a Ponzi scheme, because the debt-havers weren't promised high returns or anything. Also, the lenders don't always make money.
- Multi-level marketing: Multi-level marketing (MLM) is when companies sell investors things to re-sell directly to customers. Re-sellers can also make money by referring new re-sellers to the company. This may seem similar to a pyramid scheme, but it's not always the same thing. Honest and legal multi-level markets do exist.
Other pages[change | edit source]
References[change | edit source]
- "Ponzi Schemes". US Social Security Administration. http://web.archive.org/web/20041001-20051231re_/http://www.ssa.gov/history/ponzi.html. Retrieved 2008-12-24.
More reading[change | edit source]
- Dunn, Donald (2004). Ponzi: The Incredible True Story of the King of Financial Cons (Library of Larceny) (Paperback). New York: Broadway. ISBN 0767914996.
- Zuckoff, Mitchell (2005). Ponzi’s Scheme: The True Story of a Financial Legend. New York: Random House. ISBN 1400060397.