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How a Ponzi Scheme works

posted Mar 30, 2012, 6:02 PM by Simon Nguyen   [ updated Apr 9, 2012, 1:41 PM ]
After Madoff’s “Scam of the Century” finally came into light, the media quickly seized upon the foreign idea of a Ponzi’s scheme. In fact, Ponzi became a celebrity overnight. Yet, I do not believe the media did a good job in explaining what a Ponzi’s scheme really is. I will try my best to explain this not-too-complicated concept.

One of the main goals in life is to enjoy it to fullest. The only reason why a person chooses work over leisure is so he can enjoy a better life. After essential expenses are deducted, we are left with a certain disposable income. This is when one has to make a difficult decision – to consume or to not consume. An irrational person would spend all of his or her disposable income on consumption.

A rational person, on the other hand, thinks about the future. Life is full of uncertainties. What if he gets laid off tomorrow? What if there will be a big expenditure in the future? Eventually, he will come to the decision of consuming only a portion of his disposable income. He will either save or invest the rest.

Madoff's investors were of the rational type. Enticed by promises of decent rates of return, they continually entrusted their life savings to Madoff. Their persistence actually worked to their disadvantage in this case, as no investment actually took place. This conman was merely holding their money. He even used some of it to finance his lavish lifestyle. 

Does everyone who invested with Madoff lose money? Absolutely not. Life is full of uncertainties. During the decades Madoff’s investment firm was in business, some of his investors encountered financial difficulties that prompted them to withdraw money "invested" with Madoff. The guy was happy for comply because he did not want his fraud to be exposed. They not only got the principal money back but also the big payoff Madoff had promised them. These people were the real winners of the whole Madoff’s ordeal.

The reason why Madoff could afford to do this is because most of his investors can be classified into two groups – the wealthy and the hardworking. The wealthy investors rarely encounter financial hardships; they had no reason to withdraw their investments early or stop sending money to Madoff.

The investors from the hardworking group live a modest life; they maintain a steady job and are frugal with regards to spending money. These people didn’t have a lot of money, but they saved enough to continue to funnel the funds to Madoff.

Since there were more money coming in than coming out, Madoff was able to payoff his obligations to the few that opted to withdraw their investments early. This was the reason why Madoff’s scheme had not been exposed sooner.

But then came the economic crisis. For Madoff, it was the perfect storm. People were worried about their financial situation. Not only Madoff’s investors could no longer afford to give money to Madoff, they wanted to withdraw the principal money plus the high returns Madoff had promised. Moreover, the fraudster could not get new investors to buy into the scheme.

It was very much the end of the road for Madoff. A large portion of the money had already been transferred to the fortunate investors who withdrew their money at an earlier time. If it was just the principal money, he might have been able to pay his investors. But to hide his fraud, he would also have to pay investors the ridiculously high returns he had been lying to them. He had no choice but to plead guilty to his crime.

This explains why the government has not been able to recover all the money. They would have to identify and force former Madoff’s investors, who made money with him, to return the money. That is definitely not an easy task.

Simon Nguyen, M.A. Economics