Do bailouts encourage Ponzi schemes?

July 31, 2012

Free Market Foundation

Ponzi schemes to the extent that people realise, even subconsciously, that something is not right should work only if investors are irrational. Investors in the last round know that they will lose their money when the organiser disappears with their funds. No one wants to play the last round, making the second-to-last round actually the last. Those people will refuse to take part as well. Using this logic again and again, no one should take part, says Utpal Bhattacharya, a finance professor at the Kelley School of Business at Indiana University.

But sometimes our greed or our naiveté trumps our rationality. Almost a century after Charles Ponzi, people continue to fall victim to Ponzi schemes. However, not all Ponzi-like economic activity is bad or illegal, says Bhattacharya:

Social Security, which involves the younger generation paying some of the retirement benefits of the older generation, is a perfectly legal Ponzi scheme.

Asset pricing bubbles, where the intermediary takes in a cut every round, is a Ponzi scheme grafted to a bubble, and they are legal.

For example, when people take out mortgages they can’t afford, based on the expectation that their homes will continue to increase in value, they are engaging in legal Ponzi and bubble activity.

But what happens when the music stops and people find themselves playing the last round of the Ponzi game, asks Bhattacharya?

The U.S. federal government may choose to spend billions to bail out the last-round players to protect overall financial stability.

The Ponzi participants will get a piece of the bailout, but will still have a net loss.

The problem is that taxpayers have to foot the bailout bill, and they may have even greater net losses than the people who initially signed up for the Ponzi game.

If taxpayers stand to lose more money than Ponzi players, it is suddenly rational to play the game. That’s because only by getting a piece of the bailout will Ponzi participants protect themselves from the larger losses faced by taxpayers. This is what happened in the early 1990s in nearly all the countries transitioning from communism: promises of state bailouts encouraged gigantic Ponzi schemes. In Albania, it even led to a civil war, says Bhattacharya.

Therefore, while some Ponzi-like behaviour is legal and even beneficial for the economy, bailouts only serve to reinforce behaviour that can lead to even riskier Ponzi schemes. So, though many of us recognise deals that are too good to be true, bailouts will encourage us to take part in such deals. The $700 billion federal bailout may eventually lead to Ponzi schemes large enough to make Bernard Madoff’s reported $50 billion swindle pale in comparison, says Bhattacharya.

Moral of the story: If you want to design such a scheme and get away with it, make it legal like investments in subprime mortgages, or investments in energy from water. Then involve as many people as possible, so that it becomes “too big to fail.” Some of the $700 billion bailout money may actually be used to rescue some of your investors, says Bhattacharya.

Source: Utpal Bhattacharya, Do Bailouts Encourage Ponzi Schemes? New York Times, December 18, 2008.

For text: http://economix.blogs.nytimes.com/2008/12/18/do-bailouts-encourage-ponzi-schemes/

For more on Economic Issues: http://www.ncpa.org/sub/dpd/index.php?Article_Category=17

FMF Policy Bulletin/ 06 January 2009