What is, and what isn’t, a pyramid scheme?

Black and white picture of Charles Ponzi, a white man dressed in a suit and tie with a wide-rimmed hat, holding a walking stick in his hands.So, the other day I responded to a tweet by the author of Existential Comics which read:

A pyramid scheme is a scam where the people at the top get the money from the work done by the people at the bottom. Whereas a regular business is where…uh, well you see the shareholders, they create jobs. They spurn grown, so they should get the money from…the work done by…

This implies that there is no real difference between a pyramid scheme and a regular business, but it clearly misrepresents what a pyramid scheme actually is. When I replied saying what it actually is — a scam in which early entrants are paid off with money from new entrants, giving the impression of a “return on their investment” when in fact it had not been invested — a load of people responded asking the difference between that and a bank, or a failing business.

A pyramid scheme is called that because the number of participants expands dramatically in each ‘generation’, meaning a diagram of it resembles a pyramid. It’s true that many actual businesses have structures in which a few people get lots of money and the people at the bottom get much less, which can resemble a pyramid, but that is not what makes a pyramid scheme or Ponzi scheme (named after Charles Ponzi, an Italian con-artist of the 1920s), what it is. A pyramid scheme does not provide any service or produce anything; while maintaining the impression of an ‘investment’ scheme, it simply pays off early ‘investors’ with any new money it receives from new ‘investors’ (victims). It plays on either their ignorance of the facts — their believing the money is being invested and that the returns are profits or interest, as in the notorious Madoff pyramid scheme, or their ignorance of economics or of how business works, as with the mail-based schemes such as were being advertised on the Usenet forums in the mid-90s. Eventually they will stop attracting people to the scheme, payments will dry up and the last group of entrants will lose their money. (A Ponzi scheme is a pyramid scheme with someone administering the direction of the money ‘upwards’ and who takes a cut.)

Someone asked what the difference is with a bank. Well, a bank sells financial services for money: finance such as loans and mortgages for interest, financial services for a fee. Whatever the moral arguments, they are not a pyramid scheme because the borrower is expected to pay interest on a loan he received; the flow of money is not only upward and there is no deception involved. Someone else asked what about companies which are unable to sell all of the shares they had put on the market; the answer is that this is either a failing business or the shares are over-valued. The fact that things stop selling is not what makes it a pyramid scheme — there could be reasons for that such as that the product is redundant or there is competition from a better product or service.

I’m no economist, but it’s important to know the difference between a real business and a fraudulent fake investment scam and to counter anyone who says there is no real difference because scams flourish in ignorance. Bernie Madoff’s victims knew what a pyramid scheme was and had no reason to believe they were dealing with one, but the Albanian pyramid scheme crisis of the late 90s, which resulted in serious civil unrest, happened because people had been cut off from the rest of the world by a communist dictatorship since the 1940s and were attracted by the promise of easy money. A similar type of scheme called multi-level marketing (MLM) is popular among impoverished Asian youth in parts of England; while this scheme does involve some selling of a product, the biggest rewards of the scheme are for recruiting new members, which carries the promise of a high-flown title. A community with a tradition of entrepreneurship will not allow its young people to fall into this sort of trap.

This sort of thing should be taught in schools everywhere. Whether it is slotted into maths or into personal and relationship education or citizenship or whatever, it is important for preparing young people for the adult world in which they will face these sorts of choices. To be ignorant of these things could make them more than just an irritant on Twitter; it could leave them substantially out of pocket or on the wrong side of the law.

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