As the whole world is watching with certain satisfaction Bernie Madoff going to jail, I pause in quiet reflection. The man built what is called the largest Ponzi scheme in history. But if you take a close look at our economy, you will see that it is built on the same principles.

Here is how a Ponzi scheme works. An institution collects money from investors promising higher than normal returns. Instead of investing the money in some assets, the pyramid simply keeps it. Although no returns have been earned, the pyramid reports profits and actually pays interest to the investors. But the money used to pay this interest comes from the deposits of investors who come after. As more people see that others earn high returns, more investors want to invest in the pyramid. And their deposits are used to pay those who came before. In theory, this can continue indefinitely. Unless a significant number investors decide to withdraw their funds. At this point the pyramid collapses.

And here is how our economy works. We invest in stocks (or other investments) which have certain market value. We don’t bother finding out whether there is any real value behind those stocks. All we care about is that next year somebody else will come and pay us more than we paid for this stock today. Money from the later investors is used to pay those who came before, just like in a Ponzi scheme. And just like a Ponzi scheme, in theory this arrangement can work indefinitely. Unless a significant number of investors decide to withdraw their money. At this point the pyramid collapses. Usually this happens when investors “suddenly” realize that the real value of the underlying assets is much less than what it is presented to be. This time it started with the mortgage-backed securities. Somebody “suddenly” realized (duh!) that a house was only worth three times the median income in the area, while mortgages against many houses were three to four times larger than their real values. Home prices tumbled and that was enough for the pyramid to collapse and cause the world credit crunch.

The difference between a Ponzi scheme and our economy is that the former lies to investors to get their money while the latter is quite honest. All the information about the underlying assets is available to the public. But over and over again, we knowingly get ourselves into pyramids and act surprised every time they collapse. Whether this boom-and-bust cycle will continue or this latest crisis will make us re-think our behavior remains a question. It will certainly be interesting to watch.

Nikolay Sisan is a Certified Financial Planner and freelance writer in Vancouver.