The Whole Economy Is Rife with Ponzı Schemes
Many ordinary business practices resemble the infamous con game
The Ponzi scheme has been a recurring fixture of economic life in rich and poor nations at least since the 19th century, creating a few millionaires and ruining the lives of millions. Yet most people have only a vague idea of what they are, which may explain why so many continue to fall for their strange and almost mystical allure. This topic, of course, has acquired a certain urgency because of the recent global financial crisis and headlines about the Bernard Madoff scandal, the biggest ever Ponzi scam, which occurred at the height of the turmoil.
Anyone who followed the Madoff debacle probably thinks about Ponzis as being deliberately concocted frauds. Instead of using investor money to fund a productive business venture, the con artist channels the proceeds from new investors to pay interest to earlier ones. But economists have started to realize that this type of behavior can also occur spontaneously, even unconsciously, simply by having one expectation feed on another, creating a frenzy of speculation, an inflating economic bubble that is doomed to eventually crash.
Scholars of financial markets and behavioral economists have come to realize that Ponzi-like behavior may be endemic to the ebb and flow of global financial markets, as if they were natural phenomena akin to ocean tides or a lunar eclipse. No Madoff-like villain is required.
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Ponzis, in fact, can wear many different disguises, which makes them difficult to detect and isolate so that clear regulatory or legal action can be taken. My own research has focused on a difficult-to-discern means of manipulating a business's operations to keep it afloat, at least for a time—“a camouflaged Ponzi” that breaks no laws but can wreak economic havoc.
Interest in Ponzis has grown, not only because of tabloid headlines but because new research has found that they can be explained partially through scientific analysis that reveals their underlying mathematical structure and partially by the psychology of the con artist that appeals to our innate ingenuousness. This research is important because it raises hope that we will be able to detect malignant financial products early, before thousands are drawn to their strange attraction, bringing financial ruin and profound emotional distress.
The Basic Con
The Ponzi scheme is actually older than Carlo (“Charles”) Ponzi himself (1882–1949). Ponzi pioneered his scam in New England in 1920, but it was probably common before, as illustrated by Charles Dickens's unscrupulous fictional characters, drawn from investment scams in Victorian-era London—and in truth, some form of “rob Peter to pay Paul” arrangement has probably existed for as long as large human settlements have.
As Madoff demonstrated so well, the basic Ponzi is a get-rich-quick scheme that, with a dash of marketing wizardry, can be made to flourish—that is, until the ruse collapses. In the classic Ponzi, the con artist might promise a phenomenal return of 10 percent each month to persuade someone to put in $100. The next month two people invest $100 apiece, and $10 gets returned to the original investor while the Ponzi entrepreneur keeps $190. In this fashion, the pyramiding of the investments continues to grow. Starting from the $100 brought in the first month, and by doubling the number of investors every month, income in the 10th month will reach $46,090. This is why people who run successful Ponzis amass enormous wealth. The catch is that there is no graceful way to stop—the entire thing collapses when new investment dries up.
What makes a Ponzi so compelling, though, is that there is no well-defined point at which the crash occurs. If there were a given implosion point, then Ponzis would not be as pernicious. No one would invest one month before the crash, and knowing this, no one would invest two months before the crash, and so on. According to this relentless logic, known as backward induction, the scam would be unlikely to take off in the first place.
The absence of a defined implosion point gives rise to an important psychological conundrum. A Ponzi may ultimately be deemed a collective folly. Yet, for a given individual, investing in one is not intrinsically irrational, because it can take some time before the tenuous structure comes toppling down.
Natural Ponzis
Financial bubbles are a relative newcomer to the motley collection of Ponzis. The recognition of their status as Ponzis came about because it became clear that the psychology of an investor is the same, whether or not money is going to a realtor, a stockbroker or a fast-talking con artist. In all cases, it is the sustained rise in prices—or, more precisely, the expectations of an upswing—that keeps the process going. This is what led economics Nobel laureate Robert J. Shiller of Yale University to call it a “naturally occurring Ponzi”—that is, a bubble that forms not in response to a manipulator's baton but to natural market forces, with one person's expectations stoking the next person's.
We have seen this happen in the housing market and, through the ages, in the markets for gold, whereby you want to buy a good only because others have the same motivation, and so the prices will rise. Recently gold prices crashed—a result of herd behavior that gave rise to a natural Ponzi. Prices had risen sharply from 2009 to 2011 because investors thought the injection of liquidity by central banks to counter the financial crisis would cause gold prices to continue to go up, driving some people to off-load cash for gold as the former's value decreased. A flood of funds arrived to take advantage of the expected upswing in the market. The price of an ounce of gold rose from around $900 to $1,800 during these two years. In April 2013 a minor correction occurred, which fueled a panic to sell the metal that led to a major crash. Over two days prices collapsed more than they had in 30 years, baffling speculators and analysts.
Just as Ponzis can form naturally without orchestration, bubbles and subsequent crashes that seem natural can also be engineered. One of the most famous in the history of finance happened when John Law's “Mississippi Company” in France began supplying inflated returns in the early part of the 18th century from earnings of enterprises in the French colony of Louisiana. The scam drew in ever more investors until a run on a bank affiliated with Law's company brought the elaborate deception crashing down.
Hidden Scams
Some financial dealings that do not look outwardly like Ponzis may actually reveal themselves to be “camouflaged” instances of a pyramid scheme. They are perfectly legal, and they often arise when businesses manipulate their operations to stay afloat when times are tough. A camouflaged Ponzi poses a challenge to regulators because it comes intertwined with perfectly legitimate activities. Using regulation too bluntly to excise them can damage the surrounding healthy tissues, and leaving them unchecked is to risk the growth of malignancy. Further, these camouflaged pyramid schemes can take different forms.
One illustration is when companies and governments indulge, from time to time, in what is called loan juggling—a practice that by itself is not harmful. A company may not wish to liquidate a portion of an asset, which could entail high costs to pay back a lender. So the borrower—whether an individual, a company or a nation—performs a kind of juggling act, borrowing from one lender to pay back the first. If in doing so, the capacity to pay back a loan diminishes or an expected high return does not materialize, these events can precipitate a crash.
The early 1980s debt crisis in Peru, in which the government took out new loans to pay back preexisting ones, is considered by some economists to be a form of loan juggling. The government's expectations that the economy would improve and that it would be able to pay back the interest and principal owed never materialized. Those hopes were dashed by a major earthquake, a subsequent decline in potato and sugar exports, and a generalized debt crisis throughout Latin America, all of which translated into falling gross domestic product.
Many forms of legitimate business activity can also camouflage a Ponzi. Consider the widespread and perfectly legal practice of giving stock options to employees. It can generate profits even though the company's practices may create low-cost products of trifling value.
An iconic example would be a Silicon Valley start-up that hires highly skilled graduates by offering a starting package with low wages, below the prevailing market rate, while adding in stock options that carry the promise of large future returns. The paltry wages guarantee that the company can still make a profit even if it charges customers cut-rate prices for its products. The owner, meanwhile, keeps a part of the difference between the low-cost goods and the even more menial wages while giving away the rest as supplementary earnings to senior employees.
As the firm grows by employing more workers, the entrepreneur can earn a very high profit, even though, like all Ponzis, this one will eventually crash and leave the employees without jobs or in possession of worthless options.
A simplified example illustrates how this process works—and how it can take on the attributes of a Ponzi. A start-up offers workers a low wage, less, in fact, than the dollar value of what a worker produces. Hence, with each worker, the firm generates some profit. What makes people want to work for this firm, despite low wages, is the allure of stock options that the firm gives to its employees. Thus, in the first quarter of the start-up's operations, the company employs one worker and offers options equivalent to one half of all profits for that period on. In the next quarter, the firm doubles the size of the workforce by employing one new worker—and offers the new hire options that total one fourth of the profit from that period on. In the third period, the company again doubles its staff complement by hiring two new employees, furnishing an options package equal to one eighth of all profits for that period on, which means that each new hire is offered one sixteenth of all profits. And so on in every future quarter.
This plan will ensure that a company's profits will double each quarter. Because employees get a fixed share of profits, earnings from their options will also double each period. And the entrepreneur's income comes from the difference in the value of the goods produced by the workers and the low wages because the entrepreneur gets to keep a part of this difference while giving away the rest to employees as returns on their stock options.
The exponential growth of the value of the stock options makes a job at this company alluring even though these highly trained professionals would not have found the job attractive otherwise, given the low pay. Ultimately, however, a camouflaged Ponzi will crash and will drive the firm into bankruptcy because growing a business in this fashion requires an inexorable expansion of the workforce, an impossibility in a world with a finite population.
One case of a camouflaged Ponzi gone wrong involved the Brazilian oil firm OGX, run by the colorful former billionaire Eike Batista. The rise of OGX was nothing short of spectacular, and so was its demise. When it collapsed in October 2013, it was the largest corporate default in Latin American history. A strategy that OGX used was to poach talented employees from other companies by giving them lavish stock options. This parceling of options continued for a while, with debt building up like an inverted pyramid. And then the company imploded, leaving employees and investors broke.
Again the regulatory challenge comes from the fact that a camouflaged Ponzi can alter its character en route, ultimately rendering the venture fully legitimate. Endowed with the right economic climate and a modicum of luck, a company that indulges in such practices may end up innovating and creating more valuable products, thereby making the hiring of more workers possible even without the awarding of stock options. It can then slow down its expansion and gradually become viable, without the need for endless growth and distribution of more options. This is what makes regulation so hard. Overzealousness can kill legitimate businesses and dampen the willingness to launch new ones. On the other hand, a lack of regulation can give rise to pyramid schemes and scams that can do great damage.
Too Big to Fail
The imposing challenge in considering a set of regulations comes from the existence of activities that blend legitimate and fraudulent finance. If someone scams an investor by pretending that money is being invested productively—and current gains are being matched only by the eventual losses of future investors—the con man can face criminal fraud charges. As with other Ponzis, however, it is possible to run these operations openly and still attract money from the unwitting.
Part of the problem arises as well from basic human irrationality. It is a telling commentary on economic orthodoxy that it needed a whole subdiscipline—behavioral economics—and a raft of lab experiments to recognize that humans are often not rational beings. And along with that recognition has come the need to design laws to protect the vulnerable.
Thanks to years of accumulated data and analyses, many laws now try to prevent Ponzis that are outright scams targeted at the unsuspecting. In the U.S., the Securities and Exchange Commission is charged with shutting down fraudulent Ponzis. Increasingly sophisticated laws, such as the Dodd-Frank act that was passed by Congress in 2010, are meant to tackle the myriad forms that these pyramid schemes take. The spate of Ponzi-like schemes also led to recent discussions in India to amend the 1992 Securities and Exchange Board of India Act to make it more effective in controlling financial scams.
One major difficulty in regulating Ponzis, legal or not, has to do with the idiosyncrasies of government policy. Many governments, especially in industrial economies, have made it a point to step in and rescue very large corporations when they are about to fail. This practice of “too big to fail” (ubiquitous enough to have acquired the unpleasant acronym “TBTF”) can attract investors to a firm running a Ponzi in the belief that once the company becomes sufficiently large, the government will step in with taxpayer money at the time of collapse, thereby protecting investors fully or at least in part.
The rationale for TBTF hinges on the belief that if a big investment company goes bust, the collateral damage for ordinary citizens will be so large that the government needs to save the company. It has now become evident, however, that a well-meaning TBTF policy—or, for that matter, one that is ill meaning but well disguised—can exacerbate a crisis by assuring financial honchos that if they make a profit, it will be theirs to keep, and if they experience a loss, it will be for taxpayers to bear. This clearly played a role in the recent global financial crisis.
This situation led to reckless risk taking and irresponsible financial ventures. It is clear that what we need is a policy that may, on special occasions, entail government intervention to save a private company from ruin, but it must not save the people who run the company and make the decisions. With this realization, many nations are trying to create guidelines to ring-fence financial companies to ensure that taxpayer money will not have to be spent to save large corporations from collapse.
Among other new ideas prompted by the past decade of scams and financial crises is a system of prescription for financial products. As in the case of a physician who writes a script for a dangerous drug, this system will entail having a financial professional sign off on a new financial product, perhaps a complex home mortgage, as safe for the buyer before someone can sign to take delivery. Even if companies adopt these measures, the reality is that Ponzis and concomitant financial bubbles will remain a sometimes toxic by-product in any national economy. Every new regulation will be met by another ingeniously concocted financial product that will attempt to separate people from their money and a corresponding need for yet another response from regulators.
MORE TO EXPLORE
Irrational Exuberance. Robert J. Shiller. Princeton University Press, 2000.
Ponzi's Scheme: The True Story of a Financial Legend. Mitchell Zuckoff. Random House, 2005.
Animal Spirits: How Human Psychology Drives the Global Economy, and Why It Matters for Global Capitalism. George A. Akerlof and Robert J. Shiller. Princeton University Press, 2009.
A Marketing Scheme for Making Money Off Innocent People: A User's Manual. Kaushik Basu in Economic Letters, Vol. 107, No. 2, pages 122–124; May 2010.
FROM OUR ARCHIVES
The Art of the Con. Michael Shermer; Skeptic, March 2009.
SCIENTIFIC AMERICAN ONLINE Watch a talk about Carlo Ponzi at ScientificAmerican.com/jun2014/ponzis
This article was originally published with the title “ The Ponzı Economy ” in Scientific American Magazine Vol. 310 No. 6 ( June 2014 ) , p. 70
doi: 10.1038/scientificamerican0614-70
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