The Ponzi Scheme, or Another Reason To Distrust Wealthy Business Men
Oh, the Ponzi Scheme. Perhaps no other phrase in the English language strikes such fear into the heart of investors as this one. Of course, the average citizen probably doesn’t think about the Ponzi Scheme at all over the course of his or her day-to-day life. This can be attributed to two reasons: 1) The average citizen isn’t doing much high-level investment and 2) The average citizen has no idea what a Ponzi Scheme actually is. This is perfectly okay! According to the permanent success rate of a Ponzi Scheme (which is a nifty 0%), most people guilty of performing these ploys aren’t quite sure what they are either. Still, allow me an attempt to explain what exactly this high-profile yet highly confusing hoax is all about.
Despite its potential for ludicrously high returns, there are still several inherent flaws with the Ponzi Scheme which prevent them from ever being totally successful. First is the problem of setup. It takes a very convincing arbitrage in order to coerce investors into sending in the thousands to millions of dollars necessary to make a Ponzi Scheme work, and the truth is that there just aren’t that many things people are willing to put that much faith into. Second, and perhaps more importantly, is the problem of sustainability. Ponzi schemes end in one of four ways. The first possibility is that authorities notice it and shut it down. Second possibility: no new investors enter into the scheme causing the leader to be unable to make payouts to previous investors resulting in a structural collapse. Third: bad economic luck, such as the market downturn of 2008 which defeated Madoff’s scheme, cause investors to panic and withdraw their money from the scheme. And fourth, which is the most positive outcome: the investor gets his or her fill of investors’ money and disappears to a faraway country which holds no extradition treaties with the United States. Depending on your idea of success, I guess it’s possible to consider that last option the result of a winning Ponzi scheme. I remain unconvinced that uprooting one’s life and changing one’s identity is particularly “worth it.”
So really what we’re left with in the Ponzi scheme is a confounding form of fraud which pays dividends for, at most, a few years and subsequently is practically required to fail. Yet somehow these types of schemes continue to be played by businessmen across the globe. Perhaps it’s a desire to feel powerful and manipulative that drives one to perform the scheme or maybe it’s simply pride (“Oh but I’ll be the one whose scheme NEVER fails!”). Then again, it could just be good, old-fashioned greed that drives these things.
--Jake Smith
First, let’s take a look at the origin story. In the early 1920s,
a Boston businessman named Charles Ponzi came up with an
arbitrage plan involving postage coupons from Italy. Essentially, the idea was that Ponzi would purchase postage coupons in Italy where they were cheap and redeem them in the United States where they were more successful, therefore making a large profit; this is not an illegal business practice. The problem came when Ponzi ran into a large net of bureaucratic red tape when trying to redeem the postage coupons back in America. To cover his losses, Ponzi quickly started calling for investments which netted him an initial profit. The lucrative prospects of the venture enticed new investors to join in on Ponzi’s plan, and that’s where the trouble started.
Rather than paying his investors a return with the profits Ponzi made off of the postage coupons (which, as previously noted, were nonexistent), Ponzi simply paid off old investors with the money invested by new investors. This is the crux of the Ponzi scheme. In basic terms, investors are paid with the money that newer investors invest. This cycle can continue for years at a time. Of course, the Ponzi Scheme wouldn’t be named after Charles Ponzi if he had gotten away with it, and so the story goes. Ponzi came under investigation, and through the use of relatively simple financial analysis, it was discovered that Ponzi was defrauding his investors to the tune of millions of dollars.
Somehow, though, this high-profile failure has not stopped hundreds of businesses and businessmen from attempting their own variations on the Ponzi Scheme. Whether we’re talking about Haitian “cooperatives” which even managed to recruit Haitian celebrities to advertise for them or the case of Bernie Madoff who lost $65 billion and gained 150 years in prison, the scheme has become a staple of financial fraud ever since its inception.