The Ponzi scheme is a fraudulent financial scheme meant to cheat money. Such practice occurred since the 19th century when commerce and investment were blooming in the Victorian era. It was made famous by Carlo Ponzi in the early 20th century who created many fake financial schemes. When the schemes crashed, many families were ruined and 6 banks in Boston went broke. Ponzi schemes kept coming in various forms. The latest was the Madoff case which was the biggest Ponzi scam ever.
The scam operates in a simple way. Someone incurred a debt. He then borrowed from other persons to repay the interest, promising them high return. The capital was never repaid, and continued more creditors were incurred, until there was no more new money to repay interest and the debtor absconded. The debt was usually a form of fake investment promising high return. How come people fall for such scheme without checking on the authenticity of the scheme? The first factor is greed. People want to get rich and are blinded by the high return. The second factor is the herd behaviour where other people are doing the same thing. Ponzi scheme is so famous nowadays that people are generally more cautious about financial products promising unreasonably high return. However, a famous person with good reputation like Madoff could easily persuade his friends to invest heavily on his non-existent investment fund.
The June issue of Scientific American carries an article by Kaushik Basu on the subject. He is a professor of economics at Cornell University. His research revealed that Ponzi schemes occurred naturally in our economy. There are legal activities, genuine financial schemes, not operated by conman as a conspiracy. But the behaviour and the risk are the same, and the resultant damages to the stake holders, investors and the economy are severe.
All financial bubbles are naturally occurring Ponzi, whether they are in housing, stocks and shares, gold, currencies. The main characteristic of the bubble is the psychology of the investors where the expectation of sustained rise in price keeps the process going. The bubble is formed not in response to manipulation but to natural market forces, with one person’s expectation stoking the new person’s. When the process stops owing to some bad news, the bubble bursts and the value of investment vanished in vapour. The Ponzi phenomenon could be seen as regular bubbles and bursts in the financial market where some people just consider them as peaks and troughs.
Some Ponzi may be hidden and not be obvious to spot. The author quoted an example in the IT field where such professionals are expensive, some IT companies hired these experts at very low wages, but gave them company stock options as reward. The young professionals had high hope of these options that their value could be many folds higher when the companies grew. Under such arrangement, the company could be able to have low cost of human resources to compete with others. To sustain such competitiveness, the company would need to hire more professionals with low wages. Should the company not making a profit and could no longer grow, the stock options would be worthless.
Such rob Peter to pay Paul mentality also applies to national debts. In many countries where her spending exceeds the domestic products, such as USA, government bonds are issued, borrowing money from the citizens, banks and other countries to cover the deficit. Should there be the unfortunate circumstances that debts and interests could not be repaid when due, which happen all the time, new government bonds are issued with higher interest to attract creditors. When the national economy failed and no one was willing to buy more government bonds, a country could default her debt.
The one thing that made the Ponzi worse is the government rescue. There is a saying that some companies are too big to fail because their failure could cause wide spread damage to the population. In a democratic country, the elected legislators would pressure the government to use public fund to rescue the companies. The result is that those operated their companies like a Ponzi would never lose. The author suggested that even if a company must be rescued, the management and the persons responsible must be punished by dismissal or be held liable for the loss.