We have the Ponzi schemes we deserve

A Ponzi scheme is a con in which participants are promised a regular, and much higher than normal, return on their investment. It is made possible by the joining of new participants, whose money is used to pay the previous members. As the scheme seems successful and highly rewarding, so long as new participants flock in, more people want to join and less of the original investors are prone to take out their money and compounded interest. This is very much like the more legal “Pyramid schemes”, but with the central differences that it is based on a lie (the higher returns) and that the participant is not expecting to get his new money directly from the people he will recruit.

The name “Ponzi Scheme” comes from the first big-scale American scheme of this genre, which was started by Italian immigrant, Charles Ponzi, in 1920. The technique was not new, but it was the first time that it took such a scale and became big news. Ponzi promised his clients a 50% profit in 45 days, or a double in 90 days, based on his great “Technique” of redeeming in the US postal reply coupons from foreign countries, in something akin to today’s arbitrage. People, again, wanted to believe it was possible and flocked to his “Securities Exchange Company”. The scheme would finally bankrupt six banks and cost Ponzi’s investors USD 20 million, which in today’s dollars would be equivalent to USD 250 million.

“How do people keep falling for those schemes”, some may ask? This is simply human nature. Women want to believe that the new ingredient in the fashionable face cream will keep the years away and make them look younger. One wants to believe his chances at winning the lottery are more than infinitesimal. I do not think that it is a greater flaw than the hundreds of thousands of people in the US who thought the prices of their homes would keep going up indefinitely, took additional mortgages and created the housing bubble we are still reeling from today. People want to believe in fairy tales; just give them a reason that sounds rational enough. This is why there had been Ponzi schemes before Ponzi, notably William F Miller in Brooklyn in 1899. A Ponzi scheme is even described in one of Charles Dickens’ stories. This is why many readers would be surprised to hear that the infamous Bernie Madoff was far from the last instance of an unraveling Ponzi scheme: There have been dozens discovered since then, some smaller, some bigger, in all parts of the US and of the world. These are sometimes small operations, like the lady bank manager in France who defrauded mostly people from her village, or a shopkeeper in Northern Israel with no more than a hundred “clients”.

One of the characteristics of the successful “big” schemes is the fact that clients are not sought after—which amounts to a brilliant marketing twist. The high returns on investment are spread from mouth to ear, in a rumor-like fashion. But not everyone can become a client; one should be introduced by a client before even being considered as a potential client. It was made to look very difficult to become Bernie Madoff’s client, and even getting a simple appointment was an arduous task. The taste of the forbidden fruit being what it is, it made people want to get in even more. And it also indirectly confirmed the probable veracity of the incredible returns he could provide. This is the same principle used as the basis of the fictional story in “Rain Fund”: give clients an original rational reason for the high returns and make it difficult for them to join.

A Russian schemer recently gave a very interesting take on Ponzi’s. Serguei Mavrodi ran a huge scheme in Russia in the 1990s, promising 100% a month-returns in TV ads, and for which he did jail time. Mavrodi is now back with a more-or-less legal above-the-board Pyramid scheme. He argues that governments are the ultimate Ponzi schemers, printing money with no base value from which they pay debts and “refinance” banking institutions. This is an interesting argument, in our day and age, as the can is obviously kicked down the road to our children and grandchildren. Where is the money of Bernanke’s QE 1 to QE3 coming from? Which money is injected into Greece and Spain? Certainly not money backed by Gold Bars!  Mavrodi then goes on telling people that their returns will be assured so long as they bring more people in, and for each ten clients, they get an additional cut. This is now a clear Pyramid scheme, with money going from and to private accounts, and where everybody knows where they stand. This is a really interesting and strange story, but Mavrodi has a point when he compares Global Finance to a Ponzi scheme.

Ponzi schemes are here to stay; they will keep popping up under different guises, and humans will keep falling for them. If I were to tell you I am a well-known and respectable hedge fund manager, and I am achieving exceptional results by using autistic mathematical geniuses to chart the market, would you believe it possible? I must say that, under the right (wrong) circumstances, I could let myself be convinced it is possible.

This is one of the premises of the new thriller “Rain Fund”. The venality of Wall Street is a given, it is just the disguise of the scam that can give good reading. Of course, there is much more to this plausible fiction story: Computer hardware viruses, organized crime, spies and serial killers.