George S. May Business Blog

From Ponzi to Present

As news about Bernard L. Madoff and his Ponzi-scheme of $50 billion continues to dominate the media I wanted to take a moment to point out exactly what a Ponzi scheme is, where it came from, and a few examples of other Ponzi schemes in American history.

We’ll begin in the early 1900’s with the man responsible for the coinage of the term Ponzi-scheme, none other than Charles Ponzi. What a truly fascinating, and unfortunate I might add, life he carried. In summary, the man immigrated to Canada from Italy in 1903. There he was arrested for forgery and sentenced to prison. Ten days after his release, he was arrested and sentenced to an Atlanta prison for trying to smuggle illegal aliens into the US. After his release, he was arrested again, this time for the “Ponzi-scheme” (we’ll come back to that). After his release from federal prison, although his appeal to his state conviction was still pending, he fled to Florida where he was arrested for some sort of real estate pyramid scheme. So, he tried to flee the country. But, was caught in New Orleans and transported to Texas where he went back to jail for awhile before being deported. Ponzi allegedly died in Brazil with $75 to his name. Incredible. A Marx Brothers version Frank Abagnale Jr! However, as much as the man got caught, you have to at least give credit to his determination. Anyway, back to the recently-famous-again Ponzi scheme.

In a nutshell, a Ponzi scheme is where you take money from investors for a phony company, promising big returns for them. As the investments come in, you pay out the original investors abnormally high returns from the new investments you have received. The idea behind the scam is pretty solid actually: the first investors get paid out huge from the investments of the second set of investors, then other investors find out about the big returns and invest, and so on and so forth. As long as the money continues to come in, then the person operating the Ponzi-scheme is able to keep shuffling around the cash and everyone stays happy. The problem with the scam, happens when something triggers a market decline and investors get nervous and all want to pull out at the same time (as what happened in the Madoff case). Attorney Mark Knutson, infatuated with how far Mr. Pozi was able to take such a simple scheme ($9,500,000 at he time of his arrest), created a website dedicated to the history of Charles Ponzi. Here is an excerpt that I took explaining what exactly Ponzi was doing:

Ponzi claimed he was giving investors just a portion of the 400 per cent profit he was earning through trade in postal reply coupons. As Ponzi paid the matured notes held by early investors, word of enormous profits spread through the community, whipping greedy and credulous investors into a frenzy. Investigation later revealed that there were no coupons or profits–earlier notes were paid at maturity from the proceeds of later ones. The simplicity and grand scale of his scheme linked Ponzi’s name with a particular form of fraud. A swindle of this nature, once a “bubble,” is now referred to as a “Ponzi scheme”.

The real question is, if it is illegal, why does the government get to do it? Let me explain:

Look at the housing market, or these days, lack there of. Do you really think that the majority of buys on shares and houses actually add up to America’s stock of businesses or houses? The whole process of buying and selling houses is run on borrowed money. Think about it, sellers exchange ownership of pre-existing assets on a secondary market in an attempt to hopefully make some money and buyers jump into the rising market waiting for it to appreciate so they can do the same.

It was not always that way with the housing market. Actually economists seem to all point to the early 80’s as when Ponzi schemes started bouncing off each other. Steve Keen, an Australian writer/economist put it quite succinctly:

“The shift from predominantly productive to predominantly Ponzi can be dated to the early 80s, and America has had four bubbles in comparatively rapid succession since then: the mid-80s Stock Market and its almost immediate offpsring, the commercial real estate bubble of 87-90; the Savings and Loans fiasco; the Internet Bubble; and finally, the Sub-Prime Mortgage Bubble. The system appeared to come through the first three relatively unscathed, but in reality, the day of reckoning was simply delayed, as one debt-induced crunch was papered over by yet more debt.”

He continues on to remark of how the last scam to make money, the Sub-Prime Loan Scam, ended in quite a Ponzi-fashion – horribly that is. Honestly though, would you expect any other outcome? Here let’s lend a bunch of people money that can not afford to repay us. Oh that didn’t work? Wow, I did not see that coming. Here’s a good idea, why don’t we just try printing money and handing it out? Or is that already happening…

Nonetheless, when the US made the transitions from production to Ponzi, it triggered a vicious cycle of debt that at this point seems almost inusrmountable. How did the US not see this coming? It seems that Keen did:

“As for what the future might hold, though it is almost certain that the Federal Reserve will lower rates if the US Stock Market seriously tanks, it beggars belief that this last Ponzi scheme could be succeeded by yet another one. America might finally have to come to terms with its addiction to Ponzi schemes, and like overcoming any addiction, it will be neither easy, nor painless.”

Ding, ding, ding! Nice call Mr. Keen. I would have put you through to George W. on this earlier, but he has been far too busy searching for weapons of mass destruction in Iraq.

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