In the early 1920s America, Charles Ponzi[1]
promises his clients (then just 18 of them) 50% profits in 45 days or 100%
profits in 90 days by buying discounted reply coupons internationally and
selling them at face value in the US, in a bid to make quick money through arbitrage.
Spring of April 1992, a limited liability company by the
name Caritus[2], in
Romania, is to start attracting millions of depositors from across the country
(about 50% of households) to invest more than five billion USD for the next two
years.
With a croak in his voice, and index finger curled within the
thumb, Donald Trump hurls into the cameras that he means nothing other than enormous
tax breaks[3].
Playing into Reagon’s old and seemingly dusted trickle down economics, the veiled
intentions of the President of the United States share a common characteristic with
Charles Ponzi and Caritus, according to some observers[4].
All of them involve the emotive beliefs of a Pyramid Scheme-and
luckily, we have a better word for them. Ponzi Scheme.
Charles Ponzi’s grandiose scheme ran for over a year,
swindling its ‘investors’ worth of 20 million USD. In Romania, Caritus went bankrupt with a staggering
debt of 743 million USD in August 1994, reaping great political and economic
havoc in the state[5]. And
Donald Trump is still president. Though to be fair to him, he’s not a textbook Ponzi
Schemer, only so far showing the affections of one for the upper ranked in the
pyramid.
Although Ponzi Schemes at first impression might seem as
simple fraudulent activities, their scope lies much beyond. To put it very traditionally,
how the mechanism works is, a Ponzi entrepreneur uses the money invested by new
investors to pay old ones, rather than using that(investment) money to
productive/ investing activities. To explain this further I would use the help
of the following table:
New Investment (in dolllars)
|
Interest to be payed (10% of investment)
|
Investments left after payment
|
100
|
0
|
100
|
200
|
10
|
390 (190+100)
|
400
|
30
|
790 (400+360)
|
600
|
70
|
1320(720+600)
|
In this example, I am assuming that the ‘entrepreneur’
approached a client with a proposal that he will pay 10% interest rate to the
client for his investment every month. Hence in the first month, the entrepreneur
has 100 US dollars with him. In the second month he invited two more investors
to invest 100 dollars each. Out of the 200 dollars that they invest, the
entrepreneur pays away the first investor his due of 10 dollars(10% of 100 dollar
investment). So now our smug entrepreneur is left with 390 dollars. And the scheme
goes on.
This is a very simplistic, and often narrow way of studying
the scheme. However, it helps us understand some important features. To begin
with, the Ponzi entrepreneur though has no interest in real investment, he does
honour his interest dues. This is in some ways a sort of redistribution of
income-though in the opposite direction of welfare. This helps him building reputation
in the industry, and bank on the trusts of short-run gladdened investors who
get their “low risk, high returns”.
He is also not in for a predetermined amount of period- for
all we know it can extend theoretically to eternity. Fortunately, and perhaps
not so much, the real world does account for a tipping point which is unknown
to both the investors and the entrepreneur. For if there were the slightest
inkling of funds sinking, any rational investor would pull out his investment
one period before. Knowing this, no one would invest one period before, since
they know investments won’t come the next period. Ultimately such a rationale
would translate to a backward induction case where no one invests in the first
place [6].
But Ponzi is a success largely because of a lack of defined point of crash. And,
like every other bubble, this too has an end, and a destructive one at that. Of
course, there is wide evidence to suggest that micro level Pyramids scheme are
much more popular in developing countries, namely India, where people are often
lured for investing small amounts of funds for “high returns”[7],
we must be wary of the larger picture.
With this very rudimentary
explanation of a Ponzi scheme, we must delve deeper into the larger
consequences of letting word of mouth popularity and returns of investments get
the better of our financial markets. After all, that is what Ponzis feed off.
From the housing market bubble of the
US, to the frequent Gold price bubbles (most recent of 2009-11)[8],
and to now the speculations of the wildly discussed crypto currencies, we see
manifestations of Ponzi, only fail to recognise. Owning multiple homes, or
kilos of Gold is of no interest to the larger population, except because others
hold them and seem to be earning well. This principle added with the Ponzi’s affliction
for crash when extended to Bitcoins, is terrifying.
On those lines, the traction that
Bitcoin has garnered world over is not just related to its low transaction costs,
and easy access, but its “self-fulfilling prophecy”. [9]
With lack of regulation, and cross border recognition, Bitcoin and other
virtual currencies are making space for scammy activities. [10]
But is it only about regulations? A portion of the academic world is often cited
to say that the Ponzi problem is not so much about economics, but market
speculation. However, we forget that Ponzis can often be nondeliberate in
nature. [11]
That is, perhaps, Bitcoin is a Ponzi horcrux we did not intend to create.
Figure 2 Bitconnect Prices from Jan'17 to Jan '18: Source https://www.coingecko.com/en/price_charts/bitconnect/usd#panel
Bitconnect a platform which started in December 2016 over the course of its year was treated suspiciously by the crypto community. This anonymously run currency platform was shut down this January, for allegedly running a Ponzi scheme. It is interesting to note how from a price value of less than a dollar when it started, it clocked a price of 450 USD in Jan 2018.
As economies persist on being sceptical of cryptocurrencies,
the new Ponzi in town, we must also deal with problems far beyond that we
signed up for. As is with all such schemes, the lowest in the ‘pyramid’ are the
worst hit, and with the impression that Governments are ever-ready to bail out sinking ships, its only getting a pat on the back. And the living thumping Ponzi, Donald Trump, is the greatest example
we got.
References:
[5] https://www.nytimes.com/1993/11/13/business/pyramid-scheme-a-trap-for-many-romanians.html?pagewanted=all
[6] “Ponzis:
The Science and Mystique of a Class of Financial Frauds” Kaushik Basu. 2014. Policy
Research Working Paper
[9] “Ponzis:
The Science and Mystique of a Class of Financial Frauds” Kaushik Basu. 2014. Policy
Research Working Paper
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