THE BIZOP NEWS

Why do we investigate Ponzi schemes?  

Simon Johnson, writing at Baseline Scenario, has a conjecture that I am very sympathetic with - if we lack the ability to control Ponzi schemes, do we lack the ability to control the business cycle?  For reasons that follow, I think that the answer is "yes", the examination of the growth and demise of Ponzi schemes are essential to understanding the business cycle.

Here is Simon Johnson:

"The IMF has just released a new working paper, with more detail than you likely ever wanted to know about how Ponzi schemes work - particularly in and around the Caribbean.

Ponzi schemes are everywhere and, at least in some environments, new versions arrive frequently. 

But why are they so hard to prevent and shut down once they appear?  The paper contains some strong hints, albeit couched in very diplomatic language.

The comment competition is: what, if anything, does the failure of governments to shut down blatant Ponzi schemes imply about the prospects for a potential "macro-prudential" system/market-stability regulator implementing cycle-proof rules in the United States? 

Is there a better way to prevent the kind of behavior that led to our current financial crisis?"

The paper does not described in detail how the various Caribbean schemes worked, other than to make the standard observations.

Ponzi schemes are possible because they mimic real business transactions: they work because it is hard to figure out whether your capital is being returned, I take your $100 and give you $10 a month as a "return", or whether you have a return on capital, I take your $100, buy a equipment, sell goods, and give you a $10 a month dividend based on the selling of the goods.

As Sam Entar has explained, the Crazy Eddie fraud scheme shows exactly how hard it is to distinguish return of capital from return on capital when the real indicia of a business can be faked or counterfeited: empty boxes masquerading as inventory, manufactured receipts, compromised gatekeepers, and influence buying.

Enron is a good example of how a company can move from providing a return on capital to a return of capital.

A good con criminal knows exactly how to fake up, like a Hollywoood set designer, the trappings of a thriving business and community respect.  Allan Stanford is the latest example of a con criminal who bought success by investing in a public sport.

Roger Heath, in a comment from the interesting blog, Baseline Scenario, urges us to think about Ponzi frauds this way:

"A Ponzi scheme is a deliberate fraud whereas much of the banking failure represents excessive animal spirits.

If Ponzi schemes are difficult to control, then animal spirits will be more difficult because they will infect regulators as well as players.

Regulators did approve of ruinously low reserves for securitized mortgages.

Idealy, something like the working paper's list of red flags could be prepared for the financial sector, but it is necessary to report this information to the public to help counter insider manipulation.

Ideally, countries should coordinate efforts with an international agency publishing assessments of red flag stats by company, investment vehicle, and regulating agency.

Financial firms should be required to report red flag data to investors."

I believe this to be false, and it matters.

1.  The compliance tricks which generate the support for the return of capital fraud are the same tricks which generate the support for banking enthusiasms. The banking machinery makes this difficult to penetrate, but here is one example. As I have written before, the use of a guarantee may signal a possible increase and not decrease in risk.

Our current financial crisis seems to be caused in large part by a mania for purchasing or selling corporate debt that  was unavailable in the marketplace from parties who were not capitalized sufficiently to own the debt and so had to produce guarantees that the could deliver the returns.

2.  Red flag reporting has never stopped investors from driving through red lights in order to reach the other side.  Cognitive dissonance, as described in great detail by Cialdini, can ensure that people make bad decisions quicker than they would have but for the existence of red flags.  We have to recognize this possibility in our regulatory system.

I recommend reading all the comments about Ponzi schemes and the business cycle as some interesting suggestions are made.

(Thanks to Michael Thomas, writing at the Daily Caveat, for pointing me to the IMF paper and Baseline Scenario.)