The Imp in a Bottle: Ponzi/Madoff in a Broader Perspective

Feb. 1, 2009 — -- Less than two months ago, Bernard Madoff was arrested by the FBI for securities fraud. Given the relative amounts of money involved and pain inflicted, Ponzi schemes should perhaps henceforth be called Madoff schemes.

Whatever their outward appearance, almost all such scams involve collecting money from an initial group of investors by promising them solid and sometimes extraordinary returns. The returns to the initial group come from money contributed by a larger secondary group of people. A still larger group of people contributes to both of the smaller earlier groups, and so on.

This burgeoning process continues for a while, but the number of people needed to keep the pyramid growing and the money coming in increases exponentially and soon becomes difficult to maintain. People drop out, and the easy marks become scarcer. The system collapses under its own weight when enough new people can no longer be found.

The logic is clear, but the situation gets more interesting when many people are suspicious of the scheme or even aware of its fraudulence (as they were not with Ponzi or Madoff). In this case they generally worry only about what happens one or two steps ahead and may anticipate being able to get out before a collapse. That is, one may find it rational to buy into such an unsavory scheme if one is confident of recruiting a "bigger sucker" as a replacement.

The dot-coms' meteoric stock price rises in the late '90s and their subsequent precipitous declines in 2000 and 2001 were attenuated versions of the same general sort of scam. There was a degree of knowingness among some investors about the unsustainability of the boom. They tried to get in on the initial public offering, hold on as the stock rocketed upward, and jump off before it plummeted.

Thanks to complicated derivatives and other opaque financial instruments, the recent collapse in the housing market and the more general financial crisis it has precipitated have an even more repellent aroma to them, if I may Ponzificate a bit.