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On the Possibility of Ponzi Schemes in Transition Economies
by Utpal Bhattacharya
At the height of his success in Boston in 1920, Charles A. Ponzi was hailed by those he was cheating as the greatest Italian who ever lived. "You’re wrong," he said modestly, "there’s Columbus, who discovered America, and Marconi, who discovered radio." "But, Charlie, you discovered money," they told him.
The money-making machine that Charles A. Ponzi invented in Boston in June
1919 was elegant in its simplicity. It had
three critical components. First, he convinced a group of people about an investment idea
(coupons issued by the International Postal Union seemingly violated the law of one price
and, therefore, offered an arbitrage opportunity); two, he promised them a high return on
their investment (a 50 percent interest every 90 days); and, three, he built credibility
by initially delivering on his promises ( "interest plus principal" of the
earlier "investments" was paid by money "invested" by those who were
recruited into the scheme later). As his reputation spread by word of mouth, people
flocked from all over New England to invest. Ponzi took in about $200,000 a day. The
scheme finally crashed when the Boston Globe exposed him in August 1920.
Such types of schemes have existed before Ponzi and continue to exist after him. The first extensively recorded scheme, covered by Mackay (1841), was conceived by a Scotsman, John Law, in France in 1719. It was immediately followed by the South Sea Bubble in Britain in 1720. Today, thanks to the Internet, Ponzi schemes are making a dramatic comeback.
Financial economists have long been puzzled by Ponzi schemes because they seemingly violate the laws of rationality. An extensive literature has developed to analyze the conditions under which Ponzi schemes and other types of bubbles can arise in economies that go on forever. The existence of these conditions ensures that it is rational for agents to participate in any round because they expect to close their position in a later round at a gain. So the Ponzi scheme goes on forever.
To explain Ponzi schemes in economies that do not go on forever, additional assumptions have been introduced. This literature can be broadly classified into two strands. The first strand is behavioral, and it assumes that some agents are irrational. The second strand, maintaining neoclassical assumptions, has assumed something specific about the economy (agency problem, asymmetric information, and so on.) that drives the results. Our paper belongs to this second strand. Its purpose is to demonstrate how an unscrupulous promoter can devise a Ponzi scheme in a specific type of finite economy—a transition economy.
In this paper we argue that a Ponzi scheme is an ingenious method to expropriate state assets by a politically well-connected promoter in a transition economy. How? The promoter lures citizens with promises of incredible returns. The promoter exploits their rational belief that, if enough of them take part, the assets of the state may be used for a bailout if the scheme fails. So the Ponzi scheme in a transition economy is really a cynical exploitation of the "too big to fail doctrine" by a private citizen. The contribution of this paper is to detail how this can happen, and then link our hypothesis and its implications to some spectacular Ponzi schemes that have occurred in transition economies.
A classic Ponzi scheme is an inverted truncated pyramid. The bottom is the mass of citizens participating in the first round, the height is the total number of rounds, and the top is the mass of citizens participating in the last round. A promoter sells certificates to the citizens in each round, promising them an attractive return per round on their investment. Since the money raised in a round is used to pay off the obligation of investors from a previous round, the revenue of the promoter comes mostly from the sales in the initial round and sales in the last round, when the promoter runs away with the money collected. Also, as a record of successful payment develops and information about the fantastic scheme spreads by word of mouth (or click of mouse), most of the costs of the promoter are the marketing costs of reaching the initial group of citizens. The risk-neutral promoter designs the scheme to maximize expected profits. The promoter has one constraint: citizens should participate in each round.
The economic forces at work in the initial rounds are as follows. As the Ponzi scheme is against the public interest, it is in the interest of the state to intervene immediately. However, there is no representative government in a transition economy that will do this. Neither are the citizens pivotal enough to coordinate a stoppage. The only entity that can intervene is a regulator, who trades off the public interest against the private interest of a political class to which this promoter is linked. So intervention is not certain. The stronger the political connections of the promoter, the lower the probability of intervention. In the initial rounds, then, the promoter offers a return that is high enough to ensure that the risk-neutral citizen’s expected loss if the regulator intervenes is not greater than the expected gain if the regulator does not intervene. So the citizen takes part in these initial rounds.
The economic forces at work in the last two rounds are different. The promoter plans to terminate the scheme after collecting money in the last round, if the scheme has not already been terminated by the regulator. As money raised in any round is used to pay off the obligation of investors from a previous round, the citizens who are affected are not only the participants in the last round, but also the participants in the second-to-last round. They become very upset. Anger spurs coordination. They organize to use the state’s assets for a bailout, and as the protesters are many, and the size of the state assets is large, the probability of this bailout is not zero. As our subsequent discussion will reveal, bailouts of Ponzi schemes from state assets have occurred. As every citizen has an equal claim on the public assets, the bailout amounts to a redistribution of wealth from nonparticipants to participants. The parameters of the Ponzi scheme are set such that the expected loss incurred by participating (the price of the certificate minus the expected net redistribution gain from the bailout) is not greater than the loss incurred by not participating (the expected redistribution loss from the bailout). So the citizens take part in these last two rounds.
The final participatory constraint is the one faced by the promoter. We need to address why the promoter has to wait till the last round to run away with the revenues collected. The answer is that at every round, the promoter has to trade off the sure revenue from terminating and running away now against the expected revenue from terminating and running away a round later. The parameters of the Ponzi scheme are set to ensure that the expected revenue from termination a round later is greater than or equal to the sure revenue from premature termination now in all rounds except the last. In other words, the Ponzi scheme is subgame perfect.
An important result of this paper is that under symmetric information, where all citizens know which round they are playing, they would be willing to enter a Ponzi scheme whether the bailout is certain or only probable, as long as citizens believe that the bailout will compensate them for more than what they lost. Since compensation has never been known to exceed loss, this is an unreasonable belief. So we can conclude that, since the conditions under which Ponzi schemes will germinate in finite economies with symmetric information are unlikely to exist, Ponzi schemes would be rare in such economies.
To obtain a Ponzi scheme under a more realistic regime of a partial and uncertain bailout, we need asymmetric information. Under asymmetric information, where citizens do not know for certain which round they are playing but have a belief that holds under rational expectations, we give an example of a Ponzi scheme where the state may give only partial compensation. This is possible because, unlike in the case of symmetric information where there are two types of citizen participatory constraints (the constraint for the initial rounds and the constraint for the last two rounds), there is now just one participatory constraint (a probability weighted sum of the two types of constraints, where the probability is the rational expectations belief of the citizens that they are not playing the last two rounds). This allows the promoter an additional degree of freedom in designing his Ponzi scheme. In particular, he can compensate the citizen’s increased expected loss in the last two rounds (caused by a partial bailout) with an increased expected gain in previous rounds.
We characterize the sufficient conditions under which this constrained maximization problem of the promoter has a solution. We find that the conditions that breed Ponzi schemes are:
· A large public sector (the proportion of national wealth owned by the state is above a lower bound).
· Ambiguous laws governing the transfer of property rights from the state to the citizen (victims of a failed Ponzi scheme may organize to use the state’s assets for a bailout, the probability of which occurring is above a lower bound).
· Political connections (the probability of early termination of the Ponzi scheme by a regulator is below an upper bound).
· An inexpensive access to citizens through mass media (advertising effectiveness is above a lower bound).
The above conditions may exist in transition economies. So it may not be mere coincidence that some of the biggest Ponzi schemes in history have occurred in these economies. A careful examination of four Ponzi schemes—two past and two recent— suggests that one or more of the four factors described above may have existed in these countries when the Poonzi schemes occurred. A reading of Mackay’s (1841) account of the Mississippi Scheme indicates that John Law’s scam had the blessings of the French state, whose finances were in a mess after the death of Louis XIV. According to Mackay, "He proposed to the regent (who could refuse him nothing) to establish a company that should have the exclusive privilege of trading to the great river Mississippi and the province of Louisiana." In 1719, Law’s company, the Compagnie des Indes, was further granted the exclusive privilege of trading with the East Indies, China, and the South Seas. John Law started his scheme that year. His scam had the three critical ingredients of a classic Ponzi scheme: an investment idea (a share in the profits that were to be made by trade with exotic lands), a promised attractive return (a 40 percent annual return on the shares of the Mississippi Company) and an initial meeting of obligations (he delivered an annual return of 120 percent initially). It also had one feature that Charles Ponzi’s scheme did not—intimate involvement of the ruling class. It should be also be noted that when the scheme collapsed, the holders of useless Mississippi stock were given 2.5 percent interest-bearing notes that were secured by the municipal revenues of the city of Paris.
The South Sea Bubble in Britain in 1720 was, as Garber (1990) aptly describes, a shadow of the Mississippi Scheme. The Whig ministry had been dismissed, and public debt was at an astounding 10 millions sterling. In 1720 Parliament granted the South Sea Company monopoly rights over trade with the South Seas and, in exchange, obtained attractive refinancing terms for the state debt. The South Sea Company then acted like Law’s company: it issued successive rounds of stock that promised a share of trading profits, delivered attractive initial returns (100 percent return from February to April 1720), and then disintegrated. Parliament partially bailed out investors by writing off 7.1 million sterling of the company’s debt.
In Russia in 1994 the MMM scheme promoted by Sergei Mavrodi collapsed. He had promised annual returns of 2,000 percent, recruited 5 million Russians, and become the sixth richest man in Russia. Notable features of this scheme were that the regulators did not initially discourage it and that there was a partial bailout after the collapse. Bailouts, however, were not promised to participants in the myriad smaller Ponzi schemes (like Tibet, Ruski Dom Selenga, and Khopor) that had also sprouted.
These themes were replayed on a smaller scale in other transition economies in the 1990s. Ponzi schemes were reported in Romania (600 schemes, the biggest of which was Caritas, which involved 20 percent of the population, and promised 800 percent return in 100 days), Bulgaria, the Slovakia Republic, Serbia, and the Czech Republic.
In 1997 there was a Ponzi scheme in Albania. Maksude Kademi, Bakshim
Driza, and Rapush Xhaferi had promised returns as high as 100 percent in six months and
had sold their certificates to about half the population. They attracted a sum that was
about four times Albania’s state budget, twice its bank deposits, and roughly equal
to its GDP. When their "foundations" collapsed, about a sixth of the population
lost all their savings, and violent civil unrest erupted. A salient feature of the three
Albanian schemes was the role of the ruling class. State television actively promoted
these funds, giving the impression of official approval. Political parties endorsed
them. Election posters often included the logos of the funds. Finally, when the schemes
collapsed, the government accepted "moral responsibility" to pay back at least
some of the $370 million lost (the annual state budget is $500 million).