Madoff and Ponzi Finance

16th December, 2008

The unravelling of the Bernard Madoff Hedge Fund –  a Ponzi scheme, it seems, modelled on the scam of Charles Ponzi (pictured) – was described by Nicola Horlick of Bramdean Alternative Investment Fund as ‘the biggest financial fraud in the history of markets’. This reminds me of the witty comment of a trader at Bear Stearns –  Michael Driscoll.

Driscoll noted presciently in 2005 that  “there are 9,000 hedge funds out there. There aren’t that many smart people in the world”.

His words are recorded for posterity in ‘The Coming First World Debt Crisis’.  I sincerely hope that Michael Driscoll has landed safely somewhere after the collapse of Bear Stearns, whose foolish managers surely did not draw on his wisdom and foresight.

Back in 2003, in the opening chapter of “The Real World Economic Outlook”  (Palgrave Macmillan) I defined globalisation as a form of Ponzi Finance, explaining that “the kind of speculation indulged in by pension fund managers, investment and merchant banks is well known – especially to those who have already been duped. It is ‘Ponzi’ finance.”

This was hard to stand up, as of course a Ponzi scheme – whether on a local, national or global scale – is not visible until the proverbial tide goes out, to mix metaphors. Well, it now has – both for Madoff’s gullible and greedy investors; but also for the project dubbed ‘globalisation’.

Here, in an extract from the book is an explanation of Ponzi Schemes and their origins.

Ponzi finance
The term Ponzi finance was invented by the American economist Hyman P. Minsky as part of his analysis of financial market inflation. It describes a form of finance in which new liabilities are used to finance existing liabilities. Ponzi schemes are named after Charles Ponzi, an Italian immigrant who duped thousands of Boston investors in the 1920s with a postage stamp speculation scheme. Ponzi thought he could take advantage of differences between US and foreign currencies used to buy and sell international mail coupons. Ponzi told investors that he could provide a 40 per cent return in just 90 days compared with 5 per cent for bank savings accounts. Ponzi was deluged with funds from investors, taking in $1million during one three-hour period – and this was in 1921. Though a few early investors were paid off to make the scheme look legitimate, an investigation found that Ponzi had only purchased about $30-worth of the international mail coupons.

Decades later, the Ponzi scheme continues to work on the ‘rob-Peter-pay-Paul’ principle, as money from new investors is used to pay off earlier investors until the whole scheme collapses.

Minsky noted that Ponzi’s scheme ‘swept through the working classes and even affected ‘respectable folk’. Because they prey on the poor and the ignorant, Ponzi schemes in banking are usually banned. However, this does not prevent them from occurring in countries where it is difficult to regulate them. Ponzi schemes have surfaced in Portugal and Eastern Europe.