"The Ponzi scheme has been a recurring fixture of economic life in rich and poor nations at least since the 19th century, creating a few millionaires and ruining the lives of millions.
...economists have started to realize that this type of behavior can also occur spontaneously, even unconsciously, simply by having one expectation feed on another, creating a frenzy of speculation, an inflating economic bubble that is doomed to eventually crash.
Scholars of financial markets and behavioral economists have come to realize that Ponzi-like behavior may be endemic to the ebb and flow of global financial markets, as if they were natural phenomena akin to ocean tides or a lunar eclipse. No Madoff-like villain is required.
...some form of “rob Peter to pay Paul” arrangement has probably existed for as long as large human settlements have.
As Madoff demonstrated so well, the basic Ponzi is a get-rich-quick scheme that, with a dash of marketing wizardry, can be made to flourish—that is, until the ruse collapses. In the classic Ponzi, the con artist might promise a phenomenal return of 10 percent each month to persuade someone to put in $100. The next month two people invest $100 apiece, and $10 gets returned to the original investor while the Ponzi entrepreneur keeps $190. In this fashion, the pyramiding of the investments continues to grow. Starting from the $100 brought in the first month, and by doubling the number of investors every month, income in the 10th month will reach $46,090. This is why people who run successful Ponzis amass enormous wealth. The catch is that there is no graceful way to stop—the entire thing collapses when new investment dries up.
What makes a Ponzi so compelling, though, is that there is no well-defined point at which the crash occurs. If there were a given implosion point, then Ponzis would not be as pernicious.
...The absence of a defined implosion point gives rise to an important psychological conundrum. A Ponzi may ultimately be deemed a collective folly. Yet, for a given individual, investing in one is not intrinsically irrational, because it can take some time before the tenuous structure comes toppling down.
Financial bubbles are a relative newcomer to the motley collection of Ponzis. The recognition of their status as Ponzis came about because it became clear that the psychology of an investor is the same, whether or not money is going to a realtor, a stockbroker or a fast-talking con artist. In all cases, it is the sustained rise in prices—or, more precisely, the expectations of an upswing—that keeps the process going. This is what led economics Nobel laureate Robert J. Shiller of Yale University to call it a “naturally occurring Ponzi”—that is, a bubble that forms not in response to a manipulator's baton but to natural market forces, with one person's expectations stoking the next person's.
We have seen this happen in the housing market and, through the ages, in the markets for gold, whereby you want to buy a good only because others have the same motivation, and so the prices will rise.
...Just as Ponzis can form naturally without orchestration, bubbles and subsequent crashes that seem natural can also be engineered.
...Some financial dealings that do not look outwardly like Ponzis may actually reveal themselves to be “camouflaged” instances of a pyramid scheme. They are perfectly legal, and they often arise when businesses manipulate their operations to stay afloat when times are tough. A camouflaged Ponzi poses a challenge to regulators because it comes intertwined with perfectly legitimate activities. Using regulation too bluntly to excise them can damage the surrounding healthy tissues, and leaving them unchecked is to risk the growth of malignancy. Further, these camouflaged pyramid schemes can take different forms.
...The imposing challenge in considering a set of regulations comes from the existence of activities that blend legitimate and fraudulent finance. If someone scams an investor by pretending that money is being invested productively—and current gains are being matched only by the eventual losses of future investors—the con man can face criminal fraud charges. As with other Ponzis, however, it is possible to run these operations openly and still attract money from the unwitting.
...Many governments, especially in industrial economies, have made it a point to step in and rescue very large corporations when they are about to fail. This practice of “too big to fail” (ubiquitous enough to have acquired the unpleasant acronym “TBTF”) can attract investors to a firm running a Ponzi in the belief that once the company becomes sufficiently large, the government will step in with taxpayer money at the time of collapse, thereby protecting investors fully or at least in part.
The rationale for TBTF hinges on the belief that if a big investment company goes bust, the collateral damage for ordinary citizens will be so large that the government needs to save the company. It has now become evident, however, that a well-meaning TBTF policy—or, for that matter, one that is ill meaning but well disguised—can exacerbate a crisis by assuring financial honchos that if they make a profit, it will be theirs to keep, and if they experience a loss, it will be for taxpayers to bear. This clearly played a role in the recent global financial crisis.
This situation led to reckless risk taking and irresponsible financial ventures. It is clear that what we need is a policy that may, on special occasions, entail government intervention to save a private company from ruin, but it must not save the people who run the company and make the decisions.