Ponzi scheme

DEFINITION: A “Ponzi scheme” is a form of financial fraud which operates by paying dividends to past investors entirely out of funds obtained by attracting new investors.

ETYMOLOGY: The phrase “Ponzi scheme” is derived from the name of the Italian-born con man, Charles (Carlo) Ponzi.

While Ponzi did not invent the scheme named for him, he was the first to become famous for his association with such a scheme.

This association was due to the large scale of his operations in the US during the 1920s and to the sensational press coverage of the economic damage done to famous wealthy investors in the wake of the failure of his schemes.

USAGE: A Ponzi-style investment, by definition, is one which is based on no other source of economic value than the promoter’s ability to attract investment itself.

This ability may be based either on the promoter’s charm and personal connections or on outright misrepresentation.

An instance belonging to the latter category would be a claim to the effect that investors are purchasing a share in some entity that generates economic value, such as a gold mine, when no such entity exists.

In either case, so long as new dupes prepared to invest in the Ponzi scheme can be found, the financial venture can continue to grow and flourish, providing generous returns on investment to early investors.

Sooner or later, however, the liability owed to earlier investors must outrun the income stream generated by new investors, causing the entire financial venture to collapse.

Ponzi schemes are often considered to be inherently fraudulent and, strictly speaking, that is correct.

However, so long as there is no actual misrepresentation of the source of their financing, Ponzi schemes may be difficult to distinguish from certain legitimate investment ventures.

The underlying problem is that many legitimate forms of investment share certain features with Ponzi schemes, such as bandwagon effects and susceptibility to bubbles.

Like all economic bubbles, Ponzi schemes work by exploiting the “greater fool theory”—the notion that even though a financial venture works by attracting dupes, or “fools,” so long as a “greater fool” can be found, all will be well.

The trouble with Ponzi schemes is that their formal structure is such that they could only succeed over the long term if human potential for foolishness was infinitely great.

But the essence of economic wisdom is the recognition of scarcity—which is another name for the finiteness of the human condition.