Saturday, May 2, 2009

more detail than you likely ever wanted to know about how Ponzi schemes work - particularly in and around the Caribbean

From The Baseline Scenario:

"Ponzi Schemes Of The Caribbean (A Weekend Comment Competition)

with 8 comments

The IMF has just released a new working paper, with more detail than you likely ever wanted to know about how Ponzi schemes work - particularly in and around the Caribbean.

Ponzi schemes are everywhere and, at least in some environments, new versions arrive frequently. But why are they so hard to prevent and shut down once they appear? The paper contains some strong hints, albeit couched in very diplomatic language.

The comment competition is: what, if anything, does the failure of governments to shut down blatant Ponzi schemes imply about the prospects for a potential “macro-prudential” system/market-stability regulator implementing cycle-proof rules in the United States? Is there a better way to prevent the kind of behavior that led to our current financial crisis?

Written by Simon Johnson

May 2, 2009 at 7:34 am"


I said the following on one of James’ posts on March 12th:

“Have you ever heard of a Ponzi Scheme being stopped as soon as it began? I doubt it. That’s because it mirrors a particularly lucrative investment for quite a long time. How many people are going to let you close down there investor because you suspect that his returns are too high? They’re more likely to respond that you’re high.

There’s no stopping a Ponzi Scheme until it runs its course. It’s a perfect crime for a fairly long time. Also, notice, Madoff admitted his guilt. Stanford isn’t so stupid it seems. He doesn’t believe that the government can even figure out how a Ponzi Scheme works, let alone convict him of running one. He might turn out to be right.”

Now I can refine my view, based on that superb paper. First, this post for reference, from The Trader’s Narrative:

“The Madoff Red Flags, Let’s Count Them”

From the essay:

“Red flags. Experience shows that there are certain hallmarks that point towards the
existence of investment fraud. Thus, the development of such red flags creates a basic
tool for the identification and investigation of fraudulent schemes. The Caribbean UIS
had a number of features considered to be red flags by the Securities and Exchange
Commission (SEC) and the Commodity Futures Trading Commission (CFTC).”

I don’t think it’s an ignorance of Red Flags that’s the problem. The problem occurs here:

“validation, when
large and easy rewards earned by initial members generate strong word of mouth publicity”

If you look at the recommendations, they depend upon giving the power to a regulator to confront people who are making big money. Depending upon who these people are and their resources, that is a herculean task. In other words, depending upon who is being defrauded, the regulator might not be able to stop the scheme until the major investors in the scheme begin to get hurt. I’m simply dubious that Red Flags are enough to stop a Ponzi Scheme, nor are Regulators enough.

What regulators could do is develop a case and attempt to get the actual investors in the scheme to call for an accounting. Again, if you simply go to investors and say, “We’d like to shut down your investment because your returns are too high”, they will probably respond,”Are you high?”.


I should have said that the conclusion of my reading of Ponzi’s Schemes is that Counter-Cyclical policies, if this means restraining investment during an upturn, are not likely to work well. The idea of the Fed, for example, slowing the entire economy in order to stop a possible bubble in one area of investment, just seems unrealistic, especially when it could add to unemployment. Maybe I’m wrong. My thought experiment is to consider how hard value investing is to do well. It’s hard to invest in a downturn and to cut back in an upturn.

My reason for going to Narrow/Limited Banking is that it would place our free market system on sounder footing. There are certainly trade-offs, but allowing ourselves to be dealing with Debt-Deflation is really awful.

To the extent that we’ve dodged a Debt-Deflationary Spiral, we ought to thank God. For those of us who are terribly afraid of this possibility, we cannot allow ourselves to let this happen again. Many other people don’t seem to fear this beast. I am certainly critical of Geithner, Paulson, and Bernanke, but, to the extent that their actions have been directed at stopping Debt-deflation, I’m glad that they understood the problem, and have attacked it, if not as effectively as I would have liked.

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