The internet bubble bears some resemblance to a Ponzi scheme: a brief history of such schemes is informative.
From the earliest days of market economies, there have been financial promoters with a single objective. To persuade people to give them more money than they intend to give back.
The simplest route to lazy riches has always been to lie. I can create precious metals from base materials. There is undiscovered gold in the unexplored wilderness of Indonesia. Ostriches are a neglected source of delicious meat and nutritious protein. A few suckers are always attracted to these propositions, but the likelihood of exposure and imprisonment deters most people from advancing them.
The trick is therefore to receive more than you pay out while being honest and open about what you are doing. This requires redistribution: some people get more than they put in, others less. Those who enter the scheme must believe they are likely to be in the category who will receive more, rather than in the category who will receive less. This cannot, in aggregate, be true. But the objective is to rely on self deception by the participants, rather than overt deception by the promoters.
Virtually all schemes that have been devised fall into one of three categories – redistribution to the early, redistribution to the lucky, redistribution to the skilful. These correspond to chain letters, lotteries, and games. In each case, thoughtful players may understand that taken as a whole they will lose, but can still believe they will not be among the people who do.
Chain letters depend on an ever expanding circle of participants. Dodgy banks, from the first days of money lending to BCCI in our own times, have always used this principle. You pay withdrawals and generous interest from the savings of new depositors.
These activities are illegal because they promise generous interest. The safer route is simply to create the expectation of high return from the evidence of the success of those who joined the scheme early. Financial chain letters are now generally known as Ponzi schemes (after Charles Ponzi, who developed a celebrated example in the US in the 1920s) or pyramid selling (after a group of companies who filled the garages of their victims with unwanted detergent in the 1970s).
As Robert Shiller notes in his recent guide to financial speculation, most Ponzi schemes offer some feeble explanation of how they generate their high return. Mr Ponzi claimed that large profits could be earned from international arbitrage in postal reply coupons. Pyramid sales people were assured that direct distribution was a means of undermining the excessive profits of soap powder manufacturers. Albanians, whose economy was brought to collapse by an explosion of Ponzi schemes, were told that the transition to capitalism would allow the widespread and effortless accumulation of riches. There are people who believe the same thing today about the internet.
Because Ponzi schemes inevitably end in collapse, governments are anxious to outlaw them. Their counter measures usually rest on tackling the deception in the explanation. When a company called Titan Business Systems entered Britain with an entirely clean Ponzi scheme – they did not pretend that there was any source of revenue other than an ever increasing number of new participants – it showed that no deception is needed to induce gullible people to take part. The very openness of the scam caused the Department of Trade and Industry difficulty in shutting it down.
Chain letters are possible because players can easily persuade themselves that they are early. It is almost as easy to persuade yourself that you are skilful. When people are asked to compare themselves to the norm – as drivers, lovers or executives of large corporations – less than half the population rate themselves below average. Some of the optimists are found in betting shops, studying form. Some of them are in casinos, believing – against reason and experience – that they can predict the movement of a roulette wheel.
Other optimists are in the trading rooms of banks and large corporations. Foreign exchange trading, and secondary dealing in fixed interest securities, are – like roulette and racecourse betting – zero sum games, in which players can only win at the expense of losers. But in all these activities, a high proportion of participants believe their own dealings are profitable. Mostly, this relies on systems – whether selective memory or accounting rules – that are more effective at recording gains than losses.
Lotteries are the most transparent and enduring means of persuading people to part with more cash than you intend to return. It is harder to see how people can persuade themselves that they are more than averagely lucky than more than averagely early or skilful. But they manage it. They are also influenced by a psychological trait described as prospect theory. We focus on improbable outcomes to a degree that is not justified by their low probability. Economists call this irrational: but all they mean is that not many economists play lotteries and that running lotteries as a profitable business.
The most sophisticated financial schemes are those that combine elements of all three. Day trading, for example. It is a game, at which I am skilful. It is a chain letter, in which I am an early participant. In time, other people will ‘get it’, and my holdings can be sold on at a higher price. And it is a lottery – we all agree that most new economy stocks will fail, but one or two will prove to be immensely valuable. There is one enduring and unvarying feature of all these schemes. It is better to run them than to participate.
R. Shiller, Irrational Exuberance Princeton University Press, 2000