December 16, 2008 | posted by Michael Baxter in IABN |

“To the economist embezzlement is the most interesting of crimes…Weeks, months or years may elapse between the commission of the crime and its discovery…In good times people are relaxed trusting and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. The stock market boom and ensuing crash caused a traumatic exaggeration of these normal relationships.” John Kenneth Galbraith – The Great Crash 1929, first published in 1954.

It is just the way it is. In times like these you just know respected individuals, people who reached the top echelon in their chosen field, snappily dressed, persuasive, knowledgeable, charismatic – there are lots of people like that in the money industry – will sometimes promote schemes that are not altogether what we think they are. When it all goes pear shaped, we find out. It happened in the aftermath of 1929, it happened during the crash of 2008 – and there is probably more already waiting in the wings as we approach the aftermath of the Great Crash 2008.

It does seem a tad unfair on the great schemes of the past that the name Ponzi scheme applies to a very run-of-the-mill fraud. Charles Ponzi spotted a niche. It was about the time when the First World War came to an end. It was an arbitrage scheme to begin with. Mr Ponzi noticed that certain coupons in Italy were worth less than in the US. So he bought them in Italy and sold them in the US – and made a nice little profit. Trouble is, the supply of these Italian coupons was quite modest – the demand for investors for a bit of Ponzi magic was enormous. So he took money from investors, and repaid it out of money he took from later investors. In other words, he used investors’ money to provide a profit for other investors, and when the scheme finally unravelled, Mr Ponzi’s name was immortalized.

It was a funny thing, but back in the early 1980s pyramid schemes came back into fashion. You sent a letter to ten people, they forwarded the letter on to ten people, and so on. Then each recipient of a letter sent a sum of money to the person ten or so places above them in the scheme. Stories broke out about how some people amassed giant profits. The odd thing: people didn’t seem to be able to see the flaw in the scheme. Yours truly was at university when such a scheme was first brought to his attention, and it was amazing how many supposedly intelligent students couldn’t see the fatal flaw. Never had so many maths students been so vocal. The union bar was full of nerdy numerate students explaining to trendy art students why they were being thick.

But there have been far more spectacular Ponzi schemes than the one dreamed up by the eponymous coupon trader from 1918. The South Sea Bubble, that caught out, amongst others, Sir Isaac Newton, was such a scheme. The Mississippi Bubble from the 17th century, in which Scottish businessman John Law ran a scheme to persuade French investors to plough their money into American swampland, nearly bankrupted the French government.

As stings go, it seems that Ponzi’s scheme is a fairly poor example of a Ponzi scheme.

By contrast, Bernard Madoff, former top man at the NASDAQ stock exchange can be proud. The say the Madoff scheme will have cost around $50bn. Maybe the John Law Mississippi bubble was more expensive even than that, but even so, the former NASDAQ chairman can rest assured he will surely occupy a premier place in the pantheon of Ponnzi schemes.

Red will be the result, of course. Red faces for the likes of Nicola Horlick, as Superwoman finds herself exposed to financial kryptonite, red ink; as banks such as HSBC, known for their prudence, are forced to put a $1bn loss into their accounts.

Meanwhile, those who are responsible for regulating regulators, or maybe it will even be those who regulate the regulators of the regulators, will see red. How was this allowed to happen?

Well, it was allowed to happen because banks, fund mangers and investment managers are supposed to know what they are doing. They charge their fees because they employ this thing called due diligence.

As ever, there will be danger in overreaction. The Sarbanes Oxley Act, passed in the wake of Enron and WorldCom, had the effect of crippling the US stock market, and ceding the advantage to London.

No doubt the call to ensure no such scheme can ever happen again will see the emergence of procedures that strangle the life-blood out of an industry that has already seen a lot of life-blood escape.

Mind you, it is tempting sometimes to conclude that if you want an investment portfolio that will outperform the experts, you may be better off with a list of investment vehicles, a blindfold and a pin. It certainly seems that that selection method may prove to be equally as successful as the investment approach adopted by those who make lots of clever speeches and release sophisticated reports.

Their reports maybe be sophisticated, but they don’t seem to be able to spot Ponzi schemes.

But, then there is another type of Ponzi scheme. The economist Hyman Minsky once defined three types of borrowers: the hedge borrower who can repay debt out of existing income; the speculative borrower, who hopes that the money borrowed will enable the repayment of the loan, but in practice can often mange to pay the interest only, and not actually repay the loan; the third type is known as the Ponzi borrower, and in order to service their existing debts, these hapless individuals have to borrow more money.

Minsky said that after we see the emergence of the Ponzi borrower, we see credit dry up – this has become known as the Minsky moment.

There are those who say the global economy hit its Minsky moment in August 2007. Or, in other words, the world had been full of Ponzi borrowers just before everything went belly up.

So sure, Mr Madoff may enjoy a place in the hall of fame of Ponzi schemes. John Law may sit higher up than that, but it seems at the top of the pecking order will sit all those who participated in the great Ponzi scheme of the first few years of the 21st century. So, that’s central banks, credit agencies, commercial banks, hedge funds, buy-to-let investing schemes, and, oh yes, all those who got into debt.