Information Failures: Ponzi Schemes

Charlie Varley writes here on the information failures linked to Ponzi Schemes

The notion of an information gap can be extended into areas concerning illegality and exploitation. The difference in understanding between the agent and his/her “victim” may augment into a fraudulent system whereby those with inferior knowledge and certain behavioural tendencies are coaxed into a perpetual information trap. There are various mechanisms by which this is achieved with the basic method being a “pyramid scheme”. I am going to examine what is referred to as a “Ponzi Scheme”; termed after the notorious investment fraudster, Charles Ponzi.

This operation involves the enrollment of a fleet of investors receiving unusually high short-term returns originating from the group itself rather than any financial progress made by the organisation.

Returns are circulated amongst the investment group whom are unknowing of the logistics behind the functioning of the operation. The agent is able to exploit the members who have no in-depth understanding of finance and are enticed by the supposed financial gain. The scheme operates in such a way that there is a pervasive asymmetry of knowledge between participants. It involves the provision of misleading information to those unaware of its true workings. Thus, the agent thrives in lieu of ignorant investors.

However, there is an lack of sustainability when employing such a scheme; they are perpetually destined for collapse.

The irregularity of return and potential subsequent communication between investors ensures their downfall. To expect a consistent expansion while maintaining a consensus of ignorance would be unrealistic. Additionally, the risk of exposure and action by financial regulators increases in correlation with the scheme’s expansion. The perpetrating agent concerned with the scheme will face prosecution upon discovery. Bernard Madoff is an example of a Ponzi agent and is currently serving a 150-year sentence in federal prison. He orchestrated a multi-billion dollar scheme, successfully swindling thousands of investors by providing fake account statements to imbue confidence amongst his syndicate.

Authorities across the world may attempt to tackle these exploitative schemes, through educating consumers and raising awareness of the logistics and trickery behind such operations. They provide a list of “red flags”; the shared characteristics of Ponzi schemes found in advertisements. Essentially promoting the theme, “if it looks too good to be true, it probably is”. These include proposed high investment returns with little or no supposed risk, issues with paperwork and difficulty receiving payments.

Alternatively, some governments provide a bailout to those perishing at the hand of Ponzi schemes. However, this can lead to increased participation given the removed risks by the inclusion of a bail out; it becomes economically rational and thus more desirable - bail outs risk creating the problem of moral hazard

Ultimately, Ponzi schemes pose as an extreme form of information failure. They take the logistics behind exploitations found in such practices as second-hand car dealership and amplify them many times over. Government intervention and the sanction of stiff penalties for those guilty of Ponzi-style fraud is essential to prevent such operations. However, schemes that maintain this format, operate with underlying flaws and inevitably result in internal collapse.