The Invention of Robbing Peter to Pay Paul — The Trap Called a Ponzi

Last time, we looked at the bubble born of the crowd itself. It had no clear ringleader. But there was a man who assembled the structure of that frenzy by himself, on purpose, and left his name to posterity. Charles Ponzi. The term ‘Ponzi scheme,’ used the world over today, derives from him. The United States, 1920, Boston. What he promised was a dreamlike tale: that one’s money would double in a mere 90 days. And astonishingly, the first investors really did receive their dividends. Within that lay both the cunning of this fraud and its unavoidable collapse. In this chapter, we examine why a mechanism that pays earlier investors with the money of those who come later is doomed to collapse from the very start.

The Promise of ‘Doubling in 90 Days’ — Charles Ponzi

Charles Ponzi was born in Italy in 1882 and is said to have crossed to America as an immigrant around 1903. A man who drifted from job to job and, at times, committed crimes and served prison terms, he drew the attention of the whole world upon himself in 1920.

The trigger was the International Reply Coupon (IRC), a very plain postal mechanism. This is a coupon for sending the cost of return postage to a correspondent abroad in advance, exchangeable for stamps at the post office in each country. Ponzi fixed his eye on the fact that the price of this coupon differed from country to country. Buy coupons in a country where prices are low, exchange them for stamps in high-priced America, and a profit ought to arise from the difference — in theory, it was a sound observation.

The problem was the return he promised his investors. Fifty percent in 45 days, and in 90 days, a full doubling — figures beyond all common sense. He explained that he could generate that profit from the margin on the coupons. Yet in reality, trade on such a scale was impossible. Later investigation found that the coupons he actually purchased were trifling, nowhere near matching the funds he had gathered. In other words, the business that was supposed to be the source of profit scarcely existed.

Pay the Earlier with the Money of the Later — The True Nature of the Mechanism

So why, when there was scarcely any profit-generating business, could the early investors receive their dividends? The answer is simple, and cruel. Those dividends were paid directly out of the money paid in by those who invested later.

To set this structure in order, it goes like this. A invests. After a while, newcomers B and C invest. Ponzi hands part of B’s and C’s money to A as a dividend. A rejoices that ‘it really did grow’ and recommends it to those around. Now D and E, having heard the reputation, invest, and their money becomes the dividend for B and C. The money is merely passed from new investors to old, and nowhere is any wealth created. While feigning profit from a business, in reality the funds are simply circulating.

This is the skeleton of the fraud later called a ‘Ponzi scheme.’ A closely resembling mechanism is the ‘endless chain scheme’ (a pyramid scheme), in which participants recruit the next participants and spread in a chain; but the two differ. In a pyramid scheme, the participants themselves recruit lower-tier members and widen the pyramid, whereas a Ponzi scheme is characterized by an organizer at the center who feigns management — ‘this is a profitable investment’ — and gathers all the funds into a single hand. Investment in the telling, the reassignment of funds in fact. That very gap was the device that made people believe.

Why Is the Collapse Promised from the Start?

The most important point about a Ponzi scheme is that it does not fail by ill luck; structurally, it must inevitably collapse.

Consider it. To cover the dividend to those who entered earlier with the money of those who entered later means that, in order to keep paying dividends, the number of investors must forever go on increasing. What is more, the higher the promised return, the more the new funds required swell like a snowball. At some point, the dividends due to be paid out grow larger than the money coming in anew. The world’s population is not infinite, and there is a limit to those one can recruit. So the moment new funds thin out, the dividends stop, and everything collapses all at once. The collapse is not an accident; it is an ending built into the mechanism from the very start.

Ponzi’s scheme, too, met exactly such an end. In the summer of 1920, the newspapers and the authorities cast doubt on the reality of his trade, and as the investigation advanced, it became clear that profit from the coupons scarcely existed. Investors, seized by anxiety, demanded refunds all at once, and the circulation of funds came to a halt. Much of the money gathered did not return, and he came to be charged with fraud. What he left behind was not wealth, but a byword for ‘fraud whose collapse is promised,’ bearing his own name.

What Ponzi employed was a cunningly designed ‘mechanism.’ But through the history of fraud runs, unbroken, a more classic method that requires no complex mechanism at all. It is the art of winning another’s trust and preying on the heart itself. Why do people come to believe a complete stranger? Next time, we trace the lineage of the confidence tricksters.