Bonus: The fraudster's guide to magic money with Tim Harford

0:06Pushkin. I love a good Ponzi scheme. from Charles Ponzi himself to Bernie Madoff. I both admire the wicked intelligence of the puppet masters, and I'm fascinated by the persistent credulity of the people who fall for Ponzi schemes. Here today to discuss Ponzi's and pyramids and everything in between with me is Tim Harford, my fellow FT columnist and master of his own podcast, Cautionary Tales. Tim, how are you? I'm great, Robin. pleasure to finally get on unhedged. I'm a loyal listener. Although I always feel terribly badly dressed whenever I, whenever I even think of you, Rob, whenever I read one of your wonderful columns about sartorial elegance, I, the subtext is this column is written at you, Harford, you slob.

0:59And so I just feel slightly guilty about the whole thing, but yeah. You'll be glad to know I'm sitting in my bedroom in a t-shirt and a pair of jeans. So I hope that puts you at ease. Okay. Yeah. I feel better now. Thank you, Rob. I was fascinated to listen to the most recent episode of Cautionary Tales. It gave a lot of terrific examples, starting with the immortal Sarah Howe of Ponzi schemers. Yeah. Tell us what a Ponzi scheme fundamentally is and what you discovered about them doing that episode. Yeah, we had lots of fun. Cautionary Tales is a podcast about things going wrong and what we can learn.

1:34And this particular episode is about Ponzi schemes and pyramid schemes, which are obviously always a terrible idea, but they have a lot of lessons for us. And Sarah Howe, Sarah Howe invented the Ponzi scheme. And can you believe that it isn't called a Howe scheme? It's outrageous. Outrageous. Another woman forgotten by history, unfairly forgotten by history, all the credit taken by Ponzi. Yeah. She was even operating in the same city in Boston, Massachusetts. So Sarah Howe set up the Ladies Deposit Company and basically offered to pay ladies 8 % a month, which is basically doubling your money in a year.

2:12And of course, there's no way of actually making that return. And so as with all Ponzi schemes, people investing in this opportunity, if they decide they want to withdraw their money, then Sarah Howe just paid them out of incoming money from other people who were eager to invest. and that's the fundamental of a Ponzi scheme. Early investors who are trying to cash out get paid not out of the productive return from the productive activity, because there is no productive activity. They get paid because other people are also pouring money in, and that's the basic genius of the idea. And so Cautionary Tales talks about Sarah Howe, who did this three times, talks about pyramid schemes, and also talks about this insane Ponzi scheme run by a gentleman called Sam Israel, which is described in Guy Lawson's book, The Octopus, which is absolutely bonkers because it just goes utterly down a whirlpool of conspiracy theories and so on.

3:11So it's great fun. I want listeners to know that this is not a colloquial phenomenon of my home city, Boston. I have a good friend, and this connects nicely actually to the Sarah Howe angle. I have a good friend who about 10 years ago in Brooklyn, she's quite an entrepreneurial person and was invited by another quite entrepreneurial person to a meeting of other women and they were going to talk about investment opportunity and so forth. And as it turned out, what this meeting of 10 or 12 women was, was, you know, I have this project that I'm working on. I need seed money for this endeavor. And, you know, each of you are going to contribute X amount to my endeavor.

3:53And then in the next round, each of you will become a receiver of funds from other people in the, you know, ladies empowerment club of Brooklyn or whatever. And my friend who has her head screwed quite tightly onto her shoulders, looked around at these well-meaning kind of semi-Bohemian, semi-business class Brooklyn ladies and said, you're all going to jail if you do this. This is a Ponzi scheme. And now I looked at her aghast like they had no idea that they were engaged in something untoward or possibly illegal. Yeah. Part of the issue is that it is not always straightforward to figure out whether something is a Ponzi scheme or not, because superficially, I mean, there's an awful lot of stuff in a capitalist economy that involves, well, you invest some capital and you take a risk.

4:47And if things go well, you get paid back 10x in the phrase that everyone likes to use. Exactly right. And this was the question, listening to your episode, I most wanted to put to you. How is a market in its bubble phase, not exactly like a Ponzi scheme snowballing in size? Oh, I love it. So it's like a decentralized Ponzi scheme, right? It's a naturally occurring, decentralized, organic Ponzi scheme where the Magnificent Seven tech stocks start to go bananas. And rather than a central schemer, a Ponzi or a Howe figure, we all do our little part. Journalists like you and I, Tim, we hype things up by constantly discussing one way or the other the different stocks.

5:34Brokers have their role to play, investor chat boards do the job. And so we all kind of Ponzi each other until we're out of the next person's draw into the market bubble, at which point the bubble collapses in an exact reversal of the social structure that built it. So I love this idea. So let's use 2020 hindsight. Let's go back and let's think about Amazon 25 years ago. And I think a little bit of hindsight clarifies things. So what distinguishes Amazon from a Ponzi scheme? Because if you think about it, this is an organization which in the 1990s and the early 2000s was not making money, losing a lot of money.

6:16Yes. But it's raising money from investors. So investors are putting money in. And if they wanted to get their money out again, they could, no problem. How do they get paid? Well, because other investors are putting money in. So there's a way to get paid and more and more money gets poured into this thing. And the reason it's not a Ponzi scheme, well, there's two things. One is there's no fraud, right? Because Amazon was perfectly honest about the accounts and perfectly honest that it was losing money. And so there's no deception, there's no fraud. So that's one reason it's not a Ponzi scheme.

6:48The second reason it's not a Ponzi scheme is in the end, it all comes good. All of that investment does turn into something productive and everybody can get paid back. So the first part of that, them being honest, okay, that's important. But the second part could not be guaranteed. There's no way of guaranteeing that Amazon would ever make money. And indeed, lots of those dot-com stocks in the 1990s never did. And people could make a lot of money as long as they got out in time. And that's very Ponzi-ish. And what is so important about the Amazon example is that the kind of faith, or if you prefer, kind of credulity of Amazon's early investors is exactly what allowed Amazon to become such a great business eventually.

7:39In other words, because the investors didn't insist on being paid out of the company's profits. Amazon was able to have this wonderful cycle where it just reinvested all of its capital in itself and built this incredibly strong, deep-moded, indestructible business because it wasn't paying money to investors. It was reinvesting in itself because the investors had that faith. So I think we now have a typology. So if you're putting money in and early investors get repaid by from later investors and the accounts are a sham that's a ponzi scheme and someone's going to jail if the early investors get repaid by the late investors putting money in but there's no accounting fraud people are just over exuberant and the whole thing all collapses and it's pets.com then no one goes to jail that's not a ponzi scheme that's a bubble and if in the end, it turns into a wonderfully productive investment such as Amazon.

8:44It's neither a Ponzi scheme nor a bubble. It's the genius of capitalism. I would argue that the Ponzi scheme and the bubble case are actually very close together. They're almost indistinguishably close because other than the absence of the central figure pulling all the strings, simply because at some point in a bubble, the people involved in it, in markets, actually acknowledge that prices are no longer connected to economic fundamentals or the productivity of the companies involved. They start using words like momentum, right? And they say, you can't get in front of momentum. The market is pushing upwards.

9:24If you get out now, you're going to regret it. it's fear of missing out. And to me, that moment, you are living Ponzi logic in that moment. There will be another person who will come along and pay me more, and I will be out of this game and somebody else will be left to hold the bag. There's always a story about where the money comes from, right? And I suppose the thing about bubbly markets is the stories get less and less rigorous. People don't need a particularly strong, data-driven, compelling story. They're just like, any story will do, I'm greedy now. And a lot of the Ponzi stories, so I mean, Charles Ponzi's original story was something to do with arbitrage of international postal reply coupons.

10:09Really? That's going to work? But people believed it. There's another question I wanted to ask you, which is all of the Ponzi's you talked about in your podcast, and indeed all the ones I know of, and I'm thinking here, of course, of Bernie Madoff, the most famous of the recent Ponzi's, these all turn out very poorly for the puppet masters. Very poorly. So there's a question about why us suckers fall for them. But there's a way in which the puppet master is the ultimate sucker. They've somehow believed their own Ponzi scheme in some way, and they end up in jail or disgraced. Why do they do it?

10:47I really am not sure why they do it. I suppose you could say, well, if the Ponzi schemes do somehow work out, if the international postal reply coupon arbitrage works, then everyone gets paid back in the end. I guess Sam Israel, who ran the Bayou Capital Ponzi scheme, maybe he would have gotten away with it if one of his attempts to swing for the fences had paid off. But ultimately, there's a really interesting idea, which I was introduced to by the writer Dan Davis, who wrote this terrific book about fraud called Lying for Money. And he basically points out that if you take a typical Ponzi scheme, so let's say you're promising to double people's money every year.

11:28Okay, so you take$100 from a little old lady and you steal it. Okay, now in a year, you need to pay her$200. That's okay. So you find two other little old ladies, you steal their money, and you pay the first little old lady. Now, of course, in a year's time, you've got to do it all again. And each year, you're earning twice as much money and you need to defraud twice as many little old ladies to pay the previous little old ladies so that's all kind of obvious and it's obvious that that can't keep going forever that's an exponential process that's all going to come unraveled but what dan davis pointed out is what is easy to miss is that can balloon into thousands and thousands and thousands of dollars based on the original 100 theft the fraudster only stole a hundred dollars and somehow Now they're responsible for maintaining this enormous fraud.

12:19And no wonder so many of them end up crying with relief when they're finally arrested. Like, thank goodness, I don't have to do this anymore. So I don't know why people do this. It's the magician's apprentice story. You cast the spell and all of a sudden it's much bigger than you are. And I think there is a general point about fraudsters that clearly applies to some Ponzi fraudsters, is that they do get into it by mistake. You start a fund, you're struggling to be a legitimate investor, something goes slightly wrong, and okay, just one month I'm going to fudge the numbers so I can pitch to one more investor, and then that takes on a life of its own.

13:02You get into it incrementally by small steps, and suddenly the thing grows by leaps and bounds. And I think there's a way to read the Bernie Madoff scheme as having some of that character. And you can read Madoff's actions late in the scheme as desperately trying to keep the thing under control, turning investors away, as it were, because he couldn't handle it. and it just gets so huge that in the end the gap between the underlying reality of the investments like how much money you are really generating in a postal reply coupon arbitrage and the fiction what you're telling people you are making that gap eventually becomes impossible to bridge a lot of ponzi schemes i think it's ambiguous at the start did they mean it to be a ponzi scheme or did they actually think they were investment geniuses and everyone would get paid back there is often an ambiguity at the start, but unless you're able to close that fraudulent gap early, it becomes so unbridgeable.

14:02You don't have a chance. Tim, if you give me a hundred dollars, I have a brilliant idea. I'm all ears. We'll be right back with Long Short.

14:21welcome back this is a long short that portion of the show where we go long something we like or short something we don't like tim are you long or short something can i go for a paired trade please do excellent great so so i'm gonna go short ponzi and long pyramid schemes so we should probably very briefly explain the difference so so a ponzi scheme someone's running a ponzi scheme they're lying they're paying out earlier investors using money from later investors pyramid scheme works in a similar way but it's it's decentralized you basically get the later investors to send money to the early investors and then the later investors then have to recruit even later investors to pay them.

15:05And it's more transparent, but more to the point, there's nobody actually running the thing. And what that means is that the person who sets up each individual pyramid scheme can cash out and walk away. And in fact, the pyramid scheme I described in the cautionary tale, we have no idea who set it up. She seems to have got fairly rich and just walked away and she never went to jail. And we don't know who she is. You say she, Tim. You say she, but I think we're talking about you, Tim, aren't we? I couldn't possibly comment. Couldn't possibly comment. Rob, okay. I'm short Ponzi, long pyramid. Do you have a long or a short for us?

15:43Well, let me ask you a question. Is Bitcoin a Ponzi or a pyramid? Or neither. Or neither. I mean, I think it's more bubbly than either, but it's not a Ponzi scheme because there's nobody in charge. That's the whole point of Bitcoin, right? Nobody is in charge. So if it's anything, it's closer to a pyramid scheme where transparently, if you want to get paid for investing in Bitcoin, you get paid by other people coming in and buying your Bitcoin. So it's closer to a pyramid scheme. I'm going to be short Bitcoin just because I'm a coward. Well, I think that's your inalienable right, Rob, and I think I might join you in your cowardice.

16:20Thanks for being on the show. Oh, that's a real pleasure. Thank you, Rob. I loved it. Listeners, if you like Unhedged, you will love Cautionary Tales, Tim's podcast. Unhedged will be back in your feed before you know it. Thanks for listening. Unhedged is produced by Jake Harper and edited by Brian Ernstap. Our executive producer is Jacob Goldstein. We have additional help from Topher Forges. Cheryl Brumley is the FT's Global Head of Audio. Special thanks to Laura Clark, Alistair Mackey, Greta Cohn, Marilyn Rust, Kira Posey, and Natalie Sadler. FT Premium subscribers can get the Unhedged newsletter for free.

17:01A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Rob Armstrong. Thanks for listening.