A Ponzi Frenzy

The Deputy Inspector-General of Police, Criminal Investigation Department, Bheemashankar S. Guled, recently cautioned the public against investing in Shivam Associates. The CID investigation into the alleged fraudulent business revealed that the firm collected approximately Rs 2,400 crore from more than 40,000 investors. This company apparently offered incredible, impossible returns of 36% to 60% a year. Are these astronomical returns feasible? Absolutely not. How did they manage to stay afloat? The answer to this question is fairly simple yet baffling. According to the CID inspector, the company was running a fraudulent operation, known as a Ponzi scheme. We must understand what a Ponzi scheme is and how it is governed by various economic principles.

What is a Ponzi scheme?

In a Ponzi scheme, instead of buying stocks or real assets, the scammer simply takes money from new investors to pay “returns” to older investors. Fundamentally, a Ponzi scheme is a fake investment because it generates no actual profit. This may seem innocuous, but a Ponzi scheme is doomed from the outset. Its survival depends on an impossible mathematical problem: finding an ever-growing supply of new investors. When this inflow of funding is reduced or too many people ask for “returns”, the entire pyramid collapses.

The Economics behind a Ponzi

Let us use economic principles to decode why people fall for such gimmicks.

Asymmetric Information

Asymmetric information simply means that one person has a secret that others do not. Here, the secret is that the investment scheme is inherently fraudulent. The agent claims to have a prowess or scheme for achieving astronomical profits. Some believe him, while others do not. In this case, the scammer takes money from one group of people and gives it to the first group as “profits”. This helps him build a false reputation. Seeing others gain such unrealistic profits, the majority of the initially sceptical lot metamorphoses into prey for the scammer. Greed and FOMO eventually get the better of them. Speaking of greed, let us move to another economic aspect of this bamboozling scheme.

The Psychology of Greed

It is easy to assume that only financially illiterate people fall for such schemes. However, history tells a different story. Even Wall Street has been hoodwinked by such crafty schemes. Why is this so? Behavioural Economics explains that humans are not always rational. People suffer from the “fear of missing out” (FOMO) when they see their colleagues making easy money. High-end fraudsters do not use get-rich-quick schemes but offer incredible and consistent results. Investors also experience "confirmation bias”, meaning they ignore obvious red flags because they want to believe that the high returns are real. Scammers also use "affinity fraud”, where they target close-knit groups, such as churches, clubs, or small towns. Because people trust their friends and neighbours, they invest without conducting their own research. People not only invest but also convince others to invest. This compounding effect sometimes annihilates entire economies.

The Domino Effect of Giant Frauds

If a Ponzi scheme becomes too large, its collapse can severely damage the entire country. An eminent example of such a situation is the 1997 Albanian Unrest. A massive Ponzi network grew so large that its debts equalled half of the country's total economic output. When it inevitably collapsed, people lost their life savings. Citizens of developing nations often do not understand the modern banking system. If official banks are too strict, citizens will start looking for alternatives. When companies offer huge interest rates, greed gets the better of them. They sell their homes, empty their life savings, and give it all to these schemes. When these pyramids collapse, the results are cataclysmic. Household savings are wiped out, meaning that nobody can buy goods. Businesses go bankrupt due to low demand, inflation skyrockets, and the country’s currency loses its value. This leads to a low-level equilibrium trap, preventing the country’s economy from recovering further. Economists also consider the US economic housing bubble to be a giant Ponzi scheme, as it relies entirely on new buyers paying increasingly higher prices to keep the market afloat.

Conclusion

A Ponzi scheme sustains the illusion of profitability by paying early investors with funds from new entrants rather than from legitimate business activities. At the microeconomic level, these schemes thrive on asymmetric information and the greedy nature of humans. Financial illiteracy is an important aspect but not the only cause. On a macroeconomic scale, entire economies undergo cataclysmic annihilation. One must remain wary of investing in schemes that offer extraordinary, unfeasible returns. These are more often than not fraudulent. Reaping the benefits of such schemes is no better than living in a fool’s paradise, as these pyramid schemes eventually collapse.