Truth or consequences: Ponzi schemes and other frauds

In the financial world, the real scandal is often what’s legal, but you still have to watch out for fraudsters. If you don’t pay the costs of screening and monitoring your financial counterparties, you may lose your house (no metaphor intended).

The never-ending need for financial vigilance came to mind recently when we noticed that the 1920 home of Charles Ponzi was for sale in Lexington Massachusetts. It’s a very large house – 7 bedrooms, 6 bathrooms, 7000 square feet of space (650 square meters) on nearly an acre of land (0.4 hectares).  (You can see a picture here.)

Ponzi was a serial con artist in the 1920s and 1930s. He became so infamous for one of his scams that today such rip-offs are generically called Ponzi schemes. Promising a 50% profit within 45 days, he swindled unsuspecting investors out of something like $250 million in 2014 dollars. Ponzi never invested their money. Instead, he paid off early investors handsomely with the proceeds from future investors.

Bernie Madoff was arguably a more effective fraudster than Charles Ponzi.  Ponzi moved between frauds and prison for many years.  By contrast, Madoff was for decades a respected member of the community, triumphing repeatedly over the efforts of regulators (our financial cops) to detect any misbehavior. Madoff’s con, which may have begun as early as the 1970s, failed only when the financial crisis of 2007-2009 depleted his funds, making it impossible for him to pay off the final generation of wealthy (even financially sophisticated!) dupes. The losses in the Madoff scandal dwarf Ponzi’s racket, with the principal alone estimated at $17 billion. Similar to Ponzi, Madoff was redeeming requests for funds with what he collected from more recent investors’ deposits.

A well-functioning financial system is based on trust. Widespread belief in honesty and integrity are essential for intermediation. That is, when we make a bank deposit, purchase a share of stock or a bond, we need to believe that terms of the agreement are being accurately represented.  Yes, the value of the stock can go up and down, but when you think you buy an equity share, you really do own it.  Fraud can undermine confidence, and the result will be less saving, less investment, less wealth and less income.

Unfortunately, in a complex financial system, the possibilities for fraud are numerous and the incidence frequent. Most cases are smaller and more mundane than Madoff or Ponzi.  But they are remarkably common even today, despite enormous public efforts to prevent or expose them. One website devoted to tracking financial frauds in the United States lists 67 Ponzi schemes worth an estimated $3 billion in 2013 alone.

We simply aren’t going to get rid of these. But the mission of ferreting them out, prosecuting and imprisoning those responsible is essential if our financial system is going to work. Research suggests that things like stock market investment require trust. (See the work of Luigi Zingales and his collaborators, especially the paper here.) That’s why one of the most important foundations of a modern economy is the legal protection of property rights.

Laws and enforcement that protect people’s wealth from swindlers safeguard the smooth operation of all advanced economies. When you see economies where property rights are weak and enforcement is unreliable, you will see less supply of credit to worthy endeavors (see chart). That means lower production, lower income, and lower welfare.

Note: Each dot represents a country. Sources:  Global Financial Development Database, World Bank and Transparency International. All data is for 2010.