Transcript: Bonus — The fraudster’s guide to magic money with Tim Harford

This is an audio transcript of the Unhedged podcast episode: ‘Bonus: The fraudster’s guide to magic money with Tim Harford’

Robert Armstrong
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 Ponzis 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?

Tim Harford
I’m great, Robert. Pleasure to finally get on Unhedged. I’m a loyal listener, although I always feel terribly badly dressed whenever I even think of you, Rob, (Robert laughs) whenever I read one of your wonderful columns about sartorial elegance. The subtext is this column is written at you, Harford, you slob. And so I just feel slightly guilty about the whole thing.

Robert Armstrong
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.

Tim Harford
OK. Yeah, I feel better now. Thank you, Rob.

Robert Armstrong
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. Tell us what a Ponzi scheme fundamentally is and what you discovered about them doing that episode.

Tim Harford
Yeah, we had lots of fun. Cautionary Tales is a podcast about things going wrong and what we can learn. And 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 invented the Ponzi scheme. And can you believe that it isn’t called a Howe scheme? It’s outrageous.

Robert Armstrong
Another woman forgotten by history, unfairly forgotten by history. All the credit taken by Ponzi.

Tim Harford
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 per cent a month, which is basically doubling your money in a year. And 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. So it’s great fun.

Robert Armstrong
I want listeners to know that this is not a parochial phenomena in 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 was, she’s quite an entrepreneurial person and was invited by another quite entrepreneurial person to a meeting of other women and they were gonna talk about investment opportunity and so forth. And as it turned out, what this meeting of 10 or 12 women was, you know, I have this project that I’m working on, I need seed money for this endeavour and, you know, each of you are gonna contribute X amount to my endeavour. And 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. (Laughter) And they all looked at her aghast like they had no idea that they were engaged in something untoward or possibly illegal.

Tim Harford
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 and if things go well, you get paid back 10x, in the phrase that everyone likes to use.

Robert Armstrong
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?

Tim Harford
Oh, I love it. Like a decentralised Ponzi scheme.

Robert Armstrong
It’s a naturally occurring, decentralised, organic Ponzi scheme where, you know, something, 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. Brokers 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 to draw into the market bubble, at which point the bubble collapses in an exact reversal of the social structure that built it.

Tim Harford
So I love this idea. So let’s use 20/20 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 organisation which in the 1990s, in the early 2000s was not making money, losing a lot of money. 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 was 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. The 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, OK, 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, a lot of those dotcom 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.

Robert Armstrong
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. In 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-moated, indestructible business because it wasn’t paying money to investors. It was reinvesting in itself because the investors had that faith.

Tim Harford
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, you know, 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, it’s neither a Ponzi scheme nor a bubble. It’s the genius of capitalism.

Robert Armstrong
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 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. If you get out now, you’re going to regret it. It’s fear of missing out. And to me, that moment, you are living the Ponzi logic in that moment. There will be another person who will come along and pay more and I will be out of this game and somebody else will be left to hold the bag.

Tim Harford
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 . . . (Robert laughs) So, I mean, Charles Ponzi’s original story was something to do with the arbitrage of international postal reply coupons. Really? That’s going to work? But, you know, people believed it.

Robert Armstrong
There’s another question I wanted to ask you, which is all of the Ponzis 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 Ponzis. These all turned out very poorly for the puppet masters.

Tim Harford
Very poorly.

Robert Armstrong
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?

Tim Harford
I 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 Davies, 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. OK. So you take $100 from a little old lady and you steal it. OK. Now in a year, you need to pay her $200. That’s OK. 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 gonna come unravelled. But what Dan Davies 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 $100, and somehow now they’re responsible for maintaining this enormous fraud. And 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.

Robert Armstrong
It’s the magician’s apprentice story — that 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 OK, just one month I’m gonna fudge the numbers so I can pitch to one more investor. And then that takes on a life of its own. You get into it incrementally by small steps, and suddenly the thing grows by leaps and bounds. And I think there was 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.

Tim Harford
And it just gets so huge that in the end, the gap between the underlying reality of the investments, about how much money you are really generating in 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 that 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 you don’t have a chance.

Robert Armstrong
Tim, if you give me $100, I have a brilliant idea.

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Tim Harford
I’m all ears.

Robert Armstrong
(Laughter) We’ll be right back with Long/Short.

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Welcome back. This is 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?

Tim Harford
Can I go for a paired trade, Rob?

Robert Armstrong
Please do. Excellent.

Tim Harford
Great. So I’m gonna go short Ponzi and long pyramid schemes. So we should probably very briefly explain the difference. So a Ponzi scheme, someone’s running a Ponzi scheme. They’re lying. They’re paying out early investors using money from later investors. Pyramid scheme works in a similar way but it’s decentralised. 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. And it’s more transparent. But more to the point, there’s nobody actually running a thing. And what this means is that the person who set 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 . . . 

Robert Armstrong
You say she, Tim, you say she. But I think we’re talking about you, Tim, aren’t we? (Laughter)

Tim Harford
I couldn’t possibly comment. Couldn’t possibly comment. Rob, OK, I’m short Ponzi, long pyramid. Do you have a long or a short for us?

Robert Armstrong
Well, let me ask you a question. Is bitcoin a Ponzi or a pyramid? Or neither?

Tim Harford
Ah. 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 wanna 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.

Robert Armstrong
I’m gonna be short bitcoin just because I’m a coward.

Tim Harford
Well, I think that’s your inalienable right, Rob, and I think I might join you in your cowardice.

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Robert Armstrong
Thanks for being on the show.

Tim Harford
Oh, that’s a real pleasure. Thank you, Rob. I loved it.

Robert Armstrong
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 Bryant Urstadt. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhecz. Cheryl Brumley is the FT’s global head of audio. Special thanks to Laura Clarke, Alastair Mackie, Gretta Cohn, Marilyn Rust, Kyra Posey and Natalie Sadler. FT premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com/unhedgedoffer. I’m Rob Armstrong. Thanks for listening.

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