Understanding Ponzi Schemes
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Charles Ponzi (actually Carlo Ponzi, from Lugo, Italy, in the province of Ravenna) was living in Boston in 1918 and looking for a way to make money. Then he discovered an apparent arbitrage possibility. He could buy an international postal reply coupon (an IRC) in Italy that allowed him to buy a US stamp for less than the price of the stamp in the US. (See Ponzi’s Scheme: The True Story of a Financial Legend for a good biography.)
The mechanics of the transaction were (1) to send money to Italy; (2) convert the money to Italian lire, a currency that had depreciated after the end of World War I; (3) purchase IRCs in Italy; (4) ship the IRCs to the US; (5) use the IRCs to obtain postage stamps; (6) sell the stamps for cash. According to this account by the author of the biography noted above, sending $1 to Italy would generate $3.30 worth of stamps in Boston. Ponzi offered his friends the opportunity to earn a 50% return in 45 days.
By February 1920, Ponzi took in $5,000 and Ponzi quickly grew famous. By July millions of dollars were coming in to Ponzi every week; a careful financial analyst noted that if Ponzi was actually doing what he said (buying IRCs) he would own roughly 5000 times the number of IRCs in circulation. By November 1920 Ponzi had pleaded guilty to mail fraud and he spent much of the next 15 years in prison.
Ponzi’s secret was the continuing arrival of new investors. It is not obvious that he ever actually bought an IRC, but if he attracted enough investors, he could pay off the initial investors. Some people were foolish enough to leave their money with Ponzi (allowing him to “reinvest” their funds); others actually mortgaged thier homes in order to invest money with Ponzi. Of course when Ponzi’s scheme was finally ended, there was not enough to pay off those who had given Ponzi their money, as he had sent some to earlier investors or spent it on an extravagant lifestyle.
As a footnote, IRCs are still available today. If you want someone to write back to you, you can enclose an IRC in your letter and they can use the IRC to obtain an international airmail stamp. See here for current US rules on IRCs and here for recent news of Italian IRCs. The Italian post office does not heavily promote IRCs, but according to the article cited, an IRC costs 1.29 Euros. Unfortunately for current day arbitrageurs, a US international airmail stamp costs $0.94 today, and an IRC would cost over $1.70. But if the Euro dropped sharply, to around $.70, and if the price of the Italian IRC remained the same, then it would once again be possible for someone to buy an IRC and get the stamp and then sell the stamp.
To earn the return that the author cited above calculated, the Euro would have to drop to around $.22/Euro. Starting with $1, you would get 4.5 Euro , buy 3.5 IRCs (at E1.29/IRC) and get three and a half 94 cent stamps worth $3.30. But the Euro is well above $.22 (around $1.39 as I write today) so this transaction is not profitable.
But to make real money the Italian Posta would have to sell thousands of IRC and you would have to find someone to buy thousands of US international airmail stamps.
Current day Ponzi schemes have used other methods but the principal is similar. Bernard Madoff apparently promised steady returns (10% with very little risk); instead of buying IRCs he allowed his clients to believe that he had special market expertise, possibly related to his large and apparently legitimate market making business.