By Greenspan, Stephen
Skeptic (Altadena, CA) , Vol. 14, No. 4
THERE ARE FEW AREAS OF FUNCTIONING where skepticism is more important than how one invests one's life savings. Yet intelligent and educated people, some of them naive about finance and others quite knowledgeable, have been mined by schemes that turned out to be highly dubious and quite often fraudulent. The most dramatic example of this in American history is the recent announcement that Bernard Madoff, a highly-regarded hedge fund manager and a former president of NASDAQ, has for several years been running a very sophisticated Ponzi scheme which by his own admission has defrauded wealthy investors, charities and other funds, of at least 50 billion dollars.
In my new book Annals of Gullibility, (1) I analyze the topic of financial scams, along with a great number of other forms of human gullibility, including war (the Trojan Horse), politics (WMDs in Iraq), relationships (sexual seduction), pathological science (cold fusion), religion (Christian Science), human services (Facilitated Communication), and medical fads (homeopathy). Although gullibility has long been of interest in works of fiction (Othello, Pinnochio), religious texts (Adam and Eve, Samson) and folk tales (Emperor's New Clothes, Little Red Riding Hood), it has been almost completely ignored by social scientists. There have been a few books that have focused on narrow aspects of gullibility, including Charles Mackey's classic 19th century book, Extraordinary Popular Delusions and the Madness of Crowds (most notably on investment follies such as Tulipimania, in which rich Dutch people traded their houses for one or two tulip bulbs). (2) In Annals of Gullibility I propose a multidimensional theory that would explain why so many people behave in a manner that exposes them to severe and predictable risks. This includes myself--I lost a good chunk of my retirement savings to Mr. Madoff, so I know of what I write on the most personal level.
Ponzi Schemas and Other Investment Manias and Frauds
Although my focus here is on Ponzi schemes, I shall also briefly address the topic of investment manias (such as the dot.com bubble) and other forms of financial fraud (such as various inheritance scams). That is because they all involve exploitation of investor gullibility and can all be explained by the same theoretical framework.
A Ponzi scheme is a fraud where invested money is pocketed by the schemer and investors who wish to redeem their money are actually paid out of proceeds from new investors. As long as new investments are expanding at a healthy rate, the schemer is able to keep the fraud going. Once investments begin to contract, as through a run on the company, then the house of cards quickly collapses. That is what happened with the Madoff scam when too many investors--needing cash because of the general U.S. financial meltdown in late 2008--tried to redeem their funds. Madoff could not meet these demands and the scam was exposed.
The scheme gets its name from Charles Ponzi, (3) an Italian immigrant to Boston, who in 1920 came up with the idea of promising huge returns (50% in 45 days) supposedly based on an arbitrage plan (buying in one market and selling in another) involving international postal reply coupons. The profits allegedly came from differences in exchange rates between the selling and the receiving country (where they could be cashed in). A craze ensued, and Ponzi pocketed many millions of dollars, most from poor and unsophisticated Italian immigrants in New England and New Jersey. The scheme collapsed when newspaper articles began to raise questions about it (pointing out, for example, that there were not nearly enough such coupons in circulation) and a run occurred.
The basic mechanism explaining the success of Ponzi schemes is the tendency of humans to model their actions (especially when dealing with matters they don't fully understand) on the behavior of other humans. This mechanism has been termed "irrational exuberance," a phrase attributed to former fed chairman Alan Greenspan (no relation), but actually coined by another economist, Robert J. …