The following is an excerpt from Hall of Mirrors: The Great Depression, The Great Recession, and the Uses — and Misuses — of History by Barry Eichengreen, and examines the economics of financial schemes.
At five foot four and with a round face, Charles Ponzi hardly cut an imposing figure. Having arrived in the United States at the age of twenty-one from Parma, Italy, he did not speak English with the authority of a patrician American financier. But if small in stature, Ponzi would loom large in the literature on financial crises. In time, “Ponzi scheme” would become an indelible part of the lexicon of financial instability, surpassing even the likes of “Greenspan put” and “Lehman Brothers moment.”
Ponzi made his name, as it were, with a scheme to arbitrage the market in international postal reply coupons. These instruments were introduced in 1906 by agreement at the Universal Postal Union Congress, held, auspiciously, in Italy. They were intended as a vehicle for sending funds abroad, enabling the recipient to buy stamps and post a reply.
The 1906 congress was convened in the gold standard era, when exchange rates were locked. Delegates thus had no way of anticipating the complications that suspension of the gold standard could create for their agreement. But with the outbreak of the World War, governments embargoed gold exports. Buying gold where it was cheap and selling it where it was dear had been the mechanism through which exchange rates were held stable. With the embargoes, which effectively suspended gold market transactions, currencies began fluctuating against one another.
Among the unanticipated consequences were those for the postal coupon agreement. The United States was the only belligerent whose currency maintained its value against gold during and after the war. European currencies depreciated against the dollar as governments printed money to finance military outlays, a trend only partially reversed with the armistice. As a result,postal reply coupons purchased abroad using European currencies could buy more than their cost in stamps in the United States. In 1919, sensing an opportunity, Ponzi borrowed money from business associates, which he sent to Italian contacts with instructions to purchase postal reply coupons and forward them to him in Boston.
Why Ponzi was uniquely able to detect this opportunity is, to put it mildly, unclear. Not surprisingly, the appearance of substantial profits was an illusion. Ponzi’s contacts could assemble only a limited number of coupons, and even then, completing the transaction took time, during which funds devoted to the project were tied up.
And time was not something Ponzi possessed in abundance, since he had promised to double his investors’ money in ninety days. To pay those dividends, he was forced to employ the capital obtained from new subscriptions, leaving no funds for the postal coupon arbitrage motivating the scheme. This in turn made it essential to attract additional investors, which Ponzi did by incorporating as the impressive-sounding Securities Exchange Company and hiring a phalanx of salesmen. The scheme collapsed in August 1920 with publication of a Boston Post exposé penned by William McMasters — a journalist Ponzi had hired to generate publicity for his operation.
That Ponzi’s promise to double his investors’ money in ninety days had not raised red flags says something about the readiness of investors to suspend disbelief in the intoxicating financial atmosphere of the 1920s. One can’t help but think of the inability of investors in the equally heady 2000s to see through the ability of Bernie Madoff to generate supernormal profits with barely a fluctuation year after year after year.
Indicted for mail fraud, Ponzi pled guilty and was sentenced to three and a half years in federal prison. The investing public of New England, however, was not so easily assuaged. While still in prison, Ponzi was indicted by the State of Massachusetts on twenty-two charges of larceny. The now impecunious defendant served as his own attorney, more than capably at first. But as one trial followed another, he grew fatigued. Where the first jury acquitted, the second deadlocked, and the third found the defendant guilty. Freed on bail, Ponzi fled to the remote backwaters of Florida, where he began doing business under an assumed name.
In 1925, doing business in Florida meant transacting in real estate. Ponzi transformed himself into the promoter of a subdivision near Jacksonville. “Near” in this case meant sixty-five miles west of the city, where Ponzi set about developing (if one is permitted elastic use of the word) an expanse of scrubland covered with palmetto, weeds, and the occasional oak. Subdividing meant driving stakes into the ground to help owners identify their homestead. Once lots were staked, at an ambitious twenty-three per acre, they were offered at $10 apiece.
The capital needed to purchase, survey, and subdivide the land was provided by investors in Ponzi’s Charpon (Charles Ponzi) Land Corporation. Subscribers were promised $30 for each $10 investment in sixty days, an even more impressive return than in the earlier postal coupon operation. This of course was nothing but another pyramid scheme in which early investors were paid with cash obtained from the proceeds of selling shares to new investors. It didn’t take long for the fraud to be detected or for the perpetrator’s identity to be revealed. Ponzi was indicted for violating Florida statutes regarding trusts, tried, and again found guilty by a jury of his peers.
Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley. His previous books include Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System and Golden Fetters: The Gold Standard and the Great Depression, 1919–1939.
Featured Image: “A Confident Charles Ponzi” by Boston Public Library. CC by NC-ND 2.0 via Flickr.