Paul Krugman on March 12, 2000:
The Ponzi Paradigm, by Paul Krugman, Commentary, NY Times, March 12, 2000: Charles Ponzi wasn't the first to try it, but he has joined Dr. Bowdler and Captain Boycott among those whose names will forever be terms of abuse. And the classic scam that bears his name -- using money from new investors to pay off old investors, creating the illusion of a successful business -- shows no sign of losing its effectiveness.
Robert Shiller's terrific new book, "Irrational Exuberance," contains a brief primer on how to concoct a Ponzi scheme. The first step is to come up with a plausible-sounding but complicated profit opportunity, one that is difficult to evaluate. Ponzi's purported business involved international postage reply coupons. In a more recent example, Albanian scammers convinced investors that they had a profitable money-laundering business.
From that point on it's all a matter of timing and publicity. An initial group of investors must be pulled in, large enough to attract attention but not too large; then a larger second group, whose investments can be used to pay off the first, a still larger third group, and so on. If all goes well, stories about how much early investors have made will spread, attracting ever more people, and the continuing success of the company will silence or drown out the skeptics.
In the United States, regulators -- who know very well just how effective such scams often are -- do their best to stop them before they get started. So you might think that Ponzi schemes are mainly a historical curiosity. But Mr. Shiller is not interested in history for its own sake; he uses Ponzi schemes as a model for something much more important.
Imagine, just hypothetically, that a new set of technologies -- technologies that are really, truly, deeply fabulous -- has just emerged. And suppose also that a number of companies have been created to exploit these new technologies, in the entirely honest -- but very hard to assess -- belief that they will eventually be able to earn huge profits. For the time being they earn little if any money; even if they make an accounting profit, they must continually raise more cash to pay for equipment, acquisitions and so on. Still, as the evidence for a true technological revolution mounts, the prices of their stocks keep rising, producing huge capital gains for early investors. And this attracts ever more investors, pushing the prices still higher.
If the process goes on long enough -- and there is no reason it cannot go on for years -- the doubters will start to look like fools, and the bears will go into hibernation. Everyone (well, almost everyone) may be completely sincere; nonetheless, in effect you get a Ponzi scheme without a Ponzi, a scam with no scammer.
Given the title of Mr. Shiller's book, you can guess the punch line. He makes a powerful case that the soaring stock market of recent years is a huge, accidental Ponzi scheme in progress, one that will come to a very bad end. The book actually focuses on the market broadly defined (most numbers are for the S.&P. 500), but it reads even better as a tale of the tech stocks. It's a book that I hope many people will read; but I doubt that many will be persuaded.
You see, right now bears have an extra credibility problem. Not long ago many people were skeptical not only about the prospects for today's technology companies but about the importance of the technology itself. (I plead guilty.) And every new statistic showing soaring productivity and earnings growth shows how wrong they were. As a matter of logic you can concede the reality of a technological revolution, even while asserting that the valuations of many technology companies are crazy; but who will listen?
It's also true that savvy investors (at least they seem savvy) are following the Levi Strauss strategy: Let others get caught up in the gold rush, we'll sell them the supplies. It is quite possible that the valuations of companies that sell Internet infrastructure make sense even if those of the dot-coms do not.
Still, as you watch those who missed out on the first few thousand points of the Nasdaq's rise feverishly try to make up for lost time, you have to wonder. Will people 80 years from now talk, without quite knowing where the term comes from, about being bezosified or qualcommed?
[Follow-up column: "When things are going well there is a strong tendency to suppose that financial markets can take care of themselves. Well, they can't."]