The Optimal Design of Ponzi Schemes in Finite Economies

Abstract

As no rational agent would be willing to take part in the last round in a finite economy, it is difficult to design Ponzi schemes that are certain to explode. This paper argues that if agents correctly believe in the possibility of a partial bailout when a gigantic Ponzi scheme collapses, and they recognize that a bailout is tantamount to a redistribution of wealth from non-participants to participants, it may be rational for agents to participate, even if they know that it is the last round. We model a political economy where an unscrupulous profit-maximizing promoter can design gigantic Ponzi schemes to cynically exploit this "too big to fail" doctrine. We point to the fact that some of the spectacular Ponzi schemes in history occurred at times where and when such political economies existed - France (1719), Britain (1720), Russia (1994) and Albania (1997).

Note: Previously entitled : On the Possibility of Ponzi Schemes in Transition Economies.

Keywords: Ponzi schemes, bubbles, bailouts, moral hazard

JEL Classification: G10, G18, F36, P20