Ponzi schemer Bernie Madoff has asked President Trump to commute his sentence, CNBC reported. He’s currently serving 150 years in North Carolina for swindling investors. So why do we call it a Ponzi scheme?
According to the CNBC article, the scam that Bernie Madoff ran from Bernard L. Madoff Investment Securities “swindled thousands of investors out of billions of dollars.” If his sentence is commuted, he’ll be released from prison. His crimes are being called “the biggest Ponzi scheme in history,” but where did it get its name? The story involves postage stamps and the repeated convictions of a charismatic Italian-born con man named Charles Ponzi.
International Reply Coupons: The Main Ingredient
The original Ponzi scheme required three components to work, and the main one was its product. “In 1906, an international postal treaty had created something known as international reply coupons, which were vouchers that could be traded for stamps in any country that signed the treaty,” said Dr. Connel Fullenkamp, Professor of the Practice and Director of Undergraduate Studies in the Department of Economics at Duke University. “The purpose of the coupons was to make it convenient for people to pre-pay international return postage without having to exchange currencies in small amounts, which was completely impractical. Of course, the people who designed the system realized that the coupons needed to have the same value everywhere they circulated, so they imposed a fixed exchange rate on the coupons to achieve this purpose.”
Dr. Fullenkamp explained that at the time, this was possible because many nations worked on the gold exchange standard. However, after World War I, many of those nations’ currency values fell, but the international reply coupons remained the same. “By 1919, it was possible to spend a few cents on international reply coupons in Spain and Italy, let’s say, that could be exchanged for a dollar’s worth of U.S. postage stamps,” he said. All you’d need was someone to travel to Spain or Italy, buy up the coupons and transport them back to the United States.
Other Ingredients: Investors and Partial Delivery
Ponzi convinced investors that he could provide them a 50 percent return within 90 days on any money they invested in his securities exchange company. “Here’s the second ingredient of a Ponzi scheme: Ponzi was offering a too-good-to-be-true return, but he was open about how he delivered it,” Dr. Fullenkamp said. “He used word of mouth to attract his first customers, and then recruited many of them to become commission-based salespeople.”
After that, Ponzi took their money in exchange for certificates they could redeem in 90 days’ time. Then he promised to have investors’ money in 45 days, which he did. “That was the clincher—the third ingredient of the scheme,” Dr. Fullenkamp said. “After Ponzi made good on those first notes, the business took off.” In March 1920, his business took in $30,000. In July, it took in $6.5 million.
Even despite paying off his early customers, new money was coming in so fast that Ponzi continued to pay back the initial investments. “The amount of money invested was growing at a far higher rate than the promised returns, so it wasn’t a big problem for Ponzi to redeem maturing notes at this time,” Dr. Fullenkamp said. “This is one of the defining features of a Ponzi scheme, as well as its main weakness: As soon as the growth rate of new investments falls below the paid rate of return, the scheme runs out of cash.” According to Dr. Fullenkamp, that’s exactly what happened.
Ponzi’s new investment rate took a nosedive after attracting enough attention from the news media to warrant some investigation—both by journalists and the police—into his business. A series of investigative reports in The Boston Post, one of which included records of a forgery conviction for Ponzi several years earlier, led to the cessation of new investors and then the collapse of his Securities Exchange Company. He turned himself into authorities on August 12, 1920. Over the course of the next decade, Dr. Fullenkamp said, investors recouped just one-third of what they’d invested while Ponzi served time in several prisons until he was deported to Italy. He died in 1949.
Bernie Madoff’s future is yet to be determined. President Trump may or may not grant the commuting of his sentence. Either way, he’ll be known to history books as one of the biggest con men in American history—though they likely won’t rename it “a Madoff scheme.”
Dr. Connel Fullenkamp contributed to this article. Dr. Fullenkamp is Professor of the Practice and Director of Undergraduate Studies in the Department of Economics at Duke University. He earned his undergraduate degree in Economics from Michigan State University and his master’s and doctorate degrees in Economics from Harvard University.