Charles Ponzi didn't invent the Ponzi scheme. He just made it famous.
A Ponzi scheme pays early investors with money from later ones, and collapses when new money dries up. Charles Ponzi ran one in 1920s America built on postage coupons. But Adele Spitzeder had run one in Germany fifty years earlier, and Charles Dickens had put the idea in a novel in 1844.
The mechanics are simple. An operator promises high returns with little risk, supposedly from a clever business or secret strategy. In reality there is little or no genuine profit. Early investors are paid out of the deposits of newer ones, and the operator skims money for themselves along the way. As long as fresh cash keeps arriving and most investors leave their money in, the illusion holds.
Charles Ponzi's version claimed to profit from international reply coupons, which could be bought cheaply in one country and exchanged for postage stamps worth more in another. The idea proved unworkable in practice, and he began paying earlier investors with newer investors' money. What set him apart was publicity: his scheme was covered widely in the press both while it ran and after it collapsed, and his name stuck. Earlier examples include Adele Spitzeder in Germany from 1869 to 1872 and Sarah Howe's 'Ladies' Deposit' in 1880s America, which promised women 8 per cent interest a month.
Every Ponzi scheme has the same weakness. It needs a constant inflow of new money, so it breaks when recruitment slows or when many investors want their money back at once, much like a run on a bank. Market shocks often trigger that rush, as happened to Bernard Madoff's fraud during the 2008 financial crisis. Operators try to delay withdrawals by offering even higher returns for staying in, and by paying the few who ask promptly, to look solid.
US regulators list recurring warning signs: returns that are high with little risk, returns that are suspiciously steady whatever the market does, unregistered investments and sellers, strategies too secret or complex to explain, and difficulty getting money out. The economist Robert Shiller has described ordinary market bubbles as 'naturally occurring' Ponzi schemes, driven by each buyer's expectations feeding the next, with no single fraudster at the centre.
Source: Wikipedia — Ponzi scheme · Text summarised from Wikipedia (CC BY-SA 4.0)
