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The Goldman U-Turn   The End of the Chaos Trade
Sep 22 2008 3:53PM EDT

Abstract of the Day, Ponzi Scheme Edition

The Optimal Design of Ponzi Schemes in Finite Economies, by Utpal Bhattacharya, in the Journal of Financial Intermediation, January 2003:

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.

Bhattacharya's proof works only where more than half the population takes part, and although the credit bubble looked very Minsky-ish, it never included the levels of outright fraud necessary for a true Ponzi scheme. Still, Bhattacharya's paper is definitely more relevant today than it was when it was first published.

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