Chain letters, pyramid schemes, Ponzi finance, manias, and bubbles

Chain letters, bubbles, pyramid schemes, Ponzi finance, and manias are
somewhat overlapping terms. The generic term is nonsustainable patterns
of financial behavior, in that asset prices today are not consistent with
asset prices at distant future dates. The Ponzi schemes generally involve
promises to pay an interest rate of 30 or 40 or 50 percent a month; the
entrepreneurs that develop these schemes always claim they have discov-
ered a new secret formula so they can earn these high rates of return.
They make the promised interest payments for the first few months with
the money received from their new customers attracted by the promised
high rates of return. But by the fourth or fifth month the money received
from these new customers is less than the monies promised the first sets
of customers and the entrepreneurs go to Brazil or jail or both.
A chain letter is a particular form of pyramid arrangement; the proce-
dure is that individuals receive a letter asking them to send $1 (or $10 or
$100) to the name at the top of the pyramid and to send the same letter to
five friends or acquaintances within five days; the promise is that within
thirty days you will receive $64 for each $1 ‘investment.’
Pyramid arrangements often involve sharing of commission incomes
from the sale of securities or cosmetics or food supplements by those who
actually make the sales to those who have recruited them to become sales
personnel.
The bubble involves the purchase of an asset, usually real estate or
a security, not because of the rate of return on the investment but in

anticipation that the asset or security can be sold to someone else at an

even higher price; the term ‘the greater fool’ has been used to suggest

the last buyer was always counting on finding someone else to whom the

stock or the condo apartment or the baseball cards could be sold.

The term mania describes the frenzied pattern of purchases, often an

increase in prices accompanied by an increase in trading volumes; indi-

viduals are eager to buy before the prices increase further. The term bub-

ble suggests that when the prices stop increasing, they are likely—indeed

almost certain—to decline.

Chain letters and pyramid schemes rarely have macroeconomic conse-

quences, but rather involve isolated segments of the economy and involve

the redistribution of income from the late-comers to those who were in

early. Asset price bubbles have often been associated with economic eu-

phoria and increases in both business and household spending because

the futures are so much brighter, at least until the bubble pops.

Virtually every mania is associated with a robust economic expansion,

but only a few economic expansions are associated with a mania. Still

the association between manias and economic expansions is sufficiently

frequent and sufficiently uniform to merit renewed study.

Some economists have contested the view that the use of the term

bubble is appropriate because it suggests irrational behavior that is highly

unlikely or implausible; instead they seek to explain the rapid increase

in real estate prices or stock prices in terms that are consistent with

changes in the economic fundamentals. Thus the surge in the prices of

NASDAQ stocks in the 1990s occurred because investors sought to buy

shares in firms that would repeat the spectacular successes of Microsoft,

Intel, Cisco, Dell, and Amgen.