30 November 2022

Project Syndicate's Harold James: Faking It, Making It, Losing It

The spectacular rise and fall of FTX and Sam Bankman-Fried were driven by effective marketing, trickery, and financial speculation..they bear a striking resemblance to the disastrous eighteenth-century experiment that fueled the Mississippi Company bubble .. the template for all future Ponzi schemes

The collapse of cryptocurrency exchange FTX and the mesmerizing rise and fall of its founder, Sam Bankman-Fried, is only the most recent episode encapsulating the perils of financial innovation. At this point, it should be easy for regulators, financial institutions, and investors to spot an obvious Ponzi scheme. Why, then, must we relearn a difficult lesson over and over?

Contrary to popular belief, the persistent allure of Ponzi schemes reflects not just greed and gullibility but also a simple fact: like such schemes, valuable innovations also rely on a snowball effect. FOMO, or fear of missing out, can be exploited by scammers who manipulate it for personal gain. But it also drives many beneficial advances that can work only if enough people sign on.

That is why many entrepreneurs like Bankman-Fried embrace a “fake it till you make it” philosophy. The problems often start when this approach curdles into the more insidious “fake it till you have it.” The oldest documented originator of the Ponzi scheme, who lived 200 years before the con artist who gave the fraud its name, is widely regarded as the pioneer of monetary theory.

In the early eighteenth century, the Scottish adventurer and economist John Law transformed the French financial system with a unique and ultimately catastrophic currency experiment that collapsed in an inflationary crisis in the summer of 1720. At the time, France was deeply in debt, and Law sought to stimulate the economy by replacing all metal coins with paper money.

The scarcity of gold and silver, he argued, had been the cause of France’s economic woes, and he successfully lobbied the government to demonetize them. Law’s theories found a receptive audience, partly because France’s existing financial and monetary system was inefficient, arbitrary, and unjust. He could also point to a precedent: the bold 1694 experiment whereby England transferred much of its national debt to a private company, the Bank of England, which in exchange received the right to issue bank notes.

Law believed that the English reform was less efficient than it could have been, because metal coins were still in circulation, forcing King William III’s government to undertake an expensive recoinage operation. Law viewed this continued reliance on precious metals as inconvenient and inefficient. Much like FTX, Law’s scheme was fueled by effective marketing, trickery, and financial speculation.

His first trick was to create two corporations that worked together to inflate the value of their respective offerings. In 1716, he convinced the French government to allow him to open a bank issuing paper notes that the government would accept as tax payments. Meanwhile, the silver coinage still in circulation had been depreciated.

Law then created a company with a genuine commercial purpose – developing an apparent paradise of natural resources and productivity in the New World – called the Mississippi Company. The company, which was granted a monopoly on trade with the French colonies in North America, financed its operations by issuing stock that could be purchased with paper money from Law’s bank or with state bonds. The Mississippi Company’s shares eventually became so attractive to investors that the company assumed France’s entire national debt, turning its notes into the currency of the newly productive French economy.

Three centuries later, Bankman-Fried repeated Law’s trick. He founded two companies, FTX and Alameda Research, that propped each other up, with FTX generating its own tokens (FTT) that could be used as collateral against borrowing.

But to entice investors and state authorities, Law needed a compelling narrative. He boasted that his companies had rescued or bailed out the French financial system. As its capital increased, the Mississippi Company took over rival trading outfits such as the Company of the Indies, the Company of China, and the Company of Africa. Law was thus a private lender of last resort, another feature that Bankman-Fried imitated in the summer of 2022 when he rescued struggling crypto issuers and exchanges..

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