Financial frauds-1: Introducing Charles Ponzi

Recently there have been two major fraud scandals in the US, one perpetrated by Bernard Madoff and the other by Allen Stanford, both based on so-called ‘Ponzi’ schemes. These exploded on the financial world as big surprises. But there was a similar huge scandal that took place in 2006 but since its impact was felt mostly in Spain, the media here did not give it much publicity, though doing so might have alerted people earlier as to what Madoff and Stanford were up to. Economist Michael Hudson gives the background on the Spanish fraud.

The Spanish scheme involved the trading of rare stamps by a Spanish holding company called Afinsa that bought up a New Jersey stamp auction firm and combined it with a Spanish auction firm to create Escala, the third largest auction firm in the world, after the much better known Sotheby’s and Christie’s. Their business model was to buy and sell rare stamps for dealers and collectors, making money on safeguarding and curating the stamps while also making profits on the transactions. Since the prices of rare stamps seemed to be always going up, they were able to promise and deliver to investors steady rates of return of 6% to 10%, higher than government bonds and much of the rest of the market, and thus convince investors to put money into the company.

But in May 2006, Spanish police raided the firm and on examining the books, found that the stamps they purportedly had either did not exist or were of much lower value than claimed. The firm was accused of running a pyramid or ‘Ponzi’ scheme.

So exactly what is a Ponzi scheme? Hudson recapitulates the original scheme by Charles Ponzi that has inspired a particular kind of fraud that will be forever associated with his name.

Charles Ponzi was a poor Italian immigrant who arrived in the US in 1903. His stated business model was based on what is called ‘arbitrage’. This is where a person takes advantage of a difference in the price of something in two different markets separated by either space or time, so that if one buys in one market and sells quickly in another market for the higher price, then one makes a profit, often without the nuisance of even having to take possession of the item being bought and sold. (True arbitrage, where the buying and selling is done simultaneously in two different places, is only possible in modern times and with deals that can be transacted electronically, such as securities and currencies and other similar financial products.)

People do this with foreign currency trading if they can predict which way the value of a currency will go. Suppose that at some time a US dollar and a British pound are at parity, meaning that they have equal value. You could buy a dollar with one pound and if the pound later depreciates so that it now trades at two pounds to one dollar, then the dollar that your original pound bought can now be used to buy back two pounds, giving you a 100% profit.

The financier George Soros is supposed to have hugely increased his fortune by betting that the value of the British pound would go down. He sold so many pounds for other currencies that the market was actually influenced by his actions, with other traders thinking that he was betting on something that would actually happen and they also started selling their pounds, causing a run on the currency and driving down its price, and creating a self-fulfilling prophecy.

The catch with this kind of trading is that the differences in trading values in the two markets are usually very small, especially over short time periods and, because of fees and other costs, ordinary people cannot make money from it. One has to be a trader oneself and thus avoid the commissions or have a lot of money to invest in order to make money. But a hundred years ago in Ponzi’s time, there existed something called postal coupons that enabled an investor to make money on what seemed like a sure thing.

Postal coupons are no more (I think) but they were common when I was a student and were essential back in the days when buying and selling foreign currencies was not easy or if you lived, like me, in a country that did not allow you to convert your local currency into foreign ones.

The problem the coupons solved was this. Suppose that you needed someone in another country to mail something to you but you had to pay the cost of postage. One way was to send money to the recipient to cover the cost of stamps. But this meant that either you or the recipient had to convert your local currency into the foreign one, which could be a nuisance or even, as it was in my case in Sri Lanka, impossible except in the black market.

Postal coupons were created to solve this problem. You could legally buy such coupons in your own country in your own currency but in the denomination of the foreign currency to cover the cost of stamps in the other country, and then mail the coupons. The recipient could exchange the coupons in their post office for stamps and mail your package to you.

What Ponzi did was take advantage of the fact that the exchange rate at which postal coupons were valued badly lagged behind the exchange rates of currencies, enabling him to take advantage of the difference.

Next: How Ponzi’s original scheme worked.

POST SCRIPT: Why not calculate the budget on an abacus?

Why is it that members of Congress, during their debates, still prepare large posterboard charts that are then mounted on hard backing and placed on easels? Do they think they are still in middle school? Haven’t they heard that there are things called computers? Projection systems? PowerPoint? Is there some arcane rule that says that Congressional aides must waste their time producing huge charts that might have just one word or one number? The members of Congress using this seem to think that this produces some kind of dramatic effect when all that it indicates is the sense that the speaker is out of touch.

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Religious dogmatism

The Catholic Church, like other rigid religious belief structures such as Orthodox Islam and Judaism or fundamentalist Christianity, does not hesitate to draw lines in the sand, to state clearly what is allowed and what is not, and then follow that policy wherever it leads, even if it leads over a cliff. In the face of derision they are willing to hold on to their position for decades, even centuries, before quietly conceding that they were wrong.

For example, when they decided that Church doctrine required the belief that the Sun orbited the Earth, they pulled out all the stops to force people to oppose the Copernican model, in 1616 banning the teaching of the heliocentric model and in 1633 putting Galileo under house arrest and forcing him to recant his view under threat of torture by the Inquisition.

Of course, that didn’t work, with even Catholics rejecting that absurd policy. The church quietly reversed that position only hundreds of years later, in 1992 when Pope John Paul II lifted its edict of Inquisition against Galileo. But the Pope then went on to claim that Galileo may have been divinely inspired, saying: “Galileo sensed in his scientific research the presence of the Creator who, stirring in the depths of his spirit, stimulated him, anticipating and assisting his intuitions.” This was a rather pathetic effort to recover some dignity from an embarrassing debacle for religion.
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God save us from the Queen

One of the things about America that most endeared it to me when I first arrived for graduate studies was the lack of stuffiness in personal and business relationships. There was an easy informality, casual yet respectful, friendly yet polite, that I liked and found easy to get used to. I put this down to the American revolution, that decided that along with getting rid of direct rule by the English king, they also decided to get rid of all the pomp that went along with the English court. It seemed to reflect a sturdy democratic and republican (small ‘d’ and small ‘r’) spirit.
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The stem cell issue-2: The ethics

Yesterday, I discussed the science involved in stem cell research. Today I want to discuss the ethics.

The ethical problems associated with stem cell research occur because although the fertilized eggs were not created for the purposes of research but to help infertile couples, since the method of in vitro fertilization for the treatment of infertility has not been perfected, more fertilized eggs are created than can be used to actually generate pregnancies, and the question of what to do with these extra frozen stored embryos is problematic.
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The stem cell issue-1: The science

The decision by the Obama administration to reverse the Bush-era policy of banning the use of federal funds for stem cell research has created some controversy. The earlier policy had led to some frustration in the scientific community.

Bush’s policy was intended to be a compromise: it banned the use of federal funds for the creation of new embryonic stem-cell lines while allowing scientists to study 21 lines that had already been created. But researchers say those lines aren’t diverse enough and they have been eager to study hundreds of other lines, some of which contain specific genetic mutations for diseases like Parkinson’s. There have been practical challenges as well. The restrictions forced scientists to use different lab equipment for privately funded and government-funded research; some even built entirely separate lab space. One of the most disconcerting aspects, researchers say, has been the negative effect on collaboration, a hallmark of the scientific process. Researchers supported by private money haven’t been able to team up with scientists funded by the government, potentially holding back new insights and advances.

Stem cells are those that have three properties. Unlike most cells like muscle or blood or nerve cells, 91) they are capable of replicating themselves for a long period (making them a valuable source to regenerate the body by replacing cells that die), (2) they are unspecialized, and (3) when they reproduce they can produce either more stem cells or become specialized cells like muscle or nerve or bone (a process known as differentiation). The National Institutes of health has an informative FAQ page on this topic.

The two main kinds of stem cells are the embryonic ones and the non-embryonic ones. The embryonic ones can proliferate for a year or more in the laboratory without differentiating while the non-embryonic ones cannot do so for very long, but the reasons for this difference are not known as yet. The embryonic stem cells are capable of eventually differentiating into any type of specialized cell, and are called pluripotent. Such pluripotent cells are valuable because they can be used to repair tissue in any part of the body as needed. But eventually they need to differentiate into specialized cells in order to perform the functions that those specialized cells carry out in the body. The process by which stem cells differentiate is still not fully understood, but part of it involves interaction with the external environment in which the stem cell finds itself.

Adult stem cells are one form of non-embryonic cells and are found amongst the differentiated cells that make up the tissues of the body, such as the brain and heart and bone marrow, and they are the cells that are used to maintain and repair those tissues by differentiating when needed to produce new tissues. Some adult stem cells seem to have the capacity to differentiate into more than one type of specialized cell though the range is limited, unlike in the case of embryonic stem cells. Such cells are called multipotent.

For example, some multipotent stem cells found in the bone marrow can generate bone, cartilage, fat, and connective tissue. Stem cells taken from umbilical cord blood and the placenta seem to also have multipotent properties and thus in the future it may become routine that a stock of umbilical or placental cells will be taken after every birth and preserved for possible future use. Adult stem cells have some uses but working with them is much more difficult since they are harder to obtain and are less flexible.

To understand the ethical issues involved in using embryonic stem cells, one should be aware that creating embryonic stem cell lines for research requires extraction of cells from the blastocyst. This is the stage reached by a fertilized egg after about three to five days when, after repeated cell division and duplication, there are about 70-100 identical cells in the shape of a hollow ball containing an inner clump of cells. The inner clump becomes the embryo and the outer hollow ball becomes the placenta. When this occurs in the uterus, this stage is reached before this collection of cells gets implanted in the uterus wall. Sometimes implantation does not occur, in which case the pregnancy is spontaneously terminated.

This video explains what stem cells are and how they work.

The embryos from which embryonic stem cells are taken are produced during treatment for infertility when a woman’s egg is taken from her body and fertilized and grown to blastocyst stage in a culture outside the woman’s body. In the very early days after the egg is fertilized and the cell starts splitting and reproducing itself, all the cells are identical. Embryonic stem cells are obtained from that inner clump of cells and thus the blastocyst has to be destroyed in the process. The cells from a single blastocyst can be used to generate millions of embryonic stem cells that can be divided among researchers, and these are the stem cell ‘lines’ that are referred to. The cells in a single line are all genetically identical.

While there are promising new ways of creating embryonic stem cells using adult skin cells (called induced pluripotent stem cells), they have their own ethical issues.

Since tissues created from a person’s stem cells have the same genetic information as the host, the host body will not reject the implanted tissues as a foreign body, thus overcoming one of the biggest hurdles in organ transplants. While the possibility of growing tissues and entire organs for transplant purposes is often publicized as the biggest potential benefit of using stem cells, there are other more immediately realizable potential uses for embryonic stem cells.

One is that it enables the process by which cells differentiate into their specialized forms to be studied. Another is that by creating cells that have a particular disease, say Parkinson’s or Lou Gehrig’s, one can observe under a microscope even the earliest stages of the progression of the disease and thus hope to develop better treatments. Another use is to test the effects of drugs on cells before testing them on a real person. That would enable you to see if they are toxic to a particular individual, creating a level of personalized medicine that we do not currently have.

The potential benefits of embryonic stem cells in research are clear, even though it is very early days yet and there is still a long way to go before we can hope to even begin realizing those benefits. The key question is how to balance the ethical concerns involved in using such cells with the benefits.

This question will be examined in the next post.

POST SCRIPT: The Daily Show on stem cells

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Are religious people reliable allies on the environment?

Evolutionary biologist E. O. Wilson gave Case Western Reserve University’s annual Distinguished Lecture on March 3, 2009 in Severance Hall, the magnificent building where the equally magnificent Cleveland Orchestra plays, was packed for the occasion. It seemed to underscore the community’s support for, at least interest in, the theory of evolution.
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The colonial experience-8: The rise of nationalist feeling

(For previous posts in this series, see here.)

While colonial powers needed to create an educated, elite class to act as surrogates for them and help them rule the country, providing access to that education created its own problems. While some in the educated elite were happy to play the role of junior partner to the colonialists and enjoy the rewards, others became, as a result of this western education, more aware of the political currents that were sweeping the world as a result of the Russian and Chinese revolutions, and the rise of anti-colonialist nationalistic sentiment following World War II.

These people returned from their education abroad to organize trade unions, form political parties, and agitate for independence. Ho Chi Minh in Vietnam returned from France to lead that country’s liberation struggle against the French. English-educated Jawaharlal Nehru and Mahatma Gandhi led similar struggles in India, and Sri Lanka had its own counterparts. All these leaders tended to have socialist leanings, having visions of creating a society that was just and egalitarian and non-racial.

But as we have sadly seen, the centrifugal forces that were unleashed by the divide-and-rule policies in the colonies based on long-standing inter-tribal suspicions were too strong to be overcome and almost all countries succumbed to ethnic clashes following independence. Those leaders in the fight for independence who were non-racial were often swept aside by pandering politicians only too eager to use ethnicity as a wedge to inflame passions and ride to power on racial issues. As a result, India has seen terrible Hindu-Muslim-Sikh violence, Sri Lanka has similar conflicts between Sinhala and Tamil people, and the ethnic violence in African countries are too many and well-known to list.

As a result of these problems exacerbated by the colonial powers, many countries descended into authoritarian rule with ruthless dictators, the worst examples being Mobutu Sese Seko in what was then called Zaire and is now called the Democratic Republic of Congo, Idi Amin in Uganda, and Robert Mugabe in Zimbabwe. These tragic post-independence developments enabled colonial powers like the British to smugly claim that they were the ones who kept the peace between the warring groups, and that thus their presence was beneficial, when in reality, they were the ones who helped fan the existing tensions and suspicions into flames. While the post-independence political leaders of those countries share a huge amount of blame for the degeneration of their countries, the colonists also have blood on their hands.

One bright spot in Africa was Tanzania under its founding president Julius Nyrere. An interesting intermediate case in Asia is Singapore, where an authoritarian leader Lee Kuan Yew kept a tight lid on ethnic divisions and successfully led a program of modernization and industrialization that has made that small country a world leader in commerce and resulted in Singapore having one of the highest standards of living in the world.

So coming back to Jared’s original question about how it could be that he, the only non-Indian in a class that dealt with British colonialism in India, could see the negative aspects of it, it comes down to the depth of one’s understanding of the political history of the colonized countries. Attitudes amongst the people of the former colonies towards the colonial experience depends on, I think, the politics and background of the family from which the person comes.

Most of the students who come to the US are probably like me, the products of a relatively small, urban, English-educated elite, and thus come from the group favored by the colonial powers. There is absolutely no doubt that having the benefit of an English education has opened our minds to a world of knowledge and enabled us to go abroad and experience much more than we would have otherwise. Knowledge of the English language and its associated literature has enabled us to more easily absorb western culture and science, which are both dominant in the world today. There is no question that this particular legacy of the colonial experience has been good for us personally.

Making broad generalizations, those who left the colonial country because of the turmoil that followed independence, tend to think of the pre-independence colonial times as one of peace and prosperity, at least for the urban elite to which they belonged. This is especially likely in the case of ethnic and religious minorities who bore the brunt of the post-independence backlash by the marginalized majority against those whom they perceived as unfair beneficiaries of colonial largesse.

Against that group are those who grew up in households or communities that were more politically aware at a deeper level. I have said that my grandfather’s view of British colonial rule was positive, although he knew that they considered brown-skinned people like him as ultimately inferior. They were sufficiently nice to him and rewarding of his services that overall he thought they treated him well, and that he fared better than he would have at the hands of the majority community.

My father, on the other hand, lived during the time of transition to post-colonial rule, with almost exactly half his life growing up in a British colony and the second half in an independent state. So he grew up with all the privileges of being English educated but at a time when anti-imperialist sentiment was strong and nationalist fervor was high, especially in the universities and amongst what used to be referred to as the intelligentsia. He belonged to both and his political leanings were influenced by that experience. So he did understand the negative aspects of colonial rule while at the same time being a beneficiary of it.

The next generation, mine, is entirely post-colonial and where we stand in relation to our colonial past is also mixed. The more politically aware can see both the long-term benefits as well as the damage that colonialism has done, and we are ambivalent towards it. Others who do not go into it as deeply may have a rather one-sided view depending on their own personal situation and how colonialism affected their own lives. Those who come from families that benefited, the urban English educated class, see it as mostly a good thing while the rest may see it as largely negative.

This series had its genesis the attempt to explain to Jared why it was that the Indian students in his colonialism class seemed to have a positive view of that experience. I suspect that most émigrés are those from the English-educated urban classes, since they are the ones who have access to the means for going abroad and they, I suspect, are the ones who dominated Jared’s class. So this post ends my long-winded answer to his question.

POST SCRIPT: Interesting talk today

Jeff Hawkins will be speaking today (Tuesday, March 31, 2009 from 4:30-5:30) on the topic On Intelligence: What Intelligent Machines Can Learn From the Human Neocortex.
Hawkins is co-founder of two computer companies, Palm and Handspring, and is the architect of many computing products such as the PalmPilot and Treo smartphone, and the author of the book On Intelligence (2004).

The talk will be given in the Wolstein Auditorium on Cornell Road on the campus of Case Western Reserve University. For more details, see here.

Road rants

It is time for another edition of Road Rants where, after going on a road trip where I have time to think of these things, I note the driving practices I see that annoy me and make suggestions for improvement. The previous rants were here, here, and here.

Turning on lights

On the highway several times I came across a sign saying that there was construction ahead and to turn on the headlights. In each case there were about six or seven cars ahead of me, not one of whom bothered to turn on their lights. On the other hand, when there was a sign saying that we were about to enter a tunnel and to turn on the lights, everyone did so, though some only after entering the tunnel.
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The colonial experience-7: Majority-Minority divisions

(For previous posts in this series, see here.)

One of the most depressing features of so many countries that gained independence in the post-colonial age that began with the end of World War II is the inter-ethnic tensions, discrimination, and violence that often occurred.

It must be made clear that tensions between the different ethnic communities were not created by the colonists out of nothing. It is not the case that the different ethnic groups had been living in a harmonious paradise before the arrival of the colonists. The tribal instincts and in-group/out-group thinking that are the bane of existence and the cause of so much violence and hatred all over the world existed long before the appearance of the modern nation state. What the colonial powers did was to take those existing suspicions and animosities and use them as important elements in their divide and rule strategy, thus perpetuating and aggravating them.

The British have a history of using a minority community’s latent suspicions of the majority to woo them as allies against the majority, thus preventing any unified action against the British. They did this in ways large and small. One way they did this in Sri Lanka was to give excessive patronage rewards to the minority Tamil community. For example, the minority Tamil community was far more welcoming concerning the opening of missionary schools and churches, and as a result they ended up learning English in greater numbers and occupying the elite professions and the higher ranks of the administrative and commercial sectors in numbers that far exceeded their proportion in the population.

This had a two-fold benefit for the British. It created a spiral of behavior in which the minority communities felt more grateful to the British and tended to look to them as their protectors from the majority community and to be more ingratiating towards them, and it shifted the resentment of the majority community away from the British and towards the minority, thinking of them as somehow conniving with the British to obtain greater rewards at their expense. As a result of these and similar policies in other colonial countries, the minority communities were the ones most fearful of what would happen to them at the hands of the majority once the colonial power left. After a country gained independence, the lid came off the simmering conflict and often escalated into open-warfare. The roots of the twenty-five year long civil war that has gone on in Sri Lanka, and the insurrection that took place against the government in the 1970s and 1980s, can all be traced to these policies of the British.

Similarly, the Belgians in collusion with the Roman Catholic Church deliberately set about magnifying the extremely minor distinctions between Hutus and Tutsis in Rwanda and favoring the minority Tutsis, thus setting in motion the train of events that led to the horrendous genocide of 1994 in which over 800,000 mostly Tutsis were killed in the space of a few months at the hands of their Hutu neighbors.

One sees this pattern repeated in almost all the former colonies. In fact, it is hard to find a post-colonial country that has not had such problems. Especially in Africa, the colonial powers often created countries that had not existed as single entities before. But rather than drawing boundaries that separated nations according to traditional ethnic boundaries and thus ensuring relatively homogeneous populations, they would draw lines that divided ethnic communities and forced them into political unions with other communities with whom they had traditional animosities. As a result, we have so many brutal ethnic conflicts going on in so many countries. This was a heinous crime committed by colonial powers that is impossible to excuse.

But the British in Sri Lanka also created divisions in other seemingly minor ways. For example, the social clubs that people join and spend evenings with their friends and families are an English institution. They created such clubs in Sri Lanka too, and which had sports teams that competed with each other, and some of these clubs had explicitly ethnic affiliations with names that reflected them: Sinhalese Sports Club, Tamil Union, the Moors (Muslims) Sports Club, and the Burgher Recreation Club (the Burghers were those people whose ancestry included some Portugese, Dutch, or British). The British had their own exclusive clubs, open to whites only.

It seems incredible to me now that Sri Lankans should have tolerated such blatantly ethnicity-based social clubs for so long, even after independence, and taken them for granted. Although the clubs now have memberships that are open to all ethnicities, the very names are offensive. But they still exist and indicate that abhorrence to tribal sentiment and allegiance is not anywhere near as widespread and as strong as it should be.

POST SCRIPT: Americans are willing to pay more in taxes to improve infrastructure

It has long been treated as an article of faith that Americans hate raising taxes for whatever reason. But Republican pollster Frank Luntz finds that this is not true.

Consider this: A near unanimous 94% of Americans are concerned about our nation’s infrastructure. And this concern cuts across all regions of the country and across urban, suburban and rural communities.

Fully 84% of the public wants more money spent by the federal government — and 83% wants more spent by state governments — to improve America’s infrastructure. And here’s the kicker: 81% of Americans are personally prepared to pay 1% more in taxes for the cause. It’s not uncommon for people to say they’d pay more to get more, but when you ask them to respond to a specific amount, support evaporates. (That 74% of normally stingy Republicans are on board for the tax increase is, to me, the most significant finding in the survey.)

The Nigerian 419 scam goes meta

Is there anyone by now who has not heard of the ‘Nigerian 419’ scam or been approached by the people behind it? Hardly a week goes by that I do not receive several of these things in my email (sometimes several in one day). Word must have spread in the confidence trickster world that I look like a real sucker because I used to get these solicitations long before they became well-known as a fraud. Even before the internet I used to regularly get actual letters. But despite their notoriety, even now it appears that there are still people falling for it. In the US alone, it is estimated that about $200 million is conned per year.
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