“I can calculate the motion of heavenly bodies, but not the madness of people.” ——Isaac Newton

Primer

In the last two articles, we described a new model based on the Extended Order and Ponzi structure from both a macro perspective and a micro perspective. We analyzed the model’s effect in the global capital markets and its inherent logic of capital. Looking through the analytical lens of the Extended Order, we discovered a new perspective to review the various cases of Ponzi structure. Here we aim to use two classical and widely known cases of Ponzi structure to seek revelations from this novel analytical structure.

We would first like to differentiate bubble and scam. To many people, bubbles and scams possess substantial appeals, at the same time, they are likely to cause monetary losses for the participants. Therefore, people treat them as the same thing and shun any discussions of them. For us, the two hold quite different meanings. The result of a scam is the eventual disappearance of the Extended Order, whereas the Extended Order for a bubble, no matter how overvalued, will not disappear, but display cyclical boom and bust. Through the two examples below, we will clearly demonstrate the distinctions.

Case one: South Sea Bubble

Background Introduction

Prior to the 17th century, capital extended through lending. Due to the inability of lenders to share the substantial profits from successful ventures, while having to bear the risk of losing the principal on the loan, lenders are very cautious about lending to others, asking for substantial collaterals, either in property or in reputation. On the other hand, although borrowers may claim extreme wealth thanks to their foresights and bravery, more likely than not they would lose the ability to pay back the loan and thus losing the collaterals and became indebted for a significant period of their lives.

The emergence of global sea commerce brought about opportunities to acquire unimaginable wealth while bearing unascertainable risks. This change induced people to construct a limited responsibility firm that is based on equity shareholding. Dutch East India Company issued the first stock offering in the year 1602. Upon this innovation, people realized the tremendous demand for equity shares and the problems this novel financing method might address. Under this historical context, the South Sea Company was born.

South Sea Company was formed during the War of the Spanish Succession in 1711. On a surface, it was the designated company to carry out commerce and trade between England and the Americas. In reality, it was a private institution helping the English government finance the debts incurred for the war effort. South Sea Company was generally regarded as a promising investment by exaggerating its business prospect and conducting frauds. In 1720, Sea South Company successfully bribed the government into permitting the exchange of sovereign loan with South Seas stock, which led to the euphoric demand for South Sea stock. Stock price rose from 120 British pounds in the beginning of 1720 to around 1,000 British pounds in July the same year. Everyone was speculating on the stock.

Due to the success of the South Sea Company, many “bubble companies” came into the market in an attempt to profit on the massive speculation triggered by the phenomenal rise of South Sea Company stock price. In order to regulate the rampant fraud incurred by these illegal companies, the Congress passed the “Bubble Act”, which pushed down the speculative fever but also caused the South Sea Company stock price to slide all the way to under 190 British pound in September, which led to significant losses for the public, which included the famous physicist Sir Isaac Newton.

Staged Analysis

South Sea Bubble is the first instance of a secondary market stock bubble. The extended layer the bubble resided at the constructed extended layer which clearly possesses the characteristic of cash exchange at market price. Through the following diagrams, we will examine in detail the process of bubble formation and rupture. The time line is segregated into four different stages:

The 8-year period from 1711 to 1719 was the value discovery stage

The 9-month period from the end of 1719 to July of 1720 was the extended stage

The 5-month period from July to December of 1720 was the collapse stage

The century since December of 1720 was the value recovery period

Value discovery stage: from company formation to 1719. Initial accumulation of potential value took place in this stage, accompanied by the gradual discovery and creation of value. Capital in this stage primarily seeks support from the basis layer.

During the South Sea Bubble, the initial value came from two sources. When South Sea Company was first founded, it subscribed to English government debt in the amount of 10 million pound. In the meantime, the English government allowed the exchange between government debt and South Sea Company stock. Through these acts, the English government promised 6% interest on national debt and an extra annual income of 8,000 pound, which would be paid by taxes on various commodities and other government incomes. This was the first source of value. The second source of value was the slave trade business right with Spanish America.

Value continuously accumulated during this period. People also saw the flexibility of joint stock corporation as an investment. In comparison to investment in merchandises, investment in joint stock corporations can propagate all kinds of timely information because the corporation is always changing and adapting, and so it is more encouraging for people to take action. The potential for all kinds of information to be likely true also caused rumours and lies to breed and gave rise to significant future uncertainty in the mind of the participants. However, this model no longer had the rigid redemption requirement of debt extended layer, instead it had become a promise about value and confidence about the promise. In this period, the main source of value of the company’s stock came from the English government — its reputation had significant influence. Another source of value was the attitude of Spain on slave trade monopoly.

We believe price was illustrated through the synthesis of the respective aspects of value, promise and expectation. In the initial stage, the promises represented a significant portion of the initial value, not the expectations. Consequently, prices during this period fluctuated within reasonable bounds and didn’t deviate significantly from the underlying value.

Extension stage: During the time from the end of 1719 to the height in July of 1720, value that arose from the initial accumulation had continuously extended through a stimulative feedback mechanism. Along this course, new capital would be attracted by the emerging value, simultaneously, the feedback mechanism would induce skeptical capital to seek value support from sources that they approved of (usually from news or price actions); once such support was found, the skeptical capital would become the driving force of the next wave of stimulation, pushing the structure outward. This process would spiral upwards and repeat itself until there was not enough value support to sustain further extension.

Let us observe the stimulative feedbacks during the South Sea bubble. There were primarily two kinds, the first kind was good public news, the other was the behavior of the mass. During this period, good public news was abundant (both fake and real):

On June 2nd, House of Common passed the proposal of South Sea Company, which put forward a national debt purchase plan that exceeded the proposal put forward by the Bank of England by 2 million pounds — On June 4th, South Sea Company stock price went from £138 on 3rd to £155 (completed a simple stimulative feedback).

In March, South Sea Company’s proposal was gaining ground in the Senate and was eventually passed on April 7th. — Between March 18th and 23rd, stock price rose from £198.5 to £350.

Unreliable rumors, including news that Mexican and South American were very eager to trade gold and jewelry for wool and wool clothing. England and Spain resigned a contract allowing South Sea Company to conduct free trade with all Spanish colonies. Gold and silver mines were newly excavated in Chile, supplying significant quantity of newly found rare minerals to England. In a short instance, silver became as abundant as iron in England. Furthermore, Spain gave up the use of four ports along Chile and Peru to the South Sea Company.

Another aspect was behavioral, and that was reflected in price being a positive feedback behavior (Refer to Soros’ reflexivity and secondary chaos system for further theoretical discussion on behavior itself as feedback). On top of this, there were multiple stock offering plans; every sell-out of stock offering sent a strong positive feedback signal to participants, raising people’s expectation of the pricing reaching an unprecedented new height.

On April 14th, South Sea Company introduced the first cash subscription. 22,500 shares were offered at £300 per share, 1/5 of the share price was paid in cash, the rest were paid twice a month, in a total of 8 installments.

On April 29th, 15,000 shares were issued at a per share price of £400.

On June 17th, new shares were offered at £750.

During this time, the price went up almost in a straight line, hidden beneath this rise was the different growth rates of the value layer and the expected bubble layer. This widening gap due to positive feedback from price actions propelled price to grow almost exponentially, leading to the result that South Sea stock price was pushed by the participation of the entire country to a height near £1000 in July.

In summary, during this stage, after an initial accumulation, there would emerge a voluntary stimulative feedback mechanism that would induce all participants to have a much stronger reaction to feedback than the ordinary reactions, with the feedback itself as the starting point for the next stimulation, thus forming a positive feedback loop. This enabled price to reach an unimaginable height in a very short time. The stimulation in this process may not be associated with actual value. As we have seen, many feedbacks were the results of people selectively seeing what they would like to see as the fundamental reason for their action.

Collapse stage: From July 1720 to December, after the stimulative feedback mechanism propelled the capital structure to extend to its extreme, there would be capital that could not find enough feedback signal to support its expectation of the price. During the extension stage, negative feedback was generally covered by the next stronger positive feedback, but during collapse stage, these negative feedbacks would accumulate and slowly overwhelm the positive feedbacks, and eventually reach a critical point where a massive negative stimulant would cause the whole structure to collapse.

The cool point for the South Sea Bubble came when the Bubble Act was passed by the Senate. The Act outlawed most other limited responsibility companies that were in the market at the time, and led to reflection of the value of equity shares by many of the participants. This process was similar to the previously described phenomenon where layers in a Ponzi structure would seek support from below. The difference is, in this case people were seeking value behind all the information and behaviors. As soon as people realized the perceived value was not as significant as expected, and available information was not as reliable, or didn’t have enough support, then people would vote via behavior — selling owned shares. This process was accompanied by panic, thus price would take a nosedive slide, whose speed would far exceed that of the initial extension.

In sum, the described constructed extended layer was birthed from value, grew into a bubble and eventually contracted back to value. The process can be seen as the extension and contraction of a simple Ponzi structure.

Return to value and its significance: Even after the burst of the bubble, South Sea Company did not cease to exist. In spite of the fact that the majority of the company stock were sold to East India Company and the Bank of England, the company still operated in slave trade until 1732. Hence the company became a asset management firm, holding a significant amount of national debt and annuity. It was not until 1855 did the company go through bankruptcy. It is apparent that although the company created such a huge bubble in 1720, it successfully pioneered a new asset management company and created actual value. The company also survived for more than a century.

Of more importance, as joint stock company became increasingly accepted, stock market was continuously extended and eventually accepted by the entire society. London stock exchange was created in 1801 before the Bubble Act was abolished. In 1825, the Bubble Act was abolished. Replacing it was the Trading Company Act of 1834, and eventually the Joint Stock Company Act of 1844.

Although the South Sea Bubble was a typical case of market disaster, especially for the leveraged participants. However, looking at the entire process of value creation to the formation of the bubble and eventually to the burst of the bubble and return to value, this rollercoaster of fortune was brought about by the decoupling attempt of a constructed extended layer. It was from this experiment that stock was born and gave us a new extended order and became a new value base.

Next, let’s look at an example of debt extended layer, or otherwise familiarly known as a Ponzi scheme.

Case Two： MMM

Below is a diagram of the MMM structure

The MMM model was simple and absolute. There were two types of participants, a help-giver who lent capital, and a help-receiver, who received the capital. The help-givers could receive a daily interest rate of 1% on the money they lent out. They could find other help-givers who were willing to retrieve the initial investment after the matching period.

This is a typical case of debt extended layer capital structure that promises rigid redemption. In other words, future expected return of participating capital was fixed. Let’s take a closer look at this model:

Value “discovery” stage: In fact, the perceived discovery of value in this case was superficial. There was no value created. Compared with the South Sea Bubble, the development horizon of Ponzi schemes such as this were very brief. There was no instance of value accumulation akin to that of the South Sea Company. Its initial stage was possibly a story about creating a financing community, such as the description below:

MMM is not a bank, MMM does not charge you, MMM is not an online business, high return investment, nor multi-level marketing plan. MMM is a mutual assistance community. MMM gives you a basic technical blueprint for you to find those who need your help, and others who will help you for free, among the millions of participants around the world.

The founder of the MMM community, Sergei Mavrodi became infamous at the beginning of the 90s. The three Mavrodi brothers co-founded MMM joint stock company in February 1994 with only registered capital of 100 thousand rubles (about $1000 USD). MMM posted advertisements on all the mainstream media in Russia, enticing investors with very high return. At the beginning of this scheme, MMM stock price was around 1000 rubles per share (about $10 USD). 4 months later, price per share had skyrocketed to 30 thousand rubles per share. Tens of thousands of Russian built up MMM’s pyramid. The operation lasted 3 years and eventually collapsed in 1997.

In this instance, the Ponzi Scheme consisted wholly of this simple model. The actual impactful stimulant was the promise of outsized return by participating in this model. Going back to our previous discussion of the differences between debt extended layer and constructed extended layer, debt extended layer was attached to the basis layer, whereas constructed extended layer required the discovery and accumulation of value on top of basis layer. Thus during the initial stage, the emergence of a debt extended layer was fundamentally an attempt to lengthen the cyclical timeline of the basis layer; while constructed extended layer has to first develop a value core that it must approve of. Without this value core as prerequisite, the layer would not be able to attract adequate capital to extend outward. In the case of MMM, it promised a ludicrous daily interest rate of 1%. Just this point alone would suffice as the initial stimulant to kickstart its extension.

Extension Stage： There is little or no information for debt extended layers. Support for the layer consisted almost entirely of behavior element. Rigid redemption behavior was the most fundamental support, that is, participating capital received the promised return — interest accumulated through a daily interest rate of 1%. A typical MMM finance community worked as such, initial pay-in could be as small as 100 rubles, and will receive a return of 130 rubles; then one can put 1000 rubles in, and receive a return of 1300, investment amount gradually became larger until one decided to only retrieve some of the principal plus interest or even not at all to compound interest.

Evidently, this model would start as an experiment by the speculator with a small sum of money. The goal of this initial outlay was to experiment and obtain an initial feedback. If this feedback was positive, then it could induce a bigger investment and pave the way for another positive feedback, and so forth. As the number of positive feedbacks grew, the speculator would require less and less positive feedback in order to make an equal investment. At the beginning, he might need to retrieve both principal and interest to feel like a satisfactory feedback. After the initial feedback, he might only need 50% of the principal and interest to test whether the system would be affective, after which he might only need to extract interest as positive feedback. While the demand for feedback decreases, the speculator’s investment has not decreased and may even increase, setting the ground for the eventual collapse. At the beginning, the speed of capital influx was much faster than capital outflow, convincing people of the effectiveness of the method, at least temporarily. However, the rate of increase for the outflow would eventually undertake that of the inflow and will reach a certain point where the inflow can no longer cover the outflow. This turning point will inevitably be reached because the model itself does not provide any useful value creation, it is simply transferring capital across cycles.

At its height, MMM finance community had millions of members, with capital over tens of billions of dollars. It operated in China for over 200 days, and created at least ¥20 billion interest according to a daily interest of ¥1 billion. In April 2015, MMM entered China and extended for 8 months before it eventually collapsed in December 2015.

Collapse Stage: The collapse of Ponzi scheme usually started with the breakdown of rigid redemption. When an investor no longer receives positive feedback such as the collection of expected interest, since there is very little information other than the direct feedback behavior for support, it would become very difficult for the investor to rely on other accepted rationales for support. Moreover, negative feedback from a behavior angle is never an individual case, but would happen in tandem with negative feedbacks to other investors as well. Because once someone could not retrieve capital, that means the capital pool is dried up and other people would also be unable to retrieve their invested capital. There is no possible way for an attempt at decoupling to be successful. At this stage, the structure can only collapse in a short order. Yet even during this process, there could still be some capital inflow, but they would be quickly digested by the overwhelming demand for rigid redemption.

In December 2015, there were significant concerns regarding the inability to withdraw from the community. The reply was monotonously “system is upgrading” or “system is restructuring”. This kind of replies quickly fermented investors’ suspicion into distrust, magnifying the demand for rigid redemption. Meanwhile, the capital pool could never fulfill the redemption demand and eventually the whole scheme imploded. Ever since the collapse in 2016, MMM never again formed a sizeable capital pool.

Coincidentally, MMM founder passed away as we were writing this passage. MMM used this opportunity to announce that it will close down shop to put the curtain down on this Ponzi scheme.

Profit-seeker

Be it asset bubble or Ponzi scheme, among the participants, we will find a certain group who understands the mechanisms of this speculative game. However, they have a gambler’s mindset and hold the view that everything is okay so long as they could attract enough people to participate in order to protect their gains. Their goal is not to sustain the game into the long run, but to maximize their own capital and exit. These people act as accelerators in this model, which makes the model extends faster, but also collapses quicker when problems emerge.

Objectively, purely profit-seeking behaviors will intensify market fluctuations, but since such behaviors lack discretion, it is difficult for people to discern the actual value created by the project from the speculative bubble. By understanding extended order, we can treat bubble objectively, while knowing that without building an extended order, a Ponzi structure is a scam and will eventually collapse into oblivion.

Conclusion

Below are diagrams that summarized our article above:

Bubble is a unique phenomenon as constructed extended layer extends outwards to a boom period. In every cyclical rotation, there will be new value that emerges and goes into the next cycle.

Scam emerges only by the extension of a completely artificial debt extended layer, which does not add any new value after its collapse.

Bubble cycle is influenced by the booms and busts of the macro-economy. Scam does not have such characteristics.