Several weeks ago, Bernard Madoff became the forerunner of a rash of people joining the ranks following the financial equivalent of “The Fonz” – hitting jukeboxes for new songs, and paying returns to oldies played before. Madoff, the latest “Ponz,” is accused of having “made off” with nearly $50 billion of his investors’ money. The dust still hasn’t settled as to whether Madoff planned the scam from the outset or started, like Charles Ponzi himself, in a legal activity that got a little out of hand. No matter how it started or how you spin its conclusion, this was very bad business of the most grandiose variety, and it has the whole world talking about Ponzi schemes.  What is surprising, however, is that although Ponzi and his newest disciple clearly ran illegal and fraudulent operations, not all so-called Ponzi schemes are necessarily illegal.

First, a bit of history. Charles Ponzi, the eponymous financier, operated a firm trading International Reply Coupons (IRCs) just after World War I, when the price of stamps in the US was higher than the price of an IRC in Italy. Trading from one country to another, Ponzi could pull in quite a profit. When the operation grew in size, and he could no longer make fast enough turnover to pay interest to investors, he used new money from investors to make up the difference. Ponzi continued this way, collecting new money for old investors, until 1920 when it was realized there were not enough IRCs in circulation to be traded with all of Ponzi’s investors’ money.

In the end, Ponzi schemes are generally foiled in one of two ways: a) the money stream stops and the investors aren’t paid; or b) a pesky auditor checks the books and sees the discrepancy. Madoff transcended both. In his case, there were several opportunities to check the books, but when a man can insure his investors a positive return year after year, despite the ups and downs of the economy, who wants to look too close? Ignorance is bliss, especially when it pays. But with markets falling, Madoff’s investors – many of them charity organizations – would want their money returned. Overcome with guilt and frightened by possible collapse, he had no choice but to turn his investors out, and himself in.

Not all Ponzi schemes however, are illegal, fraudulent, or all that rare. Most professors of Economics, new and old, would define a Ponzi game as one in which an individual or firm pays some parties by borrowing from others. They also generally agree that a Ponzi scheme can be a reasonably rational course for such an individual or firm to take. Imagine, for instance, a fanciful situation in which the United States is experiencing an interest rate lower than the growth rate and a positive debt (the latter easily fulfilled, the former not so much).   New debt can be issued, faster than interest, to make interest payments, save, or make transfers. All of this would be completely rational from a strictly financial angle.

Though it is mostly unknown to us, universities similar to Wesleyan often make use of a legal, Ponzi-like scheme in the process of receiving government research grants. Most US Government research grants have a special category of funds for “Indirect Costs”, which the AAMC defines as those “institutional administrative and infrastructure costs that benefit and support research.” With this promised money, a university can float new bonds for down payments on new facilities or faculty, thus making them eligible for more Government grants. As long as more facilities increase the anticipation of new grants, a university can continue leveraging the funds. If Wesleyan does not already use such a tool, perhaps we might think about it.

Of course, there is always the possibility that if even for a short period of time Wesleyan stopped receiving new grants or was unable to increase its revenue, the whole process would come tumbling down. If Wesleyan made it work, Davenport might not be the only place on campus getting a face-lift.