Last week, more than 20 people were arrested in China over a $7.6 billion Ponzi scheme involving a peer-to-peer (P2P) lender called Ezubao.

According to a report in the Financial Times, Ezubao had 900,000 investors, utterly dwarfing Bernard Madoff’s mere 13,500.

As this latest example goes to show, we need to be extremely careful when faced with enticing sales pitches for new income opportunities. Unfortunately, it’s damnably difficult to tell whether something unconventional is a Ponzi scheme.

Worst of all, they may be getting more common.

The Economy, Ponzified

Back in 1920, when the country was still on the gold standard, Charles Ponzi had to offer 50% a month to get people buying. His scheme involved arbitrage between international postal rates that had become possible after World War I’s disruptions.

In the years to 2008, Bernie Madoff found he could attract billions by offering only 12%.

And in China this year, Ezubao offered investors just 1.2% per month, in an environment where interest rates are still much higher than in the United States.

That’s a return Ezubao could almost certainly have made through legitimate lending. Yet Ezubao’s risk controller told the Xinhua News Agency, “95% of our projects are fake.” One wonders why they bothered with the other 5%!

The economic reality is that it’s much easier to design a fake investment that yields 12% to 15% annually than to design a plausible one that yields 50% a month.

What’s more, a Ponzi scheme offering investors 12% to 15% per annum can grow much bigger and last much longer than poor Charles Ponzi’s gimcrack empire, which fell apart within months.

Thus, a much greater share of the economy will be Ponzified than in Charles Ponzi’s day. With interest rates jammed against zero, the Ponzified proportion of the world economy will be increasing all the time.

Maybe that’s the reason for the appalling productivity figure announced last Thursday, showing that productivity had fallen at a 3% annual rate in the fourth quarter and had increased by a minuscule 0.3% since the fourth quarter of last year.

If more and more of the economy is Ponzified, the productivity of real economic output has less and less room to grow.

Indeed, if a Ponzi scheme is taken to include any investment that unsustainably pays dividends out of capital, they’re all around us. Many of the energy master limited partnerships (MLPs), for example, have shown themselves to effectively be Ponzis in the recent price downturn.

The Problem With Ponzis

In any case, as income investors, we’re obvious “marks” for the Ponzi scheme scamster.

We can’t get adequate returns on ordinary dividend investments with the market so high, and bond yields are pathetic without taking too much risk. Meanwhile, we’ve heard the publicity about “alternative investments” by which the rich get richer, and about the fantastic returns supposedly available through derivative contracts.

And since we all need additional income to fund our retirements, we’re open to new investment ideas that may diversify our risk and increase our cash flow return.

But the reality is that it’s not easy to tell the difference between the slick salesmen of legitimate but unconventional investment products (usually with high commissions attached) and an equally attractive scamster peddling an outright Ponzi scheme.

In Ponzi’s day, it was fairly straightforward: Anybody offering you 50% a month was a crook. But today it’s much more difficult. There are many legitimate ways by which an investment might yield 15%, still more by which it might yield 8%.

What’s more, there are many borderline Ponzi schemes (like energy MLPs) that can carry on indefinitely buying new properties and raising new money as long as the market is favorable and energy prices are high.

Even then it can be tough to spot signs of trouble, because of the possibility of derivatives hedging. One oil MLP, Linn Energy LLC (LINE), was paying out more in dividends than its net income, but it hedged the prices of all its output in the derivatives market.

It therefore reported record income when prices dropped in 2008, because its hedges made more money than its oil production lost. Only this time around, when prices stayed down, it became obvious there was a real problem.

Then there’s Bernie Madoff’s scheme, which I’m not sure I would’ve spotted even with an MBA in finance. His claim of making money in the derivatives market would’ve been plausible, and the figures would’ve looked OK.

Only the lack of a big-time auditor would’ve raised a flag – and there have been enough frauds audited by major accounting firms that even that isn’t a sure sign.

Ezubao, too, would’ve been highly plausible. P2P lending is indeed a potentially attractive business in the giant Chinese market.

So my advice is: Stick to ordinary bond and share investments in major companies, which are probably at worst accidental Ponzi schemes like the energy MLPs. And remember that with today’s low interest rates, there are far more Ponzi schemes around than there were in Charles Ponzi’s day.