Personal Finance

A 400 year old economic theory explains who really runs the Indian stock market

 helicash

Vivek Kaul

On September 12, 2008, the Bank of England, had total assets worth £83.8 billion on its books. In the six years since then, the total assets of the British central bank have gone up by a whopping 385.6% to £ 404.3 billion, as on September 17, 2014.
Things haven’t been much different in the United States. The Federal Reserve of United States had assets worth $905.3 billion as on September 3, 2008. Since then it has jumped to $4.45 trillion, as on September 17,2014. An increase of close to 392%.
The total assets of the Bank of Japan have more than doubled since the start of 2011. In January 2012, the total assets of the Japanese central bank had stood at 128 trillion yen. Since then, it has more than doubled to 275.9 trillion yen at the end of August 2014.
Since the start of the financial crisis in the middle of September 2008, Western central banks have printed money big time. This money has been pumped into the financial system by buying bonds. These bonds have ended up as assets on the balance sheet of central banks.
The idea behind this, as I have often mentioned in the past, was to drive down long term interest rates, leading to people borrowing and spending more at lower interest rates. This would, in turn, lead to economic growth, the hope was.
When central banks started printing money, the Cassandras (which included yours truly as well) started to point out that the era of high inflation was on its way. The logic offered was fairly straight forward. With so much money being pumped into the financial system, it would lead to a lot of money chasing the same amount of goods and services in the economy, and that would drive prices up at a rapid rate, and lead to high inflation.
But that did not turn out to be the case. The Western world had already taken on huge loans before the financial crisis broke out and was in no mood to borrow and spend all over again.
This lack of inflation has been used by central banks to print and pump more money into the financial system. The hope now is that with all the money that has been pumped into the financial system some inflation will be created. This inflation will lead to people spending more. The logic here is that no one wants to pay a higher price for a product, and if prices are going up or likely to go up, people would rather buy the product now than wait. And this will lead to economic growth. That in short is the gist of what the policy of the Western central banks has been all about over the last few years.
The economist Milton Friedman had suggested that a recessionary situation could be fought even by printing and dropping money out of a helicopter, if the need be, to create inflation.
And this is what Western central banks have done since September 2008, in the hope of reviving economic growth. While they may not have been able to create “some” conventional inflation as they wanted to, there is a lot else that has happened. And that needs to be understood.
When central banks print money, they do so with the belief that money is neutral. So, in that sense, it does not really matter who is standing under the helicopter when the money is printed and dropped into the economy. But the Irish-French economist Richard Cantillon who lived during the early eighteenth century, showed that money wasn’t really neutral and that it mattered where it was injected into the economy.
Cantillon made this observation on the basis of all the gold and silver coming into Spain from what was then called the New World (now South America). When money supply increased in the form of gold and silver, it would first benefit the people associated with the mining industry, i.e., the owners of the mines, the adventurers who went looking for gold and silver, the smelters, the refiners and the workers at the gold and silver mines.
These individuals would end up with a greater amount of gold and silver , i.e., money. They would spend this money and thus drive up the prices of meat, wine, wool, wheat, etc.
This rise in prices would have impacted even people not associated with the mining industry, even though they wouldn’t have seen a rise in their incomes, like the people associated with the mining industry had.
This is referred to as the Cantillon Effect. As analyst Dylan Grice puts it : “Cantillon, writing before the days of Adam Smith, was the first to articulate it. I find it very puzzling that this insight has been ignored by the economics profession. Economists generally assume that money is neutral. And Milton Friedman’s allegory about the helicopter drop of money raising the general price level completely ignores the question of who is standing under the helicopter.”
The money printing that has happened in recent years has been unable to meet its goal of trying to create consumer-price inflation. But it has benefited those who are closest to the money creation. This basically means the financial sector and anyone who has access to cheap credit.
Institutional investors have been able to raise money at close to zero percent interest rates and invest it in financial assets all over the world, driving up the prices of those assets and made money in the process.
As the economist William Bonner put it in a column he wrote in early 2013: “The Fed creates new money (not more wealth… just new money). This new money goes into the banking system, pretending to have the same value as the money that people worked for. And people with good connections to the banks take advantage of the cheap credit this new money creates to aid financial speculation.”
This financial speculation has led to massive stock market rallies all over the world. As I wrote in a piece last week “The Dow Jones Industrial Average, America’s premier stock market index, has rallied more than 30 percent since October 2012. This when the American economy hasn’t been in the best of shape. The FTSE 100, the premier stock market index in the United Kindgom, has given a return of 15 per cent during the same period. The Nikkei 225, the premier stock market index of Japan has rallied by 53 per cent during the same period. Closer to home, the BSE Sensex has rallied by around 43 per cent during the same period.”
Let’s take a closer look at the Indian stock market over the last two years. The foreign institutional investors have invested Rs 1,82,789.43 crore during this period (up to September 19,2014). During the same period the domestic institutional investors sold stocks worth Rs 1,07,327.65 crore.
It is clear from this that foreign money borrowed at low interest rates has been driving the Indian stock market. The domestic investors have continued to stay away.
So, even though a lot of domestic investors may talk about the India growth story being strong, they really don’t believe in it. If they did, they would invest money and not simply talk about it.
Hence, even though the economic growth through large parts of the world continues to remain subdued, the stock markets can’t seem to stop rallying. The explanation lies in the access to the “easy money” that the big institutional investors have.
And this access to easy money will continue in the days to come. The Bank of Japan, the Japanese central bank is printing around ¥5-trillion per month and is expected to do so till March 2015. The European Central Bank is also preparing to print €500-billion to €1-trillion over the next few years. All this money will be available for big institutional investors to borrow at very low interest rates.
The Federal Reserve of United States has made it clear that even though it will go slow on printing money in the days to come, it is unlikely to start pumping out all the money that it has put into the financial system any time soon.
Hence, the stock market bubbles around the world are likely to continue in the days to come. As Claudio Borio and Philip Lowe wrote in the BIS working paper titled Asset prices, financial and monetary stability: exploring the nexus  “lowering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run. They promote a form of moral hazard that can sow the seeds of instability and of costly fluctuations in the real economy.”
The worst, as they say, is yet to come.
The article originally appeared on www.FirstBiz.com on Sep 27, 2014

(Vivek Kaul is the author of Easy Money trilogy. He tweets @kaul_vivek)

Trump’s wrong: How the Big Mac burger tells us Mumbai real estate ain’t cheap

donald trumpVivek Kaul

In a recent interview to the Forbes India magazine, Donald Trump the billionaire American investor and business tycoon said “Your real estate is unbelievably cheap…Mumbai is a great city and yet it is not priced like other comparable cities. It is priced lower than cities that are less important. That gives investors a tremendous amount of growth potential.” He made similar statements in interviews to several other publications.
This statement needs closer examination. Let’s do that by comparing prices in Mumbai and New York, the largest city in the United States. A July 2014 report in The Times of India quotes Pankaj Kapoor of property research firm Liases Foras as saying “In Mumbai, the average cost of a flat is Rs 1.2 crore.”
In comparison, the price of a median home in New York in July 2014 stood at $524,500. For most of July 2014, one dollar was worth Rs 60. Hence, in rupee terms the price of a median home in New York stood at around Rs 3.15 crore ($524,500 multiplied by Rs 60). While Trump did not go into these details, this is the logic he must have used to say that the real estate prices in Mumbai are cheap, in comparison to other big cities around the world.
The trouble with this calculation is that it has been carried out at the market exchange rate. It doesn’t take the purchasing power of the currencies into account. Purchasing power is essentially a concept which takes into account the fact that how many “units of a country’s currency [are] required to buy the same amount of goods and services in the domestic market[in this case India and the rupee] as a U.S. dollar would buy in the United States.” This is necessary because foreign exchange market determined exchange rates do not always take this into account.
There are several ways of taking purchasing power into account. A quick and dirty way is to consider The Economist’s Big Mac Index. This index compares the price of McDonald’s Big Mac hamburger in various countries around the world. In July 2014, the Big Mac had an average price of $4.80 in the United States. In India it was sold at an average price of $1.75.
Hence, what could be bought at $1.75 in India would need $4.8 in the United States. This means Rs 105 (Rs 60 multiplied by 1.75) is worth $4.8. Or in other words one dollar is worth Rs 21.9 (Rs 105/$4.8), in purchasing power terms.
If one dollar is worth Rs 21.9, then the price of a New York city median home in rupee terms works out to Rs 1.15 crore ($524,500 multiplied by Rs 21.9). In comparison the average cost of a flat in Mumbai is Rs 1.2 crore. Hence, the real estate prices in New York are slightly cheaper than Mumbai once we take the purchasing power into account.
As mentioned earlier, using the Big Mac index was a quick and dirty way of taking purchasing power into account. Data from the World Bank can be used to carry out a more reliable calculation. In case of the Big Mac index we are just taking the price of one particular brand of burger for taking purchasing power into account. As per World Bank data one dollar is worth Rs 16.8, once we take purchasing power into account.
This means that the price of a New York median home in rupee terms is around Rs 88.1 lakh ($524,500 multiplied by Rs 16.8). This is almost 32% cheaper than the price of an average home in Mumbai.
These calculations clearly tell us that real estate in Mumbai is not cheap by any stretch of imagination, irrespective of what Trump would like us to believe. In a recent report brought out by UBS Investment Research analyst Ashish Jagnani estimated that Mumbai had 50 months of unsold inventory of homes. This is the highest among all major cities in India. Gurgaon comes in next with 30 months of unsold inventory.
Another recent research report titled India Real Estate Outlook brought out by real estate consultants Knight Frank points out that the unsold inventory of residential apartments in Mumbai stands at 2,13,742 units. In June 2014, the quarters-to-sell ratio stood at 12.
“Quarters-to-sell(QTS) can be explained as the number of quarters required to exhaust the existing unsold inventory in the market. The existing unsold inventory is divided by the average sales velocity of the preceding eight quarters in order to arrive at the QTS number for that particular quarter,” the report points out.
Further, the “inventory level in the South Mumbai market will take the maximum time of 18 quarters (4.5 years) to sell,” the report points out. Donald Trump had come to India for the launch of the Trump Tower, located in Worli, South Mumbai.
The enormous level of inventory in Mumbai is because people are not buying homes. This has led to an inventory of unsold homes which is at a seven year high across different cities., the UBS report points out. People are not buying homes, because homes have become too expensive. As Jagnani of UBS mildly puts it, there are “affordability concerns amid property prices” going “up 13-30% in key cities over last 2-years.”
The article originally appeared on www.firstbiz.com on Sep 14, 2014
(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Here’s how India’s government unwittingly aids the growth of ponzi schemes

J164133002Over the last few years a spate of Ponzi schemes have come to light. These include Sahara, Saradha Chit Fund, Rose Valley Hotels and Entertainment and most recently PACL. A Ponzi scheme is essentially a fraudulent investment scheme in which money brought in by new investors is used to redeem the payment that is due to existing investors.
The instrument in which the money collected is invested appears to be a genuine investment opportunity but at the same time it is obscure enough, to prevent any scrutiny by the investors. So PACL invested the money it collected in agricultural land. Rose Valley, Sahara and Saradha had different businesses in which this money collected was invested.
These Ponzi schemes managed to raise thousands of crore over the years. In a recent order against PACL, the Securities and Exchange Board of India(Sebi) estimated that the company had managed to collect close to Rs 50,000 crore from investors. Sahara is in the process of returning more than Rs 20,000 crore that it had managed to collect from investors, over the years.
The question is how do these schemes manage to collect such a large amount of money. A June 2011, news-report in The Economic Times had estimated that PACL had managed to collect Rs 20,000 crore from investors at that point of time. This means that since then the company has managed to collect Rs 30,000 crore more from investors. An April 2013 report in the Mint quoting state officials had put the total amount of money collected by the Saradha at Rs 20,000 crore.
These Ponzi schemes have managed to collect a lot of money in an environment where the household financial savings in India have been falling. Household financial savings is essentially the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance etc.
The latest RBI annual report points out that “the household financial saving rate remained low during 2013-14, increasing only marginally to 7.2 per cent of GDP in 2013-14 from 7.1 per cent of GDP in 2012-13 and 7.0 per cent of GDP in 2011-12…the household financial saving rate [has] dipped sharply from 12 per cent in 2009-10.”
While the household financial savings have dipped, the money collected by Ponzi schemes has grown by leaps and bounds. What explains this dichotomy? Some experts have blamed the low penetration of banks as a reason behind the rapid spread of Ponzi schemes in the last few years. K C Chakrabarty, former deputy governor of the Reserve Bank of India, in September 2013 had pointed out that only 40,000 out of the 6 lakh villages in India have a bank branch.
Hence, investors find it easier to invest their money with Ponzi schemes, which seem to have a better geographical presence than banks. While this sounds logical enough, the trouble with this reasoning is that the bank penetration in India has always been low. It clearly isn’t a recent phenomenon. So, why have so many Ponzi schemes come to light only in the last few years?
Another reason offered is that the rate of return promised by these Ponzi schemes is high and is fixed at the time the investor enters the scheme. This is an essential characteristic of almost all Ponzi schemes. Take the case of Rose Valley. The return on the various investment schemes run by the company varied from anywhere between 11.2% to 17.65%.
In case of PACL The Economic Times report referred to earlier pointed out that “If a customer puts down Rs 50,000 for a 500 square yard plot, he or she can expect to get back Rs 1,01,365 in six years, or Rs 1.85 lakh in 10 years.” This meant a return of 12.5% and 14% on investments. An April 2013 report in the Business Standard pointed out that the fixed deposits of Saradha “promised to multiply the principal 1.5 times in two-and-a-half years, 2.5 times in 5 years and 4 times in 7 years.” This basically implied a return of 17.5-22%.
It is clear that returns promised by these Ponzi schemes have been significantly higher than the returns available on fixed income investments like fixed deposits, small savings schemes, provident funds etc., which ranged between 8-10%. Given this, it was the greed of the investors which drove them to these Ponzi schemes, and in the end they had to pay for it.
Again that would be a simplistic conclusion to draw. Rose Valley was paying 11.2% on one of its schemes. PACL was offering 12.5%. This returns weren’t very high in comparison to the returns on offer on other fixed income investments.
In fact, most Ponzi schemes tend to offer atrociously higher returns than this. Charles Ponzi on whom the scheme is named had offered to double investors’ money in 90 days. Or take the case of the Russian Ponzi scheme MMM, which came to India sometime back. Its sales pitch was that Rs 5000 could grow to Rs 3.4 crore in a period of twelve months. Speak Asia, a Ponzi scheme which made a huge splash across the Indian media a few years back, promised that an initial investment of Rs 11,000 would grow to Rs 52,000 at the end of an year. This meant a return of 373% in one year. Another Ponzi scheme Stock Guru, offered a return of 20% per month for a period of up to 6 months.
In comparison, the returns
offered by the likes of Rose Valley, Saradha, Sahara and PACL are very low indeed. But investors have still flocked to them. In fact, in its order against PACL, Sebi estimated that the company had close to 5.85 crore investors. So, the question is why are so many people investing money in such schemes?
The answer lies in the high inflation that has prevailed in the county since 2008. For most of this period the consumer price inflation and food inflation have been greater than 10%. In this scenario, the returns on offer on fixed income investments have been lower than the rate of inflation. Hence, people have had to look at other modes of investment, in order to protect the purchasing power of their accumulated wealth. A lot of this money found its way into real estate and gold. And some of it also found its way into Ponzi schemes. This is the “real” reason behind the explosion in the kind of money that has been raised by these Ponzi schemes.
But why is the rate of interest on offer on fixed income investments been lower than the rate of inflation? This is where things get really interesting. Take a look at the graph that follows. The government of India since 2007-2008 has been able to raise money at a much lower rate of interest than the prevailing inflation. The red line which represent the estimated average cost of public debt(i.e. Interest paid on government borrowings) has been below the green line which represents the consumer price inflation, since around 2007-2008. 
cost of borrowing

How has the government managed to do this? The answer lies in the fact that India is a financially repressed nation. Currently banks need to invest Rs 22 out of every Rs 100 they raise as deposits in government bonds. This number was at higher levels earlier and has constantly been brought down. Over and above this Indian provident funds like the employee provident fund, the coal mines provident fund, the general provident fund etc. are not allowed to invest in equity. Hence, all the money collected by these funds ends up being invested in government bonds.
As the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework points out “Large government market borrowing has been supported by regulatory prescriptions under which most financial institutions in India, including banks, are statutorily required to invest a certain portion of their specified liabilities in government securities and/or maintain a statutory liquidity ratio (SLR).”
This ensures that there is huge demand for government bonds and the government can get away by offering a low rate of interest on its bonds. “The SLR prescription provides a captive market for government securities and helps to artificially suppress the cost of borrowing for the Government, dampening the transmission of interest rate changes across the term structure,” the Expert Committee report points out.
The rate of return on government bonds becomes the benchmark for all other kinds of loans and deposits. As can be seen from the graph above, the government has managed to raise loans at much lower than the rate of inflation since 2007-2008. And if the government can raise money at a rate of interest below the rate of inflation, banks can’t be far behind. Hence, the interest offered on fixed deposits by banks and other forms of fixed income investments has also been lower than the rate of inflation over the last few years.
This explains why so much money has founds its way into Ponzi schemes, even though the rate of return they have been offering is not very high in comparison to other forms of fixed income investment. To conclude, the government of India has had a significant role to play in the spread of Ponzi schemes.

A slightly different version of this article appeared on Quartz India on September 10, 2014

 

(Vivek Kaul is the author of Easy Money: Evolution of the Global Financial System to the Great Bubble Burst. He can be reached at [email protected])

How PACL ran a Rs 50,000 crore Ponzi scheme

J164133002

So another Ponzi scheme has been busted.
The Securities and Exchange Board of India(Sebi) in an order issued on August 23, 2014, banned Delhi based PACL, from collecting any more money from investors. Sebi also asked PACL to refund the money to investors over the next three months.
A Ponzi scheme is essentially a fraudulent investment scheme in which money brought in by new investors is used to redeem the payment that is due to existing investors. The instrument in which the money collected is invested appears to be a genuine investment opportunity but at the same time it is obscure enough, to prevent any scrutiny by the investors.
In case of PACL, the money collected was supposedly invested in “ agricultural land”. As the Sebi order on the company written by Whole Time Member Prashant Saran points out “According to PACL, it mainly deals in the sale and purchase of agricultural land and development of the land…PACL’s business model is not limited to simple trading in barren agricultural land but to provide significant value addition to such low value barren land by developing it into productive agricultural land.”
This land bought by PACL after collecting money from the investors wasn’t handed over to them. As the Sebi order points out “PACL has also submitted that only symbolic possession of plots are handed over to the customers as fragmentation of land/ plot into smaller sizes may not be practical or permissible under the applicable revenue laws.”
The Sebi order goes on to inform that till March 31, 2012, Rs 44,736 crore was invested in PACL schemes. The company further informed Sebi that Rs 4,364.78 crore was collected by it between February 26, 2013 and June 15, 2014. Hence, the total amount collected amounts to a whopping Rs 49,100 crore. “This figure could have been even more if PACL would have provided the details of the funds mobilized during the period of April 01, 2012 to February 25, 2013,” the Sebi order points out.
The order goes on to note that “from the available records, it is also noted that since inception till 2012, PACL has allotted land to about 1.22 crore customers.” PACL also informed Sebi that the company has more than 4.63 crore customers to whom land hasn’t been allotted. Hence, “the total number of the customer of PACL comes to around 5.85 crore.”
To summarize, the company has close to 5.85 crore customers who have invested around Rs 50,000 crore with it. This is the basic back story of PACL, which has been put together brilliantly by Saran in the Sebi order. So what are the holes in this story?
First and foremost if the company has Rs 50,000 crore invested with it, it must have used that money to buy “agricultural land” worth a similar value. But the Sebi order clearly points out that PACL hasn’t done so. “The company has only lands worth Rs 11,706.96 crore [i.e. agricultural lands (Rs 7,322.11 crores) and commercial lands (Rs 4,384.84 crores)] out of which it has not only to satisfy the claim of 4.63 crore customers who have deposited Rs 29,420 crore with it but also to satisfy 1.22 crore customers to whom the land has been allotted but sale deeds have not been executed.”
PACL claims to have more land but hasn’t been able to share those details with Sebi “In view of the above, the proposal does not appear to be serious and reasonable,” writes Saran of Sebi. This throws up several questions? If the company has land worth Rs 11,706.96 crore only, where is the remaining money that it has raised from its customers? Why hasn’t it been invested?
Further, how does it plan to repay the customers at the end of the tenure of their investment? The customers have been promised a certain rate of return. And that return can be paid only when the land which PACL claims to invest in grows in value. But without the company investing money in land, that isn’t going to happen.
Also, at the end of the tenure of his investment, the investor either has the option of taking land or money. Saran of Sebi had asked PACL to provide him a sample of 500 customers. From this sample, 421 customers had taken their money back. The question is how were these customers repaid if the money being raised is not being invested totally?
In fact, in a news report published in The Economic Times in June 2011 PACL director S Bhattacharya had said that “about 80% of customers opt to take the money at the end of the plan term instead of the plot of land they supposedly paid for.” So the remaining 20% must be taking on the land, they had originally invested in, is a fair conclusion that one can draw. But as the Sebi order also points out “Not a single applicant out of the 500 samples selected has registered a sale deed of the land he had proceeded to purchase in the first instance…These facts raise serious doubt the real estate business that PACL claims to carry out.”
In fact, the situation gets even more intriguing when one considers the total number of investors in the scheme. As summarised earlier nearly 5.85 crore investors have invested around Rs 50,000 crore in the scheme. But interestingly Bhattacharya had told The Economic Times in 2011 that the “the company has no more than 50 lakh customers”. So how did the number go from 50 lakh to 5.85 crore in just over three years? Or like Sahara, PACL does not really know how many customers does it really have?
All these lacunae lead Saran to conclude that “the lack of maintenance of proper records/ data is a clear indication that the activities of PACL are in the nature of ponzi scheme.” Hence, like most Ponzi schemes which run for a while, the company over the years has managed to build in the minds of its customers some sort of a façade of a business model, where they make money by buying and selling agricultural land.
But the available data does not lead to that conclusion. What the company seems to have been doing is to take money from new investors and hand it over to the investors whose investment had been maturing. That was all it did. It did not have a business model. It was an out and out Ponzi scheme.

The article originally appeared on www.Firstbiz.com on August 26, 2014.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Nigerian frauds decoded: Why the success of scamsters lies in their dumbness

think like a freak

The following email just popped into my mailbox. Have you ever received a similar email?

My Dearest Friend,
I am MR. PAUL ARUNA, The chief auditor in bank of Africa (boa) Burkina Faso West African, One of our customers, with his entire family was among the victims of plane crash and before his death, he has an account with us valued at $27.2million us dollars(twenty-seven million two hundred thousand us dollars) in our bank and according to the Burkina Faso law, at the expiration of Ten years if nobody applies to claim the funds a grace of one year also will be given before the money will revert to the ownership of the Burkina Faso government.
My proposals is that i will like you as a foreigner to stand in as the next of kin or distant cousin for us to claim this money, so that the fruits of this old man’s labour will not get into the hands of some corrupt government officials who will later use the money to sponsor war in Africa and kill innocent citizens in the search for political power.
As a foreign partner which this money will be transfer into your account, you are entitle to 40% of the total money while 55% will be for me as the moderator of this transaction and 5% will be mapped out for any expenditure that may be incur during the course of this transaction. Please note that there will be no problem as my bank has made all effort through to reach for any of his relation but all was fruitless.
My position as the chief auditor in this bank guarantees the successful execution of this (deal) transaction.
Please send the following:
1) Your full name…..
2) Sex…..
3) Age…..
4) Country…..
5) Passport or photo…..
6) Occupation…..
7) Personal Mobile number…..
8) Personal fax number…..
9) Home & office address…..
Thanks.
MR. PAUL ARUNA.

Chances are you receive an email along these lines almost everyday or maybe even more than one a day. Instead of a chief auditor, as is the case with the above email, you might get an email from the widow of a billionaire or a deposed prince. While the details might change, the overall theme of such emails continues to remain the same.
As Steven D Levitt and Stephen J Dubner write in Think Like a Freak—How to Think Smarter About Almost Everything “In each case, the author[of the email] has rights to millions of dollars but needs help extracting it from a rigid bureaucracy or uncooperative bank.”
And this is where you come in. You will need to share your bank-account information along with other personal information. This will help the sender of the email “to park the money in your account until everything is straightened out”. As Levitt and Dubner write “There is a chance you will need to travel to Africa to handle the sensitive paperwork. You may also need to advance a few thousand dollars to cover up some up-front fees. You will of course be richly rewarded for your trouble.”
Does any of this tempt you to reply to your email? Most of us delete such an email as soon as we see the subject of the email. We don’t even bother to read it, before it goes into the junk box of our email account. This fraud is known as the Nigerian letter fraud (even though the email that I share at the beginning of this article has come from Burkina Faso.)
In fact, this is a scam that has survived the test of time. “An early version was known as the Spanish Prisoner. The scammer pretended to be a wealthy person who’d been wrongly jailed and cut off from his riches. A huge reward awaited the hero who would pay for his release. In the old days, the con was played via a postal letter or face-to-face meetings; today it lives primarily on the Internet,” write Levitt and Dubner.
Since the advent of the internet, the Nigerian scam has taken on a life of its own. But the question is all these years later, when the scam is pretty well known, do people really fall for it? Further, why haven’t these scammers gone around fine tuning their story? Why does almost everyone who uses an email continue to get emails with the same basic “sob” story when it comes to the Nigerian scam? And why does almost every scammer who sends out an email claim to be from Nigeria or some other West African country?
Cormac Herley of Microsoft Research decided to investigate this question. As he asks it in a research paper titled Why do Nigerian Scammers Say They are from Nigeria? “An examination of a web-site that catalogs scam emails shows that 51% mention Nigeria as the source of funds, with a further 34% mentioning Cˆote d’Ivoire, Burkina Faso, Ghana, Senegal or some other West African country…Why so little imagination? Why don’t Nigerian scammers claim to be from Turkey, or Portugal or Switzerland or New Jersey?”
Stupidity can’t be an answer. As Herley puts it “Stupidity is an unsatisfactory answer: the scam requires skill in manipulation, considerable inventiveness and mastery of a language that is non-native for a majority of Nigerians. It would seem odd that after lying about his gender, stolen millions, corrupt officials, wicked in-laws, near-death escapes and secret safety deposit boxes that it would fail to occur to the scammer to lie also about his location. That the collection point for the money is constrained to be in Nigeria doesn’t seem a plausible reason either. If the scam goes well, and the user is willing to send money, a collection point outside of Nigeria is surely not a problem if the amount is large enough.”
So what can possibly explain this? The Nigerian (or any other West African for that matter) scammer carrying out this fraud needs to send out many emails initially. Hence, the cost of contacting a possible victim is very low. But at the same time his chances of getting hold of a possible victim who he can engage in a conversation over email, are also very low.
“An email with tales of fabulous amounts of money and West African corruption will strike all but the most gullible as bizarre. It will be recognized and ignored by anyone who has been using the Internet long enough to have seen it several times. It will be figured out by anyone savvy enough to use a search engine and follow up on the auto-complete suggestions…It won’t be pursued by anyone who consults sensible family or fiends, or who reads any of the advice banks and money transfer agencies make available,” writes Herley.
That being the case why go through so much trouble? The Nigerian sending the email cannot know in advance “who is gullible who is not?”. As Levitt and Dubner put it “Gullibility is in this case an unobservable trait.” So what explains this?
Herley provides the answer. As he writes “Those who remain are the scammers ideal targets. They represent a tiny subset of the overall population…The initial email is effectively the attacker’s classifier: it determines who responds, and thus who the scammer attacks (i.e., enters into email conversation with). The goal of the email is not so much to attract viable users as to repel the non-viable ones, who greatly outnumber them.”
To put it in simple English, the scammer essentially wants to identify individual(s) who haven’t heard o
f the Nigerian scam. As Herley told Levitt and Dubner “The scammer wants to find the guy who hasn’t heard of it…Anybody who doesn’t fall off their chair laughing is exactly who he wants to talk to.”
Such a gullible individual is most likely to send across thousands of dollars to someone he does not know based just on an email about a lost fortune. And this is why the Nigerian scam continues to look so do dumb. Its dumbness is what makes it so successful.
As Herley puts it in his research paper “A less outlandish wording that did not mention Nigeria would almost certainly gather more total responses and more viable responses, but would yield lower overall profit. Recall, that viability requires that the scammer actually extract money from the victim: those who are fooled for a while, but then figure it out, or who balk at the last hurdle are precisely the expensive false positives that the scammer must deter.”

The article appeared on www.firstbiz.com on August 17, 2014

 

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)