The modern pyramid scam owes its existence to Carlo Ponzi, an Italian immigrant who settled in Boston at the beginning of this century and persuaded more than 20,000 Bostonians to part with a total of dollars 14m. In a Ponzi scheme money is invested in nothing: after creaming off a large share of the cash, the organisers use the investors' deposits to pay off those who invested first. As long as new investors come in, the pyramid can be sustained and those who get in early can make a profit. But the moment supplies of fresh money dry up, the entire structure collapses and those who come in late lose all their money. It is illegal in all countries.
Robbing Peter to pay Paul is as old as the Bible. Ponzi promised a 50 per cent return on capital in just six weeks by dabbling in International Reply Coupons - relatively low-value vouchers which could be obtained in one country and redeemed for postage stamps in another. Ponzi said he would buy the coupons in a nation with a weak currency, trade them for American postage stamps and then convert the stamps into cash at a huge profit. When the scam was exposed, Ponzi had only dollars 30 of postal coupons in his possession.
Over the past decade, an estimated dollars 750m is believed to have been attracted into pyramid scams in the United States alone by speculation on bizarre items such as chinchilla ranches or 'hydroponic' tomatoes. In an operation in Kansas during the Eighties, investors were asked to part with a minimum of dollars 350 for the purchase of 'activator kits'; each contained mysterious seeds which, when placed in a glass of milk and left at room temperature, produced a 'culture'. At the end of the first week, these cultures were 'harvested', dried and sent by mail to special farms. In three months, what started as a dollars 350 stake was supposed to return dollars 1,000. Needless to say, the 'cultures' were duds, and the raw materials in every 'activator kit' would have fetched no more than a dollar.
Economies depend on venture capital and many novel ideas which seemed fanciful only a few decades ago, such as shirts that change colour according to body heat, ultimately made someone rich. The problem is that smaller investors seldom associate heightened earning opportunities with greater risk, and no amount of official regulation seems capable of driving this point home. Ponzi schemes exploit this by persuading people that the investments are both risk-free and revolutionary. They are venture capital without a venture.
Invariably, Ponzi pyramids demand a small amount of initial investment and promise fast returns. The person who conceives them starts by tapping the cash of close friends: enhancing the credibility of the scheme is crucial and finding the first mugs is always the hardest part. Since early investors usually achieve promised returns (at the expense of those who follow them), once the breakthrough has been made, profits for the fraudsters are virtually guaranteed.
Salesmanship is all-important, and those who have succeeded have a criminal flair and knowledge of the psychology of their intended victims. In Utah, for instance, an organist who performed at funerals also had another occupation: aware that widows usually faced financial uncertainty after sudden bereavement, he offered them high returns on bonds in what proved to be a fictional finance company. He managed to raise more than dollars 16m before being arrested. The Ponzi schemes which have flourished throughout the former Communist countries therefore have a long pedigree.
For almost two years a certain Ioan Stoia, a relatively obscure individual, attracted an estimated four million Romanian depositors (almost one-fifth of the country's population) with a promise of a 'guaranteed' eight-fold increase in their money in precisely three months. In neighbouring Serbia, private 'banks' have offered huge interest rates on hard currency deposits and in Russia, if current claims are to be believed, 10 million investors have put their faith in the MMM operation.
Romania is a country where serious privatisation of state assets has hardly begun and financial instruments are rudimentary. The Romanian scam had to rely on much cruder reasoning: deposits in local currency which multiplied according to a 'secret formula'. In acknowledgement that profit-making is still seen as an unworthy occupation, the Romanian scheme bore the name Caritas, and all profits were supposed to be invested in 'good works'.
The scams in Serbia took a different tack. Since citizens of former Yugoslavia have been allowed to travel and work abroad for decades, many have accumulated deposits in hard currency. Offering them a 'guaranteed' return through 'normal' banks during a time of war and rampant inflation was more appropriate. In Russia, the MMM scheme worked on the difference between the talk about privatisation and shares, and the reality that few ordinary Russians have the slightest idea how a market economy works. A plan which blended the buzz words 'investment shares' with the promise of instant wealth was enough.
Nevertheless, MMM was a pioneer in the techniques of mass communication. For months, serious Russian financial papers warned that the scheme could not last. But ordinary people, bombarded with alluring television advertising about a simple worker and his family planning to buy a home in Paris on the proceeds of MMM gains, chose to believe in the dream - hardly surprising, given the persuasive power of television compared with the printed word. Russians also had another incentive to ignore the official warnings: the sight of local millionaires, all grown rich in the past few years and usually in mysterious ways. The idea that their feat could be repeated by others ultimately overcame reason.
Ever since the advent of the market economy in the East it has been obvious that financial frauds are almost inevitable; after all, the West had a craze for investments in tulip bulbs in the 17th century and in the South Sea Bubble in the following century (a scam which, incidentally, sucked in the hardly illiterate Sir Isaac Newton). All Ponzi schemes seek to exploit legal loopholes, and former Communist countries are vulnerable in this respect: both tax regimes and the central banks' regulatory functions are inadequate.
Yet the biggest difference between scams in the East and those in the West could be in their political implications. The most obvious result in the East could be that the concept of economic reform will be discredited; most East Europeans suspect the market economy is indistinguishable from fraud, and this suspicion will be strengthened. More important, the scams reveal the true extent of official corruption and the widening gulf between those governing and those governed.
Despite weak legal regulation of financial matters, most of the Ponzi schemes could have been closed much earlier. They were not closed, partly because many officials in Eastern Europe benefited personally from the proceeds. In Romania, for instance, the scam operated 'special lists' of investors who were to be repaid come what may. These lists served as both insurance and blackmailing instruments against early government action. True to tradition, a position of power in Eastern Europe is still expected to bring personal financial gain. True to tradition, too, most ordinary Russians tend to blame the government for MMM's imminent collapse.
The proliferation of Ponzi schemes in the East shows that creating a market economy is not just a matter of legal reforms; it requires practice and a much deeper level of personal understanding. Without either, many Russians simply equated the market with a vast lottery and little more. They have an entrepreneurial urge; what they do not have is knowledge of the market. MMM's unfortunate investors are the hapless victims of the political change. In at least parts of Eastern Europe, the situation today is best described as infantile capitalism: neither Karl Marx nor Adam Smith.
As far as we know, the MMM company in Russia did not have any foreign subsidiaries and the existence of companies trading under a similar name in the West is, therefore, pure coincidence.
Andrew Marr is on holiday.
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