Why there will always be pyramid schemes
A curiosity of the coverage of the $50 billion Madoff scandal was the sense of shock and surprise that professional investors made big, possibly illegal, mistakes in 2008. The same year half our banks fell apart, major investment firms went bankrupt, automobile companies beg for money, and governors offer to sell senate seats for cash. In August of 1920 Charles Ponzi was charged with similar crimes and it’s clear in the future it will happen again.
In discussions like these a book gets mentioned by some experts called Extraordinary Popular Delusions and the madness of crowds. It’s a big fat book chronicling the silly, absurd things large groups of people have bet their money on and lost. Some read the book to feel smart smart that we ourselves didn’t do any of the stupid things our ancestors did. But these days an update to the book is well overdue: an entire chapter can be written about the delusional wonders of our generation.
I’m left with this opinion: there will always be pyramid schemes, frauds and market collapses. It’s inherent in complex systems, things like democracies, free-markets and blogospheres, that these things will happen. It’s unavoidable. I’m not saying we should accept them or not try to reduce their impact (hello, SEC, where have you been?), but they will always take place. The reason? Trust.
A pyramid scheme, often referred to as a ponzi scheme, is well defined by wikipedia as an unsustainable business model, where the people who invest are not aware of how unsustainable it is. (In a ponzi scheme, victims are mostly just out of luck, in a pyramid scheme, victims are often part of the crime since they promoted the pyramid).
As the story goes the legendary Charles Ponzi told his potential investors in 1919 he could return 40% on their money in 45 days. FORTY PERCENT. At a time when the interest rates hovered around 5%. Why was he able to get their money on such a ridiculous promise? For one reason: they trusted him. That’s it. He found a way to earn their trust. The details don’t matter for the moment. Lets ask what is trust?
Trust is using what you know about someone to compensate for what you do not know. I trust my brother. I’d trust him to, I don’t know, say, watch my dogs. Now once he has my dogs I can’t be 100% certain what he might do when he watches them. He might decide to cover them with chocolate syrup, or set them loose in the meat section of my local supermarket, I can’t prevent him from doing these things. But I trust he won’t.
Similarly you trust the staff at McDonald’s not to spit in your food, the woman behind you at line in the bank not to make silly faces at the back of your head, or the gas you pump into your car to be actual gasoline and not turpentine. Our daily lives hinge on trusting all sorts of things we are too ignorant or busy to verify. And from time to time some people will take advantage of this trust because they are mean and because they can. It might only happen 1 or 2% of the time. Small enough not to make us stop trusting these things. But fraud, abuse, and pyramid schemes will always exist as long as we are free to choose who to give our trust to. Laws penalize people after they betray our trust, not before.
Look at the list of people whose trust was betrayed by Madoff: Steven Spielberg; Jeffrey Katzenberg, Sen. Frank Lautenberg (D-N.J.); New York Mets owner Fred Wilpon, fashion mogul, Carl Shapiro; real-estate developer Mortimer Zuckerman; the European bank HSBC; and on it goes. These high powered people, despite their teams of lawyers and advisers had their trust betrayed. It’s sad and shameful what happened, especially since many of their funds were tied to charities, but there’s nothing we can do to permanently prevent this from happening again. To hire someone to manage your money will always be based primarily on the wonderfully imperfect, intuition dependent, amazingly tricky thing called trust.
How do you decide who to trust? All I know is after writing this post, I’m looking at everyone I see with a suspicious eye 🙂
[Note: minor edits made 8/4/2014, changing references to 2008 to present]