Author: ken

Or As the WSJ Put It  (January 28): “Ponzi Cases Proliferate”

It is beginning to appear that the Ponzi scheme is the defining scandal of our time. The Journal noted that a “recent review of Securities and Exchange civil actions shows an increase . . . in Ponzi schemes. . . .  at least 23 cases last year, up from 15 in 2007.  It has already filed four in 2009.”

Why would this be so?  Of all the forms of fraud and corruption available to financial manipulators, why choose the scheme that is inevitably doomed to fail?  Insider traders can hope to escape detection, and no doubt many embezzlers get away with their thefts before their victims uncover their losses.  But a Ponzi scheme has no chance to succeed indefinitely.  At some point the funds will run out.  There is no alternative.

There are many interesting dimensions to this, not the least of which is what the perpetrator thinks as he propels his scheme forward at the expense of friends and colleagues.  Madoff may have been sociopathic, as the Times suggested recently, akin to a serial killer motivated by the thrill of getting away with it again and again.  But it will be some time before a credible psychological profile emerges from interviews and the recollections of those closer to the action.

The profiles of the gullible may be somewhat easier to discern.  A steady and strong return on investments is desirable, to be sure, though the ups and downs of our financial system make it unlikely to be consistent and hard to explain when it is.  Still people have hopes and project their faith into the most unlikely vessels — and Madoff certainy pulled off a very respectable image.

What interests me is the collective dimension now emerging.  Why now?  Why so many? What does it say about us?

There is an element of magic in the promises of a Ponzi scheme, just as there appeared to have been an element of magic in many of our dazzling financial successes over the past several decades.  Bill Gates became the world’s richest man in the space of a couple of decades, and his partners also made tens of billions of dollars as well.  So many young kids, fresh out of college, have made huge profits from their technology innovations, then cashed in on IPO’s or buy-outs.  Retailing innovations produced WalMart and other box stores like Costco, Best Buy and Home Depot that didn’t exist several decades ago, creating many personal fortunes in the process. More recently Amazon, eBay, Google and others have dumbfounded conventional  expectations on the internet.  The rise of hedge funds has been explosive, and international currency speculators, like George Soros, have captured the public imagination with billion dollar gambles.  CEO’s have become celebrities and billionaires.  These have been amazing times — almost magical in their production of wealth.  To be sure, there have been reverses, but it does seem that something unprecedented, dizzying, almost crazy has been going on in the marketplace.

As a result, traditional values of fiscal prudence, balance and caution have come to seem outmoded.  People acting in accordance with such logic can look like timid losers.  Our technology and housing bubbles have contributed to this, illustrating how virtually everyone can become wealthy as prices for a time have seemed to go nowhere but up — until they don’t.

In this context, a Ponzi scheme doesn’t look so implausible.  It can easily mimic the appearance of a normal investment, since the investor knows as little about how his profits are to be made as does the typical investor in a hedge fund.  It is only in retrospect that the putative source of profit is exposed as bogus.

In a sense the only difference between a Ponzi scheme and any other scheme for enrichment is the absence of a basis in reality.  It is a perfect symbol for any extraordinary, implausible investment, an alluring appearance that can correspond to almost underlying reality because it is thoroughly uncontaminated with reality at all. Completely self-referential, it is infinitely expandable, endlessly adaptable to suit every hope.

In a world that has come to seem to shower riches on so many, so lavishly and indiscriminately, the Ponzi scheme is the disturbing dream that tells us what we are about.

“Something is Happening Here”

Our minds are boggled by the recent scandals.   What is so hard to grasp is how Governor Blagojevich’s could think his attempts to sell Obama’s senate seat would not be uncovered?  How could Bernard Madoff’s believe his 50 billion dollar Ponzi scheme could succeed.  Where is reality in this?

It is not as difficult to grasp how others are deceived by such acts.  The persistence of old perceptions and the desire to believe can easily override normal doubt, particularly in a group context where the group sets up norms to which members silently conform.  But how can the “perpetrators” come to believe that they will not be found out?  Are they sociopaths, without the regulating influence of conscience?  Are they in a state of manic denial?  Could they be psychotic?  Clearly, they seem to be narcissistic, but that is hardly enough to account for such extravagant misbehavior.

These are the kinds of explanations we tend to use to account for such individual acts of self-deception, but none of them seem to fit what we know about the personalities involved.  How does fraud lose touch with reality?

First of all, there must be something about our culture that supports such audacious gambles, such extraordinary ambitions.  We have seen again and again over the past decades a number of people who seemingly arise out of nowhere to possess great wealth and fame.  It has become something of a norm, and because we tend to assume that people are responsible for their own achievements and celebrity we discount the collective efforts that lie behind such accomplishments.  In effect, we encourage a kind of delusion about what it takes to succeed.  False expectations and standards are set up.

But while that may explain how such unrealistic expectations are established, how they become goals for many to aspire to, that is not enough to explain these scandals.  I suspect that what happened here is a more gradual process.  Each man, aiming for great success, no doubt, ventured to break the rules bit by bit, starting small and then venturing more as they found they got away with it.  A little graft, to test the waters, a little cooking of the books.

Their beginning successes, no doubt, then convinced them to venture more, to up the ante — and that seemed to work as well.  At some point, they must have become convinced that the old realities just did not apply.  And it must have been that they found supporters and assistants who seemed to confirm their new beliefs along the way and they lost touch with or severed connections with those who might have challenged their judgment.  As they ventured further and further out on the thin ice, it did not break;  they became more and more confident.  Maybe the ice wasn’t so thin after all.

Another analogy:  if you put frogs in a pot of cold water and then turn on the heat, the frogs will stay in the pot until they die.  There is no signal to warn them of danger, and so they stay put until it is to late.  Indeed, they may well be enjoying their warmer environment as they lose touch with it.  Similarly our consciousness can fail to warn us about a significant shift in our environment, until is too late to change.   

In both cases, it seem clear that there were warning signs;  suspicions were aroused.  Perhaps the lesson here is that others need to be more vigilant in following up the signs of fraud, but also that we need to be more careful to speak up in the presence of delusions.  Fraud of such magnitude requires assistance if not outright collusion.  It remains to be seen who will stand accused or convicted in these cases.  But it cannot be that these were simply individual acts.

THE ECONOMY

For two hundred years our economy has endured vicious cycles of boom and bust, huge surges of capital accumulation followed by devastating contractions.  This not only profoundly affected investors (formerly known as capitalists) but shaped the lives of workers and all those who supplied them with food, clothing and shelter.  Looking back, if there is one thing which we learned from this was the need for regulation and oversight.  The investors, too preoccupied with the lure of profit,  do not attend to that, and the workers, of course, too dependent on others, cannot change the course of events.

How did we forget what we have learned?  How did we neglect the lessons of our economic history?

Now as we are discovering this lesson all over again, trying to put into place the oversight and controls needed to manage this essentially unruly system, we need to think about why we forgot.  What we don’t know we know is how investors cannot be entrusted with the job of overseeing the system.

There are I think two prominent reasons.

After the collapse of the Soviet Union, the ideology of the free market clouded our collective judgement.  More accurately, those who stood to profit from the expansion of business opportunities, deregulation, and privatization, used that ideology to inhibit any attempt to control their profits.  James Galbraith has brilliantly outlined how this happened in his new book, The Predator State.

Gradually we all became invested through pension funds, savings accounts, etc. etc.  As a result we too became blinded to the risk.  Those who took out subprime mortgages or home equity loans, those who ran up credit card balances, who overextended themselves in our new credit economy — they all lost the objectivity needed to keep in mind our economic history and the risk built into it.

As Obama puts together his new economic team and as we individually struggle to get out of this recession, how can we work to remember what we so easily forgot?