Madoff and the Flaying Trust in Capitalism

By Saliem Fakir · 29 Jan 2009

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Every-time capitalism is hit by a crisis it is described as being an errant event. The latest scandal which has rocked the US financial sector, where trusted and the likeable figure Bernie Madoff ran a Ponzi scheme for almost two decades, is once again dismissed as the work of a rogue element.

But rarely will the pundits of the new economy, which rely on the use of innovative speculative financial instruments to make inflated profits from thin air, blame its faulty free market philosophy and irresponsible agents for the failures.

A whole ideology must stand the test of time and be defended at all cost despite its failures.

What was said of Madoff was also said of Jerome Kerviel, a few months before, when he nearly, single-handedly, brought down the French financial giant Societe Generale by running unauthorised trades that nearly cost the bank $7.5 billion. Kerviel, too, was a rogue broker.

This was not true though. His bosses looked the other way as long as he was making profits on their behalf. His bosses of course only thought of their share prices and the large compensations they would receive if they were to cash-in their largesse.

The Kerviel and Madoff cases illustrate the extent to which the ethos of the financial sector, especially the role of banks, has changed with the arrival of the new economy heralded by the 1990s. With the deregulation of the financial markets, bank managers also jumped onto the bandwagon, like the rest.

Banks increased the value of their speculative portfolios because there was lots of money to be made. Banks needed the stock-markets to grow in order to ensure that the risks to their loan books were minimised: banks started giving out more ‘toxic’ debt than they should have; they needed inflated stocks to provide the necessary security.

As a commentator John Kay remarked: "Banks quickly changed from ‘utilities to casinos."

Banks, corporations, investment houses and hedge funds aided and abetted a system that increasingly took on the features of a Ponzi scheme (named after Charles Ponzi who ran the largest investment scam during World War One). 

What Madoff did was no different. He sold the same sell. He demanded lots of trust for little information. Madoff lured his clients by the promise of a handsome return on their share of investment. He could do better than the banks, the hedge funds and blue chip companies.

Madoff used his credibility as a trader and a former employee of the Security Exchange Commission to attract rich clientele, including many famous Hollywood figures and other celebrity figures in the US, to invest in his company.

Except what he handed out as ‘profits', was really the hard-earned cash from others below his pyramid scheme. A Ponzi scheme collapses when too many people try to cash in all at the same time, just like the financial crisis was precipitated by the run on the banks and hedge funds.

Madoff’s system was less complicated. He didn’t have to do all the manipulative stuff that analysts, investment houses and banks did in order to boost share prices and keep luring clients.

Madoff’s scheme could have gone on for another decade had it not been for the financial crisis. Investors who were losing money elsewhere began to panic and started withdrawing cash from as many of their investments as they could get their hands on. That’s when Madoff got caught out.

Still the issue at hand is not what Madoff did to others; it is how the greed of others gave birth to Madoff and the entire system he was operating within.

When the financial sector is cash-flushed there is no temerity -- financial capital rules over productive capital; it demands more than it deserves. And what it demands for investors, shareholders and CEOs is disproportionate to what is distributed to others.

As an illustration, workers are forced to accept lower wagers and if they do not oblige themselves to the new conditions, production capital simply relocates to countries where labour and other costs are cheaper.

The more financial capital is able to squeeze out, the more it attracts the greed of investors. Value, ultimately, is driven by a combination of the power of financial capital and expectation.

As the late Kenneth Galbraith noted in his book American Capitalism, without an adequate countervailing force - in this case, not putting faith in the self-regulatory power of free competition - but government regulation, active shareholders, strong unions and circumspect consumers; financial capital is given a free ride until it all explodes in our faces.

There is a relentless pursuit of profits. There is no restraint because in many respects, capital and government are embedded and want to achieve the same goals: unquestioned profits, the sterling performance of the stock-markets and high consumption bolster the indices.

There is an unhealthy fascination with GDP growth, which becomes an obsession and fosters a false illusion because perceived growth is really air, not real goods and services.

This has led people like George Soros to observe that the financial sector is dangerously out of proportion to the size of the rest of the economy and comes at a great cost to the public.

The current crisis is levying an unjustifiable tax on the rest of society, considering the fact that the bail-out will cost anywhere between $1-3 trillion dollars, which will be paid for by tax-payers.

But to figure out why Madoff did what he did, one can’t point a finger at the greed of a single individual, but a collective greed that has corrupted an entire system.

The Nobel Laureate for economics, Joseph Stiglitz, in his book, The Roaring Nineties (written a few years before the crisis hit), paints a picture of systemic faults from three decades of deregulation, low interest rates, tax cuts, high deficits, ignoring of warning signs early on in the system and the various investment bubbles that created a culture of ‘irrational exuberance’.

Stiglitz notes: "The bubble - and the bad behaviour - were reinforcing: the stronger the bubble, the stronger the incentives to take actions to keep it going."

Investment bubbles resemble Ponzi schemes, these include those that are legally incorporated (like the Enrons and Worldcoms) and those who flout the laws, openly defrauding their clients, like Madoff did.

It all starts when share-option schemes and bonuses, in which CEOs stand to gain the most, ensure that CEO’s tend to focus on the share price and their future compensation. There is always the temptation to cook the books.

As Enron proved, this led to fraudulent accounting and management practices that often put companies at greater risk in the long term, while the books told otherwise in the short term.

For example, one trick Enron used in its Ponzi scheme involved using energy futures to record revenues due at some future date, by booking it as income in advance without simultaneously reflecting costs in its books. In this way, Enron exaggerated its profits to its shareholders.

It was not unique to Enron. Enron just did what others were doing except that its executives went too far too quickly.

New economy instruments, such as derivatives, ideally suit dishonest accounting practices because they can be used to hide true risks to shareholders.

Madoff succeeded because there was a general reliance by investors and the public that the system will prevail and so vigilance was ceded to institutional authority and various check-and-balance systems within the financial sector.

But what ordinary investors did not realise is the extent to which the ‘guardians’ themselves were corrupted by the poison of the prevailing exuberant culture.

Madoff was able to rely both on the greed of the investor and the already compromised guardians (lax government oversight, possible collusion by accounting and auditing firms, the lack of prudence from banks, the conflict of interest between rating agencies and issuers of bonds/debt and other bodies) to pull-off what may turn out to be the US’s biggest Ponzi scheme in history -- estimated to be worth about $50 billion.

Madoff is a creature of a culture in which the moral hazard was cheered. A culture in which it predisposed trusted characters to behave in careless and fraudulent ways. As the bubble grew so did the length of their deception, their risks and bets.

Madoff merely responded to what the system wanted – more returns on investment. He did what others were doing through legal means: luring people to invest and selling them the promise of infinite and eternal profits, knowing well that there was a long distance between reality and fantasy.

Fakir is an independent writer based in Cape Town.

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Rory Short
30 Jan

Unregulated Financial Markets

Once you allow an uregulated market in financial instruments the temptations to create wealth at other people's expense is, given unredeemed human nature, too enormous for many people to resist.

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