pyramid schemes and falling dominos

So Bernie Madoff has pleaded guilty to a pretty massive investor defrauding scheme. Like Charles Ponzi, he started small, but as former chairman of NASDAQ, his fall in reputation has been rather greater. But was Madoff's truly a pyramid scheme?

A pure pyramid scheme collapses when the ever growing numbers of new recruits that are required to fuel it hits a limit imposed by finite resources. Ponzi's scheme relied on the rather ineffectual-sounding business of buying international postal reply coupons in Italy and selling them in the USA. In his case, the finite resource was the reply coupons themselves. So when a newspaper pointed out that his business would require about 6000 times the available supply of coupons, it became obvious that he must have turned to forging them.

But was Madoff's scheme - fraudulent as it evidently was - bound to collapse eventually? I have no idea, but he had been going strong for quite a while and his weakness only became exposed when the domino effect of the sub-prime mortgage fallout hit. Now don't get me wrong - fraud is fraud and I'm not trying to find excuses here. While a reasonably informed investor knows that his or her money may get eaten up by the market, any losses should all be above board and not due to a broker using your investment capital to feed someone else's fake returns, even temporarily. The funny thing is that if Madoff's scheme was primarily intended to demonstrate reliable but not unrealistic returns by temporarily borrowing from investor Peter to pay Paul during dips in the market, then he might have got away with it in perpetuity as long as there wasn't any panic-driven run on his "bank."

Again, I stress that I am not condoning his activities in any way, especially as I am too ignorant of precisely what was involved anyway. But I think it is correct to say that even conservative banks would have a hard time if everyone decided to pull out their cash at once. Since regular bank accounts are insured by the federal government, there is no reason why there would be a run on these accounts. Needless to say, this is not true of the stock market, which still has inadequate safety systems to prevent the sorts of extreme volatility that occur when people start to panic simply because they know others are panicking. The only thing we have to fear is fear itself etc.

In terms of physical systems, the stock market is like an elevator on a bungee cord. Instead of dropping down smoothly to a lower floor in response to some newly emerging reality that "the economy" needs to cool off, the market overreacts and drops down way further than required for a realistic correction. The system is mostly designed to enable microeconomic transactions to occur very quickly, with potential investors able to get their hands on up-to-date information. It is precisely these design criteria that cause problems when the mass media start to broadcast panic signals not about one particular company but about the economy as a whole.

So yes, Madoff should be made to pay for his recklessness and what was clearly totally fraudulent practice. But what would be so much more valuable than throwing all the Madoff's in jail is if we could figure out a way to keep the market as responsive as it currently is when a regular number of investors jump in or out, but add some sort of natural brake when the herd instinct starts to occur. Communist countries have traditionally enjoyed control over the mass media. How ironic to muse on the fact that the free market can get damaged so badly by the pronouncements of doom that are fed to us by the free press!