Modern ones have a few characteristics in common:
First, they involve ever growing numbers of people. They mushroom exponentially into proportions that usually threaten the national economy and the very fabric of society. All of them have grave political and social implications.
Hundreds of thousands of investors (in a population of less than 3.5 million souls) were deeply enmeshed in the 1983 banking crisis in Israel.
This was a classic pyramid scheme: the banks offered their own shares for sale, promising investors that the price of the shares will only go up (sometimes by 2% daily). The banks used depositors’ money, their capital, their profits and money that they borrowed abroad to keep this impossible and unhealthy promise. Everyone knew what was going on and everyone was involved.
The Ministers of Finance, the Governors of the Central Bank assisted the banks in these criminal pursuits. This specific pyramid scheme – arguably, the longest in history – lasted 7 years.
On one day in October 1983, ALL the banks in Israel collapsed. The government faced such civil unrest that it was forced to compensate shareholders through an elaborate share buyback plan which lasted 9 years. The total indirect damage is hard to evaluate, but the direct damage amounted to 6 billion USD.
This specific incident highlights another important attribute of pyramid schemes: investors are promised impossibly high yields, either by way of profits or by way of interest paid. Such yields cannot be derived from the proper investment of the funds – so, the organizers resort to dirty tricks.
They use new money, invested by new investors – to pay off the old investors.
The religion of Islam forbids lenders to charge interest on the credits that they provide. This prohibition is problematic in modern day life and could bring modern finance to a complete halt.
It was against this backdrop, that a few entrepreneurs and religious figures in Egypt and in Pakistan established what they called: “Islamic banks”. These banks refrained from either paying interest to depositors – or from charging their clients interest on the loans that they doled out. Instead, they have made their depositors partners in fictitious profits – and have charged their clients for fictitious losses. All would have been well had the Islamic banks stuck to healthier business practices.
But they offer impossibly high “profits” and ended the way every pyramid ends: they collapsed and dragged economies and political establishments with them.
The latest example of the price paid by whole nations due to failed pyramid schemes is, of course, Albania 1997. One third of the population was heavily involved in a series of heavily leveraged investment plans which collapsed almost simultaneously. Inept political and financial crisis management led Albania to the verge of disintegration into civil war.
But why must pyramid schemes fail? Why can’t they continue forever, riding on the back of new money and keeping every investor happy, new and old?
The reason is that the number of new investors – and, therefore, the amount of new money available to the pyramid’s organizers – is limited. There are just so many risk takers. The day of judgement is heralded by an ominous mismatch between overblown obligations and the trickling down of new money. When there is no more money available to pay off the old investors, panic ensues. Everyone wants to draw money at the same time. This, evidently, is never possible – some of the money is usually invested in real estate or was provided as a loan. Even the most stable and healthiest financial institutions never put aside more than 10% of the money deposited with them.
Thus, pyramids are doomed to collapse.
But, then, most of the investors in pyramids know that pyramids are scams, not schemes. They stand warned by the collapse of other pyramid schemes, sometimes in the same place and at the same time. Still, they are attracted again and again as butterflies are to the fire and with the same results.
The reason is as old as human psychology: greed, avarice. The organizers promise the investors two things:
That they could draw their money anytime that they want to, and
That in the meantime, they will be able to continue to receive high returns on their money.
People know that this is highly improbable and that the likelihood that they will lose all or part of their money grows with time. But they convince themselves that the high profits or interest payments that they will be able to collect before the pyramid collapses – will more than amply compensate them for the loss of their money. Some of them, hope to succeed in drawing the money before the imminent collapse, based on “warning signs”. In other words, the investors believe that they can outwit the organizers of the pyramid. The investors collaborate with the organizers on the psychological level: cheated and deceiver engage in a delicate ballet leading to their mutual downfall.
