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 cla.s.sic 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 a.s.sisted 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 fict.i.tious profits - and have charged their clients for fict.i.tious 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 inst.i.tutions 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 b.u.t.terflies 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: (1) that they could draw their money anytime that they want to and (2) 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.

This is undeniably the most dangerous of all types of financial scandals. It insidiously pervades the very fabric of human interactions. It distorts economic decisions and it ends in misery on a national scale. It is the scourge of societies in transition.

The second type of financial scandals is normally connected to the laundering of capital generated in the "black economy", namely: the income not reported to the tax authorities. Such money pa.s.ses through banking channels, changes ownership a few times, so that its track is covered and the ident.i.ties of the owners of the money are concealed.

Money generated by drug dealings, illicit arm trade and the less exotic form of tax evasion is thus "laundered".

The financial inst.i.tutions, which partic.i.p.ate in laundering operations, maintain double accounting books. One book is for the purposes of the official authorities. Those agencies and authorities that deal with taxation, bank supervision, deposit insurance and financial liquidity are given access to this set of "engineered" books. The true record is kept hidden in another set of books. These accounts reflect the real situation of the financial inst.i.tution: who deposited how much, when and under which conditions - and who borrowed what, when and under which conditions.

This double standard blurs the true situation of the inst.i.tution to the point of no return. Even the owners of the inst.i.tution begin to lose track of its activities and misapprehend its real standing.

Is it stable? Is it liquid? Is the a.s.set portfolio diversified enough?

No one knows. The fog enshrouds even those who created it in the first place. No proper financial control and audit is possible under such circ.u.mstances.

Less scrupulous members of the management and the staff of such financial bodies usually take advantage of the situation. Embezzlements are very widespread, abuse of authority, misuse or misplacement of funds. Where no light shines, a lot of creepy creatures tend to develop.

The most famous - and biggest - financial scandal of this type in human history was the collapse of the Bank for Credit and Commerce International LTD. (BCCI) in London in 1991. For almost a decade, the management and employees of this shady bank engaged in stealing and misappropriating 10 billion (!!!) USD. The supervision department of the Bank of England, under whose scrutinizing eyes this bank was supposed to have been - was proven to be impotent and incompetent. The owners of the bank - some Arab Sheikhs - had to invest billions of dollars in compensating its depositors.

The combination of black money, shoddy financial controls, shady bank accounts and shredded doc.u.ments proves to be quite elusive. It is impossible to evaluate the total damage in such cases.

The third type is the most elusive, the hardest to discover. It is very common and scandal may erupt - or never occur, depending on chance, cash flows and the intellects of those involved.

Financial inst.i.tutions are subject to political pressures, forcing them to give credits to the unworthy - or to forgo diversification (to give too much credit to a single borrower). Only lately in South Korea, such politically motivated loans were discovered to have been given to the failing Hanbo conglomerate by virtually every bank in the country. The same may safely be said about banks in j.a.pan and almost everywhere else. Very few banks would dare to refuse the Finance Minister's cronies, for instance.

Some banks would subject the review of credit applications to social considerations. They would lend to certain sectors of the economy, regardless of their financial viability. They would lend to the needy, to the affluent, to urban renewal programs, to small businesses - and all in the name of social causes, which, however justified - cannot justify giving loans.

This is a private case in a more widespread phenomenon: the a.s.sets (=loan portfolios) of many a financial inst.i.tution are not diversified enough. Their loans are concentrated in a single sector of the economy (agriculture, industry, construction), in a given country, or geographical region. Such exposure is detrimental to the financial health of the lending inst.i.tution. Economic trends tend to develop in unison in the same sector, country, or region. When real estate in the West Coast of the USA plummets - it does so indiscriminately. A bank, whose total portfolio is composed of mortgages to West Coast Realtors, would be demolished.

In 1982, Mexico defaulted on the interest payments of its international debts. Its arrears grew enormously and threatened the stability of the entire Western financial system. USA banks - which were the most exposed to the Latin American debt crisis - had to foot the bulk of the bill, which amounted to tens of billions of USD. They had almost all their capital tied up in loans to Latin American countries. Financial inst.i.tutions bow to fads and fashions. They are amenable to "lending trends" and display a herd-like mentality. They tend to concentrate their a.s.sets where they believe that they could get the highest yields in the shortest possible periods of time. In this sense, they are not very different from investors in pyramid investment schemes.

Financial mismanagement can also be the result of lax or flawed financial controls. The internal audit department in every financing inst.i.tution - and the external audit exercised by the appropriate supervision authorities are responsible to counter the natural human propensity for gambling. The must help the financial organization re-orient itself in accordance with objective and objectively a.n.a.lysed data. If they fail to do this - the financial inst.i.tution would tend to behave like a ship without navigation tools. Financial audit regulations (the most famous of which are the American FASBs) trail way behind the development of the modern financial marketplace. Still, their judicious and careful implementation could be of invaluable a.s.sistance in steering away from financial scandals.

Taking human psychology into account - coupled with the complexity of the modern world of finances - it is nothing less than a miracle that financial scandals are as few and far between as they are.

Return

The Revolt of the Poor

The Demise of Intellectual Property

A year ago I published a book of short stories in Israel. The publishing house belongs to Israel's leading (and exceedingly wealthy) newspaper. I signed a contract, which stated that I am ent.i.tled to receive 8% of the income from the sales of the book after commissions payable to distributors, shops, etc. A few months later, I won the coveted Prize of the Ministry of Education (for short prose). The prize money (a few thousand DMs) was s.n.a.t.c.hed by the publishing house on the legal grounds that all the money generated by the book belongs to them because they own the copyright.

In the mythology generated by capitalism to pacify the ma.s.ses, the myth of intellectual property stands out. It goes like this: if the rights to intellectual property were not defined and enforced, commercial entrepreneurs would not have taken on the risks a.s.sociated with publishing books, recording records and preparing multimedia products.

As a result, creative people will have suffered because they will have found no way to make their works accessible to the public. Ultimately, it is the public, which pays the price of piracy, goes the refrain.

But this is factually untrue. In the USA there is a very limited group of authors who actually live by their pen. Only select musicians eke out a living from their noisy vocation (most of them rock stars who own their labels - George Michael had to fight Sony to do just that) and very few actors come close to deriving subsistence level income from their profession. All these can no longer be thought of as mostly creative people. Forced to defend the intellectual property rights and the interests of Big Money, Madonna, Michael Jackson, Schwarzenegger and Grisham are businessmen at least as much as they are artists.

Economically and rationally, we should expect that the costlier a work of art is to produce and the narrower its market - the more its intellectual property rights will be emphasized. Consider a publishing house. A book which costs 50,000 DM to produce with a potential audience of 1000 purchasers (certain academic texts are like this) - would have to be priced at a minimum of 100 DM to recoup only the direct costs. If illegally copied (thereby shrinking the potential market - some people will prefer to buy the cheaper illegal copies) - its price would have to go up prohibitively, thus driving out potential buyers. The story is different if a book costs 10,000 DM to produce and is priced at 20 DM a copy with a potential readership of 1,000,000 readers. Piracy (illegal copying) will in this case have been more readily tolerated as a marginal phenomenon.

This is the theory. But the facts are tellingly different. The less the cost of production (brought down by digital technologies) - the fiercer the battle against piracy. The bigger the market - the more pressure is applied to clamp down on the samizdat entrepreneurs. Governments, from China to Macedonia, are introducing intellectual property laws (under pressure from rich world countries) and enforcing them belatedly. But where one factory is closed on sh.o.r.e (as has been the case in mainland China) - two sprout off sh.o.r.e (as is the case in Hong Kong and in Bulgaria).

But this defies logic: the market today is huge, the costs of production and lower (with the exception of the music and film industries), the marketing channels more numerous (half of the income of movie studios emanates from video ca.s.sette sales), the speedy recouping of the investment virtually guaranteed. Moreover, piracy thrives in very poor markets in which the population would anyhow not have paid the legal price. The illegal product is inferior to the legal copy (it comes with no literature, warranties or support). So why should the big manufacturers, publishing houses, record companies, software companies and fashion houses worry?

The answer lurks in history. Intellectual property is a relatively new notion. In the near past, no one considered knowledge or the fruits of creativity (art, design) as "patentable", or as someone "property". The artist was but a mere channel through which divine grace flowed. Texts, discoveries, inventions, works of art and music, designs - all belonged to the community and could be replicated freely. True, the chosen ones, the conduits, were honoured but were rarely financially rewarded. They were commissioned to produce their works of art and were salaried, in most cases. Only with the advent of the Industrial Revolution were the embryonic precursors of intellectual property introduced but they were still limited to industrial designs and processes, mainly as embedded in machinery. The patent was born. The more ma.s.sified the market, the more sophisticated the sales and marketing techniques, the bigger the financial stakes - the larger loomed the issue of intellectual property. It spread from machinery to designs, processes, books, newspapers, any printed matter, works of art and music, films (which, at their beginning were not considered art), software, software embedded in hardware and even unto genetic material.

Intellectual property rights - despite their n.o.ble t.i.tle - are less about the intellect and more about property. This is Big Money: the markets in intellectual property outweigh the total industrial production in the world. The aim is to secure a monopoly on a specific work. This is an especially grave matter in academic publishing where small- circulation magazines do not allow their content to be quoted or published even for non-commercial purposes. The monopolists of knowledge and intellectual products cannot allow compet.i.tion anywhere in the world - because theirs is a world market. A pirate in Skopje is in direct compet.i.tion with Bill Gates. When selling a pirated Microsoft product - he is depriving Microsoft not only of its income, but of a client (=future income), of its monopolistic status (cheap copies can be smuggled into other markets) and of its compet.i.tion-deterring image (a major monopoly preserving a.s.set). This is a threat, which Microsoft cannot tolerate. Hence its efforts to eradicate piracy - successful China and an utter failure in legally-relaxed Russia.

But what Microsoft fails to understand is that the problem lies with its pricing policy - not with the pirates. When faced with a global marketplace, a company can adopt one of two policies: either to adjust the price of its products to a world average of purchasing power - or to use discretionary pricing. A Macedonian with an average monthly income of 160 USD clearly cannot afford to buy the Encyclopaedia Encarta Deluxe. In America, 100 USD is the income generated in average day's work. In Macedonian terms, therefore, the Encarta is 20 times more expensive. Either the price should be lowered in the Macedonian market - or an average world price should be fixed which will reflect an average global purchasing power.