Can we use financial fraud to assess the health of economy? (A financial pyramid that challenged Russian leadership in the 1990s) – Part I

By Rasul Bakhshaliyev,

When it comes to corporate fraud, it is usually labelled as a negative externality of the private sector and is not used as a qualitative indicator to assess the health of economy. In other words, stigmatizing financial activity as, “financial corporate fraud” reduces it to a trivial irregularity, which occurred only because fraudsters have been exceptionally good at lying or because regulators did not do their job properly. In annual reports of big financial institutions, fraud is presented as an aggregate statistical information, focus diverted to its frequency, size, and concentration in a particular industry. Very rarely do analysts differentiate between types of fraud and go beyond quantitative analysis. By analysing one of the biggest financial pyramids to ever exist, a point is made that financial corporate fraud can be used as a qualitative indicator to better comprehend the socio-economic reality.

Sergei Mavrodi’s financial pyramid, named MMM, had been a financial miracle to 10 million Russians in 1994, generating up to 100% returns within few months. Mavrodi’s speculative scheme involved buying shares that could be sold back at a new, higher price in future. Financial pyramids are sometimes also referred to as Ponzi schemes. With subtle differences in how they are organized, Ponzi schemes and pyramids are centred around one underlying principle. Financial pyramid is a social construct that is built on human confidence in the infinity of time. X borrows a dollar from Y. To compensate his loss, Y borrows 2 dollars from Z. Therefore, Y makes a profit of 1 dollar. Z also borrows 3 dollars from W to make a 1-dollar profit. This cycle can go on infinitely and yield 1-dollar profit at each stage until there are no more people to borrow from. If we assume infinite time, the scheme is perfectly functional. However, when there are no sufficient savings from inflows to pay for outflows, a pyramid becomes dysfunctional. As pyramids grow larger, they enhance their ability to hold on to the promise that depositors’ money will be returned, thus attracting even higher rate of inflows. In a sense, a financial pyramid should function as a self-sustaining mechanism, growing exponentially as the number of comers increases and leavers decreases.

In 1994, when MMM was launched, Russia was undergoing a painful transition period to a market economy, which was characterised by hyperinflation, falling ruble, and a steadily decreasing purchasing power. The Role of an ideal government in creating a well-functioning market economy, is to function as a “neutral referee”, that guides the state from a communist economy to capitalism. Lack of policy coordination between the post-Soviet republics in key domains such as tariffs, taxation, and monetary policy was the first blow to Russian economy, considering the level of integration among post-Soviet republics. Second, with hyperinflation in Russia reaching 2509% in 1992, heavy pressure was put on the government’s ability to sponsor state projects, such as infrastructure expenditure, healthcare, and education.  Given the inability of the government to fulfil its social commitments, which was further exacerbated by rapidly declining tax revenue, it was left to the central bank to take action.

The central bank’s plan in 1992 was to provide loans to Russian enterprise via commercial banks. Ideally, this would strengthen the private sector, increasing state tax revenue and enabling the government to carry out necessary reforms. In defiance of government’s instructions, commercial banks used those loans to purchase US dollars in the liberalized Russian foreign exchange. In effect, instead of making loans to the struggling Russian businesses, banks chose to profit from ruble’s depreciation, using zero-interest government loans to buy dollars and wait for the right moment to convert back to ruble. Banks were also not interested in lending to Russian businesses because of their extremely low confidence in the ability of private businesses to repay their debts. As a result, banks did not fulfil their fundamental task, leading to further deprecation of the ruble, which diminished citizens’ purchasing power.  Given that the real value of citizens’ savings was steadily depreciating making them less likely to pay for credit, retail consumer banking services were unsustainable for commercial banks. With citizens’ purchasing power steadily declining, government unwilling to help, and commercial banks unwilling or unable to function as in exemplary market economies, citizens had two options to earn income on their savings. One option was to profit from speculations of a falling ruble like everyone else did, the other option being to invest in institutions that were created outside of Russian financial jurisdiction which promised high returns in short time. In 1994, MMM was one of them. [RB1] 

The opinions expressed in this article are the author’s own, and may not represent the views of The St Andrews Economist

Sources:

  1. Rock Charles, Solodkov Vasiliy, 2001. “Monetary Policies, Banking, and Trust in changing institutions: Russia’s Transition in the 1990s”, Journal of Economic Issue, issue 2, vol 35, pp 451-458.
  2. Mavrodi Sergei, 2011. “PiraMMMida”.

Image Source: NewsBeezer

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