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

By Rasul Bakhshaliyev,

Among numerous [RB1] fraudulent schemes that were not supervised by Russian financial regulation agencies, why was it that Mavrodi’s pyramid was the most successful allowing him to become a potent force in Russian politics? The toughest period for a financial pyramid is the first two-three months. This is the period when Mavrodi built a reputation of a liquid organization that could be trusted. Initially, Mavrodi employed a risky strategy distributing MMM shares for free making it possible for depositors to demand cash instantaneously. To pay them off he would have to use personal limited resources, that could keep him going only for a few weeks in the worst-case scenario. If the schemer has enough resources to pay what was promised to participants in the initial phase, he is deemed trustworthy and more participants take part in the scheme. However, if a schemer can’t provide cash to those demanding their investment back in the first few weeks, reputation of a swindler and an imminent collapse are doubtless[CW2] . Considering the skyrocketing number of failing “banks” that received citizens’ savings, promised high returns, declared bankruptcy and disappeared, the reputation of a reliable financier, carefully crafted by Mavrodi from the very beginnings of MMM was a rarity in Russia of 1990s.

According to Sergei Mavrodi, spare resources are the first and foremost indication of a failure. Counter to the common belief that financial pyramids yield massive profits, for Mavrodi it was integral to use all available resources to increase the number of people involved in the pyramid. Cash flowing from increasing number of depositors was used to finance a revolutionary approach to commercials in Russian television, increase the number of people working for MMM, and open many more exchange points giving out cash for shares and vice versa in many different cities across Russia. This was all done to enlarge MMM as fast and efficiently as possible.

Why was expansion so important to Mavrodi? Some fraudsters limit themselves to a fixed location aiming for a quick and maximized profit, disregarding the prospects of future enlargement and empowerment. Others, like Sergei Mavrodi, make expansion the prerogative. Is there a difference between 1000 depositors each investing USD 1 million, and 1 million depositors each investing USD 1000? Yes, Mavrodi would prefer the latter option, because having a bigger number of participants makes you less vulnerable to targeted attacks by other institutions and fluctuations in the business cycle. This way it is easy to see why Bernie Madoff’s Ponzi scheme that involved a small circle of extremely rich corporations collapsed as soon as the US economy was hit by the financial crisis of 2007-08. Contrary to other financial institutions that existed in Russia, the ambition of MMM was not to benefit from the ill-functioning banking sector of the Russian economy, the aim was to replace it.  Through expansion, he intended to redistribute resources from those that were excessively rich to those in most desperate need. Although we will never know to what extent Mavrodi was sincere in his intentions to redistribute money from the rich to the poor, his determination to expand created many internal administrative problems with-in MMM, as well as external troubles with the government agencies. When MMM expanded to include 10 million depositors and guaranteed 100% returns on investment with-in a few months, Mavrodi became a hero for many Russians, and a serious force on the political scene.  

Once MMM expanded to unforeseen proportions, revealing itself as something other than a regular joint-stock company benefiting from a falling ruble, it was increasingly perceived as an alternative to the Russian government. Thus, it was inevitable that Segrei Mavrodi would be forced into a defensive position facing attacks from the government agencies that were unhappy about the power of MMM. Fifty billion rubles demanded by the tax office was a disproportionately large sum to ask from MMM and acted more like a declaration of war from the Russian leadership. While this sum certainly put a heavy burden on the company’s outflows, the potential reputational damage incurred from having to confront the government presented a bigger risk for MMM’s future. Nonetheless, instead of bowing down to government’s demands, Mavrodi chose offense over defence by guaranteeing his depositors substantially higher return rates and by providing cash to all that wanted to sell their shares, further solidifying MMM’s reputation for strong liquidity. The only way to respond to external risks was to take more risk. What’s more, he doubled workers’ wages, doubled advertising expenditure in response to campaign by Russian state-controlled tv-channels denouncing MMM as a scam and in the end made MMM much stronger than before until he entered a new stratum of confrontation with the government.

In 1997, MMM suffered a fatal punch as Mavrodi was wanted for arrest on the count of tax evasion with the pyramid collapsing a few months later. Sergei Mavrodi justified MMM as response to a fraudulent process of mass privatization programmes in Russia in 1994 that unfairly distributed Russia’s wealth to a group of people that are now known as, “oligarchs”. The collapse of MMM brought Russia a step closer to an economy with acute problems of inequitable distribution of country’s resources that granted unmatched power to a circle of oligarchs that became excessively wealthy. The way in which financial frauds are organized, run, and advertised, together with other subtleties of the scheme, can be indicative of major problems that exist in specific systems of financial governance and regulation. Mavrodi’s MMM was a product of Russian social reality, personifying anger and hopelessness of the people that lived in a country where financial institutions were dysfunctional, and its resources were unfairly distributed.

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”.

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