Bubbles past and present

The size of the alleged Bernard Madoff scam, if it lives up to its
initial $50bn billing, is astounding, yet unsurprising. History tells
us that bubbles spawn swindles. After the biggest credit bubble of all
time, we now may have the biggest swindle of all time. As so often,
the real mystery is how such a big fraud could have been built on so
flimsy a base.

This was, after all, a hedge fund that delivered implausibly
consistent, and consistently good, returns. These were verified by a
firm of auditors employing all of three people. Mr Madoff dealt
through his own in-house broker, raising questions about custody of
assets and internal control. Many experts felt the options trading
strategy he claimed to pursue could not have generated such returns
with so many billions under management. Why were professional as well
as private investors taken in?

The economic historian Charles Kindleberger believed that "swindling
is demand-determined, following Keynes's law that demand determines
its own supply, rather than Say's law that supply creates its own
demand. In a boom, fortunes are made, individuals wax greedy, and
swindlers come forward to exploit that greed".

In practice, the requisite bait for the greedy is a good story. These
used to be colourful – so much so in the 1820s stock market boom in
London that they were parodied in a joke prospectus asking for money
"to drain the Red Sea, in search of the gold and jewels left by the
Egyptians, in their passage after the Israelites".

Mr Madoff's story was dull by comparison, but compelling in a credit
bubble where yields were everywhere falling. This is a syndrome
described by Walter Bagehot, the great theorist of central banking, in
Lombard Street, whereby "the owners of savings not finding, in
adequate quantities, their usual kind of investments, rush into
anything that promises speciously ... "

It is also the principle on which the fraudster Charles Ponzi
operated, promising in 1920 to pay 50 per cent interest for 45-day
deposits. He claimed to be generating huge returns from currency and
interest rate arbitrage. Yet in reality he was using new investors'
money to pay off earlier investors. When a wave of redemptions hit the
Madoff funds, the Ponzi scheme, as Mr Madoff himself reportedly called
it, became unworkable.

Greed is not the exclusive motive for investing in a scam. In the
South Sea Bubble, the noted bluestocking Lady Mary Wortley Montagu
punted furiously in the hope of using profits to pay off a blackmailer
with whom she had had an indiscreet romantic correspondence. And then
there is what Charles Mackay, 19th-century chronicler of speculative
manias, called "the madness of crowds". In something as big as the
South Sea Bubble, poets, bishops, Sir Isaac Newton and King George I
were drawn into the euphoria.

Another characteristic of most successful scams is a lack of
transparency. Many hedge funds are reluctant to reveal their trading
strategies in detail. The Madoff funds were no exception. Clients who
asked probing questions were asked to take their money elsewhere.

There is a clear parallel here with the investment trusts of the
1920s, which were able to reveal little about the stocks in their
portfolios because the equity bubble conferred an aura of omniscience
on their managers. Reputations inflated in the bubble promptly
evaporated in the 1929 crash, which exposed a plethora of swindles.
Redemptions in the hedge funds business are having the same effect
today.

Nothing helps a fraudster more than a big name. Edward Chancellor, in
his fine history of financial speculation Devil Take The Hindmost,
records how His Highness Gregor, cacique of Poyais, a small territory
on the border of present-day Nicaragua, arrived in London to encourage
emigration and float a £600,000 loan. The issue was a great success,
thanks in part to the services of the notable financier Sir John
Perring, a former lord mayor of London.

Yet the country was fictitious and the emigrants found on arrival that
the "capital" was a collection of mud huts surrounded by swamps and
threatening Indians. For his part, the cacique – whose real name was
Sir Gregor MacGregor, a Scottish adventurer and renegade general from
Simón Bolívar's army – fled to France with the bond issue proceeds.

Mr Madoff was himself a big name, having been a chairman of the Nasdaq
exchange, and his investors regarded him as a Wall Street insider.
Some may even have thought that the extraordinary returns he generated
might reflect successful insider dealing. Yet the betrayal of trust
may be much greater than that of the 19th-century adventurer, since
many of Mr Madoff's friends and colleagues in the Jewish community
appear to have been ruthlessly gulled.

Big swindles are often facilitated by bribery. Many nobles and
parliamentarians were secretly given shares in the South Sea Company
to help the passage of legislation favourable to the directors' plans.
The modern equivalent is campaign finance offered to politicians on
Capitol Hill by hedge funds, investment banks and others. Pleas to
keep hedge funds free from intrusive regulation thus fell on receptive
ears.

Will there be anything left for investors in Mr Madoff's funds? They
will not derive much comfort from history. Ponzi took in $7.9m and had
only $61 worth of assets on the premises when he was arrested in
August 1920, 200 years to the month after the collapse of the South
Sea Bubble.