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How Bernard Madoff's Pyramid Scheme Will Erode Trust

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By Anne Applebaum
Tuesday, December 16, 2008

Scene One: We are buying an apartment in Warsaw, sometime in the early 1990s. At every stage of the transaction, my husband and I have to turn up in person, stand in line, present identity cards. We appear at the notary's office, more than once. We appear at the tax office, more than once. Finally, we are asked to hand over a briefcase full of dollars. The seller will not accept a bank transfer and does not want to be paid in his country's currency, either.

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Scene Two: We are buying a car in Washington, D.C., sometime in the early 2000s. We test-drive a few, tell the dealer which car we want. We hand him a personal check, which the dealer accepts without asking for an identity card. My husband asks whether he isn't worried that the check will bounce. The dealer laughs, and we drive out of the dealership in a brand-new car.

Two different times, two different places, but above all, two different kinds of capitalism: If Francis Fukuyama, the author of "Trust: The Social Virtues and the Creation of Prosperity," were writing this article, he would describe the Warsaw of the first scene as a "low-trust" culture and the Washington of the second as a "high-trust" culture. One could also call them a "place where financial transactions are irritating and time-consuming" and a "place where financial transactions are easy."

Such labels do not last forever: In the two decades since the early 1990s, bank transfers, telephone transactions and use of the local currency have become the norm in Warsaw. The question now is whether, over the next two decades, American capitalism will also change -- not for the better but for the worse.

Reading the accounts of the collapse of Bernard L. Madoff Investment Securities, it is impossible not to conclude that it will. The scale of this apparent fraud stretches far beyond anything a car dealer or even the purchaser of an apartment might commit, of course: Among the alleged victims of Madoff's extraordinary pyramid scheme are major banks (BNP Paribas, Nomura Holdings), famous people (Mort Zuckerman) and Madoff's friends from the Palm Beach Country Club. In the wake of Madoff's arrest, charities are going to close, and rich people will become poor. Worst of all, everyone who invests anywhere will think just that much harder, take that much longer, demand that much more documentation. And they will do so not only because of Madoff but because of the subprime lenders, Wall Street investment banks and Enron fraudsters who have done so much to erode our faith in the reliability of our system.

The deeper irony here is that all of these schemes were possible in the first place only and precisely because we have, until now, lived in a culture with such extraordinarily high levels of trust, one in which many a customer's bona fides are accepted without question and wealthy people are thought to have earned their money. In our culture, someone like Madoff was trusted precisely because he was rich, because he was a member of the Palm Beach Country Club, because his company worked out of expensive Manhattan offices, most of which were occupied by people doing real jobs. It occurred to no one that a small group of select insiders was allegedly also operating a massive fraud scheme on the 17th floor.

In other cultures -- maybe most other cultures -- very rich people are suspect by definition. Recently, I met a wealthy Russian and automatically assumed he was the beneficiary of some shady scheme: How else would someone from that part of the world get rich? In fact, he turned out to be the chief executive of a Western-owned company in Kiev, Ukraine, and totally aboveboard. But I know why I made the mistake: I still remember -- and Russians still remember -- the fraudulent "privatization" deals and complex money-laundering operations that created so many Russian billionaires over the past two decades. I also remember the extraordinary saga of the MMM company, which in the 1990s defrauded some 2 million Russians of $1.5 billion, using what will now surely be known as the second-largest pyramid scheme of all time. At the time, we thought that such blatant fraud could occur only in the lawlessness of the post-Soviet world.

We were wrong. Madoff's alleged pyramid scheme, far broader than anything MMM dreamed up, may have been made possible by our own tradition of lawfulness. And now he will help bring that tradition down. Here's a prediction: In the coming years, American capitalism will become slower, more cautious, less productive and less entrepreneurial. We're still a long way from the Eastern Europe of the 1990s, or from the Latin America or Russia of the present. But maybe not as far as we think.

applebaumletters@washpost.com


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