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Madoff's Willing Partners

By Len Fisher
Saturday, December 20, 2008

There seems to be little doubt that Bernard Madoff is a cheat. His apparent Ponzi scheme, in which capital from new investors would have been used to pay "dividends" to earlier investors, ultimately cost the participants many billions of dollars. But was it all Madoff's fault? I contend that the losses would have been less severe, and might not have occurred at all, if many of the Madoff's investors had not been cast from the same mold that Madoff was.

The facts should have been enough to make anyone suspicious. Madoff's accounts were only perfunctorily audited, and his statements were printed with a dot-matrix printer on lightweight copier paper. Above all, his business returns were consistently good -- too good -- and he never reported a down month, let alone a down quarter or year. Let's be honest; such oddities had to have set off alarm bells. So why did so many professionals continue to invest with him?

Only one answer makes sense. Some of those investors must have suspected that he was a cheat but continued to invest because they thought they were benefiting from that cheating. In other words, they took him for a different sort of cheat from who he was -- one who was using information gained from his market-making operation to earn illegal profits rather than one who was operating a breathtakingly audacious Ponzi scheme.

And by continuing to invest with Madoff under this belief, those institutional investors became complicit in that cheating. In fact, they became cheats themselves but without being aware of all that can happen once two parties become involved in a mutual cheating game.

Those consequences can be explained through game theory, a system for examining the "best" strategies that others might use to further their interests (in normal life as well as on Wall Street) to determine the "best" strategies to use in response. It sounds simple, and it often is -- so long as you can be confident in your assessment as to which strategy the other party will use.

The most difficult "game" situations are those that present the actors with a choice between cooperation for mutual benefit or going it alone. If the other party can be trusted to use a "cooperative" strategy that will benefit both of you, then you, too, can cooperate, having confidence that you will do better than you would have on your own. That may be the choice Madoff's investors made, believing him to be acting for their mutual benefit and thus "cooperating" by continuing to invest with him.

The downside of this approach is that one or both sides may conclude that they can do better by cheating on the cooperation. Mutual cheating, though, leads to a series of classic dilemmas (brilliantly exposed in the late 1940s by game theorist John Nash, a Nobel laureate in economics) in which both parties end up worse off than if they had continued to cooperate.

Madoff and his investors got trapped by such a dilemma. The principal way to escape from such dilemmas is through mutual trust.

Social psychologist Robert Cialdini has identified six "weapons of influence" that we use to gain trust, including returning favors; commitment and consistency; being an authority figure; and being liked. The trouble is that all of these can be faked, which is just what Madoff did. Game theory suggests a stronger solution, which is for each party to demonstrate "credible commitment" to prove that it can be trusted.

If Madoff's investors had looked for this sort of proof of commitment, in the form of proper auditing and a transparent portfolio of investments whose value could be checked, they would not have been caught out in so spectacular a fashion.

Why did they fail to look? It can only have been because they thought that they would do better by not looking. By colluding in the cheating that they thought was going on, the investors who did so provided an example of one of game theory's most important and least heeded lessons: Cheats can prosper, but only when the other side isn't cheating as well.

Len Fisher is the author of the recently released book "Rock, Paper, Scissors: Game Theory in Everyday Life."

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