One of the more lurid and instructive events in recent economic history was the wave of gigantic pyramid schemes that plunged newly de-Communized Albania into chaos in 1997.
Even before Enver Hoxha's xenophobic Communist dictatorship took power at the end of WWII, Albania was the back of the beyond. During WWII, a couple of American soldiers drove their jeep up to a remote Albanian mountain village, where they were invited in for dinner by the locals. When they came out, they found their jeep upside down. The yokels explained that they had flipped the vehicle over because they just wanted to see whether it was male or female.
When Albania started to open up around 1990, one of the first foreign journalists into the country was asked by a couple of Albanians who spoke English, "What are 'microwave ovens'?"
He responded, "Well, where have you heard of microwave ovens?"
His interlocutors broke into the chorus of Dire Straits's "Money for Nothing:"
We gotta install microwave ovens
Custom kitchen deliveries
We gotta move these refrigerators
We gotta move these colour tvs
That's where'd they heard of microwave ovens: on Italian or Greek radio. And they'd been puzzling over the lyrics ever since.
So, it was hardly surprising that practically everybody in newly capitalist Albania fell hard for that recurrent disease of capitalism known as pyramid (or Ponzi) schemes.
From the March 2000 issue of IMF's quarterly magazine Finance & Development:
The Rise and Fall of Albania's Pyramid Schemes Christopher Jarvis
During 1996-97, Albania was convulsed by the dramatic rise and collapse of several huge financial pyramid schemes. This article discusses the crisis and the steps other countries can take to prevent similar disasters.
The pyramid scheme phenomenon in Albania is important because its scale relative to the size of the economy was unprecedented, and because the political and social consequences of the collapse of the pyramid schemes were profound. At their peak, the nominal value of the pyramid schemes' liabilities amounted to almost half of the country's GDP. Many Albanians–about two-thirds of the population–invested in them. When the schemes collapsed, there was uncontained rioting, the government fell, and the country descended into anarchy and a near civil war in which some 2,000 people were killed. ...
The wide appeal of Albania's schemes can be attributed to several factors, including Albanians' unfamiliarity with financial markets; the deficiencies of the country's formal financial system, which encouraged the development of an informal market and, within this market, of the pyramid schemes; and failures of governance.
When Albania started the transition from central planning to a market economy, it was the poorest and most isolated and backward country in Europe. For centuries, Albania had been largely unknown and inaccessible, and, from 1945 to 1985, its isolation was compounded by the rigid communist dictatorship of Enver Hoxha, which eliminated almost all forms of private property and virtually cut the country off from outside influences and information. When transition began in 1991, the country had been reduced to desperate poverty, and the vast majority of its population was unfamiliar with market institutions and practices.
Although Albania's transition to a market economy was rapid and quite successful, financial sector reform was very limited. Albania's formal financial system was rudimentary. There were few private banks. The three state banks, which held 90 percent of deposits, offered positive real interest rates but had growing portfolios of bad loans, prompting the Bank of Albania to impose tight credit ceilings on them. With the banks unable to satisfy private sector demand for credit, an informal credit market based on family ties and financed by remittances grew. The informal lending companies were initially regarded as benign and even as making an important economic contribution. Operating alongside them, however, were deposit-taking companies that invested on their own account instead of making loans. These companies were the ones that turned into pyramid schemes.
There were also governance problems, both in the financial sector and more generally. The regulatory framework was inadequate, and it was not clear who had responsibility for supervising the informal market. Even after the approval of a banking act in February 1996 that appeared to give the Bank of Albania the power to close illegal deposit-taking institutions, the central bank could not obtain the government's support. Indeed, the government was supportive of the companies: senior government officials frequently appeared at company functions, and, in November 1996, even as the pyramid schemes began to crumble, the prime minister and the speaker of the parliament accepted medals in honor of the anniversary of one of the companies. During the 1996 elections, several of the companies made campaign contributions to the ruling Democratic Party. There were allegations that many government officials benefited personally from the companies. ...
Some of the Albanian companies meet this definition exactly: they were pure pyramid schemes, with no real assets. Other cases are more ambiguous. Some of the largest of the companies–in particular VEFA, Gjallica, and Kamberi–had substantial real investments. They were also widely believed to be engaged in criminal activities–including violating United Nations sanctions by smuggling goods into the former Yugoslavia–that were thought to be the source of the high returns they paid.
Much like how many of Bernie Madoff's investors presumably believed he was illegally "front-running" as a NASDAQ market-maker, and they wanted in on the action.
... The proliferation of schemes had baleful effects. First, more depositors were drawn in. Although VEFA had the largest liabilities, it had only 85,000 depositors. Xhafferi and Populli between them attracted nearly 2 million depositors–in a country with a population of 3.5 million–within a few months. ... By November, the face value of the schemes' liabilities totaled $1.2 billion. Albanians sold their houses to invest in the schemes; farmers sold their livestock. The mood is vividly captured by a resident who said that, in the fall of 1996, Tirana smelled and sounded like a slaughterhouse, as farmers drove their animals to market to invest the proceeds in the pyramid schemes.
On November 19 , Sude defaulted on its payments, and the collapse began.
Sude's collapse shook the public's confidence in all of the companies and new deposits dried up. An attempt by VEFA, Kamberi, Silva, and Cenaj to convince depositors of their soundness by lowering monthly interest rates to 5 percent failed. In January 1997, Sude and Gjallica declared bankruptcy, triggering riots. The other schemes soon also ceased to make payments. The government belatedly took some useful steps. First, it refused to compensate depositors for their losses, which made achieving economic stabilization after the crisis much easier than it would otherwise have been. Second, it began to move against some of the companies. ...
By March 1997, Albania was in chaos. The government had lost control of the south. Many in the army and police force had deserted, and 1 million weapons had been looted from the armories.
Which led, bizarrely enough, to Bill Clinton going to war in 1999 against Serbia (technically, still Yugoslavia at that point).
Because Albanian soldiers and policemen weren't getting paid, they looted weapons (and as Ephraim Diverloi case and that giant fireball explosion last year outside Tirana showed, Albania remained stuffed to the gills with weaponry due to Enver Hoxha's paranoia and feeling that he must be able to fight off America or the Soviet Union single-handedly.) The most willing and convenient buyer for these stolen guns were their fellow Albanians across the border in Serbia's province of Kosovo. Albanian Kosovars had long been waging a mostly peaceful civil rights protest campaign against Serbian control, but suddenly the Kosovo Liberation Army emerged as a well-armed rebel fighting force. About 2000 people died in the subsequent fighting between Serbs and the KLA, causing Clinton and other NATO leaders to start bombing Serbia. The Serbs responded by starting a mass expulsion of Albanians from Kosovo, but eventually gave up after NATO bombed Serbia back to the industrial stone age.
Evacuation of foreign nationals and mass emigration of Albanians began. The government was forced to resign. President Berisha agreed to hold new parliamentary elections before the end of June, and an interim coalition government was appointed.
The interim government inherited a desperate situation. Some 2,000 people had been killed in the violence that followed the pyramid schemes' collapse. Large parts of the country were no longer within the government's control. Government revenues collapsed as customs posts and tax offices were burned. By the end of June, the lek had depreciated against the dollar by 40 percent; prices increased by 28 percent in the first half of 1997. Many industries temporarily ceased production, and trade was interrupted. Meanwhile, the major pyramid schemes continued to hang on to their assets, proclaim their solvency, and resist closure.
Despite the many obstacles it faced, the interim government, aided by the international community, made impressive progress in restoring order and stabilizing the economy. Winding up the pyramid schemes proved to be more difficult. ...
Few studies have been done on the macroeconomic effect of pyramid schemes on the scale of those in Albania, which, fortunately, are extremely rare. The closest analogy to such schemes is the asset bubble, whose economic impact is due to changes in perceived wealth. As a bubble expands, people believe themselves to be better off than they actually are, and their demand for goods and money increases, leading to a deterioration in a country's external current account as well as increased output or accelerated inflation or both. If the bubble attracts foreign investors, capital inflows might be sufficient to fund the current account deficit. After the bubble bursts, perceived wealth falls dramatically. Demand for goods and money, as well as output and inflation rates, can be expected to decrease, while the current account balance is likely to improve.
Some of these effects were observed in Albania but appear to have been limited and short lived. Although the current account of the balance of payments (excluding official transfers) deteriorated by about 2 percent of GDP in 1996, to 9.1 percent of GDP, because of a 35 percent increase in imports, this consumption boom seems not to have been the main factor driving inflation. The impact of the schemes' rise on output, which grew at nearly the same rate–9 percent–in 1996 as in the previous three years, is also unclear.
The collapse of the schemes seems to have had a major short-term economic impact, but the most damaging effects came from the civil disorder it precipitated. ...
The long-term effects of the pyramid scheme phenomenon are likely to be limited, reflecting not only the resilience of the Albanian economy but also–and, perhaps, most important–the government's adjustment efforts and its refusal to bail out depositors. Prices and wages are extremely flexible in Albania; as a result, the government was able to cut real public sector wages substantially in 1997 (by leaving nominal wages unchanged), and the economy suffered no loss of competitiveness when the lek appreciated. The new government's willingness to tackle the budget deficit and undertake long-overdue structural reforms was also crucial. However, the social effects were profound. In addition to the loss of life, thousands of people were impoverished either by their unwise investments in the pyramid schemes or by the destruction of their property in the ensuing violence. Less tangible, but also significant, are the effects on confidence in Albania. The resilience of the Albanian people is considerable and has been more severely tested in the past. But the pyramid scheme phenomenon was a sobering setback.
Albania's experience contains some important lessons for other countries. There are steps governments can take to make the growth of pyramid schemes less likely. These include establishing a well-functioning formal financial system, setting up a regulatory framework that covers informal as well as formal markets and has clear lines of responsibility for supervision and action, and tackling general governance problems. Although preventing pyramid schemes is not the most important reason for establishing good governance, the Albanian experience is a powerful reminder of the social costs of unchecked criminality.
When pyramid schemes emerge, they should be dealt with swiftly and firmly. Companies believed to be operating pyramid schemes should be investigated. By definition, the liabilities of pyramid schemes exceed their assets, and the schemes fund payments to investors out of new investment inflows. To determine whether a company is operating a pyramid scheme, it is necessary to find out if it has real investments and if these investments are likely to be sufficient to cover its liabilities. The investigation can be conducted by the police, a government ministry, or the central bank. The key point is that the investigators should be able to recognize financial fraud and also to assess the value of company assets. If such expertise does not exist in the country, then the investigation can be conducted by outsiders; the IMF and the World Bank should be prepared to help governments find qualified outsiders, if necessary, either from other governments or from large international accounting firms with expertise in this area.
The investigation should be swift. If a company is found to be operating a pyramid scheme, it should be closed immediately. Allowing schemes to continue will result only in more inflows of deposits and greater losses. ...
If there is a strong presumption that companies are pyramid schemes, the government should freeze and, if necessary, seize their assets during the investigation. Once an investigation of a pyramid scheme has begun, the operators will try to steal as much of the assets as possible before the truth comes out. ...
Once a scheme is closed, all assets should be seized and turned over to administrators, who could be government accountants or, if these officials do not have sufficient independence or expertise, accountants from an international firm with an insolvency practice. Legislation may be needed to void contracts made by the companies in the last several months (to prevent theft by transfer to associated parties) to give administrators full control over the assets of the companies and protect them from legal challenges.
The government should make it clear from the outset that it will not compensate depositors for their losses. If this is not done, the fiscal costs are likely to be ruinous, and the moral hazard considerable.
I'm sure I'm just feeling paranoid, but please explain to me why those last paragraphs don't apply to a number of major American financial institutions.