Arnold Kling  

The Problem of Fraud

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A reader recommends a paper by William K. Black.

"Control fraud" theory explains why the most damaging forms of fraud are situations in which those that control the company or the nation use it as a fraud vehicle. The CEO, or the head of state, poses the greatest fraud risk. A single large control fraud can cause greater financial losses than all other forms of property crime combined - they are the "super-predators" of the financial world. Control frauds can also occur in waves that can cause systemic economic injury and discredit other institutions essential to good government and society. Control frauds are commonly able to defeat for several years market mechanisms that neo-classical economists predict will prevent such frauds.

Black is arguing that fraud is a problem for economists, because we assume that it can easily be prevented through audits and such.

I think it is a problem for libertarians in general. Suppose that we do away with lots of government laws and government imprisonment. Then someone who has a Ponzi scheme or somebody who wants to pass off possibly tainted meat as pure is in a position of saying "If you catch me, I lose a little bit. If you don't, I win a lot." The fraud perpetrator has much to gain from outwitting the auditing agency and little to lose by failing to do so.

The government is, like the private sector, probably unable to eliminate fraud by auditing. However, it is in a position to send perpetrators to prison, which has some deterrent value.

Let's assume that the cost of preventing fraud solely through auditing is ridiculously high, perhaps even infinite. However, suppose that the threat of imprisonment, when accompanied by an auditing regime, prevents most fraud at relatively low cost. In a deregulated, libertarian-ish society, how would you create the deterrence value that the threat of imprisonment provides?

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COMMENTS (14 to date)
Steve writes:

Through the tort system, make the perpetrator of fraud individually liable for any shortfall in liability owed by the company he works for. This provides some serious deterrence (although I'm not sure what sort of insurance market would build up around this).

Eli writes:

It's easy in theory. Just set tort (private law) damages equal to the actual harm times the reciprocal of the probability of being caught. Let's say that 90% of fraudsters get away with it. Make the 10% who get caught pay damages equal to 10 times the actual harm, and you get efficient deterrence.

Now in practice I will concede that it is more difficult, particularly when you have to deal with innumeracy on juries. But I don't know that the problems are more severe than the ones that arise from criminal law.

Randy writes:

It is not my belief that fraud would be controlled by "audit", but rather, by reputation. I am therefore much more concerned with the potential risks presented by a political organization with extreme power than I am concerned by the risks presented by a builder who might use sub-standard materials. There is nothing I can do about the former. The latter can be destroyed by simple word of mouth.

Alex J. writes:

Private imprisonment. Also, occasionally, fraudsters get assassinated. Let the wergelds cancel.

Or, is the question: "What would you do if the government both refrained from imprisoning certain criminals and suppressed the use of imprisonment by private parties?"

CEOs might post large bonds. You might only hire young CEOs with lots of future reputation-years at stake. Possibly, certain forms of organization would no longer be economical, or would only be work in the black market, c.f. loan sharking.

If a government was motivated to stop punishments of fraudsters, how else would the government be motivated to intervene? Currently, the government intervenes on behalf of those who would otherwise face sanctions by limiting credit reports, more or less lenient bankruptcy laws, limited liability for corporations, and of course, bailouts.

Joshua Lyle writes:

I don't follow. Suppose that we do away with lots of government laws and government imprisonment. Then someone who is a victim of a Ponzi scheme or somebody who was sold tainted meat as pure is in a position of saying "If you cheat me and I kill you for it, I lose a little bit, but you loose a lot." The fraud perpetrator has much to loose, barring some other form of protection, which would seem to be just as available to their potential victim pool.

andy writes:

Well, we are talking specifically about deterring CEO/head of government fraud, without foricbly taking him to a court? Now that is tough :)

You would see significantly more partnerships; the CEO of public companies would probably be one of the owners.

However, you know what? I personally know of one partnership where one of the partners started to cheat, unfortunately very successfuly. Everything perfectly legal. How would you solve this in ANY system?

Hyena writes:

Can we stop acting like reputation is a good enforcement mechanism?

If I screw 1,000 people out of $1,000 each, then I've already won this game. If next month no one will patronize my business, it doesn't much matter.

Worse, the more fraud schemes there are at any moment, the less likely someone is to notice anything particular about yours. Even worse: the more times a particular fraud is advertised, the more people seem to think it might be real.

Tom West writes:

The latter can be destroyed by simple word of mouth.

Which is why fraud is unknown in our current society.


Seriously, it's interesting to think that in a Libertarian society the barriers to entry into fields might be much *higher* than in current society. Now, most people trust that the threat of imprisonment controls the worst fraud, making it relatively safe to patronize new businesses. In a Libertarian world of caveat emptor, reputation meaning everything might make it very difficult to be a new entrant.

Not something I'd considered.

Justin writes:

Fraud will never be completely wiped out of any economy. There will always be people that thrive to earn more money in any manner. With a successful fraud attempt, one can make enough money to satisfy them for years. Thus, with just an audit in the way, people try to cheat their way into money rather than worrying about going to jail.

To increase the deterrence value of imprisonment, the government should make those found guilty of fraud to pay for what they stole. Being responsible for all the money they take, as well as having prison time, will keep fraud from happening as often. Reputation is also a factor in preventing fraud. Being caught for fraud should completely destroy the reputation of those who commit it.

However, no matter what government does, I do not believe fraud can ever be taken out of the economy. There will always be business people with low ethics and morals who crave making as much money as possible.

MernaMoose writes:

Some of the harshest legal penalty systems known to man were born in the Middle East (though the ME has no monopoly there to be sure). I read a history book once with an interesting commentary on this, unfortunately I don't remember the book now.

The population spread in the ME has always made effective policing a hard problem. The only way rulers had to compensate for this, was to make the penalties harsh for those who got caught. Nonetheless, during many times in history, the chances of getting caught were so low that criminal were not deterred to any significant extent in spite of the harsh penalties.

This could lead to an at least semi-economic approach to developing a police and legal penalty system.

But you haven't defined your terms quite well enough here. By "libertarian-ish" do you mean, the government is stepping out of the role of providing law enforcement? In which case I see a rapid, near-instantaneous de-generation to gangland conditions.

Or do you mean that there will simply be many fewer government agencies around that are doing the watch dog thing?

In any case, deterring crime effectively is a combination of a) driving the probability of catching the perpetrator up to a high enough level and b) imposing severe enough penalties.

Brandon Berg writes:

Why not just treat fraud as a crime? The libertarian position is not that fraud should be treated solely as a tort, but that government should not intefere in reasonably informed consensual transactions, and that it should not have a monopoly on auditing.

For example, the FDA should be able to punish people for misrepresenting the cost/benefit profile of a drug, but not for accurately advertising and selling a drug which has a cost-benefit profile of which the FDA does not approve.

Thomas Boyle writes:

I don't recall anything requiring that libertarianism should prohibit jail time for fraud. In fact, IIRC, libertarianism differs from anarchism in that it recognizes a role for government to enforce agreements - just not for government to determine what those agreements should be (subject to the limitation that the agreements have material effect only on the parties involved). It's one of the few roles that libertarians see as legitimate for government to provide, no?

liberty writes:

Yes, I think Arnold blurred the line between libertarian and anarchist (or anarcho-capitalist). Libertarians favor what Brandon Berg suggests: enforcement of laws against fraud; anarchists see no role for government and would therefore require private mechanisms of enforcement.

Soylent writes:

I'd like to recommend Black's recent testimony at the Financial Crisis Inquiry Commission on the role of fraud in the current crisis:

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