First impression : Absolutely profound analysis. Will need some time for this to sink in. Want to think about this for a while, but WOW ! what great insights. Big observation : Where is this wrong ? Damned if , at least for now, I can see any serious flaws. Seems to hit the nail on the head with a sledgehammer. There are other arguments that knock the props out from under classical laissez faire ( some of which is perfectly OK, but NOT as an infallible theory that covers all bases, which it cannot do ), but this utterly flattens that theory. WWLS ? What will libertarians say ? Billy ===================================================== In a message dated 11/1/2010 9:39:21 A.M. Pacific Daylight Time, [email protected] writes:
I think Billy will like this. True, neo-classical economics in theory recognizes this as part of the danger of agency failure, but in practice virtually nobody seems to have made any effort to understand (much less mitigate) this threat. Especially since the line between "fraud" and "creativity" is awfully thin, when it comes to accounting... -- Ernie P. _http://www.schneier.com/_ (http://www.schneier.com/) Schneier on Security A blog covering security and security technology. _« Halloween and the Irational Fear of Stranger Danger_ (http://www.schneier.com/blog/archives/2010/10/halloween_and_t.html) | _Main_ (http://www.schneier.com/blog/) November 1, 2010 Control Fraud I had never heard the term "_control fraud_ (http://bizcovering.com/management/the-control-fraud-theory/) " before: Control fraud theory was developed in the savings and loan debacle. It explained that the person controlling the S&L (typically the CEO) posed a unique risk because he could use it as a weapon. The theory synthesized criminology (Wheeler and Rothman 1982), economics (Akerlof 1970), accounting, law, finance, and political science. It explained how a CEO optimized "his" S&L as a weapon to loot creditors and shareholders. The weapon of choice was accounting fraud. The company is the perpetrator and a victim. Control frauds are optimal looters because the CEO has four unique advantages. He uses his ability to hire and fire to suborn internal and external controls and make them allies. Control frauds consistently get "clean" opinions for financial statements that show record profitability when the company is insolvent and unprofitable. CEOs choose top-tier auditors. Their reputation helps deceive creditors and shareholders. Only the CEO can optimize the company for fraud. _This_ (http://www.networkideas.org/feathm/may2006/william_k_black.pdf) is an interesting paper about control fraud. It's by William K. Black, the Executive Director of the Institute for Fraud Prevention. "Individual 'control frauds' cause greater losses than all other forms of property crime combined. They are financial super-predators." Black is talking about control fraud by both heads of corporations and heads of state, so that's almost certainly a true statement. His main point, though, is that our legal systems don't do enough to discourage control fraud. White-collar criminology has a set of empirical findings and theories that are useful to understanding when markets will act perversely. This paper addresses three, interrelated theories economists should know about. "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. "Systems capacity" theory examines why under deterrence is so common. It shows that, particularly with respect to elite crimes, anti-fraud resources and willpower are commonly so limited that "crime pays." When systems capacity limitations are severe a "criminogenic environment" arises and crime increases. When a criminogenic environment for control fraud occurs it can produce a wave of control fraud. "Neutralization" theory explores how criminals neutralize moral and social barriers that reduce crime by constraining our decision-making to honest enterprises. The easier individuals are able to neutralize such social restraints, the greater the incidence of crime. [...] White-collar criminology findings falsify several neo-classical economic theories. This paper discusses the predictive failures of the efficient markets hypothesis, the efficient contracts hypothesis and the law & economics theory of corporate law. The paper argues that neo-classical economists' reliance on these flawed models leads them to recommend policies that optimize a criminogenic environment for control fraud. Fortunately, these policies are not routinely adopted in full. When they are, they produce recurrent crises because they eviscerate the institutions and mores vital to make markets and governments more efficient in preventing waves of control fraud. Criminological theories have demonstrated superior predictive and explanatory behavior with regard to perverse economic behavior. This paper discusses two realms of perverse behavior the role of waves of control fraud in producing economic crises and the role that endemic control fraud plays in producing economic stagnation. _Posted on November 1, 2010 at 6:02 AM_ (http://www.schneier.com/blog/archives/2010/11/control_fraud.html) • _16 Comments_ (http://www.schneier.com /blog/archives/2010/11/control_fraud.html#comments) To receive these entries once a month by e-mail, _sign up_ (http://www.schneier.com/crypto-gram-sub.html) for the _Crypto-Gram Newsletter_ (http://www.schneier.com/crypto-gram.html) . -- Centroids: The Center of the Radical Centrist Community <[email protected]> Google Group: _http://groups.google.com/group/RadicalCentrism_ (http://groups.google.com/group/RadicalCentrism) Radical Centrism website and blog: _http://RadicalCentrism.org_ (http://radicalcentrism.org/) -- Centroids: The Center of the Radical Centrist Community <[email protected]> Google Group: http://groups.google.com/group/RadicalCentrism Radical Centrism website and blog: http://RadicalCentrism.org
