How Trust is Abused in Free Markets
Enron's "Crooked 'E'"
William K. Black
This paper is a variant on Daniel B. Klein's article: "How Trust is Achieved in Free Markets" Issues in Ethics, 8:1 (Summer 1997) Klein is associate professor of economics at SCU.
George Akerlof shared the Nobel Prize in Economics in 2001 for his famous article on the "lemon's market" problem. A market can have a lemon's problem when one party to the transaction has far superior information to the other ("asymmetric information") and defects are not obvious. The classic bad car, the "lemon" led to Akerlof's name for his theory.
A lemon's market is inefficient. Both consumers and reputable sellers of high quality goods are harmed by the consumer's inability to distinguish superior goods. Frauds, who sell poor quality goods by misrepresenting quality are the only winners. Markets beset by lemon's problems may be improved by government intervention, which can aid both consumers and honest sellers.
In his article "How Trust is Achieved in Free Markets," Dan Klein, a libertarian, argues that government intervention is not necessary to deal with lemon's problems because the markets do so. Dan tells a car story of his own to illustrate his point. He notes that if your car breaks down far from your home you would be justifiably cautious in dealing with the local "Joe's Auto Repair." Dan extends the tale by suggesting that you would have a very different reaction if you saw a Meineke shop down the road. A nationwide chain like Meineke has a strong interest in its reputation, and Dan argues that it takes credible steps to ensure that its local franchisees do not defraud customers. Dan concludes that entities like Meineke arise whenever lemon's problems arise because the problem creates an opportunity for profit by legitimate firms and because honest firms are able to "signal" their integrity to consumers in a credible manner. One of the ways firms signal their integrity is "branding"; it makes little sense to invest vast sums in building a distinct reputation only to allow that reputation to be besmirched by fraud.
Dan concludes that concerns about lemon's markets provide no basis for regulation. First, regulation causes harm, e.g., FDA delays in drug approvals lead to premature deaths. Second, while FDA regulation may produce some benefits, "voluntary institutions would have achieved such benefits anyway."
A variant of Dan's reasoning lies at the heart of modern corporate governance. Its leading scholars assert that fraud by controlling persons (control fraud) is minimal because legitimate firms successfully distinguish themselves from control frauds. They do so through three primary devices: hiring top-tier outside auditors, insuring that their CEOs own large amounts of the company's stock, and having the company take on large amounts of debt. The savings & loan debacle and the ongoing financial crises have shown that this confidence in the ability of markets to discern control frauds was misplaced.
White-collar criminologists are less sanguine about the ability of honest firms to distinguish themselves from the control frauds in many contexts absent effective regulation. Vastly more financial losses are inflicted on Americans by "voluntary" (but fraudulent) transactions than by involuntary property crimes (e.g., theft, robbery and burglary). Moreover, insiders cause the vast majority of theft losses. These insiders are able to commit their thefts because of a voluntary transaction (employment) that builds trust. They then abuse that trust and exploit the information they have as to vulnerabilities in the company's internal controls. The situation is far worse in many countries where fraud is endemic in broad sectors of the voluntary economy and where "crony" capitalism rules.
The key theoretical difference is that neoclassical economists use a model that is only partially dynamic. Their illustrative tales always end the way Dan's tale ended. There is a potential lemon's problem. Honest firms respond by providing a credible signal of their integrity that allows consumers to distinguish the honest firms. The lemon's problem is averted. Fraud fails. There is no need for government intervention or musing about moral education. The market forces the fraudulent out of business. This conclusion reflects Adam Smith's famous observation that we trust the butcher not because he is altruistic, but because he is self-interested.
But fraud persists. The Torah and Talmud both have passages decrying fraud through dishonest weights and measures. That should alert us to the need for a more dynamic model than that presented by most economists. Weights and measures were introduced as signals of legitimacy. The fraudulent mimicked the signals. Dishonest sellers used weights and measures and cheated the customer through myriad means. "Short weighted" and "thumb on the scale" remain part of our vocabulary, as does the opposite "full measure." Both phrases reflect the quasi-evolutionary struggle between honest firms and control frauds involving biased measures. Akerlof's article on lemon markets refers to another variant common in India - mixing small stones into rice (other adulterations are even less pleasant!). Our common joke-It pays not to inquire to closely into the making of sausage and elections if one wishes to respect the results-reflected real world practices made infamous by Upton Sinclair in The Jungle.
Governments did something similar when they "debased" (i.e., secretly added "base" metal to reduce the content of precious metals) the currency making it "not worth a plugged nickel." One of the most famous scientific moments we are still taught in school is Archimedes arising from his bath and shouting "Eureka!" He realized that by immersing the crown and measuring displacement he could find the answer to the ruler's question as to whether it was really solid gold.
Fraud always involves the creation and abuse of trust. Fraudulent firms love it when legitimate firms adopt signaling devices that they can mimic. This creates greater trust and allows more lucrative fraud. Before casual clothing became the rage, bankers wore nice suits. Sophisticated con men wore nice suits. Sophisticated con women wear fabulous outfits or appear like dowdy grandmothers - whatever works best as camouflage. "Identity theft" exemplifies the process. The fraudster, like a hermit crab, appropriates all the characteristics that signal the victim's creditworthiness. This makes it easy to establish trust.
The problem is not limited to commerce. We have a rich literature about the process of inducing trust in dates and spouses for the purpose of exploiting that trust. The analogous literature about politicians is also vast. The ongoing scandals about abusive priests are rooted in the same process. Many pedophiles mimic the behavior of caring adults (e.g., volunteering to run a youth activity) for the purpose of gaining the trust of parents and their children.
The current theory is that humans ended up with such large brains because evolutionary pressures selected for traits that helped us navigate through the extraordinarily complex social structures in which we lived. Building trust and determining whom to trust helped our ancestors find a desirable mate, live long enough to reproduce, and give their progeny the training and support to make them successful. Deception was a leading contributor to the complexity of social life.
Dan Klein's example of Meineke as the reputable repair company helps illustrates my point. Dan is correct that Meineke would be a better bet than "Joe's Auto Repair" if you broke down in a distant town, and his explanation for why that is true is also correct.1 However, just before Dan's article was published, Meineke was hit with a massive judgment in a civil suit brought by its franchisees - over $400 million in damages, mostly as a result of what the jury determined was a pattern of fraud ( Broussard v Meineke Discount Muffler Shops, Inc., 3/6/97). Meineke charged fees to franchisees and promised to use the funds to advertise Meineke. In fact, Meineke diverted much of this money to a related advertising company and to general corporate purposes. This was done secretly and occurred for many years before the franchisees discovered the diversions. The jury found that this was fraudulent and the trial court found the facts strongly supported that conclusion.
The Court of Appeals for the Fourth Circuit reversed the decision, holding that Meineke owed no fiduciary duties to franchisees and that class action status should not have been granted. The deception, however, is clear.
Meineke knew that it would be difficult to cheat its customers without hurting itself. This creates a powerful incentive not to cheat as long as Meineke remains a viable company. However, two other national chains, Sears and AAMCO engaged in widespread abuses of customers at times, so this incentive does not necessarily determine corporate behavior even in solvent companies. Insolvency creates perverse incentives and can induce "reactive" control fraud even among the formerly honest.
Meineke realized that it could take advantage of its franchisees in a way that would be very difficult to detect and could provide considerable revenue. Meineke's decision to abuse its franchisees exemplifies one of the risks of relying solely on economic incentives instead of ethics or laws to restrain abuses. As long as the officers think they can get away with the fraud, the economically "rational" answer will be to defraud. Unfortunately, those who engage in major frauds are typically extraordinarily arrogant. They may systematically underestimate the risk that their frauds will be detected.
There will be many situations in which the economic incentive is to act abusively. Consider the example of laws requiring the proper disposal of toxic wastes. Toxic wastes are the quintessential "negative externality" in economic jargon. If we leave their disposal to voluntary agreements, they will be disposed of improperly. We did leave their disposal to voluntary agreements, and they were almost always disposed of improperly. Governmental intervention is essential to achieve a socially efficient disposal of toxic wastes.
I hasten to add that while governmental intervention is essential, it does not mean that the actual intervention will be effective or even desirable. The government may intervene in a perverse manner. For example, the Department of Defense has one the worst records for toxic waste disposal in the U.S., and the former communist states were invariably horrendous polluters. The "Superfund" program to clean up U.S. toxic waste sites is a travesty.
Even when the government rule is sensible, e.g., that toxic wastes have to be disposed of properly rather than dumped in a river, lax enforcement of the rule creates perverse incentives. Organized crime is active in toxic waste disposal in parts of the country. The key economic fact is that it is cheaper to dump toxic wastes improperly in a rural river than to pay the much higher fees of a facility that provides proper disposal. Absent effective enforcement, chemical companies who hire criminals and ruin the environment will achieve a cost advantage over their more honest competitors. This can create a destructive dynamic that reduces the morals of the industry to the lowest common denominator. (In economic jargon, it is a variant of Gresham's law: "Dishonest companies drive honest ones out of business.")
Vigorous, well-designed regulation and enforcement is a "win-win" proposition. It helps both citizens and honest companies. To take another auto industry example, used car dealers overwhelmingly engaged in the fraudulent practice of "rolling back" the odometer to make it appear that their cars were lower mileage and warranted a higher price. That practice is now very uncommon because of a combination of regulation, enforcement, and voluntary efforts by the most reputable dealers.
Lax enforcement breeds fraud. One of the most pernicious effects of weak enforcement is that it degrades the moral message contained in the law. "Window dressing" of financial statements (manipulating quarter-end transactions to make the financial statements unduly rosy) is a form of financial fraud. The Securities and Exchange Commission (SEC) does not bring actions to penalize the practice. It has, therefore, become pervasive in America. The CEOs and CFOs of these companies do not consider the practice to be wrong.
A constant danger is that the abusive companies will have the greatest incentive to make political contributions and secure the aid of prominent politicians to weaken regulation and prevent enforcement actions. This occurred during the S&L and Enron scandals.
One of the aspects of Vice President Cheney's secret meetings with large contributors/businesses is the effort to weaken regulation and nominate lax regulators to run the agencies. For example, SEC Chairman Harvey Pitt was best known prior to his appointment for his successful effort to prevent effective accounting regulation. Senior officials from both major parties helped defeat vigorous enforcement against control frauds in both the S&L debacle and the run up to the ongoing crisis.
Moral restraints and legal prohibitions, in a functional, representative government, are generally mutually supportive. They can also support, instead of supplant, voluntary agreement. Meineke, for example, was deeply embarrassed by the exposure of its immoral behavior. The moral outrage of the community exerted material social pressure on Meineke. The civil suit simultaneously exposed the abuse and the company's finances to enormous damage awards. Potential franchisees were more likely to sign with rival auto repair chains. Meineke reached an agreement with an association of its franchisees to reform its practices.
But it suggests a critical question dealing with Joe's Auto Repair and a broader question about the industry. Dan's analysis requires that the company would have been driven promptly out-of-business by local customers if it were unethical or even inept. So, why is going to "Joe's" risky? It has to be because Dan sees a non-trivial number of business officials as amoral, or even immoral. "Joe" acts as if he were ethical when that is profit maximizing (i.e., with local customers). But "Joe" may act fraudulently when dealing with non-locals because that is profit maximizing. Joe does not learn to be ethical when he treats local customers honestly, only to mimic how an ethical company would act. This amoral attitude and experience as a mimic aids him when he defrauds the out-of-towners.
Dan's theory would predict that every auto repair place would act ethically toward local customers. This prediction is not accurate. Overall, auto repair has a noxious reputation for abusing customers. When secret "testers" are used the results are usually horrific, even when testers pose as locals.
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