What can we learn from fraud and folly?

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The Ig Nobel Prize ceremony, for work that “makes you laugh, then makes you think”, came and went this year, with a clutch of worthy winners. I must report, more in sorrow than in anger, that no Ig Nobel Prize in economics was awarded. This is a great shame. The Ig Nobel Prizes have occasionally been known to dabble in juvenile humour, but, at their best, they illuminate important ideas that the Nobel Prizes themselves cannot reach.

Since the position of economics Ig Nobel laureate 2024 is currently vacant, then, I would like to nominate a candidate: the economist and author Dan Davies. Davies is a wide-ranging thinker, but there is a common thread in his work: he is a connoisseur of fraud and failure. (He has already given readers of this column the unforgettable story of the time 440 luckless squirrels were hurled into an industrial shredder at Schiphol airport.)

In his book Lying for Money, Davies put forward a striking proposition, which is that the best glimpses of the economy’s hidden workings come when something has gone amiss. “Just as neurologists study the consequences of head injuries,” he wrote, “we can learn about the economy by looking at currency forgers and pyramid schemes.” And shredded squirrels, of course. Or, indeed, any situation when things don’t function as they should.

This observation feels worthy of an Ig Nobel, especially if backed up by some examples. So what lessons might we learn from economic frauds, follies and failures? 

The first is that physical reality matters. Consumers, commentators and financial traders all tend to see an indirect representation of the economy, rather than the underlying truth. We don’t see slaughterhouses or food manufacturing facilities, we see the Ocado homepage. We don’t see a working parent’s despair on being sacked, we see the latest unemployment numbers. It is easy to conflate the graphs and accounting statements with the physical reality they represent, and sometimes that conflation can be exploited.

As Davies explains, this was a lesson American Express learnt the hard way in 1963. At the time, an Amex subsidiary was making enviable returns by acting as a guarantor for companies who wanted to borrow money and use commodities as collateral. In particular, a gentleman named Tino DeAngelis ran a soya oil business, and wanted to borrow money using the soya oil as collateral. Amex earned a profit by verifying that DeAngelis’s soya oil did exist and was safely stored in Amex’s own tanks.

Unfortunately for Amex, its subsidiary was “verifying” something false. The storage tanks with “American Express Field Warehousing” written on them were designed and controlled by DeAngelis. They were, in fact, full of seawater, with a little soya oil floating on the top and some false chambers designed to fool inspectors. Despite an anonymous tip-off, Amex failed for several years to properly investigate the tanks it nominally owned. When the fraud was discovered, it nearly wiped Amex out. Reality matters; always look beneath the surface of the soya oil.

A second lesson is beware “cheesecake bets”. In the musical Guys and Dolls, Nathan Detroit offers to bet with Sky Masterson that Mindy’s restaurant sells more strudel than cheesecake. A wise man would ask why Nathan is offering Sky the bet. (Nathan, of course, already knows the answer.)

Cheesecake bets come in many guises, and they are common in finance. The point is that if a clever Wall Street type in a sharp suit would like to sell you a financial product, it is worth asking yourself whether you would really like to buy it.

On this matter, Davies directs me to a thought experiment proposed by the finance writer Paul Wilmott: imagine that a stage magician asks you to name a card. You name the Ace of Hearts. The magician then pulls a card from the deck without looking. What is the probability that it is the Ace of Hearts? The best answer I can think of is “whatever the magician wants it to be”. In many deals in finance, if you aren’t the magician, you’re on the wrong end of the conjuring trick. And no matter how many degrees in mathematics you have, the chance that card is the Ace of Hearts is definitely not 1 in 52.

A third lesson is that you learn a lot when you examine points of friction or failure. Many years ago, a team led by the Peruvian economist Hernando de Soto went through every formal procedure required to legally establish a small clothing workshop — just a couple of sewing machines — in Lima. The process took 289 days. De Soto’s exercise in frustration has been hugely influential: he highlighted the fact that in many poor countries, simple tasks such as setting up a business, legally employing a worker or registering title to a property, can take months or years and cost prohibitive sums. The result is corruption, and an informal sector that pays no taxes and struggles to grow, borrow money or get insurance.

Thanks to the shift in perspective which de Soto catalysed, many countries have streamlined business regulations. The key insight came from focusing on the details about what was going wrong.

So I would be all in favour of an Ig Nobel for Dan Davies for highlighting the economics of fraud and failure. The starting point for economic analysis is often an economic Garden of Eden, a perfectly competitive market, filled with rational actors. We might learn more if instead we paid attention to the serpent and watched how he operates.

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