Archive for the ‘Madoff’ Category

Rot at the Core: Dan Ariely on financial crisis & psycho-social aspects of cheating

April 3rd, 2009 2 comments

I just ran across an interesting speech and related commentary provided last month at TED by behavioral economist Dan Ariely, professor at MIT and author of Predictably Irrational.  Both the speech and the commentary are worth a look.

Ariely’s speech, billed as “Why we think it’s OK to cheat and steal (sometimes),” discusses how we fail to test our often-wrong intuitions, and focusses on the cognitive and social aspects of cheating behavior.  The Carnegie Council (which has a sidebar with other resources on cheating and corruption) summarizes Ariely’s speech as follows:

Ariely finds that in most situations a lot of people cheat a little, and that there are predictable ways to influence honesty.  When test subjects are reminded of morality, cheating drops. When subjects are distanced from the object of reward—for example, by replacing money with redeemable tokens—cheating increases. When other members of your social group cheat, you are more likely to cheat as well.

TED also asked Ariely for his thoughts on the Bernie Madoff scandal; these are a short read (about a page), but allow me to present a “readers’ digest” here:

Madoff’s massive Ponzi scheme was horrific on many levels. But while we watch the next phase of the scandal, it’s important to ask: What lessons are we going to learn from this? I can see three lessons that relate to my work studying human irrationality — and in particular, some non-useful lessons we might [unintentionally] learn.

One lesson that individuals and foundations are likely to take from the Madoff scandal is that in addition to diversifying their portfolio across several investments (stock, bonds, equity, cash), they also need to diversify their investments among several advisors. … You will need a whole new level of coordination among them so they can have the right amount of cash, bonds, stocks etc., across all of your assets.

And I think that people will begin to over-diversify across investors. Why? Because when we have one large and salient instance in our minds, it can be so powerful that we overemphasize it. …  In general, what we find when there’s one single vivid event is that people overweight it — we focus on it too much. So that’s the first lesson: We’re going to learn from the Madoff scandal, but we are going to overdo it.

Another non-useful lesson that I think we will adopt is to start searching with more vigor for other bad apples. On one hand, it is clearly important to prevent more Madoffs, but at the same time I worry that as a consequence of searching for bad apples, we won’t pay enough attention to other financial behavior that might not be as badly wrong but that can actually have larger financial consequences.

In our research on dishonesty, we found that when we give people the opportunity to cheat, many of them cheat by a little bit, while very few cheat by a lot. In our experiments, we lost about $100 to the few people who cheated a lot — but lost thousands of dollars to the many people who each cheated by a bit. I suspect that this is a good reflection of cheating in the stock market, where the real financial cost of the egregious cheating by Madoff is actually a tiny fraction of all the “small” cheating carried out by “good” bankers.

The risk here is that if we pay too much attention to chasing bad apples, we might pay too little attention to the situations where the small dishonesties of many people can have large consequences (such as paying slightly higher salaries to cronies, making small changes to financial reports, doctoring documents, being slightly dishonest about mortgage terms), and in the process neglect the real economic source of the trouble we are in. (emphasis added)

A third bad lesson that I think people will take from this concerns the way we define acceptable levels of cheating. In a study that may parallel Madoff’s egregious dishonesty, we … [found] that when someone who is part of our own social group cheats, we find it more acceptable to cheat, but when people who are not part of our social group cheat, we want to distance ourselves from these people and cheat less. (emphasis added)

Madoff was part of the financial elite — part of an in-group of our financial leaders. Think of all these people who were in his house, who knew him well. So now, when other people in this circle see him cheating, think about the long-term consequences: Would these other people in this financial industry now be more likely to take the immoral path? It doesn’t have to be another Ponzi scheme. It just means that, now that they have been exposed to this extreme level of dishonesty, they might adopt slightly lower moral scruples.  … I don’t think that those in his circle will necessarily become more Madoff-like people, but I do suspect that they will get a substantial relief from their moral shackles. Sadly, that’s his legacy.

So, Chapter One of the Madoff scandal is over, but I worry that the negative downstream consequences of this experience are just starting …

I share Ariely’s concern that we are likely to be distracted by a focus on big “bad apples” that may satisfy our needs to string someone up, but that will ignore the rot at the core – the systemic cheating that, in the American system, is very much related to the institution of state-granted “limited liability” to corporate investors/shareholders.  This grant (1) frees investors from the downsides of losses suffered and borne by third parties as a result of corporate actions, (2) limits investor incentives – and abilities – to monitor and control risks faced by and generated by executives, managers and other employees, (3) thus incentivizing risky behavior and providing greater freedom of action to executives and managers – including freedom of action to seek favors from government , (4) leaving executives and managers freer to loot their companies by taking large bonuses, which shifting downside risks to shareholders and taxpayers, and (5) fuelling pressures by consumers and others adversely affected by corporations to seek to use legislative, regulatory and judicial mechanisms to check corporate behavior.  In sum, limited investor liability has proven to lie at the core of the moral hazards which have produced the Great American Ponzi scheme that our fearless leaders are now struggling mightily to patch together and profit from.

Did I leave anything out?  (Ah, maybe how various firms, investors and their political handlers profit while socializing climate change risks?)

Anyone game for exploring ways to reduce the destructive gaming and rampant cheating in the American system?