The sentencing this week of Apple Valley Ponzi artist Trevor Cook got me thinking about the economics of crime and how scams like his make a ‘zero-sum game’ look like a good deal.
Crime makes society worse off. This may seem obvious, but there was a time when some economists evaluated crime and government corruption in terms of “zero-sum game” transfers between people. Some saw theft as little different from one person dropping a $10 bill on the ground and someone else picking it up. The finder’s gain offsets the loser’s loss, and it is thus a “zero-sum game” (with the caveat that we cannot measure in absolute terms how much personal satisfaction each gets from one 10-spot).
But in most real-world crime, the loss of human satisfaction by victims exceeds any gains by perpetrators. People who gave their money to Cook reportedly lost a net $158 million. Cook spent some part of that living high in the historic Van Dusen mansion in Minneapolis. Other amounts went into a failed Swiss brokerage and a Panamanian real estate deal. Though we cannot measure gains or losses of human satisfaction in objective units, the emotional pain and loss felt by his victims very likely add up to much more than any additional pleasure experienced by Cook or his counterparts in Switzerland and Panama. So his crimes made society as a whole worse off.
The theft of a radio from a car is another example of such a net loss. The punk who smashes a car window and grabs a radio may get $25 for it from some pawnshop. The car owner has to pay much more to buy another radio and replace the window. Even if covered by insurance, the “transaction costs” of getting the repairs, especially in lost time, is considerable. And the monetary costs ultimately are borne by all people who buy insurance. The pawnshop dealer may make more on the deal than on a legitimate pawning because he knows the perp’s vulnerability and lack of bargaining power. Some eventual buyer may get a good radio cheap. So there are some transfers from the victim to others. But the net change in overall human satisfaction is almost certainly negative.
University of Chicago economist Gary Becker, the 1992 Nobel Laureate, analyzed crime from the point of view of rational satisfaction-maximizing on the part of criminals. A criminal, he argued, looks at the expected value he will get from the crime and compares it with the expected cost of the crime. The primary cost of the crime is getting caught and punished. But this outcome is unknown. So the criminal looks at the likely punishment and at the statistical probability of getting caught.
This implies that if you want to reduce crime, then you have to either increase the severity of punishment or the probability of catching perpetrators. Doing either will raise the expected cost of committing crime and will cause crooks to commit fewer crimes, just as higher interest rates cause farmers to buy fewer combines.
Therefore, whether you want to deter Ponzi schemes by petty scam artists or violations of securities laws by investment banks, you must either increase the penalties or the probability that violators will be caught, convicted and punished.
The probability of conviction is important. Cook’s crimes were so blatant — he didn’t even go to the trouble of creating separate accounts for individual investors — that there was little chance of a slap-on-the-wrist plea bargain or settlement.
But when banks and major investment firms violate the law, it can be a different matter.
When Christopher Cox headed the Securities and Exchange Commission, for example, it became well known that violators could work out easy “consent decree” settlements with SEC staff who knew that the full commission frequently made spontaneous reductions in settlements they thought too harsh. Some investment companies accordingly pushed the edge of legality.
Moreover, large financial firms accused of crossing the line can marshal enormous legal resources to fight charges. Regulators cannot match such legal firepower and have budgetary incentives to settle for nominal sums and avoid any indictments of individuals. But some federal judges are now taking umbrage at the implication that large crimes are committed by companies but no individual did anything criminal. Earlier this month, U.S. District Judge Ellen Segal Huvelle refused to accept a $75 million settlement Citigroup negotiated with the SEC over allegations that it misled investors, saying it was too lenient.
The Cook scandal has one other economic aspect. Why were so many people so gullible as to put $190 million into an operation that reeked of scam? Cook’s foreign currency trading operation was peddled to investors worried about the economy who didn’t trust Wall Street. They were promised double-digit returns, guaranteed.
Now, you can tire yourself out telling people there is no free lunch and that higher returns can come only by taking on more risk. But the general public is bombarded with stories about people making financial windfalls in one investment or another and willingly fall when they believe fortune has given them an opportunity to do the same.
Putting up an impressive front, as Bernard Madoff did, helps lull people. Cook obviously had skills in creating an impressive front. Basic human frailties like gullibility and greed cast veils over people’s eyes.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.