Elementary, My Dear Economist

“There is an inverse relationship between interest rates and dishonesty,” says Carson Block, a short-seller.

https://www.economist.com/business/2022/11/07/a-sleuths-guide-to-the-coming-wave-of-corporate-fraud

You’d think we would learn, but it is hard to unlearn greed, alas. Whether it is tulips in the 16th century or collateralized debt obligations in the 2000’s – or whatever will be uncovered in the weeks (or months) to come – the underlying phenomenon is as old as humanity: greed.

People, institutions and organizations have been greedy these past few years, says The Economist in a lovely little article, and now that an era of high interest rates is upon us, some of these greed related shenanigans will be uncovered. This will not be a pretty process, and the repercussions will be tough for all of us. Job losses, reduced investments, slowing economies will all manifest themselves, and a familiar story will play itself out all over again.

But how will the tragedy start? What will be the straw that breaks the camel’s back? Which card in this particular house of cards will be the first to slip, bringing the whole edifice down? The Economist points to Environmental, Social and Governance (ESG) investing, or maybe various government schemes across the world to help business during the pandemic. Fintech is another obvious candidate. My own personal favorite pick is that the housing sector in China will be the epicenter, and a lot of things will begin to unravel from there on in. My personal worry is that this is such an obvious pick that I’m missing something else that will seem even more obvious with the benefit of hindsight.

But The Economist, in this article, teaches us how to begin to be an economist-y Sherlock. What facts should we cram our heads with, what story should we start to build, and how should we go about deducing how the collapse will start?

The article talks about a ‘triangle’ of factors: motives, circumstances and rationalization. If you are in charge of a business that seems to be doing well during the ‘good times’, there is pressure on you to keep making a good story better, and that spiral can be ascended with the help of some shady bookkeeping. That’s motive.

Circumstances effectively is shorthand for saying that fraud is likely to be higher in those economies where institutions are of lower quality: regulators not doing their jobs, politicians willing to look the other way. The article mentions China (and in a throwaway sentence, India), but I’d disagree. Institutions can be of poor quality the world over, and it has more to do with incentives and greed than it does with ’emerging economies’ alone. ‘In rich countries, opportunity beckons in the latitude of accounting practices’, says the article, but surely nobody today is under the illusion that rich countries have had institutions and regulators of great quality! If your memories are long enough to go back to Polly Peck, surely they can help one remember 2008 in the US and 2011-12 in Europe? And those, to me, aren’t examples of accounting malpractice, but rather of regulators asleep at the wheel, knowingly or otherwise.

And finally, rationalization. This is simply the “but everybody is doing it, so why shouldn’t I?” argument, and it is, unfortunately, all too common in all walks of life. To expect those involved in high-stakes finance to be immune from it is dangerously problematic.

Combine these three then: motives, circumstances and rationalization, and throw in slowing growth and high inflation, and ugly stories will start to emerge. They already have, of course, so long as you know where to look.


Two additional points: Goodhart’s Law remains underrated, and this article is yet another reason to learn it, and to learn how to apply it and above all, to learn to predict outcomes by using it:

That bosses feel pressure to deliver predictable profits is well documented. Almost all the 400 managers surveyed in the mid-2000s by John Graham, Campbell Harvey and Shiva Rajgopal, a trio of academics, confessed to a strong preference for smooth earnings. Most admitted they would delay big spending line items to meet a quarterly earnings target. More than a third said they would book revenues this quarter rather than the next, or incentivise customers to buy more earlier.

https://www.economist.com/business/2022/11/07/a-sleuths-guide-to-the-coming-wave-of-corporate-fraud

And two: get better at learning the basics of accounting. Among economists, this remains a very underrated skill. Myself included, I should mention!

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