It’s easy for anyone going by media accounts of the countless scams perpetrated on the financial system — and of how easily the alleged scamsters are able to ‘loot and scoot’, typically by seeking refuge in foreign jurisdictions — to give in to a sense of despair and gloom.

In India, the scale of such ‘white-collar financial crimes’ ( a la Vijay Mallya and Nirav Modi) has only increased in recent years, and although the granular details of the modus operandi in each case may vary, they share a common attribute in that they contribute to an overall sense of distrust in the system, such as it is.

Reading Lying for Money , which details the anatomy of legendary frauds down the ages, can have a curious bipolar effect. For one thing, author Dan Davies, a former regulatory economist at the Bank of England, and a market analyst, lays bare the mechanics of fraudulent machinations of scamsters and helps enhance our understanding of the systemic failures that create conditions for racketeers to thrive.

In some ways, it is hope-inducing: you begin to believe that it’s just a matter of plugging the loopholes.

Reality bites

But in equal measure, Davies tempers those heightened expectations with a sobering account of why there is a certain inevitability about scams. Trust, he reminds us, is the basis of the modern industrial economy. Of course, some societies do it better than others: in Greece, for instance, multimillion-dollar deals are struck on a handshake.

But just as the modern world benefited from the principle of division of labour, as economist Adam Smith wrote, it also saw a growing “division of trust”.

And scams happen because, Davies notes, “the nature of fraud is that it works outside your field of vision, subverting the normal checks and balances.” And particularly in financial markets, people have been missing the wood for the trees for as long as there have been markets.

In his estimation, fraudsteres don’t play on moral weaknesses, greed or free: they play on weaknesses in the system of checks and balances, and the audit processes that are meant to supplement an overall environment of trust.

Indicatively, when we look at some of the more famous and large-scale frauds around the world, we realise that much of the skulduggery could have been brought to a halt at a very early stage if anyone had taken care to confirm all the facts.

In the author’s reckoning, such ‘blind spots’ are built into the system: they become glaringly apparent only after the whole enterprise has collapsed.

The point, to which Davies returns throughout the book, is that fraud is an equilibrium quantity. As a society we can’t afford not to check up on anything , and we cannot also check up on everything . And it is in the space between those two extremes that the level of scams find its optimal equilibrium.

The fraudster, writes Davies, exploits the fact that a world in which every single document is checked, every claim of ownership verified and every certificate of quality audited, would be a world in which a huge proportion of the business world’s time and effort is wasted by checking up on each other. “So one of the key decisions that an economy has to make is how much effort to spend on checking.”

The opportunity cost

In other words, the author reasons, commercial fraud is the evil twin of the modern economy. Taking precautions against fraudulence is expensive — or at least inconvenient. On the other hand, trust is free. “This means that people will substitute trust for precaution up until the point at which the shadow cost of trust — the expected fraud loss — begins to exceed the direct cost of precautions.”

And since this trade-off will likely involve a mixture of both, he concludes, there will always be trust – and, therefore, there will always be scams.

That may sound like an alibi for fraudsters, but in fact Davies is making a broader point: that there is an opportunity cost to eliminating dishonesty. The policy paralysis that gripped the UPA 2 government of Manmohan Singh after it was singed by a series of scams is illustrative of this.

Similarly, notes Davies, the cost of eliminating dishonesty is much more to do with the the legitimate business that never gets done. “The cost of dishonesty itself is inseparable from the extent to which bad actors drive out good. The trade-off that we need to make at the level of society is between these two quantities.”

The Golden Rule

Davies, therefore, propounds a ‘Golden Rule’ to deal with fraudulence. One of the defining characteristics of a fraud is that it will grow over time, and probably very quickly — owing to what’s called the ‘snowball effect’, as illustrated most vividly by ‘pyramid schemes’ (or Ponzi schemes).

Therefore, he writes, anything that is growing unusually quickly needs to be checked out — in a way that hasn’t been checked before. But even he concedes that the Golden Rule works only up to a point.

As an aside, Davies acknowledges that it may be tempting to read Lying for Money , with its vivid narration of how scams are perpetrated, as an instructional ‘how to’ manual.

But it’s worth bearing in mind that all of the fraudsters discussed in the book got caught. Some of them, in fact, were so stressed out by their career in crime that they literally wept with joy when they were exposed.

“The time, effort and commercial acumen that goes into almost any fraud would nearly always have been better spent on doing something productive,” he reckons.

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