Trust and Fraud

Here's James Surowiecki on the surprising link between easy credit and rampant fraud, as epitomized by the Madoff ponzi scheme:

Fraud is a boom-time crime because it feeds on the faith of investors, and during bubbles that faith is overflowing. So while robbing a bank seems to be a demand-driven crime, robbing bank shareholders is all about supply. In the classic work on investor hysteria, "Manias, Panics, and Crashes," the economist Charles Kindleberger wrote that during bubbles "the supply of corruption increases . . . much like the supply of credit." This is more than a simple analogy: corruption and credit are stoked by the same forces. Cheap money engenders a surfeit of trust, and vice versa. (The word "credit" comes from the Latin for "believe.") The same overconfidence that leads investors and lenders to underestimate the risks of legitimate investments also leads them to underestimate the likelihood of fraud. In Madoff's case, for instance, his propensity for delivering inexplicably consistent returns month after month should have been a warning sign to his investors. But in the past few years besotted investors were willing to believe lots of foolish things--like the idea that housing prices would just keep going up.

An oversupply of credulity doesn't last, of course; when the crash comes, and people get more cynical and cautious, the frauds are exposed. As Warren Buffett put it, "You only learn who's been swimming naked when the tide goes out." Did the share prices of Enron and WorldCom start plunging after their fraudulent actions came to light? Actually, it was the other way around: the financial mischief was exposed only after their stock prices tanked. In Madoff's case, the steep across-the-board decline in asset prices curbed investors' appetite for risk, so that many started to pull their money out. That effect may very well have forced Madoff to dispense more money than he could keep bringing in, especially since recruiting new investors, which you have to do to keep a Ponzi scheme going, would have become harder after the crash.

In recent years, there have been some extremely interesting experiments on the development and disintegration of trust. I've written about some of this work before:

[Read] Montague pioneered a technique known as hyper-scanning, allowing subjects in different fMRI machines to interact in real time. His experiment revolved around a simple economic game in which getting the maximum reward required the strangers to trust one another. However, if one of the players grew especially selfish, he or she could always steal from the pot and erase the tenuous bond of trust. By monitoring the players' brains, Montague was able to predict whether or not someone would steal money several seconds before the theft actually occurred. The secret was a cortical area known as the caudate nucleus, which closely tracked the payouts from the other player. (The caudate is usually discussed in the context of addiction, since it plays a central role in modulating our expectation of pleasure.) Montague noticed that whenever the caudate exhibited reduced activity, trust tended to break down.

The key point is that trust is ultimately about the expectation of rewards. We like to think that trust is rooted in personal qualities, and that we trust people who are, well, more trustworthy. Alas, the social brain isn't quite so lofty - we compute trust based on calculations of future reward and profit. This is why, as long as Madoff kept on generating those 12 percent returns, nobody (not even the SEC!) was interested in questioning his scheme. He was a liar and a cheat who seemed honest, simply because he made other people lots of money. (Of course, now we know where that money came from...) As Surowiecki notes, it wasn't until those rewards disappeared that people began to suspect that something wasn't right, even though it's clear (at least in retrospect) that Madoff's lies should have been uncovered long before.