Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't by John Jr. (books to read for 12 year olds txt) 📗

applied unsuccessfully for licenses to become a stockbroker, a real estate agent, and then an insurance salesman. Nine years later he was driving a yellow cab in New York City.74 Likewise, S.G. “Rudy” Ruderman, who broadcast Business Week’s daily market report, was convicted in 1988 of trading on stock tips before the tips appeared in the magazine. For a year-and-a-half after he left prison, he held a part-time job reading the news on a small Westchester, New York radio station. After that stint ended, he lived off his wife’s income.75

Aside from the loss of job and income, ex-convicts are likely to suffer from a variety of additional financial penalties that affect the wealthy more than the poor. These include being prevented from inheriting property, the partial or total divestment of assets, loss of life and/or car insurance, and the loss of pension funds, including the discontinuance of pension payments for ex-convicts who are already retired.76 In fact, presidential task forces have emphasized the importance of these collateral penalties and expressed concern that inattention to them will create inequities in criminal penalties.77 Of course, these penalties come on top of the loss of rights likely to be incurred by all ex-convicts regardless of their economic status, such as voting rights and parental rights, as well as the ability to serve as a juror, hold public office, and own firearms.78

Thus we see that once reputational penalties are considered, the wealthy tend to face significantly more punishment than the poor for committing the same crime. Since few people want to risk being perceived as sympathetic to white-collar criminals, however, reputational penalties are rarely mentioned in the public debate on the inequities of the judicial system.

Reputations: Keeping Corporations Honest

Consider the so-called corporate scandals of the early 2000s. The crimes committed by Enron included hidden partnerships, disguised debt, and manipulation of energy markets ....The practitioners of such [criminal] acts [by firms], especially in the realm of high finance, inevitably offer this defense. “Everybody else was doing it.” Which was largely true. One characteristic of information crimes is that very few of them are detected.

—Freakonomics79

In the above quotation, Levitt and Dubner argue that corporate fraud is rampant, but they say it’s hardly ever detected. They might forgive a reader for wondering how they can know that these misdeeds are so prevalent if no one ever finds out about them. This claim is really just an assertion of what they think might be happening; no evidence is offered because—conveniently—no evidence is possible. It’s a perfectly unfalsifiable claim.

Popular belief in rampant corporate fraud has real consequences in that it creates pressure for changes in government policy. Reflecting popular opinion that penalties against corporate fraud were too low, in 1991 the U.S. Sentencing Commission—the federal agency responsible for setting the penalty guidelines used by judges—raised median corporate fraud penalties by over twenty-fold. I fought vehemently against this move while I was chief economist at the Sentencing Commission during the late 1980s, but only succeeded in getting it temporarily delayed.

At the time, the penalties seemed small compared to the losses imposed on customers due to corporate fraud. In the late 1980s, half the corporate fraud convictions resulted in sanctions of less than fifteen cents per dollar lost from the fraud, with the average fine amounting to only seventy-five cents per lost dollar. This was much lower than the relative penalties meted out for other corporate crimes such as environmental pollution, where half the fines were $3.71 or more per lost dollar.80

Yet, the research I did with Jonathan Karpoff, a professor at the University of Washington, convinced me that there is a solid economic reason for setting corporate fraud penalties lower than for other misdeeds such as environmental crimes. When convicted of fraud, companies face collateral penalties related to their loss of reputation. And these reputational penalties usually do not apply to other kinds of corporate crime. When firms defraud their customers or don’t deliver what they promise, customers will stop buying their products or will insist on lower prices that factor in the extra risk. In contrast, aside from a small minority of activists, most customers will not reject a company’s products because it was convicted of an environmental or similar crime that does not directly affect the customers’ purchases.81

The reputational penalties suffered by a firm accused of fraud are substantial, even before the company is convicted. The market value of firms accused of fraud fell by $61 million during 1980s.82 On average, only 6.5 percent of this decline reflects legal costs, and just 1.4 percent is accounted for by penalties and fines. The rest of the drop reflects expectations of reduced sales and earnings.83 This contrasts sharply with the drop in stock prices when a firm is accused of an environmental crime, in which case virtually the entire decline reflects the firm’s legal costs and penalties. In essence, reputational penalties, on average, are non-existent for environmental crime. People may not like hearing that a company pollutes, but overall they simply will not stop buying the firm’s products based on environmental misdeeds.

Thus it is primarily the fear of legal penalties, not reputational ones, that deters environmental crimes. But this is not the case for corporate fraud. As previously noted, at the time when corporate fraud penalties were increased twenty-fold, government penalties for fraud averaged just seventy-five cents per lost dollar. When this is combined with the average reputational penalties in the form of declining sales, earnings, and stock prices, we find that the average total penalty due to a fraud accusation was already 11.5 times greater than the loss imposed on customers.

This is not mere academic curiosity; raising the criminal penalties for fraud too high can hurt customers and damage the economy. Large fraud penalties force companies to spend more money on guaranteeing product quality. While everyone values greater assurance that they are getting higher quality products, not everyone wants to pay more for this guarantee. Just as different people take different levels of