We read this morning of another instance of financial fraud in China, this time involving payola to journalists to influence their business coverage. In fact, there has been a stream of reports suggesting dishonest accounting and misleading disclosures are widespread in Chinese finance.
I have a theory of financial fraud, loosely derived from Veblen’s Theory of Business Enterprise with a little Minsky thrown in; it goes like this:
There is always a lot of fraud in the world of corporate accounting and finance; it is very hard to prevent. (a) The motive is strong. Report higher earnings, attract more investment and credit, enjoy more opportunities to launch new projects or prop up old ones, boost asset values, make money. (b) The restraints are weak. As Veblen pointed out, a large portion of valuation is speculative in any case, based on prognostications of future profits. There are insiders and outsiders, and insiders among the insiders. The booty can be shared with those, like accountants, raters and reporters, who are ostensibly there to monitor probity. Regulators are captured, politically and cognitively.
Of course, the problem with fictitious profits is that eventually events separate fact from fiction. Companies that coasted on inflated earnings forecasts crash against the shoals of realized losses. But this takes time, and meanwhile there are new companies, and new amalgams and spinoffs of old companies and new investment projects whose inflated valuations can bulk up portfolios faster than past disappointments can shrink them. Red ink can be covered over if there’s enough black, even if the black is speculative and the red is real.
This works in the boom for two reasons. First, there are lots of real profits being made, so inflated forecasts are (temporarily) validated and occasional losses can be absorbed. Second, the proportion of new projects, whose valuation is entirely speculative, to past projects is higher. Reality bites less.
All booms come to an end for one reason or another, and when they do the hidden world of fraud is exposed for all to see. It’s no longer possible to sustain the pretense: the supply of funds to those who had been losing money all along is cut off, bringing about (literally) a moment of reckoning.
I would like to distinguish between the cyclical visibility of fraud and its actual cyclicality. Fraud is exposed in the crash, but did it peak just prior to it and cause it to happen? The general opinion, and this includes Veblen-Minsky, is yes. Booms become frothy, and froth foments fraud. Perhaps. But I suspect the conditions conducive to financial fraud are always in place, and much of the fluctuation is about what we see, not what there is.
When the dotcom bubble collapsed at the beginning of the 00's we witnessed an epidemic of accounting fraud. Remember Enron, Global Crossing and Arthur Andersen for starters. The CDO deceptions of the mid-decade were exposed by the financial crisis of 2008. No doubt accounting and rating standards deteriorated during the bubble years, but this is not to say they weren’t widespread all along. Part of what changed is that the popping of the bubble removed the buffers that normally allow a bending and stretching of the numbers.
I doubt that this is a culture-bound hypothesis, true for the US but not, say, China. The extraordinary Chinese investment-led boom of the past twenty years can obscure a lot of malfeasance, but if and when the boom ends we’ll find out that much of the wealth creation was fictitious. Best-sellers will be written about brazen fraud in high places, as if this were unique to China and its final go-go years. But while it's much easier to call out corruption after the money train has stopped, this doesn't mean that an upsurge of corruption stopped the train.