Friday, September 12, 2014

Financial Fraud and the Business Cycle: The Chinese Case

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.


Bruce Wilder said...

At least for Minsky, as I suppose you know, it is the changing standards regarding the buffers that drive the cycle. What makes optimism into fraud is the diminished size of the buffer.

Sandwichman said...

Fraud, so to speak, was hardwired into the spread of Venetian bookkeeping from the start. Not to say that there weren't other motives and other benefits but one of the major incentives of learning and adopting an intellectually challenging procedure was as a prophylactic against being suspected of doing exactly what merchant bankers were in fact doing -- charging interest on loans. Raymond de Roover, "Early Accounting Problems of Foreign Exchange":

"It would be wrong to assume that the usury prohibition remained a dead letter. Quite the contrary. The canonist doctrine on usury had a profound influence on business practices, since interest could not be charged openly but had to be concealed under some form or other. As a result of the usury prohibition, bills were never discounted but were bought at a rate of exchange which fluctuated up and down according to the conditions prevailing in the money market. There is no doubt that interest was received by the banker who invested his money in the purchase of bills, for a hidden interest was included in the rate of exchange. Because of this subterfuge, the structure of the money market was such that exchange fluctuations were caused either by a change in the rate of interest or by a change in the terms of international trade. Today the existence of a special rate for sight drafts or cable transfers permits the segregation, in accounting, of exchange profits (or losses) from interest income (or expense) and the separation, in economics, of the credit problem from the transfer-of-funds problem. But in the Middle Ages credit and exchange were welded together so far as foreign banking was concerned, and this fact cannot be emphasized too strongly."

Peter said...

I find this topic very interesting and at the center of current debates. Are the banks insolvent or illiquid?

And my skepticism says that those who are screaming "insolvency!" have just as much of an axe to grind as those who advocate deregulation and the magic of the market.

When the recession and credit crunch occurs, only those with good credit credit and "real" earnings can weather the storm. Those riding on leverage will become unsustainable an insolvent.

Also during booming times, the wealthy can devote more of their surplus money to political activity instead of just investment and thereby deregulate, cut taxes, weaken credit standards etc, which enable them to earn more at the expense of sustainability. Enron was very much tied in with Republican politicians who were pushing deregulation and privatization.

Peter said...

In other words, those who advocate deregulation and unleashing the magic of the markets should be met with the counter "instead of loosening macroprudential policy and regulations, let's loosen monetary policy and lower interest rates."

Greenspan had loose macroprudential policies and it gave us damaging bubbles.

Don Coffin said...

"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."

And, because in a boom (as JKG pointed out decades ago), people are less likely o be looking for fraud. The "bezzle," as he said expands in the boom and contracts in the crash.