The Predictioneer’s Game: Using the Logic of Brazen Self-Interest to See and Shape the Future

7

FAST-FORWARD THE PRESENT

ONE OF THE great benefits of being affiliated with Stanford’s Hoover Institution is the opportunity to participate in small seminars with some of the world’s most interesting scholars and policy makers. These seminars are often off the record, which means that there is the chance for frank exchanges of views on important issues of the day. The discussion during one such seminar, on the Israeli-Palestinian dispute, led me to consider how game-theory reasoning might contribute to tackling the seemingly insurmountable obstacles to peace. The approach I thought about is not a solution to the dispute, but it is a potentially useful step toward advancing the real prospect of a lasting peace.

For all of its limitations, the idea I came up with provides an example of how game-theory reasoning can nudge us in a new direction even under the most seemingly intractable circumstances. If game-theory logic can foster progress on the Israeli-Palestinian dispute, it surely will have contributed to solving one of the most important foreign policy problems of our time. With that in mind, let’s have a fresh look at Israeli-Palestinian relations. And who knows, maybe somebody reading this book can help turn the idea into reality or can point out some fatal flaw in it.

LET’S MAKE A DEAL

Land for peace and peace for land are two formulas that are doomed to failure, whether in the Middle East or anywhere else. It’s an idea that sounds sensible, so it attracts lots of attention. Ehud Barak proposed a land-for-peace deal at the July 2000 Camp David summit between him (he was Israel’s prime minister), Yasser Arafat (then president of the Palestinian Authority), and President Bill Clinton. The Oslo Accords in 1993 also were a land-for-peace deal. Barak’s Camp David plan and its later variants failed. The Roadmap for Peace, another land-for-peace arrangement, failed too. All land-for-peace or peace-for-land deals by themselves will do the same. They are no way to end violence, because neither assures either side that the other is making a lasting promise, a credible commitment.

Each promise—land for peace or peace for land—suffers from what in game theory is sometimes called a time inconsistency problem. That is, one party gives an irreversible benefit to the other party today in the hope that the other will reciprocate tomorrow. Almost certainly instead, the side getting the irreversible benefit exploits it to seek even more gains before delivering on its promises. Giving up land on the promise of peace inevitably leads to demands for more land before peace is granted. Giving peace on the promise of land later has much the same problem. The peace giver lays down its arms to show good faith, but then the land giver is free to renege, feeling no compulsion to follow through with land the opponent can no longer take.¹

Time inconsistency problems arise in many contexts, not just land for peace or peace for land. In fact, we saw an example of this problem earlier when we discussed North Korea. The threat of reneging on promises once an adversary has disarmed is exactly why asking Kim Jong Il to dismantle his nuclear capability won’t work, but negotiating a deal in which he agrees to disable his nuclear program can work. The problem is no less consequential in the Middle East.

Look at the decision by Israel’s hard-liner prime minister Ariel Sharon to withdraw (unilaterally) from Gaza in August 2005, ceding that territory to the Palestinians. An important part of Sharon’s motivation seems to be that he concluded it was too costly to defend Gaza. So he chose to make Israeli settlers abandon their homes, whose existence was a major flashpoint with Palestinians, in the hope that yielding Gaza would help promote goodwill and peace. The belief that good deeds, whatever their motivation, will elicit a good response reflects optimism about human nature that sometimes is met by reality but all too often is met instead with greed and aggression. As you know, game theory rarely takes an optimistic view of human nature. Sharon’s optimism was predictably wrong. Shortly after the democratically elected government run by Hamas in the Palestinian Authority used force to oust Palestinian president Mahmoud Abbas’s Fatah from Gaza, Hamas increased missile attacks against Israeli towns near the Gaza border. Land, freely given with no strings attached, did not produce peace. It produced a demand for more land and an increase in violence.

Mind you, this failure on behalf of the pursuit of peace is not some particular flaw among Palestinians. The Israelis have done much the same in the past. Having defeated their Arab rivals in the 1967 war and then again in 1973, Israel not only occupied previously controlled Egyptian, Syrian, Jordanian, and Palestinian land but also allowed the spread of settlements presumptively justified by the biblical covenant between Abraham and God. In fact, Israeli settlements almost always occupy the high ground surrounding Palestinian villages, making it all but impossible for Palestinians to enjoy a sense of security within their own homes. And even more troubling, Israel for decades restricted the movement of Palestinians into and out of Israel, just as they had done within Israel to Israeli citizens of Palestinian extraction. The upshot is that the Israeli government prevented Palestinians from following a peaceful road to independence by restricting their freedom of assembly. When Israel had the opportunity to promote peace with Palestinians after the 1967 war, it fell short, just as the Palestinians have fallen short in efforts to promote peace with the Israelis.

Every land-for-peace and peace-for-land formula I know of has ended in failure. Every such effort, whether unilateral, bilateral, or multilateral, has, if anything, made the situation worse by raising false hopes only to see them dashed. They are always dashed because the peacemakers simply do not pay attention to the time inconsistency in their strategy. They rely on goodwill and building trust when there is neither. Instead, they should leverage progress toward peace on the narrow self-interest of the contending sides. They should consider whether what they propose is a self-enforcing strategy from which no one has an incentive to deviate, rather than looking for an approach that requires mutual cooperation. Remember the prisoner’s dilemma from Chapter 3? Both players in that game are better off if they coordinate with each other to pursue joint cooperation instead of ending up competing with one another. The problem is that each is even better off by not cooperating if the other player chooses to cooperate. The upshot is that neither cooperates, leaving both worse off than they could have been. That, in fact, is the dilemma. Like the Israeli-Palestinian dispute, joint cooperation is not a sustainable solution unless the structure of the game changes first.

One way to change the game is to make costs and benefits change directly and automatically in response to the actions chosen by each player. A self-enforcing strategy solves this problem and can help promote peace and prosperity for each side. Here I would like to use the power of game-theory thinking to propose an important step toward peace between Palestinians and Israelis. It is not a comprehensive peace plan, but it is a way to make peace more likely. What I will say follows logically from game-theory reasoning, but it is not a mere assessment of what is likely to happen. It is a statement of logic in support of a way to end violence. It is a prescription for progress.

Key to my proposal is the phrase “self-enforcing.” It is an arrangement that requires little or no cooperation or trust between Israelis and Palestinians. The idea I have in mind provides each side with incentives to promote peace and resist terrorism purely in their own interest and utterly without concern for whether it helps the other side. In that sense it follows game theory’s dismal view of human nature.

My idea is that the Israeli and Palestinian governments will distribute a portion of their tax revenue generated from tourism (and only from tourism) to each other. Before going into the details—where the devil resides—let’s first see why tourist revenue and not any other. Why not, for example, promote peace by setting up joint Israeli-Palestinian ventures, or allowing freer movement between regions, or some other scheme? As we will see, shared tourist revenue provides a nearly unique opportunity.

The Palestinian Authority (PA) leadership routinely identifies tourism as one of the major pillars of the future Palestine’s economy. This is an eminently reasonable expectation given the vast number of historic and religiously important sites within the current and expected future territory of Palestine. The PA’s gross domestic product in 2007 was $4.8 billion. During peaceful periods, tourism represents more than 10 percent of income, and it could be much, much higher. By comparison, Israel’s GDP in 2007 was over $160 billion. Its tourist revenue was $2.9 billion in 2005 and $2.8 billion in 2006, and it is expected to be around $4.2 billion in 2008. So tourist revenue is a nice but relatively modest source of Israel’s income.

Tourism has a feature that can be exploited to improve the prospects of peace. You see, tourism and the tax revenue generated from it are highly sensitive to violence. For example, take a look at figure 7.1. The horizontal axis shows the range of violent Palestinian and Israeli deaths resulting from their conflict for the years from 1988 until 2002.² The scale reflects a range of quarterly deaths from 0 to about 300. The vertical axis shows the number of tourists (in thousands) who visited Israel each quarter between the same period, 1988 to 2002.³ Unfortunately, I have not located comparable tourist data for the PA, but I have found enough to see that the pattern is the same. When violence goes up, tourism goes down, and when violence drops, tourism returns.

The line in the figure shows the estimated rate of tourist response three months after the reported level of violence, while the dots show the observed amount of tourism in Israel associated with actual violence that occurred three months earlier. Tourism is delayed by three months after observed violence to give prospective visitors enough time to change their plans.

FIG. 7.1. How Much Does Israeli Tourism Respond to Violence?

Clearly, more violence means a lot fewer tourists. In fact, on average, every violent death translates into 1,300 fewer tourists and 2,550 fewer hotel bed-nights sold to tourists. There were 53 violent deaths during the typical quarter covered here. That translates into nearly 70,000 fewer tourists in a three-month period suffering average violence compared to the number expected in quarters with no dispute-related violent deaths. Israel averages about 450,000 tourists per quarter, so 70,000 is a serious number. With Israel enjoying about $3 billion in tourist revenue in an average recent year, and an average year having about 280,000 fewer tourists than might conservatively be expected in a peaceful year, that translates into about $500 million tourist dollars lost each year, not counting whatever is also lost by hotels, restaurants, taxis, car rental companies, guides, and so forth on the Palestinian side of the border.

And what is the Palestinian experience like? As I mentioned, it is harder to get equivalent data for the PA, but still there is plenty of evidence that the picture is grim. For instance, there were about 90 hotels in the PA before the intifada that started in late 2000. By the end of 2001 the number had dropped precipitously to around 75. Naturally, hotel openings and closings result from how much business they do. Figure 7.2 shows the number of hotel guests in the PA for each year from 1999 through 2005, as reported by the Palestinian Authority.⁴ The intifada produced a quick, intense, and easily anticipated response: hotel stays—and tourism in general—plummeted. Estimates from the PA suggest a loss of 600 million tourist dollars between the second intifada’s inception in September 2000 and July 2002. Annual PA tourism revenue in that same period was only $300 million, so the loss was as large as the total tourist revenue. Keep these numbers in mind. We will return to them.

With these facts under our belts, we can work through the game-theory logic that points to the attractiveness of tourist tax dollars as a path toward peace. Imagine, for instance, that President Obama’s government or the United Nations presses the Israeli and Palestinian Authority governments to share with each other tax revenues arising exclusively from tourism and then administers the distribution of the funds. Each side’s share of those tax dollars is to be in direct proportion to its current proportion of the total Israeli and Palestinian populations in the PA and Israel.

FIG. 7.2. Tourism in the Palestinian Authority Since the 2000 Intifada

The tourist tax revenue arrangement need not last forever. It must include an irrevocable commitment for it to persist for a long time (say twenty years), and it is important that this tax revenue sharing be tied to a fixed formula based on the current populations and not on future changes in those populations. Opening the formula to renegotiation could create perverse incentives. It is also essential that the definition of tax revenue originating from spending by tourists be based on predetermined rules for estimating this source of income. Independent accounting firms might be used to provide a standard way to define and identify tourist revenue and the taxes derived from it. This tax revenue would then be allocated to each side over the agreed duration of the program based on a onetime fixed population-based formula with no questions asked.

Some tourist-derived tax revenues are obvious. Hotels check the passports of foreign visitors, and so, as we saw, it is straightforward to know how many tourists checked in, what their hotel bills were, and what were the tax portions of those bills. For every foreigner staying in a hotel—whether strictly a tourist or claiming some business purpose—one might stipulate that the taxes on that hotel stay go into the tourist tax revenue pot. It will be necessary to devise a good monitoring system to prevent underreporting, but that is probably something governments already have dealt with.

Restaurants don’t have as obvious a way of determining who their foreign guests are, but perhaps accountants can find a clever way to approximate the percentage of a restaurant’s taxes that is attributable to tourists. This might depend on the location of the restaurant, the proportion of foreign hotel guests in the area, the location of the bank for payments made by credit card, or many other criteria. The same might be true for shops. Those selling souvenirs, for instance, are likely to have more tourist-based revenue than those selling groceries. At passport control, visitors declare whether the purpose of their visit is business or pleasure. There, too, it is possible to create a revenue formula that approximates how much is spent by those saying they are tourists. Anyway, I am not trying to do the job of accountants, and I certainly am not qualified to do so. Accountants will be good at setting up sensible rules to identify the relevant sources of tax revenue, especially if their fees are also tied to that revenue.

On the population side, if Palestinians currently make up 40 percent of the population in the area, then 40 percent of the tourist tax dollars (or shekels, or any other currency) automatically goes to the Palestinian Authority’s recognized government and 60 percent to the recognized Israeli government. Government recognition could be determined by who selects the personnel in the Palestinian and Israeli delegations to the United Nations. This avoids the risk of a dispute over who constitutes the relevant government, since general diplomatic recognition is itself a contentious issue between the Israelis and Palestinians. Just who the Palestinians and Israelis “are” should be defined in terms of people residing in the area and should not include diaspora populations. To include them will result in the meaning of “Palestinian” and “Israeli” being manipulated for political and economic gain. The money distributed is then dictated by how many tourists come and how much they spend, regardless of whether they spend more or less in Israel, Palestine, or disputed territory. Furthermore, there are no restrictions on how the Israelis or Palestinians spend the money received under this program. If leaders invest this money in improving the quality of life for their people, that’s great. If they want to sock it away in a secret bank account, that is between them and their constituents. The key to success is that the money is neither given as a reward for advancing peace nor withheld as a punishment for hindering peace.

Recall the current situation. Israel expects to bring in about $4 billion in 2008 from tourism and expects, with peace, that this will grow sharply over the next several years. Based on the evidence in figure 7.1, we can estimate that tourist revenue would grow 50 percent relative to what it has been since 2001 if peace prevails. Probably Palestinians in the PA would experience an even greater increase in tourist earnings, as tourism seems to respond more sharply to violence in their region than in Israel. This is not surprising, given that they bear the brunt of the deaths. So, with peace, Israeli revenue would rise from about $4.2 billion in 2008 to (at least) $6.3 billion once a lasting peace was established. Palestinian revenue from tourism would probably increase from $300 million to (at least) $600 million, the amount they earned from tourism in 1999, the year before the second intifada began.

Current total tourist revenue with ongoing violence is reasonably estimated at $4.5 billion for Israel and the PA combined. With peace, the estimate rises to $6.9 billion. Assuming a 20 percent average tax rate on tourism earnings, this means a tax revenue pot worth $1.4 billion with peace compared to $900 million with ongoing violence.

Without a tax-sharing agreement and without peace, Israel’s tax revenue (continuing to assume a 20 percent tax take) from tourism is projected to be $840 million in 2008 or 2009, while the PA’s tax revenue from tourism is projected to be $60 million. With a 60-40 revenue sharing arrangement and peace, Israel’s tax take from tourism is projected to be at least $830 million—essentially a wash in terms of tax earnings between war and peace. The PA’s projected tax take under the proposed plan is $550 million, a more than ninefold increase, not to mention an increase in total revenue for the PA of around $1 billion, equivalent to a 20 percent increase in GDP. That’s serious economic growth!

Okay, so we’ve seen the numbers. Now let’s follow the logical stream. What we have seen is that so long as terrorist attacks or other forms of violence persist at a significant level, far fewer tourists visit Israeli-controlled or Palestinian-controlled sites. When there is significant violence, there will be little tourist income to distribute. Thus, if the Palestinian leadership does not engage in effective counterterrorism, it will get few, if any, funds. It will not be deprived of funds, as it is so often, merely because the Israelis or the international community do not like its policies. Money will not be withheld or payment made contingent on the Palestinians doing what anyone else demands. Money will flow or dry up purely because tourists abhor violence in the places they want to visit. If the Palestinians crack down on the sources of terrorism or other forms of attacks against Israel, then the decreased violence will almost surely be followed by a significant increase in tourism. If tourism increases ever so slightly more than my conservative estimates, decreased violence will mean more tax revenue for both governments.

Even with my conservative calculations, PA revenue skyrockets and the Israelis lose nothing. Similar gains can be realized if the Israelis control actions by settlers and other groups that may be inclined to foment trouble with Palestinians, leading inevitably to retaliatory strikes back and forth. The governing parties on each side should have the right incentives to prevent that result.

A failure to engage in effective counterterror or proper policing leaves the status quo in place. Successful counterterrorist policies and effective policing enrich both sides without either side’s having to cooperate directly with the other. Of course, it is likely that collaborative efforts between the intelligence services of each side would emerge to enhance the income of both. There is no mechanism in this proposal by which one side can improve these revenues without also improving the revenues flowing to the other side. That is why the plan is self-enforcing and potentially equally beneficial to both sides.

Obviously, the Israeli-Palestinian conflict is not only about their respective economies. And equally obviously, many economic incentive approaches have been proposed before, going back at least to the time of Winston Churchill. However, earlier economic schemes assumed investment strategies that required mutual coordination and cooperation, and gave the investing side—the Israelis—the ability to pull the plug if they didn’t get what they wanted. Such approaches fail to assign equal responsibility to the Palestinians and the Israelis for enforcing peace or for punishing violators of the peace. Such approaches also foster a fear of economic dependence in Palestinians employed by Israeli-funded businesses. Sharing tourist tax revenues has none of these limitations. Incentives are symmetric, and the responsibility for enforcement is also symmetric. Violations of the peace by either side mean a loss of revenue for both sides.

Not only is tourism important for the future PA economy, but the Palestinian Authority’s leaders have also shown that they can and will control threats to the peace that directly impact some forms of income. For example, in the case of the gambling casino in Jericho controlled by the Palestinians, we know that they have successfully secured the road to the casino. That road to casino riches experienced minimal security threats even at the height of the intifada. By securing the road, the Palestinians also ensured the flow of revenues from it. Additionally, we know that the least developed tourist areas in Jerusalem are in the Palestinian quarters, with a similar pattern of underdevelopment of tourist facilities throughout the Palestinian Authority’s territory and in areas in Israel dominated by Palestinian residents. With peace we can expect that international hotel chains, restaurants, boutiques, and other enterprises catering to the tourist trade will grow disproportionately in the underdeveloped areas, thereby making the tie between tourism-generated prosperity and peace all but self-funded in the mid- to long term.

Finally, sharing tourist tax revenue (recalling that what is shared will by its nature be minimal if there is no peace) will promote a “confidence building” step that requires no trust on either side. It also should promote more counterterrorism efforts from the Palestinian side and probably fewer new settlers on the Israeli side. If this revenue-sharing scheme helps pacify the area and helps promote effective counterterrorism, then the door is opened for more encompassing negotiations over fundamental issues. Terrorist movements, once destroyed, rarely reemerge. The revenue-sharing concept can be a way to move the “peace process” in a positive direction without relying on mutual trust, or even mutual contact, for the time being.

If religion truly dominates the divide between Israelis and Palestinians, as many believe, then the tourist tax plan will fail to promote peace, but it will reveal who the main impediments to peace truly are. Identifying who exactly is willing to sacrifice their own people’s economic and social well-being for religious or other reasons will make it easier to know with whom to negotiate and with whom it is a waste of time. That, in turn, can open the way for fragmenting resistance to peace and make subsequent counterterror efforts more focused and more effective. Either way, such a self-enforcing quest for peace is unlikely to make the situation worse, and has a good chance of making it better.

Some people resist ideas such as my tourist-tax plan because they are sure they can’t work. They think that the cultural divide between Israelis and Palestinians or Jews and Muslims is just too deep to respond to ordinary economic incentives. They think there is a culture of violence that cannot be overcome. They think this even as they see that Northern Ireland is no longer racked by daily explosions and that tens of thousands of former insurgents in Iraq are sticking to their new role as Concerned Local Citizens. Maybe they are right in the case of Palestinians and Israelis, but history does not support their assumption.

Throughout the long history of Muslim domination of the Middle East until roughly the start of the Second World War, Jews lived better and more freely among Muslims than almost anyplace else in the world. When the so-called Moors controlled Spain, Jews enjoyed the tolerance of the Muslim leadership. That tolerance came crashing down when Ferdinand and Isabella unified Spain under Catholic rule. The basis of Palestinian-Israeli conflict resides, at least for many, in economics, not religion. Religion is a politically useful and easy organizing principle that unscrupulous people use to marshal support, but it is not what the fight was or is primarily about. The fight is about land in a locale where, for most, the economy was historically tied to owning property, just as it is in all traditional societies. The economies in the territories lived in and controlled by Israeli and Palestinians still rely significantly on land, but not nearly as much as they did decades ago. Israel has a modern economy in which agriculture plays a much altered role. The Palestinians aspire to a significant degree to have a modern, service-based economy in tourism. These are the conditions that are ripe for a self-enforcing incentive plan.

Naysayers are too quick to equate what they see people do with what they think their core values are. Because terrorist acts seem so extreme, so fanatical, so incomprehensible, many of us are quick to assume that terrorists are a breed apart. They are thought of as people who cannot and will not respond to rational arguments. And yet we already know that even al-Qaeda insurgents in Iraq can be induced to change their ways for just ten dollars a day. Put the history of Jewish-Muslim relations together with the responsiveness of former insurgents to modest economic rewards, and it’s hard to see the downside to trying a new economic approach, especially one that promises virtually no economic downside for one party and huge gains for the other. As the old anti-war song says, “Give peace a chance.”

Even those who absolutely cannot believe that Palestinians or Israelis would value economic incentives over religious principles should want this tourism-incentive plan tried out. Why? Because it has a “hidden hand” benefit alluded to earlier that directly addresses the concern of naysayers. I think we can all agree that there are some hard-liners on the Palestinian side who don’t care about building a strong Palestinian economy, and others on the Israeli side who are certain God did not intend the land to be occupied by anyone other than Jews. These hard-liners will do whatever they can to thwart peace. They will foment violence to prevent tourists from coming. But we should also be able to agree that there are at least some pragmatists on each side as well. The revenue-sharing strategy will ensure that the pragmatists have a strong incentive to identify hard-liners and fight them. The pragmatists will have an incentive that they do not currently have to provide counterterrorism intelligence to their governments in order to ferret out the hard-liners and stop them from interfering with the massive economic improvements promised by this plan. Thus, it should become easier to find and punish the hard-liners, thereby strengthening the hand of pragmatists on both sides. That’s something that should appeal to those who fear the power of the hard-liners.

What I want more than anything to show in this book, and hope that I have done so to a degree so far, is that by thinking hard about the interests involved in a given problem, we have the opportunity to take the best available steps to ensure optimal outcomes. As this next example will show, when we are unaware of the interests at play, or willfully ignore them, we can invite ruin upon ourselves.

INCENTIVIZING IGNORANCE

Arthur Andersen was driven out of business by an aggressive Justice Department looking for a big fish to fry for Enron’s bankruptcy. Later, on appeal, the Supreme Court unanimously threw out Andersen’s conviction, but it was too late to save the business. Thousands of innocent people lost their jobs, their pensions, and the pride they had in working for a successful, philanthropic, and innovative company. Andersen’s senior management apparently was entirely innocent of real wrongdoing. Unfortunately, they nevertheless helped foster their own demise by not erecting a good monitoring system to protect their business from the misbehavior of their audit clients. In fact, that was and is a problem with every major accounting firm. In Andersen’s case, I know from painful personal experience how needless their sad end was.

Around the year 2000, the head of Andersen’s risk management group asked me if I could develop a game-theory model that would help them anticipate the risk that some of their audit clients might commit fraud (this is where my work related to the Sarbanes-Oxley discussion from a few chapters back began). As I have related, three colleagues and I constructed a model to predict the chances that a company would falsely report its performance to shareholders and the SEC. Our game-theory approach, coupled with publicly available data, makes it possible to predict the likelihood of fraud two years in advance of its commission. We worked out a way to identify a detailed forensic accounting that helps assess the likely cause of fraud—if any—as a function of any publicly traded company’s governance structure.

We grouped companies according to the degree to which our model projected that they were at risk of committing fraud. Of all the firms we examined, 98 percent were predicted to have a near-zero risk of committing fraud. Barely 1 percent of those firms were subsequently alleged to have reported their performance fraudulently. At the other end of our scale, about 1.5 percent of companies were placed in the highest risk category based on the corporate organizational and compensation factors assessed by the model. A whopping 85 percent of that small group of companies were accused by the SEC of committing fraud within the time window investigated by the model. This is a very effective system that produces few false positives—alleging that a company would commit fraud when it apparently did not—and very few false negatives—suggesting that a company would not commit fraud when it subsequently did.

Enron was one of the 1.5 percent of companies that we highlighted as being in the highest risk category. You can see this in the table on page 119, which shows our predictions for a select group of companies that eventually were accused of very big frauds. The table shows our assessment of the risk of fraud for each company each year. The estimates of interest are for 1997-99. These assessments are based on what is called in statistics an out-of-sample test. Let me explain what that means and how it is constructed.

Suppose you want to know how likely it is that a company is in either of two categories: honest or fraudulent. Using game-theory reasoning, you might identify several factors that nudge executives to resort to fraud when their company is in trouble. A few chapters back we talked about some of those factors, such as the size of the group of people whose support executives need to keep their jobs, and we talked about factors that provide early-warning signs of fraud, such as dividend and management compensation packages that are below expectations given the reported performance of the firm and its governance structure.

We know that some conditions, including the amount paid out in dividends, indicate whether fraud is more or less likely; but how important is the magnitude of dividend payments in influencing the risk of fraud compared to, for instance, the percentage of the company owned by large institutional investors? That too is an important indicator of the incentive to hide or reveal poor corporate performance. There are statistical procedures that evaluate the information on many variables (the factors identified in the fraud game devised by my colleagues and me, for example) to work out how well those factors predict the odds that a company is honest or fraudulent (or whatever else it is that is being studied).

There is a family of statistical methods known as maximum likelihood estimation for doing this. We won’t worry here about exactly how these methods work. (For the aficionados, we used logit analysis.) The important thing is that these methods produce unbiased estimates of the relative weight or importance of each of the factors, each of the variables, thought to influence the outcome. By multiplying each factor’s value (the number of directors, for example, or the percentage of the firm owned by institutional investors) by its weight, we can get a composite estimate of the probability that the firm will be honest or will commit fraud two years in the future. If the theory is just plain wrong, then these statistical methods will show that the factors in the equation do not significantly influence whether a firm is honest or fraudulent in the way the theory predicts.

The weights we estimated were derived from data on hundreds of companies for the years 1989 through 1996. Since the thing we were interested in predicting—corporate honesty or fraud—was unknown for 1997 in 1995, or for 1998 in 1996, or for 1999 in 1997, and so forth, the statistically estimated weights were limited to just those years for which we knew the outcomes as well as the inputs from two years earlier. Thus, the last year for which we used the statistical method to fit data to a known outcome was 1996. We then applied the weights created by the in-sample test to estimate the likelihood of fraud for the years of data that were not included in our statistical calculation. Those years are the out-of-sample cases. The out-of-sample predictions, then, cover the years 1997 forward in the table. Of course, since this analysis was actually being done in 2000 and 2001, we were “predicting” the past.

Now, you may well think this is an odd view of prediction. It is unlike anything I have discussed so far. What, you might wonder, does it mean to predict the past? That must be very easy when you already know what happened. But remember, in the out-of-sample test, nothing that happened after 1996 was utilized to create variable weights or to pick the variables that were important. Since the predictions about events after 1996 took no advantage of any information after that year, they are true predictions even though they were created in 2000 and 2001. This sort of out-of-sample test is useful to assess whether our model worked effectively at distinguishing between companies facing a high and a low risk of fraud. That is not to say that it is useful from a practical standpoint, even though it is useful from the perspective of validating the model and in providing confidence about how it could be expected to perform in the future. Let me explain what I mean:

Predicting the past can be helpful in terms of advancing science, even though it is not of much practical use when it comes to avoiding the audit of firms that have already committed fraud. But if it accurately predicted the pattern of fraud in the past, it is likely to do the same in the future.

Here’s another way to think about this: The fraud model uses publicly available data. If Arthur Andersen had asked my colleagues and me to develop a theory of fraud in 1996 instead of in 2000, we could have constructed exactly the same model. We could have used exactly the same data from 1989—96 to predict the risk of fraud in different companies for 1997 forward. Those predictions would have been identical to the ones we made in our out-of-sample tests in 2000. The only difference would have been that they could have been useful, because they would then have been about the future.

Clearly, we had a good monitoring system. Our game-theory logic allowed us to predict when firms were likely to be on good behavior and when they were not. It even sorted out correctly the years that an individual firm was at high or low risk. For instance, our approach showed “in advance” (that is, based on the out-of-sample test) when it was likely that Rite Aid was telling the truth in its annual reports and when it was not. The same could be said for Xerox, Waste Management, Enron, and also many others not shown here. We could identify companies that Andersen was auditing that involved high risks, and we could identify companies that Andersen was not auditing that they should have pursued aggressively for future business because those firms were a very low risk. That, in fact, was the idea behind the pilot study Arthur Andersen contracted for. They could use the information we uncovered to maintain up-to-date data on firms. Then the model could predict future risks, and Andersen could tailor their audits accordingly.

Did Andersen make good use of this information? Sadly, they did not. After consulting with their attorneys and their engagement partners—the people who signed up audit clients and oversaw the audits—they concluded that it was prudent not to know how risky different companies were, and so they did not use the model. Instead, they kept on auditing problematic firms, and they got driven out of business. Were they unusual in their seeming lack of commitment to real monitoring and in their failure to cut off clients who were predicted to behave poorly in the near future? Not in my experience. The lack of commitment to effective monitoring is a major concern in game-theory designs for organizations. This is true because, as we will see, too often companies have weak incentives to know about problems. Was the lack of monitoring rational? Alas, yes, it was, even though in the end it meant the demise of Arthur Andersen, LLP. Game-theory thinking made it clear to me that Andersen would not monitor well, but I must say Andersen’s most senior management partners genuinely did not seem to understand the risks they were taking.

At Arthur Andersen, partners had to retire by age sixty-two. Many retired at age fifty-seven. These two numbers go a long way toward explaining why there were weak incentives to pay attention to audit risks. The biggest auditing gigs were brought in by senior engagement partners who had been around for a long time. As I pointed out to one of Andersen’s senior management partners, senior engagement partners had an incentive not to look too closely at the risks associated with big clients. A retiring partner’s pension depended on how much revenue he brought in over the years. The audit of a big firm, like Enron, typically involved millions of dollars. It was clear to me why a partner might look the other way, choosing not to check too closely whether the firm had created a big risk of litigation down the road.

Suppose the partner were in his early to mid-fifties at the time of the audit. If the fraud model predicted fraud two years later, the partner understood that meant a high risk of fraud and therefore a high risk that Andersen (or any accounting firm doing the audit) would face costly litigation. The costs of litigation came out of the annual funds otherwise available as earnings for the partners. Of course, this cost was not borne until a lawsuit was filed, lawyers hired, and the process of defense got under way. An audit client cooking its books typically was not accused of fraud until about three years after the alleged act. This would be about five years after the model predicted (two years in advance) that fraud was likely. Costly litigation would follow quickly on the allegation of fraud, but it would not be settled for probably another five to eight years, or about ten or so years after the initial prediction of risk. By then, the engagement partner who brought in the business in his early to mid-fifties was retired and enjoying the benefits of his pension. By not knowing the predicted risk ten or fifteen years earlier, the partner ensured that he did not knowingly audit unsavory firms. Therefore, when litigation got under way, the partner was not likely to be held personally accountable by plaintiffs or the courts. Andersen (or whichever accounting firm did the audit) would be held accountable (or at least be alleged to be accountable), as they had deep pockets and were natural targets for litigation, but then the money for the defense was coming out of the pockets of future partners, not the partner involved in the audit of fraudulent books a decade or so earlier. The financial incentive to know was weak indeed.

When I suggested to a senior Andersen management partner that this perverse incentive system was at work, he thought I was crazy—and told me so. He thought that clients later accused of fraud must have been audited by inexperienced junior partners, not senior partners near retirement. I asked him to look up the data. One thing accounting firms are good at is keeping track of data. That is their business. Sure enough, to his genuine shock, he found that big litigations were often tied to audits overseen by senior partners. I bet that was true at every big accounting firm, and I bet it is still true today. So now we can see, as he saw, why a partner might not want to know that he was about to audit a firm that was likely to cook its books.

Why didn’t the senior management partners already know these facts? The data were there to be examined. If they had thought about incentives more carefully, maybe they would have saved the partnership from costly lawsuits such as those associated with Enron, Sunbeam, and many other big alleged frauds. Of course, they were not in the game-theory business, and so they didn’t think as hard as they could have about the wrong-headed incentives designed into their partnership (and most other partnerships, for that matter).

On the plus side, management’s incentives were better than those of the engagement partners. Senior managers seemed more concerned about the long-term performance of the firm. Maybe that was the result of what we call a selection effect, as people concerned about the firm’s well-being may have been more likely candidates to become senior management. Still, they also had an incentive to help their colleagues bring in business, and that meant that they were interested in making it easy for their colleagues to sign up as many audit engagements as possible. They may have preferred to avoid problems with bad clients, but the senior managers could live with not knowing about future trouble if that helped to keep their colleagues happy and business pouring in. Thus, senior management’s incentives were not quite right either. Effective monitoring had benefits for them, but it was costly in revenue and especially in personal relations. Many senior management partners tolerated slack monitoring as the solution to this problem, and likely did a quick risk calculation that litigation—not collapse—was the worst that a fraudulent client could visit upon the firm. Let’s face it, many of us would do the same thing.

We also should remember that but for what seems to have been an overly zealous prosecution by the Department of Justice, the likely risk calculation by senior management partners would have been right. Remember, while Andersen gave up its license to engage in accountancy in 2002, following its conviction on criminal charges, the conviction was overturned by the Supreme Court. Sadly for the approximately 85,000 people who lost their jobs, the Supreme Court decision came too late to save the business.

It’s hard for anyone to enforce policies that day in and day out tick off colleagues. That’s especially true if these colleagues are the ones who choose which partners will get to be the senior managing partners. In partnerships like Arthur Andersen or any of the other big accounting firms (or law firms), the people who run the organization are elected by their colleagues. Their engagement partners, not the senior managers, are the rainmakers who keep money pouring in.

The perverse incentive structure that discourages companies from accurately anticipating fraud is not unique to the accounting business. We can see the same problems in the insurance and banking industries. Suppose, for instance, you told underwriters to stop selling directors’ and officers’ insurance to a big client like Enron in 1995. In 2001 the SEC alleged that Enron had committed securities fraud starting around 1997 or 1998. Before that, Enron was a well-regarded company. During all of those years between 1995 and 2001, your colleagues, the insurance underwriters, would be screaming that you were taking their income away, that there was no evidence that Enron was doing anything wrong, that in fact it was a fine and prosperous company. In their eyes, you were giving their business away to people working for rival firms. That’s a pretty tough case to refute while you wait five, ten, or fifteen years for the other shoe to drop. You can imagine how hard it must be to get a real commitment to monitor and punish misconduct, since one must be careful, of course, not to jump in and punish employees or clients before you are sure they have done something wrong. There are big costs attached to falsely accusing a client of fraud, just as there are big costs attached to incorrectly trusting that a firm is behaving honestly.

Management can be a profile in courage by cutting off revenues today to prevent bigger headaches tomorrow, but most profiles in courage, as it turns out, lose their jobs. That’s not an easy choice for anyone. Sure, we all pay lip service to the idea that we should do what is good for us and our colleagues in the long run, but doing what is good in the long run can be very costly in the near term. As Lord Keynes so aptly observed, in the long run we’re all dead (or, anyway, retired). Losing business now to avoid lawsuits later is hard for exactly that reason.

As we’ve explored, game theory predicts that people frequently, for rational reasons, assume great risk and experience great failure. I suppose you could say that making predictions for a living makes that very possibility something of a daily routine. Thankfully, my record has been pretty good, but there have been some notable misses. And indeed there are some other associated risks with the further refinement of rational choice theory and the models I develop and employ. The next chapter will examine some of these issues.