Does Fraud Pay?
Fri 25 May 2012 by Infometrics Ltd.

Does fraud pay? In general the answer is probably not, but the recent case of a Christchurch chap suggests that this is not always the case.

The gentleman in question managed to extract over $100 million in a classic ponzi scheme. Over a period of six years or so his lifestyle included international travel, the rental of expensive apartments offshore, dining at top class restaurants and regular outings with female companions who were paid for their services.

A few weeks ago he was sentenced to eight years imprisonment with a minimum non-parole period of three and a half years. Let’s say he does six years so that we have a nice one-to-one relationship between fun years and dreary years. So on average he’s enjoyed over $8 million per year. It might be even more if he’s managed to hide some of the money in an interest earning account.

Many people have quipped to me that the overall benefit-cost ratio would look quite good to the person involved, although it was also remarked that the enjoyment of the fun period would be tempered by the knowledge that at some point in the future you’d probably have to spend time in jail. So when thinking about the happiness of the criminal the order of events is the wrong way around. Perhaps the option should exist for someone to take the punishment in advance. Most of us can recall being punished at school for something we didn’t do, only to be told to treat it as a down payment for some inevitable future infringement of the school rules.

An analogy exists with the payment of provisional tax – you have to pay it before you’ve earned the income. How about provisional punishment? You volunteer to go to prison for some term commensurate with the crime you intend to commit. Indeed to save court time and reduce legal fees there could be published guidelines. Say one year in prison for every $8m million per annum that you rip off, with optional mitigation factors such as who you rip off, your previous record, and your degree of cooperation and honesty when you finally front up for your final punishment balancing assessment. With a bit of luck and good planning you might still be in credit, leaving a small margin to cover any minor future crime. Of course you would earn interest on this – the longer your period of no further offending, the more the credit would increase, but just as with provisional tax you’d have to pay interest at a much higher rate if you’re provisional jail time turned out to be too low. Think of it as ‘use of freedom interest’ as a parallel to IRD’s ‘use of money’ interest.

More seriously, how does one decide on the punishment for what we call white collar crime, in particular fraud, embezzlement and so on? While the Christchurch chap ripped off a finance company, which you might think isn’t so bad, in effect he ripped off many small investors for whom the loss caused a marked reduction in their economic welfare.

However, losing your money is not the whole point; it’s also how you lose it. Normally there is some risk around an expected rate of rate return on any particular investment. Being ripped off though, in effect skews this risk heavily against you, without you knowing it. This makes it no different from the situation where your financial adviser or your fund manager is crooked, or indeed where your fund manager does not apply sufficient rigour to his assessment of where to place your money – as seems to have been the case with the finance company that loaned money to the Christchurch chap.

Prison sentences contain an element of deterrence. Although even economists don’t actually expect that most people would engage in the type of benefit-cost analysis delineated above, presumably most (potential) offenders have some regard for the harshness and likelihood of possible punishment relative to the expected gains of the crime. As fraudsters are presumably strongly motivated by money, their punishment could include a cap equal to the minimum wage on all of their future earnings. Any excess could go to the victims.

There is also an element of public safety. The public may not be physically injured by a fraudster, but it can certainly be financially injured. Hence prison terms or other stringent measures to prevent re-offending by white collar criminals are justified.

Society’s desire for justice adds another component to the determination of prison sentences. This is beyond the ambit of economics. Suffice it to say that with the three elements of deterrence, safety and justice, there ought to be plenty of scope to ensure that fraud does not pay.

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