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Sunday, 24 May 2009

Gaming the System

Bankers and Politicians

Using the rules of any system for personal gain is, in the parlance, “Gaming the System”. We’ve seen a lot of this recently. Not only have a variety of financial executives and employees absconded with bonuses for profits that turned out to be illusory but here in the UK the whole political system has been rocked by revelations of the extent to which our elected politicians have been using their expenses system as a personal cash machine.

Charlie Munger states that the people who design easily gameable systems belong in the lowest circle of hell. However, the reason why this happens is rooted very deeply in human psychology and causes all sorts of effects that are bad for us as societies. Those people who invent mechanisms that prevent systems being gamed do us all a favour, and this matters hugely to investors.

When Incentives Go Bad

The problem with gamed systems is that old favourite – incentives designed, unintentionally, to encourage and reward bad behaviour. That this oft-times spills over into outright cheating and fraud is simply the effect of not thinking through the consequences of the consequences of any all-human system. People can be gulled and often are so by those who think outside the box and who use the system to their personal advantage.

Those involved in the sub-prime Ponzi scheme that’s undermined the world financial system in the past few years have been extremely successful proponents of the art of system gaming. They’ve sold lots of mortgage policies and hedge fund units, been rewarded with huge bonuses for those sales and have left the scene with their profits in hand. That those sales have led to almighty losses, destabilising the world economy and costing each and every one of us a small fortune was of no consequence to the people involved. Indeed it was entirely predictable that they would oversell their products to those people least able to understand or repay: why would they not when they were subject to precious little overview and were heavily rewarded for each sale?

Blaming the individuals who gamed the system for all it was worth is to miss the point. This is what people tend to do, unfortunately. The real issue is with those who oversaw the incentive systems that allowed this to happen. The trail of blame leads to the very top of the financial organisations behind these schemes, to the very people who’ve been paid off with millions of dollars in compensation for loss of their positions.

Horse Manure and Moats

Meanwhile British politics is imploding because of another case of gaming the system, this time by Members of Parliament (MP’s), who were able to use the lack of visibility of their expense claims – afforded by rules they wrote themselves – to extend their earnings safely and considerably. Although supposedly for essential expenses they stretched the definition a little to cover such things as a trouser press, $50,000 worth of personal security, a duck house (to protect the little quackers from foxes), supplies of horse manure (oh, the irony) and moat cleansing. That’s “moat” as in the sense of the big ditch full of water surrounding a castle, I kid you not.

This has all come to light through the normal route – the failure to routinely wipe a laptop computer before passing it on. UK politics is in disarray as simple system gaming looks like an outrageous rip-off of the British taxpayer to the average UK citizen. Worse still a number of MP’s have made claims relating to second homes that look like they may have extended the game into illegality. That’s what happens when you think you’re immune to scrutiny.

Predictably Irrational

We can all feel outraged and slightly smug about the fall from grace of the rich and powerful – although the ex-financiers living high on the hog won’t care about our approbation – but the rather nasty truth is that it looks like this is something that most of us would do if we were offered the opportunity. Dan Airely’s book Predictably Irrational contains a couple of chapters of fascinating experiments on the honesty of humans (1), (2) which, to summarise, show two things.

Firstly, we’ll all cheat if we think we can and, secondly, the more removed from actual money is the fraud the more likely we are to commit the offence and the larger the amount we’ll try to get away with. Oh yeah, and we'll find ways of rationalising this to ourselves without admitting that we're doing it. Think about taking paper clips from work. Is that really a crime? OK, now if your employer had run out of paper clips would you steal money out of the petty cash to go out and buy the paper clips you so badly need at home? And, if not, where’s the difference?

Fibonacci and Patterson

For the businesses that we invest in this issue matters, lots. People who develop tools to prevent the gaming of business systems are heroes and should be lauded as such. Taking people out of the system is the main thing. Consider the invention of bookkeeping, first documented by Leonardo Pisano, aka Fibonacci, in Liber Abaci in 1202. Along with the use of the Arabic numbering system (including the rather useful invention of zero) and the moveable type printing press, which made fraudulently altering accounts much more difficult, this was the single most important business invention for a thousand years.

Another, more recent, anti-gaming mechanism dates from 1883 when John Ritter developed his “Incorruptible Cashier”, bought later by the shopkeeper James Patterson. Patterson was fed up of being gamed by his assistants who made sure as much of his takings as possible found their way from the customer into their pockets. Patterson renamed the machine the "Cash Register," set up National Cash Registers (NCR) and made a fortune offering his anti-gaming technology to other merchants, few of whom prior to this knew if they were operating at loss or profit.

Dematerialising Money Equals Bad Ethics

If Ariely and his fellow researchers are right the problem is likely to get worse, not better, as we increasingly move away from physical money to electronic, web based technologies. We find it hard, en masse, to actually steal cash but the less real it is, then the easier it becomes. Meanwhile banks and credit card companies are very keen for us to accept increasing responsibility for any losses – as well they might if these inventions encourage increased theft.

Ariely shows that making people agree to a code of conduct before performing his tests reduces fraud to negligible proportions and suggests that this offers a way forward in the real world. I’m less optimistic – in real-life such promises have a short shelf life, when not backed up by real punishments. Better keep your money as physical as possible.

Game On

For both politicians and business people we can be sure that if we create new systems that allow gaming then they’ll be gamed. Our best bet are automated mechanisms to prevent this but where this is impossible public scrutiny is the least worst option, matching rewards to success or expenses to, well, expenses.

So, game on. The arms race between those who seek to exploit weaknesses in systems for personal gain and those who seek to stop them is never-ending, from the South Sea Company to Enron and beyond. As we all look set to pay more taxes we can reflect that “victimless” crimes are rarely without cost to someone.


Related Articles: Perverse Incentives are Daylight Robbery, Time for Spiderman Economics

Reference (1): Nina Mazar and Dan Ariely, “Dishonesty in Everyday Life and its Policy Implications” Journal of Public Policy and Marketing (2006)

Reference (2): Nina Mazar, On Amir, Dan Airely, “The Dishonesty of Honest People: A Theory of Self-Concept Maintenance”, Journal of Marketing Research (2008)


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