Most of it is taken up with the stories of high-profile cases, the details of which are engaging but mostly quickly forgotten. These are, however, used to illustrate a taxonomy of fraud and to explain some background: how credit and debt work, what limited liability means, basic accounting, the importance of incentives, and so forth. And there are some thoughts on the way fraud — and the potential for fraud — have shaped and continue to shape finance.

A "long firm" runs up credit and then defaults on it, which is often hard to distinguish from an ordinary business failure. Davies looks at online drug-dealing, the 1960s 'Salad Oil' scam, the 1970s OPM computer leasing scandal, and 1980s Medicare fraud. Reputation is critical here, and scams often involve abusing the trading reputation of reputable firms — and dumping the blame on a 'patsy' or 'front'.

Ponzi and pyramid schemes fail because growth is always constrained. Davies tells the stories of Ponzi himself, of the 'Pigeon King', of Bayou Capital and, going back to the 1870s, of the Boston Ladies' Deposit Company. Obfuscating accountants and crooked auditors are useful.

Davies looks at not just the obvious kind of counterfeiting (the Portuguese Banknote Affair), but at fake mining data (Bre-X), fake medical certifications and drugs, and abuse of the clinical trial process (Vioxx).

"Cooked books" can help to attract investment funds: the possibilities include fake sales and meaningless transactions, shifting revenues and costs in time, and fake assets and unreported debts. Auditors and analysts provide only weak protection.

"If you are able to corrupt the initial due diligence process and float a fake company, it is quite possible that it will survive, and continue to publish deceitful statements, for quite a while before it goes bust. And when the cash finally runs out and the company collapses, it will be significantly less likely for the initial fraud to be connected back to you."

Davies considers a variety of "control frauds". Some involve uncontrolled risk-taking: a "Brazilian straddle" involves taking a lop-sided market position while buying a one-way plane ticket to somewhere that doesn't have an extradition treaty, but real examples include Nick Leeson's futures trading and the 1980s Savings and Loans scandals. And in the "distributed control fraud" that was PPI mis-selling, banks created a "criminogenic" system of incentives for their employees.

Examples of market crimes considered include cartels, regulatory evasion (toxic waste dumping), and manipulation of share trading (Piggy Wiggly). And there are many ways of defrauding the government; Davies looks at "carousel" and VAT fraud. And he throws in some fun historical examples of fraud: from the Bible and the Icelandic sagas, and some nineteenth century long firm examples.

Turning to broader economics and using a bit more abstraction, Davies looks at some of the ways fraud is connected to incentives, information management, complexity, risk, and quality control.

Summing up, he suggests that fraud rests on a triangle of need, opportunity, and "rationalisation" (a way of describing the crime to make it less emotionally repellent). And he proposes a Golden Rule:

"Anything which is growing unusually quickly needs to be checked out, and it needs to be checked out in a way that it hasn't been checked before".

But there are costs to eliminating dishonesty.

"Perhaps the best that we can do is to accept that fraud is an inevitable part of society, bring up our children to be honest, and adopt a sceptical — but not too cynical — attitude to things that seem too good to be true."

February 2021

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