Tag: Trust

Does Political Illegitimacy in Belarus Imply New Economic Risks?

Posted on October 5, 2020 | Policy Brief

Large group of peaceful demonstration in Belarus that represents Belarus and people who seek to avoid economic risks

Today’s political crisis in Belarus has given rise to the phenomenon classified in political science as political illegitimacy. However, this is not a pure political phenomenon. It causes adverse and severe economic adjustments. In a short-term perspective, it gives rise to numerous risks of financial destabilization. Moreover, it is likely to deepen the current recession and make it protracted. In the long-term, political illegitimacy causes adverse institutional adjustments and erosion of human capital, which is likely to lead a country into a long-lasting depression. We argue that resolving the political crisis in a way that revives trust and legitimacy is the only ‘good’ solution.

Short-term Economic Effects of Political Illegitimacy

Since August 9, 2020, Belarus has been widely discussed worldwide in mass media because of the country’s political crisis. Political scientists classify the current situation in Belarus as a case of political illegitimacy, i.e. there is no consensus in the Belarusian society concerning the recognition and acceptance of a new term for the governing regime.

In turn, the governing regime prefers to ignore the illegitimacy issue. There is an implicit assumption behind this:  illegitimacy is an intangible issue that can hardly result in any tangible threat to the sustainability of the governing regime.

We oppose this view and argue that, at least in an economic dimension, there are numerous channels through which illegitimacy transforms into tangible problems. Inasmuch as the stance of the economy affects political sustainability, it will undermine the latter.

From a short-term perspective, the issue of political illegitimacy has become part of the information accounted for in the decision-making of economic agents in Belarus. Hence, in their economic decisions they either try to struggle against it, or at least to hedge against corresponding adverse effects.

Most evident, the adjustments in decision-making has already visualized in households’ savings behavior. Directly, illegitimacy considerations gave rise to deposit withdrawals from the banking system and enlarged demand for hard currency. Consequently, this led to a rise in depreciation-/inflation-expectations and lowered public trust in the banking system, which in turn has amplified these patterns of the households’ behavior.  In August, Belarus experienced historical peaks in deposit outflows and international reserves were depleted as a result. This has substantially amplified the risks of financial turmoil.

So far, the authorities have curbed the financial stress by implementing a restrictive monetary policy. However, this does not suppress adverse patterns in households’ behavior. It only somewhat allows for a shift of adverse adjustments from financial markets towards the real economy. Moreover, it weakens but does not completely remove the threat of full-fledged financial turmoil, taking into account the systemic financial fragility in Belarus.

In addition to the illegitimacy issue itself, other adverse expectations are likely to give rise to unfavourable trends in households’ consumption behaviour as well. First, household consumption is likely to be dampened as a result of poor consumer confidence and sentiment. Second, additional losses in consumption are likely to occur due to tightening access to credit and progressing financial fragility.

Similar mechanisms are likely to be in place with respect to investment demand. First, poor confidence and sentiment undermine the investment activity of businesses. In Belarus, this channel is likely to be more powerful for private businesses, as investment plans of SOEs (due to their directive nature) are less sensitive to confidence and expectations. Second, investment activity is likely to decline due to deteriorating financial conditions and consequent contraction of credit. This linkage is especially important for the SOEs and housing investments.

The power of adverse consumption and demand trends is still questionable. However, preliminary estimates (introducing negative shocks in addition to scenarios in Kruk, 2020) show that they will reduce the output growth rate by at least 1.5-2.0 percentage points in 2020 Q3-Q4. In other words, they are expected to deepen the current recession and are likely to make it more long-lasting.

Deteriorating payment discipline is one more expected outcome from political illegitimacy. Being amplified by deteriorating financial conditions and economic activity, it can turn into a full-fledged payment crisis and fiscal instability.

Adverse Institutional Adjustments and Effects on Labor Market

Human-to-human interactions based on mutual benefit and trust are the core of a modern market-based economy. Key institutions created to support this interpersonal trust are laws and law-enforcement agencies. If a person does not trust her counterpart in a deal and does not think that she can take him to court to defend her rights, no deal will be signed. When an individual observes unrightful and politically-motivated court decisions in criminal cases, the distrust is also passed on to her beliefs that she would be able to defend her economic rights in the same court. As we observe police violence, tortures, and criminal charges of protesters with no attempt to prosecute those responsible, public trust in the law-enforcement system fades away, and thus all kinds of deals previously supported by a contract-enforcement system cease to exist.

The quality of a judicial system is widely recognized as a powerful determinant to overall institutional quality and the business environment. Hence, poor trust in it would likely undermine business activity directly. Existing businesses are to re-orient towards shorter-term strategies, being reluctant to initiating long-term and risky projects. Moreover, their inclination to geographical diversification of their business activity or even full migration is likely to rise. New entrants – that are extremely important to achieve productivity gains (Foster, Haltiwanger, and Syversen, 2008) – are less likely to start business in the country.

An increase in emigration is a usual consequence of political crisis, especially if it is accompanied by violence and politically-motivated incarcerations. What is unique about the current Belarus crises is that the list of potential emigrees include not only individuals but also firms, especially those working in the IT sector. After 11 August 2020, many IT companies found their employees detained, beaten and tortured. The offices of Yandex, Google and PandaDoc were searched and four top managers working at the latter were detained on tax evasion charges which are likely to be politically-inspired. As of the 18th of September, around 200 IT companies are considering relocation from Belarus and many more are considering partial relocation of their employees to already established foreign offices (Dev.by(2020a)). Results from a recent survey show that 33% of IT specialists have already decided to leave Belarus and the rest indicated that they will leave if the situation worsens (Dev.by(2020b)).

There are several major reasons for why the IT-sector is affected more by the current crises compared to traditional sectors of the Belarusian economy. Firstly, IT companies rarely own physical capital and thus can change their location in a matter of days by simply relocating their employees and laptops. Secondly, the IT labor market is global and mobile, and companies compete for the workers. Therefore, if many workers hold similar strong views on a particular situation, employers are bound to support them to a certain extent. As a result of the latter, many IT companies have openly voiced their disagreement with the election results and the politically motivated violence following the election. High-level employees and owners of major companies have participated in various opposition initiatives and as a result, now face retribution from Lukashenko’s government.

In addition to politically-motivated emigration, we can expect an increase in economically-driven emigration rates as the economy is expected to shrink (Bornukova and Lvovskiy, 2020).

What Is the Way Forward?

The political crisis in Belarus has triggered multidimensional adverse economic adjustments. Nevertheless, the authorities prefer to ignore the links between politics and economics. Hence, they try to overcome the problems with economic policy tools only. However, the room to maneuver with these tools is considerably restricted, and in some cases completely ineffective in suppressing adverse trends.

With respect to the short-term agenda, the authorities cannot offset the adverse trends. They can just mitigate challenges in one dimension and try to re-direct it to another one. For instance, currently the authorities focus on mitigating the probability of a full-fledged financial crisis. This consideration requires restricting monetary conditions. Otherwise, the exchange rate is likely to depreciate, which would be problematic from a corporate debt sustainability perspective. Although being somewhat effective in this regard, this policy mix dampens economic activity. From a financial dimension, the challenge is being re-directed to the real economy.

A similar picture might soon emerge in a fiscal sphere as well. An economic downturn and political crisis can result in a widening income gap. At the same time, the room for maneuver on the expenditure side is constrained. The funds accumulated from the previous periods have to a large extent already been spent to support SOEs. Hence, a further expansion of expenditures is hardly possible, as it would undermine fiscal and public debt sustainability. Therefore, fiscal stimulus is likely to fade away and can gradually even become negative.

Based on estimations in Kruk (2020), before the issue of illegitimacy appeared, the economy was developing according to a scenario of about a 3% drop in GDP in 2020 and a meagre recovery (if any) in 2021. Adding the assumptions associated with adverse adjustments due to the illegitimacy issue into the Kruk (2020) estimates, we show that the recession is likely to deepen by at least 1 percentage point in 2020. In 2021, output losses are likely to expand considerably. In regard to the long-term agenda, the situation is even worse. Conceptual decisions on economic activity by firms and households are closely linked with the issues of trust and legitimacy (Bornukova et al., 2020). Having lost them, the authorities are unlikely to have any effective tools for standing against adverse institutional adjustments and the erosion of human capital. Hence, we may expect that today’s poor growth potential of the Belarusian economy – up to 2.5% of per annum growth (Kruk, 2020) – is likely to weaken further and could even become negative. This means that the stagnation over the recent decade is likely to turn into a long-term depression.

Conclusions

The political crisis and the arising issue of political illegitimacy in Belarus impose severe economic challenges for the country. In a short-term perspective, there are numerous channels that are likely to deepen the recession and make it long-lasting. Moreover, risks to financial stability are progressing rapidly. Hence, there is little room for securing macro stabilization in the near future.

In a long-term perspective, the country is likely to suffer from the disruption of productivity enhancers. It will stem from lower business initiatives and the erosion of human capital. This is a way to a long-term depression.

Standard economic tools are mainly ineffective against both the short-term and long-term challenges. Resolving the political crisis in a way that revives trust and legitimacy is the only ‘good’ solution.

References

  • Bornukova, K. and Lvovskiy, L. (2020). Demography as a Challenge for Economic Growth, Bankauski Vesnik, 680 (3), PP. 31-35.
  • Bornukova, K. Godes, N., and Shcherba, E. (2020). Confidence in the Economy: What is It, How it Works and Why We Need it?, Bankauski Vesnik, 680 (3), PP. 95-99.
  • Foster, L., Haltiwanger, J., and Syversen, Ch. (2008). Reallocation, Firm Turnover, and Efficiency: Selection on Productivity of Profitability? American Economic Review, 98(1), PP. 394-425.
  • Kruk, D. (2020). Short-term Perspective for the Belarusian Economy, BEROC Policy Paper No. 92.
  • Dev.by. (2020a). https://dev.by/news/pochti200-relocate
  • Dev.by. (2020b). https://dev.by/news/opros-relocate-september2020.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Managing Relational Contracts

Posted on November 26, 2018 | Policy Brief

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A wide range of important economic activities depend on self-enforcing informal “relational” contracts. For instance, a firm may buy a good knowing that it cannot sue the other firm if the quality is low – instead high quality is maintained through threat of the firm not making any future purchases. Relational contracts are typically modeled as being between a principal and an agent, such as a firm owner and a supplier. Yet in a variety of organizations, relationships are overseen by an intermediary such as a manager. Such arrangements open the door for collusion between the manager and the agent. We develop a theory of such managed relational contracts. We show that managed relational contracts can be both more and less efficient than the principal agent ones. In particular, kickbacks from the agent can help solve the manager’s commitment problem. When commitment is difficult, this can result in higher quality than the principal could incentivize directly. However, making relationships more valuable enables more collusion and hence can reduce quality.

Introduction

In 2006, the American retailer Aéropostale accused its chief merchandising manager Christopher Finazzo of receiving more than $25 million in kickbacks from a supplier, South Bay. Aéropostale argued that Finazzo had paid inflated prices to South Bay in exchange. Finazzo responded that he had favoured South Bay since they provided higher quality and a willingness to adapt to Aéropostale’s procurement needs. He argued that Aéropostale often remained “loyal” and “committed” to long-time “vendors even when those vendors charged higher prices” (Droney, 2017). In 2013, a jury found Finazzo and South Bay guilty of fraud. They appealed the restitution amount and in 2017 the Court of Appeals for the Second Circuit demanded a recalculation. Judge Droney argued that it was possible that Aéropostale did not lose money as a result of the kickback scheme. He argued that instead Finazzo’s “conduct may have reduced transactions costs for South Bay” and the relationship may have made it profitable for South Bay to pay kickbacks even at non-inflated prices (Droney, 2017).

Relational contracts between organizations are ubiquitous and are crucial for enforcing promises. Indeed, “lack of trust and commitment” is behind most supplier collaboration failures (Webb, 2017). The task of maintaining these relationships is often delegated to a manager like Finazzo. As illustrated by Aéropostale’s case, the firm can never guarantee that the manager will exclusively act in the firm’s best interest. Managers can exploit the (otherwise very valuable) trust relationship with their suppliers to collude with them. Does collusion between the manager and agent crowd out quality? Is collusion always detrimental for the principal?

In a new paper (Troya-Martinez and Wren-Lewis, 2018), we develop a theory of managed self-enforcing relational contracts.

Our model features a manager and an agent who have a bilateral relational contract over time (Levin, 2003). To model that the relationship is managed on behalf of a third party, we assume that profits are shared between the manager and a principal. Every period, the agent privately exerts costly effort to produce a quality which cannot be formally contracted on. To motivate effort, the manager promises to reward high quality with a price premium. This price is paid in part by the principal and in part by the manager. The manager and agent can also make side payments (which represent kickbacks, bribes or other favours) after the quality has been realized. The payment of both the price and side payments needs to be self-enforced.

Kickbacks as an enforcing mechanism

We find that collusion resulting from a managed relational contract can disincentivize quality if the manager pays a discretionary price premium regardless of quality. In particular, she may do so when she trusts that the agent will respond by making a side payment. More surprisingly, side payments can enhance a manager’s ability to commit, and hence allow higher quality. This is because the supplier will renege on paying side payments if the manager reneges on the promised price. This is consistent with evidence that side payments can help contract enforcement. Cole and Tran (2011) analyse informal payments in an Asian country and find that when contract payments are dependent on non-contractible quality, “the kickback is paid only after all contract payments have been made”. In a similar case, Paine (2004) describes how “a purchasing official called about an overdue payment for items already received, [explaining] ‘we can get you a check by next week if you can give us a discount — in cash so we can distribute it to employees’”.

Side payments are thus not necessarily detrimental for the firm when commitment is scarce. This theory thus provides an instance of the “reduced transaction costs” mentioned by Judge Droney.

More trust is not always better

Another interesting implication of a managed relational contract is the non-monotonicity of the relation between trust and efficiency. In the standard principal-agent model of relational contracts, more trustworthy relationships produce higher quality. In managed relational contacts, we show that the opposite may happen.

Figure 1 depicts the effort (and hence quality) exerted by the agent when the manager is in charge (purple) and when the principal is in charge (green). It depicts the effort as a function of the time discount factor delta, which is a measure of how valuable the relationship is (i.e. a larger delta implies a more valuable future). More valuable relationships produce higher effort, and hence higher quality, only up to a point. Once the relationship is sufficiently valuable, extra value facilitates collusion, which reduces effort. In particular, it allows the manager to pay the agent a high price in exchange for a side payment even when quality is low. This non-monotonicity result is consistent with evidence on firms’ use of guanxi, a system of trust-based “informal social relationship” in China which is often used to ensure “that a contract is honored” (Chow, 1997). Vanhonacker (2004) observes that “it would be naive to think—as many Western executives do—that the more guanxi you have on the front lines in China, the better”. Instead, he argues too much guanxi can “divide the loyalties of the sales and procurement people”.

Figure 1. Effort (or quality) with and without delegation to a manage

Source: Troya-Martinez and Wren-Lewis (2018). This figure plots the effort incentivized by the manager (in purple) and by the principal (in green) as a function of the discount factor (delta), which is a measure of how valuable the future is.

This result has important implications for policies designed to reduce fraud or corruption in contexts where relational contracts are valuable. Many such policies involve disrupting relational contracts in order to reduce manager-agent collusion, for instance by encouraging competition or increasing personnel rotation. The results of the analysis suggest that, in some circumstances, weakening manager-agent relations may simultaneously cut corruption and improve output. In other circumstances, however, there will be a trade-off, and reducing corruption may come at the cost of holding back potentially productive relationships.

Conclusion

The paper summarized by this brief is the first paper that studies the impact of collusion on relational contracts. The main take away messages are the following: First, when trust is a scarce resource, managed relational contracts are more credible and can incentivize more quality than direct relational contracts.

Second, collusion can crowd out productive effort when the relationship between manager and agent is too strong. In this case, trust is used to overpay the agent when quality is low.

Before the most recent Aéropostale judgment, it was common to use “the value of the kickbacks” as “a reasonable measure of the pecuniary loss suffered” by the third party (Droney, 2017). Judge Droney, however, argued that this “negative correlation” between kickbacks and loss should not be taken for granted. Indeed, our model has shown when this negative correlation may not exist. Hence, our conclusions may help explain why politicians and firm owners frequently turn a blind eye to employees accepting side payments (Banfield, 1975). On the other hand, our model also identifies when side payments undermine effort. In other words, it emphasizes the complex relationship between kickbacks and productive relational contracts. This complexity needs to be accounted for in policymaking.

References

  • Banfield, Edward C. 1975. “Corruption as a Feature of Governmental Organization.” The Journal of Law & Economics, 18(3): 587-605.
  • Chow, Gregory C. 1997. “Challenges of China’s economic system for economic theory.” The American Economic Review, 87(2): 321-327.
  • Cole, Shawn; and Anh Tran. 2011. “Evidence from the Firm: A New Approach to Understanding Corruption.” In International Handbook on the Economics of Corruption Vol. II. , ed. Susan Rose-Ackerman and Tina Soriede, 408-427. Edward Elgar Publishing.
  • Droney, J. 2017. “United States v. Finazzo.” 14-3213-cr, 14-3330-cr.
  • Levin, Jonathan. 2003. “Relational Incentive Contracts.” American Economic Review, 93(3): 835-857.
  • Paine, Lynn S. 2004. “Becton Dickinson: Ethics and Business Practices (A).” Harvard Business School Case 399-055.
  • Troya-Martinez, Marta; and Liam Wren-Lewis, 2018. “Managing Relational Contracts”, CEPR Discussion Paper Series DP12645 (v. 2).
  • Vanhonacker, Wilfried R. 2004. “When Good Guanxi Turns Bad.” Harvard Business Review, 82(4): 18.
  • Webb, Jonathan, 2017. “Why Do Supplier Collaborations Go Wrong? What Can Be Done About It?”, Forbes, 28 September 2017.

Disclaimer: Opinions expressed in policy briefs and other publications are those of the authors; they do not necessarily reflect those of the FREE Network and its research institutes.

Important Policy Lessons from Swedish-Russian Capital Flows Data

Posted on March 21, 2016 | Policy Brief

A recent study of capital flows between Sweden and Russia provides many policy lessons that are highly relevant for the current economic situation in Russia. In line with studies on other countries, bilateral FDI flows were more stable than portfolio flows, which is important for a country looking for predictable external sources of funding. However, much of the FDI flows came with trade and growth of the Russian market. The sharp decline in imports and fall in GDP is therefore bad news also when it comes to attracting FDI. The conclusion is (again) that institutional reforms and reengaging with the West are crucial policies to stimulate both the domestic economy and encourage much-needed FDI.

In a recent paper (Becker 2016), I take a detailed look at the trends and nature of bilateral capital flows between Sweden and Russia over that last 15 years. Although the paper focuses on the capital flows of a relatively small country like Sweden with Russia, it sheds some light on more general theoretical and empirical issues associated with FDI and portfolio flows that are highly relevant for Russia today.

Measuring Bilateral FDI

One general qualifier for studies of bilateral capital flows is however the reliability of data; Not only is a significant share of international capital flows routed through offshore tax havens which makes identifying the true country of origin and investment difficult, but also many investing companies are multinationals (MNEs) with operations and shareholders in many countries so it is hard to have a clear definition of what is a “Swedish” or a “Russian” company. In addition, when different official data providers, in this case Statistics Sweden (SCB) and the Central Bank of Russia (CBR), report capital flows on the macro level, there are large discrepancies.

Private companies also gather company level data on FDI that can be aggregated and compared with the macro level FDI data. This data is on gross FDI flows and should not be expected to be the same as the net macro level FDI flows data but is a bit of a “reality check” of the macro data.

Figure 1. Average annual FDI flows

Fig1Sources: SCB, CBR, fDi Market, MergerMarkets

The reported annual average flow of FDI from Sweden to Russia varies from around USD500 million to USD1.2 billion depending on the data source. Russian flows to Sweden are rather insignificant regardless of the source but the different sources do not agree on the sign of the net flows (Figure 1).

The differences between data sources suggest that some caution is warranted when analyzing bilateral FDI flows. With this caveat in mind, there are still some clear patterns in the capital flows data from Sweden to Russia that emerge and carries important policy lessons in the current Russian economic environment.

FDI vs. Portfolio Investments

There is a large literature discussing the distinguishing features of FDI and portfolio flows (see Becker 2016 for a summary). Some of the key macro economic questions include which type of flows provides most international risk sharing; are most stable over time; or most likely to contribute to balance of payments crises when the flows go in reverse. In addition, there are potential differences in terms of the amount of international knowledge transfers and how different types of capital flows respond to institutional factors.

Figure 2. FDI and portfolio investments

Fig2Source: SCB

Figure 2 shows that FDI has been much more stable than portfolio flows in the years prior to and after the global financial crisis as well as in more recent years. Although all types of capital flows respond negatively to poor macroeconomic performance, and the stock of portfolio investments swing around much faster than FDI investments, i.e., portfolio flows go in reverse more easily and can contribute to external crises. This makes FDI a more preferable type of capital flow for Russia.

FDI and Trade Go Together

Since FDI is a desired type of capital flow, it is important to understand its driving forces. The first question to address is whether FDI and trade are substitutes or complements. Since the bulk of FDI comes from MNEs that operate in many countries, we can imagine cases both when FDI supports existing trade and cases when it is aimed at replacing trade by moving production to the country where the demand for the goods is high.

In the case of Sweden and Russia, the macro picture is clear; FDI has increased very much in line with Swedish exports to Russia (Figure 3). Both of these variables are of course closely correlated with the general economic development in Russia, but even so, the very close correlation between FDI and trade over the last 15 years suggests that they are compliments rather than substitutes.

Figure 3. Swedish Exports and FDI to Russia

Fig3Source: SCB

Most FDI is Horizontal

FDI flows are often categorized in terms of the main motivating force for MNEs to engage in cross-border investment: vertical (basically looking for cheaper inputs), horizontal (expanding the customer base), export-platform (producing abroad for export to third countries) or complex (a mix of the other reasons) FDI.

Looking at the sectoral composition of FDI from Sweden to Russia (Figure 4), most investments have come in sectors where it is clear that MNEs are looking to expand their customer base. Even in the case of real estate investments, a large share is IKEA developing new shopping centers that host their own outlets together with other shops. Communication and financial services are also mostly related to service providers looking for new customer. Only a small share is in natural resource sectors that would be more in line with vertical FDI, while there are very few (if any) examples of MNEs moving production to Russia to export to third countries.

Figure 4. Sectors of Swedish FDI to Russia

Fig4Source: SCB

Policy conclusions

The above figures on bilateral capital flows from Sweden to Russia carry three important policy messages: 1) FDI is more stable than portfolio flows; 2) Trade goes hand in hand with FDI; and 3) FDI to Russia has mostly been horizontal and driven by an expanding customer base.

In the current situation where Russia should focus on policies to attract private capital inflows, the goal should be to attract FDI. Instead, the government is now looking for portfolio inflows in the form of a USD3 billion bond issue. But FDI is a more stable type of international capital than portfolio flows and also come with the potential of important knowledge transfers both in terms of new technologies and management practices.

However, as we have seen above, FDI inflows have in the past been correlated with increased trade and an expanding Russian market. In the current environment, where imports with the West declined by 30-40 percent in the last year, GDP fell by around 4 percent, and the drop in consumers’ real incomes have reached double digits in recent months, it is hard to see any macro factors that will drive FDI inflows.

Instead, attracting FDI in this macro environment requires policy changes that remove political and institutional barriers to investments. The first step is to fulfill the Minsk agreement and contribute to a peaceful solution in Ukraine that is consistent with international laws. This would not only remove official sanctions but also provide a very serious signal to foreign investors that Russia plays by the international rulebook and is a safe place for investments from any country.

The second part of an FDI-friendly reform package should address the institutional weaknesses that in the past have reduced both foreign and domestic investments. It is telling that many papers that look at the determinants of FDI flows to transition countries include a ‘Russia dummy’ that is estimated to be negative and both statistically and economically significant (see e.g. Bevan, Estrin and Meyer, 2004 and Frenkel, Funke, and Stadtmann, 2004). One factor that reduces the significance of the ‘Russia dummy’ is related to how laws are implemented. Other studies point to the negative effect corruption has on FDI.

Reducing corruption and improving the rule of law are some of the key reforms that would have benefits far beyond attracting FDI and has been part of the Russian reform discussion for a very long time. It was also part of the reform program that then-President Medvedev presented to deal with the situation in 2009 together with a long list of other structural reforms that would help modernize the Russian economy and society more generally.

As the saying goes, don’t waste a good crisis! It is time that Russia implements these long-overdue reforms and creates the prospering economy that the people of Russia would benefit from for many generations.

References

  • Becker, T, 2016, “The Nature of Swedish-Russian Capital Flows”, SITE Working paper 35, March.
  • Bevan, A, Estrin, S & Meyer, K 2004, “Foreign investment location and institutional development in transition economies”, International Business Review, vol. 13, no. 1, pp.43-64.
  • Frenkel, M, Funke, K & Stadtmann, G 2004, “A panel analysis of bilateral FDI flows to emerging economies”, Economic Systems, vol. 28, no. 3, pp. 281-300.

Who Cheats on a Cartel Agreement?

Posted on March 16, 2015 | Policy Brief

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Leniency policies, widely used by antitrust authorities, aim to deter and dissolve cartels by granting a fine reduction (up to immunity) to reporting cartel members. What are the characteristics of the reporting cartel members? Marvão (2014) addresses this question by developing and testing a model where cartel members are heterogeneous in terms of the value of the cartel fine they expect to receive. The author shows that the first reporting firm in a cartel tends to be the cartel leader (in the US) or a repeat offender (in the EU). Reporting is also shown to be more likely in cartels which affect a larger market (in the US) and in cartels which have a lower number of members but which affect a geographical area wider than the EEA (in the EU).

Analysis of Leniency Policies

Cartels are a perennial problem and are one of the main concerns of the European Commission (EC) and the US Department of Justice (DOJ). As cartels are secret, measuring the rate of success of cartel detection is challenging. The increased number of detections in recent years may be the result of a higher desistance rate and/or a higher incidence of cartels. The US and EU Leniency Programmes (LPs) were thus designed to work as a device for the deterrence and dissolution of collusive agreements and have been in place since 1978 and 1996, respectively.

The DOJ’s decision on cartel fines is made in accordance with the “U.S. Sentencing Guidelines” and is, in the vast majority of cases, followed by plea-bargaining. The US Leniency Programme grants full immunity to the first firm coming forward, whereas the other firms receive no leniency reduction. However, plea bargaining is present in over 90% of cartel offences and the settlements often lead to a reduced fine for the subsequent cartel members. Firms are also liable for the damages caused by the cartel’s activity. In addition, the Amnesty Plus Program benefits prosecuted cartel members who disclose previously undetected cartels.

EU fines are set in accordance with the “EU Guidelines on the method of setting fines” and are adjusted to account for aggravating and mitigating circumstances. The total fine is capped at 10% of the total worldwide turnover of the firm in the previous year. In the current LP, the first reporter receives immunity from fines and the subsequent firms receive a reduction of 10-75%, depending on their place in the reporting queue.

The empirical literature on LPs policies is relatively short and recent. It focuses on the adequacy of the leniency reductions and presents conflicting results. However, an understanding of the characteristics of the reporting firms, and of the cartels in which they take part, is vital to make policies provide the correct incentives for firms so as to dissolve and dissuade cartels.

The Issue of Repeat Offenders

The current EU fine guidelines state that a repeat offender is any firm that was previously found to infringe Articles 101 or 102 of the EU Treaty. The DOJ defines repeat offenders as any firm that “after release from custody for having committed a crime, is not rehabilitated”. While repeat offenders are a serious issue, the LP Notices are not explicit as to whether or not they should receive a lower leniency reduction, if any.

Repeat offenders are also a highly debated issue. In Marvão (2012), it is shown that recidivism is one the factors which influence the granting and scale of EU leniency reductions. Connor (2010) has suggested that there is evidence of a significant incidence of recidivism, and identifies 389 recidivists worldwide in the period between 1990 and 2009. This number constitutes 18.4% of the total number of firms involved in 648 international hard-core cartel investigations and/or convictions. Werden et al. (2011) have contested Connor’s definition of recidivism and his calculation of the numbers of multiple and repeat offenders. The main discrepancy between the two arguments appears to be in how cartel members who merge and form a new firm are dealt with. Werden et al. (2011) follow the legal practice (DOJ and EC) and suggest that no repeat offenders have been fined in the US, since 1999.

The Model by Marvão (2014)

The aim of Marvão (2014) is to understand the specific characteristics of reporting cartel members and of the cartels in which they take part.

If firms are similar in everything but their own beliefs on the likelihood of being caught by the authorities, firms may have different incentives to report the cartel. Different beliefs may be generated from public statements issued by EU or US officials, knowledge of the budget allocated to the detection and conviction of cartels, and the proportion of convictions in cartel investigations, among others. Harrington (2013) formalizes this behaviour but his underlying assumption of homogeneity of firms only allows for symmetric equilibria.

Marvão (2014) extends the game in Harrington (2013) to include firm heterogeneity. In the first game stage, a two-firm cartel collapses for internal reasons. In the second stage, each firm receives a private signal on the expected probability of detection and conviction by the authorities. Given the signal received, and the expectations on the other firm’s behavior, firms decide to report if the signal is above their threshold level. In addition to the individual fine, the cartel sanction includes a payment for overcharges and other costs inherent to being fined. These costs may include attorney fees, negative impact on consumer’s perception (which may lead to lower sales), managers being fired, future punishment by other firms and possible future damage claims (from customers). Each cartel member can apply to the LP and receive a fine reduction.

The model shows that the cartel member with the highest expected fine will be the first to report the cartel, provided that it receives a sufficiently high and unbiased signal on the probability of being caught.

Empirical Evidence in Marvão (2014)

The theoretical model is tested with the use of data on cartel convictions. The US data employed in the empirical analysis is an excerpt from John Connor’s Private International Cartels dataset (1984-2009; 799 cartels). The EU data was self-collected by the author and includes 81 cartels in the period of 1998 to 2011.

Cartel Leaders

US data on the individual turnover are not available, but sales and overcharges are likely to be larger for the cartel leader. Although this creates a further incentive to report the cartel, the US DOJ guidelines state that leaders cannot receive immunity from fines. It is thus surprising that the results show that, in US cartels, the leader seems to be more likely to report and receive immunity from fines. The cartel leader is identified as the firm mentioned in the DOJ decision as a ringleader or mentioned in the history of the case as the cartel disciplinarian/bully. This result suggests that different definitions of ringleaders are used, or that the rule is not always enforced by the DOJ.

In the EU, it is only the coercer of the cartel who is not allowed, since the LP of 2002, to receive immunity from fines. Although the EU public statements on cartel convictions do not identify the leader or coercer of the cartel, it is likely that the coercer is also the leader of the cartel. However, with no explicit data on the leader, the results cannot be obtained.

Repeat Offenders

Surprisingly, the US results show that repeat offenders are more likely to receive immunity from fines. Even more concerning is the fact that this likelihood is larger with each additional repeat offender in the cartel.

The EU results show that firms that have colluded more than once are more likely to report the cartel and receive immunity from fines. This effect is particularly strong if the report occurs after the end of the cartel.

It may be that repeat offenders are larger in terms of sales or have better knowledge of how to interpret the signals received, perhaps due to their previous collusive agreements, and thus, are better at choosing the timing of the report and what evidence to provide the authorities with. Although it is in the authorities’ interest to give incentives to the reporting of a cartel, legislation should ensure that the deterrence effect is not diminished by the existence of excessive leniency reductions.

Additional Results

Reports are more likely to occur in US cartels which serve markets with a moderate and, to a lesser extent, large number of buyers; as well as in cartels which are shorter and smaller. This is perhaps because collecting evidence is easier and/or quicker. In addition, firms which are convicted in both US and EU are more likely to be the first reporter in the US if they received a lower EU fine, perhaps because they are quicker to report the cartel to the DOJ.

EU Reports are more likely to occur in longer and smaller cartels. The latter result is noteworthy as it contrasts with the work done in Sjoerd (2005) and Brenner (2009), where the number of cartel members is never significant.

In EU cartels reported after their end, the reporter is less likely to have received other reductions. Although these reductions could be due to firms claiming not to know that the agreement was illegal, it could also be that firms apply for other reductions if they do not expect to receive a (large) leniency reduction.

Conclusions

When the perceived probability of conviction is high, firms are more inclined to report the cartel. This prosecution effect is magnified by the existence of the EU and US Leniency Programmes. In addition, a pre-emption effect exists as when firms believe that other firms will report, there is an incentive to be the first reporter and apply for a fine reduction within the LP. Therefore, identifying the most likely reporter in a cartel is key to designing a successful LP.

Marvão (2014) shows that the main sources of fine heterogeneity are recidivism and leadership of the cartel, which illustrate the need for more proactive competition authorities.

Reports are also more likely in cartels that affect a larger market (in the US) and in cartels that have a lower number of members but which affect a geographical area wider than the EEA (in the EU). Leniency Programmes should thus be in line with these incentives, by focusing on dissolution of cartels in these markets and by increasing firm’s beliefs on the likelihood of conviction. This could be done, for example, through unannounced inspections, screenings and requests for information or for a meeting with a firm representative. These measures, provided that they are credible, would supplement and enhance leniency.

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References

  • Brenner, S., 2009. An empirical study of the European corporate leniency program. International Journal of Industrial Organization 27 (6), 639–645.
  • Connor, J. M., 2010. Recidivism revealed: Private international cartels 1990-2009. CPI Journal 6, 2.
  • Harrington, J. E., 2013. Corporate leniency programs when firms have private information: The push of prosecution and the pull of pre-emption. Journal of Industrial Economics 61 (1), 1–27.
  • Marvão, C., 2012. The EU Leniency Programme: Incentives for self-reporting. Trinity College Dublin. Working paper.
  • Sjoerd, A., 2005. Crime but no punishment. An empirical study of the EU 1996 leniency notice and cartel fines in Article 81 proceedings. Master’s thesis, Economic Faculty of the Universiteit van Amsterdam.
  • Werden, G., Hammond, S., Barnett, B., 2011. Recidivism eliminated: Cartel enforcement in the United States since 1999. Research Paper

Crisis and Trust

Posted on January 26, 2015 | Policy Brief

Authors: Maxim Ananyev and Sergei Guriev, CEFIR

Our research uses the 2008-2009-crisis experience in Russia to identify the relationship between income and trust. In 2009, Russian GDP fell an 8-percent drop in 2009. The impact of the crisis was very uneven among Russian regions because of their differences in industrial structure inherited from the Soviet times. We find that the regions that specialize in producing capital goods, as well as those depending on oil and gas, had a more substantial income decline during the crisis. The variation in the industrial structure allows creating an instrument for the change in income. After instrumenting average regional income, we find that the effect of income on generalized social trust (the share of respondents saying that most people can be trusted) is statistically and economically significant. Controlling for conventional determinants of trust, we show that a 10 percent decrease in income is associated with 5-percentage point decrease in trust. Given that the average level of trust in Russia is 25%, this magnitude is substantial. We also find that the post-crisis economic recovery did not restore the pre-crisis trust level. Trust recovered only in those regions where the 2009 decline in trust was small. In the regions with the large decline in trust during the crisis, trust in 2014 was still 10 percentage points below its pre-crisis level. This has straightforward policy implications: governments should pursue generous countercyclical policies especially in the areas that are the most vulnerable to macroeconomic shocks.

Trust and Economic Reforms

Posted on May 19, 2014 | Policy Brief

20140519 Trust and Economic Reforms Image 01

This brief discusses the importance of trust in economic development. In the aftermath of the 2008 financial crisis, many countries experienced a decline in the level of both general trust and trust and confidence in the government and market institutions. Trust is important for economic growth as it facilitates economic transactions by reducing uncertainty and risk. A lack of trust in the government hinders implementation of structural reforms needed for economic development. Hence, policies aimed at rebuilding trust in the government and institutions become especially important for countries like Ukraine.

Recent events in Ukraine have highlighted an acute crisis of trust in the Ukrainian society (such as trust in the government, politicians, institutions, etc.). Over the past two decades, in the absence of a fair and transparent legal and court system, Ukrainians have become accustomed to relying on informal and often corrupt ways of living and doing business. According to a poll conducted in December 2013, less than 20 percent of the Ukrainian population said that they trust the government, police and courts.

A low level of trust in society is not, however, limited to Ukraine; this problem is also pronounced in many other parts of the world. According to the 2012 Edelman Trust Barometer survey, the general level of trust in most countries surveyed decreased compared to 2011. The most notable decline was in Brazil (36.3%), Japan (33.3%) and Spain (27.5%). These countries also experienced large drops in the level of confidence in the government: Brazil went down by 62.4%, Japan by 51% and Spain by 53.5%. According to the OECD report, generally, less than half (40%) of the citizens trust their government (OECD, 2013).

General trust is important for economic life as it reduces uncertainty and costs associated with economic transactions. Trust affects the functioning of businesses, financial markets, and government intuitions. The level of general trust varies significantly across countries (see Figure 1). While only 3.8 percent of people in Trinidad and Tobago fully trust most people, the Scandinavian countries’ share of trusting people exceeds 60 percent (Algan and Cahuc, 2013).

Economists have in their studies repeatedly appealed to the problem of trust because there are several channels through which trust may influence economic development. First, trust creates favorable conditions for long-term investment and financial market development (Algan and Cahuc, 2013). Second, a higher level of trust in various regulatory authorities increases the level of compliance with the rules and regulations if citizens believe in the fairness of such rules and regulations (Murthy, 2004). In Tabellini (2010), the level of economic development (measured by GDP per capita) of different regions of the EU member countries is compared to their level of trust (defined as in the Figure 1) and respect (defined as the proportion of people who mentioned the quality “tolerance and respect for other people” as being important). Using data from the World Value Survey rounds conducted in the 1990s, he shows that regions with a high level of trust and respect are also the regions that are the most economically developed.

In his Master thesis, the graduate of the Kyiv School of Economics Oleksii Khodenko (Khodenko 2013) analyzed the relationship between the level of trust in the government and the attitude towards market economy (in particular, the attitude towards competition and private property). For this purpose, he used data from the World Values Survey and the European Values Survey. His results have different implications for developed and less developed countries. While a lack of trust in the government in developed countries is transformed into a desire to see more market mechanisms in the economy, this mistrust of the government in developing countries (including Ukraine) undermines the faith in the entire market economy.

Khodenko’s results highlight important policy implications for transition countries: people who grew up in a centrally planned economy tend to underestimate the benefits of the free market and, therefore, only puts confidence in the government and the state as a whole to achieve the development of market mechanisms. Thus a lack of trust hinders, or even prevents implementation of structural economic reforms, which are often “painful” for some groups or for society as a whole. In countries with a low level of trust, the long-term promise of the implemented reforms to improve the lives of people is not perceived as credible. Instead of being viewed by the general public as a today’s sacrifice in the name of future prosperity, they are rather viewed as a deadweight loss (Györffy, 2013).

Figure 1. The Level of Trust in the World
KEI_May2014_PB_Trust and economic reforms
Source: Yann and Cahuc (2013), Figure 1.
Note: Trust is computed as the country average from responses to the trust question in the five waves of the World Values Survey (1981-2008), the four waves of the European Values Survey (1981-2008) and the third wave of the Afrobarometer (2005). The question regarding trust asks: “Generally speaking, would you say that most people can be trusted or that you need to be very careful in dealing with people?” Trust is equal to 1 if the respondent answers ”Most people can be trusted” and 0 otherwise.

Moreover, low levels of trust affect all types of structural reforms. Elgin and Garcia (2012) show that the effect of the tax reform on the economy can significantly differ depending on the level of trust in the government; under low levels of trust the announced tax cuts do not lead to exit from the informal sector.

The question is then how to revive or rebuild trust? Knack and Zak (2003) argue that the most efficient policies for building general trust are policies that (1) reduce income inequality since people in countries with more equal income distribution tend to have higher levels of interpersonal trust, and (2) strengthen civil society to increase government accountability. Income inequality often resulting from unequal opportunities can be reduced via increases in educational attainment and income redistribution programs. The presence of a strong civil society with free press ensures that the government is accountable and responsive to its citizens. A government needs to be reliable, open and transparent to effectively address citizens’ demands (OECD, 2013). All these policies cannot be implemented without a fair legal system that guarantees equal treatment of all citizens.

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References

  • Algan, Y. and P. Cahuc (2013) “Trust, Growth and Well-being: New Evidence and Policy Implications”, IZA Discussion Paper No. 7464
  • Elgin, C. and M. Solis-Garcia (2012), “Public Trust, Taxes and the Informal Sector”, Journal Review of Social, Economic and Administrative Studies, 26(1), pp. 27-44
  • Györffy, D. (2013), Institutional Trust and Economic Policy: Lessons from the History of the Euro, Central European University Press
  • Knack, S. and P.J. Zak (2003), “Building Trust: Public Policy, Interpersonal Trust, and Economic Development”, Supreme Court Economic Review, 10, pp.91-107
  • Khodenko, Oleksii (2013). How Does Confidence in the State Authorities Shape Pro-market Attitudes?
  • Murthy, K. (2004), “The Role of Trust in Nurturing Compliance: A Study of Accused Tax Avoiders”, Centre for Tax System Integrity, Working paper No49
  • OECD (2013), Government at a Glance 2013, OECD Publishing.
  • Tabellini, G. (2010), “Culture and Institutions: Economic Development in the Regions of
  • Europe”, Journal of the European Economic Association, 8(4), pp. 677–71

New Tools to Fight Corruption and the Need for Complementary Reform

Posted on June 20, 2012 | Policy Brief

High office buildings facing sky representing Institutions and Services Trade

Corruption remains a serious problem for most developing countries, undermining state capacity and incentives to invest besides social cohesion and democratic institutions. It is also an increasingly important problem for many highly developed ones. In Italy, for example, corruption has increased in the last decades and the parliament is now finally struggling to pass a (rather mild)”anti-corruption law”. Even in Sweden, a country constantly considered among the least corrupt ones in the world, the problem seems to be increasing according to a recent report by the Agency for Public Management (Statskontoret), which also suggests that the current legislation needs to be improved, for example by offering some form of protection to whistleblowers.

In most Central and Eastern European countries, however, the problem appears particularly serious. Corruption seems to have been rapidly increasing in the region this last decade (The Economist, April 11, 2011 ; Nations in Transit, editions 2001-2012), although there are some virtuous exceptions (for example Georgia and Estonia).

Corruption is often caused by, and at the same time, an instrument for political developments towards autocracy, such as those recently observed in some of these countries (limiting judicial autonomy, democratic participation and the free press). This suggests that in countries where these political developments are taking place we may expect a further worsening of the corruption problem in coming years.

A country that is apparently taking the fight against corruption seriously is India, where a strong grassroots anticorruption movement has developed. The issue has become central in recent political debates and several proposals have been put forward and debated in the parliament. Among these proposals is one by Kaushik Basu, the finance minister’s Chief Economic Advisor. He suggests – for a specific class of bribes paid to obtain a service to which one is entitled for – to treat bribe paying as legal while doubling the sanctions against bribe taking (Basu 2011). The logic behind this proposal is to create stronger incentives for bribe-paying individuals to report it to law enforcers and expose corrupt civil servants: reporting should lead to the restitution of the bribe, besides the conviction of the bribe taker.

Since this proposal was made last year, there has been a lively debate both at the Indian as well as the international level. The debate has however been rather informal, and involved some (voluntary and involuntary) misunderstanding of the proposal (see Dufwenberg and Spagnolo 2011 for a short account of this debate). The proposal has been deemed as “radical” by the proponent, and has sometime been treated and dismissed as a theoretical curiosity. In fact, the proposal is similar to existing legal provisions against corruption that have been in place for quite some time in several countries. The proposal is also related to other legal provisions widely used around the world to fight related forms of illegal transactions, in primis leniency policies now used by most antitrust authorities to fight price-fixing cartels, but also accomplice-witness amnesty and protection program against mafia-like criminal organization (see Spagnolo 2008 for an overview).

We know from academic research on these related revelation schemes that they can be very powerful if appropriately designed and administered, but they may fail or even be counterproductive if they are poorly designed or run (see e.g. Spagnolo 2004, Buccirossi and Spagnolo 2006, Apesteguia et al. 2007, Miller 2009, Bigoni et al. 2009). The exact details how these subtle mechanisms are designed and then actually implemented are crucial to their success.

Asymmetric Sanctions, Leniency and Whistleblowers

As earlier mentioned, the main idea behind Basu’s proposal for India, treating partners in corruption asymmetrically is not a theoretical curiosity. It is already present in milder form in the Russian, Japanese and German (violation-of-duty) legislation, where bribe payers face lower sanctions than bribe takers and in the way prosecutorial discretion is used in Anglo-Saxon countries. An analogous provision seems to have also been introduced in China in 1997, and its effectiveness has recently been questioned by some observers, although in a very superficial way. Unfortunately we have no serious evidence of how these legislations have affected corruption.

More generally, the idea of deterring a collaborative crime by shaping the incentives of criminal partners so that one of them has the incentive to betray the others and report information to law enforcers is well established. The Prisoner’s Dilemma story, where each among the partners in crime are promised a light sentence in exchange for cooperation to convict the other criminal partners is familiar to most countries’ standard law enforcement practice.

These schemes have been the main and most successful tool in the fight against mafia and political terrorism in Italy and other countries, and they are currently regarded as the most important and effective instrument in the hands of competition authorities in their fight against cartels (US Department of Justice, Spagnolo 2008, Acconcia et al. 2009).

Apart from law enforcement, analogous “divide and conquer” schemes have been widely used ever since the Roman Empire in war-related situations to break down enemies’ coalitions. They are tools that many do not like on moral grounds, because they induce distrust and betrayal of partners, which some people see as bad even when the betrayed partnership is a criminal one and distrust prevents the criminal activity.

Still related but somewhat different are the whistleblower protection (from retaliation) and reward schemes aimed at inducing innocent witnesses to report a crime. Reward schemes for whistleblowers have been used in the US since the civil war to limit corruption in federal procurement and to fight government fraud (through the False Claim Act, sometimes called the Lincoln Law from the president that introduced it). They have more recently been introduced by the IRS against tax evasion and by the Dodd-Frank Act against financial fraud.

When witnesses are working in the same organization as the wrongdoers, or when the latter are powerful individuals (besides being prone to commit illegal acts, like violent retaliation), blowing the whistle typically generates very harsh consequences for the witness; ranging from various forms of harassment in the organization, to the loss of job, isolation and directly or indirectly induced death.[1] Legal action is typically slow and uncertain but immediate, certain, and very costly, while whistleblower protection provisions are typically imperfect (if present). This is why, even with a relatively efficient legal enforcement system like the American, large rewards are seen as necessary and justified to induce more whistleblowing and compensation for its consequences.

Trust, Distrust and Corruption

In some sense, one can see Basu’s proposal of legalizing bribe paying for services one is entitled to (while doubling sanctions for bribe taking) as transforming potential accomplice-witnesses into potential innocent whistleblowers. The question is then whether this scheme will induce more people to blow the whistle and consequently fewer bureaucrats to demand/accept bribes. Some observers have suggested that this provision might instead induce more people to pay bribes because it makes it legal and thereby may erode moral norms against bribe paying.

In Dufwenberg and Spagnolo (2011), we argued that amending Basu’s proposal in a way resembling leniency programs used in antitrust, where immunity is awarded only if the wrongdoing is reported to the law enforcement agency, is one way to avoid sending the signal that bribe paying is now legal. The real problem for these schemes is therefore whether at the end they will really induce bribe payers to report.

The way these revelation mechanisms deter corruption is by generating “distrust” among potential partners in crime (Bigoni et al. 2012). By making it very attractive to report to law enforcers for one party and very costly to be reported for the others, these schemes may deter illegal cooperation by ensuring that the parties cannot trust each other.

However, for these schemes to generate distrust and produce their potentially strong deterrence effects, the risk that accomplice-witnesses and other potential whistleblowers report must be a real one. For this to be the case, whistleblowers must trust the law enforcement agency to which they report. The example of leniency policies in antitrust is illuminating. In the US, as long as competition authorities retained discretion, colluding firms rarely applied for reporting under the leniency program. It was only when the Department of Justice gave up discretion by making immunity “automatic” – subject to an explicit set of conditions being satisfied – and committed to this policy through published rules that firms started to again to report information on cartels.

Besides a high risk of being reported, for these schemes to elicit reports and produce deterrence it is also necessary that sanctions for convicted parties are sufficient. To continue the parallel with antitrust enforcement, even after the authorities gave up discretion on the programs, they are not inducing cartel members to report in other countries than the US.

Indeed, the most serious problem for the success of the Basu proposal, as well as for that of the leniency-based modification put forward in Dufwenberg and Spagnolo (2011), remains whether witnesses/bribe payers will trust the law enforcement agency to which they should report the crime. If the law enforcement agency is inefficient or also corrupt, reporting may lead to further harassment or worse, rather than protection and justice.

When protection programs are poorly administered and law enforcement agencies inefficient or corrupt, so that potential witnesses don’t trust law enforcement agencies, it becomes very difficult to induce whistleblowers to report, as well as dangerous for the whistleblower.

A second important reason why these schemes may fail to generate reports and to produce the intended deterrence effects is, as we mentioned, the low sanctions against bribe takers. Recent experimental results (in Bigoni et al. 2012) suggest that reporting incentives provided by leniency programs are only effective in deterring collusion if the sanctions for the convicted partners are sufficiently strong. If not, these schemes may have no effects or even perverse ones (they reduce the sum of expected sanctions, and because of their complexity, they could be manipulated; see e.g. Buccirossi and Spagnolo 2006). Basu did suggest doubling the sanctions for the bribe payers. This, however, may or may not be enough for the case at hand, and would require a more thorough evaluation.

Note than in the case of corruption, there is an additional reason for sanctions to be reinforced, in particular by the requirement to always remove from office the convicted bribe taker. The reason is that if the bribe taker is not removed from office after the report, bribe payers may fear that after whistleblowing the bribe taker may retaliate in future interactions.

Conclusions

Asymmetric sanctions as proposed by Basu (2011) and leniency conditional on reporting as proposed by Dufwenberg and Spagnolo (2011) have the potential to deter corruption in a systematic way.  Necessary conditions for this to happen, however, are that:

  1. Sanctions are sufficiently robust to ensure that the increased risk of being convicted because of a report by a whistleblower dominate on the lenient treatment offered to induce reports;
  2. Potential whistleblowers trust that the law enforcement institutions will act on the report and protect them from retaliation by the corrupt and their friends, rather than harass them.

Countries with sufficiently independent and efficient law enforcement institutions should definitely consider introducing or reinforcing their revelation schemes, asymmetric treatment or leniency conditional on reporting, to counter the current widespread increase in corruption.

Simply introducing these schemes in countries with weaker institutions, in particular with a low level of independence of law enforcement agencies, may do more harm than good: after all they imply reduced sanctions and their complexity makes them easily manipulated.

These schemes can be very useful for these countries, but only if they are introduced as part of a broader set of complementary reforms that include increased judicial independence and the creation of a specialized law enforcement unit with particularly high levels of accountability and independence, able to credibly offer to whistleblowers at least confidentiality and protection from retaliation, if not monetary rewards.

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References

[1] The sad recent stories of Sergei Magnitsky in Russia and of S.P. Mahantesh in India clarify that this risks are real.