The rise of legal cheating

While many countries are making some headway in tackling corruption, a more insidious phenomenon is spreading, inflicting vast costs on societies and perhaps even threatening democracy. We are going to call this “legal cheating”: the use of non-criminal but abusive methods to game the system for personal gain.

A growing cadre of self-serving legal cheaters and influence peddlers shape our future. They are often highly educated and have become expert at exploiting complex legal structures to the limit, while often twisting and complicating them even further. Collectively they have produced abysmal outcomes for many ordinary people who are now in political revolt. Our calculations, based on recent research, reveal enormous collateral damage.

This does not go unnoticed. A 2016 poll found that 71 per cent of Americans think the economic system in the United States is “rigged in favour of certain groups.” The current authoritarian-populist revolt in many countries is sometimes blamed on the financial crisis, the power of social media, or a longer term decay in politics. Regardless of the root causes, the rise of legal cheating is an important contributor to discontent.

The new authoritarian-populist movements rarely “drain the swamp,” but can actually end up feeding the monster of legal cheating. But there are ways of making institutions less vulnerable. And political leadership that reduces cheating is sometimes handsomely rewarded by voters.

Do no harm: the US healthcare system

As an illustration of the costs of legal cheating, consider deaths in hospitals in the US. Surprisingly often, patients die because they contract antibiotic resistant bacteria during routine operations. Infections from resistant bacteria spread when too many antibiotics are prescribed. According to studies, when antibiotics are given in intensive care units they are unnecessary, inappropriate, or suboptimal about half the time. Too many physicians reject existing guidelines as a bureaucratic intrusion, or simply rush through the procedures.

Other industries also contribute to the problem. For example, over half of the antibiotics produced and sold in the US are used in additives in animal feed. The American Farm Bureau Federation, the huge organization representing the farm industry, spends millions of dollars on lobbying every year and has successfully stopped restrictions on the use of antibiotics as a feed additive to healthy animals.

Every year in the US, around 23,000 people die as a result of antibiotic-resistant bacterial infections, mostly contracted in hospitals or nursing homes. This dwarfs the number of American lives—about 3,500—lost to terrorism since 9/11. The problem is not confined to the US but in Sweden, for example, the healthcare system has been much more successful in staving off resistant bacteria and unnecessary infections during hospital visits.

Many adverse outcomes might be avoided if the rules and regulations that surround medical management, care, reimbursement systems and insurance issues in the US had not been manipulated in favour of the interests of medical professionals. Doctors are generally well respected and well intentioned. Ye even honest, law-abiding doctors are not beyond gaming the system for profit.

They organize in professional associations such as the American Medical Association (AMA), which often claims that what is good for doctors also provides the best protection for patients. Yet one of its crusades is to reduce the risks for the profession from being sued for medical errors. Based on expenditure, the AMA is the fifth-largest lobbying group in the US. It spent about $22m in 2015 lobbying, on top of contributions to political candidates.

In fact, the healthcare sector (including pharmaceuticals, hospitals and health professionals, among others) is the biggest lobbying group in the US in terms of lobbying expenditure. Collectively, healthcare groups spent more than $500m in 2015 to expedite the passage of bills that either benefit their members directly or to sideline legislation that might harm them, including protecting the size of Medicare payments to doctors, measures to reduce medical liability, as well as “protecting the business of medicine.”

It is no surprise that the healthcare bill pushed by the Obama administration in 2010 fell into a quagmire during the legislative process. This was the result of all the concessions and side payments that had to be made to these interest groups, ranging from doctors to insurance companies to the pharmaceutical industry.

The American healthcare system has suffered much from gaming: rules and regulations that lead to higher prices for medication than anywhere else in the world; loopholes in Medicare and Medicaid reimbursements that reward misdirected treatment rather than healthy patients; and insurance companies’ efforts to cherry pick healthy customers. Consequently, healthcare costs per capita in the US have ballooned to more than twice those in Britain.

The many faces of legal cheating

Legal cheating is common in other countries as well. In the European Union, farmers game the Common Agricultural Policy at high cost to consumers and farmers from non-EU countries, who encounter prohibitive trade barriers for their produce. But few legal cheaters cause such flagrant self-harm as the lawyers and lobbyists in Brussels that represent fishermen.

Twenty years ago, the eel was a staple of European fisheries. Today, it is classified as critically endangered and at point the eel population was 1 per cent of its peak level. Overfishing, combined with the pollutants that run off from over-fertilized fields that belong to over-subsidized farmers, has also decimated other species of fish. Research by the New Economics Foundation suggests that the total catch from all European fisheries would be many times higher in the long run if short-term fishing quotas were more restrictive.

Yet as recently as October 2016, the EU-commission chose to allow much more fishing than analysts recommended, even at the risk of letting some populations of fish collapse altogether. Fishermen are able to bully their national governments, who then negotiate in Brussels. The Spanish government, for example, not only blocks quota reductions, but pays fishermen huge subsidies. A Greenpeace report recently revealed that one family of fishing barons amassed about 16m euros in legal subsidies, despite a series of arrests and convictions for offences such as smuggling, illegal shark-finning and falsifying records.

Whether pursued consciously or not, the activities of lobbyists for the medical profession or for fishermen result in ever more labyrinthine regulations, which gives their members a knowledge advantage over others. When a bill is hundreds of pages long, it is easier for a member of Congress to slip in clauses that benefit campaign donors. To take one example, Congress enacted a few, apparently insignificant, changes to the tax code during the 1990s that allowed Donald Trump and a few other highly leveraged property investors to wipe out their entire tax bill for years.

A common claim is that the richest 1 per cent line their pockets at the expense of the middle class. Yet legal cheaters, especially outside the US, are not always wealthy. For example, the leaders of India’s powerful teachers’ union zealously defend lifetime employment for its members, even though World Bank research suggests that in some districts up to 40 per cent of teachers are absent on any given day. These union leaders have gamed the system to win employment security at the expense of the life chances of children.

Environmental groups and NGOs can be equally skilled at these kinds of machinations. For example, many cite concern for low income groups when they oppose new trade agreements such as the now probably defunct Transatlantic Trade and Investment Partnership (TTIP). This flies in the face of numerous studies that find that the low-paid gain the most from the new jobs that trade helps create.

How legal cheating has grown

These problems are increasing. Lobbying spending in Washington is now over $3bn annually and the number of lobbyists in Brussels has grown to over 30,000. Ironically, legal cheating may have proliferated because of well-meant liberal initiatives to create a more complex, interventionist government to promote aims such as environmental standards or improving public welfare. As the libertarian law professor Ilya Somin argues, greater complexity can easily be perverted to the benefit of special interests rather than citizens.

The value of public wealth—from shares in state-owned companies to government-owned property—has increased since the 1980s to an estimated $75 trillion worldwide, in spite of waves of privatization in many countries. These public assets are a cookie jar for those who know how to exercise political influence. Unfortunately, even a shoddy privatization process, can turn into a gold mine for legal cheaters.

As ever more resources are spent to game the system, the volume and complexity of rules has increased by orders of magnitude. In the US, the Federal Register is the daily depository of all proposed and agreed federal rules and regulations. For more than 30 years after the Second World War the volume of laws and regulations that went through remained at roughly 15,000 pages per year. In recent times, the count has topped 80,000 pages a year.

When laws and regulations are first written, they are usually clearenough for educated lay readers to understand. After years of amendments, they grow like onions, layer added upon layer in ways that are often inconsistent or contradictory. As laws become incomprehensible to outsiders, they become a boon to lawyers. Small companies are at a disadvantage when it comes to navigating America’s thicket of local, state and federal regulations.

Quantifying social costs of legal cheating

The most straightforward way of quantifying the social cost of legal cheating can be found in hundreds of studies over the past decades that have tried to measure its impact to consumers. Some research has even found that the sheer volume of regulation or the number of lawyers per capita has detrimental effects. According to these studies, the US is way beyond the threshold of the number of lawyers that is most conducive to growth.

Yet there are also the economic consequences of the wider erosion of trust from legal cheating. Research shows that institutions which promulgate legal cheating lead to dysfunctional policies that directly impair economic growth. Examples of institutions that forestall legal cheating are an efficient and independent judiciary; competition authorities and laws that favour new entrants rather than oligopolies; the protection of property rights; as well as aspects of the democratic process to avoid practices such as gerrymandering or pork barrelling.

Other studies focus on trust in public institutions. The confidence people have in these institutions closely matches how well they protect against gaming. This kind of trust, as expressed in surveys, varies widely between countries; the lower the levels of trust, the lower the willingness to invest. Lack of trust in public institutions depresses economic outcomes.

Taking all this research together, we looked at the consequences of institutions that are vulnerable to legal cheating for levels of trust, and also for economic outcomes. Our estimate of the global loss of wealth that legal cheating causes ordinary people is in the order of $150 trillion (not counting lost lives). That is twice global GDP or more than seven times US GDP.

If this massive destruction of wealth was stopped, investments would become much more profitable. The rising returns that they generated would end the malaise of slow productivity growth that has befallen most countries in the last decades. Real incomes would increase. The average global citizen’s earnings amount to approximately US$7,500. This figure would virtually double if countries adopted the world’s best practices to curtail legal cheating.

At first sight, such figures appear improbably large. But they are reflected in easily observable examples. Switzerland built strong institutions and is now the richest country in the world. By historical accident, Singapore—once a small part of Malaysia—became independent and also built institutions that are harder to game. Today, Singaporeans are much wealthier than Malays.

How legal cheating threatens democracy

Singapore is also an example of a country that is not fully democratic, but still has been able to contain legal cheating. In other less successful democracies, such as Russia, knavery is common and apparently used by the government itself to stay in power.

In democracies, the will of the people is supposed to be the ultimate check on skulduggery that promotes narrow self-interest. But faith in democracy is declining as surveys confirm that many people perceive systems to be rigged.

In an insightful 2014 article in Foreign Affairs, Francis Fukuyama argues that the US is stuck in a vicious cycle of political decay in which interest groups exercise disproportionate influence, distort both taxes and spending, raise overall deficit levels by their ability to manipulate the budget, and undermine the quality of public administration. The result is a crisis of representation, in which ordinary citizens feel that their supposedly democratic government is under the control of a variety of shadowy elites.

The academics Roberto Foa and Yascha Mounk map the rise of anti-democratic sentiments in both the US and Europe. Their more eye-catching point is that more than 70 per cent of Americans born in the 1930s think it is “essential” to live in a democracy, compared to less than 30 per cent of those born in the 1980s. There has been a similar, if less marked, decline in faith in democratic institutions in Europe and many other regions around the world.

The finance sector offers an illustration of the four horsemen of this decay: interventionist regulation driving complexity, growing opportunities for legal cheaters, ineffectual public institutions, and swelling discontent with governance.

At the height of the Depression, the US government enacted the Banking Act of 1933. Known as the Glass-Steagall Act, its purpose was “to provide for the safer and more effective use of the assets of banks, to regulate interbank control, to prevent the undue diversion of funds into speculative operations…” The whole act amounted to 37 pages.

It also helped to fend off financial crises for some 60 years. But its provisions and restrictions were gradually chipped away. In 1999, it was repealed completely by new legislation signed by President Bill Clinton, purportedly to “enhance the stability of our financial services system,” but actually allowing financiers to “diversify their product offerings.” These series of changes resulted in regulation that was vastly much more complex and full of loopholes.

The financial crash of 2007-08 cost the US economy more than $22 trillion in lost output. This sum is equivalent to one year of American GDP. A reasonable person might conclude that financial regulation should once again be made simpler and stricter. Instead, the federal government went in the opposite direction. The Dodd-Frank Act of 2010, designed to stave off future banking crises, is 848 pages. For implementation, it required an additional 398 pieces of detailed rule-making by a variety of US regulatory agencies, comprising some 30,000 additional pages of rules.

Douglas Holtz-Eakin, a former director of the Congressional Budget Office, estimates that the implementation costs of Dodd-Frank are close to a trillion dollars over a ten-year period, as banks and regulators create tens of thousands of full-time positions in compliance and administration to deal with the tsunami of paperwork—all paid for indirectly by bank clients.

The sheer complexity of the new legislation actually makes it much harder to find and close loopholes. Andrew Haldane, chief economist at the Bank of England, claims that there is “no evidence” that the new rules improve regulators’ ability to avert financial crises. Instead, it has created a playground for bankers and lawyers to explore weaknesses and to argue for ostensibly harmless small changes that benefit some but can wreak havoc for society.

Consider Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), two US government-sponsored enterprises set up to help poorer Americans afford home ownership. In 2003-04 they were rocked by a series of accounting scandals. Suddenly, politicians and regulators questioned whether they should be allowed to continue to hold mortgages—by far their most profitable activity.

After those scandals, perhaps to regain credibility with lawmakers, the two companies markedly stepped up lending to low-income borrowers, in the form of so-called subprime loans. They combined this with aggressive lobbying for laxer regulation around lending that improved turnover, profits and bonuses. Fannie and Freddie offered congressional members generous campaign contributions. Between the 2000 and 2008 election cycles, they and their employees contributed more than $14.6m to the campaign funds of dozens of senators and house representatives, mostly those on relevant committees.

Fannie Mae enlisted help from other groups profiting from their activities—the securities industry, homebuilders, and realtors—to sponsor separate fundraising events for their congressional allies. In addition to campaign funds, they set up “partnership offices” in districts and states of important lawmakers, often hiring relatives of these lawmakers to their local staff.

In the decade between 1998 and 2008, Freddie Mac spent almost $95m and Fannie Mae spent almost $80m on congressional lobbying. They were ranked 13th and 20th respectively among the biggest spending lobbyists during that period. What’s more, lobbyists and their clients often recruit former staffers and friends of members of Congress to their ranks.

In the end legal cheating and ever more complex regulation resulted in the financial crisis, and the policy response has been to make regulation even more complex. When ordinary people’s frustration boils over, they look for alternatives. And people who believe that they have been duped are more, not less, susceptible to populists and fraudsters.

Regaining trust

One way of reducing the spoils to legal cheating would be to reduce the scope and size of state intervention. This is also promised by some of the authoritarian-populists that are on the rise in many countries. But few actually do so. On the contrary, their lack of predictability may make it more worthwhile for legal cheaters to step up their efforts.

More familiar, but apparently insufficient solutions have been on the agenda for a while. They include measures such as not allowing package bills in Congress that allow additions of pork-barrel addendums, reducing gerrymandering, more transparency and limits to political donations and lobbying, and so forth.

Instead, we would like to focus on a kind of policy that is more drastic and not often discussed. The essence is to remove more day-to-day governance from easy access for political meddlers. People should demand that governance of the vast public assets in the form of state-owned firms and property should be transferred to professionally governed and politically isolated bodies.

Some countries have done this successfully by transferring their assets to National Wealth Funds, managed by independent boards at arm -length from short-term political influence. These wealth funds should also govern public real estate and perhaps be in charge of investing in state infrastructure projects, with a mandate to prioritise those that render the highest social return.

This model is familiar from central banks that usually have some political independence and clearly defined goals. In our view, central banks should also be fully in charge of the toolbox to ensure financial stability. That would almost certainly have resulted in a rule book less bureaucratic and more effective than Dodd-Frank.

This model could even be applied to national healthcare and social security administrations. Parliaments would formulate the priorities and the overall budget, and leave decisions on the the actual policy trade-offs to these administrations.

In a democracy, all of these steps will require an awareness of legal cheating as a central issue. Leaders who make a point of stopping fixers and manipulators can make a huge difference. After gaining independence in 1963, Singapore's leader Lee Kuan Yew had only his wit and an unbending determination to squelch scheming in its bud. He hired young, well educated, civil servants who were paid high salaries. But he also made clear that gaming the system was unacceptable. Today, Singapore has the highest GDP per capita in Asia.

Contrary to what many politicians believe, reforms that curtail monkey business can pay off electorally, as well as for the economy and society as a whole. For example, Canada was in bad shape when Jean Chrétien and his Minister of Finance Paul Martin, took office in the newly elected left-liberal government in 1993. They cut ties with many of the self-serving influence peddlers, and abolished their spoils such as the so-called Crow Rate—a system of transport subsidies for wheat. Initially their reforms were heavily attacked, but then Chrétien was re-elected three times amid a remarkable economic recovery.

In some ways reality has outstripped fiction. Charles Dickens’ novel Bleak House features an endless legal battle between the heirs to the Jarndyce fortune. So great is the length of the dispute between the Jarndyces that eventually legal fees devour the entire sum of money. The lawyers representing the two sides are the only winners. Perhaps half the world’s prosperity is lost in much the same way—a root cause of the age of discontent.