Insights & Reports > Kroll Global Fraud Report

As every good detective knows, all crimes need motive, means, and opportunity. For the corrupt official or business manager, the motive is a given, and they can usually find the means to strike deals that arouse little suspicion. It is just a matter of waiting for the opportunity to arise.

That has arrived, thanks to the US$5 trillion combined sum that major governments are pouring into their economies worldwide that the British Prime Minister, Gordon Brown, hailed at the London Summit of the G20 countries in April. Many economists have supported this stimulus, saying it is good both for the short-term goal of preventing the current great recession turning into another great depression, and the long-term ambition of achieving higher trend rates of growth.

Too often ignored, though, is that pumping into the world economy the equivalent to Japan’s annual national output in the space of just eighteen months creates a once-in-a-generation opportunity for corruption. Much of the spending will involve juicy, big-budget, capital projects – traditional targets of corruption. In the United States, for example, President Barack Obama has committed US$550 billion toward the upgrade of federal buildings, construction of new roads, repair of schools and colleges, and improvement of the nation’s information superhighway. Other countries are also using a fiscal stimulus to fund major investment programs.

Because corruption, by definition, happens in secret, it is impossible to determine in detail who gets what.

Each stage of a procurement contract, though, offers opportunities for different players to take a cut. Officials overseeing the deal, bidders jostling for position, agents, middlemen, and politicians can all stick their fingers into the pie.

The overall damage is striking. Transparency International estimates that corruption raises procurement contract costs by at least 10 percent. Detailed studies paint a similar picture. Econometrician Emmanuelle Auriol, using World Bank figures for 2002, calculated that, worldwide, the cost of bribes for procurement contracts represented on average 3.5 percent of such spending. Much higher was the cost of capture. How much more do taxpayers spend because a less efficient bidder gets the contract? Depending on the model, she found that this alone comes to between 4 and 10 percent of total procurement spending.

These are global figures – not just those for weak, impoverished states – and arose during stable economic conditions. They may underestimate today’s problem. Studies of procurement in emergency situations – a closer analogy to today’s rapid fiscal stimulus than business in normal times – indicate that the costs of corruption can rise to 20 to 30 percent of procurement spending. Thus, governments will likely have to struggle to keep the losses down to Transparency International’s estimate, which would still provide a staggering pot of US$500 billion in corrupt gains.

Can administrators overseeing the fiscal stimulus provide the tools to stem the resultant corruption? Corrupt transactions exist because officials explicitly or implicitly weigh the potential risks and rewards.

Central to any analysis of corruption is what economists call the Principal-Agent Framework: officials and middlemen acting as agents for those who have entrusted them with money. Much of the research of corruption in this regard draws on the experience of the developing world over the last thirty years as rich governments sought to make their aid programs more effective amid rising levels of poverty.

Researchers found that the problem was how to get the agent, whether an employee, contractor, tax inspector, or borrower, to act in the best interests of the principal – the employer, owner, government, or banker – when the agent not only knew more about the project at ground-level, but also had a different agenda.

They found that the extent of corruption could be reduced by tackling its causes. Low wages in a poor country’s civil service or police force, for example, encourage petty corruption – and can make it inevitable if the pay is low enough. Overly-complex regulation and a lack of transparency allow this to flourish. More broadly, the low level of education and imbalance of power found in many underdeveloped countries keeps citizens ignorant of their rights, making it less likely that they will challenge corruption.

Armed with such knowledge, it has been possible to fight back. Ronald Maclean-Abaroa, for example, successfully fought corruption as mayor of La Paz, Colombia. He started by firing some employees, paying the rest more, and linking pay to performance against probity metrics. Across the Atlantic, an OECD study of the customs administration in Senegal found that a reduction in import taxes, implementation of reforms reducing the discretionary powers of customs officials, and computerization of procedure, helped to reduce the level of fraud by 85 percent between 1990 and 1995.

The current award of contracts for state of the art solar technology in the United States might seem a million miles from corrupt customs practices in Senegal or on the streets of La Paz, but the parallel Principal-Agent issues provide guidance to national governments worried about corruption:

• Tendering processes must be as transparent as possible. Officials can do more than publish advertisements in newspapers, such as posting details online or even running auctions, so that an independent computer program, rather than an official, finds the cheapest bid;
• Government investigators and regulators must be properly resourced. Higher salaries reduce the risk of bribery. Higher collective budgets give authorities greater firepower in rooting out corruption. Both send a message that politicians back their efforts;
• Rewards for officials who oversee tendering should be linked to successful delivery of the project – on time and on budget – rather than simply the award of the contract. Penalties for misfeasance should be raised publicly.

All of this requires strong, consistent leadership from governments. Here again, economists see a problem. Politicians do not have the opportunity to dole out US$5 trillion every day. With unemployment rising, many will be tempted to ensure that contracts go to domestic companies, even when not the most efficient suppliers – or perhaps to firms that have donated to the ruling political party.

Governments must therefore remember that while compliance with anti-corruption rules has a cost, non-compliance carries a penalty too. Governments and firms engaging in backroom deals will suffer long-term reputational damage at home and abroad. Companies that have lost out to domestic rivals will cry foul if they suspect political favoritism. Foreign governments whose companies lose out could well respond by shutting out overseas bidders, triggering a protectionist spiral.

The world is seeing a live experiment in applying economics to corruption. What makes it more interesting will be to see how developed, rich nations fare. Most literature in the field looks at experiences in poor states. Aside from reports about former Illinois Governor Rod Blagojevich, the Mafia, and some expenses-fiddling British Members of Parliament, most people do not seem to see it as a rich country issue. If countries implementing financial stimuli are not careful, there will be no hiding that it is.

Clean governments clearly have a strong economic motive to ensure that corruption does not become a part of the eventual recovery. The coming months will show whether they have the means and the willingness to do so.

Phil Thornton is lead consultant at Clarity Economics, a consultancy and freelance writing service set up after a 15 year career as a business journalist. Clarity Economics looks at all areas of business and economics including fiscal policy, tax and regulation, macroeconomics, world trade, and financial markets. Until 2007, he was economics correspondent at The Independent newspaper of London, a post he held for eight years.