published and long after Shmuel Eisenstadt wrote numbers on a couple of napkins. That is, the modeling exercise undertaken before the 1991 Gulf War, before the first intifada, and before the Oslo Accords foresaw the territorial changes between the Israelis and Palestinians, the necessity of a Labor government coming to power in Israel, and the decline of the PFLP. It foresaw the fundamental developments far enough ahead that even today people have trouble recognizing that the seeds of the agreement in 1993 had already been planted and were growing, unseen by most onlookers, well before.
What was it that the model identified in the give-and-take between the Palestinian side and the Israeli side based on data collected in 1987 and 1989 that led to a successful prediction? This is really the crux of the matter. After all, working out that the predicted outcome could lead to a stable agreement involved more than just pondering Eisenstadt’s original, vague question: “So, you can predict how to make peace in the Middle East?” Since Arafat and the Israeli prime minister both had vetoes over any deal, it was essential to figure out whether they were likely to end up supporting the same agreement, and if so, why. Here’s what the model indicated:
Israel’s Labor Party leader, Shimon Peres, was not in power when the study was done, and it was evident in the model’s results that until Labor came to power no agreement could be reached. That meant that the focus of attention in analyzing the possibility of a peace deal—the problem put to me by Shmuel Eisenstadt—had to be on Peres and the Labor Party. The model’s logic produced output that indicated that Peres believed he would face a lot of political pressure at home over his stance regarding the Palestinians. To attain and retain power—the goal of every politician—he believed (according to the model’s logic) that he had to look as though he would be tougher in Palestinian negotiations than was implied by the quite moderate stance he took in the late 1980s. The model showed he needed to be only a bit more moderate than Shamir, leading him to agree to occupy a position in the mid- to upper 60s instead of Shamir’s drift between 70 and 85 on the scale. So Peres was predicted to be responsive to political expediency at home.
For his part, Arafat concluded, according to the model’s simulations, that he needed to moderate his own stance to keep Labor from taking too hard-nosed a view within Israel. The model suggested that he would choose a course of action based on his personal political welfare rather than the well-being of the Palestinian people per se. As I wrote in the 1990 article, “The model solution suggests that Arafat would stabilize his political position, leaving himself devoid of serious political opposition either among the Palestinians or within Israel. … If Arafat does choose to moderate his stance, this suggests that he is willing to sacrifice both the Palestinian cause and his opponents at the altar of his personal political welfare.” That seems to have been the case. Thus the analysis went from a vague question to precisely structured propositions and a detailed analysis of the negotiating dynamics that made it impossible for Shamir and Arafat to reach agreement and those that made it possible for Arafat and Peres to come to terms once Peres became prime minister.
Asking the right questions and isolating the key interests for a given problem is too often a step that’s not taken from the beginning. Instead, we settle for conventional wisdom about the reasons behind actions that seem to fit the puzzle. The costs of this laziness can be grave, particularly when the problems are the kind for which society seeks remedies in order to prevent their recurrence. With an initial misdiagnosis, the wrong treatment will most assuredly follow. Had policy makers paid attention sooner to the pulls and tugs likely to face Arafat as well as the Israelis subsequent to Oslo, perhaps they could have managed circumstances better and might have avoided many of the setbacks between the Israelis and Palestinians since 1993.
DON’T JUST LOOK WHERE THE LAMPPOST SHINES
The failure to zoom in on what the issues are, who the players are, what their incentives are, and how to fix those incentives is not limited to problems in foreign affairs. The business world suffers at least as much from the same difficulties. To take an example of this from recent years, let’s look at a model that colleagues and I developed to identify the causes of and solutions to corporate fraud.
Since the Enron debacle, Congress has made a real effort to strengthen corporate incentives to report honestly by introducing a massive amount of new regulation through the Sarbanes-Oxley bill, passed in 2002. However, I’m afraid Sarbanes-Oxley touches on but does not nail the root causes of fraud, at least not as those causes are seen by the model my colleagues and I developed. As we can see in figure 5.1, fraud litigation is once again on the rise, despite the passage of Sarbanes-Oxley. Since the recession began in 2007, fraud has skyrocketed ahead of its pre- downturn 2006 level. This is just a bit of evidence—there is more to come—for my model-based belief that the premises that guided Congress in passing Sarbanes-Oxley were misguided. President Obama promises a new wave of regulatory controls to rein in the risk of business fraud and failure. Let’s hope that his administration and the Congress are more attentive to incentives so that they get the regulations right.
FIG. 5.1. Federal Securities Class Action Litigation, 2002-2008
To regulate the risk of fraud it is fundamental that we first understand the motives for committing fraud. How does the model that my colleagues and I worked on determine which companies have an incentive to commit fraud and which do not?
Our game-theory approach is a variant on the study we did to understand how nations are governed (recall dear old Leopold). But pay attention, as the context of the corporate setting provides a most interesting twist. As we saw in our study of Leopold and other heads of state, loyalty to leaders is much weaker in democracies because the competition is over policy ideas rather than the personal enrichment of a few supporters. Much the same might be said for corporations and the survival of corporate executives. From this starting point, we might assume that the outcome in the business world would be the same as that in the political: “autocratic” leadership leads to corruption (fraud), while more “democratic” leadership does not.
Big firms have millions of shareholders. Yet few of them attend the annual shareholders meeting, and they have little idea of how the business is run or how it might have done if it had been run differently. They dutifully send in their proxy, voting the way the board suggests, or they toss their proxy statement in the recycling bin and do not vote at all. Big blocs of votes are controlled by a small number of institutional investors, senior executives, and directors. They, not the shareholders, decide how to run the company. The more institutional investors and powerful shareholders there are, the more parties to whom the management is accountable. Ring a bell? It’s the challenge presented to any leader: the more “democratic” the system (think of democracy not as an absolute concept but rather as a continuum), the more people to please.
When things are going well, the incentives for the executives running a company are not incompatible with the shareholders’ interests. Growth in profits is good for the executives and it is good for the shareholders. But sometimes things do not go well. Then the interests of management and shareholders might part ways. Let’s see why.
In developed equity markets, the fraud model indicates that accounting fraud typically results because management is trying to preserve shareholder value. Don’t get me wrong. The fraud model does not think of executives as altruists who lose sleep trying to think up ways to make shareholders better off. They commit fraud to protect their jobs in the face of poor performance rather than as a result of a desire to defraud investors per se. That means we can use public records to link the likelihood of fraud to any publicly traded corporation’s reported performance, ownership oversight, and governance-induced incentives to manage the firm truthfully.
