incentives designed into their partnership (and most other partnerships, for that matter).
On the plus side, management’s incentives were better than those of the engagement partners. Senior managers seemed more concerned about the long-term performance of the firm. Maybe that was the result of what we call a selection effect, as people concerned about the firm’s well-being may have been more likely candidates to become senior management. Still, they also had an incentive to help their colleagues bring in business, and that meant that they were interested in making it easy for their colleagues to sign up as many audit engagements as possible. They may have preferred to avoid problems with bad clients, but the senior managers could live with not knowing about future trouble if that helped to keep their colleagues happy and business pouring in. Thus, senior management’s incentives were not quite right either. Effective monitoring had benefits for them, but it was costly in revenue and especially in personal relations. Many senior management partners tolerated slack monitoring as the solution to this problem, and likely did a quick risk calculation that litigation—not collapse—was the worst that a fraudulent client could visit upon the firm. Let’s face it, many of us would do the same thing.
We also should remember that but for what seems to have been an overly zealous prosecution by the Department of Justice, the likely risk calculation by senior management partners would have been right. Remember, while Andersen gave up its license to engage in accountancy in 2002, following its conviction on criminal charges, the conviction was overturned by the Supreme Court. Sadly for the approximately 85,000 people who lost their jobs, the Supreme Court decision came too late to save the business.
It’s hard for anyone to enforce policies that day in and day out tick off colleagues. That’s especially true if these colleagues are the ones who choose which partners will get to be the senior managing partners. In partnerships like Arthur Andersen or any of the other big accounting firms (or law firms), the people who run the organization are elected by their colleagues. Their engagement partners, not the senior managers, are the rainmakers who keep money pouring in.
The perverse incentive structure that discourages companies from accurately anticipating fraud is not unique to the accounting business. We can see the same problems in the insurance and banking industries. Suppose, for instance, you told underwriters to stop selling directors’ and officers’ insurance to a big client like Enron in 1995. In 2001 the SEC alleged that Enron had committed securities fraud starting around 1997 or 1998. Before that, Enron was a well-regarded company. During all of those years between 1995 and 2001, your colleagues, the insurance underwriters, would be screaming that you were taking their income away, that there was no evidence that Enron was doing anything wrong, that in fact it was a fine and prosperous company. In their eyes, you were giving their business away to people working for rival firms. That’s a pretty tough case to refute while you wait five, ten, or fifteen years for the other shoe to drop. You can imagine how hard it must be to get a real commitment to monitor and punish misconduct, since one must be careful, of course, not to jump in and punish employees or clients before you are sure they have done something wrong. There are big costs attached to falsely accusing a client of fraud, just as there are big costs attached to incorrectly trusting that a firm is behaving honestly.
Management can be a profile in courage by cutting off revenues today to prevent bigger headaches tomorrow, but most profiles in courage, as it turns out, lose their jobs. That’s not an easy choice for anyone. Sure, we all pay lip service to the idea that we should do what is good for us and our colleagues in the long run, but doing what is good in the long run can be very costly in the near term. As Lord Keynes so aptly observed, in the long run we’re all dead (or, anyway, retired). Losing business now to avoid lawsuits later is hard for exactly that reason.
As we’ve explored, game theory predicts that people frequently, for rational reasons, assume great risk and experience great failure. I suppose you could say that making predictions for a living makes that very possibility something of a daily routine. Thankfully, my record has been pretty good, but there have been some notable misses. And indeed there are some other associated risks with the further refinement of rational choice theory and the models I develop and employ. The next chapter will examine some of these issues.
8
HOW TO PREDICT THE UNPREDICTABLE
THIS CHAPTER IS about the limitations of my models, some of my worst-ever predictions, and some of the potential dangers that can conceivably stem from “predictioneering.” Many a critic of mine will have well-worn and dog-eared pages in this stretch of the book!
My worst-ever prediction came in the months after Bill Clinton’s election to the presidency. When he was elected, it was obvious to everyone that he was going to try to push through a comprehensive health care plan. He assigned his wife to head a task force charged with designing a health program. At the time, I was engaged by a major brokerage firm to help work out what was likely to get through Congress so that they could design investment opportunities around the new program. As we all know now, the task force created a lot of heat, but no agreement on a new health care program. Instead, it failed dismally.
As it happened, my analysis of what the health care plan would look like led to one of my worst-ever predictions. Each and every detail of what came out of my analysis was both wrong and filled with lessons that improved future assessments. Models fail for three main reasons: the logic fails to capture what actually goes on in people’s heads when they make choices; the information going into the model is wrong—garbage in, garbage out; or something outside the frame of reference of the model occurs to alter the situation, throwing it off course. The last of these is what happened to my health care analysis.
In early 1993, I predicted what was likely to get through Congress sometime in 1993 or 1994. In some sense, all three of the limitations I mentioned were involved and were subsequently addressed as part of my personal learning experience. But by and large, the main problem had to do with an unforeseen event that completely altered the setting in which health care was going to be shepherded through Congress. Of course, the whole point of prediction is to forecast the unforeseen. Anyone can predict that the sun will rise in the east and set in the west tomorrow. Still, there’s unforeseen and then there’s
Although the experts who provided the data identified a great many components of a comprehensive health plan—including questions related to long-term care, proportion of the population covered, costs of drugs, distribution of the tax burden for health care across the federal and state governments, as well as employers’ costs, total spending on health care, and even questions related to ancillary care—that would get congressional approval, none did. As it happens, the model predicted that Daniel Rostenkowski, then an influential Illinois congressman and, crucially, chairman of the powerful House Ways and Means Committee, was the key to getting health care legislation through Congress. Mr. Rostenkowski, however, was indicted on seventeen felony counts of corruption in 1994 (and later convicted) based on investigations that reached their height during 1993, as the Clinton White House’s health care push began in earnest. Rostenkowski’s salience for health care plummeted, of course, first in anticipation of his indictment and then even more as he fought to salvage his reputation, maintain his leadership position in Congress, and keep himself out of prison. He failed on all counts, and my prediction, based on his effective efforts on behalf of health care, also failed. As a result, contrary to my expectations, nothing passed through Congress.
Rostenkowski’s indictment was a shattering shock to the situation as analyzed; I’ll explain why in a moment.
