Thursday, June 25, 2009

Leviathan Swallows Freemasons

The kids are finally in bed and my wife is still in basement working. A rare moment of "me" time, I replay an episode of 60 Minutes still sitting on the DVR. I was mildly interested in the story about the trader who tried to blow the whistle, more than a few times, on Bernie Madoff. Basic statistics indicated that Madoff was cheating, but the mention of "affinity crime" got my attention. "Affinity fraud" might be a better term for what Madoff did:

The Madoff tale is striking in part because it is like stealing from family. Yet frauds that prey on people who share bonds of religion or ethnicity, who travel in the same circles, are quite common. Two years ago the Securities and Exchange Commission issued a warning about "affinity fraud." The SEC ticked off a series of examples of schemes that were directed at members of a community: Armenian-Americans, Baptist Church members, Jehovah's Witnesses, African-American church groups, Korean-Americans. In each case, the perpetrator relied on the fact that being from the same community provided a reason to trust the sales pitch, to believe it was plausible that someone from the same background would give you a deal, that if offered by someone without such ties would sound too good to be true.

Unearth an affinity network and you will likely discover fraudulent activity. The irony is that the very mathematical models vilified for the current economic crisis can and do protect us from such criminal behavior. Technologies exist that expand the scope of trust beyond affinity and face-to-face interaction, but we lack the literacy necessary to employ them in an effective manner.

Comparing and contrasting new forms of social networks with more traditional ones will help me explain:

Old-style networks, however, are usually stronger than online ones, and the trust between their members facilitates transactions of all sorts. They can be particularly helpful for young companies in emerging markets. A study of entrepreneurship in China by Yusheng Peng of the Chinese University of Hong Kong, for instance, showed how kinship networks helped firms protect their property, obtain reliable information and identify opportunities. Social networks can also be speedier than formal systems: in July 2002, for example, when Vivendi, a French conglomerate, was weighed down with debt and needed to raise €3 billion (then $3 billion) in three days, its chief executive at the time, Jean-René Fourtou, turned to a group of bosses who were fellow rugby fans, including Claude Bébéar, then the chairman of the AXA Group, an insurance firm, and the money was secured.

Some old-style networks aim to bring an ethical dimension to business. Not all students at IESE, a leading business school with campuses in Barcelona and Madrid, are aware that it is “an initiative” of Opus Dei. But many of them, particularly those of Spanish origin, are invited to join the order, says one graduate who was approached during his time there. IESE has a network of 15 business schools in developing countries, some of which explicitly state a goal of bringing a Christian perspective to business. Combining family with work, for instance, is the special subject of Nuria Chinchilla, a professor at IESE.

But networks can also have baleful effects. They sometimes abet crimes (see article). At French firms there is often pressure to hire or promote people based on their connections, businesspeople say. A study by Francis Kramarz and David Thesmar published in 2006 by the Institute for the Study of Labour in Bonn looked at three French business networks: former civil servants who graduated from the École Nationale d’Administration, former civil servants who graduated from the École Polytechnique and École Polytechnique graduates who went straight into business. These two elite schools, which produce 500 or so French graduates a year, dominate the boards of France’s biggest companies. The study showed that firms run by former civil servants who maintained their links to government markedly underperformed those run by executives with purely private-sector backgrounds.

Skepticism about the advance of the Flat World is premature. We are just beginning to understand the power of online networks and how to best leverage them. Affinity networks operating in a transparent environment such as LinkedIn can offer the best of both worlds. It's the face-to-face meetings you really have to worry about.

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