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PRODUCT.|PHILOSOPHY.|LIFE.

LIBOR and democracy

The world as we know it today is a manifestation of rules (laws if you may) and penalties for not following those rules. The reasoning behind it is genius. We have a set of rules that we'd like everybody to follow for the world to be a safe and happy place that offers us the opportunity to pursue our ambitions, achieving which depend entirely on the resources that we have. The resources may be money, intelligence, influence, physical strength, anything. But its something that we have (or can acquire) at the end of the day. The penalties come in the form of fines, jail terms, so on. These are meant to prevent people from deviating from the rule book. Prevent how? Most people aspire to have a good name in society and being charged with any of these penalties goes against that aspiration. So they will stick to the rule book. So far so good.

The problem with this model is that the rules and penalties are universal. They are common for all. Its democracy, they say. And where has this lead us? The LIBOR scandal. The Manesar plant fiasco. Spectrum allocation scandal. And a million other such deviations from the rule book.

Why is the brilliant model such a failure?

The problem is the simple fact that everybody is treated the same. The penalties are designed in such a way that they make people think twice before deviating from the rule book as the consequence is detrimental to their overall goal in life. The fallacy lies in the fact that that overall goal is assumed to be the same for everyone. The bankers rigging LIBOR rates didn't give a damn about their image in the society were they to be convicted of the 'deviation from the rule book'. They did a simple cost-benefit analysis and decided that they'd be a lot happier raking in the big bucks by rigging the system and losing their job at a later date with a little black mark on their faces for being associated with the scandal, that could be washed away fairly easily.

What's the alternative?

The penalties must be designed such that they actually act as deterrents when the cost-benefit analysis is performed. The cost of incurring the penalties must at all times and for all people be more than the benefit achieved by deviating from the rule book. Now this is the hardest thing to do, because the penalties have to be different for different people.

True democracy is when the rules and the penalties have the same effect on every person. Not when the rules and the penalties are the same for every person.

 But too bad its an execution nightmare.

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3 comments:

  1. check Finland's laws..... they implement something very similar...

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  2. nice post and completely agree. here is a video where Dr Swamy explains how stern punishment is the key to deter such large scale corruption. He uses probability theory to explain it.

    http://www.youtube.com/watch?v=qIdEUo1ycEQ&feature=my_liked_videos&list=LL7_usXZpocAxI0pWiDTwb9Q

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  3. Nice one Kumar!!!

    I guess the expected payoff is not only positive but huge because of the extremely low possibility of being caught and punished. So there might three possible situations:

    1. Find some way to decrease the positive outcome from a scandal or any other misdeed(I don't really know what i mean by this);
    2. Increase the penalty to such an extent that even with the low probability the expected payoff comes out to be negative, and
    3. Increase the probability of detecting such an incident.

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