Wharton’s Philip Nichols: ‘We Have to Line up Incentives So People Don’t Act Corruptly’

Corruption is a global phenomenon — it afflicts mature economies as well as emerging ones. According to Philip M. Nichols, a professor of legal studies and business ethics at Wharton who has done research on corruption in Europe as well as Asia, corruption distorts economies as well as people who occupy positions of power. The solution, he suggests, is to take measures that increase the psychic, social and transaction costs of being corrupt. If that can be done, corruption can be controlled, if not eliminated.

An edited transcript of the conversation appears below:

India Knowledge@Wharton: You’ve studied corruption in Eastern Europe as well as in economies like Mongolia. Why is corruption so prevalent in emerging economies, and what are its consequences for economic growth?

Philip M. Nichols: You’re asking questions that have very long answers. There are a number of theories as to why corruption is prevalent in emerging economies. We should be aware that there are plenty of developing countries where corruption is even more of a problem. We should also be aware that in some mature economies, corruption is at least as much of a problem. But you are absolutely correct — corruption is prevalent in emerging economies.

There are a lot of theories as to why this is so. One reason, perhaps, is that the institutions in emerging economies are relatively new, and there is relatively little experience in using these institutions. For example, a legal system in an emerging economy might not have the chops to deal with an issue that can be as pernicious and difficult to deal with as corruption. In other countries, where they’re emerging from a period of authoritarian regimes or from a period of heavy regulation, it may have been the case that a culture was developed to deal with an authoritarian regime, or a heavy period of regulation, by bribing or by buying space from the government. In yet more countries, there may have been a flood of unaccounted-for money from the Cold War that led to behaviors in government that were not accountable, that were corrupt. In yet more countries, there may be a flood of money coming in to extract resources — and extraction of resources is the kind of industry that lends itself to corruption. We happen to exist in a period of time when all these things are happening at the same time — and we get to watch this phenomenon occurring.

Corrupt practices have a lot of different effects on emerging economies. Corruption distorts economies. Many years ago, there were theories that corruption facilitated economic interaction in emerging economies. That has been put to rest. Several years ago, there was a theory that corruption just moved money from one place to another, but the net result was zero. More dynamic analyses of the effects of corruption have put that to rest. Now, we know that corruption very much distorts economies. Corruption also distorts the people who occupy government positions in emerging economies. They tend to be people who are interested in that sort of activity, and less interested in governing well. It distorts the public relationship with governments. In Eastern Europe, until the enticement of accession to the European Union was dangled in front of them, a lot of people started yearning for the old days, and stopped supporting the democratization movement, because they equated that with the corruption that was burgeoning in these countries.

India Knowledge@Wharton: The specific instance we are focusing on is the 2G telecom scam in India. Of course, nobody’s taken aback at corruption in India. But a couple of facts make this situation different. The first is the size of the scandal. It’s about $40 billion and regarded by many people as the largest corruption scandal in India. Secondly, the public is really angry. Parliament has been consumed by this scandal. And the general mood in the country is, “Enough is enough.” The question is: Isn’t this an opportunity to introduce measures to introduce greater transparency in distribution of scarce natural resources like the telecom spectrum, or even utility infrastructure or water or electricity?

Nichols: Absolutely.

India Knowledge@Wharton: How can that be done?

Nichols: India is a really interesting place. We’re probably going to have to do something a little different than what I’m about to describe. In general, what we try to do is to make acting corruptly more expensive for an individual than acting cleanly. We have to line up incentives so people don’t act corruptly. Transparency in a process imposes several costs on acting corruptly. In India, it is a crime to accept bribes. It’s also a crime to offer a bribe. And so, transparency lowers the cost of detection and makes it more probable one will be detected. Transparency also makes an action more visible to the public, and it increases social penalties. Transparency involves checks and balances. In the U.S. we have  in the federal government — not in city governments, and that’s interesting — we have overlaying layers of authority and accountability. Transparency lowers the cost to others of checking, and holding accountable, particular government agencies. So, transparency, just in and of itself, is part of a larger process of making corrupt transactions costlier than acting cleanly.

The reason your question is interesting is that effectuating change is very difficult. If you look at the world over the last 20 years, significant changes in government have been triggered by intense public reaction to corruption scandals. Japan rewrote its constitution as a reaction to the Recruit scandal and the LDP scandal. Italy rewrote its constitution as part of popular reaction to a whole pile of scandals that all came to light at the same time. Belgium is in the process of looking at how it governs in reaction to the unfortunate pornography bribery scandals. The list goes on and on.

So, yes, this would be a great time for action to be taken in India. I don’t want to ever be characterized as criticizing India. I’ve always been incredibly warmly welcomed in India — it’s a very interesting place to teach and to study. But there is a tendency towards bloc-voting in some parts of India. And bloc-voting reduces accountability and increases the likelihood of unfortunate and extra-legal relationships between those who control blocs and those who seek the support of blocs. And so, whatever’s done in India to create transparency in procurement, should also take into account somehow dealing with the tendency in some of the states and regions to bloc voting. Transparency alone might not be sufficient in that particular case.

India Knowledge@Wharton: Countries like Finland and the U.K. score high points in Transparency International’s corruption perception index. In these countries, how do public officials allocate the country’s natural resources among companies in a transparent and ethical way? What can countries like India learn from their experience?

Nichols: You’ve already mentioned one important thing, and that is that the process has to be transparent and accountable. The agencies that either allocate or distribute are very transparent about what’s going on. There’s also, in many of these countries, a very high psychic cost. I did field work in Singapore and in Malaysia, which have very similar laws, which have very similar agencies and a lot of other similarities, but have vastly different scores on Transparency International’s corruption perception index. The difference that I found to be most significant was how embedded the dislike of corruption was. In countries like Finland and the Scandinavian countries in general, you find tremendous distaste for, or revulsion towards, and rejection of corruption. This imposes high psychic costs for misallocation of the public resources. They take their public responsibility to heart. I’m not saying that doesn’t occur in India. But it is an interesting thing to think abou, in addition to these overlapping transparent structures.

There’s also, structurally, less opportunity for an individual or individuals to monopolize the allocated resources in countries like Finland. Even Norway, which has access to phenomenal amounts of oil, has structured it so that it’s virtually impossible for an individual to corral, to monopolize these resources. That means there’s no benefit to acting corruptly. There’s nothing that can be gained from bribing someone who can’t really confer that kind of a benefit on you.

India Knowledge@Wharton: In India, the traditional argument used to be that corruption was the logical outcome of hyper-regulation. Business people had no choice but to bend the rules, it was said, because the rules themselves were so onerous.

Nichols: Sure.

India Knowledge@Wharton: But after 15 years or more of liberalization and deregulation, corruption in India seems to have actually increased rather than decreased. How can this be explained?

Nichols: Well, I would be careful about characterizing India as seeing an increase in corruption rather than a decrease. I would guess that from the perspective of outsiders going into India, their story would be the opposite: that it’s easier to do business in India now. I know when I first started doing things in India, it was impossible to get a phone line. Now you can, although it’s probably mobile. I’d be careful with that factual observation. I’d also suggest that perhaps some of the increase in corruption is actually an increase in awareness of corruption rather than the actual objective amount of corruption that’s occurring. The dollar figures may be higher, but India’s richer. It’s much richer. And there’s more stuff for people to get by acting corruptly. And that’s going to contribute to it a little bit. But the kind of ticky-tack stuff that we used to have to deal with, that might be going down.

There is, however, clearly a correlation between government actors seeking [bribes] and government actors imposing more regulation. It’s probably true that the reverse is true as well, that scaling back on regulations will eventually lead to less corruption. There may be a lag period, though.

India Knowledge@Wharton: You were speaking earlier about checks and balances. To some degree, an alert media and a strong judiciary form part of the system of checks and balances.

Nichols: Absolutely.

India Knowledge@Wharton: What’s interesting about the telecom scandal is that even the roles of the media and the judiciary have come under a cloud, making it hard for them to serve as watchdogs. What could India do to tackle these issues?

Nichols: That’s pretty scary. When the media is co-opted, that’s scary, because they’re an excellent check. With respect to the judiciary, India’s judiciary has been much studied, when people talk about corruption. I’m certainly not here to say India has a corrupt judiciary. But if, hypothetically, the judiciary of India were corruptible, one really interesting thing that a few countries are looking at now is the creation of a new judicial system. Just cut the old one loose, and start anew. Now, that is a lot more difficult than it sounds, because we talked earlier about the difficulties that flow from a new and inexperienced set of institutions. But there are countries that are saying, “We need something. What we have now doesn’t work.” Obviously, the difficulties in regulating the judiciary are that the judiciary is no longer independent, and an independent judiciary is critical to fairly resolving commercial disputes. But a corrupt judiciary isn’t independent either. So, creating a new one is an interesting possibility.

In India, one sometimes experiences something that I like to call the Big Man Phenomenon. We like to have dinner at wealthy people’s houses. And when a judge throws a dinner, we like to go. If that judge were — and again, I’m not pointing at any specific judge — to be accruing his or her wealth through bribes, we still go. That means the psychic cost to the judge of acting corruptly is pretty low. They can act corruptly, and people don’t care. We can, more easily than creating a new judiciary, care. We can censor, in our daily interactions, judges who take bribes. And we should. And India should, as well.

As for the media, the [citizen journalism] phenomenon might pose an interesting way to work around co-opted media. The United States has experienced a co-opted media before … with yellow journalism, for example. And we didn’t have the opportunity for every single person to become a reporter. We had to wait for people like [Sinclair] Lewis to come along and write his phenomenal novels. But now, we can all do it. We don’t have to wait for Lewis. Anybody with a phone that has a camera on it can be a journalist. Anybody who has access to YouTube can be a journalist. And in some countries — I don’t want to name specific ones now — you are seeing a blossoming of web sites whose sole purpose is to hold government accountable. And these aren’t web sites created by some fringe group. These are web sites created by communities that have just said, “We want to share information. We want to, as a group, hold government accountable.” India is phenomenally advanced in such matters, and it may be possible that prompted by this particular scandal, there may be a blossoming of such websites.

India Knowledge@Wharton: How would you expect foreign investors to react to scandals of this type?

Nichols: Major scandals can lead to dramatic restructuring of government. Dramatic restructuring of government of necessity means uncertainty. Uncertainty means that various types of markets need to reassess the predictability of and the risk of doing business in that particular country. So, I would imagine that some markets and industries will be slightly more cautious over the next short period of time.

In terms of businesses that take products from India — and India is a producer of a great deal of finished and unfinished products — I don’t think supply chains will be disrupted. Scandals of this type tend not to affect that type of relationship. So, there may be a little bit of looking around and seeing who else might be able to supply, but I kind of doubt it.

India Knowledge@Wharton: Apart from the legal and regulatory steps that can be taken to combat corruption, in countries where corruption prevails, there is often a broad mindset. It seems to suggest that if someone is honest, that is because he or she is not smart enough to be dishonest. What can be done to change that mindset? Can corruption be fought at a global level without changing it?

Nichols: The short answer is yes, of course. Attitudes are interesting, and they tend to be more complicated than a phrase can capture. Even in countries where people are very cynical about corruption, most people don’t like corruption and understand that their system would work much better without corruption. So, there’s always this attitude that eventually you can tap into. Attitudes can be changed. In the United States, for example, it used to be laughed at, when people would get drunk at a party and then drive home. Now, it’s pretty much socially frowned on to drink and drive. That’s a good change.

Attitudes toward corruption can be changed. Underneath it all, there generally is an understanding that this isn’t a good thing — that a dishonest person is a dishonest person. If you look at the major philosophical schools of the world, if you look at ancient Hindu texts, they’re very clear that corruption is a wrong. That it hurts. That it damages. One verse of the Holy Koran, says, “Allah loveth not the corruptor.” The Christian and Judaic texts, the Taoist texts, the Buddhist texts all condemn corruption. Even when one is cynically saying, “Well, he’s just not smart enough to cheat and lie and steal,” there’s an understanding that cheating, lying and stealing are not right and not the way we want to go, eventually. So, attitudes can change.

Do we need to change attitudes to fight corruption? Sure. In some places, corruption survives because of the very low psychic cost that’s created by the attitude of, “Well, you know, he’s cheating, but everybody cheats.” It’s hard to fight something like that, even with a great structure. But if psychic costs are high, if social costs are high and if transactional costs are high, corruption will pretty much go away.

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