Tactical Approach to Combating Corruption

Dec 25, 2009 — Neil Boyle

Some say combating institutionalized corruption is a lost cause because of the impossibility of dealing with entrenched interests whose incomes depend on illegal sources. This view is unsupported by practical experience and research studies. Anti corruption studies to date have been flawed by the absence of an acceptable analytical framework. [A]TCE makes apparent the theoretical gap that exists in orthodox microeconomic theory and practice.

Combating corruption is often cast within a legal and procedural (crime and punishment) orientation of tightened rules and regulations, including bolstering of contract enforcement mechanisms. The B/C calculus of the private investor is often based on “getting all one can get” brand of contracting PPP investments. And anti-corruption strategies often come in the form of external third party assistance. Transparent and accountability systems of organization make up the major portion of the above strategies.

Orthodoxy implicitly assumes property rights are easy to define—they are not—and that the courts knowledgeably enforce property rights and the sanctity of contract at negligible cost—which they do not. This encourages superficiality in understanding the problem of corruption and contributes toward weak explanations during negotiations when risks are allocated and safeguards are negotiated to assure loss mitigation efforts are credibly executed.

The organizational failures framework (Williamson, 1975) makes it possible to detect risk factors that lead to corruption in PPP projects. This makes it possible to design and negotiate safeguards ex-ante that will mitigate the hazards that lead to corruption. The large number exchanges involved in procuring the foreign PPP investor typically signals intense competition which ferrets out non-conforming bidders. However, in PPP projects, one cannot rely on the virtues of large number procurement as the large number exchange changes into a small number bilateral trading relation during implementation beginning with contract renewal, thereby subtly eliminating the original virtues and creating new hazards, which often  remain hidden.

Corruption comes from a particular joining of the variable environmental factors of uncertainty and small numbers exchange and the constant human factors of bounded rationality (limited cognitive capacity) and opportunism (guileful self-interest).  Organizational incentives fail and corruption prospers when bounded rationality joins with uncertainty, that is, internal organizational restraints are glossed over when limited cognition combines with uncertainty. Market incentives fail and corruption prospers when opportunism joins with small numbers exchange, that is, external constraints breakdown due to limited transparency and surveillance when guileful self-interest combines with small numbers exchange. These discriminating alignments of the human and environmental factors comprise what might be referred to as “corruption markers” that are helpful in identifying potentially hazardous situations.

What is needed is a revised due diligence that identifies the corruption markers, i.e., the specific combinations of environmental and human risk factors that lead to corruption. In doing this, it is important to acknowledge all contract hazards would vanish were it not for the twin conditions of bounded rationality and opportunism. The identified factors should not be expected to perfectly reflect their theoretical equivalents. This is exemplified in the case of small numbers combined with opportunism. Everything could end up looking like small number and opportunism conditions, but it will take practice and acquired skill and knowledge from experience to decipher which of the lot to pay attention to. Due diligence expertise of the kind described is equivalent to: (i) having intimate knowledge of the source of a firm’s profits and (ii) the ability to judge the relative benefits and costs of actions aimed at mitigating political and regulatory risks.  Experience working immersed in the microanalytics of PPP transactions, with major government policy reform projects, and having good intelligence networks helps in acquiring this very important expertise.  The following list is indicative of some of the kinds of actions that detect the potential for corruption and credibly safeguard against it:

Identify low hanging fruit—Ex-ante, assess potential for joinder of small number exchange with opportunism and bounded rationality with uncertainty and design and negotiate appropriate anti-corruption terms and conditions of the contract taking into account institutional mechanisms that have been demonstrated to have worked in a similar situation.

Correct misalignments—Misalignments foster the conditions for corruption to take root and prosper; assure transactions and governance structures are aligned throughout the project cycle to assure transparency.

Empower negotiators—Powerful negotiations is itself an anti-corruption mechanism; combine the triplet of price, safeguard, and technology whenever negotiating activities concern combating corruption.

Address source of the risk—Experience tells us that government credibility stands out as the major source of risk; and therefore attention specifically given to the credible commitment of government agreements and policy regimes that impact PPP projects and combat corruption.  Credibly committed government policies are apt to be executed efficiently because the incentives of the parties are aligned as they are assured of compensation if anything goes awry. Enlarged scope for private ordering is an effective anti-corruption mechanism because private ordering creates its own successes (i.e., generates its own wealth), which compete with income that is generated by  nefarious alternatives.

Change b/c calculus of counterparties—toward private ordering and wealth generation as a counter to the opportunism, wealth seeking and deception that are often found in current relations between trading parties; the offer and acceptance of credible commitments is critical for this calculus to be successful. Include more: local content, lobbying of local legislators and officials, vertical market restrictions (e.g., hire locals and train against quality shading), and community projects.

Actively manage incentive alignments of parties—incentive alignments tend to drift off of their original alignments as projects are implemented; it is important to realign these drifts as quickly as possible adjusting them accordingly.

Engage in reciprocal trading relationship to equilibrate trading hazards.

Incorporate bonding mechanisms, i.e., mechanisms that align the project company and contract and project managers toward the same ends.

Incorporate hostage mechanisms, e.g., by expanding the contractual relationship from unilateral to bilateral exchange whereby credible commitments are signaled without exposure to skillful negotiators.

* I wish to thank the School of Economics, University of the Philippines for hosting me as a visiting researcher (2004-2005) with special acknowledgement to Professor Ramon Clarete; special appreciation also for the contribution of Sharon Poczter, Haas School of Business, University of California, Berkeley; and special admiration for the seminal work of Professor Emeritus Oliver E. Williamson without whom TCE would not exist. Had it not been for the tolerance of two colleagues formerly with the World Bank, the work of developing [A]TCE would not have been as fruitful: special appreciation goes to Donald Strombom, President of IDBC of Venice, Italy, and Per Ljung, President of Global Infrastructure of Washington, DC. Neil Boyle is owner-founder of Infragov LLC, a firm that specializes in the application of transaction cost economics [A]TCE) to the problems of infrastructure governance.

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