A Free Market Is Not Possible Without Strong Laws Against Fraud

→ Washington’s Blog

Many economists are now starting to question long-held assumptions that
bubbles don't matter, that huge amounts of leverage are good, and that
the Federal Reserve has mastered monetary policy. They are starting to
read Minsky and other forgotten economic theorists. And Austrian economists are gaining a wider audience.

As I wrote in March 2009:

The
Austrians have been saying for well over a hundred years that big
bubbles lead to big crashes, and that - if you want to avoid depressions
- you have to avoid the bubbles.

In today's article, entitled "Ignoring the Austrians Got Us in This Mess", Barron's agrees:

The
credit crisis and the ensuing global economic contraction have failed
to make an impression on academe, where free-market orthodoxy still
reigns supreme, the New York Times asserted in an article in arts
section recently ("Ivory Tower Unswayed by Crashing Economy," March 4.)...

What
definitely is ignored in academe is the Austrian school of economics,
especially for baby boomers brought up on Samuelson's economics text,
which was pure Keynesian orthodoxy. I did not learn the names von Mises
and Hayek or their ideas until a decade or more after graduation (with a
degree in economics, by the way.)

The
Austrian view is a mirror image on the right to Minsky's from the
left. The economy, if left alone, is self-correcting, say the
Austrians. But central banks' inflationary expansion of credit produces
booms and malinvestments, which inevitably lead to a crashes and
depressions.

The only prevention
for boom and busts are sound money, which is impossible with
government-controlled central banks. Once the bust comes, the only cure
is to let it run its course; allow the malinvestments go bankrupt and
let the market reallocate the capital to productive uses....

But
the Austrians were the ones who could see the seeds of collapse in the
successive credit booms, aided and abetted by Fed policies, especially
under former chairman Alan Greenspan. ...

Greenspan
always contended that monetary policymakers can neither predict nor
prevent bubbles in asset markets. They can, however, clean up the
after-effects of the bust -- which meant reflating a new bubble, he
argued.

That had a profound effect
on risk-taking. Knowing that the Greenspan Fed would bail out the
markets after any bust, they went from one excess to another. So, the
Long-Term Capital Management collapse in 1998 begat the easy credit that
led to the dot-com bubble and bust, which in turn led to the extreme
ease and the housing bubble.

Austrian
economists assert the current crisis is the inevitable result of the
Fed's successive efforts to counter each previous bust. As the credit
expansion pumped up asset values to unsustainable levels, the eventual
collapse would result in a contraction of credit as losses decimate
banks' balance sheets and render them unable to lend. That sounds like
an accurate diagnosis of the current problems.

While
Barron's acknowledges that the Austrian school is right about how to
avoid depressions, it doesn't agree with the other main tenet of the
Austrians: that the quickest way to get out of a depression is to let
the bad investments clear themselves out of the markets by letting the
companies which made dumb decisions fail. (The sub-title for the
article is "Their ideas warned us of the bubble; their prescription for the bust is too harsh, however"; and the article ends with the phrase "Make us non-interventionist, but not yet.")

Readers
have written to me saying the same thing: the Austrians might be
right, but their remedy for an economic crisis is too draconian and we
have to do something to help the people.

So what can we do to help people and to improve the economy?

Well, as I've repeatedly pointed out, the economy cannot recover until trust and the rule of law are restored (and see this).

Imposing
accurate accounting standards, stopping high-frequency trading,
quote-stuffing and front-running, and prosecuting fraud to the fullest
extent of the law are prerequisites to restoring trust in our economy.

Indeed,
America has a long tradition of using fraud, antitrust, conspiracy and
racketeering laws to rein in the worst economic abuses. These laws are
an important part of American history, and our recent abandonment of
them must be reversed.

Austrian Economics Does Not Require Abandoning the Law ... In Fact, Laws Are Necessary for a Functioning Free Market

Just as neo-conservatives are not really conservative and neo-liberals are not really liberal, a fake, neo-Austrian legal argument has sprung up trying to excuse the criminal fraud and manipulation of the big banks.

As William K. Black - professor of economics and law, and the senior regulator during the S&L crisis - pointed out
last week, Austrian economics has been twisted by the powers-that-be
and bastardized into a basis for arguing that there should be no prosecutions for fraud or criminal conduct:

Yves
[Smith] noted that the Chamber of Commerce was leading the effort to
elect CEO-friendly judges. The Chamber is one of the points of
intersection in the discussions about electing judges and whether law
and economics has played a perverse role in causing catastrophic policy,
regulatory, and judicial blunders. The Chamber distributed a plan for
a hostile takeover of university departments of economics and finance
(and the courts and the media) proposed by Lewis Powell (the soon to be
Supreme Court Justice). Extremely conservative “law and economics”
proved to be central to this effort. The law and economics movement
began as a non-ideological approach to explaining and aiding judicial
decision-making. The scholars leading the movement had diverse views.
The Olin Foundation transformed law and economics into an ultra
ideological field dominated almost exclusively by passionate opponents
of government “interference” in “free enterprise.” Olin specialized in
creating well-funded positions in academia for scholars that had an
“Austrian” approach to economics. Austrian economics has, generally,
become more extreme since its formative years when Hayek warned that
mixed economies (e.g., the U.S. and Europe) were inevitably consigned to
the Road to Serfdom. Here is how the National Review praised the
Olin’s takeover of the field:

Law and Economics: The
John M. Olin Foundation has devoted more of its resources to studying
how laws influence economic behavior than any other project. The law
schools at Chicago, Harvard, Stanford, Virginia, and Yale
all have law-and-economics programs named in honor of Olin. “You
should not forget that without all the work in Law and Economics, a
great part of which has been supported by the John M. Olin Foundation,
it is doubtful whether the importance of my work would have been
recognized,” said Ronald Coase, who won the 1991 Nobel Prize in economics.

In
addition to these centers specializing in law and economics, Olin
created scores of endowed chairs at a wide range of universities. Some
of these are in economics departments and others are in law. Olin also
indirectly funded the “boot camps” at which U.S. judges were taught
Austrian economics as if it were undisputed science. The academic
journals in law and economics are dominated by virulent opponents of
regulation. The textbooks used to teach law and economics treat
economic theory as having demonstrated conclusively the folly of most
government actions purportedly designed to help the public. (I say
“purportedly” because Austrians almost always claim that the government
intervention was really designed to benefit a special interest rather
than a substantial portion of the public.)

Here are two
examples that illustrate how false, but so influential and harmful
these Austrian nostrums have become through teaching falsified
economics to thousands of lawyers. Austrian law and economics is based
on suppositions that have long been known to be false. Dickens
famously had Mr. Bumble (in Oliver Twist) respond to being informed
that the law supposed him to be responsible for his wife’s behavior by
remarking that if the law supposed such an absurdity then “the law is a
ass.” The dominant law and economics text on corporate law for years
was by Easterbrook and Fischel. Judge Easterbrook is a colleague of
Judge Posner on the 7th Circuit and Fischel was for a time Dean of the
University of Chicago’s law school. They assert that “a rule against
fraud is not an essential or even necessarily an important ingredient
of securities markets” (1991: 283). Their book was written after
Professor Fischel, as a consultant to three of the most notorious
control frauds of the 1980s, tried out their theories in the real world –
and found that they failed catastrophically. Fischel praised the
worst frauds. Fischel & Easterbrook did not disclose to their
readers that their theories were falsified in the real world. Note how
extreme their claim was, the utter certainty of the claim, and the
lack of any data supporting the claim – a claim they knew to be false.
The taught students that, in the context of securities, we did not
need:

1. Any laws against securities fraud
2. The FBI and the Department of Justice
3. The SEC
4. Any rules against fraud
5. Any ability to bring civil suits

Fraud
is impossible because securities markets are “efficient” and act as if
they were guided by an “invisible hand.” Markets cannot be efficient
if there is accounting control fraud, so we know (on the basis of
circular reasoning) that securities fraud cannot exist. Indeed, when
Easterbrook and Fischel try to explain why the securities markets
automatically exclude frauds their faith-based logic becomes even more
humorous. They claim that honest securities issuers send one or more of
three “signals” of honesty to guide investors to purchase their
securities – and that only honest firms can send any of these three
signals.

1. Hire a top tier audit firm
2. Have their CEO own a substantial amount of stock in the company
3. Cause their firm to have extreme leverage

In
reality, accounting control frauds “mimic” each of these signals and
each signal aids their frauds. Easterbrook and Fischel’s ideas are not
merely wholly ineffective against accounting control fraud – they are
outright criminogenic. That is why Fischel praised the real world
accounting frauds when he was a consultant. Each of the three massive
accounting control frauds that Fischel praised sent each of these three
signals – and they sent them years before Easterbrook and Fischel wrote
their book and made claims they had seen repeatedly falsified by
Fischel’s fraudulent clients without warning their readers.

Note
the continuing damage that these three law and economics dogmas about
“signaling” honesty had in the current crisis. Regulators continued to
treat professionals as if they were “independent” and provided expert
judgments on which regulators should rely. Basel II, for example,
reduced capital requirements dramatically if the rating agencies gave a
high rating to a toxic mortgage derivative. Economists,
criminologists, and reality had long falsified the claim but
theoclassical law and economics never challenges its foundational
dogmas.

Easterbrook provided a classic example of faith-based
law and economics’ misplaced faith in private professionals in a
decision that prompted Robert Prentice’s wonderful article: The Case of the Irrational Accountant: A Behavioral Insight into Securities Fraud Litigation
(2000). The plaintiff alleged that he was the victim of a securities
fraud that the outside auditor had aided. Easterbrook’s opinion stated
that the plaintiff should not be allowed to engage in discovery
designed to support this claim because it would be “irrational” for an
audit firm to aid a securities fraud. Easterbrook’s logic is so
irrational on so many different levels that it proved a treasure trove
for Professor Prentice. In the interest of space, consider only four
aspects of why Easterbrook’s logic fails. First, Easterbrook is the
one who co-authored the textbook claiming that serious securities fraud
cannot occur. That makes him someone that cannot admit that fraud
exists. He certainly doesn’t want plaintiffs finding facts
demonstrating fraud. Second, the same textbook claimed that only
honest corporations could hire a prestigious audit firm. He premised
this (long falsified) dogma on the claim that it would be irrational
for an audit firm to give a clean opinion to a control fraud. If the
plaintiff had been allowed discovery and demonstrated the falsity of
this dogma it would falsify Easterbrook’s entire thesis. Third,
theoclassical economics rests on even more fundamental dogmas –
economic actors are supposed to act rationally and almost entirely to
maximize their self-interest. Empirically, even economists have long
known what non-economists have always known – these dogmas are often
false. Why should a plaintiff not be permitted to discover evidence
that accountants act irrationally? Fourth, Easterbrook assumes away
reality even if we assume rational behavior. The “auditor” acts
through humans called audit partners. Audit partners gain income,
power, and status within the firm primarily by bringing in large
clients. Accounting control frauds understand this and select audit
partners that will give them clean opinions. They also put prospective
audit partners in competition with each other to intensify the
“Gresham’s” dynamic that turns market forces perverse and causes bad
ethics to drive good ethics out of the profession. Top economists had
explained why this dynamic explained why S&L accounting control
frauds had consistently hired top tier audit firms and been able to get
clean opinions from them despite the fact that their financial
statements were fraudulent.

As James Pierce, Executive Director
of the National Commission on Financial Institution Reform, Recovery
and Enforcement (NCFIRRE) explained:

Accounting
abuses also provided the ultimate perverse incentive: it paid to seek
out bad loans because only those who had no intention of repaying would
be willing to offer the high loan fees and interest required for the
best looting. It was rational for operators to drive their
institutions ever deeper into insolvency as they looted them.

The
National Commission on Financial Institution Reform Recovery and
Enforcement (NCFIRRE) (1993), reported on the causes of the S&L
debacle. It documented the distinctive pattern of business practices
that lenders typically employ to optimize accounting control fraud.

The
typical large failure was a stockholder-owned, state-chartered
institution in Texas or California where regulation and supervision
were most lax…. [It] had grown at an extremely rapid rate, achieving
high concentrations of assets in risky ventures…. [E]very accounting
trick available was used to make the institution look profitable, safe,
and solvent. Evidence of fraud was invariably present as was the
ability of the operators to “milk” the organization through high
dividends and salaries, bonuses, perks and other means.

The
top tier audit firms knew that the “typical large failure”
“invariably” involved fraud by senior S&L executives, who used
“every accounting trick available” in order to create fictional income
in order to aid the executives’ looting of the S&L. These lenders
followed a distinctive pattern – deliberately making bad loans – that
was rational only for accounting control frauds. The unique pattern
that optimized fraudulent accounting income was simple for an auditor to
spot. The S&L accounting control frauds always hired top tier
audit firms and virtually always succeeded in getting clean opinions for
fraudulent financial statements. That was supposed to be impossible
under Easterbrook and Fischel’s theories. NCFIRRE explained the
“agency” problem that Easterbrook and Fischel missed.

[A]busive
operators of S&L[s] sought out compliant and cooperative
accountants. The result was a sort of “Gresham’s Law” in which the bad
professionals forced out the good.

Theoclassical
law and economics scholars continued to chant the second signaling
dogma – though falsified throughout the S&L debacle and Enron era
accounting control frauds – throughout the nonprime mortgage era. They
asserted endlessly that modern executive compensation “aligns” the
interests of the CEO with the shareholders’ interests. The reality was
that it frequently magnified the long-standing misalignment of those
interests. That is the key point of Akerlof & Romer’s classic
article – the CEO profits by using accounting fraud to loot the bank
that he controls. He arranges his executive compensation to be
extremely large and based primarily on short-term reported accounting
profits. Akerlof and Romer explain why accounting fraud is a “sure
thing”— mathematically guaranteed to report extreme (albeit fictional)
profit in the short-term. The combination of accounting control fraud
(“blessed” by a top tier audit firm’s clean opinion) and deliberately
misaligned (anti) “performance pay” is that the CEO is guaranteed to
become wealthy – immediately. Moreover, by using seemingly normal
executive compensation bonuses to become wealthy he coverts large
amounts of firm assets to his personal benefit while minimizing the
risk of prosecution. The result of a strategy that employs deliberate
adverse selection in lending is typically a bankruptcy that wipes out
the shareholders. No greater misalignment of the interests of the CEO
and shareholders is possible than that caused by modern CEO
compensation. Modern executive and professional compensation are often
criminogenic, yet theoclassical economists strive even now to preserve
the ability of CEOs to loot through perverse executive compensation.

The third “signaling” dogma, however, is never discussed today
by theoclassical law and economics scholars. The Austrians generally
ignore the endemic accounting control fraud (their heroes have always
been business cowboys) in their explanation of why we suffer recurrent,
intensifying financial crises. The Austrians love to blame the Federal
Reserve and “easy money” for producing low interest rates. The
Austrians claim this led to excessive leverage, and blame the global
crisis on extreme leverage. It is inconvenient to this new meme to
recall that the extreme law and economics scholars used to light candles
to leverage and chant its praises as a unique signal of honesty.
Accounting control frauds do optimize fictional accounting income by
engaging in extreme leverage. The leverage is a tactic of the
accounting control frauds that drive modern crises, not the cause of the
crisis. Because accounting control fraud produces exceptional
reported income it is easy for the frauds to borrow enormous amounts
(lenders virtually break down the frauds’ doors in their eagerness to
lend). The more money an accounting control fraud borrows, the greater
the sums the CEO can loot.

Michael Milken was the original
high priest of the extreme leverage dogma and the claim that it
signaled honesty (Fischel was his acolyte). Milken was, of course, an
expert at signaling honesty while practicing control fraud. His time
in prison only increased his hate for U.S. government “interference” in
“free markets.” The Milken Institute, therefore, now commissions
articles about the ongoing crisis that emphasize (in huge fonts):

From Main Street to Wall Street, one common thread runs through all facets of this story: excessive leverage.

http://www.milkeninstitute.org/pdf/Riseandfallexcerpt.pdf (p. 9)

That’s
right – the fraud whose entire junk bond business model at Drexel
Burnham Lambert rested on the dogma that corporations had too much
capital and needed to massively increase their leverage (e.g., through
LBOs) is now running an institute whose scholars claim that (far
lesser) leverage that modern U.S. banks employ is the primary cause of
global catastrophe. Of course, there’s no mea culpa by Milken admitting
that his earlier dogma was false.

The fact that, empirically,
accounting control fraud is a severe problem is no barrier to
theoclassical law and economics ignoring control fraud. I invite
readers who have taken law and economics and corporate law classes to
inform me whether their textbooks discussed Akerlof and Romer’s
article: Looting: The Economic Underworld of Bankruptcy for Profit.
Akerlof was awarded the economics version of the Nobel Prize in 2001
and Romer is also a brilliant economist. Neither Easterbrook nor
Fischel is an economist. Akerlof and Romer’s article explains how the
managers that control a firm use accounting fraud to create a “sure
thing” of fictional profits. The managers get rich, the firm dies.
Akerlof & Romer provide theory, data, and real world examples. The
lawyers that seek jobs at the financial regulatory agencies are the
lawyers most likely to have taken law and economics and corporate law
courses in which Easterbrook & Fischel’s claims were treated as
objective science. In my experience, it is vanishingly rare for them to
even be aware of Akerlof & Romer’s work or the work of
white-collar criminologists documenting and explaining accounting
control fraud.

When regulators believe that control fraud is
impossible – they make control fraud certain by eviscerating regulation
and supervision. The most infamous recent example of this is Alan
Greenspan (like Fischel, a former consultant to the most infamous
S&L control fraud – Charles Keating’s Lincoln Savings). Greenspan
refused to believe that fraud could occur in financial markets. He
refused to take any effective regulatory steps against what the FBI had
warned him (in 2004) was an “epidemic” of mortgage fraud even though
they correctly predicted that it would cause a “crisis.” The Fed had
unique regulatory authority under HOEPA to regulate all mortgage
lenders.

Law and economics has, for over two decades, been
dominated by theorclassical economic dogmas that have proved false.
These dogmas are premised on an ideological hate for regulation – even
by democratic governments. The Olin Foundation did not buy the souls
of the economists and lawyers to whom it provided fellowships and
endowed chairs. It simply selected true believers for its largess. It
knew how desperately eager universities were to raise funds. There
are now tens of thousands of law and economics graduates that have
taken a class in theoclassical law and economics. They were taught
that theoclassical economic assertions (often falsified decades ago)
were objective facts devoid of ideological content. They have been
taught that economics has proven that regulation is unnecessary,
hopeless, and harmful. Some students accept this dogma as revealed
truth, but many reject it. (If your goal as a professor is to
indoctrinate students you should prepare for a life of disappointment.)
Few economics, business school, or law students have been introduced
to effective regulation or economic/finance theories that have proven
to have predictive strength. It is the non-ideologues we need to reach
and inform them about the reality-based alternative to the faith-based
version of economics they were taught.

In
truth, the leading Austrian theorists were big supporters of freedom
and liberty. You can't have freedom if a handful of oligarchs are
manipulating the economy without any checks and balances from the law.
See this.

More importantly, you can't prevent bubbles unless you crack down on the fraud which helps to inflate bubbles. As I pointed out a year ago:

Everyone knows that the Fed blows bubbles.

But William K. Black ... says that fraud by many other companies also contributes to the bubble-and-bust cycle.

In a talk Black gave in June entitled "The Great American Bank Robbery" ... he gives the following examples.

Initially,
during the S&L, Enron and subprime crises, outside audit firms and
appraisers gave their seal of approval and a clean bill of health to
the companies, allowing them to commit fraud and blow a giant
speculative bubble in toxic assets.

And the three credit rating
services also committed massive fraud which helped blow the bubble.
For example, an analyst at Standard & Poors was assigned the job of
giving a credit risk rating for derivatives backed by subprime loans.
He wanted to review a sample of loan file to assess credit risk. His
boss (a high-level officer at S&P), gave him the following written
response:

Rating Agencies as Vectors.
Any request for loan level tapes is. TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it.
[W]e
must produce a credit estimate. It is your responsibility to provide
those credit estimates and your responsibility to devise some method for
doing so. [S&P 2001]

(capitalization and punctuation
in original). In other words, he was told to make it up, and then to
make up a rationalization.

So the S&P analyst ended up giving AAA rating - i.e. zero credit risk - on something that had immense credit risk.

So the bubble was partly blown because, as Black says,"This was a trillion dollar industry based on don’t ask, don’t tell."

This
is nothing new. Black points out that the official investigation into
the S&L crisis found that in the typical large failure, fraud was invariably present.

Black
also points out that the guys covering up fraud in S&L were
promoted to head regulators in the 2000's. These regulators gave a wink
and a nod to massive fraud and insane amounts of leverage. So the
regulators helped blow the bubble and sow the seeds of the current crash
as well.

Fraud By the Banks, Lenders and Financial Service Companies

But
the most interesting portion of Black's talk was the role of fraud by
numerous businessmen in blowing and then bursting bubbles.

Black explained that fraud by a financial company usually involves the company:

1) Growing like crazy

2)
Making loans to people who are uncreditworthy, because they’ll agree
they’ll pay you more, and that’s how you grow rapidly. You can grow
really fast if you loan to people who can’t you pay you back

and

3) The use of extreme leverage.

This combination guarantees stratospheric initial profits during the expansion phase of the bubble.

But it guarantees a catastrophic subsequent failure when the bubble loses steam.

And
collectively - if a lot of companies are playing this game - it
produces extraordinary losses (more than all other forms of property
crime combined), and a crash.

In other words, the companies
intentionally make loans to people who will not be able to repay them,
because - during an expanding bubble phase - they'll make huge sums of
money. The top executives of these companies will make massive salaries
and bonuses during the bubble (enough to live like kings even even if
the companies go belly up after the bubble phase).

And since honest regulators would stop this fraudulent activity during bubbles, the corruption of regulators ensures wild bubbles and the subsequent crashes.

Of
course, the types of fraud described by Black in the S&L, Enron
and 2007 meltdowns are not just for the history books. Unless stopped,
they will continue and will be the cause of the next crash.

Indeed,
Austrian economists stress the need to minimize "malinvestments"
(investments made in response to faulty signals). The Austrians
stress that artificially low interest rates can send false signals to
investors. That is obviously true.

But criminally dishonest
behavior by private corporations and traders - such as high-frequency
trading, quote-stuffing, front-running, control fraud and accounting
fraud - does the exact same thing. If there is rampant fraud, collusion
or book-cooking, faulty signals will be sent.

Moreover, the type of radical concentration of wealth which comes from criminally manipulating the system itself destroys democracy and makes a mockery of our legal system.

Freedom of the market versus basic regulation of fraud is a false dichotomy.   A free market and laws against criminal fraud are both necessary. Indeed, they are interrelated and mutually self-reinforcing.

Even Richard Posner - probably the leading proponent over the course of
many decades for removing the reach of the law from the economy - has
now changed his mind.

Whether you follow Keynes, Friedman, Mises and Hayek, or other economists, we all need to implement a little of the Austrian economic wisdom about preventing bubbles, and of the American legal wisdom about cracking down on fraud, breaking up the too big to fail banks using antitrust laws, and imposing accurate accounting and full disclosure requirements (see this, this and this).

The economy will not recover unless we do.

Comments

[bugs_]

The missing piece is on the prosecution side.  The third branch has made it too hard to obtain a successful prosecution.  Even if a prosecution is obtained, the third branch waters down the penalty side.  Frauds come back for repeats.

[gangland]

Especially: Fcuk YOU!!! Geroge "Fucking" Washington!!!

http://www.youtube.com/watch?v=YOY_aqkUTxY&feature=related

These things
That i've
Been told
Can rearrange
My world
My doubt
In time
But inside out

This is the working hour
We are paid by those who learn by our mistakes

This day
And age
For all
And not for one
All lies
And secrets
Put on
Put on and on

This is the working hour
We are paid by those who learn by our mistakes

And fear is such a vicious thing
It wraps me up in chains

Find out
Find out
What this fear is about
Find out
Find out
What this fear is about