“When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it.” ~ Frederic Bastiat
Up with Chris Hayes is a remarkable show in which Chris Hayes and his guests have a two-hour discussion on a handful of issues. This allows in-depth discussions instead of sound bites. On Saturday, July 7, 2012, Hayes framed a discussion of Libor (London Inter-Bank Offered Rate). The segment was prompted by Barclays’ settlement with U.S. and UK authorities of claims based on the banks’ submitting false data to the British Bankers trade association so that they would announce manipulated Libor rates. Hayes used two similes for Libor to try to explain the fraud to an U.S. audience. He said it would be as if the gauge on the gas pump was tampered with by the seller so that he could over charge consumers. Let me add a few facts from my perspective as a white-collar criminologist. This is a very old problem. The bible and Talmud contain injunctions designed to forbid fraud in weights and measures. Those religious provisions are supplemented now with state inspections of gasoline pump meters. One common, sophisticated way that gasoline sellers continue to defraud their customers is a twist on something the ancient texts understood millennia ago – the actual quantity of fluids that are sold by volume is determined by their weight, not their volume. The ancients forbade pouring wine from a significant height because the admixture with air allowed the merchant to fill a glass with only two-thirds of a glass of frothy wine. A modern variant leads gasoline stations to sell their product without adjusting the fuel gages to reflect the actual (higher) temperature of the gasoline in their tanks. The higher temperature expands the fuel’s volume but not its weight or energy content. In the trade, this is known as “hot gas” or “hot fuel.”
Hayes’ second simile was that the Libor fraud was similar to firms that sold goods by length secretly shortening the length of a “foot.” There are many commercial frauds that rely on deception in measurements. By far the largest is accounting fraud, but the movie Tin Men (about sleazy sellers of aluminum siding) provides the classic riff on Hayes’ second simile:
“The Buzzard had a great gimmick. You know, when it came time to measure a job, he’d cut the yardstick and reglue it together … he took out seven inches so his square footage would always be higher. That way he’d always make a few extra bucks on the job.
Stanley laughs and looks at Carly.
Yeah… he’d always put his hand over the break when he was measuring. Nobody looks at a yardstick to see how long it is.
I never did that… I never did that… I was never very good in arts and crafts. I could never make the ruler come out right.”
Hayes then emphasized that fraud could cause indirect, severe injury by damaging trust. As white-collar criminologists we emphasize that deceit is the defining element of fraud that distinguishes it from other forms of larceny. I’m a fraud, I get you to trust me and I betray that trust in order to enrich myself at your expense. That is why fraud, particularly elite fraud, is the strongest acid for destroying trust.
Karl Smith, a young neoclassical economist teaching in UNC’s public policy school was a guest on Hayes’ show discussing Libor. Smith lost it, doubled-down as the host and fellow guests tried to save him, and then went “all-in” by making statements that will haunt his career. He committed three unforced errors, each of them more revealing of his difficulties. The first unforced error need not have proved serious. Smith explained that his view of the banks’ manipulation of the Libor rate – the rate that determines the interest rate on trillions of dollars of loans and derivatives – was: “I don’t think there is a major problem with it.” There was “no major problem” because the banks sometimes inflated and sometimes deflated the Libor rate. His fellow guests explained why this was an embarrassingly weak apologia for fraud and he could have dropped the point.
Instead, he doubled down. He explained that it was good for the world that many of the world’s largest banks provided false data to distort the reported Libor for the purpose of making it appear (falsely) that the banks were in better financial condition than they actually were. Smith said that the banks falsified Libor in order to hide from creditors and shareholders their severe financial difficulties. He argued that because many people would be severely harmed by the failure of the largest UK banks the need to stop those failures was paramount.
Smith didn’t discuss any of the intermediate steps in logic and assumed facts that would be essential to make this argument even facially sound. Assume that Barclays was solvent and at least moderately capitalized but other banks perceived it as very weak and charged it a materially higher interest rate to borrow. Under this hypothetical Barclays falsely reported a materially lower interest rate for the purpose of causing creditors and shareholders to believe that it was not suffering serious liquidity problems. The alternative hypothetical is that Barclays was insolvent or near insolvency and falsified its Libor submission by reporting a materially lower borrowing cost in order to deceive creditors and shareholders about its potential failure.
The first problem with Smith’s assertion is the implicit, false, assumption that there is no alternative to fraud to deal with either of these hypothetical fact patterns. Smith is an academic and his CV does not list any non-academic positions. There is no indication that he has been a banker or financial regulator. Under the hypothetical that Barclays was adequately capitalized but suffering a potential liquidity problem the obvious answers include the Bank of England providing additional liquidity to Barclays so that it could reduce its borrowing costs and honestly report that fact in its Libor filings. Such liquidity support would be normal in a crisis. Because the UK has retained a sovereign currency it is not vulnerable to the euro zone bond vigilantes. The Bank of England can create massive amounts of funds electronically or borrow vast sums at minimal interest rates.
Under the hypothetical that Barclays was failed or about to fail due to the combination of severe credit losses and liquidity problems the appropriate solution was not for Barclays to lie about its borrowing costs and then hope and pray that no creditor or shareholder would learn the truth about its severe financial problems. The answer would have been to place Barclays in receivership and fund an assisted acquisition. Leaving Barclays under the control of a management that had rendered it insolvent, while trying to keep that insolvency secret for months, would massively increase the risk of loss to the public.
Smith also implicitly assumed away the costs of the UK’s largest banks, the Bank of England, and the government lying and engaging in fraud. The costs are so large and myriad that I can only sketch them here. First, the lies create at least three forms of potential civil liability: fraud, securities fraud, and antitrust. Second, the scope of Libor is massive – trillions of dollars in transactions, so the potential damages are extreme. Third, exemplary damages are likely to be available. Fraud is an intentional tort that allows punitive damages. Antritrust remedies in the U.S. include treble damages. Fourth, suits can be brought in the U.S. and the defendants have substantial assets that a U.S. court could seize. Fifth, the U.S. allows broader discovery than the UK and the information released could be embarrassing and incriminating.
Antitrust violations can be prosecuted criminally in the U.S. against the bank and the officers involved. The U.S. has extradited senior UK financial officers of Nat West and seized Swiss bankers landing at U.S. airports.
The U.S. could prohibit the banks that falsified their Libor filings from doing business in the U.S. Even the threat to do so would be devastating to the banks.
The banks’ loss of trust and reputation could be severe. Libor is the City of London’s crown jewel. Libor could be replaced by a far more credible U.S. rate reported by the U.S. government. Indeed, the U.S. could bar U.S. banks from using Libor on the grounds that the reporting of Libor was unreliable.
U.S. administrative enforcement powers and resources are generally the greatest in the world. In addition, the U.S. banking regulatory agencies have direct jurisdiction over a number of the Libor banks or their affiliates.
Smith has also implicitly assumed away the cost to the regulatory agencies of engaging in fraud. Smith does not evince any understanding of regulation, what it takes to be an effective regulator, or what an effective regulator can accomplish. We depend on our reputation for integrity. It is impossible to urge banks to lie and then take supervisory and enforcement actions against banks on the grounds that they have lied (which is one of the most common and powerful form of action we take when we are effective because lies are essence of fraud). An agency that lies and encourages the banks it is supposed to regulate to lie is an agency that must fail. A financial regulatory agency that fails is a clear and present danger to the future financial health of the nation.
Smith may not realize how common the temptation is for bank regulators to lie and encourage banks to lie. The Office of Thrift Supervision (OTS), under its heads of supervision in 1982-83 and mid-1987-1989, lied on numerous occasions about the financial condition of savings and loans under the purported belief that doing so was critical to prevent systemic crises. The result was that fraudulent S&Ls were kept open and allowed to grow. We overturned these efforts at the national level in 1984-mid-1987 and the regional (West Coast) level in mid-1987-1989. Our congressional testimony in 1989 led to the resignation of the head of our agency and the demotion of its supervisory head in 1989. During the current crisis, however, OTS repeatedly promoted the disgraced former head of supervision. His promotions only stopped when he led the regulation of Countrywide, WaMu, and IndyMac. He was, of course, an abject failure as a regulator. He resigned with the agency’s Inspector General discovered that he had worked with IndyMac to allow it to knowingly file false financial information with the agency overstating its capital. Smith has no understanding of how devastating it is when the “regulatory cops on the beat” whose paramount mission is preventing fraud (lies) by banks encourage the banks to lie. Overwhelmingly, economists assume that regulators cannot succeed and are not important.
The U.S. and UK crises were largely driven by senior bankers’ lies and the failure of the anti-regulators to detect and sanction the lies. Fraudulent “liar’s loans” were the toxic core of the U.S. crisis. Encouraging bankers to lie more is insane public policy.
Smith went “all in” by gratuitously suggesting that if he had run the Bank of England during the crisis he would have ordered Barclays to lie when it reported its Libor rate and would have murdered anyone who resisted the order to commit fraud.
Smith: “If I was at the Bank [of England] … I would call [Barclays] and tell them to lie.”
“If I had the power I would demand that you do that. I would shoot you if you didn’t do that. I mean that there were peoples’ lives at stake.”
Hayes: “Just so we are clear; we’re on television. You wouldn’t literally should shoot people that didn’t do that?”
Smith: “I most certainly would.”
Smith: “[The Bank of England] did the right thing [by instructing the banks to lie about their Libor borrowings] – and you should kill people.”
Regular readers will know that one of our family rules is that it is impossible to compete with unintentional self-parody. The “crime” for which Smith would condemn regulators and lawyers to death is acting lawfully and speaking truth to power. Smith finds no irony in saying that he would “shoot” honest regulators or bankers because “peoples’ lives [were] at stake.” Smith is seriously proposing that we shoot the honest regulators and bankers and promote the regulators and bankers who lie – as his means of protecting the citizens from financial crises.
Smith teaches in a public policy school so he is teaching future government officials, including those who will serve in other nations. I know that world well having taught for many years at the LBJ School of Public Affairs at the University of Texas at Austin. Smith’s gleeful proposals to murder those that speak truth to power have a special resonance for me because I am a serial whistleblower. Powerful political officials desperately wished to prevent those truths from being disclosed. I paid a material price for doing so. Some of my colleagues paid a far higher cost. In other nations, regulators who tell the truth are in fact murdered. Hayes reminded Smith that he was speaking on television and that he should make it clear that he was not serious that regulators who told the truth should be murdered by their superiors. Instead, he claimed that he was serious. I was a guest with Smith on an earlier show with Hayes. I do not for one moment believe that Smith was serious about murdering people. He’s an academic early in his career passionately seeking fame.
I suggest two rules. One, it is not acceptable to talk, much less gurgle enthusiastically, about your desire to commit murder. Calling it a joke doesn’t make it any better.
Two, some of Smith’s students will go back to their home nations and over the course of their careers become senior officials who do have the capability to retaliate against, even murder whistleblowers in their agencies. Even his American students may have to choose whether to put their careers at risk by speaking truth to power. For some of his foreign students their choices could put their lives at risk. I taught advanced classes in financial regulation where we examined seriously these ethical questions. Public policy students need teachers who will help them understand how much they can accomplish for their nations as government officials if they establish and maintain a reputation for integrity and, judiciously, choose to speak truth to power at critical junctures. A professor who advises governments and the world’s largest banks to conspire to deceive the public about the banks’ true financial condition is useful only if the school’s mission is to prepare its students to triumph under crony capitalism. A professor who teaches that we should murder the honest and promote the liars is perfect for meeting the needs of an underserved portion of the student body – sociopaths.