Monthly Archives: April 2011

My Class, right or wrong: the Powell Memorandum’s 40th Anniversary

By William K. Black

August 23, 2011 will bring the 40th anniversary of one of the most successful efforts to transform America. Forty years ago the most influential representatives of our largest corporations despaired. They saw themselves on the losing side of history. They did not, however, give in to that despair, but rather sought advice from the man they viewed as their best and brightest about how to reverse their losses. That man advanced a comprehensive, sophisticated strategy, but it was also a strategy that embraced a consistent tactic – attack the critics and valorize corporations! He issued a clarion call for corporations to mobilize their economic power to further their economic interests by ensuring that corporations dominated every influential and powerful American institution. Lewis Powell’s call was answered by the CEOs who funded the creation of Cato, Heritage, and hundreds of other movement centers.

Confidential Memorandum:
Attack on the American Free Enterprise System

DATE: August 23, 1971
TO: Mr. Eugene B. Sydnor, Jr., Chairman, Education Committee, U.S. Chamber of Commerce
FROM: Lewis F. Powell, Jr.

Lewis Powell was one of America’s top corporate lawyers and President Nixon had already sought to convince him to accept nomination to the Supreme Court before he wrote his memorandum. Powell was famous for his successful efforts on behalf of the Tobacco Institute. The Institute was desperately seeking to prevent the government from alerting consumers to the lethal effects of tobacco and to prevent its customers from holding the tobacco corporations legally responsible for their premature deaths. The Institute played the critical role in covering up the lethality and paying for junk science designed to mislead consumers about the lethal effects of tobacco products. They were literal merchants of death, selling a product that when used as intended was likely to kill the customer.

“For the past 45 years,” Attorney General Janet Reno said at a news conference, “the companies that manufacture and sell tobacco have waged an intentional, coordinated campaign of fraud and deceit. As we allege in the complaint, it has been a campaign designed to preserve their enormous profits whatever the cost in human lives, human suffering and medical resources. The consequences have been staggering.”

Powell’s confidential memorandum begins by explaining that he wrote it at the request of the U.S. Chamber of Commerce. Powell’s first substantive sentence is that business is under assault – and anyone who disagrees with him on that point is incompetent. “No thoughtful person can question that the American economic system is under broad attack.”

Powell then explained why business was losing the public debate.

“The most disquieting voices joining the chorus of criticism come from perfectly respectable elements of society: from the college campus, the pulpit, the media, the intellectual and literary journals, the arts and sciences, and from politicians. In most of these groups the movement against the system is participated in only by minorities. Yet, these often are the most articulate, the most vocal, the most prolific in their writing and speaking.”

Ralph Nader’s Nadir: The Outrage of Calling for Criminal CEOs to be Jailed

Among these articulate voices, the person that Powell most feared was Ralph Nader, who he described as “the single most effective antagonist of American business.” Powell cited a Fortune article to explain why Nader was the great danger.

“The passion that rules in him — and he is a passionate man — is aimed at smashing utterly the target of his hatred, which is corporate power. He thinks, and says quite bluntly, that a great many corporate executives belong in prison — for defrauding the consumer with shoddy merchandise, poisoning the food supply with chemical additives, and willfully manufacturing unsafe products that will maim or kill the buyer. He emphasizes that he is not talking just about ‘fly-by-night hucksters’ but the top management of blue chip business.”

One can understand why Powell felt so personally threatened by Nader. “Willfully manufacturing unsafe products that will maim or kill the buyer” describes the tobacco industry and Powell was that industry’s most prestigious apologist.

The issue I wish to emphasize, however, is why Powell and Fortune viewed Nader’s statements as evincing “hatred” of the enterprise system. Focus on what Fortune (a virulent opponent of Nader) says that Nader argued. Nader believed that the CEOs leading anti-consumer control frauds should be imprisoned where they (1) defrauded the consumer with shoddy merchandise, (2) poisoned the food supply, or (3) willfully manufactured unsafe products that will maim or kill the buyer. Powell and Fortune view these beliefs as radical, dangerous, and hostile to what Powell refers to in his memorandum as the “enterprise system.”

I submit that Powell and Fortune are not simply incorrect, but as wrong as it is possible to be wrong – and that Powell was blind to reality despite his intellectual brilliance in corporate law. First, is Nader the only one who believes that CEOs who commit control frauds are criminals? Anti-customer control frauds have defrauded, maimed, and killed hundreds of millions of people. In my prior columns I have focused on accounting control frauds because they are the “weapon of choice” in finance. One way of classifying variants of control frauds is by their principal intended victims. Accounting control frauds target creditors and shareholders. Anti-public control frauds target the general public, e.g., tax fraud, the illegal dumping of toxic waste, or illegal trading in endangered plants and animals. Anti-employee control frauds target employees, e.g., by not paying workers wages they are due or exposing them unlawfully to unsafe working conditions.

Anti-customer control frauds target customers. The seller may deceive the customer as to the quality, quantity, or safety of the good or service or the legal authority of the seller to convey the good and/or the promised security interest in the good. Cartels are another variant of anti-customer control fraud. The fraud is that the firms purport to be competitive rivals when they are secretly co-conspirators acting against the customers. Examples of recent anti-customer control frauds that maim and kill include the recurrent counterfeit infant formula scandals (which killed six infants and hospitalized 300,000), various lead toy scandals, counterfeit cough syrup (made with toxic anti-freeze), defective body armor for U.S. soldiers, unsafe water for U.S. troops, unsafe showers for U.S. soldiers (electrocution), counterfeit medicines including anti-malarial drugs, dwellings falsely certified to comply with seismic codes that pancake in earthquakes and kill tens of thousands. Then there are cigarettes, which were actually sold via fraud, are addictive, and lethal if used as intended. This form of fraud, addiction, and lethality was so effectively marketed that it became immune from normal laws and legal restrictions for centuries. Cigarettes have killed millions of customers and others subjected to second hand smoke.

Many anti-customer frauds do not routinely maim and kill. Misrepresenting the quality of a car to a customer can cause him a serious financial loss, but most of the hidden defects will not cause him or others physical injury. (Defects involving the brakes or safety equipment can imperil the customer, passengers, and the general public.) We call a terrible quality car a “lemon” and George Akerlof’s famous article on “lemon’s” markets was published one year before the Powell memorandum. It was this article that led to the award of the Nobel Prize in economics to Akerlof in 2001.

The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. Akerlof, George A., The Quarterly Journal of Economics, Vol. 84, No. 3. (Aug., 1970), pp. 488-500.

Economists have a Pavlovian response to any mention of Akerlof’s seminal article on lemon’s markets – “asymmetric information.” The committee that awards the prize in economics in honor of Nobel cited Akerlof and his co-awardees’ work in developing the economic implications of asymmetric information. Economists have tended to ignore, however, the context of Akerlof’s famous article. The specific examples of the sale of goods that Akerlof discusses are frauds. More particularly, each is an anti-customer control fraud – a fraud instigated by the person(s) controlling a seemingly legitimate entity where the primary intended victims were the customers. Akerlof did not discuss the variants of anti-customer control fraud that maim or kill – he focused solely on examples of economic injury due to fraudulent misrepresentations by the seller of the quality or quantity of the goods sold. More precisely, two of Akerlof’s examples – the fraudulent sale of defective cars and rice deliberately intermixed with stones – do maim and kill some customers, but Akerlof did not discuss this aspect. (Biting down on a stone can easily shatter a tooth. That causes excruciating pain, but it also exposes an Indian peasant – the fraud victims Akerlof was discussing – to a greatly increased risk of dental infection, which causes an increased risk of severe cardiac illness.) Akerlof had appropriately large ambitions in his article. He sought to provide a “structure … for determining the economic costs of dishonesty” (p. 488). Goods that maim and kill the customer impose the primary economic costs of dishonesty.

So, the first problem with Powell and Fortune’s horror that Nader believed we should prosecute those CEOs who caused the sale of the goods they knew would maim and kill their customers (and others) is that Nader was obviously correct – prosecuting those CEOs should be a top priority – globally. Prosecuting the fraudulent CEOs who “merely” cause their customers financial losses by deceptive sales of defective goods and services should be a significant priority.

Second, Powell and Fortune believe that prosecuting criminal CEOs is terrible for businesses, terrible for CEOs, and terrible for “free enterprise.” They conflate support for prosecuting criminal CEOs with “hatred” for “corporate power” and they conflate “corporate power” with “free enterprise.” Recall that this is their conclusion about Nader:

“The passion that rules in him — and he is a passionate man — is aimed at smashing utterly the target of his hatred, which is corporate power.

Powell and Fortune cite Nader’s call for criminal CEOs to be prosecuted as their proof of this conclusion. But why would prosecuting criminal CEOs be bad for “free enterprise?” Powell and Fortune don’t even attempt to explain why this would be true. It is self-evident to them that a world in which criminal CEOs do not enjoy impunity from the law is a world in which “corporate power” will have been ”smash[ed]” and that absent hegemonic “corporate power” “free enterprise” is impossible. Their “logic” and rhetoric are revealing, but absurd. Wanting to prosecute criminal CEOs is not hostile to “free enterprise,” but rather essential to the success and continued existence of “free enterprise.” Akerlof explained why in his 1970 article.

“Gresham’s law has made a modified reappearance. For most cars traded will be the “lemons,” and good cars may not be traded at all. The “bad” cars tend to drive out the good” (p. 489).

“[D]ishonest dealings tend to drive honest dealings out of the market. There may be potential buyers of good quality products and there may be potential sellers of such products in the appropriate price range; however, the presence of people who wish to pawn bad wares as good wares tends to drive out the legitimate business. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence” (p. 495).

When cheaters prosper, market mechanisms become perverse and can drive the honest from the marketplace. The market becomes dominated by cheats because they obtain a competitive advantage. The most common reason that firms can cheat with impunity is that their CEOs are cronies of powerful politicians. The defining characteristics of crony capitalism are that the cronies receive subsidies, favors, and immunity from normal rules and laws. The cronies dominate the big corporations and provide reciprocal benefits to controlling politicians. Managerial incompetence and wealth flourishes under crony capitalism. Merit and efficiency suffer, income inequality surges, and class and who one knows become the primary determinants of economic and political success and power. The elites become pervasively corrupt.

Crony capitalism is the antithesis of “free enterprise.” The best way to destroy free enterprise is to allow CEOs to commit control fraud with impunity because that maximizes the perverse Gresham’s dynamic. Only big business had the power to destroy “free enterprise” in America – and Powell’s strategic plan was the best way to destroy free enterprise. As the left had long argued, it was the purported capitalists who would destroy capitalism.

“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)

Powell’s memorandum sought to glorify plunder with impunity, but he went beyond Bastiat’s warnings. Powell glorified CEOs who killed and maimed customers.

Third, and Powell is rolling over in his grave as I write this, Nader was one of the leading defenders of “free enterprise” when Powell wrote his memorandum in 1971. That was not Nader’s intent, but it was Nader’s efforts against control fraud that helped stave off for a time Powell’s embrace of a system in which elite frauds go free. That system, crony capitalism, destroys “free enterprise.” The regulators and the prosecutors are the “cops on the beat” who are essential to preventing the cheats from gaining a competitive advantage over honest businesses.

Powell could have, far more logically, characterized Nader’s position as “crusader against criminal CEOs” or “crusader on behalf of honest businesses.” Powell would never have referred to an individual calling for blue collar criminals to be prosecuted as a man determined to destroy liberty. He would have said that such an individual was increasing liberty – for criminals and crimes impair our liberty. President Nixon personally convinced Powell to accept the nomination to the Supreme Court to counter the decisions of the Warren Court, particularly the decisions adding to the constitutional protections of blue collar criminal defendants. Powell, particularly as head of the American Bar Association (ABA), was famous for his campaign against street crime. Powell’s biographer, John Calvin Jeffries, wrote that:

“Powell argued that “a root crisis of the crime crisis which grips our country is excessive tolerance by the public generally – a tolerance of substandard, marginal and even immoral and unlawful conduct.” It had reached the point of “moral sickness.”

He worried that the pendulum may have swung too far in favor of the rights of criminals. Even Little Orphan Annie quoted the ABA chief: “There are valid reasons for criminals to believe that crime does pay, and that slow and fumbling justice can be evaded.” Justice Lewis F. Powell, Jr.,(2001: p. 210.

Powell, in his address to the ABA at the end of his term as President, argued that making Americans free from crime should be the nation’s “first priority” (Jeffries & Jeffries, p. 211). (Note the phrase “the rights of criminals” instead of “the rights of those accused.”) Powell conflated criminal CEOs with honest businesses – and was blind to the fact that he did so. Had he shown any logical consistency in how he dealt with criminals, Powell would have praised Nader’s efforts to have criminal CEOs prosecuted. But Powell could not see beyond class and his own experience in aiding CEOs who were “willfully manufacturing unsafe products that will maim or kill the buyer” do so with impunity. Can there be any greater betrayal by a CEO than using deceit to willfully manufacture cigarettes that maimed and killed his customers and those exposed to their customers’ smoke – for the sole purpose of making the CEO wealthy through such sales? Powell did not normally smoke, but according to his biography he posed with fellow members of the board of directors of one of the world’s largest cigarette companies in the firm’s publicity photographs with a cigarette to demonstrate his support for smoking. He showed more than “tolerance” for “immoral and unlawful conduct” – he provided them with aid and comfort. Through his famous memorandum he created a criminogenic environment in which control fraud “does pay” because he helped remove the regulatory cops from their beat and claimed that those who wanted to prosecute criminal CEOs posed such a threat to “free enterprise” that business must show “no hesitation” in marshalling its unmatched economic and political power to “attack” them and ensure that they were “penalized politically.”

Powell: Firms that Fail to Use their full Power v. Foes are Appeasers

Powell derided corporations that gave aid and comfort to the enemy by failing to use their dominant economic power against those who wanted to hold corporations and their senior officials accountable for “defraud[ing],” “poison[ing],” and willfully manufactur[ing] unsafe products that will maim or kill the buyer.”

“One of the bewildering paradoxes of our time is the extent to which the enterprise system tolerates, if not participates in, its own destruction.

The campuses from which much of the criticism emanates are supported by (i) tax funds generated largely from American business, and (ii) contributions from capital funds controlled or generated by American business. The boards of trustees of our universities overwhelmingly are composed of men and women who are leaders in the system.

Most of the media, including the national TV systems, are owned and theoretically controlled by corporations which depend upon profits, and the enterprise system to survive.”

Powell: the Business Class are Paragons of Civic Virtue

In Powell’s telling, business interests were the political naïf in politics. Other lobbyists were “special interests” while business was dedicated to the public interest. Special interests made self-interested demands on politicians, business did not.

“Business, quite understandably, has been repelled by the multiplicity of non-negotiable “demands” made constantly by self-interest groups of all kinds.

While neither responsible business interests, nor the United States Chamber of Commerce, would engage in the irresponsible tactics of some pressure groups, it is essential that spokesmen for the enterprise system — at all levels and at every opportunity — be far more aggressive than in the past.”

Corporations and the Chamber of Commerce did not make demands on legislators and did not act as special interests. Powell was not naïve enough to believe his own propaganda, but he knew that the Chamber of Commerce and its members CEOs would delight in even the most oleaginous praise. A corporate lawyer becomes expert in pandering to power.

Powell: Use Economic Power to “Punish” Foes

Powell’s solution was for corporations to act like real corporations by using their wealth and ownership to take control of the universities and media and use that control to further corporate interests by causing the universities and media to extol the virtue of corporate dominance and by influencing the law to support corporate interests. But his central theme was that business must cease its “appeasement.” CEOs should show:

“no hesitation to attack the Naders … who openly seek destruction of the system. There should not be the slightest hesitation to press vigorously in all political arenas for support of the enterprise system. Nor should there be reluctance to penalize politically those who oppose it.”

Powell: Do what we do Best – “Produce and Influence Consumer Decisions”

Powell’s specific prescriptions for how corporations should use their economic power to achieve dominance are filled with hortatory expressions about quality.

“Essential ingredients of the entire program must be responsibility and “quality control.” The publications, the articles, the speeches, the media programs, the advertising, the briefs filed in courts, and the appearances before legislative committees — all must meet the most exacting standards of accuracy and professional excellence.”

But Powell knew corporations’ real strength – manipulating the public through advertising and marketing.

“It is time for American business — which has demonstrated the greatest capacity in all history to produce and to influence consumer decisions — to apply their great talents vigorously to the preservation of the system itself.”

American corporations didn’t demonstrate “the greatest capacity in all history to produce and to influence consumer decisions” through advertising that was limited to “the most exacting standards of accuracy.” Remember, Powell’s most important experience was representing the interests of tobacco companies. Tobacco marketing had four dominant motifs – smoking was cool, smoking was adult, smoking made you sexy, and even more dishonest efforts to minimize smoking’s health risks. The advertising, marketing, and lobbying efforts on behalf of smoking were based on deception, and they did succeed in “produc[ing] and influenc[ing] consumer decisions” that were literally suicidal and potentially fatal to their loved ones.

Again, Powell’s apparent naiveté about the propaganda campaign that he was proposing that the Chamber of Commerce unleash was pure sham. He knew that businesses frequently created demand for their products through deception and he knew that if business followed his recommendation to unleash its marketing gurus on attacking those who wanted to prosecute criminal CEOs they would do so with as much regard for accuracy as they found useful for the particular attack. If misleading voters and demonizing opponents through deceptive statements worked better as a means of attack, then Powell knew that marketing specialists would have no more scruples lying about Nader than they had against lying about smoking – but he also knew that the memorandum would eventually become public and that it should be written in as self-serving and self-glorifying a manner as possible. Advertising specialists are a cynical lot, so I’m sure they got a great laugh reading the portion of Powell’s memorandum where he conflates of “the most exacting standards of accuracy” in advertising with “professional excellence” in advertising.

Freedom is the Ability of CEOs to Commit Crimes with Impunity

Powell ended his substantive arguments with the claim that regulating business destroyed freedom.

“The threat to the enterprise system is not merely a matter of economics. It also is a threat to individual freedom.

It is this great truth — now so submerged by the rhetoric of the New Left and of many liberals — that must be re-affirmed if this program is to be meaningful.

There seems to be little awareness that the only alternatives to free enterprise are varying degrees of bureaucratic regulation of individual freedom — ranging from that under moderate socialism to the iron heel of the leftist or rightist dictatorship.

We in America already have moved very far indeed toward some aspects of state socialism, as the needs and complexities of a vast urban society require types of regulation and control that were quite unnecessary in earlier times. In some areas, such regulation and control already have seriously impaired the freedom of both business and labor, and indeed of the public generally.”

It is a measure of how successful Powell’s strategy was in spreading the ideology of corporate dominance and impunity that some of his statements would now be anathema to business. He concedes in his conclusion that: “most of the essential freedoms remain: private ownership, private profit, labor unions, collective bargaining….” In 1971, even prominent Republicans hostile to unions considered the rights to join a union and engage in collective bargaining to be “essential freedoms.” As a Supreme Court Justice, Powell proved to be a disappointment to President Nixon and movement conservatives because he remained a moderate conservative.

Powell exemplifies the limits of even exceptional intellect and great courtesy. He did not set out to harm the public. He felt he epitomized intellectual consistency, but he was blind to how his class bias on behalf of CEOs made him totally inconsistent in his view of crimes of the street and the suite.

The “areas” in which Powell warned that regulation had already “seriously impaired the freedom of both business and labor” – that language is code for rules restricting discrimination in employment based on race, gender, etc. The Civil Rights Act of 1964 and the EEOC were anathema to Powell and the CEOs of many members of the Chamber of Commerce. The anti-discrimination laws applied to unions as well as employers. Powell, careful lawyer that he was, knew not to make that nostalgia for bigotry explicit in his memorandum.

(Excerpts from this article were posted originally in Benzinga.  This article was posted originally in the UMKC-economics blog:  NewEconomicPerspectives.)

The S&P Downgrade: Much Ado about Nothing Because a Sovereign Government Cannot go Bankrupt

By L. Randall Wray

The claims about “unsustainable deficits” gained new urgency this week as S&P warned that it was downgrading US federal government debt from stable to negative (see here for recent debate).

This appeared to be a blatantly political move, designed to influence the debate in Washington, adding fuel to the fire to cut budget deficits.

The deficit hysteria has nothing to do with economics, government solvency, or involuntary default. A sovereign government can always make payments as they come due by crediting bank accounts—something recognized by Chairman Bernanke when he said the Fed spends by marking up the size of the reserve accounts of banks.

Similarly Chairman Greenspan said that Social Security can never go broke because government can meet all its obligations by “creating money” (see here).

Instead, sovereign government spending is constrained by budgeting procedure and by Congressionally-imposed debt limits. In other words, by self-imposed constraints rather than by market constraints.

In addition, government needs to be concerned about pressures on inflation and the exchange rate should its spending become excessive. Finally, it should avoid “crowding out” private initiative by moving too many resources to our public sector. However, with massive unemployment and idle plant and equipment, no one can reasonably argue that these dangers are imminent.

Ironically, the ratings agencies recognized long ago that sovereign currency-issuing governments do not really face solvency constraints. A decade ago Moody’s downgraded Japan to Aaa3, generating a sharp reaction from the government. (more here) The raters back-tracked and said they were not rating ability to pay, but rather the prospects for inflation and currency depreciation. After ten more years of running deficits, Japan’s debt-to-GDP ratio is 200%, it borrows at nearly zero interest rates, it makes every payment that comes due, its Yen remains strong, and deflation reigns. In other words, the ratings agencies got it all wrong—as they usually do.

So, as I predicted two days ago, the market reacted to the US government’s credit downgrade with a big “Ho-Hum”.

Is the Government Running Out of Money?

The Federal Government has been handed a temporary reprieve by Congress: it won’t be shut down just yet. That gives the Democrats and Republicans more time to haggle over which items to cut. The premise is that the government is “running out of money” as President Obama has put it so eloquently in numerous speeches. Let us first examine that claim and then move on to the real subject of debate: Can a sovereign government run out of money?

The answer is easy: No!

Indeed, a sovereign government neither has nor does not have money (see here). The money government uses to spend is created as it spends. That might sound bizarre or even dangerous. But, in fact, on that score it is not so different from any other spender. (see previous discussion)

Can Your Bank Run Out of Money?

Look at it this way. As economists who adopt the (French-Italian) “Circuit” approach have long argued, when a firm wants to spend it approaches a bank . The bank accepts the firm’s IOU (called a loan on the bank’s balance sheet) and creates its own IOU (in the form of a demand deposit). From the firm’s perspective, the loan is its debt and the demand deposit is its asset. The bank “intermediates” because its IOU (the demand deposit) is more widely accepted in payment than is the firm’s IOU.

Of course, the firm is not going to hold the demand deposit since the whole object of borrowing was to spend. The demand deposit will then get shifted to the seller. Now, it is of course possible for the firm to finance its spending by using a sales receipt—a credit to its demand deposit and matched by a debit to the seller’s account.

But at the aggregate level, all the demand deposits were created as the accounting offset to loans. In other words, sales receipts in the form of demand deposits required some previous bank loan. At the aggregate level, bank “money” is created and therefore equal to bank loans—that is where bank money comes from.
Can the bank “run out of money”? No. It neither has, nor does not have money. It creates the money when it makes a loan; and the purpose of this activity is to finance some kind of spending—on goods, services or assets.

Can this money creation be “excessive” in the sense of causing prices to rise? Yes. Can it be “speculative” in the sense that it helps to fuel an asset price bubble? Yes. Can it be “foolish” in the sense that the borrower defaults and the bank ends up holding a worthless IOU? Yes. Can bank lending and thus money creation be constrained by government regulations and supervision? Yes. Finally, can—and should—the bank exercise self-restraint? Yes.

So, just because we say the bank can always create money “out of thin air” by making a loan and creating a demand deposit that does not mean that it should lend “until the cows come home”, or that it does not face regulatory or self-imposed constraints.

Ultimately, good banking practice requires good underwriting—to ensure it does not end up with too many trashy IOUs; and from the macro perspective, government wants to limit bank “money creation” to finance spending in order to prevent inflationary conditions in markets for goods, services and assets.

Is Sovereign Government Different? Users and Issuers of the Curency

Almost everything that has been said above about the finance of the spending of a private firm applies to a government. Government spending occurs simultaneously with a credit to a private bank account—that is to a demand deposit at a bank. The offsetting liability on the government’s books is a credit to the bank’s reserves at the central bank (which is the “private” bank’s asset). The government cannot “run out of money” because the “money” is created when it spends.

I have detailed many times how the government actually does this—following rules for spending that Congress, the Treasury, and the Fed have worked out—and will discuss the details a bit below. But first let us compare government and nongovernment spending through “money creation” in general terms.

Government spending and hence “money creation” has all the same potential drawbacks listed above (most importantly, inflationary consequences when excessive), save one. A private borrower might fail to make payments on loans through no fault of his own. Of course, there are also deadbeat borrowers who choose not to pay. But private firms (and households) need income, or saleable assets, to raise funds to pay their debts. Default is a possibility.

Sovereign government is somewhat different. We usually say that its “income” is tax revenue—a bit different from wages or profits since taxes are at least in some sense discretionary. Further, the government’s potential “customer base” is the whole economy and potentially all economic activity—anything that can be taxed.
However, that really does not get to the more important difference: government is the sovereign issuer of the currency.

A sovereign government cannot be forced into involuntary default—it cannot go bankrupt in its own currency. Let us see why, comparing a sovereign government with the situation of a “user” of the currency.

As my professor Hyman Minsky used to argue, anyone can “create money” in the sense that anyone can issue an IOU to make purchases. In other words, you can spend by issuing an IOU to your bank, with the bank crediting your demand deposit—which you use for the purchase. The “money” is created simultaneously with the spending.

When we talk about a private borrower/spender (household or firm), the bank is concerned with credit-worthiness. There are, indeed, additional constraints facing the bank, including reserve ratios and capital ratios—plus whatever other regulations and oversight government puts on its regulated banks. In practice, reserve ratios do not constrain banks because the development of inter-bank lending markets (called the fed funds market in the US) plus access to the central bank’s discount window ensure that banks can always get reserves—at a price.

Capital ratios can bind, although again in practice the constraint is loose since a bank faced with a good borrower can move assets off the balance sheet, seek additional capital, or use creative accounting to finesse the requirements.
And, as I argued above, growing lending and spending can have consequences at the aggregate level: inflation and currency depreciation should spending be too large relative to capacity. That is why governments use a range of policies to try to constrain lending and spending—monetary and fiscal policy as well as direct limits on bank lending and (in rare cases) wage and price controls.

When government refuses to oversee and regulate private banks, underwriting standards tend to fall—which allows lending and spending to grow quickly, which can have inflationary consequences. But worse, it can lead to a catastrophic financial crisis—as we are witnessing.

What is particularly strange is the way that we treat sovereign government. The treasury’s bank is the central bank—which handles its payments and receipts. The treasury writes checks on its demand deposit at the central bank and moves tax receipts from its accounts at private banks to the central bank when it wants to spend. In the US, the Treasury tries to end each day with a deposit of $50 million at the Fed. In all these respects, the Treasury and Fed relation is much like that between a household or firm at its bank. With one big exception: the credit worthiness of the sovereign issuer of a currency cannot be called into question by financial markets because it can always make payments as they come due.

The Strange Constraints Put on Treasury

We put two constraints on our Federal Government that we do not put on private firms and households:

a) The Treasury cannot issue IOUs to its own bank;
b) Congress imposes a debt limit on Treasury

Amazingly, we do not constrain any household or firm in such a manner. We do not prevent firms or households from issuing IOUs to their banks—indeed, we would argue that such a constraint would be silly. Nor do we directly impose a specific debt limit on households or firms or even state and local governments, because we believe that “markets” can determine how much any nonsovereign entity ought to issue.

But we do impose these limits on the sovereign government that issues the currency. These constraints are adopted on the misguided belief that they will prevent the government from “spending too much”, which would cause inflation and currency depreciation. Hence, it is supposed, we cannot trust Congress and the President to keep spending under control—the budgeting process alone is not a sufficient constraint. They would happily spend so much that we’d quickly become the next Zimbabwe. Thus, we will prevent the Treasury from “borrowing” directly from the Fed since that would result in “printing money”, and if Congress could pay for everything by “printing money” it would approve every pork barrel project constituents dreamed-up. And without a debt limit, Congress would bury government under a crushing debt load that would threaten its solvency.

Let’s examine these constraints in order.

The first constraint means that Treasury can sell its IOUs (bills or bonds) to anyone EXCEPT its own bank. It can sell bonds to households, firms, or private banks but NOT to the Fed (there is a small exception that we need not go into here). So when the Treasury is deficit spending (meaning it needs to write checks for more than its deposit at the Fed), it cannot simply issue an IOU to the Fed. It must instead sell its bills and bonds to private households, firms or banks.

Here’s the problem. To spend, the Treasury must have deposits in its account at the Fed. It does no good to sell its bonds to the private sector, receiving a demand deposit at a private bank—because it cannot write a check on that account. Just as you can only write checks against your account at your bank the Treasury can write checks only on its account at its bank—the Fed. So, for example, it can sell a bond to Bank XYZ and receive credit to an account it holds at Bank XYZ. To spend it needs to transfer the demand deposit to its account at the Fed. This is accomplished by debiting the Treasury’s account at Bank XYZ, and simultaneously debiting that bank’s reserves at the Fed. The Fed then credits the Treasury’s demand deposit.

In normal times, banks do not hold excess reserves. (These are not normal times—banks in the aggregate now hold a trillion dollars of excess reserves thanks to “Helicopter Ben’s quantitative easing. We will ignore that for now.) In that case, Bank XYZ would find itself short of reserves after the Treasury transferred its deposit. There are several ways a bank can get the reserves it needs: borrow in the fed funds market, borrow from the Fed at the discount window, or sell bonds to the Fed. Note that if there are no excess reserves in the banking system, turning to the fed funds market will only cause the fed funds rate to rise. This is the signal the Fed responds to—either lending reserves at the discount window or engaging in an open market purchase to relieve the pressure in the fed funds market. Ultimately, the Fed is the source of reserves banks need.

Note that if the Fed lends reserves to banks, we end up in a position in which banks have essentially borrowed reserves from the Fed in order to “lend” to the Treasury (holding government bonds). If on the other hand the Fed buys the bonds in an open market operation, we end up in a position in which the Fed holds the Treasury’s bonds, so has effectively “lent” to the Treasury—but only indirectly because it used Bank XYZ as the intermediary. Recall that all these operations are required because we prevent the Fed from buying the bonds directly from the Treasury, thereby providing the Treasury with the demand deposits it needs to write checks. So it is doubly ironic that this prohibition then requires either that the Fed lend reserves to banks so they can buy the bonds, or that it buy the bonds from the banks.

Now, in normal times it really does not matter that we have adopted such a roundabout method of allowing the Treasury to do what any other spender can do—issue an IOU to its own bank. It all operates smoothly with the Fed using a private bank as intermediary to do what Congress prohibits it from doing directly. That is to say, what prevents the Treasury from spending its way toward Zimbabwe land is that it has a budget that must be approved by Congress and the President. The prohibition on Fed purchases of bonds directly from the Treasury is not a constraint at all. If we got a Congress and President that wanted Zimbabwean inflation, they could produce that result by agreeing on a budget of quadrillions of dollars of spending. So in normal times, we rely on rationality in Washington to constrain spending.

But these are not normal times. For two reasons. First because we are trying out Chairman Bernanke’s pet theory: quantitative easing—which is based on the belief that if you buy up all the earning assets held by banks and stuff them full of excess reserves that pay only 25 basis points, they will decide to lend. No, they won’t. Instead, they buy Treasury bonds, and then sell a portion on to the Fed that buys them through quantitative easing.

Second, we keep bumping up against the self-imposed debt limit imposed on the Federal government—not by markets but by Congress. We need to understand that the overall debt limit is repeatedly approached because we are running persistent deficits. And that is because tax revenue has been destroyed by the economic downturn caused by Wall Street’s excesses. So Congress must repeatedly raise the debt limit so that the Fed, Treasury and private banks can perform their little charade to allow the Treasury to spend the budgeted amounts. With a few brief exceptions, total outstanding Treasury debt has grown since the founding of the nation—with Congress raising the debt limit as required to let Treasury issue the bonds that banks, households, and firms want to buy.

This is usually done as a matter of routine. But the Republicans want to hold the debt limit hostage to politics—following Rahm Emmanuel’s dictum that a “crisis” should never be wasted. They intend to gut the social programs they do not like on the pretense that this will reduce the budget deficits that threaten the US with bankruptcy. In fact, cutting the social programs will not significantly reduce overall spending (because they are too small) and the US government cannot be forced into involuntary bankruptcy. Hence, neither argument follows on from the facts.

Indeed, if the US does default on any of its payment commitments, it will be because Republicans force it to do so—by forcing government to shut down because Congress will not raise the debt limit. That is the nuclear option that party politics run amuck could lead to.

Conclusion: The Only Thing to Fear is Fear Itself

I realize that whenever the actual operating details are made clear, the response always is: OMG if the government can spend simply by “keystrokes” then we are doomed to Zimbabwean inflation and eventual default on debt. Hence, we need to limit government’s ability to spend—and this can be done by preventing it from “borrowing from” the Fed, and setting a debt limit.

In reality, it is Congress that holds the fate of the US in its hands. The budgeting procedures are what keep inflation at bay, and the normal financing “triangular” operation that uses the balance sheets of the Treasury, Fed and private banks ensure the government meets its payment commitments.

Unfortunately, by using the debt limit as its hammer to destroy social programs, Congress is now threatening to disrupt financing—raising a possibility (albeit very small) that government might be forced by politicians to do what markets CANNOT force it to do: default on its commitments.

So, ironically and through the backdoor, the Republicans might actually bring on a Greek-style debt crisis on the argument that they are defending us from a Zimbabwean-style hyperinflation.

L Randall Wray in NY Times Debate “Is Anyone Listening to S.&P.?”

L. Randall Wray participated in a New York Times Opinion Pages debate monday: “Is Anyone Listening to S.&P.?” See here for the complete discussion.

Einmal ist Keinmal (Once is Never)

I can no longer say that not a single senior executive of one of the major nonprime lenders whose frauds hyper-inflated the housing bubble and caused the Great Recession has been convicted of his frauds.  A single senior executive of one of the hundreds of fraudulent nonprime lenders was convicted yesterday, April 19, 2011.  A jury found Lee Farkas, Chairman of the Board of Taylor, Bean & Whitaker (TBW), guilty of fraud.  TBW was a large mortgage banking firm that made many nonprime loans, but the prosecution does not address the fraudulent nonprime lending.    

To be fairer, this single overall case has produced four senior convictions.

Department of Justice
Office of Public Affairs
Monday, March 14, 2011
Former President of TBW Pleads Guilty to Fraud Scheme

WASHINGTON – Raymond Bowman, the former president of Taylor, Bean & Whitaker (TBW), pleaded guilty today to conspiring to commit bank, wire and securities fraud, and lying to federal agents about his role in a fraud scheme that contributed to the failures of TBW and Colonial Bank.
In June 2010, Farkas was arrested and charged in a 16-count indictment for his role in the fraud scheme.  Desiree Brown, the former treasurer of TBW, pleaded guilty on Feb. 24, 2011, and Catherine Kissick, a former senior vice president of Colonial Bank and head of its Mortgage Warehouse Lending Division, pleaded guilty on March 2, 2011, for their roles in the fraud scheme.

I congratulate everyone involved with the successful prosecutions.  The TBW/Colonial Bank cases are the exceptions that prove the rule – the senior officers of the large nonprime lenders that caused the financial crisis have been able to loot with impunity.  How did the TBW/Colonial Bank frauds come to prosecuted?  They were very special cases and their frauds and their investigations reveal many of the pathologies that explain the severity of this crisis and the underlying frauds.  First, according to the Department of Justice (DOJ), TBW was already failing by early 2002 – nine years ago!  TBW was able to continue a fraud for over seven years (it was closed in 2009). 

Court documents state that in early 2002, Bowman learned that TBW began running overdrafts in its master bank account at Colonial Bank because of TBW’s inability to meet its operating expenses….

Second, in addition to the fraud against Colonial Bank, TBW defrauded Freddie Mac by selling to Freddie Mac the same assets (bad loans) it was purportedly selling to Colonial Bank. 

In his statement of facts, Bowman admitted that he learned from Farkas and other co-conspirators at TBW that within a year of its creation, Ocala Funding had a significant collateral deficit. As Bowman acknowledged, the government could prove that by August 2009, that deficit had grown to approximately $1.5 billion and that TBW had caused Colonial Bank and the Federal Home Loan Mortgage Corporation (Freddie Mac) to falsely believe that they each had an undivided ownership interest in thousands of the same loans worth hundreds of millions of dollars.
Third, note that while a Colonial Bank officer pleaded guilty for assisting these frauds against Colonial Bank, no one has pleaded guilty at Freddie Mac.  The critical question is whether TBW actually delivered the key loan documents to Freddie Mac.  Did Freddie Mac obtain an enforceable security interest or was it defrauded by TBW?  Was Colonial Bank the only victim of the double sale/pledge? 
Fourth, a number of states identified severe problems with TBW, and brought actions against it, before the Federal authorities took any action.  Similarly, Alabama took the lead in closing Colonial Bank.
In August 2009, the Alabama State Banking Department, Colonial Bank’s regulator, seized the bank and appointed the FDIC as receiver.  
Fifth, the criminal case was brought to the FBI’s attention by the Special Inspector General for the TARP program (SIGTARP) and perhaps the HUD/FHA inspectors.  The FDIC did not initiate the criminal case or produce the key investigative findings.  The record of the banking regulatory agencies’ failure to identify and make criminal referrals against the fraudulent lenders that drove the crisis remains intact.
Sixth, the task force that supported the TBW/Colonial Bank investigation did not include federal banking examiners or supervisors.  The only federal banking regulatory personnel listed as supporting the investigation are the FDIC’s OIG staff.  That is disturbing.  The FDIC OIG is not expert in banking or banking fraud.  It is an internal audit unit and its reports on failed banks reveal a repeated inability to identify fraud even when they describe actions that only make sense if the failed bank’s officers were engaged in accounting fraud.  The FDIC has hundreds of examiners who have far greater expertise than their internal auditors with respect to banks and bank frauds.  Again, even the FDIC (and the FDIC is by far the most vigorous of the federal banking regulatory agencies) did not make support for the first major fraud prosecution of a large nonprime lenders’ officers a priority.
Seventh, TBW was not subject to the Community Reinvestment Act.  Its senior officers caused it to make bad loans, and cover up the losses on those bad loans in order to produce fictional short-term accounting income that would cause their compensation to increase.  The title to Akerlof & Romer’s 1993 article says it all:  “Looting: the Economic Underworld of Bankruptcy for Profit.”  The question is why Freddie Mac would purchase loans from a mortgage banker that was notorious for the poor quality of its underwriting.  The answer is that Freddie Mac’s senior managers’ rose dramatically when they purchased bad loans at a premium yield. 
Eighth, the senior managers of Colonial Bank were either in on the fraud or grossly negligent.  They allowed their SVP in charge of their Mortgage Warehouse Lending Division to assist TBW in carrying out an enormous, crude series of frauds for seven years.  Colonial Bank’s controlling officers and directors also appear from the DOJ allegations to have entered into transactions designed to fund TBW’s fraudulent capital injection into Colonial Bank.  
Ninth, neither the FHA nor the FDIC appear to have spotted any of these frauds even though they were enormous, crude, and growing over a seven year period.  Indeed, the FHA and the FDIC appear to have been supportive for some time of TBW’s fraudulent (and fictional) injection of capital into Colonial Bank.  The FHA allowed TBW and Colonial to grow so rapidly that they became among the FHA’s largest providers.         
Tenth, the DOJ’s March 14, 2011 press release that I have been quoting from makes one point quite forcefully.
This prosecution was brought in coordination with President Barack Obama’s Financial Fraud Enforcement Task Force.  President Obama established the interagency Financial Fraud Enforcement Task Force to wage an aggressive, coordinated and proactive effort to investigate and prosecute financial crimes. 
Got that, “President Obama” deserves the credit.  There’s some truth to this PR.  President Bush’s Attorney General Mukasey notoriously refused to create a national task force to investigate the accounting control frauds that caused this crisis.  He claimed that the mortgage frauds were so small-time that they were the equivalent of “white-collar street crimes.” 

Mukasey was right in a way – because he was so wrong.  Under his leadership the FBI investigated only the small time mortgage frauds.  There are two great truths to investigating epidemics of accounting fraud:
  1.  If you don’t look; you don’t find
  2. Wherever you look; you will find
Because he refused to look at the massive frauds he didn’t find any of the massive mortgage frauds.  Because he looked at the small frauds he found tens of thousands of small frauds.  Because his staff found only minor frauds he assigned only a minimal number of FBI agents to investigate mortgage fraud (120 nationwide in FY 2007 – one-eighth of the number of FBI agents assigned to investigate S&L frauds during the S&L debacle even though the current crisis is dramatically more severe than the S&L debacle).  His staff of FBI agents assigned to mortgage fraud cases was divided up among scores of field offices.  That meant that no field office could investigate even one of the large nonprime lenders.  (The military rightly condemns these tiny units incapable of effective action against a major foe as “penny packets.”)  Because his penny packets assigned to investigate the smaller frauds found – smaller frauds – Mukasey reached the “logical” conclusion that their investigations confirmed his assumption that mortgage fraud was equivalent to “white-collar street crime.”    

Senator Obama warned of the wave of mortgage fraud and called for increased budgets for the FBI and DOJ to investigate and prosecute the frauds.  He could have made the investigation and prosecution of the major accounting control frauds one of the nation’s top priorities.  The result would have transformed his administration and the public support for those holding the elite frauds accountable.  The DOJ press release says all the right things.

President Obama established the interagency Financial Fraud Enforcement Task Force to wage an aggressive, coordinated and proactive effort to investigate and prosecute financial crimes. 

But DOJ has not “walked the walk.”  Instead, we have one case brought not because of the underlying accounting fraud involving its lending, but because the leaders of the accounting control fraud sought to rip off TARP and came to the attention of one of our two (the other is Elizabeth Warren) most vigorous and effective public servants – Neil Barofsky (SIGTARP).  Unfortunately, Mr. Barofsky has resigned. 

One more time credit rating agencies show their incompetence

By Eric Tymoigne

Yesterday morning S&P released the following information:

“Although we believe these strengths currently outweigh what we consider to be the U.S.’s meaningful economic and fiscal risks and large external debtor position, we now believe that they might not fully offset the credit risks over the next two years at the ‘AAA’ level,” said Standard & Poor’s credit analyst Nikola G. Swann. […] “Our negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years,” Mr. Swann said.

So the credit risk of the US is potentially growing according to S&P so it threatens to downgrade the US credit rating. In order to understand how S&P arrived to this conclusion let’s have a look at how credit risk is defined in its 2007 sovereign debt primer:

QUOTE 1: “A sovereign rating is a forward-looking estimate of default probability. […] The key determinants of credit risk [are economic risk and political risk]. Economic risk addresses the government’s ability to repay its obligations on time and is a function of both quantitative and qualitative factors. Political risk addresses the sovereign’s willingness to repay debt. Willingness to pay is a qualitative issue that distinguishes sovereigns from most other types of issuers. Partly because creditors have only limited legal redress, a government can (and sometimes does) default selectively on its obligations, even when it possesses the financial capacity for timely debt service.”

S&P has two ratings, a local currency rating (default risk on domestic-currency-denominated debt) and a foreign currency rating (default risk on foreign-currency-denominated debt). The primer notes:

QUOTE 2: “A sovereign government’s ability and willingness to service local currency debt are supported by its taxation powers and its ability to control the domestic monetary and financial systems, which give it potentially unlimited access to local currency resources. To service foreign currency debt, however, the sovereign must secure foreign exchange, usually by purchasing it in the currency markets. This can be a binding constraint, as reflected in the higher frequency of foreign than local currency debt default. The primary focus of Standard & Poor’s local currency credit analysis is on the government’s economic strategy, particularly its fiscal and monetary policies, as well as on its plans for privatization, other microeconomic reform, and additional factors likely to support or erode incentives for timely debt service. When assessing the default risk on foreign currency debt, Standard & Poor’s places more weight on the impact of these same factors on the balance of payments and external liquidity, and on the magnitude and characteristics of the external debt burden.”

S&P provides a table that shows the number of defaults on foreign-denominated sovereign debt and notes that: “Defaults on sovereign foreign currency bonds occurred repeatedly, and on a substantial scale, throughout the 19th century and as recently as the 1940s.” Interestingly, however, it does not provide such a table for the domestic-denominated sovereign debt. The primer continues by noting:

QUOTE 3: “One might ask why, if sovereigns have such extensive powers within their own borders—including the ability to print money—sovereign local currency ratings are not all ‘AAA’. The reason is that while the ability to print local currency gives the sovereign, and the sovereign alone, tremendous flexibility, heavy reliance upon such an expansionary monetary stance may bring the risk of hyperinflation and of more serious political and economic damage than would a rescheduling of local currency debt. In such instances, sovereigns may opt to reschedule their local currency obligations.”

So overall here is the view of S&P:

  • Credit risk = economic risk (capacity to pay) + political risk (willingness to pay)
  • There are two type of sovereign debt: Domestic-currency denominated and foreign-currency denominated
  • Governments that can tax and issue their own currency have the full capacity to pay domestic-currency-denominated debt
  • Inflation risk is a form of default risk

Now let’s look if all this makes sense in the case of the US. First, note that the US is a monetarily sovereign country: the federal government issues its own currency, the federal government has no foreign-denominated debts outstanding, and the federal government does not peg its currency in anyways (and so does not promise to convert US dollars into another currency or gold on demand). This means that the US federal government can always meet payments that are due to its creditors anytime (today or in the future) and anywhere (in the US or abroad) by crediting bank accounts. Stated alternatively, there is NO possible risk of default for economic/technical reasons. The federal government cannot run out of money, it has a perfect capacity to pay: economic risk is zero.

The problem with S&P is that it has a shifting definition of economic risk. As quote 3shows, S&P is aware of the absence of economic risk in the case of the US but it proceeds to argue that there is one by changing the definition of default risk to include risk of hyperinflation. OK…hold on… are we talking about default or inflation risk? These are two completely different risks.

In terms of default risk, higher inflation (if revenues of borrowers are indexed to it) increases the capacity of repayment and so LOWERS default risk rather than increases it. If, following S&P’s logic in quote 2, one considers taxes a form of revenues that helps to pay debt, then tax revenues rise with inflation and so lower the risk of default.

In terms of inflation risk, inflation pressures on the demand side are very low and the risk of uncontrollable hyperinflation that S&P refers to in quote 3… give me a break! But there is a deeper misconception at play. S&P (and all politicians in Washington) seems to think that they have some meaningful control over the fiscal balance of the federal government. They do not; as the UK experience, among others, is painfully showing us. The fiscal balance of the government is ultimately driven by the net saving of the private domestic sector and of the rest of the world, as was explained many times on this blog. The following identity holds at the aggregate level:

(G – T) ≡ (S – I) + (J – X)
Government deficit ≡ Net domestic saving + net foreign saving

Stated alternatively, the US government must deficit spend currently and in the near future in order for the private sector to repay its outstanding debt and for foreigners to accumulate dollars. It is only if the private sector as a whole decides to dissave (spends more than what it earns) and/or foreigners decide to dissave (import more than they export to the US) that the government can lower its deficit and potentially run a surplus. Any attempts to go against the desires of the two sectors will lead to a recession. The deficit will go down by itself as the private and foreign sector gain confidence and decrease their net saving.

By conflating inflation risk and default risk in their rating, S&P (and probably other CRAs) creates confusions in financial markets and promotes dangerous ideas. Sounds familiar? Remember all those toxic mortgage products that were rated AAA? One more time, S&P is showing how silly it is to extend a rating methodology that was developed for corporate bonds to other sectors of the economy. Even for corporate bonds, results are far from perfect (remember all those financial institutions that had an AAA rating or so right before they failed?)

So overall there is zero default risk due to economic risk in the US, as an issuer of the currency in which sovereign debt is denominated, the US (like the UK and Japan but contrary to Eurozone countries) can always repay dollar-denominated debts it issued. But what about credit risk due to political risk, i.e. unwillingness to pay?

First and foremost, cases of voluntary default by a monetarily sovereign government on its domestic-currency-denominated date are extremely rare. Following Rogoff and Reinhart, it looks like Japan is a candidate in 1942, a very unusual political and economic situation (and probably a means to limit inflationary pressures by not adding purchasing power to the private sector, so default could be a good policy). It is hard to detect more countries given that the authors do not give us any background about the monetary system at the time of default. The US is not experiencing any massive war exhausting its resources (even that is not enough to increase the risk much), its political system is stable, and Geithner has told us many times that the debt ceiling will be raised that any chance of political problem is at best remote. True, the Congress may tie its own hands and decide not to raise the debt limit, but how realistic is that possibility?

Bottom line, credit risk is remotely remote. You have more chance to be hit by lightening twice during your life than to experience a default of dollar-denominated sovereign US debt. The only really worrisome variable is the stupidity of US congress and its willingness to try to fix something that is not broken. People love Medicare (by far the most popular program of the government), they love social security, and automatic stabilizers are working as predicted. Let them be.

Speaker Wright and Secretary Geithner’s Shared Hate for Prosecuting Criminal Contributors

By William K. Black

In the Savings and Loan (S&L) debacle Speaker Wright became enraged at the Federal Home Loan Bank Board and the Department of Justice when he learned that the FBI was investigating 400 individuals, most of them Texans, for their possible role in the S&L control frauds that were causing the regional bubble in commercial real estate (CRE) to hyper-inflate. (Akerlof & Romer’s 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit” discussed the major contribution the S&L frauds made to expanding that regional bubble.) Legend has it that an FBI agent accidentally left the list of investigative targets with an interviewee who copied it. Whatever the truth of the legend, Speaker Wright eventually reviewed a copy of the list and noticed that it had the names of many contributors to the Democratic Party. He and several senior Democratic colleagues and a staffer responded to the list by dividing up telephone calls to the FBI, Justice Department and the Federal Home Loan Bank Board (Bank Board). Wright was enraged and concluded immediately that the investigation was politically motivated. He wanted the investigation killed.

Wright began intervening with the Bank Board on behalf of a series of Texas S&L control frauds in 1986 and 1987. He eventually held the bill to “recapitalize” the Federal Savings and Loan Insurance Corporation (FSLIC) (the “FSLIC recap” bill) hostage to extort more favorable regulatory treatment for these frauds’ CEOs. Wright’s extortion focused on preventing agency actions against three Texas executives. Each of the executives shared two traits – they had voted for President Reagan in 1980 and they were now contributing to the Democratic Party. When we met with Speaker Wright in early 1987 his primary argument was the extreme fragility of Texas’ economy. (The meeting was set up by Bob Strauss, the grand old man of Texas Democrats, as a “peace meeting.”) I was the agency’s “point man” seeking to get FSLIC recap passed. The meeting was a disaster, Wright ended up claiming (incorrectly) that the head of our agency had lied to him and let loose in a swearing tirade aimed at me.

What Wright never understood was that the most politically active Texas S&Ls were so active because they were frauds and desperately needed protection from being closed by us. In particular, we intended to use the additional funds we would receive under FSLIC recap to close the worst control frauds and those frauds were located primarily in the states with the weakest regulation and supervision. Texas was the most criminogenic environment because it had the earliest extensive deregulation and the most complete state desupervision. (The top State of Texas S&L regulator later admitted to using prostitutes provided by Vernon Savings (aka “Vermin)). Vernon was the second worst control fraud in the nation and had 96% of its loans in default when it was finally placed in receivership despite Wright’s extortion. We had been so aggressive in closing the control frauds that by early 2007 we had roughly $500 million in the FSLIC fund – to insure an (insolvent) industry with $1 trillion in liabilities. We were running on fumes. Wright knew this and knew that holding the FSLIC recap bill hostage would give him exceptional leverage over our agency. Unfortunately for Wright, the result of the failed peace meeting was that we were able to convince the head of our agency that we had to take on Speaker Wright rather than continuing to capitulate to his ever increasing extortion. Doubly unfortunately, I was assigned the task of explaining to the public how the Speaker was extorting us on behalf of frauds and endangering the public. Thereafter, he tried repeatedly to get me fired. (One of the proposed ethic charges by the independent counsel for the House ethics committee investigating Speaker Wright was those attempts.)

Speaker Wright cultivated an image designed to terrorize opponents. He was nasty, asking us to fire our top supervisor in the Texas region on the “grounds” that he Wright had heard he was a homosexual. Wright had exceptional leverage over us because we were desperately short of funds and he held our access to funds hostage. Our agency (over several of our objections) gave in to many of his demands, including terminating a civil suit against a lender who had defaulted on his debts to roughly a dozen S&Ls. At no time, however, did we even consider giving in to Speaker Wright’s desire that we back off of criminal referrals, investigations, or prosecutions.

Later, under Bank Board Chairman Danny Wall, the agency’s head of enforcement wrote a “side letter” promising Charles Keating’s Lincoln Savings that the agency had no present intention of filing additional criminal referrals. (We, the Federal Home Loan Bank of San Francisco (FHLBSF), had filed criminal referrals based on the findings of a formal investigation that established that Lincoln Savings had forged thousands of signatures and scores of documents and had stuffed the files with purported underwriting files. Those files were actually created by Arthur Andersen years after the junk bonds were purchased for the sole purpose of deceiving the examiners into believing that the S&L had underwritten the bonds before purchasing them.) The FHLBSF had discovered evidence of additional likely crimes by Lincoln Savings, but had not completed the referrals, at the time the “side letter” was written. Danny Wall and Bank Board member Roger Martin removed our (the FHLBSF’s) jurisdiction over Lincoln Savings (an unprecedented act) because we refused to withdraw our recommendation that Lincoln Savings be placed in conservatorship despite the political intervention of the five U.S. Senators who became known as the “Keating Five” and Speaker Wright on behalf of Keating. The Bank Board made no criminal referrals against Lincoln Savings after it removed our jurisdiction despite finding new evidence of likely fraud. The FHLBSF was not informed of the existence of the side letter and while the deal documents detailing the Bank Board’s de facto surrender to Keating were provided to us the side letter was not. I learned accidentally about the existence of the side letter in preparing for the House hearings on the scandal of the successful political intervention on behalf of Keating – the most notorious S&L control fraud. I then exposed the side letter and its import in my testimony. The side letter sealed Danny Wall’s fate. The Committee, on a bipartisan basis, was outraged by it. Wall resigned in disgrace.

I set forth this history because of the disclosures in Gretchen Morgenson and Louise Story’s April 14 article in the New York Times “In Financial Crisis, No Prosecutions of Top Figures.”

Morgenson and Story’s reporting revealed that Timothy Geithner discouraged criminal investigations of suspected accounting control frauds. I was asked to comment on this “elite felons go free” policy by Kai Ryssdal, Marketplace’s business journalist.

Ryssdal: What about the argument, though, that the financial system is so fragile still, and these cases so complicated, that we can’t really tear things apart with substantive investigations and prosecutions because it will all fall apart again?

Black: Yeah, that’s an excellent point. We should leave felons in charge of our largest financial institutions as a means of achieving financial stability.

When more junior officials took actions discouraging criminal investigations against Charles Keating that were considerably less harmful than Geithner’s actions the Congress, the administration, and the media treated those actions as infamous and the head of the Office of Thrift Supervision, Danny Wall, had to resign. Why aren’t Geithner’s and Holder’s far more harmful and unprincipled actions, and failures to act, with regard to the elite criminals that caused the Great Recession a national scandal? Why isn’t Attorney General Mukasey, who was even more derelict than Holder, considered a national embarrassment? Have we lost our capacity as a nation for outrage? Are these elite ethical failures too powerful to hold accountable?

Fiat Justitia Ruat Caelum (Let Justice be done, though the Heavens Fall)

It is one of the paradoxes of life that the most practical means to ensure that the system does not collapse is to insist on justice for all and to ignore demands for special treatment premised on claims that justice places the system at grave risk of collapse.  Nietzsche argued that the ubermensch (generally translated as “Superman”) transcended the normal rules.  The elites claim impunity from normal rules on the basis of their purported superiority and because they claim that they are so important that applying the normal rules to them will harm society.  Some pigs are more equal than others.  What any competent financial regulator learns is that the best way to destroy a financial system is to refuse to hold the elites accountable.  Regulators that insist on doing justice prevent the heavens from falling.     

Gretchen Morgenson and Louise Story authored a column addressing one of our national scandals – the elite banking frauds who caused the Great Recession through their looting have done so with impunity.  Not a single one of them has been convicted.  This is the hallmark of crony capitalism. 

Gretchen and Louise’s reporting exposed for the first time two underlying scandals that produced the overall scandal.  In 2008, the FBI, belatedly, realized that it had improperly targeted relatively trivial mortgage frauds while ignoring the massive lenders that specialized in making fraudulent mortgages.  The FBI developed a plan to reorient its resources towards the “accounting control frauds” that always should have been its priority.  We now know that the Department of Justice (DoJ) deliberately, and successfully, sabotaged this effort to investigate the major frauds.  We need additional investigative reporting to discover why DoJ did so. 

The second underlying scandal that their column disclosed is that two key members of what Tom Frank aptly termed Bush’s “Wrecking Crew” – Geithner and Bernanke – who President Obama chose to promote and reappoint and make his anti-regulatory leaders sought to discourage or limit federal and state prosecutions, enforcement actions, and suits.  Geithner’s express rationale was that the financial system extreme fragility made vigorous investigations of the elite frauds too dangerous.
Here is how I responded to Kai Ryssdal, Marketplace’s business journalist, who asked about Geithner’s rationale:

Ryssdal: What about the argument, though, that the financial system is so fragile still, and these cases so complicated, that we can’t really tear things apart with substantive investigations and prosecutions because it will all fall apart again?
Black: Yeah, that’s an excellent point. We should leave felons in charge of our largest financial institutions as a means of achieving financial stability.
Ryssdal: See, that’s funny because I was expecting you to come back with — I don’t know, JPMorgan earned $5 billion last quarter. How shaky can they be?
In retrospect, that interchange should have been a warning to me – Ryssdal actually thought Geithner’s position favoring immunity for elite felons was acceptable when financial conditions are “shaky.”  Sure enough, Matthew Yglesias wrote a column on April 14, 2011 embracing the Geithner immunity doctrine.   He titled it: “The Fraud Free Financial Crisis” – and it proves our family rule that it is impossible to compete with unintentional self-parody. 

Here is Yglesias’ position:

[T]he key sentiment underlying the whole thing is that the Obama administration felt it was important to restabilize the global financial system. That meant, at the margin, shying away from anxiety-producing fraud prosecutions. And faced with a logistically difficult task, that kind of pressure at the margin seems to have made a huge difference. There simply was no appetite for the kind of intensive work that would have been necessary.
I’m not as persuaded as, say, Jamie Galbraith is that the failure to do this is a key causal element in our economic problems. Indeed, I’d say that if you look at the situation literally, Tim Geithner’s judgment was probably correct.

Yglesias believes that “Geithner’s judgment was probably correct” because investigating the accounting control frauds that caused the economic crisis would have been “anxiety-producing.”  Geithner’s overriding goal was to “restabilize the global financial system,” so he was correct to discourage the fraud investigations of the elite bankers.  Yglesias obviously believes that Geithner “restabilize[d] the global financial system.” 

I’ve noted the brief answer that I gave on Marketplace.  Here’s the expanded answer.  This was not a “fraud free financial crisis.”  It is a prosecution free financial crisis for the elites whose frauds caused the crisis.  Historically, “control frauds” – frauds run by the senior officers who control seemingly legitimate banks and use them as “weapons” to defraud creditors and shareholders – drive serious financial crises.  That was true of our two most recent financial scandals.  The national commission investigating the causes of the S&L debacle found that at the typical large failure “fraud was invariably present.”  The major Enron era frauds were all control frauds.  This current crisis was driven by accounting control frauds.  We have known, for well over a century, how to make home loans in a manner that limits fraud to negligible levels.  We have known for centuries that if bankers do not underwrite the inevitable results are massive losses, endemic fraud, and failure.  Honest mortgage lenders do not make liar’s loans.  No one ever forced a banker to make liar’s loans.  Only fraudulent mortgage lenders make material numbers of liar’s loans.  My prior columns have explained that it was the lenders that overwhelmingly put the lies in liar’s loans.

The FBI warned in House testimony in September 2004 that there was an “epidemic” of mortgage fraud and predicted that it would cause a “financial crisis” if it were not stopped.  It was not contained.  Everyone agrees that the mortgage fraud epidemic expanded massively after the FBI warning.  Here’s the four-part “recipe” for a fraudulent lender optimizing fictional accounting income and real losses:

1.     Grow massively
2.     By making awful loans at a premium yield
3.     While employing extreme leverage, and
4.     Providing only grossly inadequate loss reserves

Deregulation and desupervision are more extreme in some industries and regions and certain assets provide superior “ammunition” for accounting fraud.  If entry is relatively easy (and it was ridiculously easy for mortgage banking and loan brokers), then accounting control frauds will cluster in particular asset categories, industries, and regions.  Clustering, extreme growth, and the fact that accounting control frauds rapidly increase their lending even when they know that they are lending into the teeth of a massive bubble are all factors that make accounting control fraud epidemics uniquely dangerous devices for hyper-inflating financial bubbles.  All other factors being held constant, the more a bubble hyper-inflates the greater the economic inefficiency and losses and the greater the risk that it will cause a severe recession.  The second ingredient in the fraud recipe – lending to borrowers who will often be unable to repay their loans – also plays a major role in causing bubbles to hyper-inflate.  There are tens of millions of Americans who cannot afford to purchase homes and therefore are normally unable to obtain loans to purchase homes.  When accounting control frauds lend to the uncreditworthy they make it possible for millions of additional Americans to purchase homes – but not to repay their loans.  In economics jargon, this shifts the demand curve to the right.  Shifting the demand curve for housing to the right will increase the price of housing and hyper-inflate the bubble. 

How much of the bubble was driven by the accounting control fraud?  We don’t know the precise amount.  Data on the frequency of liar’s loans are uncertain.  The three major categories of home loans: prime, subprime, and “alt-a” (aka: “stated income” or “liar’s loans) had no formal definition and no standard reporting.  The loan categories are not mutually exclusive.  The best information we have is that by 2006 one-half of subprime loans were also liar’s loans.  The most reliable estimates of the total number of liar’s loans made in 2006 are that they represent between 25 and 49% of home loans.  That is a disturbingly wide range of estimates.  Even the lower bound estimate represents over a million loans.  Independent studies of the incidence of fraud in liar’s loans run from 80 – 100%.  That means that the annual number of mortgage frauds arising from liar’s loans alone is likely to be roughly one million.  (Extrapolating the likely number of frauds from the number of criminal referrals leads to a similar estimate of the annual number of mortgage frauds.)  Expanding the number of home purchasers by loaning to those who would often prove unable to repay their home loans caused a major right shift in the demand curve – providing somewhere between 25 and 50% of the total home purchasers in 2006.  Losses do not increase in a linear fashion when a bubble hyper-inflates.  A 25% increase in the bubble could produce a 100% increase in the ultimate losses.  We do not know how rapid the rise in losses will be when a bubble hyper-inflates, but our experience with the collapse of massive bubbles is generally dire. 

We could have far better data if the administration heeded our requests that we sample the Fed’s and Fannie and Freddie’s massive holdings of mortgage instruments to determine the facts.  Instead, the FDIC and OTS have created a “data base” of mortgages that is worse than useless.  It treats prime, subprime, and alt-a as mutually exclusive categories and defines alt-a not by the lack of underwriting but rather by FICO score.  Both of these practices are not only obviously wrong, but indefensibly wrong.  These errors will irretrievably cripple meaningful research and fact-based policies if senior FDIC officials fail to intervene.  

These facts about the current crisis and prior crises led prominent economists such as George Akerlof (Nobel Prize, 2001), Paul Romer, and James Galbraith to warn that accounting control fraud epidemics posed critical dangers to our economy.  Yglesias, who is not writing in an area in which he has any experience or expertise, offers a bare conclusion – he’s “not persuaded” by the economists, criminologists, or regulators who have made a specific study of the causes of the crises.  He apparently believes that the FBI’s prescient 2004 warning that the fraud epidemic would cause a financial crisis was fanciful – even though it proved correct.  Among the factors that Yglesias fails to consider is the first rule of investigating accounting control fraud – if you don’t look; you don’t find.  The people that look have to understand accounting fraud mechanisms and they have to work intensively with serious commitments of expert personnel.  Geithner blocked the investigations.  It is clear from the FBI’s own numbers that it never provided remotely adequate staff to conduct a serious investigation of any major failed bank.  We know that there were no serious investigations by the regulatory agencies.  Contrast that with the S&L debacle where our regulatory investigations led the agency to make well over 10,000 criminal referrals.  It’s easy to be “not persuaded” when no one is investigating and making public the persuasive facts.  We’ve had to rely on a Senate committee and the Financial Crisis Inquiry Commission to do a literal handful of investigations because the banking regulatory agencies (1) had their budgets and staff’s shredded and (2) were led by anti-regulators who ended the entire criminal referral process and institutions that we built up despite their proven success.  It is bizarre that Yglesias uses the paucity of publicly available data – caused by the anti-regulators’ refusal to conduct meaningful investigations and make criminal referrals – to justify his skepticism that bankers who wear nice suits could be criminals.          
 Liar’s loans are not “complicated.”  The huge commercial real estate (CRE) loans that were the dominant “ammunition” used for accounting fraud during the S&L debacle were very complicated.  We were able to get over one thousand felony convictions in “major” S&L cases (with a conviction rate of over 90%) despite the complexity of CRE deals.

I end on the fundamental problems with Geithner’s immunity doctrine and Yglesias’ support for it.  The policy represents the intersection of the curves of injustice and stupidity at their respective maxima.  Those curves have intersected to produce Secretary Geithner’s policy of protecting from prosecution the elite C-suite criminals who caused the financial crisis and the Great Recession. It is stupidity of truly epic proportions to leave felons in charge of banks.  Doing so cannot stabilize a financial system – it is certain to cause recurrent, intensifying crises.  When I was a regulator during a financial crisis our agency’s top priority was to prevent frauds from controlling S&Ls.  Our second priority was to support the prosecution of those fraudulent leaders.

The injustice of Geithner’s “elite frauds go free” doctrine is every bit as extreme as the stupidity of believing that giving fraudulent CEOs de facto immunity is the road to financial stability.  It is a travesty that I have to defend the importance of integrity and justice.  No nation can be great if it allows its elites to loot with impunity and prosecutes its whistleblowers.  Geithner is destroying the things that made America great.  He did so as part of Bush’s wrecking crew and he is doing so now as part of Obama’s wrecking crew.

Geithner’s “elite frauds go free” plan is not new.  Speaker Wright demanded that my colleagues and I go easy on fraudulent Texas S&Ls to save the Texas economy (which the S&L frauds were savaging – but he assumed they were salvaging).  The five senators that became known as the “Keating Five” told us that Lincoln Savings was critical to the health of Arizona’s economy.  In reality, it was the worst threat to Arizona’s economy.  One of my agency’s presidential appointees, Bank Board member Roger Martin, argued that if Keating was a fraud and had made Lincoln Savings insolvent by looting the S&L it was all the more important to keep him in charge so that he could use his exceptional political power to get zoning changes that would reduce losses.  He opposed any closures of insolvent, fraudulent Arizona S&Ls on the grounds that the Arizona economy was fragile.  Here’s the difference.  We, the professional regulators, explained in excruciating detail why leaving frauds in charge of S&Ls would massively increase losses and harm regional economies.  Only one of the three Board members (Larry White) listened to us – the other two (Martin and Bank Board Chairman Danny Wall) took the unprecedented action of removing our jurisdiction over Lincoln Savings because we refused to withdraw our recommendation that it be promptly taken over and Keating removed.  We told the Keating Five to their faces that they were intervening on behalf of a fraud.  Even before Wall and Martin removed our jurisdiction over Lincoln Savings they expressly ordered us to cease our examination of Lincoln Savings, to cancel the upcoming examination (nominally, they ordered us to postpone it indefinitely), and ordered that the formal investigation of Lincoln Savings (which had produced the admissions of fraud) be terminated (nominally, suspended).  The result was that Lincoln Savings became the worst S&L failure.  Losses increased substantially after our examination, investigation, and supervision of Lincoln Savings were halted.  All of this became a national scandal when House banking chairman, Henry B. Gonzalez, over the opposition of the Democratic leadership, conducted a series of intense oversight hearings that exposed the Bank Board’s capitulation to the political extortion of the Keating Five and Speaker Wright.  Danny Wall resigned in disgrace as a result of those hearings.   

For those readers who doubt that regulators can ever be trusted let me note several facts about the Keating Five meeting (which occurred 24 years and one week ago).  Four of the Senators were Democrats, one was a Republican.  Speaker Wright was a Democrat.  Four of us from the Federal Home Loan Bank of San Francisco met with the Keating Five.  To this day, I have no idea what the political affiliations, if any, of my colleagues were.  It was irrelevant to us.  We detested the frauds and their political allies.  Our job was to protect the public.  We were constantly abused, sued for hundreds of millions of dollars, investigated, and threatened with being fired.  We prioritized the most elite, most destructive frauds for removal from the industry, enforcement actions, civil suits, and prosecutions.  We persevered.
In 1990-91, as the nation entered a recession, and the banking agencies were accused of preventing the recovery of the fragile economy through excessively strict regulation, suits, and prosecutions we ignored those accusations and used normal supervisory means to end a developing wave of nonprime lending by California S&Ls.  Our supervision prevented any nonprime crisis in that era.  Indeed, we were so effective that the fraudulent S&L leaders of that era “voted with their feet” and left the S&L industry to escape our supervision.  For example, the most notorious nonprime lender of that period, Roland Arnall, the head of Long Beach Savings, gave up his federal charter and created a mortgage banking firm (Ameriquest) so that he would not be subject to our supervision.  One of his primary mortgage banking competitors was controlled by a married couple we removed and prohibited from a California S&L they controlled.   

Competent financial regulators understand that good ethics makes for good regulation.  As soon as you depart from the justice and integrity and attempt to save elite bankers from “anxiety” you become a grave threat to the public.  I have no hopes about Geithner.  What distresses me is Yglesias’ casual willingness to give up on justice because Geithner believed it might cause “anxiety” among his cronies.  Justice must not occupy a very high position in either man’s values if they are so willing to abandon it.  Powerful bankers commonly press regulators to abandon justice as soon as we find that they have violated the law.  These pleas are far more common than threats, and they are more insidious because they are far more likely than threats to be effective.  A regulator who gives in to the plea can feel great – he saved the entire system.  A regulator that gives in to a threat knows that he has violated his duty and exhibited cowardice. 

Yglesias substitutes faux violence for integrity in his vision of how to respond to the massive frauds that caused the Great Recession and cost 10 million Americans their jobs.  He muses about the desirability of Nancy Pelosi slapping a bank CEO.  His every instinct is wrong.  He trivializes the crimes and the concepts of justice and accountability.  The web has the opposite extreme – jokes about executing the senior bank frauds.  This is the not a mindset of effective regulators or white-collar criminologists.  My boss, Michael Patriarca, famously directed us to “cut square corners” in all our dealings with Lincoln Savings even though we knew it be a fraudulent operation engaged in the vilest of tactics against us and the public.  Justice, not punishment, is the key.

Effective regulators are the cops on the beat who are essential to defeating the Gresham’s dynamic that arises when frauds gain a competitive advantage.  As regulators, we know and deal regularly with a large number of honest bankers.  When we leave criminals in place as CEOs by discouraging even investigations of their fraud we endanger their honest competitors, our economy, and our democratic system.  Geithner’s path is the coward’s retreat from imagined fears.  If he really believes that the fraudulent bank CEOs are essential to the “success” of our economy then he must believe that our economy is fatally flawed and he should be leading the charge to radically transform it.        
[Please note:  my phrase about the intersection of the curves is a variant of Charles Black’s famous denunciation of a dishonest, racist statement in the infamous Supreme Court opinion in Plessy v. Ferguson upholding the constitutionality of racial segregation:  “The curves of callousness and stupidity intersect at their respective maxima.”  I am surprised that Paul Krugman has not used Charles Black’s classic phrase (or a variant such as “callousness and mendacity”) to describe Representative Ryan’s budget plan.]

Bill Black is an Associate Professor of Economics and Law at the University of Missouri-Kansas City.  He is a white-collar criminologist, a former senior financial regulator, and the author of The Best Way to Rob a Bank is to Own One.

William Black interviewed on The Real News

William Black was interviewed The Real News recently.  See video below.

Why aren’t the honest bankers demanding prosecutions of their dishonest rivals?

By William K. Black

This is the second column in a series responding to Stephen Moore’s central assaults on regulation and the prosecution of the elite white-collar criminals who cause our recurrent, intensifying financial crises. Last week’s column addressed his claim in a recent Wall Street Journal column that all government employees, including the regulatory cops on the beat, are “takers” destroying America.

This column addresses Moore’s even more vehement criticism of efforts to prosecute elite white-collar criminals in an earlier column decrying the Sarbanes-Oxley Act’s criminal provisions: “White-Collar Witch Hunt: Why do Republicans so easily accept Neobolshevism as a cost of doing business?” [American Spectator September 2005] This column illustrates one of the reasons why elite criminals are able to loot “their” banks with impunity – they have a lobby of exceptionally influential shills. Moore, for example, is the Wall Street Journal’s senior economics writer. Somehow, prominent conservatives have become “bleeding hearts” for the most wealthy, powerful, arrogant, and destructive white-collar criminals in the world. Criminology research has demonstrated the importance of “neutralization.” Criminals don’t like to think of themselves as criminals and their actions as criminal. They have to override their societal inhibitions on criminality to commit their crimes. When prominent individuals like Moore call their actions lawful and demonize the regulatory cops on the beat and the prosecutors it becomes more likely that CEOs will successfully neutralize their inhibitions and commit fraud. People like Moore have never studied white-collar crime, have no knowledge of white-collar criminology, do not understand control fraud, and do not understand sophisticated financial fraud mechanisms. They show no awareness of the economics literature on accounting control fraud, particularly George Akerlof & Paul Romer’s famous 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit.” People like Moore not only spur neutralization, they actively campaign to minimize the destructiveness of elite white-collar crime and to deny the regulators and the prosecutors the resources to prosecute the criminals.

My favorite in this genre was authored by Professor John S. Baker, Jr. and published by Heritage on October 4, 2004.

Baker concludes his article with this passage:

“The origin of the “white-collar crime” concept derives from a socialist, anti-business viewpoint that defines the term by the class of those it stigmatizes. In coining the phrase, Sutherland initiated a political movement within the legal system. This meddling in the law perverts the justice system into a mere tool for achieving narrow political ends. As the movement expands today, those who champion it would be wise to recall its origins. For those origins reflect contemporary misuses made of criminal law–the criminalization of productive social and economic conduct, not because of its wrongful nature but, ultimately, because of fidelity to a long-discredited class-based view of society.”

We “stigmatize” criminals precisely to increase the difficulty potential criminals face in neutralizing restraints against engaging in crime. Stigmatization is an important restraint reducing crime. Indeed, it is likely that stigmatization can be most effective in reducing crime in the context of elite white-collar criminals because such individuals have more valuable reputations that can be harmed by stigma. A violent street criminal may find a reputation for violence useful. Sutherland’s research demonstrated that elite white-collar criminals were often able to violate the law with impunity. The corporation they controlled might pay a fine, but the CEO was typically not sanctioned when the corporation violated the law – even when the violations were repeated and egregious. Class proved, empirically, to be a powerful predictor of criminal prosecutions, convictions, and sentencing. Sutherland correctly sought to stigmatize elite white-collar criminals and to get policy-makers, academics, and the criminal justice system to view their crimes as important. Sutherland’s partial success in doing so is what enrages people like Moore and Baker. By the way, in order to publish his famous book on white-collar crime, Professor Sutherland was forced to delete his tables setting forth the violations of law by many of America’s top corporations – even though it was all public record information. The censorship had the ironic effect of demonstrating the accuracy of Sutherland’s observation that class mattered when it came to how we framed and responded to fraud by elite criminals. What aspect of holding fraudulent CEOs criminally responsible for their crimes is “socialist”, “anti-business”, or “neo-Bolshevism”? Baker claims that “class” has long been discredited as an important variable. Baker is not a social scientist and he is flat out wrong about class. There are literally thousands of empirical studies demonstrating the explanatory power of class in a host of settings. Baker is also flat out wrong empirically in claiming that white-collar prosecutions target “productive social and economic conduct.” White-collar prosecutions of elites are overwhelmingly based on fraud. Fraud is one of the most destructive of all social and economic conduct. Consider six forms of economic injury caused by accounting control fraud.

Eroding Trust

The essence of fraud is convincing the victim to trust the perpetrator – and then betraying that trust. The result is that fraud, particularly by elites, is the most destructive acid for eroding trust. Research in economics, political science, psychology, and sociology concurs on the enormous value that trust provides in each of these settings. We have all attended conferences that provided the participants with bottled water. If we knew that one bottle in a hundred were contaminated how many of us would drink our bottle? This dynamic explains why hundreds of markets collapsed during the events leading to the Great Recession – bankers no longer trusted other bankers’ representations as to asset quality. Accounting control fraud can cause systemic risk by eroding trust.


When bubbles hyper-inflate they can cause catastrophic economic damage and systemic risk. Accounting control fraud can hyper-inflate bubbles. The first two ingredients in the recipe for lenders engaged in accounting control fraud (extreme growth though lending to uncreditworthy borrowers) have the effect of right-shifting the demand curve. Because particular assets are superior devices for accounting fraud and because accounting frauds will tend to cluster in industries in which entry is easier and regulation and supervision are weak, accounting frauds tend to cluster in particular industries and regions. Accounting control frauds drove the Southwest bubble in commercial real estate during the S&L debacle and the U.S. residential real estate bubble in the current crisis. Hyper-inflated bubbles cause catastrophic losses to lenders and (late) owners, trigger severe recessions, and misallocate credit and assets (causing real economic losses).

Misallocation of credit and human talent

Even when accounting control fraud does not lead to a hyper-inflated bubble, it misallocates credit and human and non-human capital. Accounting control fraud substantially inflates individual asset values. Individuals with strong science and mathematics skills – critical shortages in our real economy – are wasted in making models designed to inflate asset values by fraudulently ignoring or minimizing risk. Accounting control fraud commonly produces reverse Pareto optimality – the borrower and the lender on a liar’s loan made in 2006 and 2007 typically suffered losses while the unfaithful agents become wealthy by betraying their principals and customers. (It is important to recall that it was the lenders and their agents who normally prompted by false statements in liar’s loans.) Fraud makes markets profoundly inefficient.

Gresham’s dynamics

“Private market discipline” becomes perverse under accounting control fraud. Capital is allocated in abundance, at progressively lower spreads (despite massively increased risk), to fraudulent firms and professionals. In this form of Gresham’s dynamic, bad ethics drives good ethics out of the marketplace. Note that once, for example, a significant number of appraisers are suborned by the fraudulent lenders to inflate appraised value it is more likely that such appraisers will go on to commit other frauds during their career. If cheaters prosper, then honest businesses are placed at a crippling competitive disadvantage. Effective regulation and prosecution is essential to make it possible for honest firms to compete.

“Echo” fraud epidemics

Fraud begets fraud. Or to put it in criminology terminology – accounting control fraud is criminogenic. Fraudulent lenders created perverse incentives that produced endemic fraud (often by generating Gresham’s dynamics) in other fields. Fraudulent lenders making liar’s loans, for example, created overwhelming financial incentives they knew would lead their loan officers and loan brokers to engage in pervasive fraud. Indeed, fraudulent lenders embraced liar’s loans because they facilitated endemic fraud by eviscerating underwriting.

Accounting control fraud also leads to the spontaneous generation of criminal profit opportunities, causing opportunistic fraud. Liar’s loans, for example, generated a host of fraudulent entrepreneurs offering illicit opportunities to use someone else’s credit score to secure a loan. (Austrian school economists should recognize this dynamic.)

Undesired frauds arising from control fraud

Lenders engaged in accounting control fraud must suborn or render ineffective their underwriting and internal and external controls. They also select, praise, enrich, and promote the most unethical officers. The real “tone at the top” of a control fraud is pro-fraud – often overlaid with a cynical propaganda campaign extolling the Dear Leader’ astonishing virtues. The result is that the firm environment is criminogenic. Some officers may loot the firm through private schemes, e.g., embezzlement at Charles Keating’s Lincoln Savings and self-dealing at Enron.

White-collar crime prosecutions are overwhelmingly taken against frauds. There is nothing economically productive about fraud. When Heritage and the Wall Street Journal feature odes to elite frauds they are fertilizing the seeds of the destruction of capitalism and its replacement by crony capitalism.

Moore’s article has the same tone and themes as Baker’s complaints against prosecuting elite white-collar criminals. 

“[T]he anti-capitalist left … [is] using the criminal law for the endgame purpose of striking down the productive class in American that they so envy and despise….”

Moore decries the passage of “Sarbanes-Oxley and other such laws criminalizing economic behavior….” He claims that prosecuting CEOs leading control frauds will harm shareholders – which he plainly sees as prohibiting criminal liability for corporate officers. Moore’s complaints about SOX are confusing because Sarbanes-Oxley does not criminalize honest “economic behavior.” “Economic behavior” is not privileged. It can be honest or dishonest. Only honest economic behavior is potentially productive. Even honest economic behavior may prove unproductive or cause severe negative externalities. Dishonest economic behavior can benefit shareholders. A firm that gains a competitive advantage over its market rivals through fraud will be more profitable and should have a higher share price. That increased profit and share price is bad for the world. It creates a Gresham’s dynamic and misallocates capital. It may also maim and kill if the competitive advantage arises from selling harmful products to consumers or firms.

Moore eventually explains that what disturbs him most about white-collar prosecutions is that the CEO of a publicly traded company can be prosecuted for accounting fraud. SEC rules require that registrants comply with GAAP, so material accounting fraud constitutes securities fraud (a felony). Criminologists have long pointed out that accounting is the “weapon of choice” for financial firms. Moore objects to prosecuting the most destructive property crimes committed by elite white-collar criminals. Accounting control fraud drove the second phase of the S&L debacle. The first phase was interest rate risk and ultimately led to roughly $25 billion in losses. The Enron-era frauds prosecuted by the federal government were accounting control frauds. The current crisis was driven by the accounting control frauds – the largest nonprime lenders, Fannie, and Freddie. The officers that were prosecuted during the S&L debacle and the Enron-era frauds were not members of the “productive class.” No one destroyed more wealth, for purposes of personal greed, than these fraudulent elites. Their crimes and the harm they caused, however, pale in comparison to the accounting control frauds that drove the current crisis. That makes it all the more astonishing that not a single fraudulent senior officer at the major nonprime lenders, Fannie, or Freddie has been convicted. The shills for elite white-collar criminals have swept the field. The administration they constantly deride as socialist has continued the Bush administration’s policy of de facto decriminalization of accounting control fraud. Moore and Baker have, once more, proven Sutherland correct – we treat elite white-collar criminals in a way that bears no relationship to street criminals. We now bail them out after they loot and cause “their” banks to fail and change the accounting rules at their demand to hide their losses. We even invite them repeatedly to the White House to advise us on what policies we should follow.

The anti-regulators got their wish – they took the regulatory cops off the beat. The banking regulatory agencies ceased making criminal referrals, the SEC ceased bringing even their wimpy consent actions against the massive accounting control frauds, and the Justice Department ceased prosecuting the accounting control frauds during the run up to the crisis. The results were multiple echo epidemics of fraud, a hyper-inflated bubble, and the Great Recession. If Baker and Moore think these fraudulent CEOs constitute the “productive class” – then capitalism was killed by the producers. The financial frauds, however, were not productive. They were weapons of mass financial destruction. Their fraudulent CEOs were motivated by the most banal of motivations that every major religion warns against – unlimited greed, ego, and a radical lack of empathy for their victims. The most pathetic figures in the crisis, however, are not the CEOs but their shills. Why aren’t the honest bankers leading the charge to prosecute their fraudulent rivals?

Why Iceland Voted “No”

By Michael Hudson

About 75% of Iceland’s voters turned out on Saturday to reject the Social Democratic-Green government’s proposal to pay $5.2 billion to the British and Dutch bank insurance agencies for the Landsbanki-Icesave collapse. Every one of Iceland’s six electoral districts voted in the “No” column – by a national margin of 60% (down from 93% in January 2010).

The vote reflected widespread belief that government negotiators had not been vigorous in pleading Iceland’s legal case. The situation is reminiscent of World War I’s Inter-Ally war debt tangle. Lloyd George described the negotiations between U.S. Treasury Secretary Andrew Mellon and Stanley Baldwin regarding Britain’s arms debt as “a negotiation between a weasel and its quarry. The result was a bargain which has brought international debt collection into disrepute … the Treasury officials were not exactly bluffing, but they put forward their full demand as a start in the conversations, and to their surprise Dr. Baldwin said he thought the terms were fair, and accepted them. … this crude job, jocularly called a ‘settlement,’ was to have a disastrous effect upon the whole further course of negotiations …”

And so it was with Iceland’s negotiation with Britain. True, they got a longer payment period for the Icesave payout. But how is Iceland to obtain the pounds sterling and Euros in the face of its shrinking economy. This is the major payment risk that is still unaddressed. It threatens to plunge the krona’s exchange rate.

Furthermore, the settlement included running interest charges on the bailout since 2008, even the extra-high interest charges that led depositors to put their funds in Icesave in the first place. Icelanders viewed these interest premiums as compensation for risks – that were taken and should be lost by the high-interest Internet depositors.

So the Icesave problem will now go to the courts. The relevant EU directive states “that the cost of financing such schemes must be borne, in principle, by credit institutions themselves.” As priority claimants Britain and the Netherlands will indeed get the lion’s share of what is left from the Landsbanki corpse. That was not the issue before Iceland’s voters. They simply aimed at saving Iceland from an open-ended obligation to take the bank’s losses onto the public balance sheet without a clear plan of just how Iceland is to get the money to pay.

Prime Minister Johanna Sigurdardottir warns that the vote may trigger “political and economic chaos.” But trying to pay also threatens this. The past year has seen the disastrous experience of Greece, Ireland and now Portugal in taking reckless private sector bank debts onto the public balance sheet. It is hard to expect any sovereign nation to impose a decade or more of deep depression on its economy inasmuch as international law permits every nation to act in its own vital interests.

Attempts by creditors to persuade nations to bail out their banks at public expense thus is ultimately an exercise in public relations. Icelanders have seen how successful Argentina has been since it imposed a crew haircut on its creditors. They also have seen the economic and political disruption in Ireland and Greece resulting from trying to pay beyond their means.

Creditors did not give accurate advice when they told Ireland that it could pay for its bank failures without plunging the economy into depression. Ireland’s experience stands as a warning to other countries about trusting overly optimistic forecasts by central bankers. In Iceland’s case, in November 2008 the IMF staff projected yearend-2009 gross external public and private debt at 160% of GDP – but observed that an exchange rate depreciation of 30% would push the ratio to 240% of GDP, which would be “clearly unsustainable.” But the most recent IMF staff report (January 14, 2011) shows end-2009 gross external debt at 308% of GDP, and estimates end-2010 gross external debt at 333% – even before taking the Icesave and other debts into account!

The main problem with Iceland’s obligation to Britain and the Netherlands is that foreign debt is not paid out of GDP. Apart from what is recovered from Landsbanki (now with the help of Britain’s Serious Fraud Office), the money must be paid in exports. But there has been no negotiation with Britain and Holland over just what Icelandic goods and services these countries would be willing to take in payment. Already in the 1920s, John Maynard Keynes pointed out that the Allied creditor nation had to take some responsibility just how Germany could pay its reparations, if not by exporting more to these countries. In practice, German cities borrowed in New York, turned the dollars over to the Reichsbank, which paid Britain and France, which paid the money back to the U.S. Government for their Inter-Ally Arms debts. In other words, Germany tried to “borrow its way out of debt.” It never works over time.

The normal practice would be for Iceland to appoint a Group of Experts to lay out the strongest possible case. No sovereign nation can be expected to acquiesce in imposing a generation of financial austerity, economic shrinkage and forced emigration of labor to pay for the failed neoliberal experiment that has dragged down so many other European economies.