Daily Archives: December 27, 2011

What if the SEC investigated Banks the way it is investigating Mutual Funds?

By William K. Black 

The Wall Street Journal ran a story today (12/27/11) entitled “SEC Ups Its Game to Identify Rogue Firms.”

“Rogue” is an interesting word with a range of definitions. When it is used as an adjective its meaning is: “a playfully mischievous person; scamp.” The trivialization of the most destructive elite frauds is one of the most common forms of what criminologists call “neutralization” of the moral content of wrong doing. Neutralization increases crime.

The actual story makes it clear that the criminals that the SEC was identifying were not “rogues.” They were the CEOs of seemingly legitimate firms. The SEC is identifying “accounting control frauds” – the frauds that cause greater financial losses than all other forms of property crime combined. The SEC is not identifying a few rotten apples, but roughly 100 hedge funds likely to have engaged in accounting fraud. The WSJ describes the SEC’s identification system:

“The list is the low-tech product of a high-tech effort by the SEC to crack down on fraud at hedge funds and other investment firms. After the agency failed to detect the $17.3 billion Ponzi scheme by Bernard L. Madoff, who wowed investors with steady returns over several decades, SEC officials decided they needed a way to trawl through performance data and look for red flags that might signal a possible fraud.

In 2009, the SEC began developing a computer-powered system that now analyzes monthly returns from thousands of hedge funds. Officials won’t say exactly how it works or how much it cost to build, but the agency has announced four civil-fraud lawsuits filed as a result of what it calls the “aberrational performance initiative.””The SEC should be applauded for finally understanding that “if it’s too good to be true; it probably isn’t true.” Our agency put a similar system in place in 1984 to identify the S&L accounting control frauds that were driving that crisis. A quarter-century later, the SEC began to follow our well-trodden trail – but only with regard to felons inhabiting the middle of the fraud food chain (hedge funds). 

The SEC has, inevitably, discovered that accounting fraud is common among hedge funds. It is unlikely that the SEC system is really “high-tech” in information science terms. Low-tech information systems have been capable of identifying “aberrational performance” for at least thirty years. We did not have to create any pioneering software in 1984 in order to identify aberrational performance. The cost and time to create our “red flags” was trivial (a few hours of programming time by an agency staffer). (We were collecting the data and computing the necessary ratios anyway. One simply decides the level of a few key variables worthy of being flagged. There’s nothing magic about a “flag.” All it means is that suspicious levels are highlighted on the computer screen and on physical copies of the periodic reports so that they capture the reader’s attention.)

The SEC took two years to create its “aberrational performance” system and is embarrassed enough about the cost that it wants to keep it secret. The two year development process allowed the SEC to make a major advance relative to our system – they invented a title consisting of two words and eight syllables. Devising a title that recondite doubtless accounts for six months of the time it took the SEC to develop its flags.

The most interesting aspects of the WSJ story, however, are two unexamined topics that should have been central to the story. First, there is not a word in the article about criminal prosecutions for the frauds the SEC has identified. The frauds, as described in the article, are so blatant that they would make relatively simple to prosecute. There is no indication that the SEC wanted the WSJ to know that they had made well over a hundred criminal referrals against hedge fund CEOs and senior officers. There is no indication that the WSJ reporters were interested in whether the SEC had made criminal referrals against these moderately elite felons. As a result, we have no information on whether the SEC has in fact made hundreds of criminal referrals against the senior officers at the hedge funds that they have identified as having engaged in likely fraud. Indeed, we have no evidence that they have made any criminal referrals. Neither the SEC nor the WSJ reporters indicated that any prosecutions, or even Department of Justice investigations, resulted from the SEC hedge fund investigations.

Second, why isn’t the SEC’s top priority the systemically dangerous institutions (SDIs)? The SDIs are the financial institutions that are so large that the administration fears that their failure will cause a new global crisis. The SDIs pose by far the greatest risk to the economy and investors of any entity. Their frauds reached “epidemic” proportions and drove our ongoing crisis and the Great Recession. The SEC, however, applied its “aberrational performance” system to its smallest entities and is now expanding it to mutual funds. There is no indication that the SEC intends to use the system to spot fraudulent SDIs. There is no indication that the SEC has even contemplated using the system to spot fraudulent SDIs. There is no indication that the WSJ reporters asked why the SEC was failing to use its system where it was most needed.

Applying the SEC system to the SDIs would have led the SEC to develop a more sophisticated analytical approach to identifying fraud. There is no indication that the SEC has any familiarity with the criminology, economics, and regulatory literature about how to identify accounting fraud. Admittedly, the SEC (finally) has taken seriously the warning that generations of parents have impressed upon their children – “if it’s too good to be true; it probably isn’t true.” The Achilles’ heel of the SEC analytics is that it assumes fraud must be aberrational and its flags are (at least as described in the story) all tied to identifying aberrations premised on the implicit assumption that fraud cannot be endemic. The SEC official told the WSJ reporter that they looked for “outliers.” Accounting control fraud, however, can become endemic, particularly in a product line, because it produces a “Gresham’s dynamic” in which bad ethics drives good ethics out of the market. Accounting control frauds report results that are too good to be true, but they all report extraordinary results because accounting fraud is a “sure thing” (George Akerlof and Paul Romer, “Looting: the Economic Underworld of Bankruptcy for Profit, 1993). Accounting control fraud was far more common among the SDIs than the SEC system has identified among hedge funds.

Public Money for Public Purpose: Toward the End of Plutocracy and the Triumph of Democracy – Part Three

By Dan Kervick

Consequences of Monetary Sovereignty

Now so far, I have described the operations of the monetarysovereign as though money were the only thing in the world.   But this is clearly not thecase.   The model of themonetary sovereign I have developed is intended to be a model of agovernment.   And whilegovernments might have nearly unlimited and very easily deployed power in thecreation and destruction of money, a government also participates in theexchange of real goods and services.   And these goods and services are clearly finite.    So there is something veryspecial about money which is yet to be considered.

Let’s remember that government spending – insertions ofmoney – can come in different varieties: there are purchases, in which money is inserted into a private sector accountin exchange for some good or service delivered to the sovereign; and there arestraight transfers, in which somemoney is inserted into a private sector account without condition, with thegovernment receiving nothing in return.    Similarly,we need to recall that government receipts – removals of money –  can come also in different varieties: there are sales, in which money is removed from aprivate sector account in exchange for some good or service delivered by thegovernment to the owner of that account – as when someone buys a carton from thepostal service, for example – and there are taxes,in which some money is removed from a private sector account without condition,with the owner of that account receiving nothing in return.

In a democratic society, we should think of the owner of themonetary sovereign’s account as the entire public, representing a significantportion of the economy usually called the publicsector.   The publiccannot create valuable goods out of nothing at will, or receive the benefits ofvaluable services at will.  Thesethings come in finite amounts, and it is a very big deal to the public whetheror not it possesses some good – like a bridge, a park, or a work of publicsculpture, or a dam, or a rocket engine.    It is also a very big deal to the public whetherit is performing some service for a private sector individual or firm, orwhether that individual or firm is providing a service to the public.  So, while it might make littledifference whether we think of the monetary sovereign’s monetary possessions accordingto the infinite account model, the empty account model or the quotidien accountmodel, we have no such freedom when considering the public’s possession andexchanges of real goods, or its receipts and provisions of the benefits of realservices.   When it comes tothe exchange of real goods and services, what the public possesses matters.  As democratic citizens, decisions over the public sectorprovision or acquisition of real goods and service are among the most frequentand important decisions we have to make.

And herein lies an important difference between theproduction of money and the production of other goods.  Traditionally, the difference in costbetween producing some unit of money, and the value that can be fetched by thatmoney in the market when it is used to purchase something, is called“seignorage”.    Inearlier times, when the public’s money was fashioned from material resourceslike gold, which had to be mined from the ground, refined and shipped at a substantialcost, seignorage was still important, but less significant than today.   But in the world of modern money,when money in colossal denominations can be created at very low cost, simply bymoving a few electrons around on some hard drives by virtue of a few keystrokeson a computer keyboard, the value that is derived from seignorage is even moresignificant.

A democratic public that possesses seignorage power shouldbe very hesitant to give it up, as it would for example, by ceding monetarypower to private sector corporations with their relatively small collections ofself-seeking owners and their hierarchical, non-democratic forms of government.   If the creation of the variousforms of money were permitted to be strictly a private sector endeavor in themodern world, we might reasonably suspect it would all end up in the hands of afew financial sector oligarchs – Goldman Sachs, Barclay’s, Chase, etc. – justas these oligarchs have come to dominate other forms of financial power.   Nor should the public take acasual attitude toward free-styling monetary entrepreneurs who might seek toemploy innovative technologies to invent forms of money that have the potentialto succeed in supplanting the public’s money.  They would thereby reap seignorage profit for their ownprivate benefit, while at the same time diminishing public control over thepublic’s monetary system, and robbing a democratic public of its monetary power.    And the romantic andentrepreneurial monetary rebel of today could easily become the monopolizingmonetary kingpin of tomorrow without the restraint of democratic governance.

So let’s turn away from these anti-democratic nightmarescenarios of the public’s monetary powers falling into private hands, andreturn now to our simple model of the monetary sovereign, which we will regardas a democratic government connected to a public sector, wielding its monetaryand other powers on behalf of public purposes.

It is important to recognize that a monetary sovereign hasno operational need, strictlyspeaking, to borrow or tax in orderto spend.  By an operational need Imean something that the government must do in order to carry out someoperation, and without which that operation simply cannot occur.   Because the monetary sovereign canalways create any money it needs in order to carry out a spending operation,there is no operational need for it first to acquire that money from some othersource.   In the end, recall,the monetary sovereign is responsible for all of the money that exists in themonetary system which it governs. It is the producer of the currency in that system, not a mere user ofthe currency.  It is just flatwrong to view a monetary sovereign as an enterprise like any other enterprise –such as a household, a small business, a corporation – mere users of the monetary sovereign’s moneywhose monetary power is limited to the making of exchanges, and whose monetaryscorecard is subject to ordinary budget constraints.

So the monetary sovereign has no operational need to tax orborrow in order to spend.   However,the monetarily sovereign government may have a policy need to tax or borrow. That is, the government may have reasonable policy goals – such as themaintenance of price stability, the encouragement of private sector productionand commerce, the promotion of economic equality or other goals- that are bestcarried out with the aid of taxing or borrowing.  The economist Abba Lerner encouraged us to view allgovernment financial operations functionally– that is in terms of their effects. Whether a monetarily sovereign government should engage in some particularmonetary or financial operation depends entirely on the government’s policygoals, and the degree to which the operation helps advance those policy goals.  Lerner thus called this approach togovernment financial operations “functional finance”, and contrasted it withthe ideal of “sound finance” – an ideal based on misconstruing monetarilysovereign governments as mere currency users subject to ordinary budget constraints.

Now this idea of a monetary sovereign might seemfrightening.   Surely thediscretionary power to create and destroy the money that is in common use is anawesome and potentially threatening power indeed.   The trepidation experienced here is not at allmisplaced.   But it is alsoimportant to realize that the existence of such power, or at least thepotential existence of such power, is inherent in the very idea of governmentalsovereignty, and that much therefore depends on the specific form of governmentthat possesses this sovereign power, and the wisdom of those who determine theactions of that government.  A democratic public – in which sovereignty is distributed equally among itsentire people, which endeavors to subject itself and its own governmentaloperations to the rule of law and appropriate checks and balances, underdurable and vigilantly maintained democratic institutions – can employ itsmonetary sovereignty wisely and on behalf of enlightened public purposes andthe general good.

The idea of monetary sovereign can also inspire a differentkind of emotional reaction in people: not fear, but disapproval.   The public sector under amonetarily sovereign government, if such a thing exists, seems to receive somethingfor nothing by virtue of a seignorage power.  The employment of that power effectively delivers benefitsto the public that are not received inexchange for something else.    All the rest of us private individuals, on theother hand, are generally required to produce something of value in exchangefor the benefits we received.  This asymmetry might not seem fair or appropriate, since the monetarilysovereign government has an unfair advantage over private sector economicactors.   Various inhospitable terms might come to mind here todescribe the monetary sovereign’s advantage:  “free lunch”, “ill-gotten gains”, “theft over honest toil”, “counterfeiting”etc.

This emotional reaction can be hard for people to shake, andis even in some sense natural, but it is grounded in a profoundly wrongheaded andfalse analogy between the sovereign role of a self-governing people under ademocracy, on the one hand, and the role of private individuals, households andcompanies on the other.   First of all, The United States government and its people have made asubstantial investment – of work and sweat and tears, and even including aninvestment of many lives – in order to secure something approaching monetarysovereignty for their society.  So if they exercise this monetary sovereignty in the pursuit of publicpurposes and the general good they are hardly receiving something fornothing.   They have investeda whole lot of something in the pastin order to control a monetary system they can use to accomplish these public goals.

Second, a democratic government like the government of theUnited States is not just one enterprise among others in a competitive economicgame of rising and falling fortunes, a game in which the government musttherefore “play by the same rules” as every private sector individual,household or firm.   TheUnited States government is the instrument by which we the people are supposedto organize and direct our common efforts toward the fulfillment of our mostimportant national goals and aspirations, including such things as “promotingthe general welfare” and “establishing justice.”   It is absurd to suggest that because a corporationlike Goldman Sachs, for example, does not possess the seignorage power thatcomes from monetary sovereignty, then the American people must decline toemploy that power themselves, in the spirit of fairness to Goldman Sachs and thedesire for a level playing field.   Goldman Sachs is not entitled to a levelplaying field with the sovereign American people.   We’re the constitutionally recognized boss in oursociety.   If the people ofthe United States have been strong enough, and diligent enough, and havesacrificed enough to deny seignorage power to Goldman Sachs but preserve it forthemselves and their democratic government, then tough for Goldman Sachs.   But good for us.

Finally, it is absurd to claim, as some monetarycommentators across the generations sometimes have, that government money printingor its modern electronic equivalents represent something analogous tocounterfeiting, as though the money used by a sovereign government were theproperty and creature of some mysterious third party or extra- governmentalpower or entity that the government then fraudulently manufactures foritself.  In modern economies moneyis the creature of a government, and its creation and regulation subject to thelaws of that government.  Under ademocratic government, the power to create and regulate money belongs to thepublic.   The public, workingthrough its government, can’t be the counterfeiter of its own legally ordainedmoney.  It might make foolishdecisions from time to time in the way it deploys its money-creating power, butthese decisions do not encompass the counterfeiting of its own money.  It is impossible for the rightfulissuer of a currency to counterfeit that currency.

So the emotional aversion some feel to the exercise ofmonetary power by a democratic government is misguided.  Much political energy, however, hasgone into perpetuating these irrational reactions.   The owners and servants of concentrated privatefinancial power sometimes seek to shield the US public from a clear awarenessand understanding of its own monetary powers, and from recognizing that it candeploy its inherent monetary sovereignty for public purposes so long as itorganizes itself to lay hold of these powers and command them.   They would like the American people to believe that thepeople themselves, and their democratic government, are mere users of amysterious currency they do not control, and are thus dependent on the will ofothers in exercising whatever monetary power the people are permitted to wieldby those mysterious powers.   Theplutocrats promote these myths and taboos of monetary superstition because aninformed public with a clear-eyed appreciation of monetary matters wouldobviously work to prevent the further usurpation of their powers by plutocrats.

This is Part Three ofa six-part series.