Eduardo Porter’s “Folly”—Why we must end the “Race to the bottom”

By William K Black

Eduardo Porter began by studying physics but decided not to complete his studies and pursue a career in that field in favor of becoming a journalist.  He worked for the Wall Street Journal before joining the New York Times, where he writes a periodic column.  His primary interest is now economics.  I was intrigued by a recent column he did entitled “The Folly of Attacking Outsourcing.”

I reviewed a number of Porter’s NYT columns to get a feel for his views.  Defending outsourcing and minimizing the criticisms of undocumented immigrants are his twin passions.  He has written roughly a dozen columns on each of these topics.  Porter’s starting point is neo-liberal economics.  As I will show, he does so despite knowing that neo-liberal economics dogma has proven disastrously wrong.  He often sees the errors, but he remains incapable of developing an alternative perspective.

“Free trade” is the foundational neo-liberal creed.  It is closely associated with a belief in the Schumpeter’s ode to “free markets” as a means to achieve “creative destruction.”  These creeds define orthodox, neo-liberal economics and it is virtually impossible to be a member of the guild if one rejects these dogmas.  The central difficulty with these beliefs is that they are labels that often have little to do with reality.  Markets are not “free.”  Indeed, the definition of “market” is a vague construct that is often defined circularly to produce “free” markets.  When neo-liberal economists (rarely) try to provide a real definition of “free trade” actual trade is rarely “free” under that definition.  Neo-liberal economists almost always simply assume that destruction is “creative,” when a business fails and workers lose their jobs even when the circumstances indicate that the destruction was the unproductive result of unlawful conduct or subsidies provided to less productive rivals who maximize their rents by destroying more productive competitors.

Porter knows that the neo-liberal creeds have been repeatedly falsified by reality even though he does not understand that the falsifications invalidate the creed he uses as the starting (and often ending) point for his analysis.  On July 11, 2012 he wrote to decry “The Spreading Scourge Of Corporate Corruption.”

Perhaps the most surprising aspect of the Libor scandal is how familiar it seems. Sure, for some of the world’s leading banks to try to manipulate one of the most important interest rates in contemporary finance is clearly egregious. But is that worse than packaging billions of dollars worth of dubious mortgages into a bond and having it stamped with a Triple-A rating to sell to some dupe down the road while betting against it? Or how about forging documents on an industrial scale to foreclose fraudulently on countless homeowners?

Porter is distressed that our most elite banks repeatedly engage in control fraud against their customers.  But such frauds are impossible under the neo-liberal creed.  The pervasive frauds make a mockery of “free markets,” “free trade,” and “creative destruction.”  Assume a hypothetical honest Wall Street bank that must compete with systemically dangerous institutions (SDIs) that cheat so that they can turn losing trades into wins (the Libor frauds), or sell to their customers collateralized debt obligations (CDOs) they know to be (not effectively) “backed” by endemically fraudulent liar’s loans (the financial “green slime”) as purported “AAA” credit, or lie hundreds of thousands of times on affidavits in order to foreclose on their customers’ homes.  The honest bank cannot compete with its dishonest competitors.  It will fail.  That failure is profoundly uncreative and harmful.  The dishonest banks that should fail will prosper.  Honest banks will fail.  The dishonest banks routinely misallocate capital and destroy wealth, yet they dominate the financial system.  The fraudulent CEOs who run those dishonest SDIs dominate our real economy and our political system.  They use their political power to create crony capitalism, which again makes a mockery of “free markets” and democracy and destroys the most productive firms.

This perverse dynamic has a name that is well known among good economists, white-collar criminologists, and financial regulators – a “Gresham’s dynamic.”  That phrase was used in the economics literature over forty years ago in a famous 1970 article that led to the award of the Nobel Prize in Economics to George Akerlof in 2001.

[D]ishonest dealings tend to drive honest dealings out of the market. 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.

Akerlof’s 1970 article discussed control frauds aimed against customers.  His title used the term “lemons” because he explained the fraudulent sale of poor quality cars passed off as high quality cars as his most famous example.  Perceptive observers recognized the same perverse dynamic centuries ago.

The Lilliputians look upon fraud as a greater crime than theft.  For, they allege, care and vigilance, with a very common understanding, can protect a man’s goods from thieves, but honesty hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage (J. Swift, Gulliver’s Travels).

When a Gresham’s dynamic persists bad ethics drives good ethics out of the markets and fraud becomes endemic.  The Gresham’s dynamic so distorts market incentives that that they become perverse.

While Porter appears to be unaware of the term “Gresham’s dynamics” we know that he is acutely aware of the concept because it is the subject of his most embarrassing column. He published it on the 4th of July in 2004, and titled it “Corporate Greed? The Other Guy Started It.”

Porter structured his column discussing the Gresham’s dynamic around an interview with the Harvard economist Andrei Shleifer.  The column was substantively incoherent and the choice of Shleifer was deeply embarrassing to Porter.  It showed that he was not plugged into the world of economists.  I begin with the incoherence.

WHAT drives executives to cook the books seems painfully obvious: it’s greed, isn’t it? That cupidity — well oiled by stock options — would appear to be the principal cause for the spread of creative accounting during the 1990’s, provoking executives from Computer Associates to Enron to inflate sales, mask debts or embellish profits, enhancing their own incomes along the way.

Despite the moral tidiness of greed as a motive, there is another powerful incentive helping to spread mischief in the executive suite. Competition, a primal force of capitalism, can steer even the nongreedy executive down an unethical path.

Andrei Shleifer, an economics professor at Harvard, argues that if unethical behavior drives down corporate costs, rivals will be compelled to do the same just to stay in business. In other words, companies will find the cost of ethical behavior too high.

”I really don’t believe the saints-and-crooks theory,” Mr. Shleifer said of the tendency to demonize business executives who engage in creative accounting. ”Evidence tells us very clearly, even the most saintly C.E.O.’s were involved” in such accounting because of market pressure.

So, if you are “even the most saintly C.E.O.” you will commit accounting fraud because of “market pressure” – not “greed.”    If you respond to “competition, a primal force of capitalism” you are not motivated by “greed.”  No CEO can resist a “primal force?”

Let’s review the bidding.  Porter concedes that accounting control fraud occurs when CEOs     “inflate sales, mask debts or embellish profits.”  He also concedes that accounting control fraud is a sure thing that invariably leads to the CEOs “enhancing their own incomes.”  But these explanations require us to examine why Shleifer claims that accounting fraud produces a Gresham’s dynamic.

Andrei Shleifer, an economics professor at Harvard, argues that if unethical behavior drives down corporate costs, rivals will be compelled to do the same just to stay in business. In other words, companies will find the cost of ethical behavior too high.

Here’s the problem.  The anti-purchaser control fraud that Akerlof described does “drive down corporate costs” because the used car dealer can purchase lemons far more cheaply than its honest competitors can purchase a good quality car.  If the fraudulent used car dealer can exploit his asymmetrical information advantage to deceive the purchaser and sell the lemon for the same price as honest dealer can sell the good quality car then honest dealers will be driven into bankruptcy.  Most forms of control fraud produce real (albeit unethical) profits for the firm.

But “inflat[ing] sales, mask[ing] debts or embellish[ing] profits” does not reduce overall costs.  Indeed, the accounting control fraud “recipe” that makes accounting fraud a “sure thing” and optimizes a lender’s (or purchaser’s) fictional reported income, maximizes the CEO’s compensation, and increases the firm’s costs and causes catastrophic losses and the firm’s failure.  The recipe has four ingredients.

  1. Grow exceptionally rapidly by
  2. Making (purchasing) bad quality loans at a premium yield, while
  3. Employing extreme leverage, and
  4. Providing only grossly inadequate allowances for loan and lease losses (ALLL)

So, the Gresham’s dynamic that Shleifer and Porter cite does not explain the accounting fraud their article seeks to explain.  “The principle works equally to explain accounting fraud, bribery or the use of child labor, Mr. Shleifer says.”  But that is not true.  If Washington Mutual (WaMu) makes hundreds of thousands of fraudulent “liar’s” loans pursuant to the fraud recipe its competitors can sit back and cheer while they watch WaMu’s managers make loans that will cause the bank to fail.  Indeed, they can gleefully send their worst loan applicants to WaMu to speed its failure.  The accounting fraud recipe causes the firm to fail.  Accounting control fraud may, as Shleifer argued, temporarily reduce some financing costs, but its net effect places the firm at a competitive disadvantage vis a vis its honest rivals so crippling that it typically causes the firm to fail.

Accounting control fraud is a very old fraud scheme, but the fact that it does not directly produce a Gresham’s dynamic explains why accounting control fraud was used to be far less likely to become epidemic.  It is the Gresham’s dynamic that is essential to cause market incentives to become so perverse that they cause the frauds to dominate the industry.  There is a different, newer Gresham’s dynamic mechanism that has arisen in the modern accounting control fraud context and has become more intense.  Its rise is one of the key reasons why we now suffer from recurrent, intensifying financial crises.  Shleifer and Porter would have known about that newer Gresham’s dynamic if they had read and understood the best of the economics, criminology, and regulatory literature that began to be written in the early 1990s.  Shleifer was well aware of Akerlof’s 1970 “lemons” article and George Akerlof and Paul Romer’s 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”).  The Akerlof & Romer article (and our work as regulators and criminologists) explained why modern executive compensation drove the Gresham’s dynamic in the accounting control fraud context.  Porter is familiar with the article, but does not understand it.

A 20-year-old study by the economists Paul Romer and George Akerloff [sic] pointed out that the most lucrative strategy for executives at too-big-to-fail banks would be to loot them to pay themselves vast rewards — knowing full well that the government would save them from bankruptcy.

Well, no.  Akerlof and Romer explained that whether or not banks were “too-big-to-fail” their controlling officers could find it maximized their wealth to loot the bank.  As their title makes clear, their analysis of the CEO’s incentive to loot the bank he controlled was not based on any assumption that the bank would not fail and be placed in receivership.  Akerlof and Romer stressed that the bank’s failure was not a failure of the controlling officers’ fraud scheme.  The controlling officers became wealthy by following the accounting fraud recipe that caused the catastrophic losses that caused the bank to fail.

Shleifer also failed to understand the portions of the fraud literature that he read.  The average tenure of a CFO is roughly three years, but CFOs who are inclined to be honest rightly fear that if WaMu reports record earnings by following the accounting fraud recipe (and the CFO and CEO receive massive bonuses) while their banks report only modest earnings that do not trigger the CEO’s massive bonus their tenure may be three months (one reporting period) rather than three years.  The pressure to trigger the CEO’s maximum bonus and the desire of CFOs to maximize their own bonuses push in the same direction to commit accounting control fraud.  Similarly, high bonus income for more junior officers based largely on short-term (fictional) reported corporate income creates perverse incentives for such officers to engage in accounting fraud and not blow the whistle on the fraud.

Modern executive and professional compensation makes it possible for CEOs to suborn “independent” professionals and induce officers, employees and agents (e.g., mortgage loan brokers) to assist accounting control fraud and produce “echo” fraud epidemics in other professions and industries.  Collectively with the three “de’s” (deregulation, desupervision, and de facto decriminalization), modern executive and professional compensation have produced the powerfully perverse Gresham’s dynamics that have shaped the criminogenic environments that are driving our recurrent, intensifying financial crises.

Once we understand the actual Gresham’s dynamic variant active in accounting control fraud (the subject of Porter’s article) we can see why Shleifer’s claim that greed and ethics are not important to the decision to commit accounting control fraud is specious.  The CEO could shape the bank’s executive and professional compensation in the manner recommended by every professional.  Executive compensation would be based on real, long term earnings and the officer’s actual contribution to those earnings.  Loan officers and brokers would be compensated on the basis of the sound loans they made in a manner that was also likely to be good for the borrower.  Professionals would be compensated on the basis of their demonstrated expertise, independence, and professionalism.  These forms of compensation would prevent a Gresham’s dynamic from arising.  CEOs know this – they choose to adopt perverse executive and professional compensation.  They choose to create Gresham’s dynamics so they can suborn professionals and cause others to implement the accounting fraud recipe.  They choose to do so not because they have no choice – they are not subject to the “primal force of capitalism.”  CEOs that engage in accounting fraud are the ones who deliberately create the “primal force” to coerce others to assist their frauds.  The primal force they create and rely on most commonly is greed.  Substantively, Shleifer and Porter proved they do not understand accounting control fraud’s special Gresham’s dynamic.

Porter demonstrates another aspect of his analytical incoherence in this passage:

Greed, of course, is a very powerful motive. It is no coincidence that the boom in earnings manipulation during the 1990’s coincided with a surge in equity-based executive compensation packages, as business gurus recommended that corporate boards award managers big lumps of stocks and options to align their incentives with those of other stockholders.

Porter makes two key concessions.  Greed is a very powerful motive and modern executive compensation increased accounting control fraud.  All this is spoiled, however, by his fundamental failure to understand the nature, purpose, and effect of modern executive compensation.  The persons that run control frauds are typically CEOs and they dominate the board of directors and the compensation committee.  The executive compensation firms exist to boost CEO compensation massively.  The purported rationale for massive compensation is to remedy a severe “agency” problem in corporate governance.  “Agency-cost” theorists recognized that the CEOs dominated large firms – not the shareholders or boards of directors.  They stressed that the CEO did not run the firm for the benefit of the shareholders, but rather for the CEO’s benefit.  What kind of “business gurus” would recommend “that corporate boards award managers big lumps of stocks and options to align their incentives with those of other stockholder?”  Again, review the agency’s theorists’ key analysis about the problem:

  1. The CEOs dominated the firms and the boards of directors
  2. The CEOs did not act to benefit the shareholders
  3. The CEOs acted to benefit the CEOs

Under that analysis what must happen if the CEOs’ compensation was vastly increased?  It is not in the interest of CEOs to align their interests with those of the shareholders.  A CEO wants a “sure thing.”  He wants to get wealthy.   Accounting control fraud is a “sure thing.”  The compensation scheme that will maximize an abusive CEO’s income is clear – huge bonuses dependent largely on short-term reported income (which is easy to inflate).  Modern executive compensation can dramatically increase the misalignment of CEO incentives.  Accounting control fraud is the ultimate “agency” problem and modern executive compensation both prompts the fraud and provides a means to convert firm assets to the controlling officers’ personal benefit while minimizing the risk of prosecution.  Porter must know much of this, but he presents the “alignment” justification for modern executive compensation as if it were a fact.

Porter ends his column about the Gresham’s dynamic with a series of embarrassing apologias for accounting fraud as a means to reduce a firm’s cost of capital.  Porter repeatedly minimizes the ethical content of the crimes.  He uses the word “fraud” only once; and that in a paraphrase he attributes to Shleifer.  Instead, Porter provides a stream of euphemisms for fraud and ridicules those who criticize fraudulent CEOs by relying on the “moral tidiness of greed.”  Porter’s apologias and euphemisms for CEO’s accounting fraud include:

  • “cook the books”
  • “creative accounting”
  • “mischief in the executive suite”
  • “books are massaged”
  • “earnings manipulation”
  • “tinkered … with their accounting”
  • “accounting sleight of hand”
  • “a specific manipulation — propping up profits by changing the expected rate of return of a company pension fund”
  • “surge in pro forma accounting and similar shenanigans”

The embarrassing part of Porter’s article is discussed in an “editor’s note” that the NYT published a week after it published his article.

Editors’ Note: July 11, 2004, Sunday The Economic View column last Sunday described the role of competition in spreading unethical corporate behavior. It quoted Andrei Shleifer, an economics professor at Harvard, as saying that if unethical behavior drove down a company’s costs, rivals would be compelled to behave similarly to stay in business. ”I really don’t believe the saints-and-crooks theory,” Mr. Shleifer said of the tendency to demonize business executives who engage in creative accounting. ”Evidence tells us very clearly, even the most saintly C.E.O.’s were involved” in such accounting because of market pressure. The columnist was unaware of relevant background information about Mr. Shleifer. On June 29, a judge in United States District Court in Boston found in a civil suit that he conspired to defraud the federal government in the 1990’s by investing in Russia while working on a federally financed project to help develop Russian economic institutions.

We can conclude that while Shleifer is weak enough on understanding fraud mechanisms to get caught in the act, he is richly endowed in chutzpah.  Five days after the judge’s finding of fraud he is the lead “expert” cited by a NYT columnist on fraud.  Porter was “unaware of the relevant background information about Mr. Shleifer.”

We can now bring this discussion back to an analysis of Porter’s claim that it is “folly” for us to be concerned about the outsourcing of U.S. jobs.

Americans’ fear of foreign trade has grown sharply in the last 20 years, in tandem with a rising tide of globalization that has exposed American workers to overwhelming competition from laborers in developing countries.

That admission refutes Porter’s claim that it is “folly” to confront outsourcing.  Why would we expose American workers to “overwhelming competition” from laborers in developing countries?  If the wages of laborers in developing nations are so low that they must “overwhelm” any attempt by American workers to compete then not confronting outsourcing is a “do-nothing” prescription for national disaster.

Porter, however, embraces hopelessness for the American workers whose jobs are outsourced.  They are necessary victims to economic efficiency.

The political debate about globalization tends to get stuck between a couple of propositions: on the one hand, globalization tends to reduce prices of goods and services and bolster economic growth, helping companies become more efficient. On the other, it hurts the workers who are brought into direct competition with cheaper labor overseas.

Yet the debate often ignores an essential fact: regardless of who wins and who loses from the process, it is pretty much irreversible.

Well, no.  This does not follow at all.  It ignores Porter’s column on the Gresham’s dynamic.  Recall what he told the readers in that column.

Andrei Shleifer, an economics professor at Harvard, argues that if unethical behavior drives down corporate costs, rivals will be compelled to do the same just to stay in business. In other words, companies will find the cost of ethical behavior too high.

The principle works equally to explain accounting fraud, bribery or the use of child labor, Mr. Shleifer says. For instance, if a company gains a cost advantage by hiring children, and can thus offer lower prices to consumers, its rivals have a powerful incentive to hire children, too.

If a company can lower costs by paying bribes to government officials in exchange for a permit or to avoid a tax, other companies may be tempted to do the same to stay in the business. ”The keener the competition, the higher is the pressure to reduce costs, and the more pervasive is corruption,” Mr. Shleifer said.

It cannot be assumed that the firms that win contracts through the outsourcing of American jobs are more efficient than U.S. firms.  Instead, the winners often succeed through corruption, fraud, and other unethical conduct.  If they are allowed to win such contracts, illegality and inefficiency will increase.

Porter’s assumption that outsourcing increases economic efficiency also ignores his very recent article about “The Spreading Scourge of Corporate Corruption.”

Company executives are paid to maximize profits, not to behave ethically. Evidence suggests that they behave as corruptly as they can, within whatever constraints are imposed by law and reputation. In 1977, the United States Congress passed the Foreign Corrupt Practices Act, to stop the rampant practice of bribing foreign officials. Business by American multinationals in the most corrupt countries dropped. But they didn’t stop bribing. And American companies have been lobbying against the law ever since.

Porter knows better.  CEOs structure their own compensation and they generally ensure that they will become wealthy.  They are not “paid to maximize profits.”  Banks, for example, often maximize reported (albeit fictional) profits – and the best way to do that is often to maximize real losses through the accounting control fraud recipe.  But consider the implications for outsourcing of Porter’s admission that CEOs “behave as corruptly as they can” if unconstrained by an effective rule of law.  (He implicitly assumes that a concern for reputation constrains fraud.  It can constrain or motivate fraud.  Because accounting control fraud is a “sure thing” and produces extreme wealth and because wealth tends to bolster reputations, a concern for reputation can encourage fraud.)  He knows that American workers lose their jobs to outsourcing overwhelmingly to firms based in nations that are highly corrupt and have weak rules of law.  These nations may have laws against unsafe work conditions, failure to pay overtime, pollution, bribery, and securities fraud but if these laws are not enforced (and they typically are not enforced in these nations) then the result is not increased economic efficiency.  The result is a race to the bottom that harms many workers in both nations.

This recent article by Porter must be read in conjunction with his article on the Gresham’s dynamic that shows that if even a few firms are able to cheat with impunity in these highly corrupt nations the result is “rampant” “bribing.”  Some firms will be able to cheat with impunity in any highly corrupt nation.  We do not want to encourage American firms to “compete” in an ethical race to the bottom with unethical firms in other even more corrupt nations.  Recall that the point of a Gresham’s dynamic is that it causes market forces and competition to become perverse and produce greater social ills.  The only way to win a race to the bottom is to refuse to enter that race.  Instead, it is essential to a race to integrity through international enforcement of minimum ethical norms.  Allowing outsourcing under conditions that encourage a race to the bottom is an insane, inhumane, and economically inane policy that will create a nasty, brutish world of extreme inequality and crony capitalism.

But the fact that globalization is here to stay doesn’t mean that nothing can be done for workers, who have come to fear the process of global integration as a zero-sum game, which ends with their jobs moving somewhere where labor is cheaper.

Well, no.  American workers, correctly, fear that outsourcing is a negative-sum game that causes net harm.  Accounting control frauds are weapons of mass financial destruction.  Anti-purchaser control frauds kill and maim tens of thousands of customers.   They too produce net harm.

Porter’s most self-revealing passage describes his real concern about what he aptly terms the “scourge” of corporate corruption that he admits is spreading.  Porter is not worried or enraged that the dogma of “free markets” has turned into an anti-regulatory creed that produces an environment so criminogenic that it drives our recurrent, intensifying financial crises.  Porter does not write his “scourge” article to warn about the rise of crony capitalism, the inevitable impairment of democracy that crony capitalism causes, the tens of millions of victims who have lost their homes or much of their wealth to the frauds, or the Great Recession.  He recognizes each of these problems, but Porter’s passion is his fear that American might respond to perverse market forces producing endemic fraud by losing their faith in capitalism.  He is afraid that the fact that corporate corruption is a spreading scourge (due to the Gresham’s dynamic) could lead Americans to question “free market” dogmas and not trust the (often fraudulent) bankers.

We should be alarmed that corporate wrongdoing has come to be seen as such a routine occurrence. Capitalism cannot function without trust. As the Nobel laureate Kenneth Arrow observed, ”Virtually every commercial transaction has within itself an element of trust.”

Actually, the problem has sometimes been excessive trust in banks and perverse market forces, which made it easy for CEOs to defraud their customers, creditors, and shareholders.

Porter eventually ends by implicitly admitting that (1) unless we break the race to the bottom dynamic (another example of the Gresham’s dynamic) the results will be disastrous in certain contexts such as regulation and taxation and (2) the U.S. must counter the race to the bottom by creating internationally enforceable minimum standards.

Multinational companies’ freedom to move their money across borders, to wherever the return is highest, raises new issues. Corporations can relocate to escape taxes and regulation, setting up shop where the rules are easiest. Investment in machines and high-technology plants abroad erodes the productivity edge that American workers hold over workers in China or Brazil.

Multinational companies’ freedom to move their money across borders, to wherever the return is highest, raises new issues. Corporations can relocate to escape taxes and regulation, setting up shop where the rules are easiest.

The challenges call for a more sophisticated debate about trade. American policy makers might consider global taxation treaties, to reduce the scope for tax competition. They could engage foreign countries in a debate on global standards — overcoming mistrust of American protectionism to develop rules protecting workers from abuse by footloose corporations seeking the cheapest labor. And they could think about the kind of safety net needed to protect workers from the dislocations that the relentless onslaught of globalization is sure to bring.

Note that none of the locational decisions he discusses in these passages are based on economic “efficiency.”  They are based on the desire of CEOs to outsource American jobs in order to obtain low taxes and weak, ineffective regulation.  If we engage in a race to the bottom on taxes we make it far harder for nations that lack a sovereign currency, e.g., Eurozone nations, to raise adequate revenues.  Most American outsourcing is driven not by “efficiency,” but by efforts of U.S. corporations and their wealthy executives to evade U.S. taxes.

We have seen in the ongoing global crisis the terrible cost of the competition in regulatory laxity in the finance context.  Trillions of dollars of wealth – many orders of magnitude greater than all the supposed gains of outsourcing American workers’ jobs – were destroyed by that competition.  In other words, Porter ends his article by implicitly admitting the essential need, rather than the “folly” of attacking the multiple corrupt and destructive races to the bottom posed by the international economic competition in laxity.