Krugman Now Sees the Perversity of Economics’ “Culture of Fraud”

By William K. Black

Paul Krugman has written an article entitled “Culture of Fraud” about the Romney economics team.

Still on vacation, but I have internet access for a bit, and have checked in on a few matters. The big story of the week among the dismal science set is the Romney campaign’s white paper on economic policy, which represents a concerted effort by three economists — Glenn Hubbard, Greg Mankiw, and John Taylor — to destroy their own reputations. (Yes, there was a fourth author, Kevin Hassett. But the co-author of “Dow 36,000″ doesn’t exactly have a reputation to destroy).

And when I talk about destroying reputations, I don’t just mean saying things I disagree with. I mean flat-out, undeniable professional malpractice. It’s one thing to make shaky or even demonstrably wrong arguments. It’s something else to cite the work of other economists, claiming that it supports your position, when it does no such thing….

Is it really surprising, then, that the economists who have decided to lend their names to the campaign have been caught up in this culture of fraud?

I have often written about economists’ tribal taboo on taking fraud seriously or even using the “f-word.”  (For economists, it’s like saying “Voldemort” out loud.)  It is one of the leading shapers of the intensely criminogenic environments that create the perverse incentives that drive our recurrent, intensifying financial crises.  Krugman seems particularly surprised that Mankiw (Harvard) would join the fraudulent culture, but Mankiw has been notorious in this regard for nearly two decades.  He was a discussant at Brookings in 1993 when George Akerlof and Paul Romer presented their paper (“Looting: the Economic Underworld of Bankruptcy for Profit”).  Akerlof and Romer explained how accounting “control fraud” occurred, why it was a “sure thing,” and how it hyper-inflated bubbles and drove financial crises.  Akerlof and Romer (working in conjunction with savings and loan regulators and white-collar criminologists), ended their article with this paragraph in order to emphasize their central message:

Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself” (George Akerlof & Paul Romer, 1993: 60)

Mankiw dismissed the article’s thesis and conclusion using the economists’ favorite term of disdain (“anecdote”).  Mankiw’s dismissal was dishonest, the article he was reviewing was not anecdotal.  Mankiw’s infamous conclusion was that “it would be irrational for savings and loans [CEOs] not to loot.”  Indeed, he expanded on his fraud-friendly thesis:

Consider an owner of a savings and loan who is taking excessive risks, hoping that they pay off and make him rich. It is only prudent for him to loot as much as he can, because he knows that his gambles might not pay off.

Looting one’s shareholders and creditors was not only “rational,” it was the “only prudent” strategy under “Mankiw-morality.

Mankiw rejected Akerlof and Romer’s explanation of how deregulation created the perverse incentives that drove the fraud and claimed that the problem was overregulation.  Akerlof and Romer’s warning (a warning that we the regulators and white-collar criminologists made contemporaneously) could have prevented a repeat of the financial disaster.  Unfortunately, the Clinton and Bush (II) administrations followed Mankiw’s policies and produced the criminogenic environments that drove the accounting control fraud epidemics that produced the Enron-era crisis and the ongoing crisis.

Reading Mankiw’s claims as discussant, where he missed everything important in Akerlof and Romer’s (and the S&L regulators’ and criminologists’) insights and pronounced his faith in the dogma of efficient markets preventing all fraud make particularly painful reading today.  His statements as discussant foreshadow all the most destructive creeds that produced the Enron-era and ongoing fraud epidemics.

It is vital to understand that the claim that “accounting fraud” is impossible was not an isolated dogma shared by only a few acolytes.  Under even the weakest variant of the efficient market hypothesis, accounting control fraud could not exist or markets would (particularly given the Gresham’s dynamic that Akerlof explained in his 1970 article on “lemons) not be efficient.  Because the efficient market hypothesis is the foundation on which all of “modern finance” is built, the circular belief that fraud is impossible because we know markets are efficient was the dominant dogma among finance theorists.

The Frontline special (“The Warning”) explains that Alan Greenspan believed that fraud could not exist and therefore eagerly destroyed Brooksley Born’s (CFTC Chair) effort to protect us from credit default swaps (CDS).  It was that same dogma that led Greenspan to an even more catastrophic refusal to act.  The Federal Reserve had the unique authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to ban endemically fraudulent liar’s loans.  Greenspan refused to do so despite pleas from colleagues and housing advocates (including ACORN).  Indeed, the refused pleas to even send the Fed’s examiners in to the holding company affiliates making the fraudulent liar’s loans to determine the facts.  Greenspan and the Fed economists then, having refused to find the data, shamefully dismissed pleas to use HOEPA to ban liar’s loans by experts who explained how the frauds and predatory lending occurred on the grounds that the experts’ reports were “merely anecdotal.”

Similarly, a generation of American lawyers who have studied corporate law have been reading Frank Easterbrook and Daniel Fischel’s assertion that: “a rule against fraud is not an essential or … an important ingredient of securities markets” (Easterbrook & Fischel 1991).  They do not inform the reader that Fischel, in his capacity as an expert economist for Charles Keating (who looted Lincoln Savings), tried applying this fraud-free dogma in the real world.  He, and Greenspan (who served as both an economist and lobbyist for Keating – Keating used Greenspan to recruit the five senators who became known as the “Keating Five) opined that Lincoln Savings was a superb S&L with stellar management.  Lincoln Savings proved to be the most expensive S&L failure and Keating the most infamous fraud.

To sum it up – the surprise is that Krugman is surprised.  Neo-liberal economists, globally, have been the most valuable allies to control frauds.  Mankiw is not a late convert, but among the earliest and most strident apologists for the elite frauds.  Mankiw’s mendacity has been on open display for nearly two decades.  Here’s the really bad news:  the room full of prominent economists who listened to his praise for the looters expressed no disapproval of his “friending” of the frauds.  Harvard, under Larry Summers, epitomized the economics taboo against taking fraud seriously.  Andrei Shleifer remained the editor of the most prominent journal in the field, protected by Summers from any consequences.  My recent column explained how a New York Times columnist (Eduardo Porter) cited Shleifer as his primary source on fraud and the Gresham’s dynamic it can produce without Shleifer informing the journalist of the fraud decision that had just dome down against Shleifer.

The culture of fraud in economics is a severe problem, and Harvard is a “hot spot” of that culture.

5 responses to “Krugman Now Sees the Perversity of Economics’ “Culture of Fraud”

  1. Pingback: Bill Black: Krugman Now Sees the Perversity of Economics’ “Culture of Fraud” « naked capitalism

  2. Ah! the good ol’ Harvard School of Business Chicanery (with a W.C. Fields style presentation), a key member of another troika of corruption to match the European troika (IMF, ECB and EU Commissioners) of intentional economic ignorance. In the “Discourses on Livy”, the historian of the Roman Republic makes an observation that Rome had fortuitous luck, in that every generation had their corrupt members, (corruption being a part of the human condition when wealth and power are involved), that the corruption was not pervasive to the extent that corrective measures became impossible. Also remarked was the corrective measures were the same as those known to every farmer using herding animals, that once the dog had tasted blood, its days were finished. a wisdom going back to the beginnings of time. By this measure, it appears the S&L prosecutions marked the ultimate time such actions were possible in the US Republic although doubtlessly sham repetitions will provide circus for a while as it suits the purpose of power and wealth to appear otherwise. The second ‘American’ Republic is dead, deceased of massive carcinomas to the body politic resulting in massive organ failures. But then, when it was created it was known that the life expectancy was about two centuries for a republic and much shorter still for a democracy and the bright sparks combined the two. It is the use-by date, stupid! to paraphrase Billy Clinton’s folks.

  3. I just finished reading “Bailout” by Neil Barofsky. Good stuff. It’s good to know that there are still honest, competent criminal-justice prosecutors out there. But the story is overwhelmingly about Geithner’s fawning slavishness to Wall Street and Obama’s indifference to the details. How will the frauds ever end? Will they eventually just pull the country down around all our ears, and then retire to the south of France with their winning?

  4. Justice For Sale: Shortchanging the Public Interest for Private Gain
    Washington, D.C.: Alliance for Justice, 1993

    Justice For Sale describes a “multi-faceted, comprehensive, and integrated campaign” coordinated over the past 20 years by large corporations and “ideologically-compatible foundations” to create tax-payer subsidized law firms, to change the civil justice system, to shape law school curriculum, to organize and reward law students, to affect the minds and decisions of sitting judges.

    The goal of this “relatively quite but significant effort” was “to rewrite American jurisprudence. . . advanc[e] their agenda before judges, lawyers, legal scholars, and government policy makers. In addition, by focussing extensively on law schools and the next generation of lawyers, they have sought to assure control over the future direction of the law.”

    * * *

    In 1971, Virginia attorney (later Supreme Court Justice) Lewis Powell wrote a memorandum for the United States Chamber of Commerce. As Justice For Sale describes it, Powell warned against zealous environmentalists, consumer activists and others who “propagandize against the system, seeking insidiously and constantly to sabotage it.” It was time, Powell said, “for the wisdom, ingenuity and resources of American business to be marshalled against those who would destroy it.”

    A successful corporate counterattack, in Powell’s view, would require broad-based and coordinated activism on campuses, in the media, in political arenas and — most importantly — in the courts: “Under our constitutional system, especially with an activist-minded Supreme Court, the judiciary may be the most important instrument for social, economic and political change,” Powell wrote.

    Among Powell’s recommendations, Justice For Sale notes, was to establish a business-sponsored legal center that would promote business interests and not hesitate to “attack the Naders” and others who “seek destruction of the system.”

    Soon the California Chamber of Commerce would propose what would become in 1973 the Pacific Legal Foundation, a nonprofit set up in Sacramento, California, from seed money raised by J. Simon Fluor of the Fluor Corporation. And in 1975, the National Legal Center for the Public Interest (NLCPI) was formed “to assist in the establishment of independent regional litigation foundations dedicated to a balanced view of the role of law in achieving economic and social progress.”

    NLCPI helped create seven more such firms around the country, six of which operate today with money from the Olin, Scaife, Bradley, and Smith Richardson Foundations. In courts around the nation, they are challenging Superfund/hazardous waste programs, environmental regulations. and rent control statutes — all of which they regard as grave challenges to economic freedom. They are also designing litigation around “takings” — the doctrine that some government regulations constitute takings of private property without due process and just compensation, thereby violating the Fifth Amendment. With this tactic, they are seeking not merely to invalidate specific laws or to argue interpretations of laws. Rather, they are seeking to eradicate categories of laws by changing prevailing legal theory and establishing new precedents.

    These legal foundations claim they are expanding the property rights and resource access rights of persons. But because the corporation under law is considered to be a person, with every victory they actually expand the property and resource access rights of corporations.

    Olin Foundation president William Simon, a former Treasury Secretary, has been a major player in these efforts. He is quoted in Justice For Sale: “Funds generated by business . . . must rush by multimillions to the aid of liberty . . . to funnel desperately needed funds to scholars, social scientists, writers and journalists who understand the relationship between political and economic liberty.”

    Simon and many others have orchestrated and coordinated “sophisticated media offensives, academic research, and advocacy efforts” with lavish funding from Aetna Life And Casualty Corporation, Exxon Corporation, Pfizer Corporation, RJR Nabisco Corporation, General Electric Corporation, Dow Corporation, Monsanto Corporation and other legal fictions chartered in our names in our several states.

    Corporate money has also been rushed by multimillions to corporate fronts such as the American Enterprise Institute, the Heritage Foundation, the Manhattan Institute for Policy Research, the Insurance Information Institute, the Product Liability Coordinating Committee, and the American Tort Reform Association (ATRA). (The ATRA is made up of corporation trade groups such as the National Association of Manufacturers, the Chemical Manufacturers Association, the Pharmaceutical Manufacturers Association — thus giving corporations a decoy and accomplice group two full steps removed from their board rooms.) Judge Robert Bork, Irving Kristol, and law schools at Stanford, Yale, Columbia, George Mason, Chicago and Virginia universities have also been beneficiaries of this corporate largess.

    Corporate money created the Federalist Society in 1982, helping it to gather 10,000 members at 120 law schools. “Dedicated to purging law schools and the legal system of the `orthodox liberal ideology which advocates a centralized and uniform society,'” declares Justice For Sale,

    the Society is now the principal organization for recruiting, educating and mobilizing conservative students on law school campuses and showcasing conservative legal scholarship. . . . The group’s influence is perhaps best exemplified by the success of its three co-founders. As a member of the White House Office of Legal Counsel, Lee Liberman was considered the “ideological gatekeeper for the Bush Administration’s process for selecting judges.” David McIntosh served as Executive Director of Vice President Quayle’s Council on Competitiveness, and Steven Calabresi, now a professor at Northwestern University School of Law, was a special assistant to Reagan Attorney General Ed Meese.

    In sum, paying for and orchestrating law and economics professors and curricula at the nation’s elite schools, sponsoring conferences, Continuing Legal Education workshops, legal research and theoretical writing, as well as for massive advertising and strategic litigation, these corporation initiatives “to make conservative economic theory the cornerstone of legal decision making,” documents Justice For Sale, have set up an “institutional network that will advance and sustain their cause well into the future. Integrated and intergenerational, this infrastructure includes representatives from all segments of the legal establishment — judges, scholars, practitioners, and young apprentices hailing from the Federalist Society.”

    Justice For Sale is a frightening report, meticulously documented with references to the professors, theorists, and foundations behind this campaign. “Intended to provoke debate” and “instigate true reform of the legal system,” it should be a catalyst for public debate and strategizing. Read it.

    * * *

    Readers, however, should consider this report in a broader political and historical context than the one the Alliance establishes for its hue and cry.

    For example, as former Supreme Court Justice Felix Frankfurter pointed out decades ago, the history of constitutional law is “the history of the impact of the modern corporation upon the American scene.” But Justice For Sale interprets current corporate efforts as seeking “to shift the law from its traditional foundations of public justice and equity . . . to elevate corporate profits and private wealth over social justice and individual rights as the cornerstones of our legal process.” Alas, such shifts and elevations were engineered by the forbears of today’s corporations over a century ago and steadily extended ever since.

    Justice For Sale also posits as our public policy choices only government regulation, on the one hand, and unregulated markets on the other. It makes no mention of alternatives to private corporations — public ownership of enterprises, cooperatives or worker- and municipally- owned businesses — well within American traditions.

    The report does not discuss how corporations shaped and dominated the operations of (to cite only a few) the Interstate Commerce Commission, the Employment Act of 1946, the Taft-Hartley Act, the Wilderness Act of 1964, the Atomic Energy/Nuclear Regulatory Commission, and the latest Clean Air Act Amendments. We must therefore inquire, after Morton J. Horwitz (The Transformation of American Law, 1780-1860 [1977]): what evidence is there for this report “characterizing most forms of government activity as a promotion of the public interest?”

    Lastly, this report stops far short of where its own internal logic clearly points: the need for major, coordinated, well-funded citizen counter strategies directed at the public, law schools and the courts, and for strategies that challenge the legitimacy and existence of today’s corporations.

    From a strategic perspective, it is vital to understand that Justice Powell wasn’t just whistling Dixie when he counseled the Chamber of Commerce in 1971 that “the judiciary may be the most important instrument for social, economic and political change.” As Professor Horwitz has observed in his book on legal history from the ratification of the Constitution to the Civil War:

    A major transformation of the legal system took place . . . it enabled emergent entrepreneurial and commercial groups to win a disproportionate share of wealth and power in American society. . . . [T]he law had come simply to ratify those forms of inequality that the market system produced. . . . [T]he American judiciary — especially aggressively procommercial [and not-elected — RG] federal judges — managed to overthrow earlier economic commercial legal rules. . . . [A]s political and economic power shifted to merchant and entrepreneurial groups . . . they began to forge an alliance with the legal profession to advance their own interests through a transformation of the legal system . . . to create legal doctrines that simply mirrored the market.

    Despite such accomplishments, the judiciary did not rest from its labors. Throughout the rest of the nineteenth and well into the twentieth centuries, appointed judges gave privilege after privilege to corporations. They invented new doctrines such as freedom of contract, substantive due process and managerial prerogative, which they used to overturn state laws asserting even limited citizen sovereignty over corporations, and to bestow upon corporations constitutional authority over investment, production, and the organization of work.

    According to Professor Martin J. Sklar, by establishing “new trends in legal doctrine and political-economic theory” allowing “the corporate reorganization of the property-production system,” the Supreme Court helped to sabotage blossoming social protest movements against corporate power and corporate harms. [See The Corporate Reconstruction of American Capitalism, 1890-1916: The Market, The Law and Politics (Cambridge University Press 1988).]

    So the law had already been stacked on behalf of corporations when attorney Lewis Powell penned his memorandum to the Chamber of Commerce in 1971 and when former Treasury Secretary William Simon started soliciting corporate millions. Justice For Sale describes what is only the latest in a long history of corporate efforts to use judges and the law to shape legal doctrines governing investment, production, natural resources, the rights of workers, the rights of stockholders, the liabilities of corporations and their executives. Simon’s initiative is but another corporate campaign to limit citizens’ constitutional rights, to close off the courts as a means of redress against concentrations of capital.

    By virtue of their claimed right to influence the electoral process (upheld by the courts under the doctrine of “commercial free speech”), corporations have been major opponents of citizen referenda and initiatives to stop corporate harms, and major proponents of referenda and initiatives to shape government intervention in the economy. Via contributions to House and Senate candidates, they have bought the best Congress money can buy. Via campaign contributions to state legislators and with help from the American Bar Association and state bar associations, they have been rewriting corporation, tort, contract, property and liability laws. Never known for thinking small, they are today unabashedly writing such laws for former Soviet Union and Eastern European countries — places where these same corporations are seeking natural resources, cheap labor and vast markets.

    * * *

    Justice For Sale has correctly identified a major strategy of large and powerful corporations to undermine citizen efforts to protect worker rights, community rights, constitutional rights, biological diversity, and the earth itself. But if we intend to “instigate true reform of the legal system and a return to a process that seeks to secure justice for all,” we must go well beyond this report’s recommendations.

    Three hundred years ago, the corporation was understood to be a convenience devised by monarchs. merchants, explorers and men of wealth. It was a legal device to gather up resources and hold property, to exploit and dominate people. After the American Revolution, it was generally understood that the people were — and desired to remain — sovereign over corporations. Accordingly, Americans limited corporate existence to a set number of years and spelled out rules each corporation had to follow.

    Today, the 15 largest global corporations have gross incomes greater than the gross domestic products of over 120 countries.

    The 100 largest global corporations have incomes greater than half the member nations of the United Nations.

    The havoc such corporations cause — documented in every issue of The Workbook, combined with the research reported in Justice For Sale — make clear that people must again extend our inquiries, political debates and active citizenship beyond “government regulation,” on the one hand, and “the free market” on the other.

    We can challenge the legitimacy — and the existence — of large corporations doing harm. As Paul Hawken, a founder of Smith and Hawken Corporation, recently offered as a first step toward a sustainable world economy [Utne Reader, Sept/ Oct 1993]:

    Take Back The Charter. . . . Although corporate charters may seem to have little to do with sustainability, they are critical to any long-term movement toward restoration of the planet. . . . Corporations are chartered by, and exist at the behest of, citizens. Incorporation is not a right but a privilege granted by the state that includes certain considerations such as limited liability. Corporations are supposed to be under our ultimate authority, not the other way around. The charter of incorporation is a revocable dispensation that was supposed to ensure accountability of the corporation to the society as a whole. . . . We should remember that citizens of this country originally envisioned corporations to be part of a public-private partnership, which is why the relationship between the chartering authority of state legislatures and the corporation was kept alive and active. They had it right.

    Justice For Sale concludes by reiterating that the direction in which the legal system is moving and the corporate forces propelling it raise “troubling and provocative concerns.” In order to protect academic freedom, as well as our system of justice, the book’s authors maintain, there must be “informed debate within law schools” and “full disclosure.” Further, legislators, judges, and juries must “apply exacting scrutiny to the message and messengers of the so-called `civil justice reform’ movement,” and any “fine-tuning” of the civil justice system must depend on “accurate. relevant data.” Finally,

    the litigation strategy pursued by the business-funded `public interest law firms,’ complemented by the scholarship flowing from law schools and think tanks . . . mandate a corresponding vigilance of their actions in the courts, in `judicial seminars,’ in the law schools and in the legislatures.

    Troubling and provocative concerns? Full disclosure and informed debate? Exacting scrutiny? Fine-tuning? Accurate, relevant data? Corresponding vigilance? Well, yes, of course.

    But fantastically wealthy and powerful corporations have a 20-year head start on expanding the legal rights and powers they usurped over the previous 150 years. So we the people need ambitious, well-planned, coordinated, public counter strategies in each of the realms the report details, plus the real money to extend and expand these strategies over several decades.

    We need law professors, law students, tacticians and organizers, unions and environmental groups, civil rights and consumer groups, garden clubs, students and enlightened business people, plus the growing locally based movement for environmental and economic justice here and around the world, to organize an array of coordinated short- and long- term efforts.

    The Alliance For Justice and other organizations should convene meetings to plan for more than fine-tuning the law, for more than restoring the legal system to what it was in 1970. Starting with denying the corporation personhood under the Constitution and reformulating managerial prerogative and liability, we need to reverse the transformation of the law that corporations accomplished over a century ago.

    These counter-strategies also need to redesign the corporations — which throughout U.S. history have been rewriting the rules of their own existence — to redefine in fundamental ways those legal fictions that Thomas Hobbes labeled, “worms in the body politic.”

  5. Bayard Waterbury

    Mr. Black, I am so pleased to read this piece. I so look forward to your opining. It is always timely, knowledgeable, coherent, and relevent. There is only on comment I have regarding this particular article. That is that it shows the true power of what has been called “intellectual capture” most particularly in the part where you indicate the unwillingness of listeners to criticize Mankiw’s idiotic statements regarding the inevitability and acceptability of fraud as a rational reponse to corporate attempts to use their internal power for personal gain. What has happened to the world in which we live. Morality has gone far beyond the bounds of relativistic, and into the area of the passe or non-existent. I also note that this is what I would expect from Mr. Summers, who, for my money, embody’s a level of arrogance rarely seen, even in the highest academic circles. Nausea is my knee jerk response to the entire problem, which, left to continue, will ultimately destroy any shred of belief in business acumen which may, I say may, still exist. These guys make the proverbial used car salesman look like the Pope in his ethics.