In a rational world the Office of Management and Budget (OMB), under Presidents Bush and Obama, would have responded to the financial crisis by demanding an emergency effort as a top national priority to develop superb regulatory capacity in the financial sphere and in many other fields. Regular readers will recall the questions I emphasize we must answer – why do we suffer recurrent, intensifying financial crises? That may sound like one question, but it asks multiple questions. The two most critical are:
- What is causing our financial crises?
- Why are we failing to learn the correct lessons from the crises and instead making finance ever more criminogenic?
The tragedy, of course, lies in the answer to the second question. It is obscene that we are making things even worse in response to each of our crises. The fact that we repeatedly do so demonstrates how criminogenic theoclassical economics is and how dogmatic those economists are. This makes them incapable of learning the correct lessons from the crises. Instead, they double-down on their criminogenic policies and produce even more perverse environments.
OMB and Fed are the Temples Devoted to the Worship of Theoclassical Economic Dogmas
The OMB has failed to ask itself, much less answer, either question. Answering those two questions would lead the OMB to ask similar questions about other fields such as how to protect the environment through essential regulation. If the OMB were to ask itself these questions, and answer them honestly, they would have to give up their dogmas. Instead, those dogmas prevent them from even asking the correct questions and would make them incapable of answering the questions honestly even if they were to face the questions.
Four Lessons that OMB Failed to Learn from the Crisis
Rather than leading the emergency, top priority effort to adopt the regulations to end the criminogenic environment in finance, OMB remains a leader of the effort to prevent effective regulation. There were four obvious things that even OMB should have learned from the financial crisis if it were even making a pretense of trying to learn from the crisis. First, economists were the problem, not the solution and the theoclassical economists who dominate OMB under every administration should be excluded from any policy role because of their record of repeated, epic fails.
Second, the paramount factor driving the crisis was that identified by successful regulators, economists, and white-collar criminologists over two decades ago – epidemics of accounting control fraud.
Third, the epidemics are not random events. They are produced by intensely criminogenic environments. Among the most destructive forces shaping that criminogenic environment three de’s” – deregulation, desupervision, and de facto decriminalization. The CEOs that lead control frauds deliberately create Gresham’s dynamics in order to suborn professionals that are supposed to serve as “controls.” Control fraud theorists and behavioral finance scholars agree with effective regulators that “information disclosures” rules and guidelines typically fail completely to protect consumers and investors and to achieve market efficiency.
Fourth, the methodologies used by economists, relying primarily on econometrics and financial models will support the worst possible policies in the presence of material accounting control fraud. The models are inherently and devastatingly false because they implicitly assume out of existence the criminogenic environments that produce the fraud epidemics that drive our recurrent, intensifying financial crises.
In sum, OMB should have realized that its passionate embrace of the three “de’s,” failed theoclassical dogmas, criminogenic policies, and horrifically wrong econometric studies and financial models was a major cause of our problems. Instead, OMB recurrently doubles-down on its destructive dogmas and creates ever more criminogenic environments.
OMB’s Primer: Not even an Attempt to Learn the Lessons
OMB has created a “Primer” on “regulatory impact analysis” to explain how agencies must justify adopting rules.
The Primer is written in a style that is redolent with the authors’ dogmatic belief that it represents the embodiment of hyper-rationality and that any reasonable person would agree that its precepts represent an indisputable ideal. OMB’s self-delusion is total. Consider first the words that the Primer does not contain:
- Gresham’s dynamic
- Fraud or Control Fraud
- Crisis or Systemic Crisis
- George Akerlof
- Behavioral finance
The Primer uses the word “model” only once to urge “peer review” for “novel” models. It does not warn that conventional financial models inherently overstate asset values and that the problem would arise for an agency if it used the common – failed – model and that the solution would be to give such common models no consideration.
The Primer Would Have Caused the S&L Debacle to Grow Catastrophically
The Primer ignores modern white-collar criminology and behavioral finance. It ignores past financial regulatory successes. It ignores past financial regulatory failures created by the three “de’s” – which the Primer continues to champion. The Primer is therefore wholly anti-scientific and anti-common sense. Had the Federal Home Loan Bank Board been governed by the Primer in 1983-1987 when Chairman Edwin Gray reregulated the industry, or in 1990-1991 when the Bank Board’s successor agency, the Office of Thrift Supervision (OTS) drove (what we now call) “liar’s” loans from the S&L industry, the OMB would have blocked the reregulation that was essential to stopping the surging epidemic of accounting control fraud. The result, as we can now understand by reviewing the current crisis, would have been to add many trillions of dollars to the cost of the S&L debacle and the hyper-inflation of real estate bubbles that would have caused a financial crisis and a severe recession.
Recall what our strategy was in containing the S&L fraud epidemics. In both cases – 1983 and 1991 – we recognized that we were dealing with accounting control frauds that would create multiple Gresham’s dynamics and produced endemic fraud. We acted in each case while the S&Ls involved were reporting high earnings. We do not have to hypothesize what conventional and theoclassical economists would have recommended in such circumstances, for prominent economists lined up in unison to denounce our reregulation as irrational and to argue that we should be encouraging the practices we were banning because the S&Ls employing those practices reported high profits.
Our reregulation in 1983-1987 was denounced by OMB, but as an independent regulatory agency we were not subject to OMB’s views on “cost-benefit analysis.” OMB was so enraged by our reregulation that it threatened to file a criminal referral against Chairman Gray for the “crime” of closing too many insolvent S&Ls! We do not have to guess what OMB would have done to our reregulation of the S&L industry had we been subject to OMB’s “cost-benefit analysis” – they would have destroyed the reregulation that saved the Nation from catastrophic harm.
Has OMB never read Akerlof & Romer (1993)?
George Akerlof and Paul Romer concluded their famous 1993 article (“Looting: The Economic Underworld of Bankruptcy for Profit”) with this paragraph in order to emphasize their central finding.
“The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the regulations of the 1980s were 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” (Akerlof & Romer 1993: 60).
Note three things that are very unusual about the paragraph. First, their language is blunt and stark – deregulation was “bound to produce looting.” Second, they are writing to their own profession – economists. Third, they are praising the “regulators in the field” “who understood what was happening from the beginning.” Akerlof was made a Nobel Laureate in 2001. In any scientific field, such a stark warning by a Laureate would (1) be acknowledged by any other scholar in the field who was purporting to provide a “Primer” on the subject and (2) would be followed by any other scholar in the field or (very rarely) explicitly contested through a tightly reasoned examination of the evidence. But OMB simply ignores Akerlof and Romer’s article on looting and Akerlof’s 1970 article (on “lemons”) describing the Gresham’s dynamic arising from control fraud.
“[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.” George Akerlof (1970).
The Primer also ignores effective financial regulators and white-collar criminologists, but its theoclassical authors have no knowledge about such matters.
The Primer Could Never Survive Competent Benefit-Cost Analysis
The Primer could never survive a competent benefit-cost analysis. Beneath a patina of faux neutrality lies a core that is sharply antagonistic to effective regulation. The OMB should, years ago, have revisited the decisions to increase the three “de’s” from 1993-2008 and why OMB supported acts that were “bound to produce looting.” OMB needed to revisit the dogmas cited in support of these acts of regulatory self-mutilation and examine why those dogmas proved so attractive to OMB and the agencies’ lead anti-regulators. Instead, the Primer starts out with a presumption against regulation. The Primer treats regulation as inferior to “markets” rather than understanding that regulation – the rule of law – is essential to the creation of effective markets in which honest competitors will prevail (as Akerlof keeps explaining to them).
Even when regulation is essential, the Primer expresses a strong presumption against effective regulation and in favor of regulatory approaches we know will fail and prove criminogenic. During the lead up to the financial crisis this same anti-regulatory approach was used as the excuse to gut effective regulation. The Obama administration Primer describes itself as a guide to complying with OMB Circular A-4 (September 17, 2003).
The Circular was crafted to advance the Bush administration’s efforts to destroy effective regulation. The date of the Circular demonstrates the depth of the anti-regulatory dogma that captured OMB. There is a huge literature on “regulatory capture,” but it frequently ignores the central role of the OMB as the “vector” that spreads the anti-regulatory dogmas that maximize the three “de’s.” Within two years of the criminogenic environment, created by the intersection of the three “de’s,” the rise of modern executive and professional compensation, and the death of effective private market internal discipline with the removal of true partnerships with joint and several liability, that produced the accounting control fraud epidemic that defined the Enron-era frauds the OMB was actively trying to enshrine the three “de’s” as the ideal policy.
OMB’s response to the Enron-era frauds – let’s expand the three “de’s” and make the financial world even more criminogenic – explains why we suffer recurrent, intensifying financial crises. It is essential to keep in mind that by September 21, 2003 the next three epidemics of accounting control fraud that would produce our current crisis were already enormous. OMB was pushing to make things worse in response to unambiguous warnings of those frauds. The report of the Financial Crisis Inquiry Commission (FCIC) revealed that:
“From 2000 to 2007, a coalition of appraisal organizations … delivered to Washington officials a public petition; signed by 11,000 appraisers…. [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] “blacklisting honest appraisers” and instead assigning business only to appraisers who would hit the desired price targets”( FCIC 2011: 18).
Note that the written warning was delivered a year before Enron’s failure and roughly three years before OMB issued the Circular that was crafted to make the financial realm even more criminogenic. The appraisers’ warning was the clearest signal OMB could hope to receive. It was totally credible. It identified the fraud as coming from the lenders. No honest lender would ever inflate an appraisal – much less commit a felony of extorting an appraiser to inflate an appraisal. The practice is unambiguous proof that the lenders’ controlling officers are leading an accounting control fraud. The warning is a superb example of how the fraudulent officers controlling the lenders deliberately generated a “Gresham’s” dynamic to suborn professionals (appraisers) to aid and abet their frauds. Given the frequency of the appraisal fraud and the frequency of secondary market sales it was also unambiguous that the same controlling officers had to be making fraudulent “representations (reps) and warranties” to sell the fraudulently originated loans to the secondary market.
OMB, however, rather than leading an emergency, top priority effort to end the criminogenic environment producing the fraud epidemics did the opposite. Indeed, the situation is actually worse than FCIC indicates, for the rival appraisal organizations began their efforts to warn the federal government in 1998. It took the rivals two years to settle on a common strategy (the petition) and a common text for that petition. The banking regulatory agencies all employed appraisers and one of the tasks assigned those appraisers was to keep abreast of the key issues in appraisals, so the Clinton administration’s anti-regulatory appointees knew no later than 1998 that an epidemic of appraisal fraud was growing.
The current financial crisis had its roots in the rapid expansion of the three “de’s” that began in 1983 when the Clinton/Gore administration made “Reinventing Government” its leading domestic policy initiative once the health care initiative collapsed. This began to sow the seeds of the current crisis.
The Clinton/Gore administration, however, was immensely fortunate in its timing. It inherited, due to the extraordinary regulatory scouring of the senior officers leading the financial control frauds that occurred under the first President Bush, the cleanest financial industry in history. Indeed, there was no historical parallel. More criminal prosecutions, removals and prohibitions, and civil suits were brought against elite financial leaders under the first President Bush than at any time in our history – and there is no era that comes close. I believe that more senior financial officers and their co-conspirators were subject to such governmental actions under the first President Bush than in all other years from 1950 to the present – combined. The data are not available to allow me to be definitive in this claim, but I believe I’m correct.
I’m making such a bold claim, despite the lack of definitive data, because I believe it is one of the critical dynamics that explains much of the purported “Great Moderation” and the timing of the current crisis. It takes time, in this case a full decade, for accounting control fraud to become endemic from a starting position of extraordinary success in removing the worst elements of the profession. It is no surprise that the strongest roots of the crisis, therefore, come from the virtually unregulated sectors of finance – mortgage bankers such as Ameriquest and its ilk, loan brokers, investment banking firms, and bank affiliates, and suborned professionals. This in turn produced the Gresham’s dynamic that spread the fraudulent lending practices throughout the more regulated realms of finance.
“Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share…. The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete” Miller, T. J. (August 14, 2007). Iowa AG.
As the Gresham’s dynamic kicks in the rate of growth in the frauds increases dramatically. The accounting control fraud “recipe” makes the frauds the ideal means of hyper-inflating a financial bubble. The saying in the trade is that “a rolling loan gathers no loss.” As the bubble hyper-inflates the lenders are able to (improperly) defer loss recognition for years by simply refinancing bad loans. This makes the timing of OMB’s release of the Circular in 2003 all the more troubling. The massive expansion in the three fraud epidemics that drove the crisis occurred from 2003-2006. Liar’s loans expanded by over 500% from 2003-2006 to roughly 40% of all home mortgage loans originated in 2006. They were the “marginal” loans that hyper-inflated the bubble even as conventional lending declined materially. Similarly, surveys of appraisers showed that between 2003 and 2006 the percentage of appraisers who reported that they had personally been subjected to efforts by lenders to extort them to inflate appraised values rose from 55 to 90 percent. These twin epidemics of fraudulent loan origination required an epidemic of fraudulent reps and warranties to sell the loans to the secondary market. This brings to mind two other words that are not contained in the Primer: “urgent” and “emergency.” One of the most vital concepts in effective regulation – the need to identify developing emergencies produced by criminogenic environments and react urgently by reregulation to dramatically reduce that criminogenic environment do not exist in the Primer.
At the moment (2003) the fraud epidemics that drove the most recent financial crisis were becoming pandemic OMB acted to make the financial industry even more criminogenic. The second President Bush destroyed his father’s legacy of successful financial regulation, enforcement, and prosecution. It ignored also the Enron-era epidemic of accounting control fraud.
It would have been a travesty for the Obama administration to continue the Bush administration’s unholy war on regulation had there been no epidemics of accounting control fraud driving the U.S. into a Great Recession that cost over 10 million jobs and $21 trillion in lost production.
Obama has kept in force Executive Order 12866 – an order that is hostile to regulation and should have been discredited by multiple financial crises resulting from the fraud epidemics caused by the three “de’s.” The Circular emphasizes the Executive Order’s absurd presumption that modern financial “markets” exist and could function well without the rule of law that can only be established through vigorous regulation, supervision, and enforcement. The Executive Order treats regulation and markets as dichotomous rather than as essential complements.
“Executive Order 12866 states that ‘Federal agencies should promulgate only such regulations as are required by law, are necessary to interpret the law, or are made necessary by compelling need, such as material failures of private markets to protect or improve the health and safety of the public, the environment, or the well being of the American people … .’”
The Primer thinks it is displaying optimal decision-making in passages such as this:
“Consistent with Executive Order 13563, section 4, an agency might consider flexible approaches that maintain freedom of choice. If, for example, an agency is considering banning the sale of a potentially unsafe product, it might consider instead requiring disclosure of health risks to the public.
Once an agency identifies the least burdensome tool for achieving its regulatory objective….”
This approach guarantees recurrent, catastrophic regulatory failure. A firm produces an unsafe product for one of three reasons. First, incompetence, which often leads to the firm not knowing that its design or production are defective – which means that they are not able to provide a warning. Second, the firm gains a competitive advantage over its competitors with integrity who do not produce unsafe products for sale to the public. Third, the firm is anti-purchaser control fraud that deliberately gains a competitive advantage over its competitors by misleading the consumers about quality.
In the case of incompetence the discovery by the regulator of the hidden defect is vital as is banning the product and sanctioning the manufacturer as a means of providing specific and general deterrence. In the case of lack of integrity and control fraud it is essential that the perverse advantages of producing and selling unsafe products be stopped by the regulators so that a Gresham’s dynamic is prevented. What does not work is trying to educate hundreds of millions of potential consumers about the reasons why the product is unsafe and the special steps that the consumer should take to reduce the risk of being maimed or killed by the product. Note that many unsafe products – think GM”s ignition system – endanger not only the purchaser but anyone driving the car and anyone driving at the same time and place when the inherently unsafe ignition system suddenly turned off the car’s electrical system. Without the electrical system the car was turned into an unguided ground missile that endangered the safety of everyone on the roads.
There is an immense literature on why information measures fail to protect consumers and investors. The validity of that literature was (again) proven in the most recent financial crisis. OMB remains immune to science that falsifies its theoclassical dogmas.
“Informational Measures. If intervention is contemplated to address a market failure that arises from inadequate or asymmetric information or poor information processing, informational remedies will often be preferred.”
OMB’s failure to understand the Gresham’s dynamic and the fact that consumers and investors typically do not optimize their purchases also leads it to demand that agencies use a quantification process in performing benefit-cost analysis that must inherently produce unreliable data that will typically systematically understate the benefits of the rule and overstate its costs.
OMB’s constant thrust is to achieve the least burdensome rule rather than the most effective rule – even when the issue is protecting consumers from being maimed and killed, saving over 10 million American jobs, or preventing over $21 trillion in losses in GDP.
The Madness of Econometrics and Financial Models
The refusal of OMB’s theocrats, including Obama’s theocrats, to learn even the most glaring answers demonstrated by the most recent crisis is demonstrated by the Primer’s treatment of econometrics and financial models. The econometric tests of the desirability of proposed regulations designed to stem an epidemic of accounting control fraud will always be disastrously wrong. These tests evaluate a proposed rule, e.g., to ban fraudulent liar’s loans, by looking at whether the lending practice is associated with increased reported profits (or higher stock prices, but they are largely driven by reported profits). The obvious problem, which we have known for 30 years – but which OMB refuses to recognize – is that whatever lending practices optimize accounting control fraud will have the strongest positive correlation with reported (fictional) profits.
The problem with models is that they assume there is an exogenous distribution of economic events. No one who knows anything about statistics (or economics or finance) believes this to be true. (The “Black Swan” author pretends that there is an exogenous distribution but that we have failed to count the really bad parts of distribution accurately. I am confident that if he was asked point blank whether he believes there is a fixed, exogenous distribution of economic events. The truth is that our policies shape the distribution of economic events.) If we continue to create ever more criminogenic environments we will suffer ever more catastrophic crises. In finance, the officers who develop and choose the economic models used to measure risk have powerful conflicts of interest. If they understate the risk of owing an asset – dramatically – the value of the model will assign a much higher “market” value to the asset. The officer, and his superiors’, bonuses will be significantly larger if the model inflates the market value. These deliberate modeling errors are massive. The deliberate model errors led to “toxic waste” (CDOs “backed” largely by fraudulent liar’s loans) being rated “AAA.” A rough approximation is that the models claimed that the toxic assets were worth twice their true value, so they claimed that assets worth about $1 trillion were worth $2 trillion. The roughly $1 trillion overstatement of toxic securities was a primary driver of the crisis.
The Primer is oblivious to both of these methodological disasters and blithely demands that agencies go down the same failed road. Note the subtle manner (“central scenario for the baseline”) in which OMB marginalizes financial crises – the paramount risk that should be driving our highest priority financial regulatory actions. OMB’s directives are (1) contrary to every principle of valuing costs and benefits and (2) systematically, and massively, understate the benefits of effective regulation.
“Calculate the benefits and costs associated with each scenario. Once the set of plausible scenarios has been specified, the agency can calculate the benefits and costs associated with each scenario. At this stage, the agency has all of the information it needs to conduct a sensitivity analysis. A sensitivity analysis examines how the benefits and costs of the rule change with key uncertain variables.
Construct a range of values. When the agency cannot specify probabilities for the relevant scenarios, the agency should develop a central scenario for the baseline and for each regulatory alternative that reflects the agency’s best estimate of the likely consequences of each regulatory alternative. The agency should use the benefits and costs of these best estimates to approximate the expected value of the benefits and costs of each regulatory alternative to use in its regulatory decision-making. The agency should also characterize ranges of plausible benefits, costs, and net benefits of each regulatory alternative.”
The fable that there is an exogenous distribution that would allow the (sensible) use of statistical techniques in financial regulation remains sacrosanct at OMB. The reality is that the agencies are forced to waste massive amounts of time producing faux econometric and statistical analyses that have crippling biases against effective regulation, which even more theocratic judges can then use to strike down any effective regulation.
Overall, the sick joke is that due to OMB’s dominance of cost-benefit analysis the fact that theoclassical economists were the primary architects of our three modern financial crises has led to them gaining ever greater, and more destructive power. The more incompetently OMB behaves and performs and the more crises it causes; the more power it gains to screw up the world.