The Urgent Need to Save Orthodox Economists from their Crippling Myths

William K. Black
February 29, 2016     Brooklyn, N.Y.

A blogger has trolled all heterodox economists as believers in the “occult.”  More precisely, he is upset about “econ people” (who are likely not economists) and who tweet him or post comments on his blog site.  The blogger further complains that these commenters say that they believe in heterodox economics and “new methodologies [that] are poised to topple mainstream economics.”  He then goes on to say:  “My typical response is to ask what these new methodologies are. But incredibly, I can almost never get an answer.”

The UMKC economics department is chock full of heterodox economists who share the blogger’s experience.  We too get weird blogs and tweets that are long on revolutionary conclusions and short on specifics.  Some of these messages come from folks who say they are heterodox and some from those that write to denounce heterodox economics.  We also get an endless stream of policy nostrums from orthodox economists that promise to transform America (in good ways).  They have, collectively, transformed America in terrible ways.

The blogger summarizes his complaint in this paragraph.

So far, the main “heterodox” econ “schools” – Post-Keynesian, MMT, and Austrian – show every indication of having no new methodology whatsoever. Anyone who points this out will, of course, be greeted with a shower of insults from ardent followers of this “school”. But when polite, patient requests for enlightenment and information have failed enough times, what else can we conclude?

The blogger conflated “new methodology” with “heterodox.”  He provides no rationale for conflating those concepts, so the entire denunciation of heterodox economics wilts upon examination.  My colleagues and I use conventional research methodologies to reach predictions and policy recommendations that vary greatly from orthodox economists, and we win hands down in predictive abilities because of the soundness of our use of conventional research methodologies.

I have explained this many times in posts that are not behind pay walls (which the blogger understandably complains about).  My colleagues have provided scores of detailed posts on MMT that are freely available.  None of the bloggers examples relate to us.  “Ardent followers” are, of course, beyond any scholar’s control.  The kind who “shower” with “insults” “polite” requests for information are acting badly and need to be barred.  All bloggers face this problem and we never blame orthodox scholars for the insulting actions of their “ardent followers.”

I have personally had a perfectly collegial exchange in person with the blogger at a conference where I made a presentation complete with lots of slides.  Anyone can have a copy of my slides without charge.  My work rests on very old research methodologies that one is taught in a doctoral research methods class in almost every social science – except economics.  Economists are often trained almost exclusively about a tiny subset of research methods – econometrics (a subset of statistics).  In any event, the keys to sound research remain predictive ability, logical consistency, and hypothesis testing.

For the sake of brevity, I will describe only a few examples of the heterodox implications of sound, conventional research methodologies that I employ.  As a savings and loan regulator, my office “autopsied” every failure beginning in late 1984 to look at what was contributing to their failures.  At this time, orthodox economists “knew” that the failures were due to “gambling for resurrection.”  They also “knew” that our reregulation and re-supervision of the industry was a terrible mistake and that we should be encouraging further deregulation.  They described “gambling for resurrection” as a product of “moral hazard” and they claimed that our reregulation was absurd on the basis of econometric studies that found that the S&Ls that invested most heavily in the assets we proposed to restrict reported the highest profits.  They recommended that we encourage such “profitable” investments.

Our autopsies revealed a number of patterns that proved critical to our analysis, predictions, and policy prescriptions.  For the sake of brevity I will not define here terms I have explained in hundreds of blogs, articles, and slides.  As I noted, the blogger has heard me present and define the terms.  First, we came to understand that the S&Ls were “control frauds.”  Second, we found that “accounting” was the “weapon of choice” in finance – we were dealing with “accounting control frauds.”  Third, we realized that accounting control fraud had become epidemic.  Fourth, we realized that the control frauds were so numerous and concentrated (by asset type, commercial real estate loans (CRE) and geography) and growing so quickly that they were hyper-inflating regional real estate bubbles in the Southwest.  Fifth, we identified the four “ingredients” of the fraud “recipe” for a lender.  Sixth, we recognized that the CEOs running control frauds ran them for their personal benefit, by looting the S&L.  Seventh, we recognized that firms following the fraud recipe were mathematically guaranteed to report record (albeit fictional) profits.  Eighth, we realized the truth of the industry saying: “a rolling loan gathers no loss.”  Ninth, we identified the recurrent scams by which S&L control frauds, individually and collectively, transmuted massive losses into fictional gains.  Tenth, we realized that the CEOs running accounting control frauds were routinely able to suborn supposed “controls” by using the ability to hire, fire, and expand the engagement (in the case of outside auditors and counsel) to generate a “Gresham’s” dynamic (Akerlof 1970).  Eleventh, we realized that the accounting control frauds had a great “tell” – they had to gut their underwriting and internal controls to follow the first two ingredients of the fraud recipe.  Twelfth, we saw that the fraud recipe created an Achilles’ “heel” – the need for extreme growth, so we adopted a rule limiting growth.

These insights, in turn, led us to realize that orthodox econometric analyses that purported to evaluate the desirability of S&Ls investing in particular asset categories would produce the worst possible policy recommendations.  Whatever asset categories best facilitated accounting fraud would show the strongest association with higher profits (or stock prices) in the early years.  The massive losses would only appear years later.  We, therefore, ignored Lincoln Savings’ experts (Alan Greenspan and Daniel Fischel) and sharply limited direct investments.  Every S&L in the entire group of roughly 34 S&Ls that made heavy direct investment that had been praised by Charles Keating’s experts because those S&L reported far higher profits than the industry average soon failed.  We openly targeted the S&Ls reporting the highest profits for priority in examinations.

We also realized the importance of the concept of a criminogenic environment and the implications for the invalidity of financial models that assume and exogenous distribution.  Any criminologist realizes that crime can become endemic if we shape sufficiently perverse incentives.  Again, this fact along with the perverse incentives to game the models to overstate asset values in order to maximize compensation, explains the horrific failures of the pricing and risk models in most recent current crisis.

George Akerlof and Paul Romer, in their classic 1993 article entitled “Looting: The Economic Underworld of Bankruptcy for Profit,” stressed the success of these heterodox analyses.

Neither the public nor economists foresaw that the [S&L deregulations] 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.

Similarly, we demonstrated that S&Ls did not act as economists assumed to engage in (legal) “gambling for resurrection.”   First, the pattern of reported returns made no sense for honest but ultra-high risk “gamblers.”  Why would they all report in the near term extraordinary profits – followed invariably by catastrophic losses even in markets with booming economies?  Second the pattern of behavior – particularly the destruction of underwriting – made no sense for an honest gambler that only profits if the gamble succeeds.

“[S]omeone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending: maintaining reasonable documentation about loans … verifying information on loan applications…. applications”5

5Black (1993b) forcefully makes this point.

(Akerlof & Romer 1993: 5).

Note how Akerlof and Romer stressed their agreement with my “forceful” point that what would eventually became known as “liar’s” loans would “never” be made by honest lenders.  Note also that orthodox economists not only ignored Akerlof and Romer’s warnings but also their hopes that they might “learn from experience.”  Instead, economists today “know” that the S&L debacle was caused by “gambling for resurrection” and deposit insurance.  (That was another area in which our heterodox analysis and predictions proved superior when the Enron-era scandals were driven overwhelmingly by accounting control frauds by firms that lacked deposit insurance or any other implicit or explicit government guarantee.  As we predicted, lenders did not provide effective private market discipline.  Instead, they eagerly funded the massive growth and leverage of the Enron-era frauds that, for years, reported epic profits.)

The story is similar in MMT, but I will leave that to my colleagues.  They started by actually understanding the real world monetary system just as we made the “investment” to understand the real world of S&Ls.  The results for MMT scholars have been markedly superior predictive ability and considerable respect in the professional investment community.  The blogger will agree that orthodox macro models are a travesty when it comes to money, banks, and finance.

I don’t see any actual dispute among the blogger and UMKC’s economists.  His column strikes me as a made up quarrel based on the obviously phony premise that heterodox scholars invented some secretive methodology that they (whoever “they” are) have refused to provide him without charge.

We urge economists of any label to push to cease to ignore critical economic principles that our examiners had figured out by 1983.  Top of that list would be control fraud.  It is shameful that prominent economists such as the Richmond Fed’s Research Director, Kartik Athreya, still repeat these multiple myths falsified three decades ago as if they were revealed truths not requiring the refutation of a Nobel Laureate, the findings of regulators, over a thousand successful felony prosecutions, or the Nation’s top white-collar criminologists (2013: 335-336).

“An unfortunate side effect of the introduction of deposit insurance is that it creates a principal-agent problem.  Namely, if depositors do not care about the health of a bank (and why would they, if they are insured?), then they will fund its activities irrespective of the ownership stake held by the present management.  This can create tremendous difficulty in bad macroeconomic times.

The savings and loan crisis of the late 1980s, followed by the recent recession, drove many banks and S&Ls to the brink of worthlessness, setting up a toxic dynamic in which the very thing that was supposed to render banking safe made the rest of society far less so.  [Deposit insurance leads CEOs to] “gamble for resurrection by picking long-shot projects which, if they succeeded, would enrich the owners”  “This irresistible setup has led in the past to great damage and misallocation of resources.  For this reason, deposit insurance, while crucial to any firm that looks like a DD [Diamond Dybvig] firm, needs oversight.  It is why all modern societies at least try to regulate banks.”

Each of those quoted sentences is false.  Athreya isn’t trying to be malicious, he is simply illustrating the sad state of orthodox economics, which needs to be rescued by people of good will.  This is not a classic left v. right debate.  The orthodox economics world of the “New Democrats” chants the same long-falsified myths with the same absence of any supporting citation or reasoning that could pass the most elementary test of logic in hypothesis testing. The Council of Economic Advisers (CEA) issued a remarkably similar clunker under President Obama (2010: 159, 169).

Although the system of regulation put together during the Depression served us well for many years, warning signs appeared periodically. The savings and loan crisis of the late 1980s and early 1990s showed how banking regulation itself can have unintended consequences. At that time, deregulation coupled with generous deposit insurance combined to create a dangerous pattern of risk-taking that eventually led to a large Federal bailout of the financial system.


A constant tension in macroprudential regulation is that the attempt to prevent bank runs can itself lead to new forms of moral hazard. Because they have deposit insurance, small depositors no longer need to monitor the safety of their banks; therefore, unless regulators are watching carefully, the banks may take excessive risks with no fear of losing deposits. This latent problem was exacerbated during the 1980s by deregulation in the thrift industry. Following this deregulation, thrift institutions began aggressively seeking out deposits by paying ever-higher interest rates and then intermediating these deposits into speculative investments. This strategy allowed thrifts to use FDIC insurance to gamble for solvency, and when the investments failed, a wave of thrift failures swept through Texas, the Midwest, and New England in the 1980s and early 1990s. This wave, now known as the savings and loan crisis, represented the first significant increase in bank failures since the Great Depression. The failures, it should be noted, were not caused by bank runs—they were not driven by a liquidity mismatch between deposits and loans. Deposit insurance remained intact, and no insured deposit lost any money. Rather, the bank failures were caused by the insolvency of the banks, as they gambled and lost with (effectively) government money.

Note that the fraud epidemic that drove the S&L debacle disappears from both accounts by orthodox economists without any need to explain the bowdlerization of history.  Not every sentence in the CEA excerpts I quoted contains a false statement, but nearly every sentence fails that test.  Again, I am not suggesting they are out to do harm, but I cannot imagine a field other than economics in which scholars in that field would ignore the work of a Nobel Laureate (and the regulators, criminologists, and criminal justice system) that explains why the claim they are repeating is false.  Orthodox economists have a primitive tribal taboo against using the “f” word (fraud).

The failure to understand the role of epidemics of accounting control fraud in driving each of our three modern financial crises is not a small failure of orthodoxy, it should be viewed as a crisis that endangers the global economy.  We should all be working together urgently to repair that failure, which will require a multi-disciplinary and multi-methodological effort.  Some of us have been trying to do this for decades.  We hope the blogger will join us in that ongoing effort.  Your fears that you need to learn a newly invented, secret and “occult” methodology in order to practice effective economics are baseless.  Reading Akerlof and Romer (available free on line) and some of our hundreds of freely available articles is a good start.

33 responses to “The Urgent Need to Save Orthodox Economists from their Crippling Myths