By William K. Black
May 8, 2016 Kansas City, MO
N. Gregory Mankiw writes leading textbooks in economics that present neoliberal economic nostrums as economic “principles.” Mankiw wrote a column in the New York Times entitled “The Economy Is Rigged, and Other Presidential Campaign Myths.” The title reflects the central nature of his attack on Bernie Sanders explaining how the economy is rigged in favor of elite bank fraudsters. This first column in a series responds to Mankiw’s myths about the rigged financial system. The next column deals with Mankiw’s myths about the trade deals.
Mankiw misfires immediately because he does not even attempt to refute Bernie’s explanations of how finance is rigged. Instead, Mankiw conflates income inequality and the rigging of finance.
The economy is rigged.
To be sure, we live in challenging times. Meager growth and rising inequality have resulted in stagnant incomes for much of the working class and declining incomes for those with the lowest levels of education.
But to say that the economy is rigged, as Mr. Sanders and Mrs. Clinton have done, assumes that some small group of oligarchs planned this outcome. Clearly, the wealthy and powerful try to protect their interests, and they sometimes succeed. But the economy is a complex, decentralized system. Many outcomes are under no one’s control.
Bernie’s explanations of how the financial system is rigged, however, use conventional economics that people like me (one of his economic advisers) have long employed in our research. I will show that Mankiw is actually spreading rather than refuting myths about the rigged system. Mankiw’s own economic “principles” support Bernie’s explanation of why the financial system is rigged. In the second column I will show that the same is true of Mankiw’s myths about the trade deals which have next to nothing to do with “trade” and everything to do with rigging the system by attacking effective regulation.
Neoliberal Economic Theory Supports the Conclusion that Finance is Rigged
Oliver Williamson was awarded the Nobel Prize in economics in large part for his work on institutional economics. Once the absurd assumption of perfect, costless information (which implicitly defined fraud out of existence) was removed, the standard economic assumption of self-interested behavior became a nightmare for conservative economists. Williamson noted that self-interested behavior meant that business people and consumers would act “opportunistically.” Williamson explained that this meant that they would combine self-interest and “guile.”
While economists’ implicit assumption that fraud could not exist was, implicitly, eliminated by ending the assumption of perfect, costless information, economists are so crippled by their unacknowledged ideology that they continue to ignore fraud and use euphemisms such as “guile” and “opportunistic” behavior for fraud. Williamson rarely uses the word when he describes fraud. The passage below contains a barrage of euphemisms for fraud.
Economic agents are permitted to disclose information in a selective and distorted manner. Calculated efforts to mislead, disguise, obfuscate, and confuse are thus admitted (Williamson, 1996: 56).
Mankiw is a strong supporter of the view that CEOs will not only defraud customers, but defraud shareholders by looting the firm. “[I]t would be irrational for savings and loans [CEOs] not to loot.” “Mankiw morality” decrees that if you have an incentive as CEO to loot, and fail to do so, you are not moral – you are insane. Mankiw morality was born in Mankiw’s response as discussant to George Akerlof and Paul Romer’s famous 1993 article “Looting: The Economic Underworld of Bankruptcy for Profit.”
It follows that Mankiw must believe that CEOs have an incentive to lie, cheat, steal, and abuse and will rationally do so whenever they have the incentive and the ability to loot. Mankiw’s theories predict that CEOs will seek environments in which they can lie, cheat, steal, and abuse with impunity. White-collar criminologists term such an environment “criminogenic” and realize that such environments can produce epidemic levels of fraud. It also follows logically that Mankiw recognizes that CEOs of large firms will rationally use the firms’ enormous power to rig the system to create criminogenic environments. CEOs can and do make fraud epidemic by deliberately creating a “Gresham’s” dynamic (Akerlof 1970: bad ethics drives good ethics out of the industry or profession). The CEOs did so most obviously by extorting appraisers to inflate appraisals. Criminologists have demonstrated that these rigged systems and the resultant epidemics of elite fraud drive our recurrent, intensifying financial crises.
That brings us back to the key Mankiw myth about the non-rigged financial system.
[T]o say that the economy is rigged, as Mr. Sanders and Mrs. Clinton have done, assumes that some small group of oligarchs planned this outcome. Clearly, the wealthy and powerful try to protect their interests, and they sometimes succeed. But the economy is a complex, decentralized system. Many outcomes are under no one’s control.
The second clause of the first sentence is a strawman. There is no logical reason why a financial system can only be rigged by the actions of a “small group of oligarchs.” Indeed, the claim is bizarre coming from an economist who starts his textbooks with his purported “10 Principles.” Number four is:
People Respond to Incentives.
Behavior changes when costs or benefits change.
CEOs craft the incentive structure and “people respond to incentives” by changing their behavior to maximize their benefits (compensation and promotions) and minimizing their costs (being criticized or fired for refusing to change their behavior to that desired by the CEO. Each of the three fraud epidemics that drove the financial crisis was the product of financial CEOs looting the firm by changing incentives in ways that were totally perverse in terms of the interests of the financial firm. The goal was to cause “behavior changes” by employees, officers, agents (loan brokers), and outside professionals such as appraisers by creating a Gresham’s dynamic.
The behavioral changes the CEOs desired, pursuant to the “fraud recipe” for a lender or loan purchaser, were aimed at underwriters, loan brokers, appraisers, and customers. The CEOs’ goal was to cause each group to act the opposite of how they would normally act as honest bankers and brokers. The CEOs want to induce the massive overstatement of borrower income (via fraudulent liar’s loans) and appraised values (by extorting appraisers). The same perverse compensation incentives drove the third fraud epidemic – the sale of mortgages and mortgage product through fraudulent reps and warranties.
There is no dispute that the senior managers of the banks created – and maintained for years – powerful financial incentives to make loans that were fraudulent and had a dramatically higher probability of default – and loss upon default. Under Mankiw’s theories, financial CEOs understood the incentives they were creating and crafted them to change the employees, agents, and professionals’ behavior to optimize the fraud recipe and enrich the CEO.
We know empirically how extraordinarily effective these perverse incentives crafted by the senior managers were in producing endemic fraud. The incidence of fraud in liar’s loans was 90 percent (MARI 2006). By 2006, the percentage of appraisers who responded to surveys by stating that they had personally been subject that year to efforts to induce them to commit appraisal fraud was 90 percent. From 2006 through mid-2007, the percentage of reps and warranties that Clayton found to be false in secondary market loan sales was 46 percent – and Clayton was designed to be the easiest of graders.
Mankiw knows from Akerlof and Romer’s 1993 article, and the over 1,000 felony convictions in cases designated as “major” by the Department of Justice, that the savings and loan system was rigged by the criminal CEOs. He knows that the system was rigged by the corrupt CEOs in the Enron-era scandals. He knows that the system was rigged by the fraudulent CEOs to cause the three fraud epidemics that drove the current crisis as I just explained. Mankiw is (largely) right about incentives – he ignores whistleblowers and the tens of thousands of bank and broker employees that left their jobs rather than do the wrong thing and thousands of financial CEOs who remained ethical – and those are major omissions as the most recent crisis demonstrates.
Mankiw also knows that the system is rigged in myriad ways that go beyond the three epidemics of “accounting control fraud” that drove the crisis. He surely knows of the 50 billion pounds of “payment protection insurance (PPI) sold by banks to UK customers. This product was priced so outrageously that not a single policy would have been sold if conventional economic theories about consumer choice had any basis in reality. Similarly, in the United States, yield spread premiums (YSP) (and the same kind of abuses in car financing) were massive – and could not have existed under Mankiw’s mythical “principles.” By definition, YSP represents the ability of the bank or mortgage broker (or car salesman) to overcharge borrowers for their loans. Mankiw must know that YSP abuses frequently targeted blacks and Latinos.
There are numerous other scams in lending, including foreclosure fraud, aiding tax fraud, money laundering for mass murderers, kleptocrats, and drug groups such as the Sinaloa cartel, and violating sanctions on designed to prevent the funding of terrorists and nuclear proliferation. Banks also systematically rigged their check clearing operations to maximize “insufficient funds” fees.
Frauds and scams are common and massive in other industries. VW has admitted to committing 11 million frauds. Recalls on Takata’s defective airbags – defects its officers covered up – are now in the tens of millions. GM covered up product defects that posed a lethal risk and Mitsubishi falsified its reports on emissions from 1991 to 2016.
Mankiw is trying to suggest that people who realized that the financial system is rigged are conspiracy loonies who think there are a handful of bankers who meet periodically to “plan” how to rig the system. Again, an economist who stresses the critical importance of incentives (Mankiw’s purported Principle No. 4) and four other purported principles that collectively add up to proposition that people in private business act deceptively to optimize their income, Mankiw knows that he is presenting a second strawman argument. Bank CEOs do not need to meet and do not need to “agree” on a “plan” to commit control fraud and rig the financial system. Self-interest and optimization by CEOs would, under Mankiw’s (unprincipled) principles suffice to produce endemic control fraud.
Financial CEOs understand the accounting control fraud recipe. Following the recipe produces three “sure things” of “looting.”
- The firm will promptly report record (albeit fictional) profits
- The CEO will promptly be made wealthy by modern executive compensation
- The firm will eventually suffer severe losses
The CEO can implement each of the four “ingredients” of the fraud “recipe” for a lender (or loan purchaser) without outside help, agreement, or “plan.” The fraud recipe is easy to for any CEO to mimic.
- Grow like crazy by
- Making (buying) crappy loans at a premium nominal yield while
- Employing extreme leverage, and
- Providing grossly inadequate allowances for loan and lease losses (ALLL)
Any CEO that follows the recipe is guaranteed to promptly produce record (albeit fictional) reported income and (real) wealth for the CEO. Those exceptional (albeit fraudulent) reported profits and increase in wealth for the CEO will be covered in financial media and will be known immediately by other financial CEOs. Under Mankiw morality, any CEO who does not mimic the “first-mover” CEOs who begin popularizing the fraud scheme is “irrational.” Mankiw’s unprincipled principles predict that every CEOs will loot because they claim that CEOs are rational optimizers of their own wealth without any regard for morality or ethics.
Criminologists do not assume that every, or even most, bank CEOs will loot (unless a Gresham’s dynamic is created and persists). We do not view being ethical as being “irrational.” The point is that conventional economic nostrums would over-predict the incidence of control fraud by lenders and loan purchasers by predicting that such frauds would become universal. Conventional economists, however, due to their crippling ideology and lack of understanding of control fraud, invariably claim that it is absurd to think that control fraud could be material.
We can now dispose of the remaining Mankiw myths that he claimed proved the financial system is not rigged.
Clearly, the wealthy and powerful try to protect their interests, and they sometimes succeed. But the economy is a complex, decentralized system. Many outcomes are under no one’s control.
These two sentences again show that Mankiw’s myths are purely rhetorical in pursuit of his neoliberal ideology. They are not based on economics, logic, or data. Under Mankiw’s own theories, “the wealthy and the powerful” would not simply “try to protect their interests.” First, under Mankiw’s own theories many of “the wealthy and powerful” in finance became so by leading or aiding control frauds. Second, under Mankiw’s own theories they would not simply seek to “protect” their wealth and power – they would seek to maximize their wealth and power. The optimal way to maximize their wealth and power is to rig the financial system. Wealth and power are precisely the resources that make it possible to successfully rig the system.
Control fraud by CEOs causes such extraordinary harm precisely because the CEO has unique power. As I explained above, financial CEOs can use their unique power to cause the lender or loan purchaser to operate under the fraud recipe. Because the fraud recipe provides the three “sure things,” financial CEOs and elites that aid their frauds will not “sometimes succeed” – they will succeed. They will succeed not in “protect[ing]” their wealth and power, but in greatly expanding their wealth and power.
The last sentence of Mankiw’s myth further refutes his assertions. The fact that “many outcomes are under no one’s control” makes the “sure thing” of rigging the system all the more attractive. The fact that “many” strategies lack any guarantee of substantially expanding the financial CEO’s wealth and power makes the control fraud strategy optimal under Mankiw’s own principles of optimization under conditions of Mankiw morality in which good ethics by a CEO is “irrational” if the CEO can use the fraud recipe to loot “his” firm.