Tag Archives: criminogenic

The City of London continues to drive the criminogenic regulatory race to the bottom

By William K. Black
(Cross posted at Benzinga.com)

Two years ago, I wrote an article entitled “The Bank of England Sows the Seeds of the Next UK Crisis.”

I was not vain enough to believe that the British establishment would listen to my critique.  The books authored recently by Jeff Connaughton, Neil Barofsky, and Sheila Bair have made clear that the dominant strategy of the Bush and Obama administrations has been providing aid and comfort to the banksters who drove the crisis rather than holding them accountable for their crimes.  The Brits are following the same dominant strategy.

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Fiat Justitia? Breuer fires blanks on elite financial frauds

By William K. Black

Beurre blanc is the classic white butter sauce of France.  Americans who hate the French claim that they became adept at saucing to cover up the rot in their meat in earlier times.  A beurre blanc does not remove the rot.  It masks the bad taste and the bad color of bad meat.  Indeed, the sauce makes the dish even less healthy.  If the rotten meat doesn’t get you, the sauce’s cholesterol will.

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Too Big To Jail

In a recent article (9/8) at Huffington Post, NEP’s William Black  provides support as to why Wall Street executives should face criminal charges relating to the financial crisis.


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.”

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Mankiw’s Ode to the Governmental Competition that Made Romney Wealthy

By William K. Black
(Cross-posted from Benzinga.com)

This is the second part of my discussion of N. Gregory Mankiw’s column asserting that governmental competition is desirable for the same reason that private competition is.  Mankiw was Chairman of President Bush’s Council of Economic Advisors from 2003-2005.  He was one of the principal architects of the perverse incentive structures that proved so criminogenic and drove the ongoing financial crisis.  He gave no useful warnings of the necessity for containing the developing crisis – even after the FBI’s September 2004 warning that mortgage fraud was become “epidemic” and would cause a financial “crisis” if it were not contained.  He is now Mitt Romney’s principal economic advisor.  His column favors the “competition” argument that led him to support crippling financial regulation even as private sector competition led to endemic fraud.  Mankiw is a moral failure as well as a failed economist.  His infamous response to Akerlof and Romer’s 1993 paper (“Looting: the Economic Underworld of Bankruptcy for Profit”) was that it would be “irrational” for CEOs not to loot “their” corporations.  He ignored all of the prescient warnings we made about how accounting control fraud drove our crises and he continues to ignore those warnings and the reality of our recurrent, intensifying financial crises.  He wants the U.S. to move even more rapidly downward in the “competition in regulatory laxity” that is driving those crises.

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Wall Street’s Broken Windows

By William K. Black

James Q. Wilson was a political scientist who often studied the government response to blue collar crime. The public knows him best for his theory called “broken windows.” The metaphor was what happens to a vacant building when broken windows are not promptly repaired. Soon, most of the windows in the abandoned building are broken. The criminals feel little compunction against petty destruction because the building’s owners evince no concern for the integrity of their building. Wilson took social norms, community, and ethics seriously. He argued that as community broke down fewer honest citizens were active in monitoring and policing behavior. The breakdown in community was criminogenic – it led to widespread serious blue collar crime. He urged us to take even minor blue collar crimes and breaches of civility seriously and to demand that they be contained through social pressure and policing.

New York City’s police strategy embraced “broken windows.” The police increased the priority with which they responded to even minor offenses that upset the community – “squeegee men,” graffiti, and street prostitution. Reported blue collar crime fell in New York City. It also fell sharply in most other cities, which did not implement “broken windows” programs, but Wilson and the NYPD got the credit and popular fame for the sharp fall in reported blue collar crime in New York City. Wilson became one of the most famous blue collar criminologists in the world.

Wilson’s broken window theory remains controversial among many blue collar criminologists. As a celebration of his life and research I offer this discussion of applying “broken windows” theory and policies to elite white-collar crime.

Wilson was strongly conservative. His research focus in criminology was almost exclusively blue collar crime. That was a shame because “broken windows” theory is most compelling in the context of elite white-collar crime and because the application would reveal interesting twists in the theory’s potential. Such an application, however, would have been outside Wilson’s comfort zone. Wilson tended to use the word “crime” to refer exclusively to blue collar crime and his emphasis was on very low status criminals. In a book entitled, Thinking About Crime, Wilson argued that criminology should focus overwhelmingly on low-status blue collar criminals.

This book [does not deal] with “white collar crimes”…. Partly this reflects the limits of my own knowledge, but it also reflects my conviction, which I believe is the conviction of most citizens, that predatory street crime is a far more serious matter than consumer fraud [or] antitrust violations … because predatory crime … makes difficult or impossible maintenance of meaningful human communities (1975: xx).

I am rather tolerant of some forms of civic corruption (if a good mayor can stay in office and govern effectively only by making a few deals with highway contractors and insurance agents, I do not get overly alarmed)…. (1975: xix).

Notice that Wilson’s explanation is antithetical to his “broken windows” reasoning. There are, of course, relatively minor white-collar crimes. Wilson emphasized that it was the willingness of society to tolerate relatively minor blue collar crimes that led to social disintegration and epidemics of severe blue collar crimes, but he engaged in the same willingness to tolerate and excuse less severe white collar crimes. He predicted in his work on “broken windows” that tolerating widespread smaller crimes would lead to epidemic levels of larger crimes because it undermined community and social restraints. The epidemics of elite white collar crime that have driven our recurrent, intensifying financial crises have proven this point. Similarly, corruption that is excused and tolerated by elites is unlikely to remain at the level of “a few deals.” Corruption is likely to spread in incidence and severity precisely because it undermines community and the rule of law and it is likely to grow more pervasive and harmful the more we “tolera[te]” it.

“Broken windows” theory, in the white collar crime context, would lead us to make the prevention and deterrence of consumer frauds and anti-trust violations through prosecutions a high priority because of their tendency to produce a “Gresham’s” dynamic in which businesses or CEOs that cheat gain a competitive advantage and bad ethics drives good ethics out of the markets. These offenses degrade ethics and erode peer restraints on misconduct.

The ongoing crisis demonstrates that anti-consumer frauds are a direct assault on community. Mortgage fraud – and it was overwhelmingly the lenders and their agents who put the lies in millions of liar’s loans – physically and socially destroy community by producing mass defaults, homelessness, and vacant homes.

Taking Wilson’s “broken windows” reasoning seriously in the elite white collar crime context would require us to take a series of prophylactic measures to restore integrity and strengthen peer pressures against misconduct. Indeed, we have implicitly tested the applicability of “broken windows” reasoning in that context by adopting policies that acted directly contrary to Wilson’s reasoning. We have adopted executive and professional compensation systems that are exceptionally criminogenic. We have excused and ignored the endemic “earnings management” that is the inherent result of these compensation policies and the inherent degradation of professionalism that results from allowing CEOs to create a Gresham’s dynamic among appraisers, auditors, credit rating agencies, and stock analysts. The intellectual father of modern executive compensation, Michael Jensen, now warns about his Frankenstein creation. He argues that one of our problems is dishonesty about the results. Surveys indicate that the great bulk of CFOs claim that it is essential to manipulate earnings. Jensen explains that the manipulation inherently reduces shareholder value and insists that it be called “lying.” I have seen Mary Jo White, the former U.S. Attorney for the Southern District of New York, who now defends senior managers, lecture that there is “good” “earnings management.”

Fiduciary duties are critical means of preventing broken windows from occurring and making it likely that any broken windows in corporate governance will soon be remedied, yet we have steadily weakened fiduciary duties. For example, Delaware now allows the elimination of the fiduciary duty of care as long as the shareholders approve. Court decisions have increasingly weakened the fiduciary duties of loyalty and care. The Chamber of Commerce’s most recent priorities have been to weaken Sarbanes-Oxley and the Foreign Corrupt Practices Act. We have made it exceptionally difficult for shareholders who are victims of securities fraud to bring civil suits against the officers and entities that led or aided and abetted the securities fraud. The Private Securities Litigation Reform Act of 1995 (PSLRA) has achieved its true intended purpose – making it exceptionally difficult for shareholders who are the victims of securities fraud to bring even the most meritorious securities fraud action.

The Supreme Court has held that banks and other entities that aid and abet securities fraud are immune from suit by the victims of securities fraud. Only the federal government may sue those that aid and abet fraud. The federal government has cut the number of financial fraud prosecutions by over one-half over the last twenty years even as financial fraud has grown massively. No elite CEO leading a control fraud that helped drive the current crisis has even been indicted. Elite CEOs can defraud with near impunity and become wealthy. Elite white collar fraud is a “sure thing” – the only strategy likely to make a mediocre CEO wealthy and famous.

Because Wilson did not research elite white collar crimes he did not direct his formidable intellectual energies and expertise to the study of who could prevent the breaking of corporate windows and repair those that were broken. This was a great loss because his studies of varieties of police behavior in response to blue collar crime are justly famous among criminologists. The central truth he would have quickly recognized had he thought of seeking to reduce elite white collar crimes is that only the financial regulators can serve as the “regulatory cops on the beat.” The police do not deal with elite white collar crimes. A small cadre of FBI special agents works on elite white collar crimes. There are roughly three special agents assigned to white collar crime investigations per industry in the U.S., so they never “patrol a beat.” They investigate only when someone brings a possible white collar crime to their attention. That means whistleblowers, but it overwhelmingly means criminal referrals from the federal financial regulators. Financial institutions may make criminal referrals against their customers, but they will virtually never make them against their CEOs. Only the regulators can make the thousands of criminal referrals against elite white collar criminals essential to a successful prosecutorial effort against the epidemics of accounting control fraud that drive our worst financial crises. In the lead up to the ongoing crisis we gutted the federal regulators, preempted the state regulators, and appointed anti-regulators to head the agencies. A majority of the U.S. House of Representatives is trying to further gut the Commodities Futures Trading Commission (CFTC). If we want to stop the criminals who are destroying our economy and our communities by breaking windows on an epic scale the first step is to rebuild a regulatory force committed to serving as the essential “cops on the beat.”

I listened in stunned amazement to the presentations of law professors who specialize in white collar crime and securities law at the two annual meetings that followed the ongoing financial crisis. Virtually every speaker in these sections presented arguments calling for reducing white collar criminal liability and liability for securities fraud. At the time they were speaking, the Justice Department had already ceased prosecuting major firms and the SEC brought a pathetically high percentage of its small number of enforcement actions against tiny firms with fewer than 10 employees.

We have systematically reduced effective peer restraints in our most important controls against financial fraud. Law firms, audit firms, and investment banks used to be professional partnerships. Each partner was potentially liable for any firm misconduct, which maximized the incentive to insist on higher levels of integrity. These firms are now virtually all corporations or limited liability partnerships. The incentive of partners to monitor other partners’ actions to ensure their integrity has largely been lost.

In the elite white collar crime context we have been following the opposite strategy of that recommended under “broken windows” theory. We have been breaking windows. We have excused those who break the windows. Indeed, we have praised them and their misconduct. The problem with allowing broken windows is far greater in the elite white collar crime context than the blue collar crime context. The squeegee guys make tiny amounts of money and are hated and politically powerless. The mediocre financial CEO who engages in accounting control fraud because it is a “sure thing” causes the bank to report record (albeit fictional) profits and becomes wealthy and politically powerful. He uses his wealth to make charitable and political contributions that make him far harder to sanction. He claims that any crackdown on him is “class warfare” by “neo-Bolsheviks.” Incredibly, the Wall Street Journal continues to serve as the cheerleader and apologist for those who become wealthy by breaking windows, communities, and economies.

Wilson warned of blue collar “super predators.” He called them “feral” – wild animals. These criminals are in fact dangerous, but they are odd candidates for the title of “super predators.” Wilson noted that they were disproportionately black and that they were confined almost entirely to the poorest neighborhoods in America where their pickings are poor. Accounting control frauds occupy Wall Street and other financial centers – the richest neighborhoods in the world. Their “take” from fraud is extraordinary. The blue collar criminals that occupied Wilson’s attention late in his career were politically and socially powerless. The fraudulent CEOs that drive our recurrent, intensifying financial crises are wealthy and socially and politically dominant.

Wilson had a fabulous career and added greatly to the policy debate about how to respond to blue collar crime. Our most fitting tribute to him and contribution to his legacy would be to apply his “broken window” theory to the elite white collar crimes and criminals that drive our financial crises. The troubling paradox is that the strongest proponents of “broken windows” theory and policies in the blue collar crime context are the strongest opponents of applying analogous policies in the elite white collar crime context. The Wall Street Journal is the most prominent example of this class-based incoherence.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.

Follow him on Twitter: @WilliamKBlack

Mark Steyn’s Ode to Criminogenic Environments

By William K. Black
(Cross-posted from Benzinga.com)

This column was prompted by listening to Mark Steyn (an ultra right writer) giving a C-SPAN talk on his new book that asserts that America has destroyed itself and will be superseded soon by China. Steyn is best known for his fear of a Muslim takeover of Europe. (During the C-SPAN talk he warned that the “Mullahs of Dearborn” had created “Michiganistan.” I grew up in Dearborn, Michigan, so perhaps I am agent of this dread conspiracy that has subjugated one of our states – and cleverly disguised its takeover by radical Islamic agents by electing conservative Republicans to run the state.)

Steyn’s contradictory concerns are that the United States government borrows too much money and spends too little on the military and too much on education. (He opines that university educations are a “waste” for “most” college students. Again, I may be an agent of this evil conspiracy to educate our kids.) He was a strong supporter of our recent invasions. He expressed his distress that the U.S. military was not leading the war in Libya. Under Steyn’s view of how financial systems work, those invasions were financed primarily by issuing large amounts of debt and were major contributors to what he terms a “debt catastrophe.” Indeed, he emphasizes his support for the massive amount of money that the U.S. spends on its military even when we are not a war – roughly the same amount as the rest of the world combined. He also claims that Western Europe is able to fund its generous social programs because they are “free riders” on the U.S. military. In other words, he argues that military spending limits U.S. growth and increases Treasury debt – and we should expand our spending and our invasions. His views are logically incoherent.

Steyn claims that he is most concerned about “wealth that is not yet created.” That is an excellent concern, one that competent economists stress. It is a concern that has virtually disappeared, however, in the context of the budget deficit games. We have roughly 25 million Americans that want to work full time but cannot do so because of the Great Recession. Their potential productivity is the quintessential example of “wealth that is not yet created” – the thing Steyn purports to find most distressing. Keeping twenty-five million Americans who want to work full time unemployed and underemployed constitutes the definition of “waste” and the gratuitous destruction of “wealth that has not yet created.” The waste and destruction of wealth are pointless – there is no benefit. The waste and damage are far broader than economic. Unemployment damages people, particularly adults, and communities. We can end all but a small residual of transitional unemployment any time we choose to do so. Doing so would shorten the Great Recession and greatly reduce its damage.

It is deficit hawks like Steyn, however, that keep us from creating the “wealth that is not yet created.” Steyn can’t understand that the primary reason that the deficit rose sharply was because of the Great Recession. Steyn is so unaware of economic theory that he wants the U.S. to adopt pro-cyclical policies that would have made the Great Recession far worse. He also thinks that governments with sovereign currencies are just like households when it comes to their debt. Worse, he thinks budget deficits are “moral” issues rather than financial issues. “It’s not a spending crisis, it’s a moral one.” “We are looting the future to bribe the present.”

There is a moral component to this crisis and “looting” is the key. George Akerlof and Paul Romer captured the component in the title of their famous 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”). There are real looters out there, running many of our largest financial institutions. Their frauds hyper-inflated the financial bubble and drove the Great Recession. Running a deficit in a recession is not “looting.” Balancing a budget during a recession is insanely pro-cyclical. In 1937, when President Roosevelt made the grave mistake of listening to his conservative economic advisors and tried to balance the budget the policy through the U.S. back into the worst of the Great Depression.

Steyn is correct that the core of the real moral crisis is that we are “… absolving the citizenry for responsibility from their actions.” The citizens we are absolving are the perpetrators of the looting. The CEOs running the “control frauds” are not being prosecuted. They simultaneously caused catastrophic losses and profited enormously from their frauds (“bankruptcy for profit”). Steyn explicitly warns about the damage that elite frauds do to a nation, stressing “the fragility of civilization.” He claimed that the U.S. was about to become a Latin American nation entrenched in crony capitalism characterized by a wealthy, corrupt elite and vast numbers of the poor. He is correct that this crisis both represents and causes “the diversion of too much human capital into wasteful and self-indulgent activity.” The CEOs that run control frauds cause enormous, inefficient diversion of capital to the least productive investments and do so for the most self-indulgent reasons and in the most indulgent manner. They gloried in their toys, the private jets and many luxury cars. In a nation with a grave shortage of citizens with expertise in mathematics and the hard sciences we took many of our top graduates and made them financial “quants.” The quants, acting in accordance with the perverse financial incentives that the senior officers created, destroyed wealth. The full opportunity cost of diverting quantitative experts from science to aiding fraudulent finance includes the scientific research opportunities foregone. Steyn claims that college is a “waste” for “most” people who attend, but I’m one of the millions who are alive because of health research by university-trained scientists.

Steyn, however, is again a major part of the problem. He is notorious for his defense of the CEOs found guilty of running control frauds, i.e., his friend and fellow Canadian Conrad Black (no relation to me). Rather than holding these elite frauds accountable, Steyn is one of the leaders in the effort to allow them to loot with impunity. As Akerlof explained in his classic 1970 article on a market for “lemons,” fraud can create a “Gresham’s” dynamic in which markets become powerfully perverse. When frauds prosper, bad ethics drives good ethics from the marketplace. It is imperative that regulators serve as the regulatory “cops on the beat” to ensure that the frauds do not prosper and prevent economic catastrophe. Steyn is a virulent opponent of effective financial regulation. In his talk, he expressed no concern over the fraudulent elites extracting billions of dollars in wealth from creditors and shareholders. His rage was addressed to schoolteachers. Ignoring the trade-off they made between receiving lower salaries but superior pensions, Steyn focuses solely on the pensions received by public workers and claims that they are outrageous. He does not explain why his outrage is reserved for the little people, and only for the one portion of their compensation that is not sub-market.

The U.S. followed Steyn’s anti-regulatory policies for years, creating the criminogenic environment that produced our recurrent, intensifying financial crises. The three “de’s” – deregulation, desupervision, and de facto decriminalization – that led to the current crisis disappear in Steyn’s telling of the tale. Instead, he claims: “We see an unprecedented transfer of resources from the productive class to the obstructive class – to government, to regulators, to bureaucracies.” “We are redistributing liberty.” “Law has been supplanted by regulation.” Many of the regulators are “to the left of either party.” They U.S. is engaged in unprecedented, “hyper-regulatory direct rule….”

The reality is that the financial regulatory agencies, for decades, have been led overwhelmingly by conservative business people who are reflexively opposed to regulation. There are exceptions, but Steyn is correct that our financial policies are “rule[d] by a monopoly of ideas.” That monopoly is the opposite of the one Steyn fears – it is the neoclassical economics and modern finance idea that markets are efficient and automatically exclude fraud and that regulation is therefore unnecessary and harmful.

Steyn appears to assume, contrary to fact, that the CEOs of the financial firms are the “productive class.” He contrasts them to President Obama: “We entrusted a multi-trillion dollar enterprise to a guy who has never created a dime of wealth in his life and then we were surprised that for some reason it did not work out.” Let’s recall reality. We entrusted the U.S. government to President Bush. As a serial failure as an oil executive, our nation’s first MBA president destroyed wealth. He was repeatedly bailed out and ultimately made wealthy by political opportunists. As President, he destroyed staggering amounts of wealth and life. The CEOs of the nonprime lenders and investors destroyed massive amounts of wealth (roughly $10 trillion) – and were made personally wealthy because they did so.

But for the bailout by the U.S. government, the financial system would have collapsed. Steyn praised Americans as unique. Nearly all other Western nations experienced major protests demanding that the government take on the elite bankers, but in the U.S. the Tea Party protests were funded by the most conservative business factions and the protests demanded that the government adopt those factions’ anti-regulatory agenda. Steyn claimed that the Tea Party message was that they would be just fine if only the government were to do nothing in response to the crisis. That message is false as a matter of economics. Only the government was able to protect the Tea Party members from alling into a depression. Individuals cannot protect themselves effectively from a Great Depression or a Great Recession.

Steyn concluded his substantive argument with these words.
“I quote Milton Friedman: ‘don’t elect the right people to do the right things, create the conditions whereby the wrong people are forced to do the right things. There should be nothing controversial [about that statement].’”

What Steyn fails to understand is that Friedman’s point refutes Steyn’s anti-regulatory thesis. Friedman was simply making the fundamental point of economics – focus on the incentives and ensure that they are (1) powerful and (2) prevent perverse behavior. Control fraud both arises from and causes intense, perverse incentives. Fraud begets fraud. Accounting control frauds deliberately create perverse Gresham’s dynamic to spur fraud within their product line and create criminogenic environments that produce “echo” fraud epidemics in related fields. The CEOs of the lenders that specialized in making fraudulent nonprime loans, for example, used their ability to hire, fire, and compensate to create these perverse incentives among appraisers, loan brokers, loan officers, and credit rating agencies. Note that this allowed the fraudulent CEOs to suborn “controls” into their most valuable fraud allies and created deniability while making it more difficult to prove the CEO’s intent to defraud.

Once more, Steyn is a leading critic of the reforms that are essential under Steyn’s logic to prevent these crises. A Gresham’s dynamic can cause good people to do the wrong things. Vigorous financial regulators who serve as the regulatory “cops on the beat” are essential to the creation of the proper incentives so that the wrong CEOs are forced to do the right things.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.