The False Dichotomy between Banking Honesty and a Sound Financial System

It's exceptionally hard to kill bad ideas. The most spectacularly bad idea in economics and finance is that regulating business honesty is bad for business. The idea is exceptionally criminogenic. The idea ebbs briefly after each epidemic of control fraud it unleashes leads to crisis and scandal, but it quickly returns and intensifies. The bad idea has grown for three decades, which is why we have suffered recurrent, intensifying financial crises. Both major parties' dominant economic policy makers embrace this bad idea. Nothing is better for honest firms than effective police, prosecutors, and regulatory “cops on the beat.” These things make possible “free markets.” Fraud cripples markets. Criminologists know this. The best economists have known this for over 40 years. But really bright people explained why 285 years ago.

The Lilliputians look upon fraud as a greater crime than theft. For, they allege, care and vigilance, with a very common understanding, can protect a man's goods from thieves, but honestly hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage.

Swift, J. Gulliver's Travels, London, Penguin (1967) p. 94. See Levi, M. The Royal Commission on Criminal Justice. The Investigation, Prosecution, and Trial of Serious Fraud. Research Study No. 14, London, HMSO (1993) p. 7. As I've written, these words should be inscribed on the walls of every relevant regulatory agency. George Akerlof echoed Swift's words in a formal economics argument in his seminal 1970 article “The Market for ‘Lemons': Quality Uncertainty and the Market Mechanism.”

“[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.”

This is the article that led to the award of the Nobel Prize in Economics in 2001 to Akerlof. Akerlof went on to explain that fraud could lead to a “Gresham's” dynamics in which bad ethics drove good ethics out of the marketplace. The bad idea that rules designed to reduce business dishonesty harms business is premised on a false claim that markets automatically exclude fraud. Alan Greenspan is the most famous anti-regulatory who once held this view. He has, subsequently, admitted his shock at the financial fraud that defined the current crisis. He admits that his belief that markets automatically self-corrected by excluding fraud proved false. Frank Easterbrook and Daniel Fischel (1991) are the most famous proponents of the view that markets automatically exclude fraud: “a rule against fraud is not an essential or … an important ingredient of securities markets.” A generation of American law students has been taught to believe this theoclassical dogma. Easterbrook & Fischel did not alert their readers that Fischel had, in his consulting work on behalf of three of the leading control frauds of the 1980s, applied these dogmas to make a series of predictions. Those predictions proved embarrassingly false because Fischel did not understand accounting control fraud. He ended up praising the worst frauds and claiming that regulators were incapable of providing any useful information because the markets price already incorporates all useful information (he adopted a perfect markets hypothesis). This false dichotomy between regulatory efforts against dishonest firms and improved market performance has particular importance given the ongoing attacks on Elizabeth Warren and the new Consumer Financial Protection Bureau (CFPB). The situation can be summarized briefly. Fraudulent loans hurt everybody who is honest and many of those who are somewhat dishonest. That's what criminologists, the best economists, and effective regulators (plus geniuses like Swift) have long understood. I'm writing to a financially literate audience, so I do not need to explain that making fraudulent liar's loans was never “profitable.” The reported “profits” were fictional and depended on either (i) making a fraudulent sale to another party or (ii) not creating a remotely adequate allowance for loan and lease losses (ALLL). The incidence of fraud on liar's loans was so extreme, the number of liar's loans made in 2004-2007 was so large that it hyper-inflated and extend the bubble, the role of fraudulent loans in causing the collapse of the CDO market was so great, and Lehman's liar's loans were so suicidal that reducing fraud should have been a top national priority. The fraudulent lenders and the loan brokers they incentivized to engage in endemic fraud put the lies in the typical liar's loan – in the loan application and the appraisal. That meant that millions of working class people were induced by the lenders' and their agents' frauds to purchase a home at a greatly inflated price that they could not afford. The result was the greatest loss of working class wealth in modern U.S. history. Another result was that the lenders were made deeply insolvent. We achieved the precise opposite of what market transactions are supposed to produce – Pareto anti-optimality. Both of the parties to the lending transaction were made worse off. Many fraudulent agents gained. Markets became spectacularly inefficient and even failed. Much of the world fell into the Great Recession. Private market discipline didn't simply fail, it became doubly perverse. First, the commercial and investment banks that were supposed to deny credit to and refuse to purchase loans from fraudulent and imprudent firms actually funded the massive growth of the worst lenders notorious for making endemically fraudulent liar's loans. Second, when private market discipline did finally occur it proved disastrous. Private market discipline arose when Lehman collapsed, but it did not function in accordance with finance theory. Theory says that private discipline is greatly superior to governmental action because it is so much more flexible and rational. It is supposed to distinguish between strong and weak credits and it is supposed to be so flexible that markets remain stable. The reality was far messier, with little differentiation based on credit quality among a broad group of potentially impaired credits and credit restrictions so severe that hundreds of markets ceased functioning. The Great Recession caused losses estimated at $10 trillion. Fraud epidemics can cause staggering losses. What does this have to do with Elizabeth Warren and the FCPA? Elizabeth Warren was one of the experts who warned about the bubble and nonprime loans. Had the FCPA existed under her direction the U.S. would have suffered far fewer losses and could have avoided the Great Recession. Reducing mortgage fraud is unambiguously good for the world. Protecting consumers from mortgage fraud by banning liar's loans would have led to a massive reduction in mortgage fraud. Why then are the Republicans promising to block any appointment to head such a vital agency? We know it is not because of their stated reasons (hyper-technical diversions about commission v. director leadership) because the Republicans have typically favored directorship leadership in the past for other financial regulators (e.g., the Office of Thrift Supervision). We know it has everything to do with blocking Warren's appointment. Senator McConnell says: “We're pretty unenthusiastic about the possibility of Elizabeth Warren.” Why? Because he fears that under her leadership the CFPB “could be a serious threat to our financial system.” Why can't we appoint one leader with a track record of success? We've appointed many regulatory leaders with track records of failure. We've appointed many anti-regulatory leaders because they doing so created self-fulfilling prophecies of regulatory failure. The results have been disastrous. Why not try a novel approach? Let's appoint people because they are brilliant, honest, committed to helping the public, and get the big issues right. Warren could have saved both banks and borrowers from hundreds of billions of dollars of losses had she led a CFPB in 2002-2008. We know that fraud causes recurrent, intensifying “serious threat[s] to our financial system.” Honesty poses no threat to our financial system. McConnell is posing a severe threat to our financial system by blocking Warren's appointment.

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.