A Free Market Is Not Possible Without Strong Laws Against Fraud

Many economists are now starting to question long-held assumptions that bubbles don't matter, that huge amounts of leverage are good, and that the Federal Reserve has mastered monetary policy. They are starting to read Minsky and other forgotten economic theorists. And Austrian economists are gaining a wider audience.

As I wrote in March 2009:

The Austrians have been saying for well over a hundred years that big bubbles lead to big crashes, and that - if you want to avoid depressions - you have to avoid the bubbles.

In today's article, entitled "Ignoring the Austrians Got Us in This Mess", Barron's agrees:

The credit crisis and the ensuing global economic contraction have failed to make an impression on academe, where free-market orthodoxy still reigns supreme, the New York Times asserted in an article in arts section recently ("Ivory Tower Unswayed by Crashing Economy," March 4.)...

What definitely is ignored in academe is the Austrian school of economics, especially for baby boomers brought up on Samuelson's economics text, which was pure Keynesian orthodoxy. I did not learn the names von Mises and Hayek or their ideas until a decade or more after graduation (with a degree in economics, by the way.)

The Austrian view is a mirror image on the right to Minsky's from the left. The economy, if left alone, is self-correcting, say the Austrians. But central banks' inflationary expansion of credit produces booms and malinvestments, which inevitably lead to a crashes and depressions.

The only prevention for boom and busts are sound money, which is impossible with government-controlled central banks. Once the bust comes, the only cure is to let it run its course; allow the malinvestments go bankrupt and let the market reallocate the capital to productive uses....

But the Austrians were the ones who could see the seeds of collapse in the successive credit booms, aided and abetted by Fed policies, especially under former chairman Alan Greenspan. ...

Greenspan always contended that monetary policymakers can neither predict nor prevent bubbles in asset markets. They can, however, clean up the after-effects of the bust -- which meant reflating a new bubble, he argued.

That had a profound effect on risk-taking. Knowing that the Greenspan Fed would bail out the markets after any bust, they went from one excess to another. So, the Long-Term Capital Management collapse in 1998 begat the easy credit that led to the dot-com bubble and bust, which in turn led to the extreme ease and the housing bubble.

Austrian economists assert the current crisis is the inevitable result of the Fed's successive efforts to counter each previous bust. As the credit expansion pumped up asset values to unsustainable levels, the eventual collapse would result in a contraction of credit as losses decimate banks' balance sheets and render them unable to lend. That sounds like an accurate diagnosis of the current problems.

While Barron's acknowledges that the Austrian school is right about how to avoid depressions, it doesn't agree with the other main tenet of the Austrians: that the quickest way to get out of a depression is to let the bad investments clear themselves out of the markets by letting the companies which made dumb decisions fail. (The sub-title for the article is "Their ideas warned us of the bubble; their prescription for the bust is too harsh, however"; and the article ends with the phrase "Make us non-interventionist, but not yet.")

Readers have written to me saying the same thing: the Austrians might be right, but their remedy for an economic crisis is too draconian and we have to do something to help the people.

So what can we do to help people and to improve the economy?

Well, as I've repeatedly pointed out, the economy cannot recover until trust and the rule of law are restored (and see this).

Imposing accurate accounting standards, stopping high-frequency trading, quote-stuffing and front-running, and prosecuting fraud to the fullest extent of the law are prerequisites to restoring trust in our economy.

America has a long tradition of using fraud, antitrust, conspiracy and racketeering laws to rein in the worst economic abuses. These laws are an important part of American history, and our recent abandonment of them must be reversed.

Austrian Economics Does Not Require Abandoning the Law ... In Fact, Laws Are Necessary for a Functioning Free Market

Just as neo-conservatives are not really conservative and neo-liberals are not really liberal, a fake, neo-Austrian legal argument has sprung up trying to excuse the criminal fraud and manipulation of the big banks.

As William K. Black - professor of economics and law, and the senior regulator during the S&L crisis - pointed out last week, Austrian economics has been twisted by the powers-that-be and bastardized into a basis for arguing that there should be no prosecutions for fraud or criminal conduct:

Yves [Smith] noted that the Chamber of Commerce was leading the effort to elect CEO-friendly judges. The Chamber is one of the points of intersection in the discussions about electing judges and whether law and economics has played a perverse role in causing catastrophic policy, regulatory, and judicial blunders. The Chamber distributed a plan for a hostile takeover of university departments of economics and finance (and the courts and the media) proposed by Lewis Powell (the soon to be Supreme Court Justice). Extremely conservative “law and economics” proved to be central to this effort. The law and economics movement began as a non-ideological approach to explaining and aiding judicial decision-making. The scholars leading the movement had diverse views. The Olin Foundation transformed law and economics into an ultra ideological field dominated almost exclusively by passionate opponents of government “interference” in “free enterprise.” Olin specialized in creating well-funded positions in academia for scholars that had an “Austrian” approach to economics. Austrian economics has, generally, become more extreme since its formative years when Hayek warned that mixed economies (e.g., the U.S. and Europe) were inevitably consigned to the Road to Serfdom. Here is how the National Review praised the Olin’s takeover of the field:

Law and Economics: The John M. Olin Foundation has devoted more of its resources to studying how laws influence economic behavior than any other project. The law schools at Chicago, Harvard, Stanford, Virginia, and Yale all have law-and-economics programs named in honor of Olin. “You should not forget that without all the work in Law and Economics, a great part of which has been supported by the John M. Olin Foundation, it is doubtful whether the importance of my work would have been recognized,” said Ronald Coase, who won the 1991 Nobel Prize in economics.

In addition to these centers specializing in law and economics, Olin created scores of endowed chairs at a wide range of universities. Some of these are in economics departments and others are in law. Olin also indirectly funded the “boot camps” at which U.S. judges were taught Austrian economics as if it were undisputed science. The academic journals in law and economics are dominated by virulent opponents of regulation. The textbooks used to teach law and economics treat economic theory as having demonstrated conclusively the folly of most government actions purportedly designed to help the public. (I say “purportedly” because Austrians almost always claim that the government intervention was really designed to benefit a special interest rather than a substantial portion of the public.)

Here are two examples that illustrate how false, but so influential and harmful these Austrian nostrums have become through teaching falsified economics to thousands of lawyers. Austrian law and economics is based on suppositions that have long been known to be false. Dickens famously had Mr. Bumble (in Oliver Twist) respond to being informed that the law supposed him to be responsible for his wife’s behavior by remarking that if the law supposed such an absurdity then “the law is a ass.” The dominant law and economics text on corporate law for years was by Easterbrook and Fischel. Judge Easterbrook is a colleague of Judge Posner on the 7th Circuit and Fischel was for a time Dean of the University of Chicago’s law school. They assert that “a rule against fraud is not an essential or even necessarily an important ingredient of securities markets” (1991: 283). Their book was written after Professor Fischel, as a consultant to three of the most notorious control frauds of the 1980s, tried out their theories in the real world – and found that they failed catastrophically. Fischel praised the worst frauds. Fischel & Easterbrook did not disclose to their readers that their theories were falsified in the real world. Note how extreme their claim was, the utter certainty of the claim, and the lack of any data supporting the claim – a claim they knew to be false. The taught students that, in the context of securities, we did not need:

1. Any laws against securities fraud
2. The FBI and the Department of Justice
3. The SEC
4. Any rules against fraud
5. Any ability to bring civil suits

Fraud is impossible because securities markets are “efficient” and act as if they were guided by an “invisible hand.” Markets cannot be efficient if there is accounting control fraud, so we know (on the basis of circular reasoning) that securities fraud cannot exist. Indeed, when Easterbrook and Fischel try to explain why the securities markets automatically exclude frauds their faith-based logic becomes even more humorous. They claim that honest securities issuers send one or more of three “signals” of honesty to guide investors to purchase their securities – and that only honest firms can send any of these three signals.

1. Hire a top tier audit firm
2. Have their CEO own a substantial amount of stock in the company
3. Cause their firm to have extreme leverage

In reality, accounting control frauds “mimic” each of these signals and each signal aids their frauds. Easterbrook and Fischel’s ideas are not merely wholly ineffective against accounting control fraud – they are outright criminogenic. That is why Fischel praised the real world accounting frauds when he was a consultant. Each of the three massive accounting control frauds that Fischel praised sent each of these three signals – and they sent them years before Easterbrook and Fischel wrote their book and made claims they had seen repeatedly falsified by Fischel’s fraudulent clients without warning their readers.

Note the continuing damage that these three law and economics dogmas about “signaling” honesty had in the current crisis. Regulators continued to treat professionals as if they were “independent” and provided expert judgments on which regulators should rely. Basel II, for example, reduced capital requirements dramatically if the rating agencies gave a high rating to a toxic mortgage derivative. Economists, criminologists, and reality had long falsified the claim but theoclassical law and economics never challenges its foundational dogmas.

Easterbrook provided a classic example of faith-based law and economics’ misplaced faith in private professionals in a decision that prompted Robert Prentice’s wonderful article: The Case of the Irrational Accountant: A Behavioral Insight into Securities Fraud Litigation (2000). The plaintiff alleged that he was the victim of a securities fraud that the outside auditor had aided. Easterbrook’s opinion stated that the plaintiff should not be allowed to engage in discovery designed to support this claim because it would be “irrational” for an audit firm to aid a securities fraud. Easterbrook’s logic is so irrational on so many different levels that it proved a treasure trove for Professor Prentice. In the interest of space, consider only four aspects of why Easterbrook’s logic fails. First, Easterbrook is the one who co-authored the textbook claiming that serious securities fraud cannot occur. That makes him someone that cannot admit that fraud exists. He certainly doesn’t want plaintiffs finding facts demonstrating fraud. Second, the same textbook claimed that only honest corporations could hire a prestigious audit firm. He premised this (long falsified) dogma on the claim that it would be irrational for an audit firm to give a clean opinion to a control fraud. If the plaintiff had been allowed discovery and demonstrated the falsity of this dogma it would falsify Easterbrook’s entire thesis. Third, theoclassical economics rests on even more fundamental dogmas – economic actors are supposed to act rationally and almost entirely to maximize their self-interest. Empirically, even economists have long known what non-economists have always known – these dogmas are often false. Why should a plaintiff not be permitted to discover evidence that accountants act irrationally? Fourth, Easterbrook assumes away reality even if we assume rational behavior. The “auditor” acts through humans called audit partners. Audit partners gain income, power, and status within the firm primarily by bringing in large clients. Accounting control frauds understand this and select audit partners that will give them clean opinions. They also put prospective audit partners in competition with each other to intensify the “Gresham’s” dynamic that turns market forces perverse and causes bad ethics to drive good ethics out of the profession. Top economists had explained why this dynamic explained why S&L accounting control frauds had consistently hired top tier audit firms and been able to get clean opinions from them despite the fact that their financial statements were fraudulent.

As James Pierce, Executive Director of the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) explained:

Accounting abuses also provided the ultimate perverse incentive: it paid to seek out bad loans because only those who had no intention of repaying would be willing to offer the high loan fees and interest required for the best looting. It was rational for operators to drive their institutions ever deeper into insolvency as they looted them.

The National Commission on Financial Institution Reform Recovery and Enforcement (NCFIRRE) (1993), reported on the causes of the S&L debacle. It documented the distinctive pattern of business practices that lenders typically employ to optimize accounting control fraud.

The typical large failure was a stockholder-owned, state-chartered institution in Texas or California where regulation and supervision were most lax…. [It] had grown at an extremely rapid rate, achieving high concentrations of assets in risky ventures…. [E]very accounting trick available was used to make the institution look profitable, safe, and solvent. Evidence of fraud was invariably present as was the ability of the operators to “milk” the organization through high dividends and salaries, bonuses, perks and other means.

The top tier audit firms knew that the “typical large failure” “invariably” involved fraud by senior S&L executives, who used “every accounting trick available” in order to create fictional income in order to aid the executives’ looting of the S&L. These lenders followed a distinctive pattern – deliberately making bad loans – that was rational only for accounting control frauds. The unique pattern that optimized fraudulent accounting income was simple for an auditor to spot. The S&L accounting control frauds always hired top tier audit firms and virtually always succeeded in getting clean opinions for fraudulent financial statements. That was supposed to be impossible under Easterbrook and Fischel’s theories. NCFIRRE explained the “agency” problem that Easterbrook and Fischel missed.

[A]busive operators of S&L[s] sought out compliant and cooperative accountants. The result was a sort of “Gresham’s Law” in which the bad professionals forced out the good.

Theoclassical law and economics scholars continued to chant the second signaling dogma – though falsified throughout the S&L debacle and Enron era accounting control frauds – throughout the nonprime mortgage era. They asserted endlessly that modern executive compensation “aligns” the interests of the CEO with the shareholders’ interests. The reality was that it frequently magnified the long-standing misalignment of those interests. That is the key point of Akerlof & Romer’s classic article – the CEO profits by using accounting fraud to loot the bank that he controls. He arranges his executive compensation to be extremely large and based primarily on short-term reported accounting profits. Akerlof and Romer explain why accounting fraud is a “sure thing”— mathematically guaranteed to report extreme (albeit fictional) profit in the short-term. The combination of accounting control fraud (“blessed” by a top tier audit firm’s clean opinion) and deliberately misaligned (anti) “performance pay” is that the CEO is guaranteed to become wealthy – immediately. Moreover, by using seemingly normal executive compensation bonuses to become wealthy he coverts large amounts of firm assets to his personal benefit while minimizing the risk of prosecution. The result of a strategy that employs deliberate adverse selection in lending is typically a bankruptcy that wipes out the shareholders. No greater misalignment of the interests of the CEO and shareholders is possible than that caused by modern CEO compensation. Modern executive and professional compensation are often criminogenic, yet theoclassical economists strive even now to preserve the ability of CEOs to loot through perverse executive compensation.

The third “signaling” dogma, however, is never discussed today by theoclassical law and economics scholars. The Austrians generally ignore the endemic accounting control fraud (their heroes have always been business cowboys) in their explanation of why we suffer recurrent, intensifying financial crises. The Austrians love to blame the Federal Reserve and “easy money” for producing low interest rates. The Austrians claim this led to excessive leverage, and blame the global crisis on extreme leverage. It is inconvenient to this new meme to recall that the extreme law and economics scholars used to light candles to leverage and chant its praises as a unique signal of honesty. Accounting control frauds do optimize fictional accounting income by engaging in extreme leverage. The leverage is a tactic of the accounting control frauds that drive modern crises, not the cause of the crisis. Because accounting control fraud produces exceptional reported income it is easy for the frauds to borrow enormous amounts (lenders virtually break down the frauds’ doors in their eagerness to lend). The more money an accounting control fraud borrows, the greater the sums the CEO can loot.

Michael Milken was the original high priest of the extreme leverage dogma and the claim that it signaled honesty (Fischel was his acolyte). Milken was, of course, an expert at signaling honesty while practicing control fraud. His time in prison only increased his hate for U.S. government “interference” in “free markets.” The Milken Institute, therefore, now commissions articles about the ongoing crisis that emphasize (in huge fonts):

From Main Street to Wall Street, one common thread runs through all facets of this story: excessive leverage.

http://www.milkeninstitute.org/pdf/Riseandfallexcerpt.pdf (p. 9)

That’s right – the fraud whose entire junk bond business model at Drexel Burnham Lambert rested on the dogma that corporations had too much capital and needed to massively increase their leverage (e.g., through LBOs) is now running an institute whose scholars claim that (far lesser) leverage that modern U.S. banks employ is the primary cause of global catastrophe. Of course, there’s no mea culpa by Milken admitting that his earlier dogma was false.

The fact that, empirically, accounting control fraud is a severe problem is no barrier to theoclassical law and economics ignoring control fraud. I invite readers who have taken law and economics and corporate law classes to inform me whether their textbooks discussed Akerlof and Romer’s article: Looting: The Economic Underworld of Bankruptcy for Profit. Akerlof was awarded the economics version of the Nobel Prize in 2001 and Romer is also a brilliant economist. Neither Easterbrook nor Fischel is an economist. Akerlof and Romer’s article explains how the managers that control a firm use accounting fraud to create a “sure thing” of fictional profits. The managers get rich, the firm dies. Akerlof & Romer provide theory, data, and real world examples. The lawyers that seek jobs at the financial regulatory agencies are the lawyers most likely to have taken law and economics and corporate law courses in which Easterbrook & Fischel’s claims were treated as objective science. In my experience, it is vanishingly rare for them to even be aware of Akerlof & Romer’s work or the work of white-collar criminologists documenting and explaining accounting control fraud.

When regulators believe that control fraud is impossible – they make control fraud certain by eviscerating regulation and supervision. The most infamous recent example of this is Alan Greenspan (like Fischel, a former consultant to the most infamous S&L control fraud – Charles Keating’s Lincoln Savings). Greenspan refused to believe that fraud could occur in financial markets. He refused to take any effective regulatory steps against what the FBI had warned him (in 2004) was an “epidemic” of mortgage fraud even though they correctly predicted that it would cause a “crisis.” The Fed had unique regulatory authority under HOEPA to regulate all mortgage lenders.

Law and economics has, for over two decades, been dominated by theorclassical economic dogmas that have proved false. These dogmas are premised on an ideological hate for regulation – even by democratic governments. The Olin Foundation did not buy the souls of the economists and lawyers to whom it provided fellowships and endowed chairs. It simply selected true believers for its largess. It knew how desperately eager universities were to raise funds. There are now tens of thousands of law and economics graduates that have taken a class in theoclassical law and economics. They were taught that theoclassical economic assertions (often falsified decades ago) were objective facts devoid of ideological content. They have been taught that economics has proven that regulation is unnecessary, hopeless, and harmful. Some students accept this dogma as revealed truth, but many reject it. (If your goal as a professor is to indoctrinate students you should prepare for a life of disappointment.) Few economics, business school, or law students have been introduced to effective regulation or economic/finance theories that have proven to have predictive strength. It is the non-ideologues we need to reach and inform them about the reality-based alternative to the faith-based version of economics they were taught.

In truth, the leading Austrian theorists were big supporters of freedom and liberty. You can't have freedom if a handful of oligarchs are manipulating the economy without any checks and balances from the law. See this.

More importantly, you can't prevent bubbles unless you crack down on the fraud which helps to inflate bubbles. As I pointed out a year ago:

Everyone knows that the Fed blows bubbles.

But William K. Black ... says that fraud by many other companies also contributes to the bubble-and-bust cycle.

In a talk Black gave in June entitled "The Great American Bank Robbery" ... he gives the following examples.

Initially, during the S&L, Enron and subprime crises, outside audit firms and appraisers gave their seal of approval and a clean bill of health to the companies, allowing them to commit fraud and blow a giant speculative bubble in toxic assets.

And the three credit rating services also committed massive fraud which helped blow the bubble. For example, an analyst at Standard & Poors was assigned the job of giving a credit risk rating for derivatives backed by subprime loans. He wanted to review a sample of loan file to assess credit risk. His boss (a high-level officer at S&P), gave him the following written response:

Rating Agencies as Vectors.
Any request for loan level tapes is. TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it.
[W]e must produce a credit estimate. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so. [S&P 2001]

(capitalization and punctuation in original). In other words, he was told to make it up, and then to make up a rationalization.

So the S&P analyst ended up giving AAA rating - i.e. zero credit risk - on something that had immense credit risk.

So the bubble was partly blown because, as Black says,"This was a trillion dollar industry based on don’t ask, don’t tell."

This is nothing new. Black points out that the official investigation into the S&L crisis found that in the typical large failure, fraud was invariably present.

Black also points out that the guys covering up fraud in S&L were promoted to head regulators in the 2000's. These regulators gave a wink and a nod to massive fraud and insane amounts of leverage. So the regulators helped blow the bubble and sow the seeds of the current crash as well.

Fraud By the Banks, Lenders and Financial Service Companies

But the most interesting portion of Black's talk was the role of fraud by numerous businessmen in blowing and then bursting bubbles.

Black explained that fraud by a financial company usually involves the company:

1) Growing like crazy

2) Making loans to people who are uncreditworthy, because they’ll agree they’ll pay you more, and that’s how you grow rapidly. You can grow really fast if you loan to people who can’t you pay you back

and

3) The use of extreme leverage.

This combination guarantees stratospheric initial profits during the expansion phase of the bubble.

But it guarantees a catastrophic subsequent failure when the bubble loses steam.

And collectively - if a lot of companies are playing this game - it produces extraordinary losses (more than all other forms of property crime combined), and a crash.

In other words, the companies intentionally make loans to people who will not be able to repay them, because - during an expanding bubble phase - they'll make huge sums of money. The top executives of these companies will make massive salaries and bonuses during the bubble (enough to live like kings even even if the companies go belly up after the bubble phase).

And since honest regulators would stop this fraudulent activity during bubbles, the corruption of regulators ensures wild bubbles and the subsequent crashes.

Of course, the types of fraud described by Black in the S&L, Enron and 2007 meltdowns are not just for the history books. Unless stopped, they will continue and will be the cause of the next crash.

Indeed, Austrian economists stress the need to minimize "malinvestments" (investments made in response to faulty signals). The Austrians stress that artificially low interest rates can send false signals to investors. That is obviously true.

But criminally dishonest behavior by private corporations and traders - such as high-frequency trading, quote-stuffing, front-running, control fraud and accounting fraud - does the exact same thing. If there is rampant fraud, collusion or book-cooking, faulty signals will be sent.

Moreover, the type of radical concentration of wealth which comes from criminally manipulating the system itself destroys democracy and makes a mockery of our legal system.

Freedom of the market versus basic regulation of fraud is a false dichotomy. A free market and laws against criminal fraud are both necessary. Indeed, they are interrelated and mutually self-reinforcing.

Even Richard Posner - probably the leading proponent over the course of many decades for removing the reach of the law from the economy - has now changed his mind.

Whether you follow Keynes, Friedman, Mises, Hayek and Rothbard, or other economists, we all need to implement a little of the Austrian economic wisdom about preventing bubbles, and of the American legal wisdom about cracking down on fraud, breaking up the too big to fail banks using antitrust laws, and imposing accurate accounting and full disclosure requirements (see this, this and this).

The economy will not recover unless we do.