Renowned Economist: "In a Few Short Decades the West Undercut 150 Years of Legal Reforms that Made the Global Economy Possible"

I've repeatedly demonstrated that fraud caused the Great Depression and the current economic crisis, and that the economy cannot stabilize until the rule of law is restored, and criminal fraud on Wall Street is prosecuted.

Famed Peruvian economist Hernando de Soto provided a great overview of this fundamental truth in April, showing that the breakdown in the rule of law is the main cause of our economic problems:

The very systems that could have provided markets and governments with the means to understand the global financial crisis—and to prevent another one—are being eroded. Governments have allowed shadow markets to develop and reach a size beyond comprehension. Mortgages have been granted and recorded with such inattention that homeowners and banks often don't know and can't prove who owns their homes. In a few short decades the West undercut 150 years of legal reforms that made the global economy possible.

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The importance of economic facts may not be obvious to Americans. "What does the fish know about the water in which it swims?" asked Albert Einstein. But it's easy to grasp from the perspective of the developing and former communist countries where I live and work. In these countries, most of our assets and relationships are in the informal sector, outside the legal economy. Because they're not recorded in public memory systems, they cannot be written up as facts and are, in effect, invisible. All we have are shadow markets.

Without standardization, the values of assets and relationships are so variable that they can't be used to guarantee credit, to generate mortgages and bundle them into securities, to represent them in shares to raise capital. Nor do they fit the standard slots required to enter global markets. That's why credit crunches and massive unemployment are chronic conditions for most people forced to operate in the informal economy. These are the ones you see protesting in the streets of Arab countries or living in tents surrounding Port-au-Prince. We know only too well that facts don't speak for themselves: They have to be constructed through legal processes and kept transparent. They have to be defended, too.

When then-Treasury Secretary Henry Paulson initiated his Troubled Asset Relief Program (TARP) in September 2008, I assumed the objective was to restore trust in the market by identifying and weeding out the "troubled assets" held by the world's financial institutions. Three weeks later, when I asked American friends why Paulson had switched strategies and was injecting hundreds of billions of dollars into struggling financial institutions, I was told that there were so many idiosyncratic types of paper scattered around the world that no one had any clear idea of how many there were, where they were, how to value them, or who was holding the risk. These securities had slipped outside the recorded memory systems and were no longer easy to connect to the assets from which they had originally been derived. Oh, and their notional value was somewhere between $600 trillion and $700 trillion dollars, 10 times the annual production of the entire world.

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Already the lack of facts is being felt around the U.S.: Courts from Kansas to New York have decided that foreclosures have been improper, and some authorities can't figure out whom to tax. Without facts, credit will continue to be scarce, the value of bonds backed by mortgages will be at best doubtful, the value of houses is likely to slide further, foreclosure backlogs should increase, and banks will see their balance sheets burdened by more nonperforming paper.

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Robert Engle, a Nobel laureate who teaches economics at New York University, has said that proposals for reforming CDSs by Western governments are "good as far as they go, but they don't go far enough." European central banker Alexandre Lamfalussy and others have so far been unsuccessful at trying to collect information or even at creating a "risk office" at the Bank for International Settlements (BIS). In the last quarter of 2010, various BIS publications noted that statistics on international debt still had too many gaps and overlaps—and that banks, fearful over their proprietary obligations, were reluctant to provide information.

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When the recession sent the prices of financial holdings spiraling downward, some banks and financiers were exempted from the U.S.'s long-established "mark-to-market" accounting standards, which force firms to report the value of their assets at current market prices. It's reasonable to establish value other than through market prices, according to proponents, if the market is unusually depressed. But such a privilege creates the ability to destroy facts by hiding losses, increasing the price of assets to levels at which no one will buy. In the U.S., the Financial Accounting Standards Board and the Securities and Exchange Commission are reviewing accounting rules, while Congress has been holding hearings on the subject. Meantime, businesses are left to figure out reality on the basis of connections, influence, and private information. Just like we do in developing and former communist countries.

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The modern balance sheet can be traced to Luca Pacioli, the 15th century mathematician and father of accounting. In the 1990s governments began destroying Pacioli's legacy by allowing companies in financial difficulty to pass facts concerning debts from their public balance sheet to a less visible memory system called a special purpose entity (SPE) (or to sweep debt information into the balance sheet's footnotes in words so obtuse that the statements cease being factual). Such "off-balance-sheet accounting" makes companies appear more profitable, despite their debts. By the time Enron closed its doors in 2002, it had created some 3,500 SPEs. According to Frank Partnoy, a professor of securities law at the University of San Diego and one of the most insightful observers of the financial crisis, "abusive off-balance-sheet accounting" was its major cause.

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Greece is the most notorious example of a country using derivative-based currency swaps to swell the value of government assets by pushing national debts into the future. Gustavo Piga, a professor of economics at the University of Rome Tor Vergata, revealed this fact-destroying practice: A country issues a debt in one currency—dollars, let's say—at fictional exchange rates that it swaps for a euro debt for a certain period of time. Thus it gets an inflow of money that makes the ledger look positive because the actual debt appears as a swap that has produced income. Governments and banks can also distort facts by getting short-term funds against their assets in the so-called repo market, which, as a result of new rules in the past decade, they don't have to report as loans in their memory systems. This is apparently how Lehman Brothers made it look like it had some $50 billion less in loans outstanding than it really did.

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Dodd-Frank is essentially silent on the issue of repo markets. Gary Norton at the Brookings Institution has argued that we still do not have the vaguest idea of the size of the repo market.

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We are now staring at a legal and political challenge. A legal challenge because American and European governments allowed economic activity to cross the line from the rule-bound system of property rights, where facts can be established, into an anarchic legal space, where arbitrary interests can trump facts and paper swirls out of control. The rule of law is much more than a dull body of norms: It is a huge, thriving information and management system that filters and processes local data until it is transformed into facts organized in a way that allows us to infer if they hang together and make sense.

Mainly, though, it's a political challenge. Politicians must raise the financial crisis to commanding heights, where the entrenched institutional problems of a failing order can be addressed. Markets were never intended to be anarchic: It has always been government's role to police standards, weights and measures, and records, and not condone legalized sleight of hand in the shadows of the informal economy. To understand and repair one of mankind's greatest achievements—the creation of economic facts through public memory—is the stuff of nation-builders.