The Perversity of Economics’ “Culture of Fraud”

By William K. Black

Paul Krugman has written an article entitled “Culture of Fraud” about the Romney economics team.

Still on vacation, but I have internet access for a bit, and have checked in on a few matters. The big story of the week among the dismal science set is the Romney campaign’s white paper on economic policy, which represents a concerted effort by three economists — Glenn Hubbard, Greg Mankiw, and John Taylor — to destroy their own reputations. (Yes, there was a fourth author, Kevin Hassett. But the co-author of “Dow 36,000″ doesn’t exactly have a reputation to destroy).

And when I talk about destroying reputations, I don’t just mean saying things I disagree with. I mean flat-out, undeniable professional malpractice. It’s one thing to make shaky or even demonstrably wrong arguments. It’s something else to cite the work of other economists, claiming that it supports your position, when it does no such thing….

Is it really surprising, then, that the economists who have decided to lend their names to the campaign have been caught up in this culture of fraud?

I have often written about economists’ tribal taboo on taking fraud seriously or even using the “f-word.”  (For economists, it’s like saying “Voldemort” out loud.)  It is one of the leading shapers of the intensely criminogenic environments that create the perverse incentives that drive our recurrent, intensifying financial crises.  Krugman seems particularly surprised that Mankiw (Harvard) would join the fraudulent culture, but Mankiw has been notorious in this regard for nearly two decades.  He was a discussant at Brookings in 1993 when George Akerlof and Paul Romer presented their paper (“Looting: the Economic Underworld of Bankruptcy for Profit”).  Akerlof and Romer explained how accounting “control fraud” occurred, why it was a “sure thing,” and how it hyper-inflated bubbles and drove financial crises.  Akerlof and Romer (working in conjunction with savings and loan regulators and white-collar criminologists), ended their article with this paragraph in order to emphasize their central message:

Neither the public nor economists foresaw that [S&L deregulation was] bound to produce looting.  Nor, unaware of the concept, could they have known how serious it would be.  Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better.  If we learn from experience, history need not repeat itself” (George Akerlof & Paul Romer, 1993: 60)

Mankiw dismissed the article’s thesis and conclusion using the economists’ favorite term of disdain (“anecdote”).  Mankiw’s dismissal was dishonest, the article he was reviewing was not anecdotal.  Mankiw’s infamous conclusion was that “it would be irrational for savings and loans [CEOs] not to loot.”  Indeed, he expanded on his fraud-friendly thesis:

Consider an owner of a savings and loan who is taking excessive risks, hoping that they pay off and make him rich. It is only prudent for him to loot as much as he can, because he knows that his gambles might not pay off.

Looting one’s shareholders and creditors was not only “rational,” it was the “only prudent” strategy under “Mankiw-morality.

Mankiw rejected Akerlof and Romer’s explanation of how deregulation created the perverse incentives that drove the fraud and claimed that the problem was overregulation.  Akerlof and Romer’s warning (a warning that we the regulators and white-collar criminologists made contemporaneously) could have prevented a repeat of the financial disaster.  Unfortunately, the Clinton and Bush (II) administrations followed Mankiw’s policies and produced the criminogenic environments that drove the accounting control fraud epidemics that produced the Enron-era crisis and the ongoing crisis.

Reading Mankiw’s claims as discussant, where he missed everything important in Akerlof and Romer’s (and the S&L regulators’ and criminologists’) insights and pronounced his faith in the dogma of efficient markets preventing all fraud make particularly painful reading today.  His statements as discussant foreshadow all the most destructive creeds that produced the Enron-era and ongoing fraud epidemics.

It is vital to understand that the claim that “accounting fraud” is impossible was not an isolated dogma shared by only a few acolytes.  Under even the weakest variant of the efficient market hypothesis, accounting control fraud could not exist or markets would (particularly given the Gresham’s dynamic that Akerlof explained in his 1970 article on “lemons) not be efficient.  Because the efficient market hypothesis is the foundation on which all of “modern finance” is built, the circular belief that fraud is impossible because we know markets are efficient was the dominant dogma among finance theorists.

The Frontline special (“The Warning”) explains that Alan Greenspan believed that fraud could not exist and therefore eagerly destroyed Brooksley Born’s (CFTC Chair) effort to protect us from credit default swaps (CDS).  It was that same dogma that led Greenspan to an even more catastrophic refusal to act.  The Federal Reserve had the unique authority under the Home Ownership and Equity Protection Act of 1994 (HOEPA) to ban endemically fraudulent liar’s loans.  Greenspan refused to do so despite pleas from colleagues and housing advocates (including ACORN).  Indeed, the refused pleas to even send the Fed’s examiners in to the holding company affiliates making the fraudulent liar’s loans to determine the facts.  Greenspan and the Fed economists then, having refused to find the data, shamefully dismissed pleas to use HOEPA to ban liar’s loans by experts who explained how the frauds and predatory lending occurred on the grounds that the experts’ reports were “merely anecdotal.”

Similarly, a generation of American lawyers who have studied corporate law have been reading Frank Easterbrook and Daniel Fischel’s assertion that: “a rule against fraud is not an essential or … an important ingredient of securities markets” (Easterbrook & Fischel 1991).  They do not inform the reader that Fischel, in his capacity as an expert economist for Charles Keating (who looted Lincoln Savings), tried applying this fraud-free dogma in the real world.  He, and Greenspan (who served as both an economist and lobbyist for Keating – Keating used Greenspan to recruit the five senators who became known as the “Keating Five) opined that Lincoln Savings was a superb S&L with stellar management.  Lincoln Savings proved to be the most expensive S&L failure and Keating the most infamous fraud.

To sum it up – the surprise is that Krugman is surprised.  Neo-liberal economists, globally, have been the most valuable allies to control frauds.  Mankiw is not a late convert, but among the earliest and most strident apologists for the elite frauds.  Mankiw’s mendacity has been on open display for nearly two decades.  Here’s the really bad news:  the room full of prominent economists who listened to his praise for the looters expressed no disapproval of his “friending” of the frauds.  Harvard, under Larry Summers, epitomized the economics taboo against taking fraud seriously.  Andrei Shleifer remained the editor of the most prominent journal in the field, protected by Summers from any consequences.  Myrecent column explained how a New York Times columnist (Eduardo Porter) cited Shleifer as his primary source on fraud and the Gresham’s dynamic it can produce without Shleifer informing the journalist of the fraud decision that had just dome down against Shleifer.

The culture of fraud in economics is a severe problem, and Harvard is a “hot spot” of that culture.

This post was originally written for the blog site New Economic Perspectives.