Greenspan's Laissez Fairy Tale: How Flawed Economic Theories Fail to Account for Financial Fraudsters
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We continue to witness remarkable developments in the intersection of the related fields of economics, finance, ethics, law, and regulation. Each of these five fields ignores a sixth related field – white-collar criminology. The six fields share a renewed interest in trust.
The key questions are why we trust (some) others, when that trust is well-placed, and when that trust is harmful. Only white-collar criminologists study and write extensively about the last question. The primary answer that the five fields give to the first question is reputation. The five fields almost invariably see reputation as positive and singular. This is dangerously naïve. Criminals often find it desirable to develop multiple, complex reputations and the best way for many CEOs to develop a sterling reputation is to lead a control fraud. Those are subjects for future columns.
This column focuses on theoclassical economics' use of reputation as “trump” to overcome what would otherwise be fatal flaws in their theories and policies. Frank Easterbrook and Daniel Fischel, the leading theoclassical “law and economics” theorists in corporate law, use reputation in this manner to explain why senior corporate officers' conflicts of interest pose no material problem. The most dangerous believer in the trump, however, was Alan Greenspan. His standard commencement speech while Fed Chairman was an ode to reputation as the characteristic that made possible trust and free markets. I've drawn on excerpts from one example: his May 15, 2005 talk at Wharton. I find Greenspan's odes to reputation as the antidote to fraud to be historically inaccurate and internally inconsistent in their logic. Here, I ignore his factual errors and focus on his logical consistency.
“The principles governing business behavior are an essential support to voluntary exchange, the defining characteristic of free markets. Voluntary exchange, in turn, implies trust in the word of those with whom we do business.
Trust as the necessary condition for commerce was particularly evident in freewheeling nineteenth-century America, where reputation became a valued asset. Throughout much of that century, laissez-faire reigned in the United States as elsewhere, and caveat emptor was the prevailing prescription for guarding against wide-open trading practices. In such an environment, a reputation for honest dealing, which many feared was in short supply, was particularly valued. Even those inclined to be less than scrupulous in their personal dealings had to adhere to a more ethical standard in their market transactions, or they risked being driven out of business.
To be sure, the history of world business, then and now, is strewn with Fisks, Goulds, Ponzis and numerous others treading on, or over, the edge of legality. But, despite their prominence, they were a distinct minority. If the situation had been otherwise, late nineteenth- and early twentieth-century America would never have realized so high a standard of living."
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"Over the past half-century, societies have chosen to embrace the protections of myriad government financial regulations and implied certifications of integrity as a supplement to, if not a substitute for, business reputation. Most observers believe that the world is better off as a consequence of these governmental protections.
Accordingly, the market value of trust, so prominent in the 1800s, seemed by the 1990s to have become less necessary. But recent corporate scandals in the United States and elsewhere have clearly shown that the plethora of laws and regulations of the past century have not eliminated the less-savory side of human behavior. We should not be surprised then to see a re-emergence of the value placed by markets on trust and personal reputation in business practice.
After the revelations of recent corporate malfeasance, the market punished the stock and bond prices of those corporations whose behaviors had cast doubt on the reliability of their reputations. There may be no better antidote for business and financial transgression. But in the wake of the scandals, the Congress clearly signaled that more was needed.
The Sarbanes-Oxley Act of 2002 appropriately places the explicit responsibility for certification of the soundness of accounting and disclosure procedures on the chief executive officer, who holds most of the decision-making power in the modern corporation. Merely certifying that generally accepted accounting principles were being followed is no longer enough. Even full adherence to those principles, given some of the imaginative accounting of recent years, has proved inadequate. I am surprised that the Sarbanes-Oxley Act, so rapidly developed and enacted, has functioned as well as it has. It will doubtless be fine-tuned as experience with the act's details points the way.
It seems clear that, if the CEO chooses, he or she can, by example and through oversight, induce corporate colleagues and outside auditors to behave ethically. Companies run by people with high ethical standards arguably do not need detailed rules on how to act in the long-run interest of shareholders and, presumably, themselves. But, regrettably, human beings come as we are--some with enviable standards, and others who continually seek to cut corners.
I do not deny that many appear to have succeeded in a material way by cutting corners and manipulating associates, both in their professional and in their personal lives. But material success is possible in this world, and far more satisfying, when it comes without exploiting others. The true measure of a career is to be able to be content, even proud, that you succeeded through your own endeavors without leaving a trail of casualties in your wake."
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"Our system works fundamentally on trust and individual fair dealing. We need only look around today's world to realize how valuable these traits are and the consequences of their absence. While we have achieved much as a nation in this regard, more remains to be done.”
Greenspan appears to have relied on the trump of reputation as the basis for causing the Fed to oppose financial regulation generally and at least five specific examples of proposed or existing regulation designed to deal with conflicts of interest. He supported the repeal of the Glass-Steagall Act despite the conflict of interest inherent in combining commercial and investment banking. He supported the passage of the Commodities Futures Modernization Act of 2000 despite agency conflicts between managers and owners of firms purchasing and selling credit default swaps (CDS).
He opposed using the Fed's unique statutory authority under HOEPA (1994) to regulate ban fraudulent liar's loans by entities not regulated by the Federal government. He opposed efforts to clean up outside auditors' conflict of interest in serving as auditor and consultant to clients. He opposed efforts to clean up the acute agency conflicts of interest caused by modern executive compensation. He opposed taking an effective response to the large banks acting on their perverse conflicts of interest to aid and abet Enron's SPV frauds.
Greenspan's Hypothesis: Reputation Trumps Perverse Incentives
Greenspan's overall anti-regulatory hypothesis seems to be that laissez faire led to substantial control fraud, which gave business actors a strong incentive to avoid being defrauded. This caused them to care a great deal about reputation, which successfully prevented fraud. Indeed, the frauds “had to adhere to a more ethical standard in their market transactions, or they risked being driven out of business.”
The most obvious logic problem with this hypothesis is why laissez faire led to substantial control fraud. Here is his key sentence, discussing business life under laissez faire: “In such an environment, a reputation for honest dealing, which many feared was in short supply, was particularly valued.” How could “many” American business people operating under laissez faire fear that reputations for honest dealing were “in short supply” among their counterparts?
Under Greenspan's logic reputations for honest dealing should have been omnipresent among American business people during laissez faire. Greenspan assures us that under laissez faire even frauds “had to adhere to a more ethical standard in their market transactions, or they risked being driven out of business.” If this is true, then the “many” who “fear[ed]” that “a reputation for honest dealing “was in short supply” must have been irrational. Reputations for honest dealing should have been virtually universal under Greenspan's logic.
Markets Make the Mensch Greenspan asserted that unethical CEOs who act like scum in their personal lives engaged in a daily “Road to Damascus” conversion whenever they worked. Greenspan concedes that CEOs dominate corporations and that a honest CEO will prevent any material corporate fraud (“if the CEO chooses, he or she can, by example and through oversight, induce corporate colleagues and outside auditors to behave ethically”). In short, Greenspan asserts (contrary to Adam Smith's warnings) that there is no serious “agency” problem caused by the separation of ownership and control in corporations. Markets force CEOs to act as if they were honest because a good reputation is essential to the CEO.
The CEO, in turn, is able to ensure that subordinates act ethically. But Greenspan then contradicts his logic again, despairing that: “regrettably, human beings come as we are--some with enviable standards, and others who continually seek to cut corners.” Greenspan has just asserted that humans do not “come as we are” to business. Markets force us to behave as if we are moral regardless of our actual morality. When we are in our business mode we are at our patriarchal Grandfather's house on our best behavior in constant fear of arousing his ire. Greenspan Claimed That We Were in the Midst of a Renewal of CEO Honesty – In 2005.
In September 2004, the FBI warned that there was an “epidemic” of mortgage fraud and predicted that it would cause a financial “crisis” if it were not contained. The fraud epidemic grew massively, and I have shown why we know that it was overwhelmingly lenders who put the lies in liar's loans – at a rate of roughly a million fraudulent mortgages annually at the time that Greenspan gave his talk at Wharton in mid-2005.
“We should not be surprised then to see a re-emergence of the value placed by markets on trust and personal reputation in business practice. After the revelations of recent corporate malfeasance, the market punished the stock and bond prices of those corporations whose behaviors had cast doubt on the reliability of their reputations. There may be no better antidote for business and financial transgression.”
Again, my emphasis here is on Greenspan's logic. It does not follow that because “the market punished the stock and bond prices of those corporations” that collapsed because they were looted by their CEOs this served as the best “antidote” to prevent future accounting control frauds. George Akerlof and Paul Romer published their famous article in 1993 (“Looting: the Economic Underworld of Bankruptcy for Profit”). Indeed, George Akerlof received the Nobel Prize in economics in 2001. Greenspan was Charles Keating's principal economic expert and had seen him loot Lincoln Savings in the late 1980s.
Accounting control frauds are funded by stock and bond sales. The markets fund accounting control frauds, and they do so massively even when the CEO is looting the firm and causing losses principally to the shareholders and creditors. The CEO walks away wealthy from the husk of the failed corporation. Almost everyone agrees that leverage is one of the great causes of losses in our recurrent, intensifying financial crises here and abroad. Debt drives leverage.
Debt is supposed to provide the “private market discipline” that prevents accounting control fraud, and reputation is supposed to be the piston that adds immense power to this great brake. But accounting control fraud, as Akerlof & Romer (and we criminologists) emphasize is a “sure thing” – it produces record (albeit fictional) profits in the near-term. When there are epidemics of accounting control fraud, bubbles hyper-inflate.
The combined result is that loss recognition is hidden by refinancing. Reporting record profits and minor losses via accounting control fraud is the surest means for a CEO to grow wealthy and develop a strong reputation. Creditors rush to lend to corporations reporting stellar results, which is what produces the extraordinary leverage. Far from acting as an “antidote” to accounting control fraud, reputation helps explain why private market discipline becomes an oxymoron. Reputation is the great booster shot aiding and encouraging accounting control fraud.
In any analogous context we would consider Greenspan's “antidote” claim to be facially insane. If the head of the public health service announced proudly that the service had triumphed because, while one million Americans had died of an epidemic of cholera, the death rate had been so severe and rapid that the epidemic had burned out, we would consider him to be delusional and heartless. The death of the pathogen's host (us) does not constitute a triumph over cholera. It also does not leave the survivors who were not exposed to the pathogen with additional antibodies that will prevent future epidemics.
I distinguished Texas triumphs from Pyrrhic victories. The origin of that phrase comes from King Pyrrhus' (of Epirus in Greece) victory over the Romans in 279 BC at the battle of Asculum in Apulia (on the Eastern side of the Italian peninsula). The Roman legions were elite and outnumbered Pyrrhus' forces (which had many mercenaries).
Nevertheless, he twice defeated the Roman forces, inflicting significantly greater casualties on their forces. After the battle of Asculum he responded to congratulations by remarking that one more such victory would undo him. He was a great commander who defeated highly competent opponents defending their own lands.
Only theoclassical economists could call the failure of our most elite firms that were looted by their CEOs a triumph of capitalism. I wrote: “Martin Wolf repeated the well-worn claim that Enron's failure demonstrates capitalism's virtues in 2003. It is a view most famously stated by Larry Lindsey, a member of George W. Bush's first (failed) economic team, when he said in January 2002 that Enron's failure was “a tribute to American capitalism.” The then treasury secretary, Paul O'Neill, wasn't to be outdone. He insisted Enron's failure proved “the genius of capitalism.””
Our family's rule that it is impossible to compete with unintentional self-parody remains intact. A discipline (economics) that counts massive looting by the CEOs of elite control frauds as its greatest triumphs desperately needs an intervention. None of these control fraud failures (and that includes Fannie and Freddie) involves valiant efforts by economists to prevent the looting.
The theoclassical failures to prevent control fraud did not occur because the economists strove to prevent the looting but were defeated by impossible odds. Theoclassical economists were the anti-regulatory architects of the criminogenic environments that produce our epidemics of control fraud. They are the elite frauds' most valuable allies.