This is a syndicated repost published with the permission of New Economic Perspectives. To view original, click here. Opinions herein are not those of the Wall Street Examiner or Lee Adler. Reposting does not imply endorsement. The information presented is for educational or entertainment purposes and is not individual investment advice.
Perhaps the only useful thing to come out of the Obama administration’s inept contest between Larry Summers and Janet Yellen as Ben Bernanke’s successor is the purported agreement among economists and other policy makers that the Fed Chair should make the introduction of effective regulation and supervision by the Federal Reserve a top priority. It would be even better if this agreement were real and would be sustained. Regulation and supervision have never risen above tertiary concerns at the Fed and every institutional pressure will push the new Fed Chair to ignore supervision.
Here is the preliminary reality test that any candidate to run the Fed should be asked: Do you agree that it is an untenable conflict of interest for examiners and supervisors to be employees of the regional Federal Reserve Banks, which are owned and controlled by the banks that the regional banks examine and supervise? Note that our Nation has already reached a policy decision that this type of conflict is untenable, which is why we ended the analogous role of the Federal Home Loan Banks as the employers of the examiners and supervisors. The long-time former head of Fed supervision told the Financial Crisis Inquiry Commission that the close ties to the member banks that the regional Federal Reserve Banks maintain harms supervisory vigor (Spillenkothen white paper). Any candidate who answers “no” to the reality test question has, at a minimum, failed to think serious about effective supervision. The crisis should have taught any thoughtful person that such gratuitous conflicts of interest are intolerably destructive.
In reading the arguments of economists who urge that Summers would be a superior regulator and supervisor I have discovered a common theme. Summers thinks the critical issue for a range of topics related to regulation is brilliance v. stupidity.
The key advantages of effective examination, supervision, enforcement, regulation, and assistance to prosecutions come when each of these functions is integrated under a comprehensive understanding of avoiding or terminating the criminogenic environments that produce the perverse incentives that drive our epidemics of control fraud and the resultant financial crises. This allows the regulators to avoid financial crises (as we did in 1990-1991 by ending an incipient epidemic of fraudulent liar’s loans in California). It also allows regulators to contain existing epidemics as we did with the overall S&L debacle. I’ll mention only four of the scores of steps we took because we understood control fraud mechanisms. We adopted a rule restricting growth. This struck the Achilles’ “heel” of every accounting control fraud. We also understood the distinctive traits that lenders engaged in accounting control fraud exhibit and used them to identify the worst frauds, and prioritize them for enforcement actions and closure, while they were still reporting record (albeit fictional) profits. We deliberately popped the bubble in Southwest real estate by cracking down on the frauds that were hyper-inflating that bubble. We ended the regulatory race to the bottom by prohibiting states from engaging in competitive regulatory laxity.
Summers, according to his supporters, sees none of these points. He comes from a very different perspective in which comparative IQ is the key explanatory variable.
“Mr. Summers is known for perhaps the most efficient rejoinder to the efficient-markets theory. ‘THERE ARE IDIOTS. Look around,’ he famously wrote in an unpublished paper.”
This is the type of statement that is considered “clever” by economists and makes your name. I explain below why I think the statement is dangerously misleading. The same NYT article explains Summers’ rationale for the disastrous Commodities Futures Modernization Act of 2000 which created a regulatory “black hole” for credit default swaps (CDS).
“At the time, Mr. Summers emphasized that he wanted to maintain the status quo to preserve the stability of domestic markets, and to avoid pushing the business overseas. In July 1998, he told Congress that he also saw no reason for regulation because ‘the parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves.’
The Clinton administration subsequently agreed with Congressional Republicans to formalize the lack of regulation, allowing the market to grow in the dark. That helps explain why regulators were blindsided a decade later when the world’s largest derivatives gambler, the American International Group, nearly brought down the financial system.”
Note that Summers endorsed the regulatory race to the bottom that proved so devastating here and in the Eurozone. Because he did not understand accounting control fraud he thought that CDS promoted market “stability” when it did the opposite. The NYT reporter remains blind to accounting control fraud, describing AIG as a “gambler.” As George Akerlof and Paul Romer (and regulators and criminologists) explained two decades ago, AIG’s officers engaged in a “sure thing.” Looting: The Economic Underworld of Bankruptcy for Profit (1993). The officers controlling AIG’s CDS operations sold CDS “protection” to other firms guaranteeing them against loss on assets that were frequently “backed” (sic) by endemically fraudulent “liar’s” loans. AIG booked the fee immediately as income and set aside zero loss reserves for the inevitable losses. This creates three “sure things.” AIG was guaranteed to report huge (albeit fictional) profits in the near term. AIG’s officers selling the CDS protection were guaranteed to be made wealthy quickly through modern executive compensation. AIG was guaranteed to eventually suffer catastrophic losses. As Akerlof and Romer pointed out in their famous 1993 article, why “gamble” on high risk strategies when one can get wealthy through a “sure thing.” Note that this fraud scheme does not require any great IQ.
It would be good if economists read the criminology literature on control fraud. It would be good if economists read the regulatory literature on control fraud. It should be unacceptable that economists fail to read the economics literature about control fraud by a Nobel Laureate (Akerlof, 2001). Summers missed the most fundamental point about accounting control fraud. Here’s the key passage again: “the parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves.” “Institutions” are not the issue – the controlling officers are the issue. In accounting control frauds the controlling officers loot “their” “institutions.” “Institutions” are “[in]capable of protecting themselves” from their controlling officers.
“Sophisticat[ion]” is not the issue. Immorality, the ability to loot with impunity, the ability to become quickly wealthy through modern executive compensation, and the presence of a Gresham’s dynamic are the key issues. The “sophistication” of the fraudulent controlling officers is relevant, but as the AIG example demonstrates, it takes minimal sophistication for the controlling officers to engage in accounting control fraud. The key psychological characteristic that determines how much injury a fraudulent officer will cause is audacity, not IQ.
We can now see why Summers’ claim that markets are inefficient because some investors are “idiots” is so dangerously wrong. Control fraud makes markets inefficient and control fraud epidemics make markets outright perverse by creating powerful Gresham’s dynamics, hyper-inflating financial bubbles, and driving severe financial crises. None of this requires “idiots.” Fraud relies on deceit, and intelligent people are deceived routinely by control frauds. The world’s allegedly most sophisticated creditors eagerly fund control frauds – they typically do not “discipline” them.
Jared Bernstein’s effort to support Summers’ regulatory reformation reprises his IQ fixation.
“It was not that he didn’t believe in more oversight, or thought that banks with insured deposits should blithely trade their own books. It was that he believed that the financial ‘innovators’ would always be numerous steps ahead of the regulators.”
As S&L regulators we were consistently ahead of “the markets” and “sophisticated” economists. Summers hasn’t caught up to where we were 20 years ago – even with the aid of our example.
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.
Follow him on Twitter: @williamkblack