Markkula Center of Applied Ethics

Criminologists Needed

By William K. Black

During the recent sniper crime wave in the Washington D.C. area, the talk shows were filled with interviews of criminologists and former FBI officials. The police enlisted the criminologists in trying to profile the snipers and figure their most likely place of residence.

There is another crime wave. Trillions of dollars of market capitalization have been lost due to the recent financial scandals. I have not seen or heard of a single criminologist being interviewed about this crime wave. The regulators and prosecutors are not drawing on criminologists to try to limit this crime.

The experts who get interviewed about the massive financial frauds are economists and stock analysts. This is a bit strange, for these are the very people who helped bring about the prior epidemic of fraud by controlling persons ("control fraud") and gave such awful public policy advice that they set the stage for the recent bubble in the stock market and the ongoing scandals.

Here's the short version of that track record. Dick Pratt, a professor of finance, was made Chairman of the federal savings and loan regulatory agency. He decided to deregulate and desupervise the industry at a time of mass insolvency—even though economic theory unambiguously predicted that would produce a disaster (it did!). Not one economist warned contemporaneously that this was unwise. Pratt left the agency in triumph (he used phony accounting to make the industry, and him, look good) to join Merrill Lynch and sell mortgage securities to the S&L industry.

George Benston was Charles Keating's lead economist in fighting against reregulation of the industry. Benston lauded 33 S&Ls that engaged in an investment that Pratt's successor was restricting. Every one of them failed; most of them were control frauds. He was given an endowed chair at Emory.

Alan Greenspan was Keating's "name" economist. He helped recruit the five senators who became known as the "Keating Five" when they pressured us to go easy on Lincoln Savings. Greenspan said that Lincoln Savings posed no risk to the taxpayers. Oops. It cost the taxpayers $3 billion and became the most expensive S&L failure.

Another "law & economics" scholar praised both Keating and one of his fellow control frauds, David Paul, and said that their S&Ls posed no risk to the taxpayers. He went on to become Dean of the University of Chicago's law school.

Economists proved that hindsight is not always 20:20. They claim that fraud was trivial during the debacle and is a "distraction." That won't wash; over 1000 S&L insiders were convicted of felonies.

Law & economics scholars dominate the field of corporate governance despite their dismal track record. They controlled the public policy response to the debacle. Here are their primary conclusions that shaped that policy:

  • Markets have X-ray vision. "Transparency" is not important; markets see through the most opaque accounting and spot frauds easily.

  • Rules against fraud are neither essential nor important because markets promptly exclude anyone engaged in fraud.

  • Honest firms use three means to distinguish themselves from control frauds. They hire a top tier audit firm (these scholars claim control frauds cannot hire such firms). They have the CEO own substantial stock in the company so that they cannot harm the company without harming themselves. They borrow heavily. Highly "leveraged" companies are said to have only two choices - make lots of money to pay the heavy interest costs or be forced into bankruptcy.

  • Stock analysts' recommendations are reliable and at least "an order of magnitude" superior to any advice from a regulator.

  • Rules against conflicts of interest by company officers and board members are too strict and, along with other fiduciary duties, should be weakened.

I don't need to rebut these claims; the scandals have done it for me. So here's my modest proposal; instead of getting our guidance exclusively from the folks who designed the disaster and keep talking about the fraudulent CEOs as "risk takers," why not draw on the expertise of those who study how to limit white-collar crime?

William K. Black is an Assistant Professor at the LBJ School of Public Affairs of the University of Texas at Austin and a Visiting Scholar at the Markkula Center for Applied Ethics of Santa Clara University. He is a lawyer and criminologist and a former regulator. He teaches microeconomics (and some of his best friends are economists).

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