House Republicans Creating World's Worst Criminogenic Environment

By William K. Black, New Economic Perspectives

14 June 12

n criminology, we recognize that one of the leading restraints on the effectiveness of law enforcement is “systems capacity.” Indeed, my mentor, Henry Pontell (UC Irvine), defined the concept. In the context of crimes of the street (other than Wall Street), there is normally no lobby trying to allow the typically lower class criminals to commit their crimes with impunity. In crimes of the business suites, however, it is the norm that there are well-funded, powerful, and seemingly legitimate lobbyists for the elite criminals who seek to allow them to commit their crimes with impunity. Similarly, it is rare for street criminals to consult a lawyer before they commit their crimes. Elite white-collar criminals often consult with expert legal counsel before, during, and after they commit their crimes in order to try to minimize the risk of being sanctioned.

One of the most obvious ways to produce a criminogenic environment is to create systems incapacity to detect and sanction crime. House Republicans are doing that in the context of elite white-collar crime. That context also happens to be the leading campaign donors for both parties.

On June 9, 2012, The New York Times published an important editorial entitled “Lost the Vote? Deny the Money.” The editorial will be ignored by the Obama administration and Republicans but it is well worth reading in full. Here are some key excerpts.

If you wanted to reproduce the conditions that led to the Great Recession in 2007, the easiest way would be the plan unveiled last week by House Republicans: gut the regulators who are supposed to keep the worst business practices in check.

At a time when the economy is still reeling from the downturn, House Republicans released a spending bill that would severely cut the budget of the Commodity Futures Trading Commission, which would keep it from regulating potentially toxic swaps and other derivatives. It refused to give the Securities and Exchange Commission the extra money it needs to carry out the Dodd-Frank financial reform bill.

And the bill would cripple the Internal Revenue Service, limiting its ability to detect tax avoidance, particularly by businesses and the wealthy. (The I.R.S. cut, designed to impede the agency’s role in health care reform, will inevitably increase the deficit.)

With 710 employees, the C.F.T.C. staff is barely big enough for its current responsibilities, let alone its new mission under Dodd-Frank to oversee the huge over-the-counter swaps market. Its budget is $205 million, which President Obama proposed increasing to $308 million for 2013 to deal with swaps. The House Appropriations Committee has proposed slashing next year’s budget to $180 million.

The agency’s chairman, Gary Gensler, said: “The result of the House bill is to effectively put the interests of Wall Street ahead of those of the American public, by significantly underfunding the agency Congress tasked to oversee derivatives — the same complex financial instruments that helped contribute to the most significant economic downturn since the Great Depression.”

As Mr. Gensler pointed out, the market in swaps, at $300 trillion, is eight times larger than the futures market his agency has been regulating, and yet the House wants to cut the agency’s budget significantly. The House committee chairman, Harold Rogers, said the agency should return to its “core duties,” a statement that brazenly ignores a new set of duties Congress put on the books.

In this essay I make four brief points. First, the House Republicans’ proposals would produce the most criminogenic environment in the world that risks an even larger financial crisis and outright depression. This isn’t simply the lesson of the current crisis. George Akerlof and Paul Romer explained the point in 1993 in their classic article (“Looting: the Economic Underworld of Bankruptcy for Profit”). They made this paragraph their conclusion in order to emphasize the 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” (Akerlof & Romer1993: 60).

Akerlof was made a Nobel Laureate in economics in 2001.

Second, the losers from creating a criminogenic environment that encourages looting are not “merely” the public – the losers include honest businesses. When cheaters gain a competitive market, competition becomes perverse and firms controlled by the least ethical CEOs can drive their honest competitors from the marketplace. Akerlof made this point explicitly in his even more famous 1970 article on markets for “lemons” where he wrote about the economics of anti-purchaser control frauds. He called it a “Gresham’s” dynamic.

“[D]ishonest dealings tend to drive honest dealings out of the market. The cost of dishonesty, therefore, lies not only in the amount by which the purchaser is cheated; the cost also must include the loss incurred from driving legitimate business out of existence.”

Modern executive compensation causes accounting control fraud to produce a powerful Gresham’s dynamic. CFOs rightly fears that their tenure may be measured in months if they do not mimic their rivals’ use of accounting control fraud to produce what Akerlof and Romer aptly termed a “sure thing” of record reported income that, in turn, produces enormous executive compensation.

Classic economists stressed the essential role of government – providing a rule of law and preventing and punishing criminal acts, including fraud. Ayn Rand stressed that government had a duty to prevent fraud. The essence of crony capitalism is the ability to commit fraud with impunity. The Tea Party opposes crony capitalism and the House Republicans quake in fear of upsetting the Tea Party and being challenged in the Republican primary.

We have deregulated, desupervised, and de facto decriminalized finance in the U.S. and Europe to an unprecedented extent in the last 30 years and the results have been uniformly catastrophic. Governor Romney states that he intends to repeal the entire Dodd-Frank Act and recreate the criminogenic environment that caused the financial crisis and the Great Recession.

We have four dogs that have failed to bark. Conservatives have long claimed to be the party of law and order – where are they. The data are in – the Bush and Obama administrations have been soft on elite white-collar crime (by their largest campaign donors). Libertarians and Tea Party supporters who hate crony capitalism – rise up and demand an end to the elites who grow wealthy by committing fraud with impunity and cost millions of Americans and Europeans their jobs.

And where are President Obama and Attorney General Holder on this issue? The editorial quotes only regulators. The President and the Attorney General should be taking the lead and denouncing the deliberate recreation of a criminogenic environment. Here is the central fact that Holder and Obama have never grasped – effective investigations and prosecutions of epidemics of elite financial frauds are only possible where the regulators and the SEC do the heavy lifting. The regulators will only do the heavy lifting if their leaders understand control fraud and make its detection, termination, sanctioning, and prosecution their top priorities. Bush and Obama have overwhelmingly appointed failed, anti-regulators like James Gilleran, John Reich, John Dugan, Timothy Geithner, Alan Greenspan, Ben Bernanke, Harvey Pitt, and Susan Schapiro. They have also appointed attorney generals who have all been weak on elite financial fraud.

The epidemic of accounting control fraud by financial institutions that drove the Great Recession was the largest and most costly example of white-collar crime in history. But all we have heard from Obama and Holder is minimization of the role of fraud in the crisis and the same abject failure as the Bush administration to prosecute the elite frauds that drove the crisis. The minimization of fraud comes from the death of criminal referrals by the regulatory agencies. Neither the banking regulatory agencies nor the FBI has conducted what would have been considered in our era a serious investigation of an elite financial institution. When it comes to elite frauds; if you don’t look you don’t find. Having falsely claimed that there were only trivial violations of the law, the Obama administration has emasculated its ability to go credibly to the public and warn that the House Republicans are about to recreate the criminogenic environment that produces our recurrent, intensifying financial crises. Holder and Obama cannot credibly claim that the House Republicans are about to allow our financial elites to again grow wealthy through fraud because Holder and Obama are continuing Mukasey and Bush’s policy of granting de facto immunity to the elite criminals who caused the crisis.

Prominent Republican writers have recently urged their Party to destroy crony capitalism. Instead, their representatives are trying to entrench it. Prominent progressives have been urging Obama to destroy crony capitalism. Instead, he has entrenched it by taking his financial advice from Robert Rubin, Lawrence Summers, Geithner, and Bernanke. Neither party is willing to take on their leading source of political contributions. We need a party, an attorney general, and a slew of regulators who will make it their mission to end crony capitalism in America. Europe needs the same thing.

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.