Neoclassical economists have long been convinced that they would make exemplary regulators – and that the unique advantage they would bring to the task is their knowledge that those that regulated the least would regulate the best. Consider two crises in which economists controlled regulation – the S&L debacle and the U.S. nonprime crisis. Dick Pratt (Federal Home Loan Bank Board Chairman in 1981-83) and Alan Greenspan (Federal Reserve Chairman in 1987-2006) failed because of bad theory, methodology, and crippling ideology. These deficiencies interacted and led them to adopt regulatory policies that were intensely criminogenic.
Dick Pratt and Alan Greenspan shared an ideological hate for regulation. They both pushed deregulation in circumstances where even neoclassical economic theory predicted would be disastrous. Pratt deregulated at a time when virtually every savings and loan (S&L) was insolvent on a market value basis – which neoclassical economics predicts will maximize “moral hazard.” Greenspan refused to regulate at a time when it was becoming the norm for mortgage lenders to engage in deliberate “adverse selection” – which meant that the “expected value” of their loans was negative.
Deliberate adverse selection is a hallmark of “accounting control fraud” (those that control a seemingly legitimate entity use accounting as their fraud “weapon”). The FBI warned publicly in September 2006 that there was an “epidemic” of mortgage fraud and predicted that it would cause a financial “crisis” if it were not stopped. Greenspan took no meaningful action against the fraud. He was the prisoner of the “efficient market hypothesis.” Material accounting control fraud cannot exist under even the weakest variants of the efficient market hypothesis, so Greenspan believed such frauds could not exist (even though he served as an expert for the most notorious S&L accounting control fraud – Charles Keating’s Lincoln Savings). Greenspan (and Bernanke until 2008 – after the barn had burned down) refused to use the Fed’s unique statutory authority under HOEPA (passed in 1994) to regulate the otherwise unregulated mortgage bankers that originated most of the nonprime loans.
Neoclassical economists are proud of their methodology – econometrics – and believe that it makes them the only “social scientists” worthy of the word “scientists.” Standard econometric studies, however, fail catastrophically whenever a financial bubble is inflating or when there is substantial accounting control fraud. Regulators that base their policies on econometric studies in either of these environments will encourage accounting control fraud. The typical econometric study uses either income or stock price as the dependent variable to test putative independent variables’ association with improved firm performance. Stock price is largely driven by reported income. The problem is that disastrous business practices optimize accounting control frauds and hyper-inflate financial bubbles. The worst lending practices display the strongest positive association with reported accounting income – right up the point that everything collapses and the true (negative) “sign” of the correlation emerges.
The recipe for a lender engaged in accounting control fraud that seeks to maximize reported accounting income has four ingredients: (1) extreme growth, (2) lend even to the uncreditworthy – at premium yields, (3) extreme leverage, and (4) provide only minimal general loss reserves (ALLL).
Lenders that follow this recipe are mathematically guaranteed to report record income in the near term – which makes their officers wealthy given modern executive compensation. George Akerlof (Nobel Laureate in Economics in 2001) and Paul Romer emphasized that accounting fraud was “a sure thing” in their famous 1993 article (Looting: The Economic Underworld of Bankruptcy for Profit).
Absent a bailout or subsidy, the lender will eventually fail, but the senior officers will can walk away wealthy. At any given time, particular assets (which lack a readily verifiable market value) and industries (because of weak regulation and supervision) will provide a superior environment for accounting control fraud. This causes such frauds to cluster and, particularly if entry is easy, can lead to epidemics of accounting control fraud in an industry. This causes financial bubbles to hyper-inflate, which allows the frauds to extend the (fictional) profits and hide the (real) losses by refinancing bad loans.
The accounting fraud recipe causes regulators that rely on econometrics studies to make the worst possible policy decisions. Making bad loans at a premium yield, combined with extreme growth and liquidity, and minimal loss reserves simultaneously maximizes fictional income and real losses. The econometric study will show that making bad loans exhibits a powerful positive correlation with income. Greenspan kept getting this wrong. During the S&L debacle he endorsed an econometric study by George Benston that concluded that we were insane to restrict “direct investments” by S&Ls because the 33 S&Ls that made substantial amounts of direct investments were exceptionally profitable. Greenspan also opined that Lincoln Savings posed “no foreseeable risk” to the FSLIC insurance fund. Two years later, all 33 of the S&Ls had failed. Lincoln Savings was the most expensive S&L failure.
Pratt made the same blunder. He modeled the federal S&L deregulation bill (the Garn-St Germain Act of 1982) on the State of Texas’ deregulatory bill – because Texas S&Ls reported that they were the most profitable in the nation. S&Ls based in Texas ultimately caused over 40% of the total S&L losses. Their high reported profitability was driven by the Texas accounting control frauds. Pratt could not have chosen a worse model for federal deregulation than Texas. Passage of the Garn-St Germain Act sparked a “competition in laxity” with the States. California “won” the “race to the bottom” by providing no significant regulation or supervision. Neoclassical economists applauded this competition because their ideology and theories led them to assure the nation that the greater the deregulation the stronger our economy would be.
Federal S&L deregulation occurred nearly 30 years ago. The inability of neoclassical economists to learn from the recurrent financial disasters and epidemics of accounting control fraud demonstrate that we are dealing with a faith-based economics. America continues to export failed economic theory and theoclassical economists. Until we break their grip on policy we will continue to suffer recurrent, intensifying financial crises. In my next several columns I’ll discuss the perverse regulatory policies we are following that are delaying and weakening our economic recovery and making future crises more likely and more severe.
Bill Black is the author of The Best Way to Rob a Bank is to Own One, which has been praised by Paul Volcker and George Akerlof (Nobel Laureate in Economics). His work as a regulator is cited by public administration experts as an exemplar of success and integrity. Bill’s academic articles, congressional testimony, and musings about the financial crisis can be found at:
William K. Black