When Fragile becomes Friable: Endemic Control Fraud as a Cause of Economic
Stagnation and Collapse
William K. Black
Executive Director, Institute for Fraud Prevention
IDEAS Workshop: Delhi, India
Financial Crime and Fragility under Financial Globalization
December 19-20, 2005
Individual “control frauds” cause greater losses than all other forms of property crime
combined. They are financial super-predators. Control frauds are crimes led by the head
of state or CEO that use the nation or company as a fraud vehicle. Waves of “control
fraud” can cause economic collapses, damage and discredit key institutions vital to good
political governance, and erode trust. The defining element of fraud is deceit – the
criminal creates and then betrays trust. Fraud, therefore, is the strongest acid to eat away
at trust. Endemic control fraud causes institutions and trust to become friable – to
crumble – and produce economic stagnation.
White-collar criminology emphasizes incentive structures. A criminogenic environment
is one that has strong positive incentives to engage in crime. While economists stress
incentive structures, economics ignores criminogenic environments. The weakness
comes from three sources. Economic theory about fraud is underdeveloped, core neoclassical theories imply that major frauds are trivial, economists are not taught about
fraud and fraud mechanisms, and neo-classical economists minimize the incidence and
importance of fraud for reasons of self-interest, class and ideology.
Neo-classical economics’ understanding of fraud is so weak that its policy prescriptions,
if adopted wholly, produce strongly criminogenic environments that cause waves of
control fraud. Neo-classical policies simultaneously make control fraud easier and more
lucrative, dramatically reduce the risk of detection and prosecution by maximizing
“systems capacity” problems, and encourage crime by making it easier for fraudsters to
“neutralize” the social and psychological constraints against deceit and fraud. Thus the
paradox: neo-classical economic triumphs produce tragedy. Perverse policies led to four
recent crises: the deregulation and desupervsion of the savings & loan (S&L) industry
produced the 1980s crisis, “shock therapy” caused the collapse of the Russian economy,
the “Washington consensus” produced a wave of control fraud in Latin America, and the
desupervision of the U.S. economy in the 1980s and 1990s led to an epic wave of control
fraud that contributed materially to the $9 trillion loss in U.S. stock market
capitalization.’’ With globalization, these crises can transmit to other nations through
“contagion” or by causing key international investors to fail.
These recurrent disasters have discredited neo-classical policy nostrums through most of
the world. In Latin America, for example, the perverse policies have led to the election
of a series of explicitly anti-U.S. and anti-free market leaders. In Russia, the perverse
policies discredited neo-classical economics and nascent democratic institutions. Yet,
neo-classical economists learn nothing and proceed from failure to failure.
It is vital that criminological findings and theories about fraud become part of the
economics canon. If it is bad criminology it is bad economics. If neo-classical
economics predicts something (e.g., that control frauds cannot fool creditors and
shareholders) that criminologists have shown to be false, then the economic theory is
incorrect. Criminologists have found that neo-classical economic policies, taken to the
extreme, erode the institutions that constrain control fraud and make markets more
efficient. Neo-classical policies damage markets and aid the financial super-predators
whose predations discredit markets and democracy and bring Hugo Chavez to power.
The intriguing issue is whether these results are unintended consequences or deliberate.
White-collar criminology has a set of empirical findings and theories that are useful to
understanding when markets will act perversely. This paper addresses three, interrelated
theories economists should know about. “Control fraud” theory explains why the most
damaging forms of fraud are situations in which those that control the company or the
nation use it as a fraud vehicle. The CEO, or the head of state, poses the greatest fraud
risk. A single large control fraud can cause greater financial losses than all other forms
of property crime combined – they are the “super-predators” of the financial world.
Control frauds can also occur in waves that can cause systemic economic injury and
discredit other institutions essential to good government and society. Control frauds are
commonly able to defeat for several years market mechanisms that neo-classical
economists predict will prevent such frauds.
“Systems capacity” theory examines why under deterrence is so common. It shows that,
particularly with respect to elite crimes, anti-fraud resources and willpower are
commonly so limited that “crime pays.” When systems capacity limitations are severe a
“criminogenic environment” arises and crime increases. When a criminogenic
environment for control fraud occurs it can produce a wave of control fraud.
“Neutralization” theory explores how criminals neutralize moral and social barriers that
reduce crime by constraining our decision-making to honest enterprises. The easier
individuals are able to neutralize such social restraints, the greater the incidence of crime.
Unfortunately, white-collar criminology has had no influence on neo-classical
economics. This is largely due to mutual mono-disciplinary blinders – neither field reads
the other field’s work. Some white-collar criminologists do now read the relevant
economic literature. We have found that our core theories and recommended praxis are
contradictory. White-collar criminologists (unlike many of our blue-collar counterparts)
emphasize incentive structures and generally proceed from the starting assumption of
rational, self-interested behavior and stress that the key attribute of a good model is
predictive power – not descriptiveness. This is consistent with neo-classical economics,
so the question becomes why our disciplines produce contradictory results.
White-collar criminologists believe that their empirical work established over 60 years
ago that elite U.S. corporations frequently acted unlawfully. Sutherland’s (who coined
the term “white-collar crime”) classic work reached this conclusion by relying on a study
of adjudicated findings of violations of the law. There are inherent empirical limitations
in studying such elite crimes that cause the findings to be substantially understated.
Unlike typical blue-collar crimes, the victim of an elite white-collar crime generally does
not know that they have been victimized. Most such crimes are secret and create indirect,
generalized injuries, e.g., a cartel. Frauds, by definition, are hidden and elite frauds, e.g.,
the CEO that loots a firm by using abusive accounting to create fictional profits that make
his stock options valuable, may never be discovered. Governments such as the U.S. keep
detailed records of non-elite property crimes – but not elite property crimes. Even if a
regulator or prosecutor believes that an elite fraud caused he injury no case may be
brought. When regulators bring enforcement actions they typically settle through a
consent decree that has no adjudication of guilt. Sutherland’s findings are more powerful
given these limitations.
Several neo-classical economic and finance theories, however, predict that control frauds
will be trivial. These theories are logical extensions of the core theories underlying
modern neo-classical economic and finance theory. These extensions rest on predictions
about the behavior of other economic actors, e.g., external auditors, which assert that
these actors will virtually never act abusively. White-collar criminologists’ theories
predict the opposite and have demonstrated superior predictive power. Top audit firms
routinely provide “clean” opinions to deeply insolvent, pervasively fraudulent companies.
I argue that if it is bad criminology, it is bad economics and if it is good criminology it is
good economics. Where economics, on the basis of an economic theory, makes a
prediction about crime that criminologists prove to be empirically false the economic
theory is false. Where criminology accurately predicts and explains perverse market
behavior it should be become part of the economics canon.
White-collar criminology findings falsify several neo-classical economic theories. This
paper discusses the predictive failures of the efficient markets hypothesis, the efficient
contracts hypothesis and the law & economics theory of corporate law. The paper argues
that neo-classical economists’ reliance on these flawed models leads them to recommend
policies that optimize a criminogenic environment for control fraud. Fortunately, these
policies are not routinely adopted in full. When they are, they produce recurrent crises
because they eviscerate the institutions and mores vital to make markets and governments
more efficient in preventing waves of control fraud. Criminological theories have
demonstrated superior predictive and explanatory behavior with regard to perverse
economic behavior. This paper discusses two realms of perverse behavior – the role of
waves of control fraud in producing economic crises and the role that endemic control
fraud plays in producing economic stagnation.
Typologies of private sector control frauds
Control fraud theory explains why these frauds cause such disproportionate losses. In the
private sector, the individual that controls the company (in practice) is typically the CEO.
When the nation is used as a fraud vehicle (“kleptocracy”) the head of state typically
controls the nation. One can classify private sector control frauds by the nature of the
primary intended victim of the fraud. In “looting” control frauds the CEO loots the
company’s creditors (which include the workers) and shareholders. Accounting fraud is
the looter’s “weapon of choice.” The CEO uses it to overstate the company’s profits and
net worth in order to convert company assets to his personal use through seemingly
normal and legitimate corporate mechanisms (e.g., salary, bonuses and stock options).
In anti-customer control frauds the CEO can use the company as a weapon in three
distinct manners. He can join with other firms in a cartel. Not all cartels are unlawful –
the ultimate success in control fraud is for the government to make one’s action lawful.
Most cartels, however, are unlawful and have to be kept hidden through deceit – fraud.
Another way to use the company as a weapon against consumers is the “scam.” The
seller defrauds the consumer about the quality, existence, or delivery of the good or
service. These are classic “lemons” market frauds. Scams against suppliers typically
involve not paying the supplier for the goods. The other means of defrauding the
consumer is procurement fraud. Such frauds rely on bribery the customer’s agent in
order to defraud. Procurement fraud can be used against both buyers and sellers.
A common anti-public control fraud harms the public by increasing pollution. A firm
hired to dispose properly of toxic waste can decrease its expenses substantially by
dumping the waste in a river and a company that pays an effluent tax can reduce the tax
by fraudulently underreporting its emissions. Another common variety of anti-public
control fraud is corporate tax evasion.
These forms of control fraud are all similar in several respects. Each is predatory. Each
creates and betrays trust (though that is more tenuous in the toxic disposal case).
Widespread control fraud operates like a strong acid that erodes trust. In each form of
control fraud the gain to the CEO is far smaller than the loss to the victims. Each form of
control fraud materially increases economic inefficiency. In each case the losses are far
greater because the CEO rather than a more junior official runs the fraud. The CEO has
unique ability to optimize the company for control fraud, unique capacity to shape the
external environment to aid the fraud, unique apparent legitimacy, and can secure a larger
gain in status from the fraud than any junior officer.
The three forms of private sector control fraud do not operate in the same manner.
“Looting” control frauds create fictional income and real losses. Indeed, one the reasons
they produce extraordinary losses is that they create perverse incentives to enter into the
worst transactions because they produce the best accounting “profit.” One optimizes a
looting control fraud by rapid growth, e.g., by operating as a “Ponzi” scheme that uses a
portion of the new funds brought in through growth to pay off old creditors. The Ponzi
scheme extends the life of the fraud, increasing the “take” and the losses. If a wave of
looting control frauds occurs it means that the companies will continue to invest in the
asset categories optimal for accounting fraud, e.g., commercial real estate. This causes,
and extends, a bubble. The bubble causes further economic inefficiency and the collapse
of the bubble can cause systemic economic injury (e.g., the collapse of Japan’s twin
bubbles in 1990). Looting control frauds will eventually collapse unless they are
protected by public sector control frauds. This is a variety of “crony capitalism.”
The other two forms of private control fraud produce real economic profits, indeed, they
are undertaken in order to reap supra normal profits. Anti-consumer and anti-public
control frauds frequently endanger public safety. Inferior products are frequently unsafe
products because it is more expensive to design and produce a safe product. The process
of producing unsafe goods may also be unsafe, so workers may also be victims of lemons
markets. The risk to public safety of improper waste disposal or the deceptive emission
of additional pollutants is obvious.
Whenever fraud creates real cost savings an additional problem arises. Analogous to
Gresham’s law (hyperinflations causes “bad money to drive good money out of
circulation”), frauds that produce a competitive advantage must be vigorously prevented
by public authorities or they will create an incentive for rivals to emulate the fraud.
KPMG (1998), for example, adopted a scheme of selling illegal tax shelters to rich clients
on the explicit bases that (1) all of its competitors did so already and that acting
unlawfully would put them at a competitive disadvantage, (2) the IRS was overwhelmed
and was unlikely to spot the crime, and (3) the penalties for acting unlawfully were far
smaller than the fees the firm would earn. The first point is a classic Gresham’s law
dynamic that made tax fraud endemic at top tier firms (according to KPMG) and the
second two points are classic examples of severe “systems capacity” limitations that
criminological theory predicts will lead to criminogenic environments and increased
Cartels operate very differently from looting control frauds. Instead of expanding
production and growing rapidly, a cartel optimizes by restraining production.
Looting control frauds and procurement fraud inherently cause damage to other critical
institutions because they can only succeed by suborning agents, e.g., outside auditors and
law firms or purchasing officers, who are supposed to protect the company and the
public. This corrupts these institutions and harms the economy directly and by creating a
Gresham’s law-style dynamic in which bad accounting can drive out good accounting
(NCFIRRE 1993; Black 2005).
The optimization of looting control frauds
The primary manner in which criminological and neo-classical economic theory
contradict arises from looting control frauds.1
This paper will explain briefly how looting
control frauds optimize as an exemplar. Control frauds are the optimal form of looting
because the CEO has four unique advantages. First, the CEO can suborn internal and
external controls and pervert them into allies. The principal external control against
accounting fraud is supposed to the outside auditor. CEOs control the hiring and firing of
internal employees and non-governmental external controls. They, therefore, have the
unique ability to “shop” for an auditor that will aid their looting. This does not require
any explicit conspiracy. The CEO simply looks for an audit partner that stresses his
aggressiveness and sophistication. Control frauds have consistently, world wide, shown
the ability to get “clean” opinions for financial statements that purport to show that the
company is highly profitable and solvent when the company is in fact deeply insolvent
and unprofitable and pervasively corrupt. Moreover, the CEOs that engage in looting
control frauds do not merely “defeat” the internal and external controls – they almost
invariably choose top tier audit firms and use their reputation and “blessing” of their
financial statements as their primary means of deceiving creditors and shareholders.
Second, only the CEO can optimize the company for fraud. He optimizes the company
by having it invest primarily in assets that have no readily ascertainable market value.
Professionals must value such assets – this allows the CEO to hire an appraiser or
accountant that will provide a grossly inflated asset value. Because the asset has no
obvious market value it makes it extremely difficult for the regulator (much less
prosecutor) to contest the valuation. Such assets are also optimal for extending the life of
the fraud. I have explained that rapid growth extends the life of the fraud, and increases
the “take”, by allowing a Ponzi scheme. The CEO has the unique ability to cause the
firm to follow such a scheme. The CEO can also extend the fraud by arranging false
“sales” of the troubled assets to “straws” or related parties – at grossly inflated prices that
produce additional profits.
The combination of the first two factors means that the only real check on control frauds
is often limited audacity. Audacious control frauds invariably get clean opinions for
financial statements purporting to show record profitability. Indeed, the false profits
claimed by audacious looters are far greater than the real profits produced by control
frauds that target consumers or the public.
Third, CEOs have the unique ability to convert company assets into personal funds
through seemingly legitimate corporate mechanisms. Accounting fraud is the key to this
conversion. The record, albeit fictional, profits blessed by the top tier audit firm cause
the stock to appreciate. The (U.S.) CEO will typically have a large percentage of his
wealth invested in “his” company’s stock. The CEO can then sell a large block of shares
and profit. The CEO will also be rewarded with a raise (very large in the U.S.), a bonus,
additional perks and new stock options. The CEO will also gain in status and reputation.
The theories also contradict with respect to cartels. Modern neo-classical economists argue that cartels
are inherently unstable because they create an incentive for participants to defect. This destroys cartel
discipline. Criminology has documented how illegal cartels can be extremely stable and cause severe
injury (Black 2004).
Fourth, the CEO has the unique ability to influence the external environment to aid his
fraud. Thus, Enron boasted of creating the “regulatory black hole” that left energy
derivatives unregulated. Enron exploited this systems capacity limitation to form a cartel
and produce the California energy crisis by taking production plants off line. During the
S&L debacle the most audacious control frauds used their political contributions to fend
off the regulators by influencing key members of the Reagan/Bush administration and
Congress (Black 2005; NCFIRRE 1993; Calavita, Pontell & Tillman 1997). CEOs use
the company’s assets to burnish its apparent legitimacy by making charitable
contributions. The political and charitable contributions also enhance the CEO’s status
Economic theories relevant to looting control frauds
Prior to Akerlof & Romer (1993), economics had no theory or model of fraud. As noted
above, it assumed that cartels posed no significant problems because it predicted that they
could not maintain discipline. Akerlof (1970) provided a theory of markets for lemons –
and all of the examples that Akerlof presented were examples of consumer control frauds
– but Akerlof does not describe them as frauds. Indeed, in their 1993 article, Akerlof &
Romer explicitly assumed that looting control frauds could not exist but for special
circumstances, such as deposit insurance, that removed the normal incentive of private
creditors to prevent such frauds. Akerlof & Romer assumed that efficient contracts
theory and the efficient markets hypothesis demonstrated the efficacy of creditors of risk
in preventing fraud (1993: 5-6). This assumption is somewhat remarkable. If efficient
contracts prevent fraud then lemons markets should not exist. Akerlof (1970) argued that
lemons markets arose because of information asymmetry – the seller knew far more
about the true quality of the goods than the buyer. Reading the article also makes clear
that, though he does not stress this point, Akerlof knew that the seller in his examples was
intentionally misrepresenting the quality of the goods in order to deceive (defraud) the
buyer. So, it is curious that Akerlof & Romer did not explore whether the
borrowers/stock issuers know more about their true financial value than
creditors/shareholders and whether the optimal strategy (under lemons theory) was to
optimize the extent of the asymmetry through deception.
In 1993, the U.S. economics profession was focused on the S&L debacle and their
universal assumption was that deposit insurance was the sine qua non for the enormous
losses. While the conventional economic wisdom asserted that fraud was trivial during
the debacle, even the three economists (Akerlof, Pierce and Romer) that realized that
fraud was a major contributor to the debacle asserted that the looting was only possible
because deposit insurance unhinged private market discipline. (Pierce’s views can be
found in NCFIRRE 1993: 2-6.) This conventional wisdom can still be found in many
contemporaneous economic articles. This is an example of bad criminology making for
bad economics. Criminologists’ empirical work found over 1000 felony convictions of
senior S&L insiders (in an industry of 3,000 S&Ls) (Calavita, Pontell and Tillman 1997;
NCFIRRE 1993). Criminologists have also shown that the pattern of the worst failures
and the business practices of the worst failures are inconsistent with the “honest gambler”
hypothesis and consistent with the control fraud hypothesis (Black, Calavita & Pontell
1995; NCFIRRe 1993; Akerlof & Romer 1993: 4).
(Subsequently, Akerlof and Romer have modified their views and believe that looting is
possible even when there is a financial incentive for creditors and shareholders to engage
in private market discipline. As of 2003, Pierce maintained his 1993 position.)
Neo-classical economics had one additional theory about looting – but overwhelmingly
interpreted it to exclude fraud. The theory was “moral hazard.” Moral hazard theory
relies on asymmetry of outcomes. Limited corporate liability is a common source of
moral hazard. When a corporation is impaired the shareholders have a strong incentive
for the firm to engage in control fraud and/or take high risks. The logic is that because of
limited liability the creditors – not the shareholders – will bear the resultant losses should
the fraud or excessive risks fail. Conversely, should the fraud or gamble succeed the
shareholders will capture the great bulk of the financial gain. In 1993, however, virtually
every economist assumed (typically, implicitly without any explanation) that S&Ls
would engage only in ultra high-risk investments – not fraud. There was no basis for this
assumption, as Akerlof & Romer note, fraud was a “sure thing” (1993: 5).
There was one area of neo-classical economics with explicit predictions about fraud – but
those predictions were that fraud could not exist. The neo-classical theory of law &
economics predicted that looting control fraud could not exist for two reasons.
First, they argued that markets were easily able to spot control frauds (Easterbrook &
Fischel 1991: 20-21). Second, they argued that even if the markets could not spot control
frauds they would effectively exclude such frauds because the markets could identify
honest firms. While acknowledging that control frauds had an incentive to “mimic”
honest firms, the authors asserted that honest firms had both a financial incentive and
unique ability to signal that they were honest. Honest firms could send three signals:
they could retain top tier auditors, they could have the CEO invest the bulk of his wealth
in “his” company and they could be extremely leveraged (1991: 282). The logic for these
three points was as follows:
(1) a top tier audit firm has such a valuable financial interest in maintaining its
reputation that it would never provide a clean opinion to a fraudulent company,
(2) a CEO that invests heavily in “his” company “bonds” his faithful performance –
he cannot gain unless the shareholders do, and
(3) a company that is highly leveraged has only two choices – it can be well-run and
produce profits to meet the debt expenses or it can fail – promptly. In either event
it is not a major fraud risk.
The authors reach these propositions through logical extensions of the efficient markets
and efficient contracts hypotheses. They recognize that these models implicitly exclude
control fraud, because fraud would falsify both hypotheses. The minimum requirement
of the efficient markets hypothesis is that the markets have no systematic pricing bias.
But looting control fraud creates a systematic bias because it is used to overvalue
(massively) assets and understate liabilities. If control fraud is material, then neither the
contract nor the capital markets would be efficient. Therefore, Easterbrook & Fischel
had to find a way to exclude control fraud.
Moreover, given their strong priors against government and regulation, they had to
develop theories under which the markets would reliably exclude fraud – even if fraud
were legal. They had no empirical support for their proposition that the markets easily
spot control frauds or any of their three signaling devices. Indeed, by the time they
published in 1991, each of these four propositions had been falsified during the S&L
debacle. Moreover, Fischel was a lead consultant to three of the most notorious control
frauds in that era – Drexel Burnham Lambert (which the “junk bond king” Michael
Milken controlled), Lincoln Savings (which Charles Keating controlled) and CenTrust
Savings (which David Paul controlled). Fischel, relying on these same theories that are
the core assumptions of modern finance theory, predicted that each of the control frauds
was exceptionally well run, profitable and safe. In each case the company was able to get
clean opinions from top tier auditors – right up to their collapse. In each case the
executives owned substantial equity in the company – and found ways to become rich
while looting the creditors and shareholders. In each case the company was highly
leveraged – and collapsed many years later after growing massively. In each case their
financial statements showing record profitability made massive growth easy – creditors
and shareholders want to invest in companies that report record profits and receive clean
opinions from top tier audit firms. Once more, the neo-classical economic theory of
corporate law is bad economics because it is bad criminology (Black 2003).
Why neo-classical economics produces policies that cause economic crisis
Because neo-classical theory is virulently hostile towards government and has no explicit
theory of fraud and implicitly assumes that control fraud cannot be material, it repeatedly
produces recommended praxis that, if adopted, would optimize the criminogenic
environment for control fraud. When neo-classical thought triumphs societies adopt
simultaneously many elements of this anti-governmental agenda. This produces waves of
control fraud and crisis.
The central problem is that neo-classical praxis simultaneously increases the gains from
control fraud, maximizes system capacity limitations and enhances neutralization. This
trifecta optimizes the environment for control fraud. Neo-classical nostrums increase the
gains from private sector control fraud by permitting private interests to gain control of
companies (which are vastly more deadly “weapons” of fraud than are individuals) and
by greatly increasing the scope of the assets that these companies can invest in – which
aids accounting fraud.
Neo-classical policies maximize system capacity problems in a host of ways that vary by
country and context. However, it typically harms capacity in four characteristic ways.
First, the policies limit the number and quality of regulators. Second, the policies limit
the power of regulators. It is common for the profits of control fraud to greatly exceed
the maximum allowable penalties. Third, it is common to choose lead regulators that do
not believe in regulation (Harvey Pitt as Chairman of the SEC and, more generally,
President Reagan’s assertion that “government is the problem”). Fourth, it is common to
choose, or retain, corrupt regulatory leaders. Privatization, for example, creates ample
opportunities, resources, and incentive to corrupt regulators.
Neo-classical economic policy further aggravates systems capacity problems by advising
that the deregulation, desupervision and privatization take place very rapidly and be
radical. These recommendations guarantee that even honest, competent regulators will
be overwhelmed. Overall, the invariable result is a self-fulfilling policy – regulation will
fail. Discrediting regulation may be part of the plan, or the result may be perverse
Neo-classical policies also act perversely by easing neutralization. Looting control frauds
are guaranteed to produce large, fictional profits. Neo-classical proponents invariably
cite these profits as proof that the “reforms” are working and praise the “entrepreneurs”
that produced the profits. Simultaneously, there is a rise in Social Darwinism. The
frauds claim that the profits prove their moral superiority and the necessity of not using
public funds to keep inefficient workers employed. The frauds become the most famous
and envied members of high society and use the company’s funds to make political and
charitable contributions (and conspicuous consumption) to make them dominant.
In sum, in every way possible, neo-classical policies, when they are adopted wholesale,
sow the seeds of their own destruction by bringing about a wave of control fraud.
Control frauds are a disaster on many different levels. They produce enormous losses
that society (already poor in many instances) must bear. They corrupt the government
and discredit it. They inherently distort the market and make it less efficient. When they
produce bubbles they drive the market into deep inefficiency and can produce economic
stagnation once the bubble collapses. They eat away at trust.
Thus the paradox, neo-classical triumphs produce tragedy. The S&L industry was highly
regulated for decades. It was the bane of neo-classical economists. But the sharp rise of
interest rates (which rendered the industry, which was exposed to systemic interest rate
risk, insolvent) and the election of President Reagan provided an opportunity to radically
transform the industry. It was, within one year, suddenly deregulated and desupervised.
Within two years, roughly two hundred control frauds had entered the industry. Larry
White, a banking specialist, famously noted that there were “no Cassandras” among
economists – none warned that the policies would produce a disaster (1991). But White
is less well known for also stating that the frauds immediately understand the
opportunities. This demonstrates the cost of economic ignorance.
Neo-classical economists learned nothing from this disaster. Instead, they denied that
fraud was more than trivial and denied that deregulation and desupervision had anything
to deal with producing the crisis. They also suffered no reputational risk. George
Benston, for example, opined that 33 S&Ls that had taken advantage of deregulation
were much more profitable and safer as a result. Every one of the 33 failed – the great
bulk were control frauds (Black 2005). He was given an endowed chair at Emory after
going 0 for 33. I noted Daniel Fischel’s record of error – he was made Dean of the
University of Chicago’s law school. Another economist predicted that Lincoln Savings
(the worst S&L control fraud, costing the taxpayers over $3 billion) “posed no
foreseeable risk” to the taxpayers. His name was Alan Greenspan, he was made
Chairman of the Fed.
The next situation in which neo-classical nostrums were adopted wholesale was “shock
therapy” in Russia. The effects of privatization in producing the dramatic fall in Russian
GDP, sharp rise in corruption, and sharp fall in life expectancy is well documented. This
case was particularly striking because a number of the leading neo-classical economists
benefited personally from the privatizations. Self-interest is a powerful contributor to the
refusal of neo-classical economists to admit that their policies are responsible for the
The “Washington consensus” represents the third triumph of the neo-classical economic
policies. Once again, the early results of looting control frauds led to claims, particularly
in Argentina, that the policies were successful and were creating a new wave of
entrepreneurs who would lead their nations to modernity. Once more, the result was a
wave of control fraud, increased corruption, and budgetary and economic crisis. Another
result, which occurred in all four of the cases discussed here, was a sharp increase in
economic inequality. Collectively, these results discredited privatization, freer trade,
government and the U.S. Virtually every recent election in Latin America, other than
Columbia, has brought to power leaders who are explicitly anti-American and virulently
opposed to privatization.
The fourth case in which neo-classical economics triumphed was the progressive
desupervision of U.S. financial markets in the 1980s and 1990s. Again, this reflected a
consensus in which Democrats and Republicans implicitly supported this policy. We
tested the Easterbrook & Fischel prediction that neither rules nor regulators were needed
to prevent control fraud. The result was the ongoing wave of control fraud in the U.S.
Once again, however, no economist has suffered any reputational injury. Alan
Greenspan, for example, retained his hero status.
Endemic control fraud can cause the key anti-fraud institutions and mores to crumble
and produce economic stagnation and tyranny
Endemic control fraud occurs when corruption becomes pervasive. Corruption is a form
of public sector control fraud. The means by which corruption becomes pervasive and
the relationship between the public and private sector frauds varies by nation. Mixed
systems of cooperating public and private control fraud are common. While the link
between corruption and slower growth and a wide range of bad social factors is now well
established, there has been little discussion of the role of fraud in corrupt systems.
Endemic corruption invariably produces endemic fraud in both the public and private
sector. Pervasive corruption simultaneously increases the take from fraud, maximizes
system capacity problems, and leads to the most extreme form and breadth of
neutralization. In deeply corrupt nations (non) taxpayers do not simply neutralize their
guilt – they perceive themselves as heroes that have risked prosecution to deny the
corrupt state additional funds they would steal. Fraud, at least among non-family
members, becomes common and desirable. Again, fraud’s defining element is deceit.
This goes beyond corruption and causes not only economic stagnation, but also a culture
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