In Better Bankers, Better Banks, Claire Hill and Richard Painter of the University of Minnesota Law School signal their approach in the subtitle: “Promoting Good Business through Contractual Commitment.” This review explains why their thesis is so timely in terms of the most important theoretical debates boiling in economics and banking regulatory policy and the severe degradation of bankers and banks over the last 30 years. Contractual commitment was, of course, the heart of Dr. Oliver Williamson’s approach to explaining modern capitalism. Williamson, in work that led to being made a Nobel Laureate in Economics, argued that corporations were not simply a “nexus of contracts,” but also that these contracts had evolved to suppress the enormous danger to commerce posed by the powerful incentive of profit-maximizing actors to engage in “opportunistic behavior” whenever “information” was “asymmetrical.” In The Economics Institutions of Capitalism, Williamson defined opportunistic behavior broadly and starkly as “self-interest seeking with guile.”
“This includes but is scarcely limited to more blatant forms, such as lying, stealing, and cheating…More generally, opportunism refers to the incomplete or distorted disclosure of information, especially to calculated efforts to mislead, distort, disguise, obfuscate, or otherwise confuse” (Williamson, 1985, p. 47)
“Opportunism” is obviously a severe problem for a neoclassical microeconomist, but neoclassical macroeconomists, particularly from the so-called “freshwater” school of thought (of which the University of Minnesota is one of the principal leaders) are now writing that fraud (though they refuse to use the “f” word) is the key to the failure of their models to explain or predict finance – precisely the field that Hill and Painter also identify as a field in which things have gone horribly wrong. Kartik Athreya, the Richmond Fed’s Research Director, makes the point for a general audience in Big Ideas in Macroeconomis: A Nontechnical View (2013). Artheya says finance has fewer “spot” transactions and more transactions that involve performance over long time periods. He argues that spot markets are far less vulnerable to abuse, so finance is the area where we would expect the neoclassical assumptions of general equilibrium and Pareto efficiency to go wrong.
Athreya says that the two key conceptual problems in finance are “moral hazard” and “commitment” problems. Commitment problems prevent “complete markets” and can produce severe inefficiency. Commitment problems occur when contracting is a poor solution, typically because no cost-effective enforcement can be assured. Commitment problems and moral hazard interact in finance because one or more of the parties to the transaction have what can be powerful incentives to breach in precisely the circumstances where contract formation and enforcement is most expensive and least reliable. In sum, motive and opportunity to breach are both present in many finance transactions. The subtitle of Hill and Painter’s book shows that they have knowingly and correctly situated their work at the heart of the most troubling issue for the prevailing neoclassical models.
Athreya begins his book by explaining how neoclassical macroeconomists approach their field.
“In sum, if there’s one rule we play by, it is this: it takes a model to beat a model. One measure of the difficulty of achieving this can be seen in the high payoff to succeeding; it is what essentially all of the profession’s biggest names, such as Paul Krugman, Edward Prescott, and George Akerlof, each did at some point.”
Athreya returns later to explain the significance of Akerlof’s model and why it “beat” the prior neoclassical model.
“[A]symmetric information could throw a wrench into the efficiency of decentralized trade. In fact, the seminal paper of Akerlof (1970) first helped economists recognize the potential effects of what we have come to call adverse selection, whereby the quality of goods available for sale falls with price it is expected by sellers to fetch—sometimes to the point of driving all sellers of high-quality goods out of the market. Akerlof’s work suggested this possibility in the context of the spot market for used cars. Akerlof’s work showed that economists that linear prices could not be presumed to work efficiently.”
Note that Akerlof’s work was so troubling to neo-classical economists, particularly those hostile to government “interference” in the market because it showed that even in the “spot” context where contracting is often feasible, fraud could flourish. Indeed, Akerlof showed that fraud, unless blocked, could create a “Gresham’s” dynamic in which market forces became so perverse that bad ethics would drive good ethics from the markets.
“[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.”
Akerlof’s 1970 article also emphasized that such a perverse dynamic was by no means certain. Akerlof explained how a number of practices used in real markets could be viewed as institutional, contractual, and signaling means to avoid a Gresham’s dynamic. Specifically, the honest merchant needed to find a way to signal to consumers that the merchant had made a reliable commitment to providing high quality goods when the consumer paid for high quality goods. Again, Hill and Painter are focused on what the leading theorist in the field (Akerlof) has identified as the key means of preventing a Gresham’s dynamic. Preventing future fraud epidemics led by financial elites is among the greatest of challenges that the world faces, and Hill and Painter offer their take on a key change to attempt to restrain such epidemics.
Akerlof was made a Nobel Laureate for his work on asymmetric information and his 1970 article on “lemons” – the fraudulent sale of poor quality used automobiles – was his most famous theoretical contribution. Akerlof has returned to this subject many times, including his famous article entitled “Looting: The Economic Underworld of Bankruptcy for Profit” in 1993 with Paul Romer. Their 1993 article explored the role of elite insider fraud as a fundamental cause of the second phase of the savings and loan debacle (“evidence of looting abounds”). Their article rejected the conventional neoclassical story about the debacle – honest, but unlucky “gambling for resurrection.” Their model showed that the CEO had an incentive to cause the bank to deliberately make enormous amounts of bad loans that would create the “sure thing” of huge reported (albeit fictional) accounting income in the early years but would actually produce massive losses that would only be recognized years later. Akerlof and Romer stressed that the loans typically had a negative expected value at the time they were made. This was a radical departure from normal neoclassical models, which almost always assume profit maximization. “Agency” problems concerning CEO were discussed, but as Williamson noted, this was almost always limited to “shirking.” Athreya’s book shows that macroeconomists continue to assume profit maximization.
The conventional wisdom of neoclassical economists about the S&L debacle was that it was simply “moral hazard,” or as the phrase went purportedly honest “gambling for resurrection.” Akerlof and Romer’s model rejected that claim (as did we the regulators, the courts and juries, and the criminologists). They first pointed out that fraud was a vastly superior strategy to gambling.
“[M]any economists still seem not to understand that a combination of circumstances in the 1980s made it very easy to loot a financial institution with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?” (Akerlof & Romer 1993: 4-5).
They then added that the pattern of conduct at the S&Ls made no sense for honest gamblers, but was optimal for insider “looting” through accounting fraud.
“[S]omeone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending: maintaining reasonable documentation about loans … verifying information on loan applications…. applications”5
5Black (1993b) forcefully makes this point.
(Akerlof & Romer 1993: 4-5 & n. 5).
Akerlof and Romer emphasized how weakly developed economic theory was when it came to understanding elite frauds by financial elites, particularly when aided and abetted by “independent professionals.” Their concluding paragraph, obviously addressed to economists, ended on an optimistic note.
“Neither the public nor economists foresaw that the [S&L deregulations] of the 1980s were 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” (1993: 60).
As Hill and Painter document and explain, we did not “learn from experience” and history repeated itself in increasingly nasty reruns – the Enron-era frauds and the three most destructive epidemics of financial fraud in history that hyper-inflated the U.S. real estate bubble, caused the financial crisis, and triggered the Great Recession. Those three epidemics, the fraudulent origination of loans through appraisal fraud and “liar’s” loans and the fraudulent sale of those loans to the secondary market through fraudulent “reps and warranties,” created intense Gresham’s dynamics. Hill and Painter give many useful details on the nature of this third fraud epidemic and even more useful descriptions of how the secondary market and mortgage derivative markets made the “sausage” of toxic mortgages that opportunistic behavior by credit rating agencies, deliberately induced by the sausage-makers transmuted into “AAA” gold.
One of the strengths of Hill and Painter’s book is repeatedly providing evidence on the exceptional income generated by purportedly independent professionals that “blessed” the creation and sale of mortgages and financial derivatives where the “underlying” was actual or “synthetic” mortgages. None of this was possible without massively overstating the value of the mortgages. Akerlof and Romer explained the point.
“We begin with a point about accounting rules that is so obvious that it would not be worth stating had it not been so widely neglected in discussions of the crisis in the savings and loan industry. If net worth is inflated by an artificial accounting entry for goodwill, incentives for looting will be created. [E]ach additional dollar of artificial net worth translates into an additional dollar of net worth that can be extracted from the thrift” (Akerlof & Romer 1993: 13).
The heart of Hill and Painter’s reform proposals are premised on their accurate description of how we have run an uncontrolled experiment for 30 years in which we have – without the benefit of any cost-benefit analysis – systematically removed or rendered illusory the historic sources of private and public discipline of elite market participants. Hill and Painter make a convincing case that one of the most destructive changes was to ownership form. By virtually eliminating true partnerships in which the general partners bore “joint and several” liability we encouraged the leadership of former true partnerships to make people senior managers who would have been rejected for partnership in a true partnership because of their lack of integrity and dramatically reduced the incentive of senior managers to engage in the costly process of monitoring their peers.
At the same time as we rendered nugatory the private and public barriers to opportunism, we dramatically increased the potential gains from opportunism through radical changes to executive and professional compensation. The result, as Williamson and Akerlof predicted (as did white-collar criminologists and real financial regulators) was an epidemic of purposeful “opportunism” by elites. Hill and Painter explain why finance was the “canary” – it is inherently easier to cheat (as the macroeconomists now stress), the rewards to elites cheating are now vastly greater, the ability of elite bankers to cheat through “accounting control fraud” makes fraud a “sure thing” and means that the frauds will frequently never be discovered, and banking more than any other industry counted on independent professionals in true partnerships (particularly attorneys, auditors, investment bankers, and credit rating agencies) to restrain such fraud opportunities. Financial deregulation, desupervision, and de facto decriminalization (the three “de’s”) has also been far more radical than deregulation in other fields because of the power of finance and the deliberate instigation of the international “regulatory race to the bottom”) in which the largest banks threaten to move to other nations with even weaker public controls. The apex of this problem of lost controls is occupied by the systemically dangerous institutions (SDIs) that are treated as “too big to fail.” These firms hold the global economy hostage. When Lehman was allowed to collapse it triggered (not “caused”) the acute phase of the global financial crisis. The independent professionals lost their independence when they ceased to be true partnerships. It became easy for financial CEOs engaged in opportunism to suborn auditors at the top tier firms into becoming their most valuable fraud allies.
Hill and Painter’s thesis is that we broke the most fundamental rule adults should live by in the financial sphere – “if it ain’t broke; don’t fix it.” They show that rather than fixing the problem, our radical abandonment of institutional and contractual forms that had been developed over the course of centuries as essential means of reducing opportunism by CEOs made the CEOs’ already perverse incentives far nastier. Hill and Painter correctly urge that part of the solution is to go back to what works.
As I hope I have explained, this places their work dead center of where micro and macroeconomists are struggling to figure out how to explain what has gone so calamitously wrong with finance – because what has gone wrong is automatically excluded as a possibility by their neoclassical models of general equilibrium. Hill and Painter, in essence, have confirmed that Akerlof, Romer, and Williamson (and the criminologists and real regulators) have made “a better model” that beats the existing models and explains why they fail. Falsified paradigms die ugly, after lengthy rearguard actions to protect their intellectual retreats. Hill and Painter have added another barrage on that failed conventional wisdom and have proposed a real world answer that could be part of a realistic solution to the pathologies of modern finance.
Review by Dr. William K. Black.
Black is an Associate Professor of Economics and Law at the University of Missouri at Kansas City and the Distinguished Scholar in Residence for Financial Regulation at the University of Minnesota’s Law School. Black is also a former financial regulator and a white-collar criminologist. His research focus is on financial regulation, financial crises, and elite white-collar crimes.