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The Lie that Prosecuting Bank Fraud Will Destabilize the Economy Is What Is REALLY Destroying the Economy
Posted By Washingtons Blog On December 23, 2012 @ 1:30 am In Bailouts,Think Tank | Comments Disabled
The Departments of Justice and Treasury are pretending  that criminally prosecuting criminal banksters will destabilize the economy.
The exact opposite is true.
Failing to prosecute criminal fraud has been destabilizing the economy since at least 2007 … and will cause huge crashes in the future.
After all, the main driver of economic growth  is a strong rule of law.
Nobel prize winning economist Joseph Stiglitz says that we have to prosecute fraud or else the economy won’t recover :
The legal system is supposed to be the codification of our norms and beliefs, things that we need to make our system work. If the legal system is seen as exploitative, then confidence in our whole system starts eroding. And that’s really the problem that’s going on.
I think we ought to go do what we did in the S&L [crisis] and actually put many of these guys in prison. Absolutely. These are not just white-collar crimes or little accidents. There were victims. That’s the point. There were victims all over the world.
Economists focus on the whole notion of incentives. People have an incentive sometimes to behave badly, because they can make more money if they can cheat. If our economic system is going to work then we have to make sure that what they gain when they cheat is offset by a system of penalties.
Nobel prize winning economist George Akerlof has demonstrated  that failure to punish white collar criminals – and instead bailing them out- creates incentives for more economic crimes and further destruction of the economy in the future.
(Review of the data on accounting fraud confirms that fraud goes up as criminal prosecutions go down .)
The Director of the Securities and Exchange Commission’s enforcement division told  Congress:
Recovery from the fallout of the financial crisis requires important efforts on various fronts, and vigorous enforcement is an essential component, as aggressive and even-handed enforcement will meet the public’s fair expectation that those whose violations of the law caused severe loss and hardship will be held accountable. And vigorous law enforcement efforts will help vindicate the principles that are fundamental to the fair and proper functioning of our markets: that no one should have an unjust advantage in our markets; that investors have a right to disclosure that complies with the federal securities laws; and that there is a level playing field for all investors.
Paul Zak (Professor of Economics and Department Chair, as well as the founding Director of the Center for Neuroeconomics Studies at Claremont Graduate wrote  a paper called Trust and Growth, showing  that enforcing the rule of law – i.e. prosecuting white collar fraud – is necessary for a healthy economy.
One of the leading business schools in America – the Wharton School of Business – published  an essay by a psychologist on the causes and solutions to the economic crisis. Wharton points out that restoring trust is the key to recovery, and that trust cannot be restored until wrongdoers are held accountable:
According to David M. Sachs, a training and supervision analyst at the Psychoanalytic Center of Philadelphia, the crisis today is not one of confidence, but one of trust. “Abusive financial practices were unchecked by personal moral controls that prohibit individual criminal behavior, as in the case of [Bernard] Madoff, and by complex financial manipulations, as in the case of AIG.” The public, expecting to be protected from such abuse, has suffered a trauma of loss similar to that after 9/11. “Normal expectations of what is safe and dependable were abruptly shattered,” Sachs noted. “As is typical of post-traumatic states, planning for the future could not be based on old assumptions about what is safe and what is dangerous. A radical reversal of how to be gratified occurred.”
People now feel more gratified saving money than spending it, Sachs suggested. They have trouble trusting promises from the government because they feel the government has let them down.
He framed his argument with a fictional patient named Betty Q. Public, a librarian with two teenage children and a husband, John, who had recently lost his job. “She felt betrayed because she and her husband had invested conservatively and were double-crossed by dishonest, greedy businessmen, and now she distrusted the government that had failed to protect them from corporate dishonesty. Not only that, but she had little trust in things turning around soon enough to enable her and her husband to accomplish their previous goals.
“By no means a sophisticated economist, she knew … that some people had become fantastically wealthy by misusing other people’s money — hers included,” Sachs said. “In short, John and Betty had done everything right and were being punished, while the dishonest people were going unpunished.”
Helping an individual recover from a traumatic experience provides a useful analogy for understanding how to help the economy recover from its own traumatic experience, Sachs pointed out. The public will need to “hold the perpetrators of the economic disaster responsible and take what actions they can to prevent them from harming the economy again.” In addition, the public will have to see proof that government and business leaders can behave responsibly before they will trust them again, he argued.
Note that Sachs urges “hold[ing] the perpetrators of the economic disaster responsible.” In other words, just “looking forward” and promising to do things differently isn’t enough.
Robert Shiller – one of the top housing experts in the United States – says that the mortgage fraud is a lot like the fraud which occurred during the Great notes :
Shiller said the danger of foreclosuregate — the scandal in which it has come to light that the biggest banks have routinely mishandled homeownership documents, putting the legality of one of the main causes of the Great Depression.
Economist James K. Galbraith wrote  in the introduction to his father, John Kenneth Galbraith’s, definitive study of the Great Depression, The Great Crash, 1929:
The main relevance of The Great Crash, 1929 to the great crisis of 2008 is surely here. In both cases, the government knew what it should do. Both times, it declined to do it. In the summer of 1929 a few stern words from on high, a rise in the discount rate, a tough investigation into the pyramid schemes of the day, and the house of cards on Wall Street would have tumbled before its fall destroyed the whole economy.
In 2004, the FBI warned publicly of “an epidemic of mortgage fraud.” But the government did nothing, and less than nothing, delivering instead low interest rates, deregulation and clear signals that laws would not be enforced. The signals were not subtle: on one occasion the director of the Office of Thrift Supervision came to a conference with copies of the Federal says:
There will have to be full-scale investigation and cleaning up of the residue of that, before you can have, I think, a return of confidence in the financial sector. And that’s a process which needs to get underway.
James Galbraith recently said  that “at the root of the crisis we find the largest financial swindle in world history”, where “counterfeit” mortgages were “laundered” by the banks.
As he has repeatedly noted, the economy will not recover until the perpetrators of the frauds which caused our current economic crisis are held accountable, so that trust can be restored. See this , this  and this .
No wonder James Galbraith has said  economists should move into the background, and “criminologists to the forefront.”
The bottom line is that the Departments of Justice and Treasury have it exactly backwards: by failing to prosecute criminal fraud, they are destabilizing the economy … and ensuring future crashes.
Article printed from The Big Picture: http://www.ritholtz.com/blog
URL to article: http://www.ritholtz.com/blog/2012/12/the-lie-that-prosecuting-bank-fraud-will-destabilize-the-economy-is-what-is-really-destroying-the-economy/
URLs in this post:
 pretending: http://dealbook.nytimes.com/2012/12/10/hsbc-said-to-near-1-9-billion-settlement-over-money-laundering/
 main driver of economic growth: http://www.washingtonsblog.com/2012/07/the-main-determinant-of-gdp-growth-strength-of-the-rule-of-law.html
 we have to prosecute fraud or else the economy won’t recover: http://www.washingtonsblog.com/2010/11/another-nobel-economist-says-we-have-to.html
 demonstrated: http://www.examiner.com/economic-policy-in-national/nobel-prize-winning-economist-described-the-root-of-the-financial-crisis-1993
 notes: http://www.washingtonsblog.com/2011/02/william-black-slams-financial-crisis.html
 this: http://www.washingtonsblog.com/2010/12/letting-fraud-continue-will-not-restart.html
 this: http://www.washingtonsblog.com/2009/11/galbraith-administrations-sole-goal-is-to-restore-system-of-5-or-10-years-ago-but-confidence-wont-be-restored-unless-fraud-is-prosecuted.html
 this: http://www.washingtonsblog.com/2011/03/top-economists-trust-is-necessary-for-a-stable-economy-but-trust-wont-be-restored-until-we-prosecute-wall-street-fraud.html
 this: http://www.washingtonsblog.com/2010/04/fraud-finally-makes-news.html
 fraud goes up as criminal prosecutions go down: http://dailybail.com/home/how-obama-is-guaranteeing-the-next-financial-crisis-will-be.html
 told: http://www.sec.gov/news/testimony/2009/ts120909rk.htm
 wrote: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=136961
 showing: http://www.tilburguniversity.edu/nl/over-tilburg-university/schools/economics-and-management/organisatie/dept/eco/schaik/ZAKKNACK.pdf
 published: http://knowledge.wharton.upenn.edu/article.cfm?articleid=2204
 notes: http://finance.fortune.cnn.com/2010/10/26/foreclosuregate-playing-with-systemic-fire/?section=money_topstories
 wrote: http://books.google.com/books?id=YoXZWqBIIE8C&pg=PR7&lpg=PR7&dq=%22the+main+relevance+of+the+great+crash+1929+to+the+great+crisis+of+2008+is+surely+here%22&source=bl&ots=6Ia0uLuxI-&sig=9zEfcqDebYIMOWPwhdmfLBPBW-U&hl=en&ei=IGHKTO-mOIjUtQOC4d2FDg&sa=X&oi=book_result&ct=result&resnum=1&sqi=2&ved=0CBMQ6AEwAA#v=onepage&q=%22the%20main%20relevance%20of%20the%20great%20crash%201929%20to%20the%20great%20crisis%20of%202008%20is%20surely%20here%22&f=false
 said: http://www.washingtonsblog.com/2010/10/at-root-of-crisis-we-find-largest.html
 said: http://www.washingtonsblog.com/2010/04/well-known-economist-says-economists.html
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