The False Dichotomy between Banking Honesty and a Sound Financial System
Tuesday, June 14, 2011
By William K. Black
It’s exceptionally hard to kill bad ideas. The most spectacularly bad idea in economics and finance is that regulating business honesty is bad for business. The idea is exceptionally criminogenic. The idea ebbs briefly after each epidemic of control fraud it unleashes leads to crisis and scandal, but it quickly returns and intensifies. The bad idea has grown for three decades, which is why we have suffered recurrent, intensifying financial crises. Both major parties’ dominant economic policy makers embrace this bad idea.
Nothing is better for honest firms than effective police, prosecutors, and regulatory “cops on the beat.” These things make possible “free markets.” Fraud cripples markets. Criminologists know this. The best economists have known this for over 40 years. But really bright people explained why 285 years ago.
The Lilliputians look upon fraud as a greater crime than theft. For, they allege, care and vigilance, with a very common understanding, can protect a man’s goods from thieves, but honestly hath no fence against superior cunning. . . where fraud is permitted or connived at, or hath no law to punish it, the honest dealer is always undone, and the knave gets the advantage.
Swift, J. Gulliver’s Travels, London, Penguin (1967) p. 94. See Levi, M. The Royal Commission on Criminal Justice. The Investigation, Prosecution, and Trial of Serious Fraud. Research Study No. 14, London, HMSO (1993) p. 7.
As I’ve written, these words should be inscribed on the walls of every relevant regulatory agency.
George Akerlof echoed Swift’s words in a formal economics argument in his seminal 1970 article “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.”
“[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.”
This is the article that led to the award of the Nobel Prize in Economics in 2001 to Akerlof. Akerlof went on to explain that fraud could lead to a “Gresham’s” dynamics in which bad ethics drove good ethics out of the marketplace.