As I was putting the finishing touches to a speech on whether greed and corruption are endemic in the City of London, which I'm due to give in the Institute of Directors on June 12, I remembered someone claiming that neoclassical economics provides a perfect smokescreen for rampant financial fraud.
At first I thought it might have been Steve Keen, professor of finance and economics at the University of Western Sydney (Keen, who I had the pleasure of meeting at the Just Banking conference in Edinburgh in April - Viewpoint article to follow - was recently interviewed by Paul Mason for an Analysis program on BBC Radio 4). However I think he only accused neoclassical economics, with its zany belief in 'perfect markets', of providing cover for a massive Ponzi scheme (which are, of course, criminal, although many seem to have forgotten this!).
Then I thought it may have been William K Black, associate professor of economics and law at the University of Missouri, Kansas City, who had drawn the parallel. So I revisited the testimony that he gave to the Federal Crisis Inquiry Commission in September 2010 and found this:
Neoclassical theory, which dominates law & economics, is criminogenic because it assumes that control fraud cannot exist while recommending legal policies that optimize an industry for control fraud. Its hostility to regulation, endorsement of opaque assets that lack readily verifiable market values, and support for executive compensation that creates perverse incentives to engage in accounting control fraud and optimizes fraudulent CEOs’ ability to convert firm assets to the CEO’s personal benefit have created a nearly perfect crime.
In his testimony, Black also said:
By the time this crisis began economists (Akerlof & Romer 1993), regulators (Black 1993); and criminologists (Calavita, Pontell & Tillman 1997; Black 2003; Black 2005) had developed effective theories explaining why combining financial non-regulation and modern executive and professional compensation produced criminogenic environments that led to epidemics of accounting control fraud.
We also explained why these were near perfect frauds and explained how control frauds used their compensation and hiring and firing powers to create a “Gresham’s” dynamic that allowed them to suborn the “independent” professionals that were supposed to serve as “controls” and transform them into allies. (This is similar to HIV’s ability to infect the immune system.)
So there you have it. Extrapolating from Black, the 'Big Four' accountancy firms Deloitte, Ernst & Young, KPMG and PWC, whose duties as auditors are supposed to be to the shareholders not to the management of a company, have been behind the creation of a "Gresham's" dynamic.
By this, I mean they have provided a cover for 'white collar' crime, in exchange for inflated audit fees (or what are increasingly being termed by the accountancy professor Prem Sikka and others as "bungs for silence"). If true this makes them dangerous institutions, whose imprimatur should increasingly be seen as a negative rather than a positive by investment management firms with a genuine interest in safeguarding their investors money.
These are thing I intend to explore in subsequent blog posts, and will definitely be incorporating into my London speech. But don't forget the initial premise. If people had not had such faith in neoclassical economics, none of the above would have been possible.
Ian Fraser and Nick Kochan are proposing the motion that 'This house believes the City is rife with greed and corruption' in a debate organized by Chris Skinner and the UK Financial Services Club. The debate is to be held in the Institute of Directors' New Broad Street, City of London premises at 6pm on Tuesday June 12. Details and registration details here.
Further reading on financial fraud, 'white collar' crime, corruption and greed:
- Neo-classical economics led us into a cul-de-sac. Now we must find a way out by Ian Fraser
- Freezing out fraud by Nicholas Kochan
- FSA's failure to tackle 'white collar' crime endangers the City of London by Ian Fraser
- Lehman Bros: Time for Sarbanes-Oxley to be reghought post-Valukas by Ian Fraser
Tags: accounting fraud , BBC Radio 4 , big four , corruption , Deloitte , Ernst & Young , Federal Crisis Inquiry Commission , Financial Services Club , fraud , greed , Just Banking , KPMG , Lehman Brothers , neo-classical economics , neoclassical economics , Ponzi scheme , PWC , Steve Keen , William K Black