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OpEdNews Op Eds    H3'ed 10/28/13

Economics could be a Science if More Economists were Scientists

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Akerlof and Romer made this passage their concluding paragraph in order to gives special emphasis to the message to their field.

"Neither the public nor economists foresaw that [S&L deregulation was] 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" (George Akerlof & Paul Romer1993: 60).

Economists overwhelmingly supported the deregulation of S&Ls.  Larry White's famous phrase was that there were "no "Cassandras'" in his field who warned that deregulation would produce a disaster.  Economists overwhelmingly and vociferously opposed our reregulation of the S&L industry (claiming we were economically illiterate).  Economists did not provide us with "lukewarm support" -- they were our leading opponents in our successful effort to contain the epidemic of accounting control fraud that drove the crisis.  Chetty denied the problem, but the "facts" are what demonstrate that economists as a field performed during the S&L debacle as "a fake science whose findings cannot be a useful basis for making policy decisions."  In every case the policies that proved disastrous were based on precisely the econometric practices that Chetty claimed were "transforming" his field into a "science."

George Akerlof received the Riksbank award in 2001.  The Akerlof work that the award committee singled out for praise was his 1970 article on markets for "lemons" in which he explained anti-purchaser control frauds in which the seller deceives the purchaser about the quality of the goods or services.   Akerlof (1970) and Akerlof and Romer (1993) both studied natural experiments.

Chetty's article disses economists who are theorists and praises quants.  He mentions two theorists, Paul Krugman and Janet Yellen (both of whom have done extensive quantitative research) in a manner that implies that they are primitives who have missed the field "transforming" into a "science" based in "facts" -- Paul Krugman and Janet Yellen.  Krugman is another recipient of the Riksbank prize and Yellen is President Obama's nominee to run the Federal Reserve (and Akerlof's spouse).  If Chetty's dichotomy between theorists and scientists were true we would have to wonder why economics continues to bestow its top honors on economists whose work is not scientific because it is not "firmly grounded in fact."  But Chetty's dichotomy is false.  He is simply engaged in the highly scientific practice of a Harvard prof dissing his more prestigious peers who have taught at Princeton and Berkley.

Akerlof and Romer exposed the most fundamental problem with Chetty's theory of the scientific method.  Fact and theory are both vital.  If economists' dogmas and mono-disciplinary blinders prevent them from understanding that control fraud exists then Chetty's supposed recipe for science -- "formulating and testing precise hypotheses" -- will consistently produce failed empirical studies that economists will interpret as supporting policies that cause our recurrent, intensifying financial crises.  Good theory is essential to constructing good empirical studies.

Akerlof and Romer worked closely with a financial regulator (me) in drafting their famous article.  That meant that they had the advantage of being firmly grounded in fact and a wealth of multi-disciplinary learning (including white-collar criminologists whose work I was drawing on) -- an advantage that Akerlof and Romer enthusiastically welcomed.  Note that Akerlof and Romer rightly stressed other forms of learning that proved far superior to "scientific" economists precisely because the examiners exemplify the concept of learning that is "firmly grounded in fact."  Akerlof and Romer praised "the regulators in the field who understood what was happening from the beginning"."

Chetty has conflated "data" with "facts."  Accounting control fraud produces fraudulent accounting data that economists and finance scholars treat (implicitly) as facts.  During the expansion phase of a bubble or an expanding epidemic of accounting control fraud the traditional econometric study will lead the "scientific" economist to support the worst possible policies that most aid accounting control fraud.  Whatever practices best facilitate the creation of fictional income will show the highest positive correlation with the firm's reported income (or stock price).  The true (negative) "sign" of the correlation will only emerge after the bubble bursts or years after the fraud epidemic begins.  By then, of course, it is too late to prevent the crisis brought on by the "scientific" economists' disastrously bad policy recommendations.

Note how pernicious this methodological failure is when combined with neo-classical economists' insistence that it be made unlawful to adopt regulations until the regulators can produce data demonstrating that the benefits of the new rule would outweigh the costs.  The D.C. Circuit, controlled by ultra-conservative law and economics devotees is using this as the pretext to block the SEC from adopting vital regulations.  The D.C. Circuit has effectively resurrected the discredited anti-regulatory "substantive due process" abuses that the judiciary abused 80 years ago.

Chetty is a mono-methodologist.  Only quant work is "scientific."  Other social sciences that use multiple research methodologies, e.g., criminology must not be "scientific."  Chetty's view of the scientific method represents dogma and personal predilections rather than science.

Competent bank examiners never forget that accounting data can be the product of accounting control fraud.  Examiners produce the equivalent of hundreds of detailed case studies that can be examined rigorously for common characteristics.  It was our "autopsies" of every failed S&L that led to our development of the concept of control fraud and the subset we now call accounting control fraud.  The autopsies led to our identification of the fraud "recipe" for a lender.  We consistently studied natural experiments to test precise hypotheses in order to formulate the radical policy changes that contained the epidemic of accounting control fraud that drove the second phase of the S&L debacle.  But we did more that test hypotheses -- we formulated theories such as the concepts of control fraud and accounting control fraud and the fraud recipe.

We synthesized a theory of control fraud, building it from economics, law, criminology, accounting, governance, and political science.  We built in many economic concepts that proved immensely useful.  We stressed the perverse incentives arising from "agency" problems in corporations and how modern executive compensation aggravates the incentives, allows the CEO leading the control fraud to signal other officers on the practices they should follow to aid the fraud, and serves as a means to loot the firm.  We realized that the decline of financial partnerships with "joint and several liability" greatly increased agency problems by eroding "private market discipline."  We understood how the CEOs manipulated professional compensation to create a "Gresham's" dynamic that drove good ethics from professions and markets.  The art was for the CEO to suborn purported "controls" and pervert them into fraud allies.  The professionals' reputation aided the fraud scheme.  We understood that markets were frequently deeply inefficient because the fraud recipe made reporting record profits a "sure thing."  Banks do not create private market discipline -- they fund the massive growth of firms that report record profitability due to the fraud recipe.  We realized that lenders following the recipe had to gut their underwriting standards and suborn their internal controls.  We used this to identify the frauds while they were still reporting record profits.  We understood that these practices created intense "adverse selection" and meant that the lending had a "negative expected value" at the time they were made.  We determined that the recipe was a superb means of hyper-inflating a financial bubble and realized the significance of the industry expression "a rolling loan gathers no loss."  We developed a superior understanding of "moral hazard" and the nearly universal practice of economists implicitly assuming control fraud out of existence and assuming that moral hazard led solely to honest gambles.

Understanding the recipe allowed us to identify the worst accounting control frauds at an early point while they were still reporting record profits.  The recipe also allowed us to target the frauds' Achilles' "heel" -- the need to grow extremely rapidly.  Our rule restricting growth doomed even the S&L control frauds we could not close promptly because we lacked the funds.

As S&L regulators, we made our top supervisory priority the S&Ls reporting the highest income.  Economists viewed this as proof that we were economically illiterate.  Charles Keating famously sent a letter to much of the Nation's political leadership on July 8, 1986 that specifically attacked us for this prioritization.  The letter calls us "Nazi" and then cheerfully mixed its sensational similes by concluding that our policy was "like Jupiter eating his children."

Bank Board Chairman Edwin Gray began S&L reregulation in 1983 -- the year after the Garn-St Germain Act implemented federal deregulation and triggered a regulatory "race to the bottom" among state regulators.  By 1984, there were 300 S&L control frauds growing at an average annual rate of 50 percent.  It is only with the benefit of hindsight informed by our experience with the current crisis that we can now understand how incredibly valuable it was that Gray began the reregulation of the industry so promptly.  The reregulation was done in the teeth of vicious opposition from the Reagan administration, James Wright, Jr., the Speaker of the House, a majority of the members of the House, the five U.S. Senators who became known as the "Keating Five," every outside economist who expressed an opinion, the industry, and the business media.  It soon rendered Gray unemployed and unemployable for over two decades.  Absent that prompt reregulation, resupervision, and beginning criminal referrals and prosecutions the S&L debacle would have become vastly more damaging.  In retrospect we can see that good regulatory theory saved trillions of dollars and that bad economic studies that followed Chetty's claims of proper scientific method would have led  to terrible policies that would have added trillions of dollars of losses had we (the S&L regulators) not countered the studies and followed the opposite policies.

The advantages of good theory were demonstrated in 1990-1991 during the S&L debacle when the control frauds opened a second "front" in Orange County, California (where all good U.S. financial fraud epidemics begin).  The primary "ammunition" used for accounting fraud during the debacle was commercial real estate loans.  Orange County control frauds began to make significant amounts of what are now called "liar's" loans.  They had no such warning label in this era.  We were the regional regulators with jurisdiction over Orange County S&Ls and we listened to our examiners.  Our examiners stressed that no honest mortgage lender would make such loans without underwriting key information such as the borrower's income.  Absent such underwriting, a mortgage lender creates severe adverse selection and the lending has a negative expected value.  In plainer English, the lender will lose money.  Liar's loans do, however, make sense for an accounting control fraud.  We drove liar's loans out of the S&L industry.  We did this while heavily occupied dealing with the overall S&L debacle.  It was one of the easiest supervisory calls we ever made.

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William K Black , J.D., Ph.D. is Associate Professor of Law and Economics at the University of Missouri-Kansas City. Bill Black has testified before the Senate Agricultural Committee on the regulation of financial derivatives and House (more...)
 
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