This column was prompted by William Galston's review of Tyler Cowen's new book Average is Over. Galston's column worries about the huge, permanent underclass that Cowen envisions will grow in the United States. I write to challenge Cowen's assumption that winners will prevail through a process of "hyper-meritocracy." Cowen's embrace of Social Darwinism assumes that the winners have a selective advantage that arises from "merit" -- which Cowen conflates with the ability to create wealth. This is passing strange as we are still suffering from an orgy of wealth destruction led by the "winners." The people who grew wealthiest were often the people must responsible for the largest destruction of wealth in history. In this first column I show that it is the most anti-meritocratic system. We do not live in a "winner-take-all" Nation. We increasingly live in a "cheater-take-all" system.
What Cowen has missed is the famous (but nearly famous enough) warning sounded by George Akerlof and Paul Romer in 1993 in their classic article "Looting: The Economic Underworld of Bankruptcy for Profit."
"[M]any economists still [do] not understand that a combination of circumstances in the 1980s made it very easy to loot a [bank] 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).
The result of these perverse incentives is the epidemics of accounting control fraud that drive our recurrent, intensifying financial crises. In the savings and loan debacle, for example:
"The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures". [E]very accounting trick available was used". Evidence of fraud was invariably present as was the ability of the operators to "milk' the organization" (NCFIRRE 1993).
The large Enron-era frauds were all accounting control frauds.
Worse, when cheaters prosper market forces become perverse because of the "Gresham's" dynamic in which bad ethics drives good ethics out of the markets and professions. George Akerlof explained this in his most famous article on "Lemons" in 1970.
"[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 was not the first expert to understand the dynamic.
"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 honesty 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: 1726).
The mortgage fraud crisis occurred because the fraudulent CEOs whose banks created the twin epidemics of mortgage origination fraud deliberately generated a series of Gresham's dynamics that produced an unethical race to the bottom in the professions that aided and abetted the loan origination fraud. The earliest warnings of this were made by honest appraisers in 2000.
"From 2000 to 2007, a coalition of appraisal organizations " delivered to Washington officials a public petition; signed by 11,000 appraisers". [I]t charged that lenders were pressuring appraisers to place artificially high prices on properties [and] "blacklisting honest appraisers" and instead assigning business only to appraisers who would hit the desired price targets"( FCIC 2011: 18).
A national survey of appraisers conducted in early 2004 found that 75% of appraisers had been urged within the prior 12 months to inflate an appraisal. A 2007 survey found that the percentage of appraisers reporting that they had been urged to inflate an appraisal within the past 12 months had risen to 90% and honest appraisers were forced to pay a high price for refusing to give in to the coercion: 68% reported losing a client and 45% did not get paid for their work. Note that a Gresham's dynamic does not have to drive all the honest professionals out of the field to produce epidemic levels of fraud. Even if only a small percentage of the appraisers are suborned they can inflate all the appraisals required.
New York Attorney General (now, governor) Cuomo investigation of Washington Mutual (WaMu) found that it had blacklisted honest appraisers. Cuomo described WaMu as typical of nonprime lenders.
Similar Gresham's dynamics have been documented in many crises and professions.