Failing to Prosecute Wall Street Fraud Is Extending Our Economic Problems

http://www.washingtonsblog.com/2010/12/letting-fraud-continue-will-not-restart.html

MONDAY, DECEMBER 13, 2010
Failing to Prosecute Wall Street Fraud Is Extending Our Economic  
Problems
Bill Gross, Nouriel Roubini, Laurence Kotlikoff, Steve Keen, Michel  
Chossudovsky and the Wall Street Journal all say that the U.S. economy  
is a giant Ponzi scheme.

Virtually all independent economists and financial experts say that  
rampant fraud was largely responsible for the financial crisis. See  
this and this.

But many on Wall Street and in D.C. - and many investors - believe  
that we should just "go with the flow". They hope that we can restart  
our economy and make some more money if we just let things continue  
the way they are.

But the assumption that a system built on fraud can continue without  
crashing is false.

In fact, top economists and financial experts agree that - unless  
fraud is prosecuted - the economy cannot recover.

Fraud Leads to a Break Down in Trust and Instability in the Markets

As Alan Greenspan said recently:


Fraud creates very considerable instability in competitive markets. If  
you cannot trust your counterparties, it would not work


Similarly, leading economist Anna Schwartz - co-author of the leading  
book on the Great Depression with Milton Friedman - told the Wall  
Street journal in 2008:
"The Fed ... has gone about as if the problem is a shortage of  
liquidity. That is not the basic problem. The basic problem for the  
markets is that [uncertainty] that the balance sheets of financial  
firms are credible."
So even though the Fed has flooded the credit markets with cash,  
spreads haven't budged because banks don't know who is still solvent  
and who is not. Thisuncertainty, says Ms. Schwartz, is "the basic  
problem in the credit market.Lending freezes up when lenders are  
uncertain that would-be borrowers have the resources to repay them. So  
to assume that the whole problem is inadequate liquidity bypasses the  
real issue."
***
Today, the banks have a problem on the asset side of their ledgers --  
"all these exotic securities that the market does not know how to  
value."
"Why are they 'toxic'?" Ms. Schwartz asks. "They're toxic because you  
cannot sell them, you don't know what they're worth, your balance  
sheet is not credible and the whole market freezes up. We don't know  
whom to lend to because we don't know who is sound. So if you could  
get rid of them, that would be an improvement."
And economics professor and former Secretary of Labor Robert Reich  
wrote in 2008:

The underlying problem isn't a liquidity problem. As I've noted  
elsewhere, the problem is that lenders and investors don't trust  
they'll get their money back becauseno one trusts that the numbers  
that purport to value securities are anything but wishful thinking.  
The trouble, in a nutshell, is that the financial entrepreneurship of  
recent years -- the derivatives, credit default swaps, collateralized  
debt instruments, and so on -- has undermined all notion of true value.
Robert Shiller - one of the top housing experts in the United States -  
said recently that failing to address the legal issues will cause  
Americans to lose faith in business and the government:

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 foreclosures and  
related sales in doubt -- is a replay of the 1930s, when Americans  
lost faith that institutions such as business and government were  
dealing fairly.
Nobel prize-winning economist Joseph Stiglitz says about the failure  
to prosecute Wall Street fraud:


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.

Wall Street insider and New York Times columnist Andrew Ross Sorkin  
writes:

“They will pick on minor misdemeanors by individual market  
participants,” said David Einhorn, the hedge fund manager who was  
among the Cassandras before the financial crisis. To Mr. Einhorn, the  
government is “not willing to take on significant misbehavior by  
sizable” firms. “But since there have been almost no big prosecutions,  
there’s very little evidence that it has stopped bad actors from  
behaving badly.”
***
Fraud at big corporations surely dwarfs by orders of magnitude the  
shareholders’ losses of $8 billion that Mr. Holder highlighted. If the  
government spent half the time trying to ferret out fraud at major  
companies that it does tracking pump-and-dump schemes, we might have  
been able to stop the financial crisis, or at least we’d have a  
fighting chance at stopping the next one.
Economics professor James Galbraith 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.

No wonder Galbraith says that economists should move into the  
background, and "criminologists to the forefront".

Failure to Stop Fraud and Prosecute Criminals Causes a Loss of Trust  
in Government, Which Makes Government Less Effective

As Shiller stated in the quote above, the failure of government  
officials to stop fraud and prosecute the financial fraudsters has  
caused a lack of trust in government itself.

Indeed, polls show that people no longer trust our economic "leaders".  
See this and this.
A psychologist wrote an essay published by the Wharton School of  
Business arguing 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.
Government regulators know this - or at least pay lip service to it -  
as well. For example, as the Director of the Securities and Exchange  
Commission's enforcement division toldCongress:


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.

If people don't trust their government to enforce the law, government  
will become more and more impotent in addressing our economic  
problems. If government leaders take action, the market will not  
necessarily respond as expected. When government leaders make  
optimistic statements about the economy, people will no longer believe  
them.

Trying to Cover Up the Truth Extends Financial Crises

Elizabeth Warren, William Black and others say that attempting to  
cover up the truth extended Japan's financial problems into an entire  
"Lost Decade".

As Joseph Stiglitz said about Wall Street fraud:


So the whole strategy of the banks has been to hide the losses, muddle  
through and get the government to keep interest rates really low.

***
As long as we keep up this strategy, it's going to be a long time  
before the economy recovers ....

Pam Martens - who worked on Wall Street for 21 years - writes:

The massive losses by big Wall Street firms, now topping those of the  
Great Depression in relative terms, have yet to be adequately  
explained. Wall Street power players are obfuscating and Congress is  
too embarrassed or frightened to ask, preferring to just throw money  
at the problem and hope it goes away. But as job losses and  
foreclosures mount and pensions and 401(k)s shrink, public policy  
measures to address the economic stresses require a full set of  
unembellished facts...

It was four years after the crash of 1929 before the major titans of  
Wall Street were forced to give testimony under oath to Congress and  
the full magnitude of the fraud emerged. That delay may well have  
contributed to the depth and duration of the Great Depression. The  
modern-day Wall Street corruption hearings in Congress ... must now  
resume in earnest and with sworn testimony if we are to escape a  
similar fate.To the extent that the government tries to cover up -  
instead of openly discuss - financial fraud, it will only extend  
America's economic malaise.

Failing to Prosecute Fraud Encourages Financial Players to Take Bigger  
and More Blatantly Illegal Actions

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. Joseph Stiglitz, Professor  
Black, and many others agree. See this, this and this.

It was largely fraud which brought down the financial system in 2008.  
Unless we prosecute the fraudsters, they will do even bigger, stupider  
and more blatantly illegal things in the future which will lead to  
even bigger crises.

Failure to Prosecute Fraud Exacerbates the Sovereign Debt Crisis

The governments of the world have spent trillions trying to paper over  
the fraud and prop up the big, insolvent banks, instead of forcing  
them to restructure and forcing bondholders and shareholders to take a  
haircut.

A study of 124 banking crises by the International Monetary Fund found  
that propping up banks which are only pretending to be solvent drives  
up the costs to the country:


Existing empirical research has shown that providing assistance to  
banks and their borrowers can be counterproductive, resulting in  
increased losses to banks, which often abuse forbearance to take  
unproductive risks at government expense. The typical result of  
forbearance is a deeper hole in the net worth of banks, crippling tax  
burdens to finance bank bailouts, and even more severe credit supply  
contraction and economic decline than would have occurred in the  
absence of forbearance.
Cross-country analysis to date also shows that accommodative policy  
measures (such as substantial liquidity support, explicit government  
guarantee on financial institutions’ liabilities and forbearance from  
prudential regulations) tend to befiscally costly and that these  
particular policies do not necessarily accelerate the speed of  
economic recovery.
***

All too often, central banks privilege stability over cost in the heat  
of the containment phase: if so, they may too liberally extend loans  
to an illiquid bank which is almost certain to prove insolvent anyway.  
Also, closure of a nonviable bank is often delayed for too long, even  
when there are clear signs of insolvency (Lindgren, 2003). Since bank  
closures face many obstacles, there is a tendency to rely instead on  
blanket government guarantees which, if the government’s fiscal and  
political position makes them credible, can work albeit at the cost of  
placing the burden on the budget, typically squeezing future provision  
of needed public services.
The American banks and government have certainly pretended that all of  
the big banks are solvent. As ABC wrote in October 2009:


The Treasury Department and the Federal Reserve lied to the American  
public last fall when they said that the first nine banks to receive  
government bailout funds were healthy, [the special inspector general  
for the Troubled Asset Relief Program] states in a new report released  
today.Similarly, the stress tests were a complete and utter sham.

The government has given the giant banks huge amounts in loans and  
guarantees based upon their false representations about their  
financial health. The Fed has larded up its balance sheet with toxic  
assets from the banks.

Debt levels are also getting dangerously close to the level that they  
become a drag on the economy. See this and this. When Keynesian  
economists argue that debt does not harm the economy, they are talking  
about debt incurred to pay for stimulus and productive things for the  
economy. But throwing trillions at the giant banks - who are mainly  
using the money to gamble - is not stimulus. It helps the executives  
of the big banks and their shareholders and bondholders, but not the  
broader economy.

Indeed, attempting to prop up big, insolvent banks is preventing  
stimulus from getting out into the economy.

Fraud Causes Growing Inequality, Which Undermines the Economy

Growing inequality is very harmful to our economy. Indeed, if wealth  
is concentrated in too few hands, the "poker game" ends, as one or two  
fat cats are left with all of the chips. Seethis, this, this and this.

Fraud benefits the wealthy more than the poor, because the big banks  
and big companies have the inside knowledge and the resources to  
leverage fraud into profits. Joseph Stiglitznoted in September that  
giants like Goldman are using their size to manipulate the market. The  
giants (especially Goldman Sachs) have also used high-frequency  
program trading (representing up to 70% of all stock trades) and high  
proportions of other trades as well). This not only distorts the  
markets, but which also lets the program trading giants take a sneak  
peak at what the real traders are buying and selling, and then trade  
on the insider information. See this, this, this, this and this.

Similarly, JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup,  
and Morgan Stanley together hold 80% of the country's derivatives  
risk, and 96% of the exposure to credit derivatives. They use their  
dominance to manipulate the market.

Fraud disproportionally benefits the big players (and helps them to  
become big in the first place), increasing inequality and warping the  
market.
Fraud Increases the Severity of Boom-Bust Cycles

More and more people - such as the Bank of International Settlements  
and Barons - are saying that bubbles inevitably lead to busts, thus  
destabilizing the economy.

Professor Black says that fraud is a large part of the mechanism  
through which bubbles are blown.

Without strong laws against fraud, bubble after bubble will be blown,  
guaranteeing that the financial system cannot be stabilized in any  
fundamental sense.

Failure to Prosecute Fraud Is Worsening the Housing Crisis

Finally, failure to prosecute mortgage fraud is arguably worsening the  
housing crisis. Seethis and this.

So trying to ignore the fraud will not work.
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