The Journal of Socio-Economics 36 (2007) 978–983

Book reviews

The Best Way to Rob a Bank is to Own One: How Corporate Executives and PoliticiansLooted the S&L Industry, W.K. Black. University of Texas Press, Austin, TX (2005). 329pp., Price: $24.95, ISBN: 0-292-70638-3

William Black’s The Best Way to Rob a Bank is to Own One: How Corporate Executives andPoliticians Looted the S&L Industry is an excellent first-hand account of the savings and loancrises of the 1980s written by a senior S&L regulator at the center of the crisis.1 According toNobel Laureate George Akerlof, William Black “is the first person to truly understand both indetail and in theory exactly how that crisis occurred.2” Focusing on the concept of “control fraud”(which Dr. Black identified in 1984 long before it was understood by economists), the book offersimportant lessons that apply not only to the S&L crisis lessons but also to contemporary Post-Enron financial regulation and to economic development in both rich and poor nations around theworld.

Dr. Black argues that the perpetrators of control frauds are “financial super predators.” Theirobject is to loot the companies they control with the full, self-interested expectancy that theirlooting will render their ownership stake in the company worthless. They use companies, auditors,appraisers, attorneys, economists, other consultants, and politicians as “weapons” and “shields”to mislead market professionals and regulators and defraud investors. According to Black, suchfrauds cause greater financial losses than all other forms of property crime combined. With vastsums of money to distort market incentives and absolute power to make and destroy careers,control frauds subvert and even turn to their advantage both the markets and the governance andoversight mechanisms established to guard against fraud.

In very readable prose, Black’s book uses criminology to identify the factors that made the S&Ldebacle so devastating, and argues that similar factors explain Enron, WorldCom, and financialcrises in many other nations. In the process, Black constructs a model drawn from his thoroughunderstanding of criminology, economics, accounting, leadership and political science that iden-tifies the circumstances that produce fraud “waves.” The result is an exemplar of the benefits ofsound socio-economic analysis.

1 When the savings and loan crises was over, Black obtained a Ph.D. in criminology, taught at the LBJ School of PublicAffairs at the University of Texas, and now heads the Institute for Fraud Prevention. Black’s regulatory career is profiled inChapter 2 of Professor Riccucci’s book Unsung Heroes (Georgetown U. Press, 1995) and Chapter 4 (“The ConsummateProfessional: Creating Leadership”) of Professor Bowman et al.’s book The Professional Edge (M.E. Sharpe, 2004) forhis professional and ethical public leadership.

2 Letter of George Akerlof to Robert H. Wilson, Mike Hogg Professor of Urban Policy. Lyndon B. Johnson School ofPublic Affairs, dated 11 August 2003.

1053-5357/$ – see front matter © 2007 Elsevier Inc. All rights reserved.

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Black shows that fraud by the person that controls the company is distinctly different fromfrauds by more junior officers. Only the person that controls the company can use its powerand legitimacy to make it an unparalleled weapon of fraud. Some control frauds make real, butdishonest, profits. These frauds target consumers or the public. Black’s book concentrates on athird variant, “looting.” Control fraud looters use accounting fraud as their “weapons of choice.”Indeed, one of Black’s central insights is that CEO-looters suborn internal and external controls(e.g., the inside and outside auditors), and turn them into allies that camouflage the company’sfraud. Control frauds hire top tier audit firms in order to “mimic” legitimate companies. Only theCEO can optimize the company for accounting fraud by having it invest in assets that have noclear market value (which makes it easy to hide real losses and create fictitious profits) and growrapidly by suckering in a growing number of investors who are impressed with the appearance ofextraordinary profits (a Ponzi scheme). The CEO is uniquely positioned to use the firm’s apparentlegitimacy and large financial contributions to shape the external environment. Black cites Enron’sboast that it created a “regulatory black hole” in energy derivatives trading which it used to causethe 2001 California energy crisis (as belatedly acknowledged by FERC, the Federal EnergyRegulatory Commission). The CEO is uniquely positioned to combine accounting fraud – whichproduces guaranteed but fictitious record profits – and his control over his own compensation toconvert company assets to his benefit through normal corporate mechanisms. The ability to usethese combined strategies make it very difficult to prosecute control frauds.

Black also provides a detailed, compelling explanation of exactly how economic deregula-tion and desupervision policies regarding savings and loan institutions, based on the abuse ofneoclassical economics (and implemented at a time when the industry was insolvent), created a“criminogenic environment” that optimized the industry for a wave of control fraud. Like the toptier auditors, prestigious economists aided the frauds, but unlike the auditors, the economists wereprofessionally and/or ideologically committed to a theory and were hired and rewarded based onthat commitment.

Black’s approach is not a rejection of neoclassical theory, which he thoroughly understands,nor of its principled application in appropriate contexts; but his book does provide a trenchantcritique of its misapplication and abuse in corporate regulatory contexts where its validity andpredictions are refuted by clear evidence and where its abuse stands as a serious impediment tonecessary remedial action in the public interest.

As noted by Hersh Shefrin, a top behavioral finance specialist, Black’s theories challenge thedominant approach of modern finance and the law and (neoclassical) economics approach ofcorporate law espoused, for example, by Easterbrook and Fischel (1991).3 These fields rest onthe “efficient” contracts and markets hypotheses, which assume that lenders and investors protectthemselves against control fraud—without regulation or law. According to those approaches, (1)markets easily spot control frauds, (2) only honest companies can get a “clean” opinion from a toptier auditor (because such audit firms have a profit incentive to maintain their reputation), and (3)honest companies can “signal” that they are honest in ways that control frauds cannot “mimic.”Appreciable control fraud cannot occur if markets are efficient. So the recognition of control fraud

3 “Professor Black’s work is absolutely fundamental. Agency theory is central to modern microeconomics and to themodern theory of corporate finance. Professor Black’s work raises a series of fundamental challenges about the extentto which the paradigms that currently dominate these disciplines are seriously incomplete in their ability to explain andpredict the manner in which private sector institutions deal with conflicts of interest.” Letter by Hersh Shefrin, Mario L.Belotti Professor of Finance, Leavey School of Business and Administration, Santa Clara University to Robert H. Wilson,Mike Hogg Professor of Urban Policy. Lyndon B. Johnson School of Public Affairs, dated 26 August 2003.

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as a serious problem contradicts the efficient markets hypothesis. Rather than question the capitalmarket efficiency hypothesis in the light of the evidence, as the scientific method requires, someneoclassical economists simply ignore the evidence, treat the hypothesis of market efficiency asunquestionable fact, and insist that fraud must therefore not be a serious problem. The existence ofcontrol fraud, in contrast, both reflects and creates capital market inefficiency and makes regulationessential.

Black exposes how anti-regulatory ideology blinded some economists to the disastrous effectsof their own policies. For example, based on a misapplication of neoclassical theory, economistsstrenuously opposed regulatory growth limitations on S&Ls, insisting that firm growth should bedetermined by market forces rather than regulators. However, Black shows how Federal HomeLoan Bank Board Chairman Edwin Gray ultimately killed the frauds by imposing growth limita-tions based on the deeper understanding that Ponzi frauds must grow rapidly or die. Thus, ratherthan misapplying neoclassical theory (by ignoring the problem of moral hazard), Gray properlyapplied neoclassical economics by recognizing that moral hazard theory does predict the realpossibility of fraud and suggests that rapid growth must be curtailed to avoid enormous losses.Further, Gray enriched the proper application of neoclassical economics by going beyond it intosocio-economics—by understanding the fraud mechanism and the Ponzi’s vulnerability to growthlimits. Socio-economics’ embrace of multi-disciplinary, empirical, and consciously ethical anal-ysis triumphed where economists misapplying neoclassical theory failed and would have causedcatastrophic losses.

Black also shows that “ethics free” approaches to economics and law make for bad economicsand law. When top economists shilled for the worst control frauds, their findings were invariablyincorrect not merely somewhat in error, according to Black, but as wrong as it is possible to be.The economists praised the frauds and condemned the honest S&Ls. Yet, these failures sparkedno introspection by the economists. Lawyers for control frauds always told Black that they wereproviding their clients with zealous advocacy. Black notes that the client was the S&L—whichthe CEO was destroying. The CEO was the crook, not the client—but the CEO decides whichlaw firm is hired and the lawyers served the CEO at the expense of the client. Taking conflicts ofinterest into account helped the S&L regulators to develop more accurate economic predictionsand more effective reforms.

The importance of ethics and social forces, recognized by socio-economics but ignoredby the dominant neoclassical approach, is also evidenced by the debate over the market forcontrol of companies. According to the efficient capital market hypothesis, facile change incontrol will root out entrenched management and promote greater corporate efficiency. But theoverwhelming majority of S&L control frauds were perpetrated by new management with con-flicting outside interests and little or no prior connection with the S&L over which they acquiredcontrol.

In showing how improbable the agency’s success was, Black’s book provides a dramaticnarrative. Chairman Gray, like other Reagan appointees, came to office as a deregulation apostle,and underwent a “Road to Damascus” conversion. The administration responded by attemptingto stack the board with allies of Charles Keating’s (the most infamous of the S&L control frauds)and almost succeeded in handing Keating control of the Board. The control frauds used theircontributions to enlist House Speaker Jim Wright and the “Keating Five” Senators to hold theBank Board’s funding hostage to extort favorable treatment for the two worst control frauds. Theworst control frauds employed prominent economists, including Alan Greenspan, to lead the effortto block reregulation. Black explains how their effort (had it not been frustrated by courageousopposition) would have cost the nation over a trillion dollars.

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Black also documents how some economists sought to insulate their models from being falsi-fied by the wave of S&L control fraud by arguing that the control frauds occurred because depositinsurance removed “private market discipline.” Black makes a persuasive socio-economic casethat not only are the economists wrong, but that the prevalence of their views insured that noreforms would be instituted that might prevent future frauds such as Enron and World Com. Heshows that both fraud waves relied on accounting fraud and looting, and neither requires depositinsurance. The CEO suborns a top tier audit firm to “bless” abuses of generally accepted account-ing principles (GAAP) that make insolvent companies appear to be extraordinarily profitable.Creditors compete to lend to profitable companies (accounting fraud guarantees record ficti-tious profits), and the borrowing fuels massive growth. Massive growth and record profits justifyextraordinary salaries, bonuses, dividends and perks and makes the CEO’s options and sharesextremely valuable while boosting his status and power to influence politicians and regulators.S&L control frauds routinely defrauded uninsured “sophisticated creditors”—shareholders andsubordinated debt holders. Many neoclassical economists consider “sub debt” the ideal form ofprivate market discipline, but the sophisticated creditors lost tens of millions of dollars becausethey never spotted an S&L control fraud.

Black’s theories go to the heart of what is wrong with primary reliance on a narrow applica-tion of neoclassical economics in the regulatory context and what socio-economics has to offer.Neoclassical theory provides neither comprehensive explanations nor comprehensive preventa-tive strategies for the crime that causes greater financial losses than all other forms of propertycrime combined. Socio-economics provides a comprehensive theory. Neoclassical economics hasno theory to explain control fraud waves; and by failing to recognize their existence or identifytheir causes, neoclassical deregulatory policies actually create the conditions that promote theirrecurrence. Socio-economics explains the structures that produce these waves. Socio-economicapproaches led to policy changes that stopped the S&L frauds. Had the neoclassical abusersremained in control, the wave of S&L control fraud would have caused systemic damage to theU.S. economy.

The failure of the narrow application of the neoclassical paradigm to address the problem ofcontrol fraud adversely affects economic education and policy well beyond what occurred in theS&L crisis. Excessive reliance on neoclassical theory has adversely affected a number of majorfinancial crises of the last two decades: the S&L debacle, the failure of “shock therapy” in Russia(and many other former Soviet states), the wave of failed privatization in the developing world,sponsored by the International Monetary Fund, and other entities based on the “the Washingtonconsensus,” and the massive American corporate frauds. The disasters have led to reregulation, andin some countries, to the election of anti-American heads of state. Neoclassical abuses, however,are all too often celebrated, not discredited, by their colleagues for the failure of their predictionsand the damage they have caused. They generally deny that their policies cause any problemsand insist that the markets “spontaneously” cure all ills. The dominant neoclassical approachinvariably suggests that fraud is a “distraction” and that government is almost always the problemand never part of the solution.4 The reductio ad absurdum came when some neoclassical abuserswent so far as to claim that Enron represented a “triumph” and the “genius” of capitalism. Dr.

4 For e.g., “[A]ny treatment of the S&L debacle that focuses. . . on the fraudulent is misguided and misleading [and]diverts attention from an understanding of how and why government policies went awry and distracts policymakers fromthe difficult but necessary policy reforms. . .” White, Lawrence J. 1991, p. 117. The S&L Debacle: Public Policy Lessonsfor Bank and Thrift Regulation. NY: Oxford University Press.

982 Book reviews

Black’s systematic framework for identifying and preventing control fraud counters the perniciouseffects of neoclassical abuse.

Insensitive to the problem of control fraud, neoclassical economics has shown poor ability toexplain why some nations are locked in intractable poverty. In contrast, based on Black’s theoryof control fraud, Dr. Akerlof has praised Black “as pioneer in a field that is of fundamentalimportance, not just for the United States, but also in explaining why some economies grow andothers stagnate.5”

Black’s book demonstrates the crucial importance of taking a socio-economic approach tothe effective formulation and enforcement of regulatory policy in the public interest and alsoconvincingly reveals the disastrous consequences that can result from relying primarily on theneoclassical approach to regulatory policy and enforcement. Robert Kuttner, in his 12 September2005 Business Week column, aptly termed Black’s book the “definitive” account of the debacle.He went on to emphasize that control fraud theory was an important advance that explained manyongoing scandals. In a review of a draft of Black’s book written for the University of Texas Press,Dr. Akerlof agreed, stating that “Black’s book . . . is of great scholarly interest to a whole swath ofeconomists and political scientists as well” and predicting that the book will become “a classic.”

Robert Ashford ∗Syracuse University College of Law, Syracuse,

NY 13244, United States

∗ Tel.: +1 315 677 4680.E-mail address: Rhashford@aol.com

doi: 10.1016/j.socec.2007.01.027

Growing Public: Social Spending and Economic Growth Since the Eighteenth Century, P.H.Lindert. Cambridge University Press (2004). vol. 1: xvii + 377 pp., vol. 2: vii + 230 pp., ISBN:0 521 82174 6 (hardback), 0 521 52916 6 (paperback)

Does high social spending funded by taxation reduce economic growth? Simple economicanalysis might suggest that high taxation and generous welfare payments reduces incentives towork and save for both those being taxed and those receiving income-related benefits. However,the process may not be so simple. As Lindert demonstrates, a larger burden of taxation to financesocial spending does not correlate negatively with either the level or the growth of GDP percapita. Furthermore, there has been no real ‘crisis’ in the welfare state since the beginning of theReagan–Thatcher era. Indeed there has not even been a fall in funding except for a few categoriesin a few countries. For example since 1980 only 2 of the 21 leading OECD countries have cut theshare of GDP spent on total social transfers, only 3 have cut the share supporting public healthcare, 3 have cut the share spent on unemployment and none has cut public funding for education.

Peter Lindert sets out to examine the growth in social spending and the effect it has had oneconomic growth. Since the subject matter is of wide interest Volume 1 ‘is written for humanbeings and Volume 2 for social scientists’. Part 1 in the first volume presents an overview and thefindings of the study. Part 2 provides a fascinating account of the rise of social spending covering

5 Letter of George Akerlof to Robert H. Wilson, Mike Hogg Professor of Urban Policy. Lyndon B. Johnson School ofPublic Affairs, dated 11 August 2003.