Anyone who has worked for a large government or firm knows their tendency to be bureaucratic. Everyone has had the experience of dealing with bureaucratic mentalities, including the volunteer soccer referee who lets power go to his head and becomes an arrogant demigod. Everyone has had to deal with a public clerk or a private insurance company’s claim official who drives one nuts. Working for a federal agency meant that I often had to deal with a bureaucratic personality to get things done. That is why so many of us that have worked for a large government or firm are passionately anti-bureaucratic.
As a federal financial regulator we took actions that logically should have made us the heroes of the Clinton administration’s “reinventing government” movement (led by Vice President Gore). Our reregulation and resupervision of the savings and loan (S&L) industry in the 1980s involved actions that were as innovative and courageous as they were successful. Leaders like Ed Gray and Joe Selby knew they were likely to sacrifice their careers to confront the fraudulent CEOs and their political allies who were driving the second phase of the S&L debacle. The recent crisis, driven by fraudulent “liar’s” loans, makes our success in ending liar’s loans by S&Ls in 1990-1991 all the more remarkable and impressive. We succeeded because we listened to our examiners, the people in the field closest to the facts. While it is far less known, we (the West Region of the Office of Thrift Supervision (OTS)) also reduced a wide range of rules and approval requirements.
The foreword to Bob Stone’s book on the Clinton/Gore reinvention movement (“Confessions of a Civil Servant” 2002, 2004) was written by Tom Peters. It begins with a quotation from Stone: “‘Some people look for things that went wrong and try to fix them. I look for things that went right and try to build on them.’—Bob Stone/ Mr. ReGo/ Energizer-in-Chief.” That is an excellent, albeit incomplete approach. As financial regulators dealing with the S&L debacle we looked for both the things that had gone wrong and the things that went right. We prioritized and addressed both, because it is essential to learn from both our failures and successes. Our regulatory actions are the subject of three scholarly publications by public administration experts who cite them as exemplars of successful public service. Our actions are profiled in Chapter 2 of Professor Riccucci’s book Unsung Heroes (Georgetown U. Press: 1995), Chapter 4 (“The Consummate Professional: Creating Leadership”) of Professor Bowman, et al’s book The Professional Edge (M.E. Sharpe 2004), and Joseph M. Tonon’s article: “The Costs of Speaking Truth to Power: How Professionalism Facilitates Credible Communication” Journal of Public Administration Research and Theory 2008 18(2):275-295. One would expect that “Mr. ReGo” (Gore’s nickname for Reinventing Government), Gore’s lead Reinventor, and a man who claims that his signature approach is to “look for things that went right and try to build on them” would make our actions the centerpiece of his movement. We did not simply make things go “right” – we did so in circumstances where the military (Stone was military) would have called the “correlation of forces” suicidal. We were extorted, sued by the most notorious frauds in our individual capacities for hundreds of millions of dollars, threatened with criminal prosecution, excluded from meetings, secretly investigated by private and agency investigators, had our jurisdiction over notorious frauds removed, and some of us were made unemployed and unemployable. Tonon was correct, the cost of speaking truth to power was high and it took enormous professionalism and dedication to serving the Nation, rather than corporations, to produce so many things that “went right.”
I have not been able to find a word of praise for our efforts in any of the Clinton administration’s “reinvention” documents. An electronic search of Stone’s book found no reference. Stone did not search for examples of regulatory efforts that “went right” – he searched for examples that “went right” and reinforced his dogmas, particularly his insistence that government leaders should not “waste one second going after waste, fraud, and abuse.” The S&L regulatory response would have falsified his central dogmas, so he excluded it. I have been unable to find more than one (bizarre) sentence even mentioning the S&L debacle and its implications for reinventing government in any document prepared by the Reinventors. (This article addresses that sentence below.) If anyone has access to additional discussions of the debacle by the Reinventors I would appreciate being sent a copy.
My thesis is that the reinventing movement was, net, a catastrophic failure. That does not mean that it did not produce hundreds of useful reforms. Any massive effort to reconsider how to run the federal government or a large corporation is bound to produce many successes. In soccer terms, the coaches running the reinvention effort became infatuated with the offense and abandoned defense. They increased their goal output, but their defense became a sieve and they lost so many games that they were relegated out of the professional leagues to the semi-pros. An enormous number of the goals they gave up were “own goals.”
The Clinton administration Reinventors were not unlucky. Their vision and their approach to improving government made their (net) failure certain. By the time the Clinton administration, under Vice President Gore’s leadership, geared up its “Reinventing Government” initiative in 1993, the factual record showed that much of the initiative was based on assumptions about private firms and their practices, the government, and the three “de’s” (deregulation, desupervision and de facto decriminalization) that were false. The “Reinventors,” however, studiously ignored the lessons of the savings and loan debacle or reinvented the history of the debacle.
Even in retrospect, the Reinventors have failed to acknowledge the pathologies they inflicted. The Reinventors’ central failures fell in three broad areas. First, they not only lacked a coherent theory, they disdained theory and data. Instead, they embraced simple “just so” stories deliberately presented in a journalistic manner. They dismissed opposing views as illegitimate obstruction. Second, they had no positive view of the essential and unique role that effective regulation and prosecution plays in preventing the “Gresham’s” dynamic that turns markets perverse and criminogenic. Third, they were hostile to the government and dangerously naïve about the pathologies of the private sector. These flaws interacted to produce a mindset of complacency. Businesses were intrinsically honest, so fraud was inherently a trivial problem. Regulation, supervision, enforcement, and prosecutions were the real problems. Minimizing regulations and replacing it with “partnerships” with business and “service” to the agency’s business “customers” were the solutions.
The S&L debacle falsified the Reinventors’ dogmas about business
The S&L debacle demonstrated the falsity of the Reinventing movement’s dogmas. First, deregulation was a critical contributor to the creation of the criminogenic environment that produced the epidemic of accounting control fraud that drove the second phase of the debacle. “Control fraud” occurs when the people who control a seemingly legitimate entity use it as a “weapon” to defraud. In finance, accounting is the “weapon of choice.” George Akerlof and Paul Romer made these points in their famous 1993 article (“Looting: the Economic Underworld of Bankruptcy for Profit”).
“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 Romer.1993: 60).
Second, the National Commission on Financial Institution Reform, Recovery and Enforcement (NCFIRRE) reported in 1993 on the endemic nature of accounting control fraud at the worst S&L failures. Note that Akerlof and Romer and NCFIRRE confirmed the S&L regulators’ analysis that the “weapon” was accounting and that “performance” executive compensation was one of the principal means of looting the firm.
“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).
Third, by 1993 we had obtained over 1,000 felony convictions of S&L defendants in cases designated as “major” by the Department of Justice. Fourth, we had confirmed each of these facts in our capacity as financial regulators. Akerlof and Romer, NCFIRRE, and the S&L regulators had confirmed the existence of a “Gresham’s” dynamic in which bad ethics tended to drive good ethics out of the professions suborned by the officers running the control fraud.
“[A]busive operators of S&L[s] sought out compliant and cooperative accountants. The result was a sort of “Gresham’s Law” in which the bad professionals forced out the good” (NCFIRRE 1993).
A Gresham’s dynamic perverts markets into destructive forces. Akerlof’s most famous article (1970) on markets for “lemons” describes the result.
“[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.”
As NCFIRRE explained, supposedly “independent” expert outside controls like the world’s most prominent audit firms were consistently suborned by S&L control frauds to give clean opinions to fraudulent financial statements that purported that massively insolvent S&Ls were among the most profitable S&L in the Nation. Any “control” that the fraudulent CEO can hire and fire, promote, make miserable, or compensate can be suborned or removed by the CEO. “Private market discipline” routinely aids accounting control frauds by funding their growth. Lenders love to lend to firms reporting record income, and Akerlof and Romer agreed with the S&L regulators and criminologists that one of the defining characteristics of accounting control fraud is that it is a “sure thing” – lenders that follow the “recipe” for optimizing accounting control fraud are mathematically guaranteed to report record income in the near term. Private lenders fund the growth of accounting control frauds – they feed rather than discipline these elite frauds.
These facts are what make vigorous government regulation and enforcement essential. As regulators and prosecutors we are unique. We cannot be hired and fired by the frauds. The police do not investigate or prosecute elite white-collar crimes. Even the FBI’s white-collar agents do not and cannot walk a beat. They come only in the rare and episodic cases in which a whistleblower sends them a tip that they take seriously enough to investigate and when the regulators make a criminal referral. (The OTS made over 30,000 criminal referrals during the S&L debacle – it made zero during the ongoing crisis.) The regulators are the unique group that can, and must, serve as the regulatory “cops on the beat.” To do so effectively they must maintain their independence from the industry’s they regulate. They must maintain a dedication to their mission to the Nation and never mistake the firms they regulate for “customers” or “partners.” When they fail to do so they do not cause simply the government to fail – they allow the private sector to fail due to the Gresham’s dynamic. Markets perverted by the Gresham’s dynamic become extraordinarily criminogenic and produce epidemics of control fraud. These fraud epidemics hyper-inflated the world’s largest financial bubbles and produced the global systemic crisis. The current crisis has cost over 20 million people their jobs and destroyed over $20 trillion in wealth. Only massive public sector bailouts prevented a total collapse of the private financial sectors.
The Reinventors optimized the criminogenic environment
The best way the government can aid the private sector is to support vigorous regulation, enforcement, and prosecution. The irony is that the Reinventors assumed that the only salvation for the problems of the public sector was to ape the private sector practices that posed the gravest threat to the world. The Reinventors saw the private sector practices that were a disaster in the making and assumed that they represented salvation. The extended irony is that the Reinventors’ total ignorance of the pathologies of the private sector exceeded even their profound ignorance of the successes that vigorous regulation had just produced in the financial sphere. Instead of building on those successes, the Reinventors adopted the private sectors’ greatest failures at the time that those failures had just led to the (then) greatest financial scandal in U.S. history and were beginning to build the criminongenic environments that drove the Enron-era accounting control frauds and the current fraud epidemic that drove the global crisis. The Reinventors began the process of destroying effective federal financial regulation by perverting it through the redefinition of its mission to serving the interests of their banking “customers.” This did not simply destroy effective financial regulation. It also robbed the U.S. government of its integrity and produced a return to crony capitalism that has perverted even our democracy and led to the scandal of the frauds that caused this crisis being treated as “too big to prosecute.”
Championing the regulatory race to the bottom
Gore was a strong proponent of the regulatory “race to the bottom” – the perverse dynamic that must, and did, lead to global regulatory failure. Gore claimed that to regulate was to force the Nation’s economy into a “noose.”
“In a global economy where capital can be invested anywhere, red tape is like an economic noose that says: if you send your investments here, we’re going to strangle them with bureaucracy, inefficiency, and forms, fees, and requirements you can barely even understand.”
“Don’t waste one second going after waste, fraud, and abuse”
Gore and Clinton led the Wall Street wing of the Democratic Party’s reinvention of CEOs as moral paragons. Bob Stone, who Gore put in charge of the Reinvention movement, explained how Gore came to be a fraud denier. Stone was a fraud denier and ignorer.
Stone writes in his book that when he first met Gore he was able to convince him to ignore fraud (pp. 68, 175). Stone told Gore his three rules for reinventing government. His third rule includes this gem: “don’t waste one second going after waste, fraud, and abuse.” Stone reports that Gore promptly “embraced” Stone’s three goals as a result of this initial meeting (p. 175). Remember, this meeting is contemporaneous with (1) NCFIRRE reporting that fraud was “invariably” present at “the typical large failure,” (2) Akerlof and Romer confirming the major role that accounting control fraud played in driving the second phase of the S&L debacle, and (3) rapidly approaching over 1,000 felony convictions in “major” S&L fraud cases. Akerlof and Romer explained how deregulation was “bound” to produce widespread “looting” by CEOs. NCFIRRE, Akerlof and Romer, the S&L regulators, and white-collar criminologists had all identified modern executive compensation as a key problem in terms of creating both perverse incentives and a mode of looting that made prosecution far more difficult. It is in that context that Stone announces his purportedly universal three rules of effective government. The third rule, which proclaimed that one should not “waste one second going after waste, fraud, and abuse” was the only substantive rule that Stone pressed Gore to embrace. His first two rules were about how to make effective propaganda.
- Have a simple uplifting message that you repeat over and over and over.
- Use colorful stories in plain English, with props….
Denying and ignoring the government’s essential and unique role in limiting control fraud was the heart of Stone’s message that Gore embraced. Stone had to be a fraud denier because if he admitted that corporate control fraud was a serious problem his version of “reinvention” would become a deadly danger to the Nation.
The Reinventor’s rage at the Inspector Generals and other critics
Stone reserved his greatest hate for the Inspector Generals, claiming in his book (Confessions of a Civil Servant) that their primary “contribution” to government is “stifling innovation” (p. 156). Stone wrote that he has no confidence that IGs are effective against fraud, makes the old joke that their function is to “shoot the wounded” after a battle, and then cites favorably the even older quotation from President “Teddy” Roosevelt deriding “critics” of the “strong man.” The tone of the quotation is one of disgust that “cold and timid souls that know neither victory nor defeat” (the IGs) have the impertinence to criticize great men like Teddy (and Stone and CEOs) – who are infinitely superior to IGs. The “strong man” transcends normal moral codes. (Teddy was a contemporary of Friedrich Wilhelm Nietzsche.)
“It is not the critic who counts; not the man who points out how the strong man stumbles, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood; who strives valiantly; who errs, who comes short again and again, because there is no effort without error and shortcoming; but who does actually strive to do the deeds; who knows great enthusiasms, the great devotions; who spends himself in a worthy cause; who at the best knows in the end the triumph of high achievement, and who at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who neither know victory nor defeat.”
I have written previously on the essential and rare role that government officials play when they “speak truth to power.” Roosevelt and Stone and many government leaders share a virulent contempt for those who speak truth to power when they hold power. Tom Peters’ foreword to Stone’s book emphasizes Stone’s arrogance and nastiness to anyone who had the temerity to disagree with him, noting that he was famous for his refusal to “suffer fools lightly.” Stone knew that any government official who sought to prevent fraud was such a “fool.” The Reinventors shared this contempt for anyone who disagreed with their dogmas. In a prior article, I quoted in some detail their openly expressed intention to force out anyone who disagreed with their policies. The journalist who led the “reinventing government” movement advised that it was essential that the Clinton administration not “tolerate resistance” to the movement’s dogmas.
The Reinventers relied on diktat rather than persuasion for the excellent reason that they could not win an honest debate in most contexts. While the Reinventers often mouthed contempt for “one size fits all,” the reality was that they embraced it. They ordered all agencies, even the financial regulators, EPA, OSHA, and the FDA, to act as if private firms were their “customers.” That order is grotesquely improper for a regulator because it is a superb means of maximizing the Gresham’s dynamic. It often makes sense for the Social Security Administration to treat recipients as customers. I showed in my prior article that the Reinventers decided one size fits all and ordered even the regulatory agencies to treat firms as customers. This was mindless.
Neil Barofsky (SIGTARP) explains in his book how the IGs responded to the Reinventors’ unholy war against the IGs (Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street). The IGs became exceptionally cautious in speaking truth to power. Gretchen Morgenson rightly emphasized this process in her analysis of the key disclosures in Barofsky’s book.
“‘The common refrain went like this,’ Mr. Barofsky writes. ‘There are three different types of I.G.’s. You can be a lap dog, a watchdog or a junkyard dog.’ A lap dog is seen as too timid, he was told. But being a junkyard dog was also ill-advised.
‘What you want to be is a watchdog,’ he continues. ‘The agency should perceive you as a constructive but independent partner, helping to make things better for the agency, so everyone is better off.’ He also learned, he says, that success as an inspector general meant that investigations come second. Don’t second-guess the Treasury. Instead, ‘focus on process.’”
The banks are our friends, and regulators exist to service their needs
More broadly, Barofsky shows the harm arising from Treasury’s view that elite financial institutions are their “customers.” Barofsky documents that the Reinventors did not reinvent government. Crony capitalism is the ancient, disgraceful pattern. Gore and Stone and their colleagues’ policies disinterred crony capitalism. During the “Robber Baron” era the U.S. government disgraced itself by being a willing partner in crony capitalism. The Reinventors added greatly to what became the intensely criminogenic environment that produced the epidemic of accounting control fraud that drove the ongoing crisis. One of the destructive steps Gore and Stone championed was crippling the effectiveness of the government’s internal cops on the beat (the IGs). They declared a need to reinvent the IG function to transform the IG into allies of crony capitalism rather than officials focused on preventing elite fraud by corporations and the government officials they suborn.
Barofsky’s book demonstrates the success of their efforts to emasculate the IG function – and the harm it caused. One of the harms that Barofsky emphasizes is that the government’s treatment of the systemically dangerous institutions (SDIs) as “customers” has impaired the public’s trust in government. The Reinventors claimed that their efforts were essential to restore public trust in government, but their policies have ended up doing the opposite. No one has any respect for crony capitalism.
Stone convinced the Clinton administration to embrace the defining element of crony capitalism – ordering even the financial regulators to refer to the banks as their “customers” and to think of the banks – not the American people – as their “customers.” Peters’ foreword to Stone’s book admits the action, but is clueless about the impact.
“Bob Stone’s insistence on using the word “customer” was mocked by some—but made an enormous difference over the course of time. In general, he changed the vocabulary of public service from ‘procedure first’ to ‘service first.’”
In my experience, Stone wasn’t “mocked” for insisting that we refer to the banks as are “customers” and think of them as customers we should “service.” When Gore rolled out the road to crony capitalism, we (the S&L regulators of OTS’ West Region) were appalled and enraged. We were not amused by the orders to treat S&Ls as “customers.” We realized immediately that the “customer” approach (1) would destroy effective regulation and supervision, (2) was immoral and would erode the agency’s integrity, (3) would produce future financial crises, and (4) had already demonstrated its capacity for severe harm because the acting head of our agency (Jonathan Fiechter, an economist who was willing to have us “serve” rather than regulate S&Ls) had agreed to make it agency policy. When the head of your agency, who knows that the policies the administration is directing him to implement will produce a disaster instantly rolls over and endorses those policies the staff realizes that the leader is no longer willing to bear the price of speaking truth to power and is no longer dedicated to accomplishing the agency’s mission. When the head of your agency, an agency that achieved a record of unmatched success by following policies that were the opposite of the Clinton administration’s policies remains silent about those successes and refuses to speak truth to power and support his people the agency immediately loses much of its capacity to be effective.
A vital and destructive institutional change had occurred by the time Fiechter became the acting head of the agency. The Federal Home Loan Bank Board had been an independent regulatory agency. The FIRREA legislation of 1989 created a successor agency, the Office of Thrift Supervision (OTS). President Bush viewed ending the Bank Board’s independence as a high priority. OTS was made a bureau within the Treasury Department.
The Clinton administration was hostile to effective banking regulation, but it reserved special scorn for the OTS. The Clintons were subjects of the Whitewater investigation because of their role as borrowers and partners in a real estate investment with an Arkansas S&L control fraud. (I was an expert for the Independent Prosecutor in that investigation. No criminal charges were brought against either Mr. or Mrs. Clinton on these issues.) The Clinton administration refused to nominate an OTS Director to run the agency. They left the holdover from the Bush administration, Fiechter, the “acting” head of the agency – for nearly four years. When Fiechter finally left, the Clinton administration replaced him with a part-time director. It took the Clinton administration nearly six years to appoint a full-time OTS director. The administration approach was to let the agency twist slowly in the wind. The administration’s treatment of OTS defines the term “irresponsible.”
OTS’ alternative to “service [to S&Ls] first” was not Peters’ and Stone’s false dichotomy of “procedure first.” The alternative we embraced had three key components. First, we served as the regulatory cops on the beat – detecting fraud and insider abuse, taking thousands of supervisory and enforcement actions, and providing the vital support that made it possible to convict over 1,000 felons in cases designated as “major” by the Justice Department.
Second, we acted proactively to limit existing epidemics of accounting control fraud and prevent future crises. We removed the policy failures (the three “de’s” – deregulation, desupervision and de facto decriminalization) that made the S&L environment so criminongenic. We deliberately burst the Southwest real estate bubble. We ended “liar’s” loans in 1990-1991 because we realized that S&Ls that made significant numbers of such loans were inherently fraudulent. We targeted the “Achilles’ ‘heel’” of accounting control frauds by restricting S&L growth.
Third, we spoke truth to power. We stood up to the Reagan administration, the head of our agency (who removed our jurisdiction over Charles Keating’s Lincoln Savings because we refused to treat it as a “customer” and instead treated it as what it really was – a fraud), Speaker of the House James Wright, Jr., a majority of the members of the House, and the five U.S. Senators who became known as the “Keating Five.” In doing so, we produced a dramatic rise in public trust for our agency.
Effective financial regulation saves vastly more than the Reinventors’ claimed savings
The reregulation and resupervision of the S&L industry that Federal Home Loan Bank Board Chairman Edwin Gray led beginning in 1983 – only one year after federal deregulation passed the House and the Senate nearly unanimously – was remarkably aggressive and successful. With the aid of the ongoing crisis, where the paralyzing and corrupting reinventing process of treating banks as “customers” produced a decade of regulatory rigor mortis, we can evaluate the savings that Gray’s policies produced. There were roughly 300 control frauds in 1983 and they were growing annually at an average rate of 50%. There were roughly 100 new control frauds entering the industry annually, and that number was accelerating rapidly.
Prior to the ongoing crisis, when I explained the savings that Gray produced by regulating and resupervising the S&L industry I estimated the savings at $1 trillion based on the assumption that no regulator could have stood by for five or more years and watch the S&L debacle grow and the real estate bubbles hyper-inflate. I also ignored the savings that occurred under the first President Bush in 1990-1991 when we forced the end of liar’s loans by S&Ls. The ongoing crisis has shown that the poison of treating banks as “customers” and ignoring fraud can lead to over a decade of regulatory paralysis even in the face of the most costly epidemic of elite fraud in history. This paralysis continued despite the massive growth of liar’s loans (to roughly 40% of all loans originated in 2006), the small clue that the industry called the loans “liar’s loans,” and the publicly reported fact that 90% of such loans were fraudulent. The current regulators also had the advantage of our crackdown on liar’s loans a decade earlier and the loss experience of S&Ls that made “stated income” loans (which is what such loans were called by the industry even behind closed doors in 1990-1991). None of this mattered – the modern regulators took no effective regulatory, supervisory, or enforcement action against liar’s loans. They never stopped liar’s loans. Liar’s loans died in the markets – after they destroyed the global financial markets in many nations.
At an annual growth rate of 50%, losses grow massively if the crisis lasts ten years rather than five years (and the entry of new frauds greatly accelerates the growth rate of the losses). The losses increase even faster that the growth rate of the lenders for loan quality must deteriorate substantially to sustain that growth and because the fraudulent loans become such a large portion of total loans that they cause bubbles to hyper-inflate. The growth in the losses also begins to cause the failure of so many SDIs that it causes systemic crises. It is now clear that Gray’s reregulation and resupervision saved over $5 trillion if the alternative was the over decade-long embrace of the three “de’s” under the spell of the Reinventors. Similarly, if we assume that the alternative to our 1990-1991 elimination of liar’s loans from the S&L industry was over a decade of regulatory inaction, the savings would again be over $5 trillion.
The remarkable fact about the successful regulatory response to the S&L debacle and the 1990-1991epidemic of fraudulent liar’s loans was that it was ignored, or history was re-invented, by the Reinventing movement. Both of these episodes of regulatory success would have made superb examples of the success of “reinventing” government. First, we succeeded in both cases, as Akerlof and Romer noted, because we listened to the people in the field closest to the facts. Second, we were zealously dedicated to results, not process (other than the requirement that we provide the constitutionally-required due process). Third, we were exceptionally innovative. Fourth, we took exceptional risks – repeatedly. Gray and Selby knowingly sacrificed their careers to contain the S&L debacle. Fifth, we showed the combination of skill and integrity in the face of powerful attacks from the industry’s leading frauds and their political allies that led experts in public administration to cite our work as the exemplar of effective regulation. Sixth, we not only produced vastly greater savings (by roughly two orders of magnitude) than all the savings claimed from every Reinventing project during the entire Clinton administration, we also helped produce the most effective prosecutorial effort against elite white-collar criminals in history.
The Reinventors summarized their claimed accomplishments at the end of the Clinton administration. The relevant portion describing their claimed major savings reads:
“Ending the Era of Big Government
- Reduced the size of federal civilian workforce by 426,200 positions between January 1993 and September 2000. Thirteen of 14 departments reduced in size; Justice grew because of Administration’s fight against crime and drugs. The government workforce was for the first time the smallest it had been since the Eisenhower Administration.
- Action on more than two-thirds of NPR recommendations resulted in savings of more than $136 billion.
The subtitle the Reinventers chose to describe their accomplishments exemplifies perfectly their approach to making their claims. It is preposterous to claim that they ended the era of big government. Most of the purported savings come from their cutting the workforce – and most of those cuts did not come from “reinvention.” They came from cutting staff and programs.
The damage caused by the Reinventors vastly exceeded their claimed benefits
Two of the important agency’s that suffered severe cuts were the FDIC (collectively under Clinton and George W. Bush they lost over three-quarters of their staff) and the OTS (which lost over half its staff). This had nothing to do with “reinventing” these agencies and everything to do with crippling them, which is what it helped accomplish. This was only one of the many actions of the Reinventors that combined to cripple financial regulation. The Clinton and Bush administrations’ assaults on financial regulators helped produce the criminogenic environments that led to the Enron-era and current era epidemics of accounting control fraud. The cost that these crises imposed is even larger than the savings we produced by containing the S&L debacle and ending the 1990-1991 wave of liar’s loans. Combining these costs and savings and comparing them to the paltry and inflated “savings” (which actually produced (net) losses) claimed by the Reinventors demonstrates that the Reinvention effort of the Clinton and Bush (II) administrations was by far the most catastrophic governmental “reform” failure in our Nation’s history.
Our vastly greater success as S&L regulators and the damage caused by the Reinventors’ assault on effective financial regulation compared to the Reinventors’ claimed savings poses insoluble problems for Stone, Gore, Peters, David Osborne, and Clinton. Their claim was that the government was a dismal failure and the private sector was a shining success. The solution was for the public sector to adopt the approaches, such as performance pay, that made the private sector a success. CEOs were good people and if the government would only cease to treat them (unjustly) like criminals and instead serve them as “customers” and work with them as “partners” all would be well. Fraud is not a problem and the government should not “waste a second” worrying about it. Deregulation (which Akerlof and Romer warned was “bound” to produce “looting”) was vital. Reregulation and resupervision were great evils. The S&L debacle and the successful termination of liar’s loans falsified too many of the Reinventors’ dogmas. So the S&L debacle disappeared or was reinterpreted as a story consistent with the dogmas. The original Gore report, “From Red Tape to Results: Creating a Government that Works Best & Costs Less” (1993: 81) claimed, in a sentence without benefit of logic or citation, that the S&L debacle arose because of “lagging” government “management information systems.” I leave the refutation of this fiction to the reader.
Stone, Gore, and Peters created a false dichotomy in which the only alternatives available to a financial regulator are serving banks as our “customers” or being useless drones focused solely on “procedures.” What we do not know is whether they were so ignorant of, and hostile to, effective financial regulation that they believed the dichotomy or whether they were deliberately disingenuous. Note that their framing of this false dichotomy betrays their false assumption that effective financial regulation is not an option.
Stone was not the most extreme of the Reinventors
Gore and Stone were not the most extreme leaders of the Clinton administration’s Reinvention movement. Stone’s book reports that immediately after Stone advised Gore to ignore fraud, Bob Knisely told Gore that the U.S. government “was the last bastion of communist management.”
Gore made Stone and Knisely leaders in his Reinventing movement on the basis of these two substantive claims – that government officials should not waste “one second” worrying about stopping fraud and that the U.S. government “was the last bastion” of communism.
The 1995 administration speeches that put us on the road to regulatory ruin
On February 21, 1995, Vice President Gore gave a speech on reinventing government and his support for the three “de’s.”
“[F]rom the very beginning, when President Clinton launched the National Performance Review, he told me time and time again that regulatory reform must be a central part of reinventing government….”
The Reinventors used the term “regulatory reform” as a euphemism for deregulation – never the adoption of vital rules that would prevent a criminogenic regulatory “black hole.” Gore began his substantive discussion by listing the lessons he had learned about deregulation.
“[We] learned two basic practical lessons. First, we can cut back on the volume of regulations, and we are doing just that. Secondly, we can improve the relationship between regulators and the people they regulate. And when we do these things we get better results for our country.
If you rummage through the Code of Federal Regulations, as we’ve been doing, you will find things that look worth keeping, things that seem old-fashioned….”
We begin in these passages to see how hostile the administration was to regulations and regulators. Deregulation was not sufficient – it was essential to “improve the relationship between regulators and the people they regulate.” Note the use of “people” instead of “businesses.” We also see the administration’s hostility to any rule the industry claims is “old-fashioned.” The administration’s premise was that rules created in the “industrial age” were presumptively archaic and harmful in the new “information age.” To be “old-fashioned” was to be condemned. It is no accident that the administration’s two major harmful forays into legislative deregulation bore the word “modernization” in their titles. The administration’s presumption was typically false. There is no logical basis for assuming that the rise of information technology makes most substantive regulation archaic.
President Clinton spoke immediately after Gore. He emphasized the archaic theme.
“We do want to get rid of yesterday’s government so we can meet the demands of this new time. We do want results, not rules. We want leaner government, not meaner government.”
Clinton’s theme was that government was outdated. It ignored results and it was mean. Rules aren’t important to producing “results.” Clinton knew where we could find the answers to pathological government. He explained that the key was: “to give the people a government as effective as our finest private companies, to give our taxpayers their money’s worth.” The private sector was inherently superior, but the public sector could improve greatly were it to model itself after the private sector.
One part of government most upset Clinton – the examiners who checked for threats to the safety and soundness of banks and businesses.
“The federal government to many people is not the President of the United States, it’s the person who shows up on the doorstep to check out the bank records, or the safety in the factory, or the integrity of the workplace, or how the nursing home is being run. I believe that we have a serious obligation in this administration to work with the Congress to reduce the burden of regulation and to increase the protection to the public. And we have an obligation on our own to do what we can to change the destructive elements of the culture of regulation that has built up over time….”
The federal examiners that expose the banks, workplaces, and nursing homes that engage in fraud or abuse provide a vital and unique service not only to the public, but specifically to honest competitors by blocking the Gresham’s dynamic that control fraud produces. Clinton, however, is unaware of this dynamic. This type of regulation does not (net) “burden” honest businesses – it makes it possible for them compete by relieving them of the impossible burden of competing with control frauds. Clinton sees regulation not as episodically failing, but as the inherently flawed product of a “destructive” “culture of regulation.”
Clinton then singled out the worst examiners – bank regulators.
“When I was out in New Hampshire in 1992, I heard more grief about the regulation of the private sector by the Comptroller of the Currency than any other single thing. And now every time I go to New England, they say, we’re making money, we’re making loans, and we can function, because we finally got somebody down there in Washington who understands how to have responsible and safe banking regulations, and still promote economic growth. I hear it every time I go up there, and I thank you, sir, for what you’ve done on that. (Applause.)”
Vice-President Gore had already praised the OCC head, Gene Ludwig, for embracing the three “de’s.” Gore was particularly impressed that the bankers’ lobbyists were praising Ludwig. Readers will vary on what they infer from that praise, but Gore thought the only possible inference was that Ludwig’s deregulatory policies were superb.
The context of Clinton’s comments is interesting. There are simply not that many national banks (which is what the OCC regulates) in New Hampshire so we can infer that Clinton was hearing the complaints against the OCC largely in his fundraising efforts when he pitched corporations and banks. Clinton is complaining about the belated (relative to S&Ls) regulatory crack down on banking control frauds under the first President Bush. Those vigorous (but late) regulatory actions (barely) prevented what many banking experts were predicting – the need for a federal bailout of failed bank resolutions to save the FDIC fund from insolvency in the early 1990s.
Ludwig ended the regulatory crack down and reversed course. He was famous for being comfortable with far broader investments by national banks. In particular, a literal handful of the largest banks began to make extraordinary investments in financial derivatives. Ludwig’s deregulatory policies drove other federal agencies into a domestic “competition in laxity” that, in conjunction with the international competition in laxity with Germany and the City of London, ensured a dramatic expansion of the three “de’s” and the creation of a criminogenic environment “bound” to produce “looting.” Allowing fraudulent banks to make extraordinary amounts of bad loans does not “promote economic growth” – it promotes faux growth through the hyper-inflation of financial bubbles and real recessions and depressions. Gore and Clinton, however, praised the policies that were setting us on the path to catastrophe as exemplifying the best of reinventing government.
Gore made it explicit that the administration saw desupervision and de facto decriminalization as vital accompaniments of deregulation.
“But the number of complex regulations is only half the problem. As President Clinton has repeatedly emphasized, it is also the adversarial and seemingly mindless enforcement methods that really get under people’s skins. Business owners are sick of being treated like criminals. They see a government that just doesn’t make sense, that charges them with safety violations when no one is in harm’s way.”
Taking this passage in conjunction with Clinton’s slam of the OCC’s regulatory crackdown under the first President Bush produces a remarkable realization. A Democratic administration claimed that its Republican predecessors led an anti-business jihad consisting of (1) a “culture” of “destructive” regulation that included banking rules that made banks unprofitable and harmed economic growth, (2) “mindless enforcement,” and (3) “treat[ing] [business owners] like criminals.” As a reality check, it may help the reader to know that Vice President Bush chaired President Reagan’s task force on financial deregulation, which vigorously pushed the deregulation that was “bound” to produce the S&L “looting” that Akerlof and Romer condemned in their 1993 article. In their 1995 speeches, Gore and Clinton positioned themselves to run for re-election in 2006 far to the right of Bush and Reagan on the three “de’s.” The Wall Street wing of the Democratic Party sought to demonstrate its absolute fidelity to the interests of Wall Street’s CEOs.
Gore faced an obvious problem in denouncing the enforcement actions and prosecutions against CEOs – we were overwhelmingly winning the actions because the CEOs had intentionally directed the violation of laws. OTS had pursued thousands of successful enforcement actions and helped the Justice Department obtain over 1,000 felony convictions in “major” cases. We had worked closely with the Justice Department to prioritize the “Top 100” fraud schemes, involving roughly 300 fraudulent S&Ls and roughly 600 senior individual defendants. We achieved a 90% conviction rate – against the best criminal defense lawyers in the world who spent money like water to keep the CEO from being convicted. CEOs were being “treated like criminals” for an excellent reason – they led the control frauds that were “invariably” present at the “typical large failure” (NCFIRRE 1993). (The Clinton administration, in 1993, decreed a major reduction in the priority of S&L prosecutions that involved re-tasking hundreds of FBI agents and prosecutors who had been working our cases, or the number of convictions in “major” cases would have been far higher.)
Gore reinvented history to make enforcement actions “mindless” and CEOs the powerless victims of vicious (Republican) regulators who inexplicably and falsely “treated [CEOs] like criminals.” To Gore; it was so obvious that CEOs could not be criminals that their innocence could be implicitly assumed. The reader can see why it was essential that the Reinventors ignore the reality of the S&L debacle and the successful regulatory and prosecutorial responses to it and the 1990-1991 wave of fraudulent liar’s loan lenders. The facts falsified all of their anti-regulatory and pro-business dogmas.
Gore then claimed that enforcement agencies are really just like “traffic cops.”
“We found out what causes this problem. It involves an elementary management principle. You get what you measure. Generally speaking, regulatory agencies have been measuring process and punishment. They evaluate the performance of front-line workers in those terms. Now, I know there are plenty of exceptions on the part of pioneers who have helped lead the way and who have helped us learn this lesson that informs what the president is ordering today, but, generally speaking, this has been the case. They evaluate whether people have checked all the forms properly, they evaluate how many violations they’ve found, they evaluate how many fines they have issued. It’s the same kind of pressure that some traffic cops have to meet when they’re given a ticket quota for each month. Over 80 percent of front-line performance measures involve process or punishment. Agencies even measure their corporate productivity in terms of process and punishment. Investigations, inspections, arrests.”
Gore and Clinton unintentionally revealed in this passage how little they understood about the private sector. There is indeed an “elementary management principle” that “you get what you measure.” Consider the revolutionary importance of understanding that principle for understanding why the private sector has become so criminogenic that it produces the epidemics of control fraud that drive our recurrent, intensifying financial crises that have now escalated to the point that they cause global crises that destroy over $20 trillion in wealth and cost over 20 million jobs. What does the private sector “measure” when it decides executive compensation? The overwhelming answer is short-term reported income. What strategy produces a “sure thing” – record short-term reported (albeit fictional) income (and real, catastrophic losses)? The answer is the accounting control fraud “recipe” for a lender or purchaser of bad assets. For first-time readers, the accounting control fraud recipe for a lender is:
- Grow like crazy by
- Making really crappy loans at premium yield, while
- Employing extreme leverage, and
- Providing only grossly inadequate allowances for loan and lease losses (ALLL)
Go to the next step in the analytical chain that Gore began – what happens when some lenders follow the fraud recipe and report the “sure thing” – record short-term income and their officers receive exceptional bonus pay for easily meeting their “stretch goals?” The answer is that it creates a powerful Gresham’s dynamic. A CFO who fails to adopt the fraud recipe will almost certainly report far lower short-term income. Even if the CFO is honest and has strong integrity and is willing to accept a far lower compensation by failing to meet the stretch goal the CEO may not be willing to do so. Now consider the third step in the analytical chain – as the Gresham’s dynamic leads many firms to follow the fraud recipe the initial result will be to hyper-inflate the bubble. As the bubble hyper-inflates the bad loans can be refinanced to allow the fraud scheme to last far longer (the saying in the trade is: “a rolling loan gathers no loss”). The result of the recipe and the hyper-inflated bubble is catastrophic losses. (Consider the four “ingredients” closely and you will understand how they interact to maximize real losses to the lenders and purchasers of the bad assets. This explains the title of Akerlof and Romer’s famous 1993 article – “Looting: the Economic Underworld of Bankruptcy for Profit.” The lender will often fail, but the officers can walk away wealthy.)
All of the Reinventors missed all of the dynamics I have just explained even though they had available the findings of the OTS, NCFIRRE, Akerlof and Romer, and some of the Nation’s top white-collar criminologists explaining the fraud dynamics and the criminogenic nature of modern executive compensation. Again, it was essential for the Reinventors to ignore or reinvent the history of the S&L debacle for them to ignore the massive “high tech” bubble and epidemic of accounting control fraud (largely concentrated in high tech/information firms) that was developing even as the clueless Reinventors praised the very private sector policies and firms leading us to the Enron-era crisis.
Even after the Reinventors saw the criminogenic private sector practices, particularly faux performance pay, drive the Enron-era frauds they continued to peddle the same disastrous policies. Stone’s book was first published very late in 2002 after the explosion of the Enron-era accounting control frauds, the collapse of the high tech bubble, and the recognition that the information technologies they praised had aided the frauds. My electronic search of his 2004 paperback edition found no reference to Enron. As with the S&L debacle, the Reinventors continue to reinvent or ignore history whenever it proves inconvenient to their dogmas.
Gore and Clinton were also wrong about the public sector compensation. First, precisely because the federal government did not base significant compensation on any measure of enforcement actions, any incentive to bring baseless enforcement actions in order to attain a bonus was trivial. Second, the regulatory sphere responsible for the highly publicized enforcement actions and criminal prosecutions of CEOs was S&Ls and banks. None of our employees or officers had their compensation based on number of enforcement actions taken. None of the financial regulators ever had a “quota” of supervisory or enforcement actions analogous to traffic tickets. Third, it was the Reinventors who pushed the public sector to ape the criminogenic private sector’s (faux) performance pay. The Reinventors’ support for performance pay for the public sector was particularly pernicious because they explicitly sought to use such pay to coerce civil servants to support the Reinventors’ destructive policies.
The Reinventors’ solution to the problem of regulators treating fraudulent CEOs like criminals was crony capitalism – the government and corporations should form “partnerships” that would avoid “punishment.”
“And we found quite a few excellent models of partnership between business owners and regulators, partnerships that are focused on results, not on process and punishment.”
Note the implicit, false dichotomy between “results” and “punishment.” Punishment has everything to do with the results. Punishment of frauds is essential to break the Gresham’s dynamic and allow honest firms to prosper and achieve desirable “results.”
Clinton used his speech to issue directives to all regulators, including the command: “to create grass-roots partnerships with the people who are subject to these regulations and to negotiate rather than dictate wherever possible.” Note the use of “people” again when the reality is “business.” An effective regulator cannot be a “partner” with business. The directive to “negotiate” rules with the industry (but not the public) was unworthy of the administration. It gives the power to delay vital rules to the industry and maximizes their power to block regulations. It was designed to make it far harder to regulate, and it succeeded. It also led to the banks being invited inside the Basel II tent, where they successfully negotiated the Basel II deregulatory provisions that made the U.S. and Europe so criminogenic. (The FDIC deserves credit for its valiant resistance to the Basel II capital requirements.)
Clinton went on to state what he asserted was the inherently benign nature of corporations.
“Most people in business in this country know that there is a reason for these regulations, for these areas of regulations. And most people would be more than happy to work to find a way that would reduce hassle and still achieve the public interest we seek to achieve.”
Again, Clinton deliberately substitutes the word “people” for “firms.” Clinton’s claim is an empirical claim made without any empirical support. It ignores the destructive role of the Gresham’s dynamic. The good CEOs he posits who are willing to be regulated will not survive and the market will be dominated by those with the worst ethics. Clinton’s assertion is also internally inconsistent with another point he makes at several points in his speech.
“There are proposals pending in the Congress today which go beyond reform to rol[l] back, arguably even to wrecking.
These protections are still needed. There’s not too little consumer fraud; toys are not too safe; the environment is still not able to protect itself. Some would use the need for reform as a pretext to gut vital consumer, worker, environmental protections; even things that protect business itself. They don’t want reform; they really want rigor mortis.
Some in Congress are pushing a collection of proposals that, taken together, would bring federal protection of public health and safety to a halt.
Later this week the House will vote on an across-the-board freeze on all federal regulations.
It sounds good. But this stops in its tracks federal action that protects the environment, protects consumers, and protects workers.”
“It sounds good?” Clinton reveals simultaneously how deeply the Reinventors had gone in their reflexive support of regulatory rigor mortis and how determined House Republicans were to destroy the government’s ability to prevent corporate fraud and abuse. But he also reveals an internal contraction in his logic that he does not recognize. Corporate CEOs, the people that Clinton asserted overwhelmingly supported regulation were giving overwhelming support to the House Republican effort to cripple regulation. Clinton inadvertently falsified his empirical assertion that CEOs were overwhelmingly benign.
Indeed, the situation was worse than I have just described. The actual context was the House Republican’s insistence on the Contract with America – which was a compilation of industry lobbyists’ proposals expressly designed to make it nearly impossible to regulate, supervise, sanction, or prosecute corporations and their officers. Clinton described the context:
“But the Contract with America, literally read, could pile so many new requirements on government that nothing would ever get done. It would add to the very things that people have been complaining about for years — too many lawsuits, everything winds up in court. The Contract, literally read, would override every single health and safety law on the books, distort the process by giving industry-paid scientists undue influence over rules that govern their employers in the name of private property, could literally bust the budget by requiring the government to pay polluters every time an environmental law puts limits on profits.
These are extreme proposals. They go too far. They would cost lives and dollars. A small army of special interest lobbyists knows they can never get away with an outright repeal of consumer or environmental protection. But why bother if you can paralyze the government by process?”
The corporate CEOs did not simply support crippling regulation – the industry provided the proposed language designed to achieve that result. Economists trust “revealed preferences” far more than self-serving speeches. The CEOs who controlled our corporations revealed their true preferences – an unholy war on corporate accountability – when they paid the “small army of special interest lobbyists” to destroy the ability of regulators to protect the public even from lethal hazards. The Reinventors were so blind to the faults of the CEOs that they missed both the fact and the importance of their revealed preferences. The Reinventors also missed the CEO’s revealed preferences about a host of other issues. It turns out that the CEOs actually support the ability to bring massive lawsuits – as long as the law is perverted to help them win such suits and protect them from lawsuits. The CEOs are simply revealing that they have no controlling moral principles. They seek only to maximize their self-interest. They are also revealing that they do wish to have the power to make defective drugs with impunity and pollute with impunity even when the effects are lethal to their neighbors and workers. Clinton speech reveals that he understood how extreme the CEOs’ actual anti-regulatory positions actually were. This means that he had the facts necessary to realize that his anti-regulatory mandates would prove disastrous.
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.
Follow him on Twitter: @williamkblack
This piece is cross-posted from New Economic Perspectives and Benzinga with permission.