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“Control fraud” theory explains why the most damaging forms of fraud are situations in which those that control the company or the nation use it as a fraud vehicle.
Individual “control frauds” cause greater losses than all other forms of property crime combined. They are financial super-predators. Control frauds are crimes led by the head of state or CEO that use the nation or company as a fraud vehicle. Waves of “control fraud” can cause economic collapses, damage and discredit key institutions vital to good political governance, and erode trust. The defining element of fraud is deceit – the criminal creates and then betrays trust. Fraud, therefore, is the strongest acid to eat away at trust. Endemic control fraud causes institutions and trust to become friable – to crumble – and produce economic stagnation.
While economists stress incentive structures, economics ignores criminogenic environments. The weakness comes from three sources. Economic theory about fraud is underdeveloped, core neo-classical theories imply that major frauds are trivial, economists are not taught about fraud and fraud mechanisms, and neo-classical economists minimize the incidence and importance of fraud for reasons of self-interest, class and ideology.
Neo-classical economics’ understanding of fraud is so weak that its policy prescriptions, if adopted wholly, produce strongly criminogenic environments that cause waves of control fraud. Neo-classical policies simultaneously make control fraud easier and more lucrative, dramatically reduce the risk of detection and prosecution by maximizing “systems capacity” problems, and encourage crime by making it easier for fraudsters to “neutralize” the social and psychological constraints against deceit and fraud.
Thus the paradox, neo-classical triumphs produce tragedy. The S&L industry was highly regulated for decades. It was the bane of neo-classical economists. But the sharp rise of interest rates (which rendered the industry, which was exposed to systemic interest rate risk, insolvent) and the election of President Reagan provided an opportunity to radically transform the industry. It was, within one year, suddenly deregulated and desupervised. Within two years, roughly two hundred control frauds had entered the industry. Larry White, a banking specialist, famously noted that there were “no Cassandras” among economists – none warned that the policies would produce a disaster (1991). But White is less well known for also stating that the frauds immediately understand the opportunities. This demonstrates the cost of economic ignorance.
Neo-classical economists learned nothing from this disaster. Instead, they denied that fraud was more than trivial and denied that deregulation and desupervision had anything to deal with producing the crisis. They also suffered no reputational risk. George Benston, for example, opined that 33 S&Ls that had taken advantage of deregulation were much more profitable and safer as a result. Every one of the 33 failed – the great bulk were control frauds (Black 2005). He was given an endowed chair at Emory after
going 0 for 33. I noted Daniel Fischel’s record of error – he was made Dean of the University of Chicago’s law school. Another economist predicted that Lincoln Savings (the worst S&L control fraud, costing the taxpayers over $3 billion) “posed no foreseeable risk” to the taxpayers. His name was Alan Greenspan, he was made Chairman of the Fed.