By William K. Black. This article was first published on New Economic Perspectives.

Michael Strong is an American businessman who is a devotee of  the Austrian school of economics.  Austrians view democratic governance as so inherently illegitimate that they claim that virtually any governmental program irretrievably consigns us to the “Road to Serfdom.”   Strong has decided to save Hondurans from their government.  He wants his corporation to buy a Honduran city named Puerto Castilla and turn it into his first global “model city.”  The Honduran government, which holds power through a coup that the Bush administration and the IMF applauded, approved the sale.  The Honduran government is strongly identified with Honduras’ wealthy elite.  The constitutional chamber of Honduras’ Supreme Court (which provided a fig leaf of respectability for the coup) rule 4-to-1 that it was unconstitutional to create privately run cities.  (The decision is expected to be appealed to the full Supreme Court.)

The U.S. has a deplorable history of private adventurers carving out personal fiefdoms in Latin America.  The fact that Honduran business elites want to renew that tragic history demonstrates how divorced they are from the lives and views of most Hondurans.

Strong’s bio emphasizes that his great ally is John Mackey, the CEO and co-founder of Whole Foods and that their joint goal is to “liberate” entrepreneurs.  Mackey likes to write about the “moral case for capitalism,” but all one needs to know about his idea of business morality is that he employed a “sock puppet” (a fictional internet identity) to secretly disparage his competitors and praise his own physical appearance.  Mackey is a pathetically vain hypocrite who attacks other firms anonymously and then has the chutzpah to lecture others on how capitalism creates moral leadership.

Strong claims to be a leftist converted to libertarianism who is motivated by the same, high ethical goals that motivated him when he was a leftist.  He urges liberals to convert to libertarianism in a document that can be accessed from this site:

The left is often animated by the various harms and crimes committed by large corporations.  Leftists experience a tremendous sense of outrage at the fact that under capitalism not only do bad people get away with doing bad things, they often become rich and powerful by means of doing so.  Worse yet, under capitalism often highly decent, hard-working human beings are harmed by these evil people, and are impoverished, or may be actively harmed by the actions of evil, rich capitalists.

He then goes off the rails of anything approaching logic.

The implicit assumption on which Leftist beliefs are founded is that the initiatives designed by the Left to counteract the harms done by capitalism do more good than harm.

The left makes the opposite assumption.

Strong then describes his faith in public choice theory (ignoring the “private choice” reality he has just described in which the private sector has perverse incentives).  Strong’s conclusion is that we need to give up on government and democracy as inherently perverted by private interests and instead cede power to those perverted private interests.  Strong writes that the inherent weakness of democracy “does not mean that we should give up altogether on democracy,” but his next word is “but” and the reality is that he does give up on democracy and government and relies on the private sector as the alternative, not complement, to democracy.  Strong and Mackey have formed an organization, FLOW, with a blog devoted to developing competitors to modern governments developed by corporations.  Sympathetic libertarian supporters of Strong agree with my view that Strong has rejected democracy in favor of “markets.”

Here’s how the blog defines its purpose: “Like any technology, democracy was once a radical innovation, thought unlikely to work. Now, it is the industry standard. Our aim is to find, analyze, and debate the innovations in governance today that may become the standards of tomorrow, especially those that utilize the best technology for social organization ever developed–the market.”

For a sample of what you’ll find there, see FLOW chief Michael Strong on a “Cambrian explosion in government”:

The anti-democratic right has moved from the failed experiment in “reinventing government” by adopting corporate practices to replacing government entirely with corporate satraps run by “the market.”

Strong’s blog urging others to become libertarians is revealing.  He illustrates what inevitably happens when one rejects democracy and embraces plutocracy and markets “freed” from regulation.  Strong implicitly admits that his vision of “economic freedom” requires that business elites have de facto immunity from being prosecuted for the crimes that made them wealthy even if they cause catastrophic financial crises and maim and kill millions.  For a man who hates communists, Strong has bought in fully to the idea that in order to make an omelet one must break many eggs.  He wants to start by breaking tens of thousands of Hondurans.

But creativity, innovation, and entrepreneurship are crucially dependent on freedom.  One of the reasons I became a libertarian is the realization that I care more about making peoples’ lives better than I cared about “social justice” or tracking down bad people who made money being bad.  While I remain interested in reputation systems to ensure that bad people less frequently get away with getting rich by being bad, I have decided that it is far more important to focus on making lives better than to focus on prosecuting the bad.  I believe with increased freedom we can create peace, prosperity, happiness, and well-being for all, rapidly, in an environmentally sustainable world, and this goal is far more valuable than is the goal of fighting bad guys who happen to get rich through pandering and deceit.

This passage is so puerile on so many levels that it should be required reading in every class in white-collar criminology. What a wonderful city father jefe Strong will be for his Honduran subjects.

Let us consider first who will rise to power in business, and as our rulers, under Strong’s anti-democratic vision of a world in which the corporate CEOs will run our economy, our pseudo-governments, and (if sufficiently megalomaniacal) our private lives.  In an earlier passage in the same document, Strong emphasizes Haykek’s prediction that the worst people inevitably rise to leadership in a communist system because there is no rule of law.  The largely peaceful dissolution of communism and the USSR should cause some caution in accepting Strong’s claim of inevitability.  What Strong ignores is what classical economists understood hundreds of years ago. Without a rule of law the worst people will tend to prevail through force and fraud.  Strong also ignores the Gresham’s dynamic.  As Jonathan Swift explained in Gulliver’s Travels and as George Akerlof showed in his classic 1970 article on markets for “lemons,” when cheaters gain a competitive advantage market forces become perverse and “bad ethics drives good ethics” from the market place.

The need to block a Gresham’s dynamic is one of the lessons we stress as white-collar criminologists.  Entire industries can become dominated by “control fraud” when a Gresham’s dynamic arises.  Consider Strong’s examples of the elite business crimes he doesn’t worry all that much about.  It turns out that he gives no examples.  He doesn’t do so for an excellent reason.  As soon as one begins to discuss actual business crimes it becomes impossible to believe that anyone who is indifferent to such crimes is fit for decent society.  Note that Strong’s emphasis is his indifference to elites becoming wealthy through “deceit.”  His excuse for this indifference, which he repeats (with minor variants) in three successive sentences is that “I care more about making peoples’ lives better.”  The logical disconnect, obvious to anyone who has read white-collar criminology or George Akerlof and Paul Romer’s article (Looting: the Economic Underworld of Bankruptcy for Profit), is that business crimes make peoples’ lives worse.  Strong claims Paul Romer as one of the principal influences on his work, so he has no excuse for ignoring the terrible consequences of business “deceit” for peoples’ lives.  Strong also ignores what he had written only a few sentences earlier:

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Worse yet, under capitalism often highly decent, hard-working human beings are harmed by these evil people, and are impoverished, or may be actively harmed by the actions of evil, rich capitalists.

I will only summarize why business crimes make peoples’ lives worse.  Each of these forms of control fraud can kick off a Gresham’s dynamic absent vigorous government enforcement:  accounting control fraud (which drove the S&L debacle, the Enron-era frauds, and the ongoing crisis), anti-employee control frauds which can endanger workers’ health and lives, anti-purchaser control frauds (Akerlof emphasized lemons with poor quality, but did not emphasize that they can maim and kill the customer), and anti-public control frauds that target the general public (e.g., bribery, tax fraud and illegal dumping of toxic waste).  Frauds can also cause extreme negative externalities.  The defining element at law of fraud is deceit.  I get you to trust me then betray that trust in order to become wealthier by stealing from you.  Elite fraud, therefore, is the most effective acid for eroding trust.  Trust is vital to the success of most institutions.  The ongoing crisis became acute when bankers no longer trusted other bankers’ asset valuations and thousands of markets shut down.

Strong’s inability to see that business crimes harm people is inexplicable given his earlier admission that they do so, but it is one of several logical failures in the same paragraph.  He also fails to see why it is destructive for CEOs to become wealthy through crime.  Remember that Strong’s fundamental critique arises from public choice theory.  He argues that wealthy special interests will use their power to distort public decisions so that they benefit the wealthy and powerful rather than the overall public.  If CEOs can become wealthier through running control frauds than their more talented, honest peers, then the worst CEOs will dominate pubic policies and use those policies to harm their honest competitors and the general public. They will also be the CEOs most likely and most able to hire the most vicious mercenaries in order to conquer, loot, and intimidate opponents.

Control fraud produces particularly pernicious implications of “private choice” theory.  It can be extremely difficult for an honest CEO to guide the firm to high profitability, but as Akerlof and Romer emphasized fraud is often a “sure thing.”  The result is that many CEOs can easily mimic the fraud scheme that their rival has adopted to report exceptional profits.  Fraudulent CEOs will typically ensure that their compensation is very large and based largely on short-term reported income.   The reported exceptional profits produced by control frauds other than accounting control fraud are real – a firm gains a real competitive advantage by not paying corporate income taxes, bribing a governmental or corporate officer to obtain valuable contracts, or dumping toxic waste in the river.  The ability of other CEOs to mimic easily the tax fraud, bribery, or illegal dumping means that the Gresham’s dynamic is likely to be particularly powerful and swift when these forms of control fraud are not stopped by government regulators and prosecutors.

Accounting control fraud does not create a real competitive advantage, but modern executive compensation created a Gresham’s dynamic for this form of fraud because the CFO who fails to mimic a rival’s accounting fraud has only a trivial chance of reporting extraordinary (albeit fictional) profits.  If the CFO fails to mimic his rival’s accounting fraud he and his CEO will not “earn” enormous bonuses and the CFO will be at increased risk of being fired.  Even an inept CFO can easily mimic the accounting control fraud “recipe,” which produces a “sure thing” – record reported (albeit fictional) profits and a guarantee of nearly instant wealth for the CFO, the CEO, and other senior officers.

The accounting control fraud recipe begins to explain why fraud can cause hundreds of millions of peoples’ lives to be worse.  The recipe that makes accounting fraud a “sure thing” and maximizes a lender’s (or a purchaser’s) reported income has four ingredients.

  1. Grew like crazy (preferably around 50% annually) by
  2. Making (or purchasing) really crappy loans at a premium yield, while
  3. Employing extreme leverage, and
  4. Providing only miniscule allowances for loan and lease losses (ALLL) for the inevitable extreme losses that the fraud recipe must produce

Note that this recipe maximizes real losses.  Indeed, Akerlof and Romer emphasized that it produced loans that – at the time they were made – had a negative expected value.

The recipe also calls for extreme growth even when there is a glut of whatever product the loans are funding.  If a significant number of firms mimic the same fraud scheme employing the fraud recipe they can hyper-inflate a financial bubble and cause severe financial crises, severe recessions and depressions causing terrible unemployment, the collapse of many markets, and steep drops in stock prices and in the price of whatever product was funded by the fraudulent lenders when the bubble inevitably bursts.  Accounting control fraud epidemics like the epidemic of fraudulent “liar’s loans” by lenders that drove the ongoing crisis make hundreds of millions of peoples’ lives horrifically worse.  Strong assumes that increased “economic freedom” helps everyone:  “I believe with increased freedom we can create peace, prosperity, happiness, and well-being for all, rapidly, in an environmentally sustainable world….”  Private mercenary wars fought on behalf of rival privatized city-states would cause wars.  The three “de’s” – deregulation, desupervision, and de facto decriminalization – produce criminogenic environments that Akerlof & Romer warned about in their 1993 article on looting.

“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).

Again, Strong says Romer is his guru on the concept of “model cities.”  He needs to absorb the warning that Akerlof and Romer issued about removing the vital regulatory “cops on the beat.”  Strong does not “know better” because he has refused to “learn from experience.”

It is revealing that Strong believes he has to choose between preventing control fraud and “economic freedom.”  His logic requires a belief that we would cripple “economic freedom” if we prevented or even punished those who became wealthy through control fraud.  Economic freedom, as Strong implicitly defines it, is a very strange concept if it means the “freedom” to become wealthy by looting the public and causing recurrent, intensifying financial crises.  Somehow, I doubt that he explained this unique concept of “economic freedom” to the citizens of Honduras.

In the same document, Strong denies that global climate change is a serious, present risk and endorses the claims that environmentalists are “terrorists” and represent the greatest threat to the environment and humanity.  (No, he has no relevant expertise.  See my column yesterday on why ideology explains conservatives’ rejection of science and embrace of the pseudo-science known as theoclassical economics.  Strong is a devotee of theoclassical economics.)  When denial fails, Coase is Strong’s preferred answer to all environmental issues (i.e., corporations or plutocrats should own all the wild animals, the atmosphere, national monuments, the mountains, glaciers, forests, waterfalls, lakes, rivers, aquifers, the ocean, canyons, bridges, dams, roads, airports, railways, water and sewer systems, and the rest of the universe).  Honduras is a great place to experiment with the gentle mercy of plutocrats who will own not only the city but everything else.  For the sake of brevity, I simply urge the reader to read the assumptions Coase said were necessary for privatization to “work.”  The assumptions are never met in the real world and will not be met in Honduras.  Strong, however, believes that private ownership automatically optimizes the environment.  Because he believes that environmentalists are “terrorists,” Honduran “greens” should begin to create “safe houses” on an urgent basis.  They may soon need to escape Strong’s mercenaries in the Honduran Supreme Court reverses the panel decision.

Strong is not even the most extreme advocate of privatized governments not subject to antiquated democratic restraints.

Patri Friedman [Milton’s grandson] thinks mankind needs to take to the seas and start new countries.

“Let a thousand nations bloom on the high seas,” he says.

“We’re still using the legal systems of 1787,” he told a crowd of more than 300. “Why don’t we see more innovation in politics,” he asked.

Think of governments as businesses, he argues. “This is the world’s biggest industry,” he says. The most successful franchise … loses more than a trillion dollars a year. “The worst companies kill many of their own customers,” he adds.

What a business opportunity. “What we need are new countries,” he says. “Seasteading is the entrepreneurial way to fix government, by competing with governments rather than complaining.”

The first step would involve boats providing services such as medical tourism. Then seasteaders could move on to platforms. Finally, in several decades, floating cities.

The stability of the U.S. Constitution, instead of reflecting well on the Framers, becomes an indictment.  Something so old, which has produced the most successful nation in history, must be obsolete.  [The federal budget deficit is not remotely akin to a business losing a trillion dollars.  The federal government is not akin to a business.]  Why do we “need new countries?”  What kind of constitution do Friedman and Strong want?  They do not want to tell us because they would produce grossly inferior anti-democratic constitutions that would fail within a generation.  The crushing economic and environmental problems of creating viable “floating cities” are so severe – and gratuitous – that the idea can only make sense to someone who despises existing democratic governments.  The unforgivable sin of America and so much of post-World War II Europe to the anti-democratic fringe like Strong and Petra Friedman is that they work so well without being on the road to serfdom.

Strong’s Honduran effort showed moral defects from the beginning.  Strong says that he got the idea to buy a Honduran city after listening to a TED talk by Paul Romer.  Romer has long advocated creating model governments that would follow best practices in fighting corruption and providing responsive government.  Romer clearly had strong concerns that the corporate owners who might be most eager to acquire a Honduran city would be the worst possible leaders of a city and could discredit Romer’s entire project.  Romer worked with the Honduran government to try to create standards for the project and the acquirer.  Romer wanted a principle of total transparency.  Honduras’ government initially indicated approval of such standards and the appointment of a commission led by Romer to monitor proposed acquirers and their compliance with the standards.  The Honduran government is very weak, of dubious legitimacy, corrupt, and seeks to serve the interests of the thin crust of wealthy Hondurans.  These characteristics made Honduras an attractive place to experiment with model cities and greatly increased the chances that Honduras would approve the purchase of a Honduran city by a U.S. corporation – an action that would normally cause a Latin American government to fall.  These same characteristics made it unlikely that the Honduran government would actually adopt and enforce good government standards.  It was equally unlikely that Honduras would appoint (and listen to) an independent commission that would monitor compliance and provide transparency.  When Honduras reneged on both protective aspects, Romer publicly withdrew from the entire process and plan, an event that prompted a New York Times story on September 30, 2012 entitled “Plan for Charter City to Fight Honduras Poverty Loses Its Initiator.”

But now, Mr. Romer, an expert on economic growth, is out of his own project, tripped up by the sort of opaque decision making that his plan was supposed to change.

An internal contradiction in the theory is playing out: To set up a new city with clear new rules, you must first deal with governments that are trapped in the old ones.

The tipping point came with the announcement a few weeks ago that the Honduran agency set up to oversee the project had signed a memorandum of understanding with its first investor group.

The news came as surprise to Mr. Romer. He believed that a temporary transparency commission he had formed with a group of well-known experts should have been consulted. He withdrew from the project.

The law setting up Honduras’s experiment in a charter city, a special development region, or RED in its Spanish initials, creates flexibility that promotes innovations, but requires strict disclosure along the way, Mr. Romer said. “The one absolute principle is a commitment to transparency,” he said.

The investor group is led by Michael Strong, an activist who has worked in the past with libertarians like John Mackey, the founder of Whole Foods. He promises that his investors include Silicon Valley entrepreneurs and Central American investors, but when pressed for details, named only one Guatemalan businessman.

With $15 million on hand, he said, the group will begin with a small pilot project to build infrastructure and is already talking to prospective tenants.

Mr. Strong also said he had plans in the future to build low-cost housing and set up schools, but he admitted that “A lot of things we don’t know until the RED government goes up.”

With so few details made public, even the normally pro-government newspapers in Honduras have begun to question whether there is any real money behind the project.

Opponents on the left have been filing challenges with the Honduran Supreme Court against the charter cities plan. The news of the investment deal brought more.

According to Mr. Strong and others involved in the project, including Mark Klugmann, an American consultant who is working with Mr. Sánchez, the transparency board never legally existed. Mr. Sánchez agreed, although he had never disputed the existence of the board in the past.

Mr. Romer said that President Lobo signed the decree in his presence in December. But he acknowledged that the board was on tenuous legal footing because of the challenges in the Supreme Court. The decree was never published.

The defects of the Honduran government would have been reduced if the acquirer who stepped forward were a supporter of Romer’s vision and voluntarily complied with these standards and sought an independent review of their proposal by Romer and other experts who would rigorously critique their plans.  Strong claims that Romer prompted Strong’s plan to acquire a Honduran city, but Strong deliberately ran right over Romer.  Strong’s claim that the failure of the Honduran government to honor its commitments designed to ensure transparency and prevent abusive takeovers justifies his failure to provide transparency and pass a rigorous, independent review exemplifies Strong’s moral failures.  He illustrates why “economic freedom” without democratic protections leads to a race to the bottom in which the worst CEOs will end up owning our cities.  Romer is brilliant, but he has been betrayed by both the Honduran government and Strong.  Indeed, Strong’s supporters are blogging attacks on Romer.