William K. Black, August 8, 2016     Bloomington, MN

(3d column in my series on Friedman advising Hillary to Move Hard Right)

In this column I focus on Thomas Friedman’s plea that Hillary Clinton embrace deregulation, desupervision, and de facto decriminalization (the three “de’s”) and the Trans-Pacific Partnership (TPP) as a “knock-out” political strategy against Donald Trump and as a means to produce dramatic economic growth and financial stability.  He claims that embracing the three “de’s” and the TPP creates an “open system.”

Friedman presented this advice in two columns he addressed to Hillary to mansplain the economy to her.  His first column was the unintentionally hilarious “Web People vs. Wall People.”  It consists of a surfeit of slogans masquerading for analysis.

Web People understand that in times of rapid change, open systems are always more flexible, resilient and propulsive; they offer the chance to feel and respond first to change.

As I explained in my last column, “open systems” is systems theory jargon for a system that adapts to change by self-organizing.  I explained why social systems, including economics, are not “open systems.”  I showed that “flexible, resilient, and propulsive” were amoral and euphemistic descriptors for what, in the social sphere, would include genocide, mass rape, slavery, and torture.

In this column I apply the “open systems” jargon to Friedman’s endorsement of the three de’s in finance.  In my next column I deal with his support for further eviscerating health and safety regulation through the TPP.  Friedman’s heroes as heads of state were Bill Clinton (he urges Hillary to emulate his economic policies) and Tony Blair.  Blair consciously modeled driving “New Labour’s” economic policies far to the right on the identical strategy that Bill Clinton and his fellow “New Democrats” used to drive the Democratic Party to adopt what had traditionally been (harmful) Republican policies.  The “New Democrats’” structure was the Democratic Leadership Council (DLC), which was funded by Wall Street elites and worked assiduously and slavishly to advance the interests of those elites.

Under Blair, Clinton, Gordon Brown, and George W. Bush the City of London and Wall Street induced their political cronies to engage in a regulatory race to the bottom.  The City “won” that race to the bottom, barely nosing out Wall Street, which is why it became the financial cesspool of the world.

This kind of interactive anti-regulatory competition is not truly an open system for the reasons I have explained, but it is what Friedman incorrectly believes to be an open system.  The regulatory race to the bottom does produce rapid change and rapid “respon[se]” to change.  The UK and the U.S. were the “first” (and second) to change – repeatedly – as they engaged in numerous acts of the three “de’s” that prompted a cascade of competitive responses that eviscerated effective financial regulation and supervision and virtually eliminated prosecutions of financial elites in both nations.  The regulatory race to the bottom evinced “flexibility” in both nations and was “propulsive” – as the competitive dynamic propelled assaults on regulation and supervision that in turn propelled ever more aggressive adoption of the three “de’s.”

Friedman’s paramount idea – financial deregulation – turns out to be a superb means of testing Friedman’s “open systems” slogan.  By examining the financial regulatory race to the bottom for which Friedman was a cheerleader, we can observe that “flexible” and “propulsive” can aptly describe a catastrophic policy failure that literally caused the collapse of much of the financial system until it was bailed out by Friedman’s Great Satan – “socialism.”

That history demonstrates that the three “de’s” did not make finance more “resilient.”  They did the opposite.  They made the financial system perverse, destructive, corrupt, rigged, endemically fraudulent, and fragile.  Friedman observed these facts, particularly in two places, the City and Wall Street, that Friedman worships and often lunches with financial CEOs.

Friedman appears to be unaware that there were economic claims that the financial regulatory race to the bottom was inherently stabilizing for the economy.  Ben Bernanke made famous the claim that deregulation was part of the reason for the “Great Moderation.”  Alan Greenspan explicitly endorsed the regulatory “competition in laxity,” claiming that unregulated financial derivatives inherently made the financial system far more resilient and stable because they would diffuse risk and ensure that the firms taking financial risks were the ideal firms for holding such risks.  Greenspan asserted that regulation was unnecessary and harmful because unregulated financial markets would automatically exclude fraud.  Each of these claims proved not simply incorrect; the opposite was proven true in the real world.  Friedman, of course, ignores Minsky.

Friedman’s unsupported assertion that open systems always “respond first to change” is also dubious.  I’ll repeat the caution that there is no “open” economic system and cannot be.  But let us test Friedman’s claim using what appears to be his (incorrect) view that the three “de’s” produce an economic system that is an “open system.”  Was the supposed economic “open system” actually the “first” to “respond” to “change?”

That turns out to be a trick question.  I’ll explain with the aid of three examples from finance.  In late 1983, one year after the onset of the second phase of the savings and loan debacle, made possible by the aggressive and dogmatic adoption of the three “de’s” and a regulatory race to the bottom between the federal and state governments, 300 fraudulent CEOs controlling savings and loans were growing at an annual rate of at least 50 percent.  Plainly, these CEOs responded rapidly to the change (the adoption of the three “de’s) that made the S&L industry the most criminogenic industry in the Nation by entering the S&L industry and locating overwhelmingly in the states that “won” the regulatory race to the bottom.

Those fraudulent S&L owners did not simply “respond” to “change,” they used the economic and political power of the firms they controlled to cause radical “change” in a host of settings.  They crafted their hiring, promotion, and compensation systems to create powerful, perverse incentives among their officers, employees, auditors, attorneys, and appraisers.  They deliberately generated a series of “Gresham’s” dynamics in which bad ethics drives good ethics from the markets and professions as a means of suborning these “controls” into (not remotely) “independent professionals” that would aid and abet the CEO’s looting of “his” S&L by massively inflating the reported value of the assets and hiding real losses.  They grew extremely rapidly and employed massive leverage.  Many employees, officers, and appraisers responded rapidly to these changes crafted to the CEOs and became the CEOs’ most valuable fraud allies.

What Friedman was presumably trying to claim, however, was the opposite – that the valiant “Web People” of the private sector banded together to end the S&L debacle.  How many of the 300 S&L “accounting control frauds” were shut down by “private market discipline?”  Zero.  They never responded to the change of the entry of the frauds by stopping the frauds.  They often responded by praising and aiding the fraudulent CEOs.

The S&L regulators began to reregulate the industry one year after the key federal deregulatory legislation and only a few months after the regulatory agency had a new leader – Edwin Gray.  Gray continued to respond for years to the changes (the three “de’s”) that created the criminogenic environment that created the epidemic of accounting control fraud that drove the second phase of the S&L debacle.  What was the response of what Friedman incorrectly claims to be the “open [S&L] system” created by the three “de’s?”  That system ridiculed, attacked, and sought to destroy Gray and his removal of the three “de’s.”  Had those opponents succeeded in destroying Gray’s removal of the three “de’s” the cost of the debacle would have grown by trillions of dollars.

The second example began in 1989 in Orange County, California – where all top U.S. financial frauds begin.  The overall S&L debacle was raging.  California and Texas tied in the regulatory race to the bottom, so California was an epicenter of the debacle.  Our examiners in the Office of Thrift Supervision (West Region) were overwhelmed dealing with the paramount epidemic of accounting control fraud – commercial real estate.  A new type of home loan began to become material in 1989.  At that time, it was call a “low documentation” loan.  These were loans made without verifying the borrower’s income.

Our examiners had been trained to understand the fraud “recipe” for a lender.  Our examiners understood that it was essential for a lender following the recipe to gut its underwriting system.  Gutting your underwriting is the great “tell” that allows examiners who understand fraud schemes to identify these frauds while they are still reporting record profits and minimal losses.  Failing to verify the borrower’s income is an obvious invitation to inflate the borrower’s income, which optimizes the fraud recipe and which no honest lender would do.  Our examiners recognized this immediately and called the likely fraud to the attention of the OTS-West’s leadership.

Despite being engulfed by the epidemic of commercial real estate frauds, we concluded that it was critical to prevent a second fraud epidemic from arising.  We decided to drive these fraudulent loans out of the industry before that second epidemic could develop.  The biggest and worst of the low doc lenders, Long Beach Savings, eventually gave up its federal deposit insurance and its charter as a savings and loan for the sole purpose of escaping our regulatory jurisdiction.

Long Beach converted to a virtually unregulated mortgage bank.  It’s controlling owner changed its name to Ameriquest.  It continued its frauds and increasingly specialized in defrauding blacks and Latino borrowers.  There was no “private market discipline” restraining Ameriquest’s endemic frauds and discrimination.  The largest investment banks eagerly provided the loans to help Ameriquest dramatically increase the size of its frauds.  Ameriquest was largest specialist making low doc loans for decade.  Everyone involved on the lender’s side of the table knew that the loans were endemically fraudulent and that the massive inflation of the borrowers’ income helped the lenders sell the fraudulently originated loans at a premium price to the secondary market.

By early 2006, the Mortgage Bankers Association’s own fraud experts, MARI, warned the entire lending industry in writing:

  1. The incidence of inflated income in such loans is 90%
  2. The loans are an open invitation to fraud
  3. The loans deserve the term the industry now uses to describe them: “liar’s” loans
  4. The industry seems to have forgotten that these loans caused hundreds of millions of dollars in losses in the early 1990s [as we were driving them out of the S&L industry]
  5. Even the Bush administration anti-regulators are warning against making the loans

From 2003-2006, liar’s loans increased by over 500 percent.  By 2006, liar’s loans represented 40% of all the loans made that year, and half the loans called “subprime” were also liar’s loans.  Liar’s loans were the loans that hyper-inflated the real estate bubbles.  Far from being a pariah, Washington Mutual (WaMu) and Citigroup eagerly acquired Ameriquest’s endemically fraudulent operations and personnel.  The finance industry behaved in the opposite manner of providing “private market discipline.”

Greenspan and his successor Bernanke refused to use the Fed’s unique statutory authority (HOEPA) to ban all liar’s loans because of their anti-regulatory ideologies and because the industry fought bitterly to prevent any effective regulation of liar’s loans.  Liar’s loans were the single most destructive financial fraud scheme in world history.

Under Friedman’s (false) claim that the three “de’s” make the economic system an “open system,” none of this should have happened.  Books and movies celebrate the supposed genius of John Paulson for realizing in 2006 that he should short liar’s loans, but our examiners figured that out in 1989.  The first differences are that our examiners figured it out when such loans were brand new and had minimal losses and that when our examiners learned of the problem they immediately raised the alarm so that we could act to prevent a financial catastrophe.  Paulson had all the benefit of our examiners figuring it out 17 years before he did, MARI’s warnings, and the enormous increase in defaults on liar’s loans.  By 2006, liar’s loans had vastly increased default risk compared to 1989, because of a host of other loan characteristics.

The second difference between our examiners and Paulson is that instead of preventing a crisis by promptly issuing a warning, Paulson did everything he could to keep the news from getting out so that he could become personally wealthy by “shorting” liar’s loans.  Our examiners were evil “socialist” “Wall People” under Friedman’s rubric because not a single one of them was sufficiently “capitalist” to resign and get rich shorting lenders making liar’s loans.  Friedman must think that perverse incentives, a global financial collapse, and a Great Recession are the hallmarks of an “open system.”

The regulators responded first and effectively to liar’s loans as a new fraud “ammunition.”  We responded many years before the industry began calling these fraudulent loans “liar’s” loans.

The third example is appraisal fraud.  It was common during the S&L debacle, particularly because it is far more difficult to accurately appraise “spec” commercial real estate, particularly acquisition, development, and construction (ADC) loans.  ADC loans, unsurprisingly, were the S&L fraudsters “ammunition of choice.”  As S&L regulators, we worked closely with the appraisers’ associations in an effort to block the Gresham’s dynamic that the CEOs looting “their” S&Ls deliberately created to extort appraisers to inflate appraised values.  No honest lender, of course, would inflate appraised values because the collateral should be the great protection against loss.

Flash forward a decade to 1998, late in the Clinton administration.   In that year the rival professional associations of appraisers begin meeting to find a common strategy to repel the return of the fraudulent lenders extorting appraisers to inflate market values of homes pledged as collateral on real estate loans.  By 2000, they had reached agreement on the common strategy and implemented it.  They create an on-line petition, written in plain English, that eventually had 11,000 signatories of professional appraisers.  The petition, sent to the relevant regulatory agencies, pulled no punches.  It informed the regulators that lenders were extorting appraisers to inflate values by blackballing appraisers who refused to help them commit fraud.  I have been unable to find any meaningful action taken by any regulator or any lender in response to this warning.

In this third example, it was not regulators, but honest appraisers who responded first.  They responded brilliantly in a way that should have been totally persuasive.  They should, along with the OTS-West examiners of 1998, be the heroes who prevented the two most destructive epidemics of financial fraud in history, prevented the hyper-inflation of the bubble, and prevented the Great Recession.  The “capitalist” entities that Friedman valorizes did the opposite.  They responded to the fraudulent “changes” by feeding the frauds and profiting from them and then collapsed under the weight of the fraud epidemics until they were bailed out by “socialism.”

These three examples make clear that the obviously more important question than who responds most quickly to change is how the financial system “respond[s]” to the “change.”  Friedman is so clueless that he simply assumes that the “respon[se]” of an unregulated financial system to “change” will be desirable rather than disastrous.  This is one of the “tells” that demonstrates that Friedman has no understanding of systems theory, economics, finance, regulation, fraud, or logic.  The three examples I provided show that the response of the putatively “open” financial system was perverse – it massively increased the problem.  The response of the government regulators and the non-profit professional appraisers’ associations (both closed systems) was often prompt and highly desirable.  The regulatory response saved trillions of dollars during the S&L debacle and, had it been mirrored in response to the current crisis it would have saved even more trillions of dollars.

Similarly, Friedman provides no content on what “change” he is referring to.  The way he uses the word suggests he thing “change” is generic.  George Akerlof’s point in coining the term “Gresham’s” dynamic in his classic 1970 article on markets for “lemons” was that when the change is fraud by sellers, the “market” can become perverse and drive honest firms and high quality goods and services out of the markets.  Even if you have never studied systems theory, any rigorous thought about the concept would lead you to the realization that the nature of the “change” can be enormously important to how a “system” will respond.

“Open systems” is simply part of a stream of slogans for Friedman.  It is not a mode of analysis; it is a means of pronouncing that “open systems” are “always” superior, defining (incorrectly) his ideas as producing an “open system,” and declaring that his ideas are irrefutably correct because “open systems” are “always” superior.  He has no understanding of how the financial system is rigged by elite CEOs and their political allies.