Testimony Before the Financial Crisis Inquiry Commission, Miami, Florida September 21, 2010

Abstract

Control are seemingly legitimate entities controlled by persons that use them as a fraud weapon. (The person that controls the firm is typically the CEO, so that term is used in this testimony.) A single control fraud can cause greater losses than all other forms of property crime combined. Neo-classical economic theory, methodology, and praxis combine to optimize criminogenic environments that hyper-inflate financial bubbles and produce recurrent, intensifying financial crises. A criminogenic environment is one that creates such perverse incentives that it leads to widespread crime. Financial control frauds’ weapon of choice is accounting. Neoclassical theory, which dominates law & economics, is criminogenic because it assumes that control fraud cannot exist while recommending legal policies that optimize an industry for control fraud. Its hostility to regulation, endorsement of opaque assets that lack readily verifiable market values, and support for executive compensation that creates perverse incentives to engage in accounting control fraud and optimizes fraudulent CEOs’ ability to convert firm assets to the CEO’s personal benefit have created a nearly perfect crime. Studies have shown that control fraud was invariably present at the typical large S&L failure. There is a consensus about the decisive role of control fraud in the Enron era frauds. The FBI began testifying publicly in September 2004 that there was an epidemic of mortgage fraud and predicting that it would cause an economic crisis if it were not contained. Similar widescale control frauds have driven financial crises in other nations. It is astounding, therefore, that neo-classical economists overwhelmingly ignore even the possibility of control fraud in the current crisis.