Neo-Classical Economic Theories, Methodology, and Praxis Optimize Criminogenic Environments and Produce Recurrent, Intensifying Crises

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“Control frauds” are seemingly legitimate entities controlled by persons that use them as a fraud “weapon.” A single control fraud can cause greater losses than all other forms of property crime combined. This article focuses on the role of neo-classical economic theory, methodology, and praxis is optimizing criminogenic environments that hyper-inflate financial bubbles and produce recurrent, intensifying financial crises. 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. Neo-classical economics has also failed to develop a coherent theory of bubbles and financial crises.

Neo-classical economists value econometrics as the only “scientific” research methodology. Reliance on econometrics, however, produces the worst possible policy advice during the expansion phase of a bubble. Fraudulent lenders produce guaranteed, exceptional short-term “profits” through a four-part strategy: extreme growth (Ponzi-like), lending to uncreditworthy borrowers, extreme leverage, and minimal loss reserves. Whatever business practices, e.g., not underwriting borrowers’ creditworthiness, allow a lender to make the largest quantity of bad loans will show a powerful, positive correlation with corporate income (or share price). It is only after the bubble collapses that the true sign of the correlation will emerge. Making bad loans, of course, leads to massive losses (not exceptional profits). The sign of the correlation reverses (becomes negative) if one studies the actual performance of the loans after the bubble bursts.

Accounting control fraud’s exceptional “profits” render “private market discipline” perverse. It produces a Gresham’s dynamic in which CFOs that optimize accounting profit maximize their CEO’s compensation while honest CFOs report dramatically lower (but real) profits and their CEO’s receive far less compensation. The accounting control fraud optimization strategy hyper-inflates and extends the life of financial bubbles, which causes extreme financial crises.

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Creighton Law Review