Free Markets, Families and Regulating Fraud

I’ve been reading several calls for prosecution of fraud on Wall Street lately. No, these aren’t coming from the Occupy Wall Street crowd. Instead, top economic and business commentators and scholars are noting the dearth of prosecution and the role this is playing in our economic challenges. This is a fascinating debate and I only have time to capture enough to spark your interest in hopes that you will check out some of the sources I post. For starters,

I’ve been interested for some time in the notion that many seem to ascribe to that if we want a free market then we don’t want regulation. This post by Barry Ritholz (who has been noted as one of the top 15 economic journalists) captures some great thoughts by leading free market economists on the role of regulation and prosecution of fraud. Here are a few quotes:

There is a widespread myth that free market supporters are against regulation or prosecuting fraud. In fact, Adam Smith – the father of free market capitalism – was for regulation of banks, and believed that trust is vital for a healthy economy. Because strong enforcement of laws against fraud is a basic prerequisite for trust, Smith would be disgusted by the lack of prosecution of Wall Street fraudsters today. Smith railed against monopolies and their corrupting influence. And Smith was pro-regulation, so long as the regulation benefited the little guy, as opposed to the wealthiest:

In addition to Adam Smith, Ritholz also notes that more contemporary free market economists are also for regulation and prosecution of fraud as a means to keep the free market working properly. Incuding Richard Posner, Alan Greenspan, Ludwig von Mises and even Friederich Hayek.

Here is a quote Ritholz attributes to Hayek:

There remains, however, one other kind of harmful action that is generally thought desirable to prevent and which at first might seem distinct. This is fraud and deception. Yet, though it would be straining the meaning of words to call them ‘coercion,’ on examination it appears that the reasons why we want to prevent them are the same as those applying to coercion. Deception, like coercion, is a form of manipulating the data on which a person counts, in order to make him do what deceiver wants him to do. Where it is successful, the deceived becomes in the same manner the unwilling tool, serving another man’s ends without advancing his own. Though we have no single word to cover both, all we have said of coercion applies equally to fraud and deception. … Liberty not only means that the individual has both the opportunity and the burden of choice; it also means that he must bear the consequences of his actions…. Liberty and responsibility are inseparable.

Another quote from Ritholz attributed to Mises:

Government ought to protect the individuals within the country against the violent and fraudulent attacks of gangsters, and it should defend the country against foreign enemies.

Interestingly, Ritholz notes that it is fraud combined with poor monetary policy that leads to bubbles in the economy such as we’ve experienced with the dot.com and real estate bubbles in the past decade or so. Ritholz then notes that the current administration has a terrible record for prosecuting fraud. He says:

Obama has prosecuted fewer financial crimes than any president in decades – less than Ronald Reagan, less than George H.W. Bush, less than Bill Clinton, and less than George W. Bush. The economy is worse than it has been since the Great Depression, if not before. See the connection?

Now to be fair, this connection is not necessarily a clear one. However, Ritholz is not alone in saying that the economy is being held back because fraud is not being prosecuted. He continues on his blog to discuss the differences between good and bad regulation and asserts that good regulation is critical to the operation of the free market. I tend to agree but only to a point.

Instead of a focus on regulation, I would say that trust must exist for the operation of a free market and trust can be obtained either by a good regulator/enforcer who prevents and punishes fraud or it can be obtained by self regulation. The best way to have trust is to have self-regulation by an ethical populace. Self-regulation has been described as “obedience to the unenforceable.” For example, Harvard's famous Professor Clayton M. Christensen refers to self-regulation and notes an essay written by the “Lord John Fletcher Moulton, the great English jurist, who wrote that the probability that democracy and free markets will flourish in a nation is proportional to ‘The extent of obedience to the unenforceable.’”

In other words, when the populace regulates their behavior based on ethical and religious beliefs, trust can exist without much government regulation. Imagine an economy where everyone lives the golden rule and words and handshakes are always honored. A lot of occupations, including auditors, lawyers, fraud examiners, virus software developers, policeman, military, security guards, etc., etc. would be in much lower demand or eliminated altogether. Instead, economic efforts would be focused on productive pursuits and we would have a high standard of living with much less effort since we wouldn’t need to support all these regulatory mechanisms. However, as the family and society fails to produce a populace who are obedient to the unenforceable, a need for government regulation arises to punish fraudsters. As this need gets too big in a given economy then the opportunity arises for a more ethical society to step in and take over the economic opportunities because they can do so at a much lower cost.

This topic of trust in the economy and prosecuting fraud is the subject of another blog post by Ritholz. He quotes numerous economists and scholars and notes that our economy won’t recover until trust is restored and trust won’t be restored unless the government prosecutes and punishes the executives on Wall Street and in the financial industry who were involved in the mortgage meltdown.

This brings me to my last reference. If you are really interested in learning more about the role of fraud in the mortgage meltdown, I highly recommend listening to this excellent interview about how the banks committed fraud in the mortgage industry. You can download the MP3 file and listen to it, like I did, while exercising. It’s worth the time. I’ve read a few books on the mortgage meltdown and found this to be informative in addition.

In my opinion, (as I've mentioned on this blog before) the bottom line is that the American family is failing to produce a populace that is obedient to the unenforceable. As a result, there is a bigger need for other mechanisms to prevent, detect and prosecute fraud and other forms of economic corruption. Many are observing that the government seems to be headed in the other direction and allowing top executives to get away with their corrupt activity. This is a recipe for more hard times to come and potentially for a more righteous society to gain economic advantage. What is to be done? Strengthen families in the long run and build stronger mechanisms to prosecute and regulate fraud in the short run.