Mises Daily

Do Austrians Wink at Business Fraud?

With corporate meltdowns the past year at Enron and WorldCom and the government's destruction of the once-respected Arthur Andersen firm, much anger and invective—especially from the political classes and their allies—has been aimed at U.S. business in general.  

Not surprisingly, contributors to publications put out by the Ludwig von Mises Institute have painstakingly pointed out time and again that (a) business fraud has played a miniscule role in the current business slowdown and was exposed mainly because of the recession, (b) the expansion of credit by the Federal Reserve System was the real engine of inflation that led to a number of firms trying to prop up their stock prices, and (c) the accounting practices of the U.S. Government, which has been the most vocal anti-business critic during this latest downturn, are infinitely more dishonest than the worst fraud any set of business executives could have committed.

I have received a large number of hostile emails from readers who are incensed because they believe that either I blindly believe that business managers can do no wrong, or that somehow I care only about fraudulent practices of government, and give business a free ride.  While I do not believe I have ever insinuated such beliefs in my articles, at the same time I know that on a subject like this, I have to be absolutely plain where I stand.

When it comes to accusations of fraud, however, I believe that we need to be clear on a number of subjects.  First, the modern legal term of "fraud," especially fraud as outlined in federal law, is not necessarily what most of us could consider fraudulent practices to be.  Second, we must remember that fraud on as large a scale as we saw with Enron and WorldCom does not proceed from a vacuum, as it would have been highly unlikely for any firm to have been able to engage in some of those practices undetected as long as they did during a period of normal business conditions.  

Although I believe that individuals who have defrauded customers, employees, and stockholders bear ultimate responsibility for their actions, I don't think the spectacular failures we saw in the last year occurred because corporate executives are a criminal class of people or that Harvard School of Business does not teach enough business ethics courses.

Beyond the condemnation of fraud, there also exists the problem of what to do about it.  At the current time, the typical reaction of the political classes and the media elites is first to declare undying outrage for what has occurred, second, to demand harsh punishment for the alleged malefactors, and last, to call loudly for new laws and regulations as a way of ensuring that the particular public sin committed will not be repeated.  

That a number of these "scandals" have come about largely as a result of government laws and regulations that were enacted ostensibly to deal with previous "scandals" seems to be ignored by politicians and their amen choruses.  Then again, one might even assume that "reform" actually is farthest from the minds of those who make policy.

As others and I have noted on these pages, the Federal Reserve System during the 1990s engaged in aggressive expansionist monetary creation through the creation of credit by central bank fiat.  While many hyped Alan Greenspan's inflationary policies as the key to "creating prosperity," Austrian Economists were more skeptical, pointing out that the end result of the boom would be an inevitable bust.  

It was the Austrians, one might recall, who refused to join in the "new economy" mantra that the Maestro and the Bill Clinton Administration had sent the business cycle onto the ash heap of history through its "wise" tax and spend policies.  And it is the Austrians who have pointed out that the Fed's cutting of its interest rates to near-zero levels will not bring the U.S. economy into a strong recovery, and may very well help retard the anemic recovery that we are presently experiencing.  Furthermore, Austrians have patiently pointed out that the modest tax cuts pushed through by the Bush Administration in 2001 did not create the recession, as Clinton, Al Gore, and Paul Krugman have declared.

Yet, one may ask what the fed's reckless monetary policies have had to do with corporate fraud, and the answer simply is "plenty." First, keep in mind that the kind of monetary expansion that Greenspan's Fed initiated during the 1990s was in and of itself a major fraud.  The creation of "money" fed style is fraudulent because it actively destroys the value of money that individuals already are holding.  Furthermore, as new money is sifted through the economy, it insidiously undercuts the basis of the present economic order, substituting an inflation-based order instead.  

This would be bad enough, but the consequences of what the Fed is doing do not stop simply with the undermining of the price system. The artificial lowering of interest rates also has other effects in the business world.  First, the creation of new excess reserves literally out of thin air encourages banks to be more aggressive (or irresponsible) in their pursuit of new business lenders.  Second, as interest-bearing securities become less attractive to investors, they tend to throw their money into lines of investment that are more speculative and risky.

Finally, the explosion of new money ultimately turns many areas of investment into fertile ground for speculative bubbles and for the kinds of financial shenanigans that we observed with some large but financially unstable firms.  During the last years of the boom, a number of firms found their bottom lines to be rather shaky, but with stock prices artificially inflated due to Greenspan's artificial injections of credit, the pressures placed upon them to keep up their own stock prices at any cost—in hopes that the downturn would not last—provided incentive enough to engage in the number of shady practices that already have become famous.

This is not a "Greenspan made us do it" defense of Enron and the others, but rather an explanation of how the table was set that enabled many of these executives and their accountants to hide losses as long as they did.  Without knowing the mindset of those who have been accused of fraud and other financial crimes, I cannot help but believe that what occurred was not so much the "corporate crime wave" as the political classes have declared, but rather a situation in which the government created an environment in which the reckless "high roller" types could dominate.  

Granted, there are dishonest people distributed throughout the population, including business executives, but please remember that a "normal" monetary regime is less likely to reward those who are careless with other people's money.  What prevailed in the last years of Bill Clinton's administration was sheer recklessness, and there is no doubt the atmosphere created by the "Maestro" and his political friends made it easier for Enron and other near-bankrupt firms to engage in shady practices.

The second—and perhaps more controversial—issue is how to deal with accounting fraud once it happens.  I believe that the current trend to criminalize large numbers of questionable transactions is wrongheaded and does not serve so much the interests of justice as it does the career aspirations of federal prosecutors and politicians.  In fact, I would like to see much of what now is relegated to criminal prosecution be handled in civil courts with private plaintiffs, not the U.S. Department of Justice.

For those folks who have enjoyed the recent spectacle of CEOs being handcuffed and paraded before television cameras in "perp walks," what I suggest would be considered near heresy.  However, very few people actually understand how much of the federal criminal code actually works.  

When we hear of someone being indicted on multiple counts of "fraud," "conspiracy," "money laundering," "making false statements," "wire and mail fraud" and the like, the charges sound deadly serious.  In reality, most federal charges actually fall under a category of what I call "derivative crimes."  Like "derivatives" in financial markets in which the value of a number of securities is "bundled" into an index, which is then bought and sold in the open market, crimes like "fraud" and "money laundering" generally do not reflect what has actually occurred.

For example, in his infamous prosecution (persecution?) of Michael Milken during the late 1980s, Rudy Guiliani used the Racketeering Influenced and Corrupt Organizations Act (RICO) passed by Congress in 1970.  Originally enacted in order to prosecute "mafia" figures that were beating the rap in state courts, the RICO statute permits federal prosecutors to "bundle" relatively minor legal transgressions into "crimes" that carry serious jail time.

Add that in the modern American prosecutorial state, criminal intent, or mens rea,—once the cornerstone of criminal law in this country—carries absolutely no weight.  Prosecutors and judges are not interested in whether or not a person intends to commit a crime, but whether or not an infraction of either the law or regulatory code has been violated, period.

To put it another way, take the example of someone who is driving down a city street when a child suddenly darts in front of his car, and the driver being unable to stop, hits the child, and kills the youngster.  One would expect the law in this case to differentiate between an accident like the one I described and a deliberate act in which a motorist deliberately runs down someone in cold blood.  Unfortunately, all too often federal prosecutors do the equivalent of charging the person who accidentally kills the child with murder.

In the areas of accounting, securities, and business regulations, however, federal prosecutors and judges apply the law unevenly and often unfairly, and the results are often tragic and terribly unjust.  It was never proven that Milken, for example, actually had violated any federal laws.  However, Guiliani's staff examined a number of "gray area" transactions in which attorneys on all sides, along with outside experts, were not able to agree were regulatory violations.  That did not matter to the ambitious Guiliani as he ordered his prosecutors to take those questionable transactions and bundle them into "fraud" and "conspiracy" charges.  

Likewise, in the latest set of "scandals," executives often operated in the "gray" area of accounting practices, but were not actually charged with real crimes, but rather the garden-variety RICO violations, for which the burden of proof is not much more than it would be in civil court.  To put it another way, a number of people will go to prison because the law has been written in such a vague way that it is almost impossible for people charged with such violations to successfully defend themselves.

(Let me also add that if someone is guilty of a crime like embezzlement or actually has engaged in real theft, then criminal prosecutions are warranted. However, it is doubtful that the current crop of executives in the dock are going to be charged with actual crimes such as felony theft or embezzlement, as the RICO laws are much more prosecutor-friendly and, given the penalties are much more harsh than they are for real crimes, politically-minded federal prosecutors will always follow the path of least resistance.)

The better—and more just—route to follow is for individual stockholders, employees, and others who might have been adversely affected by the actions of rogue executives to seek redress in civil court.  First, if harm has been done, it is they, not the government who have been harmed, and any action, criminal or civil, by the state will soak up resources that otherwise could have been paid out to the injured individuals.

Second, it places the burden of responsibility upon the plaintiffs to prove that they had been adversely affected and that the parties charged actually committed these acts.  If they can demonstrate in a court of law—or through an arbitration process—that the defendants harmed them, they can gain redress that they never would obtain if the government simply tries the accused on vague charges and tosses them into prison, thus impoverishing them, their families, and creating turmoil in the business firm.

I strongly believe in the common law process, although the modern regulatory state through its onerous ability to regulate has all but killed much of common law.  This is far more tragic than most people realize, for the traditional common law venues provide ample opportunities for individuals to seek justice against those that do them harm.

Real justice, of course, is not good enough for the political classes, who are constantly attempting to intimidate the rest of us. Yes, people have been defrauded, and yes, justice needs to be served. However, by pursuing people by using the vague and unjust RICO and "insider trading" laws, the politicians appeal not to our need for justice, but to the baser emotions of envy, resentment of wealthy people, and a gut-level desire to commit mayhem.  We can do better than that, and I am happy to count Austrians and their fellow travelers in the group that wants justice, not blood.

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