il Moralista

Anti-meritocratic boys’ club

That Yellen, if confirmed, would become the first female Fed chair is noteworthy — though not simply for that reason. More important, it  demonstrates anew that while we tend to think of fields like the military as bastions of sexism, it is actually finance that stands out as a last refuge of those that demean women’s abilities.

The economist Tyler Cowen claims that America is rapidly becoming a hypermeritocracy and that the elite bankers are the vanguard of this movement. The reality, however, is that many financiers became wealthy through orchestrating the frauds that wrecked the global economy. The elite bankers’ real expertise is destroying trillions of dollars of wealth and the jobs of tens of millions of people. They would be swept away, rather than fawned over, if finance were even modestly meritocratic.

The story of why finance is anti-meritocratic has to do in part with its persistent sexism. Finance remains an old boys’ club of men without merit banding together to minimize competition from meritorious women. It was Summers, Obama’s first choice to run the Fed, of course, who suggested in analogous circumstances that women do not excel in science because they lack the intellect to rise to the top of a hypermeritocracy. His nomination was publicly endorsed by male friends and associates who were, like him, insiders in government and finance. In one such endorsement, Cass Sunstein, Obama’s former administrator of the White House Office of Information and Regulatory Affairs, bizarrely claimed that such support by close male friends was a “paradox.”

Yellen was the obvious choice as Bernanke’s successor. She holds the No. 2 position at the Fed. She had two stints as a governor of the Federal Reserve. She has chaired the President’s Council of Economic Advisers. She was president of the Federal Reserve Bank of San Francisco. She has neither been involved in scandal nor made any famously stupid comments in any of these four senior positions. She did not push policies that proved disastrous. A study by the Wall Street Journal found that she was the most accurate economic prognosticator of any Fed leader.

Despite her record of extreme competence and integrity, she was not Obama’s top choice to lead the Fed. Instead, Summers was favored by the president and each of his six primary economic advisers. Summers was known for scandal and famously embarrassing comments and for championing a series of disastrous antiregulatory policies that led to the financial crisis. Obama’s preference was all the more remarkable because it was accompanied by claims that he wanted to appoint someone who would make vigorous regulation a top Fed priority. Summers was, by contrast, the Democratic economist most infamous for weakening and deriding regulation and trivializing the risk of white-collar fraud. He would have been the perfect nominee for a president who wanted to continue the lax regulatory era of the previous Fed chiefs.

The novelty of Fed regulation

To understand the novelty that the Fed would take regulation and fraud by elite bankers seriously, one must understand that for a quarter-century Greenspan and Bernanke fought effective regulation. Greenspan praised the global competition in regulatory laxity that gutted effective oversight in the U.S. and Europe. Greenspan did not believe that there should even be laws against financial fraud.

Brooksley Born, head of the Commodity Futures Trading Commission during the Clinton administration, recalled in an interview with the Stanford alumni magazine a conversation she had in 1996 with Greenspan, then the Fed chair:

“Well, Brooksley, I guess you and I will never agree about fraud,” Born … remembers Greenspan saying.

“What is there not to agree on?” Born says she replied.

“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” she recalls. Greenspan, Born says, believed the market would take care of itself.

Greenspan, along with allies Treasury Secretary Robert Rubin and then–Deputy Treasury Secretary Summers, later defeated Born’s attempt to regulate derivatives — a key financial product — as part of the CFTC’s mission. The subsequent lack of regulatory oversight of derivatives contributed to the financial crisis.

A Financial Crisis Inquiry Commission report reveals that the Fed’s top supervisor twice received permission to brief the Fed’s senior leaders about massive fraud by the megabanks that he believed posed a severe danger. Both briefings left Greenspan enraged at the Fed’s supervisors for daring to criticize the largest banks. In fact, he was so convinced that fraud could not exist that he refused to allow the Fed examiners to find the facts about the pervasiveness of so-called liar’s loans — loans that were overwhelmingly fraudulent because they were made without verifying vital information about the borrowers — that many of the largest banks’ affiliates were making. Greenspan also refused to use the Fed’s unique statutory authority to prohibit such loans, despite their role in hyperinflating the housing bubble.

Had Greenspan used that authority, there would have been no crisis. This is not hypothetical. During the savings-and-loan crisis, I and fellow regional S&L regulators with jurisdiction over Orange County, Calif., drove liar’s loans (called no-doc loans at the time) out of the S&L industry in 1991 because we realized that they were inherently fraudulent and certain to cause losses to the federally insured banks while making the banks’ controlling officers wealthy. The Fed had the benefit of our regulatory experience and analytics, numerous warnings that such loans were overwhelmingly fraudulent and growing massively (by over 500 percent from 2003 to 2006), and the fact that by 2000, industry players themselves called them liar’s loans — which lacks a certain subtlety. Only someone blinded by ideology to detest all regulation — someone like Greenspan — would refuse to ban liar’s loans.

Bernanke was appointed as Greenspan’s successor in early 2006. He, too, refused to ban liar’s loans, until succumbing to intense congressional pressure in July 2008 (by which time virtually no lenders made liar’s loans). Even then, he delayed the effective date of the rule by 15 months to ensure that he would not inconvenience the industry. To guarantee that he would never have to be troubled by the Fed’s top supervisor’s criticizing the largest banks for fraudulent lending, Bernanke put Patrick Parkinson, a Fed economist, in charge of supervision. Parkinson had no regulatory experience or expertise and was infamous for leading the deregulatory charge that created the barrier forbidding any federal or state official from regulating financial derivatives. The Fed economist supported Greenspan’s absurd claim, echoed by Summers, that fraud was impossible because the firms trading financial derivatives were too “sophisticated” to be duped.

Controlling Wall Street

This background shows how vital it is that the new Fed chair make her top priority the creation of the first effective regulatory system in the Fed’s 100-year history.

The same history, however, demonstrates how bizarre it was that Obama and his top advisers preferred Summers to Yellen. Summers had the advantage of being male, and he also had the advantage, along with Obama’s six top economic advisers, of being a protégé of Robert Rubin — a former Treasury Secretary under Clinton and the leader of the Wall Street wing of the Democratic Party. Both Clinton and Obama are fervent supporters of that wing and were recipients of campaign donations from it, which explains why they appointed Republicans Greenspan and Bernanke to run the Fed. They were not reappointed despite their absurd positions that banking fraud could not exist and that financial regulation is harmful and should be dramatically reduced because financial markets are self-correcting. Rather, they were reappointed because the Wall Street wing of the Democratic Party shared those positions. That wing also encouraged the deregulatory push that destroyed effective oversight in the U.S. and Europe.

If Yellen genuinely intends — as she should — to make the creation of a vigorous regulatory system a top Fed priority, she will announce that goal and then pursue the following:

1. Appoint a new head of supervision who has supervisory expertise and a track record as a vigorous regulator.

2. Propose that Congress end the conflict of interest built into the Fed system in which bank examiners and supervisors are employees of the regional Federal Reserve Banks — which are, in turn, owned by the banks they are supposed to regulate.

3. Support the elimination, through dramatic reduction in size, of too-big-to-fail banks, or systemically dangerous institutions that threaten the stability of the U.S. and global economies.

4. Support the restoration of Glass-Steagall, the Depression-era law that separated commercial and investment banks.

5. Support the repeal of the Commodities Futures Modernization Act of 2000, the law supported by Rubin, Greenspan and Summers that bars the regulation of derivatives, the financial products that were responsible for the financial crisis.

6.Train Fed staff and officials, particularly economists, about control fraud— the dangerous situation in which a CEO uses his power to induce subordinates to commit accounting fraud and other crimes for the personal enrichment of himself and cronies at the expense of shareholders and the government. A good start would be to require that they all read George Akerlof and Paul Romer’s 1993 article about how bank CEOs “loot” their banks and why deregulation is “bound to” lead to widespread looting. (Note: Yellen and Akerlof are spouses.)

7. Create a new senior Fed position: chief criminologist — i.e., someone who understands the perverse incentives, lax regulatory environment and criminal techniques that lead to control fraud.

I am hopeful that Yellen will support all these measures, but I believe that she will likely implement only the first and sixth reforms on my list. The smart bet has always been on the Fed’s not taking bank fraud or supervision seriously. But if this bet finally fails to pay out for elite bankers, it will be a tremendous boon for the country.

William K. Black