For Capitalism to Survive, Crime Must Not Pay

Unequal enforcement of the law will distort and destroy any capitalist society, and we may be witnessing just such a downward spiral in the financial sector.

Capitalism is not an abstract idea. It is an economic system with a distinct set of underlying principles that must exist in order for the system to work. One of these principles is equal justice. In its absence, parties will stop entering into transactions that create overall wealth for our society. Justice must be blind so that both parties — whether weak or powerful — can assume that an agreement between them will be equally enforced by the courts.

There is a second, perhaps even more fundamental, reason that equal justice is essential for capitalism to work. When unequal justice prevails, the party that does not need to follow the law has a distinct competitive advantage. A corporation that knowingly breaks the law will find ways to profit through illegal means that are not available to competitors. As a consequence, the competitive playing field is biased toward the company that does not need to follow the rules.

The net result of unequal justice is likely to be the destruction of the overall wealth of our society. I don’t mean the wealth of individuals; I mean the total wealth of goods and services that are the benefits of healthy competition. To the extent that unequal justice prevails, entities that are exempt from the laws will, in all likelihood, be more profitable than law abiding competitors. Then they use their profits to further weaken competitors by using their illegal profits to further build their businesses at the expense of competitors. All of this business building activity is based on a foundation of sand, and ultimately the entire industry — or even the larger economy — becomes distorted. The “rogue” company gains power, changes markets, and destroys direct and indirect competitors because it is playing by different rules.

The above scenario is not simply a hypothetical example. It is exactly what happened at Worldcom. As the company succeeded because of its then-unknown illegal activities, it grew, managed to take over MCI (one of the true innovators in the industry), and weakened competitors who could not match its profitability. Ultimately the whole edifice collapsed, causing massive wealth destruction in the telecommunications industry and the economy as a whole.

In the WorldCom example, appropriate legal enforcement and prosecution did not occur until the accounting fraud and other crimes were detected. Thus, while it is more an example of undetected accounting fraud than unequal justice, the results are illustrative. In a society with unequal justice, the appropriate laws are never enforced, so entities acting outside the law continue to grow more profitable and powerful (as compared to everyone operating according to the rules). Moreover, the profits from illegal activities can be used to subsidize competition across the spectrum of business activities of companies acting outside the law — which further enforces the competitive advantage, and possible hegemony, of entities operating on a different playing field.

Now, here’s why the above discussion is so important if we hope to return our economy to the dynamo of wealth creation for the entire society that is, in part, what made America a great nation. As economic inequality increases, two sets of laws implicitly develop: one set for powerful members of society and another set for the weaker. These two sets of laws are often defined by a single question: who is prosecuted for crimes and who is not. When powerful members of society can break the law without fear of prosecution, they will inevitably exploit this competitive advantage by engaging in profitable (but illegal) activity. At the same time, the weaker members of society can’t compete; they are shackled by the need to follow the laws of the land. Meanwhile, everyone loses as the profits of companies violating the law distort the competitive playing field and the activities of everyone in it and divert societal activity from the creation of real wealth.

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In effect, equal enforcement of the law is not simply important for democracy or to ensure that economic activity takes place, it is fundamental to ensuring that capitalism works. Without equal enforcement of the law, the economy operates with participants who are competitively advantaged and disadvantaged. The rogue firms are in effect receiving a giant government subsidy: the freedom to engage in profitable activities that are prohibited to lesser entities. This becomes a self-reinforcing cycle (like the growth of WorldCom from a regional phone carrier to a national giant that included MCI), so that inequality becomes ever greater. Ultimately, we all lose as our entire economy is distorted, valuable entities are crushed or never get off the ground because they can’t compete on a playing field that is not level, and most likely wealth is destroyed.

The central question for the nation right now is whether we are, in fact, in the middle of the dire and dangerous cycle described above. Washington insiders have reported that the Justice Department is explicitly choosing not to prosecute seemingly illegal bank activities. Indeed, in my previous column I noted that the audits released by the Office of the Inspector General of the Department of Housing and Urban Development detailed activities by senior banking officials associated with the robo-mortgage scandal that seem to constitute clear evidence of multiple federal felonies, and most likely violated state laws as well. Yet no one has been indicted.

In an entirely different sector of financial services, the venerable American Banker just completed a three-part series on past credit card debt collection practices. Many of these activities are now under investigation by the Office of the Comptroller of the Currency. But if the past is prologue, it’s unlikely that any criminal indictments will result, no matter what these investigations uncover.

Indeed, as has been repeatedly documented, when illegal activity is detected, the SEC settles with the banks in civil lawsuits for sums that, while appearing to be large, are a pittance compared to the profits of the institutions involved. While these same activities would in many cases constitute criminal violations, no prosecutions have occurred. The bankers who operate our largest financial institutions can rightfully assume that they are above the laws that constrain everyone else.

The evidence that crime does, in fact, pay is perfectly clear. Before the 1990s, the total profits of the financial services sector rarely accounted for more than 20 percent of the total corporate profits of the nation’s economy. By 2005, they averaged about one-third of all corporate profits. After sinking as a result of the crash, they rebounded dramatically. By early 2011, the sector once again accounted for about 30 percent of total corporate profits. As The Wall Street Journal noted, “That’s an amazing share given that the sector accounts for less than 10 percent of the value added in the economy.”

Finance serves a valuable function. Its principal role is to ensure that capital is most efficiently allocated in a society. However, financial services are also an intermediate good. They grease the wheels, through capital allocation, so that real goods and services that people consume or experience can be created. Yet, as the Journal noted, the sector’s profits are far in excess of the value the sector adds to the overall economy. At the same time, recent academic research has suggested that the financial sector has become less efficient over time, with the gains from information technology cancelled out by increases in trading activity (whose social value is certainly open to question).

This will ultimately lead us in a downward spiral: A few large powerful entities and people operate above the law, inequality is extreme, citizens have lost faith in their political systems, real societal wealth is not created, and political instability becomes a potential reality. John Adams held that “We are a nation of laws, not men” for a valid reason. Now, we need those charged with enforcing our laws to do their job.

Bruce Judson is Entrepreneur-in-Residence at the Yale Entrepreneurial Institute and a former Senior Faculty Fellow at the Yale School of Management.