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Special Report
Last Updated: 03/20/2009
Legal Corruption: the Cause of the Global Economic Crisis?
Errol P. Mendes

The multi-million dollar bonuses that American International Group (AIG) is handing over to nameless "executives", after accepting billions in US taxpayer bailout money is, understandably, causing a great deal of alarm in the media and American public in general.

This massive misallocation of wealth, and the government's inability or unwillingness to prevent it, is exposing a system of "legal corruption". As Errol P. Mendes explains, the ability of economic elites to influence the political oversight and regulation of their activities through lobbying led directly to the current economic crisis.

Mendes concludes with a call to fiscal responsibility, a concerted effort to root out corruption (including so-called "legal corruption"), and some way to encourage ethical behaviour among elites.

President Obama and many leaders of governments around the world are desperately combating the free fall of their economies while also trying to inoculate their economies from future such economic disasters. Perhaps most critically they should examine whether the root causes of the global economic crisis was caused by what a leading anti-corruption expert at the World Bank, Daniel Kaufman called “Legal Corruption”.

Before leaving his post, Kaufman described legal corruption as a form of state capture by economic and political elites. In this model of state capture, these elites working just  within the bounds of the law, collude, purchase and unduly influence the rules of the economic and political game, capture oversight agencies and determine the policies, regulations and laws that result in obscene benefits for the few and potentially misery for the many. While many of those in the complacent developed world thought that such legal corruption was only to be found in unstable countries of the South and the former communist countries of Eastern Europe, some have now realized that it has reached its apotheosis in the power corridors of Washington, New York and London.

The main goal of these most destructive forms of legal corruption was the financial sectors of Europe and the United States. There have been detailed reports as to how the 377 highly paid employees of the AIG  branch in London, the giant insurance company, that knew it was too big to fail, managed to work around the  lax oversight and loopholes in the regulations, to develop ever more sophisticated forms of  extraordinarily risky derivative trading that produced approximately half a trillion dollars of unhedged risk. This form of financial Russian roulette eventually brought its parent giant  that employed over 110,000 people in 130 countries to the brink of bankruptcy and forced the U.S. taxpayers to shell out $150 billion to prevent a catastrophic knock on effect on financial institutions around the world. There is growing evidence that the lack oversight and ineffective regulations was the product of high priced lobbying in Washington D.C. and other corridors of political power.

It seemed astonishing both for Daniel Kaufman ,and it would be for average citizens around the world, who are the worst victims of the global economic crisis, to learn that one of the main oversight agencies in Washington, D.C., the Office of Thrift Supervision relied on fees paid by the banks and insurance companies it regulated guaranteeing dangerously lax oversight. In a similar vein, Mr. Kaufman details how in April of 2004, the five largest investment banks  managed to convince the Securities and Exchange Commission (SEC) to significantly relax the oversight and capital requirements  governing their activities after a 55 minute meeting in a basement of a New York building. The rest is history as the death of Lehman Brothers and the massive bailouts of Bear Stearns, Goldman Sachs, Citigroup and others in the financial sector followed. Is it any wonder that the monster of the financial sector, Bernie Madoff, would come out of this culture of legal corruption.

Daniel Kaufman details how similar high priced lobbying in the U.S. Congress resulted in the mortgage giants Freddie Mac and Fannie Mae getting sufficient regulatory leeway to help them hugely expand the market for subprime mortgages. The prospect that the law and regulatory agencies would permit the purchase of homes by citizens with little or no financial ability to carry them, preyed on the unrealistic hopes and expectations of millions. Soon their foreclosed homes, that starting dropping in value below the resetting option ARM mortgages, would trigger an economic tsunami that would start in the U.S., but lash around the world sparing nobody even as far away as China and India.

President Obama and other government leaders around the world should be aware that the fight against corruption therefore can no longer just be limited to the illegal bribe payers and takers around the world. It must extend to those economic and political elites who use undue influence and political fundraising to effect state capture resulting in lax oversight and regulation, both in the richest countries of the North and the developing countries of the South. This is a global war that potentially creates more victims than the so called war against terror. The main weapons in this global battle must be transparency in the workings of oversight agencies and state legislatures and the process of creating effective regulations for the sectors of the economy that are most at risk of state capture by economic and political elites.

However, along with more transparency, effective oversight and appropriate regulation, one other safeguard will still be sorely missing, namely the self-policing of ethical and moral behaviour by these same elites. Despite the massive regulation of corporate behaviour such as the U.S. Sarbanes-Oxley Act and similar types of regulation in the wake of the Enron, WorldCom and other international corporate frauds, massive unethical behaviour still has the potential to ruin the lives of millions of people  around the world. Our government leaders should demand that transparency must be linked to ethical and moral corporate governance and integrity if we are to avoid future economic disasters. Instilling this linkage must begin not only in the boardrooms and public office holders of the world, but also in the high schools and universities of the world.

Professor Mendes is a Professor Constitutional Law, Public and Private Sector Governance and International Law at the University of Ottawa and is an advisor to governments and the private sector on corporate responsibility, governance and integrity.