Gretchen Morgenson and Louise Story have a must-read article in the New York Times on an important aspect of our two-tier justice system, in which only little people seem to be subject to the full force of the law. The article describes how, starting with the Bush Administration and continuing under Obama, the Department of Justice decided to exit the business of prosecuting suspected corporate criminals.

This section is stunning:

But by 2005, a debate was growing over aggressive prosecutions, as some business leaders had been criticizing the approach as perhaps too zealous. That May, Justice Department officials met ahead of a session with a cross-agency group called the Corporate Fraud Task Force… In the meeting, the deputy attorney general at the time, James B. Comey, posed questions that surprised some attendees, according to two people there who asked to remain anonymous because they were not supposed to discuss private meetings. Was American business being hurt by the Justice Department’s investigations?, Mr. Comey asked, according to these two people, who said they thought the message had come from others. He cautioned colleagues to be responsible. “It was a total retrenchment,” one of the people said. “It was like we were going backwards.”

This is ass backwards. First, it is of absolutely no concern to a prosecutor what the impact of his work is on the quality of life of criminals. Would you ever hear a prosecutor say, “Gee, we better not bust that drug dealer. His mom would be distraught, and think what it would do to his kids”? Prosecutors are in the business of enforcing the law. If there is something wrong with the law, that’s a different question, and remedies should fall to the legislature (but we’ve been plagued with an awfully creative Supreme Court). A ttorneys general do not have social or economic engineering as part of their job description.

Second, American business is hurt by the failure to investigate corrupt and potentially criminal activities. The failure to go after bad actors puts the good guys at a competitive disadvantage. Want to give American corporations a lousy reputation? The best way is to enable crooks. Honest businessmen will be under pressure to match the growth and profits of the miscreants.

Subprime lending is the poster child of why this “enable bad businessmen” idea is a horrorshow. All the leaders in that business, Countrywide, New Century, Indymac, were criminal enterprises. They engaged in consumer and investor fraud, and not just one scam, but multiple scams. They left smoldering wreckage across the economy, imposting costs on individuals and enterprises that were innocent bystanders.

The history of economic development also shows corruption reduces economic competitiveness. We’ve mentioned repeatedly Amar Bhide’s 1994 Harvard Business Review article, “Efficient Markets, Deficient Governance,” in which he pointed out that one of the biggest reasons that the US had such liquid and deep capital markets was that foreign investors felt safe sending funds here due to the tough policing, specifically disclosure rules, prohibitions against insider trading, and rules against market manipulation (if you’ve ever done international deals, foreign investors are marks, so they have legitimate reasons to be worried about being taken for a ride).

Similarly, as the US is sliding into banana republic status, it needs to consider the insight of Lee Kwan Yew, who was the prime minister of Singapore for thirty years and is often described as its founding father. When the island nation gained its independence from Malaysia in 1965, it had nothing going for it: no natural resources, no technology, no world class manufacturers. His strategy was that Singapore could still compete by having a highly educated workforce and having clean government. Yew’s approach to policing citizens is admittedly heavy handed, but his policies designed to forestall official corruption are shrewd. For instance, top government bureaucrats are paid at the same level as private sector professionals (think partners of top law firms). That means no revolving door (staying in government is an attractive career path) and little incentive to cheat (you don’t have much to gain if you are well paid and have a lot of status and power already). He also put in place tough, independent internal audits.

By contrast, look at the effort to hamstring the watchdogs in the Executive Branch, the inspectors general. Morgenson and Story use Beazer Homes, which came under scrutiny in March 2007, as a case example:

Investigators found that Beazer had been offering a lower mortgage rate if buyers paid an extra fee, but then not giving them the lower rate. And it was enticing homeowners by offering down payment assistance, but not disclosing that it then raised the price of the house by the same amount.

Yet the further investigations were held at bay. No Beazer employees or customers were interviewed while Beazer and its law firm conducted their own “investigation”. I wonder how much coaching of executives and staff took place and how many records disappeared. If subpoenas have not been issued, I would assume some targeted file tidying up can’t be construed to be destroying evidence.

And the toughest internal watchdog, the inspector general, was leashed:

A year after the settlement, Kenneth M. Donohue, the inspector general of HUD at the time, raised questions about its handling. He said he was disturbed by the interference by the Justice Department and its calls to stop pursuing Beazer executives so the deferred prosecution deal could be completed. “As a law enforcement official for over 40 years,” Mr. Donohue wrote in a letter to Eric H. Holder Jr., the attorney general, “I have never witnessed a like action in any of my varied dealings.” In a recent interview, Mr. Donohue, now a senior adviser at the Reznick Group, an accounting firm in Bethesda, Md., said of the Justice Department: “The most important point of this whole thing is the fact that they threatened the HUD office of the inspector general that we would not be allowed to go forward with our investigation of executives if we didn’t agree to their settlement.”

The problem is that while inspectors general have substantial law enforcement powers (for instance, most can execute search warrants and make arrests), they are not full fledged prosecutors; they can subpoena records, but not witnesses. So they are forced to work with the DoJ if a matter rises to a criminal level. So if you have a DoJ that is in “see not much evil” mode, you have a very effective Catch-22. Here is the bland bureaucratic formulation:

David A. Brown, acting United States attorney on the case, said: “What we do is work cooperatively as a team in conducting these investigations. We don’t tell agencies to stand down when they are working as part of the team.”

“Working at part of the team” means “not challenging our decision to do not all that much”.

That isn’t to say the DoJ is doing absolutely nothing. The new business-friendly approach is the “deferred prosecution agreement”, which became DoJ policy in mid 2008 and was used in Beazer. Again from the article:

Federal prosecutors officially adopted new guidelines about charging corporations with crimes — a softer approach that, longtime white-collar lawyers and former federal prosecutors say, helps explain the dearth of criminal cases despite a raft of inquiries into the financial crisis. Though little noticed outside legal circles, the guidelines were welcomed by firms representing banks. The Justice Department’s directive, involving a process known as deferred prosecutions, signaled “an important step away from the more aggressive prosecutorial practices seen in some cases under their predecessors,” Sullivan & Cromwell, a prominent Wall Street law firm, told clients in a memo that September. The guidelines left open a possibility other than guilty or not guilty, giving leniency often if companies investigated and reported their own wrongdoing. In return, the government could enter into agreements to delay or cancel the prosecution if the companies promised to change their behavior.

While deferred prosecution agreements had been used before 2008, they had not been formally set forward as an options They were adopted last year by the SEC. The article argues, convincingly, that this change embodies an official posture of going easy on white collar crime.

Fundamentally, this is the same intellectually bankrupt reasoning that also gave us deregulation of financial markets. The push was for more efficiency and the hell with safety. But any real systems designer, be it a software designer, an architect, a civil engineer, will tell you safety is a first order design consideration and efficiency is second. It’s more important than the skyscraper not fall down than it be built for the lowest possible price. Yet what we are doing is the legal equivalent of gutting building codes and hoping for the best.