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Poisoning Capitalism's Well

"Economic feedom—the entrepreneurship it unleashes—is the most important weapon for achieving higher living standards in the world."

James Gwartney (left)

Corporate Sins Blot Out Market Magic

Adelphia, Arthur Andersen, Enron, Global Crossing, Merrill Lynch, WorldCom, and Tyco— a list that could easily appear in both business and crime reports.

A yearlong national horror show of corporate scandals has raised suspicions that there is something fundamentally wrong with how American corporations conduct business. Last July, Ralph Nader called U.S. corporate corruption "greed on steroids," and characterized the entire debacle as poison to capitalism worldwide.

In the first half of this year, the Security and Exchange Commission (SEC) initiated 128 investigations of corporate accounting and reporting practices, a number unmatched in the past decade. Has American business indeed abandoned what once was called "common ethics" or were the revelations of the past 12 months aberrations?

History, at least, doesn't hold for the aberration argument. This is hardly the first time American corporations have gotten themselves into big trouble. Kevin Phillips in Wealth and Democracy, (Broadway Books, 2002), examined five similar periods since 1800 when businesses used questionable tactics and disrupted the national economy. Voters responded by electing reformers to Congress and the White House reacted by reining in much of the power of the monied elite. The most recent episode of corporate naughtiness occurred in the 1920s and triggered a series of laws—Roosevelt's New Deal—that created the modern regulatory state.

Economist James Gwartney draws a distinction between today and the Roarin Twenties or the Gilded Age of the late 1800s. He thinks the latest corporate misdeeds are not the product of deregulation, a perennial favorite on the conservative agenda.

"People may eventually conclude that today's scandals reflected an era when the rewards for executives were huge if the stocks did well and the temptation to cheat were correspondingly great," says Gwartney.

Gwartney would find support in a study prepared by Sanford Bernstein, a New York-based investment research firm. An analysis of Fortune 500 companies' profits between 1995-2000 found that one-third of profits reported during the period was a result of accounting gimmicks, such as not counting as expenses stock options awarded to executives. This accounting sleight-of-hand created phantom profits used to attract investors.

Gwartney says the problem is a lack of truth, of honesty, i.e., accurate information. CEOs and boards of directors lied to the public and shareholders to enrich themselves, and lying short-circuits the entire feedback system that markets depend on to survive.

True market economies, says Gwartney can't exist without accurate information that enables investors to make informed decisions. Each of the corporations named above, stand accused by someone—regulators, stockholders or investors-of publishing either misleading or outright false information. By cooking their books and not telling the truth, they eat away at the foundation of economic freedom, the very same system that gave them birth.

Gwartney's solution? Surprisingly, tougher government control.

Tighter regulations will— and must—stop such shenanigans, he says. "The SEC should require publication of the statements that corporations submit to stockholders and the one submitted to the IRS," says Gwartney. "Then it's easy to spot any disparities."

For decades, a favorite trick worked out by auditors and CEOs has been to have a set of books for the public, to attract investors, and another for the government, to pay taxes. Corporate reform legislation signed by President Bush in July may make it more difficult to perform such trickery. CEOs and chief financial officers are now required to sign a document swearing, under oath, that their financial reports did not contain an untrue statement of a material fact and did not omit to state a material fact.

It was a lack of transparency, the inability of investors to find accurate information that enabled Enron and Arthur Andersen to make it appear that business was booming when it wasn't.

"They stole money," says Gwartney referring to Enron executives and someone must be held accountable for that, he believes. "If we had a system where Enrons and Arthur Andersens were not prosecuted then we would have less confidence in the market and it would not work as well."

Despite the long list of corporate thievery, Gwartney's faith in market forces is unshaken. In fact he sees them already busy mending things.

"People are going to demand accurate information before they make an investment," he says. A great premium will be placed on hard-nosed auditors. The investor has an incentive to patronize businesses with those auditors and corporations have a strong incentive to protect their reputations." In all likelihood, that's how Adam Smith saw it, too. —J.C.