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Article Excerpt
Introduction
It has long been recognized that capitalism depends upon the rule of law and property rights. Without the enforcement of these two underpinnings of a free market system, capitalism does not operate efficiently. As Hayek (1960:159) put it: "When we obey laws, in the sense of general abstract rules laid down irrespective of their application to us, we are not subject to another man's will and are therefore free." Nevertheless, as business activities have become more complex, and as business interests have become more politically powerful, the laws and rules that underpin the capitalist economic model have come under increased scrutiny. The public perception is that some of these laws and rules are weak and foster "loophole mining" and a culture of business dishonesty. This is particularly so after the scandals of 2002 when companies such as Enron, WorldCom, and Adelphia were the focus of media attention and government legislation.
During the last century, capital markets became increasingly important for corporate financing and growth, particularly in a rising stock market. Attempts to align owners' goals (greater wealth) with management goals (company expansion/increased market power) led boards of directors to motivate executives with compensation packages tied to corporate stock prices, particularly stock options. Per Levitt (2002:2), "By 2001 some 80% of management compensation was in the form of stock options. But instead of aligning employees' interests with shareholders, options gave executives an incentive to use accounting tricks to boost the share price on which their compensation depended."
These incentives, however, fostered an environment that 1) sacrificed the long-term goals of sustainable company growth for short-term goals of increased profit, and 2) inflated measures used for financial purposes while simultaneously deflating numbers used for income tax purposes. A company might choose to optimize its stock position by being "honest" enough in its financial accounting to be perceived as a high-quality firm, while skewing tax numbers, using as many gray areas as possible, in the company's favor. Some might argue that managing earnings numbers is the best way to produce a favorable financial output on all fronts, thus protecting the investor. Others would say that while all financial statements contain some approximations, presenting extremely diverging stories to the government and stockholders likely prevents at least one of those stories from straying materially from the truth. Practically, the stakes can be high: two diverging stories were told to Enron stockholders and the IRS regarding Enron's 1993 and 1994 income tax returns. In 1998, an unnamed IRS appeals officer concluded that "the report to shareholders 'fooled' both investors and securities regulators about its financial condition" (Johnston, 2003, Section C, page 1). The unnamed appeals officer made strenuous attempts to persuade the IRS to reject Enron's position, asking in a memo "[s]hould the IRS condone this?" The IRS national office overruled the officer protests. (1) Theoretically, auditors should prevent material misstatements before audited financial statements are released, and where there is doubt as to accounting treatment, opt for the more conservative approach. (2) However, the audited companies pay public auditors, and that in itself creates an ethical conflict. Prior to recent scandals, IRS auditors had little incentive to perform beyond the basic level necessary to remain employed, but accounting scandals have highlighted the need for additional attention to the system to ensure complete disclosure.
This paper will identify economic problems with the U.S. capitalist model, propose possible solutions to the external structure, and discuss the pros, cons, and political realities of the proposed solutions.
Characterizing the Problem with the U.S. Capitalist Model
Is there a problem with the U.S. capitalist model? Certainly articles appearing in both the media (3) and in the academic literature appear to say there is. (See the papers in a recent symposium on Enron and conflicts of interest, most notably Healy and Palepu (2003), Lev (2003) and Demski (2003)). The problem appears to be one of skewed incentives and the honest provision of information and has manifested itself in the corporate scandals that first broke with Enron in late 2001.
Economics can identify incentives for both good and bad behavior inherent in financial statement systems, and this applies in particular to problems in the financial statement and accounting system. In economics, asymmetric information problems are classified as either adverse selection or moral hazard. Adverse selection is defined as a problem that occurs before a transaction takes place (e.g., health insurance, used car purchases, bank loans), and is usually characterized by market inefficiency. For example, low health-risk clients, "peach" vehicles, or good-credit customers, respectively, are not recognized as a different segment of the market in contrast to high health risk clients, "lemon" vehicles, or bad-credit customers. The adverse selection problem leads to higher prices being paid by the very customers that companies are anxious to insure or lend to. Akerlof's (1970) Nobel Prize winning paper on the market for second hand vehicles showed how many good second vehicles would not even appear on the market, because their owners might be reluctant to part with them at average market prices. The adverse selection problem can be solved by forced disclosure, using intermediaries (used car dealers, for example), or by screening applicants.
The second type of asymmetric information, known as moral hazard, occurs after the economic transaction has taken place. It is often evident in labor markets (shirking), venture capital transactions (e.g., internet company spending on entertainment), and any situation where the seller of a security may have incentives to hide information and engage in activities that are undesirable for the purchaser of the security. Sometimes moral hazard can be dramatic. Fire insurance may encourage arson, automobile insurance may encourage accidents, and disability insurance may encourage dismemberment.
A particular form of moral hazard problem involving two economic entities is known as the principal/agent problem. Here, for example, the owners of equity (the principals) are not the same as the managers of the firm (the agents), so the managers may act in their own interest rather than in the interest of the stockholders. Since larger shareholders might be able to exert pressure on management, there may be an argument to allow a single shareholder to own large blocks of shares, as shareholders with much smaller stakes are at a disadvantage in identifying and correcting financial problems. Principal/agent problems exist only if incentives diverge between principals and agents, so this partially explains the trend toward internalizing the problem in recent decades by negotiating share options as part of the compensation of senior management. The traditional deterrent to the principal-agent problem has been the presence of an effective, independent, outside audit. An internal audit, conducted by company auditors under the direction of management (who can hire and fire them), is not considered a viable deterrent. Management...
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