Chapter Six, Part V

The social benefits of trust and cooperation are, at this point, relatively unquestioned. But they do create a problem: the more people trust, the easier they are for others to exploit. And if trust is the most valuable social product of market interactions, corruption is its most damaging. Over the centuries, market societies have developed mechanisms and institutions that are supposed to limit corruption, including auditors, rating agencies, third-party analysts, and, as we’ve seen, even Wall Street banks. And they have relied, as well, on the idea that companies and individuals will act honestly—if not generously—because doing so is the best way to ensure long-term financial success. In addition, in the twentieth century a relatively elaborate regulatory apparatus emerged that was supposed to protect consumers and investors. These systems work well most of the time. But sometimes they don’t, and when they don’t, things come apart, as they did in the late 1990s.

The stock-market bubble of the late nineties created a perfect breeding ground for corruption. In the first place, it wiped away, almost literally, the shadow of the future for many corporate executives. CEOs who knew that their companies’ future cash flow could never justify their outrageously inflated stock prices also knew that the future was therefore going to be less lucrative than the present. Capitalism is healthiest when people believe that the long-term benefits of fair dealing outweigh the short-term benefits of sharp dealing. In the case of the executives at companies like Enron and Tyco, though, the short-term gains from self-interested and corrupt behavior were so immense—because they had so many stock options, and because their boards of directors paid them no attention—that any long-term considerations paled by comparison. In the case of Dennis Kozlowski, the CEO of Tyco, for instance, it’s hard to see how he could have made $600 million honestly if he had stayed CEO of Tyco. But dishonestly, it was remarkably easy. Investors should have understood that the rules of the game had changed, and that the incentives for CEOs to keep their promises, or to worry about the long-term health of their businesses, had effectively disappeared. But they didn’t, and because they were so intoxicated with their bull-market gains, they also stopped doing the due diligence that even trusting investors are supposed to do.

At the same time, the mechanisms and institutions that were supposed to limit corruption ended up facilitating corruption rather than stopping it, The business of Wall Street and the accounting industry is supposed to be to distinguish between the trustworthy and the trustworthless, just as the Underwriters Laboratory distinguishes between safe and dangerous electrical equipment. If Goldman Sachs underwrites a stock offering for a company, it’s saying that the company has real value, as is Merrill Lynch when one of its analysts issues a buy recommendation. If the New York Stock Exchange lists a company, it’s attesting to the fact that the firm is not a fly-by-night operation. And when Ernst and Young signs off on an audit, it’s telling us that we can trust that company’s numbers.

We are willing to believe Ernst and Young when it says this because its entire business seems to depend on its credibility. If the Underwriters Laboratory started affixing its UL mark to lamps that electrocuted people, pretty soon it wouldn’t have a business. In the same way, if Ernst and Young tells us to trust a company that turns out to be cooking the books, people should stop working with Ernst and Young. As Alan Greenspan has said of accountants, “The market value of their companies rest[s] on the integrity of their operations.” So accountants don’t have to be saints to be useful. In their self-interest alone will compel them to do a good job of separating the white hats from the black. But this theory only works if the firms that don’t do a good job are actually punished for their failure. And in the late nineties, they weren’t. The Nasdaq listed laughable companies. White-shoe firms such as Goldman Sachs underwrote them. The accountants wielded their rubber stamps. (Between 1997 and 2000, seven hundred companies were forced to restate their earnings. In I98 1,just three companies did.) But none of these institutions paid a price in the marketplace for such derelictions of duty. They got more business, not less. In the late nineties, Arthur Andersen was the auditor of record in accounting disasters like Waste Management and Sunbeam. Yet investors chose not to look skeptically at companies, such as WorldCom and Enron, that continued to use Andersen. In effect, investors stopped watching the watchmen, and so the watchmen stopped watching, too. In a world in which not all capitalists are Quakers, trust but verify remains a useful byword.

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