Friday, October 06, 2006
Corporate Scandals, Economic Crises, and the State
Karl Marx predicted that the successive economic crises, which are inherent to the capitalist system, would eventually lead to revolution and to the downfall of capitalism. Max Weber contradicted this view in a speech held in
This latter view is highly relevant to the contemporary debate on corporate governance. In fact, an analogy can be made between economic crisis and corporate scandals. Of course one could object that a corporate scandal, involving only one company, cannot be compared to a full-scale economic crisis that can menace the wealth of an entire population. Right…but still, if we look at the size of modern companies, the analogy does not seem that far-fetched after all. Multinational companies (MNCs) have annual sales that exceed the GDP of not just some poor sub-Saharan states but of quite large European countries (e.g. the sales of Ford exceeded the GDP of the
Be that as it may, Max Weber’s prediction has been supported by evidence from many crises and scandals throughout the 20th century. From the ‘Kreuger Crash’ triggered by the suicide of the Swedish ‘Match King’ Ivar Kreuger on March 12, 1932 in Paris, to the failures of Enron and WorldCom, corporate failures have often had as a consequence an increased activism by policy makers and major changes in the legal framework governing the economy. And there are certainly good reasons to do so. In fact, corporate failures and economic crises are bad for those involved, but good for people who are interested in understanding the functioning of the economy. In fact, crises and scandals reveal the functioning of the economy much better than any other economic phenomenon. They reveal loopholes in the existing legislation, and allow us to learn a great deal about economic practices that develop in between the lines of the legal text. This can be profitable to policy makers. In fact, policy making is of course much easier with the benefit of hindsight. So, why should the state not learn from past mistakes and integrate the new insights in new laws?
Well, many examples show that the scurried adoption of legislation subsequent to a scandal might not always lead to the best results. Take the Sarbanes-Oxley Act of 2002, which was adopted right after the Enron and WorldCom disasters when the gun was still smoking. Of course, this piece of legislation brought about some improvements notably concerning accounting rules. However it was adopted – under the pressure of the popular outrage – first and foremost in order to show that politicians are capable of effective crisis management. The result was a not so well thought-out law that introduced arguably unrealistic dispositions implying enormous costs for companies. The compliance costs with the SOA were especially for smaller companies completely out of scale so that the Securities and Exchange Commission (SEC) eventually proposed to exempt them from compliance at least with section 404 of the SOA (Report of management on internal control over financial reporting).
A similar precipitous law could be adopted in
Such a rule may seem sensible at first glance. Especially if one thinks of another – minor – recent scandal that implied one of the investment companies belonging to Bank am
Hence, ‘parallel trading’ is clearly not the most urgent problem – if it is a problem in the first place – that the legislator should tackle. In fact, Here, policy makers propose – under the pressure of public opinion and because an opportunity window for new regulation was opened by the scandal – to regulate a question, which is not even remotely responsible for the actual scandal. The question is if politicians are aware of the fact that they are off the mark concerning this question, but just don’t care, or if this the result of overhasty policy making. Be that as it may, rather than firing a snapshot in the heat of the battle, what the Swiss Parliament should do in this situation is continue the reform of pension fund surveillance that was commenced by the Federal Government before the Swissfirst scandal. Maybe for once the proverbial slowness of the Swiss decision making process can have a positive effect in the sense that in a couple of weeks factual and dispassionate problem-solving could be possible again …
Very interesting point you're making indeed! Maybe I’m too much influenced by the ubiquitous complaints by liberal economists, politicians but also by normal citizens that our actions are more and more constraint by laws and regulations...
The US banking law you’re referring to was the Glass-Steagall Act (GSA) of 1933, which prohibited banks to be active at the same time in commercial and investment banking (see http://www.investopedia.com/articles/03/071603.asp). This law put thus a term to the universal bank system as we know it notably from Germany and Switzerland. It was indeed a reaction to the 1929 stock market crash and the following failures in the banking sector. The GSA was finally abolished in 1999.
I think one could find other examples for a cyclical regulation and deregulation processes. But I still have the feeling that even when regulations are abandoned, this happens in a ‘regulated way’ (the social scientist Steven K. Vogel talks of “freer markets, more rules” ). This may sound paradoxical, but if you think of capital markets for instance: in many countries restriction on capital movements and on different financial instruments have been considerably weakened. However, there is always some kind of "shadow of the state"; some save-guards. The risk-aversion of our contemporary societies, it seems to me, makes that just abolishing rules is not acceptable; deregulation happens in a controlled way.
Of course, there are phenomena, which just were not taken into account by regulators, either because they were not considered to be important, or because they simply didn't exist at the time the regulations were established. Think for instance of the hedge fund industry were regulations in most countries still are very embryonic, or even inexistent. To be sure, once a major scandal involving hedge funds will occur, new regulations will follow. A first hint at this can be seen in the crisis of Amaranth - a US hedge fund - that lost about half its value ($ 5b) in two weeks this September. This will certainly spur the claim for increasing regulation. (A first attempt by the SEC to regulate the hedge fund industry was made in 2004. However, this decision was overruled by an appeal court shortly after) (NZZ, September 19, 2006).
It may very well be that such a new regulation will - because of the impact of the crisis on public opinion - go rather far. But then eventually, once the scandal is a thing of the past and public opinion starts to worry about other things, the interested actors’ claims for a weakening of the law might be heard by politicians and steps could be taken to attenuate the measures. I think that's about what is happening with the SOA and it’s a plausible story in general. But of course, one should think about the cyclical nature of scandals and regulations more systematically!
The major problem however with assessing if there are cycles of regulation and deregulation or not may be linked to the length of these cycles. The example of the GSA that you mentioned for instance shows that they can be rather long. In fact, 60 years passed between the coming into force of the law – followed by a phase of rather increased regulation – and its eventual abolition.
At a very macro-level one could identify the following phases: a first phase of unregulated modern capitalism during the 19th century (what is usually called the “founding years”); an increasing role of the state in regulating the economy starting in the late 19th, early 20th century and lasting most of the 20th century; and finally the liberalisation and deregulation frenzy starting in the 1980s. With one phase lasting for 80 or so years, it might be that we just don’t have enough historical distance in order to really judge if it’s a story of cycles or just of ups and downs that do not reveal any systematic pattern. Or, maybe if we look at different industries particular, such phases of regulation and the regulation would appear to be shorter? Anyway, very interesting questions…
Anyway, the issue of perverse effects of a legislation, which you raised in your post, could be yet pushed a little bit further by taking this kind of legislation as a form of risk management, or say, meta-risk management, as Grabosky calls it. That is, firms invest in the management of their own risks, and public authorities make sure they do this well by giving them a more or less constraining framework to follow. By so doing, they are a part of the risk management. Now, if you put it this way, it is in no way certain that self-regulation of risk management would not produce its own internal perverse effects (which public legislation could counterbalance), just as public legislation could produce perverse effects in its own right...
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