Improving Business Practices—and Profits
April 29, 2002
by Irwin Stelzer
The amazing thing about American capitalism is its ability to profit both from its excesses and the subsequent, inevitable reforms. This explains its durability, and the inability of rival ideologies to win more than marginal attention from the American public.
In the latter part of the nineteenth century the so-called “robber barons” built the railroads and established the giant, vertically integrated corporations that came to dominate the steel, oil, and other industries. These free-wheeling entrepreneurs and empire builders over-reached, manipulating share prices, playing games with balance sheets, squeezing out competitors with anticompetitive tactics and, if necessary, physical violence.
The result was Teddy Roosevelt, a trust-busting president who brought to heel what he called “the malefactors of great wealth” by pushing the Sherman Antitrust Act through Congress, thereby laying the basis for the breakup of the giant trusts. As a consequence, American capitalism entered the twentieth century with two huge assets: highly efficient refineries, steel mills, and other factories, knitted together by a superb rail system, and a set of reforms that quieted discontent and put the economy on course to become the world’s most competitive.
When the Great Depression and unsound banking practices and monetary policies almost brought capitalism down in the 1930s, a time when the competing systems of National Socialism in Germany, Fascism in Italy, and Communism in Russia were gaining adherents, another Roosevelt, Franklin, rallied a coalition in support of reforms of banking and financial markets. Again, American capitalism was the winner, ending up with the world’s most efficient capital markets, reformed to eliminate the worst excesses of the Roaring Twenties.
Now we are in the midst of another wave of reform, this one jointly driven by government and by the market. The collapse of Internet and other technology shares, combined with the Enron bust, are reshaping American capitalism every bit as much as the two Roosevelts did in their time. Corporate governance is suddenly a front-burner issue, perhaps more so than at any time since 1936, when two scholars, A. A. Berle and Gardiner Means, predicted that dispersed share ownership in large corporations conferred unchecked power on managers, enabling them to stuff their pockets with perks and with pay unrelated to their performance, without consulting the real owners of the business.
Which is just what happened. It took Mike Milken to bring that party to an end by making credit available to thrusting entrepreneurs who cleaned out the corprocrats and refocused America’s corporations on what businesses are supposed to be about—making money for their owners by lowering costs and improving their product lines. Once again capitalism self-corrected, leaving America with an enormous asset—lean and mean companies that could drive productivity up and participate in a long-running, inflation-free period of economic growth.
Now we are in the midst of another correction. The Internet bubble has burst, but the productivity-enhancing technologies it wrought remain. Enron is gone, but the nation is left with a more competitive energy sector. And with a set of reforms that promise to make capitalism more efficient than ever.
Audit firms are finding that it is no longer acceptable to be soft on the their clients in the hope of winning large consulting contracts. A combination of advisors’ unwillingness to risk the wrath of their investors by tolerating shabby audits, and government regulations will give investors a truer picture of the financial condition of America’s public companies. One of the first things to go may be share option schemes that have not been recorded as expenses by the managers who vote themselves these generous salary supplements.
Corporate audit committees and outside (non-executive) directors are now wary of being co-opted by management, and are likely to be given new powers and resources with which to protect the shareholders rather than the managers that CEO-friendly boards have been so lax in supervising. Business is in a race with governments to get reforms on the table. In Britain, the CBI will soon move from reactive to proactive mode by forming a high-level committee to devise reforms for the way corporations are governed, rather than wait for the government to come up with what might be less realistic suggestions.
Then there are the stock-pickers who, it turns out (Shock! Horror!) have helped their investment banking partners win business by recommending the shares of certain undeserving companies. Or, at minimum, by failing to scrutinize balance sheets with the care that investors have the right to expect of highly paid professionals. Thanks to the increased unhappiness of those responsible for investing the funds of millions of shareholders, and the aggressive attack of New York attorney general Eliot Spitzer on Merrill Lynch analysts who in private emails described as “s***” companies whose shares they were touting to investors, these conflicts of interest are headed for severe regulation or, with luck, the dustbin of history.
So the day may be dawning when investors will be able to base their decisions on appraisals from unconflicted analysts and from rating agencies that have in the past been slow to downgrade the credit rating of falling angels, but are now rushing to keep their ratings in line with the up-to-date realities of corporations’ financial strength.
In addition to the major improvements in corporate governance, the greater integrity of auditing and financial reporting, and more honest analyses by professional share-watchers, there is still another reform: the restructuring of the companies that are the subject of all these changes. More transparent and accurate financial reforms impose severe penalties on companies with loss-making subsidiaries, off-balance sheet debt, and other devices to hide errors. Made transparent, they must be corrected. Investments that have gone sour are being written down to market value; operations that make no sense when properly accounted for are being closed.
The result: a twenty-first century-model capitalism that is outperforming the economies of Euroland and unreformed Japan, economies that many thought would overtake America’s by the end of the last century. Those wishful thinkers hadn’t counted on the ability of American capitalism to self-correct, and then get on with the business of making Americans still richer.
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.