Editor’s note: This is the first of two columns on the importance of good information in economics. The second column is External pressure holds grip on fiscal honesty.
There was a lot of irony in the news this week.
Deceptive corporate financial practices returned to public attention as two separate reports on WorldCom were released, ImClone head Sam Waksal was sentenced to jail and Freddie Mac fired top officials and became the target of a new federal investigation.
At the same time, Gov. Tim Pawlenty and finance commissioner Dan McElroy put in three days trying to convince bond-rating analysts not to downgrade our state’s ratings. Analysts are concerned the state used fiscal sleight of hand to “close” Minnesota’s $4.2 billion budget deficit.
Coming just two weeks after Congress passed the Bush administration’s tax-cutting bill, Minnesota’s scramble to defend its fiscal capers highlights an uncomfortable truth. Practices that are illegal for corporations remain common practice at the state and federal levels of our government.
The WorldCom reports, one written by a former U.S. Attorney General, criticized that firm’s use of one-time cash flows and arbitrary shifts of items between accounting periods to boost reported revenues.
Minnesota’s governor and Legislature just shifted $1.3 billion from one-time reserves and arbitrarily changed when $700 million in revenues and expenses are booked. These two maneuvers account for nearly half of the $4.2 billion gap that we supposedly “closed.”
At the federal level, the Bush tax cut supposedly will total $350 billion over 10 years, but the Congressional Budget Office estimates that it will increase our federal deficit by $61 billion this year alone. The discrepancy between $61 billion in one year and $350 billion over 10 years comes primarily from arbitrary “sunsets” on several of the tax cuts, including the special treatment for dividend income that is the center of the Bush supply-side economic strategy.
If misrepresentation and fraud is so bad in corporate financial reporting, why is nearly identical misrepresentation acceptable by government?
Deceptive reporting by government is just as harmful as that committed by businesses, perhaps more so. However, it is easier to deal with the latter than with the former.
Start with the basics. Both corporate and government misrepresentation of finances are examples of what economists term “information problems” and “principal-agent problems.” Both hurt society by making it less efficient, that is by reducing the level of well being we can achieve by using a given amount of resources.
Investors need accurate information about the financial standing of corporations in order to make sound investment decisions. When numbers are misrepresented, capital will flow to the wrong, less productive, use.
If published accounts frequently are bogus, investors will take precautions, and the cost of capital will be higher than otherwise. Output — goods and services to meet people’s needs — will be lower than it should be.
Just as investors need reliable numbers for capital markets to function well, voters need reliable information for democracy to work. Citizens can only make good decisions about which policies and candidates to support if they get reliable information about the outcomes of different proposed alternatives.
Information will never be perfect in either case, and there always will be honest disagreements on the wisdom of corporate as well as governmental actions. Nevertheless, efforts to conceal the truth inevitably make things worse.
The “principal-agent” issue refers to the fact that while honest information is valuable to both investors and voters and to society as a whole, corporate managers and elected officials both face strong motivations to dissemble. Their personal well-being may hinge on doing something different from what is good for society.
CEOs may face incentives to pump up short-term profits and thus get bonuses, even if it hurts longer-term wealth. Elected officials want to return to office. That often involves pushing problems under the table until after the next election.
Neither the media nor the public is blameless in all of this. News reporting is a business, subject to the same competitive pressures as any other business. Uncovering fiscal misrepresentation by corporations or government seldom results in catchy stories that grab readership. Moreover, our experience in recent years demonstrates that both investors and voters like hearing exactly what they want to hear. XYZ stock is going to go up and up in price. Candidate ABC will cut taxes without decreasing services.
It is no different from raising children. If lying is rewarded, children, CEOs and elected officials keep on lying.
The irony is that most public officials are honest, just as are most corporate managers. The problem our society faces is designing institutional structures that reduce incentives for individually honest people to collectively do dishonest things. Possible solutions are different for government than for businesses. However, the whole question is too broad to deal with in one column so we will return to it on Sunday.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.