Economists prefer to ignore the influence of culture on the economic performance of nations. It is hard to model mathematically. But most people who study economic history know just how important culture is, even if unquantifiable. And so, while reading the newspaper this morning, I felt like the acerbic Shakespearean character who grumbles ‘lechery, lechery; still, wars and lechery; nothing else holds fashion.’
However, having just read details of the New York attorney general’s lawsuit against Ernst & Young over its role in Lehman Brothers’ financial shenanigans and that Deutsche Bank had joined KPMG in settling with the Justice Department over fraudulent tax shelters the two firms had created, my plaint was “corruption, corruption, still moral hazard and corruption, nothing else holds fashion.”
Having been a history major before turning to economics, I know that neither politics nor business in our country is as corrupt as it was in the last decades of the 19th century. And having spent years in Latin America and having done consulting in the Balkans, I know U.S. business and politics are clean compared with many other countries.
Yet, one cannot ignore the fact that a cold-blooded willingness to spurn ethical considerations and bend — or even break — the law lies at the root of many current economic problems.
One should not prejudge legal cases without knowing all the evidence, but the Lehman case sounds damning. Lehman used financial instruments known as repurchase agreements, or “repos,” to temporarily move tens of billions of dollars of debt off its balance sheets at the end of each quarter so that its financial statements would look better than they actually were, according to the lawsuit. This misled investors considering whether to buy or sell Lehman stock about the true risk and return they would take on, the lawsuit claims.
Lehman also is accused of misleading other firms considering financial transactions with Lehman about its risk as a counterparty. For investors and counterparties alike, these actions prompted bad decisions that caused financial losses.
Ernst and Young’s role was not just that of an auditor that failed to find a discrepancy on the books. Rather, the lawsuit maintains it overtly certified these repos as “true sales” and not as temporary transactions. The accounting firm denies the lawsuit’s claims.
From an economist’s point of view, bad information, whether intentional or not, causes individuals and companies to misallocate resources. This causes economic inefficiency, with fewer of society’s needs and wants being satisfied than could have been the case with better information. It is this inefficiency and waste of resources that is the major cost to society of dishonesty.
The broader the perception that financial markets are a rigged casino, the more hesitant people are to participate in them and the less efficiently capital is allocated.
That correct perception of corruption plagues Russia right now, as U.S. diplomatic cables posted on WikiLeaks noted to the rage of Vladimir Putin. It also plagues India and myriad other developing countries.
For decades, the United States, along with the United Kingdom, Switzerland, and the Netherlands, enjoyed a reputation for honest financial markets. U.S. markets and financial institutions probably remain more honest than those in many other areas. But the alleged actions of the major investment and commercial banks and the largest accounting firms over the last decade are rightly undermining that reputation. We will all pay the price.
The question is how such a trend can be reversed. One instinctive reaction is increased regulation. Sarbanes-Oxley was a reaction to similar conniving by Arthur Anderson with Enron. Among other things, it made executives liable for the honesty of their firms’ financial statements. It is not clear whether federal action against Lehman Brothers is still in the works, but it might be good for the country if former CEO Dick Fuld spent a few years playing checkers with Bernie Madoff.
One also could devote more resources to enforcement of existing laws. One of the great scandals of the ongoing debacle is the failure of the Securities and Exchange Commission, especially under Christopher Cox, to discern any of these shenanigans as they took place. He and other commissioners rather thought it more important to reduce regulation of U.S. firms so they could better compete in a global economy.
However, honesty in business is at its root a cultural value that is not altered greatly by laws or by ethics courses hurriedly tacked onto MBA curricula. U.S. financial markets and firms were substantially more honest in the 1950s and 1960s than they had been in the 1870s and 1880s. They were more honest then than they are now. Exactly why or how such changes come about is beyond the expertise of the discipline of economics. That is too bad.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.