The Conflicts of Interest Driving US Financial Scandals are Being Replicated on a Global Scale

Of late, there has been much discussion of corruption in the public sector of many developing countries. It was inevitable corruption of public servants that, in part, made it important to privatize in developing countries. Advocates of privatization also lauded the private sector's ability to compete. But I'm not sure these private sector advocates quite had in mind the abilities that American corporate capitalism has demonstrated so amply recently: corruption on an almost unfathomable scale. They put to shame those petty government bureaucrats who stole a few thousand dollars or even a few million. The numbers bandied about in the Enron, WorldCom and other scandals are in the billions, greater than the GNP of many countries.

With perfect information - an assumption made by traditional economics - these problems would never have occurred. With perfect information, shareholders would instantaneously have realized that the books were being cooked, and roundly punished the corporate officers. Instead, because of tax advantages and inappropriate accounting practices - which received support from the US treasury under both Republican and Democratic administrations - firms were encouraged to reward their executives handsomely with stock options. By this means, corporate officers could ensure that they were extremely well paid, without at the same time taking out anything from the corporation's bottom line. It was almost too good to be true: while executives were receiving millions, no one seemed to be bearing the cost.

It was a mirage: shareholder value was being diluted. But it was worse than just being dishonest: stock options provided managers with strong incentives to get the value of their stocks up quickly - what mattered was not long-term strength but short-term appearances. Corporate officers responded to the incentives and opportunities. Over the last 15 years, executive rewards in America have soared, and so has the fraction of it which is related to stock prices - to the point where the fraction related to real long-term performance is quite small. Effectively managers have been discouraged from looking at these fundamentals.

Incentives matter: but inappropriate incentives do not lead to wealth creation - they lead to the massive misallocation of resources, the consequences of which America is now suffering. Over inflated prices have led firms to over invest. More generally, when information is imperfect - as it always is - Adam Smith's invisible hand, by which the price system is supposed to guide the economy to efficient outcomes, may disappear. With the kinds of incentives that were in place in corporate America, there was a drive for the creation of the appearance of wealth, not for the creation of actual wealth.

By the same token, auditing firms that make more money from consulting than from providing auditing services have a conflict of interest: they have (at least in the short run) an incentive to go easy on their clients or even, as consultants, to help their clients think of ways to improve the appearance of profits - "within" the rules. Analysts at investment banks that earn large fees from stock offerings may, as we have seen, have an incentive to tout the stocks, even when they have their doubts. And if they have a commercial bank division, they may have an incentive to maintain credit lines beyond the level which is prudent, simply because were they to cut them, they risk losing high potential future revenues from mergers and acquisitions and stock and bond issues.

But the problem of incentives can be traced back further: the US treasury had an incentive to urge the continuation of the bad accounting practices (as it did in the mid-1990s): it responds to the interests of Wall Street, and the financial community benefited as much as did the corporate executives from the artificial boom and bubble to which it contributed. The accounting firms had an incentive to try to squelch the Securities and Exchange Commission's attempt to limit the conflict of interests between their role as auditors and consultants. The banks had an incentive to push the US treasury for the repeal of an act which required the separation of investment and commercial banks.

These examples illustrate the intertwining of public and private incentives: there are private incentives to distort public policy in ways which in turn distort private incentives, and sometimes to prevent public policy from correcting market failures. These problems arise at both the national and international levels. And the public, as they have recognized this vicious nexus, have occasionally taken actions to break or at least weaken it.

It is, for instance, precisely because we worry about distorted incentives of public officials that many democracies have instituted rules against revolving doors. There is a suspicion of government officials who too quickly move to jobs related to their public role. We worry about conflicts of interest in the private sector - accounting firms that make more money from lucrative consulting practices may be soft in enforcement of accounting standards - and in the public. There is a cost to the restrictions intended to limit (though they seldom eliminate) such conflicts of interest. In the case of the public sector, such restrictions sometimes deter qualified individuals from accepting public employment. Such restrictions are imposed because of imperfect information: we cannot really be sure what is motivating individuals. And there is a high cost to the loss of public confidence - a price which in the case of the private sector is reflected in the billions of dollars lost from share value.

In my book, Globalization and its Discontents, I observe that there seems to be no such rule on revolving doors in place at the International Monetary Fund [ IMF ]; its first deputy managing director moved from his senior public sector job to the vice-chairmanship of one of America's largest financial institutions. The IMF is widely viewed as reflecting the ideology and interests of the financial community, of responding more to its concerns than those of the developing countries it is supposed to be helping. In Indonesia, there were billions of dollars to bail out foreign creditors, but paying out far smaller sums to provide food and fuel subsidies for those thrown out of their job or who saw their wages plummeting was viewed as a waste of money. Western banks benefit from such bail-outs.

The IMF is a public international institution, but critics claim that it is not democratically accountable - and that as the central bank governors to whom it reports increasingly become more independent, it is becoming even less so. The lack of sensitivity to the problem of revolving doors - and the lack of rules which reflect that sensitivity - only reinforces such sentiments.

Conflicts of interest will never be fully eliminated, either in the public or private sector. But by sensitizing ourselves to their presence, by increasing required disclosures - as the old saying goes, sunshine is the strongest antiseptic - by becoming aware of the incentives that are in place that can exacerbate these conflicts of interest, and by imposing regulations that limit their scope, we can do much to mitigate their consequences, both in the public and the private sector.