How Not to Combat Corporate Corruption

Article excerpt

The recent and unusually rich spate of corporate fraud by creative accounting has set off two streams of verdicts. One condemns capitalism as a rule system that has no moral and cultural foundations of its own. When the foundations it has inherited from earlier rule systems get eroded by wear and tear, capitalism becomes a source of iniquity and corruption. It is intrinsically evil, cannot be reformed, and must be done away with.

This view is an evergreen. Besides its other weaknesses, it ignores a clear lesson of history. Every rule system ever tried by mankind that was not based, as capitalism is, on finders keepers, the protection of ownership, and the freedom of contract has been found to be at least as corrupt and iniquitous as capitalism, and also much less able to relieve poverty and deliver the material prosperity all save saints crave. Anti-capitalists seem never aware of tangling themselves up in this self-contradiction.

The other, reformist stream accepts the ground rules of the system, albeit with reservations about the freedom of contract. However, it believes the system generates abuse by virtue of its increasing complexity. To stamp out abuse, the ground rules must be supplemented by regulations that, too, must become increasingly complex and demand vastly larger resources for their operation and enforcement.

However, going down the regulatory path may not turn out to be an advance. The more elaborate the regulations, the more elaborate become the abuses that evade them. The cost of enforcement keeps going up, and the operation of the regulated economy grows progressively more cumbersome, lawyer-ridden, and sluggish. At some point, the game is no longer worth the candle. Where this point lies is a matter of subjective judgment rather than cost-benefit measurement. Maybe we are still short of it, maybe already past it. The answer is not as important as is the constant awareness that such a point exists.

Instead of flailing blindly at the elusive white-collar crook, and writing reams of new laws and regulations, we should first seek a clearer understanding of what we are dealing with. Corporate fraud is a contingent but probable byproduct of the fundamental principal-agent relation that results when ownership and management are separated. (More generally, principal-agent problems arise when a function is carried out by an agent whose participation in the costs and benefits generated by the function differs from those of the principal. The most important principal-agent problem seems to be the one between society and its government.) The principal-agent problem separating the shareholders from the managers of a corporation is the price the former must pay for the specialized skill, attention, and effort the latter bring to the enterprise. It cannot be avoided altogether without abolishing the agents and requiring the principals to step in their place, that is, without reverting to owner management. Doing so would bar multiple ownership and throw away the advantages of the division of labor. Short of that, the problem can be mitigated by intelligent use of the freedom of contract.

The early forms of getting round the problem were to motivate the salaried manager by a pay raise or some ad-hoc reward for success, a bonus. More systematically, he would be entitled to profit-sharing according to some formula. This had obvious drawbacks, encouraging short-- termism, a bias to seek profits even by risking unduly high losses, as well as a weakening of the enterprise through the cash outflow going to the manager. An improved solution seemed to be offered by the stock option, two incendiary words that act as a red rag to set off much current fury, some of it misplaced, some not. The stock option does not encompass the whole corporate principal-agent problem, but is certainly at the heart of it.

Like profit-sharing, the stock option rewards profits and fails adequately to punish losses and recklessness, particularly while the option is "out of the money. …

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