Guilty! … Guilty! … Guilty! Judge Sim Lake’s reading of the jury’s findings had a staccato rhythm to it. Lay, who was standing not with his lawyers but in the front row of spectators close by his wife, Linda, clutching her hand, turned red, his face strained. Skilling responded with a peculiar smirk. The prosecutors remained impassive, but celebrated later that evening at a Houston tapas restaurant, clearly relieved to have won.

Why was this such a “great” victory for federal prosecutors? McLean goes on:

Let’s acknowledge some unambiguously positive implications of the Enron verdict. First, it finally offers a measure of consolation – or retribution – for those employees who lost everything in Enron’s bankruptcy. And it reinforces a critical notion about our justice system: that, despite much punditry to the contrary, being rich and spending millions on a crack criminal defense team does not necessarily buy freedom.

The response from journalists and politicians across the country was unanimous: Enron was a fraudulent entity and a number of executives and employees got what they deserved by going to prison. However, I have been among the critics not only of the verdicts, but also of the government’s conduct throughout this sorry affair. Thus I am part of a larger public effort to tell people there is another side to the story.

Before going further, however, let me say that Enron’s demise should not have been a surprise, as it was a product of the Federal Reserve’s late 1990s boom. Alan Greenspan’s easy-credit regime permitted Enron and other firms to boost their stock prices to levels well above where the fundamentals said they should have been. Furthermore, because it was too easy to borrow money and paper over fundamental issues, Enron’s leadership began to believe the “Masters of the Universe” accolades that came from a then-worshipful financial press.

When the stock bubble burst and interest rates went back up, Enron’s leadership was in a hard place. Available cash dried up, and the company was leveraged well beyond its capacity to fund that debt service and still pay its bills. In short, even though Enron was riding high during the boom, it clearly was not prepared for the bust, which none of the leadership really understood. (The late Ken Lay, Enron’s chairman for many years, was a Ph.D. economist, but he should have received an education in Austrian economics; at least then he might have understood why his company was in so much trouble.)

Short Sellers Not to Blame

Lay’s contention that Enron was “done in” by short sellers was incorrect. Short sellers exposed Enron; they did not bring it down. When the market spoke, it spoke harshly, and both Lay and Skilling, who had almost all of their wealth tied up in Enron stock, lost millions.

Unfortunately, federal prosecutors are armed with “legal” weapons that permit them to criminalize all sorts of entrepreneurial error, and I believe Enron was such a case. As Harvey Silverglate has noted in his classic book, Three Felonies a Day, Enron’s accounting methods were legal and Enron reported the details in its financial documents. However, the legality of what Enron’s leadership did was not an obstacle to federal prosecutors, and that hardly should surprise anyone, given the absolute power that federal officials have in this country, something I pointed out in my column last week.

I am participating with attorneys and other economists and financial experts in a project that urges people to take another look at the Enron story, called “Ungagged.” We take a hard look at what really happened, and we also scrutinize the government’s conduct and find it wanting. (Subornation of perjury was a favorite tactic of federal prosecutors. Houston attorney Tom Kirkendall has an excellent account of one incident on his own blog.)

There is another story to tell about Enron, and I am helping to tell it.

Bradley, who worked for 16 years at Enron, becoming a confidant of CEO and Chairman Ken Lay, devotes many pages to the company, perhaps the most spectacular business failure in American history. Many readers will be surprised to learn that Enron was extraordinarily dependent on political favors, a perfect example of crony capitalism. Bradley digs deep to expose the real causes of Enron’s demise, but he goes much further, showing that Enron was but one instance of the ruinous relationship between government and business.

Bradley makes his case in three parts: Heroic Capitalism, Political Opportunism, and Energy and Sustainability.

Each chapter in Part I is devoted to an individual whom Bradley considers a heroic, as opposed to a political, capitalist—that is, an advocate of free markets. Readers of The Freeman will be familiar with Adam Smith and Ayn Rand, but most likely will be unfamiliar with the Scottish moralist Samuel Smiles, whom Bradley calls “the father of the self-improvement movement.” Bradley’s profiles help delineate the positive moral ground of capitalism: self-reliance, respect for the rights and property of others, cooperation, abiding by one’s contracts, and so on.

In Part II Bradley drives home the point that political capitalism is the “intersection of business opportunity and political opportunism.” Here he vividly contrasts the positive features of free markets with the grubby, furtive nature of political capitalism, which hinges on “connections,” favoritism, and secret deals to make profits, injure competitors, and pin losses on taxpayers.

Bradley throws a wider net than we usually see in the pro-market literature. In chapter 4, for example, he discusses the influence of business writers such as Gary Hamel, Peter Drucker, and Jim Collins. He even includes a well-informed section on accounting principles, where he warns against the “invited manipulation” of fair-value accounting. And chapter 6, “U.S. Political Capitalism,” includes numerous examples of industry representatives scheming with politicians to establish government rules and regulations (and entire agencies) to limit competition for the benefit of the current members of the industry at the expense of new competitors, consumers, and taxpayers. The alarming truth is that political capitalism is slowly strangling heroic capitalism.

In Part III Bradley enlightens the reader on many issues relating to the production of energy. “The Dark Decade,” for example, focuses on the foolish governmental meddling in energy from Nixon to Carter. It’s an especially timely topic, given the Obama administration’s infatuation with “green energy” schemes that require government financial support.

At the end of the book Bradley turns to Enron. He describes its founder, Ken Lay, as a “Ph.D. economist, interested in the big picture and the ways of political power. His résumé was top-heavy with Washington experience, acquired at three federal jobs, the last two regulating the energy industry.” As Enron’s CEO he was the master of the government-favor game.

Bradley gives examples of how Enron played both sides of the political aisle and how it “politicized” its tax and accounting systems to create the illusion of profitability. Bradley states that Enron “was a logical, albeit grotesque, outcome of the mixed economy writ large.” Most Americans think that Enron’s collapse shows some inherent weakness in capitalism, but what Bradley shows is that it rose only because Lay and others in the firm knew how to game the political system. Equally important, Enron’s collapse came about because investors in the world of real capitalism finally discovered that the company was a hollow shell and dumped its stock.

Bradley’s Capitalism at Work is actually the first book in a planned trilogy called Political Capitalism. The forthcoming volumes are titled Edison to Enron and Enron and Ken Lay: An American Tragedy. I’m looking forward to both of them.

by Goetz Aly

Metropolitan Books • 2007 • 431 pages • $32.50

Reviewed by Richard M. Ebeling

In Hitler’s Beneficiaries, German historian Goetz Aly “focus[es] on the socialist aspect of National Socialism” so as to better understand “the Nazi regime as a kind of racist-totalitarian welfare state.”

Since the 1930s many historians on the left have tried to portray Nazism as an extreme right-wing system meant to preserve and serve the German capitalist order. The use of the word “socialist” in the full name of the Nazi movement—the National Socialist German Workers Party—has been interpreted as a ruse meant to manipulate and deceive the people of Germany.

Aly emphasizes that the ideology and practice of the Nazi regime were in fact deeply socialist. Within Germany, among the German people of “pure Aryan blood,” the ideal was an egalitarian social order in which every German would be freed from traditional class barriers so that he might have the opportunity to rise to any level of success in serving the fatherland. The welfare-state policies begun by Bismarck in late nineteenth-century imperial Germany were viewed by the Nazis as a prelude to a complete guarantee of a quality standard of living for all “real” Germans that would be paternalistically provided by the National Socialist state.

The problem was that the promises of the welfare state could not be fulfilled within Germany’s 1933 borders. If the German people were to have this material paradise on earth, someone would have to supply the manpower and the resources to provide the means for this massive redistribution of wealth.

Aly points out that before and during World War II, the German “capitalist class” was made to pay its “fair share” for the benefit of the rest of the German people. Taxes were proportionally far higher on the “rich” in Germany than the rest of the population. During the war the government established mandatory overtime pay in all industries and imposed wage increases to keep “the masses” loyal to the regime—all at the expense of German business. At the same time, German industry worked under government-commanded four-year plans from 1936 until the end of the war in 1945.

But it was only after the war started that the machine of redistributive plunder was really set into motion. Every country overrun by the German army not only had to pay the costs of the occupation, but also was systematically looted for the benefit of the German population as a whole.

Aly’s book is remarkable because, rare among histories of the period, it explains how the Germans used inflation to loot the occupied countries. After most of France was occupied in June 1940, German soldiers were issued scrip that by mandate had to be accepted by French businesses. Retailers willingly accepted the scrip because the Nazis also mandated French banks to redeem it in francs; the banks in turn could redeem it for francs it at the Bank of France. The only way for the French central bank to meet this obligation was to print more money. With some variation Germany did this in every country it conquered.

German servicemen stationed in occupied Europe were regularly given scrip bonuses at holiday times so they could buy up virtually anything and ship it to family and friends. Thus along with the soldiers, tens of millions of Germans back home benefited from the inflationary plunder of Europe.

On top of this the German government imposed taxes and surcharges on the governments in the occupied countries—their contribution to Germany’s establishment of the “new order” for the “benefit” of all the people of Europe. In many cases the redistributive tax burden was larger than the nation’s annual prewar budget.

Both within Germany and around the rest of Europe, the great “enemy” that the Nazis were determined to eliminate was the Jews. Before the war the regime had attempted to pressure German Jews to leave the country. After the war began the government was determined to expel all Jews in western and central Europe to “the East.” Finally, the “solution” to the “Jewish problem” was found in the concentration and death camps.

But beginning in 1941 and 1942 the expelling of Jews from Germany and the rest of occupied Europe was accelerated as part of the Nazi welfare state. When Britain began to bomb German cities, first thousands and then tens of thousands of Germans found themselves homeless, with all their belongings destroyed. Municipal governments, with the approval of the Nazi leadership in Berlin, began to confiscate the Jews’ houses and apartments, including the contents, to make room for racially pure Germans needing new places to live.

In every occupied country the Nazis initiated similar confiscatory policies with local accomplices with whom they shared looted Jewish property. (Only in Belgium and Denmark did large segments of the population and the bureaucracy resist participating in this plunder of the Jews.) The Nazis first nationalized Jewish property and then distributed it to those deemed worthy among the German or occupied populations.

Hundreds of trainloads of stolen Jewish property were either given away or sold at discounted prices in German cities, large and small, throughout the war. Aly estimates that because of this looted property and the goods sent back to Germany by soldiers, many, if not most, Germans enjoyed a more comfortable standard of living throughout most of the war than the civilian population in Great Britain.

What also fed a large part of this Nazi plunderland was the invasion of the Soviet Union in June 1941. In the East, Hitler wished to show none of the minimal “niceties” with which the people of western Europe were treated. The vast and rich lands of Russia and Ukraine were to become the economic Promised Land in the Nazi dreams of the future. Under the plan at least 20 million Russian peasants would be worked and starved to death in the countryside after a German victory to make room for a huge German resettlement that would provide the living room for the Aryan race. The cities of Moscow and Leningrad were to be razed, their populations left to die.

Besides the official plundering of the Soviet cities and countryside, there was a vast black market at work in the East that left those under German occupation with almost nothing.

The vast majority of German families continued to feast, even under the allied bombings, thanks to the locust-like seizure of anything and everything across occupied Europe. Aly estimates that during the five-and-a-half years of war, the Nazis plundered $2 trillion worth of property, goods, and wealth from the peoples of Europe—a large sum by any standard, but truly huge considering the much lower levels of output and income in Europe 70 years ago.

Of course, the German people finally paid dearly for their adventure into international welfare redistribution through war. When Germany finally surrendered in May 1945, millions of Germans had been killed in the conflict, all the major cities of the country were in ruins, capital accumulated over decades was destroyed, and Germany was occupied and divided by the victorious Allies for more than half a century. It was high price for pursuing the ideal of National Socialism.

* * *

The Big Ripoff: How Big Business and Big Government Steal Your Money

by Timothy P. Carney

Wiley • 2006 • 241 pages • $24.95

Reviewed by Sheldon Richman

Timothy Carney has written a refreshing book. There is no shortage of books critical of big business, but almost without exception their authors are hostile to free markets. Carney is an avowed fan of free markets and a critic of big business’s collusion with government—collusion that enables businessmen to gain profits they could never obtain under free, open, and unprivileged competition.

The Big Ripoff is a myth smasher. Leftists and rightists alike tend to think that business people favor laissez faire, which is well defined as the political-economic system that lacks any government-sponsored privilege. But it is a rare business person who wants the government out of the picture. Free competition is nerve-wracking. It respects no vested interests or historical market share. As Frank Sinatra sang, “You’re ridin’ high in April, shot down in May.” Those darn consumers are fickle. So business people (including agribusiness people) have lobbied for regulations, licensing, price floors, price ceilings, codes, inspection, tariffs, import quotas, subsidies, loan guarantees, taxes, tax exemptions, eminent domain, and more. It is easy to assume that no big company would want new taxes and regulations, until one realizes that those things burden smaller and yet-to-be-started companies more heavily. Government impositions are de facto subsidies and barriers to entry.

Big companies have had no trouble getting such things from Congress and the various state legislatures—because another myth is that government tends to be hostile to business. In a mercantile society such as the United States, business people are highly influential. Politicians see them as indispensable to economic stability, jobs for constituents, even labor peace, and hence want to keep them happy. Business has always had political clout in America, both nationally and locally. The period usually regarded as the most hostile to business, the Progressive Era, was nothing of the sort, as historian Gabriel Kolko documented in The Triumph of Conservatism. To his credit, Carney appreciates Kolko’s research and helps to dispose of the fairy tale that statism in the early twentieth century was the product of Marxism and other foreign left-wing imports. While “progressive” intellectuals saw opportunities for power and prestige in the rise of American-style corporatism, they were riding the coattails of the Morgans, Rockefellers, Carnegies, and others who turned to the state to tame unruly (read: competitive) markets. (This is not to overlook the relatively few true entrepreneurs described by Burton Folsom in The Myth of the Robber Barons.)

Things haven’t changed much since the Progressive Era. In our time business people are as influential as ever, perhaps more so. And the influence is rarely in the direction of more economic freedom. Carney documents the quest for corporate welfare (which, curiously, gets much less attention from the right wing than that other kind of welfare), regulation, taxes, and environmental—yes, environmental—controls.

Do you want to know why Phillip Morris joined the “war on tobacco,” why General Motors pushed for clean-air legislation, why Boeing supports the Export-Import Bank, why Archer Daniels Midland likes ethanol, and why the Chamber of Commerce often supports higher taxes? Do you think Enron was a creation of the market and supported general deregulation? Read Carney’s book to find out.

The Enron story is valuable because misunderstanding about that company has provided an abundance of ammunition against the deregulation of energy markets. “Most analysts use the term deregulation to describe the setting in which Enron thrived, deceived, and then collapsed. But in nearly every corner of the Enron tale, we can find the fingerprints of big government,” Carney writes. If Enron’s CEO, the late Ken Lay, was what a New York Times reporter called him—“an evangelical believ[er] in free markets”—then Britney Spears is up for Mother of the Year.

Would a free-marketeer have called for a government bailout when his company began to collapse? (Fortunately, Lay didn’t get it.) While running the company, would he have supported export subsidies, energy regulations and price controls that favored Enron’s interests, and the Kyoto Protocol limiting carbon emissions? Obviously not. So why did Lay do it? Because he had no principled objection to using government power—physical force—to advance his company’s fortunes (not to mention his own).

Carney’s reporting clarifies our understanding of political economy. Regulation and taxation are anti-competitive. Incumbent firms don’t like competition, so they like intervention. But competition is good for worker-consumers because their welfare is enhanced by unhampered bidding for their business and services. Thus they constitute the real natural constituency for the free-market movement.

* * *

Income and Wealth

by Alan Reynolds

Greenwood Press • 2006 • 223 pages • $55.00

Reviewed by George C. Leef

Writing in the Wall Street Journal shortly after the 2006 election, Jim Webb, the victorious U.S. Senate candidate in Virginia, argued that the American economy has become a rigid class system. The rich are getting richer while the poor are getting poorer. Top business executives used to earn about 20 times as much as average workers, but now they’re raking in more than 400 times as much, Webb complained. The United States, he said, was “literally a different country” from the one in which he grew up. Webb viewed his election and the Democratic takeover of Congress as proof that people want the government to do something about this horribly unfair situation.

Many other politicians and writers have repeated this economic indictment, which has political “traction” both with the envious poor and the guilt-ridden wealthy. As Alan Reynolds shows in Income and Wealth, however, the indictment should be summarily dismissed since it is based on misleading statistics and tendentious rhetoric. H. L. Mencken once wrote that politics is just about frightening people with “an endless series of hobgoblins” to keep them clamoring for politicians to protect them. After reading Income and Wealth, it’s clear that the campaign to convince Americans that we face disaster unless the government does something about “the income gap” is another of those hobgoblins.

The first point Reynolds, a senior fellow at the Cato Institute, makes is that the current frenzy over inequality has nothing to do with poverty. Back in the 1960s and 1970s, “liberals” worried about the poor and there was a national debate on how best to improve the lives of people at the bottom of the income scale. That changed in the early 1990s. “Starting around 1992,” Reynolds writes, “inequality began to be redefined in such a way that nearly all the attention shifted away from the troubles of the bottom quintile to the high incomes of the increasingly tiny number of people at the top.” (He doesn’t speculate on the reasons for that shift. My surmise is that the leftists knew they had gotten all the mileage they could out of the plight of the really poor—after all, the government had been running all sorts of antipoverty programs for decades without much success—so they decided to fashion a new “issue” out of the enormous wealth of a few.)

Creating this new issue called for resourcefulness to make people think that dark, momentous changes were occurring in the economy. There have always been some super-rich; the trick was to get people up in arms by suggesting that those people were profiting unconscionably at the expense of the disappearing middle class. Reynolds easily refutes that idea. The middle class isn’t disappearing, although quite a few people who used to earn “middle class” incomes now earn significantly more—scarcely a problem.

Furthermore, it’s not true that the earnings of middle-income workers have been “stagnant” since the 1970s. That illusion, Reynolds shows, is based largely on the fact that due to tax-law changes in 1986, increasing amounts of investment income common to middle-class people no longer show up in income-tax data—401(k) and college savings plans, for example. Other changes in tax law tend to have the opposite effect on the reported income of the wealthy. If instead of looking at income-tax data, you look at data on consumption spending, the whole “crisis” vanishes.

Another major component of the “income gap” mania is supposedly excessive compensation paid to business executives. Is it really the case that the average CEO now makes more than 400 times as much as the average worker? No. Reynolds handily demolishes the notion that greedy CEOs are robbing workers (or, more plausibly, stockholders) of money that should be theirs.

What’s really going on here is an elaborate cover for a host of interventionist policies desired by various special-interest groups. “Nobody who uses income distribution figures as an argument for adopting their pet government policies would advocate different policies even if they could be persuaded their statistics are wrong,” Reynolds observes. Those who are against free trade, for example, cite the “shrinking middle class” as an excuse for protectionism. For union advocates, the same myth serves to justify their desire for new pro-union laws.

Not only is there no “income gap” problem, but the remedies offered would be economically harmful. In his concluding chapter, Reynolds makes the case that laissez-faire policies to reduce the size and meddlesomeness of the government will continue the real trend in our economy: the rich get richer and the poor get richer, too. If, however, we adopt the policies of the egalitarians and interest groups, we actually will “improve” the income gap. Everyone would be poorer, but the wealthy would lose proportionally more.

Reynolds has given us an important and timely book, a refutation of the economic equivalent of the global-warming scare.

* * *

The Sarbanes-Oxley Debacle What We’ve Learned; How to Fix It

AEI Press • 2006 • 135 pages •
$25.00 paperback

The Joy of SOX: Why Sarbanes-Oxley and Service-Oriented Architecture May Be the Best Thing That Ever Happened to You

by Hugh Taylor

Wiley • 2006 • 283 pages • $50.00

Reviewed by Barbara Hunter

These two books cannot really be considered two analyses of the Sarbanes-Oxley Act, which was signed into law in 2002 following several high-profile corporate scandals. The first book examines the law, its effects on the conduct of publicly traded businesses, and its failure to accomplish its purported purposes of preventing fraud and restoring investor confidence. The second simply adopts the thesis that Sarbanes-Oxley is a beneficent and effective law and that all that is required is to learn the best methods for compliance.

The Sarbanes-Oxley Debacle raises an issue rarely so much as mentioned in the voluminous literature on this law: the return on investment resulting from time, money, and talent expended on behalf of the law’s many requirements. This is no small matter when considering a law whose annual direct compliance costs on business run into the billions.

The cost figures bandied about in the popular financial press ignore the manner in which the law now influences the minutiae of individual corporate decision-making when the shadow of bureaucratic enforcement hangs over every decision, from internal production methods to mergers and acquisitions. This must inevitably produce a significant opportunity cost that will, to some extent, deter risk-taking in business. Professors Butler and Ribstein make that point very clearly.

Another unique point in this book, and one that has been virtually ignored by other writers, is that no combination of laws and penalties can produce total protection from fraud at every possible level within a company. Thus shareholders may understandably accept the possibility of some level of fraud if, on the one hand, its influence on the company’s bottom line is considered insignificant and, on the other hand, the cost (in time and money) of ferreting out every such conceivable instance is exorbitant.

The book further notes that Sarbanes-Oxley circumvents and in effect nullifies existing state laws that may have been more effective than the new law, and federalizes yet another field that historically has been within the purview of the states.

For such a slim volume, The Sarbanes-Oxley Debacle manages to include a startling number of significant arguments relating to the deleterious effects of this ill-considered law.

A review of The Joy of SOX needs to be tempered by the fact that its author is an officer of one of the ever-growing number of companies dealing in computer programs devoted largely to compliance with the Sarbanes-Oxley Act. In light of this, it may not surprise the reader that Sarbanes-Oxley’s negatives, especially its compliance costs, are never mentioned. Even within this perspective, however, its exuberant embrace of the law occasionally borders on the absurd. The author goes so far as to dismiss those who contend that the costs of the law exceed its benefits as “whiners.”

Taylor assumes that Sarbanes-Oxley places everyone on the same compliance basis and thus is not a problem. Sadly, experience has demonstrated that the cost of compliance is far from equal; in fact, its burden on small companies, as a percent of sales, is far higher than on large companies. Regulation tilts the playing field.

On occasion, the author’s acceptance of the near-axiom that government regulation is beneficial and therefore desirable leads him to use examples that are badly at variance with the truth. In his introduction Taylor writes, “In the last century, American businesses resisted labor organizations and workplace entitlements, only to discover that modern labor practices and diversity programs created long-term loyalty among employees and helped build strong brands.” Many businesses, of course, have found just the opposite—that the effects of dictatorial federal labor regulation have been very harmful—and in any event it does not follow that Sarbanes-Oxley is beneficial just because some other federal laws allegedly are.

The structure of the book is a theoretical discussion by the department heads of an imaginary company that, on the one hand, must comply with Sarbanes-Oxley and, on the other hand, must be able to make quick decisions in order to meet customer needs and competitive pressures. The book’s pervasive themes are two: “agile compliance” and “compliant agility.” It soon becomes evident, however, that compliance comes first and the firm’s well-being comes second, as is the case with every regulatory compliance regime.

Those who expect any insight into the effects of Sarbanes-Oxley will find this volume a disappointment, and those who have read The Sarbanes-Oxley Debacle will laugh at the idea that this law could be “the best thing that ever happened”—unless you’re in the business of selling compliance software.

If any person or any group had set itself the task of creating a law whose purpose was to destroy the American free-enterprise system, it could not have done a better job than what has been produced by the Sarbanes-Oxley Act of 2002. The law is predicated on the principle that all companies are inherently evil and untrustworthy and thus must be governed from above by benevolent bureaucrats with both dictatorial and second-guessing powers.

What brought on this draconian law? In all likelihood, anyone born before 2000 who has been living in anything other than a deep cave is familiar with the name Enron, which is emblematic of corrupt corporate dealing and disastrous losses to employees and stockholders. It is significant, however, that the fraudulent acts of the principals of that company were prosecuted under existing law and within the then-existing rules of the public stock exchanges. It follows that new laws were not in fact necessary either for punishment of the malefactors or for prevention of further criminal acts. What was needed, however, at least from the view of members of Congress, was some evidence of their “doing something”; that is, not a legal solution but a political solution.

What then has Sarbanes-Oxley accomplished? So far, the history of the law has been an endless list of compliance requirements that (with few exceptions) have been of no productive benefit but that have inflicted enormous losses on the affected companies both in dollars and time.

Sarbanes-Oxley imposes such draconian demands that everybody’s money is affected—including yours. The full text of the law essentially turns much of the nation’s corporate governance on its head. Its effect is to place a new government agency—the Public Company Accounting Oversight Board (PCAOB)—in charge of the financial, accounting, reporting, procedural, and security operations of every corporation registered with the Securities and Exchange Commission (SEC). The Board is authorized in effect to look over every corporation’s shoulder, decide whether the firm “complies” with the Board’s own interpretations of law, and even punish the principals (such as the chief operating officer, chief financial officer, and chief information officer) with fines and, incredibly, incarceration for such infractions as failure of sufficient supervision. As noted in a “white paper” (informational document) prepared for a prominent software company, Sarbanes-Oxley “significantly increases penalties . . . with maximum jail terms that now exceed the penalties for crimes such as armed robbery, assault with a deadly weapon and negligent homicide.” Congress can pass laws pretty much at will, with little concern for the associated costs on those who must comply. It should come as no surprise that former government employees are valued, even sought after, by companies forced to deal with the new bureaucracy. For many companies, compliance skills now trump an understanding of corporate goals.

Sarbanes-Oxley empowers the Board with the most authoritarian powers imaginable. It can conduct investigations and disciplinary proceedings at will and can impose fines and otherwise discipline companies and the accounting firms they employ. In effect, it is prosecutor, judge, jury, and executioner. The notorious Section 404 requires that any “process” that could in any way affect financial results be audited and reported and, further, that the chief executive of the company must personally accept responsibility for the accuracy of all reports, under penalty of up to 20 years in prison. Exhaustive procedures required have entailed thousands of hours of work and expenditures in the billions of dollars. Because these requirements affect all publicly traded corporations, large and small, the law has had the perverse result of according large companies an unfair advantage over their smaller rivals, which must devote a larger percentage of their time, money, and human assets to obeying the law.

To add insult to injury, the Board is permitted to make any changes it wishes, which places companies in the position of forever trying to hit a moving target. The changes issued last November, eliminating some of the minutely detailed auditing requisites, were widely hailed as good news. Unfortunately, this does not take into account that both the companies and the auditing firms had already instituted these procedures at enormous cost in money and computer-design talent, and thus would be unlikely to expend even more of the same to undo these efforts. (This is explained further below.)

The law prohibits auditors from providing any other services, such as bookkeeping, financial information-systems design and implementation, appraisal or valuation services, fairness opinions, or other advisory services. The result is that auditors must report whatever may be amiss but are forbidden to advise the company how to correct it and thereby comply.

Also thanks to the new law, audit continuity will be a thing of the past, because an accounting firm can provide audit services for no more than five years. And in a provision that sets up the Board as final arbiter of corporate America, it is authorized to prohibit national securities exchanges and associations from listing any stock from a corporation that fails to meet its audit rules.

According to the Board’s rules, every e-mail and even every instant message must be preserved permanently, giving rise to a whole new industry offering products (both hardware and software) that can store almost inconceivable quantities of data. One effect is likely to be that more communications, especially simple questions or comments, will be made by telephone or in person. The perverse effect is to make information less available.

Field Day for Law Firms

Sarbanes-Oxley has contributed mightily to the demand for lawyers at all levels of government, as well as for legal assistance for the companies themselves. To make things even worse, the stock exchanges (NYSE, ASE, and NASDAQ), at the behest of Sarbanes-Oxley, have mandated that the majority of company directors be “independent”; that is, directors can have no material relation to the firm itself, either directly or indirectly, within the previous five years. It appears the requirement for director independence would exclude anyone who knows anything about the company.

The accounting firms that haven’t already been sued out of existence have more work than they can handle. However, the law is certainly doing corporations, and by implication their shareholders, no favors. The now-overburdened larger accounting firms can cherry-pick the most lucrative clients, leaving the other companies to find whatever they can among the second-string firms.

If Sarbanes-Oxley has been difficult for publicly listed companies, it has been positively sunshiny for consultants and producers of software dealing with sales, financial reporting, and document storage. It is all but impossible for corporations to comply with the various rules, or even to determine whether they have complied, without the purchase of pricey software. Trade publications and websites are replete with advertisements for products to assist in both complying and testing compliance. Consulting services have been raking in abundant revenue based in part on the sheer difficulty of knowing how to meet requirements.

In addition to the quandary faced in locating independent auditors, the hefty filing fees embodied in the new law, similar to the other expenses detailed above, have hit small companies especially hard.

The hope that the law’s requirements would eventually provide payback in more effective company management once the initial measures were put in place has been illusive for most firms. This effort and expense is especially galling to the majority of companies, which have striven throughout their existence to maintain the highest standards of business ethics. For them Sarbanes-Oxley has been an endless series of repetitions of what they already knew and were already doing in principle, if not in precise form.

But the costs are tremendous. According to CNNMoney.com last year: “A recent study conducted by the Securities Industry Association estimated that the cost of compliance has nearly doubled in the past three years to an estimated annual total of more than $25 billion in 2005, up from $13 billion in 2002.” Note that the costs were supposed to go down with time.

The law’s toll on time, talent, and productivity has affected virtually every publicly listed company. It isn’t bad enough that the actual productive activities of companies have been delayed to the detriment of both profitability and competitive advantage. Once they actually get started on the postponed work, the Sarbanes-Oxley hammer is wielded anew. Company projects, especially those involving information technology and other computer-related activity, must now document the same type of internal controls as are mandated for the company as a whole. The effect on project life-cycles in many cases has been little short of disastrous with regard to meeting deadlines, which are the heart of profitability.

Effects of the Data-Retention Rules

The requirements of retaining all data (every change, every correction, every previous version) in unerasable form has created an information behemoth that is not only massively expensive to create and run, but is also far more difficult to search and otherwise use than anything required heretofore. If one multiplies the size of such documentation by the number of companies affected by the law, it becomes evident that no matter how massive a bureaucracy may be created, there is close to zero possibility that any of this will benefit companies, shareholders, or the public.

With Sarbanes-Oxley bureaucrats watching everyone in corporate America, there can be no doubt that companies are practicing defensive management. The chairman of a large software house has commented, “We might have killed the goose that lays the golden egg. . . . You’re mitigating every possible risk that can be conceived. Risk didn’t use to be a bad thing.” This person has suggested that, as a result, the biggest opportunities for private equity companies over the next ten years will be in China and India.

In light of the foregoing, it may seem attractive for publicly listed companies simply to go private, and in fact the rush to do so has become a torrent—almost 200 companies as of mid-2005. However, it may not be either as simple or as helpful as it might seem. There is a significant possibility that even privately held companies may come within the Sarbanes-Oxley sway in the future. While on the surface this may seem remote, it should be borne in mind that all incorporated companies are subject to many state and federal laws, not just publicly listed ones. In this case, the PCAOB has been delegated enormous powers by Congress, and at least so far, most of those powers have not been challenged either for legality or constitutionality.

In 2004 the full force of the law took effect for foreign firms listed on U.S. exchanges, and the result has been an unmitigated disaster. Bearing in mind that other countries, as well as the EU, already have their own requirements, Sarbanes-Oxley has only heaped more burdens on the backs of foreign entities. According to the law, a foreign company listed on a U.S. exchange must meet all the Sarbanes-Oxley requirements if its shareholders include at least 300 Americans (even if they are merely invested indirectly through funds). Thus we see the phenomenon of U.S. law being enforceable on non-U.S. companies. As noted in a French-language paper directed to U.S. readers:

The largest European conglomerates want to leave Wall Street but are having a hard time making this move happen. The French Association of Privatized Industry, a powerful group of corporate heads, has just joined their German, British, Greek, Dutch, Italian, Austrian, Swiss and Polish counterparts in an effort to persuade the Securities and Exchange Commission (SEC), the federal regulatory agency of the American securities market, to liberate them. . . . In other words, these corporations are trapped, held captive by their American shareholders, whose interest is protected above all else. As of 2002, or more specifically, since the Sarbanes-Oxley Law was passed . . ., this law has become increasingly repressive and costly to foreign owned companies.”

It is indeed sad that foreign firms now view the U.S. financial markets, which were once the shining example of freedom and opportunity in the world, as something from which to be “liberate[d],” “allowed to leave,” but are “trapped,” “held captive” by “repressive” U.S. laws. How far we have come! Some foreign firms have already decided to do the obvious: They are buying out U.S. shareholders.

The other effect of the demands on foreign firms (which certainly should have been understood and anticipated) is that their new listings on U.S. exchanges have been reduced almost to zero. As a Wall Street Journal editorial succinctly expressed it: “In 2000, nine out of every 10 dollars raised by foreign companies through new stock offerings were done in the U.S. . . . [L]ast year [2005] not one of the top 10 initial public offerings (IPOs) measured by market capitalization was registered in a U.S. market.”

Is There Hope for Meaningful Change?

What has Sarbanes-Oxley accomplished? The answer is that it is just what would be expected of a law that was thrown together in great haste in order to “do something” about corporate malfeasance. Everyone pays the price, although, as noted, the price is larger for some.

By the usual standards by which the federal bureaucracy is judged, we might be tempted to throw in the towel and live with whatever Sarbanes-Oxley sends our way.

There is, however, one faint ray of light: a legal challenge to the PCAOB from a Washington D.C.-based lobbying group that has joined with a small Nevada-based accounting firm. The basis of the suit is that the Board has government-like powers, such as the ability to levy fines, but little oversight by the government and thus is a violation of the Constitution’s separation-of-powers clause.

It is also possible (though not likely) that the powers that be in Congress will realize that Sarbanes-Oxley has been one giant mistake brought about by misguided notions of where such qualities as honesty and ethics come from and will revisit the law and its reason for existing. It makes sense, but don’t hold your breath.

The full extent of the destructiveness of this law may not be known for years. However, there is no denying that the bloom of creative possibilities has been replaced by the blight of endless fears of compliance violations. Will the Law of Unintended Consequences eventually be recognized and the effects ameliorated? Only time will tell.

This approach is a bit more subtle and is immune from the empirical refutations that destroyed old-fashioned socialism. But the effect of the new critique could be as deadly as the familiar anti-capitalist nostrums. And it cannot be denied that capitalists themselves have been the main source of the new critique. Because of the business scandals of recent years, the opposition has been aided by the behavior of personnel in the business system. As I shall demonstrate, the problems of business today relate to some familiar quirks of the capitalist system, and naturally the critics have got it all wrong.

There are some easy targets. Unrestrained capitalism, it is said, produces unadulterated greed, and its problems can only be alleviated by yet more government regulation and more restraints on entrepreneurship, the creative driving force of business. And, of course, parallels are already being drawn between today’s malfeasance and the infamous “decade of greed,” the 1980s. But although both eras involve the same business problems, the mechanics of business change and behavior are rather different.

One of the greatest achievements of capitalism was the invention of the limited-liability, or joint-stock, company; its easily exchangeable shares and legal personality led to that flexibility which is the envy of markets that have not developed it. There are indeed two types (at least) of capitalism: the Anglo-American system, which emerged from the common law of contract, and the European system, which is the product of code law.

The Anglo-American theory of the corporation, despite legislative and judicial depredations, endures.¹ The managers of a corporation have a fiduciary (strict) duty to advance the interests of the owners, the stockholders. In the European model of capitalism, other groups, known as stakeholders, are thought to have a significant role in decision-making in the corporation. This is best exemplified in the German company, which has the two-board management system in which trade unions and others, often politicians and public figures, can be decisive. The statute that created the limited-liability company in 1870 decreed this. Though not eliminated, owners’ rights are reduced. That is why takeovers are rare.

But the Anglo-American corporation, despite its many virtues, has been afflicted by one problem since its beginnings. It was first identified by Adam Smith and is known as the “agency” problem. The owners are the principals, the managers the agents.² The question is: how do we get the agents to observe their fiduciary duties and not run off with company assets, shirk on the job, and pursue their self-interest. They do have considerable discretion, especially in America under the “business judgment” rule, by which courts are prepared to accept almost anything done by managers as being in the interests of the company. Smith thought that the only viable form of business enterprise was the owner-managed firm.

If we compare the 1980s with the early years of the 21st century, we see the same problem but with widely different answers. It is a serious mistake of the critics of capitalism to bundle the two eras under the common name—greed. They are very different.

The 1980s saw a really significant shift in wealth and power from the managers to the owners. This was a response to the earlier accumulation of wealth and power by corporate executives. True, takeovers took place in the earlier period, but they were not designed to advance stockholder value. Rather they were to increase the wealth and power of the managers. This led to the creation of unwieldy conglomerates that held back American economic progress. Clever entrepreneurs like T. Boone Pickens and adroit financiers such as Michael Milken broke them up. Companies were captured by raiders, only this time to advance stockholder value. They were often taken private; management was slimmed down; and the companies were brought back to market to yield even more profits. The personnel involved in this were despised and their methods excoriated, yet the whole experience underlay the remarkable American prosperity at the end of the twentieth century. This was the result of the spontaneous evolution of capitalism.

Victims of Managerial Power

The very opposite happened at the beginning of this century. Stockholders had become the victims of a new era of managerial power. And, in comparison to the much-despised 1980s, which were characterized by rather high levels of probity, there was massive cheating by executives. They deceived the stockholders at every turn and rigged the stock market, and that much-prized value, transparency, which should be the main feature of good corporate governance, descended into a mystifying opaqueness. It was difficult for stockholders to know what was going on until it was too late.

Of course, the market eventually wreaked its revenge, and big companies all but collapsed under a sea of debt. The market does eventually punish wrongdoers, but a lot of people lose serious money on the way. A crucial feature here was the decline in effectiveness of the auditors and accountants. Supposedly independent of management, they are charged with the duty of providing stockholders with essential information about the company. But they were also engaged in lucrative consultancy work for the company. This obviously gave them an incentive not to reveal vital information. It would obviously have a deleterious effect on the price of the stock.

None of this had much to do with today’s morality. Indeed, the people involved in scandals had high moral profiles. They gave money to charity (though that was often company money), practiced affirmative action in the workplace, and generally followed the dictates of conventional business ethics. But what the aberrant companies did in the last five years was to breach those conventions of good business practice that had grown up independently of statute and departments of moral philosophy at Ivy League universities.

Enron Collapses

Enron collapsed with massive debts in December 2001.³ It was a hugely successful energy-trading company, though it began as a small gas firm. Its problems arose because it had embarked on highly ambitious schemes and engaged in complex derivative trading and various offshore ventures. It had managed to conceal its difficulties from the public and investors, and was still getting good reports from the press right up to its demise, although the credit-rating agencies always thought it a risky company.

The virtue of Anglo-American capitalism is that Enron-type disasters are avoided, or their worst effects mitigated, through constant stockholder pressure, either through “voice” (harassing management at annual general meetings) or “exit” (selling their stock to a raider). These are checking devices that have emerged spontaneously to solve the agency problem. But to be effective they require transparency on the part of companies.

In the Enron case, stockholders were deceived about the true state of the company. This was done in a number of ways, the most important being the creation of Special Purpose Entities (SPEs). These are a kind of partnership within the firm, and they have the advantage, for someone anxious to conceal the truth, that their figures do not appear in the company’s books. SPEs are not illegal. However, they are certainly imprudent, and in Enron’s case their existence enabled the managers to evade the responsibility of telling the truth to investors.

Enron executives were distinguished by the fact that the bulk of their income came from stock options. This gave them an incentive to keep the price of the stock artificially high. Their auditors, the now-ruined Arthur Andersen company, helped them in this. The auditors were not defenders of the stockholders’ assets, but were conspiring with the managers.

Neither federal nor state law was any help to the stockholders. The federal Williams Act of 1968 made it difficult for outside stockholders to organize tender offers and threaten management with surprise bids. Equally significant was the fact that all 50 states had passed their own anti-takeover laws in response to the boom of the ’80s. This was largely at the behest of incumbent managers worried about their jobs. These laws were designed to protect the allegedly defenseless employees and investors. They did precisely the opposite, entrenching management instead.

Perhaps one of the most questionable acts of the Enron executives was to persuade workers to keep on buying stock in the company when the executives knew it was in desperate trouble. They were unloading shares at what was then a high price. One, CEO Kenneth Lay, has been charged with insider dealing (and other federal criminal offenses), a law of which I have written critically in the past: but this was not the real error in the case. It has been cogently suggested that Lay had good reasons for selling his Enron stock and that his sale was not merely a preemptive response to a future fall in its price.⁴ But the appropriate remedy here for any wrongdoing should have been civil action. Enron executives were in breach of their fiduciary duties to the firm and its investors (especially the workers). However, the Justice Department has become adept at turning civil wrongs into serious criminal offenses. It is clear that that the action against Lay is more political than legal, and the long delay in bringing him to trial suggests this. Like other “white collar criminals” in the past, he has been so publicly vilified that a jury is unlikely to be impartial. Of course, the government wanted someone to blame. And the workers, through their representatives, were remiss in not demanding more information. No doubt they were misled into thinking that regulation would save them.

The WorldCom Case

The scandal at WorldCom, whose bankruptcy in 2002 matched that of Enron, revealed similar features of business malpractice. This was a small telecommunications company that became a world leader, largely through some spectacular takeovers. But it had suffered from bad investment decisions and some extraordinary extravagance by employees. Its founder and former chief executive, Bernard Ebbers, was said to have “borrowed” up to $408 million from the company. All the time information was withheld from the market so that investors could not make informed choices. An example was the company’s representing as working profit $2 billion put aside for bad debts. These malfeasances had been going on since 1999, when Arthur
Andersen was the auditor, and were only revealed by the replacement firm, KPMG.

Another great scandal that shocked the Anglo-American corporate world was the affair at Tyco International. This did not involve the complexities of corporate finance that Enron featured. It was more a case of straight theft from the firm. But it illustrates the familiar agency problem. Its chief executive, Dennis Kozlowski, and the chief financial accountant, Mark Schwartz, treated the company like a personal cash cow. Kozlowski is said to have spent $1 million of company money on his wife’s birthday celebration and, equally notoriously, $6,000 on a shower curtain for his home. The pair eventually faced a 32-count indictment, including charges of grand larceny. A mistrial was eventually ordered because of witness tampering, but the defense argument that the expenditure had board approval and that there was no criminal intent may prevail, bizarre though that seems.

The lesson drawn by some business observers is that stockholders should be more active in the running of publicly quoted companies. But that is a little misleading, for traditionally the ultimate exercise of ownership rights, selling out to a raider, had been sufficient to keep management in line. In normal circumstances it is not in the rational self-interest for small owners to be involved in management. However, the aforementioned federal and state laws restricting takeovers have blunted that weapon; so a new form of stockholder activism might be required. And here there is clearly a role for big equity owners to take an interest in the company. They can see more clearly the effect of management on the value of their stock. Already this is happening. The huge public-sector pension organization, the California Public Employees Retirement System (CalPERS) is active in corporate governance and the practice is spreading throughout the Anglo-American capitalist world. After all, managers of pension funds have fiduciary duties to their members.

Limits of Morality

But in all these issues it is important to understand the nature and limits of morality. Moral philosophers have been far too anxious to stress supererogatory duties, that is, those that are worthy but not compelling, and have underplayed the basic rules by which we all live. The latter may not be glamorous, but successful business would be impossible without their observance.

The eighteenth-century Scottish philosopher David Hume was acutely aware of the dangers of a strident morality. He said that ethics has no basis in reason and was entirely a function of the passions. But this did not make him an immoraliste, for he believed that human experience shows how strict conventions (the basic and uncomplicated rules of morality) come to be adopted, especially for law, property, and economics.⁵ By playing “repeat games” we overcome the absence of trust in human affairs so that self-interested utility-maximizers advance their own goals by cooperating. He was worried that morality had a tendency to become an “enthusiasm” detached from human experience. He would regard modern business ethics as one such enthusiasm. All the recent business scandals have involved clear breaches of fiduciary duties. We don’t need a new moral philosophy to tell us that corporate theft and lying to stockholders are wrong. We only need to understand conventions.

European Capitalism

Just as the Europeans were preening themselves on their virtue in the light of American business scandals, they were suddenly shocked by the revelation that Parmalat, the huge Italian company, was facing bankruptcy with losses of 14.5 billion euros. This was in the Enron and WorldCom class for corporate chicanery.

Part of the original European claim for financial probity was that companies there were not primarily vehicles for the enrichment of greedy stockholders. European companies are “stakeholder driven” organizations in which a variety of groups essential to the business have a share in its governance. Owners (stockholders) are simply one of them. The influence of stockholders is further reduced because most investment capital is raised by bank loans rather than share issues. Since banks are also considerable equity holders, unlike in the United States or the United Kingdom, this gives them excessive influence in company policy. The banks are important figures on the supervisory boards of German companies, enabling them to put together coalitions of interests to resist the sanitizing effects of corporate raiders. Banks also act for minority stockholders. Since the restless search for stockholder value has not been a feature of German business, the significance of ownership is less than in the Anglo-American corporation.

However, as Italian experience reveals, the stakeholder system, so far from “democratizing” the corporation and making it responsive to demands of groups other than stockholders, has entrenched the management of a small group of self-interested insiders. True, Italian companies are quoted on the stock exchange, but they are effectively controlled by families. The Agnelli family’s reluctance to cede control of Fiat, which has slid near bankruptcy, is the classic example. Italians have not developed the Anglo-American style of corporate governance because they have not developed a notion of trust (or reliance on Humean conventions). The anonymity of large-scale capital markets, as opposed to the intimacy of family ties, is alien to them. Italy is the heartland of “crony capitalism.”

If crony capitalism is bad for business, as it unquestionably is, then the Parmalat case took it to new heights of venality.⁶ Despite the absence of a love interest, a diva, and a dagger, it was worthy of a Verdi opera. Parmalat was originally a successful company specializing in dairy products. But gradually it lost interest in milk and cheese and acquired worldwide holdings in a variety of unrelated products.

Parmalat was able to carry on without restraint because of the absence of any checking mechanisms, least of all from stockholders, in the company. It was effectively controlled by one family, the Tanzi, and the dominant figure was Castilio Tanzi. He ruled the company like a medieval tyrant, and corporate governance was abysmal. Extensive bank loans were raised and companies bought at inflated prices. And unlike in American takeovers, the companies were not turned into viable business enterprises, but became the personal property of the Tanzi family. When disaster struck, Parmalat was an incomprehensible, impenetrable, and debt-ridden colossus with no discernible business strategy.

Stakeholders Silent

And what did the legendary stakeholders do about all this? Precisely nothing, except blame one another. The crisis could have been averted if investors and bankers had taken action. As it turned out, they were silent and inactive and lost large amounts of money. There were culpable individuals involved, but the whole culture was rotten. In Italian business the importance of family control is so strong that the checking bodies are reluctant to stand up to them. That had not been too serious in the past, but the successful spread of globalization requires a notion of trust that extends beyond family members. And indeed, Parmalat’s problems emerged when it became a globalized company.

Only in Germany are there signs of stockholder activism. Although the country had established a full-fledged market system under Ludwig Erhard in the 1950s, it had never adopted Anglo-American business techniques. Firms were always run by stakeholders, especially bankers, and stockholders had little influence. The apogee of German stakeholderism was reached in 2001 with the defeat of the hostile bid for Krupp by Thyssen. It was turned into a tame merger.

But the successful bid for Mannesmann by Vodafone in 2002 was a significant blow for Anglo-American capitalism.⁷ The case had a curious aftermath. Mannesmann executives awarded themselves massive American-style “golden parachutes.” This angered stockholders and caused great controversy in German business. The executives were eventually charged with criminal offenses, and although they were acquitted, the whole saga marked a turning point in German business. There are other cases pending, and German stockholders are now demanding, vociferously, an Anglo-American-style of business with a new emphasis on stockholder value.

Despite their obvious differences, recent events in American and European business reveal a remarkable similarity: the shift in wealth and power to company executives. In America the investors were the losers, and in Europe other stakeholders suffered as well. In the 1980s the threat of a takeover kept agents (company executives) in line. Sadly, that has been seriously weakened through legislation, and in Europe it has always been moribund. But the natural, self-correcting mechanisms of the market are the only secure devices against fraud and the exploitation of the owners by managers.⁸

Notes

1. See Norman Barry, “The Theory of the Corporation,” in Ideas on Liberty, March 2003, pp. 22–26, www.fee.org/~web/0303iolpdf/feat5.pdf
2. See Adolph A. Berle and Gardner C. Means, The Modern Corporation and Private Property (New York, Macmillan, 1932) for a critique of capitalism from this perspective.
3. See William A. Niskanen, A Preliminary Perspective on the Major Policy Lessons from the Collapse of Enron, Cato Institute, July 2002.
4. William L. Anderson and Candice E. Jackson, “Is Ken Lay a Criminal?” Ludwig von Mises Institute Daily Article, August 16, 2004, www.mises.org/fullstory.aspx?control=1589 Mises.org.\5. See Norman Barry, “Political Morality as Convention,” Social Philosophy and Policy, vol. 21, 2004, pp. 266–92.
6. See Financial Times, April 13, 2004.
7. Norman Barry, “The Logic and Morality of Takeovers,” Ideas on Liberty, July 2000, pp. 33–37.
8. The Sarbanes-Oxley Act of 2002 got some things right. For example, auditors must rotate every five years, and they cannot be consultants. But it also imposed heavy compliance costs on companies. However, companies could have done these things themselves, and were going to, without the heavy regulatory burdens.

“When you think of Enron, you think of Houston,” writes Mr. Carlson. “You probably don’t think of Mauritius, a tiny island republic off the east coast of Africa. . . . By the beginning of 2000, [Enron] had no fewer than 43 subsidiaries” there. “Why was Enron doing so much business on an island in the Indian Ocean?” he asks. “Taxes. Avoiding them.”

Tucker Carlson’s complaint stems from the fact that “Individuals pay income taxes on what they earn, no matter where they earn it.” By comparison, “Corporations play by different rules. They pay federal income taxes only on money that enters the United States. In other words, if your Mauritius-based company earns $10 million, and that money never comes back to the United States, you don’t pay taxes on it.”

And his litany continues: “It’s a nifty deal if you’re a corporation, infuriating if you’re an ordinary taxpayer,” he says. “Over the next ten years, tax-dodging companies are expected to cost the U.S. Treasury $6 billion—money that will have to come out of your pocket and mine.”

Please pardon a slight digression here. I remember when I was delivering pizzas a few years ago to earn some extra money for my household, my manager tacked up a newspaper story on his office door about how the Internal Revenue Service was going to begin cracking down on servers and delivery drivers, rather than their employers, for not declaring their tips. I’ll never forget my shock when reading that the IRS spokesman said that by not declaring our full income, we were depriving the government of money. By what stretch of the imagination, I wondered, could the federal government be considered to be “losing” money in this arrangement? After all, what if I had just stayed home?

But back to Mr. Carlson, and the “infuriating” evasions by corporate America. The only way that “tax avoidance” could possibly fall unfairly on “your pocket and mine” is if the government doesn’t adequately adjust its budget to reflect a lowering of expected revenues when a corporation moves out of the country. This any third-grader could figure out. If I have just $10, and my bills are expected to exceed $10, then perhaps I am spending too much money. But let’s not start talking fiscal responsibility to the federal government. That would be truly outrageous.

And speaking of fiscal responsibility, isn’t it just a little outrageous that a member of the “conservative” establishment, those fellows that are always talking about government being too big and the tax burden too great, could be upset over a business venture that, faced with an oppressive tax regime, opts for a loophole? Bear in mind that “loopholes” were described by one great economist as “remaining freedoms.” We should be happy they got away.

Move to Bermuda

Mr. Carlson does raise a good point that might lead the reader to conclude that he is on to the problem. He writes of the Stanley Works corporation, whose shareholders voted early in 2002 to relocate company headquarters to Bermuda. The shareholders cast their votes on the advice of CEO John Trani, who claimed that the decision would save the company $30 million in taxes and increase stock values.

What they didn’t count on, however, was the chunk Uncle Sam will get in corporate gains tax when the company leaves the United States. Mr. Carlson quotes a New York Times calculation which found that “even if Stanley’s stock price goes as high as Trani says it will, these shareholders ‘will barely break even after taxes.’”

But wait. Before you can say, “Why, Tucker, I think you’ve got it,” his next statement quickly dispels any illusion that he is actually on the right scent. “As for the government,” he concludes, “it would lose $240 million in corporate income taxes from Stanley over the next eight years.” The sky is indeed falling. The government might “lose” some more money.

But that is not Mr. Carlson’s only gripe. He appears genuinely upset that companies would be engaging in such chicanery at a time of crisis. “All this [tax dodging],” he laments, “at a time when the United States is straining its treasury to fight a war against terrorism.” And what blast of corporate America would be complete without someone to coin the perfect denunciatory slogan? “Republican Senator Chuck Grassley of Kansas calls foreign tax havens an example of ‘profit over patriotism.’” Which means, of course, that the government isn’t able to skim as much geld off of these corporations as it desires.

The fact is, if anyone bears responsibility for the endless quest on the part of corporate America to find the ultimate tax haven, it is the U.S. government and its lengthy, draconian, inconsistent, unfathomable, monstrosity of a tax code and the oppressive taxation it represents. Even if the tax code were perfect, no business should feel compelled to stay put simply out of nationalistic concerns. Corporations exist to turn a profit—they do not exist to keep the federal government in lots of tax revenue.

Much like the Wizard of Oz, who implored his visitors to “pay no attention to that man behind the curtain,” so Mr. Carlson wishes to distract us from the real issue. Capital tends to go where it isn’t penalized. If Mr. Carlson objects to corporations moving out of the United States, then he should be criticizing the disincentives that exist for them to stay put—especially since he so obviously recognizes that taxes are the underlying motive for corporate relocation. For it is obvious that corporate America, much to the disappointment of social engineers and military interventionists, is tired of being milked to quench government’s endless thirst for other people’s money.

Scott McPherson is a freelance writer in Fairfax, Virginia.

Consider financial regulation. Kuttner writes, “Only regulators (and their proxies, such as the Financial Accounting Standards Board) can force corporations to disgorge potentially embarrassing information.” When I read such a statement, I don’t know whether to laugh or cry. Kuttner correctly identifies the FASB as a proxy regulator: the Securities and Exchange Commission, a government agency, requires corporations to comply with standards set by the FASB. Which means that Kuttner, who advocates increased regulation, is arguing that only the kind of regulation we have will work. There’s one little problem with his view: the current regulations didn’t work. The agencies that Kuttner trusts as the only ones that can force embarrassing information into the open didn’t do so.

But wouldn’t we have even more Enrons if we got rid of all regulation? Probably not. The reason is that many of us value information about the firms we invest in and we are willing to pay for that information. Why do I trust the toaster I buy not to explode in my face and the motel I stay in to have clean sheets? There are two main reasons. First, the companies making these products treat customers well in order to establish a reputation for quality. A famous example of a firm that did well by producing a safe product, while those about them were producing dangerous ones, is Standard Oil of New Jersey. Kerosene, which began to be widely used in the late nineteenth century, had a nasty habit of blowing up and burning people to death. The reason: the product was not standardized. John D. Rockefeller came along and standardized it so that people knew it was safe: thus the company’s name, Standard Oil.

The other reason we trust products and services is that private certifying organizations such as Underwriters Laboratory (UL) diligently examine firms’ products to make sure they meet their standards. If tomorrow the government stripped the FASB of its government-granted monopoly on standards, then certifying agencies would come along that would give publicly held companies the equivalent of a UL certification.

But wouldn’t companies aggressively game the system, as Enron did, to find ways to meet the standards while still misleading the public? Possibly, but a private certifying agency, with its own reputation at risk, would have a stronger incentive to spot these shenanigans quickly than does a government-backed monopoly with zero wealth at stake.

Kuttner goes for the hat trick, using the Enron scandal to argue for increasing regulation in two other areas as well. First, he claims, Enron’s large profits in California’s electricity market show that deregulation of electricity doesn’t work. It shows no such thing. California’s government did not deregulate electricity in the mid-1990s; it re-regulated it, replacing the old rate regulation with some new regulations that only a market socialist could love. One of the new regulations was a vertical disintegration of the industry, which forced retail electricity providers to buy their power from generating companies. A related regulation prevented the retailers from having any contact with those who sold them the electricity, and also prevented them from buying on anything other than the daily spot market. In other words, all trades had to be made anonymously. One final regulation required each buyer to pay the highest price agreed to by any buyer that day. What that meant was that in times of short supply, generating companies would be foolish not to charge high prices. Refraining from doing so would not establish a reputation that would help them because no electricity buyer would be able to knowingly give his business to such a company in the future. This regulatory brew certainly did help Enron, but if this was deregulation, then Sweden’s economy is laissez faire.

Coerced Employee Stock Ownership

Kuttner also claims that “Enron employees were coerced to put the bulk of their tax-subsidized retirement savings into—guess what?—Enron stock.” He’s right about coercion, but wrong about the entity doing the coercing. Enron gave its employees strong incentives to hold Enron stock in their 401(k) plans. But Enron never used coercion. Rather, it gave them what looked like a sweet deal due, in part, to the federal government’s coercion of Enron. Specifically, the Employee Stock Ownership Plan, introduced by the federal government in 1974 with the Employee Retirement Income Security Act, gave companies a tax cut for selling stock to its employees. In other words, the federal government coerced money, literally, out of companies if they didn’t play along and then reduced the coercion if they had their employees own stock.

Kuttner writes that it “should be illegal” for a corporation “to force its employees to put all their retirement eggs in one basket.” I agree. But the issue is irrelevant because as mentioned above, Enron didn’t use force. Even if Enron insisted that its employees buy its stock, which it didn’t, that simply would have been terms of a contract that every Enron employee was free to refuse by not working there. But Kuttner probably knows that, and is misusing the language of coercion to hide his own advocacy of real coercion. If a company and its employees agree, unwisely in my opinion, that they will hold only the company’s stocks in their 401(k)s, I’m guessing that Kuttner would want to stop them—using real coercion, the kind that puts people in jail for resisting.

After detailing all the ways in which Enron and other companies should be regulated, Kuttner writes: “Enron was the ultimate politically engaged company. Its chairman, Kenneth L. Lay, was an intimate of the Bush family and was wired to Democrats as well. Enron’s operatives relentlessly lobbied state legislatures to provide a lax climate in which to pursue its market manipulation.

Kuttner is half right. Enron was “the ultimate politically engaged company.” But, as Cato Institute’s Jerry Taylor pointed out in the Wall Street Journal (January 21, 2002), the only thing consistent about Enron’s lobbying was that it was in Enron’s self-interest. If this meant lobbying for deregulation, then fine. If it meant lobbying, as in California, to get utilities out of generating electricity to make room for Enron, and for strict price controls on the use of transmission grids, then that was fine too.

Does Kuttner really think that increasing regulation will make companies lobby less?

But some are not content to learn such narrow lessons. They want to look at the big picture. And so when studying Enron, they have learned the lesson that the invisible hand doesn’t work. Or it doesn’t apply any more. Here is Marjorie Kelly, cofounder and editor of the journal Business Ethics, on the Enron affair: “The ideal of the unregulated free market is flawed, and it’s time we said goodbye to Adam Smith’s ‘invisible hand.’”

Numerous other writers have invoked the failure of the invisible hand to protect us from Enron.

When Adam Smith wrote about the invisible hand, he was referring to the effect of investors’ putting capital into domestic industries in search of the highest profit. He argued that the desire to find the highest return on their money led to beneficial effects for society as a whole.

But what most critics have in mind when they invoke the invisible hand is something more complex. They are referring to the worldview that says that markets are self-regulating, that there are natural restraints on greed and dishonesty built into the market system.

I agree with that worldview. Let me flesh it out a little further. Those of us who are sympathetic to this view believe that human nature is self-interested. There are greed and even malice along with altruism and kindness. What is the best way to restrain that self-interest from being harmful? In the Smithian worldview, competition and market forces impose costs on dishonesty.

But that does not eliminate greed. It does not eliminate dishonesty. Even in a free-market system, there are con men and scams and products that are poorly made and even sometimes unnecessarily dangerous. The claim of the Smithian worldview is that such behaviors are hard to sustain. The market punishes dishonesty. The market drives out products that are mediocre or unnecessarily dangerous.

If the maker of a first-rate product decides to cut corners and live off its reputation, it may get away with it for a while. Lexus and Southwest Airlines could continue to thrive for a while if they lowered their quality. But they will pay a price as information spreads and consumers acting in their own self-interest choose alternatives. The threat of those alternatives is an incentive for market leaders to try to maintain their high quality.

The critics of the Smithian worldview seem to be arguing that the Enron disaster is, in and of itself, evidence of the failure of the Smithian worldview. On one level, this is a little hard to understand. After all, Enron is bankrupt. Its stock price the last time I looked was under a dollar. No one thinks Kenneth Lay is a genius any more. Arthur Andersen’s reputation is in tatters. It may go out of business. It has hired Paul Volcker to try to re-establish some piece of its former reputation and has given him significant control to do so.

On this level, the unregulated system seems to have worked fairly well. As soon as it became widely known that Enron had overstated its earnings dramatically, the stock price plummeted. And it plummeted well below what was consistent with the new corrected level of earnings. The new stock price reflected the loss of trust caused by dishonesty. Enron’s credibility was shot.

And of course the system is not really unregulated. Numerous state and federal statutes will be brought to bear on the executives of Enron and Arthur Andersen, and some of them may be fined or put in jail.

So why do the critics of the Smithian worldview find the Enron story so decisive? One possibility is that they are upset that some Enron executives appear to have managed to make a great deal of money by selling their shares before the fall in stock prices. Others appear to have gotten fabulously rich using complex partnership structures with debt financing. These techniques may or may not have been illegal. What is clear is that these techniques have become dramatically less attractive.

Broken Hand?

What I think the critics of the Smithian worldview have in mind when they bring up Enron is something simpler: there was wrongdoing, ergo the invisible hand is broken. Why weren’t there more “checks and balances to stop it?” asks Marjorie Kelly.

This is a strange standard of evidence. CBS News recently tested the new airport security systems and found that some bags were not inspected correctly. Does this mean that the current system of federalized security is a failure? I happen to be against federalizing airport security systems. But I don’t expect a federal system to be perfect. Its imperfection doesn’t prove my case.

Sometimes the President of the United States gathers power beyond what the Constitution has in mind. Does that mean the constitutional system of “checks and balances” is a failure?

The government takes our payroll “contributions” and spends them. There is no real Social Security trust fund, only an accounting fiction. I would like to see a purely private retirement system. But does the fact that the government solution has this marketing dishonesty about it prove my case? I wish it did, but it doesn’t. The argument has to be made on a fuller set of principles.

Neither private nor public control is perfect. If you are a pure pragmatist, then the issue is simply one of which system works better. But perfection should never be the standard. It is not a standard that any system or solution can meet.

I am sure there are changes that could be made to our current regulatory system which might make the probability of future dishonesty less likely. The interesting question is whether these changes require more or less regulation. What would the world look like without the current state of federal and state laws that regulate financial disclosure? Does the current web of such laws destroy private systems that might work even better?

Those who dislike the decentralized solution of the marketplace would protect us from Enron by increasing such requirements and limiting the freedom companies have to use stock options to provide incentives to employees and management. I hope that in the current hysteria we preserve the freedom of individuals to make these choices voluntarily.

Reviewed by John Samples

Responding to Watergate, Congress a generation ago passed draconian restrictions on campaign spending and fundraising. The Supreme Court eventually struck down the spending limits, but affirmed contribution ceilings and the legality of the new agency empowered to oversee the regulatory regime, the Federal Election Commission (FEC). Over time, inflation has made the contribution limits more restrictive, but campaign spending has increased apace.

In the mid-1990s Senator John McCain took up the cause of legislating new restrictions on campaign finance emphasizing the issue during his failed presidential effort in 2000. That cause was reinvigorated, thanks to the eagerness of many to see the Enron debacle as proof of the corrupting influence of campaign contributions. With the recently signed reform bill heading to the U.S. Supreme Court, Smith’s book could not be more timely.

The cause of campaign finance “reform” attracts a strange mélange of civic puritans, who decry corruption, and traditional egalitarians, who attack the “undue influence” of the affluent. Among the puritans should be counted McCain himself, who is nothing if not self-righteous, and the numerous Washington interest groups like Common Cause and the Naderite factions, all of which lobby to rid money from politics while taking millions from leftist foundations like the Joyce Foundation and the Pew Memorial Trust.

Like earlier puritans, McCain and his allies prefer religious zeal to public reason; they rarely support their claim that campaign donations corrupt American government. Smith nonetheless examines their assertion with scholarly care. Political scientists have extensively studied the links between campaign giving and congressional voting. As Smith, a law professor at Capital University currently serving as an FEC commissioner, notes, they have found little if any connection between the two, an important finding since the only constitutionally acceptable rationale for restricting contributions would be preventing corruption or the appearance of corruption. In fact, academic studies say party affiliation, ideology, and constituent preference are more important factors affecting congressional votes.

The most intellectually serious—and most dangerous—proponents of campaign finance restrictions are the traditional egalitarians, who profess their cause in our most eminent law schools. Some law professors argue that we must restrict the political speech of some to enhance public debates and thereby realize “First Amendment values.” Others say the Fourteenth Amendment requires government action to promote a de facto equality of influence in politics.

Smith invokes the clear meaning of the Constitution against the “First Amendment values” argument. The framers intended to exclude government regulation of the marketplace of ideas. They defined political liberty by the absence of governmental intervention and not as a goal to be achieved through positive state actions. They knew that politicians could not be trusted to regulate the electoral process. Once we abandon the clear language that Congress “shall make no law . . . prohibiting freedom of speech,” Smith persuasively argues we are only a step from “suppression pure and simple.”

Other academics argue that government must substitute public for private financing of elections to attain “equal protection under the law.” Yet, as Smith notes, the Fourteenth Amendment protects citizens against governmental discrimination. It places no positive obligations on government to fund political campaigns. The Constitution guarantees equality before the law, not equal influence over elections or policymaking. Smith’s treatment of the Supreme Court cases in this regard is comprehensive and masterful.

He touches on many other issues in this work. Fully at home in constitutional law, he crosses disciplinary boundaries without fear, evincing an adventuring spirit that is needed on this topic. He has clearly written a book that will stand as the last word in defense of free speech in political campaigns.

I might mention in closing two great ironies about this work. John McCain appears late in the book. McCain’s obsession with campaign finance has always been a bit of a mystery, a puzzle possibly tied to his bad conscience about the Keating Five Affair. (Readers may recall that five senators, including McCain, were accused for doing favors for S&L figure Charles Keating in return for campaign contributions.) Smith examines the evidence and suggests McCain did nothing wrong or improper—Smith is more than fair toward a public figure who is rarely fair to others.

The other irony: Smith now serves on the FEC. When he was nominated to that position, the “reform” lobby attacked him along the low road, comparing him to David Duke, the Unabomber, and Slobodan Milosevic. The resistance held up his nomination for over a year, during which he finished the work under review. Rarely has sweet revenge and a profound public service been so winningly combined. Every friend of political liberty should read Unfree Speech.

John Samples is director of the Cato Institute’s Center for Representative Government.

Critics of markets claim that the Enron debacle shows how “capitalism” is defective and proclaim that the government should increase the regulation of corporations and financial markets. There does need to be a change in government policy, but not in the direction of greater interference with business.

A market needs to have clear rules about property rights, and this implies a general Law of the Market about telling the truth. What we need is a clearer codification of the Law of the Market, enforcement, and penalties against fraud. Fraud is a type of theft, and theft is a violation of market rules.

Let’s start with the accounting firms that are supposed to audit corporations. The purpose of such audits is to ensure that the company has truthfully and fully accounted for its operations. This implies that the auditor should be impartial and not be swayed by any financial interest in the company.

That was not the case with Enron. Its auditing firm, Arthur Andersen, was also a consultant to Enron. In my judgment, that constituted a potential conflict of interest. If the auditor reported accounting problems, that might reduce its consulting income. Some argue that the government should prohibit auditing firms from also doing consulting work for the firm it audits. I argue for a noninterventionist policy.

The Law of the Market would require that all statements made by firms be truthful unless the company charter clearly and explicitly states that it might lie. The Law of the Market would also require that external audits of corporations be impartial, with firms having no financial interest in the company or any links other than the auditing, unless it is clearly and explicitly stated in the charter that it might have other business with the auditing firm, or that it might not be audited at all. It should be up to the shareholders to take on risks, but they should know what those risks are regarding company reports.

If the company’s charter states that it may be audited by firms that also have other financial interests in the company, then all shareholders are warned that the audits might be suspect, and that the accounting reports—the balance sheet and income statements—might be misleading. The value of the shares will then be discounted to reflect this.

The Law of the Market would also specify that the accounting reports of a company fully show all assets and liabilities of the firm at current market prices, unless its charter states otherwise. Enron was able to hide liabilities in partnerships, which were not fully disclosed. A firm’s business includes its membership in partnerships, and if a firm wishes to hide part of its balance sheet in partnerships, this policy should be clearly stated in its charter for all to see. Then shareholders will be warned, and the value of the stock will be lower to reflect this.

Honest Statements

Likewise, the Law of the Market would require that when the executives or board members of a corporation make public statements about its prospects, these are to be honest, unless the charter lets the company spokesmen lie. If the charter does not state that they may lie, they should be legally required to tell the truth to the best of their knowledge.

It is tragic that many Enron employees put much of their retirement funds in the company’s stock. One of the basic principles of personal finance is to diversify your portfolio. “Don’t put all your eggs in one basket” is age-old advice many of us learn from our parents.

This should be a financial lesson for everybody. Markets are efficient because the ineffective firms fail and go out of business. Most investors don’t know what is going on inside a company. It can look good on the outside but be crumbling on the inside. Even those working for Enron did not know what was really going on, yet many put most of their retirement funds in the company’s stock. A general rule for investing is not to put more than 5 percent of your assets in the stock of any one company.

The Enron problem was not a fault of the market, but a violation of the ethical rules of the market. There will always be those who try to defraud others. That is why we need laws against theft and fraud. The Enron debacle is the fault of government for not having a clear Law of the Market making auditing conflicts illegal unless the company charter states that it would engage in such practices. The Law of the Market need not even be a governmental law, but given that governments enact laws against theft and fraud, this one would clarify the property rights involved. A company should be presumed honest unless its charter states otherwise, in which case the company’s basic documents would be honest.

The pure free market does not include force or fraud, but rather consists of voluntary activity. Vague and confusing government laws and regulations provide the illusion of safety, but actually prevent shareholders and employees from recognizing the risks they are taking. Once again, government, not the market, failed.

Fred Foldvary teaches economics at Santa Clara University.