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Biting the Invisible Hand

By Christopher Farrell It's been a year since the Enron scandal broke and, sadly, Corporate America remains in disgrace. It's not just the yearlong revelations of fraud, malfeasance, conflicts of interest, deceptive accounting, weak boards of directors, and outrageous compensation in executive suites that cost investors billions upon billions of dollars. No, it's the lack of genuine reform that's now troublesome.

The Bush Administration is trying to sweep the problem under the rug, for the most part. After a summer of angry rhetoric aimed at CEOs subpoenaed to testify before committees and passage of the so-called Oxley-Sarbanes Act, lawmakers on Capitol Hill have pretty much forgotten about the issue. After all, the midterm elections are over. Meanwhile, the Securities & Exchange Commission is in disarray, with Harvey Pitt about to step down as chairman after a string of self-inflicted wounds that raised questions about his integrity. And the Financial Accounting Standards Board is backsliding on enforcing tougher and fairer accounting rules.

Oh, sure, the U.S. stock market has staged a dramatic rally in recent weeks. The market is up some 20% since hitting a five-year low on Oct. 9. But does this mean the business scandal is over and worries about fraudulent business elites exaggerated? Are calls for reform in corporate disclosure and corporate governance misplaced?

DEPRESSING PARALLEL. Hardly. Let's not forget the full history of the stock market crash of 1929 and the Great Depression, which was precipitated by a crooked plutocracy that lined its pockets by rigging Wall Street in its favor during the 1920s. It's largely forgotten today that, in 1933, the stock market staged its greatest rally of the 20th century. President Franklin D. Roosevelt had hiked the price of gold above world market levels. The move drew reserves into the U.S. banking system, boosted commodity prices, and jump-started the economy.

Investors gambled that the Depression was over -- wrongly, as it turned out. And it took a series of major New Deal reforms, including the Glass-Steagall Act splitting investment banking from commercial banking, the creation of national deposit insurance, and the formation of the watchdog Securities & Exchange Commission, to restore widespread faith in America's financial system.

Similarly, today's investors are anticipating that the economic recovery will stay intact, despite the slowdown of recent months. Yes, there's uncertainty surrounding a possible war with Iraq and the ongoing battle against terrorism. But the outlook is improving following the last half-point rate cut by the Federal Reserve and widespread anticipation of more fiscal stimulus from a Republican-dominated Congress and White House come the New Year.

With bond yields at levels not seen since Andy Williams first sang Moon River and West Side Story was voted best film of the year (that's 1961, for the youngsters out there), investors are willing to gamble that equity values offer better moneymaking opportunities. Whether we're witnessing another powerful short-term rally like 1933 -- or the start of another bull market as in 1982 -- is an open question.

"CONVENIENT COVER STORY." Corporate America and Washington should be paying closer attention. In an October talk before the Financial Management Association International, Martin Fridson, chief high-yield strategist at Merrill Lynch and a market historian, drew a critical distinction by calling on Adam Smith's famous image of the Invisible Hand. Fridson noted that the Invisible Hand, a metaphor for harnessing individual self-interest to serve the general well-being, is a powerful principle.

And in my view, it's worked well, perhaps better than ever, in the 1990s. Barriers to trade fell with the collapse of communism and the embrace of freer markets around the world. Deregulation unleashed competitive forces in previously cosseted and inefficient industries. The traditional command-and-control corporate hierarchy broke down as management embraced a more flexible, entrepreneurial culture. The Internet, a remarkable technology for financial democratization, created direct pipelines to consumers. Wall Street was no longer a private club for the wealthy, and equity ownership spread to the mass of employees.

Excesses emerged toward the end of the era, however. And here's where Fridson's second observation about the Invisible Hand comes into play: It's a "very convenient cover story for people who are actually trying to stack the deck in their favor," he says. America's business and finance elite preached the virtues of competitive capitalism while practicing the crony variety. The elites took no risks, and pocketed outsized rewards, by gaming the system with deceptive accounting practices and backroom compensation deals.

INVESTING IN REFORM. The business and finance elites are still laboring in the shadows to hold on to their ill-gotten gains. Vast sums of lobbying money are being spent in Washington to keep reform at bay. Chief executives -- so eager during the heady 1990s to lecture mayors, lawmakers, and foreign heads of state on the miracle of free markets -- are now silent, hoping they can ride out this turbulence and preserve their outsized compensation packages.

The market has brought about some needed correction. But the rules of the market are still far too open to manipulation, in my view. A broad-based equity culture requires a reform agenda deeply committed to more disclosure and ensuring dependable financial numbers. If you look at it in capitalist terms, there's a return on reform: Strong economic growth and a widespread social stake in the capitalist system. Wise up, all you captains of industry. The right course is clear. And take Washington with you. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online

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