J.P. Morgan's Character Lesson

Honesty, integrity, trust -- they're old-fashioned concepts in this Age of Enron, and their scarcity endangers America's future

By Christopher Farrell

One of the most famous exchanges in the history of finance took place almost a century ago on Capitol Hill. An aging J.P. Morgan, the most powerful financier in the world and America's unofficial central banker, testified before a House committee investigating the tangled web of financial interests that dominated the economy of the emerging industrial nation. Morgan's inquisitor was Samuel Untermyer, a tough corporate lawyer.

Untermyer: "Is not commercial credit based primarily upon money or property?"

Morgan: "No sir. The first thing is character."

Untermyer: "Before money or property?"

Morgan: "Before money or property or anything else. Money cannot buy it...because a man I do not trust could not get money from me on all the bonds in Christendom."

Like the velvet-collared Chesterfield topcoat he wore and the mahogany cane he walked with on that mild December day in 1912, Morgan's language is from another era. But his essential insight remains true today. Markets work on a foundation of trust. And it's a lack of trust -- in a sense "character" -- that largely explains the disturbing divergence between an economy gaining traction and a stock market flailing lower.


  Make no mistake: The economy has a lot of momentum behind it after bouncing back from the twin blows of recession and terror, and doing so much faster -- and in much better shape -- than most economists thought possible. The consumer is the economy's stalwart. And the manufacturing sector is now showing signs of significant improvement -- productivity is up smartly and corporate profit margins are widening.

Even the labor market is showing signs of better days ahead, with the National Federation of Independent Business saying its members are putting up "help wanted" signs. Meanwhile, Manpower, the nation's largest temp agency, reports that employers are ramping up their temp-hiring plans. Corporate layoff announcements plunged to 84,978 in May, the first time in 12 months that the figure came in under 100,000. The case for a double-dip recession is fading.

Yet investors can't shake their funk. Big Business may well face its most threatening crisis of confidence since the 1930s. The scandal at collapsed energy giant Enron is reminiscent of Wall Street's "cockroach theory": When you see one cockroach scuttling across the floor, there's bound to be a whole lot more hiding in the cracks. And so it has proved. Each day brings new revelations of insatiably greedy executives who stand accused of deceptive behavior.


  The pivots of the economy are morally tarnished. CEOs at too many companies have cut back on employee benefits while locking up lucrative pensions and lifetime health-care payments for themelves. They've pocketed huge stock-option gains while being less than forthright with shareholders about the state of the balance sheet -- all the while claiming a divine right to gargantuan pay packages with no financial penalty for failure. There's widespread mistrust of the numbers certified by chief executives and their investment bankers, accountants, lawyers, and other professionals. Character, to paraphrase J. P. Morgan, is lacking.

Maverick billionaire Warren Buffett certainly agrees. Indeed, he's the rare corporate chieftain willing to criticize the nation's business and financial elite. It's worth quoting at length a searing condemnation from his "Letter from the Chairman" in Berkshire Hathaway's 2001 annual report:

"Charlie [Munger, his business partner] and I are disgusted by the situation, so common in the last few years, in which shareholders have suffered billions in losses while the CEOs, promoters, and other higher-ups who fathered these disasters have walked away with extraordinary wealth. Indeed, many of these people were urging investors to buy shares while concurrently dumping their own, sometimes using methods that hid their actions. To their shame, these business leaders view shareholders as patsies, not partners."


  Though Enron has become the symbol for shareholder abuse, there's no shortage of egregious conduct elsewhere in Corporate America. One story I've heard illustrates the all-too-common attitude of managers toward owners: A gorgeous woman slinks up to a CEO at a party and purrs through moist lips, "I'll do anything -- anything -- you want. Just tell me what you would like." With no hesitation, he replies, "Reprice my options."

The radius of trust (to use a term favored by social philosopher Francis Fukuyama) is the bedrock concept behind what economists and sociologists like to call "social capital." Although difficult to measure and define, social capital is the dense network of connections, values, norms, and reciprocal relationships in a community.

Like physical capital (say, a computer) and human capital (such as a college education), social capital affects economic growth and vitality. The stronger the ties that bind, the greater the potential for the kind of trust and cooperation that improves everyone's standard of living. The opposite also is true. A lack of trust produces less cooperation and investment. It stands to reason that nations with high levels of trust allow for more innovation and risk-taking since business will be more confident about the future.


  Scholars have been on a quest over the past decade to better understand and measure the interplay between social relationships and economic performance. The empirical evidence is suggestive rather than definitive. Volker Bornschier, a sociologist at the University of Zurich, looked at the economic performance of 24 rich countries and 9 newly industrialized nations from 1980 to 1998.

Bornschier found that high levels of trust and tolerance had a measurable impact on economic performance, along with several other variables, including technological capital. (You can read Bornschier's study, Trust and Tolerance-Enabling Social Capital Formation for Modern Economic Growth and Societal Change online. The World Bank also devotes a section of its Web site to social capital.)

How can trust be restored? It starts with the recognition that the economy is increasingly dominated by high-octane finance, from hedge-fund gunslingers to venture capitalists to global mutual-fund managers. At the same time, the people's capitalism, the widespread embrace of investing for retirement in the capital markets by the mass of American workers, is here to stay. What binds these two groups together is their need for better information and more corporate transparency to make sensible investing decisions. Openness or transparency is a practical policy for reestablishing trust in a market economy.


  There are some positive signs. The community of global investors is forcing some needed reforms in bookkeeping and corporate reporting. Federal and state regulators are pressing for clearer financial statements and the disclosure of more real-time information. Standard & Poor's new measure of corporate profits, the so-called core earnings, should eliminate much accounting chicanery and provide investors by providing a more accurate gauge of corporate profits.

Still, these market-driven reforms are hampered by a lack of bold leadership. The White House is compromised at this juncture in history by its once-incestuous relationship with Enron. The recent revelations of aggressive accounting techniques at Halliburton, one of the world's largest providers of products and services to the energy industry, during Vice-President Dick Cheney's tenure as CEO doesn't help either.

Former Federal Reserve Board Chairman Paul Volcker -- a model of personal and professional integrity -- valiantly tried to set a new standard for the accounting industry with his reform plan for Arthur Andersen. But the industry has brushed aside his proposals with the firm's indictment. The personal uprightness of Harvey Pitt, the head of the Securities & Exchange Commission, is unquestioned, but he's politically tone deaf and hampered by his close ties to the accounting industry. No one trusts Wall Street these days. CEOs are all too silent, and many more need to talk about how to enforce equity, fairness, and responsibility.

A staple in the history of capitalism ever since the emergence of the publicly traded corporation is the conflict between management's desire for secrecy and investors' need for more openness. The rise of market-based finance, as well as the investor class, makes it urgent that the nation's finance and business elite embrace transparency. The risk is too high that the economy will stagnate without substantial reform.

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

Edited by Beth Belton

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