Today's Markets Need a Whole New Set of Rules

Regulations from the '30s couldn't stop the scams of the '90s. So Congress needs to go far beyond simply cracking down on miscreants

By Robert Kuttner

America's financial markets are in a tailspin, chillingly reminiscent of the 1930s. What's similar is not the depth of the bust--our economy has far more stabilizers now than in 1929--but the self-dealing that led to the misallocation of trillions of invested dollars, the absence of necessary regulation, and the ensuing collapse of investor confidence.

How could this have happened again? The common element in the two eras is the conflicts of interest that benefitted insiders. Contrary to Chicago School economic theory, market forces were not able to detect, or to discipline, this opportunism. The culprits include: auditors who had become the servants of managers rather than of shareholders; brokers serving their own accounts rather than offering dispassionate advice to investors; bankers who put aside fiduciary duties to cut deals with dubious investment partners; directors who were subservient to CEOs rather than vice versa; and executives who put their own short-term enrichment through stock options ahead of creating wealth for shareholders. Although many of the particulars are new, all of these abuses echo the 1920s.

Despite President George W. Bush's contention that some corrupt individuals failed the system, it is the newly deregulated system that failed. This reality overturns a generation's conventional wisdom about the efficiency of free markets. In theory, markets capitalize all available information. Hence, prices are essentially accurate, investors discipline impostors, and regulation only retards the market's genius for spurring innovation.

But in each of the recent cases, market discipline and self-regulation failed utterly. It was just too easy to cook the books, pump up the stocks, and spread the gains around to the insiders. Markets were along for the ride, delighted as long as share prices kept rising. But markets were not competent to ferret out the fraud. And because of the prestige of the market and the low esteem accorded regulation, Congress would not permit the regulatory agencies to keep up with "innovations" that turned out to be scams.

It's true that 1930s regulation was not well suited to 1990s markets. But that's not because the New Economy no longer needs regulators; it's because the particular maneuvers of the '90s were not imagined in the '30s. Before the Great Crash, insiders used holding companies and other stock-watering schemes to bilk both investors and consumers. Banking houses combined brokerage, underwriting, and commercial banking to sell securities to the gullible. More and more people invested "on margin." The policy innovations of the '30s blocked a repetition of these abuses by regulating securities markets, separating commercial banking from investment via the Glass-Steagall Act, limiting margin investing, and so on.

But by the '90s, a host of newly invented abuses overwhelmed the regulatory regime of the '30s. Who needs margin when you have derivatives? By the time Glass-Steagall was formally repealed, the creative breaching of its wall had become commonplace. So the point is not that "the genie can't be put back in the bottle." It's that naive worshipers of the market smashed the bottle, and that new genies require new bottles. Despite Republican hesitancy, Bush will likely sign legislation separating auditing from consulting, toughening accounting standards, criminalizing new categories of fraud, holding CEOs personally accountable for financial statements, mandating more independence for corporate boards, and perhaps changing the rules for stock options. This will be adequate to prevent the next wave of such abuses, until new scams are devised. It remains to be seen how much damage has already been done to the real economy.

But the disgrace of the laissez-faire experiment calls for a much more searching reappraisal of the market fundamentalism that has characterized this economic era. It isn't just that corrupt insiders were able to cook books and reap illicit rewards. Deregulated markets steered trillions of dollars to uses that will never pay back a penny. In industries like telecommunications, deregulation led to competitive overbuilding and mergers that were sheer economic waste. The collapse of antitrust enforcement stimulated a new wave of economic combination that served no purpose other than the concentration of market power and the enrichment of senior executives. The prestige of markets has lent credence to for-profit social institutions--HMOs, nursing homes, schools, hospitals--with perverse incentives to maximize earnings by avoiding the expensive cases and stinting on service.

Efficient capitalism is never built on a wholly free market. Markets do many things well. But they aren't so good at policing themselves, or allocating resources in sectors that are natural monopolies or social goods. If Congress merely cracks down on the flagrant self-dealing, it will not have learned enough from this vast wave of economic damage.

Robert Kuttner is co-editor of The American Prospect and author of Everything for Sale

Before it's here, it's on the Bloomberg Terminal.