What We Learned in 2002
The year 2002 won't be missed by many. Shell-shocked investors withdrew from the markets to nurse wounded feelings of loss and betrayal. A stunned corporate elite retreated to ponder the plunge in respect it suffered from a wave of business scandals. If 2001 was a wild ride caused by a bursting tech bubble--and exacerbated by September 11--then 2002 was a painful learning experience for a chastened nation. We began to understand just what went wrong in the '90s boom when the excess started.
As the new year begins, let's reflect on what we learned over the past 12 months. The lessons are sobering, and should motivate us to complete the job of restoring the checks and balances of our capitalist system--in corporate governance, accounting, Wall Street, and government regulation--that so failed us. The stakes are high. Risk-taking is a quintessentially American trait and plays a large role in its economic success. But over the past year it has been replaced by risk-aversion and extreme caution. Unless investor trust is restored and confidence returns to the managers of Corporate America so that they are willing to invest for the future, no amount of tax-cutting can restore the U.S. to its true economic potential.
Lesson No. 1: The problems revealed by the scandals were systemic, not the result of a few bad apples. While only a few CEOs may go to jail for breaking the law, the breakdown was endemic to both the corporate and financial systems. Most CEOs, not just a few, were overcompensated for success and protected from failure. Many, not just a few, accountants, analysts, attorneys, regulators, and legislators failed, to one degree or another, in ensuring the accuracy of financial statements and the free flow of honest data in the markets.
Lesson No. 2: Regulation matters. The failure to set rules in new markets cost investors and consumers billions of dollars. The absence of virtually any regulation in Internet energy-trading markets led to false shortages, fake trades, huge profits, and enormous financial and economic losses in California. Deregulation should not mean anarchy, deceit, and greed hiding behind a twisted interpretation of Chicago School economic theory. Markets need clear rules and policing to be open, transparent, and fair.
Lesson No. 3: On Wall Street, conflicts of interest are not synergy, as Jack Grubman would have it. Analysts who sit in on board meetings, go on road shows, mislead individual investors, and feign objectivity on CNBC but get paid for generating investment banking business are not being synergistic. They are being corrupt. Separation of financial activities, solid Chinese Walls and, above all, serious managing of conflicts of interest are crucial to the honest operation of capital raising and investment in the economy.
Lesson No. 4: Boards count. The most important check on CEO behavior is the board of directors. The failure of boards to do their job as shareholder representatives--and advocates--was a major cause of corporate scandal in 2002. Many boards condoned outlandish CEO demands for millions of options, personal loans, repricing of underwater options, loose accounting, and, in the case of Enron Corp., deliberately abandoning the corporate code of ethics. Independent board members heading audit and compensation committees are essential to the proper functioning of companies. Separating the function of CEO and chairman, who oversees the CEO, may also be needed at some companies.
Lesson No. 5: CEO pay is too high. Execs weren't entitled to become super-rich in the roaring '90s and are certainly not today. In the past decade, companies that granted 90% of all options to CEOs and a few top managers performed worse than those that distributed options more evenly and fairly among employees. There is no justification for increasing the compensation of CEOs from 40 times that of the average employee in the '60s to nearly 600 times today. Stock prices have come down since the bubble burst, investors have lost billions, people have been laid off, retirement funds have been cut, and profit projections have been trimmed. Yet CEO pay remains sky-high. This is untenable.
Lesson No. 6: We know a lot less than we think we know about economic policy. Supply-siders and deficit hawks battle over tax cuts, deficits, interest rates, and growth, but neither side has the economic theory or data to prove it's right. The failure of economy theory to decide key economic issues makes policy-making extremely ideological and partisan.
Lesson No. 7: Deflation is the new enemy. Our grandparents knew this from the '30s, but we're only discovering it now. Technology, higher productivity, greater competition and globalization (meaning huge imports from China), plus inflation-fighting monetary policies, have combined to send many prices lower, perhaps too low. Companies have difficulty generating profits partly because they can't raise prices. Without officially saying so, the Fed has gone into deflation-fighting mode, flooding the economy with money, cutting interest rates, and allowing the dollar to fall 5% on a trade-weighted basis this year. The result? Nonoil commodity prices and prices for imported consumer goods are slowly rising, helping companies to rebuild their profit margins.
This Christmas season finds most Americans anxious about their economic future. They should take heart, however, in the fact that the markets in 2002 began to develop a new, more solid foundation for future gains. There is a focus on companies with real assets and simple, comprehensible balance sheets with reasonable valuations. Checks and balances are being restored in the financial system and corporate governance is improving. We learned some difficult lessons in 2002, and 2003 is going to be better. Maybe a lot better.