Dishonest Capitalism Won't Go Unpunished

Innovation can't offset the damage and waste caused by corruption

By Robert Kuttner

Here is a puzzle. The U.S. economy squandered trillions as a result of the 1990s stock market bubble and Wall Street conflict-of-interest scandals. In optical fiber alone, investors laid out tens of billions of dollars that will never return a penny, gulled by misleading corporate balance sheets and demand projections. Deeper systemic corruption, such as stock analysts feathering their own nests, harmed both the efficient allocation of capital and investor confidence.

But in causing lasting damage, these affronts to honest capitalism seem to be the dog that didn't bark. Corporate profits and gross domestic product growth have done nicely since 2002. If the economy is entering a cyclical downturn, the causes are more likely a weak dollar and high oil prices. For those who believe in transparent capitalism, it's even more disconcerting that Germany and France, which got through the 1990s with no comparable scandals, clearly trail the U.S.

So, is transparency overrated? Is it O.K. for insiders to pad earnings, line their own pockets, and fleece investors as long as they generate plenty of new activity?

Not necessarily. Consider that when economists talk about efficiency, they usually mean the allocative efficiency celebrated by Adam Smith -- supply and demand producing accurate price signals. In the case of capital markets, stock prices signal investors with different appetites for risk where to put their money. The more dishonest the earnings reports, the more distorted are these price signals -- and presumably the greater is the damage done to efficient allocation.

BUT PERHAPS CAPITAL markets can withstand a fair amount of corruption and inefficiency if they are offset by other gains. For example, there are two other kinds of efficiency, linked with economists Joseph A. Schumpeter and John Maynard Keynes. Schumpeter was the prophet of technology as the source of growth. He didn't mind some price inefficiency. He even had a kind word for monopolies: True, they distorted prices but also generated profits that the monopolist could invest in innovations to protect his dominance. (Schumpeter would have loved Bill Gates.) As Thomas L. Friedman points out in his latest book, The World Is Flat, the past decade has been a Schumpeterian Age. Evidently, it didn't much matter that the Chinese have rigged the prices of their currency and capital costs. Innovation trumped allocative efficiency.

Then there's the efficiency of Keynes, who could accept price distortion as long as it got idle resources back into productive use. In our day, Keynes has had some improbable allies, with names like Reagan, Bush, and Greenspan. Federal Reserve Chairman Alan Greenspan's principal Keynesian contributions were threefold: He let the New Economy grow much faster than many thought prudent, he served as chief enabler of President George W. Bush's fiscal deficits, and he cleaned up market messes that would have clobbered growth.

Indeed, at least four times in the past 20 years the Fed has overridden market pricing verdicts. In the early 1980s, when money-center banks were under water from nonperforming Third World assets, the Fed loosened reserve requirements to let them stay afloat. After the stock crash of 1987, the Fed flooded the system with liquidity. In the late 1990s the Fed lowered interest rates after the Long-Term Capital Management and East Asian speculative meltdowns. Indeed, a key difference between the Roaring '20s and the freewheeling '80s and '90s is that central bankers latterly countermanded markets to keep things from coming off the rails.

So are corruption and self-dealing trivial if innovation keeps coming, if the Fed saves the system from its excesses, and if borrowing keeps the show afloat? Not quite. Dishonesty and bad debt can do lasting damage. The 1930s, like the 1990s, were years of heroic technological innovation, but inventions such as television could not be commercialized because the economy was becalmed. Schumpeterian innovation is not a cure-all if the financial system is a mess. Just ask a Japanese banker.

As for debt, even Keynes did not favor borrowing in all seasons. New borrowing can compensate for a lot of bad debt, but only up to a point. George Bush's public deficits have entered an unsustainable red zone, and private debt is also alarming money markets. Greenspan, finally, is having to raise rates in an economic slowdown. So the pricing efficiency of Adam Smith may be somewhat overrated, but dishonesty increases the system's vulnerability to bubbles and crashes.

Robert Kuttner is co-editor of The American Prospect ((

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