THE GREED CYCLE.(Brief Article)

Publication: The New Yorker

Publication Date: 23-SEP-02

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COPYRIGHT 2002 All rights reserved. Reproduced by permission of The Condé Nast Publications Inc.

There are many ways to take the measure of what has happened to corporate America in recent years. As good a way as any is to flip through some back copies of the Financial Times, which recently published a remarkable series of articles on what it termed the "barons of bankruptcy--a privileged group of top business people who made extraordinary personal fortunes even as their companies were heading for disaster." The F.T. examined the twenty-five biggest business collapses since the start of last year. From the beginning of 1999 to the end of 2001, senior executives and directors of these doomed companies walked away with some $3.3 billion in salary, bonuses, and the proceeds from sales of stock and stock options. Some of the names on the list were familiar to anybody who reads the papers: Global Crossing's Gary Winnick ($512.4 million); Enron's Kenneth Lay ($246.7 million); and WorldCom's Scott Sullivan ($49.4 million). However, there were also many names that haven't received much public attention, such as Clark McLeod and Richard Lumpkin, the former chairman and the former vice-chairman, respectively, of McLeodUSA, a telecommunications company based in Cedar Rapids, Iowa. These two corporate philanthropists cashed in stock worth ninety-nine million dollars and a hundred and sixteen million dollars, respectively, before the rest of the stockholders were wiped out.

Even veteran observers have been taken aback by recent events. "It became a competitive game to see how much money you could get," Paul Volcker, the former chairman of the Federal Reserve Board, told me when I visited him at his office in Rockefeller Center a couple of weeks ago. Earlier this year, Volcker tried and failed to rescue Arthur Andersen, Enron's accounting firm, which ended up going out of business. "Corporate greed exploded beyond anything that could have been imagined in 1990," Volcker went on. "Traditional norms didn't exist. You had this whole culture where the only sign of worth was how much money you made."

Economists from Adam Smith to Milton Friedman have seen greed as an inevitable and, in some ways, desirable feature of capitalism. In a well-regulated and well-balanced economy, greed helps to keep the system expanding. But it is also kept in check, lest it undermine public faith in the entire enterprise. The extraordinary thing about the last few years is not the mere presence of greed but the way it was systematically encouraged and then allowed to career out of control. Kenneth Lay, in quietly selling stock and exercising stock options worth more than two hundred million dollars shortly before Enron collapsed, wasn't just being a selfish, unscrupulous individual: he was defying the social contract that underpins a system, which, despite its faults, has lasted almost two hundred years.

In 1814, Francis Cabot Lowell, a Boston merchant, founded the first public company, when he built a textile factory on the banks of the Charles River in Waltham, Massachusetts, and called it the Boston Manufacturing Company. Lowell had smuggled a plan of a power loom out of England, and he intended to compete with the Lancashire mills. But he couldn't afford to pay for the construction and installation of expensive machinery by himself, so he sold stock in his company to ten associates. Within seven years, these stockholders had received a cumulative return of more than a hundred per cent, and Lowell had established a new business model. Under its auspices, mankind has invented cures for deadly diseases, extracted minerals from ocean floors, extended commerce to all corners of the earth, and generated unprecedented rates of economic expansion.

Initially, most economists were skeptical of Lowell's innovation. At the heart of any public company there is an implicit bargain: the managers promise to run the company in the owners' interest, and the stockholders agree to hand over day-to-day control of the business to the managers. Unfortunately, there is no easy way to make sure that the managers don't slack off, or divert some of the stockholders' money into their own pockets. Adam Smith was among the first to identify this problem. "The directors of such companies . . . being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private [company] frequently watch over their own," Smith wrote in "The Wealth of Nations." And he went on, "Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company."

Smith thought that private companies would remain the normal way of doing business, but technological change and financial necessity proved him wrong. With the development of the railroads, for example, companies like the New York Central and the Union Pacific needed to raise tens of millions of dollars from outside investors to lay track and buy rolling stock. And because the administrative complexity of the railroads was too much for a single entrepreneur to handle, a new class of full-time executives, men like Collis P. Huntington and Edward C. Harriman, emerged to run them. Though the emerging industry attracted dubious financiers like Jay Gould, most of the professional managers were content to collect generous salaries and pensions rather than habitually attempt to rob the stockholders and bondholders. "It is a strong proof of the marvelous growth in recent times of a spirit of honesty and uprightness in commercial matters, that the leading officers of great public companies yield as little as they do to the vast temptations to fraud which lie in their way," the British economist Alfred Marshall said in 1890.

Alas, by the late nineteen-twenties it was clear that corporate perfidy was prospering in an impressive variety of forms, most of them involving insiders exploiting their position to fleece outsiders. After the stock-market crash of 1929, congressional investigators uncovered widespread insider trading, stock-price manipulation, and diversion of corporate funds to personal use. Then, as now, the revelations of corporate wrongdoing prompted the federal government to respond. The Securities Act of 1933 imposed extensive disclosure requirements on any company wanting to issue stock, and outlawed insider dealing and other attempts to manipulate the market. In 1934, the Securities and Exchange Commission was set up to enforce the new regulations.

Public confidence in business eventually recovered, but the potential conflict of interest at the heart of public companies was never fully resolved. During the nineteen-sixties and early seventies, corporate managers were often cavalier about the interests of stockholders. Back then, the chief executive's compensation was usually linked to the size of the firm he ran--the bigger the company, the bigger the paycheck. This encouraged business leaders to build sprawling empires rather than focus on their firms' profitability and stock price. Many of them spent heavily on perquisites of office, such as lavish headquarters and corporate retreats, and they kept on spending even when their companies ran into trouble.

In theory, the stockholders could have joined together to force out managers, but organizing such a collective effort was costly and time consuming, and it rarely happened. Nor was managerial waste constrained by competition from rival firms that didn't splurge on pink marble for the office bathrooms. Companies like General Motors saw their businesses decimated by foreign competition, but C.E.O.s, such as G.M.'s Roger Smith, rarely suffered. From a stockholder's perspective, something more potent was required to get those who ran the companies to serve the interests of those who owned the companies. When the solution materialized, it would turn out to be more potent than anybody had imagined.

Thirty years ago, two obscure young financial economists provided the spark for reform. Michael Jensen and William Meckling had graduate degrees from the University of Chicago, where Milton Friedman and his disciples taught that there was little wrong with the American economy that more competition wouldn't resolve. During the early seventies, Jensen and Meckling, who were then both at the University of Rochester, tried to apply this idea to the internal workings of the public company. They began with the supposition that senior managers, faced with competition from other firms, would do the best they could for their stockholders, by cutting costs...

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