Corporate Fraud and the "New Economy":  The Neoliberal Paradox

by Jim Crotty, CPE Staff Economist

The Popular Economist.  The Newsletter for the Center for Popular Economics Fall 2002

            Everyone knows that the stock market boom from 1997 through mid-2000 was based largely on corporate fraud.  Even Fed Chairman Alan Greenspan acknowledged that an "infectious greed" had gripped corporate America in recent years.  But why did greed suddenly become so destructive only in the late 1990's?  After all, in our capitalist economy greed in supposed to be the motive that always drives corporation decision-making.

            The answer lies in deep structural changes that have taken place in national economies in the past quarter century.  We have moved from a system in which governments regulated domestic business and finance and controlled most cross-border transactions to a system that offers free reign to corporations n an increasingly integrated global economy.  The new system, often called neoliberal globalization, has destroyed conditions needed for healthy long-term economic performance and created an economic and political environment in which an outbreak of corporate fraud became almost inevitable.   

            Under the new regime, the rate of growth of sales of goods and services has deteriorated.  United Nations data show that the global growth rate was 45% lower in the 1980's and 1990's than it was in the 1960's and 1970's.  At the same time, governments everywhere removed barriers to imports and investment by foreign corporations, opening national product markets to dog-eat-dog competition.  The combination of sluggish sales growth and destructive competition makes it impossible for most large nonfinancial corporations (NFCs) to achieve adequate profit most of the time.  At the same time, modern financial markets pressure NFC's to achieve ever-rising profits.  If they fail to do so, they face falling stock prices, collapsing managerial incomes and the prospect of hostile takeover.  I call this demand for higher profits in a system that cannot consistently generate them the neoliberal paradox. 

            From the end of World War II through the early 1970's, rapid demand growth and limited competition allowed U.S. NFCs to achieve high average profits.  By the early 1980's, however, just as product market competition was becoming intense, fundamental changes were taking place in U.S. financial markets.  Ownership of U.S. corporations was moving from patient individual stockholders to impatient institutional investors who demanded higher stock prices.  Corporations that failed to raise their stock price fast enough became vulnerable for the first time in the post war period to hostile takeovers.  NFC managers thus had to raise the firm's stock price or lose their jobs. 

            By the 1990s, institutional investors owned almost as much stock as individuals and executed three fourths of stock trades, so they could exert even stronger pressure on NFC management to keep stock prices rising.  But the drive for ever-rising stock prices also became internalized within NFC top management through the spreading use of stock options.  The typical stock option contract grants executives the right to buy company stock at the current stock price.  Thus, all subsequent price increases generate opportunities to sell at a capital gain.  An analysis based on an annual survey by Forbes Magazine showed that total pay for top CEOs rose from $1.3 million in 1970 to 37.5 million in 1999 (at which time it was 1,044 times the average worker's pay), and that the percent of top CEO pay in the form of exercised options rose from 22% in 1979 to 50% in the late 1980s and to 63% from 1995-1999. 

            Thus, by the late 1990s, as belief in the "New Economy" solidified, to NFC management was committed to generating the average annual stock price increases of 20% that institutional investors demanded.  Yet as stressed in the neoliberal paradox, NFCs cannot sustain high profits over the long term.  Government data show that NFC profit actually peaked in 1997, then fell in 1998 and 1999.  Yet rising stock prices require rising reported profit.  Management's response to this dilemma was simple - they cooked the books!  The profits reported by S&P 500  corporations rose by 42% from 1997 to 2000, as NFC management's used all the tricks made available by lax regulation, elastic accounting principles and sophisticated financial 'engineering' to deceive investors.

             The extent of the fraud became clear when many of the largest and fastest-growing NFCs were caught cheating.  WorldCom, which hid $3.8 billion in costs in its 2001 report had $107 in assets when it declared bankruptcy, and world-class cheater Enron noted:  "the scale and scope of the corporate management transgressions of the late 1990s now coming to light, exceeding anything the U.S. has witnessed since the years preceding the Great Depression." 

            Severe conflicts of interest deeply embedded in our neoliberal economic system allowed this massive fraud to occur.  Giant accounting firms signed off on deceptive NFC reports because consulting contracts generated more money for them than audits.  Bank stock analysts issued "buy" recommendations for weak NFCs because their banks needed the firms' investment banking business.  Congress defeated proposals to force firms to provide accurate accounting information because the financial and accounting industries are among the largest campaign contributors to politicians in an era when elections are obscenely expensive.  Thus, U.S. corporate executives were not suddenly "infected" by greed in the late 1990s as Alan Greenspan would have us believe.  Rather, qualitative change in our basic economic and political structures allowed the greed that is always present to poison the system, creating not only massive corporate fraud, but a severely damaged economy as well.

 Fraud was not the only serious problem brought on by neoliberalism.  The hostile takeover movement loaded NFCs with a trillion dollars of additional debt.  Successful raiders transferred debt used to buy the firm's stock to its books, while target firms took on new debt to buy their own stock and deliberately increased the firm's debt burden, which made takeover both more expensive and less attractive.  As a result, interest payments as a percent of JFC cash flow (profits after tax plus the depreciation allowances used to maintain plant and equipment) rose from less than 10% in the 1950s and 1960s to 30% at the end of the 1980s.  In the 1990s, firms had to increase their dividend payments to make their stock more attractive to institutional investors.  Dividend payments as a percent of cash flow rose from about 15% in the 1980s to over 25% by the end of the 1990s.  Finally, as stock sales from exercised stock options exploded in the late 1990s, NFCs were forced to buyback their own stock to avoid a fall in its price.  While defensive stock buybacks to prevent hostile takeovers in the 1980s reached a peak of 25% of cash flow, in the late 1990s sock buybacks cost NFCs 30% of cash flow. 

            NFCs need a secure source of patient and inexpensive finance so they can maintain consistently high investment in the capital goods, technology and employees they require to function properly over the long run.  Before the 1980s, retained cash flow provided a secure and reliable source of patient and inexpensive capital.  However, in the neoliberal era, NFCs were forced to disgorge most of their cash flow to financial markets, then compete with other firms, banks and individuals to get them back, often at high cost.  Total payments to financial markets by NFCs was less than 30% of cash flow in the early post war decades, but they averaged about 50% after that, peaking at over 70% in the late 1980s and late 1990s.  Under these financial arrangements, it is simply not possible for NFCs to make the long-term investments they need to sustain growth and create jobs. 

             The moral of this story is that the structural changes we call neoliberal globalization, though  supported by most economists, businessmen and politicians, pose a serious threat to our future economic well-being.