Following the Enron scandal, there have been widespread calls for more government regulation of accounting and financial markets. I take the opposite position and suggest that it has been exactly an increase in rules and regulations that brought us to Enron and other cases of faulty accounting in recent years. I think that the real solution to the problem is to properly deregulate financial markets and the financial accounting system.

A radical idea? Yes, but one I hold with good company. The NYU Stern School of Business’ most famous Alumnus, Alan Greenspan, predicted that government regulations could lead to this kind of mess almost forty years ago in an essay “The Assault on Integrity,” later republished in Ayn Rand’s “Capitalism: The Unknown Ideal.” While Alan Greenspan is now known as a master of obfuscation, back in 1963, under Ayn Rand’s auspices, he wrote with remarkable vigor and clarity. Here are some choice quotes few would guess were penned by Greenspan:

“Reputation, in an unregulated economy, is a major competitive tool. It requires years of consistently excellent performance to acquire a reputation and to establish it as a financial asset…Thus the incentive to scrupulous performance operates on all levels… It is a built-in safeguard of a free-enterprise system…Government regulation is not an alternative means of protecting the consumer. It does not build quality into goods, or accuracy into information. It’s sole “contribution” is to substitute force and fear for incentive as the “protector” of the consumer… What are the results?”

“To paraphrase Gresham’s Law: bad “protection” drives out good. The attempt to protect the consumer by force undercuts the protection he gets from incentive. First, it undercuts the value of reputation by placing the reputable company on the same basis as the unknown, the newcomer, or the fly-by-nighter. It declares, in effect, that all are equally suspect…Second it grants an automatic guarantee of safety to the products of any company that complies with its arbitrarily set minimum standards…The minimum standards, which are the basis of regulation, gradually tend to become the maximums as well…A fly by night securities operator can quickly meet all the S.E.C. requirements, gain the inference of respectability, and proceed to fleece the public. In an unregulated economy, the operator would have had to earn a position of trust…”

“Protection of the consumer by regulation is thus illusory. Rather than isolating the consumer from the dishonest businessman, it is gradually destroying the only reliable protection the consumer has: competition for reputation…Government regulations do not eliminate potentially dishonest individuals, but merely make their activities harder to detect or easier to hush up.”

It is important here to distinguish that by a unregulated economy I do not mean anarchism, i.e., no government laws, but I mean capitalism operating under a “rule of law”. Under such a system there are laws which punish the violation of rights, but there are no laws explicitly “regulating” individuals who are not violating the rights of others. The difference is that regulations hold someone guilty until he is able to prove himself innocent to a government official; under a rule of law one is free to do what one wishes until one is proven guilty. This is an essential difference between a “common law” system and statutory or “code law” system.

The financial accounting system has become joined at the hip with the government regulatory apparatus. The SEC has delegated powers to the FASB, and has, in return, gained influence over the accounting profession. This, in turn, has caused financial accounting and auditing to move away from its English “common law” roots, where judgment, disclosure, and fairness are the key to winning the confidence of investors, and in which companies and auditors strive to preserve their reputations. The US financial accounting system, due to government regulations, is increasingly moving towards the “code law” system, where disclosure is fit into the straightjacket of government dictates, leaving companies and auditors to see themselves as merely bureaucrats filling out government forms.

The star witness of the Enron investigations, Sherron Watkins, alluded to this in a brilliant moment, the importance of which was overlooked by her congressional questioners:

“Somehow in this country our financial accounting system has morphed into the tax code. In tax accounting if you follow the codes, whatever result you get, you’re justified in using that. In financial accounting, a number of my accounting friends have said if you follow the rules, even if you get squirrelly results, you have a leg to stand on. I’m surprised the financial accounting system has morphed into that because you should still fairly represent your financial condition.”

The key idea here is that the government, by regulating required disclosures, gives a false sense of security to accountants, companies and investors. Companies and their auditors can cover their behinds in tricky situations by saying they complied with the letter of the law (or accounting rule). Ironically, Congress, after hearing Ms. Watkins’ testimony is likely to propose more onerous regulations moving the financial accounting system further down the code law path. As usual, capitalism and freedom–the solution–takes the blame for an accounting system that is being distorted by its opposite, government controls.

NYU’s brilliant accounting professor Baruch Lev has made some excellent points relevant to this subject. In my first Financial Accounting class, Professor Lev brought in a financial report prepared by US Steel from around 1903, a time before the government established the SEC or got involved in accounting standards. He pointed out that in almost every respect, US Steel’s financial statements offered as good or better disclosure and better information than financial statements do today. And they were provided more frequently, monthly. Back then, US Steel and its auditor had to EARN investors’ trust in the marketplace. Now, companies just try to get away with murder, while minimally adhering to the letter of the law and accounting rules.

On 1/22/02, Lev wrote a provocative and thoughtful article, “Too Gray For Its Own Good” in the Wall Street Journal. In it, he pointed out that there is no competition among auditors to produce the best-quality product to its ultimate customers, the shareholders, and that auditors instead seek to just “get by and meet government regulations. Auditors are gray, undifferentiated, and produce the same bland statements. He observed that “an impediment to differentiation in many markets is the difficulty of observing the quality of product.” Lev hoped that somehow, competition could be introduced to the audit profession.

I suggest that Alan Greenspan, forty years ago, identified the most fundamental cause of auditors’ current moral and professional grayness. Government regulation has diminished the value of establishing one’s reputation on the free market, and thus reduced the benefits of differentiation. Why compete to be the “best” governmental-form-filler-outer? When standards are seen as government-authorized, there is little reward but great risk in deviating from or going beyond those standards. Of what value are notes one makes on the margins of one’s IRS Form 1040?

Why should a company seek superior auditors in today’s system? Analysts and investors already assume that if companies have complied with the massive amounts of rules and regulations already in existence, then everything must be fine. Since practically all companies are asserted to be in compliance with accounting rules the SEC delegated to the FASB, investors tend to assign equal reputations to all companies.

I propose that the solution is to remove regulations on financial markets, and remove government’s influence on the accounting process. We should return to the financial markets’ and accounting’s common law heritage. Fraud would of course be punished severely, as a violation of property rights, as it has been for hundreds of years under contract law. Prosecution of fraud would likely be easier, not harder in a common law (as opposed to code law) system, as Auditors would not be able to hide behind the letter of the law, and investors could sue them if they can make a case that auditors knowingly failed to provide full disclosures.

In deregulated markets, companies and their auditors would need to compete for the trust of investors by providing real, digestible, information, not by just meeting government requirements and no more. Deregulation would also strip away the false and dangerous notion that investors can trust government regulations and standards to make all companies “safe” and “trustworthy.” Investor skepticism is the first line of defense against fraud in a free economy, but becomes dull in a regulated environment. An unregulated free market provides the environment in which auditors who differentiate on a reputation for quality and useful disclosures could add value to their business, and their customers’. And crooked auditors, once their reputations were lost, would find themselves quickly out of business, a prospect likely to inspire much stronger internal controls.

I’ll give Alan Greenspan the final word: “Capitalism is based on self-interest and self-esteem; it holds integrity and trustworthiness as cardinal virtues and makes them pay off in the marketplace. It is this superlatively moral system that the welfare statists propose to improve upon by means of preventative law, snooping bureaucrats, and the chronic goad of fear.”



About Andrew West

Andrew West is a Contributing Economics Editor for Capitalism Magazine. In 1997 he received the Chartered Financial Analyst designation from the Association for Investment Management and Research.