The corporate scandals of the past year and a half have sent shock waves through Wall Street — and generated numerous proposals for reform on Capitol Hill.
So far, the most significant piece of legislation to emerge is the Corporate Responsibility Act, more commonly referred to as Sarbanes-Oxley after the law's two sponsors. Among other things, it requires that companies' accounting firms be selected by the audit committees of the boards of directors and that top executives certify personally the accuracy of their companies' financial statements. In addition, the New York Stock Exchange and Nasdaq have implemented new rules of their own. Some observers have called these reforms inadequate. They argue that accounting firms should not be able to provide both auditing and consulting services for companies, as Arthur Anderson LLP did for Enron Corp., and that companies should have to rotate accounting firms periodically. In the following interview, Robert Litan argues that such additional changes would do little good and that, while the worst of the corporate scandals may be behind us, they are probably far from over.
Litan is vice president and head of economic studies at the Brookings Institution, arguably the most prominent think tank in Washington, D.C. An economist and lawyer, he has held positions with the Office of Management and Budget and the Department of Justice. He also has lectured at the Yale Law School and served as a consultant to the Department of the Treasury. In addition to speaking about corporate governance, Litan shares his thoughts on the role of think tanks in the public policy process, the state of international trade policy, and the economic promise of the Internet. Aaron Steelman interviewed Litan at Brookings on Sept. 26, 2002.
RF: Brookings is a large research organization with prominent scholars doing academic work across a variety of fields. Yet many of these scholars are also intensely interested in changing the way Washington operates. How do Brookings and other think tanks affect public policy?
Litan: I think that all think tanks want to be policy-relevant, and to differing degrees they work directly and indirectly toward that goal. One way is through close contact with policymakers. Sometimes, for instance, think tank staffers might help draft a piece of legislation or regulation. That type of influence is direct and often immediate. We also have contact with the media and the academic world. By having our views known through books, articles, and editorials — and then having our ideas diffused through academia — there is an indirect impact from the sum of all these activities.
I'll give you three examples of how I think Brookings has contributed to policy in the past. My predecessor as economic studies director, Joe Pechman, spent his entire career arguing for a fairer and simpler tax code by cutting out loopholes in return for lowering rates. Joe was a Democrat. But the administration that ultimately adopted his view was the Reagan administration. It pushed through the 1986 Tax Reform Act, which I think was a monument to Joe's lifelong work and which unfortunately has been substantially undone by so many incremental changes to the tax code. But I think Brookings helped lay the intellectual foundations for a fairer and simpler tax code.
The second area in which I think Brookings has had an effect is the budget deficit. We wrote about the topic ad nauseum throughout the 1980s. And I think that a lot of the arguments for deficit reduction — the notion that it would lower real interest rates and so on — were made and strengthened by people here at Brookings.
Finally, Charles Schultze and others were very active in opposing large-scale industrial policies that were popular in the 1980s and early 1990s. Fortunately, in the end, the United States didn't adopt the central-planning policies that have been tried without success elsewhere. And part of that, I think, can be attributed to the efforts of people at Brookings.
RF: Let's talk about your work on corporate governance. Some have argued that firms should be prevented from providing both auditing and consulting services for their clients. But you have maintained that such a law would have little effect.
Litan: The charge that has been leveled against the accounting firms is that if they are involved in all these other activities, they will either explicitly or implicitly bend over backward to favor management. Exhibit A, of course, is Enron, where Arthur Andersen had $27 million in fees from nonaudit work and $25 million from audit work during its last year. The claim is that Arthur Andersen went along with Enron's shenanigans because they feared losing the $27 million. My point is that if we end up restricting accounting firms to only audit work, some firms will still be tempted to please management, because they will not want to take the chance of losing their only source of income. This demonstrates that the central problem that needs to be addressed is: Who hires the auditor? If it's management, then there will always be a potential danger of the auditors bending to management's will. But if it's somebody else, that danger is reduced. Through a combination of actions by the exchanges and Congress, the rule now is pretty clear that the auditors have to be hired by the audit committees of boards of directors. These committees are one or two steps removed from management and that, I think, significantly increases the chances for auditor independence. So, in my view, this is the real reform. Telling auditors that they shouldn't be in the consulting business is attacking the symptom of the problem, not the source of the problem.
RF: One problem with such a reform is that you might have difficulty finding people who would be willing to serve on boards of directors. How would you respond to that criticism?
Litan: It is true that serving on a board is now fraught with much greater responsibility and risk than appeared to be the case a couple of years ago, especially if you serve on the audit committee. It's not a full-time job, but it's a significant part-time job. It seems to me that the only way you are going to attract quality people to serve on these kinds of committees will be if you pay them more. This is one example among many of how the Enron-related scandals are going to lead to higher costs for corporate governance.
RF: Given what you said about the proposal to prohibit firms from providing both auditing and consulting services, I assume you are also skeptical of the idea of mandatory rotation of audit companies. Is that right?
Litan: Under the Corporate Responsibility Act, there is a requirement that the auditing firm rotate the individual partner in charge every five years. But the law did not require mandatory rotation of the firms themselves. That idea, I think, is being evaluated by the General Accounting Office. I have been skeptical of such a proposal for at least two reasons. First, the auditing industry is very concentrated, so we are only talking about a handful of firms. The second concern is, if you are worried about auditing firms bending too far in the direction of management, then why aren't you worried, in a world of mandatory rotation, that one of the three firms left to bid for a new job will make an implicit agreement with management to go easy on them?
RF: One could argue that the examples of Arthur Andersen and Enron will lead companies to act more prudently. Do you think that the market could provide much of the discipline necessary to correct the problems of corporate governance?
Litan: Even before Congress and the exchanges took action, there had already been substantial market self-correction. Accounting firms got tougher, boards of directors got tougher, the analysts got tougher, the rating agencies got tougher, and management got scared. This had nothing to do with legislation. And then, of course, we are going to have the lawsuits. All these things are part of the self-correcting mechanism of our system of governance, and they will help prevent future Enrons. But scandals and episodes of excess have a way of coming and going, and memories have a way of fading. For example, we know that when real estate cycles go bust, lending officers are seared by the experience. But when a new crop of officers take their place, they make many of the same mistakes. So, while self-correction is helpful, I don't think it hurts that we have institutionalized some of these additional changes.
RF: Do you think that the worst of the corporate scandals are behind us?
Litan: Speaking here in late September 2002, I still think it is premature to say that we are finished with these type of corporate scandals. The major reason I say this is that Congress has just given the Securities and Exchange Commission (SEC) several hundred million more dollars to enforce the disclosure laws, and we have a new oversight committee for the auditing industry. With all these extra resources, it would surprise me if we don't find more scandals. I don't know if they will be the size of Enron or WorldCom. But the fact is with more cops on the beat, the chances are more crimes will be reported and discovered. I can virtually guarantee that there will be more earnings restatements and more enforcement actions as a result of all this initial effort that will be poured into scrutinizing accounting standards.
RF: It seems that your last response begs the question: Is it worth it? After all, the optimal amount of crime isn't zero, because it would be too expensive to get such a result. How will we know when we are spending the right amount of resources on enforcement?
Litan: At this point, I don't know how you would do a cost-benefit analysis. All I know is that we are pouring more resources into monitoring: we have increased the budget of the SEC, we are spending more on corporate boards, accountants are charging more money, and liability insurance rates are going up. You add all those things together, and it wouldn't surprise me that you find that several billion dollars more will be devoted to corporate governance. Will that be worth it in terms of restoring investor confidence? I think that the answer is yes. I have recently completed a paper with two colleagues at Brookings in which we attempt to quantify the economic costs of the corporate accounting scandals. We estimate that the macro costs would be somewhere in the range of $40 billion on an annual basis. I'm not going to say that's a permanent cost, because eventually I think the market will recover. But, at least on the surface, it appears that the extra monitoring costs will be worth it.
RF: Is there something about an extended economic expansion that makes Enron-like shenanigans more likely?
Litan: I don't think it was the boom so much as the shift toward performance-based pay and the related move to award executives handsome stock options. Now, I am not against performance-based pay. In fact, I'm all for it. I think that there are very good reasons why management's compensation ought to be tied to corporate performance. However, what I think we have learned as a result of this mess is that when you base compensation on measures that are related to the stock market — and earnings are one such measure — you are tempting the unscrupulous to cook the books. And there is some fraction — some tail of the distribution — that will go over the edge.
I don't know if there is a rise in the number of unscrupulous people running corporations now compared to the early 1990s. Let us assume that it's the same percentage. It's just that with different sets of incentives, the unscrupulous were given greater reasons to act that way in the late 1990s than they were a decade before. I think it's the only plausible explanation as to why we got so many people willing to engage in accounting manipulation.
RF: Are banks special, in some sense, when it comes to corporate governance issues?
Litan: Let's break that question down into two parts. First, do banks have themselves any special obligations to be holier than thou on corporate governance issues? We know banks are special, for reasons that Jerry Corrigan [the former president of the New York Fed] articulated well in the early 1980s. They help create money, and they are critical to the lending process. But we also know that banks are a lot less special than they used to be. But the fact that they are special means that we have ended up insuring their deposits and heavily regulating them. And given that there is a regulatory regime in place, this attenuates the need for any special corporate governance rules.
Now, there's a separate issue. Should banks in their capacity as lenders be more vigilant in exercising oversight of corporations they lend money to? My instinctive response is no. When we speak of corporate governance, we are typically thinking about shareholders, not creditors. Creditors don't need to govern — they have loan agreements and covenants that protect them. The reason why we need governance rules typically is to protect equity shareholders. So, if banks were allowed to directly make equity investments in companies, then I would say that banks would have a tremendous obligation to oversee companies, just as banks now do in Germany. But in our system, banks don't own equity, so I'm not sure that they should be charged with anything extra in the corporate governance area.
RF: In 1998 you and three co-authors published a book called Globaphobia: Confronting Fears About Open Trade. Since that time, there have been a number of high-profile protests at meetings of the World Trade Organization, the World Bank, the International Monetary Fund, and other groups. What do you think is the current state of the debate on globalization?
Litan: I think that the protest movement has elevated concern for the poor in the Third World. For example, I doubt that Paul O'Neill would have gone on a tour of Africa with Bono talking about debt reduction without the protests. So we should give them credit for raising these issues.
But the protest movement is an amalgamation of many different groups advocating many different things, some of which are contradictory and some of which make no sense. If you were to go out and talk to these people on the street, I bet that a lot of them would say that the way to help the poor is to require developing countries to raise labor and environmental standards or else we shouldn't take their products. To me, that's just another excuse for protectionism. I think you would find other people who wouldn't be even that sophisticated and who would say let's not trade abroad at all. On the other hand, you would also find groups like Oxfam, which in a recent report looked at America's trade barriers and came to what I thought was a sensible conclusion — that America is hypocritical. The United States argues for free trade while at the same time it subsidizes agriculture and maintains import barriers for textiles and other goods that are produced in the Third World. This is very sensible, yet Oxfam presumably would be lumped in this group of antiglobalization people, even though it is saying things that would not be supported by a lot of people on the street.
Let's go to the larger outlook for trade liberalization. Here, I am somewhat of a pessimist. I think that there is very little evidence that our Congress is interested in making the kinds of concessions necessary to induce other countries to open their markets. For example, I don't think Congress wants to change our antidumping laws or cut agricultural subsidies. In fact, we see a lot of evidence to the contrary. The administration faces a very tough uphill road in pursuing the multilateral agenda, which is why I think toward the end of the Bush term you are going to see much greater enthusiasm for bilateral trade deals. There are a number of countries that have lined up — Australia, Singapore, Chile — asking for potential deals. Those are much more likely to be enacted than, say, a free trade for the Americas deal.
RF: You've also recently written a book with Alice Rivlin titled Beyond the Dot.Coms: The Economic Promise of the Internet. You argue that it hasn't been all hype — that the Internet will, in fact, have a significant effect on the economy. In what areas do you think the benefits will be most widely felt?
Litan: The economic benefits of the Internet basically don't have much to do with the dot-coms. It's the technology itself that provides the boost to productivity. And this technology is spreading throughout the economy in much the same way that electricity diffused throughout the manufacturing sector many decades ago. Alice and I estimated that the diffusion of this new technology is going to add anywhere between .25 percent and .5 percent to annual productivity growth over the next five years. I have also done another study with Hal Varian in which we ask companies themselves to make estimates of what they think the benefits of using the Internet will be. We tabulated those results from almost 2,000 companies and came up with results that are very similar to what Alice and I got. I still remain optimistic that the Internet will have these productivity payoffs, even if almost all the dot-coms that are left today are dead five years from now.