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Congress, Accounting, and the Free Market

Mises Daily: Tuesday, July 09, 2002 by

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The argument may be tired and hackneyed, but advocates never grow weary of presenting the same scenario, which goes as follows: Free markets are desirable, and unnecessary government regulation may stifle business growth, but we are living in a period of the Big Exception. Today, markets are in trouble, betrayed by the very practitioners of capitalism, and only new, outside regulations imposed by the state can bring back investor confidence and permit free markets to flourish once again.

The latest self-appointed “savior” of capitalism is Sen. John McCain of Arizona, who likes to speak of himself as “straight talking,” but who actually is nothing more than one of the many gasbags of Congress producing enough hot air to warm the planet many times. In a New York Times op-ed, McCain declares that the latest “string of corporate failures and scandals from Enron to WorldCom” have occurred because of lax regulation.[i] Thus, McCain intones, while being reluctant to impose even more regulations on the system, he believes the time is ripe to burden the system with, well, more regulations.

Before examining McCain’s proposals, I think it appropriate to ask why a member of Congress, of all people, believes he has the right to demand standards of accountability from anyone, let alone U.S. businesses. For example, he declares that corporations have “fabricated revenues, disguised expenses, and establish off-balance-sheet partnerships to mask liabilities and inflate profits.”

This statement is breathtaking, because he is describing current accounting practices of the U.S. government. Remember the nonexistent “surpluses” that seem to have disappeared?  It seems that for political purposes, Congress fabricated revenues. Is there a greater scheme of financial fraud than Social Security, a Ponzi construction which, if practiced in the private sector, is a sure ticket to prison? Ever hear of “off budget” agencies like Ginnie Mae, Freddie Mac, and Sallie Mae? These outfits are created precisely to hide the trillions of dollars of financial obligations that ultimately fall upon U.S. taxpayers.

To put it bluntly, McCain is party to what can be considered the greatest set of financial frauds in world history, something that puts the collapse of Enron and WorldCom in better perspective. It might seem more instructive for the physician to heal himself than for him to try to impose his will upon other parties.

However hypocritical McCain and his congressional mates might be, I realize there is still the need to answer his criticisms and to examine his proposals to “bring back confidence” to free markets. In other words, just because McCain may personally be a fraud does not automatically make his proposals fraudulent.

Unfortunately (or fortunately, as one might see it), McCain misdiagnoses the patient and calls for prescriptions which, if not killing it, will certainly do great harm.

Let us begin. McCain and all of the modern critics are absolutely wrong when they declare that a “crisis of ethics” exists. McCain is hardly alone here, as I have read columns by people of all political and religious stripes declaring that what is needed is a new batch of ethical standards.

In one sense, the problem is ethical, but not in the way the critics think. The current wave of “scandals,” if I may call them that, did not emanate from dishonest motives per se, but rather from the business climate brought about by the reckless efforts by Alan Greenspan’s Federal Reserve System to expand credit and create an unsustainable boom.

Because people are trained to view the Fed’s credit expansions as beneficial to the economy, they are unable to understand just how such actions create opportunities for financial shenanigans. The first thing to remember here is that the Fed’s efforts are absolutely dishonest in themselves, creating monetary reserves literally out of thin air. Once that is done systematically for a long time, it is inevitable that the rules of the game will change as well.

An atmosphere of reckless credit expansion creates all sorts of incentives for “creative” accounting practices. Take McCain’s accusation of false revenue projections, for example. It is little wonder that, during a credit-induced artificial boom, firms caught up in the financial madness will be much less careful in projecting future revenues than they would be in normal economic times or during a bust.

This is because the economic rules that apply during the boom are not the same rules that exist during the bust, when the realities of malinvested resources come to the fore. The boom permits business owners to play much faster and looser with assets and equity, since it seems that whatever decisions they make are good ones. This is the characteristic of the boom, in which most business owners look like financial geniuses; it is only during the bust that what Ludwig von Mises calls the “cluster of errors” made by businessmen are made known.

Right now, it is impossible to know if the overprojections made by executives at WorldCom were the result of deliberate fraud or simply came about because of boom-induced calculations. Everyone now knows that those calculation were in gross error, yet under the conditions that existed because of the Fed-caused artificial boom, WorldCom’s projections might very well have been reasonable.

That does not mean those projections were a good thing, given the conditions of the boom. Credit-induced booms are unsustainable, and someone must ultimately pay the piper. Furthermore, since they were based on an unreal state of the economy, one can say they were fraudulent in the larger sense of the word, although not fraud as McCain would define it. (Since the write-downs are in the billions of dollars, I doubt that anyone in his right mind would have cooked up such a scheme as a deliberate criminal fraud, since the market in the end always has a way of bringing such things into balance.)

If McCain wishes to hold Congress and the U.S. government to the same standards that they wish to impose upon private enterprise, perhaps his rhetoric should be aimed at Alan Greenspan, or even himself and the politicians and staff members that populate Capitol Hill. For example, he writes:

Top executives should be required to certify personally that the company’s public financial reports are accurate and that all information material to the financial health of the company has been disclosed. If their certification is false, they should go to jail.

This is a stunning statement--one that deserves thorough debunking--not to mention being one that is a sign of depraved hypocrisy. Does McCain mean that if a business makes revenue projections that do not pan out, then the executives should be imprisoned? How does one determine the “financial health of the company,” since those standards change drastically with business conditions and also with the latest set of regulations that come from the government?

For example, “tax reform” of 1986, as well as regulatory “reform” in 1989, exacerbated the collapse of many savings and loan institutions which otherwise were relatively healthy. When Congress, by the stroke of a pen, changed tax laws regarding real estate holdings, a number of thrifts which one day were healthy the next day became insolvent. Like the WorldCom and Enron debacles of today, many members of Congress, not to mention their media amen chorus, blamed the entire episode upon criminal fraud and were ultimately able to railroad innocent people, such as Charles Keating, into prison.

To put it otherwise, to implement such a policy would devastate American businesses, as every executive in this country would be in danger of being imprisoned because his or her company did not meet financial expectations. Such people would be prey for politically minded federal prosecutors, who have a vast array of weapons at hand to make people bow down to the criminal law apparatus of the government. It is easy for people like McCain, who do not have to meet a payroll or make important decisions regarding the life and health of an institution, to demand accountability standards that he himself would refuse to meet. Unlike Congress, businesses cannot take in revenues upon coercion. If I refuse to shop at Wal-Mart, for example, that is my right; if I refuse to give Congress the financial support it demands, then I go to jail.

Furthermore, if McCain really wants to impose these standards upon U.S. businesses, perhaps he first should begin with his own legislative house. After all, in calling for the resignation of Securities and Exchange Commissioner Harvey Pitt, McCain declares, “Government’s demands for corporate accountability are only credible if government executives are held accountable as well.” Does that mean U.S. senators? Should McCain be held criminally liable for campaign promises that he fails to honor? Should he be held criminally liable when he fails to keep his oath to “protect and defend” the U.S. Constitution?

These are questions I doubt the good senator would want to answer. Instead, we see the moral grandstanding that seems to be an occupational disease in Washington, D.C. One could only hope that real justice would prevail, and that the John McCains of this world would have to be subject to the same sets of laws and penalties they impose upon everyone else. Instead, we have legislation that will devastate private enterprises concocted as a scheme to “save capitalism.” Senator, we do not need to be protected from “predatory capitalism.” The real predators are in Washington, and they are you and your political allies.


William Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University. Send him MAIL.  See his Mises.org Articles Archive.


[i] John McCain, “The Free Market Needs New Rules,” New York Times op-ed, July 8, 2002.