Capitalism's high noon: The high profile scandals of Enron, Parmalat

Alberto Alesina and Francesco Giavazzi, Project Syndicate

Europe's Enron-induced schadenfreude is kaput. Last year's Vivendi and this year's Parmalat scandals have seen to that. Europe, like America -- indeed, like the entire capitalist world -- must now become more hawkish in demanding prosecution and punishment of bosses who loot their companies.

American prosecutors in the Enron case have made important progress lately, with some important crooks, like Andrew Fastow, offering both guilty pleas and a willingness to testify against their former colleagues. Fastow will go to jail for ten years; those he testifies against will face even longer sentences.

Italian prosecutors seem zealous to make those who looted Parmalat pay a similar price. But these cases go beyond the companies robbed and the shareholders betrayed. What is at stake is no less than the perception of the fairness of the market and political support everywhere for market-oriented policies.

Capitalist economies produce inequality, often large ones. Up to a point, and to the extent that income differences are due to differences in ability, effort, investment in education, etc., they are necessary to providing the correct incentives to invest, work, innovate, and grow.

But the more tainted the market's reputation for fairness, the more average citizens will see income differences merely as the result of corruption, illegal activities, connections with public officials, and so on. This will increase demands for more regulation and heavy government involvement in the economy, so as to bring unruly and untrustworthy capitalists under greater control.

Moreover, the more that wealth accumulation is viewed as "unfair" (i.e., the result of corruption and illegality), the more pressure for stiff taxation of "ill-gotten gains" will mount. If any of these populist measures would make markets fairer and better functioning, we would say, "So be it."

Unfortunately, reacting to corrupt businessmen in this way sets in motion a vicious circle: More regulation may lead to even more corruption in order to avoid it; higher taxes on wealth will bring about even more tax evasion, making the system even more tainted.

Sadly, nowadays, things as disparate as highly paid executives, the Enron and Parmalat scandals, contested mergers and acquisitions, stock market volatility, "junk bonds," and asset-price bubbles are all lumped together under the snide heading "cowboy capitalism." Europeans are particularly prone to see things this way -- and to see a powerful government as the sheriff to keep the cowboys from shooting up the town.

This is especially worrisome because Europe has recently begun moving in the right direction by deregulating its markets. With political support for these changes still shaky, the risk is that opponents may use Parmalat, Enron, Vivendi, and other cases as an excuse to reverse the process.

In many developing countries, weak regulators and a widespread perception of corruption often stand in the way of pro-market reforms; the left (populist or otherwise) can credibly argue that capitalism is "corrupt" and so must be taken under the wing of the government.

This is a big reason why market capitalism has such a hard time taking root in the developing word. If capitalists are corrupt, how can you convince a poor peasant to believe in the market economy? He will vote for populist policies. The result is even more corruption and less growth in a sort of "corruption- induced" poverty trap.

The Parmalat scandal may have been a blow to global capitalism, but in Italy it is hoped that it might sound the death knell for an economic system traditionally based much more on "connections" amongst private groups -- and between these groups and the public sector -- than on competitive markets.

For Italy, the obvious solution is to strengthen the country's investigative and financial institutions, and improve the design of regulatory agencies, particularly the quality of their personnel.

This, however, will not happen overnight, and in the meantime the demand for more regulation may result in a structure that is heavy, ineffective, and in the end impedes, rather than corrects, market forces.

Supervision inside Italian firms should be strengthened by making sure that a sufficient number of non-executive directors sit on the boards of public companies. A single independent director would probably have been enough to blow the whistle at Parmalat: There were none on its board.

Similarly, it might help to have accounting firms be selected by minority shareholders or paid by the stock exchange, rather than by a company itself.

Here, even the recent changes in the U.S. have not gone far enough: They prevent accounting firms from also serving as advisors to a firm, but they still leave the decision about remunerating the accountants in the hands of the company, thus creating a perverse incentive to play fast and loose with financial reporting.

It is surprising that while the Italian government is busy redesigning the regulatory and supervisory structure of the country's financial institutions and financial markets, nothing is being said about independent directors and accounting firms. After all, good sheriffs need active citizens to be in their posses and to serve on juries. Clean capitalism needs the same sort of widespread engagement.

Alberto Alesina is Professor of economics at Harvard University and Francesco Giavazzi is Professor of economics at Bocconi University, Milan.