Just how corrupt are the United States' capital market?

Robert J. Shiller, Professor of Economics, Yale University Project Syndicate

Why has the U.S. stock market done so well in recent months -- the Dow increased over 30 percent since its low on March 11, 2003, and closed above 10,000 on Dec. 11 -- even with the media reporting one financial scandal after another? We have seen Enron-style fraud from corporate management, Arthur Anderson-style smoke and mirrors from accountants, and now Putnam Funds-style market-timing irregularities from mutual funds. After all this dirt, why aren't more investors voting with their feet?

The most important reason is a sharp improvement in corporate earnings, and in economic conditions in general. The scandals may be pushing the boat of market sentiment downwards, but their effect is being overwhelmed by the rising tide of economic prosperity, at least for now.

To be sure, television, radio, newspapers, magazines, and Internet sites have been hyping financial misconduct, awakening and shaping the type of emotional responses that often have a powerful influence on financial markets. But attention-getting emotions (such as anger) are not the only factors that drive investment decisions.

Investors may respond emotionally, but they are unlikely to let their anger cause them to miss what appears to be a substantive increase in value. The excessive optimism of the late 1990s lingers, so investors are more impressed by the recent upsurge in corporate earnings -- seen as confirming their optimism -- than they are by the financial scandals. Next to the US$100 billion annual rise in after-tax corporate profits in the U.S. in 2003, the scandals look puny.

Indeed, the scandals look even punier when one realizes that the list of crooked U.S. companies, like Enron, is short. In 2002, Harvey Pitt, the former chairman of the U.S. Securities and Exchange Commission, made a dramatic call for CEOs of U.S. companies with revenues exceeding $1.2 billion to sign their financial statements by Aug. 14, 2002 -- and then be held criminally liable if the statements turn out to be fraudulent. The world anticipated a wave of "restatements" of past performance by anxious CEOs. But, of the more than 600 CEOs who signed by the deadline, not a single one admitted major error.

Is accounting in worse shape? The major accounting firms have clearly established a culture of permissiveness towards earnings manipulation. The 1990s saw an unprecedented rise in the number of quarters in which earnings beat analysts' estimates by a penny a share, suggesting that more irregularities could be discovered. But the fact that earnings beat estimates by a penny a share every quarter is itself only a sign of quarter-to-quarter manipulations of earnings, not of their wholesale fabrication.

Finally, the market-timing practices of mutual funds that have been revealed to date simply don't amount to all that much in the broader scheme of things. Eric Zitzewitz of Stanford University estimates that market timing has cost U.S. mutual fund investors about $5 billion a year -- less than 0.1 percent of the $7 trillion mutual fund assets. This amount, akin to a modest management fee, is simply not a dominating consideration for investors. (Some media accounts have made Zitzewitz's estimates appear much larger by taking them as a percent of the most vulnerable mutual funds' assets, rather than of all mutual funds assets.)

Paradoxically, the scandals themselves have highlighted America's strong regulatory system. If anything, they are evidence not of widespread corruption, but of the vigilance of U.S. regulatory authorities -- which is precisely why the cases now in the news are the exception rather than the rule.

This vigilance is also reflected in the prompt legislative response to recent financial scandals. The Sarbanes-Oxley Act of 2002 has made it a lot more difficult to repeat the kinds of things that Enron and Arthur Anderson did. The U.S. House of Representatives has passed a reform bill that would prevent mutual-fund market-timing abuses.

Similarly, regulatory agencies are now better equipped to deal with financial irregularities. The SEC's fiscal 2004 budget set by the House spending bill is $811 million, roughly twice as much as it was before the scandals surfaced. This is higher than that of regulators in other major countries.

Investors also see that the U.S. regulatory system is stronger than the SEC alone. Revelations of malfeasance have also come from the governments of New York (Attorney General Elliott Spitzer) and Massachusetts (Secretary of the Commonwealth William Galvin). These states have set a standard for action, and there are 48 more states that could do the same. So investors know that even if a Federal agency like the SEC overlooks or ignores serious regulatory problems, another regulator might step in.

The best evidence for continuing confidence in the integrity of U.S. securities markets comes from foreign investors, who would be among the first to flee if they feared rampant corporate fraud and inadequate regulation. Being removed from the U.S., they should be highly sensitive to any whiff of information that their money may not be safe there. But net foreign purchases of U.S. stocks for the first ten months of 2003 are still positive (although down about 90 percent from the same period of 2000, the bubble-peak year).

In short, most investors -- while not always the most rational species -- do know a good thing when they see it. The market may not value U.S. stocks perfectly, but it is not irrational to believe that the corporate scandals are not a major factor.

The writers is the author of Irrational Exuberance and The New Financial Order: Risk in the 21st Century.