During my nearly four years as ambassador to France I frequently gave a speech I called “Popular Capitalism in America” to audiences throughout France. This is a subject of intense interest to the French and to most other Europeans, who envy us our high rates of growth and low unemployment but who often believe that the price we pay for these benefits is an inadequate social safety net, a tolerance for speculation, and unacceptable inequality in wealth and income. They also see the American system as one that inflicts high levels of poverty and unemployment on developing countries by the harsh stabilization measures required by the IMF and other Western-directed financial institutions. I made this speech to dispel some of these notions and to encourage reforms in European countries in matters such as taxes, investment, and employment. These, I argued, would, to our mutual benefit, align our systems more closely.

In doing so, I defended our economic model as one that could deliver more jobs, and more wealth, to a higher proportion of citizens than any other system so far invented. A major component of this system is its ability to include increasing numbers of working Americans in the ownership of US companies through IRAs, pension funds, broad-based stock options, and other vehicles for investment and savings.

I agreed with, and cited, Federal Reserve chairman Alan Greenspan’s statement that “modern market forces must be coupled with advanced financial regulatory systems, a sophisticated legal architecture, and a culture supportive of the rule of law.” After forty years on Wall Street I had no doubt that, despite occasional glitches, our economy met Greenspan’s requirements.

However, as I regularly traveled back to America between 1997 and 2001 there were developments in our financial system that deeply troubled me. The increase in speculative behavior in the stock markets was astonishing. In 1998, as a result of reckless speculation by its managers, the giant hedge fund Long Term Capital Management went bankrupt and, in doing so, threatened the financial system itself. The New York Federal Reserve organized a group of banks and investment houses to rescue the company at a cost of several billion dollars. The sharp rise in dot-com stocks came soon after, together with relentless publicity campaigns to push the markets higher and higher. TV ads of on-line brokers urged everybody to buy stocks and trade them day by day. So-called independent analysts made fantastic claims about their favorite stocks in hopes of generating investment-banking business for their firms. These claims were often supported by creative accounting concepts such as “pro forma earnings”—a management-created fiction intended to show strong results by excluding a variety of charges and losses and one that was implicitly approved by supposedly independent auditors. A large part of the stock market was becoming a branch of show business, and it was driving the economy instead of the other way around.

The financial regulators—whether in the Treasury Department, the Federal Reserve, the SEC, or other agencies—were either unwilling or unable to check this behavior. The then chairman of the SEC, Arthur Levitt, tried to adopt rules that would prevent the more obvious of the conflicts of interest that were widespread among auditors. He was blocked from doing so when the accounting industry lobbied members of Congress to oppose his initiative. The Federal Reserve could have raised the margin requirements for stocks listed on the NASDAQ, which would have sent a powerful signal to the rampant speculation on that market and somewhat limited the damage caused by it. The Federal Reserve chose not to do so.

When the inevitable happened and the bubble burst, $4 trillion of market value evaporated, much of it in high-tech stocks. Half of all American families own listed stocks, and as more and more middle-income Americans saw their savings disappear, and company after company went bankrupt and thousands were laid off, I began asking myself whether I could make that speech again. Was our popular capitalism in fact providing both for the creation of wealth and for regulation that would protect the public and encourage high standards of corporate governance? Alan Greenspan’s belief in the effectiveness of responsibly regulated market forces clearly was not being matched by reality.

The events surrounding the bankruptcy of Enron go beyond the sordid situation of Enron itself and raise the larger question of the integrity of our financial markets. That integrity must be maintained to protect our own investors, to finance economic growth, and to maintain the flow of foreign investment. As of the end of 2001 about 15 percent of all shares listed on the New York Stock Exchange and the NASDAQ were foreign-owned. They had a value of approximately $2 trillion. We must keep in mind that we require about $1 billion per day of capital inflows to finance our trade deficit. A decrease in foreign investment would have seriously damaging effects on the securities markets, the stability of the dollar, and the economy generally. The last thing we should tolerate is a loss of confidence in our capital markets.


While it is too early to make definitive judgments, recent events suggest that our regulatory system is failing. Enron, one of America’s Fortune 50 public companies, reporting over $100 billion in sales and almost $1 billion in earnings, melted into bankruptcy during a period of six months, with a loss of $90 billion in market value. As many did not realize, Enron was not only a supplier of energy but a major financier of dealings in energy, and eventually in other commodities as well. In carrying out its trading operations, the company organized more than a thousand financial partnerships and other entities, some involving Enron executives, whose losses were not fully disclosed to the public, and these losses ultimately caused huge write-downs in earnings and assets. Parts of the company’s record in its dealings in the commodity futures called derivatives and in other risky financial operations appear to have been deliberately concealed and the company’s overall financial position was misrepresented. Enron’s management and auditors knew about these matters but did not make them public.

Nor in many cases, apparently, were they obliged to. The derivatives market had been deregulated in December 2000 by the Commodity Futures Modernization Act. Although Enron was in effect a financial institution, it had, for a considerable period, no legal obligation to submit some of its important financial operations to regulators for scrutiny; and no state or federal agency was responsible for regulating some of its most important transactions.* The company’s accounting firm, for its part, has now admitted destroying documents. Most troubling of all, Enron’s senior executives and board members sold over $1 billion of Enron stock while many of the company’s 25,000 employees lost much of their savings, which, trusting the company’s assurances, they had invested in Enron-managed 401(k) retirement plans.

In a single six-month period one of America’s leading companies became the symbol of the defects in American capitalism claimed by its critics. And Enron’s failure is only the latest in a series of events that have cast a shadow on the integrity of our markets and the efficacy of the regulators over the past few years. If we allow continued abuse of our securities markets, one of the basic functions of our system will be destroyed. As Congress examines the fate of Enron’s stockholders, creditors, and employees, it should bear in mind the other abuses of the system that, over the last few years, have caused immense harm.

In 1932, the congressional hearings conducted by Ferdinand Pecora of New York started a major process of reform of our financial system. As a result a regulatory structure was created which, until recently, has served us well, although such episodes as the savings-and-loan debacle required strong government action. Serious reforms again are needed, particularly to ensure that accounting firms will henceforth act honestly and responsibly. The securities laws require full disclosure; the accounting firms must ensure that their clients’ profits, losses, and assets are disclosed accurately and coherently. The current self-regulation of the accounting industry should be closely scrutinized, and, if necessary, abolished and replaced by a new system of controls. At present, five accounting firms have a virtual monopoly on the audits of most of the US companies listed on the stock markets, a highly unusual level of concentration for any industry.

These firms had enough political power to prevent former SEC chairman Arthur Levitt from adopting rules that would prohibit the conflicts of interest inherent in the present system, in which accounting firms often audit the accounts of a company while also acting as its paid financial consultant. For the accounting industry to rely on a system of “peer review,” by which the major accounting firms are responsible for reviewing one another’s work, is evidently unsatisfactory. During the forty years or so that I have served on the boards of directors, and often on the audit committees, of a variety of companies, I do not recall a single instance when a negative peer review was brought to the attention of an audit committee. During this period, the technology of finance and the creation of innumerable derivatives and other new financial instruments (and the problems that resulted) certainly warranted a different approach. Just who should regulate the auditors is an important question for Congress to debate, but there is no question that a new system of regulation is necessary.

Harvey Pitt, the new chairman of the SEC, believes in creating a new agency that will establish more stringent accounting standards but would address neither of the two central issues: the need for a governmental review mechanism that is independent of leading accounting firms, and the need to eliminate the conflict of interest between auditing a firm’s accounts and acting as its financial consultant. Arthur Levitt strongly dissents from Pitt’s view, and considers the issue of independence to be fundamental. They are both right: accounting standards have to be dealt with more effectively but so do conflicts of interest. (Increased fees for basic audit services would help to offset the loss of income from consulting.) The SEC has considerable powers in these matters, and if more extensive powers are needed, Congress can provide them, as well as the budgets to enable the SEC staff to deal with them.


One possibility worth considering for any new regulatory system would be a requirement that companies periodically change their accounting firms, for example every five years. This would be expensive and somewhat cumbersome, but in addition to keeping auditors on their toes, since their work will be subject to scrutiny, it might also generate greater competition in the industry by encouraging new accounting firms to enter it. We should bear in mind that the crucial accounting functions for any companies must be carried out by its own internal auditing and will depend on the strength of its internal controls. (Internal auditors should be company employees with no recent affiliation with the company’s outside auditors.) In a new system the continuity of these internal functions would be maintained while outside auditors would come and go.

Potential conflicts of interest, of course, are not limited to the work of auditors; there is a lot of blame to be shared. To cite only a few other examples, questions have also been raised about the objectivity of securities analysts who are pursuing investment banking business; about the way investment banks allocate underwritings of hot new issues among their clients; and about the activities of banks, following the repeal of the Glass-Stegall Act, in acting simultaneously as lenders, underwriters, financial advisors, and principal investors in some transactions.

American popular capitalism is a highly sophisticated system that needs sophisticated regulation—whether in finance or in other fields. The government itself does not seem to have acted illegally in the Enron case; it is the government’s failure to anticipate and prevent what happened that is the problem. Unless we take the regulatory and legislative steps required to prevent a recurrence of these events, American market capitalism will run increasing risks and be seen as defective here and abroad. That could have deeply serious consequences not only for our domestic economy but for the world economy as well. Enron’s failure was a failure of particular people and institutions but it was above all, part of a general failure to maintain the ethical standards that are, in my view, fundamental to the American economic system. Without respect for those standards, popular capitalism cannot survive.

This Issue

February 28, 2002