Don’t blame the scandals
After the string of corporate scandals in the US, the public is blaming the destruction of trillions of dollars of “shareholder value” on the malfeasance of top management. This is misguided.
In fact, the frauds serve to conceal the economic readjustment which inevitably follows periods of great innovation. Joseph Schumpeter observed that booms occur at times when “swarms” of entrepreneurs simultaneously attempt to apply some new innovation. He claimed that both the profits in the boom and losses in the ensuing depression were “essential elements in the mechanism of economic development.”
This process can be likened to evolution in nature. The information revolution created what biologists would call a new “adaptive zone” for businesses to operate in. Many companies which sought to enter this new space have found that either their business models were ill-adapted or that there were too many competitors. In an uncertain world, “the struggle for existence,” doomed many new entrants to failure.
Corruption is not the cause of the current crisis for such companies. It simply accompanies their failure. After all, had the demand for broadband technology been as great as many expected a couple of years ago, then the infamous trio-Enron, Global Crossing and WorldCom-would all be thriving today and their former bosses would still be hailed as heroes, rather than villains, of the business world.
In the long run, irrational investors should lose money and have no influence on share prices or the allocation of capital. That, at least, is what financial theory dictates. During stock market bubbles and their aftermath, however, there are opportunities for fools to become rich at the expense of the wise. In a paper titled “Feedback and the Success of Irrational Investors,” three American finance professors, David Hirshleifer, Avanidhar Subrahmanyam and Sheridan Titman, sketch a model in which the prospects of a company improve after its share price has been driven up by irrational speculators, so causing its intrinsic value to rise.
This process works in several ways. For instance, potential customers and suppliers may be more willing to do business with a company whose share price is soaring. Likewise, potential employees may be attracted to the company (particularly when enticed with stock options) and the providers of capital may be more forthcoming with funds. In addition, some companies benefit from the so-called “network effect,” when the value of their business increases…