Norm-based behavior and corporate malpractice

Journal of Economic Issues, March, 2007 by Miguel A. Duran

Thus, using spontaneously-arising norms to interpret these remarkable events enables the practical limitations of Hayek's theoretical framework to be shown. He charged the advocates of the "middle way," such as Commons or Keynes, with coming up with a non-existent conflict between the individual and society (Atkinson and Oleson 1998; Carabelli and De Vecchi 2001, 236). However, the context-specific analysis of the corporate misbehavior of the 1990s provides a fact-based proof of that conflict and shows the need to found economic policy on "middle-way" principles. On the other hand, the notion of "spontaneous norms" makes for an unusual institutionalist approach to recent corporate deception. This approach is a complement to other interpretations pointing out the perverse results market forces might bring about. Specifically, it shows that if the right legal rules and principles and the means to enforce them are not provided, the logic of the market produces its own endogenous norms. These norms may damage the collective good and contribute to the destabilization of the economic system. In brief, the notion of "spontaneous norms" helps "to address the seeds of potential disorder" (Hodgson 2004, 298).

Liberalization Policies and Spontaneous Norms

Spontaneous norms may emerge even in regulated sectors of the economy, because no legal system covers each and every aspect of human activity. However, the more unregulated a market or practice is or the less strictly enforced legal rules are, the easier it is for spontaneous norms to appear. In this regard, the last twenty-five years have been a liberalization period, specifically in capital markets and the financial industry. During this period, the predominant economic policies in these sectors have been founded on the assumption that market freedom is the means to efficiency. Economic authorities have also been inspired by the idea that reputation and the threat of being expelled from competitive markets guarantee that there is no problem in having the economic system rest on individual decisions. (2) Indeed, the relevance of reputation and trustworthiness for the success of modern corporations is highlighted by two related facts: first, the increasing weight of financial assets on the balance sheets even of nonfinancial firms; and second, what Veblen ([1904] 1978) describes as "expected earning-capacity" has become the effective basis for capitalization of contemporary corporations (Hake 1998; 2004; 2005; Niggle 1986; Raines and Leathers 1992; 1996).

As a result of these liberalization policies, regulatory structures were undermined or weakened, and the space of agents to decide unrestrictedly expanded. That is, the space where norms governing agents' decision-making can arise spontaneously grew. There was a combination of two great types of political measures that helped extend the space favorable to the appearance of endogenous norms in the financial sphere. (3)

First, wide-ranging deregulation processes reduced the number and intensity of legal curbs on agents' behavior. A noteworthy legislative modification in this regard is the passing of the Gramm-Leach-Bliley Act. Since it came into force in 1999, functional separation of financial institutions has no longer been required by law. In particular, the distinction between investment and commercial banks has blurred (Barth, Brumbaugh, and Wilson 2000). Another notable legal change is that the fixed commissions charged by brokerage houses for each stock market transaction were deregulated in 1975. As a result, profit margins shrank, and the habit of using some of the funds obtained from these commissions to finance free research died out. Indeed, at the beginning of the 1990s the main source of funds for financial research lay in the fees charged by investment banks for underwriting initial public offerings and other financial transactions. Thus, the potential conflict of interest between investment banks, in-house analysts and corporations intensified. In the auditing sector, the main organization of public accountants eliminated a series of rules restraining competition at the end of the 1970s to comply with requests from the Federal Trade Commission. This opened a period of aggressive competition between the large audit firms, reducing domestic auditing fees. Besides promoting concentration in the auditing industry, the result was, on one hand, that auditors pursued a high-volume strategy, trying to attract new clients and to retain existing ones. On the other hand, under a diversification strategy, revenues from auditing services fell dramatically while those from consulting services increased. Indeed, auditing services were even used as a mere way of securing a higher-margin consulting service with a client. In brief, the earnings of auditors became increasingly dependent on maintaining a cordial relationship with corporate management (Previts and Merino 1998). In addition, international mobility of capital was favored by the removal of capital controls and regulations limiting foreign financial investment (Wolfson 2002). Note, however, that the neoliberal agenda was not only focused on capital markets and the financial industry. It also carried out major deregulation in other sectors, such as the natural gas and telecommunications markets.