SYNOPSIS: How Gordon Gekko's ideology failed in the 1990s

"The point is, ladies and gentlemen, greed is good. Greed works, greed is right. . . . and greed, mark my words, will save not only Teldar Paper but the other malfunctioning corporation called the U.S.A."

Gordon Gekko, the corporate raider who gave that speech in the 1987 movie "Wall Street," got his comeuppance; but in real life his philosophy came to dominate corporate practice. And that is the backstory of the wave of scandal now engulfing American business.

Let me be clear: I'm not talking about morality, I'm talking about management theory. As people, corporate leaders are no worse (and no better) than they've always been. What changed were the incentives.

Twenty-five years ago, American corporations bore little resemblance to today's hard-nosed institutions. Indeed, by modern standards they were Socialist republics. C.E.O. salaries were tiny compared with today's lavish packages. Executives didn't focus single-mindedly on maximizing stock prices; they thought of themselves as serving multiple constituencies, including their employees. The quintessential pre-Gekko corporation was known internally as Generous Motors.

These days we are so steeped in greed-is-good ideology that it's hard to imagine that such a system ever worked. In fact, during the generation that followed World War II the nation's standard of living doubled. But then, growth faltered — and the corporate raiders arrived.

The raiders claimed — usually correctly — that they could increase profits, and hence stock prices, by inducing companies to get leaner and meaner. By replacing much of a company's stock with debt, they forced management to shape up or go bankrupt. At the same time, by giving executives a large personal stake in the company's stock price, they induced them to do whatever it took to drive that price higher.

All of this made sense to professors of corporate finance. Gekko's speech was practically a textbook exposition of "principal-agent" theory, which says that managers' pay should depend strongly on stock prices: "Today management has no stake in the company. Together the men sitting here [the top executives] own less than 3 percent of the company."

And in the 1990's corporations put that theory into practice. The predators faded from the scene, because they were no longer needed; corporate America embraced its inner Gekko. Or as Steven Kaplan of the University of Chicago's business school put it — approvingly — in 1998: "We are all Henry Kravis now." The new tough-mindedness was enforced, above all, with executive pay packages that offered princely rewards if stock prices rose.

And until just a few months ago we thought it was working.

Now, as each day seems to bring a new business scandal, we can see the theory's fatal flaw: a system that lavishly rewards executives for success tempts those executives, who control much of the information available to outsiders, to fabricate the appearance of success. Aggressive accounting, fictitious transactions that inflate sales, whatever it takes.

It's true that in the long run reality catches up with you. But a few years of illusory achievement can leave an executive immensely wealthy. Ken Lay, Gary Winnick, Chuck Watson, Dennis Kozlowski — all will be consoled in their early retirement by nine-figure nest eggs. Unless you go to jail — and does anyone think any of our modern malefactors of great wealth will actually do time? — dishonesty is, hands down, the best policy.

And no, we're not talking about a few bad apples. Statistics for the last five years show a dramatic divergence between the profits companies reported to investors and other measures of profit growth; this is clear evidence that many, perhaps most, large companies were fudging their numbers.

Now, distrust of corporations threatens our still-tentative economic recovery; it turns out greed is bad, after all. But what will reform our system? Washington seems determined to validate the judgment of the quite apolitical Web site of Corporate Governance (corpgov.net), which matter-of-factly remarks, "Given the power of corporate lobbyists, government control often equates to de facto corporate control anyway."

Perhaps corporations will reform themselves, but so far they show no signs of changing their ways. And you have to wonder: Who will save that malfunctioning corporation called the U.S.A.?

Originally published in The New York Times, 6.4.02