Hamish McRae: A good deal of changing to do

When the head of Goldman Sachs joins the head of the Securities & Exchanges Commission in calling for changes in US corporate practice you know something serious is up. The trouble is, both the SEC and Goldman are failing to attack the most serious problem: the deal-driven culture of Wall Street.

The SEC's job is to police the world of finance – it is the gamekeeper – and given the string of US corporate scandals you would expect it to growl. But Goldman is a poacher, at least in the sense that it will seek to maximise the number of fish it can catch. If it wants the rules tightened, there must be something wrong with the fishing.

Last week Hank Paulson, chief executive of Goldman, said that confidence in American companies was the lowest he had known "in my lifetime". Mr Paulson is 55 years old, so that carries us through the Sixties and Seventies scandals as well as the recent crops. But I think he is wrong, at least as far as the US economy's resilience is concerned, and that is a function of its companies' performance. In the early Nineties there was a profound sense of gloom about the US economy, which was being outpaced most notably by Japan, and challenged by Germany. Now there are grave worries about its corporate governance, sure, but the relatively brisk recovery from the downturn and the vibrancy of US corporate management is not really in question. Outstandingly, US companies have gone on increasing their productivity right through the downturn. Now it is the Japanese and the German companies that are struggling to catch up.

It is an important distinction, for the problem is easier to fix. If you are worried about the competence of US corporate management, the effort needed to lift performance is huge. If you are worried about their honesty, you can fire the worst offenders and tighten the rules for the rest. But why is Wall Street so worried?

There are two reasons. Finance is in the firing line too; and lack of confidence in corporate reporting is undermining share values. "Enronitis" is contagious.

Mr Paulson noted the implications of Enron, calling for a ban on accountancy firms doing consultancy work for audit clients and he also attacked executives who sold shares ahead of bad results. But the financial community is also under attack, in particular for puffing the shares of its clients ahead of share issues, knowing that there were weaknesses in those companies.

The Enron management rightly carried the can for its collapse. But the company was the creation of the investment banks, which had egged it on to transform itself from an oil service company into a financial service one.

Another problem in the demands of the Wall Street community is that investment analysts demand steady growth in profits. But to get steady growth requires an element of massage to the numbers. In moderation that is acceptable. But in the real world there are enormous uncertainties month by month. At is simplest, you have to make a judgement when, or maybe even if, a customer will pay his debts. Wise businesses who have had a very good quarter will keep a little back just in case.

But a little smoothing of results can slither into deceit when things go wrong. Companies, here as well as in the US, can put enormous pressure on auditors to approve dodgy accounts. Now auditors will feel emboldened to challenge companies.

So there will be a market solution to the auditing problem. Power has shifted back to auditors. Whether there is a formal separation of consultancy and auditing is less important. Three years from now, company accounts will be more trustworthy statements of performance.

But tightening corporate accounts, however essential, does not solve the Wall Street problem: the extent to which US capitalism has become deal-driven. We have seen huge errors in corporate restructuring in the last three or four years. AOL/ Time Warner is clearly a deal that should never have been done, and I suspect Compaq/Hewlett Packard will be a similar disaster. Yet the fees are so large Wall Street devotes its cleverness to arguing why it is right to do the wrong thing.

In any case, US share prices are still overvalued by historical standards. You can see this from the graphs. The recent great surge in prices came when profits were falling as a percentage of GDP (see the left-hand graph above), and prices are still well above their long-term trend (centre). The clever valuation measure developed by the Bank Credit Analyst team in Montreal, an independent group not, note, based in New York, suggests that US shares are only just back into their 1960-2001 range (right).

So US markets are in a bind. To restore confidence three things have to happen. First, as the SEC and Goldman want, there will have to be a series of technical and legal changes in accounting practice and corporate governance. Second, the present modest revival in US company profits will have to develop into something deeper. And third, there has to be a change in culture in finance. Investment banks have to go back to being genuine advisers both to corporate and investment customers, caring about their long-term interests, rather than being just deal creators.

The first is certainly going to happen. The second, well, there is some sort of profit recovery going on, but it may be difficult to sustain under conditions of low and falling inflation. Still, fingers crossed.

As for the third, a change of culture on Wall Street? I fear I don't see enough sign of it just yet. The investment analysts' craft is undoubtedly being changed by investor suspicion. Puffery will be out of fashion for a while. But a change of tone in the corporate finance market? I cannot see it until a few more high-profile mergers come unstuck and – crucially – the investment banks that put them together start catching the blame.