Over half of American households now own stock. When this threshold was reached a year ago, it was hailed by conservatives and libertarians as a key turning point in the movement for more freedom and less government. Stockholders, like homeowners, are less susceptible to the anti-business bromides of liberal politicians.
Today, with the stock market down to levels of four years ago and the news filled with stories about corporate scandals, the mood is different. People from virtually every occupation and station in life are talking about Enron, WorldCom, and Arthur Andersen. They are watching their life savings dwindle and wondering if they were sold a bill of goods by conservatives and libertarians.
The Great Depression Myth
At moments such as this, anti-capitalist myths are created. During the 1940s, prominent intellectuals such as Karl Polanyi attributed the Great Depression to “the failure of the market utopia.” “In the last resort,” he wrote in 1944, “impaired self-regulation of the market led to political intervention.”
Milton Friedman and Anna Jacobson Schwartz effectively rebutted that thesis in 1963 with a magisterial book titled A Monetary History of the United States, 1867-1960, in which they identified nearly a dozen specific government actions that caused and perpetuated the Great Depression. But by then it was too late.
Large majorities of the public believe capitalism is unstable, that it caused the Great Depression and government got us out of it. Three generations have been told repeatedly that government was there for us when capitalism imploded.
The myth that capitalism caused the Great Depression still casts a shadow over conservative and libertarian views on a wide variety of issues. It is most obvious in discussions of privatizing Social Security, but it extends to any issue where the integrity of big businesses and the ability of markets to be self-regulating are key, which is to say, every major issue of the day.
TANSTAAFL
Executives at Enron defrauded millions of investors by falsifying income and profit statements. How did they get away with it? Is this scandal, and others like it, evidence capitalism is not self-regulating after all?
Enron revealed gaps in the system now in place to ensure that managers focus on maximizing shareholders’ interests rather than only their own. One gap is the lack of transparency in financial reporting. Joint ventures with special-purpose entities, off-balance-sheet financing, counting as assets such intangibles as brands and good will, not reporting share options awarded to employees as expenses, and removing “non-recurring expenses” from the bottom line all make GAAP (Generally Accepted Accounting Principles) accounting less meaningful and reliable than in the past.
This gap in the market’s anti-fraud armor is the most discussed, but also the most oversold. Even Enron’s artful accounting did not conceal that it was operating at a loss well before investors stopped buying its stock. The business press reported problems at WorldCom a year before its meltdown. Many investors and analysts, perhaps under the spell of what Alan Greenspan called “irrational exuberance,” simply failed to exercise proper diligence.
The appropriate lesson to be drawn, then, is not that the system is “fixed” against investors or that executives of big corporations routinely act corruptly, but TANSTAAFL: “There ain’t no such thing as a free lunch.” A generation of first-time investors learned investing is not the same as saving. Investors need to work to earn their returns.
Corporate Governance
Enron also shows how auditors can get too cozy with their clients and how boards of directors dominated by insiders beholden to the CEO can fail to protect shareholders’ interests. Enron demonstrated what many compensation experts were saying: Making share options a substantial part of managers’ compensation, though meant to bring their interests in line with those of other shareholders, can encourage manipulation of earning statements to maximize short-term share prices.
Listing these problems suggests solutions. Harvey Pitt, chairman of the Securities and Exchange Commission (SEC), is pushing for new standards requiring firms to disclose material relevant to the market sooner, to all investors, in plain English. Requiring more outside directors and a mandatory rotation of auditors every five years seems to be in order. Share options can continue to be part of executive compensation plans, but longer holding requirements can create a stronger link to the firm’s long-term financial health.
To some extent the problems revealed by Enron were the unintended results of tax and regulatory policies. “If you did not have the convoluted tax law,” says Larry Abraham, publisher of the Insider Report, “you wouldn’t have the limited partners ponying up to become limited partners to shelter their income.” The double taxation of dividends, in the words of Steve Stein, has led to the use of increasingly complex schemes to “turn equity into debt for the IRS and debt into equity for Wall Street.” Efforts to regulate such schemes have served mainly to elevate the status of lawyers in business by creating a culture that rewards the ability to parse words and find regulatory loopholes.
For this reason, new government regulations are unlikely to solve problems of corporate governance. Institutional investors (such as pension funds), the managers of index funds (such as Vanguard), and the accounting profession can do much to see these reforms are adopted without any new government regulations. There also seems to be a market opportunity for a new firm that reviews, translates into plain English, and certifies the financial statements of public companies.
The Lessons of Enron
There is a simple and accurate way to explain “the lessons of Enron” to ensure Enron does not become our generation’s Great Depression.
Greed drove Enron’s executives to conspire with their company’s auditor to misreport the firm’s profits in order to cash in on stock options. They got caught and are going to jail (or at least should go to jail if government does its job properly). The company and its auditor (Arthur Andersen) were quickly forced into bankruptcy.
Enron’s collapse was a rare incident where several systems that ordinarily protect investors from fraud malfunctioned simultaneously. Auditors, board members, industry analysts, and individual investors all could have prevented the debacle. Complicated federal tax rules and regulations, some of them designed to protect investors, unintentionally smothered or helped lull to sleep these market watchdogs.
New policies and institutions are being created right now to protect investors. New financial disclosure requirements, requiring more outside members on corporate boards, mandatory rotation of auditors, and putting restrictions on executive share options are just four of the reforms in the offing that will make corporate executives more accountable to shareholders. Investors should insist companies adopt these policies before investing in their stock.
The principal “lesson of Enron” is that capitalism quickly reveals and terminates corruption and fraud. It is doubtful whether the alternatives to markets—government, socialism, or communism—could have done a better job. The corruption that takes place in government every day makes Enron look like small potatoes. The former Soviet Union collapsed because its institutions were saturated with corruption and no one could root it out.
Finally, Enron didn’t cause the stock market crash. Market sages have different theories about why stock prices boomed in the first place and whether investors acted rationally. Many experts believe the boom was good for innovation and consumers even if investors didn’t make money. The Enron scandal came late in the game, after technology stocks had already collapsed and carried the rest of the market down with them.
Be a Myth Buster!
The next time you’re chatting with neighbors or colleagues at work, ask them what they think about the Enron scandal and “what it means about capitalism and the stock market.” The correct answer is: “Capitalism is self-regulating.” If the answer you get is different, go to work persuading them otherwise. Because if you don’t, no one else will.
