While the facts (as we know them today) of the Enron debacle are easily available in most newspapers and on the Internet, they are accompanied by a number of myths that are being spawned by politicians and their media allies. (For example, in decrying the Enron mess, columnist George Will declared, "It will remind everyone--some conservatives, painfully--that a mature capitalist economy is a government project.") I would like to tackle a few of these economic and political "old wives' tales" and help set the record straight.
This seems to be a recurring theme, most recently given by Sen. John McCain during an appearance on CBS's "Face the Nation." The story goes as such: Enron was able to gain political favors by supplying campaign money to politicians from both major parties, thereby blinding these otherwise public-spirited people from performing their duties to the people.
Part of this story is true; Enron has given vast sums of cash to both Republicans and Democrats. While Democrats are presently attempting to link Enron and its chairman, Kenneth Lay, to President George Bush and Vice President Richard Cheney, they conveniently seem to have forgotten that Enron in 1997 contributed $100,000 to the Democratic Party immediately after President Bill Clinton directly intervened to help Enron gain a $3-billion project in India.
The problem here is that the politicians have it backward. The energy business, including oil and electricity, has been thoroughly politicized for about a century. Producers of electricity, despite what mainstream economists like Paul Krugman tell us, have been and continue to be heavily regulated, both by state and federal agencies. Electricity production has undergone some changes in its regulatory structure in recent years, but to call this process "deregulation" (especially in California, which launched a crazy quilt of reregulation that led to the recent energy crisis there) does violence to the language.
Producers of electric power are regulated in every sense of the word, from the fuel they use to the prices they can charge customers. Furthermore, the process is subject to the whims of regulators and politicians, and that makes it very difficult to plan for the long term, as the stroke of a politician's pen (like that of California Governor Gray Davis) can wipe out a lifetime of profitable investments.
Oil is another thoroughly politicized commodity. Government determines when and where individual firms can drill for oil, the extraction processes they can use, and, since much of the remaining oil-producing land in the United States is in the hands of the federal government, nearly every exploration and drilling project is controlled at some level by the political process. The fact that Congress continues to bar oil firms from tapping vast oil fields located beneath barren lands in northern Alaska bears eloquent witness to the fact that the political classes are doing everything they can to deny consumers the benefits of fossil fuels.
Given this set of circumstances, any firm that has anything to do with oil, natural gas, or electricity is going to have to pay tribute to our political masters. As Fred McChesney of the Northwestern University Law School so eloquently put it, the vast amount of political contributions is nothing more than protection money that companies must give to politicians in order to be permitted to stay in business.
Do payments to politicians "buy" political favors? Of course they do. However, the process does not originate with capitalists, but rather has been imposed upon capitalists by the politicians. The line of causality is vital, as the politicians once again are trying to blame the wrong people.
Again, the pundits have it backward. The supposed scenario as presented by the media elite is one of the sharp-eyed regulator being stymied in his vital work by the politicians who have been bought off by the capitalists. A favorite example is that of the "Keating Five," which was a group of five senators (including the "honorable" John McCain) who intervened with banking regulators on behalf of Charles Keating, a savings and loan CEO whose operations went belly up.
While the tale sounds good, it is just that: a tale. To assume that government is not a political entity is to assume that dogs do not bark. Regulators are part of a system put into place by politicians to benefit politicians and their friends.
Furthermore, this myth is based upon the fiction that regulators care more about the health of a business than do its owners. Take the savings and loan crises of the late 1980s, for example. The oft-repeated story in the media was that regulators and bank examiners could see the problems coming, but were held at bay by their political masters.
In the latter 1980s, it seems that Washington was doing both to the S&Ls. On the one hand, changes in the regulatory structure enabled these firms to better compete with banks by expanding the range of loans they could make. On the other hand, Congress voted in tax law changes that damaged real estate values, thus devaluing the major set of assets held by S&Ls.
Furthermore, S&L executives, having learned their trade in a heavily regulated environment, suddenly found themselves facing a new set of rules and constraints. It is not surprising that many of them made frightful errors in their loan portfolios. When one combines that lack of free-market experience with the congressional order that S&Ls immediately sell their high-risk, high-return bonds (called "junk" bonds) assets, it was inevitable that there would be a collapse in that financial sector.
Natural monopoly theory, which was concocted by economists about a century ago, went like this: Industries where large economies of scale are prevalent will soon find one or two firms dominating production and exchange. In order to keep these firms from being able to charge monopoly prices, government must step in and regulate them.
While Austrian economists from Mises on have never subscribed to "natural monopoly" theory, others in the profession have also "discovered" that electricity, oil, natural gas, and telephone services can be bought and sold as commodities in free markets. As entrepreneurs moved into these areas, we found that the regulatory straitjackets around these industries ostensibly to "protect" consumers actually were keeping consumers from enjoying products and services in more abundance and at lower prices than were possible within the regulatory regimes.
Enron has been one of those "ground floor" firms that both pushed the envelope that exposed energy regulation for what it was and created new opportunities for the trading of electricity. That was and will continue to be a positive development. In other ways, however, Enron pushed a gospel of statism, especially in environmental matters.
Lay, a member of the Union of Concerned Scientists, a radical environmentalist and anti-free-market organization, supported the disastrous Kyoto Accords on "global warming." Enron had banked on trading permits for carbon dioxide emissions, which would have been based upon the existing permit system for sulfur dioxide emissions from coal-burning electric power plants. When the Bush administration refused to sign the Kyoto treaty, however, Enron was left out in the cold.
(It needs to be said that a system of trading permits, while carrying a façade of free-market operations, is nothing more than state control of production. Such a system has no private property rights and is controlled by the arbitrary whims of bureaucrats.
One of the things that characterized the Enron enterprise was its freewheeling ways in financial markets. There is nothing in economic theory that declares free markets are only possible when entrepreneurs wallow in irresponsibility.
However, the Enron mess demonstrates that the marriage of reckless entrepreneurs and irresponsible government is always a recipe for disaster. During the late 1990s, the Fed engaged in unprecedented credit expansion. Of course, the flip side of credit is debt, and there can be no doubt that the freewheeling Fed also set the table for Enron's shenanigans.
The final blow to the "Enron represents free markets" myth is the action that Lay took as it became obvious Enron could not cook its books any longer. Lay phoned the U.S. Department of the Treasury to ask for help. (To its credit, the Bush administration did not attempt to bail out the rogue firm.)
There is no doubt that the Enron debacle is a disgrace, both to the executives who made these unconscionable decisions and to the federal and state governments that made that firm seem as though it was invulnerable to market realities. It is "crony capitalism" at its worst. Let us remember, however, that it was the politicians who corrupted capitalism, not the other way around.
William Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University. Send him MAIL. See his Mises.org Articles Archive.
Concerning the federal court conviction of Ken Lay and Jeffrey Skilling, the punditry has been consistent: the "system" works because people who committed huge crimes have been convicted and will spend all or most of their last years in prison. Thus, Forbes ("The Guiltiest Guys in the Room" by Bethany McLean and Peter Elkind) could crow:
Guilty! … Guilty! … Guilty! Judge Sim Lake's reading of the jury's findings had a staccato rhythm to it. Lay, who was standing not with his lawyers but in the front row of spectators close by his wife, Linda, clutching her hand, turned red, his face strained. Skilling responded with a peculiar smirk. The prosecutors remained impassive, but celebrated later that evening at a Houston Tapas restaurant, clearly relieved to have won.
Indeed, as one follows the Forbes account, the usual platitudes of "the prosecutor as hero" stand out. The prosecutors won a "big one," but so did the "regular" people who lost money in the Enron collapse. According to Forbes:
Let's acknowledge some unambiguously positive implications of the Enron verdict. First, it finally offers a measure of consolation - or retribution - for those employees who lost everything in Enron's bankruptcy. And it reinforces a critical notion about our justice system: that, despite much punditry to the contrary, being rich and spending millions on a crack criminal defense team does not necessarily buy freedom.
Yet, as one continues to follow the story, it is clear that the case is not about what historically has been considered criminal behavior. Instead, Lay and Skilling were convicted because Enron became a colossal business failure. Write McLean and Elkind:
The most important implication of the verdict, though, is the lesson it delivers for business itself. In the beginning it seemed such a simple story, demanding swift justice: A highflying company disappeared almost overnight; a CEO bolted before the collapse; top executives sold tens of millions of dollars worth of stock - some of it secretly - while employees and investors were left with nothing.
Ultimately, at the heart of the story, for everything else one might hear, Lay and Skilling went down because Enron went down. Their crime was being in charge when the company was in the process of tanking. Contrary to Lay's assertions during his testimony, Enron was not done in by the short sellers; rather, the short sellers exposed Enron's house of cards. Because of the size of the business failure, and because of the earlier California electricity fiasco in which politicians wrongly blamed traders and producers for problems caused by the state's government, Enron's top people had no political capital, and they were easy targets.
In the aftermath of the convictions, however, I think it is instructive to look one more time at the substance of the charges for which Lay and Skilling were convicted. Furthermore, it is time to look at the bigger picture, for if there really was wide-scale financial fraud, it was committed by people other than Lay and Skilling and dozens of other Enron managers who are going to prison. Indeed, the maestro of the fiasco was part of the same government that prosecuted and now will imprison the two men, but Alan Greenspan will never have to face a jury in a court of law for the financial crimes that he committed.
In previous articles, I have noted that the stock bubble that inflated Enron's Wall Street prices did not originate from corporate America but rather from the Fed. When I first questioned the charges levied against Lay, I wrote:
The Bush Administration has taken much heat for the economic downturn that has marked much of its tenure, and the government has been looking for someone in the business community to blame. Instead of admitting its own faults (remember the steel tariffs and other economic shenanigans) and telling the truth about why this recession has occurred, Bush and his underlings have looked for scapegoats in the private sector and Lay and many of his associates have been juicy — and politically popular — targets. Lay and other executives that have been charged with crimes did not cause the recession — that is Alan Greenspan's accomplishment — but the government has been glad to jump on the "corporate crime wave" bandwagon and the lapdog press has followed suit.
One needs to remember how this business first began. The Greenspan Fed during the late 1990s aggressively pumped up bank reserves through open market operations, forced down interest rates, and touched off an unsustainable economic boom. The bubble first appeared in the stock markets, as stock prices became wildly inflated.
However, corporate profits peaked in 1998, so we were left with the untenable situation in which the boom was pushing stock prices to the stratosphere, but the fundamentals that should have been helping to shore up those prices simply were not there. The market itself was a house of cards, but the pundits and apologists for the Bill Clinton Administration claimed that this "prosperity" actually was the "New Economy" created by a 1993 tax increase that Clinton pushed. So, we were left with the ridiculous notion that increasing the top personal income tax brackets from about 33 percent to 39.6 percent touched off a wave of permanent prosperity.
In the aftermath of the stock bust, not surprisingly there were some spectacular business collapses, Enron not being the only firm that tanked after riding high. Like the failure of many savings and loans in the late 1980s and early 1990s following government interventions and bad policies, most of the business failures occurred because of issues other than fraud. But that did not keep the pundits from claiming that a sinister conspiracy had been in the works.
(Not surprisingly, the government blamed Michael Milken for the S&L collapse and the recession that followed. As Candice E. Jackson and I noted in a recent paper, the real villain in this whole affair was the US government, and especially US attorney Rudolph Giuliani.)
There is another myth that follows this conviction, that being that this was a "complicated web of financial transactions." At one level, this is true. According to Fortune:
…in the five years that followed — as government investigators devoted countless hours to unraveling the Enron riddle — many experts opined that a case against the two former CEOs wasn't winnable. The accounting issues were just too complicated.
Anyone who has attended a finance or accounting seminar can attest to the eye-glazing numbers, terms, and formulas that are presented; and trials — whether civil or criminal — that involve such information can inflict pain and boredom upon those who must pay attention. However, all accounting and finance practices are based upon rather simple premises, be they time value of money or some other form of opportunity cost. The various means or instruments that are used to finance various business projects can be complicated in how they are carried out, but ultimately can be understood without requiring years of experience on Wall Street.
The authors of the Fortune piece then opined: "The tactic that the prosecutors ultimately used, to great success, was to make the case about lies." Would that it were so, for if it were, then prosecutors might be forced to say that their employer, the US government, uses a huge web of financial deceit in the form of the federal budget, and, thus, is a criminal element itself.
If the Lay-Skilling case were simply about lies, then one also could point to the testimony of former officers and managers who were forced into guilty pleas — or face a huge pile of contrived charges that would bankrupt them even if successfully defended against — and then were instructed to give the government's take on things when they took the witness stand. I suspect that if one really did a fly-spec of the testimony, one could find half-truths and lies, all courtesy of US attorneys.
The way that US attorneys work is that they pry guilty pleas from lower-level employees, who have neither the means nor the experience to fight the mountain of charges that prosecutors threaten to dump on them. That the charges generally are nebulous or do not reflect mens rea, which used to be the bedrock of US criminal law, is irrelevant to federal prosecutors, who simply are playing to win by using all "tools" Congress and the federal courts have given them. That these "tools" generally violate the spirit — and sometimes the letter — of the US Constitution and all of the traditions of historical US and English law matters not a whit to prosecutors who are looking for a victory and who have journalists and most Americans cheering them from the sidelines.
The ultimate irony of the Lay-Skilling case is that they were convicted on criminal charges that were wrapped around legal activities. From the sale of Enron stock (for which they received guidance from company attorneys — more on this later) to the various accounting measures that the company took in order to hide losses, all of these activities in and of themselves can be deemed legal, or, at worst, in the gray area of securities and accounting laws and regulation.
Indeed, the US government engages in a number of activities to hide losses and deficits, called "off budget" expenditures. Thomas DiLorenzo and James Bennett have exposed the entire federal scam in one of their books. Moreover, even in 1999 and 2000, when the government was claiming it was running budget surpluses in the billions of dollars, the real "surplus" came from the Social Security System, and those surpluses were immediately transferred into government bonds, thus adding to the national debt. While politicians claimed that surpluses were to be used to "pay down the national debt," in reality the opposite was true. The portion of the federal budget paid by all other taxes ran deficits, which were made up by borrowing surpluses from Social Security. In other words, Congress and the president were committing criminal fraud — if one were to apply the same standards that US attorneys apply to private citizens.
Lay's jury convicted him of an "illegal" stock sale, and this conviction especially is troubling in its implications. As is the case with many CEOs, Lay had large amounts of Enron stock and sold some of it to pay margin calls and for other things. According to the record, he did not report the sale, which was the basis for the "crime." However, the record also shows that Lay sought advice from attorneys regarding whether or not to report the sale, and they advised him not to do it.
The troubling part here is that if a person who is not a lawyer seeks legal counsel and then acts on that counsel, unless he knows or strongly suspects that he is being advised to break the law — and that did not seem to be the case here — then the person is acting in a manner that he or she believes is legal. In other words, the mens rea standard should apply here, but prosecutors (and the jurors) decided that getting popular convictions are more important than applying the bedrock standards that for centuries separated the English and US legal systems from those based upon some form of Justinian (and later Napoleonic) code in which defendants are assumed guilty until proven innocent and law is reduced to rules passed by legislators solely to protect and promote the power of the state.
In fact, if Lay and his associates believed that the accounting methods they used were legal, and that they were assured by counsel that they were, then it would seem that a mens rea standard should apply. Instead, prosecutors invoked the usual "derivative" crimes in which a number of actions — some, if not all, legal in themselves — are bundled into another category called "fraud." Thus, Lay was accused of "securities fraud," which is highly nebulous and difficult for people charged with the crime to refute in a defense.
For example, federal prosecutors charged Martha Stewart with "securities fraud" because she declared publicly that she was not guilty of insider trading, which ostensibly was the "crime" for which the government was investigating, involving her original sale of Imclone stock. Although the judge threw out the "novel prosecution theory" ("novel" was the term used by the Wall Street Journal), it is also clear that had the charges remained, the jury would have convicted her of that "crime," too.
"Crimes" like "securities fraud" are a godsend for prosecutors, who can manipulate the law to charge just about anyone of anything. Like Martha Stewart's company, Enron was a "public" firm and its stock sold on the open market. There is no doubt that Enron's executives wanted to hide or at least mitigate some of their losses in order to keep the Wall Street analysts happy, but in some way or another, firms are almost always attempting to keep their stock prices high, even if some of the fundamentals demonstrate potential or current problems.
Yet, does this constitute a form of "criminal fraud"? First, executives will always learn — usually to their sorrow — that the market ultimately uncovers the problems with a company. Lay blamed short sellers for the company's downfall (just as some politicians blame energy traders for high oil prices — and Paul Krugman blamed Enron for the California energy fiasco that was caused by the state's price controls on electricity). Instead, short sellers realized that Enron was vulnerable and took advantage of that situation, just as Enron played according to the Byzantine rules laid out by California's politicians and bureaucrats.
Second, the job of any executive is to try to keep a company going. Prosecutors themselves unwittingly said as much in their closing statements when they declared that Lay and Skilling were hoping that there would be a turnaround in the market. Yet, someone who was simply using the company to enrich himself would not have cared to keep a company going; instead, he would have absconded with whatever money he could gather and leave the country. Indeed, it was the shenanigans of the Federal Reserve itself that pushed stock prices well beyond their fundamental limits, leading to the rise and crash of the dot-com companies that were the darlings of investors before the market spoke in unrelenting terms.
When Lay declared that Enron stock was still a good buy (and, yes, he even bought some Enron stock himself during that time, something the jury apparently did not want to take into consideration), he was doing what any good executive should be doing. (When President George W. Bush tells us that "progress" is being made in Iraq, are federal prosecutors waiting to charge him with "making false statements"?) Yes, Enron employees lost their paper millions when the stock crashed, but so did Skilling and Lay. There is no evidence that Lay was secretly selling all or most of his stock in hopes that he somehow could jump ship and swim to the proverbial Caribbean island to live his last days in splendor. Instead, Lay, too, went down with Enron.
Yes, those who approve of the verdict might answer, but wouldn't Lay be able to get away with millions of dollars while Enron employees had to start over? The answer is the civil suit, which is where this case belonged in the first place. Lay and Skilling, as well as other Enron executives, had a fiduciary responsibility to Enron stockholders and, unlike what used to be the case in criminal law, mens rea does not apply in the civil arena.
In other words, stockholders were free to sue Lay and the others down to their underwear if they so chose, and it would have been extremely difficult for them to hold onto their wealth, since they would have had no chance at all in civil court. Instead, the government stepped in and stripped these people of their freedom and relieved them of their money, too. Stockholders will get nothing.
Judging from the reaction of former Enron employees, they are happy to see Lay and Skilling go to prison. One employee was quoted as saying that she hoped Lay would "die" there, which says much more about her than it does about Lay. I suspect that if the judge were to sentence the two to being hanged, drawn, and quartered, most people in Houston, not to mention the rest of the United States, would claim that such a sentence was not harsh or cruel enough.
As I pointed out before, this was not a case of executives looting their company and then hiding those assets in offshore bank accounts and absconding with their ill-gotten gains. Instead, it was a case of executives who believed their own hype — and that of the financial press — and failed to apply the fundamentals of sound business practices to their decisions.
Lay and Skilling are hardly alone. The difference is that they are going to prison. Former presidents make big money speaking on the mashed potato circuit, former secretaries of the US Treasury gain jobs on Wall Street or on corporate boards, and Alan Greenspan now earns millions for speaking obtusely to cheering audiences (who probably have no idea what the guy is saying) instead of to worshipful committees of Congress, whose members inherit lucrative lobbying practices when they leave that august body of legislators.
Yet, if one examines their careers, their decisions, and their statements, one finds a series of lies, dishonest actions, misstatements, and outright deceptions that are always harmful to the public and to the economy. Compared to them, Lay and Skilling are Boy Scouts.
William Anderson, an adjunct scholar of the Mises Institute, teaches economics at Frostburg State University. Send him mail. See his Mises.org Articles Archive. Comment on the blog.
What Brought Down Enron?
I write these words while driving away from an interdisciplinary business conference that my colleagues and I attended this past week. One might think that business professors might have a handle on what happened with the collapse of the Enron Corporation and the implosion of other firms whose failures, while not as spectacular as the former Houston energy giant, seem to be part of a pattern of bogus accounting practices and huge conflicts of interest.
Thus, I sat through sessions in which presenters looked at Enron balance sheets, stock prices, and other financial indicators. I found out about the symbiotic relationship between Enron and Arthur Andersen, which met its demise in the wake of Enron’s breakdown. In the end, I was told that the whole thing could be chalked up to a sudden wave of greed and lack of government regulation. To put it another way, I learned absolutely nothing. The blind were leading the blind.
In the first chapter of his classic Principles of Economics, Carl Menger writes, “All things are subject to the law of cause and effect.” His words are simple and profound, and clearly were ignored at this conference--and about anywhere else where individuals are discussing the Enron case. We are supposed to believe that all of a sudden, the decision makers at Enron and elsewhere became greedy and decided to engage in massive fraud. It just happened, period.
An alternative explanation seems to be that as soon as George W. Bush ascended to the presidency, companies no longer feared regulators, so everyone became sloppy in their accounting processes and things went downhill from there. Like all other tripe that issues forth from the political classes, this explanation should be accompanied with the offer of the sale of the Brooklyn Bridge, especially since a number of the accounting violations were occurring when someone else was in the White House.
The typical explanation defies belief. If we are supposed to assume that a lack of regulations or failure to enforce regulations on the books as the cause for these business crashes, then we have a major problem explaining why companies would engage in practices outside the realm of the regulatory boundaries when failure to obey the laws would result in their own demise. To put it another way, why would companies knowingly commit suicide?
Another explanation, as put forth recently by Paul Krugman in his New York Times column, is that a number of businesses, especially in high-technology areas, engaged in overinvestment (Krugman’s term). Why did these companies commit such errors? Krugman and others assume that they just did, period. Perhaps it was the presence of “animal spirits” as put forth by John Maynard Keynes, or maybe capitalists are stupid.
In other words, we are dealing with sheer cluelessness on behalf of the people who are supposed to have answers for these things. Instead, the answers we receive from the academics are not answers at all, in that, at best, they deal only with effects or, at worst, reverse the pattern of cause and effect. To put it another way, the people who are supposed to know the answers don’t even know what questions they should pursue.
During the sessions that I attended, not once did anyone mention the policies of the Federal Reserve System during the 1990s. Like Al Gore, who declares that we had a booming economy in 1998 and 1999 because his government raised income taxes in 1993, the people with the “answers” have no way of linking monetary policies to the performance of the economy, especially when it applies to the huge capital investments in the high technology and telecommunications sectors. Instead, we hear things like “broadband was overbuilt because it is easy to overbuild.” That is not an explanation, for it does not tell why business decision makers chose to build in the amounts they did. (In fact, when economists give such explanations, they undercut their own arguments given in typical microeconomics texts that firms facing “downward sloping demand curves” always hold back supplies in order to support their monopoly prices. Gee, what is it, do firms “overinvest” and increase supply, or do they hold back supply? It cannot be both, but that is what they are telling us.)
Furthermore, one of the “positive” developments as given by one presenter was that we are likely to return to a 1930s regime of regulation. As I reminded those present, the 1930s was the time of the Great Depression, which was created and sustained by both the Federal Reserve and regulatory and tax regimes of the Hoover and Roosevelt administrations. Unless we want to lose our jobs and incomes, we really should not be championing the cause of the New Deal.
Yet, there it was. Capitalist greed caused the Enron collapse, and only the ubiquitous presence of the state can save us. And this came from the business professors; I can only imagine what they are saying in liberal arts.
In attempting to explain at least a portion of the Austrian business cycle theory to those present, I reminded them that individuals always have been greedy. Furthermore, I also reminded them that regulatory regimes almost always create perverse incentives, and that the tax law changes created by Congress a decade ago that sought to limit executive salaries created incentives for “creative financing” of pay and perks for CEOs. I pointed out that Congress has no business involving itself in what executives receive for compensation, especially when the government is trying to say that the head of a major corporation should be paid less than a kid who just finished high school and signs a contract with the National Basketball Association.
Finally, we heard that we had a sudden crisis of ethics in the business world. No, we had a regulatory and monetary regime straight from Washington that all but guaranteed that firms that tried to be honest about their financial conditions would find themselves swamped by lawsuits from angry shareholders demanding to know why those firms were not doing everything they could to prop up their stock prices. Massive monetary creation as practiced by the Fed during the 1990s has a way of creating illusory profits and stock price bubbles.
As I left the conference, it occurred to me that no one had connected the dots. Instead, they were championing government practices that are sure to bring down the U.S. economy, prevent recovery, and expand the state. It would have been encouraging to me had someone there figured out how to put the puzzle together, but from what I can tell, the people who teach business are no more informed about what really happened at Enron than the typical demagogue who occupies a seat in Congress.