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Enron and Greenspan's Bubble

Tags Big GovernmentBooms and BustsThe EnvironmentU.S. EconomyU.S. History

02/26/2002James Sheehan

The media/political movement for expanded accounting regulations is driven by the claim that more government intervention will "stop the next Enron from happening." Yet the existing rules did nothing to stop the real Enron. In fact, some of the worst aspects of the Enron calamity would not have happened without government intervention in the marketplace.

Regulatory intervention began during the Great Depression. The federal government mandated financial disclosure and established accounting standards, ostensibly designed to help investors identify sound companies. Back then, the government assumed that investors really wanted such information.

But what kind of information investors want on companies varies, depending on the circumstances, and such standards should be determined via market competition. Companies have every incentive to disclose any information that investors desire, if for no other reason than to persuade people to buy their stocks at the highest possible price. Requiring them to do so creates a false sense of security and discourages investors from demanding information for themselves. 

During the 1990s, at the height of the Greenspan bubble, investors demonstrated most convincingly that they were not interested in well-managed companies. They were not concerned about profits, as evidenced by the fact that they bought Internet firms that had hardly any customers.

Even profitable companies issued pro forma financial results, meaning that they departed from normal accounting conventions in order to boost reported earnings. Numerous "restatements" of earnings were also reported, in which companies admitted to having provided misleading numbers. Investors swallowed these fake numbers willingly, speculating that easy money from the Fed would cause stock prices to inflate further still. 

The government can try all it wants to mandate better disclosure, but this is just a Band-Aid that won't fix an unintended consequence of another bad policy: flawed monetary policy.

That audit firms like Arthur Anderson regularly went along with aggressive accounting tricks should not come as such a surprise. Such tricks were welcomed by shareholders as a way of lowering earnings as reported to tax authorities, which reduced their tax liabilities. 

Had the government not overtaxed corporations in general and double-taxed dividends in particular, much of the accounting industry would not even need to exist. Here again, the government wants greater control over the audit and reporting process to address an outgrowth of flawed tax policy.

In Enron's case, outright fraud was used to bury losses and manufacture phony profits. Laws already on the books will be used to prosecute the guilty parties. Therefore, no additional regulation is necessary to put guilty parties in jail.

Indeed, it can be argued that existing regulatory agencies are not competent to detect fraud anyway. The crooks at Enron were caught, not by the SEC, but by hedge fund manager James Chanos. He read the company's financial reports and immediately realized that they were deceptive. The profit motive led him to short the shares and make a profit from exposing company chicanery.

In contrast, the SEC failed to act for years, even though it had the exact same information as Mr. Chanos, if not more. The agency failed to review Enron's public filings for four years, complaining that they were too complicated to understand. Under the Public Utility Holding Company Act, Enron was required to provide the SEC details of its various investments, holding companies, and off-balance sheet financing transactions  This law was mysteriously waived by the SEC in 1994, one of the many government mishaps that prevented discovery of Enron's fraudulent practices.

Those who desired information about Enron's regulatory disclosures would also find themselves stymied by the SEC's bizarre administrative procedures. The agency has voluminous files containing correspondence between companies and SEC accountants. This paperwork may contain material information concerning questions the SEC had about the aggressiveness of corporate accounting representations. 

Yet investors do not have ready access to this data. In order to see it, they have to file cumbersome Freedom of Information Act requests. Then, they must wait patiently for months on end as the bureaucracy processes paperwork.

Much of the regulatory apparatus apparently broke down because lawmakers in Congress, who had received generous campaign contributions from Enron, pressured the agencies to be lenient. This is an inherent flaw in any political approach to regulation. No amount of political graft could convince James Chanos to go easy. The market eventually rewarded him nicely for revealing the truth after years of government lies about Enron.

Like the baseless arguments put forward for more accounting regulation, proponents of big government want more controls over 401(k) retirement plans--never mind the abject failure of Social Security. 

The Feds now are angling to meddle further in a process whose flaws they created. For example, the law encourages companies to compensate employees using stock options without counting them as expenses on the balance sheet. For years, Washington did everything it could to "stimulate" private retirement savings. As a result, some Enron employees made bad decisions to take full advantage of these rules, and they overloaded on company stock. Companies could not hire investment advisers to recommend against overloading on one asset because of a flawed legal system that would hold the companies liable for the investment advice. 

Fearing debilitating lawsuits, companies simply can't provide any investment advice to their employees. Post-Enron, Congress wants to restrict investment choices and put onerous requirements on the structure of company pension plans. The net affect of these changes will be to discourage companies from offering generous retirement matching programs at all. 

The role played by maestro Greenspan and the Federal Reserve has been almost completely obscured during Enron's congressional investigations. After all, it was the Fed-inspired boom that turbo-charged questionable companies like Enron. With shaky companies sporting lofty valuations, healthy companies felt pressure to manage earnings rather than their businesses. They did so through various legal and illegal accounting tricks involving aggressive recognition of revenues. Profits were overstated, and earnings quality was abysmal. The Fed had debased all normal financial standards and benchmarks relied upon by investors. 

Fed maestro Greenspan fully encouraged this process, not only through inflationary monetary policy but also through his widely publicized speeches and congressional testimony. He claimed that the bull market was due to a "productivity miracle" that he himself created.

Pronouncements of this nature fueled the mania and discouraged a close scrutiny of company fundamentals. Investment capital was misallocated toward companies with no visible earnings or real prospects. Speculators pursued Internet start-ups as well as the seemingly innovative but highly leveraged Enron. 

Since the collapse of the Greenspan bubble, investors have placed a new premium on earnings quality and transparent accounting. The market is already acting without the passage of new laws by the grandstanders in Congress. Companies that were too aggressive in their financial reporting are being punished in the stock market. Since Enron, many other firms--notably Tyco, IBM, and GE--have had their accounting scrutinized. Even companies that merely pushed the envelope of legitimate accounting practices are being shunned. 

Accountants and auditors are responding to consumer demands by getting tough on their corporate clients. Likewise, they are discontinuing technology and tax consulting work to settle conflict of interest concerns. The market is not even waiting for Congress to wrap up its Enron hearings--an embarrassing display of politicians' ignorance about business matters.

Opponents of the market say we have to stop another Enron from happening again. Yet all the government's watchdog agencies completely missed Enron. The system of cronyism in Washington, D.C., made the debacle possible and made it harder for the public to find out what was going on. Existing laws will put Enron executives behind bars, but they won't touch any of Enron's accomplices in Washington. They are too busy devising additional laws that pretend to protect us from fraud, while obscuring the biggest fraud of all.



James Sheehan

James Sheehan works for the Competitive Enterprise Institute.

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