Tuesday, February 26, 2002
Forgive me for posting anything nice about Michael Lewis, but this recent column is right on the money. I would add to his arguments another big one: the moral hazard of knowing that the government will protect shareholders will result in wider spreads in the credit markets, which will do more damage than the drop in the equity markets has.
I worry about the direction the Enron story has taken. On the one side, more and more arguments are being made that Enron proves the need for greater regulations. But the kinds of regulations being proposed would, in most cases, do nothing to prevent another Enron. Some would do real damage to the capital markets. And none address the real fallout from Enron: a crisis of confidence that has dramatically raised the risk-premium.
There's an effect I've heard discussed, I don't know what it's called, that suggests that personal risk-taking has an equilibrium, and that when one aspect of risk is reduced, if social risk preferences are unchanged, other behavior will become more risky to compensate (and vice versa, if one aspect of risk increases). Thus, more effective contraception means more sexual partners, safer automobiles means more - and more aggressive - driving, etc. (I wonder sometimes whether the 1990s penchant for extreme sports didn't have something to do with the fact that society wasn't generating enough risk for its physical risk-seekers - for example, fighting wars or colonizing Mars.) In any event, the point is that effective risk-reduction enables a society to take more risk. In the economy, the ability to take more risk means the ability to achieve more reward. Effective regulation is where the regulation's costs are substantially less than the benefit of the additional risky activity made possible by the reduction of risk.
The classic example is the government role in enforcing transparency in the market. If market participants have the confidence that we are all getting good information in a timely manner, they will provide capital to businesses more cheaply. They will lend money in greater amounts at lower rates, and they will bid stock prices up. And this is good for everyone, so long as the confidence is well-placed.
Where it isn't, and this is exposed, you can have a crisis in confidence. And this is precisely what is happening now in the market. I happen to be the proud and angry owner of a number of shares of Tyco International stock. That company is currently essentially shut out of the market for commercial paper because the market is concerned about their accounting. They are not concerned because they see smoke and assume there is fire; the concern is that they are not convinced that, post-Enron, they will be able to see the smoke if there is smoke. There is a crisis of confidence in the accounting profession. One consequence is that a good company that plays by the rules and has added significant value to the world may be destroyed. (I'm still a shareholder - added to my position recently, in fact - so I obviously think they won't be destroyed but will come through fine. But I'm playing the odds. Once you have a liquidity crisis, bad things can happen for no good reason. As Keynes, I believe, said: the market can remain irrational for longer than you can remain solvent.)
It is very difficult to prevent self-dealing and corruption of the sort that was clearly practiced at Arthur Anderson. Indeed, there's a cultural component to this: if the culture has internalized the notion that corruption is normal, then it will be normal, and hard to root out; where the culture has internalized an ethic of honest dealing, corruption will be more infrequent, and easier to root out. I am certainly not convinced that a corrupt ethic is a necessary consequence of capitalism; indeed, it is often cited as one of the biggest impediments to the advance of capitalism in the Third World that many of these countries lack an ethic of honest dealing.
(Theodore Dalrymple made the interesting case several months ago in City Journal for the proposition that corruption is in fact the logical cultural response to rampant statism - that entrepreneurship and individualism can survive in over-regulated environments only through corruption. This, he argues, is the reason why Italy has economically outperformed Britain in the post-war years. Britain after the war enacted one degree or another of Socialism, and, because the British have a cultural ethic of honest dealing and aversion to corruption that go naturally with their long tradition of liberty, the economy groaned under over-regulation. The Italians, meanwhile, having little experience with free government, are used to the idea that one must break the rules, and so have survived better under over-regulation - by ignoring the regulations. An interesting argument, I think.)
Returning to the specific issue of accounting: several times during the 1990s, legislation or administrative regulations were proposed to rein in various kinds of accounting abuses - including proposals to prevent audit firms from selling consulting services. These were always shot down by bi-partisan coalitions of pro-business politicians. In the 1990s, it seemed that the interests of business and the interests of capitalism were one and the same, and pretty much everyone wanted to be on a bandwagon that was making us all rich. But it isn't true that they are always the same, and there is a real danger now that the backlash will do real damage to capitalism.
One of the more depressing aspects of the Enron fiasco is the way it has given strength to (what I consider) the wrong side of two arguments: campaign finance reform (about which I am ambivalent, and which has no obvious relevance to Enron), and social security reform (stocks have risk! better not help people who don't already own them get their hands on them). Even worse, it has propelled a new crusade, by Senators Boxer and Corzine (two of my least favorite among that century of worthies), to regulate 401(k) plans. This Wall Street Journal editorial does a reasonable job of outlining the case against regulation, if in their usual obnoxious tone. In fact, Enron should be undertstood as a story about the corruption of those responsible for regulation and oversight.
Enron's board did not exercise its function to properly oversee management; we are long overdue for regulations mandating greater independence for boards of directors.
Enron's auditors did not exercise their function to properly police Enron's accounting; we are long overdue for regulations to limit conflicts of interest in audit firms such as arise when these firms are also consultants to audit clients.
Enron's analysts on Wall Street did not exercise their function to properly evaluate the company's health and prospects - there were all kinds of warning signs - poor return on capital, dropping margins, confusing accounting, and yet ever-escalating earnings - yet no major Wall Street house showed skepticism because skepticism didn't sell. We are long overdue for regulations separating research from investment banking.
And, lastly, the Federal Government did not perform its function of protecting the citizenry from fraud by repeatedly making regulatory decisions not on the basis of what improved transparency and the functioning of markets but on the basis of what best served the immediate interests of the business class. And we are long overdue for a political party beholden neither to corporate nor bureaucratic interests but to the interests of the citizenry. An argument for the kind of regulation that increases transparency at a reasonable cost should be familiar to Republicans. Such arguments are a staple of the editorial pages at the Wall Street Journal and Barrons, and have been made by star GOP legislators like Phil Gramm in the past. But the party as a whole does not do a good job of making such arguments, whether out of fear or feebleness I don't know. And some legislators - such as Billy Tauzin - have been poster-boys for mis-governance.