Why Enron Was Government’s Fault

Everyone from accounting firms to economists to politicians has claimed publicly that the Enron debacle is the result of markets being too free. Just as one example, Frank Partnoy, a law professor/consultant/expert on the topic of derivatives, in a single appearance before Congress listed all the government entanglements that made the Enron case possible while calling for more laws, more oversight, more government involvement in the financing of private businesses. Below are a few of the government intrusions that made the whole fiasco possible, intrusions without which such shenanigans as the Enron executives executed would be discovered before billions of investor dollars disappeared down black holes.

The Good Ol’ Boy Network

Enron gave campaign contributions to over half of our representatives on Capitol Hill. As Congressman Ron Paul reports, Enron collected over $600 million in corporate welfare through the Export-Import bank alone. This is quite a return on the few millions that Enron paid out in campaign contributions. Congressional staffers are digging everywhere to find information on Enron and its ties to government now; where were they two years ago? They were ignoring the signs because Enron was their friend.

Partnoy’s Gatekeepers

In his testimony before Congress, Frank Partnoy listed the "gatekeepers" that are empowered by Federal law to protect you and me from opportunistic corporations. These include law firms, banks and investment banks, auditors, some securities analysts, credit rating agencies, and more. These gatekeepers are authorized by the SEC to oversee the dealings of publicly-held firms and publicly declare them sound. The SEC itself also declares dealings sound, allowing only itself to confer final blessings on new debt/equity issues. In many cases, the gatekeepers enjoy near-monopoly (oligopoly) markets for their services – conditions they would not enjoy without government intervention.

With all these gatekeepers declaring Enron (and Kmart, and nearly every other publicly-held company) sound, investors labor under false confidence and proceed to invest. This would have extended not only to many individual investors, including employees of Enron, but to other companies, including many of Enron’s roughly 3,000 subsidiaries and partners.

Web of Laws I

Among the reporting requirements Enron scrupulously obeyed were those involving their partially-held subsidiaries. If your corporation owns 51% of the stock of another, you must report the held corporation’s gains and losses with your own. Per Partnoy’s research, Enron made sure to own 49-50% of its most prominent subsidiaries. When a law is created by government, it often carries with it a formula for using that law to your advantage. There are untold thousands of pages of Federal regulations that govern everything from reporting requirements to financial practices – the regulations are so numerous that unscrupulous financiers with vast resources can find ways to work around them, while ordinary folks may violate many of them in the course of normal (sound) business without realizing it. And you and I might be more willing to invest, since we had every reason to believe Enron followed prescribed accounting procedures.

As to the reporting itself, nothing produced by an auditor can be trusted. The auditor is paid to dig up dirt on the client, while being in the client’s employ. This conflict of interest cannot be explained or scrupled away, and it is created and maintained exclusively by government regulation. There are plenty of large corporations out there dabbling – or more than dabbling – in derivatives to make their books look better. As long as their cash flow is sufficient to prevent bankruptcy, no one complains. (More about auditing in a moment.)

Web of Laws II

Among the disincentives to managerial rent-seeking (i.e., managers’ acting in their own interest when it may be to the detriment of stockholders) is the market for corporate control. That is, the possibility of being bought out by another company, and likely losing his job, is one of the things that keeps a CEO honest. The SEC requires you to report to them your intentions once you’ve acquired 13% of the stock of a company you mean to take over. This serves mainly to give the target company’s managers time to marshal resources to fight off the takeover. Such a disincentive for the acquirer makes the attempt far less likely, effectively neutralizing one important control on managers’ behavior.

Restrictions on financial institutions’ ownership of large blocks of stock in corporations removes another effective mechanism of stockholder control. You can be sure that a single bank’s having large ownership interests in Enron would have helped prevent the disaster; would have mitigated it significantly, or would have required Enron managers to go to far greater lengths than they did to perpetrate the fraud they did. A bank as a partial owner would have a strong incentive to audit carefully and honestly, and there is none of the conflict of interest faced by paid auditors. With a market full of such corporations, other corporations lacking a financial institution as a major stockholder would at least have more rigorously audited competitors than is the case today. Many benefits would arise from this, including that corporations without banks as major owners might have more difficulty attracting equity capital; and large upsurges in profits and stock price would raise alarms more quickly than was the case for Enron (all businesses would be more competitive, making above-market profits less common).

Attractive Nuisance

The very existence of government largesse – corporate welfare, the favor of legislators in exchange for campaign contributions, and so on – provides a temptation for many executives. Unfair advantage can be gained through channels that many may deem relatively licit. It works; just compare governmental scrutiny of Enron over the last few years to that directed at Microsoft. Enron gathered $600 million of your money, money Enron didn’t have to earn, but instead "bought" for pennies on the dollar. Government and business are both corrupted when government involves itself in corporate financing.

Some free-market economists like to refer to campaign contributions as extortion. Politicians, the ones with the legal power to use coercion, demand contributions so that nothing unfortunate will befall the contributors after the election. Microsoft, again, is a case in point. But it does work both ways. As nothing bad happens to corporations that don’t deserve it when they make contributions, Congress does fewer bad things to contributing corporations that do deserve it. Make no mistake, there are bad guys in industry. Right now, they have bad guys in government to help them do bad things.

The only solution is to get government out of the business business. The popular solution right now is to pile on more government regulations. We know such regulations will have either no effect, unintended random effects, or the opposite of the intended effect, yet will unproductively absorb wealth and activity regardless. It is time to start erasing regulations and allowing investors and creditors to do their own competitive oversight of capital-intensive (and all other) enterprises.

For more on the Enron debacle, see Gary North (1, 2).

February 9, 2002

Brad Edmonds [send him mail], MS in Industrial Psychology, Doctor of Musical Arts, is a banker in Alabama.

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