Remember the East Asia crisis, when the
US treasury and its IMF allies blamed that region's problems on crony
capitalism, lack of transparency, and poor corporate governance?
Countries were told to follow the American model, use American auditing
firms, bring in American entrepreneurs to teach them how to run their
companies. (Never mind that under the leadership of their own entrepreneurs
East Asia grew faster than any other region — and with greater stability
— over the previous three decades.) The unfolding Enron scandal
brings new meaning to two favourite American sayings: "What goes
around comes around,'' and "People in glass houses shouldn't throw
stones.'' Enron used fancy accounting tricks and complicated financial
products (derivatives) to mislead investors about its value. No transparency
here. It used its money to buy influence and power, shape US energy policy,
and avoid regulations.
Crony capitalism is not new; nor is it the province of a single party.
Former US treasury secretary Robert Rubin reportedly tried to influence
the current government to intervene on behalf of Enron in its hotly contested
dispute in India. In office, he had intervened when the supposedly independent
board for setting accounting standards tried to clean up the accounting
of senior executives' share options.
Partly thanks to him, this effort to make corporate accounting more transparent
was stymied. America's willingness to provide multi-billion dollar bail-outs
to airlines or to create cartels to protect its steel and aluminium industries
suggests that free market ideology is but a thin guise for old-fashioned
corporate welfare: give to those with the appropriate connections.
To some, the fact that Enron was not bailed out and the problems uncovered,
is testimony to the absence of crony capitalism. I have a different interpretation:
it is testimony to the importance of a free press, which may not stop
but can curtail abuses. As the press started taking a closer look at Enron,
the number of members of Congress who had accepted money from Enron became
clear. Campaign contributions were not just a matter of public spirit,
but an investment. Like many of Enron's investments, it worked well in
the short run, but did not pan out in the long run.
Many lessons emerge. Some concern politics: the Enron scandal strengthens
the case for campaign finance reform, and the need for even stronger laws
requiring public disclosure. Democracies are undermined by corporate interests
being able to, in effect, buy elections. The Bush administration, however,
refuses to disclose information which would show the role of corporate
interests in setting its energy policy.
Other lessons concern economics, especially the economics of information.
For markets to work, for the appropriate signals for efficient resource
allocation to be provided, investors must have as much information as
possible. There are inherent conflicts of interest: owners and managers
have a natural incentive to present a picture as rosy as possible. Auditing
is intended to put limits on potential abuses. But who is to guard the
guardians? Who is to audit the auditors?
We rely heavily on incentives. Auditors desire to maintain their reputation. But the interlinking of consulting and auditing practices puts other perverse incentives in place: an incentive to please the clients, who dislike unfavourable reports. Arthur Levitt, the former chairman of the Securities and Exchange Commission, recognised the conflict: as many within the auditing firms focus on their own short-term interests, the integrity of the audits could be compromised.
He is perhaps the unsung hero of the entire debacle. But the auditing firms and their corporate clients — not surprisingly, given the cabal that developed — roundly attacked his proposal for separating consulting from auditing. What Levitt grasped — and what the Enron debacle shows so clearly — is that incentives matter, but that unfettered markets by themselves may not provide the right incentives. Markets may not provide incentives for wealth creation; they may provide incentives for the kind of shenanigans Enron pursued.
The new economy — and its complicated new financial instruments — enhance the problems of reliable accounting frameworks; they make it easier to obfuscate. Rather than facing up to the issues, corporate America systematically turns its back — aided and abetted by crony capitalism, American style.
The central issue of our time is finding the right balance between the government and the market. The status quo will argue that Enron is an exception: that its demise was due to fraud, that we have laws against fraud, and that those who violate these laws should and will bear the consequences. But much of what Enron did was not illegal. Its auditors claim that its central practices were within the law; that thousands of firms do the same.
They are right — and that's the problem. Investors need assurance that information received adequately reflects the economic situation of a firm. Within the current regulatory and legal environment, with derivatives and other off-balance-sheet liabilities, there is no way for investors to have that assurance today. We need better standards and stronger laws. While we will never be able to prevent all abuses, we can get the incentives right. We can try to inculcate better ethical standards. But we cannot rely on them when so many worldly people see nothing wrong with revolving doors. They claim to manage conflicts of interest; but we see that they may manage them for their own interests. But even as evidence for such abuses becomes apparent, new venues for abuse are repeatedly opened up — take the US repeal of the Glass Steagall Act, which separated commercial from investment banking.
Repeatedly, we have seen the consequences of the excesses of deregulation, of unfettered markets. Now we must resist the temptation to go to the other extreme. The challenge is: get the balance right.