Waving Goodbye to the Invisible Hand:
What Enron teaches us about economic system design
By Marjorie Kelly
Sometimes it’s the little things that say it all. The little thing that lingers in my mind is the story about Enron’s creation, when the original plan was to call it Enteron – until somebody figured out this was the Greek word for “intestines.” There you have it. In the end, the story of Enron’s implosion is not about one diabolical company. It’s about the guts of our economy.
It’s about many gut-level issues that confront us: corporate control of politics, executives getting rich while their company sinks, employees laid off by the thousands, 401(k) plans tanking, messes left by deregulation, a corporate board asleep at the switch. All are themes in the Enron soap opera, yet not one is unique to Enron. The problems the scandal reveals are systemic. The individuals involved may have been uniquely greedy and unethical, but they were empowered by a system that exalted greed as it diminished ethics and accountability.
The most basic issues of Enron are system issues. These come down to two, not unrelated truths:
1) The ideal of the unregulated free market is flawed, and it’s time we said goodbye to the invisible hand.
2) Managing a company solely for maximum share price can destroy both share price and the entire company.
These are foundational flaws in theory, flaws in how we conceive of markets and how we define business success. They are system design flaws. For beyond the juicy tales of villainy at Enron, the deeper issue is why the system lent so much power to villainy, and why there were so few checks and balances to stop it.
A key reason is that we are told – and, more incredibly believe – that checks and balances are bad, because free markets are good. Unregulated markets are ideal. Left free to work its magic, self-interest (ie. greed) ostensibly leads things to work out to the benefit of all, as though guided by an invisible hand. This myth is taught in Economics 101 as gospel truth, trumpeted routinely in the business press, and sold abroad as the cure for what ails all economies.
The lie of it has been exposed many times. Think of the Great Depression, the savings and loan crisis, or the collapse of Asian economies in 1997-98. Unregulated free markets often lead to disaster. Self-interest is an insufficient regulator for a complex economy. (Duh.) Yet we seem to have to learn this lesson again and again.
Enron is the latest case in point. Consider California’s experiment with electricity deregulation. At an Enron Senate hearing, Sen. Barbara Boxer demonstrated how the experiment left the state “bled dry by price gouging.” Jeffrey Skilling, as CEO of Enron, had predicted deregulation would save California $9 billion a year. But as Boxer noted, the state’s total energy costs instead soared from $7 billion to $27 billion in a single year. Prices rose a gut-wrenching 266 percent.
Not coincidentally, Enron’s stock also shot up. Total return to shareholders in 1998 was a remarkable 40 percent. The next year, a miraculous 58 percent. And in 2000, a jaw-dropping 89 percent. Deregulation did indeed work the magic it was designed to work, by turning Skilling’s stock options into a gold mine – just before it turned the company into rubble.
California wasn’t the only one duped by the magical thinking of deregulation. Enron helped convince Massachusetts, New York, and Pennsylvania to deregulate energy markets. And it did the same with Washington.
In 1993 Enron persuaded the SEC to grant it an exemption from the Public Utility Holding Company Act (PUHCA), a Depression-era law that prevented utilities from diversifying into unrelated risky businesses. Enron pursued this diversification, to its disaster. As Rep. Ed Markey (D-Mass.) put it, “If Enron had been regulated under PUHCA, I seriously doubt that the types of transactions that brought this company down would have occurred.”
Strike two against the myth of deregulation came in 1997, when the company won exemption from the Investment Company Act of 1940, allowing it to leave debt from foreign power plants off its books. This led to dubious offshore partnerships, which contributed to the firm’s undoing.
Strike three came in 1999, when Congress killed the Glass-Steagall Act of 1933, which had separated commercial from investment banking. This allowed J.P. Morgan, to use one example, to entangle itself with Enron in dangerous conflicts of interest. It underwrote bonds for Enron, traded derivatives contracts with the company, bought stock in the firm, and had a research analyst covering the company (recommending it as a buy until last fall), even as the bank risked billions in loans to Enron. Lured by millions in investment banking fees, J.P. Morgan was left holding the bag on $2.6 billion in Enron debt. And that’s what Glass-Steagall was designed to prevent.
One could go on. Enron successfully opposed regulation for derivatives trading, then used such trades to mask debt. Arthur Andersen helped defeat a proposal to separate auditing and consulting practices, which left it reluctant to challenge a client. Businesses across the board opposed truthful accounting for stock options, which led to over-reliance on options and in some cases inflation of stock prices.
Piece by piece, protections that might have prevented the debacle were defeated. Layer by layer, existing protections were removed. The result was the train wreck of Enron.
What’s astonishing is not that this wreck occurred, but that – time and again – we bought the deregulation myth that led inexorably to it. We swallowed this absurd fairy tale about some invisible hand.
An earlier generation wasn’t so credulous. Those who lived through the Depression saw the absurdity of economic faith healing (“only believe in free markets and all ills shall be healed”). They knew what we have forgotten. Even the editors of Fortune magazine acknowledged, in a June 1938 editorial, that what failed in the Depression “was the doctrine of laissez-faire.” They wrote, in language that would get a business editor fired today: “Every businessman who is not kidding himself knows that, if left to its own devices, business would sooner or later run headlong into another 1930.”
Or an S&L crisis. Or Medicare fraud. Or Enron.
As though under mass hypnosis, we have denied what we know in our gut: the theory of laissez-faire is bankrupt. It’s a hoax. Why were there so few checks and balances to stop the villainy of Enron? Because we pretended we didn’t need them. We believed the hucksters who sold us the elixir of unregulated free markets.
Of course, unregulated markets are never really unregulated. Complex economic interactions need rules. The question is who makes those rules: elected representatives serving the public good, or a financial elite serving only itself.
With Enron, the rules were made by folks like CEOs Kenneth Lay and Jeffrey Skilling, and chief financial officer Andrew Fastow, as well as the financial powers entangled with them. Like all elites, they preferred to run things without public oversight. This is why the invisible hand keeps rising out of the grave. As I show in my book The Divine Right of Capital (Berrett-Koehler, Nov. 2001), free market mythology is a smokescreen that disguises the real nature of elite power – much like the divine right of kings. It allows elites to run our economy to suit themselves, without interference, and with a veneer of legitimacy.
Which brings us to our second question about Enron: Why did the system design lend so much power to greed? Because doing so was in the interest of the financial elite, including Enron executives and Wall Street. Lay and Skilling both were “laser-focused” on shareholder gain, which led to their own option gains. They succeeded at this so well -- with annual gains of 40, 60, 90 percent -- no one asked questions. Those who did were brushed aside, like Sherron Watkins and her memo to Lay. Why disturb the goose laying so many golden eggs?
In the wake of Enron, some have called for closer alignment between executive and stockholder interests. But this close alignment was itself the problem. When we define business success as maximum share price, a soaring price makes it impossible to see problems. What could be wrong? The business is succeeding beyond anyone’s wildest dreams.
We fail to recognize that managing a corporation with the single measure of share price is like flying a 747 for maximum speed. You can shake the thing apart in the process. It’s like a farmer forcing more and more of a crop to grow, until the soil is depleted and nothing will grow. It’s like an athlete using steroids to develop more and more muscle mass, until the body itself is destroyed.
The problem with Enron was not a lack of focus on shareholder value. The problem was a lack of real accountability to anything except share value. This contributed to a kind of mania, a detachment from reality. And it led to a culture of getting the numbers by any means necessary.
If maximum share price is an irresponsible management theory, and deregulation a flawed economic theory, there are better theories already at hand. It’s intriguing that the movie “A Beautiful Mind” is up for Academy Awards during the Enron scandal – because its protagonist John Nash won a Nobel Prize for proving Adam Smith’s theory was incomplete. Self-interest alone can lead to disaster for all, Nash demonstrated mathematically. Self-interest coupled with concern for the good of the group is most likely to lead to the benefit of all.
Nash’s mathematics revolutionized “game theory” and is central to the “evolutionary economics,” which emphasizes that cooperation is as vital as competition. It’s a more evolved theory than the invisible hand, more appropriate for an economy that has become more humane than the aristocratic world of Smith.
Viewed through the lens of Nash’s theory, the Enron scandal can lead us to question our fundamental assumptions. Do we really believe corporations are only about making money? Or do we care how they make their money? Do we really care about ethics and public accountability?
If we do, then we need real accountability. We need actual sanctions for ethical infractions, not a flimsy ethics code that the Enron board could waive on a moment’s notice, as it did in allowing Fastow to earn millions from off-balance sheet partnerships.
We need checks and balances not only on the side of shareholder value, but on the side of public accountability. That means changing the system design. What a new design might look like is explored at length in The Divine Right of Capital, but the concept most appropriate to Enron is the idea of graduated penalties for unethical conduct.
Firms caught cooking the books, for example, might lose all government contracts. A federal contractor responsibility rule could prohibit the government from contracting with egregious corporate law-breakers. Such a rule was put in place by President Clinton as he left office, but was overturned by President Bush. It should be reinstated and made permanent through legislation.
If Enron had faced the prospect of losing millions in revenues, it wouldn’t have waived its ethics rules so blithely. Watkins might have been empowered to approach the board, and the board might have been inclined to listen – since real financial consequences were at stake.
A more serious penalty was suggested by the attorney general of Connecticut, who recommended pulling the license of Arthur Andersen, so it could no longer do business in the state. If all accounting firms – and all corporations – knew they faced this ultimate sanction, they would be less inclined to push the limits. We would start to see ethics and accountability with real teeth.
The ultimate lesson of Enron is that effective system design requires our conscious choice. It cannot be left to some invisible hand. It’s time we sent that creepy appendage back to the grave where it belongs.
Marjorie Kelly (MarjorieHK@aol.com) is publisher of Minneapolis-based Business Ethics magazine and author of the recently released The Divine Right of Capital (Berrett-Koehler, Nov. 2001, www.DivineRightofCapital.com), from which portions of this are adapted.
Note to editors: This piece ran in the San Francisco Chronicle Sunday 2-24-02. Rights purchased were first publications rights only. The piece is available FREE for reprinting in other publications or on web sites, without further permission. Please send clips to Business Ethics, PO Box 8439, Minneapolis, MN 55408. BizEthics@aol.com. Phone 612/879-0695.