A System Corrupted by Paul Krugman

Original Source: http://www.nytimes.com/2002/01/18/opinion/18KRUG.html

A System Corrupted

Clearly, Larry Lindsey shouldn't have described the Enron affair as a "tribute to American capitalism," and Paul O'Neill shouldn't have declared: "Companies come and go. It's part of the genius of capitalism." Both the top White House economist and the Treasury secretary have been excoriated for their callousness. But did they have a point?

Yes, they did but their remarks suggest that they still don't understand what happened. The Enron debacle is not just the story of a company that failed; it is the story of a system that failed. And the system didn't fail through carelessness or laziness; it was corrupted.

Mr. Lindsey and Mr. O'Neill were, in effect, patting themselves on the back for allowing Enron to fail. Indeed, that is one redeeming feature of the saga. It turns out that you can be too well connected; Enron was so enmeshed with the Bush administration that any bailout would have been politically disastrous.

But it's missing the point to focus on Enron's eventual failure. The real issue is what Enron executives got away with during the good times.

We usually take the viability of the modern corporation, in which professional managers look after the interests of shareholders, for granted. But as economists since Adam Smith have warned, a separation between ownership and management opens the possibility of insider abuse. Indeed, Smith thought that such a separation was a bad idea, except in a handful of businesses.

But you can't run a modern economy with family-owned companies and partnerships. So capitalism as we know it depends on a set of institutions many of them provided by the government that limit the potential for insider abuse. These institutions include modern accounting rules, independent auditors, securities and financial market regulation, and prohibitions against insider trading.

The Enron affair shows that these institutions have been corrupted. None of the checks and balances that were supposed to prevent insider abuses worked; the supposedly independent players were compromised.

Enron's byzantine network of 3,000 subsidiaries and partnerships one for every seven employees made a mockery both of accounting rules and of rules against insider trading. Not incidentally, the network also allowed the company to evade taxes in four of the last five years. And Enron executives knew what they were doing. A letter last August from an Enron vice president to the chairman, Kenneth Lay, described how shell companies with names like Condor and Raptor were used to create fictitious profits, and quoted one manager as saying, "We are such a crooked company."

The accounting firm of Arthur Andersen was told of these concerns. Yet it gave Enron a free pass, and shredded documents when questions arose. The regulators were nowhere to be seen, partly because politicians with personal ties to Enron, like Senator Phil Gramm, took care to exempt Enron from regulation.

Mr. Lindsey and Mr. O'Neill would have us believe that all's well that ended badly; because Enron was allowed to fail, justice was done and the system worked. But Enron isn't a person; the evildoers here were Enron executives, who collectively walked off with at least $1.1 billion.

It's not just a matter of the utter unfairness of it all employees lose their life savings while crooked executives walk away rich. It's also a matter of what it takes to make capitalism work. Investors must be reasonably sure that reported profits are real, that executives won't use their positions to enrich themselves at the expense of stockholders and employees, that when insiders do abuse their positions their actions will be discovered and punished.

Now we have seen a graphic demonstration that the system that was supposed to provide those assurances doesn't work. And nobody I know in the financial community thinks Enron was an isolated case.

Yet all the evidence suggests that the Bush administration doesn't get it. On the contrary, until the latest revelations it was moving in the wrong direction. Harvey Pitt, the new chairman of the Securities and Exchange Commission, made his reputation as a lawyer who represented accounting firms including Andersen in struggles to maintain auditor independence. Now we've seen what Andersen did with that independence.

The truth is that key institutions that underpin our economic system have been corrupted. The only question that remains is how far and how high the corruption extends.