Re: Enron, Spawn of Business Journalism

From: Technotranscendence (
Date: Fri Feb 08 2002 - 04:04:42 MST

On Wednesday, February 06, 2002 2:19 PM Hal wrote:
> So Gary North does not have much credibility with me. Should I bother
> to read his article, given his track record of being not just wrong on
> an
> important issue, but being flagrantly, obnoxiously, infuriatingly
> wrong?

It is one issue. A guy who's helped me to fix cars a lot is a Baptist.
Does this mean he doesn't know cars?

> Here is where the ad hominen fallacy raises its head. Usually it is
> used as a debating tactic. But the real point is that it can be an
> error in our own thinking. Should we reject possibly-valid analysis
> and
> information just because of flaws in the source? On the one hand, we
> do need filters; we can't read everything that is written by the
> entire
> human race. But on the other hand, we risk filtering out useful data.

In this case, it's a blessedly short read...

> In any case, I read the article, and while it is not badly written, in
> fact I don't agree with most of it. However the errors that I see are
> not blatant and some of what North says seems correct. Errors include
> his conclusion that Enron and the dot-com debacle disprove the
> efficient market hypothesis,

The EMH is questionable in itself, but that's really a topic for a very
long thread.

> and that the Enron failure is largely due to
> government subsidies.

Even so, it is true that Enron benefited heavily from government
intervention on its behalf in the market.

> I agree that the story does illustrate groupthink among
> journalists and investors, but IMO that is not newsworthy analysis.

For you, no. For most people, it is news.

> I think the core of the Enron story is and will be that the people
> entrusted with management defrauded the investors. This is a constant
> problem in the capitalist world, at all scales.

I don't think this is a feature of capitalism so much as it is a feature
of living in any type of society -- of living with other people period.
It's the problem of trust in general.

> Each of us puts our
> savings into other people's hands, meaning that we have to trust them.
> And such trust is risky. Every day people lose money because they are
> cheated by people they trusted.

See my Tuesday, January 22, 2002 10:43 PM post to this list where I

"[L]ife is full of failures as well as successes. This is especially
true in business and the stock market. Everyone can't be right at the
same time in stocks (or commodities or futures), especially if each
investor is betting that she or he is right and everyone else is wrong.
That's why it might be a good idea not to stick your nest egg in your
company's stock options or even your company's 401(k). Diversify and be
vigilant! After all, it's your future you're playing with."

> In business, the issue is whether the management truly represents the
> interests of the owners, the stockholders. Every company is aware
> of this risk. The entire structure of the business firm is set up to
> try to minimize this problem. It's similar to cancer in an organism,
> where a part of the whole decides to advance its own interests at the
> expense of the larger body. Biological organisms have defense in
> against cancers, but sometimes those defenses fail. In the same way,
> firms have all kinds of checks and balances to try to keep individuals
> from enriching themselves at the expense of the business. But these
> aren't perfect either.

Well, this is where government intervention does play a role.
Government intervention in the financial markets, through controlling
credit and "safeguarding" investments, creates an atmosphere where
people don't develop strong mechanisms to deal with risk or weeding out
the good from the bad. The story of the 1990s seems to be one of
repeated episodes of investors making risky investments without any
notion of the costs and then having the government bail them out when
they go sour -- as in Mexico, East Asia, Russia, with LTCM, and probably
next in Argentina and with Enron.

This has setup the context in which an Enron can happen often and can
take many investors unawares. (The real question is not so much why did
Enron collapse -- businesses go under all the time -- but why so many
people didn't see the warning signs. Fraud too happens a lot, but, on
this scale, it seems to show that the government's intervention has
created a climate where investors are less likely to be skeptical, to
take a second look, or to try to reduce risk through well tested money
management practices.)

> In the case of Enron, I believe the evidence indicates that this is
> what
> happened, that the managers looked after their own interests rather
> than
> those of the company's owners whose investments they were supposed to
> be protecting. The use of complex financial structures defeated the
> checks and balances; no one could tell where the money was going, so
> it
> was too tempting to direct it into their own pockets.

The problem here is that such pyramiding schemes have happened before
and probably will happen again. The fact is investors, especially
experienced ones, should have taken such complexities as a red flag.
(To be sure, some investors did and either stayed away from Enron or
treated it as a live one. I forget the name of one analyst from Texas
who had almost none of his portfolio in Enron because he found the
nearly unreadable earnings statements to be such a warning sign. He was
interviewed on NPR...)

> Enron, in fact, was killed by cancer. (Technically it's not quite
> dead
> yet; it is dying of cancer.) It's newsworthy, because it doesn't
> happen
> often to businesses at this scale. But the real lesson is that
> investors
> need to be aware of this new risk. They need to make sure that their
> managers are not in a position to cheat the company through the use
> of complex financial instruments. The use of derivatives and swaps
> can be profitable, but unless there is effective auditing in place,
> the business is risking its own life in using these instruments.
> Investors need to think of derivatives as carcinogenic stimulants.
> They produce short term benefits but can lead to long term
> destruction.

This is the same story as that of LTCM. (See _When Genius Failed: The
Rise and Fall of Long-Term Capital Management_ by Roger Lowenstein and
"Too Big to Fail? Long-Term Capital Management and the Federal Reserve"
by Kevin Dowd in his _Money and Markets_.) However, this is just, as
I've said on this list, a variation on the theme of "if it's too good to
be true, then it probably isn't true" -- something investors, especially
small investors, have to keep in mind whenever they plan to put money in
any securities, be they stocks, bonds, or derivatives.

> IMO the Enron bankruptcy does not show the need for more government
> supervision, or fewer government subsidies, or most of the other
> lessons people are trying to draw. It shows the need for investors to
> be more careful. It shows a failure of one of the main limits against
> corruption, the use of independenet auditors. Investors will want to
> protect themselves by insisting that their employees, the managers,
> hire auditors who have no financial incentive to cheat the investors
> whom they are supposedly protecting.

See my above self-quote.:)

I do, however, think that, as I've also said above, government
interventions in the market have set the stage for failures like this --
i.e., of this magnitude and with this amount of surprise. I'm not
saying under total laissez faire, no business will fail or that
sometimes investors won't be taken unawares, but I think under such a
system most investors would not take the same amount of risks or lose as
much because the information and incentives would be there to manage
risk better and to be prepared for big losses -- as opposed to expecting
the SEC to be omniscient and the Fed or Congress ever ready to bail out
any bad beats.

> These are the kinds of lessons which Enron teaches, and they are
> the kinds of lessons which the capitalist system excels at learning.
> Even without any regulatory changes, Enron will lead to a new
> of risk, and new techniques to manage it. The end result will be a
> system which is more robust and more able to fight the cancers which
> constantly threaten business survival.

I partly agree. I think changes to the whole system need to be made,
but in the direction of less regulation so that systems to control risk
can spontaneously emerge -- and so that people who really don't have a
clue will stay out of the financial markets. (How did I ride out the
stock market plummet of 2000 and 2001? By having most of my funds out
of the stock market! What is there is long term stuff that I don't (or
hopefully won't) need to touch right for years. I did this while
friends of mine lost lots of money in their investments. Of course, I
didn't make any big killings, but I haven't suffered any big losses
[yet] either.)


Daniel Ust

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