Source: Carnegie
Reprinted with permission from Delovie Lyudi (Business in Russia) No. 132, March 2002
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The United States? advocacy of free market global capitalism took on a new significance in the world in the 1990s, as new technologies, expanded trade and investment, and an ideological shift helped to globalize the world economy. It was during the same period that Russia took up the historic task of founding its domestic regime anew. Russia?s curiosity at the collapse of America?s seventh largest corporation is as understandable as its experienced skepticism at economic systems that promise great rewards.
Curiosity and skepticism are good guides to the truth, and Enron?s debacle is truly instructive for any people taking a fresh look at the bedrock of their own political economy. It is also a clue to some of what lies ahead for the world in the coming months.
What exactly happened at Enron? The complete story remains untold by the few who know it. But important elements are clear. The company?s senior management concealed large financial obligations from the investing public and exaggerated the company?s earnings. Enron was thereby made to seem a much better investment than in fact it was, and banks, investment funds and individuals were lulled into taking greater risks than they knew.
The truth about the company?s condition eventually began seeping out in forms that triggered financial obligations no one expected. Enron lacked both the money to pay its creditors and a good explanation to disarm growing skepticism among observers. Owners of the company?s stock took note and began to sell. A brisk pace became a stampede as each investor tried to save what could be saved. In the end, the company was bankrupt and its stock valued in pennies. Many company leaders sold their personal stock in the company for huge profits when they saw the end coming, while persuading and even compelling employees who had invested in the company to hold their shares to help prop up the price. Many employees lost their life savings.
Americans are stunned and appalled by what has happened. If the nation?s outrage is mitigated, it is only by preoccupation with events of last September and the terrorist threat. Enron may not be so large that its collapse will have a major impact beyond the individuals and institutions directly affected. But the demand for justice in this affair is a national passion.
Beyond the particulars of Enron, however, policy leaders in the United States are increasingly concerned with what has become known as the "systemic crisis" underlying Enron?s collapse.
That crisis could have several dimensions, all of which would be important for the health of American capitalism. Boards of directors are supposed to provide governance to corporate management. But there now is concern that too many boards are compromised by their relationships with management ? relationships that can include lucrative consulting contracts ? and unwilling or unable to exercise the authority vested in them. Public accounting firms are mandated to assure through formal audits that the legally required reports of public companies conform to standard accounting practices. But the audited companies themselves pay for those audits, and in recent years, they have increasingly paid for consulting work beyond the audits. The fear is growing that such financial dependence undermines accountants? professional independence. Stock and bond analysts are supposed to provide investors with in-depth evaluations of companies as investment instruments. But they too may be compromised by their role in investment banks and trading companies with interests not always best served by analyst candor.
In the case of Enron, each of these components of America?s system of corporate oversight failed to cut through to the truth before enormous damage was done. The deeper problem, however, is that it is hard to believe that Enron could have happened without a more general erosion of the systemic checks and balances intended to keep companies honest. And there is at least some evidence ? however difficult it may be to interpret ? that such erosion has indeed taken place.
If it has, the root of the current systemic problems may lie not so much in failures as in success. Rapid growth in corporate earnings during the early 1990s generated high expectations for future growth that were ultimately unsustainable. By the second half of the decade, however, failure to "make your numbers" ? that is, falling below stock analyst expectations for a quarter ? could have a devastating impact on a company?s stock price. Analysts punished such companies by downgrading their public recommendations, and investment funds sold out of the stock. The resulting price volatility could destabilize a company far beyond what was warranted by lower than expected earnings. It would hardly be surprising in such an environment if some corporate executives tried to conceal their earnings shortfalls by pushing the accounting rules. Enron may have been a breathtakingly egregious case, but they were probably not the only case of a company making its numbers through creative accounting.
Such business practices are not possible on a broad scale unless accountants compromise their professional standards, and there are now concerns that too many of them may have done just that during the 1990s, allowing an American business culture to emerge in which "aggressive accounting" was the norm. Trustworthy corporate reports would have been the first victims.
Exaggerated stock and bond values would soon have become a staple product of the 1990s American business culture. Inflated earnings necessarily lead investors to believe a stock is worth more than would be justified by its true earnings. Similarly, interest rates on corporate bonds understate risk when balance sheets are riddled with gimmicks. Such practices create only the illusion of wealth in the form of higher stock and bond values than can be justified by the underlying businesses.
The implications of such practices would be insidious. No one can yet know their extent or that of any overvaluation they caused, but there is now a growing suspicion that the value of U.S. stock and bond markets ? and with them, the wealth of the American people ? is significantly overestimated. Added to uncertainty about exactly how much they are overestimated, that suspicion will have consequences in the U.S. and around the world.
American investors have already become skittish, and they will remain so. Even American consumers, usually a hardy breed, may balk when their invested savings enter a twilight zone where real value is indeterminate. Corporate capital spending ? like consumer spending, a mainstay of the U.S. economy ? will contract as companies try to meet earnings expectations in a sluggish economy with the stricter accounting practices we can now anticipate. It will tighten more if liberal use of accounting tricks helped inflate their earnings in prior years. American banks are already tightening credit as they reassess the corporate debt on their books.
One could go on in this vein, but only a few of these factors would probably be sufficient to stall the tepid economic recovery now expected later in the year. And in a global economy, a U.S. stall means a slowdown everywhere.
The consequences may not be economic alone. China?s economic disparities and social instabilities and Japan?s teetering debt crisis have implications for Asian regional stability that readily illustrate the vulnerability of world politics to economic weakness and U.S. economic gyrations.
China and Japan, however, are not the only important sources of instability around the world. Many such challenges exist today, all under the terrorist?s shadow. Now, though, they must be met with fewer resources, fewer options, and more frustration and risk than was anticipated before Enron?s bankruptcy unveiled what may be a profound malfunction of American capitalism.
Globalization itself has been put at some risk. Global economic integration transformed the world?s prospects within a decade and gained a wide following, if not without dissent. The heart of the system, however, is trust, including trust that capitalism is not a euphemism for swindle. The spectacle of Enron?s employees bereft of their life savings is today being absorbed by people of every nation. It could well play a part in their thinking tomorrow when they are asked to build further ? through expanded free trade, for example ? on their faith in a globally integrated free market economy.
What might all of this mean for Russia and Russians? For one thing, the world economic future in the short and mid-term is now at least a little darker than we expected it would be. That means the world through which Russia must navigate will be at least a little ? perhaps a lot ? riskier than was expected. The mind returns to the festering financial crisis in Japan and the question of how many straws the Japanese camel can tolerate. More generally, the rapid global economic growth of the 1990s, with its happy capacity to support fresh starts in many parts of the world, cannot be expected in at least the first half of the present decade. The Asian crisis of the late 1990s has now been complemented by a less profound, less dramatic, but nonetheless important crisis of confidence within the U.S. A genuine systemic crisis may underlay it. Time will be required for the U.S. to work its way through all of this, but until it does things will be tighter than they would otherwise have been everywhere. One cannot yet know how much tighter, but none of this is good news for a people struggling with their own basic economic strategy for the new century.
There is, however, a more positive story as well. The U.S. Congress, the regulators, the Administration and accounting professionals are moving quickly to address the array of problems. With mid-term congressional elections about eight months away and the Congress narrowly divided between Republicans and Democrats, partisanship will no doubt play a role. But so far it has been a muted one. It would probably be best for the President to form a special commission of distinguished individuals to take a fresh look at America?s whole approach to corporate governance and the role we expect the corporation to play in the 21st century. The world for which America?s present institutions were built has now been absorbed into a global economy within which behemoth-like multinational corporations are having a historic impact made possible by profound revolutions in technology, ideology, trade and finance. Only a body well above the political fray will have the standing to recommend and the stature to insist on the bold measures that may be best for America and the world. Better still if business leaders themselves were to request such a complete review. But whether through such means or others, trust will be restored.
The role of trust is perhaps the most valuable lesson to be drawn from Enron?s fall and the failures that may now be perceived in the American system of corporate oversight. Trust breeds confidence that the economic world is what it appears to be, despite the short-term incentives of some to make it otherwise. Such confidence renders much of the world intelligible and risk measurable. Measurable risk allows one to make rational investments for the future. Such investments are the soul of capitalism. If there is one lesson that Russians should take away from America?s successes and its failures, it is to give the highest priority to building that trust in their society on the firmest bedrock available.