Freeman

IT JUST AIN'T SO

Enron Shows Need for More Regulation?

How Regulation Made the Enron Crisis More Severe

JULY 01, 2002 by DAVID R. HENDERSON

Filed Under : Free Market, Regulation

In his December 24, 2001, Business Week column, journalist Robert Kuttner claimed the Enron scandal “suggests the need for tougher regulation.” That Kuttner would make such a statement is not surprising; he consistently advocates increasing the government’s power over our economic lives. But even many people who are generally sympathetic to economic freedom are questioning their belief that an unregulated market works best. But the Enron debacle happened in a regulated market. Without such regulation, the Enron crisis would likely not have been as severe as it was.

Consider financial regulation. Kuttner writes, “Only regulators (and their proxies, such as the Financial Accounting Standards Board) can force corporations to disgorge potentially embarrassing information.” When I read such a statement, I don’t know whether to laugh or cry. Kuttner correctly identifies the FASB as a proxy regulator: the Securities and Exchange Commission, a government agency, requires corporations to comply with standards set by the FASB. Which means that Kuttner, who advocates increased regulation, is arguing that only the kind of regulation we have will work. There’s one little problem with his view: the current regulations didn’t work. The agencies that Kuttner trusts as the only ones that can force embarrassing information into the open didn’t do so.

But wouldn’t we have even more Enrons if we got rid of all regulation? Probably not. The reason is that many of us value information about the firms we invest in and we are willing to pay for that information. Why do I trust the toaster I buy not to explode in my face and the motel I stay in to have clean sheets? There are two main reasons. First, the companies making these products treat customers well in order to establish a reputation for quality. A famous example of a firm that did well by producing a safe product, while those about them were producing dangerous ones, is Standard Oil of New Jersey. Kerosene, which began to be widely used in the late nineteenth century, had a nasty habit of blowing up and burning people to death. The reason: the product was not standardized. John D. Rockefeller came along and standardized it so that people knew it was safe: thus the company’s name, Standard Oil.

The other reason we trust products and services is that private certifying organizations such as Underwriters Laboratory (UL) diligently examine firms’ products to make sure they meet their standards. If tomorrow the government stripped the FASB of its government-granted monopoly on standards, then certifying agencies would come along that would give publicly held companies the equivalent of a UL certification.

But wouldn’t companies aggressively game the system, as Enron did, to find ways to meet the standards while still misleading the public? Possibly, but a private certifying agency, with its own reputation at risk, would have a stronger incentive to spot these shenanigans quickly than does a government-backed monopoly with zero wealth at stake.

Kuttner goes for the hat trick, using the Enron scandal to argue for increasing regulation in two other areas as well. First, he claims, Enron’s large profits in California’s electricity market show that deregulation of electricity doesn’t work. It shows no such thing. California’s government did not deregulate electricity in the mid-1990s; it re-regulated it, replacing the old rate regulation with some new regulations that only a market socialist could love. One of the new regulations was a vertical disintegration of the industry, which forced retail electricity providers to buy their power from generating companies. A related regulation prevented the retailers from having any contact with those who sold them the electricity, and also prevented them from buying on anything other than the daily spot market. In other words, all trades had to be made anonymously. One final regulation required each buyer to pay the highest price agreed to by any buyer that day. What that meant was that in times of short supply, generating companies would be foolish not to charge high prices. Refraining from doing so would not establish a reputation that would help them because no electricity buyer would be able to knowingly give his business to such a company in the future. This regulatory brew certainly did help Enron, but if this was deregulation, then Sweden’s economy is laissez faire.

Coerced Employee Stock Ownership

Kuttner also claims that “Enron employees were coerced to put the bulk of their tax-subsidized retirement savings into—guess what?—Enron stock.” He’s right about coercion, but wrong about the entity doing the coercing. Enron gave its employees strong incentives to hold Enron stock in their 401(k) plans. But Enron never used coercion. Rather, it gave them what looked like a sweet deal due, in part, to the federal government’s coercion of Enron. Specifically, the Employee Stock Ownership Plan, introduced by the federal government in 1974 with the Employee Retirement Income Security Act, gave companies a tax cut for selling stock to its employees. In other words, the federal government coerced money, literally, out of companies if they didn’t play along and then reduced the coercion if they had their employees own stock.

Kuttner writes that it “should be illegal” for a corporation “to force its employees to put all their retirement eggs in one basket.” I agree. But the issue is irrelevant because as mentioned above, Enron didn’t use force. Even if Enron insisted that its employees buy its stock, which it didn’t, that simply would have been terms of a contract that every Enron employee was free to refuse by not working there. But Kuttner probably knows that, and is misusing the language of coercion to hide his own advocacy of real coercion. If a company and its employees agree, unwisely in my opinion, that they will hold only the company’s stocks in their 401(k)s, I’m guessing that Kuttner would want to stop them—using real coercion, the kind that puts people in jail for resisting.

After detailing all the ways in which Enron and other companies should be regulated, Kuttner writes: “Enron was the ultimate politically engaged company. Its chairman, Kenneth L. Lay, was an intimate of the Bush family and was wired to Democrats as well. Enron’s operatives relentlessly lobbied state legislatures to provide a lax climate in which to pursue its market manipulation.

Kuttner is half right. Enron was “the ultimate politically engaged company.” But, as Cato Institute’s Jerry Taylor pointed out in the Wall Street Journal (January 21, 2002), the only thing consistent about Enron’s lobbying was that it was in Enron’s self-interest. If this meant lobbying for deregulation, then fine. If it meant lobbying, as in California, to get utilities out of generating electricity to make room for Enron, and for strict price controls on the use of transmission grids, then that was fine too.

Does Kuttner really think that increasing regulation will make companies lobby less?

ASSOCIATED ISSUE

July 2002

ABOUT

DAVID R. HENDERSON

 

David R. Henderson is a research fellow with the Hoover Institution. He is also an associate professor of economics at the Naval Postgraduate School in Monterey, California.

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