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Victor Canto shares the view that Enron was like a hedge fund.

its demise may have reminded you of a number of players in the past few years that have used sophisticated financial instruments to soar to incredible heights only to crash later. Long Term Capital Management (LTCM) and several other hedge funds that imploded come to mind.

As he points out, it is quite difficult to evaluate the balance sheet of this type of company. So-called market value accounting, in which every item on the balance sheet is valued at current market prices, is widely viewed by economists as a the right approach. That is fine in theory, but in practice it is rarely followed.

Discussion Question: If you use market value accounting to measure the current levels of assets and liabilities, then should you not use market value accounting to measure income? That is, let income be the change in the market value of assets minus the change in the market value of liabilities?

Recent research suggests that people differ greatly in their willingness to save, and that this helps determine their position in the class structure of wealth. As Thomas Stanley and William Danko put it in the popular bestseller The Millionaire Next Door, "ordinary people can become wealthy." They can do so by adopting a frugal lifestyle that provides ample room for saving for retirement.

Last month, Hal Varian argued that too many people rely on Social Security instead of saving for retirement. In his column, he reported on research by Stephen F. Venti and David A. Wise on saving behavior. What Venti and Wise found is that there are high-income people with very little in savings, and vice-versa.

They concluded that most of the observed variation in retirement wealth is primarily a result of different propensities to save.

If ordinary people can become wealthy by saving, then one policy implication is that people should be encouraged to save. Today's New York Times has an article suggesting that many people need to be tricked into saving. For example, people who will not contribute to an IRA now might be willing to commit to contribute their next raise to an IRA.

A less subtle way to encourage saving would be to reduce the tax burden on people who save. Along those lines, many economists favor moving away from an income tax and toward a tax only on consumption. Income that people devote to saving would not be taxed.

Discussion Question. If we abolished the income tax and replaced it with a consumption tax, then people who save would get rich and yet have much of their income exempt from taxes. Is that a cause for concern?

I have just read Barriers to Riches, by Edward Prescott and Stephen Parente, in which the authors argue that trade barriers are an important cause of the unequal distribution of world income. Their analysis is focused on policies that poor countries impose that keep out efficient productive processes. However, not all trade barriers are self-inflicted. For example, on Friday there appeared this reminder that the textile industry of Bangladesh has been held back by U.S. tariffs and quotas designed to protect our garment industry.

Parente and Prescott argue that incumbent suppliers often propose trade barriers in order to avoid having to compete against efficient competitors. To succeed, the incumbents must work in industries with some degree of monopoly power and they must have some support from the government.

By 1958, Willie Mays, Ernie Banks, Hank Aaron, and Frank Robinson already had demonstrated the skills that put them in the top tier of the Hall of Fame. They would soon be joined by Juan Marichal, Willie McCovey, Roberto Clemente, Maury Wills, and Bob Gibson, giving the National League a distinctly higher quality of star players. If the All-star game is used as a measure of inter-league parity, then it took almost twenty-five years for the American League to recover from the damage caused by holding on to racist practices.

In October 1964 David Halberstam writes that after Jackie Robinson broke the color line,

the National League moved with speed, but the American League moved with deliberate speed...

In the American League, the tone was set by the New York Yankees...and their ownership in those critical years was, to be blunt, racist...the National League gradually began to pull away as superior, with better teams and more exciting younger players.

By 1964 the National League had virtually all the best young black players...[p. 54-55]

In baseball, the incumbent suppliers (white players) were threatened by a superior process, which was to field the best team, regardless of color. With a monopoly position, protected by a government exemption from anti-trust laws, major league baseball was able to maintain a barrier against the superior process until 1947. Even by 1964, ballplayers who were black had to be stars to earn roster positions, and not even stars were welcome on many American League teams.

When we think of the damage done by the color barrier in baseball, the most obvious harm was to the black baseball players. However, harm also was done to the quality of major league baseball, which kept some of the best players out of view of the typical baseball fan. I believe that this detrimental effect on quality is a metaphor for the way Prescott and Parente would explain the low standard of living in underdeveloped countries.

Discussion Question: In the case of major league baseball, the trade barrier now seems particularly odious because it was racist. The tariffs and quotas that we impose on foreign textiles are not racist...or are they?

Yesterday, Ford announced a large restructuring plan, that ultimately will involve cutting 35,000 jobs.

But the plant closures and many of [the] future job cuts are years away. Ford did not give details on when the plants will be closed other than to say it will occur by mid-decade.

The current labor contract with the United Autoworkers union, which runs through fall of 2003, does not allow plant closings ...

The Ford situation illustrates an apparent conflict between macroeconomic stability and growth. From the perspective of efficiency and long-term growth, companies need to adapt, make changes, and shift resources away from inefficient uses. However, layoffs put people out of work.

Keep in mind, however, that the unemployment rate depends on flows in two directions:

1. People looking for work, either as new entrants to the labor force or because they separated from a previous job
2. People hired into new jobs

As long as new hiring is strong, the economy can absorb layoffs without an increase in the unemployment rate. In fact, the 1990's were a period of falling unemployment, even as large companies such as General Electric and IBM made dramatic reductions in their work forces.

Discussion Question: Many countries have laws that make it costly for companies to eliminate jobs. Do such laws help to keep the unemployment rate down in those countries?

CNNFN offers some data that shows accounting fraud rising.

The number of fraud cases investigated by the Securities and Exchange Commission jumped 41 percent in the last three years, according to agency data...

I listened to the PBS News Hour on the radio last night, and they were pointing out that the profit restatements by Enron were relatively small. This begged a question, which was asked, but not answered:

My guess is that the answer is that Enron was operating like a hedge fund. It was trying to earn profits from complex, leveraged transactions in illiquid markets involving swaps. A swap is an illiquid version of a derivative. A derivative is an option or futures contract whose value is derived from that of an underlying asset. A swap is a contract between two private parties that has the financial characteristics of a derivative. However, swaps are not traded on the market, and hence are not liquid.

When your strategy relies on swaps, everything depends on your borrowing cost remaining stable. If your borrowing cost goes up, the deals that were winners at the time they were negotiated are losers today.

Restating profits meant that Enron went down a rung in creditworthiness, which raises their borrowing costs, which was fatal to their strategy. That is why former Treasury Secretary Robert Rubin and other Enron pleaders were calling Federal officials and asking for help. With some kind of government guarantee to bolster their credit rating, Enron might have survived. But evidently the Bush administration rebuffed the approaches by Enron and let them fail.

Discussion Question: Should a company that engages in complex swap transactions be required to disclose the sensitivity of the firm's net worth to a hypothetical increase in its cost of borrowing?

In Our Wretched States, Paul Krugman discusses the fiscal situation of state governments. The mainstream analysis and policy prescription is:

One impact of a recession is to reduce state revenues. Because they are obliged to balance their budgets, this leads them to reduce spending. The result is to reinforce the downturn. However, with revenue sharing, the states would have less need to cut back.

In conclusion, I believe that a large, temporary revenue-sharing program would be a good approach for fighting a recession. This form of fiscal stimulus would quickly find its way into the economy.

However, that is not what Krugman writes. It is what I wrote, in December of 2000. I'm sure that Krugman would understand my position. In fact, I believe that he would agree with it. But for his columns, he wants to stick to pure anti-Republican hysteria.

Discussion Question: Consider two issues:

1. the appropriate share of government spending in the economy
2. the appropriate short-term fiscal stimulus

Are these issues best lumped together or treated separately?

David Brin is a physicist, science fiction writer, and under-appreciated social thinker. His book The Transparent Society is an absolute must-read for anyone trying to sort out the issues of privacy and security that have become so salient since 9-11.

In Disputation Arenas: Harnessing Conflict and Competitiveness for Society's Benefit, Brin en passant does a nice job of articulating New Growth Theory.

Consider four marvels of our age -- science, democracy, the justice system and fair markets...for years, rules have been fine-tuned in each of these fields of endeavor, to reduce cheating and let quality or truth win much of the time. By harnessing human competitiveness, instead of suppressing it, these "accountability arenas" nourished much of our unprecedented wealth and freedom.

Brin argues that the "four marvels" combine "centrifugal structures" that allow people the freedom to innovate with "centripetal structures" where adversaries resolve conflicts and the best ideas win out. In a market, for example, every individual is free to try to build a better mousetrap, but the mousetraps that survive are the ones that consumers buy.

Brin says that in the world of political and social thought, we lack centripetal structures. Thus, ideas that are wrong can persist.

I was reminded of this last night, when I attended what was billed as a seminar on the topic of media bias. What I noticed was that:

1. All of the panelists were liberals, and none of them represented the point of view that the media are biased.

2. Representatives of The Washington Post and The Jerusalem Post both reported that their online audiences now exceeded their print readership, and that the online audiences were largely from out of the paper's local area.

3. When I asked the panelists about the phenomenon of web logs, which are used by conservatives to mobilize against perceived liberal bias in the media, the panelists were not aware of these web logs. Obviously, they had not read A Technological Reformation, by Greg Reynolds.

The implications I drew from this are:

1. Liberals are insulated from those who disagree with them.

2. The Internet has become a significant arena for forming opinion on social and political issues.

One near-term outcome is that liberal reporters and conservative web loggers will continue to talk past each other. However, my impression is that the web loggers are engaging alternative points of view more directly, which should lead the conservatives to evolve more strongly.

Discussion Question: How do market forces work to overcome resistance to change?

Alan Blinder, Brad DeLong, Paul Krugman, and I share an intellectual heritage. Three of us got Ph.D's in economics at MIT, and DeLong's MIT connection is that he taught there.

All of us would agree with what I might call the Growth Doctrine:

Over a period of a decade or more, the most important determinant of economic well-being in a society is economic growth. Economic growth is the most reliable way to address average living standards, poverty, fiscal soundness, the viability of programs such as Social Security, etc.

This is not some right-wing dogma.

• DeLong, a liberal Democrat, makes a very strong case for the Growth Doctrine in his new textbook, Macroeconomics. The chapter on the facts of growth is outstanding.

• Blinder, another liberal Democrat, articulated the growth doctrine in a relatively little-noticed book called Growing Together.

Paul Krugman has written numerous columns on fiscal policy and Social Security, including this recent example. Yet I cannot recall a single column that spoke to the issue of how fiscal policy and Social Security policy affect economic growth.

The fact that he always comes down against the policies of George Bush may win Krugman fans in some quarters. However, he is consistently lowering the level of the debate and misleading the public by failing to frame the issue in terms of which policies would lead to more economic growth. Therefore, I believe that it is no understatement to say that Krugman is irresponsible.

Discussion Question (difficult): President Bush has promoted tax cuts and partial privatization of social security. What aspects of these policies might inhibit economic growth? What aspects of these policies might promote economic growth?

In contrast to Lawrence Lessig (see post 10), computer science professor Edward Felton understands that the recording industry is losing the music distribution war even if it is winning the legislative battle. In this interview, Felton says that the distributors should be trying to use a carrot rather than a stick to reach consumers. He recommends

Interactive applications that help you find music you like, help you index and search, give you additional information about the artist you're listening to...

Overall, the trend will be less emphasis on copy protection and more emphasis on technologies that make music more compelling for the legitimate user.

I agree. The ultimate winners in the music distribution industry will not be the companies that try to force people to buy CD's. They will be companies that provide music subscription services that offer the variety of music swapping along with features that add value.

Discussion Question: describe the features (including monthly subscription price) of a music service that you think could be successful.

Accounting scandals, called "earnings restatements," have been in the news lately. For example, Homestore.com took a hit, and the CEO resigned. This was not the first time their accounting had been called into question--see this piece in the defunct Industry Standard.

(If you peruse my personal web page, you will see that I developed a web site that competed with and then was bought by Homestore. However, I no longer own any shares in the company.)

Also this week, the Washington Post ran a four-day front-page retrospective on the rise and fall of Microstrategy. Its stock bubble was popped by an accounting scandal in March of 2000, one of the turning points in the Internet boom.

Then of course, there is Paul Krugman's favorite whipping-boy, Enron. Is this the start of an epidemic of accounting fiascos?

Here is a dire warning about accounting:

In short, there is not a company anywhere whose income statement and profits cannot be changed, by the management and accountants, by counting things one way instead of another.

That quote comes from The Money Game, the 1967 best-seller by "Adam Smith."

As the 35-year-old passage shows, there has always been a reason to worry about accounting. So far, though, we have managed to muddle through with only a few isolated scandals.

I am less concerned about accounting than I am about the expectations that investors have for corporate earnings growth. Everyone thinks that the companies in which they are investing are going to have double-digit earnings growth for many years, even though in the aggregate the economy is not going to grow at 10 percent per year. Something has to give...

Discussion Question: Do you think that company managers and their accountants have more incentive to report earnings honestly or to report dishonestly?