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Most pundits who have commented on Enron have dealt in generalities. For some specific understanding of how Enron hid its problems and then collapsed, this testimony by law professor Frank Portnoy is worth reading. For example, Enron parked shares of some high-flying stocks in a subsidiary called Raptor, using a complex loan transaction.

Enron got the best of both worlds in accounting terms: it recognized its gain on the technology stocks by recognizing the value of the Raptor loan right away, and it avoided recognizing on an interim basis any future losses on the technology stocks, were such losses to occur.

It is painfully obvious how this story ends: the dot.com bubble burst...at the start of these deals, Enron’s obligation amounted to seven percent of all of its outstanding shares. As Enron’s share price declined, that obligation increased and Enron’s shareholders were substantially diluted. And here is the key point: even as Raptor’s assets and Enron’s shares declined in value, Enron did not reflect those declines in its quarterly financial statements.

Of course, what is on every investor's mind is the question of how many other Enron's are hiding out there? Portnoy says,

...accounting subterfuge using derivatives is widespread. I believe Congress should seriously consider legislation explicitly requiring that financial statements describe the economic reality of a company’s transactions.

After reading this testimony, I am struck by the amount of effort and expense required to construct Enron's Potemkin Village. Although it is possible that there are other companies that are as focused on creating an accounting mirage of profitability, it strikes me as unlikely.

Discussion Question. Portnoy lists a number of "gatekeepers" who might have made a fuss over Enron's business and accounting practices: auditors, investment bankers, law firms, credit rating agencies, and stock analysts. What can be done to increase the incentives of such parties to blow the whistle on abuses?

Columnist Robert J. Samuelson is not enamored of executive stock options.

As more executives developed big personal stakes in options, the task of keeping the stock price rising became separate from improving the business and its profitability. This is what seems to have happened at Enron.

Samuelson points out that stock options give executives considerable upside benefits at very little downside risk. This creates incentives for excessive risk-taking.

However, I am not convinced that stock options encourage executives to engage in criminal cover-ups. It seems to me that, if anything, the generosity of stock option plans ought to discourage illegal behavior on the part of executives. If the legal path to riches is easy, what is the incentive to stray off that path?

Discussion Question. Stock options create asymmetric payoffs, in that the executive wins a lot from success and loses relatively less from failure. How does that asymmetry encourage risk-taking, and are there enough offsetting factors within the corporate environment to restrain executives from making rash bets?

Although I only recently became aware of the Open Spectrum movement, it has been around for years. With Open Spectrum, regulators would do away with the system of licensing frequencies to different uses. Instead, all frequencies could be accessed by equipment that conforms to protocols that enable everyone's communications to get through.

An economist, Eli Noam, proposed the idea in 1995(!).

To allocate access one need not grant permanent allocation rights, but rather to charge an access fee that is set dynamically at a level where the available capacity is fully utilized...

the proposed open spectrum access system will not be adopted anytime soon. But its time will come, and fully bring the invisible hand to the invisible resource.

Noam took the view that the problem in allocating the radio waves is not "interference" but "congestion," which is known in economics as the peak-load problem. He argued that congestion could be dealt with up to a point using technology, and beyond that point using pricing to incent people to refrain from sending low-priority messages at critical times. His article cites earlier advocacy of open spectrum by Paul Baran (a co-inventor of packet switching, the fundamental concept in the Internet) and also by George Gilder. However, they did not anticipate the pricing solution to the congestion issue, and instead focused on technological solutions.

Another advocate of Open Spectrum was legal scholar Yochai Benkler, in this article published in 1998. Recently, the success of local wireless protocols, such as WI-FI, has kindled strong interest in Open Spectrum.

Discussion Question. A congestion-based surcharge also was advocated for the Internet, by Hal Varian among others, but it never was adopted. Instead, engineers focus on technology-based solutions, such as caching servers. Would not a pricing solution be less expensive?

I got an email from David Reed that mentioned legal scholar Yochai Benkler. I Googled Benkler and found this powerful polemic, which is from last year.

Benkler draws a contrast between traditional economic activity and the alternative of "peer production." Academic research, open-source software, and web logs are examples of peer production, in which people add value to one another's work without the formal co-ordination of a boss or the pricing mechanism of a market.

Property is a hindrance, not an aid, when peer production of a good like information is possible...

Stakeholders from the older economy are using legislation, judicial opinions, and international treaties to retain the old structure of organizing production...Copyright law and other intellectual property, broadcast law, spectrum-management policy, and e-commerce law are all being warped to fit the hierarchical organizations of yesteryear. In the process, they are stifling the evolution of the distributed, peer-based models...

Benkler implies that the peer production model needs to be protected from the legal assaults of old economy producers, such as the court case that shut down Napster. However, I think that the peer production model is being held back by more than corporate legal belligerence. There are still some unsolved economic problems with the peer model.

The peer production model works well for academic research as long as the "customers" for research are fellow academics. Once the prospect opens for broader applications, the peer production model tends to break down. As Paul Romer points out (see post 1 in the first archive), somewhere along the line between research and implementation, markets tend to improve the outcome.

The problem, in my opinion, is to develop robust economic models for peer production. If content is going to be distributed for free, how are content-creators going to be paid? If software is going to be made available for free, how are non-technical users going to be enfranchised?.

Discussion Question. One fascinating aspect of the Internet is that there are "peering arrangements," by which the major networks agree to carry one another's traffic without requiring monetary compensation. Is there a way that this model can be applied to other endeavors?

If you want to see visions of the Internet that are polar opposites, read this Fortune recent article on America Online's goal and then compare Bob Frankston's essay from last October.

AOL offers this scenario for the future:

Imagine a customer who pays AOL $24 a month for the basic subscription, plus around $30 a month for broadband service... it can then persuade him to pony up another $30 for a special "family plan" that lets the whole household use AOL at the same time...another $20 a month so that he can download unlimited jazz onto the stereo's hard drive... another $15 ordering up interactive games... another $40 a month for unlimited voice and wireless calls... and pretty soon you're closing in on $159 per month.

This prospect strikes me as rather dubious. These services are available today from separate providers at lower prices.

It seems to me that the only way AOL can ever get away with this sort of pricing is if competitors are shut out from offering similar services to AOL customers. Frankston argues that this is exactly the problem with integrated companies. Referring to existing telephone and television companies, he says,

As long as we allow the incumbents to use their control over both connectivity and services/content to thwart competition in services/content, we will suffer economically...Just as the FCC required that television networks divest themselves of the production companies we need a period during which the connectivity business and the services/content business are distinct.

What Frankston is saying is that what consumers need is not television or telephony but connectivity. Once the consumer has a broadband connection to the Internet, that connection can be used for telephony, television, or other services. For now, however, the cable television industry wants its wires to carry television programs as a top priority, and the telephone industry wants its wires to carry voice phone calls as a top priority.

AOL seems to be taking a more eclectic view of connectivity--in fact there is no reason why their futuristic scenario could not include a television subscription as well. But apparently Frankston believes that for now consumers would be better off if AOL were prevented from combining the connectivity business with the content and services business.

Discussion Question. Is it really feasible to draw a distinction between "pure connectivity" and services? If so, what are the pros and cons of prohibiting companies from providing both?

The difficulty of assessing the effect of tax cuts on economic growth is illustrated by the Washington Post's E.J. Dionne, Jr. in this op-ed piece on Democratic political strategy.

People out there liked Clinton's you-have-a-problem-I-have-a-proposal approach...

Every new Democratic proposal that involves spending will face that old, annoying question: How will you pay for that without increasing the deficit? That's exactly the effect Bush hoped his tax plan would have. It's why Daschle and the even bolder Ted Kennedy are right to challenge the future tax cuts.

As I pointed out in The Growth Doctrine and Policy, a tax cut that reduces the government surplus almost surely reduces growth. However, a tax cut that reduces spending on feel-good programs probably enhances growth. The analysis requires a political calculation.

Dave Cotton, an accountant, writes in today's Washington Post that the fundamental conflict of interest in the accounting profession is that accountants are hired by management rather than by shareholders.

Let's set up a system by which the stock exchanges would use a competitive process to select CPA firms to audit the financial statements of companies whose stock is traded on their exchanges.

This proposal raises a number of questions. For example, the process of choosing a CPA firm could be contentious. Would the firm that offers to conduct the audit at the lowest price be skimping on quality?

On balance, there is much to be said for Cotton's proposal. If what we want are outside auditors, then taking the selection process out of the hands of senior management is an obvious improvement.

Discussion Question. Once an accounting firm has audited a company once, it has a competitive advantage in auditing the firm in subsequent years. Would this lead auditing firms to become closely tied to the companies that they audit, even though the audit process is paid for by the stock exchange? What could the stock exchange do about this?

I have written two essays on what I call the Growth Doctrine. This doctrine can be summarized by a quote from Brad DeLong.

Ultimately, long-run economic growth is the most important aspect of how the economy performs. Two major factors determine the prosperity and growth of an economy: the pace of technological advance and the capital intensity of the economy. Policies that accelerate innovation or that boost investment to raise capital intensity accelerate economic growth. -- Brad DeLong, Macroeconomics, p. 89

In the first essay, I conclude

Tax policy is debated in terms of who "deserves" a tax cut. Social security is debated in terms of arcane accounting shell games. This is not to say that the Growth Doctrine favors Republican or Democratic economic policy. Rather, we should lament the fact that neither side appeals to the Growth Doctrine to support its positions.

In the second essay, I conclude

when we try to assess whether government policies are helping to promote economic growth, it is not enough to "follow the money." Government affects growth by the way its rules and regulations set the framework in various endeavors. Better design of the regulatory framework has significant potential to improve the outlook for growth.

Both essays use specific examples to illustrate the points. In fact, the second essay brings in the issue of FCC spectrum regulation, discussed earlier in posts 35, 39, and 40.

Discussion Question. New discoveries in biology and genetics should be a major source of economic growth. What regulatory issues will be important?

Pop Quiz: Can you name an example recently in the news that indicates a scandalous relationship between politicians and big business?

If you answered "Enron," you need to re-take the test. First, read Virginia Postrel's pieces on steel import quotas in The Wall Street Journal or in The New York Times. In the latter column, she wrote

So the free-trade president has just adopted a blatantly protectionist position. His action will raise prices for everyone who buys or makes anything that uses steel. But it will please two steel-making states: West Virginia, which President Bush won by merely 40,000 votes in last year's election, and Pennsylvania, which he lost by only 200,000 votes.

Discussion Question. Opponents of free trade argue that what we need instead is "fair trade." If another country offers us goods at "unfairly" low prices, why would it help us to put up trade barriers in response?

Morgan Stanley's Steve Roach, who makes Eeyore sound cheerful, sees the war on terrorism as having contractionary effects.

Three factors seem likely to account for a downshift of potential GDP growth -- the first being a slowdown in trend productivity traceable to subdued capital spending, higher business operating expenses associated with fighting the war on terrorism, and rising defense outlays. Also at work is a likely setback for globalization...reinforced by the functional equivalent of a tax on cross-border connectivity traceable to the battle against terrorism...

The first point is that capital will be diverted from investments that enhance productivity to investments that enhance security. The second point is that growth in cross-border trade will be slowed because there is a war going on.

Both of these points suggest to me that the war on terrorism adversely affects the economy's economic capacity, or aggregate supply. And yet, most of the near-term concern about the economy is about a drop in demand. The latter is due, as Roach points out, to the correction of the "lingering excesses" of the late 1990's. In plain English, the dotcom bubble is over, and now those folks need to find work in the real world.

I will state an awkward opinion here, which is that it may be that on balance the war on terrorism is helping the economy. Neither of the supply-side effects seems large enough quantitatively to worry about. In fact, in the trade arena, the biggest potential problem would be a spike in oil prices, but since September 11 we have had just the opposite.

On the other hand, the war on terrorism helps from a demand perspective. It soaks up some of the resources that would have been unemployed without it.

Ordinarily in war, the strains on supply are quite serious and excess demand puts upward pressure on inflation. The fact that policymakers are not facing an inflation threat, and instead are discussing a demand-stimulus package, suggests to me that the economic consequences of the war on terrorism are trivial.

Discussion Question. In a true wartime economy, would policymakers be concerned with raising the level of consumer spending?