Of Enron, Argentina & Capitalism
Uncommon Sense
Jim Cohen
jcohen@americasvoices.org
americasvoices.org
"History is one of those immutable facts of life -- there is absolutely
nothing any of us can do to change it. We can change the future."
-- Walter Williams, economics professor & commentator
January 28, 2002
The simultaneous implosions of Enron and Argentina, though unrelated, would
appear to give credibility to those who claim that capitalism is a flawed
system that inevitably enriches the few and shafts the many. In leftist
circles the world over, there is much salivating at the prospect of an
opening for socialistic values after two decades of widespread support for
free markets and private enterprise. This is not the right lesson to be
drawn from either Enron or Argentina, however. In fact, the two crises do
have a key similarity, and once that similarity is understood, it becomes
clear that capitalism is the solution, not the problem.
The obvious similarity between the collapses of Enron and Argentina is that
in both, the central issue was debt. In Enron's case, it was debt that was
hidden in order to improve the appearance of the balance sheet; in
Argentina's case, it was debt that was simply too large to service. But in
both cases, the debt reached a level that investor confidence could no
longer tolerate, which precipitated the respective collapses.
But though debt was the proximate cause in both cases, the debt was itself
a symptom of a larger problem. The key question is, why was the debt
allowed to reach a level that threatened investor confidence? Was it
simply a matter of poor judgment or overextension, or was there something
else at work? I would contend that in both cases, the debt was being used
to paper over another problem that no one wanted to deal with.
Let's examine Argentina first. To understand what happened in Argentina,
it's necessary to look back at least ten years, to the bout of
hyperinflation that took place in the early 1990s. This hyperinflation
came about because the government printed money in order to cover the
excess of spending over tax revenue. Cutting public spending wasn't
politically palatable, so rather than bite the bullet, the government chose
the easy way out, and inflation topped 1,000%. After that horrific
experience, the decision was made to close down that shortcut by pegging
the peso to the dollar. That way, the government couldn't print any money
which it could not back up with dollars on hand.
This seemed to solve the problem; inflation fell to almost nothing
overnight. But inflation wasn't really the problem-the problem was
excessive public spending. Inflation was merely a side effect. Fixing
inflation with a currency peg is like fixing a fever by putting ice in your
mouth when taking your temperature. Once the peg was in place, the
government continued to spend as before, but now it simply borrowed the
money to cover the excess of spending over revenue. Of course, at the same
time, economic conditions were improving because of a worldwide economic
expansion in which Argentina was playing an ever larger role because it
chose that time to open its markets. This allowed investors to raise their
estimation of the level of debt Argentina could sustain.
Free market critics have made it appear that it was the market opening that
caused the collapse. Nothing could be further from the truth. The only
role that open markets played was a modest reduction in exports, and even
that was due less to open markets than to the currency peg, which caused
the peso to be overvalued relative to other non-pegged currencies. The
cause of the collapse was simple: the Argentine government was spending
money unproductively at an unsustainable rate.
But rather than reduce spending or increase taxes, it chose instead to
borrow money until it could no longer service its debt, just as ten years
before it had allowed inflation to rise so high that the currency
collapsed. Argentina is addicted to public spending, and like any addict,
it used every means at its disposal to avoid facing its addiction, even to
the point of total implosion. It remains to be seen whether Argentina has
hit rock bottom and is ready to deal with the unions and other
constituencies that have demanded unsustainable levels of public
spending. The pronouncements from President Duhalde that free markets are
a "failed system" do not look promising.
Enron's situation, though outwardly different, is actually quite
similar. Faced with pressure from Wall Street as well as from their own
employees and executives to keep their stock price ever rising, Enron
managers chose to hide their business problems by shifting debt to a
variety of "partnerships" tailor-made for the purpose rather than deal with
them openly and take the valuation hit. Outside Enron, questions about
Enron's conditions were raised only in a prescient Fortune article, which
delved a bit more deeply than most and found that the numbers didn't add
up. For the most part, Wall Street was only too happy to blindly accept
the rosy picture of Enron and ride the stock price ever higher.
The main difference between the two (apart from the obvious) is that Enron
concealed its debt, so that its confidence collapse was due as much to the
surprise of discovering that an apparently successful company was actually
drowning in debt, and the loss of trust due to the lying, as it was to the
size of the debt itself. But in both cases, the true cause of the collapse
was the misuse of debt to avoid facing reality.
So what does this teach us about capitalism? Some would like to draw the
conclusion that these cases show it doesn't work. However, the facts do
not support that. Capitalism is not about reality avoidance techniques;
quite the opposite, in fact: it is socialism that employs reality
avoidance techniques in an attempt to soften the impact of changing
economic conditions on people.
Since ancient times, it has been observed that the only constant is
change. However, change is often painful and unpleasant, and frequently it
turns winners into losers, even as it turns losers into winners. From time
immemorial, winners have attempted to use their power to prevent change
that would damage them or cause their power to be reduced. Protectionism,
union rules, rent control, farm subsidies, non-convertible currencies, all
are attempts to use political power to alter or avoid economic reality.
Sooner or later, all such attempts fail. And the longer it takes for
failure to set in, the more spectacular the failure is, because the
disconnect between policy and reality grows over time. The result is
catastrophe that inundates people and causes tremendous dislocation and
suffering.
So the choice is really between constant, gradual change and episodic,
catastrophic change. Constant gradual change is much easier for living
organisms to absorb. It is easier to adjust to changing circumstances when
the change is gradual than it is when the change is catastrophic. However,
the temptation to use power to prevent change has been all too often
insurmountable. The genius of capitalism as an economic system is that it
is based on free enterprise, which consists of individuals constantly
self-adjusting to changing circumstance. When practiced properly, in
conditions of full information, catastrophic change is avoided and total
suffering is kept to a minimum.
In fact, it is really wrong to speak of capitalism as a "system". In fact,
capitalism would be better described as the lack of a system. Capitalism
is based on free market economics, which is really just a description of
natural unfettered human economic behavior. Although economists like to
think of their field as a hard science governed by immutable mathematical
rules, in fact economics is really based on psychology. Its "rules" are
simply mathematized descriptions of human behavior. Many people have
observed the intricacy and complexity of capitalism and mistaken it for a
brilliantly engineered system imposed from above, but in reality,
capitalism is simply what happens when people trade and negotiate among
themselves, absent other constraints or wide disparities in knowledge or power.
There have been many critiques of capitalism over the years, and many
alternative economic systems proposed. However, there really is no
alternative to capitalism, in the sense that capitalism is always there,
whether you like it or not. The laws of economics cannot be repealed
because they are the laws of human behavior. Rules attempting to redirect
and change human behavior can be imposed on top of capitalism, but human
behavior being what it is, such rules usually fail in a flood of unintended
consequences-as in the Soviet Union, for example. The critiques of
capitalism are really critiques of human nature; any alternative system
would require changes to that nature, which is why they so often end up in
utopian dreams-and disutopian realities.
The best answer is to avoid the temptation to use power to forestall change
and allow failure to happen. Both Enron and Argentina illustrate this
principle. Had Enron been honest about its obligations and financial
condition all along, its stock price would have been lower, but it would
probably still exist today. And if not, it would have failed before it
grew so large that thousands of people were hurt, since it's highly
unlikely that its debt would have been allowed to grow as high as it did
when it was invisible.
Similarly, Argentina would have been better off allowing its currency to
float and controlling inflation by cutting spending. Some people would
have been dislocated and some politicians would have been voted out of
office, but the country would not have faced total financial meltdown,
which has caused so much suffering for so many.
So it was not capitalism that caused them to fail; instead, their failures
were due to their attempts to short circuit capitalism. Thus the solution
is not restrictions on the free market but a fuller implementation of free
market principles. |
