Just over twenty years ago, at the dawn of the 1980s, a conservative theorist named George Gilder published a million-copy international best-seller entitled Wealth and Poverty, providing an intellectual case for the superiority of free markets and entrepreneurial capitalism over government programs and state regulations.
That book, and the ideas it promoted, played a significant role in maintaining deregulatory momentum in the era that followed, a period that lasted from the Reagan years until the present day. By the late 1990s, America’s thinking elite had so clearly embraced the ideology of markets rather than government regulation, that even most on the political Left grudgingly accepted the declaration of their own Democratic President that the “era of big government was over.”
As the stock market rose and rose, both political parties seemed to largely converge in their economic and fiscal policies—and their fundraising practices. Meanwhile, in the popular culture, multi-millionaire (or even multi- billionaire) entrepreneurial businessmen frequently replaced Hollywood stars or leading sports figures on magazine covers, while in the popular mind these CEOs vied with academics or philosophers as our supposedly deepest thinkers.
As all of us know, the last year or two has not been kind to our utterly inflated stock market, nor to the utterly inflated economic illusions that it once fostered. With many leading technology stocks down 80% or 90% from their peak—or vanished into bankruptcy—our previously widespread but naïve assumptions about the close connection between wealth and genius have required enormous reexamination. And what we have discovered has not been heartening.
Consider, for example, the case of Worldcom, not a mere upstart and money-losing dot-com, but a hundred-billion-dollar corporation whose stock was among the most widely held in America and whose core businesses included providing the backbone of the Internet. By some estimates, almost half of the world’s email moved along Worldcom pipes.
Today, Worldcom value has completely evaporated in the wake of a bankruptcy brought on by nearly four billion dollars in revealed accounting fraud, with an additional three billion in further fraud revelations merely adding insult to already total injury. Investors in Worldcom stock and bonds— rich and poor alike—have lost almost everything.
But to me, the more fascinating side of this mammoth corporate debacle, one of many, came in a recent front page story in the New York Times, attached below, that probed the actual business practices and performance of that vast and powerful company and its top executives, who bestrode the world like boardroom gods just a few quarters ago.
We have recently heard that former Worldcom CEO Bernard Ebbers will rest his legal defense on the astonishing claim that despite his billions in personal wealth and tens of millions in annual compensation, he was so incompetent and ignorant a fellow that for years he had never actually realized that the nominal profits of his supposedly highly-profitable corporation were essentially fictitious. But as the long New York Times story below indicates, this claimed defense may be absolutely legitimate and true.
Ebbers himself and his unusual personal background had long been the stuff of entrepreneurial legend, a real-life case of rags-to-riches success. Numerous glowing business profiles had outlined the tale of how an Evangelical Christian from small- town Mississippi, a college drop-out whose only previous professional experience had been coaching high school football and managing discount motels, within just a few years become the billionaire founding CEO of the world’s most rapidly growing and powerful telecommunications company.
But as the Times reveals, it now appears that Ebbers’ executive management skills were about what we would expect of a Mississippi discount motel operator. His company seems to have been a business and operational shambles from almost the beginning, its fatal flaws temporarily masked by the deceptive accounting impact of its exponentially-growing list of corporate acquisitions. The entire rise of Ebbers and Worldcom now seems based on a mixture of stock market insanity, Wall Street analyst corruption, and—eventually—outright accounting fraud.
A few years ago, a top-ranking Republican House leader said that “Government is dumb and markets are smart.” Given these facts about one of America’s largest and most heavily scrutinized companies, in which the markets invested—and lost—a hundred billion dollars or more, I would amend that to read: “Government may be dumb, but markets—and those who mindlessly worship them— are often dumber.” I would also suggest that America retroactively shift the Congressional pensions of its more market-worshipping elected officials into Worldcom stock.
And the story is hardly limited to Worldcom. As the London Economist recently pointed out, our equity markets have now lost approximately half their peak value, or over seven trillion dollars. Given that our entire federal budget, exclusive of transfer payments, isn’t much over a trillion dollars, seven trillion dollars is serious, serious money by any measure.
Admittedly, probably much less than a trillion of these vanished dollars represent absolutely wasted investment capital, resources spent on producing useless things, with the balance being paper losses in inflated stock. But much of that stock had changed hands one or more times, meaning that many trillions of those dollars may have been transferred from the gullible or the unlucky to the dishonest or the lucky.
At the height of the Bubble, a leading Silicon Valley venture capitalist grandiosely claimed that the numerous dot-coms he and his friends had created represented the “largest legal creation of wealth in the history of the world.” Given the collapse of that Bubble—and the tens or hundreds of billions in cash that he and his fellows extracted for themselves before the collapse—what we actually have witnessed might better be described as the largest unjustifiable transfer of accumulated wealth in the history of the world, with potentially devastating consequences for our economy and society. Yet the apologists for this failed system continue their apologias, apparently assuming that the “market” possesses at least one attribute normally associated with the Divine: it can do no wrong.
During the middle decades of the 20th Century, America—and the world economy—was seriously threatened by the disastrous economic policies of Marxist-Leninists. During the last decade or so of that century, one might make a case that the greater threat came from Market-Lunatics.
One recently much-debated aspect of this obvious lunacy is the conflict over the accounting treatment of stock options. Respectable accounting professionals and leading investors—from Warren Buffett on down—are virtually unanimous that since stock options have obvious value, companies cannot give them away to executives or employees without recording that distributed value as an expense for accounting purposes. Critics of this proposal, such as former American Express CEO and current Dow Jones Board Member Harvey Golub in an op-ed in Thursday’s Wall Street Journal, attached below, disagree, claiming that since no cash is spent, total corporate earnings should be unaffected.
The obvious reason for this resistance is that recording options payments as expenses would severely reduce or even eliminate the stated profits of many companies, especially in the technology field, with mighty Intel’s 2001 profit reduced by 80% under such an analysis. Since we have learned from the example of Worldcom that accounting fraud is the easiest means of generating high profits, we should explore Golub’s arguments with considerable suspicion.
First, we should note that Golub’s argument could be applied equally well to the issuance of new stock itself, since that involves no direct cash outlay either.
Second, since both stock and options have a clear market value, workers and executives could receive their entire compensation in this form, which they could then sell to pay their ordinary living expenses. According to Mr. Golub, this stratagem should allow corporations to completely eliminate all their salary costs from an accounting perspective, since no cash is spent. Corporate profits would soar if salary expenses vanished.
Next, similar financial engineering would allow corporations to barter their shares or options for rent, raw materials, advertising, capital equipment, and everything else, thereby completely eliminating all these drags on profit margins since not a single actual dollar could change hands. Corporations could quickly reduce their total accounting expenses to zero, allowing profits to equal revenues.
Finally, if the issuance of options should not be an accounting expense, companies could abandon the difficult task of providing actual goods or services, and instead switch their business activity to merely issuing and selling options directly into the marketplace, generating enormous cash revenue at no accounting expense whatsoever.
Thus, it appears that Mr. Golub has stumbled onto a wonderful perpetual-motion engine for financial activities, one which will allow unlimited revenues and profits to be created out of thin air (or at least blank corporate stock certificates). Perhaps he could now be persuaded to develop a similar mechanical device that would allow us to run our cars without fuel and our lights without electricity.
If so prestigious a financial figure writing in so prestigious a financial publication cannot come up with a better justification for the accounting status quo, then we can safely assume that there is none. It appears likely that anyone who opposes the expensing of stock options is either wittingly or unwittingly endorsing accounting fraud.
This is the point made in another in a series of witheringly effective pieces by the New York Times’ star economic columnist Paul Krugman, appearing in this morning’s edition. Krugman’s piece, attached below, points out that if options costs were properly accounted, Cisco Systems in particular would have had consistent losses over the last decade, a very strange financial basis for a company that at the peak of the Bubble became the world’s most valuable, with market value north of $500 billion.
A plausible case can be made that in recent years, the key technology powering the financial success of most leading Silicon Valley companies had shifted from the microchip or the fiber optic strand to perpetual motion devices.
That such blatant fraud remains widely accepted even after the financial calamities of the past couple of years is a devastating statement about the remarkable and bipartisan corruption of our political system.
This is certainly the conclusion recently drawn by Peter Beinert, editor of the New Republic, in a powerful column pointing out the dishonest policies followed by the so-called “New Democrats,” whose high tech donors would find their corporate profits devastated by honest accounting. The Global Crossing insider option deal that left DNC Chairman Terry McAuliffe a multi-millionaire at the expense of countless ruined small investors falls into much this same category.
As an individual from a liberal Democratic family background who became a Republican under Reagan, the disgusting behavior of today’s Republicans on issues ranging from “English” to corporate corruption sometimes tempts me to take a second look at the Democratic Party. But what I see there immediately tells me “don’t bother.”
Still, there are areas in which the two parties have some significant differences, notably regarding the long-debated privatization of Social Security, a popular topic among conservatives (and also many “New Democrats”) until the recent market collapse turned the issue into a terrifying political albatross.
Now the basic concept behind this proposal is a sound and reasonable one. There is solid historical evidence that over long periods of time, the returns from equity investments easily outpace those from fixed income instruments, let alone government bonds. I have little doubt that it would be possible to devise a system that simultaneously ensured retirees considerable security together with returns much higher than those of our pay-as-you-go system of transfer payments. But there are many devils in these details.
First, simply allowing our government to invest gigantic social security funds in the stock market would amount to socialization of almost our entire private sector, which–although perhaps tempting to extreme leftists—would be an almost certain disaster. This would turn our capital markets into the pork barrel to end all pork barrels, with all major investment decisions being decided by politics rather than by economic viability. Given the track record of state socialism in the Soviet Union or Eastern Europe, we should avoid the same approach in America.
On the other hand, simply allowing ordinary workers to invest their social security money as they see fit—effectively turning the system into one of super 401(k)s—would raise equally serious problems. Most obviously, what would happen to those prospective retirees who lost much or even all of their retirement money? Equities do tend to rise on average and in the long run, but as we have recently seen, they also sometimes fall sharply or even evaporate completely. For decades, large telecom stocks such as AT&T and MCI were natural choices for “widows and orphans,” but any widows or orphans who followed this strategy have lost over 80% of their peak investment in the former and everything in the latter, following its acquisition by Worldcom.
Furthermore, if enormous numbers of totally inexperienced investors were suddenly forced to begin stock picking on their own for the first time, unscrupulous companies might easily target their advertising to this huge market segment. For example, television stars or celebrities of a certain era and aura might effectively persuade naïve individuals to bet their retirement savings on the worst and riskiest companies. William T. Shatner, pitchman for Priceline.com comes naturally to mind.
Even if most investors did succeed in their strategies, many or at least some would fail, and what should be done for these elderly and completely ruined citizens? It is politically unlikely that our elected officials would allow them to become destitute and homeless. Instead, the result would most likely be a massive government bail-out of injured small investors, very similar to what occurred during the S&L collapse of the late 1980s, but on an enormously greater scale, with all the corresponding fiscal and economic damage. Furthermore, given the predictable likelihood of such a bailout, we might expect a considerable fraction of investors to make their risk allocations accordingly, assuming a scenario of “heads I win, tails the government loses.”
Certainly, some sort of equity-based retirement system might be far more economically efficient than existing Social Security. It is even likely that some mixture of private investment and public guarantees might produce an optimal mix of both performance and security. But economic choices are not made in a political vacuum, and leaders who ignore the likely unintended consequences of massive changes to a multi-trillion-dollar pension scheme brought on by politics and popular opinion are doing a severe disservice to their country. Those who suggest such changes without even considering these obvious factors should have little credibility.
Certainly, in recent years, credibility has been in generally short supply with regard to conservative economic nostrums, which have taken on a fiscally ludicrous if financially rewarding tinge. Since the early 1990s or so, numerous Republican officeholders and conservative thinktanks have tirelessly proposed the elimination of all taxes on interest, dividends, capital gains, and inherited wealth, while drawing their campaign contributions and other funding from America’s wealthy, who, perhaps entirely coincidentally, derive virtually all of their income from interest, dividends, capital gains, and inherited wealth. A much more direct approach might simply be to propose a law forever exempting all rich people in America from paying income taxes.
Unfortunately, the extraordinary intellectual dishonesty and financial illiteracy of these proposals has unfairly tainted related measures that seem prudent and sensible. For example, today’s Wall Street Journal carried an op-ed, attached below, by a trio of financial academics suggesting that America eliminate the double taxation of dividends, a misguided policy that is almost certainly a hidden culprit behind the current waves of accounting fraud.
Today, our government double-taxes corporate dividends and half-taxes capital gains, enormously increasing the incentives for manifesting profits in the latter form. However, while paying a dividend requires real cash profits for a company, capital gains can easily be produced based on the fictitious profits produced by accounting fraud or creative bookkeeping, whether legal or illegal. Hence the Bubble, the scandals, and the collapse. Putting the taxation of dividends and capital gains on an equal footing would go an enormous distance toward removing the tax incentives for corporate fraud, and simultaneously smooth our increasingly volatile governmental income tax streams.
Naturally, the shocking proposal that different types of income be taxed in approximately the same way attracts little support on either the Left or the Right, especially among our political leaders, or the wealthy, who might be permanently forced to pay their share of taxes but would also avoid the very real risk of losing their fortunes in sudden market collapses, let alone the possible demagogic populist backlashes these might inspire.
This is hardly surprising. In my own limited experience, wealth and stupidity seem to be as often closely correlated as not, with this fact frequently becoming evident despite widespread popular assumptions to the contrary and hordes of paid PR flacks working very hard to maintain those foolish illusions.
Consider, for example, the unfolding and unfortunate example of William E. Simon, Jr., current Republican gubernatorial candidate in America’s largest state, whose multimillion-dollar fortune was established through his one shrewd business decision, made at an impressively young age, to select William E. Simon, Sr. as his father.
After spending his life seldom voting and, as far as can be determined, expressing absolutely no interest in either politics or policy, he decided at the age of fifty that instead of discovering a quick cure for cancer or winning a series of Nobel Prizes, he would instead seek the second highest office in America. Presumably he was persuaded by his political consultant that only he (and the rich political-consulting commissions lurking deep within his wallet) could rescue the Golden State of California from the clutches of the appalling wickedness of Democratic Gov. Gray Davis.
This prospect of facing a political titan such as Simon so terrified our good governor that the latter spent almost ten million dollars of advertising in the Republican primary to ensure Simon’s nomination, a political investment that now appears among the best in history. For after floundering around for several months in a disorganized fashion, the hapless Mr. Simon suddenly generated coordinated headlines from Calexico to Yreka as a Los Angeles jury found his company guilty of fraud and levied damages of $78 million against him for swindling his business partner, one of America’s leading (retired) drug- dealers.
Now being a business partner with a retired drug kingpin is bad enough for a conservative Republican running for highest office, but having a jury unanimously fine you nearly $80 million for defrauding said drug kingpin is even worse. The magnitude of this embarrassment is seen in the immediate response of Debra Saunders of the San Francisco Chronicle, one of California’s most prominent Republican-leading political columnists, who suggested that the Republicans quickly persuade Simon to withdraw from the race since a Republican write-in candidate would have a far better chance at the polls.
But as it happens, Mr. Simon has a strong and compelling defense against the fraud verdict, namely his claim that he had never suspected that the man to whom he paid some $30 million was a convicted drug-dealer or that the business in which he was investing (and which he soon drove into bankruptcy) seems to have been a money-laundering operation.
Certainly if Simon’s political campaign is any indication, this defense of sheer ignorance and incompetence seems absolutely plausible. I have heard that even hard-core Republican activists are beginning to call the nominated head of their statewide ticket “Simple” Simon.
Finally, George Gilder’s own subsequent career provides an ironic coda to the financial debacle that so threatens our capital markets.
During the 1990s, Gilder moved from general conservative musings to a special focus on technology issues and the Internet—the world of what he called the “telecosm”—and with Global Crossing and Worldcom as his special favorites, he inspired and then rode the Bubble to unprecedented wealth and influence.
At its peak, his Gilder Technology Newsletter had annual revenues of $20 million, mostly from stock- pickers eager for his investment tips. Gilder plowed much of these earnings into dubious ideological ventures, such as funding a media campaign to replace wicked Darwinist theory with Creationism, but when the Bubble burst, his did as well, leading him to recently tell Wired Magazine that he’d been driven into personal financial ruin, with a lien on his house.
Instead of admitting the existence of a Bubble or widespread accounting fraud, he claims that excessive government regulation produced the market collapse and his own. Wealth and poverty indeed.
- For WorldCom, Acquisitions Were Behind Its Rise and Fall
New York Times, Thursday, August 8, 2002
- The Real Value of Options by Harvey Golub
Wall Street Journal, Thursday, August 8, 2002
- Clueless in Crawford by Paul Krugman
New York Times, Tuesday, August 13, 2002
- This Tax Cut Will Pay Dividends by Paul Gompers, Andrew Metrick, and Jeremy Siegel
Wall Street Journal, Tuesday, August 13, 2002