|Cato Policy Analysis No. 470||February 20, 2003|
by Christopher L. Culp and Steve H. Hanke
Christopher L. Culp is adjunct professor of finance at the Graduate School of Business at the University of Chicago, a principal at Chicago Partners LLC, and senior fellow in financial regulation at the Competitive Enterprise Institute. He is coeditor with William A. Niskanen of Corporate Aftershock: The Public Policy Lessons from the Collapse of Enron and Other Major Corporations, forthcoming in June. Steve H. Hanke is professor of applied economics at the Johns Hopkins University, a principal at Chicago Partners LLC, and a senior fellow at the Cato Institute.
The collapse of Enron Corporation has been portrayed as the result of accounting fraud and greed. Not everything that Enron did, however, was wrong or fraudulent. Fraud contributed to the timing of Enron's failure but was not the root cause of that failure. In analyzing Enron, it is critically important to distinguish what Enron did wrong from what it did right.
Enron's basic business strategy, known as "asset lite," was legitimate and quite beneficial for the marketplace and consumers. By combining a small investment in a capital-intensive industry such as energy with a derivatives-trading operation and a market-making overlay for that market, Enron was able to transform itself from a small, regional energy market operator into one of America's largest companies.
Enron contributed to the creation of the natural gas derivatives market, and, for a while, it was the sole market maker, entering into price risk management contracts with all other market participants. Its physical market presence, as a whole-sale merchant of natural gas and electricity, placed the Houston-based company in an ideal position to discover and transmit to the market relevant knowledge of energy markets and to make those markets more efficient.
When Enron applied that same strategy in other markets in which it had no comparative informational advantage or deviated from the asset-lite strategy, it had to incur significant costs to create the physical market presence required to rectify its relative lack of market information. The absence of a financial market overlay in several of those markets further prevented Enron from recovering its costs. It was at that point that Enron abused accounting and disclosure policies to hide debt and cover up the fact that its business model did not work in those other areas.
For its innovations, Enron should be commended; for their alleged illegal activities, Enron's managers should be prosecuted to the full extent of the law. But under no circumstance should Enron's failure be used as an excuse to enact policies and regulations aimed at eliminating risk taking and economic failure, because unless a firm takes the risk of failure, it will never earn the premium of success. As was demon-strated in the case of Enron, markets—not politicians— are the best judges of success and failure.
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