December 17, 2001  

Enron, Bankruptcy, and Easy Credit

The recent bankruptcy filing by Enron has shaken the economy, with investors, employees, and creditors losing billions in a few short months. The shocking and sudden demise of America's seventh-largest company raises serious issues about stock valuations and the financial health of America's big companies. Questions are being raised about improprieties on the part of Enron management and its accounting firm. If evidence of fraud or other criminal activity exists, management and auditors should of course be held responsible. People are understandably angry, especially those who suffered serious financial losses. However, we should be careful not to blame the free market for the actions of a few in what is actually a very highly regulated market.

It is a mistake for Congress view the Enron collapse as an justification for more government regulation. Publicly held corporations already comply with massive amounts of SEC regulations, including the filing of quarterly reports that disclose minute details of assets and liabilities. If these disclosure rules failed to protect Enron investors, will more red tape really solve anything? The real problem with SEC rules is that they give investors a false sense of security, a sense that the government is protecting them from dangerous investments.

In truth, investing carries risk, and it is not the role of the federal government to bail out every investor who loses money. In a true free market, investors are responsible for their own decisions, good or bad. This responsibility leads them to vigorously analyze companies before they invest, using independent financial analysts. In our heavily regulated environment, however, investors and analysts equate SEC compliance with reputability. The more we look to the government to protect us from investment mistakes, the less competition there is for truly independent evaluations of investment risk.

The SEC, like all government agencies, is not immune from political influence or conflicts of interest. In fact, the new SEC chief used to represent the very accounting companies now under SEC scrutiny. If anything, the Enron failure should teach us to place less trust in the SEC and to question its existence. Yet many in Congress and the media characterize Enron's bankruptcy as an example of unbridled capitalism gone wrong.

Few in Congress seem to understand how the Federal Reserve system artificially inflates stock prices and causes financial bubbles. Yet what other explanation can there be when a company goes from a market value of more than $75 billion to virtually nothing in just a few months? The obvious truth is that Enron was never really worth anything near $75 billion, but the media focuses only on the possibility of deceptive practices by management, ignoring the primary cause of stock overvaluations: Fed expansion of money and credit.

The Fed consistently increased the money supply (by printing dollars) throughout the 1990s, while simultaneously lowering interest rates. When dollars are plentiful, and interest rates are artificially low, the cost of borrowing becomes cheap. This is why so many Americans are more deeply in debt than ever before. This easy credit environment made it possible for Enron to secure hundreds of millions in uncollateralized loans, loans that now cannot be repaid. The cost of borrowing money, like the cost of everything else, should be established by the free market- not by government edict. Unfortunately, however, the trend toward overvaluation will continue until the Fed stops creating money out of thin air and stops keeping interest rates artificially low. Until then, every investor should understand how Fed manipulations affect the true value of any company and the level for the markets.