Worksheet

1 WHAT IS
ECONOMICS?

When do self-interest and the social interest coincide? This is the big question raised in the first chapter of your
text. Let's consider that question in the context of the recent controversy over extravagant pay packages for
1
corporate executives who had been systematically lying to shareholders through fraudulent accounting . As
reported by Gregg Easterbrook in an article called “Greed Isn’t Good”,

“ The overt cheaters have profited brazenly: Kenneth Lay of Enron pocketing an extra $101 million in the
months before Enron's collapse wiped out shareholders; Bernard Ebbers of WorldCom "loaning" himself
$366 million in the months before his cooked books wiped out shareholders; L. Dennis Kozlowski of
Tyco paying himself $426 million, from 1998 to 2002, even as his self-serving decisions were wiping
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out shareholders and driving the company into the ground.”

The CEOs were clearly pursuing their own interests but in the process, they wasted shareholders’ money,
destroyed livelihoods, and increased the perceived risk of investing in corporate stock. That is, their self-interested
behavior turned out to be socially malignant. Yet economists claim that in the context of competitive markets,
individuals pursuing their own gain will unintentionally serve the public interest as well.

Why should you believe this? What is the argument that underlies that conclusion? And how can we account for
the failure of this doctrine in the case of Enron, WorldCom, Tyco, and HealthSouth?

The reasoning behind the assertion that self-interest and the public interest are aligned is as follows. A CEO’s
value to a firm is directly related to her ability to generate profit. To generate profit, the CEO must manage the
firm’s resources in a way that creates maximum value for its customers. The social benefits arising from this
incentive system are twofold: (1) the CEO must strive to learn what the customer values, and (2) she must deliver
that value at a cost that’s less than the customer’s willingness to pay. The discipline of competition from other
firms intensifies the firms’ efforts on both of these fronts, resulting in maximum value creation from a given set of
resources.

So where did this process breakdown in the recent rash of corporate scandals? The flaw arose in the very first step.
In the recent fraud cases, each CEO recognized that his value to the firm was directly related to his ability to
generate the appearance of profit, rather than the reality of profit. The skills and behaviors necessary to generate the

1
For examples of recent corporate fraud cases, see http://www.newsmax.com/hottopics/Corporate_Scandals.shtml,
http://www.forbes.com/2002/07/25/accountingtracker.html, or search for “Bernard Ebbers, Kenneth Lay, or
Richard M. Scrushy on Wikipedia.com.
2
Gregg Easterbrook, “Greed Isn’t Good”, Daily Express, New Republic Online, 1 July 2002,
http://www.tnr.com/doc.mhtml?i=express&s=easterbrook070102 (28 November 2006).
24 CHAPTER 1

appearance of profit are very different from those required to produce actual profit, and they do not serve the
interests of customers, shareholders, or the general public. Gregg Easterbrook identifies the problem succinctly:

“Economic theory says markets work best with "transparency"--information must be accurate and must flow
openly in order for markets to be efficient. Markets can't be efficient if corporations are lying about their financial
condition, clouding the air with disinformation. "Clearing," one of the essential tenets of free market economics--
driving all prices to their true value--can also happen only in the presence of accurate information available to
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anyone.”

1. Why didn’t independent accounting firms and stock analysts uncover the fraud in these cases?

In many cases there was a conflict of interest. Some of the companies accused of fraud were big
important customers of investment banks for whom the stock analysts worked. Accounting
firms may have been reluctant to upset clients that generated lots of fees.

2. Who did eventually uncover the fraud?

Journalists. In late July of 2000, Jonathan Weil, a reporter at the Dallas bureau of the Wall
Street Journal, got a call from someone he knew in the investment-management business. Weil
wrote the stock column, called “Heard in Texas,” for the paper’s regional edition, and he had
been closely following the big energy firms based in Houston—Dynegy, El Paso, and Enron.
His caller had a suggestion. “He said, ‘You really ought to check out Enron and Dynegy and see
where their earnings come from,’ ” Weil recalled. “So I did.”
Weil got copies of the firm’s annual reports and quarterly filings and began comparing the
income statements and the cash-flow statements. “It took me a while to figure out everything
I needed to,” Weil said. “It probably took a good month or so. There was a lot of noise in the
financial statements, and to zero in on this particular issue you needed to cut through a lot of
that.” Weil spoke to Thomas Linsmeier, then an accounting professor at Michigan State
University, and they talked about how some finance companies in the nineteen-nineties had
used mark-to-market accounting on subprime loans—that is, loans made to higher-credit-risk
consumers—and when the economy declined and consumers defaulted or paid off their loans
more quickly than expected, the lenders suddenly realized that their estimates of how much
money they were going to make were far too generous. Weil spoke to someone at the
Financial Accounting Standards Board, to an analyst at the Moody’s investment-rating agency,
and to a dozen or so others. Then he went back to Enron’s financial statements. His
conclusions were sobering. In the second quarter of 2000, $747 million of the money Enron
said it had made was “unrealized”—that is, it was money that executives thought they were
going to make at some point in the future. If you took that imaginary money away, Enron had
shown a significant loss in the second quarter. This was one of the most admired companies in
the United States, a firm that was then valued by the stock market as the seventh-largest
corporation in the country, and there was practically no cash coming into its coffers.
Weil’s story ran in the Journal on September 20, 2000. A few days later, it was read by a Wall
Street financier named James Chanos. Chanos is a short-seller—an investor who tries to make
money by betting that a company’s stock will fall. “It pricked up my ears,” Chanos said. “I
read the 10-K and the 10-Q that first weekend,” he went on, referring to the financial
statements that public companies are required to file with federal regulators. “I went through it
pretty quickly. I flagged right away the stuff that was questionable. I circled it. That was the

3
Ibid
W HAT IS ECONOMICS? 25

first run-through. Then I flagged the pages and read the stuff I didn’t understand, and reread it
two or three times. I remember I spent a couple hours on it.” Enron’s profit margins and its
return on equity were plunging, Chanos saw. Cash flow—the life blood of any business—had
slowed to a trickle, and the company’s rate of return was less than its cost of capital: it was as
if you had borrowed money from the bank at nine-per-cent interest and invested it in a savings
bond that paid you seven-per-cent interest. “ They were basically liquidating themselves,”
Chanos said.
In November of that year, Chanos began shorting Enron stock. Over the next few months, he
spread the word that he thought the company was in trouble. He tipped off a reporter for
Fortune, Bethany McLean. She read the same reports that Chanos and Weil had, and came to
the same conclusion. Her story, under the headline “IS ENRON OVERPRICED?,” ran in March
of 2001. More and more journalists and analysts began taking a closer look at Enron, and the
stock began to fall. In August, Skilling resigned. Enron’s credit rating was downgraded. Banks
became reluctant to lend Enron the money it needed to make its trades. By December, the
company had filed for bankruptcy. 4

3. What is the role of the media in a market economy? And the role of accounting firms? The legal system?

This is a big question; but in a nutshell the role of the media is to generate accurate
information; accounting firms the same. Transparency is required in order for trust to prevail.
And without trust, only on-the-spot transactions can take place. The legal system has many
roles in society, but from an economic standpoint it establishes contract law, enforces property
rights, and establishes the rule of law.

4
“Open Secrets,” by Malcolm Gladwell, The New Yorker, Jan 8, 2007.