The Bear's Lair: Business needs values too

By MARTIN HUTCHINSON   |   Nov. 15, 2004 at 1:47 PM
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WASHINGTON, Nov. 15 (UPI) -- According to exit polls, the most important single issue to the U.S. electorate on November 2 was moral values. It thus probably wouldn't be smart for the re-elected George W. Bush administration to indulge in a wholesale relaxation of corporate reform measures -- it's likely that committed Christians oppose business fraud as much as they do gay marriage.

The late 1990s bubble, like all large bubbles, generated a plethora of funny numbers, in corporate and in this case government accounting. Company management discovered that it could reward itself more or less ad infinitum with stock options, without disclosing to shareholders through the income statement how much of their profits and assets were being diverted to the corporate leeches.

Company management also discovered that fiddling around with the organization structure every 3-4 years had a number of advantages. Attractively, it enabled top managers to pay off old scores by closing down or selling off the divisions of their rivals who had lost out in the power struggle. Even more attractively, it enabled them every 3-4 years to announce a "restructuring," the cost of which could be inflated beyond all belief and deducted directly from capital, without going through the income statement at all. If they were clever, they could take additional reserves in the big write-off, and then add them back in subsequent quarters -- through the income statement, this time, as if they related to current operations -- when they were needed to boost earnings to the levels expected by Wall Street.

Cisco, for example, took directly against capital a $2.5 billion write-off of inventory in 2001, because it had overstocked -- surely a normal operating expense if ever there was one -- and was then able to write back some of the $2.5 billion in subsequent quarters, as it sold some of the old inventory and needed extra earnings during the recession of 2001-02.

Funny numbers have always been a feature of stock market bubbles:

-- In the South Sea bubble of 1720, the company, having no significant operations, prepared no accounts, but got the stock price moving by making fictitious awards of stock at below-market prices to well-placed politicians (including two of King George I's mistresses) thereby ensuring that "word of mouth" and the government treasury both operated to support the stock price.

-- In the South American bond boom of 1825, the young Benjamin Disraeli wrote entirely persuasive, beautifully written prospectuses for South American countries that didn't exist.

-- In the mining bubble of 1895-96, savvy prospectors would "salt" mine sites with lumps of gold bearing ore, allowing mining engineers to discover them and produce totally fictitious estimates of the wonderful gold content of the mine site.

-- In the boom of 1928-29, "investment trusts" were created to buy each others' shares and thereby restrict the share supply artificially, allowing speculative demand to create a pyramid balanced on its point, with very few operating assets at the bottom. (The Google promotion of 2004 showed that the art of allowing huge speculative demand to act on artificially restricted supply has not been entirely lost!)

-- In the late 1960s boom, National Student Marketing invented the accounting concept of the "unbilled receivable" -- sales that you hoped to make, but for which you couldn't send an invoice because you hadn't actually made them yet.

-- In the late 1980s Japan, companies created profits through "zaitech" -- buying each others' eurobonds with warrants attached, recording the warrants' cost at zero (and the bonds at the package's full purchase cost), selling the warrants in the market, and reporting the "profit" as operating income.

In the 1990s, government got in on the act too. Concerned that economic growth numbers weren't very exciting, while inflation remained stubbornly present, the U.S. Bureau of Economic Analysis in 1995 invented the concept of "hedonic pricing" in which "quality improvements" in the tech sector would be recorded as price declines. As the cost of a megabyte of RAM halved every two years, this would be allowed to offset price increases in other sectors, rebalancing at least annually so that the tech sector price declines could be maximized as a share of the total.

Of course, in reality the benefit of each doubling in RAM, clock speed or other technological factor produced nothing like a doubling in the "hedonic" benefit of the product to the consumer, while the cumulative effect of the rebalancings was seriously distorting -- as if we had been paying $600,000 for our PCs in 1994 compared with $600 now. In addition, only the tech sector was allowed to be hedonic; deterioration in consumer "hedonic satisfaction" in other areas -- for example, through computer-automated telephone answering systems, or government mandated but useless environmental and fuel-efficiency features on cars -- was ignored.

The result has been to reduce growth in the consumer price index and the GDP deflator by about 1 percent per annum below what it would have been if conventional prices had been used for the indices. Very attractively for government, this has increased the announced growth rate in real gross domestic product by the same 1 percent per annum (because nominal GDP stays the same, while the GDP price deflator is deflated.) Even more attractively, it has also increased reported productivity growth by the same 1 percent per annum.

The U.S. markets have thus been relying since about 1997 on a "productivity miracle" that is nothing more or less than a statistical error produced by the BEA. In reality, multi-factor productivity has since 1995 been growing rather more slowly than before, because of the inefficiency of the enormous misallocation of capital in the late 1990s to such areas as un-needed fiber-optic cable capacity and Internet pet food distribution.

Europe has not adopted hedonic pricing, hence its GDP growth is not overstated in this way. When you adjust both sets of statistics to the same basis, the "dynamic" United States is growing no more quickly per capita than Old Europe.

After 2000, the Enron collapse and the Sarbanes-Oxley Act appeared to have created an unstoppable momentum for correcting many of the abuses, at least in the corporate sector, but the economic recovery of 2003-4 has in many cases reversed that momentum, as has Bush's election win. The Financial Accounting Standards Board in October voted to postpone implementation of its new rules on stock option accounting until June 2005, giving time for an energized Republican U.S. Senate to block the rules (though Senate Finance Committee Chairman Richard Shelby, R.-Ala., has said he favors the FASB proposal).

The two Republican commissioners of the five on the Securities and Exchange Commission are reportedly bringing pressure on SEC Chairman William Donaldson to relax enforcement of the Sarbanes-Oxley Act, and there are rumors that Donaldson, a strong chairman with long Wall Street experience (he was a founder of the investment bank Donaldson, Lufkin and Jenrette) may be eased into retirement. It now appears that the SEC proposal to allow shareholders to propose company directors directly will be withdrawn -- this would be a significant blow to shareholders in companies such as Hewlett-Packard and Disney, where runaway management has rewarded itself enormously and failed to protect shareholder interests.

Both the Fed and the U.S. Treasury continue to cry up U.S. productivity achievements, and there appears to be no significant constituency to restore order to the BEA's economic statistics.

So I come back to the election results. If Republicans are to gut the attempt to restore honest accounting to business and government, then why should an electorate that holds moral values important vote Republican? Honesty and fair dealing are surely central to any workable concept of ethics, and I cannot believe that in the long run a morally-oriented electorate will continue to ignore them. It is after all in the interests of the Democrats and the liberal elements of the media to raise moral outrage against business and administration sleaze, so in the long run, as the memory of the ethically equivocal Bill Clinton years fades, any attempt by the Administration to relax efforts against fat-cat fraud must surely be electorally counterproductive. I am a free market conservative (NOT a Big Government Conservative, an oxymoron if ever I saw one) and about as pro-business as it's possible to be, but I'm also strongly in favor of integrity in both business and government activities. The two views should NOT be incompatible.

The administration and the Senate Republicans are currently flushed with victory. If they fall into the trap of hubris, rewarding tech-sector campaign contributors who oughtn't to be rewarded and failing to clean out funny numbers from government statistics, then they will achieve a very unpleasant nemesis indeed -- the frauds will catch up with them economically, and moral outrage will catch up with them politically.


(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)


Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site

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