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Why Enron Always Happens

June 2024
17min read

And how history shows it’s actually good for us

THERE’S AN OLD JOKE ABOUT A COMPANY’S NEEDING TO hire a new accounting firm. The chief executive invites the heads of eight firms to come in for interviews and he hires one right away. A friend asks him how he did it. “Simple,” the chief executive replies. “I just asked each of them one question. How much is two plus two?”

“That’s easy,” the friend says.

“Sure it is. Seven of them said four. So I gave the job to the eighth. He said, ‘What number do you have in mind?’”

The reputation of the accounting profession, indeed that of capitalism itself, is in a bad way these days for sometimes letting the need for a good number on the bottom line dictate the numbers above it, rather than the other way around. One of the great American accounting firms of the twentieth century, Arthur Andersen, is almost certainly at the end of its existence thanks to scandal after scandal. Enron, once the seventh-largest company in the country as measured by gross revenue, has been found to be a tissue of accounting deceptions and has plunged into bankruptcy, wiping out much of the accumulated wealth of its investors and employees. WorldCom, the second-largest long-distance provider and by far the largest carrier of Internet traffic, counted $7 billion worth of routine maintenance expenses as capital investments, making the company seem profitable when it was not. Tyco’s chief executive, unchecked by a supine board of directors, turned that company into his personal piggy bank to buy real estate, paintings, and a now-infamous $6,000 shower curtain. Indictments have been handed up by the dozen, with many more undoubtedly to follow.

What is going on? Listening to much of the public commentary and political pronouncements on this issue in recent months, one might think that the crisis of capitalism, so long predicted by its enemies, is at hand. It is not. This is capitalism.

The present crisis is just a normal part of the messy, two-steps-forward-one-step-back way in which capitalism evolves and progresses—in the long term—to ever-greater capacity for wealth production and ever-wider distribution of that wealth. But why is the capitalist system so messy? The answer is almost as simple as that to the question about two plus two.

Capitalism, unlike socialism and all the other economic isms dreamed up by economists, politicians, and social philosophers over the years, is not a system at all. Rather, its ways are determined by two ineluctable facts. First, capitalism is an artifact of human nature itself and thus manifests all of that nature’s passions, genius, obsessions, and foolishness, not to mention the human weakness for the seven deadly sins. Second, capitalism is a game, no different in a mathematical sense from football or poker except for one thing. Poker is a zero-sum game that merely redistributes the wealth of the players according to their luck and skill. The game of capitalism creates wealth, sometimes in prodigious quantities. It can also, of course, destroy it.


These two facts are deeply intertwined, but let’s consider them separately. To put the fact that capitalism is an artifact of human nature another way, let’s say that it is what happens when human beings are free to pursue their own economic happiness, which is to say their self-interest. It appears spontaneously in all cultures, despite sometimes ferocious efforts to kill it. As a Vietnamese proverb has it, trying to stop a market is like trying to stop a river. Indeed, no small part of the reason for the failure of all forms of socialism—from the sort practiced in democratic Britain after World War II to the unspeakable tyrannies of various Communist regimes, including North Korea’s—is that so much political effort must be exerted just to prevent capitalism from erupting spontaneously among the citizenry. This has profound consequences and explains much about why economic history has been what it has.

Human genius inheres in individuals, for instance, but foolishness can be, and often is, a crowd phenomenon. One of the most famous books ever written about human behavior is Charles MacKay’s 1841 Memoirs of Extraordinary Popular Delusions . Many of MacKay’s examples, such as the Crusades and the Salem witch trials, have nothing to do with economic behavior. But many others, such as the tulipomania that seized the Netherlands in the early seventeenth century and the South Sea Bubble of early-eighteenth-century England, were financial in nature.

One of the most common progenitors of these financial manias is new technology. The success of the Manchester & Liverpool Railway, which opened in 1829, demonstrated the possibilities of the most important practical application of the steam engine, and in the early 1830s dozens of railroad ventures were started in America. Their stocks and bonds were soon trading on Wall Street, and investors rushed in, often with little thought other than to get aboard while the getting was good, despite the fact that most of the new railroads had yet to carry any freight, let alone turn a profit. Some people were investing in railroads merely because other people were investing in railroads.

Unfortunately for the investors, no one in the 1830s knew how to run a railroad, and many of them proved far more expensive to build than had been estimated. The boom turned to bust when the hoped-for profits all too often failed to materialize. It would be the 1860s before some railroads, notably Commodore Vanderbilt’s New York Central, became cash cows.

This series of technological innovation, rosy scenarios, herd instinct, soaring stock prices, earnings disappointment, and crash has been repeated over and over again. The Internet bubble of the 1990s was one more example of this all-too-human tendency to go overboard. Because the potential of the Internet, the most revolutionary practical application of the microprocessor, is so great, the bubble it induced was similarly large. But 10 years after the Internet began to take off, no one, except pornographers and eBay, had really learned how to make money from it. The Internet’s Commodore Vanderbilt has not yet appeared.


Another way in which human nature affects the working of capitalism is expressed in the dictum that institutions tend to evolve in ways that benefit their elites. This is true whether the institutions are financial, governmental, educational, or even charitable.

For an example of this tendency in the financial world, consider the New York Stock Exchange in the 1920s. Although it was the biggest and most important securities market on earth, it was still governed largely the same way it had been in the 1820s, when 5,000 shares a day were heavy volume. This suited the members just fine. It was, in both theory and practice, a private club, owned and operated for the benefit of its members. Only they (or their designees) could trade on the floor. Some of them did a regular retail brokerage business. Others, often called independent floor traders, traded only for their own clients. And then there were specialists, who bought and sold one or a few securities and were charged with maintaining an orderly market in those securities. The specialists’ order books, which listed all the stop-loss and buy orders, were a gold mine of insider information regarding future demand.

THE FLOOR TRADERS OFTEN MANIPULATED STOCKS , forming pools to stage bear raids or to bull a stock to new highs and using information from the specialists to know just when to buy and sell. This made investment in securities on the exchange hazardous for the general public. But because the market soared during the 1920s, no one was interested in whether the system was functioning well. When the bottom dropped out, in 1929, however, the search for explanations became intense, and it didn’t take long to find practices that were indefensible.

Still, Wall Street, led by the broker Richard Whitney, who became president of the exchange in April 1930, resisted fiercely. “The Exchange is a perfect institution,” he advised a journalist. Whitney and the old guard of floor traders and specialists blocked change as much as they could, while a growing number of brokers, who catered to small investors, clamored for it.

Fortunately for the New York Stock Exchange and the country, Richard Whitney turned out to be a crook. Addicted to a lavish lifestyle that his income did not support, he borrowed frequently from friends and relatives. When that did not suffice, he began to loot the accounts of his clients and his clubs and even his wife’s trust fund.

As embezzlements usually do, Whitney’s fell apart and he was arrested. (The “perp walk” for felonious businessmen is not a new invention, by the way; Whitney was much photographed on his way to jail.) Wall Street was devastated, and 5,000 people crowded into Grand Central Terminal to watch the former president of the New York Stock Exchange be put on a train for Sing Sing. The Securities and Exchange Commission, itself part of the reformation of Wall Street, moved at once to take advantage of the disarray. Soon the New York Stock Exchange had a new constitution whereby the president was a paid employee, not a member. Brokers had to conform to new audit requirements and were forbidden to have margin accounts of their own if they did business with the public. Firm debts were limited to 15 times capital, making companies much less subject to sudden failure. Customers’ accounts had to be kept separate from firm accounts. The exchange was still a private organization owned by its members, but it had ceased to be a private club operating only for their benefit. It transformed itself into the quasi-public institution it had long in fact been.

In recent years it has been publicly held corporations that have most conspicuously evolved in ways beneficial to their elites, which is to say their top management. In theory the stockholders of a corporation elect the board of directors, which then hires the management and evaluates its performance, rewarding it or firing it as necessary. But in the last few decades chief executive officers in many corporations have come to control their boards, often loading them with executives who work for the CEOs and are thus in no position to act as an effective check. Even the outside directors are often so handsomely paid that they, too, are disinclined to rock the boat.

As a result, CEO salaries have gone through the roof, and such perks as private jets, luxurious apartments, no-cost and often forgiven loans, and vast stock options have proliferated. During the go-go nineties these abuses largely went unnoticed, just as the excesses of Wall Street did in the twenties. But when the market turned down and the stocks of these companies began to slide, the shenanigans began to attract attention, and reforms are being instituted.

As I said above, in mathematical terms capitalism is a game. It has players (everyone from chief executives to janitors, not to mention writers and editors), it has a means of keeping score (in a modern economy, money), and it has rules. The players are out to win the game—or more exactly, since the game of capitalism never ends, to be in the lead. As the players seek to score, they constantly devise new tactics and strategies. Some of these are good ideas, such as the idea of standardized money itself, first used around 700 B.C. , and are made a permanent part of the game, and some of them are not, such as secret rebates from railroads for big shippers like Rockefeller’s Standard Oil, and are banned after a period of experimentation.

In this way capitalism is no different from, say, American football. That sport began in 1869 when Princeton played Rutgers in a soccerlike game with 25 men on a side, and goals were scored by kicking a round ball under the crossbar of the goalposts. Over the next few years the game evolved rapidly.

Harvard, which favored a more rugbylike game, used an eggshaped ball and permitted a player to run with it if pursued. Yale, which played a soccerlike game, wanted to play Harvard, so the two forms were arbitrarily combined in the 1870s.

As the game changed, the players sought a balance between offense and defense that was challenging for them and entertaining for the spectators. They also, of course, sought advantage over their opponents in order to win and constantly developed new tactics. Some of these were very effective in the short term but disastrous for the game overall. The flying wedge, first used in the 1880s or early 1890s, depending on whose account you believe, made the offense nearly invincible and caused numerous injuries. It was banned 10 years later. The forward pass, however, first legalized in 1906 and much expanded in 1912, revolutionized the game.


Even today football’s evolution continues, although at a much slower pace. Videotape made it possible for referees to check their first impressions before making a call, but after a period of experimentation, doing so was thought to slow down the game too much, and the idea was abandoned.

Capitalism has had a similar history. The industrial corporation was virtually unknown in 1800, yet some today have annual gross revenues that exceed the gross domestic product of most sovereign countries. Money then was gold and silver or, sometimes, paper directly backed by precious metal. Today money is largely electronic blips stored in computers.

A vast number of rules have had to be devised and tested on the fly in order for these developments to work for the good of all. A whole corpus of law governing incorporation, for instance, has had to come into being. In 1800 it was state legislatures that granted corporate charters, and politics played a very large part in determining which charters were granted and which were not. By mid-century every state had standard procedures and rules governing incorporation, with politics largely taken out of the process. But many of these new rules forbade or discouraged industrial companies from operating in more than one state. As the railroads, telegraph, and telephone knitted the country into a single continent-spanning market, and as companies grew to take advantage of economies of scale to better serve this new market (and, of course, make more profit), these obsolete provisions proved ever more confining.

To get around the old rules and operate efficiently, companies such as Standard Oil of Ohio adopted a trust form of organization beginning in 1882. Then, in 1888, New Jersey—in pursuit of tax revenue as much as economic efficiency, to be sure—rewrote its statutes regarding corporations, taking modern reality into account. Companies flocked to the state to take advantage of them. The trust form of corporate organization disappeared a mere decade after its invention. But a growing fear and dislike of the burgeoning power of these new, vast concerns did not, and the term trust stuck.

The first federal antitrust legislation, the Sherman Antitrust Act, had been enacted in 1890 to prevent companies from coalescing through mergers into monopolies that could threaten the market as a whole. Much of the public debate regarding corporations since then has revolved around striking a balance between allowing economic efficiency on the one hand and preventing economic heeemonv on the other.

The rules governing accounting have also had to be developed, and new techniques and tools evaluated. As long as firms were small and family-owned there was little problem, but when very large corporations began to proliferate, new accounting and statistical tools were needed to manage them successfully. Still, the accounting interests of stockholders and management were not the same. Shareholders wanted honest, complete accounting; managers, naturally, wanted the affairs of their corporations to look as good as possible. Sometimes managers lurched over the line into outright fraud, as those at WorldCom and Enron appear to have done.

Wall Street too has had an interest in getting timely and truthful numbers from the corporations whose shares trade there, but until the late nineteenth century most publicly held corporations did not even issue regular reports, let alone conform to specified accounting standards. When the New York Stock Exchange asked the Delaware, Lackawanna & Western Railroad for information about its finances, the road curtly replied, “Railroad makes no report [and] publishes no statements.…”

Then, in the 1890s, Henry Clews, a major broker on the Street, began campaigning for periodic reports prepared by independent accountants. The number of these self-employed accountants climbed. In 1884 there were only 81 accountants listed in the directories for the three largest cities in the United States (not counting Brooklyn, which was still enjoying its independence from what would soon be Greater New York). Five years later, there were 322. In 1896 New York became the first state to recognize accounting as one of the professions, establishing criteria that a person must meet to be licensed as a certified public accountant, a term coined in that law. By the start of World War I companies that wanted their securities to be listed on the New York Stock Exchange or sought profitable relationships with banks had no choice but to issue quarterly and annual reports that were certified by independent accountants as accurate and in conformity with generally accepted principles.

That is not to say, of course, that crooked accounting has vanished. Accounting is not a static science, and it always involves many judgment calls. As the profession has developed, new concepts have come into being. Cash flow, for instance, is now considered one of the most important measures of a company’s financial condition. But the very phrase cash flow entered the English language only in 1954. These new ideas have provided new opportunities to skate near the edge of what is allowed. And always some have skated over the edge.

In recent decades accountants seeking to expand the reach of their profession moved heavily into business consulting. This often proved more remunerative than accounting itself. Unfortunately it caused a conflict of interest. Accountants, though hired by management and paid by the companies whose books they audit, have a fiduciary duty to stockholders and the public at large to ensure that the books are honest and give a true picture of a firm’s financial condition. Fear of losing the highly profitable consulting jobs that now often accompanied auditing created a pressure in close calls to see things the company way. This, in some cases, caused a slippery slope into increasing deceit, such as at Enron, where Arthur Andersen was earning millions in consulting fees.


The solution, once the problem became apparent, was obvious and is already now law: Accounting firms must not serve as consultants to firms they audit. Again, scandal has led to effective reform.

In a friendly, neighborhood touch-football game, peer pressure keeps the players honest. With bragging rights the only tangible reward of victory, there is little to be gained and much reputation to be lost by cheating. But when the stakes of the game get higher, the temptation to cheat increases proportionally. With millions at stake in the Super Bowl every winter, for instance, if there were no referees on the field, the game would quickly come to resemble the famous football scene in the movie M.A.S.H.

The same is equally true of the game of the free market. As Adam Smith explains in The Wealth of Nations , “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” In other words, if the problem with socialism is socialism itself, the problem with capitalism is always capitalists. That’s why free markets are not self-regulating and never can be as long as human beings are human.

There is no better example of what happens in a free market when there are no referees on the playing field than the so-called Erie Wars that broke out on Wall Street in the 186Os when Cornelius Vanderbilt tried to buy control of the Erie Railway, then under the control of a board that included Daniel Drew, Jay Gould, and Jim Fisk.

Wall Street’s securities market dates back to shortly after the Revolution, and the New York Stock and Exchange Board, as the New York Stock Exchange was called until 1863, was formally organized in 1817. But much trading took place in often ephemeral rival exchanges that cropped up from time to time and on the Street itself, and there was no Wall Street institution at this time powerful enough to regulate stock trading effectively. Neither the state nor the federal government regarded the regulation of markets as part of its duties, and because the New York State judiciary was profoundly corrupt, even the ordinary rules of law were at best sporadically enforced. No one was in charge, and what rules there were could be ignored with impunity. But as lone as the mar- ket was very small, peer pressure kept matters under control.

The Civil War changed everything. The national debt ballooned, and an avalanche of new federal securities was soon being traded on Wall Street, which became the second-largest securities market on earth, after London. With millions suddenly at stake, for a few years on Wall Street it was capitalism red in tooth and claw.

The Erie Railroad, which competed directly with Vanderbilt’s New York Central, was largely run for the benefit of its management, which speculated freely in its stock rather than act for the benefit of its stockholders. Vanderbilt resolved to force the feckless Erie to be run in a businesslike manner and thus rationalize the competition among the railroads serving New York City, and he decided to do so by simply buying control of it, by acquiring a majority of the 251,050 shares of common stock outstanding. Being the richest man in the country, with unimpeachable credit, he should have found it easy. He didn’t.

To make sure that the Erie board couldn’t interfere with Vanderbilt’s plans, his lawyer asked Justice George G. Barnard of the New York Supreme Court to issue an injunction suspending Daniel Drew from the board and forbidding the company from converting any bonds into stock or issuing any new stock. Drew responded by having a Justice Gilbert, sitting in Brooklyn, issue injunctions voiding Barnard’s and, all important, ordering the company to continue converting bonds into stock as usual. The Erie directors were now in a nearly no-lose situation. As one writer of the day explained, “Since they were forbidden by Barnard to convert bonds into stock, and forbidden by Gilbert to refuse to do so, who but the most captious could blame them for doing as they pleased?”


While the Vanderbilt brokers bought all the Erie stock that was offered, Jim Fisk delivered another newly minted 50,000 shares for sale. “If this printing press don’t break down,” he commented, “I’ll be damned if I don’t give the old hog all he wants of Erie.” Vanderbilt kept right on buying, and by the end of the day he held almost 200,000 shares. Was it a majority of the stock? No one knew, except possibly Drew, Fisk, and Gould, for no one knew how much stock was outstanding.

The Erie directors had taken the precaution of converting their ill-gotten gains into greenbacks, and they fled to New Jersey, safely beyond Judge Barnard’s arrest warrants. At that moment it was a standoff. Fisk, Gould, and Drew had the Erie Railway and seven million dollars of the Commodore’s money, but Vanderbilt had New York. The battle for ultimate control moved to Albany and the New York state legislature.

In the 1860s that body was, perhaps, the most corrupt legislature in history. Jay Gould, according to the New York Herald , went to Albany with a trunkload of $1,000 bills. Arrested and held on the colossal bail of $500,000, he simply posted it in cash and went back to work on the legislators. Meanwhile, Vanderbilt, though as honest a man as his times allowed him to be and far more respected by everyone than the rascals running the Erie, realized there was growing opposition to his controlling the Erie as well as his other railroads. That would give him a near-monopoly on trunk-line rail transportation in New York State, and any victory he purchased in Albany might turn out to be very short-lived. He decided to get in touch with Drew and settle matters.

VANDERBILT DEMANDED THAT THE NEWEY PRINTED stock be taken off his hands at a price near what he had paid for it. To get their agreement. lay Gould and Jim Fisk were made president and controller of the Erie Railway. The main losers were the genuine stockholders of the Erie, whose equity in the company the new shares had diluted by about 35 percent.

While the nation’s newspapers had a field day with the Erie Wars—the story got far more play than the contemporaneous impeachment of President Andrew Johnson —Wall Street bankers, brokers, and lawyers were appalled. The New York Stock Exchange and the Open Board of Brokers quickly forced reform in the rules. The exchanges, which merged the following year to become the country’s overwhelmingly dominant exchange, required that companies henceforth maintain open registries of their securities and announce any new issues of stock 30 days in advance. The merged exchange also required that member firms trade listed securities only on the floor of the exchange, where all the members could keep an eye on things.

New York’s legal establishment also moved to clean things up. In 1870 the city’s leading lawyers formed the Association of the Bar of the City of New York to police the profession, and other cities and states quickly followed suit. The bar association established a committee to look into corrupt judges and called for the impeachment of Barnard and others, who resigned or were convicted. The state’s civil procedure was changed to make it impossible for judges to interfere with one another’s injunctions, and in 1874 a stiff provision against bribing public officials was put into the state constitution, safely beyond the reach of the legislature.

Because of the Erie Wars and the reforms they engendered, American capitalism began to grow up, and the corruption of public officials, historically no more well behaved than corporate managers, began to wane. We have had nothing so spectacular as the Erie Wars in more recent times, but the process they exemplify of excess, scandal, and reform has continued unabated as the American economy has developed, enlarged, and embraced an endless stream of new technology and new opportunities. There is no doubt that it will continue on this path in the future as well.

In the 350 years since Thomas Hobbes described life in a state of nature as “solitary, poor, nasty, brutish, and short,” an economic system unknown in his day, democratic capitalism, has made possible a standard of living—and a longevity—for the average citizen that would have boggled his mind. But the road from Hobbes’s world of poverty for almost all to our world of widespread abundance has been anything but smooth. There have been recessions, scandals, corruption, and chicanery aplenty.

As we enter an era of the most profound economic change since the advent of the steam engine more than 200 years ago, this time driven by the microprocessor, there is no doubt whatever that we will see plenty more chicanery, for the game will always be played by human beings. But whatever its flaws, however messy and sometimes wasteful capitalism is, it has one inestimable advantage over any other means of organizing an economy yet devised: In the long run, it works.

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