Why Enron Always Happens

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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.

A VAST NUMBER OF RULES HAVE HAD TO BE DEVISED ON THE FLY TO MAKE CAPITALISM WORK.

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.