Thursday, February 9, 2012

Enron was a Virus: The Difference Between Viral Replication & Real Growth

I recently finished reading The Smartest Guys in the Room. It’s a good book, and it yields a frightening look into a company that was able to survive for so long because it was so intimately linked to what drives society (rates of return, energy & power plants), but so out of touch with the basic means of growing life (positive rates of return on work investment.) Meaning…many people were willing to invest in Enron because they thought that it was an energy company, but only a small part of Enron was actually in the business of producing cheap energy. Mostly, Enron was just a scheme to generate and to spend other people’s money and energy…a virus.

As has been pointed out by many authors (including Robert Bradley Jr.), Enron was living in a fantasy world in which one could make money without owning assets. The problem was that it did own assets (that were really liabilities) and the asset-lite world of online trading is as unstable as an active volcano. The story of Enron and its political corruption is well told by Robert Bradley Jr. in his books Capitalism at Work and Edison to Enron. I've only skimmed through these books so far, but from what I've read, I highly suggest reading his books on this subject, especially because he worked for Enron and got to experience this fantasy world first-hand.

Why is it important to go back and study the problems with Enron? Because, as a country, we don’t seem to be that much smarter than we were ten years ago. Even though there have been a lot of positive developments in recent years (such as the rapid increase in the number of shale oil/gas wells using horizontal drilling), we seem to be as delusional about our economy as we were ten years ago. For example, we have a Federal Reserve Chairman who thinks that growth comes from lowering interest rates. (And it's not just him that believes in this fantasy tale.) Let me state this clearly…growth does not come from lowering interest rates. Growth comes from building power plants that achieve high rates of return on investment. If you lower interest rates to zero percent, you encourage the development of power plants with low rates of return on investment…and hence “No Growth.” Only when we have interest rates above 5%/yr can we ever hope to achieve growth rates above 5%/yr. Like Enron, we are living in a fantasy world in which we think that we can achieve growth while discouraging investment and savings. In another example, I'd like to point out that there are entire countries (like Germany and Japan) that believe you can grow the economy while decreasing the production of electricity. This is all part of a post-modern fantasy that economic growth can be decoupled from generating electrical and mechanical work. It's a fantasy that some of us might wish were true, but it's a fantasy all the same. The only way out of the fantasy is to accept reality:  The goal of life is to grow and the only way to achieve global growth is to build power plants with high rates of return on work invested.

In this post, I’d like to point out the four main reasons why I think that Enron was a virus…surviving off of the energy of its host. It’s important to point out the differences between the virus (Enron) and host (the taxpayers and the power plants in the US.)

1) Mark-to-Market Accounting is a Ponzi Scheme
The type of accounting that Enron used allowed them to count future profits as today’s profits. Investors thought that this was real profit, encouraging them to invest in the company. However, most of the ‘expected’ profits never came to fruition because Enron often invested in seemingly good ideas that often turned into money sinks (such as power plants in India, water treatment plants in Peru & the U.K., and fiber optic cables in the US.) It’s not that the ideas were bad; it’s just that they didn’t have the business-know-how to actually make a positive return on investment from these projects. Mark-to-market accounting was a Ponzi scheme because it could only last as long as they continued to sign contracts with major firms. But once new contracts stopped being signed, investors eventually saw the negative rates of return on investment from the assets that Enron owned. The house of cards came crumbling down.

2) Viral Replication in California’s Energy System
Enron's tricks to make money in California (like the one called Death Star) were literary viruses that could replicate and grow inside of California’s energy system. Enron found ways to cause power outages and make money off of the power outage. In this way, Enron was no different than your common flu virus that replicates based off of some defect in your cell’s evolved “software.” It’s hard to design computer software to be virus free, and it’s obviously hard to design political laws that are virus free. California obviously had some defects in its laws for electricity regulation and generation (just like Microsoft has defects in its software that allows viruses to replicate…and just like I have defects that allow me to catch a cold nearly every winter.) It’s probably impossible to eliminate all viruses. (I’m guessing that somebody has already proved this using Godel’s theorem, but I didn’t see anything when I did a quick search.) The question is: after you realize that you have a virus, what do you do? You fix the code; you take a bunch of vitamins; and you sue the viral company for breaking the law.

3) Political Lobbying
I think that we are all aware of the problem that spending $1 in lobbying has a return on investment much greater than $1. This is like a virus because if we all started doing this, then we would kill the host (the tax payer.) While it’s true that there are benefits to lobbying, this is a little bit like the problem of the commons. If we all spend $1 lobbying our elected officials, we will end up wasting a lot of money…money that should be invested into growing the economy. Those companies that do lobby are often rewarded because not everybody lobbies. There’s a reason why many people hate companies that lobby excessively…because we all know that it’s not sustainable and it’s not healthy for us all to do it. So, it’s a little bit like the prison’s dilemma: I’ll lobby my senator and try to keep other people from knowing that I was lobbying my senator to give me money to build a new wind turbine in his/her state using all taxpayer’s dollars. In this sense, political lobbying is a virus. It’s not a real source of energy…it’s just like a virus that lives off of the energy of its host. (In this case, the host is the US taxpayer.)

4) The 'asset-light' model
The wealth of a nation is equal to its capability to do work. Until we magically find some way of generating electrical or mechanical work that is ‘asset-light’, then the whole idea of making money without owning assets is a little silly. (Just as silly as the idea that the goal of life is to maximize happiness.) Now, with that having been said, good information is worth a lot of money. And having good information doesn’t mean owning large power plants. But good information becomes worthless very quickly. This means that you must continuously be finding out good information in order to make money off of it; and you can’t outgrow the people who are paying you for the information. Somebody has to actually be generating electrical and mechanical work, and somebody has to actually own the power plants, the factories, the hospitals, the farm lands, etc…None of those are ‘asset-light’ businesses. Software companies and Information companies shouldn’t become like viruses and try to kill the host by taking all of their money (and energy.) Enron was such a virus. For example, it would often give bonuses to those people who signed contracts (such as Rebecca Mark) that were larger than the total profits that were ever generated at the power plant or water treatment facility. That is a classic sign of a virus…replicating until all of the energy of the host is going to the virus.

So, in summary, I think that the economy we have today in the US (averaged over the last twenty years) is better than any other economic system that the world has had so far. Yes, I’d even say that it’s better than in the days of Andrew Carnegie. But we clearly need to do better. In this post and in other posts, I've pointed out the obvious and some of the not-so-obvious problems with our current economic system. I think that it's important to do some small tinkering around the edges. By 'small tinkering' I don't mean that this will be easy or that it's only a small amount that we need to fix. What I mean is: let's do this slowly and carefully. Slow and careful normally wins out in the end. Right now, we just need to focus more on investing and less on consuming, to focus on reducing the national debt by decreasing the size and scope of government, and to focus on fixing our laws regarding such items as lobbying, electricity regulation, and the Federal Reserve.

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