The potential bankruptcy of Arthur Andersen LLP, largely through litigation risks, brings into focus an interesting question: Are there some service industries that, far from contributing to the nation’s economy, in fact are parasites, so that their output should be subtracted from rather than added to gross domestic product figures?
This two-part analysis examines this question, which may have serious implications for the U.S. economy. In this part, I examine examples of service industries that appear to me to have become largely parasitic. In the second part, to be published Tuesday, I look at the economic implications of this problem, and suggest what might be done about it.
While we are on tricky economic ground here, there would appear to be a case to answer.
Andersen is not unique among the big accountants in its disregard for the interests of shareholders, for whom theoretically the partnership works. Ever since the Financial Accounting Standards Board decision on management stock options in 1995 which allowed greedy management, by awarding themselves stock options with no charge against company income, to drive a truck through shareholders’ property and scoop up all the spare cash that might be lying around, many company accounts, both inside and outside the tech sector, have been unrepresentative of actual economic results.
When Alcoa Inc., the Old Economy company then chaired by current Treasury Secretary Paul O’Neill paid out 30 percent of its 1999 earnings as stock option exercise costs without recognizing it on the income statement, accounting had become the tool of company management, not of the stockholders as it should be.
What does this cost?
In the case of stock options, management gets more money, and knows it, while the shareholders lose value, and don’t recognize it. In this sense, current accounting for stock options is equivalent to undetected embezzlement, which increases GDP until the embezzlement is detected and the embezzled-against realizes he’s lost money.
In other cases, such as hiding “extraordinary items” below the line and not taking them through reported earnings, the effect is simply to inflate the stock price, allowing existing shareholders, including management, to sell to newcomers at an inflated valuation. Higher share prices, it may be argued, reduce the cost of equity capital and thus increase investment and thereby economic growth — surely an unalloyed economic benefit?
Not so.
In the classical economic model, even if it appeared that greater investment was beneficial, greater investment that was generated through creative accounting would not be. Insiders, largely company management, would be taking advantage of the imperfect information and poor understanding of outsiders. The Adam Smith model of the economy requires buyers to be knowledgeable so that if they pay a higher price they receive a corresponding benefit, material or psychological. If, as in the case of creative accounting, the benefit is not merely psychological but imaginary, then the model breaks down.
In the classical model, the market is supposed to punish fraud and chicanery through an adverse reputation effect: In the long run, people will not deal with fraudsters. In the stock market, it is likely that this punishment is still effective. Investors who have been “suckered” by creative accounting into overpaying for stock will realize their mistake in the next recession/bear market. At that time, investor distrust of earnings statements will increase, and investors will then invest less than they should in stocks, thus depressing the stock market below its equilibrium level.
This effect has started to appear in the investor disquiet over accounting following the Enron debacle. Stocks have made a recovery as investors believe: economic recovery is imminent; productivity has moved onto a permanently higher plateau so traditional stock valuations are outmoded; and that Enron was an isolated case of cowboy management and a corrupt auditor.
In fact, Andersen was not significantly more corrupt than its competitors, Enron will not prove an isolated example, productivity may have increased modestly, but nowhere near enough to justify current valuations, and economic recovery is likely to be transient.
Once these factors become evident, the true cost of accounting shenanigans will become clear. Creative accounting, which in the long run will have depressed economic output, should have been subtracted from not added to GDP. The useful service of auditing that gave confidence to investors in true results of the companies in which they invested, has become parasitic.
Accounting is by no means alone. A second service that has become parasitic is the legal profession, and in particular the tort bar.
Traditionally, U.S. tort law, with its class action suits and contingency-payment fee structure, was a useful if crude weapon to keep Big Business honest and provide some means of legal redress to the consumer, who otherwise would have been helpless against Big Business’s greater financial and legal resources.
Much though it irks one to admit it, this was a useful function. It provided a good second line of defense for the consumer beyond the reach of food and drug and consumer protection legislation. Just as food and drug legislation regulated companies such as Coca-Cola Co., which before the legislation had happily adulterated its beverage with cocaine, so tort lawyers, energized by consumer advocates like Ralph Nader, forced companies like General Motors to pay attention to such factors as safety that were not themselves influential in moving the product.
In recent years tort law has moved beyond its original, useful purpose to become destructive. The tobacco settlement, which had the effect of a sharp increase in tobacco taxation, about 20 percent of which went to the lawyers, was simply a heist of resources by the legal profession. More damaging has been the asbestos litigation, which moved beyond bankrupting companies which had produced asbestos in the past to threatening with extinction companies that owned a subsidiary which may have used asbestos in their past activities, generally now 40 years to 50 years after the event.
At this point, tort lawyers unacceptably increase the arbitrariness of the market, thus increasing the risks — and legal costs — of doing business without any corresponding economic gain.
Contrary to traditional Marxist opinion, traditional merchant/investment banking was both important and beneficial to the economy. John D. Rockefeller’s comment on the death of J.P. Morgan: “And to think, he wasn’t even a rich man” is both a recognition of the huge importance of Morgan to the development of the U.S. economy and an expression of surprise that his economic contribution had not been better rewarded.
Nevertheless, after the abolition of fixed brokerage commissions in 1975, when traditional investment banking combined with brokerage (also a productive, if less elevated activity) new businesses emerged whose economic rationale was less clear. Trading, whether of bonds, equities, foreign exchange or derivatives, is economically useful when it provides liquidity and serves customers, but is less so when, as is the case today in the foreign exchange market, 97 percent of trading volume is represented by inter-trader transactions rather than genuine customer demand.
The number and remuneration of traders has increased beyond all recognition, but it is not clear that the economy as a whole has benefited. “Principal trading” in particular, another new investment banking business, is just short-term speculation with the firm’s capital. It tends to make money in bull markets — such as we have had in both bonds and equities since 1982 — but it ties up both capital and highly skilled people that could be better deployed elsewhere.
Sell side equity research, also, is nothing more than a sales mechanism for ever-more dubious stocks. It allowed the stock market to reach unprecedented heights in 1995-2000, but it has failed to fulfill its ostensible function of assisting investors in understanding their investments. Further, it led to serious misallocation of capital and consequent economic disruption.
Computer software initially was the key to an enormous new industry, and as such was highly productive, comparable to J.P. Morgan in his prime. But in the case of Microsoft’s Bill Gates, it was much more highly rewarded. As computers became commodities, software writers were compelled to design mechanisms whereby their products wouldn’t. After all, if you can produce adequate documents on a 1981 IBM PC, the value added in word processing by successive iterations of Moore’s law on the hardware (doubling its capacity every 18-24 months) and increasing software complexity is limited.
Had software manufacturers merely responded to market demands, there would have been only two great iterations in computer hardware and software, the introduction of the PC in 1981-85 and the addition of the Internet around 1995. Since say Windows 95, and the Word and Excel programs that accompanied it, there has been little upgrade in functionality for the user and hence, were it not for software industry marketing, a 1995 Pentium-chip computer would be entirely adequate today.
This would have been unattractive for both PC hardware and software manufacturers. Hence Microsoft, in particular, has introduced generation after generation of new programs for the basic functions of word processing, database and spreadsheet, which have offered little additional useful functionality but which are not backward compatible. As soon as a co-worker or correspondent gets a new version of one of these programs, it is necessary for the user also to install the new version, otherwise he can’t read documents he receives. However, the new version works very slowly and awkwardly on an old generation computer, so that too must be upgraded. The result is continuing high investment in new hardware and software, little of it to significant economic benefit. A further result is that the software concerned, being far too complex to edit as a whole, will have a tendency to bizarre, unexpected and dangerous “bugs” that can have catastrophic results.
In the software area, another economic parasite has appeared in the form of the software consultant. Consultants are paid by the hour, so have a natural interest in magnifying the complexity and duration of the work they do. For a conventional consultant, the client has the alternative of, for example, designing a business strategy itself, so there is some check on this tendency. In the software area, the service being sold is so complex that the client cannot undertake it itself. Hence explosion of costs and duration are inevitable; they are in the consultant’s interest, and the client has no means of preventing them without scrapping the project altogether, since only on completion is there a usable output.
Companies such as SAP and Accenture are thus enabled to extract resources far in excess of the value of their product, in terms of profitability of the company concerned — there have been a number of cases of a new software system costing a company one or even two years’ entire profits.
Thus, in accounting, tort law, investment banking and software, a business that began as economically productive has metastasized in the 1980’s and 1990’s into one subtracting value from the economy.
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(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 the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. 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.)
This article originally appeared on United Press International.