Outlook: Retribution is one thing; reforming the system quite another

Biblical retribution Ê

The big question on everyone's lips yesterday: how on earth could Andersen have missed, as it claims to have done, a $3.8bn fraud, and one, moreover, that was achieved through the old and blatant fiddle of treating operational costs as investment? There is, perhaps, no excuse capable of mitigating Andersen's failure, but few frauds come out of a clear blue sky. There is nearly always a backdrop of widespread malpractice, sloppy application of standards and out of control, aggressive behaviour against which they take place.

That was certainly the case in the deregulating telecommunications market, which by the late 1990s had become the wild west frontier of free market capitalism. The speed of deregulation was part of the problem. Fast back just 10 years, and the industry was largely dominated by a collection of protected national monopolies, all of which charged very high prices and generated huge amounts of cash.

Most of the managers and executives who ran these companies had no understanding of the value of capital or the meaning of competition. It was a brave new world they were entering when the barriers came down, and they were completely unequipped to deal with it. Into their midst rode a veritable army of cowboys and buccaneers, as it always does when a huge and previously lucrative market is opened to all comers.

Unused to having to watch the pennies, everyone spent like crazy trying to get into everyone else's previously closed market, and there followed a period of profligacy unprecedented in the modern age. It never seemed to occur to anyone that deregulation is a zero sum game. There are only so many customers to go round and although it might have seemed a great achievement to have nicked a customer from your competitor, it was all too likely that he'd meanwhile be doing the same to you. The advent of the internet was meant hugely to expand the size of the market, but all the benefit was competed away in plunging prices.

In any case, making the numbers work seemed to require the use of increasingly aggressive accounting techniques. In the boom conditions of the time, managers were under enormous pressure to deliver perpetually rising revenues and earnings. The effect was compounded by the favoured valuation tool of the boom – Ebitda, or earnings before interest, tax, depreciation and amortisation. The more cost that could be loaded on to depreciation and amortisation (nobody paid any tax, for heaven's sake), the better the numbers looked.

This is what happened at WorldCom. The two main costs fraudulently categorised as investment, which can be depreciated rather than written off against revenue, were labour costs associated with maintaining the network and the costs of leasing capacity from rivals. Few telecoms executives can put their hands on their hearts and say they've never done anything similar. The conservative approach to leasing capacity from others is to write it off as a cost, sometimes over the period of the lease but more usually all in one go. WorldCom aggressively categorised such spending as investment. Others may have behaved in a similar way, though presumably not on the same massive scale as WorldCom.

Likewise, it may have been legitimate to capitalise some labour costs while the network was under construction. The labour cost of constructing a network is, after all, part of its capital cost. But to carry on doing so after the network is up and running is plainly much more contentious. Even so, you can see why Bernie Ebbers, WorldCom's former chief executive, might have thought he could get away with it. The WorldCom deception was based on boosting earnings by treating costs as a balance sheet item. At Global Crossing, the wheeze was to boost revenue by swapping capacity with others. The capacity thus given away was booked as a sale, even though no cash changed hands. On the other side of the ledger, the capacity acquired would be treated as a capital cost to be depreciated over the life time of the lease. Clever, effective, but essentially fraudulent.

Biblical retribution

After the boom, comes the clean-up, the recriminations, the prosecutions, the litigation, the tightening of standards, the slamming and bolting of doors by previously half-asleep regulators. There is something almost biblical about the way capitalism punishes each period of excess with a countervailing period of austerity and self flagellation. In the 19th century Karl Marx and other political and economic thinkers thought that the boom to bust nature of markets would eventually end up destroying capitalism entirely, but it hasn't turned out that way. In fact the system emerges from each cycle refreshed and strengthened. Capitalist democracies have survived because they have learned to regulate themselves, so as to nip the worst excesses of the boom and provide a safety net during the subsequent bust.

This is where the present generation of radical free market thinkers have got it hopelessly wrong. Capitalism needs regulation as much as it needs entrepreneurs and free markets. The lesson of the American technology boom, and its accompanying excesses, is that when the restrictions are eased too far too fast, markets run riot and end up caving in on themselves. As the good times roll, bankers investors and managers alike become oblivious to risk and, in a process that Wall Street sometimes refers to as "reaching for yield", end up throwing caution and normal standards of probity to the wind in their pursuit of easy money.

There are big dangers in the subsequent crackdown too. Too much regulation, and you end up up killing the goose that laid the golden egg. The system gets clogged up with rules, codes, standards and officialdom and the wheels of economic prosperity grind to a halt. In the present atmosphere of near hysteria on the other side of the pond, that's a real possibility. Punishing the perpetrators of these deceptions is one thing. Judging by recent comments from Paul O'Neill, the US Treasury Secretary, he'll be leading the posse from the front. He wants to hang people like Mr Ebbers from the highest branch. But reforming the system requires altogether more considered thinking and debate.

The Chancellor suggested at the Mansion House dinner the other night that Britain would remain comparatively immune to the accounting scandals sweeping corporate America. He's got good reason to be smug. We had our accounting frauds in the late Eighties and early Nineties, and moved to tighten standards accordingly. Since then, the Government has also brought all financial regulation under one roof, the Financial Services Authority, and equipped the new super regulator with the requisite powers to root out and punish abuse. Nobody's saying it couldn't happen here, but we do seem to be getting the balance about right in a way the Land of the Free is plainly struggling with.

There have already been some truly loopy ideas for reform suggested since WorldCom admitted its giant fraud, including that of getting rid of executive directors altogether and going over to the German system of having a supervisory board with managers beneath. This is precisely the sort of over reaction that needs to be avoided. The traditional guardians of the public interest – lawyers, accountants, regulators, non-executive directors and the rest, have failed, and the free market system needs to be buttressed so that it can do a better job. But let's not throw the baby out with the bathwater.

jeremy.warner@independent.co.uk