Illusion Or Hoax?

The American economy is being widely hailed for stepping along the road to recovery after the mildest recession in the past half-century. Better still, a recorded productivity gain of 3.5%, annualized, for the fourth quarter is generally acclaimed as proof that the productivity miracle, the key hallmark of the"New Economy," remains alive and well. The comforting explanation of the recession's unusual briefness and shallowness is that corporations have been unusually quick to cut excesses and costs. This, it is argued, promises fatter profits in the upturn - and therefore justifies today's lofty share prices. Equity analysts, on average, forecast a 37% rise in the profits of companies in the S&P 500 index to the fourth quarter of 2002.

The easiness with which American economists turn everything black into glaring white in assessing the U.S. economy keeps amazing us. Despite overwhelming evidence, it took them a long time to concede the possibility of a recession. Now they see the economy's immediate recovery in every statistical blip. Everybody simply grabs at the most flimsy data as conclusive evidence a recovery is starting. It's a discussion that lacks any intellectual depth.

Whatever some economic data and indicators may say, the essential conditions for a sustainable recovery simply do not exist. Yet unbelievable complacency still rules. Irrespective of overwhelming evidence to the contrary,"new paradigm" optimism remains largely intact, as does blind faith in Alan Greenspan and the Fed. Even though profits have collapsed as never before, profit expectations and forecasts remain ridiculously high. The main problem seems to be that the consensus is at a complete loss to understand what is happening.

Every economic downturn has its origin in the economic and financial maladjustments that have accumulated during the prior boom. That is why we keep scrutinizing the last boom's pattern. It is now clear as daylight that the vaunted profit miracle was not only a mirage but an outright hoax. Taking a closer look at the equally vaunted investment boom and productivity miracle of the past few years, we identify a lot of creative GDP accounting. The fabulous"wealth" creation of the late 1990s has consisted entirely in soaring financial assets and debts. The fact is that such phantom wealth promotes speculation and capital consumption. Creation of productive wealth in tangible assets went begging.

ALMOST A CULTURE OF CORRUPTION AND FRAUD

"This is almost a culture of corruption," said Senator Byron Dorgan, heading the congressional Enron hearing. To us, this seems a gross understatement. What happened at Enron was definitely a lot more than just corruption. It is the business world's single largest fraud in history. For sure, it is an extreme case of fraud. But the fact that an unprecedented number of American corporations are using ever more aggressive reporting and accounting tricks to deceive investors about their poor profit performance has been a regular topic in the media for quite a while. On May 14, 2001, BusinessWeek carried an extensive article titled"The Numbers Game." It was headed by a sentence in big letters:"Companies use every trick to pump earnings and fool investors. The latest abuse: Pro forma reporting." So the Enron case in itself was nothing to be surprised about. It was simply too big to be shrugged off.

Executives, external directors, auditors, bankers, lawyers and market analysts all knew.

Yet their common, overriding interest was to keep the stock market booming. We, ourselves, had no inside information, of course. But we noticed years ago the vast and soaring divergence between skyrocketing S&P 500 earnings computed from the corporate profit reports and the unusually poor profit performance as reflected in the government's national income accounts. The two differed like day and night. It was manifest for years that the companies and their CEOs were using many accounting and reporting tricks to deliver the continually rising sales and earnings per share that Wall Street wanted to see.

By so-called pro forma reckoning, the companies in the S&P 500 stock index earned $45.31 per share in 2001, giving the market a price-to-earnings ratio of 24.7, according to Thomson Financial/First Call. But by using generally accepted accounting principles, earnings were just $28.31 per share in the 12 months through September, equating a P/E ratio just under 40.

Most visible to any somewhat critical observer, however, was the soaring discrepancy between the profits that the corporations reported and that went into the S&P 500 earnings, and the profits reported by the Commerce Department within its national income and product accounts. In particular since 1997, there could be no doubt anymore that the corporate numbers were just trash. Yet even the Commerce Department figures were heavily inflated for years by capital gains in the stock market.

When the capital gains vaporized with the skidding stock market in 2000, American corporations had to rely on profits truly earned in production for the first time in many years. Not surprisingly, this stepped up pressure on desperate CEOs to somehow shore up earnings. Resorting to more and more aggressive accounting tricks was one of the ways. But in the face of rapidly worsening profits, these tricks essentially had their limits. It needed ever more and ever bigger ploys to mislead unwary investors.

The answer was to top crooked corporate accounting with even more crooked profit reporting. EBITDA earnings - earnings before interest, taxes, depreciation and amortization - commonly also called"operating earnings," became common practice even for blue-chip firms."Pro forma" profits are the evil cousin of operating earnings. The particular attraction of this profit formula is that it literally allows a company to omit any expenses it cares to choose and to report any profit it wants. No less evil in essence is the new practice to no longer compare reported profits with objective, past earnings but with arbitrarily slashed expected profits. All these gimmicks are really so primitive that they offend common sense and probity. But both are clearly absent in today's world of finance.
Complete obfuscation and chaos is the new reality in corporate profit reporting in the United States.
Virtually ignored in the same vein is the simultaneous escalation in the number and size of corporate bankruptcies.

THE STARTER: OVER-HYPED EXPECTATIONS

Such gross and widespread dishonesty in the world of business and finance has no precedent in history, neither in America nor in the rest of the world. Why? What is it that led to this culture of corporate corruption and fraud? Our short answer is: It started with over-hyped expectations that deluded corporate management into strategies that impaired economic growth and profitability in the longer run. The manifest chief cause of this accounting crisis is a profits crisis. The decisive fact is that the corporations have been unable to deliver the lofty profits that they had promised and that everybody had come to expect from them. Actually, their profit performance not only disappointed the over-hyped expectations, it has been the worst profit performance in the whole postwar period. Instead of maximizing profits, the new corporate strategies minimized them. It was America's first profitless boom.

It started with surprisingly good news about the U.S. economy from 1995 on, following several years of sub par economic growth. All of a sudden it was as if the economy had transformed itself into an entirely different economy. Real GDP growth and productivity took off at rates that had not been seen for decades, while inflation and unemployment fell. Essentially, this provoked questions about the underlying causes.

In no time there was talk of a"new paradigm" economy performing virtual miracles of efficiency and profitability. There was quick agreement that this primarily owed to the dazzling wonders of the new information technology. Many hailed it as the biggest leap forward since the Industrial Revolution, if not even a bigger revolution. Double-digit corporate earnings growth was no longer regarded an exceptional achievement. It became a general mandate, a benchmark of normality for years to come, being presented as an integral part of the new shareholder-value culture. Stock valuations took off to unprecedented levels.

There were other, more arcane claims supposedly justifying the new sky-high P/E ratios for stocks. Mr. Greenspan meditated in public that the exponential gains in the speed of information, thanks to the new technology, had created an unprecedented low-risk, high-certainty economy that had made the traditional risk premium on stock prices obsolete. Other than Mr. Greenspan, the most prominent advocates of that view were James Glassman and Kevin Hassett, authors of the book Dow 36,000.

Last but not least, it became a big argument, also frequently advanced by Mr. Greenspan, that the low inflation rates, supposedly resulting from the productivity-enhancing high-tech capital spending, allowed the Fed to underpin economic growth with a looser monetary policy than in the past. In a congressional testimony on June 10, 1998, he said:"The essential precondition for the emergence and persistence of the virtuous circle is arguably the decline on the rate of inflation to near price stability - which, in turn, provides the preconditions for a stock market boom."

Yet this tale of economic high-tech wonders had an important supplementary chapter. It concerns corporate governance and said that the U.S. economy has also immensely benefited from a quantum jump in the quality of corporate management, owing to the triumphant progress of the shareholder-value movement. Starting out with the postulate that companies have ultimately one single boss, that is, the shareholder, it led to the emphatic conclusion that corporate management ought to, therefore, concentrate its energies single-mindedly on aiming to maximize shareholder value through aggressive profit creation. In order to entrench the rigorous pursuit of this goal in the mind of executives, it was recommended that they establish a strong joint interest between themselves and their shareholders through the wide introduction of share option schemes keyed to sales and profits.
Respected International Banker, Economist and Author

Dr. Kurt Richebächer's articles appear regularly in The Wall Street Journal, Barron's, The Fleet Street Letter and other respected financial publications. France's Le Figaro magazine did a feature story on him as 'the man who predicted the Asian crisis.' Dr. Richebächer is currently warning readers to be cautious in the face of The Crisis Almost No One Sees Coming.

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