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Raghavendra Rau

Raghavendra Rau

Paul Krugman on the ice-cream parlor model to explain business scandals

SYNOPSIS: In the tradition of the baby-sitting co-op and the dogs and buns model, Paul Krugman now presents the ice cream parlor model to explain the recent business scandals of Enron, Worldcom, etc.

So you're the manager of an ice cream parlor. It's not very profitable, so how can you get rich? Each of the big business scandals uncovered so far suggests a different strategy for executive self-dealing.

First there's the Enron strategy. You sign contracts to provide customers with an ice cream cone a day for the next 30 years. You deliberately underestimate the cost of providing each cone; then you book all the projected profits on those future ice cream sales as part of this year's bottom line. Suddenly you appear to have a highly profitable business, and you can sell shares in your store at inflated prices.

Then there's the Dynegy strategy. Ice cream sales aren't profitable, but you convince investors that they will be profitable in the future. Then you enter into a quiet agreement with another ice cream parlor down the street: each of you will buy hundreds of cones from the other every day. Or rather, pretend to buy — no need to go to the trouble of actually moving all those cones back and forth. The result is that you appear to be a big player in a coming business, and can sell shares at inflated prices.

Or there's the Adelphia strategy. You sign contracts with customers, and get investors to focus on the volume of contracts rather than their profitability. This time you don't engage in imaginary trades, you simply invent lots of imaginary customers. With your subscriber base growing so rapidly, analysts give you high marks, and you can sell shares at inflated prices.

Finally, there's the WorldCom strategy. Here you don't create imaginary sales; you make real costs disappear, by pretending that operating expenses — cream, sugar, chocolate syrup — are part of the purchase price of a new refrigerator. So your unprofitable business seems, on paper, to be a highly profitable business that borrows money only to finance its purchases of new equipment. And you can sell shares at inflated prices.

Oh, I almost forgot: How do you enrich yourself personally? The easiest way is to give yourself lots of stock options, so that you benefit from those inflated prices. But you can also use Enron-style special-purpose entities, Adelphia-style personal loans and so on to add to the windfall. It's good to be C.E.O.

There are a couple of ominous things about this menu of mischief. First is that each of the major business scandals to emerge so far involved a different scam. So there's no comfort in saying that few other companies could have employed the same tricks used by Enron or WorldCom — surely other companies found other tricks. Second, the scams shouldn't have been all that hard to spot. For example, WorldCom now says that 40 percent of its investment last year was bogus, that it was really operating expenses. How could the people who should have been alert to the possibility of corporate fraud — auditors, banks and government regulators — miss something that big? The answer, of course, is that they either didn't want to see it or were prevented from doing something about it.

I'm not saying that all U.S. corporations are corrupt. But it's clear that executives who want to be corrupt have faced few obstacles. Auditors weren't interested in giving a hard time to companies that gave them lots of consulting income; bank executives weren't interested in giving a hard time to companies that, as we've learned in the Enron case, let them in on some of those lucrative side deals. And elected officials, kept compliant by campaign contributions and other inducements, kept the regulators from doing their job — starving their agencies for funds, creating regulatory "black holes" in which shady practices could flourish.

(Even while loudly denouncing WorldCom, George W. Bush is trying to appoint the man who drafted the infamous "Enron exemption" — a law custom-designed to protect the company from scrutiny — to a top position with a key regulatory agency. And some congressmen seem more interested in clamping down on New York's attorney general, Eliot Spitzer, than in doing something about the corruption he has been investigating.)

Meanwhile the revelations keep coming. Six months ago, in a widely denounced column, I suggested that in the end the Enron scandal would mark a bigger turning point for America's perception of itself than Sept. 11 did. Does that sound so implausible today?

Originally published in The New York Times, 6.28.02