Wednesday, April 21, 2010

The Fall of the House of Finance: More Sarbanes Oxley on the Way

Some time ago, I was sitting in my opthamologist's office and chanced on a magazine I'd never heard of--Stocks, Futures and Options. In it was an interview with George Friedman, who noted the financial elite have lost all credibility. He added the political elite have stepped in to the vacuum. He also said the government and the financial communities "regard one another as incompetent."

The difficulty, Friedman added, is magnified by the fact the "government is not financially efficient. It is built to be politically efficient...Obama has to demonstrate that our institutions or government is capable of effective action, because what would terrify people and create a new crisis is if the political elite appear to have the same incompetence as the financial elite. All hell would break loose...On one side, the political state is saying the financial community is a bunch of greedy scoundrels, while the financial community says the government is a bunch of incompetent bureaucrats."

We are at the impasse Friedman so eloquently and succinctly delineates. The fact of the matter is that the American people no longer have confidence in either their financial institutions or their government. Some 76% of the American public don't trust the government. And most don't trust finacnial insitutions such as Goldman Sachs.

Friedman's assessment has come true, and all hell is breaking loose.

In the effort to put itself in the driver's seat, reclaim the confidence of the American people--or at least divert attention away from its incompetence--and to fatally weaken Wall Street, the administration is seeking further control over the financial sector. Doubtless we will be looking at another Sarbanes Oxley Act--on speed.

The result will be an economy that is furthered weakened. The above mentioned Sarbanes Oxley Act has already weakened corporations by demanding a flood of paper work and extra employees to manage accounting procedures. None of the reforms has actually dealt with the underlying problems the Enron scandal exposed and to which congress reacted, as Friedman points out, with political rather than economic efficiency. What Friedman, an Obama supporter who believes the president can restore trust to government, does not note is that political "efficiency" exhibited as total regulatory control always cripples economic efficiency.

Sarbanes Oxley is a perfect illustration of the truth that political solutions have a way of retarding or crippling industry. As Alan Reynolds of the Cato institute notes:

The Sarbanes-Oxley law was unnecessary, inadequate and harmful. It was unnecessary because the SEC already had the authority to do everything the law demands about accounting or corporate boards. Sarbanes-Oxley was inadequate, if not irrelevant, because it failed to deal with any fundamental institutions, laws or incentives that might have contributed to major bankruptcies in the wake of the 2001 recession. The 1968 Williams Act has made it too difficult to take over mismanaged companies, for example. And higher tax rates on dividends before 2003 helped devious managers camouflage overstated earnings (companies can't pay dividends with bogus earnings).

Sarbanes-Oxley has proven harmful to the U.S. economy, and to the value of stocks still listed on U.S. exchanges, because it greatly increases the costs and risks of doing business as a publicly traded U.S. corporation and it increases the risks of serving as a director or officer. Sarbanes-Oxley has essentially the same effect as a large but unpredictable increase in corporate taxes. Congress must at least lighten the heavy load of this ill-considered regulatory tax, assuming insufficient humility and courage to repeal it. Even in politics it is generally wiser to admit mistakes and fix them than to fall into the familiar bad habit of assuming that good intentions excuse bad results.

Stephen Boyko, author of We're All Screwed warns that toxic regulation will crush the free market system. He writes:

Bad rule writing has resulted in bad legislation, such as the Sarbanes Oxley Act of 2002, and has created an ineffective system for regulating the U.S. capital markets. If we don't act fast, the 2008 subprime stack market crash could potentially result in more toxic regulation. [A prescient comment, as more toxic regulation is on its way.]

He advocates an answer: "fostering entrepeneurialsm; segmenting the market to account for size, capital and scope; and using a three dimensional model for regulation."

While GeorgeFriedman probably would not say so, Milton Firedman would say the more the political sphere of influence intrudes into the economic sphere of influence, the more likely the slide into socialism and tyranny.

The halt to this slide will only occur by embracing two major reforms. The first is a return to true federalism with an emphasis on states' initiatives, whence have come some brilliant economic models. My own state of Delaware once had such a model intitated by Governor Pete duPont, but it has been seriously eroded under the last few administrations.

The second is a return to a balance of governmental and economic spheres of influence. Any institution's integrity and effectiveness cannot remain if it is unceasingly violated and controlled by another. (This truism is valid for any institution, be it religious, governmental, economic, military or educational.)

If at one time American industrialists had too much power over the federal and state governments, that certainly is not the case now. Beginning with Theodore Roosevelt and accelerating steadily throughout the last century, the ascension of federal control over the states, traditionally a breeding ground for economic innovation and the financial institutions of our country, now at least temproarily discredited and under increased scrutiny and attack, is nearly complete.

It looks like this current administration is poised to push the accelerator to the floor by pushing the enactment of another Sarbanes Oxley Act.

More onerous regulation is not the answer for giving renewed health to our financial institutions. There are plenty of regulations already on the books, some legitimate; some not. A massive effort to distinguish between the necessary and unecessary regulations already on the books is long overdue and would result in a burst of economic prosperity scarcely imaginable in these dark economic times.

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