What Is Killing The Stock Market? Government Regulation

by | Jul 25, 2002 | POLITICS, Regulation

Politicians and economic analysts are shocked. They have told us for weeks that the stock market is crashing because of low “investor confidence” in response to a “crime wave” of corporate fraud–made possible by “a climate of lax regulation” and “the lure of heady profits.” Yet despite politicians’ unanimous promises to be “tough on business”–to […]

Politicians and economic analysts are shocked. They have told us for weeks that the stock market is crashing because of low “investor confidence” in response to a “crime wave” of corporate fraud–made possible by “a climate of lax regulation” and “the lure of heady profits.” Yet despite politicians’ unanimous promises to be “tough on business”–to pass new accounting regulations, to make CEOs “more accountable,” to create “independent” oversight committees that will curb the “infectious greed” of businessmen–the market has not dramatically recovered, but instead falls to ever-greater depths. Indeed, since President Bush’s promise, on July 9, to clamp down on corporate CEOs, the market has tumbled by more than 14 percent.

This decline is fueled by investors’ realization that increasing government constraints on corporate America, on its CEOs and on its boards will harm business and the economy–not help them.

Consider the SEC’s intent to audit, under yet unspecified accounting standards, the largest 1,000 companies in America. Before these audits begin, the CEOs of these companies will be required to sign a document stating that their accounting numbers are SEC-compliant–a demand that holds them criminally liable for the actions of every accountant in their company. Should investors be reassured by the prospect of American CEOs functioning under perpetual fear of going to prison?

The new threats by the SEC, coupled with promises made by the President and Congress of longer jail time and new regulatory burdens, will undoubtedly discourage many talented individuals from seeking the CEO position. Indeed, many high-quality CEOs will resign rather than succumb to the new arbitrary and dangerous standards of regulators.

Investors also legitimately fear calls for “independent” management of businesses–such as John McCain’s proposal that corporations have “independent” boards of directors with “no material relationship with the company.” Who would invest in an energy company in which the government has assigned the “independent” Ralph Nader to the board–or a multinational corporation in which “independent” antiglobalization protestors call the shots? How can board members represent the interests of shareholders if they are not shareholders themselves? That our government wants to subject its businessmen to the arbitrary decrees of people with no knowledge of business and no interest in profits is a bad sign for investors–whose well-being depends on corporate profits.

Instead of launching a witch-hunt against CEOs and rushing to give the government wider powers over business, we should stop to consider why the existing system has failed. The common explanation that “greed” is to blame makes no sense–the abuses in companies like Enron and WorldCom were not exercises in self-interest, but in self-destruction. The shareholders of these companies lost huge amounts of money thanks to corporate mismanagement–mismanagement reflected by plummeting stock prices long before any scandals broke. Why did they tolerate incompetence for so long?

The reason lies in existing regulations that prevent shareholders from acting in their own interest. Anti-hostile takeover legislation (passed in 1968 and reinforced by a myriad of state regulations) has made it difficult and costly for shareholders to replace incompetent management, thus allowing bad managers to get rich while driving companies into the ground, a la Enron. Arcane regulations passed in the 1930s limit the ability of the most knowledgeable shareholders to be involved in the board and therefore in decision-making. For example, financial entities, such as pension funds, insurance companies and mutual funds that own large stock positions in corporations, are either prohibited or strongly discouraged by law from board participation. Bankers who possess the financial resources and knowledge to take large positions in companies and promote rational corporate governance (as J. P. Morgan did at the turn of the century) are not allowed to do so.

America’s boards of directors do not need disinterested, “independent” members if they are to promote shareholder interests–they need directors who care about the fate of shareholders because they are major shareholders.

Government regulations also encourage bad accounting. Over the past several decades, the government’s practice of issuing ever-longer, more complex and contradictory rules has caused many of the ill effects now being blamed on the “free market”–a general decline in accounting standards that conform to ambiguous and often irrational standards. Federal accounting standards are so bad that most companies in the semiconductor industry–including Intel and AMD–issue two sets of accounting numbers: one that follows Federal Accounting Standards Board rules and is mandated by regulation, and another based on different accounting standards that they view as more informative for investors.

Rational managers have an incentive to provide accurate information to shareholders–it establishes their credibility and reputation and allows them to raise capital when needed. Misinformation is treated harshly by the market–as recent declines in the stocks of companies reporting accounting discrepancies makes evident. In a truly free market accounting standards would improve as accountants and corporations compete to offer the best information to shareholders.

In an unfettered free market the desire for profit is satisfied by honest, long-range, rational behavior: by innovating, by hiring the best employees, by selling quality products and by providing accurate information to the owners of the corporation–shareholders. As for short-range managers, the markets will not tolerate them. As for the real swindlers, existing laws against force and fraud are sufficient to protect us.

If our politicians are indeed concerned about the stock market, let them demonstrate it by eliminating, not adding, regulations and making the market truly free.

–Yaron Brook, a former finance professor and a managing partner in a financial advisory firm, is the Executive Director of the Ayn Rand Institute. Alex Epstein is a writer for the Ayn Rand Institute in Irvine, Calif. The Institute promotes the philosophy of Ayn Rand, author of Atlas Shrugged and The Fountainhead.

If you want to read more editorials produced by the Ayn Rand Institute go to http://www.aynrand.org/medialink/

Yaron Brook is the executive director of the Ayn Rand Institute (ARI) in Irvine, CA. Alex Epstein is a writer for the Ayn Rand Institute.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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