Another Confidence Game

June 28, 2002 • Commentary
This article originally appeared on National Review Online.

The Washington establishment is suspiciously eager to “restore confidence” in the stock market, which invariably turns out to mean jailing a few businessmen and demonizing the rest. It never seems to occur to anyone that investors have good reason to be far more worried about the proposed “reforms” than about the problems. The big problems are mainly specific to a few firms that racked up huge debts in the telecom industry (including Enron, Global Crossing, and WorldCom). Many proposed political and regulatory solutions, however, would introduce a much broader systemic risk.

Hundreds of editorials and columns have been written in recent days using flamboyantly outraged rhetoric to make the following familiar point: Business is bad, government is good, therefore we need much more government control over business. I find that logic unpersuasive, even naïve. Some structural reforms could help keep the heat on bad managers, such as Henry Manne’s recent advice in the Wall Street Journal to remove legal obstacles to hostile takeovers. But what is passing for reform these days is mainly rewarding chronically incompetent regulatory bureaucracies with more money, staff, and authority. Some reform schemes are even worse than that.

I’m all for suing the pants off anyone proven guilty of fraud, barring co‐​conspirators from serving as corporate officers or directors, and using prison sentences when appropriate (though victims can’t squeeze much reimbursement out of jailbirds). It is the uncritical rush to “reform” accounting and to encourage runaway regulation that worries me. The curiously trendy idea that investors welcome unlimited regulatory “investigations” by the Securities and Exchange Commission (SEC) seems particularly hazardous.

I worry when even someone as wise as Gene Epstein of Barron’s writes about “the sort of creative accounting that did Enron in.” What did Enron in, and what at least almost did WorldCom in, was the sheer inability to keep paying the bills for huge debts. Accounting tricks were merely a cover‐​up to buy time (and postpone being fired) by hiding the problems. If we expect too much from accounting, we are sure to be disappointed. When there is a cyclical collapse in profits, firms with big debts go bankrupt. The only alternative is taxpayer bailouts, which just leave you with a zombie economy. When politicians promise “no more Enrons,” that sounds too much like promising that big companies will never again be allowed to go belly up. And that, in turn, implies big future taxes on successful enterprises to shore up the losers — a strategy guaranteed to destroy whatever is left of investor confidence.

To cut through this year’s increasingly shrill anti‐​business rhetoric, it helps to understand that all the media’s favorite “reformers,” inside the government and out, have obvious incentives to engage in scapegoating. Exhibit One is Henry Paulson, the CEO of a previously private company gone public, Goldman‐​Sachs.

The Wall Street Journal recently ranked Wall Street firms by the accuracy of their advice about which stocks to buy, hold or dump. Merrill‐​Lynch, the main target of New York prosecutor Eliot Spitzer’s mindless witch‐​hunt, came in second. If that was the result of deception, we could use more of it. Goldman Sachs, by contrast, was only in 14th place when it came to useful stock advice. Goldman Sachs has long been more famous for political contributions and contacts, even before former executive Jon Corzine paid $63 million for a Senate seat. Naturally, Goldman’s Paulson found this an excellent time to take the spotlight off investigations of his own company by pandering to Washington’s National Press Club and proposing extensive federal meddling in other firms’ affairs. Business Week and others jumped at this tasty bait, declaring Paulson an instant media hero.

Then there is Standard and Poors, a leader in the government‐​protected three‐​firm cartel charged with warning us about credit risks. As usual, sleepy analysts at S&P neglected to downgrade Enron’s credit rating until a few days before the worst news hit the headlines. To appear now to be doing something, regardless how irrelevant, Standard and Poors decided to arbitrarily redefine “core” corporate earnings in the politically correct downward direction, thus making their own company another new darling of the press. Similar pro forma tinkering with earnings has been widely condemned by the press if companies do it, even when required by the Financial Accounting Standards Board as in the case of employee stock options. Yet S&P’s flawed variety of pro forma accounting won nothing but uncritical praise. It was called a reform, after all, and how can reform ever be bad?

The veteran manager of Legg Mason Value Trust, Bill Miller, is having a tough year partly because he recently bought a bunch of Tyco stock at about twice its current price. Suddenly, Miller is all over the major newspapers and magazines griping quite ignorantly about executive stock options. But those options, unlike the salary and bonus of mutual‐​fund managers, are widely publicized and fully explained in corporate reports.

Berkshire Hathaway is also losing some luster and the company’s plan to sell bonds that pay less than zero in interest has raised a few eyebrows. Yet Chairman Warren Buffett, one of the wealthiest individuals in the world, has taken to unseemly griping about the relatively piddling, highly risky and rapidly dwindling compensation of corporate CEOs.

Finally, there is Harvey Pitt, chairman of the SEC. Nearly everyone, even the Wall Street Journal, complained that this head of an agency dealing with securities laws on Wall Street has too much experience as a Wall Street securities lawyer. Would it be better to have a physician or plumber take charge of the SEC? Following similar illogic, Pitt himself has proposed to have future accounting standards dominated by people who know nothing about accounting. That too is called a reform, so it must be another smart idea.

In any case, Pitt is just one more guy trying to shift some media criticism to scapegoats. In response to all the noisy press cheerleaders encouraging Pitt to look tough, the SEC has been making a big show of investigating oodles of companies and making sure the press knows there is something mysterious going on.

SEC bureaucrats investigate everything and find virtually nothing — they did not even notice WorldCom’s $3.1 billion misreporting for last year alone. What the SEC does is follow others, including newspaper tips and Eliot Spitzer’s great adventure, and then Pitt makes a pathetic effort to grab some credit. It has gotten so out of hand that the journalists’ list of sinful corporations invariably includes companies that have not been found guilty of anything but attracting the SEC attention. The former CEO of Tyco is accused of evading state sales tax on art, for example, but Tyco itself has been accused of nothing specific.

Unfortunately, every time we learn that the SEC is merely asking some company a few questions the stock collapses, and the stock drop alone often triggers a credit squeeze that can push a marginal company over the brink. As one small investor who used to be a bigger investor, my confidence would be restored only by a much quieter, more selective and more professional SEC. Arthur Andersen aside, I would also much prefer to leave accounting to accountants rather than to amateurs or politicians. In any event, stocks will rise if and when profit reports start look better. And what happens to profits is only loosely and indirectly linked to all the amateurish chatter about investors yearning for heavy‐​handed regulation.

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