The Dow Congress
An alternative theory of why the market collapsed.
EVEN AFTER its 489-point rally last Wednesday, the stock market's recent performance remains dismal. What's wrong? The economic news is good, if not great. Earnings have been better than expected, with positive surprises outnumbering negative by four to one. Interest rates remain among the lowest in history, and Fed chairman Alan Greenspan has indicated he won't raise them soon. While terrorism remains a threat, no attacks have occurred on U.S. soil in 10 months.
That leaves the accounting scandals. Or does it?
The last significant revelation--that WorldCom, Inc., had overstated its earnings by $3.8 billion--came on June 25, nearly a month ago. The next morning, the Dow Jones Industrial Average fell nearly 300 points, then rallied into the afternoon and the next day.
Since then, stocks have fallen almost relentlessly. The Dow Jones Industrial Average dropped on 15 of the 19 days between the close of trading on June 27 and the close last Thursday. Despite the huge jump on July 24, the Dow is still off 12 percent in this short period. Consider, by contrast, the decline of the market during the entire period when the worst accounting scandals were unmasked. A good starting date is last November 8, when Enron announced that its financial statements from 1997 to 2001 "should not be relied upon." Then came Adelphia, Tyco, Global Crossing, ImClone, Xerox, WorldCom, and more. Nevertheless, between November 8 and June 26--the period of these disclosures--the Dow dropped only 3 percent.
In other words, in the past four weeks, which have been relatively scandal-free, the Dow has dropped four times as much as it did in the preceding scandal-ridden seven and a half months.
What's the explanation? In the past month, politicians have entered the fray, unanimously passing ill-considered, sweeping laws, driven by hysteria and misreporting. The sharp drop in the market, then, appears to be the result not so much of the accounting scandals as of the political reaction to those scandals.
It's easy to understand why Congress and the White House feel the urge to respond quickly to the pain of small investors--and to inoculate themselves against charges of coziness with fat cats. But the rush to legislate--and, in the case of President Bush, to use overheated rhetoric to condemn capitalist evildoers and to denounce the "binge" of the 1990s--only makes investors more nervous.
The suggestion is that, first, the accounting scandals are an unimaginable horror, utterly out of control; second, that the changes in the rules governing securities transactions will be broad and deep; and, third, that new costs will be loaded onto corporations already struggling to make enough profits to increase capital investment and get animal spirits flowing again. What Washington is doing is no encouragement to investors. In fact, it is scary as hell.
Things started much better. When Enron's deceptions became public-- thanks to a short seller (one of the best discovery mechanisms markets have to offer)--investors simply destroyed the company and its auditing firm along with it. Such brutality was encouraging, and President Bush's swift reaction--a list of principles for new laws and regulations--focused on personal responsibility, fairness, and choice. The SEC quickly adopted its share of the proposals, and the rest were incorporated in a solid bill sponsored by Michael Oxley, a Republican congressman from Ohio, which passed the House, 334-90, with majorities of both parties in support. A more radical offering by Senator Paul Sarbanes, the Maryland Democrat, was considered unlikely to become law. But then came WorldCom. The Sarbanes bill passed committee easily, and, in the frantic atmosphere of the past few weeks, it zipped through the full Senate on July 15th without a dissenting vote, as did a measure boosting criminal penalties for executives.
The Sarbanes bill, which is the basis of the conference legislation President Bush will soon sign into law, sets up what amounts to a parallel SEC, with broad and vague powers. Writing last week on Economy.com, Richard Moody noted that "the current environment calls to mind the aftermath of the collapse of the banking system during the Great Depression." While legitimate steps helped restore confidence, "Congress also took the opportunity to impose a host of rigid and unjustified regulations on the operations of banks in the form of the Glass-Steagall Act," which took more than 60 years to repeal. Imagine the similarly unintended consequences of what the president is now set to sign.
But don't current rules make it easy for companies to deceive? Not unless they commit fraud--and we have plenty of criminal laws in that arena. In fact, U.S. markets are the cleanest in the world, as academic studies show consistently. For instance, research published last year by Christian Leuz of the Wharton School, Dhananjay Nanda of the University of Michigan, and Peter Wysocki of MIT found that U.S. firms "managed," or distorted, their earnings the least among companies in 31 countries studied. While financial markets, which rely on trust, cannot tolerate lying, the media have grossly exaggerated the extent and seriousness of accounting problems.
For example, a recent headline in the Wall Street Journal proclaimed, "Merck Recorded $12.4 Billion In Revenue It Never Collected." Well, yes and no. The truth is that Merck provided a rebate on drugs, and the company faced a choice: (1) record the entire value of the gross sale as revenue and list the rebate as a cost, or (2) record only the sale, net of the rebate, as revenue. Both methods produce the same profit. Merck decided to list the gross sale and the rebate separately, instead of just the net sale. That seems perfectly reasonable, and, indeed, more informative for investors. But, on the surface anyway, it's another accounting scandal.
In the face of the deluge of stories, some persist in arguing that the cause of the recent decline in the market is that investors believe politicians aren't doing enough. Alan Blinder, vice chairman of the Federal Reserve during the Clinton administration, wrote in the New York Times on July 21, "Can it be true that financial markets want the government to regulate them more? Paradoxically, the answer is yes."
Blinder's proof is that markets were disappointed that President Bush "spoke loudly but carried a small stick in his speech to Wall Street" on July 9. In fact, Blinder has it backwards. The Bush speech more likely frightened investors because he indicated he would back the most extreme legislation that was working its way through Congress.
In the current environment, perhaps it is too much to expect politicians to stick up for the thousands of publicly traded companies that play by the rules and that have provided the United States since 1982 with the most prosperous two decades the world has ever seen. Any top manager warning about the costs of the wild new laws coming out of Congress risks being portrayed as a corporate crook himself. But a little courage would be good to see.
After vigorous lobbying, corporate executives have now been rolling over--and may soon pay the price. The new accounting reform law creates byzantine regulations where even honest managers could face prison time. Requiring them to personally "ensure" the gathering of information for financial statements may seem innocuous enough, but consider that firms must frequently refile corrected statements not because of intentional deception but because new information has come to light. Prosecutors might need only to point out two conflicting certified statements to show perjury or fraud. Making a simple mistake or being fooled by subordinates may not be enough of a defense. At the very least, CEOs will be wasting time verifying accounting statements, time better spent running a business.
The only good news is that all this bad political news may now have been fully taken into account by investors. Unfortunately, the same cannot be said for misguided laws, whose effects can linger for decades--as, alas, can misguided politicians.
James K. Glassman and John R. Lott Jr. are scholars at the American Enterprise Institute. Glassman is also host of www.TechCentralStation.com.