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Press Release

    Can Washington Boost Investor Confidence?

    07/09/2002

    Washington loves a crisis, and the recent spate of corporate misdeeds has the city buzzing with a sense of urgency or the need to “do something.” Unfortunately, much of the concern appears driven by political posturing rather than an insightful examination of the accounting standards that govern corporate behavior. While the crisis in corporate governance is real, a rash attempt to fix the problem through more regulation may do more harm than good. Grandstanding politicians may harangue their counterparts in corporate America, but they actually have more in common than they would care to admit: exploiting opportunities for personal gain rather than seeking to serve the public.

    Robert Higgs contends that in times of crisis, government grows. In post-September 11 America, it is hard to argue with his assessment. Government spending continues to soar despite the return of budget deficits, everyone from airlines to farmers to insurers are clambering for government bailouts, President Bush has announced the creation of the new, cabinet-level Homeland Security Agency, and Congress has yet to adopt a budget resolution to constrain appropriators as they piece together next year’s budget. Now, Washington is training its sights on Wall Street, with the Senate racing to create a new board with sweeping powers over the markets responsible for generating the economic growth that drives our nation forward.

    Democrats have seized the crisis as an opportunity to denigrate President Bush and Republicans for turning a blind eye to corporate wrongdoing because of their cozy relationship with big business. The Senate is set to vote this week on S. 2673, the “Public Company Accounting Reform and Investor Protection Act of 2002,” introduced by Sen. Paul Sarbanes (D-Md.), The bill would create a new “Public Company Accounting Oversight Board” with sweeping powers over who may conduct an audit, and how the audit is to be conducted.

    For their part, Republicans have not been idle. The Republican-controlled House has already passed H.R. 3763, the “Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002,” which seeks to create private accounting oversight agencies that would work in conjunction with the Securities and Exchange Commission (SEC) to monitor and discipline auditors. In turn, the SEC has developed proposed regulations to create a similar private enforcement board.

    While proposals to create new oversight boards may compel corporate America to adopt new annual audit procedures that entail significant new burdens, it is not evident that these boards are necessarily the most effective source for establishing new standards, or that they can do better at ferreting out securities fraud. The SEC already has oversight, and fraudulent behavior is subject to legal sanction and criminal penalties. Traditionally, standards have been established through private organizations and enforced by professional organizations that license accountants, much the way lawyers and doctors are licensed. As William Niskanen of the Cato Institute notes, in light of the recent scandals that have surfaced, such private organizations are in the process of introducing new policies to address potential problems. Investor confidence is critical for a healthy market, which means that business, the stock exchanges, and institutional investors all have incentives to improve accounting standards and Niskanen points out that all of these groups are working to establish new standards. Stock exchanges, for example, may require tougher standards before agreeing to list a company’s stock.

    At the same time, the impact of the existing regulatory and tax structure on corporate governance cannot be overlooked. As economists such as Henry Manne have noted, past regulatory policies have insulated corporate management to a degree from outside pressures, creating a divergence between shareholder interests and management interests. Moreover, a tax code that favors interest over dividends has generated incentives for debt financing that may entice overextended corporations to adopt more “creative” accounting practices. While this does not excuse misconduct, it does raise the concern that poor regulations can do more harm than good.

    The Harvard Business School’s Michael Jensen notes that we are in the throes of a Third Industrial Revolution. Since the 1970s technological and organizational changes have been transforming corporate America in ways that expand the potential for economic growth and increased productivity. These changes are indicative of markets, which are dynamic and continually evolving. Unfortunately, government policies are hardly dynamic. While markets are continually absorbing new information and identifying more efficient organizational structures, Washington’s attempts to regulate markets are static and developed to address markets as they exist at a point in time. Establishing new standards through regulatory or legislative processes has the potential to establish standards that may quickly become irrelevant or obsolete.

    Corporate governance certainly has demonstrated its shortcomings in the wake of Enron’s collapse in December of 2001. Dubious accounting practices and perhaps outright fraud have led to a crisis in investor confidence that has weakened the market and shaken the dollar in world currency markets; foreign investors have become skittish, pulling resources out of U.S. markets. As corporations struggle to adapt to new economic conditions, the threat of further scandals remains as corporate managers feel pressured to boost earnings statements. Changes in accounting standards are inevitable if investor confidence is to be restored. But before rushing into the broad new mandates of a bill such as S. 2673, it may be wise to evaluate all the potential alternatives.