Government Meddling Greater Threat to Social Security Reform than Corporate Misdeeds

Because Republicans have been reluctant to discuss the issue of Social Security reform – particularly in the context of the 2002 midterm elections – the relationship between the declining stock market and proposals for personal retirement accounts has been an afterthought. Democrats may incorporate the supposed dangers of Social Security “privatization” into their “Republicans are too cozy with corporate crooks” election theme, but beyond that scarcely a word has been spoken about the relation between the two.

In a speech at the National Press Club, Sen. John McCain (R-Ariz.) made the connection explicit when he explained his support for both Social Security reform and new laws to address corporate malfeasance. He asked rhetorically, “How can we expect to convince Americans that the one pension plan every American is entitled to is safe in private investments when the stock market and our economy are daily battered by revelations of corporate wrongdoing?” McCain further explained how “a growing portion of the public depends more on private retirement plans than on Social Security for their retirement income,” meaning government action is necessary not only to pave the way for Social Security reform, but also to guard the investments of near retirees under the current system.

This line of thinking is important for would-be reformers mired in the current climate of corporate wrongdoing. But it offers a solution – new regulations and corporate oversight – for a problem – declining stock prices – that may not be related to the abuses the new laws seek to curb. McCain believes his tough corporate crackdown proposal (and, by extension, the bill that passed the Senate 97-0 on Monday) would restore confidence in markets and make Social Security reform more palatable to voters.

But the markets opened down by over 100 points the day after the “Corporate Responsibility Act” passed the Senate. If it succeeded in calming investors’ fears about corporate disclosure, then these fears must have been unrelated to the recent stock market skid. McCain has been alone in his willingness to discuss Social Security reform in the face of the recent scandals, but by coupling scandals with recent stock market performance, he confuses the issue and makes false promises, despite his good intentions.

The need to shore up investor confidence has been paramount in the debate over new regulations on accounting and corporate governance. But what if investor confidence has less to do with honest accounting than future prospects for corporate profits? Congress can pass a law to execute every corporate official who misleads stockholders and prospective investors; it cannot pass a law to guarantee year-on-year portfolio advances for every American saving for retirement.

Decline in Equity Prices

Weakness in demand, a lack of pricing power, softness in credit markets, and overcapacity have combined to put a downward pressure on stock prices. While these factors are often mentioned as causes of the stock slide in the U.S. financial press, they are treated as secondary to “investor concerns” about accounting misdeeds.

But is this really the case? For example, coverage of the recent decline in pharmaceutical stocks has centered on investor unease following the news that Merck & Co. may have fraudulently accounted for co-payments and that the SEC is investigating Bristol Myers Squib. But a recent research note from Morgan Stanley blames stock declines on a “decline in the broader market,” “weakness in the sector,” “delays in product launches,” and “competition from generics.”

Moreover, the stock of the drug firm Wyeth lost 24 percent of its value when it was discovered that its estrogen therapies increased women’s risk of developing heart disease and breast cancer. Such a shocking revelation about a Food and Drug Administration (FDA) approved therapy “raised questions about safety of other drugs,” increasing the sector’s risk and depressing its stocks.

Similarly, UK-based GlaxoSmithKline’s new 5-year low was the result of a successful generic bid by Swiss manufacturer Geneva. As the table below indicates, the largest pharmaceutical firms have all seen their stock prices fall between 16 and 34 percent over the past 3 months, but the reasons for the fall are based on real economic performance, not investor squeamishness caused by disreputable accounting.

GlaxoSmithKline (GSK); Johnson and Johnson (JNJ); Merck & Co. (MRK); Pfizer (PFE); Eli Lilly (LLY)

Which brings us to questions about the broader market. What if underlying economic weakness, not investor skittishness, is the cause for the malaise in U.S. equities? As U.S. equity indexes fell to four and five year lows this week, British and European indexes matched their losses. In fact, as the chart below indicates, with the exception of Japan, the stock markets of all the world’s major developed economies have seen their capitalization fall dramatically over the past 6 months. The FTSE 100 – London’s stock benchmark – hit 5-year lows this week. Are we to believe that U.S. corporate wrongdoing is the cause of devaluation of British equities? And what of Friday’s 3.4 percent decline in the Bloomberg 500 index European stocks, which brings its cumulative devaluation for the year to 21.4 percent?

With mountains of debt, declining asset values, and unclear profit forecasts amid slumping worldwide demand, European stocks have been just as hard hit as their U.S. counterparts. The difference, of course, is that accounting misdeeds cannot be blamed for the devaluation.

From the July 12, 2002 Wall Street Journal As calculated
by Morgan Stanley Capital International Perspective, Geneva. Each index,
calculated in local currencies, is based on the close of 1969 equaling 100.

Many policymakers and commentators have suggested that problems with financial reporting has caused foreign investors to flee the U.S. in favor of more regulated, and presumably transparent, capital markets. According to such analysts, the supposed widespread disillusionment with U.S. assets has led to a commensurate decline in the value of the dollar, which has declined by 7 percent against the Japanese yen and 12 percent against the Euro since mid-March.

Yet if the dollar’s well-documented decline is, in fact, related to a capital exodus from the United States to financial markets whose audit requirements are more scrupulous than the derided private standards set by Fair Accounting Standards Board (FASB), this is a conclusion reached in spite of evidence. As the graph below makes clear, stock prices denominated in the Euro and Pound, both of which have appreciated against the dollar, have not risen in relation to the U.S. market. In fact, over the past six months both indexes have tracked the United States market at every turn.

As mentioned above, the Japanese stock market is the anomaly, as it has shed only 5 percent of its value since mid-January, compared to about 20 percent for the U.S, and the yen has gained about 7 percent against the dollar in that time. But this can hardly be attributed to transparency, as the real performance of the Japanese financial system is unknown to outsiders and often completely fabricated. In April of this year, the Japanese regulator, the Financial Services Agency (FSA), investigated the disclosure practices of banks after it was discovered that Mycal, a leading retail group, filed for bankruptcy even as its principal banks all classified their loans to Mycal as sound.

Unsurprisingly, the regulators ignored the problems and continued to allow the banks to continue to treat non-performing loans (NPLs) in the same fashion, predicting that such loans could be completely disposed of in two years. However, independent analysis from Goldman Sachs and Standard & Poor’s dismisses this rosy scenario. Goldman estimates that NPLs in the system total “roughly eight times the officially acknowledged amount,” while Standard and Poor’s questioned the bank income figures used as a proxy for their ability to write-down the losses and downgrading the credit worthiness of Japan partly because of “the inadequacy of the FSA.”

Moreover, the stock indexes that have seen the greatest gains in the past six months are those of nations not known for transparent and reliable financial systems, to put it kindly. As the graph below shows, during this period the Russian stock market has outperformed the United States by 70 percent, the Stock Exchange of Thailand has risen by 42 percent relative to the United States, and the stock market of South Korea has appreciated by more than 30 percent against the United States. This is not surprising given the growing profit potential and increasing returns presented by many of the publicly traded corporations in these nations, but this evidence should confound the 97 U.S. senators who believe that a lack of stern regulatory oversight is fueling the decline in U.S. asset prices.

Russia (MTMS), Thailand (SETI), and South Korea (KS11)

Given the facts, it seems absurd to the point of willful ignorance or mendacity to argue that falling U.S. asset prices are the product of shoddy financial disclosure, or that the yen is gaining on the dollar because of a capital flow recalibration caused by audit integrity. More likely, the relative strength of the yen is more likely a natural process caused by an overvalued dollar. As of March, when the dollar was equal to 123 yen, the relative purchasing power index calculated by the Economist suggested that the dollar was overvalued by 19 percent against the yen. If this was the case at that time, the dollar still has 12 percent to fall before the purchasing power between the two currencies will return to equilibrium.

As Fed Chairman Alan Greenspan observed in his testimony to Congress, “an exchange rate is a very complex price that balances, on the one hand, the demand for, for example, dollars stemming from the demand for dollar investments and for U.S. exports against, on the other hand, the demand for foreign currencies by U.S. investors desiring to acquire foreign assets and by U.S. importers of foreign goods and services.” Greenspan further explained that no economic variable or statistical measure “has been found to be consistently useful in forecasting exchange rates.” Simply put, fluctuations in exchange rates can be explained after the fact by weighing relative returns to equities in different countries, productivity gains, and trade balances, but no one can be confident in predicting future exchange rates no matter what the circumstances.

Conclusions to be drawn for Social Security Reform

As stock prices return to levels not seen since Greenspan made his famous “irrational exuberance” speech in December of 1996, it is appropriate to consider the bear market’s effect on Social Security reform.

If the market downturn were a product of shoddy accounting and lawless corporate officers, as Sen. McCain suggests, new laws to prosecute executives and regulate accountants may be worth considering as a price to pay for confidence in personal retirement accounts. But as the evidence indicates, this argument is a red herring: The Senate legislated not to improve confidence, but to respond to political pressure to “do something” and place the wayward accounting industry under its control.

To make a government agency the absolute authority in the market for audits is to create a political market for audit services independent of the actual marketplace. In addition to servicing customers, accountants must now also serve political bodies. This will be sure to increase the political donations and personal rents policymakers can expect to extract from accountants in exchange for special rules and goodwill from policymakers. The first example of this dynamic was the Senate bill’s ban on auditors also serving as consultants. The auditors that had already spun-off, or rid themselves of their consulting arms were more than happy to acceded to the condition in the expectation that it would disadvantage competitors who rely on consulting fees to compensate for a staff with more specialized industry (often information technology) knowledge.

Further problems in the markets will provide elected officials with further opportunities to aggrandize their role in the economy, PARTICULARLY if Social Security reform begins to gain acceptance. This is not to say that personal retirement accounts are an undesirable policy option; nothing could be further from the truth. But it is worth noting that nothing creates more anxiety among voters than retirement finances, and when future scares arise, policymakers will capitalize on them to internalize prospective rents. Future scares could lead to regulations on acceptable financial services firms, portfolio composition, and financial products – all to the benefit of the policymakers who make the relevant decisions instead of investors. Thus Social Security reform must remain faithful to idea of “privatization, ” if not its verbiage, if it is to maximize its benefit to retirees.

Properly designed Social Security reform would accomplish two major objectives: allow current workers to invest in real assets for retirement instead of relying on the good will of politicians and public resources that may or may not be available upon retirement; And to relieve the tax burden, caused by demographics, on future workers, who will be expected to hand over about a fifth of their salary to pay retirees’ benefits. If policymakers are allowed to use every economic hiccup along the way to regulate, tax, and police America’s system of corporate finance, the results will be disastrous as government officials both internalize the benefits intended for retirees and reduce the productive capacity of the economy by limiting investment, innovation, and financial flexibility.

Sen. McCain was courageous to address Social Security reform at a time when so many Republicans are running from the idea, but the lesson to be drawn from this feeding frenzy is not that government action is necessary to bolster the case for reform, but that government action may do more to undermine the benefits of reform than any corporate misdeed.