Washington vs. Wall Street: Will New Rules Boost the Market?

This week, the Senate passed a bill creating more layers of oversight for corporate accounting while President Bush has announced tough new standards of corporate accountability. Unfortunately, the current rush for more regulation and increased federal oversight of market activity raises a number of questions while offering few solutions. It is not likely that political wrangling will have much effect on stock market jitters. If anything, excessive new regulations could hamper the workings of the equity markets without generating new information that is useful to investors or that boosts confidence in markets. Rather than more legislation or regulatory controls on accounting practices, a better approach would examine the fundamentals of the current market.

The stock market is an important component of the modern economy that provides an opportunity to match investors and borrowers in ways that have expanded productive capacity. The market has allowed a degree of specialization that generated significant increases in output. Particularly, investors are able to provide resources without incurring the costs of management (and, as a corollary, any losses are limited to the price of stock shares). Modern capital markets have allowed an unprecedented boost in economic growth.

One of the primary reasons that capital markets work is that they are efficient. That is, they are able to process information very quickly, which means that stock prices provide a relatively accurate reflection of the future earning potential of a company. As technology advances, as consumer demand shifts, or as the supply of inputs shift, stock prices adjust, signaling new market conditions. Overvalued or undervalued stocks offer potential gains for investors based on new information. As investors bid for resources in the equity market, prices adjust, incorporating the information identified by potential investors. Through this process, capital markets drive resources toward their most efficient uses, generating production and economic activity where consumer demand is high.

In this sense, the market coordinates the economic activity of producers, consumers, and investors in a manner suggested by Nobel economist Friedrich Hayek. A market economy is made up of millions of individuals, all with their own plans and information. Prices provide the signals necessary to coordinate these plans, by providing information about scarcity and consumer demand. Stock prices do the same, and relatively efficiently. The rise of the NASDAQ exchange facilitated a massive growth of technology investment. And, in the case of Enron and WorldCom, the market’s correction to emerging problems was a swift devaluation of stock prices.

Given its critical role allocating resources, the accuracy of information is important to the market’s performance. Therefore, accounting is important, because it can contribute to better information for assessing stocks. But it does not follow that broad new regulatory powers must be created to control markets. The SEC already has full authority to regulate securities, fraud is already a criminal act, and a number of organizations exist to set standards of auditing and accounting. If anything, lack of enforcement has posed a greater problem than lack of rules.

Decisions to invest in particular companies are not risk free. Poor management, changing technologies, and shifts in supply and demand can all have adverse effects on stock prices. Investors must recognize this and allocate their resources carefully. Fortunately, stock markets have the virtue of being an efficient mechanism for handling risk. A diversified portfolio allows investors to minimize overall risk in the marketplace by spreading risk across the economy as a whole to offset the potential threat of a particular sector facing adverse conditions. More recently, mutual funds have emerged as an option for individual investors to enjoy specialized management of their investments by expert investors that manage large portfolios of stocks and other assets. Index funds also provide investments that track the performance of the market as a whole.

In the wake of bull market of the 1990s, many appear to have downplayed or ignored the inevitable risks associated with the stock market. Poor management, or changes in underlying conditions can rapdily drive stock prices down; price volatility is an inherent component of the marketplace. Yet, over time, stocks can generate significant investment income. As Professor Jeremy Siegel of the Wharton Business School notes, the total return on stocks have exceeded the total return of any other class of asset. But stock prices are variable. According to Professor Siegel, “In every thirty year period from 1872 to the present, and in every 10 year period from 1929 to the present, stocks have outperformed both long- and short-term government bonds.”

The stock market has become an important financial resource for many Americans. In fact almost half of all American households owned stock. This is either direct ownership or indirect investments through retirement plans. In total Americans have nearly $11 trillion in the stock market. The equity markets provide an important alternative to traditional savings, with the potential of significant growth over the long run. In fact, the long-run annual return on the market is roughly 7 percent annually, adjusted for inflation.

Importantly, such gains take time. Markets are volatile and subject to wide swings in the short run. According to financial columnist James Glassman, the stock markets were down 22 of the last 76 years. The long boom of the 1990s and the media’s hype of the dot.com market generated what Federal Reserve Chairman Alan Greenspan termed “irrational exuberance,” leading investors to ignore the importance of risk and the fundamentals of the marketplace. No investment is without risk, and there is much to suggest that rather than accounting woes, market corrections are underway to address misdirected investments in a rapidly transforming market. If this is the case, new accounting standards cannot be expected to enhance market performance.

Yet the media continues its push for a corporate lynching, and politicians appear more than willing to comply. CEOs have been paraded through hearing rooms while national headlines have focused on the inability of George Bush to prop up the market even in the face of tough new regulations. Markets rely on a rapid flow of information about future revenue streams. To the extent that the threat of intervention from Washington can limit the flow of information, it is not impossible that markets remain weak because of uncertainty over new regulations that may hamper the markets efficiency. This is not to say that all is well in corporate America. There are real concerns about corporate governance that should be addressed in order to ensure that the interests of management and shareholders are aligned. But Washington’s regulatory frenzy appears to be driven more by politics than by markets, and the rush to score a quick fix may overlook more fundamental challenges.

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