>
>
> The Dow Congress
> An alternative theory of why the market collapsed.
> by James K. Glassman & John R. Lott Jr.
> 08/05/2002, Volume 007, Issue 45
> The Weekly Standard
>
>
> 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.
> \
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