How Capitalism Will Save Us

by Steve Forbes

  REAL WORLD LESSON

  Regulations do not mitigate risk in markets. Layers of regulation offer no perfect guarantee of protection against marketplace disasters and may create new distortions that result in future problems down the road.

  Q WASN’T THE SARBANES-OXLEY LEGISLATION NECESSARY TO CLARIFY “THE RULES OF THE ROAD” IN CORPORATE GOVERNANCE AND ACCOUNTING?

  A NO. SARBANES-OXLEY SERVES AS A PRIME EXAMPLE OF HOW POORLY DESIGNED REGULATION PRODUCES DAMAGING, UNINTENDED CONSEQUENCES THAT HINDER ECONOMIC ACTIVITY.

  Sarbanes-Oxley, or the Public Company Accounting Reform and Investor Protection Act of 2002, typifies the problems that can take place when politicians are pressed to “do something” in response to a crisis. Passed in 2002 in the wake of accounting and corporate-governance scandals that brought down Enron and other corporations, SOX was supposed to bring about better corporate accounting standards. But instead of improving corporate governance, the SOX legislation—as is typical of laws and regulations enacted in an emotional atmosphere—produced a host of economically destructive, unintended consequences.

  Fraud, of course, is illegal. Executives from Enron and other corporations were indicted and convicted under existing statutes. Many experts thus believe SOX wasn’t needed. “The SEC already had the authority to do everything the law demands about accounting or corporate boards,” wrote Alan Reynolds of the Cato Institute in 2005.6 SOX also has not prevented further scandalous corporate failures. One example: the sensational bankruptcy of the large commodities broker Refco, caused by the accounting criminality of its CEO. Banker and financial relations adviser Mallory Factor observed in The Wall Street Journal in 2006:

  Over 700 prosecutions have been launched since 2002 to address corporate crimes. Nevertheless, not one conviction was a result of Sarbox. Sarbox clearly failed to prevent the massive accounting scandal at Fannie Mae.7

  But haven’t investors been helped by the elaborate, expensive bookkeeping tests and controls required by SOX? Reynolds of Cato says those rules weren’t needed either:

  The market characteristically gets wind of what’s going on inside companies and prices it into the stock: The bookkeeping obsession of Sarbanes-Oxley might nonetheless be defended as helpful to stockholders were it not for the fact that investors saw through Enron and WorldCom’s exaggerated earnings and hidden debts long before accountants or federal regulators did.8

  Another problem with the law was that it requires, in Reynolds’s words, “that the audit committee of every corporate board be comprised entirely of independent directors with no company experience plus one financial expert who claims to grasp all 4,500 pages”9 of GAAP. Yet as he points out, board independence was never an issue in the Enron scandal. The Enron board, he reminds us, “was 86 percent independent.”10

  T. J. Rodgers, founder, president, CEO, and a director of Cypress Semiconductor Corporation, complains that the FASB rules were created by a small group of ivory-tower “experts” with limited understanding of the Real World issues of corporate accounting:

  FASB is a group of seven theoretical accountants based in Norwalk, Connecticut. Its website shows that no FASB member ever started or ran a successful business and that only one member has even held a senior position in a prominent public company other than an accounting firm. 11

  According to Rodgers, GAAP’s complicated accounting standards have only made it more difficult for even top executives to understand a company’s financials.

  I first noticed the misleading nature of Generally Accepted Accounting Principles a few years ago when an investor called to complain about the small amount of cash on our balance sheet. Since we had plenty of cash, I decided to quickly quote the correct figures from our latest financial report. But to my surprise, I could not tell how much cash we had either. With its usual—and almost always incorrect—claim of making financial reporting “more transparent,” the Financial Accounting Standards Board had made it difficult for a CEO to read his own financial report.12

  But the worst part of SOX has been its impact on the U.S. financial sector, driving up accounting and compliance costs—both in regulatory fees and man-hours. Audit costs for U.S. corporations have risen 30 percent or more as a result of more stringent accounting and audit standards. In the Board’s first year of operation alone, the act’s regulations resulted in more than $35 billion in compliance costs imposed on the nation’s businesses.

  The costs of being a U.S. public company are now more than triple what they were before the law passed, according to a study conducted by the Milwaukee-based law firm Foley & Lardner.

  Fees required by the Public Company Accounting Oversight Board can run as high as $2 million annually for large firms. According to the accounting firm Deloitte, large companies have on average spent nearly seventy thousand additional man-hours complying with the new law.

  But SOX has been hardest on smaller firms unable to shoulder the financial and manpower burden. According to one study, companies with annual sales below $250 million incurred a staggering $1.56 million, on average, in SOX compliance costs. Some smaller firms report that they are spending 300 percent more on SOX compliance than on health care for their employees. A survey by the American Electronics Association found that companies with sales of $100 million or less are spending 2.6 percent of their revenues on SOX compliance.

  The gargantuan burden of SOX has driven public companies from U.S. stock exchanges and discouraged privately held companies, especially small ones, from going public. A 2006 study by the Committee on Capital Markets Regulation found that only 8 percent of new stock offerings are now executed on U.S. exchanges, compared with 48 percent in the 1990s. According to the report, SOX’s compliance fees “are absolutely killing the U.S. in terms of maintaining listings dominance.”13

  A joint study by the Brookings Institution and the American Enterprise Institute found that the direct and indirect costs of SOX total a staggering $1 trillion dollars.

  Fears of criminal prosecution for governance and accounting transgressions have made corporations more risk averse. The result: fewer innovations and less growth. In 2006, a University of Rochester study concluded that the total effect of the law was to reduce the stock value of American companies by $1.4 trillion.

  Rather than increasing transparency and creating a better environment for investors, SOX has done the opposite—it has added to the regulatory tangle, increasing balance-sheet confusion. SOX helped to create an environment that destroyed far more wealth than was ever destroyed through the prior corporate scandals put together.

  REAL WORLD LESSON

  SOX illustrates the damage that can occur when regulators overreact and micromanage markets.

  Q DOESN’T SOCIETY NEED LAWS TO PROTECT HEALTH, SAFETY, AND THE ENVIRONMENT?

  A YES. BUT TOO LITTLE ATTENTION IS FOCUSED ON WHETHER THE BENEFITS OF THOSE LAWS ARE WORTH THE COST.

  There’s no question that many government regulations have worked to promote public health, safety, and a cleaner environment. But some haven’t. Geology professor Seth Stein and engineer Joseph Tomasello write about the case of Memphis, Tennessee. The city is located in the New Madrid seismic zone, an area of the central United States prone to earthquakes. The region experiences really big quakes “only every 500 years or so, far less often than in California. As far as we know,” they write, “no one has ever died in an earthquake in the New Madrid zone.”14 The last significant tremor to hit the area—a moderate 5.5—occurred a little more than forty years ago, in 1968.

  Yet the Federal Emergency Management Agency wanted Memphis and the rest of the seismic zone to adopt anti-earthquake standards like California’s. That meant using expensive antiquake construction methods on new buildings, and retrofitting existing ones.

  According to Stein and Tomasello, meeting the new standards “could increase a building’s cost 5 percent to 10 percent.”15 FEMA also wants to retrofit hospitals, highways, and bridges. Retrofitting just one of these projects, the
Memphis Veterans’ Hospital, they say, would cost about $100 million, “comparable to the cost of a new building.”16

  Stein and Tomasello raise the question, should hundreds of millions of dollars be spent on preparing Memphis for major earthquakes that occur only once every five hundred years? After all, so much spending on earthquake safety would divert funds from needs that are far more immediate:

  Money spent strengthening schools isn’t available for teachers’ salaries, upgrading hospitals may mean treating fewer uninsured patients, and stronger bridges may result in hiring fewer police officers. The proposed code may over time save a few lives per year, while the same money invested in health or safety measures (flu shots, defibrillators, highway upgrades) could save many more.17

  FEMA’s building codes are among countless regulations from numerous government agencies whose costs drastically outweigh their benefits. Among the latest measures, and one of the most draconian in some time, is the new Consumer Product Safety Improvement Act. Passed in 2008 after the panic over tainted Chinese toys and lead paint, it requires expensive third-party testing to verify the safety of all products primarily intended for children under twelve. As Manhattan Institute fellow Walter Olson explains,

  That includes clothing, fabric and textile goods of all kinds: hats, shoes, diapers, hair bands, sports pennants, Scouting patches, local school-logo gear and so on.

  And paper goods: books, flash cards, board games, baseball cards, kits for home schoolers, party supplies and the like. And sporting equipment, outdoor gear, bikes, backpacks and telescopes. And furnishings for kids’ rooms.

  And videogame cartridges and audio books. And specialized assistive and therapeutic gear used by disabled and autistic kids.

  Again with relatively few exceptions, makers of these goods can’t rely only on materials known to be unproblematic (natural dyed yarn, local wood) or that come from reputable local suppliers, or even ones that are certified organic.18

  In short, Olson says that the list includes almost everything—even older products sold at thrift shops and, possibly, books.

  Children’s sections at libraries and bookstores will, at minimum, face price hikes on newly acquired titles and, at worse, may have to rethink older holdings.

  After all, no one has the slightest idea how many future violations lie hidden in the stacks and few want to play a guessing game about how seriously officialdom will view illegality. “Either they take all the children’s books off the shelves,” Associate Executive Director Emily Sheketoff of the American Library Association told the Boston Phoenix, “or they ban children from the library.”19

  Violators face criminal prosecution and fines of $100,000. Olson writes that the law promises “to wipe out tens of thousands of small makers of children’s items from coast to coast, and taking a particular toll on the handcrafted and creative, the small-production-run and sideline at-home business, not to mention struggling retailers.”20

  How could such a heavy-handed, misguided piece of legislation have been passed by policy makers? Unfortunately, it is typical of the failure of bureaucrats to grasp how excessive, overbearing regulation can damage the economy and hurt people. Economist Robert W. Hahn estimates that more than 40 percent of American regulations impose costs on the economy that outweigh their benefits.

  In a report for the American Enterprise Institute, Hahn asserts that insufficient analysis of the relative costs and benefits of health, safety, and environmental regulations has been a failure of both Republican and Democratic administrations.

  He and others pose a sticky question: is it worth spending billions of dollars on rules that promise health, safety, or environmental benefits that, in some instances, may be realized by very few people?

  Requiring third-party testing of library books and many other totally harmless items—as the new Consumer Product Safety Improvement Act does—is not only costly. It’s just plain dumb. In 2008, the Competitive Enterprise Institute published a list of “The Five Dumbest Product Bans.” Among them: the lifesaving Cardio-Pump, whose use in the United States has been outlawed by the Food and Drug Administration. This lifesaving device is commonly used in Britain, France, Israel, Chile, and a dozen other countries. In fact, according to one study published in the prestigious New England Journal of Medicine, survival rates of heart attack patients resuscitated by the plungerlike heart pump were much higher than those treated with traditional techniques. Why did the FDA ban the device? Apparently, for bureaucratic reasons: the FDA was unable to carry out its own study of the device because patients in the throes of cardiac arrest are unable to give “informed consent” to participate.

  In other words, the FDA decided that the mere possibility that the device might not work perfectly in a minority of cases outweighed its already demonstrated benefits—that it raised the likelihood of heart attack survival by most people.

  We’ve already mentioned CAFE standards. Yes, today’s cars burn less gas—they’re 50 percent more efficient than they were in the 1970s. But CAFE standards have major downsides, too. They’re a primary cause of the troubles that have hobbled the Detroit automakers. They’ve also resulted in lighter cars and more auto fatalities. A 2001 report from the National Academy of Sciences estimated that between 1,300 and 2,600 deaths a year may be attributed to the smaller passenger cars that were manufactured to improve fuel efficiency.

  Increased fuel-efficiency standards actually encourage consumption. Believing their vehicles are energy efficient, people have fewer qualms about driving more and having bigger cars. The number of miles driven and the number of vehicles have virtually doubled since the mid-1970s. The same phenomenon has been observed with refrigerators. As they became more energy efficient, people bought bigger and bigger models. In other words, government regulations have improved fuel efficiency, but they haven’t curtailed energy usage.

  Robert Hahn says that regulation would be improved if lawmakers and others paid more attention to the Real World impact of proposed rules. Some laws are definitely more costly—or beneficial—than others. According to Hahn, laws mandating seat-belt use are a bargain, costing about $69 per “life-year” saved. Government-required airbag installation, meanwhile, costs about $120,000 per life-year saved. Requiring reductions in radiation exposure from X-ray equipment means $23,000 per life-year saved. All three regulations are more cost-effective than radiation controls at uranium fuel-cycle facilities—which require $34 billion per life-year saved. This doesn’t mean expensive safeguards aren’t needed, but the cost should be considered.

  Cost-benefit analysis is receiving more attention in Europe, whose economy has stagnated under its regulatory burden. Hahn and his fellow economists have been criticized for placing a dollar value on human life. However, congressional economist Ike Brannon says that such analysis can be necessary in the Real World: “Because society has limited resources that it can spend on health and safety improvements, it should obtain the greatest benefit for each dollar spent, and ascertaining an appropriate value is necessary to that effort.”21

  Danish author Bjørn Lomborg maintains that a lack of cost-benefit awareness is the problem with many environmental regulations. Lomborg’s controversial book The Skeptical Environmentalist gained notoriety for questioning the thinking of environmentalists. However, his critics miss the point. Lomborg acknowledges the possibility that man may have contributed to global warming. The problem, he says, is that the costs of the standard solutions far outweigh the benefits that may—or may not—be realized in the future:

  [W]e should first focus our resources on more immediate concerns, such as fighting malaria and HIV/AIDS and assuring and maintaining a safe, fresh water supply—which can be addressed at a fraction of the cost and save millions of lives within our lifetime.22

  As congressional economist Ike Brannon points out, “society cannot spend an infinite amount of money to protect and extend each person’s life.” Hard as it may be for some to accept, “choices have to be made.”23
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  REAL WORLD LESSON

  Cost-benefit analysis should be a greater part of the debate over proposed regulation, given the limitations on government and taxpayer resources.

  Q AREN’T CAP-AND-TRADE REGULATIONS A MARKET-BASED WAY TO CONTROL POLLUTION?

  A NO. CAP-AND-TRADE FAILED IN EUROPE BECAUSE IT CREATES AN ARTIFICIAL MARKET THAT DOES NOT REFLECT REAL WORLD CONDITIONS OR THE NEEDS OF PARTICIPANTS.

  Cap-and-trade regulation is supposed to be a “market-based” way to control industrial emissions of carbon dioxide (CO2), thought by many to cause climate change. Here’s how the system is supposed to work: Government sets a “cap” on how much carbon dioxide can be emitted each year. Each company or institution is then granted a predetermined number of permits. Companies that need to produce more emissions can buy permits from others that don’t need them. Another way to distribute permits is for the government to simply auction them off. This avoids the politically charged process of determining the number of permits granted to each company or institution—and the auctions raise bundles of money. Either way, say proponents, carbon emissions are controlled, while a market is created that allocates the right to pollute according to need.

  One congressional proposal under consideration would require CO2 emissions to be reduced to 83 percent of their 2005 level by 2020, with further reductions thereafter. Meanwhile, cap-and-trade programs have been under development in several states. One such effort is a multistate cap-and-trade program for greenhouse-gas emissions, the Regional Greenhouse Gas Initiative (RGGI), covering Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont. RGGI is expected to begin capping emissions in 2009. California is actively considering the feasibility of a similar cap-and-trade program for CO2 emissions.

  Politicians are enamored of cap-and-trade because it is, in essence, a big tax increase that would rake in tens of billions of dollars each year. But the Real World problem with a cap-and-trade system is that it significantly boosts the cost of energy. Prices of CO2-intensive products—including gasoline, electricity, and many industrial products—would soar. Dispassionate experts estimate that a national program could double electricity prices. Gas prices are expected to skyrocket almost 75 percent—or higher. Experts such as economist Martin Feldstein predict the cost of living for the average household will shoot up by $1,600 a year.