Archives For financial regulation

The Securities and Exchange Commission (SEC) recently scored a significant win against a Maryland banker accused of naked short-selling. What may be good news for the SEC is bad news for the market, as the SEC will now be more likely to persecute other alleged offenders of naked short-selling restrictions.

“Naked” short selling is when a trader sells stocks the trader doesn’t actually own (and doesn’t borrow in a prescribed period of time) in the hopes of buying the stocks later (before they must be delivered) at a lower price. The trader is basically betting that the stock price will decline. If it doesn’t, the trader must purchase the stock at a higher price–or breach their original sale contract.Some critics argue that such short-selling leads to market distortions and potential market manipulation, and some even pointed to short-selling as a boogey-man in the 2008 financial crisis, hence the restrictions on short-selling giving rise to the SEC’s enforcement proceedings.

Just one problem, there’s a lot of evidence that shows restrictions on short-selling make markets less efficient, not more.

This isn’t exactly news. Thom argued against short-selling restrictions seven years ago (here) and our late colleague, Larry Ribstein, followed up a couple years ago (here).  The empirical evidence just continues to pile in. Beber and Pagano, in the Journal of Finance earlier this year examine not just US restrictions on short-selling, but global restrictions. Their abstract reads:

Most regulators around the world reacted to the 2007–09 crisis by imposing bans on short selling. These were imposed and lifted at different dates in different countries, often targeted different sets of stocks, and featured varying degrees of stringency. We exploit this variation in short-sales regimes to identify their effects on liquidity, price discovery, and stock prices. Using panel and matching techniques, we find that bans (i) were detrimental for liquidity, especially for stocks with small capitalization and no listed options; (ii) slowed price discovery, especially in bear markets, and (iii) failed to support prices, except possibly for U.S. financial stocks.

So while the SEC may celebrate their prosecution victory, investors may have reason to be less enthusiastic.

TOTM friend Stephen Bainbridge is editing a new book on insider trading.  He kindly invited me to contribute a chapter, which I’ve now posted to SSRN (download here).  In the chapter, I consider whether a disclosure-based approach might be the best way to regulate insider trading.

As law and economics scholars have long recognized, informed stock trading may create both harms and benefits to society With respect to harms, defenders of insider trading restrictions have maintained that informed stock trading is “unfair” to uninformed traders and causes social welfare losses by (1) encouraging deliberate mismanagement or disclosure delays aimed at generating trading profits; (2) infringing corporations’ informational property rights, thereby discouraging the production of valuable information; and (3) reducing trading efficiency by increasing the “bid-ask” spread demanded by stock specialists, who systematically lose on trades with insiders.

Proponents of insider trading liberalization have downplayed these harms.  With respect to the fairness argument, they contend that insider trading cannot be “unfair” to investors who know in advance that it might occur and nonetheless choose to trade.  And the purported efficiency losses occasioned by insider trading, liberalization proponents say, are overblown.  There is little actual evidence that insider trading reduces liquidity by discouraging individuals from investing in the stock market, and it might actually increase such liquidity by providing benefits to investors in equities.  With respect to the claim that insider trading creates incentives for delayed disclosures and value-reducing management decisions, advocates of deregulation claim that such mismanagement is unlikely for several reasons.  First, managers face reputational constraints that will discourage such misbehavior.  In addition, managers, who generally work in teams, cannot engage in value-destroying mismanagement without persuading their colleagues to go along with the strategy, which implies that any particular employee’s ability to engage in mismanagement will be constrained by her colleagues’ attempts to maximize firm value or to gain personally by exposing proposed mismanagement.  With respect to the property rights concern, deregulation proponents contend that, even if material nonpublic information is worthy of property protection, the property right need not be a non-transferable interest granted to the corporation; efficiency considerations may call for the right to be transferable and/or initially allocated to a different party (e.g., to insiders).  Finally, legalization proponents observe that there is little empirical evidence to support the concern that insider trading increases bid-ask spreads.

Turning to their affirmative case, proponents of insider trading legalization (beginning with Geoff’s dad, Henry Manne) have primarily emphasized two potential benefits of the practice.  First, they observe that insider trading increases stock market efficiency (i.e., the degree to which stock prices reflect true value), which in turn facilitates efficient resource allocation among capital providers and enhances managerial decision-making by reducing agency costs resulting from overvalued equity.  In addition, the right to engage in insider trading may constitute an efficient form of managerial compensation.

Not surprisingly, proponents of insider trading restrictions have taken issue with both of these purported benefits. With respect to the argument that insider trading leads to more efficient securities prices, ban proponents retort that trading by insiders conveys information only to the extent it is revealed, and even then the message it conveys is “noisy” or ambiguous, given that insiders may trade for a variety of reasons, many of which are unrelated to their possession of inside information.  Defenders of restrictions further maintain that insider trading is an inefficient, clumsy, and possibly perverse compensation mechanism.

The one thing that is clear in all this is that insider trading is a “mixed bag”  Sometimes such trading threatens to harm social welfare, as in SEC v. Texas Gulf Sulphur, where informed trading threatened to prevent a corporation from usurping a valuable opportunity.  But sometimes such trading creates net social benefits, as in Dirks v. SEC, where the trading revealed massive corporate fraud.

As regular TOTM readers will know, optimal regulation of “mixed bag” business practices (which are all over the place in the antitrust world) requires consideration of the costs of underdeterring “bad” conduct and of overdeterring “good” conduct.  Collectively, these constitute a rule’s “error costs.”  Policy makers should also consider the cost of administering the rule at issue; as they increase the complexity of the rule to reduce error costs, they may unwittingly drive up “decision costs” for adjudicators and business planners.  The goal of the policy maker addressing a mixed bag practice, then, should be to craft a rule that minimizes the sum of error and decision costs.

Adjudged under that criterion, the currently prevailing “fraud-based” rules on insider trading fail.  They are difficult to administer, and they occasion significant error cost by deterring many instances of socially desirable insider trading.  The more restrictive “equality of information-based” approach apparently favored by regulators fares even worse.  A contractarian, laissez-faire approach favored by many law and economics scholars would represent an improvement over the status quo, but that approach, too, may be suboptimal, for it does nothing to bolster the benefits or reduce the harms associated with insider trading.

My new book chapter proposes a disclosure-based approach that would help reduce the sum of error and decision costs resulting from insider trading and its regulation.  Under the proposed approach, authorized informed trading would be permitted as long as the trader first disclosed to a centralized, searchable database her insider status, the fact that she was trading on the basis of material, nonpublic in­formation, and the nature of her trade.  Such an approach would (1) enhance the market efficiency benefits of insider trading by facilitating “trade decod­ing,” while (2) reducing potential costs stemming from deliberate misman­agement, disclosure delays, and infringement of informational property rights.  By “accentuating the positive” and “eliminating the negative” conse­quences of informed trading, the proposed approach would perform better than the legal status quo and the leading proposed regulatory alternatives at minimizing the sum of error and decision costs resulting from insider trading restrictions.

Please download the paper and send me any thoughts.

In light of yesterday’s abysmal jobs report, yesterday’s Wall Street Journal op-ed by Stanford economist John B. Taylor (Rules for America’s Road to Recovery) is a must-read.  Taylor begins by identifying what he believes is the key hindrance to economic recovery in the U.S.:

In my view, unpredictable economic policy—massive fiscal “stimulus” and ballooning debt, the Federal Reserve’s quantitative easing with multiyear near-zero interest rates, and regulatory uncertainty due to Obamacare and the Dodd-Frank financial reforms—is the main cause of persistent high unemployment and our feeble recovery from the recession.

A reform strategy built on more predictable, rules-based fiscal, monetary and regulatory policies will help restore economic prosperity.

Taylor goes on (as have I) to exhort policy makers to study F.A. Hayek, who emphasized the importance of clear rules in a free society.  Hayek explained:

Stripped of all technicalities, [the Rule of Law] means that government in all its actions is bound by rules fixed and announced beforehand—rules which make it possible to foresee with fair certainty how the authority will use its coercive powers in given circumstances and to plan one’s individual affairs on the basis of this knowledge.

Taylor observes that “[r]ules-based policies make the economy work better by providing a predictable policy framework within which consumers and businesses make decisions.”  But that’s not all: “they also protect freedom.”  Thus, “Hayek understood that a rules-based system has a dual purpose—freedom and prosperity.”

We are in a period of unprecedented regulatory uncertainty.  Consider Dodd-Frank.  That statute calls for 398 rulemakings by federal agencies.  Law firm Davis Polk reports that as of June 1, 2012, 221 rulemaking deadlines have expired.  Of those 221 passed deadlines, 73 (33%) have been met with finalized rules, and 148 (67%) have been missed.  The uncertainty, it seems, is far from over.

Taylor’s Hayek-inspired counsel mirrors that offered by President Reagan’s economic team at the beginning of his presidency, a time of economic malaise similar to that we’re currently experiencing.  In a 1980 memo reprinted in last weekend’s Wall Street Journal, Reagan’s advisers offered the following advice:

…The need for a long-term point of view is essential to allow for the time, the coherence, and the predictability so necessary for success. This long-term view is as important for day-to-day problem solving as for the making of large policy decisions. Most decisions in government are made in the process of responding to problems of the moment. The danger is that this daily fire fighting can lead the policy-maker farther and farther from his goals. A clear sense of guiding strategy makes it possible to move in the desired direction in the unending process of contending with issues of the day. Many failures of government can be traced to an attempt to solve problems piecemeal. The resulting patchwork of ad hoc solutions often makes such fundamental goals as military strength, price stability, and economic growth more difficult to achieve. …

Consistency in policy is critical to effectiveness. Individuals and business enterprises plan on a long-range basis. They need to have an environment in which they can conduct their affairs with confidence. …

With these fundamentals in place, the American people will respond. As the conviction grows that the policies will be sustained in a consistent manner over an extended period, the response will quicken.

If you haven’t done so, read both pieces (Taylor’s op-ed and the Reagan memo) in their entirety.

In criticizing Governor Romney’s involvement with Bain Capital, President Obama commented both on private equity and on profit maximization.  Most of the comments I have seen dealt with the private equity.  I thought a comment on profit maximization was important as well.

  • OPINION
  • Updated May 23, 2012, 7:51 p.m. ET

A Tutorial for the President on ‘Profit Maximization’

Profits provide the incentive for firms to do what consumers want.

By PAUL H. RUBIN

In justifying his attacks on Bain Capital, President Obama argues that “profit maximization” might be an appropriate goal for a private-equity firm, but not for more general public policy. This argument ignores one of the most basic premises of economics.

We economists assume that firms always maximize profits, and that profit maximization by firms (all firms, not just private-equity ones) is a very good thing. But this is not because profits are in themselves good. Rather, profit maximization is good because it leads directly to maximum benefits for consumers. Profits provide the incentive for firms to do what consumers want.

Consider what contributes to profit maximization. In simple terms, profit maximization means producing the products earning the highest returns, and producing these products at the lowest possible cost. Both are socially useful behaviors that benefit consumers.

Which products produce the highest returns? The answer is the products that consumers want and are currently underproduced. If there are excess returns (profits) to be earned in some market, that is because consumers are willing to pay more for those products than the current cost of production.

Profits are earned by producing more of these products—that is, by satisfying unmet consumer demands. Profit maximization means doing the best job of satisfying these unmet demands, and so providing benefits to consumers. If the unmet demand is for a currently nonexistent product that consumers will value when it is produced (Facebook, the iPhone, Google search), then of course even more profits can be earned.

A firm such as Bain that is involved in investing capital can only make money if it succeeds in satisfying consumer demands. Of course, its goal in deciding where to invest is to maximize returns for its investors, but that is a detail. It will only succeed in this goal if it does a good job of identifying and satisfying consumer demands for products.

The second trick to maximizing profits is to reduce costs as much as possible. This may involve eliminating some unneeded resources, which may translate into unemployment in the short run. It may involve recombining resources into more productive configurations, or restructuring governance of the firm.

The immediate purpose of reducing costs is to increase the profits of investors, but the ultimate result is to benefit consumers. In the textbook ideal of a purely competitive economy, cost reductions will immediately translate into lower prices for consumers. But in any market structure—competition, monopoly or oligopoly—profit-maximizing behavior translates reduced costs into reduced prices for consumers.

Consider the converse: What if a business does not maximize profits? Then it is either not making the products that consumers want the most, or it is not producing its products at the lowest cost. In either case, consumers are harmed. Any argument against “profit maximization” is an argument against consumer welfare.

Maximizing consumer welfare is the ultimate justification for an economy. Consumers are of course also workers and voters. Contrary to President Obama’s claim, skill at profit maximization does translate directly into skill at governing the economy. Failure to understand this simplest and most basic point is probably itself enough to disqualify someone from the presidency when economic issues are paramount.

Mr. Rubin is a professor of economics at Emory University and president elect of the Southern Economic Association.

Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

 

 

New York Times columnist Gretchen Morgenson is arguing for a “pre-clearance”  approach to regulating new financial products:

The Food and Drug Administration vets new drugs before they reach the market. But imagine if there were a Wall Street version of the F.D.A. — an agency that examined new financial instruments and ensured that they were safe and benefited society, not just bankers.  How different our economy might look today, given the damage done by complex instruments during the financial crisis.

The idea Morgenson is advocating was set forth by law professor Eric Posner (one of my former profs) and economist E. Glen Weyl in this paper.  According to Morgenson,

[Posner and Weyl] contend that new instruments should be approved by a “financial products agency” that would test them for social utility. Ideally, products deemed too costly to society over all — those that serve only to increase speculation, for example — would be rejected, the two professors say.

While I have not yet read the paper, I have some concerns about the proposal, at least as described by Morgenson.

First, there’s the knowledge problem.  Even if we assume that agents of a new “Financial Products Administration” (FPA) would be completely “other-regarding” (altruistic) in performing their duties, how are they to know whether a proposed financial instrument is, on balance, beneficial or detrimental to society?  Morgenson suggests that “financial instruments could be judged by whether they help people hedge risks — which is generally beneficial — or whether they simply allow gambling, which can be costly.”  But it’s certainly not the case that speculative (“gambling”) investments produce no social value.  They generate a tremendous amount of information because they reflect the expectations of hundreds, thousands, or millions of investors who are placing bets with their own money.  Even the much-maligned credit default swaps, instruments Morgenson and the paper authors suggest “have added little to society,” provide a great deal of information about the creditworthiness of insureds.  How is a regulator in the FPA to know whether the benefits a particular financial instrument creates justify its risks? 

When regulators have engaged in merits review of investment instruments — something the federal securities laws generally eschew — they’ve often screwed up.  State securities regulators in Massachusetts, for example, once banned sales of Apple’s IPO shares, claiming that the stock was priced too high.  Oops.

In addition to the knowledge problem, the proposed FPA would be subject to the same institutional maladies as its model, the FDA.  The fact is, individuals do not cease to be rational, self-interest maximizers when they step into the public arena.  Like their counterparts in the FDA, FPA officials will take into account the personal consequences of their decisions to grant or withhold approvals of new products.  They will know that if they approve a financial product that injures some investors, they’ll likely be blamed in the press, hauled before Congress, etc.  By contrast, if they withhold approval of a financial product that would be, on balance, socially beneficial, their improvident decision will attract little attention.  In short, they will share with their counterparts in the FDA a bias toward disapproval of novel products.

In highlighting these two concerns, I’m emphasizing a point I’ve made repeatedly on TOTM:  A defect in private ordering is not a sufficient condition for a regulatory fix.  One must always ask whether the proposed regulatory regime will actually leave the world a better place.  As the Austrians taught us, we can’t assume the regulators will have the information (and information-processing abilities) required to improve upon private ordering.  As Public Choice theorists taught us, we can’t assume that even perfectly informed (but still self-interested) regulators will make socially optimal decisions.  In light of Austrian and Public Choice insights, the Posner & Weyl proposal — at least as described by Morgenson — strikes me as problematic.  [An additional concern is that the proposed pre-clearance regime might just send financial activity offshore.  To their credit, the authors acknowledge and address that concern.]

That’s the title of an interesting article by Emmanuel Farhi and Jean Tirole in the current issue of the  American Economic Review. Here’s the abstract (emphasis added):

The article shows that time-consistent, imperfectly targeted support to distressed institutions makes private leverage choices strategic complements. When everyone engages in maturity mismatch, authorities have little choice but intervening, creating both current and deferred (sowing the seeds of the next crisis) social costs. In turn, it is profitable to adopt a risky balance sheet. These insights have important consequences, from banks choosing to correlate their risk exposures to the need for macro-prudential supervision.

The Federal Trade Commission conference announcement is below; note that public comments on the date of the conference.  This is an important space and should attract some excellent speakers.  The topics suggest a greater focus on consumer protection than competition issues.  Here is the announcement:

The Federal Trade Commission will host a workshop on April 26, 2012, to examine the use of mobile payments in the marketplace and how this emerging technology impacts consumers. This event will bring together consumer advocates, industry representatives, government regulators, technologists, and academics to examine a wide range of issues, including the technology and business models used in mobile payments, the consumer protection issues raised, and the experiences of other nations where mobile payments are more common. The workshop will be free and open to the public.

Topics may include:

  • What different technologies are used to make mobile payments and how are the technologies funded (e.g., credit card, debit card, phone bill, prepaid card, gift card, etc.)?
  • Which technologies are being used currently in the United States, and which are likely to be used in the future?
  • What are the risks of financial losses related to mobile payments as compared to other forms of payment? What recourse do consumers have if they receive fraudulent, unauthorized, and inaccurate charges? Do consumers understand these risks? Do consumers receive disclosures about these risks and any legal protections they might have?
  • When a consumer uses a mobile payment service, what information is collected, by whom, and for what purpose? Are these data collection practices disclosed to consumers? Is the data protected?
  • How have mobile payment technologies been implemented in other countries, and with what success? What, if any, consumer protection issues have they faced, and how have they dealt with them?
  • What steps should government and industry members take to protect consumers who use mobile payment services?

To aid in preparation for the workshop, FTC staff welcomes comments from the public, including original research, surveys and academic papers. Electronic comments can be made at https://ftcpublic.commentworks.com/ftc/mobilepayments. Paper comments should be mailed or delivered to: 600 Pennsylvania Avenue N.W., Room H-113 (Annex B), Washington, DC 20580.

The workshop is free and open to the public; it will be held at the FTC’s Satellite Building Conference Center, 601 New Jersey Avenue, N.W., Washington, D.C.

Jonathan Macey (Yale) defends private equity against nonsensical attacks from Newt Gingrich, Jon Huntsman and others (Rick Perry is spared by Macey, but not by Bainbridge) in today’s Wall Street Journal:

Mitt Romney’s candidacy is subjecting the entire private-equity industry—where Mr. Romney spent most of his business career—to vicious attacks by journalists and several of his rivals for the Republican presidential nomination.

Newt Gingrich’s political action committee is sponsoring a film called “When Mitt Romney Came to Town” that accuses Mr. Romney and his former company, Bain Capital, of taking over companies, looting them, and then tossing their workers out on the street. Jon Huntsman’s attacks on his rival include the description of private equity as a business that “breaks down businesses [and] destroys jobs, as opposed to creating jobs and opportunity, leveraging up, spinning off, [and] enriching shareholders.”

This is anticapitalist claptrap. Private-equity firms make significant investments in companies, mainly U.S. companies. Most of their investments are in companies that underperform industry peers. Frequently these firms are on the brink of failure.

Professor Macey ends with a sharp, and I think wholly appropriate, note:

Assaults on the private-equity industry really are attacks on economic freedom, because the private-equity process is nothing more and nothing less than free-market capitalism at work. Shame on all the people, particularly those who claim to be friendly to capitalism, who attack Mitt Romney because of his association with the U.S. private-equity industry.

There is, of course, another angle to evaluating the attacks against Romney’s private equity experience.  As Larry Ribstein was fond of pointing out, for example here and here:

I understand what the OWS crowd will make of this story.  But they need to persuade me why this story should make Romney look worse than the typical presidential candidate who has spent his life in politics and whose job history has consisted mainly of engineering wealth transfers from weak interest groups (e.g., taxpayers) to more powerful ones (e.g., big banks).

Larry’s critiques, unfortunately, should be mandatory reading not just for the “OWS crowd,” but for the Republican candidates — especially the few that claim to be market-oriented.

Via Professor Bainbridge, I read today about the nonsense surrounding Mitt Romney enjoying firing people.  I’m late to the this one, but here is the quote in context for anybody who missed it:

“I want individuals to have their own insurance,” he said. “That means the insurance company will have an incentive to keep you healthy. It also means if you don’t like what they do, you can fire them. I like being able to fire people who provide services to me.

“You know, if someone doesn’t give me a good service that I need, I want to say I’m going to go get someone else to provide that service to me.”

Bainbridge explains why, even if one was to take this quote and extend it to Romney’s days at Bain Capital, the ability to fire people who are are failing to provide a needed service is a feature of a well-functioning market for corporate control, not a bug:

In many cases, restoring a business to efficiency and profitability thus requires the kind of shakeup occasioned by a corporate takeover, such as the sort of LBOs in which Romney specialized, which brings in new managers who are willing to fire people.   LBO specialists who like to fire people thus played — and still play — a critical role in ensuring that US corporations are sufficiently lean to compete effectively in a pitiless global economy.

The economic point goes well beyond the market for corporate control.  The ability to impose sanctions on an economic partner is fundamental to modern contracting.  In nearly every treatment of the economics of contracting, one begins with the notion that the transacting parties potentially have at their disposal both reputational capital — that is, self-enforcement — and written enforcement as means for assuring contractual performance.  Klein & Leffler (1981) is the model that comes to mind.  The key insight is that parties do not have to rely upon imperfect court enforcement, but can create self-enforcement mechanisms were performance is assured not by litigation, but by threat of termination of the economic relationship.  The costs imposed on the non-performing party are not damages, but the loss of the expected premium stream from the economic relationship. In the economic literature, self-enforcement has been used not just to explain economic relationships in which court enforcement is entirely unavailable, but the complementary nature of written terms and reputational enforcement in a wide array of complex contractual arrangements including franchising arrangements, tying, resale price maintenance and exclusive dealing.  I discuss the distinction between standard economic approaches to contract that ignore these complementarities and the Klein (and also Oliver Williamson) approach to self-enforcement here.

The role of termination in facilitating well functioning economic relationships is critical in not just the market for corporate control,  but it all kinds of product and service markets.   It is hard to take these arguments against Romney seriously — even harder than the arguments disparaging his role at Bain.   In context, what Romney actually said is unremarkable.  How many of us don’t want to be able to terminate our economic relationship with the restaurant that feeds us low quality food or the service person who we find out shirked and provided shoddy quality work after the fact?  Our ability to do so constrains economic opportunism.  Perhaps the real objection is not that Romney talked about termination, but that he expressed a preference for terminating shirkers with whom he has economic relationships.   Not only does he fire people, but he likes it!  Perhaps the appropriate response then, from an economic perspective, is not to pillory him for it a la Huntsman, but to thank him for allowing us to free-ride on his efforts.

Roberta Romano has just posted her paper, Regulating in the Dark. Here’s the abstract:

Foundational financial legislation is typically adopted in the midst or aftermath of financial crises, when an informed understanding of the causes of the crisis is not yet available. Moreover, financial institutions operate in a dynamic environment of considerable uncertainty, such that legislation enacted even under the best of circumstances can have perverse unintended consequences, and regulatory requirements correct for an initial set of conditions can become inappropriate as economic and technological circumstances change. Furthermore, the stickiness of the status quo in the U.S. political system renders it difficult to revise legislation, even though there may be a consensus to do so. This essay contends that the best means of responding to this dismal state of affairs is to include, as a matter of course, in crisis-driven financial legislation and its implementing regulation two key procedural mechanisms: (1) a requirement of automatic subsequent review and reconsideration of the legislative and regulatory decisions at some future point in time; and (2) regulatory exemptive or waiver powers, that encourage, where feasible, small scale experimentation, as well as flexibility in implementation. Both procedural devices will better inform and calibrate the regulatory apparatus, and could thereby mitigate, at least on the margin, the unintended errors which will invariably accompany financial legislation and rulemaking originating in a crisis. Given the centrality of financial institutions and markets to economic growth and societal well-being, it is exceedingly important for legislators acting in a financial crisis with the best of intentions, to not make matters worse.

It’s worth noting that Henry Butler and I, in our book about SOX (at 96-97, footnotes omitted), also suggested “sunset” provisions as an antidote to crisis-driven regulation:

[S]ignificant new financial and governance regulation like SOX that displaces and supplements prior regulatory approaches should be subject to periodic review and sunset provisions. Although Congress, of course, can always undertake such reviews, prior experience indicates that it will not. Legislation is a one-way regulatory ratchet. It arises when the conditions for reform are ripe for a regulatory panic. The conditions for a “deregulatory panic” are less likely to develop. Firms learn to live with the extra costs and may not be willing or able to bear the costs of lobbying for repeal, at least in the absence of a regulatory cataclysm. Thus, it is not surprising that SOX sponsor Michael Oxley, despite recognizing that SOX was “excessive” in some respects, and admitting that it had been rushed through Congress, suggested that Congress would not be revisiting the issue, even as to the seriously affected small companies. He said, “If I had another crack at it I would have provided a bit more flexibility for small- and medium-sized companies.” In other words, Congress normally does not have “another crack” at regulation. A sunset or review mechanism would change that.

Perhaps Congress can learn some lessons from itself. The USA Patriot Act was passed less than one year before SOX and, like SOX, was passed by an overwhelming majority. Unlike SOX, the USA Patriot Act includes sunset provisions for some of its most controversial provisions. The Patriot Act’s sunset provision forced Congress and the president to reevaluate and debate those provisions, in an atmosphere far  removed from the immediate post-9/11 panic. American investors would benefit from a sober reevaluation of SOX. Perhaps the courts will provide that opportunity. For future regulatory panics, Congress would do well to remember the lessons of the Patriot Act.

One footnote in Romano’s article particularly grabbed my attention.  Referring to Jack Coffee’s criticism of sunset provisions in a non-yet-public manuscript (“The Political Economy of Dodd-Frank: Why Financial Reform Tends to be Frustrated and Systemic Risk Perpetuated”), Romano notes:

Coffee (2011:4, 6,9) sweepingly seeks to dismiss the scholarship with which he disagrees by engaging in serial name calling, referring to the authors, Steve Bainbridge, Larry Ribstein and me, as “the ‘Tea Party Caucus’ of corporate and securities law professors” (a claim that would have been humorous had it not been said earnestly), “conservative critics of securities regulation,” (a claim, at least in my case, that would be accurate if he had dropped the adjective), and further referring to Bainbridge and Ribstein, as “[my] loyal adherents.”

 She also observes in this footnote:  

[I]n the American political tradition and academic literature, advocacy of sunsetting has historically cut across political party lines. It has had a distinguished liberal pedigree, having been advocated by, among others, President Jimmy Carter, Senator Edward Kennedy, political scientist Theodore Lowi, and Common Cause (Breyer 1982; Kysar 2005).”

Like Butler and me, she cites the Patriot Act precedent.

Well, I’m proud to be included in Romano’s and Bainbridge’s “tea party” and surprised at being there because I advocated an idea also endorsed by Carter, Kennedy, Lowi and Common Cause.  It’s sad a scholar of Coffee’s stature sees a need to resort to such rhetoric, though almost understandable since Romano’s devastating critique doesn’t leave him much of a ledge to sit on.

 As for Romano’s article, definitely do read the whole thing.  Rather than simply condemning Dodd-Frank, she argues persuasively for a way to avoid future financial over-regulation.

Update:  Matt Bodie confuses blogs and scholarly articles, statutes and people. Bainbridge sets him straight, and Leiter agrees.  But do read Bodie’s post anyway because he links to some great Gretchen posts which even I had forgotten.

The NYT reports:

When he rejected a new European accord on Friday that would bind the continent ever closer, Prime Minister David Cameron seemingly sacrificed Britain’s place in Europe to preserve the pre-eminence of the City, London’s financial district. The question now is whether his stance will someday seem justified, even prescient.

Mr. Cameron refused to go along with the new European plan of stricter fiscal oversight and discipline hammered out in Brussels this week, in great part because of fears that the City would be strangled by regulations emanating from Brussels. * * *

But will it matter?  The article points out that:

  • Non-British banks in the UK will still be subject to EU regulation.
  • European activity might be redirected from the UK to Frankfurt.
  • Europe could prohibit its banks from dealing with UK firms that didn’t adhere to EU regulation.
  • But the UK could exit the EU, reducing the impact of EU regulation in the UK.
  • European banks would still have a powerful incentive to remain global by competing in the UK market. 
  • Even if excluded from Europe, UK banks would still compete powerfully for U.S. and Asian business.  The UK didn’t lose its edge when it stayed with the pound, and likely won’t if it opts out of EU regulation.

And of course there’s the question whether UK hedge funds and other financial institutions will be better global competitors without being saddled by more intrusive European regulation.

Cameron’s move is a reminder that the EU has a double edge:  it promotes competition within the EU, but erects a regulatory cartel for the EU against the rest of the world.  With or without the cartel, it’s still a global economy, governed by the powerful forces of jurisdictional competition.  Federal cartels can slow down that completion but not stop it.

It’s a lesson worth remembering for U.S. securities regulators.

Krugman on private equity

Larry Ribstein —  10 December 2011

Paul Krugman, writing in Thursday’s NYT, sees Romney as a real life version of Oliver Stone’s Gordon Gekko in the film Wall Street.  He characterizes Romney and his private equity ilk as job-destroyers, and argues that they should be taxed (and presumably also regulated) accordingly. He contrasts this with the supposed position of the GOP “to canonize the wealthy and exempt them from the sacrifices everyone else is expected to make because of the wonderful things they supposedly do for the rest of us.”

I earlier wrote on the NYT’s previous attempt to make political hay out of Romney’s business career.  The story focused a lot of unfavorable rhetoric on one of Bain’s deals.  I pointed out that, clearing away the rhetoric, although there was some short-term job and salary loss, the restructured company ultimately

became an industry leader, just as Bain Capital had intended. With its overseas acquisition, the company’s labor force swelled to 7,400 workers. The business invested in and refined products, like a test that rapidly detects whether a heart attack has occurred, that became widely used. From 1995 to 1998, Dade’s annual sales rose to $1.3 billion from $614 million. Its assets grew to $1.5 billion from $551 million. But another number was climbing just as fast — Dade’s long-term liabilities, which surged to $816 million from $298 million.

There was a bankruptcy after Romney was no longer associated with Bain, but

In 2007 it was sold to Siemens for $7 billion — 15.5 times the price paid in 1994 for an “ailing” orphaned division of a big corporation. The article concludes with the suggestion that the “painful” layoffs “ultimately worked.”

In short, the story’s details don’t support its slant. Romney’s “brand of capitalism” seems to have worked in this instance, even if its success was colored by events that occurred after he left Bain. Although I’m not suggesting that Romney should or would run the country the way he ran Bain and Dade, I’m also not troubled by his history as a deeply invested owner and manager of Bain. True, he and the other “elites” at his firm made a lot of money. But if every deal was like Dade, it’s not clear society as a whole, including the working class, came out worse.

Now along comes Krugman with his own take on Romney-the-job-destroyer. Krugman seeks to support his point by comparing Romney to a fictional character. 

Now, I’ve spent more than a little time deconstructing Hollywood’s anti-capitalist bent in general and Oliver Stone’s fanciful Gekko invention in particular.  One would think that a Nobel laureate could do a little better than to draw support for his criticism of an industry from a cartoonish portrayal of it, even if the laureate in question has traded academic journals for the editorial pages. 

In fact, Krugman does do a little better by citing a “recent analysis of “private equity transactions” as concluding that, while they both create and destroy jobs, “gross job destruction is substantially higher.” Based on this evidence Krugman concludes:

So Mr. Romney made his fortune in a business that is, on balance, about job destruction rather than job creation. And because job destruction hurts workers even as it increases profits and the incomes of top executives, leveraged buyout firms have contributed to the combination of stagnant wages and soaring incomes at the top that has characterized America since 1980. * * *

The truth is that what’s good for the 1 percent, or even better the 0.1 percent, isn’t necessarily good for the rest of America — and Mr. Romney’s career illustrates that point perfectly. There’s no need, and no reason, to hate Mr. Romney and others like him. We do, however, need to get such people paying more in taxes — and we shouldn’t let myths about “job creators” get in the way.

There are a number of holes in this “analysis.”  Let’s start with the evidence Krugman relies on.  Curiously, he omits one of the main findings of the paper.  In the paragraph immediately following the quote about gross job destruction the authors observe:

While noteworthy, these results make up only part of a richer and more interesting story about the employment effects of private equity. Using our ability to track each firm’s constituent establishments, we estimate how employment responds to private equity buyouts on several adjustment margins, including job creation at greenfield establishments opened post buyout. This aspect of our analysis reveals that target firms create new jobs in greenfield establishments at a faster pace than control firms. Accounting for greenfield job creation erases about one-third of the net employment growth differential in favor of controls. Accounting for the purchase and sale of establishments as well, the employment growth differential is less than 1 percent of initial employment over two years.

In other words, private equity doesn’t destroy jobs, but reallocates them from less productive uses to more productive uses in new, or “greenfield,” businesses.  This point is emphasized in the abstract of a much more recent version of the paper Krugman chose to ignore, released last summer (emphasis added):

Private equity critics claim that leveraged buyouts bring huge job losses. To investigate this claim, we construct and analyze a new dataset that covers U.S. private equity transactions from 1980 to 2005. We track 3,200 target firms and their 150,000 establishments before and after acquisition, comparing outcomes to controls similar in terms of industry, size, age, and prior growth. Relative to controls, employment at target establishments declines 3 percent over two years post buyout and 6 percent over five years. The job losses are concentrated among public-to-private buyouts, and transactions involving firms in the service and retail sectors. But target firms also create more new jobs at new establishments, and they acquire and divest establishments more rapidly. When we consider these additional adjustment margins, net relative job losses at target firms are less than 1 percent of initial employment. In contrast, the sum of gross job creation and destruction at target firms exceeds that of controls by 13 percent of employment over two years. In short, private equity buyouts catalyze the creative destruction process in the labor market, with only a modest net impact on employment. The creative destruction response mainly involves a more rapid reallocation of jobs across establishments within target firms.

Krugman’s analysis has other holes in addition to its evidence deficit.  First, it is fair to say that private equity’s objective isn’t to create jobs but to make money.  One hopes that the two will go hand in hand, but there are many reasons why they may not, including government policy.  In other words, there’s a problem when employing people costs firms money, but private equity is only the messenger. The point of my earlier blog post on this is that Romney’s experience restructuring firms gives him a lot better idea than many politicians, including the current president, of what government needs to do to fix the underlying problems.

Second, Krugman seeks to leverage his analysis of private equity into criticism of the 1%, concluding that “we do. . . need to get such people paying more in taxes.” Even if you are willing to conclude that private equity destroys jobs and shouldn’t get any breaks, this is far from killing the argument that business as a whole would thrive if less burdened. This could include some of the businesses that Bain profited by restructuring.

The bottom line is that one shouldn’t read Krugman without a grain, or perhaps a whole tub, of salt.