"Once abolish God and the government becomes the God." -G.K. Chesterton

Monday, April 26, 2010

When Reform is Worse Than the Status Quo

It goes without saying that people usually associate the word reform with positive connotations. But what happens in the real world is often different from what's in our heads or even our best intentions. Rather than improving a situation, the wrong reforms often exasperate the problem.

Take Sarbanes-Oxley and the mark-to-market accounting rules the collapse of Enron and WorldCom ushered in. Two corrupt companies run by greedy, manipulative CEOs once the darlings of Wall Street went from the penthouse to the outhouse in a matter of months. Did they cook the books? Yes. Was what they did illegal? Yes. Did investors lose millions? Yes. Did it cost the workers in these companies their pensions while the executives made out like bandits? Sadly, yes. But when the house of cards collapsed, it wasn't because the status quo encouraged this behavior. In fact, it was the exact opposite. 

Cheat the free market system, try to make up the data, and at some point you are going to pay for your hubris. Remember: Ken Lay called the Bush administration begging for a bailout. Wisely, Treasury Secretary Paul O'Neil said no. The end result was a tragedy, but it was nothing compared to the tragedy we would have had on our hands had the government intervened to save a corrupt, smoke-and-mirrors Enron at the taxpayers expense.

Enter Congress. While no bailout occurred, our elected officials tried to score cheap political points by attacking not the robber barons who flaunted the law and ran these companies into the ground, but instead the system itself. They came up with Sarbanes-Oxley as a response and many economists point to it as the beginning of the collapse of our financial sector.

We already know what a disaster the mark-to-market accounting rules were for the housing bust. A number of historians have pointed to FDR's elimination of these accounting rules as the beginning of the end of the Great Depression. And you'll note in our own current crisis the removal of these strict accounting procedures helped bring the banks and markets back. But PC Magazine sheds light on the unintended consequences of Sarbanes-Oxley in regards to IPOs:

What Sarbanes-Oxley has done is add an outrageous reporting burden, which costs an estimated 4 percent of revenue to implement. All American corporations are immediately put at a disadvantage to the tune of 4 percent off the top. And what’s the point of these new requirements? Simply to get accounting firms off the hook for cooked books or criminal activity. It has nothing to do with protecting the public, just protecting the accounting firms.
Venture capitalist Tim Draper once told me that a company has to make $300 million a year to be able to afford the overhead required to comply with Sarbanes-Oxley. Less than that and public corporations just bleed to death.
No matter what you think of Sarbanes-Oxley, one thing is very noticeable: Since the law’s inception, the number of little Silicon Valley start-ups that went public is close to nil. This is the worst IPO market in years, and it’s stifling the country. IPOs have been a traditional form of wealth creation and corporate protection unlike anything else. And you’ve seen what has happened without them. It’s no coincidence that the economy is tanking. Sure, you can blame the housing bubble. But I blame the whole financial collapse on Sarbanes-Oxley and a moribund Silicon Valley.

The financial overhaul legislation Obama and Dodd are pushing is sure to bring these same kind of unintended consequences. In essence, what they are proposing are more loopholes for special interests and less options for smaller companies who play by the rules. What you end up with is a two tier system: preferential treatment for the government's buddies, donors, and those deemed "too big to fail" and standard bankruptcy procedures (which work quite well) for everyone else. This, of course, means the big boys of industry can take unnecessary risks without precautions and expect a permanent bailout at taxpayer expense. But what often goes unmentioned is successful companies suddenly find tax dollars from their earnings going to prop up their failing competitors. So unless you're spending a fortune on lawyers in Washington, you're screwed. Or as I like to say, if you voted for Obama, you've been "hopewinked."

This isn't reform. It's the deformation of capitalism and the slow transformation of our economy into crony capitalism. It's forcing businesses to get in bed with government and spend more time and money lobbying to earn the good grace of the government gods. In other words, the Obama Way.

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