The latest jobs report shows that the real economy is strong and growing impressively. But there are continuing weaknesses in the financial sector that are worrisome and could drag the real economy down unless addressed.
One area of concern is the stock market. Since the beginning of last year, the Dow Jones Industrial Average has basically been flat. It moves up and down within a narrow range and has never been able to sustain an upward trend. Shockingly, the Dow is no higher today than it was six years ago and is still below its 2000 peak.
Given the state of the economy and relatively robust corporate profits, one would expect the stock market to be higher. One reason it may not be is that traders are implicitly discounting corporate profits to account for some risk factor. It would be the flip side of the argument that was often made during the 1990s stock market boom that there had been a decline in risk that justified higher price-earnings ratios than existed historically.
I believe that one factor holding back the market may be the Sarbanes-Oxley legislation, enacted in 2002 as a knee-jerk reaction to the corporate scandals of Enron, WorldCom and others. Reports suggest that the cost of this legislation is extremely high just in terms of out-of-pocket expenses. But the intangible costs could be far, far higher.
In the May issue of the Yale Law Journal, professor Roberta Romano of Yale Law School excoriates Congress for enacting legislation consisting of little more than a bunch of rehashed proposals that had been kicking around for years, with little, if any, connection to the actual causes of the corporate scandals. She calls it "quack corporate governance."
Estimates of the cost of the legislation in terms of higher audit fees and lost productivity have risen every year, as companies learn more about its provisions. It is now commonly estimated to be about $15 billion per year, or about $1 million per $1 billion of sales. This estimate is pretty consistent among the organizations that have looked at Sarbanes-Oxley carefully, including Financial Executives International, a trade group; Foley and Lardner, a Chicago law firm; and A.R.C. Morgan, a Dutch consulting company.
However, some companies have reported much higher costs. AIG, the big insurance company, has said that it is spending $300 million per year on Sarbanes-Oxley compliance.
Two University of Illinois accounting professors estimated last year that companies had spent 120 million hours complying with Sarbanes-Oxley and that outside auditors had spent another 12 million hours, for a total of 132 million hours. This is equivalent to 66,000 people working for one year on nothing else.
But these direct costs pale in comparison to intangible costs. Corporate executives report an enormous amount of distraction from their core businesses as the result of Sarbanes-Oxley, and they have become much more conservative in their investment strategies. Sun Microsystems CEO Scott McNealy likened the legislation to throwing "buckets of sand into the gears of the market economy."
A number of companies report that they are having great difficulty in attracting qualified corporate directors due to Sarbanes-Oxley, and many are considering going private in order to get out from under its requirements. There are also reports of private companies that were considering going public having changed their minds, and foreign companies that have delisted from U.S. stock exchanges because of the legislation.
The latest study looks at how the stock market reacted to passage of Sarbanes-Oxley. University of Rochester economist Ivy Zhang found that passage of the bill wiped out $1 trillion of market capitalization. Zhang found no economic benefits to the legislation whatsoever, a view echoed by other analysts, such as UCLA securities law professor Stephen Bainbridge.
Another intangible cost is the undermining of federalism. Corporate governance historically has always been the province of state law. Now it has largely been taken over by the federal government, despite the oft-stated desire of President Bush and Republicans in Congress to respect federalism.
Romano concludes that Sarbanes-Oxley was "seriously misconceived" and has done nothing to improve business performance or investor value. Even if it had been in place long ago, it would have done nothing to prevent the particular misdeeds that brought down Enron. She urges that the legislation be rescinded and that Congress resist enacting such legislation in the aftermath of scandals, because it leads to such poor public policymaking.
Columnist Robert Novak reports that Bush administration officials are well aware of the negative effects of Sarbanes-Oxley on the economy and the stock market, but they will not do anything about it — a view recently reiterated by Rep. Michael Oxley, Republican of Ohio and co-author of the legislation. They would rather see businesses and investors continue to suffer than admit the possibility of error.