Regulatory Sneak Attacks and Stock Prices

0:00My topic is regulatory sneak attacks and stock prices, and I'd like to start off by mentioning a very interesting article, one of my favorite articles in the financial literature that we academics read. It was by Michael Jensen, this was 1978, Michael Jensen, who is now at the Harvard Business School and William Meckling, who at the time was the Dean of the Business School at the University of Rochester, and it was published in the Financial Analyst Journal, and they They offered an extraordinarily gloomy prediction for the future of capitalism back then, 1978, and what they said was, quote, the most spectacular period of economic growth in our history is over because government is destroying two vital instruments of that growth, the system of contract rights and a large corporation, end quote.

0:49And they go on to say how constitutional and electoral constraints on political plunder have effectively proven to be ineffective, they're no longer holding in the United States and in most other constitutional republics and with regard to the stock market they made a comment that sounds very similar to what the Austrian economists call the calculation problem, the problem of economic calculation and they don't use the word economic calculation but this is the gist of their article what they said with regard to the fact that regulation has really wrested control to a very large degree of business decisions from business decision makers There's two politicians, essentially, and they said, as a result, quote, investors have become much less certain that any contract they enter into now will be subject to the same rules and regulations in the future.

1:42An early consequence of the erosion of property rights will be a reduction in the capitalized values of corporate securities, with many corporations able to remain in business only so long as they can finance their operations from internally generated cash, flow or government subsidy, end quote. Pretty gloomy, pretty gloomy prediction. And that was 1978, and they certainly had a good point if you look at how the government has wrested control over decision-making from corporate decision-makers, socialism, if you will, government control over the means of production. Just to mention, you know, in the U.S., the Securities Exchange Commission has thousands of regulations, the FTC claims authority to regulate just about every business practice.

2:27If you're practicing labor law, I recently ran across a statistic that it cost the average law firm in the US between $60,000 and $80,000 a year just to keep updated on all the new regulations that are passed regarding labor relations. Not to mention the stock of information you have to keep. The Justice Department must be consulted on all mergers. OSHA, the Occupational Safety and Health Administration, has over 4,000 regulations that include even the permissible shape of toilet seats and the height of ladders. Of course, the EPA is the biggest government bureaucracy in the world. Food and Drug Administration regulates food. The biggest scam, I think, the biggest regulatory scam, which I'm going to talk about in a little bit in the United States, is something called the Community Reinvestment Act, and a lot of other countries have this too.

3:16And the way it works in the U.S. is any bank that wants to merge, expand, build a new branch has to satisfy the Fed, the Comptroller of the Currency, or the FDIC, Federal Deposit Insurance Corporation, that it has been making enough bad loans in the community in which it exists. That is, the government forces them to make loans to uncreditworthy borrowers, and they call it community lending. And if you haven't made enough bad loans, your merger proposal or whatever can be stopped. And so the government has funded hundreds, literally hundreds of so-called community groups that issue these protests to the Fed. And what they do is they'll say, we're going to have a written protest against this merger or this expansion, and unless you give us, us, millions of dollars, not the poor people or the people who need mortgages, but us, the community group, we won't withdraw the protest.

4:14And so of course the banks do, they give them the money. And there's a group in Boston I'll talk about later that has an 80 million dollar a year budget and the whole budget is funded through this extortion racket, legal extortion racket. And now all of this existed in 1978 when Jensen and Minkling made these gloomy predictions. But the degree of regulation of markets has vastly expanded since then, of course, in 1980 the budgets in the U.S. for federal regulatory agencies totaled about $6.2 billion but had grown threefold to over $18 billion by 1999, not just the budgets. And this is about a 60% increase even in constant dollars. There are about 10,000 more federal regulators today than there were in 1980.

5:04And this is a chart that shows the spending on federal regulatory activity from 1960 to current day and the top line, the black part is economic regulation and the sort of shaded part is social regulation in the U.S. And I just want to make the point that it has grown unimpeded, regardless of the so-called Reagan Revolution or the Republican Revolution of 1994 that they talk about in the US, some revolution. And now, as far as Jensen and Meckling's gloomy protest, well you know the Dow Jones average is about 15 times higher now than it was when they made their predictions.

5:49I don't think so. I think it's still true that the effect of increased governmental control over capital allocation, essentially, and labor allocation, that resource allocation, by the state, certainly reduces the value of capital assets because the decisions are more and more made according to political criteria rather than economic criteria and the market might well be in much better shape than it is. The main thing I think though is that regulation makes markets extremely volatile, much more volatile than they would otherwise have been, but makes it difficult, if not impossible, for investors to understand what's happening, why the stocks are so volatile.

6:36This new regulation is certainly not the only reason for volatility in markets, but it adds a great degree of volatility and it makes economic calculation by investors that more difficult, if not impossible. Now, I have a section, I've written up my remarks here, I have a section here called Political Entrepreneurship and to understand how the regulatory process works and how it affects stock prices, I think you have to understand that even though regulators are blamed all the time, they're always blamed for the problems that the regulations sometimes causes, it's ultimately the elected politicians who are responsible. The U.S. Labor Department may enforce the minimum wage, but it's Congress that passed the law. We have a bureaucracy in the U.S. that enforces the Americans with Disabilities Act, which has forced American companies to hire, I guess there was a 500 pound bus mechanic that New York City was forced to hire,

7:57and Federal Politics whereby politicians and their accomplices in the bureaucracy dish out benefits to special interest groups at the expense of primarily the owners of corporations and shareholders and consumers and the reason why this is so easy and always has been so easy is that corporations are particularly susceptible to attacks by politicians pandering to these special interest groups because corporate ownership is relatively invisible especially when you consider institutional ownership I can't pinpoint exactly who's being harmed very easily by these things. It's widely dispersed among millions of people and the shareholders are politically incohesive. They're not very well organized politically as a rule.

8:42There are some exceptions. And the stock market is so volatile and complex anyway that the owners of corporations, shareholders, find it difficult, if not impossible, to identify declines in their share values to specific governmental acts. They just might have a vague idea that this is not good for business, but they can't really, it's very difficult to pinpoint. And so you don't know who to blame. If you don't know that your stock has gone down because of a government action X, it's hard to hold anybody responsible for government action X. And so we don't. Politicians are not merely passive bystanders who go on listening tours of their constituencies and then faithfully enact the kinds of laws that their constituencies want. They're entrepreneurs. They fish around for ways to enhance their power and their prestige, and they use regulation to do this.

9:31And this, of course, makes the stock market much more volatile. This is why politicians are inclined to label, they're always trying to create a crisis of one kind or another. And if there's not a real crisis, like a war, politicians typically try to create the perception of a crisis. And I'd refer you to another one of my books entitled, Official Lies, How Washington Misleads Us. And it's all about the idea of creating the perception of crises that don't really exist because that's what allows politicians to gain more power over economic decision making. The agricultural sector, for example, for at least 60 years in the U.S., government policy has simultaneously increased and decreased supply. Increases supply through price support programs and subsidies to research, for example, decreases supply through acreage allotments.

10:19and naturally that creates volatility in agricultural markets but it's always the markets that are blamed, it's not so much the agricultural policy. Now the fundamental effect of this regulatory propaganda machine, the constant repetition that there's a crisis in markets and the government needs to take more control, is to convince more and more investors, in my view, that the rights of corporate managers to use the assets of corporations in the best interest of the stockholders and creditors is tenuous if not abrogated completely. The politicization of corporate decision-making via regulation, I think, causes an overall decline in capital values as corporate decisions are made more and more to please the whims of bureaucrats and politicians and less and less on genuine economic criteria.

11:11Now, the next step I have in my write-up here is a section called political blackmail on the stock market. And government regulation is often a crude version of blackmail. The Environmental Protection Agency in the US, for example, issues regulations that are so complex and require such great paperwork burdens on companies that no human could possibly comply with them. with them. For example, with regard to hazardous wastes, businesses are required to keep a written documentation of the location of every hazardous waste on the premises at every moment and the EPA defines even Windex as a hazardous waste and so according to this regulation any corporation that does not have written on paper exactly where every bottle of Windex is, let alone everything else on the premises, can be subject to massive fines.

12:09And so the EPA regulators will storm into a business, a place of business and demand this paperwork. And if it's not there, there are very, very big fines. And the former New York State Environmental Protection Commissioner named Thomas Jorling described this as, quote, a kind of extortion, end quote. I would leave out the a kind of out of that sentence. And it is extortion. And Fred McChesney, who's a law professor at Cornell University, published a book by Harvard University Press called Money for Nothing a few years ago. And I find the fact that they published this book a miracle, Harvard University Press, because it's a scholarly treatment, a scholarly expose of how government regulation and much of taxation is essentially a political extortion scheme.

12:58It's not the kind of thing you expect to hear coming from Harvard University Press, but and the idea is that political entrepreneurs threaten harmful regulation sometimes to corporations and then sit back and collect campaign contributions and personal bribes in the form of speaking honoraria or jobs for relatives from the corporations or being treated to fabulous resorts all around the world and that sort of thing, indirect bribes When the campaign contributions and the bribes come in, they withdraw the harmful regulation. They get the bureaucracy to withdraw it, or the legislation, and they just don't pass the law.

13:43And it works the other way, too. They make promises of regulations or legislation that can benefit company X or industry X, but only if the campaign contributions come in. And, for example, politicians call this legislation, they call them milker bills or cash cows. One California politician explained it this way, A politician in need of campaign contributions has a bill introduced which excites some constituency to urge the legislator to work hard for its defeat, which is easily achieved, of course, pouring funds into his campaign coffers." Other names politicians give to this are juicer bills. These are American congressmen I'm referring to. Canada is a much more highly socialistic country than the U.S., so I assume it's even worse here than what I'm most familiar with.

14:38Juicer bills are called juicer bills because they're designed to squeeze cash out of corporations in return for not harming the corporation with regulation. They also use the language of fetcher bills, as in go fetch it. They're also said to be capable of fetching gobs of Now, the politician in the United States that has the one name, I think is my favorite name for a politician, is Representative Jim Leach. I got a perfect name for a politician, Jim Leach. And here's a newspaper article I dug up describing Leach. It said, Representative Jim Leach quietly introduced a bill a few days ago aimed at reducing speculation in financial futures. Barely 24 hours later, the Iowa Republican learned that Chicago commodity traders were gunning to kill his proposal. Rep. Leach said, one Illinois lawmaker told him the bill was shaping up as a classic fetcher bill. Sure enough, one of the first to defend the traders was Rep. Curtis Collins of Illinois, a recipient of $24,500 from Futures Industry Political Action Committees.

15:39So that's how it works. It's political entrepreneurship, if you will, and the consequence is more and more volatility in stock prices as this information is made public about these proposed regulations and legislation, and of course traders act on it in the stock markets. Many, many examples. I'll offer a few examples of my favorite of political blackmail as I call it. Last year in the U.S. there was a battle over reducing the illegal blood alcohol content level from .10 to .08. The federal government has announced its ultimate goal is .04, which is probably one beer for a guy my size to be legally drunk. That would create a statistical epidemic of drunk driving because it would not create more hazardous driving, Well, what Congress ultimately did was to say, we're not going to reduce the level from 0.10 to 0.08, but here's what we'll do. We're going to set up a slush fund of $500 million and we're going to use this to bribe individual states to reduce the level to 0.08. But the law runs out in 12 months. So every 12 months, you start all over again lobbying against reducing the blood alcohol content rate to 0.08 to 0.08.

16:54and so the alcoholic beverage industry knows that forever they're going to be lobbying and pouring campaign cash into Washington to defeat this sort of thing. So they didn't make it for two years or five years, one year, and every year they'll pass a new bill like this. One of the most notorious examples of political blackmail was the Clinton administration's proposals to impose price controls on doctors, hospitals and the pharmaceutical industry During its campaign to impose a sort of a Soviet style health care system on the United States a few years ago. Actually I had an article published in the Wall Street Journal that explained it as much more like Mussolini's Italy than the Soviet Union back in 1994. The New York Times said this about this after they proposed price controls in the medical industry.

17:45The Congress and the President were, quote, receiving vast campaign contributions from the medical industry, an amount apparently unprecedented for a non-election year. While it remains clear who would benefit and who would suffer under whatever health plan is ultimately adopted, it is apparent that the early winners are members of Congress, end quote. Congressman Jim Cooper offered a slightly, slightly less socialistic version of this health care reform than the Clinton plan, and the Clinton Plan and in return he received almost a million dollars in campaign contributions in four months of 1994 because the medical industry thought it was better than the Clinton Plan and the campaign contributions of that whole year were about a third higher than the previous non-election year of 1991 and another thing that happened during this time is that Hillary Clinton's not so blind trust was selling short pharmaceutical stocks every time she would make a speech blasting the pharmaceutical industry This was widely reported in American media all over the place and there's a book called In Defense of the Corporation by Robert Hessen that was published in 1979 and he dug deep into Ralph Nader's organizations and behavior and he found the same kind of thing.

18:58He found that Nader himself was selling short stocks of companies that one of his groups would come out with a big expose on claiming they're poisoning the public or something like that and they would short the stock of that company. Company. And so this, I guess maybe Hillary learned it from Nader. I'm not sure where her learned it from, but that was widely reported as she was doing that. During this whole fiasco, it was reported that the value of pharmaceutical stocks dropped by over $40 billion in aggregate wealth during this whole time. But of course, after the pharmaceutical industry poured millions of dollars into Washington, the plan was dropped. And most recently, I think this is a major I get the Washington Post at home. I work in Baltimore, Maryland. I live halfway between Baltimore and Washington. And for a long time there, the Post had all these sneering articles written by these Washington insiders who write for the Washington Post about how naive and

19:59stupid Bill Gates is to think that he could just go into business and make computer products and not pay a price in Washington, that is, not pay the highwaymen their share, and it was just sneer after sneer about how naive and stupid the guy was, and of course he's been educated over that, and now that they've brought these lawsuits and investigations against him, he too is pouring millions of dollars hiring former congressmen and lobbyists and making all the campaign contributions to try to salvage his company, and of course Most of tobacco industry settlement as they call it in the United States is a classic extortion scheme. It really reminds me, if you remember the movie Godfather 1 at the very beginning before Vito Corleone takes over, he assassinates the existing Mafia Don and the Mafia Don was just going door to door in Brooklyn, New York getting protection money from all the businesses with of course the threat of breaking their kneecaps by one of his thugs if they didn't

21:02Well, I'm not accusing the United States government of breaking anyone's kneecaps. They blow people up and use other means for that and burn their houses down and things like that, churches down and things like that. But what they do do in the case of tobacco is to say, we will let you exist, but only if you give us a quarter of a billion dollars over the next 25 years, then you can exist. So I think that's essentially the same thing, to me it is. Now regulation can have a calamitous effect on markets. It's not just the minor effects on individual stocks that we're talking about. It was mentioned earlier by one of the speakers that Murray Rothbard was probably the only person who really predicted the 1987 stock market crash.

21:53And he, of course, noticed the vast expansion in money supply that had been taking place throughout the 80s up until then, which generates malinvestments, and it suckers a lot of people into making investments that are not really economically sound, they're based on artificially low interest rates and so forth. And he was writing that this was about to lead to a crash of some sort, but, of course, no one can predict exactly when the crash is going to happen. It happened to be on October 19th, and there was a very interesting article that was published in the Journal of Financial Economics by two economists named Mark Mitchell and Jeffrey Netter that I think provides a pretty reasonable explanation as to why October 19th was the day. They don't really deal with the Austrian business cycle part of it, and my point is that Murray Rothbard was right that this was inevitable, but I don't think he really explained why it happened on the day that it happened, October 19th.

22:48I think Mitchell and Netter do, and it has to do with regulation being sort of a trigger, that this was building up and what was going on in the arena of regulation in Washington was the trigger that made it happen, collapse, at that day. And if you recall, there was a, the Dow Jones Industrial Average fell 508 points, or about 23% on one day, October 19th. And essentially what was happening was Congress was working to crack down on corporate takeovers. Corporate takeovers are a very beneficial part of the capitalist system. It's an important means by which capital is allocated to people who value it more highly and who can make better use of it. We're not omniscient, so takeovers don't always work out. But a lot of companies that acquire companies and then find they can't manage them are in turn taken over by somebody who will manage them better, so that the corporate takeover market is a very important part of capitalism, one of the keystones of capitalism, I would argue.

23:48Ludwig von Mises said that the one distinguishing feature of a capitalist economy that distinguishes it from a socialist economy is free capital markets, because that's how capital gets reallocated in a free market. Anyway, in October of 1987, Congress was doing this, they were eliminating deductions for interest expenses exceeding $5 million per year on debt incurred to acquire a majority of another firm's stock, they were eliminating the ability of an acquiring firm to use mirror subsidiaries to dispose of assets of the target firm without recognition of the corporate level gain for tax purposes, prohibiting interest deductions on any debt used to finance a hostile takeover attempt, imposing a 50% non-deductible excise tax on profits from so-called green mail payments. They were going to put an end to corporate takeovers.

24:36They clearly wanted to with all this proposed legislation. And Mitchell and Netter calculated that these tax law provisions would have reduced the value of acquiring a company to a takeover by about 25%. And what they conclude is this, the stock market crash on October 19th began the preceding three trading days when the market fell by more than 10%, the largest three-day decline since 1940. We provide evidence that the takeover bill, tax bill introduced on the evening of October 13th by Democrats on the House Ways and Means Committee had a major impact on these prices, stock prices. We find a negative reaction by the stock market to the news that the bill was progressing and a positive reaction by the market to the news that Congress was backing off from the proposal. Proposal. So they make a compelling case, I think, that that was the trigger mechanism, the attack on corporate takeovers, regulation of corporate takeovers, once again, that caused this decline.

25:29There's a new paper coming out in the Journal of Financial Economics by George Bittlingmeier and Tom Hazlett that takes a look at Microsoft, and they do a similar kind of analysis. And the assumption by Janet Reno and the enemies of Microsoft is generally that whatever is Microsoft is good for the computer industry because Microsoft is allegedly excluding other elements of the computer industry from competition. Well, they did a similar thing. They got all the Wall Street Journal news reports from 1991 to 1997 regarding the government investigation and lawsuit of Microsoft. And here's what they found. When Microsoft receives good news, its stockholders experience average market adjusted returns of 2.4 percent. 4%. But the news is also good for the industry as a whole, which sees average returns of 1.2% over the same dates. So when there's news that Janet Reno is losing her lawsuit, the entire computer industry, stocks go up. Investors are optimistic over that. And that would seem to disprove her take on this. And this should be no surprise that antitrust

26:36Prosecutions are bad for the stock market in general. After the attack on the Standard Oil in the early 20th century, the Standard and Poor Stock Index fell by 38%. When Teddy Roosevelt launched 44 antitrust cases, the stock market did not return to its 1908 level until 1924, so there's a long precedent of this sort of cataclysmic effect on stock prices through this. I'll wrap up now by the conclusion of my paper. I have a sort of subtitle, The Tobaccoization of Industry? And I think the so-called tobacco settlement in the United States has some ominous implications for the future of government regulation and how it's likely to affect stock prices and the modus operandi of the anti-smoking movement in the U.S. is already being used in other industries. The model is for a government The government funded attack on various industries and the demonization of the management of those industries.

27:36Most of the anti-smoking activists who have carried forward this campaign against the tobacco industry have been funded by the government. I wrote two books on this, one's called Cancer Scam, and the Food and Drink Police touches on it to some degree, and another one called Unhealthy Charities. So this was not just a spontaneous grassroots protest, this was a government funded junket here, and they also funded lots and lots of junk science, such as one article that was very influential claiming that if restaurants ban smoking their profits will go up. Apparently entrepreneurs were too dumb for hundreds of years to realize that if they banned smoking they could all get rich. All Get Rich, but the one article was published by a government-funded researcher with a $100,000 public relations budget to publicize the results of this junk science, and it became very influential in helping to get smoking bans in place all over the United States.

28:34So the industry's management is demonized, portrayed as corporate outlaws, and the notion of individual responsibility is thrown out the window. We're not responsible for our own smoking, for drinking, for reckless driving, use of firearms, you name it. Somebody else is responsible, that is, the manufacturers of cigarettes and a beer and firearms and so forth. And Florida, Vermont and Maryland actually rewrote laws. In my state of Maryland, the state was suing the tobacco companies. They rewrote a law. They're the litigant. They rewrote a law saying that the tobacco companies cannot enter into argument in court The notion that smokers may have known that smoking is bad for them. They were not permitted to even make that argument. And so naturally, they would win their own case.

29:22I talk about a Soviet-style kangaroo court. Three states did that, Florida, Vermont and Maryland. That's why the tobacco companies capitulated, because this is what the tactic is being used. Well, the bad news is that there's no reason to believe politicians will not do the same to other industries. Tort lawyers are now touting plans to do this, use this program, this process in assaults against lead paint, pharmaceuticals, beer, wine and liquor, chemical additives, fatty foods, sport utility vehicles and many other products, and of course firearms is the one they've chosen next. These industries will be demonized, more and more severe regulatory restrictions and excise taxes will be imposed on them, their stocks will tumble, and no industry is safe from the greedy hand of regulatory extortion, in my view.

30:11I think my time is up. Thank you.