Book Review: Norbert Michel & Jennifer Schulp’s ‘Financing Opportunity’
America is the wealthiest nation on earth, with financial markets that are the envy of the world. Those markets have contributed to America’s rise for the past 250 years. Yet, many single-minded critics continue to paint these markets negatively. Pop culture, for instance, from 1987’s Wall Street to 2013’s The Wolf of Wall Street, often portrays those who work in finance as an incorrigible group of elite fraudsters.
Norbert J. Michel and Jennifer Schulp, finance experts at the Cato Institute, demonstrate that such cynical views of America’s financial markets are frequently unfounded. Unfortunately, government regulators have seized on this distorted image as justification for meddling in the markets. They often decide which assets are too speculative or risky and justify curbing investor freedom in the name of promoting financial stability.
In Financing Opportunity, the authors set out a better approach. They show that markets tend to be stronger with fewer constraints that trap and direct capital. In their estimation, to keep leading at the world stage, America “must shift away from a regulatory system that requires federal officials to make decisions for people, and toward one that protects them from fraudulent behavior” (pg. 4).
Financial markets and America’s founding
America’s banking and securities sectors fueled the nation’s economic growth. The first national bank was chartered in 1792, just four years after the US Constitution was ratified. This quickly led to the creation of 15 state-chartered banks in 1801 that were viewed by historians like Benjamin Klebnar as the most important commercial corporations of the eighteenth century.
By 1840, America had 834 commercial banks, holding $4.26 million in capital, scattered across our (then) 26 states. A unique aspect of America’s banking sector was the competitive enterprise structure that new banks enjoyed, including limited liability for bank managers. It took the rest of the world 70 years to catch up to this innovative framework.
With America’s securities industry, much of the same structured finance procedures perfected in the 1980s US stock market were first conceptually realized here in the 1780s. This is to say that, since their inception, both America’s banking and securities sectors have competed with rival nations using the same foundational tools. And, just as the first national bank was chartered in 1792, so too did the first national stock exchange—New York Stock Exchange—emerge.
As today, investors of old traded futures, options, and short-sale contracts. Stock exchanges grew in major urban areas like Boston, Baltimore, and Philadelphia to eventually rival England’s much older equity market by 1825 (the US’s $171 million compared to the UK’s $183 million valuation).
This growth marked America’s rapid ascent as an economic powerhouse. It also facilitated lucrative overseas investment between the US and UK, providing a robust foreign exchange market. Based on trends in empirical research, there appears to be a strong positive relationship between a robust financial sector and overall economic growth. The authors remind readers that one of the reasons financial markets are often blamed for economic downturn is that, in some markets, financial risks are consolidated in a single institution. Thus, a nation with a growing and diversified finance sector is better absorb economic shocks and set the stage for even greater growth going forward..
They also debunk two popular myths about the financial markets. One is that the 2008 crisis was caused by the legal integration of the investment and banking sectors. The second is that stock market deregulation led to excessive speculation. The evidence on both counts says otherwise.
Regarding the first myth, Schulp and Michel show that the remerging of investment banking did not spark the 2008 crisis. The US investment banking industry had existed cohesively for more than 100 years prior to the 2008 recession. While the Glass-Steagall Act of 1933 legally separated both sectors for much of the 20th century, the Gramm-Leach Act of 1999 repealed key elements of the law, enabling re-integration.
There is no concrete evidence that such re-integration of investment and banking services spurred the 2008 crisis. Similarly, regarding the second myth, major deregulation of the markets did not lead to excessive speculation. To the contrary, the authors provide ample evidence showing that there was a compounding of federal regulation (not deregulation) of securities and banking transactions in the decade leading up to the 2008 crisis.
Financial firms have also helped to democratize the markets over time. Many companies provide ease of access to 401(k) or 403(b) retirement savings accounts, while exchange-traded funds (ETFs) offer low-risk access to capital markets to those without high levels of wealth. There has been an increasing interest in companies offering employee stock ownership plans (ESOPs). ESOPs enable employees to build an equity stake in the firm they work for.
Financial markets also provide liquidity by connecting buyers and sellers on a frequent basis, ensuring that certain assets can be sold with little to no loss in value. America’s equity market is by far the largest and most liquid in the world, currently at $40.3 trillion (3.5 times the size of China’s market). The US also holds 40 percent of global fixed income (bond)assets at $51.9 trillion.
Modern financial markets maintain a healthy balance of both public and private securities offerings. In the public markets, mutual funds offer diversified investment opportunities for retail investors, while ETFs provide indexed funds with generally lower fees. By contrast, private hedge funds enable portfolio managers to “hedge” against certain market risks by insulating returns from potential volatility in ways that regulators prohibit with mutual funds. The benefit to having a comparatively less regulated private market vs. public market is that flexible investors can pursue trade-offs across both market spheres. Where private fund investors are exposed to greater risks than public equities, they enjoy the prospect of higher returns and portfolio diversification.
DC doesn’t understand finance
The authors address the popular misunderstanding of corporate stock repurchasing, aka buybacks. Critics charge that companies buy their own shares to such an extent that they underinvest in economic production or job creation. The empirical evidence suggests otherwise.
Investment in research and development has steadily risen alongside trends in stock repurchasing, showing that we live in a financial world of both/and, not either/or. Sadly, Congress has not understood the evidence here. This is evidenced by the Inflation Reduction Act’s added tax on stock buybacks. It can be hard to appreciate how sprawling the bureaucracy governing financial institutions in America truly is, but the authors lay it out clearly for readers. In the banking sector, for instance, there are at least eight federal regulators that examine, supervise, and enforce laws on the banks.
When it comes to securities regulation, the bulk of trading activities conducted across exchanges are regulated at the federal level by the SEC, which uses its statutory disclosure authority to compel material information from public companies about their offerings.
Such disclosure can be used to iron out information asymmetries to foster greater transparency between the issuer of securities and investors. However, certain disclosures have gone farther by seeking invasive, politically controversial information that risk undermining the reputation of the disclosing firm.
The most glaring example of this is the SEC’s final climate disclosure rule, which is currently facing pushback in the Eighth Circuit Court of Appeals by 25 states and multiple industry groups. If implemented, the rule would compel companies to disclose potential climate-related financial risks, data on greenhouse gas emissions, projected financial harm from weather-related disasters, and even information concerning how corporate boards assess climate change risks. According to the authors, this sort of expansive disclosure apparatus “may be one factor in the decline in the number of public companies since the 1990s” (pg. 99).
Despite the proliferation financial regulation in America, critics almost never cast blame on overregulation or poorly crafted regulation as a culprit, but perhaps they should. The US financial markets are the most sophisticated and heavily regulated among developed countries. And yet America has recently suffered the greatest number of bank failures, namely, 14 between 1837 and 2009.
Michel and Schulp provide a timeline of several pieces of regulation that likely contributed to these failures of American finance, including the Sarbanes Oxley law.
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