Regulation Is Good for America

Over the last 80 years, we've been led to believe that governmental regulation of the economy is bad for society. Politicians say it's a slippery slope to socialism. Economists argue that it impedes the efficient allocation of resources. And the financial elite claim that it stymies their incentive to excel.

These feelings manifested themselves recently in the Jumpstart Our Business Startups Act, or JOBS Act, which President Obama signed into law at the beginning of this month. In short, this piece of legislation effects a sweeping overhaul of the initial public offering process and exempts wide swaths of securities from the watchful eyes of the Securities and Exchange Commission.

But what if I were to tell you that this entire thesis is flawed? That governmental oversight of the economy isn't bad for the vast majority of investors? And that our regulatory framework is in fact more responsible for our global economic hegemony than any other discrete and identifiable group of modern policies?

Would you believe me? I doubt you would, even though it's demonstrably true.

The birth of securities regulation in America
The securities laws as we know them sprung from the Great Depression.

At the time of their creation, bank failures numbered in the thousands, one in four families had lost their life savings, unemployment was 25%, industrial production had been cut in half, signs of malnutrition among schoolchildren were increasingly evident, and the Hoover administration had even ordered the violent dispersal of World War I veterans from the National Mall for demanding early payment of a promised bonus for wartime service.

With this as the backdrop at the beginning of 1933, a little-known prosecutor named Ferdinand Pecora succeeded at eliciting admissions from the nation's richest and most powerful bankers that they had knowingly defrauded the country's burgeoning middle class and systematically manipulated the stock market.

To cite a prominent example, Charles Mitchell, the president of National City Bank, the predecessor of Citigroup (NYS: C) and the largest bank in America at the time, testified before Congress that the lender's affiliated investment bank, National City Company, had funded stock pools to inflate the value of specific stock prices, concealed the losses of its parent company, bribed foreign officials, and literally bankrupted unsuspecting investors by selling them unsound securities derived from bad loans to Latin American countries. "Mitchell more than any 50 men is responsible for [the] stock crash," said Senator Carter Glass.

It was in the midst of this reality, in turn, and notably not in the sterilized world of classical economics textbooks, that our principal securities laws were born.

The first was the Banking Act of 1933, otherwise known as the Glass-Steagall Act, which established the Federal Deposit Insurance Corporation and severed the affiliation between commercial and investment banks. The second was the Securities Act of 1933, which required that newly issued securities be registered with the Securities and Exchange Commission unless otherwise excepted from doing so. And the third was the Securities Exchange Act of 1934, which formally established the SEC and regulated the trading of pre-existing securities and stock exchanges.

Regulation is needed now more than ever
In case you think the aforementioned behaviors are a thing of the past, which would ostensibly eliminate the need for continued governmental oversight, consider the role that the now-infamous multitrillion-dollar swaps market played in the recent economic crisis.

In 1998, Federal Reserve Chairman Alan Greenspan testified to Congress that proposed regulation of this market was "unnecessary" because "participants in financial futures markets are predominantly professionals that simply do not require the customer protections that may be needed by the general public."

Yet 10 years later, the failure of this very market convinced a Republican Treasury Secretary and former CEO of Goldman Sachs (NYS: GS) -- anything but a rampant socialist -- to nationalize the world's largest insurance company, American International Group (NYS: AIG) , and forcibly inject capital into the country's largest banks including Bank of America (NYS: BAC) and JPMorgan Chase (NYS: JPM) , among others.

To Greenspan's credit, of course, he subsequently admitted that his blind faith in the free market was misguided. In 2008, for instance, he told the House Committee on Oversight and Government Reform, "Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief." And he went on to state, albeit in his typically opaque manner, that he had "found a flaw" in the ideology that pushed him to resist regulation of the derivatives and subprime mortgage markets.

The persistence of a flawed ideology
In open defiance of history, proponents of deregulation nevertheless continue to pontificate upon the virtues of a completely unfettered market and the vices of governmental oversight. They argue that the latter stymies economic growth and aggravates unemployment, among other things.

As above, however, even a cursory glance at reality disproves this.

Consider the impact of a well-regulated market on the cost of capital in the United States relative to other countries around the world. My colleague Ilan Moscovitz recently dug up revealing statistics about this with respect to China, which is not insignificantly the second-largest economy in the world. According to Ilan, in the last year and a half alone, the cost of capital for small Chinese companies increased by a staggering 160%. And today, investors charge these companies five times as much for their equity as they charge their U.S. peers.

The reason for this is simple: Global investors trust regulated American capital markets more than their unregulated Chinese counterparts. And for good reason. Over the last few years, the financial news has been replete with stories of fraud emanating out of China.

Probably the best known of these was the case of the Chinese forestry company Sino-Forest Corp. In the middle of last year, shares in the company fell 72% in two days after the short-seller Muddy Waters questioned its accounting and whether it inflated the value of its forestry assets. Although the company denied the claims, an internal committee last month issued a report saying "there remain issues which have not been fully answered" about its business and relationships with land owners.

And the list of examples like this goes on. Fellow Fool Dan Newman identified no fewer than seven instances of recent potential fraud by different Chinese companies. And in a report cited by my colleague Alyce Lomax, GovernanceMetrics International noted that many Chinese companies listed in the United States have little to no intrinsic value, are thinly capitalized, and almost all have simply relied on the China brand to go public, much like unprofitable Internet companies did in the run-up to the tech bubble.

Ultimately, the benefits of deregulation are a myth
There's a commercial that airs on Bloomberg business channel for Citigroup. It has sweeping and majestic views of lower Manhattan, the Stock Exchange building draped with the American flag, and Citi's stately former headquarters at 55 Wall Street. Yet you never hear the narrator disclose the institution's central role in repeatedly crashing the economy and decimating the financial lives of thousands, if not millions, of Americans.

Well, it's this type of one-sided propaganda that's led us to believe in the virtues of deregulation. Is it good? Yeah, no doubt about it. But only for Wall Street's snake-oil salesmen who use it to effectively steal Main Street's hard-earned money. Thus, unless you fall into the former class, I recommend you revisit the premises underlying your faith in Wall Street's idea of a free market.

At the time thisarticle was published Fool contributor John Maxfield owns shares in Bank of America. The Motley Fool owns shares of Citigroup, Bank of America, and JPMorgan Chase.Motley Fool newsletter serviceshave recommended buying shares of The Goldman Sachs Group. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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