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Wednesday, Aug. 07, 2002

In response to the recent corporate accounting scandals, last week President Bush signed into law the Sarbanes-Oxley Act. The law stiffens penalties for corporate officers who knowingly file false financial statements; bans personal loans to corporate officers and directors; tightens restrictions on insider trading; and requires CEOs and CFOs to reimburse their companies for bonuses or options paid on the basis of earnings reports that were later restated downward. The law also creates the Public Company Accounting Oversight Board, a private five-member body with the authority to set standards for, and conduct investigations of, the accounting industry.

Does the Sarbanes-Oxley Act go far enough to remedy what ails Wall Street? In a new nationwide survey commissioned by Columbia Law School, most Americans said no.

Then what additional steps should be taken? When asked about various other possible responses, Americans overwhelmingly favored tightening restrictions on corporate donations to politicians, while dividing over proposals regarding taxes and Social Security.

Americans' Portfolios: High Investment Rates Make Us Vulnerable to Downturns

The Columbia Law survey of a representative sample of a thousand Americans began by asking respondents whether they had invested in the stock market in the last decade. Just over half said yes, a reflection of the transition from defined benefit pension plans to 401(k) contribution plans. The historically high proportion of stock ownership is both a good sign and a bad one.

Broadly diffused ownership of corporations is good for democracy, because it means that corporations do not simply serve the interests of a narrow few. To be sure, shares are not evenly distributed among the Americans who own stock; Bill Gates still has a much larger say in the management of Microsoft than I do. But collectively, the interests of the holders of relatively small portfolios can make a difference.

The bad news, however, is that with high stock ownership rates, the bear market on Wall Street can more readily have an impact upon the real economy. Seeing their portfolios decline in value, Americans may spend less money than they otherwise would have, thereby worsening the recession.

Belt-tightening is especially likely among those people closest to retirement. A thirty-four-year-old who sees her 401(k) decline by thirty percent from its year 2000 peak figures that she has over thirty more years of working to cover her losses. So a smaller retirement statement probably won't affect her decision whether to buy a new car.

By contrast, a sixty-four-year-old who is counting the days to retirement does not draw much of a distinction between retirement savings and other assets. For him, paper losses are real losses, and having less money, he will likely spend less money. That is why it is concerning that stock ownership is higher among fifty-five to sixty-four-year-olds than among any other age group.

Americans' Investment Strategies: Evidence of the "Endowment Effect"

Nevertheless, I wouldn't predict a lengthy recession--and not just because I'm not an economist. The Columbia Law survey also asked respondents how the corporate accounting scandals and market decline had affected their investment strategy. Only eleven percent said they were moving some or all of their money out of the market and into safer investments.

Eighteen percent said they had not changed their overall investment strategy, and twenty-seven percent said that while they were not buying new stocks, they were leaving their existing money where it was.

That last number could be explained by apathy, inertia, or what is sometimes called the "endowment effect." This term, popularized by economist Richard Thaler, who was building on the work of Daniel Kahneman and Amos Tversky, refers to a well-documented phenomenon among human beings: we tend to demand more for something if we're asked to sell it than we would be willing to pay to buy it.

Thus, people who bought stock when the Dow was above 11,000 are unwilling to sell with the Dow hovering at 8,000, even though those same people are not about to invest more money. The endowment effect therefore also explains why only four percent of respondents to the Columbia Law survey said they viewed the current bear market as a buying opportunity.

More broadly, the endowment effect will likely prevent a further dramatic downward spiral in the stock market. Even jittery investors do not want to sell for what feels to them like an unduly low price.

Americans' Seemingly Puzzling Policy Prescriptions

Ultimately, the health of the markets and the broader economy will depend upon investors' ability to trust corporate earnings reports. Yet, fifty-three percent of the people surveyed thought that the Sarbanes-Oxley Act does not go far enough. Barely a third thought the law adequate.

What policies do Americans favor? The Columbia Law survey asked respondents about three proposals: (1) stricter limits on corporate donations to politicians; (2) abandoning efforts to privatize Social Security; and (3) repeal of the 1.6 trillion dollar tax cut Congress enacted last year.

In response to the first proposal, over eighty percent favored restricting corporate campaign donations. The results for the second and third proposals were less clear. Respondents split evenly on Social Security privatization, while those who opposed repealing the tax cut just slightly outnumbered those who favored repeal.

At first blush, these responses may seem puzzling. Congress recently passed a campaign finance reform measure that, among other things, limits the ability of candidates to raise so-called soft money from corporations or individuals. Further limits would, at best, have an indirect impact on corporate accountability.

Granted, effective campaign finance regulation can ensure that politicians don't succumb to the wishes of large donors by undermining market-monitoring measures. However, campaign finance regulation is not itself a form of corporate accountability.

By contrast, both the Social Security and tax cut issues are immediately relevant. The argument for Social Security privatization, for instance, is that the stock market provides a better return on investment than the government.

That argument was always somewhat disingenuous, because the government rate took account of the fact that the Social Security system is funded on a pay-as-you-go basis, whereas the market payout rate was calculated based on the false assumption that contributions to the Social Security system are earmarked for the contributors only, in the same way that Individual Retirement Accounts are. But even putting aside this inconsistency, one might have thought that the precipitous decline in the stock market would have frightened Americans who foolishly came to believe in the 1990s that stock prices only ever rise. The market decline should have led Americans to oppose Social Security privatization in far greater numbers.

Similarly, the original argument for last year's tax cut was that the federal government was collecting more revenue than necessary. With the economy in recession and the budget strained by the costs of the war on terrorism, we now face large deficits, not a surplus - suggesting that we need more revenue to combat the deficit .

Moreover, while deficit spending is a plausible means of stimulating a moribund economy, the Bush tax cut is targeted at the wealthiest Americans and kicks in over the course of many years. It is hardly what one would design as a short-term effort to stimulate broad-based consumer spending.

Americans Still Distrust Government: The Best Explanation for Survey Responses

How then do we explain the fact that by and large Americans prefer the indirect response of campaign finance reform to abandoning either Social Security privatization or the tax cut?

The answer, I would guess, is that Americans instinctively distrust government. They distrust politics enough to seek additional corporate donation limits. They would rather manage their own retirement savings than leave the job to government. And they reflexively favor tax cuts, even if they receive virtually no benefit from them.

If I am correct that the Columbia Law survey ultimately reveals a skepticism towards government, that is interesting news. In the wake of September 11, after all, opinion polls showed very high levels of support for our rulers in Washington - suggesting a strong belief in their ability to govern.

Congress and the President may still receive high marks and enjoy the public's trust when it comes to their conduct of the war on terrorism. But the survey shows that Americans' views about corporate accounting and the stock market may not display the same trust, and thus our leaders probably will not get a free pass more generally.

In an odd way, the Columbia Law survey thus provides comforting evidence that things have gotten back to normal in American politics.

Michael C. Dorf is a Professor of Law at Columbia University.

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