Thoughts on the SEC, 1977 Edition.

Thomas Frank on Porn and the SEC (my bold):

Now, if you’re looking for reasons why the SEC failed in the past they aren’t hard to come by. Start with political leaders who clearly didn’t believe in the mission; proceed to the agency’s grotesquely underfunded workplace where lawyers had to do their own filing, mail-sorting and photocopying; and arrive, finally, at the revolving door, which sometimes transformed SEC jobs into stations on the Wall Street career path and worked fairly predictable effects on enforcement.

This was an agency whose mandate, essentially, was to crawl out on an ice floe and die…What all of this overlooks is the highly advanced concept known as “change.” The purpose of federal agencies can be redefined and their personnel changed. Once upon a time, the SEC performed well; then it performed poorly.

And now that it threatens to perform well again, we are told it can only fail, that no federal operation can ever overcome the unalterable depravity of its employees.

I bring it up because I’ve been reading a lot about financial reform from the late 1970s. And it’s still a point right before the financial industry went big, and right before the efficient markets hypothesis took over, where people could still argue for the need for financial regulation over conflicts of interests, transparency and honesty without having an overwhelming burden of proof work against them.

I’m reading the 1977 version of The Transformation of Wall Street, Joel Seligman’s definitive history of the SEC. It’s been updated to take it through 2001, but I like this old version because it’s being written during a transformation time, when the agency was under assault by academic theorist and a brand new type of lobbying. You can see the old midcentury guard coming out in defense of the prosperity they helped build.

Check out this blurb: “Myths breed myths. The myth that the ICC and SEC are there to protect consumers against the villains created the counter-myth that they are there to serve the industry’s interests. Joel Seligman’s airing of the facts of the SEC history clears the mind of lots of rubbish.” – Paul A. Samuelson.

From the book, check out this completely un-ironic defense of how Wall Street has changed for the better after the New Deal:

During the last half-century, this nation’s system of corporate finance has been fundamentally transformed. Long gone are the days when new securities sales were doominated by private investment banks, such as J.P. Morgan and Company, when references to “bear raids” or stock market “pools” daily appeared in the nation’s press, when the New York Stock Exchange fairly could be described as a “private club,” when Senate hearings riveted the nation’s attention with revelations of fraudulent Peruvian bond sales, “preferred” stockholder lists, bribed journalists who “touted” securities, or stock price manipulation. Gone too are teh public utility holding companies, the least justifiable corporate structure to evolve during the 1920s’ “bull” market, “blank” corporate proxies, and the time when securities fraud usually was irremediable because of the deficiencies of state corporate law. In the past decade, fixed minimum commission rates, a way of life on the New York Stock Exchange since 1792, have been abolished. Efforts today are under way to supplant, partially or fully, the hardwood floors of this nation’s securities exchanges with an electronically linked national securities market system.

The principal actor in this transformation of corporate finance has been the Securities and Echange Commission. During and immediately after the New Deal period, the SEC earned the reputation as one of the most ably adminstered federal regulatory agencies….

Ten years later you get Oliver Stone’s “Wall Street.” And now we don’t even have a coherent language to criticize the private club of Wall Street as anything other than a symbol of national pride and an omniscient calculator of everything our country should value.

The book deals with the crisis the agency had from not taking on the fixed commissions of Wall Street. Even though they were shining a spotlight in a dark corner of the economy, the accusations of cronyism and cartelizing a business line for Wall Street was there, and the SEC didn’t react quickly enough.

But what’s fascinating is in the last 10 pages of the 550+ page book is a new challenge – an academic theory that postulated that the SEC was incapable of doing anything. That the omniscience of an efficient market made the job of forcing companies to disclose information to all its stakeholders and potential investors superfluous.

Jump forward to the end of the book,

Nevertheless, beginning in the 1960s, economic research on the investment process raised fundamental questions about the usefulness of the SEC’s corporate disclosure program. Several studies appeared to corroborate the “efficient market” hypothesis…For securities law, the crucial implication of the efficient market hypothesis was that securities prices theoretically would be the same regardless of whether most investors ever received or read mandator corporate prospectuses and reports. All that was necessary was that a “sufficient” number of investors act on available public data.

Similar fundamental questions were raised by what was called the “portfolio” theory. This theory suggested that since investment risk could be substantially reduced by diversification of an investment portfolio, the value of data concerning any individual security’s risks or potential rewards was substantially reduced.

Two libertarian economists, the University of Chicago’s George Stigler and the University of Rochester’s George Benston, attempted to corroborate a more sweeping hypothesis: that there was no value whatsoever to the mandatory disclosures required by the 1933 and 1934 Securities Acts….

Data errors in Stigler’s research and some highly debatable inferences he drew from his study “substantially invalidated” Stigler’s conclusion, in the words of Wharton School profressor Morris Mendelson and the opinion of others….In particular, Benston’s suggestion that there was little securities fraud before 1934 was ludicrous…

But the cumulative significance of economic theories such as the “efficient market hypothesis” and “portfolio theory” and the Stigler and Benston critiques did prompt the SEC…to publish a rationale for a mandatory corporate disclosure system that took into account the recent economics literature.

The report offered four grounds for doubting that market forces alone would result in the publication of sufficient, reliable and timely data. First, “very often there are significant motives for at least temporary concealment of adverse information on the part of corporate executives…second, the actual experiences of many financial analysts led them to believe that in the absence of requirements imposed by federal law they would be seriously handicapped in securing corporate data…

Third, even if analyst interest could prompt disclosure of adequate firm data, the vast majority of publicly traded securities were not followed by analysts. Finally, securities analysts sought information for themselves and their customers: “they do not regard themselves as surrogates for the universe of investors and hence do not feel under obligation to disseminate widely information which they secure.”

Though the important ideas of informational asymmetries, free-riding and short term manipulation are an obvious defense of the importance of the SEC’s mission, you can practically hear the priority being downgraded and budgets not kept in line as everyone focuses on the dubious relevance of the beautiful mathematics of martingale theory to the ugly rip-the-face-off-the-client world of Wall Street.

It’s kind of an amazing game of three-card monte. Libertarians simply claim that the SEC can’t do anything. The mission of the SEC is downgraded accordingly. The SEC fails, and libertarians take that as proof that the SEC can’t do anything. Rinse, and repeat.

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17 Responses to Thoughts on the SEC, 1977 Edition.

  1. engineer27 says:

    Why should the SEC be immune, when every other government agency gets the same treatment from the anti-government conservatives?

    Frank ought to know He wrote the book.

  2. The passages you quote show that the challenges by “Libertarians” were met by the SEC. From where does your last paragraph’s suggestion that the SEC’s mandate was softened come from?

    Quick googling found that the SEC’s budget has tripled in the last 15 years (in nominal terms).

  3. Mike says:


    I love Thomas Frank.


    Were they? I know a ton about the efficient markets hypothesis as the best theory ever, and very little about the complaints they brought up, in both the press and the academic literature.

    And doh! I forgot to link to the fantastic Scenes From The Ninth Circle Of Financial Bureaucracy By Moe Tkacik where senior members of the SEC have to wait in line for Kinkos and you can see that they are completely underbudgeted and understaffed (in quality as well as quantity) for the challenge they face.

    I think it’s fair to say that the scope of what needed to be covered by the SEC has expanded dramatically, and it isn’t the SEC alone. Bill Black is good on this – he points out how the government would put 40 regulators into an SnL in the late 1980s as a result of that crisis; we put 3 people into Lehman

  4. Although I strongly favor the restoration of a number of traditional New Deal regulations such as the substance of the Glass-Steagall Act, I also have to question the role of “deregulation” and weak (non-existent?) SEC enforcement versus a change in mindset of investors.

    It seems likely that investing was dominated in dollar terms up until the 1980′s by investors who had lived through or grown up during the Great Depression and had first hand experience with the financial shenanigans and so forth that have reappeared in recent decades. So investors, by which in dollar terms I mean primarily the retired middle and upper-middle class and those nearing retirement, were rather wary of stock market investments, strange securities like derivatives, and so forth.

    Would people in 1950, even if the SEC and other government agencies sat on their hands, buy the fluffy financial statements, “pro forma” numbers, perennial “one-time charges”, and numerous other dubious accounting and business practices that proliferated in the 1990s?

    It seems like something approaching a religious faith in the “free market” or “the private sector” coupled with unrealistic ideas about technological progress and economic growth has contributed heavily to uncritical acceptance of obviously dubious claims. So long as the mindset persists, additional regulations may prove both very difficult to enact and largely ineffective even if put in place. It is difficult to protect people, in this case a large fraction of the US investing population who have bought into successive speculative bubbles, from their own wishful thinking. The widespread tactic of blaming the present financial fiasco on the Community Reinvestment Act and poor minority home buyers further enables the US investing population to avoid facing their own mistakes and breaking free of this mindset. If investors are convinced that their unwise investments in a second home or remodeling of their current home and so forth was not the problem; it is all the fault of irresponsible poor minority would-be home owners in the inner city, then the current economic problems will continue, worsen, and another speculative bubble will probably occur.

    It seems to me that actual economic growth and technological progress has been low since about 1970, probably in large measure due to very limited progress in power and propulsion technologies compared to earlier times. This is reflected in current energy prices rises and problems. The problem has been obscured by buoyant rhetoric about growth and heavy hype about computer and electronic technology where a relatively high rate of progress is still occurring. This fueled the tech bubble of the 1990′s directly and the housing bubble of the 00′s indirectly through the dubious valuation models used for the derivative securities. I think it is probably necessary to directly confront these exaggerated concepts of the current rate of progress and growth to free people of the mindset; people need to take a more critical look at highly touted technological advances and purported “growth”.



  5. The SEC staff has been increasing by over 1% per year (on average) since Clinton.

    Perhaps you meant to say that the popular discourse since the rise of neoliberalism has become more hostile to the SEC (i.e. its become more libertarian). But the facts don’t support the trends suggested by the popular discourse.

    BTW, I don’t see the passage you quote from Frank at the link you provide…

    • Barry says:

      Will, how much has Wall St activity been increasing each year?
      How much has Wall St complexity been increasing each year?

  6. Ahhh, so the growth rate of the SEC was outpaced by the growth rate of their charge?

    The problem here is that the SEC’s budget has increased faster than the finance industry’s output in that period.

  7. engineer27 says:

    Will and Mike:

    The under-performance (regardless of budget) of the SEC starts from the top. It was painfully obvious from reading Sorkin’s book that SEC chairman Cox was sorely out of his depth when dealing with the Lehman collapse. One can almost hear Bernanke and Geithner roll their eyes when Paulson tells them that they have to step aside and let Cox handle Fuld and Lehman — because he was their nominal regulator. When the chairman is that clueless, no amount of budget is going to make the organization anything other than dysfunctional. And Thomas Frank, Mike, and I are convinced that this was intentional.

  8. Well, you, Thomas Frank and Mike have to come to grips with the fact regulator incompetence is a fact of life whether or not its intentional. Life would be wonderful if it were not for Republicans and not for the cognitive and information inadequacies of individual regulators.

    We have to create institutions that are robust to Republican presidencies and human frailties.

    • engineer27 says:

      Indeed… How do we get people to properly govern who are fundamentally opposed to all forms of government?

      The answer lies in informal institutions, like those alluded to by Krugman in his post (linked below). But these are societal and generally cannot be enforced from the top down.

      [Actually, Frank goes even farther. He maintains that this is just what Money does. The only way to combat it is with Revolutionary Idealism, typified -- for Frank -- by the New Dealers.]

      • Have you considered the idea that this is a principled opposition?

        BTW, what a strange tension in your comment and Krugman’s post: why all the focus on the SEC and explicit regulation when the problem is “soft” stuff like social norms? Does the SEC, now or in its apparent glory days, have a role to play in fostering those informal institutions? Its at least possible that increasing top-down paternalistic-type regulation will be detrimental to those social norms.

        A banker in a world with a stronger SEC may not see it as his job to watch out for the common good when making his decisions. He’ll think its the SEC’s job. And bankers make too many decisions for the SEC to be able to police them all. Instead, let’s come up with institutions that get the banker’s decision making process lined with what’s best for the rest of us…

  9. Pingback: The Way We Were - Paul Krugman Blog -

  10. It’s crucial to note how the political party in power, and their ideology, can shape government, and then how all of this can strongly influence culture.

    We’ve seen how Republican ideology and actions can be immensely costly in degrading ethics, and therefore trust among people. This, in turn, can make it much harder for people to work together productively – which is crucial for high tech, large scale, high productivity in the modern complicated world.

    A great example of how culture can be positively affected by good government is from a fantastic short article by leading growth economist Paul Romer at:

  11. To whet your appetite a quote from the very important Romer post:

    “Hong Kong provides a compelling counterexample, showing that a change in rules can defeat a culture of corruption.”

  12. curmudgeonly troll says:

    The simple problem in the case of Madoff and the numerous Ponzis is that the SEC has a lawyer’s mentality of dotting the i’s and cross the t’s – they’re parking enforcers instead of financial detectives.

    Clearly they didn’t recognize an obvious criminal (that no reputable institution invested in despite huge returns) even when confronted by the evidence.

    For that the SEC is clearly to blame. As far as derivatives and ending Glass-Steagall go, clearly that was a politics and you can’t lay that at the door of the SEC.

  13. Pingback: Liveblogging the Paulson Geithner Hearing « SpeakEasy

  14. Pingback: Discretion and Funding the SEC « Rortybomb

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