Evan Soltas
Apr 13, 2012

Sugar in the Growth Engine

America's broken IPO market and how it hurts the long run

I had written on my blog yesterday, after hearing from David Beckworth, that I was going to talk about America's pressing need to rewrite the laws governing corporations, particularly as they concern the regulatory and taxation ends.

And then I found this post, doing my Internet reading rounds, by Matt Taibbi of Rolling Stone. Not that I respect Taibbi as anything but a polemicist, but his article -- a critique of the Jobs Act, which would significantly deregulate capital market access for small firms, i.e. those with annual revenues under $1 billion -- gives me a sense of duty to write this post. I'm not going to rebut his specific charges, but if you're interested, you can read the bill -- don't worry, it's only 22 pages, and I did -- and see where is he wrong, or where his criticisms are misplaced.

So let's get right to the main act. The number of initial public offerings, at all points in the business cycle, is clearly lower after 2002's passage of the Sarbanes-Oxley Act, which significantly increased regulatory compliance and disclosure hurdles for corporations.

The fewer IPOs are a predictable consequence of increasing the costs of going and being a public firm on American exchanges. Now, don't get me wrong -- I think we need corporate disclosure requirements and investor protections, but there's a cost-benefit calculation to make here.

The cost of capital decreases when investors are more confident in the financial transparency of their investments, but the cost of capital increases when regulatory burdens raise the cost of compliance by 46 percent. The author of the just-cited study, in fact, puts it nicely:

The enactment of the Sarbanes-Oxley Act in 2002 may represent the final act in regulation of corporate disclosure. By that I mean that the costs of regulation clearly exceed its benefits for many corporations. When Congress originally enacted the Securities Acts in the 1930s, one justification given was that these laws would restore investor confidence and allow businesses to raise capital once again. The relevant question today is whether regulation has gone so far as to force honest businesses, at least those of modest size, to consider abandoning public markets for less regulated private markets. Similar questions arise with respect to foreign issuers that have the option of foreign markets of increasingly competitive quality. [My emphasis]
Another consequence is that it's been a lost decade for venture capital funds who do IPOs, because nobody wants to do them anymore until they've exhausted all of the other alternatives. That represents a suboptimal outcome for capital markets and economic efficiency.

Also, let's keep in mind that no amount of disclosure can eliminate risk, and even risk of fraud. Nor is trying to make capital markets the safest they can be the best regulatory policy. Instead, we should aim for -- again -- reasoned cost-benefit analysis, and it's very clear that we are regulating poorly, and regulating too much, when it comes to the IPO market.

By the way, I know the "sugar in the gas tank" thing is a myth, but it is an excellent metaphor for how poorly-functioning capital markets affect the long-term growth of an economy, which is a significantly more complicated idea.