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Twin Threats To Financial Market Security

By Richard A. EpsteinHoover Institution

It has long been an open secret that the Biden administration has adopted, hook line and sinker, the hard-line positions of the progressive wing of the Democratic Party. Nowhere is that more apparent than in two recent developments that threaten to make mischief at both the Securities and Exchange Commission and the Federal Reserve Bank—perhaps the two most powerful regulators of financial markets. 

The two major initiatives are, first, to increase the control that the SEC exerts over nonpublic corporations, and second, to increase the authority of the Federal Reserve over activities affecting climate change. Thus Allison Lee, now an SEC commissioner, first appointed by President Trump as one of the Democrat commissioners and then reappointed by President Biden, is determined to bring to heel private corporations—those that are not listed on public exchanges like the New York Stock Exchange or NASDAQ.  She wants to both require extensive disclosure of their financial operations and restrict their access to capital, reversing a Trump-era decision that went the other way. Next, Biden has nominated Sarah Bloom Raskin, a Duke Law School professor, to serve in a key position at the Federal Reserve as vice chairman for supervision. Raskin’s top goal appears to be strengthening the Fed’s role in promoting climate change regulation through its oversight function for banks.

Both moves are deeply problematic.

Turn first to the SEC’s effort to expand its control over private corporations. Commissioner Lee’s case starts with the simple proposition that private capital markets have raised huge pools of fresh capital without any public oversight whatsoever. By appealing only to wealthy investors, new firms are able to avoid the extensive costs and liabilities associated with going public, and subsequently being subjected to constant oversight by the SEC and the public exchanges. As a matter of first principle, there is no ideal way to determine the proper mix of public and private companies, because each has advantages over the other. One common pattern is for companies to start small and private and then grow into unicorns with $1 billion or  more in assets. There are about four hundred of these businesses in the United States, and nearly nine hundred worldwide. Once these companies thrive, the original investors can either cash out or retain their shares when the company goes public, allowing the growing firm greater access to capital markets.

For many years this trend has been slowing down, creating the unfortunate situation in which individuals with the skills and wealth to run new ventures have found it more difficult to move out of relatively low-risk firms to free up capital to start the cycle anew with another set of private firms. Fortunately, the willingness in the post-COVID age to go public has increased substantially, but there were still far fewer public corporations in 2021(about 4,200) than there were in 1997 (about 7,200). Public oversight is in general far too onerous.

Hence the question arises: why does SEC Commissioner Lee want to regulate these private corporations by forcing them to reveal information on a biennial basis? Normally, the claim for additional regulation should follow on the heels of some well-identified market failure. But Lee points to no such failure in the private equity markets that continue to thrive. Instead, she makes this startling claim: “When they’re big firms, they can have a huge impact on thousands of people’s lives with absolutely no visibility for investors, employees and their unions, regulators, or the public.” 

This charge makes no sense at all. Her use of the term “investor” contains a deliberate ambiguity. The investors in each of these firms are contractually entitled to receive relevant information. And there is no reason why the general investment community should be entitled to information about the internal operations of any firm in which they have no stake. The same ambiguity covers employees. Those who work for the firm will get information on wages and benefits. The employees of other firms should receive nothing at all. The current labor law, moreover, contains detailed rules that establish that “[an] employer has a statutory obligation to provide requested information that is potentially relevant and will be of use to a union in fulfilling its responsibilities as the employees’ exclusive bargaining representative, including its grievance-processing duties.” Private corporations are not exempt. These corporations are also subject to multiple disclosure regimes as part of their ordinary business obligations, such as making loans or issuing insurance policies. And it is downright dangerous to encourage widespread disclosures, as that information often contains trade secrets that are of great interest to competitors but of little relevance to the public at large, which has direct access to the price and quality of the goods and services offered for sale.

What makes this especially galling is that the SEC does not have an unmoored authority to regulate, as Lee claims, in the “public interest.” As Bernard Sharfman of George Mason University has written, “Whenever the term ‘in the public interest’ appears in the [security] Acts, the term ‘for the protection of investors’ is almost always sure to follow.” Without that connection the SEC can move with impunity to regulate the entire economy, including private corporations whose sophisticated investors are well able to protect themselves. No principle of deference should ever allow the SEC to unilaterally expand the scope of its jurisdiction.

The question of mission creep is equally apparent in the looming fight over the Raskin nomination. The Fed’s mission is “[c]onducting the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of maximum employment and stable prices.” The “in pursuit” language is a source of real uneasiness because is unclear how the Fed’s ability to deal with interest rates allows it to obtain “maximum employment.” On employment, direct regulation, or (better) deregulation, of labor markets is a far more efficient way to proceed, and it eliminates the need to resolve difficult question when the objectives of monetary policy and full employment clash. A single instrument—the control of the quantity of money—cannot be sensibly pressed into service to mediate between two conflicting ends.

The situation will not get any better if the Fed injects itself further into climate policy by seeking to shift the balance of returns from carbon-intensive investments to other forms of energy, which is why the confirmation battle over Raskin is so important. Nothing that she has ever said or written indicates any awareness of the complex trade-offs that are needed in dealing with energy issue. She is just gung-ho when she writes that regulators “need to ask themselves how their existing instruments can be used to incentivize a rapid, orderly, and just transition away from high-emission and biodiversity-destroying investments,” without once asking whether various improvements in the production and distribution of fossil fuels could be better than the blunderbuss approach that she apparently favors.

Yet the warning signs of energy breakdown are everywhere, given the evident difficulties of both wind and solar energy, which today can operate only because of massive subsidies in cash and in-kind — but only when the wind blows and the sun shines. Climate change is best addressed by some mix of private initiatives by corporations in the management of their own supply chains and regulators who deal with the emissions directly. Even without Raskin, Fed head Jerome Powell already takes it as his mission to starve the fossil-fuel companies of the capital that they need to survive, even as coal consumption worldwide continues to increase, especially in China, which today produces about nine times the amount of coal produced in the United States. The Fed, however, has no jurisdiction over China. Thus, its effort to rebalance the US energy portfolio will have little or no effect on the global output of coal or any resulting changes in global temperatures.

Yet its focused actions can wreak havoc not only in oil but also in natural gas. Just that grim transformation is evident in both Great Britain and Germany. Ironically, the inefficiency of solar and wind energy has forced Germany to increase its reliance on dirty coal—yet another application of the law of unintended consequences.

And matters are still worse from a geopolitical perspective, given that the constriction in fossil-fuel products from both the United States and the EU gives the whip to Vladimir Putin, from whom no public-spirited action has ever taken place, or ever will. Energy prices throughout the United States are already on the rise, and this country, already in the throes of an inflation spiral, could easily be next in line for major dislocations if Powell and Raskin have their way. It is a huge mistake to think that stopping the use of efficient fossil fuels, especially natural gas, is the path toward climate control.

So in both cases progressive policies make the common error. Mission creep is dangerous. The SEC should lay off private corporations; and the Fed, which already has too many things on its plate, should stay out of the energy and credit business. It is far superior to do one thing well than to do many things badly. The Senate should understand that a little humility is needed in the selection of powerful positions in the Fed, and turn down the Raskin nomination.


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