Money: The Small Investor As Serf

While we've mentioned the problem before, it never hurts to remember that when inflation is running at 9 percent (the old fashioned, single digit kind), a taxpayer in the 30 percent bracket has to earn 17 percent interest on his money in order to net three percent real earnings after tax.

Unfortunatly, nowhere outside of the loan shark racket can you earn 17 percent interest. It is impossible for a saver under these conditions to earn any time interest on his savings. This results, of course, from government controls on the savings rates available to the small saver. These controlled rates, together with progressive tax rates, result in the steady destruction of his capital.

The only avenues open are high risk obligations, in which the return represents payment for risk and not true interest, or equity investments.

But here, too, Big Brother is at work to keep the little guy in his place, through the device of securities regulation.

There are two theories of securities regulation: disclosure and merit. Disclosure, which purports to be the theory behind the Federal securities regulation, holds that the investing public is adequately protected if all the relevant information is made available. Merit regulation, on the other hand, holds that the public, or some portion thereof, should not be trusted to make intelligent assessments of risk, even if all relevant disclosures have been made, and should be forbidden outright from making certain kinds of investments.

Some jurisdictions have a variant of the merit rule, called the "sophisticated investor rule," which permits these investments to be sold to investors who are thought able, by the securities commission, to manage their own affairs. In practice, "sophisticated" simply means "wealthy," i.e., it is a net worth test. The rest of us are shut out of the market. Merit regulation is the explicit philosophy behind the securities law regulation of several of the states. The practical effect of the merit rule is to keep small investors out of the high risk—and potentially high yield—market for the shares of new, small companies.

This result is not limited to the states having merit regulation. The high costs of registration also serve to deter small, high risk firms from offering their shares on the market at all. If they are to secure financing, they are essentially limited to a private placement, usually with a financial institution or venture capital firm, at terms less favorable than they could have obtained in a share offering on the open market.

While the high cost of compliance with securities regulation restricts the shares offered, it also restricts the competition among brokers. High compliance costs have driven out a large number of small broker-dealers, according to a study by University of Miami law professor James Mofsky.

The benefits to the investor of these substantial restrictions on his investment freedom are open to question. Professor Henry Manne, in his recent book Wall Street in Transition, cites a number of empirical economic studies which have sought to measure the benefits of enforced disclosure. Despite the use of elaborate models and analytical techniques, the impression these studies convey is that the investor has not benefitted by this regulation.

The regulators have a particularly bad record of ferreting out evil-doers before they have done their evil. Bushels of regulations did not stop Equity Funding, National Student Marketing, Home-Stake Oil, Bar-Chris, Yale Transport, and Continental Vending.

There is some hope for change. In Florida, a state once proud of its "Little SEC," the work of Professor Mofsky and others has produced a serious effort to get the state out of securities regulation. Mofsky's work has led to the introduction of a bill in the Florida legislature to substantially reduce the state's intervention in the share market. The bill has the backing of the prestigious Florida Law Revision Council.

But in the meantime, the investor without $100,000 chunks of money to invest in the comparatively free market on certificates of deposit, Treasury bills, or commercial paper, or without the connections to get an unregistered private offering, is left to the steady capital erosion of "approved" investments. Or he must take his chances on precious metals plans, real estate, gold coins, collectibles or some other relatively free investment market, all of which require some kind of specialized knowledge, present liquidity problems, or require constant tending. He must do all this to keep his capital from being eaten by inflation. In the old days, before the government improved things, you could do the same thing by leaving your money in a savings account and forgetting about it.

AN AFTERTHOUGHT

The foregoing discussion suggests one interesting question: If we are correct in our initial assumption about the need for subtracting inflation from the nominal rate in order to measure the real rate of return for interest, and if we really have been experiencing double digit (or high single digit) inflation, then why don't the interest rates realized in the comparatively free certificate of deposit, commercial paper, or treasury bill markets reflect this?

If our assumptions are correct, then this means that—for significant periods of time during the past few years—there was little if any real rate of interest being received on the money obligation of all investors, big and little alike, and the American economy is experiencing a constant erosion of real capital of major proportions.

Davis Keeler's Money column alternates monthly in REASON with John J. Pierce's Science Fiction column. © 1975 Davis E. Keeler.