“It’s Difficult to Produce Good Policy in Thin Political Markets”

Harvard Business School’s Karthik Ramanna, author of Political Standards, outlines the potential harms of thin political markets and offers ways to mitigate capture. “It’s difficult to produce good policy in thin political markets if you accept the normative implications of the current economic theory of the firm.”

 

 

final-2
Karthik Ramanna

In the world of regulation and rule-making, there are issues that remain cloaked in obscurity. While presidential hopefuls like Hillary Clinton, Bernie Sanders, and Donald Trump argue over the future of Medicare or Social Security, it’s difficult to imagine politicians debating over issues like actuarial standards or bank capital ratios with the same kind of ferocity.

 

In his book Political Standards: Corporate Interest, Ideology, and Leadership in the Shaping of Accounting Rules for the Market Economy (University Of Chicago Press, 2015), Harvard Business School associate professor Karthik Ramanna calls these esoteric areas of regulation “thin political markets”: processes where narrow commercial interests, due to their vast experiential expertise and a lack of public interest, are essentially able to shape the rules of the game. Compared with thicker areas of regulation and policy, where vigorous political competition ensures a lively public debate, thin political markets are characterized by a relative lack of vibrant dissent.

 

While thin political markets largely reside outside of public attention, they are crucial for the functioning of capitalist economies. Very few people concern themselves with the issues of auditing standards or bank governance regulations, and even fewer people have the technical expertise necessary to ponder their design. As a result, the rules made in these markets often reflect the interests and ideologies of special interests and not necessarily those of the general public.

 

In an interview with the Stigler Center blog, Ramanna analyzes the relation between capture and thin political markets, outlines the harms of fair value accounting, and explains why the only way to solve the problem of thin political markets is to rethink the modern economic theory of the firm.

 

Q: How do you define thin political markets?

 

Thin political markets are processes wherein technical, esoteric rules that underlie the basic institutions of capitalism are determined. To me, the obvious example of a thin political market is the process through which accounting rules that are the basis on which corporations report their yearly or quarterly profits are determined. But thin political markets could extend to other esoteric regulatory areas such as bank governance regulation, actuarial standards, auditing standards, insurance standards—things that are essential for modern complex capital markets to work but are largely outside the attention of the general public.

 

In my studies on the political economy of accounting rule-making, I encountered a number of instances where a small group of informed special interests with deep experiential expertise were able to shape the rules of the game in self-serving ways.

 

To me, that looks like evidence of capture. But the political economy literature is skeptical of claims of capture, much like the finance literature is skeptical of claims of market inefficiency. There is plenty of evidence that, on average, competition in political processes equilibrates the role of special interests: while one or two special interests might dominate for a small amount of time, the dominance of special interests is not expected to the degree that it might create a major problem from the perspective of social welfare. The question then is, how do we reconcile the theoretical resistance to capture with the evidence of special-interest influence in accounting rule-making? To effect this reconciliation, I drew on the institutionally deep political science literature on regulation and developed the notion of “thin political markets.”

 

Two factors distinguish thin political markets from political processes where competition would equilibrate special interest lobbying. The first is that the nature of knowledge that’s necessary to adjudicate in the political process usually resides in the expertise of few concentrated commercial interests. And, importantly, the nature of this expertise is experiential. It’s what we call tacit or implicit knowledge, and it contrasts with explicit or theoretical knowledge. For instance, when we decide what accounting rules for mergers and acquisitions should look like, we rely on the experiential expertise of investment banks that live and breathe this stuff. They can inform us on what is practicable and what are the relevant compliance costs, knowledge that’s not gleaned from accounting theory.

 

The second aspect that distinguishes thin political markets is what I call low issue salience. The subject matter that’s being adjudicated in thin political markets is largely outside the interest of the general public. The public is interested in some technical issues, like Social Security or Medicare, because these issues are salient in their minds. But accounting rules or auditing rules are boring to most people, and that creates a lack of direct public accountability. Public intermediaries like the press or elected politicians are also not incented to intermediate, again because their principals—the public—are not animated by these issues. 

 

Q: Can you elaborate on the actual harm caused by the emergence of thin political markets, specifically in an accounting context?

 

Conceptually, it’s easy to make the case for the importance of accounting rules in a complex market economy. Accounting rules enable comparative performance evaluation and thus facilitate efficient resource allocation across competing projects.

 

Empirically, one way to make this argument is through the rise of fair value accounting in U.S. GAAP.

 

Over the last 30 years, one of the biggest innovations in accounting has been the gradual adoption of fair value as a basis for accounting. Of course, not all fair values are bad. There are many circumstances where fair value accounting is likely to be the most effective method of accounting. In fact, the initial reintroduction of fair value accounting in GAAP in the early 1990s was likely precipitated by the savings and loan crisis, where you had a number of financial institutions that had insolvent assets on their balance sheets recorded at historical costs. So reintroducing fair value was very much meant to bring reconciliation to these bloated balance sheets—by precipitating write-downs.

 

But fair value accounting has spread beyond that, to so-called level 2 and level 3 fair value assets that are essentially mark-to-model. There is considerable discretion here, and it can be abused.

 

For instance, when you look at the role of fair value accounting in the early to mid-2000s, a number of financial institutions likely held what would come to be called level 2 and level 3 fair values on their balance sheets. Some of these were subprime mortgage-backed assets, and as underlying housing prices were increasing in the period leading up to the 2008 crisis, the conjectured gains in these assets were recognized as income in the financial statements of these banks. Since these institutions use a fair bit of performance-based pay, this income likely resulted in paying out bonuses. Perversely, such bonuses likely created incentives for even more subprime securitization. So while fair value accounting did not cause the financial crisis, it plausibly catalyzed the conditions that led to 2008.

 

Another such instance with fair value accounting was in the 1920s. We tend to think of fair value accounting as a relatively recent innovation, but it played an important role in the 1920s, so much so that it was implicated in the stock market crash of 1929.

 

Robert E. Healy, who was one of the founding commissioners of the Securities and Exchange Commission in the 1930s, and before that a counsel for the Federal Trade Commission, investigated the role of public utilities in the period leading up to the crash of 1929 and found that during that period fair value played an important role in the manipulation of financial reports. He argued that there had been circumstances where these public utilities were writing up assets to effectively generate income, using what we call level 2 and level 3 fair values today.

 

Steve Zeff argues that Healy was very influential in the SEC in the early 1930s, and Healy played an important role in creating a moratorium on the use of fair values, a moratorium that lasted from the 1930s to the 1980s. But the lessons of history are often unlearned, and somehow that moratorium and the history behind it was unlearned by the 1990s, and we played the fair value movie again and saw the consequences, to an extent, in 2008.

 

 

Q: You said that thin political markets are “thin” because the high level of expertise they demand rests almost solely with the industry. In a way, capture is inevitable?

 

This is right. The regulator relies on industry expertise, and so, not surprisingly, the regulation reflects the interests of the regulated. This is capture. But it’s not necessarily the Stiglerian notion of capture—the quid pro quo notion of capture, where there’s a promise of lucrative employment to regulators, or bags of money, or the like. The model of capture here involves the co-option or embrace of certain special interest ideas or ideologies. It’s what James Kwak calls cultural capture.

 

 

Q: Is it possible to produce policies that benefit the general public in thin political markets?

 

I think it’s difficult to see how good public policy can be produced in thin political markets if you accept that the current economic theory of the firm should provide the normative guidance for managerial behavior in these situations. After all, what firms are doing in thin political markets—shaping the rules of the game to their benefit—is entirely consistent with the economic theory of the firm. Now, some economists may argue that this is not an issue for the theory of the firm, because the theory itself is purely descriptive. But theories in social science, especially if they are widely disseminated, can become self-fulfilling. And the economic theory of the firm is a prominent part of the MBA curriculum in most business schools. So, as long as prospective managers are taught that successful firms solely focus on their own profit, it’s hard to see how we’ll get good policy outcomes in thin political markets.

 

Q: How did the financialization of the U.S. economy contribute to the creation of thin political markets? And did it make once-thick political markets thinner?

 

One of the things that financialization seems to have done is make a certain set of interest groups, in particular those from asset management and investment banking, more influential in regulatory decision making. These groups come with enormous resources and deep expertise. It becomes very hard to counter their influence in the process.

 

Q: What can be done to thicken thin political markets? In the book you outline four possible mechanisms, like encouraging managers to recognize their public responsibility by threat of penalties, and on the other hand developing ways to reward public-spirited behavior. Will that be enough?

 

 

One additional mechanism that I’ve been thinking about is related to the observation that the political process in accounting rule-making is relatively genteel. Because the people generally involved in accounting rule-making tend to have similar backgrounds and experiences, there isn’t as much dissonance in accounting debates as you experience in the debates on Social Security or Medicare, which are equally technical issues.

 

Of course there are downsides to the heated debates on Social Security, but there’s an important upside: the debates surface competing viewpoints and ideas and mitigate the likelihood of capture that might otherwise occur.

 

This is by no means a perfect solution, but what if we can bring these different viewpoints into accounting rule-making? Within certain accounting regulatory bodies we have so-called “professional fellows,” who come on rotation from the audit firms and fulfill a very important role in supporting the boards in their decision making. What if, for every one of these professional fellows from the accounting firms, we bring in a really smart public policy graduate? They likely will not understand all the nuances that are associated with designing accounting rules, but they’re smart, and they’re going to be able to ask tough common sense questions. That will at least bring different experiences into the room and breed a culture of skepticism. This process can lower the likelihood of cultural capture. It’s the same principle behind academics presenting their ideas at workshops. Oftentimes, in such workshops, the presenter has more subject matter expertise than the audience. But the skeptical questioning in the workshop prompts the presenter to consider alternatives, and in the end this generally makes the academic output better.

 

This is a relatively simple, low-cost way to try to thicken thin political markets in accounting rule-making.

 

Q: Wouldn’t these public fellows run into the same problem that regulators are faced with today, though? They too will lack tacit knowledge and technical experiential expertise.

 

Yes, it’s not going to solve the knowledge problem. But it will create a little more dissonance in the process. And that can help prevent cultural capture.

 

The systemic solution to thin political markets will likely involve reimagining the normative implications of the economic theory of the firm, and the role of managers therein, when it comes to setting the rules of the game in these obscure areas that lack political competition. But, of course, that’s not going to happen overnight, partly because the current theory is so deeply ingrained in economics. But as evidence of capture, and the harms thereof, starts to build, I expect open-minded economists will begin to rethink the normative limitations of the current theory of the firm.

 

Disclaimer: The ProMarket blog is dedicated to discussing how competition tends to be subverted by special interests. The posts represent the opinions of their writers, not those of the University of Chicago, the Booth School of Business, or its faculty. For more information, please visit ProMarket Blog Policy.

One comment

Comments are closed.