2012 Year in Review

I haven’t been updating this blog much recently. But in the tradition of year-end roundups, I’ve decided to collect a few personal favorites from the things I’ve written over the last year.

This last piece was a personal favorite, and I hope to build on these ideas in the coming year. I hope to get a few long form things written this next year too and to finish another law review piece, this time on federalism.

Thanks to everyone who read and responded.

Reimagining the Corporate Form: Toward a More Democratic System of Corporate Governance

This entry was also posted at the HLPR Blog: Notice & Comment.

Occupy Wall Street has, in the words of John Paul Rollert, “come to embody a common sense that something is wrong with American capitalism.” The problem Rollert points to is not with capitalism itself, but with a particular American version that has ceased to work for broad cross-sections of its population. Given America’s Depression-level income inequality and near-record levels of private indebtedness, it is extremely tempting to focus on bad outcomes as the problem. But the real issue is that many of the economic and political structures that we take for granted repeatedly produce unequal, undesirable outcomes. If reformers seek to make American capitalism more inclusive, the focus needs to be on fixing these structures and getting the rules right.

It has been a steady mantra of Occupy Wall Street not to make demands of existing political leaders and institutions. But as Matt Langer explained, “the reasoning behind not making demands most certainly does not preclude making demands of our collective imagination.” Whether people prefer to work within existing structures or not, the next essential step is to understand how broken institutions and flawed incentives created this mess and to start imagining what structures can be built in their place. Where better to start than with corporations?

Current Governance Structures and Their Shortcomings

Consider the role that our system of corporate governance has played in producing some of our current imbalances. Excessive risk-taking, stagnating wages, and the spike in executive compensation can all be linked back to a system of corporate governance that privileges management’s interests at the expense of other actors.

It’s by no means an original observation to say that boards are under the sway of management. Indeed, the US is something of a global outlier in allowing a business’ president/CEO to appoint its board of directors, and in some cases the president/CEO actually serves dually as the chair of the board. Not only is the composition of the board not reflective of its owners, employees, or investors, boards are only subjected to a relatively relaxed legal standard. As a result, directors often find that their interests (i.e. staying on the board) are best served by taking a passive role and letting management make most of the choices. In light of this structural failure to limit conflicts-of-interest, it should be unsurprising then that the interests of employees, shareholders, and other stakeholders are, at best, secondary to those of executives. As Harvard Law Professor Mark Roe succinctly phrased it, “the US is managerialist, not capitalist.

Current governance arrangements have had an enormous impact on the larger economy and on the distributive features of American capitalism. To begin with, the existing corporate governance system (in conjunction with other regulatory failings) has proven inadequate to keep excessive managerial risk-taking under control. Despite the Enron disaster, the fall of Bear Sterns and Lehman Brothers, and the near-collapse of many of America’s overleveraged financial firms in 2008, we appear to have done nothing to address this issue. These risk-induced failures were repeated last week in the near-overnight fall of MF Global. As though nothing was learned, the star-studded MF Global board sat by and, in Steven Davidoff’s words, “gave executives []free rein to take tremendously risky bets that brought the house down.

In 2008, Martin Lipton and his colleagues at Wachtell prepared an excellent memoranda on boards’ responsibility over risk-management which was posted at the HLS Forum on Corporate Governance. In discussing the legal framework for risk-management, they advised corporate boards to go beyond the minimal requirements created by the leading state law case, In re Caremark. Nonetheless, this is how they summarized the state of the law: “These cases demonstrate that it is difficult to show a breach of fiduciary duty for failure to exercise oversight; these cases do not require the board to undertake extraordinary efforts to uncover non-compliance within the company.” Federal laws like the Sarbanes Oxley Act do require auditing and increased oversight from the board, but the overall implications remain: the decision-making center of gravity remains largely with executives, whose personal incentives to post short-term profits can fuel excessive risk-taking, and current law gives boards few incentives to keep that risk-taking in check.

The problem is not just that boards are passive and deferential, but that those who want risk limited cannot make themselves heard. These high-risk strategies often run counter to the interests of other stakeholders, including bondholders and shareholders, whose interests are not reflected in the board’s composition and thus are not sufficiently represented. The idea that the broader public or the employees whose jobs are on the line would have a say is, under current thinking, not even a remote possibility.

The resultant proximity between Boards and management has a lot to do with runaway executive pay. Board members usually have a stake in their position, and because they are appointed by management, it’s often not in a director’s interest to start ruffling the CEO’s feathers. As Lucian Bebchuk and Jesse Fried argue in their excellent book Pay Without Performance, “structural flaws in corporate governance have produced widespread distortions in executive pay.” Their argument, briefly, is that boards have too many incentives to go along with management and are therefore unable to contract with executives at arm’s length. This broken feedback loop is at the root of the ridiculous pay packages, bonuses, and golden parachutes we’ve seen over the past decade.

The wage stagnation that’s affected the remainder of the workforce shares a common origin: all stakeholders other than executives are systematically excluded from decisions that determine compensation. The fact that corporate profits remain at near record highs suggests that the problem is indeed structural and not attributable simply to changes in the labor market. The absence of a voice for employees either in management or on the board of directors, in conjunction with weakening collective bargaining rights, means that the record profits businesses have been posting get funneled mostly to executives and do not translate into gains for the average American worker. The rules that determine who gets to cut the pie, in other words, have a lot to do with the fact that CEOs went from making 24 times what the average worker did in 1965 to making 185 times as much in 2009.


Ratio of CEO compensation to of average worker’s compensation.
Source: Economic Policy Institute, 2011, via SCSPI.

More Inclusive Alternatives to Minority-Rule Governance

Corporations do not have to be organized in this way in order for the private sector to prosper or for the economy to grow. Recent events should make it clear that keeping down transaction costs is not the only concern here. A number of compelling alternatives exist. I start with the more moderate reform proposals and conclude by proposing that we look to the German corporate model or other structures that afford investors and employees a role in a company’s management.

Calls are frequently made to enhance the role of shareholders in decisions involving executive compensation and risk-management that happen at shareholders’ expense. Bebchuk and Fried have argued that it’s possible to improve transparency and accountability by giving shareholders a greater say on pay, by strengthening shareholders’ ability to unseat and replace directors, or by increasing the number of independent directors (i.e. directors not employed by or doing business with the company). Another proposal they describe would allow shareholders the ability to amend the corporation’s charter. Any long-term solution to these agency problems entails providing investors and owners with a permanent vote or some structural role in decisions that affect them.

An increased role for employees is also necessary to prevent some of imbalances that have arisen between management and the average member of the workforce. Randall Thomas and Kendell Martin, for example, have argued that labor unions and related entities should be allowed to make shareholder proposals. It would be possible to go even further by affording both investors and labor a role on the board and a larger say in major decisions that affect a company’s future. This is precisely what the German corporate governance system does. The German Codetermination (Mitbestimmung) system provides employees a role in the company’s management and has proven remarkably successful across a number of economic sectors. And although German income inequality has grown in recent years, “income inequality in Germany is a long way from reaching US proportions.

I point these out not to advocate any particular corporate form, but to observe that there are alternatives that can address failings of the existing system. It’s important also to observe that things were not always this way. The internet has fostered an explosion in new forms of social organization, and cooperative membership structures are another potential source of ideas. There’s no reason that running a successful business means accepting a one-size-fits-all corporate model, particularly when that model marginalizes a company’s most committed participants—its investors and its employees.

Capitalism isn’t a single thing or a system of natural laws. It is a system whose rules are shaped by political—and ideally democratic—choices. Nowhere is this more obvious than in the reified legal fiction of the modern corporation. The absence of democracy within corporations is a central reason that the US has seen such a proliferation of high-risk investment strategies, and an unprecedented divergence in incomes. The concerns of both investors and employees have been systematically subordinated to the interests of America’s managerial class. The failure to create an inclusive economy is fundamentally a failure to build inclusive institutions. And the first step to fixing this problem is remembering that the rules that govern institutional decisions can be different.

Short-termism is a kind of contagion

An emphasis on short-term performance does not always produce a long-term viable strategy. That looks obvious enough when typed out. But short-termism has become the prevailing logic of many American institutions, none more radically than those institutions that make up its financial sector. As Sheila Bair noted in an op-ed on her last day as chairman of the FDIC, our media, political institutions, and businesses fall victim to this tendency, and it has begun to undermine our long-term stability.

To persist in acting this way would require a kind of insane faith that what’s good for now is good for tomorrow. It’s the story of how every tragedy of the commons ends badly. These attitudes, however, persist less because of any rational deliberation than because institutions can easily devolve toward incentives that reward short-term results.

One principal reason for this is that short-term strategies have a tendency to spread. In a way, this might even be a more general feature of unrestrained competition. I want to make a slightly tenuous comparison to evolution before returning to the more general point.

Assume there is a small plot of land with two unrelated breeds of plant. If plant A can absorb soil nutrients faster and outbreed plant B, it will proliferate and might eventually displace plant A entirely. This is known as exploitation competition. The evolutionary pressures on A become: 1) either depend on fewer nutrients, 2) develop a some alternate replication strategy, or 3) simply beat B at its own game, by reproducing faster and extracting nutrients more quickly. The last of these is the one I want to emphasize: Short-termism is self-reinforcing and it is contagious. When B’s reproductive strategy is on short-term success, it redefines the game for A. Eventually it becomes the only game left. This is what kudzu did when introduced in the southeastern United States. Taken to an extreme, quite literally, this is the logic of cancer.

In other words, if B chooses to play a shorter-term game than A, that redefines the game A must play to survive. Market competition is also susceptible to this dynamic, and in many ways it may account for some of markets’ successes. The process can weed out under-performers and produce more efficient manufacturing processes. But it also weeds out other business models that under other conditions would be perfectly viable and sustaining.

This fact alone should also provide a compelling reason for market regulations—something I’ll write about another time—but this dynamic also means the following: If a business starts engaging in rent-seeking activities (i.e. attempting to influence government into creating a legislative or regulatory playing-field more favorable to its interests), then quickly other competitors, other businesses, and even entire sectors may be forced to follow suit.

To make the link now to the financial sector: Incentives in the financial community have become tied closer than ever to short-term performance. Such incentives have the potential to reward speculation, and the 2008 crisis revealed that these incentives have the potential to reinforce bubble-generation. Extreme short-termism redefined the terms of competition. It drove firms that emphasized longer-term performance and responsible practices to obscurity and irrelevance, and it drove many organizations into riskier positions to remain competitive (e.g. the decision at Fannie Mae to get into subprime mortgages in 2007). It should not be surprising that given the ways that incentives were linked to performance that the terms of competition became what they did.

Nor is it surprising, as Bair notes, that short-termism has come to characterize many of Wall Street’s interactions with Congress and other regulators. Rent-seeking through lobbying and other activities directed toward obtaining a favorable regulatory playing-field have now become part of the ways that businesses in America compete. To take one easy example, provisions of Dodd-Frank that were seen as restraints on business were cut, watered down, and those that were left in have been implemented half-heartedly. And that happened despite a general consensus that Dodd-Frank was not aggressive enough in providing the US the framework it would need to respond to another financial crisis.

[Legislators are now plagued by a similar dynamic of having to fund-raise to keep up with each other, with a short-term focus on reelection rather than on governance. This further exacerbates the influence Wall Street spending can have].

Given the various ways in which Wall Street successfully defeated attempts to impose new regulations after the 2008 crisis, we would expect that the financial sector would be well-positioned for the coming decade or to handle another crisis. But this hardly seems to be the case. The shadow banking system, probably the single largest accelerator of the crisis’ spread remains largely unregulated. Banks are fighting tooth and nail against hightened capital requirements. And the fact that large financial institutions pushing for austerity measures is so shorted-sighted as to ignore any possible interdependence between growth and a healthy middle class. Etc. etc.

Perhaps the most insane thing about all of this is that large financial institutions and proponents of deregulation are so short-sighted that they believe this kind of game is actually serving their interests. [Or maybe the game is just to be the last one standing?]

To quote a post at Digby’s blog about Murduch’s ability to rapidly corrupt the WSJ, one of the world’s “most important sources of financial news”:

I think this may be the best sign yet of just how crippled our institutions have become. If there is one group in the world who should demand unadulterated facts and data it is the financial community. Sure, they’ll play it to their advantage, and care not a whit about how it affects our democracy. That’s not their job (although it is their duty as citizens.) But they simply cannot function properly if their information is tainted.

The ‘invisible hand’ produces races to the bottom just as often as it produces self-regulating systems. We have failed utterly to keep the terms of this game from keeping this short-term contagion in check. When that happens, even the winners are at risk.

Photo credit: Galen Parks Smith.

Disclosure is not the cure-all liberals want it to be

This entry was originally written for HLPR Online: Notice & Comment.

Disclosure rules have become a kind of last resort for policy makers looking to reduce institutional corruption. There have been proposed disclosure rules for economists, particularly those who had strong ties to the financial sector. Others have called for general transparency for any academics who receive private funding for their research or who testify before Congress. The Affordable Healthcare Act imposed new disclosure requirements for physicians, and Dodd-Frank requires increased transparency into executive compensation. And until recently, disclosure had reasonably broadbipartisan support as a partial fix to the torrent of campaign spending that was opened up by the now infamous Citizens United decision.

The motivating idea behind all these proposals is that by revealing funding sources and other conflicts of interest, corruption will become apparent and the most egregious activities will be driven from the marketplace. Politically, these regulations probably owe much of their support to the fact that they’re generally viewed as consistent with free market principles. Recently, even that has come into question. Conservatives and industry insiders have expressed worries that disclosure rules add costs and stymie speech. There’s plenty to read aboutthat debate, but it basically boils down to the fact that Republicans benefit more by keeping disclosure rules lax.

Before Democrats go on championing disclosure laws as the solution to all forms of institutional corruption, however, they should recognize its limits. While transparency is a crucial element of anti-corruption regulations and is necessary to police many of our public and private institutions, it would be a terrible mistake to stop pursuing substantive conflict of interest regulations and accept disclosure as the solution to all forms of corruption.

As Cain, Moore, and Loewenstein phrased it, that there are times “when sunlight fails to disinfect.” Treating disclosure as an end-in-itself requires a misplaced faith in the ability of markets to answer all of society’s problems. And there is emerging empirical support that disclosure rules often fail to accomplish their purported goals. I’ve tried to separate out at least two reasons to be skeptical about disclosure’s ability to eliminate conflicts of interest:

1) Because disclosure often comes into play when there are significant information asymmetries, more information does not enable policymakers, voters, or consumers to make better decisions. If a patient goes to a doctor who says he met with a drug rep before prescribing a certain medicine, the patient is not able evaluate whether or not to take the medication. He’s not going to ask another doctor or know how to assess the risks involved. Similarly, when an economist is testifying during a financial crisis before the Senate, how is a Senator to properly discount testimony that has industry support? The element of duress makes the ineffectiveness of disclosure rules even more pronounced.

2) Disclosure in many ways legitimates conflicts of interest by telling politicians and professionals, in effect, ‘so long as you told everyone what you’ve done, whatever questionable activity you engaged in was presumably acceptable.’ It might even be making behavior worse. As research by Cain, Moore, and Loewenstein revealed, disclosure seems to give experts the impression that they have dealt with the ethical problems posed by their conflict of interests and can sometimes exacerbate the extent to which expert statements become self-serving. As Courtney Humphries at the Boston Globe noted, policymakers may be treating disclosure as a panacea and refusing to address the conflicts of interest that are the real source of corruption.

Beyond this, disclosure reinforces the patently false norm that markets self-regulate. And naively supporting disclosure legislation risks lending weight to the deregulatory ideology that has already produced so many harmful conflicts of interest at the core of our political and financial systems. There are certain arrangements, that no matter how transparent, are simply incompatible with good government or a stable financial system.


The Real Cult of Personality

This entry was originally written for the HLPR Blog: Notice and Comment.

Matt Yglesias wrote a short blog post the other day asking why an advanced democracy like the United States bothers with term limits. The obvious objection to term limits is that they often force the most desirable and capable candidates out of office. They’re inherently undemocratic, because if the candidate weren’t the most electable, he or she would be ousted through the political process.

The second, more subtle and insightful objection he makes is this: term limits are undemocratic because they empower unelected staffers and unelected lobbyists who will be there even after the office changes hands. All the institutional memory, all the industry ties, and all the insider knowledge of the legislative process remains in a democratically unaccountable class of well-educated and politically connected civil servants.

My point in drawing attention to Yglesias’ post is not that we necessarily need to abolish term limits. (Although that’s certainly a conversation worth having.) The point I’m getting at, which the second objection highlights, is that a candidate’s attributes—whether personality or policy preferences—often matter far less than the institutional structures into which she’s elected.

One of the most striking observations in Pierson and Hacker’s excellent Winner Take All Politics is that the real locus of power in American government has been obscured by our obsession with election- and personality-driven politics. (See my longer review here.) Since the 1970s, the two major political parties in the United States have invested in institutional structures and political organizations that wage full-time lobbying and campaign efforts. These well-funded party organizations, bolstered by think-tanks, PACs, nonprofits, and media affiliates, engage in full-time agenda setting. They are expert at rotating people in and out of the country’s highest offices. Links to special interests and campaign contributors are a constant presence, and their media-access and agenda-setting power is massive.

Americans need to stop putting their hope in lone individuals, who they believe can “change the way Washington works.” The expectation that an elected official would disrupt the organizational structure and vote his or her conscience, or even reflect the electorate’s political preferences, is simply implausible. Such expectations overlook the institutions within which our representatives operate. (There is more on this point at Crooked Timber).

The game in American politics is not the game that most people think it is. Changing who is in office matters, but it is by no means the only thing with which Americans should be concerned. Republicans recognized this in the 1970s and began building a party apparatus and organizational structure that can reliably set the country’s political agenda even when Republicans are not in office. If Americans (and Democrats in particular) care about seeing their policy preferences realized, they need to focus on more than who’s name goes on the door.