KARTHIK RAMANNA
We’ve come to expect bickering from our politicians. We’re often exasperated by this state of affairs and sometimes we yearn for a quieter, gentler age, when compromise wasn’t a dirty word. But the raucous rivalry in Washington has its benefits: a political process thick with competition. By contrast, political competition in other important parts of our democracy is worrisomely thin.
Narrower interests that would otherwise find themselves straining to shape political outcomes often prevail unchallenged. Somewhat perversely, we may well be better off when politics is a bazaar of ideas and incentives.
Consider the technical regulations that govern capital markets - the tedious but critical details that determine how companies account for profits, whether banks have as much capital as they say they do, and how insurance and pension entities should measure their obligations. We might think these regulations are somehow self-evident, derived from fundamental laws of economics. In reality, they are largely social constructs, reflecting expert opinions and political necessities. The meetings where these esoteric rules are imagined into existence are often eerily amiable.
I call these regulatory processes thin political markets because they seldom attract wide public participation. On any specific rule-making issue, there are usually a handful of business executives - often fewer than 50 - who are truly experts on the subject. They also have the greatest stakes in the outcome. They meet with regulators in genteel isolation, obligingly offering direction for regulation. The rules of the game that emerge reflect their interests.
But there are no manifest villains here. Executives get involved when they understand an issue, and it matters to them. When they participate, they rarely face serious opposition. Those who might oppose them are sometimes not even aware of the regulatory proceedings. What arises in aggregate is a system of rules that looks as if it was produced by a quilt of special interests. Society as a whole bears the costs of this subtle subversion of capitalism.
Look at our system for corporate accounting rule making. We don’t often think about the quality of the accounting rules underlying our economy, but without sound measures for corporate performance, markets cannot function fairly or efficiently. Distortions in accounting rules can resonate harshly through the economy.
Over three decades of academic research suggests that on average publicly listed firms pursuing corporate acquisitions overpay for their targets. With tens of trillions of dollars spent on corporate acquisitions over that time period, why would this overpayment persist? One likely reason is that the corporate managers and investment bankers involved have found ways to game the accounting rules used to assess a merger’s long-run performance.
To see how that happens, one has to peek inside the Financial Accounting Standards Board, a small, private organization operating out of an office park in Norwalk, Conn., that is largely responsible for setting the accounting rules for corporate America. Back in 2000, when F.A.S.B.’s leaders sat down to reconsider rules for corporate acquisitions, they were joined by representatives from what were then the country’s three largest investment banks and by lobbyists for companies routinely engaging in acquisitions, like the tech giant Cisco Systems.
Accounting rules can help moderate overpayment by the chief executives who are acquiring companies. In particular, effective rules would hold an acquiring firm accountable for any excess paid over its target firm’s independently verifiable value. This premium is the most capricious element of an acquisition. It represents conjectural future profits that an acquiring chief executive hopes to unleash by bringing two companies together.
Accountants call this premium the “goodwill” acquired. On average over the last several years, acquiring C.E.O.s have allocated about half of what they’ve paid in corporate acquisitions to goodwill. In other words, they’ve paid twice the independently verifiable value of their targets. In the case of Cisco, a senior executive estimated that intangibles such as goodwill accounted for about 95 percent of acquisition value in the period leading up to its lobbying efforts in 2000.
It’s notoriously difficult to convert the nebulous notion of goodwill into hard cash. Much depends on the sometimes impossible task of getting two very different corporate cultures to work together. The investment bankers and other lobbyists who joined the F.A.S.B. meetings pushed for rules that gave acquiring C.E.O.s substantial discretion in timing when they would be held accountable for goodwill acquired. Because the rules dampen responsibility for potential overpayment, the investment bankers can benefit from higher deal values (which drive their own fees). In other words, the system can enable wealth transfers away from ordinary shareholders.
Acquiring managers can also boost their own compensation by avoiding timely goodwill accountability. Between its high in 2000 and the close of 2001, as the tech bubble crashed, Cisco experienced a decline of over 75 percent in its market value, a loss of over $400 billion. The decline largely persisted through 2014. Nevertheless, the company, which carried billions of dollars of goodwill on its books, did not record any substantial goodwill-related charge over that period. Of course, it’s difficult to say conclusively that avoiding goodwill charges helped drive anyone’s pay, but it is worth noting that the company’s chief executive was awarded over $200 million in pay during that period.
Thin political markets abound in many abstruse, lucrative corners of our regulatory system, from the rules that determine how companies are audited to the regulations that keep nuclear power plants safe. They embody a peculiar problem for our democracy.
Special interests attempt to dominate political processes across the regulatory spectrum, but some areas, like Social Security and health care, animate us more than others, like accounting and auditing rules. The result is that politicians and journalists who intervene on behalf of ordinary citizens in areas crowded with attention are seldom drawn to thin political markets.
In fact, the F.A.S.B.’s own oversight body - the Financial Accounting Foundation - is so obscure that when one longtime financial-industry chief executive was tapped to serve as its chairman, he admitted to never having heard of it.
“The social responsibility of business,” Milton Friedman famously said in this newspaper 45 years ago, “is to increase its profits.” But he was careful to clarify that his dictum for business held true “so long as it stays within the rules of the game.” Our acute reliance on industry experts in thin political markets and the instances of their self-serving behavior together raise a curious challenge for capitalism. What is the social responsibility of business when it comes to setting the rules of the game? Can it ever be legitimate to manipulate the definition of profit in the pirit of increasing profits?–NY Times