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Governance Not Regulation

di - 14 Aprile 2009
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As well as these “negative” arguments against imposed standards, there are “positive ones.
They can stifle or even forbid independent judgment. They can reduce competition in ideas, and restrict evolution. They may legitimize bad accounting; and they can mislead by raising expectations unduly. On the first, they can lead to “… an approach [which] implies that unless the rules explicitly forbid it, anything goes.” (Myddleton, op. cit. p99). In a voluntary regime, views on the treatment of difficult issues can evolve slowly; disclosure of the method is what matters. As for compelling bad accounting, many argue (for example) that the treatment of research expenditure under SSAP requires just that (Myddleton, op. cit. p104). And finally, people can be confused by the clear implication that the presentation of accounts has no grey areas. Everything is not black or white; but compulsory standards imply that it is.

As with the previous example, capital standards in banking, it is clear that governance had for a long time done a good job – governance in this present context being a situation where auditors who prepare and check company accounts prosper by being independent, honest, and providing information helpful to the users of the accounts.

At least in those areas, governance appears to trump regulation. Now, one cannot generalize simply from two cases. But there is a well developed body of analysis, neglected in this area, which is helpful in exploring the issues further and considering whether the argument is generalisable.

A neglected approach
So far it has been maintained in two cases that detailed prescription of processes will not necessarily produce desired outcomes.
The alternative implied by the above discussion is to consider what kind of behaviour is desired, and then put in place the appropriate “governance” within the firm so as to promote that behaviour.
We can specify the objective. Can we design contracts to deliver these objectives?
Contract design has over the years received a good deal of attention from economists. It is usually handled under the heading of “The Principal-Agent Problem”, the nomenclature invented by Steve Ross in 1973. The “principal” is the person who wants something done, the “agent” is the person employed to do it.

The “problem” can arise for a variety of reasons.

Adam Smith touched on the subject in some detail. This he did at several points. His most detailed, and best known, discussion arises in the context of his explanation for the decline of agriculture in Europe after the fall of the Roman Empire. The system was one where the land was worked by “metayers”:

“The Landlord furnished them with the seed, cattle, and instruments of husbandry. The produce was divided equally between the proprietor and the farmer”. (Book 3 chapter 2)

Now, what was the problem?
“It could never, however, be the interest even of this last species of cultivators (the metayers) to lay out, in the further improvement of the land, any part of the little stock they might save from their own share of the produce, because the lord, who laid out nothing, was to get one-half of whatever it produced …… It might be the interest of metayer to make the land produce as much as could be brought out of it by means of the stock furnished by the proprietor; but it could never be in his interest to mix any part of his own with it.” Smith (1776, bk. 3, chap 2. p 367) There would be underinvestment.

Hume (1740) seems to have been the first to state the “free rider” problem.
“Two neighbours may agree to drain a meadow, which they possess in common; because it is easy for them to know each other’s mind; …But it is very difficult, and indeed impossible, that a thousand persons shou’d agree in any such action; it being difficult for them to concert so complicated a design, and still more difficult for them to execute it; while each seeks a pretext to free himself of the trouble and expence, ….”
-Hume (1740, p 538)

This was followed up in 19th century discussions of public finance – on the “benefit approach” and the “ability to pay approach” to taxation. Various writers, notably Pantaleoni and de Viti de Marco, advocated the benefit approach. Wicksell (1896) pointed out what became known subsequently as the free rider problem with this approach.

“If the individual is to spend his money for private and public uses so that his satisfaction is maximized he will obviously pay nothing whatsoever for public purposes. … Whether he pays much or little will affect the scope of public service so slightly, that for all practical purposes, he himself will not notice it at all. Of course, if everyone were to do the same, the State will soon cease to function.”
-Wicksell (1896, p 81)

In other words, it can be advantageous to the individual to conceal preference. That, too, is a problem for contract design.

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