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Governance Not Regulation

di - 14 Aprile 2009
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The problem of monopoly regulation has also been recognised as essentially one of contract design. This is due to Loeb and Marget (1979) who recognised that (as with the voting problem above) the difficulty is lack of information. The regulator, in advance of setting the regulation, knows less about costs (and possibly demand) than does the regulated firm.
The problem of concealment (or non-disclosure) of course also lies behind the problem of moral hazard that has been recognised for centuries in insurance. A number of economists have grappled with how to design contracts for this – see, for example, Arrow (1963) Pauly (1974) and Grossman and Hart (1983).

If we now stand back to see the problems of contract design that economists have grappled with since Hume and Smith what do we find?
We see first why the subject temporarily (for at least a hundred years) vanished from view. In a large economy, with many buyers and many sellers and no entry barriers (such as natural monopoly) to a particular activity, the problems vanish. Rational individual behaviour translates into profit maximisation for firms’ owners. This leads to cost minimisation, and hence to productive efficiency. Similarly, consumers facing exogenous prices have the appropriate incentives for utility maximisation.

But of course that treated the firm as a “black box”. How did the owners of firms align the interests of the various members of the firm (workers, managers) with profit maximisation? The moment that question returned to view, we came to the issue of contract design. The extensive and often complex literature touched on above, which has examined contract design problems, faces such difficulties and sometimes reaches impasses because of three main types of information problem – adverse selection, moral hazard and non-verifiability. Do these three issues arise in the examples with which this paper opens?

Relevance in the Examples
Consider the examples – banking system stability, and accountants and auditors producing “accounts of stewardship” which are fit for that purpose.

Banking sector instability is all too visible. The results of faulty audits reveal themselves, not necessarily immediately, but in due course. In both cases there is ex post visibility which can be verified by a third party. So one of our problems is not present. What about adverse selection and moral hazard?

Neither of these is relevant . For in the cases under review we are concerned only with observable outcomes after the event, and not at all with what goes on inside the firms; and we can observe the outcomes.

Now, what goes on inside these firms is of course of concern for their owners, but it is no concern of ours. We need specify only that the contracts have characteristics which regardless of their other features will provide what the authorities regard as desirable

An example shows how this might be done.

My friend and colleague Charles Goodhart has proposed (I think partly in jest but am not sure) that the Chairman of any bank which gets into difficulties should be put in the stocks outside the Bank of England, and then, as was traditional with those placed in the stocks, be pelted with rotten fruit. This, he suggests would sharpen their attention to their respective bank’s stability. He is I am sure right. But I am not persuaded that even today any prospective British government would adopt that measure.

Another course, much more plausible, is however prompted by the proposal. The proposal was designed to make senior management focus on stability. This could also be done by insisting that contracts do not grant options with no risk of loss; that management have to place its wealth, the more senior they are the higher the proportion, in the bank’s stock, and that stock be held, untradeable, by trustees until, say, five years after retirement of the respective manager (and that any contract designed to offset the risk be unenforceable at law); and, if it were so wished, to sharpen incentives also for the owners double or even triple liability for each shareholder could be reintroduced.

Where does that lead in general? What general lessons can be drawn?

General Conclusion
Regulation has invariably led to attempts to circumvent it. Accordingly, it is surely worth considering an approach which aligns the interests of the regulated with the regulators, rather than the latter simply telling the former what to do. There is extensive work by economists on contract design. It is worth attempting to draw on that. This claim is surely reinforced by the work of lawyers – notably Richard Posner – showing how judicial interpretations under common law tend to evolve towards economically efficient outcomes. Law, a form of governance, has worked. Why not try it again?
As the economic literature discussed above has shown, there can sometimes be substantial problems with attempting to do so. But so long as there is public concern only with observable outcomes, governance can replace regulation. It will be more durable in its effects, and relying on it, and thus focussing on outcomes rather than processes, will ensure that the regulated firms seek the most economically efficient way of doing what the government wants. We would thus be exploiting the most fundamental of all economic insights, one stated by Adam Smith and reiterated by Hayek in his famous “The Use of Knowledge in Society”. Each individual knows more about his own situation, interests, and desires than any outside observer can. This insight has been neglected in the field of regulation. Ending this neglect might well prove productive.

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