Incentives and Ideology

The following post comes to us from James Kwak at University of Connecticut School of Law.

The financial crisis that began in 2007 prompted a tidal wave of thinking about financial regulation. One major theme that has been pursued by the Financial Crisis Inquiry Commission, journalists, and scholars—most recently in Other People’s Houses, by Jennifer Taub—is the question of what went wrong in the years or decades leading up the crisis. A second strand of research answers the question of what substantive regulations we should have; one important book in this genre is The Banker’s New Clothes, by Anat Admati and Martin Hellwig. But beyond the issue of what regulations are appropriate for today’s complex financial system, a third important area of inquiry is the political and administrative landscape in which financial regulations (whether statutes, rules, administrative guidances, or court opinions) are hammered out. After all, if it were somehow possible to design a perfect regulatory framework, it could only become effective by navigating through the complicated web of interests and incentives that encompasses the legislative and executive (and perhaps judicial) branches.

In a recent Harvard Law Review article, Adam Levitin argues that the primary lesson we should take from the crisis is not that specific financial regulations need to be more sophisticated, but that the governance of financial regulation itself must be improved. I agree. My response to Levitin’s article, Incentives and Ideology, focuses on the question of why the regulatory system tilted toward the interests of major financial institutions in the decades prior to the crisis and what needs to change today.

There are two categories of mechanisms by which a regulated industry can influence regulatory policy. One, which can generally be labeled “incentives,” makes up the traditional story of regulatory capture, dating back to Mancur Olson and George Stigler. Industry groups make campaign contributions to legislators, who then use their oversight authority to put pressure on regulatory agencies. Or industry uses its superior resources to relentlessly lobby both legislators and regulators. Or agency officials are tempted by the “revolving door,” which enables them to gain high-paying jobs in industry. In any case, the result is regulatory policies that favor the industry over the public interest.

The other category includes a different set of mechanisms, including ideology and more subtle channels of influence sometimes called “cognitive capture,” “social capture,” or “cultural capture.” According to these stories, public policy again turns out to favor industry, but not necessarily because politicians or regulators are acting in their own self-interest. Instead, they may be susceptible to the intellectual pedigree of certain industry arguments, or to the social pedigree of industry representatives, or to the pressure created by social familiarity, or some similar form of influence.

The regulatory failures that helped produce the financial crisis cannot be fully explained by traditional, incentives-based theories of capture, even though there was certainly plenty of suspicious-looking behavior (e.g., the Office of Thrift Supervision’s successful attempts to court Countrywide and AIG as regulatory “clients,” Phil Gramm’s assuming a vice chairmanship at UBS after a Senate career fighting regulations on large banks). There is plenty of evidence that many of the key decision-makers, from Alan Greenspan on down, legitimately believed that they were acting in the interests of society.

The important historical question is why so many people in key positions seem to have believed in a specific set of ideas (e.g., financial markets are self-correcting, markets involving sophisticated actors do not need regulation) that by no means enjoyed a consensus among academics and other experts. And the important policy lesson is that we must be attentive to the power of ideology and to sway regulatory outcomes. We urgently need structural reforms that sever the link between industry preferences and politicians’ and regulators’ self-interest, such as the insulation of the Consumer Financial Protection Bureau from the congressional appropriations process. But we also need a way to level the playing field of ideas and other “soft” forms of influence, which may be even more difficult.

The full response is available for download here.

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